Chapter 11 buying an existing sm es-esbm10e-05

C5 Buying an Existing BusinessC5 Buying an Existing Business 5-5-11
CopyrightCopyright ©2012 Pearson Education, Inc. publishing as Prentice Hall©2012 Pearson Education, Inc. publishing as Prentice Hall
Buying an Existing
Small and Medium
Business

Buying a BusinessBuying a Business
 Average business acquisition requiresAverage business acquisition requires
19 months from starting the search to19 months from starting the search to
closing the dealclosing the deal
 Important questions:Important questions:
 Does the business meet your lifestyle andDoes the business meet your lifestyle and
financial expectations?financial expectations?
 Do you have the ability to operate theDo you have the ability to operate the
business successfully?business successfully?

 AdvantagesAdvantages
 Business may continue to be successfulBusiness may continue to be successful
 Leverage the experience of the previousLeverage the experience of the previous
ownerowner
 ““Turn key” businessTurn key” business
 Superior locationSuperior location
 Employees and suppliers in placeEmployees and suppliers in place

 Advantages:Advantages:
 Equipment installedEquipment installed
 Inventory in placeInventory in place
 Trade credit establishedTrade credit established
 Easier access to financingEasier access to financing
 High valueHigh value

 Disadvantages:Disadvantages:
 Cash requirementsCash requirements
 Business is losing moneyBusiness is losing money
 Paying for “ill will”Paying for “ill will”
 Unsuitable employeesUnsuitable employees
 Unsatisfactory locationUnsatisfactory location

 Disadvantages:Disadvantages:
 Obsolete equipment and facilitiesObsolete equipment and facilities
 Change and innovation challengesChange and innovation challenges
 Obsolete inventoryObsolete inventory
 Value of accounts receivableValue of accounts receivable

Valuing AccountsValuing Accounts
ReceivableReceivable
Age of
Accounts
(days)
Amount
Probability of
Collection Value

0-30
31-60
61-90
91-120
121-150
151+
Total
$40,000
$25,000
$14,000
$10,000
$7,000
$5,000
$101,000
.95
.88
.70
.40
.25
.10
$38,000
$22,000
$9,800
$4,000
$1,750
$500
$76,050

 DisadvantagesDisadvantages
 Obsolete equipment and facilitiesObsolete equipment and facilities
 Change and innovation challengesChange and innovation challenges
 Obsolete inventoryObsolete inventory
 Value of accounts receivableValue of accounts receivable
 Business may be overpricedBusiness may be overpriced

How to Buy a BusinessHow to Buy a Business
 Analyze your skills, abilities, andAnalyze your skills, abilities, and
interestsinterests
 Develop a list of criteriaDevelop a list of criteria
 Prepare a list of potentialPrepare a list of potential
candidatescandidates
 Remember the hidden market ofRemember the hidden market of
companies that may be for sale butcompanies that may be for sale but
are not listed as “for sale”are not listed as “for sale” Rays Market

How to Buy a BusinessHow to Buy a Business
 Investigate and evaluateInvestigate and evaluate
candidate businesses andcandidate businesses and
select the best oneselect the best one
 Negotiate the dealNegotiate the deal
 Explore financing optionsExplore financing options
 Ensure a smoothEnsure a smooth
transitiontransition
Ray’s Market

Five Critical Areas forFive Critical Areas for
Analyzing an ExistingAnalyzing an Existing
BusinessBusiness
1.1. Why does the owner want to sell...theWhy does the owner want to sell...the realreal
reason?reason?
2.2. What is the physical condition of theWhat is the physical condition of the
business and its assets?business and its assets?
3.3. What is the market potential for theWhat is the market potential for the
company's products or services?company's products or services?
 Customer characteristics andCustomer characteristics and
compositioncomposition
 Competitor analysisCompetitor analysis
1.1. What legal aspects must I consider?What legal aspects must I consider?

