Entrepreneurship 1: Lecture 9 Buying an Existing Business Avimanyu (Avi) Datta, Ph.D.

Why buy an existing business? May continue to be successful Best location Equipment installed Hit the ground running Use previous experience Easier financing

Why buy an existing business? Established Customer base Established customer base at present location Supplier relationships already in place Experienced Employees Inventory is in place and trade credit is established

Why buy an existing 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. ◦ NOTE: Buy a great Business when they are in financial distress.

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.

Disadvantages of Buying a Business 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

Disadvantages of Buying a Business Previous owner may have created ill will “Inherited” employees may be unsuitable Location may have become unsatisfactory Equipment may be obsolete Changes can be difficult to implement Inventory may be stale Accounts receivable may be worth less than face value It may be overpriced

Key Questions to Consider Before Buying a Business Is the right type of business for sale in the market in which you want to operate? What experience do you have in this particular business and the industry in which it operates? How critical is experience in the business to your ultimate success? What price and payment method are reasonable for you and acceptable to the seller?

Key Questions to Consider Before Buying a Business Should you start the business and build it from the ground up rather than buy an existing one? What is the company’s potential for success? What changes will you have to make – and how extensive will they have to be – to realize the business’s full potential? Will the company generate sufficient cash flow to pay for itself and leave you with a suitable return on your investment?

Five Critical Areas for Analyzing an Existing Business 1.Why does the owner want to sell.... the real reason? 2.What is the physical condition of the business? 3.What is the potential for the company's products or services? Customer characteristics and composition. Competitor analysis. 4.What legal aspects must I consider? 5.Is the business financially sound?

Why Does the Owner want to sell

Why does the owner want to sell. 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

Why does the owner want to sell. 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?

Physical Conditions

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? What is the condition of the area around the business? ◦ Are traffic routes or parking regulations likely to change

Physical Conditions Building Inventory Accounts receivable Lease arrangements Business records Intangible assets Location and appearance

Potential for Company’s products and Services

Customer characteristics and composition-who, why, how often, loyalty, new customers, well- defined, growing? Competitor analysis-number and intensity, saturation point reached, reason for survival, sales comparison, uniqueness? 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?

Legal Aspects

Liens Bulk Transfers Contract assignments Covenants not to compete Ongoing legal liabilities

Legal Aspects: What are 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.

Bulk Transfer Seller must give the buyer a 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).

Contract Assignment 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.

Financial Matters

Value of Tangible Assets Value of Intangible Assets Profit Potential Purchase Price + +

Tangible Assets The inventory ◦ timely, fresh, and well balanced The equipment ◦ current, usable machines and equipment

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

Financial Matters: 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.

Financial Matters: 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

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

Determining Value of Business: Balance Sheet Technique Book Value of Net Worth = Total Assets - Total Liabilities = $266,091 - $114,325 = $151,766 (value) Variation: Adjusted Balance Sheet Technique: (Adjusted for negatives or positives from balance sheet in inventory, equipment, land/buildings/receivables, etc) Adjusted Net Worth = $274,638 - $114,325 = $160,313 (value)

Determining Value of Business: Earnings Approach Step 1: Compute adjusted tangible net worth Adjusted Net Worth = =$274,638 - $114,325 = $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

Determining Value of Business: Earnings Approach 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.

Determining Value of Business: Capitalized earning method Variation 2: 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. Value = $74,000 - $25,000 = $196,000 25%

Determining Value of Business: Discounted earning method Variation 3: Discounted Future Earnings Method: Compute a weighted average of the earnings: Step 1: Project earnings five years into the future: Pessimistic + (4 x Most Likely) + Optimistic 6 $$ 3 Forecasts: Pessimistic Most Likely Optimistic

Determining Value of Business: Discounted earning method Step 1: Project earnings five years into the future: $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, Year Pess ML Opt Weighted Average

Determining Value of Business: Discounted earning method (continued) Step 2: Discount weighted average of future earnings at the appropriate present value rate: Present Value Factor = (1 +k) t where... k = Rate of return on a similar risk investment t = Time period (Year - 1, 2, 3...n) 1

Determining Value of Business: Discounted earning method Year Weighted Average x PV Factor = Present Value $75,500$89,167$99,000$107,333$111,667 Step 2 (continued): Discount weighted average of future earnings at the appropriate present value rate: $60,400$57,067$50,688$43,964$36,593 Total $248,712

Determining Value of Business: Discounted earning method Step 3: Estimate the earnings stream beyond five years: Weighted Average Earnings in Year 5 x 1 Rate of Return = $111,667 x 1 25% Step 4: Discount this estimate using the present value factor for year 6: $446,668 x.2622 = $117,116

Determining Value of Business: Discounted earning method Step 5: Compute the value of the business: = $248,712 + $117,116 = $365,828 Estimated Value of Business = $365,828 Value = Discounted earnings in years 1 through 5 Discounted earnings in years 1 through 5 + Discounted earnings in years 6 through ? Discounted earnings in years 6 through ?

Determining Value of Business: 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 = Step 2: Multiply the average P-E Ratio by next year’s forecasted earnings: Estimated Value = x $74,000 = $294,150

Negotiation

Negotiations 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.

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.