PowerPoint Presentation by Charlie Cook The University of West Alabama chapter 10 Part 3: Enterprising Strategies © 2008 Cengage Learning All rights reserved. Purchasing a Business

© 2008 Cengage Learning. All rights reserved.10–2 Key Concepts 1. 1.Purchasing a business is one of the most popular ways to become an enterpriser, and buying an existing firm can be a faster and more cost-effective route to business ownership than a start-up. Before making a business purchase, however, enterprisers must perform a thorough analysis of the business, from business model to market environment, operations, and financial feasibility. This due diligence process is similar to evaluating a new venture, except that it applies to a going concern. The objective is the same: to determine if the enterpriser can successfully operate the business and earn an appropriate return on the investment of time and money.

© 2008 Cengage Learning. All rights reserved.10–3 Key Concepts (cont’d) 2. 2.A business’s value is ultimately what a buyer is willing to pay for it and depends upon many factors. The value of an ongoing business should be based on the business’s ability to generate earnings. Enterprisers can choose from different valuation techniques, such as asset-based (book value, replacement value, liquidation value), market-based, earnings formulas, and cash flow methods. Each has advantages and disadvantages.

© 2008 Cengage Learning. All rights reserved.10–4 Key Concepts (cont’d) 3. 3.The terms negotiated between the buyer and seller can be as important as the price for the business. These include whether the buyer acquires only the assets or the entire business and the payment terms, each of which carries different tax implications for the parties. Often sellers provide financing for the purchase; they may also take a portion of the payment in future payments of either a percentage of profits, a noncompete fee, or an employment contract. Enterprisers should consult both an accountant and an attorney during the extensive due diligence process.

© 2008 Cengage Learning. All rights reserved.10–5 Make or Buy? (cont’d) Why Buy an Existing Business:Why Buy an Existing Business:  The business is a proven business concept.  Purchasing it is a quick way to get into business.  Its track record makes its purchase easier to finance.  Purchasing the business may cost less than starting one from scratch.  The enterprise is producing positive cash flow.  The business is undervalued.  Seller financing motivates the previous owner’s interest in the continuing success of the business.

© 2008 Cengage Learning. All rights reserved.10–6 Make or Buy? (cont’d) Drawbacks to Buying a Business:Drawbacks to Buying a Business:  Raising the purchase financing.  Setting the right price.  Discovering problems after the fact.  Underestimating the commitment required to operate the business.  Verifying the seller’s claims. Why Is the Owner Selling?Why Is the Owner Selling?  The owner may be ready to retire or be in poor health.  The enterpriser is ready to move on to new ventures.  The enterpriser may lack managerial expertise.

© 2008 Cengage Learning. All rights reserved.10–7 exhibit 10.1First Questions to Ask Before Buying a Business 1. What are your primary reasons for taking the purchase route to business ownership? Keep them in mind as you look at various businesses. 2. Are you buying a business as a full-time or a part-time endeavor? What are your income expectations? 3. Would you prefer to buy a business in your current industry or go into a new field? 4. What appeals to you about a particular industry? How well have you researched this field? 5. Why does this particular business opportunity excite you? Would you feel proud to own this type of business? 6. Why is the owner selling this business? 7. What skills and experience do you bring to the business? Do you need to hire people to provide expertise in specific areas? 8. Can you identify ways to improve the business to make it more successful? 9. Will you need partners to help you finance or operate the business successfully? If so, do you want to work with partners or would you prefer solo ownership? 10.Does the business make sense financially? What factors indicate the potential of revenue and earnings growth? 11.On what are the valuation and price based? Do they seem reasonable? 12.How easily will it be for you to obtain the financing you’ll need to buy the business? 13.How well has the business been managed? Do you want to keep many of the current managers or employees? 14.Does it make sense to buy rather than start this type of business?

© 2008 Cengage Learning. All rights reserved.10–8 Business for Sale Life Cycle Issues Poor Business Choice New Interests Management Problems Why Is the Owner Selling?