The Legal Aspects ofThe Legal Aspects of
 Lien – creditors’ claims againstLien – creditors’ claims against
an assetan asset
 Bulk transfer – protects businessBulk transfer – protects business
buyer from the claims unpaidbuyer from the claims unpaid
creditors might have against acreditors might have against a
company’s assetscompany’s assets

Bulk TransferBulk Transfer
 Seller must give the buyer a sworn list ofSeller must give the buyer a sworn list of
creditorscreditors
 Buyer and seller must prepare a list of theBuyer and seller must prepare a list of the
property included in the saleproperty included in the sale
 Buyer must keep the list of creditors and propertyBuyer must keep the list of creditors and property
for six monthsfor six months
 Buyer must give notice of the sale to eachBuyer must give notice of the sale to each
creditor at least ten days before he takescreditor at least ten days before he takes
possession of the goods or pays for thempossession of the goods or pays for them
(whichever is first)(whichever is first)

 Contract assignment - buyer’s ability toContract assignment - buyer’s ability to
assume rights under seller’s existingassume rights under seller’s existing
contractscontracts
 Lien - creditors’ claims against an assetLien - creditors’ claims against an asset
 Bulk transfer - protects business buyerBulk transfer - protects business buyer
from the claims unpaid creditors mightfrom the claims unpaid creditors might
have against a company’s assetshave against a company’s assets

 Covenant not to compete (restrictiveCovenant not to compete (restrictive
covenant) - contract in which acovenant) - contract in which a
business seller agrees not to competebusiness seller agrees not to compete
with the buyer within a specific timewith the buyer within a specific time
and geographic areaand geographic area
 Ongoing legal liabilities - physicalOngoing legal liabilities - physical
premises, product liability, and laborpremises, product liability, and labor
relationsrelations

Five Critical Areas for AnalyzingFive Critical Areas for Analyzing
an Existing Business (continued)an Existing Business (continued)
5.5. Is the business financially sound?Is the business financially sound?
 Income statements and balance sheets forIncome statements and balance sheets for
the past three to five yearsthe past three to five years
 Income tax returns for the past three to fiveIncome tax returns for the past three to five
yearsyears
 Owner’s Compensation (and that of relatives)Owner’s Compensation (and that of relatives)
 Cash FlowCash Flow

Determining the Value of aDetermining the Value of a
BusinessBusiness
 Balance Sheet TechniqueBalance Sheet Technique
 Variation: Adjusted Balance Sheet TechniqueVariation: Adjusted Balance Sheet Technique
 Earnings ApproachEarnings Approach
 Variation 1: Excess Earnings ApproachVariation 1: Excess Earnings Approach
 Variation 2: Capitalized Earnings ApproachVariation 2: Capitalized Earnings Approach
 Variation 3: Discounted Future EarningsVariation 3: Discounted Future Earnings
ApproachApproach
 Market ApproachMarket Approach

Balance SheetBalance Sheet
TechniquesTechniques
"Book Value"of Net Worth = Total Assets - Total Liabilities"Book Value"of Net Worth = Total Assets - Total Liabilities
= $266,091 - $114,325= $266,091 - $114,325
== $151,766$151,766
Copyright ©2012 Pearson Education, Inc. publishing as Prentice HallChapter 5 Buying an Existing BusinessChapter 5 Buying an Existing Business
5-185-18

"Book Value"of Net Worth = Total Assets - Total Liabilities"Book Value"of Net Worth = Total Assets - Total Liabilities
= $266,091 - $114,325= $266,091 - $114,325
== $151,766$151,766
Variation: Adjusted Balance Sheet Technique:Variation: Adjusted Balance Sheet Technique:
Adjusted Net Worth = $279,738 - $114,325Adjusted Net Worth = $279,738 - $114,325
== $165,413$165,413
Balance SheetBalance Sheet
TechniquesTechniques
5-195-19

EarningsEarnings
ApproachesApproaches
Variation 1: Excess Earnings MethodVariation 1: Excess Earnings Method
5-205-20

Adjusted Net Worth = $279,738 - $114,325 =Adjusted Net Worth = $279,738 - $114,325 = $165,413$165,413
Step 1Step 1: Compute adjusted tangible net worth:: Compute adjusted tangible net worth:
EarningsEarnings
5-215-21

Step 2Step 2: Calculate opportunity costs of investing:: Calculate opportunity costs of investing:
Investment $165,413 x 25% = $41,353Investment $165,413 x 25% = $41,353
SalarySalary $35,000$35,000
Total $76,353Total $76,353
EarningsEarnings
5-225-22

Step 3Step 3: Project earnings for next year:: Project earnings for next year:
Step 2Step 2: Calculate opportunity costs of investing:: Calculate opportunity costs of investing:
Investment $165,413 x 25% = $41,353Investment $165,413 x 25% = $41,353
SalarySalary $35,000$35,000
Total $76,353Total $76,353
$88,000$88,000
EarningsEarnings
5-235-23

