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Section 2:
The Entrepreneurial Journey Begins
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Essentials of Entrepreneurship and Small
Business Management
Ninth Edition
Chapter 7
Buying an Existing Business
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Learning Objectives (1 of 2)
1. Describe the advantages and disadvantages of buying an
existing business.
2. Explain the five stages in acquiring a business: search, due
diligence, valuation, deal, and transition.
3. Explain the three steps in the search stage of buying a
business.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Learning Objectives (2 of 2)
4. Describe the four areas involved in conducting due diligence
on a business: the seller’s motivation, asset valuation, legal
issues, and financial condition.
5. Explain the various methods used to estimate the value of a
business.
6. Describe the basic principles of negotiating a deal to buy a
business and structuring the deal.
7. Understand how to manage the transition stage when a deal is
done.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Buying an Existing Business (1 of 2)
• Before you buy, ask:
– Is the right type of business for sale in a 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 to your ultimate success is experience in the
business?
– What is the company’s potential for success?
– What changes will you have to make – and how
extensive will they be – to realize the business’s full
potential?
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Buying an Existing Business (2 of 2)
– What price and payment method are reasonable for
you and acceptable to the seller?
– Is the seller willing to finance part of the purchase
price?
– Will the company generate sufficient cash to pay for
itself and leave you with a suitable rate of return on
your investment?
– Should you be starting a business and building it from
the ground up rather than buying an existing one?
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Types of Business Buyers
Figure 7.1 Types of Business Buyers
Source: “Meet the Buyers,” by Darren Dahl, Inc., April 1, 2008, pp. 98–99. © 2008 by Inc. Magazine.
Reprinted with permission.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Advantages of Buying an Existing
Business (1 of 2)
• Successful existing businesses often continue to be
successful.
• Superior location.
• Employees and suppliers are in place.
• Installed equipment with known production capacity.
• Inventory in place.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Advantages of Buying an Existing
Business (2 of 2)
• Trade credit is established.
• The turnkey business.
• The new owner can use the experience of the previous
owner.
• Easier access to financing.
• High value.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Disadvantages of Buying an Existing
Business (1 of 2)
• Cash requirements.
• The business is losing money.
• Paying for ill will.
• Employees inherited with the business may not be
suitable.
• Unsatisfactory location.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Disadvantages of Buying an Existing
Business (2 of 2)
• Obsolete or inefficient equipment and facilities.
• The challenge of implementing change.
• Obsolete inventory.
• Valuing accounts receivable.
• The business may be overpriced.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Stages in Acquiring a Business
Figure 7.2 The Acquisition Process
Sources: Based on Buying and Selling: A Company Handbook (New York: Price Waterhouse, 1993), pp. 38–42;
Charles F. Claeys, “The Intent to Buy,” Small Business Reports, May 1994, pp. 44–47.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Five Stages of
Buying a Business
Figure 7.3 The Five Stages of
Buying a Business
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Search Stage
• There are three steps in conducting an effective search for
the right business to buy:
1. Conduct a self-inventory, objectively analyzing skills,
abilities, and personal interests to determine the
type(s) of business that offer the best fit.
2. Develop a list of the criteria that define the “ideal
business” for you.
3. Prepare a list of potential candidates that meet your
criteria.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Step 1: Self-Inventory (1 of 2)
• What business activities do you enjoy most? Least? Why?
• Which industries or markets offer the greatest potential for
growth?
• Which industries interest you most? Least? Why?
• What kind of business would you enjoy running?
• What kinds of businesses do you want to avoid?
• What do you expect to get out of the business?
• How much time, energy, and money can you put into the
business?
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Step 1: Self-Inventory (2 of 2)
• What business skills and experience do you have? Which
ones do you lack?
• How easily can you transfer your skills and experience to
other types of businesses? In what kinds of businesses
would that transfer be easiest?
• How much risk are you willing to take?
• Are you willing and able to turn around a struggling business?
