BUYING AN EXISTING BUSINESS

1. INTRODUCTION

1.1 ACQUIRING A BUSINESS  Analyze your skills, abilities, and interests.  Prepare a list of potential candidates (Remember the “hidden market”).  Investigate and evaluate candidate businesses and select the best one.  Explore financing options.  Ensure a smooth transition. Ray’s Market

1.2 PROS AND CONS ADVANTAGESDISADVANTAGES 1. Customers familiar with location 2. Planning can be based on known historical data 3. Established customer base at present location 4. Supplier relationships already in place 5. Inventory and equipment in place 6. Experienced employees 7. Possible owner financing 1. Image difficult to change 2. Employees may be ones whom you would not choose 3. Business may not have operated the way you like and could be difficult to change 4. Possible obsolete inventory and equipment 5. The business’s location may be undesirable - or a good location may be about to become not so good 6. Potential liability for past business contacts 7. Financing costs could drain your cash flow and threaten the business’s survival

1.3 Advantages of Buying a Business  Less Risk  Starting a business brings with it the possibility of a critical element in the operation of the enterprise being overlooked or not adequately addressed.  With the purchase of an ongoing business, this kind of planning omission is less likely to occur.  Less time and effort  For a business to establish operations requires considerable attention to a wide range of details.  The management of an existing business has developed relationships and procedures that allow the business to operate.

 The Possibility of Buying at a Bargain Price  The prospective buyer of an organization can uncover candidates for purchase that are under priced.  The likelihood of finding such a bargain depends on who is doing the selling and the conditions under which the sale is made.

1.4 Disadvantages of Buying a Business  The environment  Some businesses are available for sale because they face a difficult set of problems.  When these problems are outside the firm, a shrinking market for example, the outlook can be quite bleak.  Departure of the Current Owner  Many small firms have an existence that is closely associated with the founder.  These businesses may suffer greatly with the departure of the owner.

 Internal Problems  One thing that is likely to prompt an owner to sell his/her business is difficulty with its current operations.  Anyone who intends to buy a business with internal problems would be well advised to develop the means to cope with these problems before proceeding

2. FINDING THE BUSINESS

 There is an active market for the sale and purchase of small businesses.  Among the more prominent channels for these businesses to use are business brokers and the classified ads of many newspapers. 2.1 Businesses that are on the market

2.2 Businesses that are not on the market  According to the view of some people, the best opportunities for acquisition of a business are those that are not on the market.  This reasoning leads to the recognition of the importance of finding the right business from among those in operation without restricting the search.

2.3 Five Critical Areas for Analyzing an Existing Business  Why does the owner want to sell.... the real reason?  What is the physical condition of the business?  What is the potential for the company's products or services?  Customer characteristics and composition.  Competitor analysis.  What legal aspects must I consider?  Is the business financially sound?

2.4 What Do You Look For in a Business?  How long has the business existed?  Who founded it?  How many owners has it had?  Why have others sold out?  What is the profit record?  Is profit increasing or decreasing?  What are the true reasons for the increase or decrease?  What is the condition of the inventory?  Are the goods new or obsolete?

 Is the equipment in good condition?  Who owns it?  Are there liens against any of it?  How does it compare with competitors’ equipment?  How long does the lease run?  Is it a satisfactory lease?  What are its conditions?  Can it be renewed?

 Are there dependable sources of supply?  Are any franchises or other special arrangements expiring soon?  What about present and future competition?  Are new competitors or substitute materials or methods visible on the horizon?  What is the condition of the area around the business?  Are traffic routes or parking regulations likely to change?

 Does the present owner have family, religious, social, or political connections that have been important to the success of the business?  Why does the present owner want to sell?  Where will he or she go?  What is he or she going to do?  What do people (customers, suppliers, local citizens) think of the present owner and of the business?  Are personnel satisfactory?  Are key people willing to remain?

 How does this business, it its present condition, compare with one that you could start and develop yourself in a reasonable amount of time?

4. LEGAL ASPECTS OF BUYING A BUSINESS

4.1 What is involved?  Lien - creditors’ claims against an asset.  Bulk transfer - protects business buyer from the claims unpaid creditors might have against a company’s assets.  Contract assignment - buyer’s ability to assume rights under seller’s existing contracts.

4.2 Bulk Transfer  Seller must give the buyer a sworn list of creditors.  Buyer and seller must prepare a list of the property included in the sale.  Buyer must keep the list of creditors and property for six months.  Buyer must give notice of the sale to each creditor at least ten days before he takes possession of the goods or pays for them (whichever is first).

4.3 From legal perspective  Restrictive covenant - contract in which a business seller agrees not to compete with the buyer within a specific time and geographic area.  Ongoing legal liabilities - physical premises, product liability, and labor relations.