(Continued)
EEP = Projected Net Earnings - Total Opportunity CostsEEP = Projected Net Earnings - Total Opportunity Costs
Step 4Step 4: Compute extra earning power (EEP):: Compute extra earning power (EEP):
= $88,000 - 76,353 = $11,647= $88,000 - 76,353 = $11,647
Excess Earnings MethodExcess Earnings Method
5-245-24

(Continued)
EEP = Projected Net Earnings - Total Opportunity CostsEEP = Projected Net Earnings - Total Opportunity Costs
Step 4Step 4: Compute extra earning power (EEP):: Compute extra earning power (EEP):
Step 5Step 5: Estimate the value of the intangibles ("goodwill"):: Estimate the value of the intangibles ("goodwill"):
Intangibles = Extra Earning Power x "Years of Profit" Figure*Intangibles = Extra Earning Power x "Years of Profit" Figure*
= $88,000 - 76,353 = $11,647= $88,000 - 76,353 = $11,647
* Years of Profit Figure ranges from 1 to 7; for a normal risk* Years of Profit Figure ranges from 1 to 7; for a normal risk
business, it is 3 or 4business, it is 3 or 4
= 11,647 x 4.1 == 11,647 x 4.1 = $47,752$47,752
Excess Earnings MethodExcess Earnings Method
Copyright ©2012 Pearson Education, Inc. publishing as Prentice HallChapter 5 Buying an Existing BusinessChapter 5 Buying an Existing Business 5-255-25

Value = Tangible Net Worth + Value of IntangiblesValue = Tangible Net Worth + Value of Intangibles
Step 6Step 6: Determine the value of the business:: Determine the value of the business:
Estimated Value of the business = $213,165Estimated Value of the business = $213,165
= $165,413 + 47,752 == $165,413 + 47,752 = $213,165$213,165
Excess EarningsExcess Earnings
MethodMethod (Continued)
5-265-26

Variation 2: Capitalized Earnings Method:Variation 2: Capitalized Earnings Method:
Value =Value =
* Rate of return reflects what could be earned on a* Rate of return reflects what could be earned on a
similar-risk investmentsimilar-risk investment
Net Earnings (Net Earnings (AfterAfter Deducting Owner's Salary)Deducting Owner's Salary)
Rate of Return*Rate of Return*
Capitalized Earnings MethodCapitalized Earnings Method
5-275-27

Variation 2: Capitalized Earnings Method:Variation 2: Capitalized Earnings Method:
Value =Value =
* Rate of return reflects what could be earned on a* Rate of return reflects what could be earned on a
similar-risk investmentsimilar-risk investment
Net Earnings (Net Earnings (AfterAfter Deducting Owner's Salary)Deducting Owner's Salary)
Rate of Return*Rate of Return*
Value =Value = $88,000 - $35,000$88,000 - $35,000
25%25%
== $212,000$212,000
Capitalized Earnings MethodCapitalized Earnings Method

Variation 3: Discounted Future Earnings Method:Variation 3: Discounted Future Earnings Method:
Compute aCompute a weighted averageweighted average of the earnings:of the earnings:
Step 1Step 1: Project earnings five years into the future:: Project earnings five years into the future:
Pessimistic + (4 x Most Likely) + OptimisticPessimistic + (4 x Most Likely) + Optimistic
66
3 Forecasts:
 Pessimistic
 Most Likely
 Optimistic
Discounted Future EarningsDiscounted Future Earnings
MethodMethod

Step 1Step 1: Project earnings five years into the future:: Project earnings five years into the future:
(Continued)(Continued)
Year Pess ML Opt Weighted AverageYear Pess ML Opt Weighted Average
$75,000$75,000
$78,000$78,000
$82,000$82,000
$85,000$85,000
$88,000$88,000
$88,000$88,000
$91,000$91,000
$95,000$95,000
$103,000$103,000
$110,000$110,000
$92,000$92,000
$98,000$98,000
$105,000$105,000
$109,000$109,000
$115,000$115,000
$86,500$86,500
$90,000$90,000
$94,500$94,500
$101,000$101,000
$107,167$107,167
11
22
33
44
55
MethodMethod