© 2008 Cengage Learning. All rights reserved.10–9 Finding Businesses for Sale Business BrokersBusiness Brokers RealtorsRealtors People knowledgeable about the industryPeople knowledgeable about the industry Business ownersBusiness owners Business valuation seminarsBusiness valuation seminars “Business wanted” ads“Business wanted” ads

© 2008 Cengage Learning. All rights reserved.10–10 Valuation: What Is a Business Worth? The ultimate value of buying an ongoing business must be based on the business’s ability to generate earnings.The ultimate value of buying an ongoing business must be based on the business’s ability to generate earnings. Factors in Valuing a Business:Factors in Valuing a Business:  The value of the opportunity  The enterprise’s business model  The future feasibility of the enterprise.  The specific ways the business operates—the business plan.

© 2008 Cengage Learning. All rights reserved.10–11 exhibit 10.3Financial and Legal Documents to Request when Purchasing a Business All financial statements for the past five years Income tax statements for the past five years List of equipment and the depreciation schedule List of Accounts Receivables and their age (when they were due) List of Accounts Payables and their age (when they were due) Inventory list Any leases (rental agreements, equipment leases, automobile leases) Any contracts (customer, supplier, employment, loan agreements, labor contracts, royalty agreements, franchise agreements) List of partners and stockholders (indicating percentage of business owned and/or amount of stock held) Compensation for owners of the business (salaries and perks) Insurance documents Legal documents (articles of incorporation, partnership agreement) Copies of licenses and other documents pertaining to government regulations Tax payments for federal, state, and local governments

© 2008 Cengage Learning. All rights reserved.10–12 Valuing a Business Assets Cash Flow Market Earnings Bases for Valuing a Business

© 2008 Cengage Learning. All rights reserved.10–13 exhibit 10.4Asset-Based Valuation Methods 1.Book value: The value according to the business’ current financial statements, as shown on the balance sheet (financial statement listing assets and liabilities). 2.Modified book value: The asset values adjusted to their actual, or current, values. 3.Replacement value: The amount required to replace, at current market rates, the assets the business owns. 4.Liquidation value: The value of the assets if the business needed to be sold immediately. The liquidation value is likely to be much lower than the replacement value of these assets. This is not an especially useful figure, as why sell a business for the same amount you would receive for liquidating it?

© 2008 Cengage Learning. All rights reserved.10–14 Market-Based Valuations Market-Based ValuationMarket-Based Valuation  Looks at prices paid for comparable firms.  Industry valuation and multiplier formula valuations are two categories of market-based valuation. Fair Market ValueFair Market Value  The price that a business would command from a knowledgeable buyer and a seller with the relevant information about the business and willingness to undertake the transaction.

© 2008 Cengage Learning. All rights reserved.10–15 Market-Based Valuations Factors Influencing the Market Value of a Business Buyer Synergies Risk Perception Tax Considerations Different Estimates of Future Earnings

© 2008 Cengage Learning. All rights reserved.10–16 Other Valuation Methods Earnings ValuationEarnings Valuation  Considers the value of past, present, and future earnings of the business.  Allows for consideration of the contribution of intangibles (e.g., goodwill) to the success of the business. Discounted cash flow (DCF) TechniqueDiscounted cash flow (DCF) Technique  Finds the present value of a future cash flow stream at a specified discount rate that represents the buyer’s expected cost of capital plus desired rate of return.

© 2008 Cengage Learning. All rights reserved.10–17 Structuring the Deal What Are You Buying?What Are You Buying?  Stock sale: Purchase of the whole business  Asset sale: Purchase of the assets of the business Arranging FinancingArranging Financing  Banks or other lenders: asset (collateral) financing  Investors: partners or equity stake  Seller: “earn-outs” (payments from future earnings)

© 2008 Cengage Learning. All rights reserved.10–18 Structuring the Deal Noncompete AgreementNoncompete Agreement  Agreement prohibiting the seller from entering into a similar kind of business for a set time period within the geographic area in which the purchased business competes. Employment ContractEmployment Contract  Seller is retained as contract employee. Other ConsiderationsOther Considerations  Soundness of business model  Due diligence

© 2008 Cengage Learning. All rights reserved.10–19 exhibit 10.5Accounting and Legal Issues to Examine An audit would explore such issues as: Collectability and age of accounts receivable Age, condition, and value of inventory Age, condition, and value of equipment and physical plant Unknown liabilities Credit problems Tax payments On the legal front, an attorney can review Compliance with local zoning and environmental regulations Validity of all required licenses and similar documents Current leases and contracts Insurance policies Existing and pending lawsuits against the business