Buying an Existing Business Chapter 5 Buying an

Buying a Business Average business acquisition requires 19 months from starting the search to closing the deal n Important questions: n Ø Does the business meet your lifestyle and financial expectations? Ø Do you have the ability to operate the business successfully? Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -2

Buying a Business n Advantages Ø Business may continue to be successful Ø Leverage the experience of the previous owner Ø “Turn key” business Ø Superior location Ø Employees and suppliers in place Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -3

Buying a Business n Advantages: Ø Equipment installed Ø Inventory in place Ø Trade credit established Ø Easier access to financing Ø High value Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -4

Buying a Business n Disadvantages: Ø Cash requirements Ø Business is losing money Ø Paying for “ill will” Ø Unsuitable employees Ø Unsatisfactory location Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -5

Buying a Business n Disadvantages: Ø Obsolete equipment and facilities Ø Change and innovation challenges Ø Obsolete inventory Ø Value of accounts receivable Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -6

Valuing Accounts Receivable Age of Accounts (days) Amount Probability of Collection Value 0 -30 31 -60 61 -90 91 -120 121 -150 151+ $40, 000 $25, 000 $14, 000 $10, 000 $7, 000 $5, 000 . 95. 88. 70. 40. 25. 10 $38, 000 $22, 000 $9, 800 $4, 000 $1, 750 $500 Total $101, 000 Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall $76, 050 5 -7

Buying a Business n Disadvantages Ø Obsolete equipment and facilities Ø Change and innovation challenges Ø Obsolete inventory Ø Value of accounts receivable Ø Business may be overpriced Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -8

How to Buy a Business Analyze your skills, abilities, and interests n Develop a list of criteria n Prepare a list of potential candidates n Ø Remember the hidden market of companies that may be for sale but are not listed as “for sale” Rays Market Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -9

How to Buy a Business Investigate and evaluate candidate businesses and select the best one n Negotiate the deal n Explore financing options n Ensure a smooth transition n Ray’s Market Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -10

Five Critical Areas for Analyzing an Existing Business 1. 2. 3. 4. Why does the owner want to sell. . . the real reason? What is the physical condition of the business and its assets? What is the market potential for the company's products or services? Ø Customer characteristics and composition Ø Competitor analysis What legal aspects must I consider? Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -11

The Legal Aspects of Buying a Business Lien – creditors’ claims against an asset n Bulk transfer – protects business buyer from the claims unpaid creditors might have against a company’s assets n Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -12

Bulk Transfer n n 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) Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -13

The Legal Aspects of Buying a Business Lien - creditors’ claims against an asset n Bulk transfer - protects business buyer from the claims unpaid creditors might have against a company’s assets n n Contract assignment - buyer’s ability to assume rights under seller’s existing contracts Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -14

The Legal Aspects of Buying a Business Covenant not to compete (restrictive covenant) - contract in which a business seller agrees not to compete with the buyer within a specific time and geographic area n Ongoing legal liabilities - physical premises, product liability, and labor relations n Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -15

Five Critical Areas for Analyzing an Existing Business (continued) 5. Is the business financially sound? § Income statements and balance sheets for the past three to five years Income tax returns for the past three to five years Owner’s Compensation (and that of relatives) Cash Flow § § § Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -16

Determining the Value of a Business n Balance Sheet Technique Ø n Variation: Adjusted Balance Sheet Technique Earnings Approach Variation 1: Excess Earnings Approach Ø Variation 2: Capitalized Earnings Approach Ø Variation 3: Discounted Future Earnings Approach Ø n Market Approach Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -17

Balance Sheet Techniques "Book Value"of Net Worth = Total Assets - Total Liabilities = $266, 091 - $114, 325 = $151, 766 Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -18

Balance Sheet Techniques "Book Value"of Net Worth = Total Assets - Total Liabilities = $266, 091 - $114, 325 = $151, 766 Variation: Adjusted Balance Sheet Technique: Adjusted Net Worth = $279, 738 - $114, 325 = $165, 413 Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -19

Earnings Approaches Variation 1: Excess Earnings Method Chapter 5 Buying an Existing Business Copyright

Earnings Approaches Variation 1: Excess Earnings Method Step 1: Compute adjusted tangible net worth: Adjusted Net Worth = Chapter 5 Buying an Existing Business $279, 738 - $114, 325 = $165, 413 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -21

Earnings Approaches Variation 1: Excess Earnings Method Step 1: Compute adjusted tangible net worth: Adjusted Net Worth = $279, 738 - $114, 325 = $165, 413 Step 2: Calculate opportunity costs of investing: Investment Salary Chapter 5 Buying an Existing Business $165, 413 x 25% = $41, 353 $35, 000 Total $76, 353 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -22

Earnings Approaches Variation 1: Excess Earnings Method Step 1: Compute adjusted tangible net worth: Adjusted Net Worth = $279, 738 - $114, 325 = $165, 413 Step 2: Calculate opportunity costs of investing: Investment Salary $165, 413 x 25% = $41, 353 $35, 000 Total $76, 353 Step 3: Project earnings for next year: $88, 000 Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -23