5. FINANCIAL MATTERS INVOLVED

5.1 Total payment Value of Tangible Assets Value of Intangible Assets Profit Potential Purchase Price + +

5.2 Tangible Assets  The inventory  timely, fresh, and well balanced  The equipment  current, usable machines and equipment

5.3 INTANGIBLE ASSETS  Goodwill  enables a business to earn a profit in excess of the normal rate of return earned by other businesses of the same kind  Leases and Other Contracts  a lease on a favorable location is a valuable business asset  Patents, Copyrights, and Trademarks  intellectual property can be a valuable intangible asset

5.4 Determining the Price of a Business  Anyone considering the purchase of a business must recognize and understand the difference between price and value.  Any system of evaluation of a business should incorporate the value of the firm’s assets and its expected flow of future earnings.

5.5 Calculating the purchase price for an existing business 1. Adjusted value of tangible net worth$224, Earning power at 15%$33, Reasonable salary for owner or manager 40,000 $73, Average annual net earning before subtracting owner’s salary (83,600) 5. Extra earning power of business$10, Value of intangibles, using four-year profit figure for moderately well- established firm (4 x line 5) 40, Offering price264,000

5.6 Determining Value of Business  Balance Sheet Technique  Variation: Adjusted Balance Sheet Technique.  Earnings Approach  Variation 1: Excess Earnings Approach.  Variation 2: Capitalized Earnings Approach.  Variation 3: Discounted Future Earnings Approach.  Market Approach - Willing buyer & willing seller

5.6.1 BALANCE SHEET TECHNIQUES "Book Value"of Net Worth = Total Assets - Total Liabilities = $266,091 - $114,325 = $151,766

5.6.2 Earnings Approaches "Book Value"of Net Worth = Total Assets - Total Liabilities = $266,091 - $114,325 = $151,766 Variation: Adjusted Balance Sheet Technique: Adjusted Net Worth =$274,638 - $114,325 = $160,313

5.6.3 Excess Earnings Method Step 1: Compute adjusted tangible net worth Adjusted Net Worth = =$274,638 - $114,325 =$274,638 - $114,325 $160,313 = $160,313 Step 2: Calculate opportunity costs of investing Investment = $160,313 x 25% = $40,078 + Salary=$25,000 Total=$65,078 Step 3: Projected earnings for next year: $74,000 Step 4: Compute extra earning power =Projected Net Earnings - Total Opportunity Costs =Step 3 - Step 2 =$74, ,078 == $8,922

Step 5: Estimate the value of the intangibles ("goodwill"): Intangibles = Extra Earning Power x "Years of Profit Figure*" = 8,922 x 3 = $26,766 Step 6: Determine the value of the business: = $160, ,766 = $187,079 Estimated Value of the business = $187,079 * Years of Profit Figure ranges from 1 to 7; for a normal risk business, it is 3 or 4.

Variation 2: Capitalized Earnings Method: Value = CAPITALIZED EARNINGS METHOD * Rate of return reflects what could be earned on a similar-risk investment. Net Earnings (After Deducting Owner's Salary) Rate of Return*

5.6.4 Capitalized Earnings Method Value =Net Earnings (After Deducting Owner's Salary) Rate of Return* = % = Rate of return reflects what could be earned on a similar-risk investment. Normal business  25% to 33% High risk  > 50%

5.6.5 Discounted Future Earnings Method Step 1: Project earnings five years into the future: 3 Forecasts: Pessimistic Most Likely Optimistic Compute a weighted average of the earnings: Pessimistic + (4 x Most Likely) + Optimistic 6 6

YearPessimisticMost likelyOptimisticWeighted Average 12345$65,000$74,000$82,000$88,000$88,000$74,000$90,000$100,000$109,000$115,000$92,000$101,000$112,000$120,000$122,000$75,500$89,167$99,000$107,333$111,667

Step 2: Discount weighted average of future earnings at the appropriate present value rate:

YearWeighted Averagex PV Factor= Present Value 1$75, $60,400 2$89, $57,067 3$99, $50,688 4$107, $43,964 5$111, $36,593 TOTAL$248,712

Step 3: Estimate the earnings stream beyond five years Step 4: Discount this estimate using the present value factor for year 6:

Step 5: Compute the value of the business:

5.6.6 Market Approach Step 1: Compute the average Price-Earnings (P-E) Ratio for as many similar businesses as possible: Company P-E Ratio Average P-E Ratio = Value = Average P/E Ratio X Estimated Net Earnings Value = X $74,000 = $294,150

6. NEGOTIATION STEP

6.1 The negotiation process  The way in which the process leading to a deal proceeds affects the satisfaction experienced by both the buyer and the seller. Price Versus Value  Many business owners do not know the value of the business but must nonetheless set the price when it is time to put it on the market.  The price of the business is whatever the owner chooses; its value, however, is established in the market only when a buyer agrees to pay the price.

6.2 Sources of Power in Negotiations  Among the sources of power held by the parties in negotiations, the most important is probably information  Others factors affecting the power of the parties are timing and the availability of alternatives.