Step 2: Discount weighted average of future earnings at theStep 2: Discount weighted average of future earnings at the
appropriate present value rate:appropriate present value rate:
Present Value Factor =Present Value Factor =
11
(1 +k)(1 +k) tt
where...where...
k = Rate of return on a similar risk investmentk = Rate of return on a similar risk investment
t = Time period (Year - 1, 2, 3...n)t = Time period (Year - 1, 2, 3...n)
MethodMethod

Year Weighted Average x PV Factor = Present ValueYear Weighted Average x PV Factor = Present Value
11
22
33
44
55
.8000.8000
.6400.6400
.5120.5120
.4096.4096
.3277.3277
$86,500$86,500
$90,000$90,000
$94,500$94,500
$101,000$101,000
$107,167$107,167
Step 2Step 2: Discount weighted average of future earnings at the: Discount weighted average of future earnings at the
appropriate present value rate:appropriate present value rate:
$69,200$69,200
$57,600$57,600
$48,384$48,384
$41,370$41,370
$35,119$35,119
TotalTotal $251,673$251,673
MethodMethod
5-325-32

Step 3Step 3: Estimate the earnings stream beyond five years:: Estimate the earnings stream beyond five years:
11
Rate of ReturnRate of Return
Weighted AverageWeighted Average
Earnings in Year 5Earnings in Year 5 xx ==
= $107,167 x= $107,167 x
11
25%25%
= $428,668= $428,668
MethodMethod
5-335-33

Step 3Step 3: Estimate the earnings stream beyond five years:: Estimate the earnings stream beyond five years:
11
Rate of ReturnRate of Return
Weighted AverageWeighted Average
Earnings in Year 5Earnings in Year 5 xx ==
= $107,167 x= $107,167 x
11
25%25%
= $428,668= $428,668
Step 4Step 4: Discount this estimate using the present value factor: Discount this estimate using the present value factor
for year 6:for year 6:
$428,668 x .2621 =$428,668 x .2621 = $112,354$112,354
MethodMethod
5-345-34

Step 5: Compute the value of the business:Step 5: Compute the value of the business:
= $251,673 + $112,354 == $251,673 + $112,354 = $364,027$364,027
Estimated Value of Business = $364,027Estimated Value of Business = $364,027
Value =Value = Discounted earningsDiscounted earnings
in years 1 through 5in years 1 through 5
++
Discounted earningsDiscounted earnings
in yearsin years
6 through ?6 through ?
MethodMethod
5-355-35

Market ApproachMarket Approach
Company P-E RatioCompany P-E Ratio
1
2
3
4
3.3
3.8
4.3
4.1
Step 1Step 1: Compute the average Price-Earnings (P-E) Ratio for: Compute the average Price-Earnings (P-E) Ratio for
as many similar businesses as possible:as many similar businesses as possible:
Average P-E Ratio = 3.875Average P-E Ratio = 3.875

Company P-E RatioCompany P-E Ratio
11
22
33
44
3.33.3
3.83.8
4.34.3
4.14.1
Step 1Step 1: Compute the average Price-Earnings (P-E) Ratio for: Compute the average Price-Earnings (P-E) Ratio for
as many similar businesses as possible:as many similar businesses as possible:
Average P-E Ratio = 3.875Average P-E Ratio = 3.875
Step 2: Multiply the average P-E Ratio by next year'sStep 2: Multiply the average P-E Ratio by next year's
forecasted earnings:forecasted earnings:
Estimated Value = 3.875 x $88,000 =Estimated Value = 3.875 x $88,000 = $341,000$341,000
Market ApproachMarket Approach

The Art of the DealThe Art of the Deal
 Establish the proper mindsetEstablish the proper mindset
 Understand the rules of successfulUnderstand the rules of successful
negotiationsnegotiations
 Develop a negotiating strategyDevelop a negotiating strategy
 Be creativeBe creative
 Keep emotions in checkKeep emotions in check
 Be patientBe patient
 Don’t become a victimDon’t become a victim

The Five Ps of NegotiatingThe 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
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
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

Exit StrategiesExit Strategies
 Straight business saleStraight business sale
 Sell controlling interestSell controlling interest
 Restructure the companyRestructure the company
 Use a two-step saleUse a two-step sale
 Family limited partnership (FLP)Family limited partnership (FLP)
 Establish an employee stock ownership planEstablish an employee stock ownership plan
(ESOP)(ESOP)
 International buyerInternational buyer

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

Chapter 11 buying an existing sm es-esbm10e-05

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