Excess Earnings Method (Continued) Step 4: Compute extra earning power (EEP): EEP = Projected Net Earnings - Total Opportunity Costs = $88, 000 - Chapter 5 Buying an Existing Business 76, 353 = $11, 647 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -24

Excess Earnings Method (Continued) Step 4: Compute extra earning power (EEP): EEP = Projected Net Earnings - Total Opportunity Costs = $88, 000 - 76, 353 = $11, 647 Step 5: Estimate the value of the intangibles ("goodwill"): Intangibles = Extra Earning Power x "Years of Profit" Figure* = 11, 647 x 4. 1 = $47, 752 * Years of Profit Figure ranges from 1 to 7; for a normal risk business, it is 3 or 4 Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -25

Excess Earnings Method (Continued) Step 6: Determine the value of the business: Value = Tangible Net Worth + Value of Intangibles = $165, 413 + 47, 752 = $213, 165 Estimated Value of the business = $213, 165 Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -26

Capitalized Earnings 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 Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -27

Capitalized Earnings 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 = Chapter 5 Buying an Existing Business $88, 000 - $35, 000 = $212, 000 25% Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -28

Discounted Future Earnings Method Variation 3: Discounted Future Earnings Method: Step 1: Project earnings five years into the future: Ø Ø Ø 3 Forecasts: Pessimistic Most Likely Optimistic Compute a weighted average of the earnings: Pessimistic + (4 x Most Likely) + Optimistic 6 Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -29

Discounted Future Earnings Method (Continued) Step 1: Project earnings five years into the future: Year 1 Pess $75, 000 ML $88, 000 Opt $92, 000 2 $78, 000 $91, 000 $98, 000 $90, 000 3 $82, 000 $95, 000 $105, 000 $94, 500 4 $85, 000 $103, 000 $109, 000 $101, 000 5 $88, 000 $110, 000 $115, 000 $107, 167 Chapter 5 Buying an Existing Business Weighted Average $86, 500 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -30

Discounted Future Earnings Method (Continued) Step 2: Discount weighted average of future earnings at the appropriate present value rate: 1 Present Value Factor = (1 +k) t where. . . k = Rate of return on a similar risk investment t = Time period (Year - 1, 2, 3. . . n) Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -31

Discounted Future Earnings Method (Continued) Step 2: Discount weighted average of future earnings at the appropriate present value rate: Year Weighted Average x PV Factor = Present Value 1 $86, 500 . 8000 $69, 200 2 $90, 000 . 6400 $57, 600 3 $94, 500 . 5120 $48, 384 4 $101, 000 . 4096 $41, 370 5 $107, 167 . 3277 $35, 119 Total Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall $251, 673 5 -32

Discounted Future Earnings Method (Continued) Step 3: Estimate the earnings stream beyond five years: 1 Weighted Average x Earnings in Year 5 = $107, 167 Chapter 5 Buying an Existing Business x = Rate of Return 1 25% = $428, 668 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -33

Discounted Future Earnings Method (Continued) Step 3: Estimate the earnings stream beyond five years: 1 Weighted Average x Earnings in Year 5 = $107, 167 x = Rate of Return 1 25% = $428, 668 Step 4: Discount this estimate using the present value factor for year 6: $428, 668 x. 2621 = $112, 354 Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -34

Discounted Future Earnings Method (Continued) Step 5: Compute the value of the business: Value = Discounted earnings in years 1 through 5 = $251, 673 + Discounted earnings in years 6 through ? + $112, 354 = $364, 027 Estimated Value of Business = $364, 027 Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -35

Market Approach Step 1: Compute the average Price-Earnings (P-E) Ratio for as many similar businesses as possible: Company P-E Ratio 1 3. 3 2 3. 8 3 4 4. 1 Chapter 5 Buying an Existing Business Average P-E Ratio = 3. 875 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -36

Market Approach Step 1: Compute the average Price-Earnings (P-E) Ratio for as many similar businesses as possible: Company P-E Ratio 1 3. 3 2 3. 8 3 4 4. 1 Average P-E Ratio = 3. 875 Step 2: Multiply the average P-E Ratio by next year's forecasted earnings: Estimated Value = 3. 875 x $88, 000 = $341, 000 Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -37

The Art of the Deal n n n n Establish the proper mindset Understand the rules of successful negotiations Develop a negotiating strategy Be creative Keep emotions in check Be patient Don’t become a victim Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -38

The Five Ps of Negotiating Preparation - Examine the needs of both parties and all of the relevant external factors affecting the negotiation before you sit down to talk Poise - Remain calm during the negotiation. Never raise your voice or lose your temper, even if the situation gets difficult or emotional. It’s better to walk away and calm down than to blow up and blow the deal Patience - Don’t be in such a hurry to close the deal that you end up giving up much of what you hoped to get. Impatience is a major weakness in a negotiation Persuasiveness - Know what your most important positions are, articulate them, and offer support for your position Persistence - Don’t give in at the first sign of resistance to your position, especially if it is an issue that ranks high in your list of priorities

Exit Strategies n n n n Straight business sale Sell controlling interest Restructure the company Use a two-step sale Family limited partnership (FLP) Establish an employee stock ownership plan (ESOP) International buyer Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -40

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall Chapter 5 Buying an Existing Business Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 5 -41