• What size company do you want to buy?
• Is there a particular geographic location you desire? What
business skills and experience do you have? Which ones do
you lack?
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Step 2: Develop a List of Criteria
• The goal is to identify the characteristics of the “ideal
business” for you so that you can focus on the most viable
candidates as you wade through a multitude of business
opportunities.
• These criteria will provide specific parameters against
which you can evaluate potential acquisition candidates.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Step 3: Prepare a List of Potential
Candidates
• Many businesses that can be purchased are not publicly
advertised but are available either through the owners
themselves or through business brokers and other
professionals.
– Hidden market: low-profile companies that might be
for sale but are not advertised as such.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Business Purchases
by Type of Business
Figure 7.4 Business
Purchases by Type of
Business
Source: Based on data from “BizBuySell’s 2016 Report: Why Buying or Selling a Business Is Becoming a Big Deal,”
BizBuySell, 2017, http://www.bizbuysell.com/htmlmail/2017/content/BizBuySell-Small-Business-Infographic-
2016.pdf?utm_source=bizbuysell&utm_medium=blog&utm_campaign=infographicarticle021417.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Due Diligence Stage (1 of 2)
• Once you have a list of prospective companies, ask:
– What are the company’s strengths? Weaknesses?
– Is the company profitable? What is its overall financial
condition?
– What is its cash flow cycle? How much cash will the
company generate?
– Who are its major competitors?
– How large is the customer base? Is it growing or
shrinking?
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Due Diligence Stage (2 of 2)
– Are the current employees suitable? Will they stay?
– What is the physical condition of the business, its
equipment, and its inventory?
– What new skills must you learn to be able to manage
this business successfully?
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Due Diligence Process
• Due diligence: the process of studying, reviewing, and
verifying all the relevant information concerning an
acquisition.
1. Motivation. Why does the owner want to sell?
2. Asset valuation. What is the real value of the
company’s assets?
3. Legal issues. What legal aspects of the business are
known or hidden risks?
4. Financial condition. Is the business financially sound?
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Motivation
• Why does the owner want to sell?
– The most common reasons business owners give for
selling their businesses are:
 Planned retirement (40%)
 Burnout (21%)
 Desire to own a bigger business (20%)
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Asset Valuation
• What is the true nature of the firm’s assets?
– Are the assets really useful, or are they obsolete?
– Will the assets require replacement soon?
– Do the assets operate efficiently?
• Investigate:
– Accounts recievable
– Lease arrangements
– Business records
– Intangible assets
– Location and apperance
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Legal Issues (1 of 2)
• Liens: claims by creditors against a company’s assets.
• Due-on-sale clause: a clause that requires the buyer to
pay the full amount of the remaining loan balance or to
finance the balance at prevailing interest rates, thus
preventing the buyer from assuming the seller’s loan at a
lower interest rate.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Legal Issues (2 of 2)
• Covenant not to compete (or restrictive covenant): an
agreement tied to the sale of a business in which the seller
agrees not to open a competing business within a specific
time period and geographic area of the existing one.
• Product liability lawsuit: a lawsuit which claims that a
company is liable for damages and injuries caused by the
products or services it sells.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Financial Condition
• Is the business financially sound?
– Examine:
 Income statements and balance sheets for at least
three years
 Income tax returns for at least three years
 Cash flow
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Valuation Stage
• Non-disclosure agreement (NDA): a legal contract that
requires a prospective buyer to maintain the confidentiality
of the business, its owner, and any information, financial
and otherwise, that the buyer sees as part of the due
diligence process.
• Methods for Determining the Value of a Business
– Business valuation is partly an art and partly a science.
 Balance sheet method
 Earnings approach
 Market approach
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Balance Sheet Method
• Net worth (or owner’s equity):
– Net worth = Assets − Liabilities
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Earnings Approach (1 of 2)
• Excess earnings method: a business valuation method that
combines both the value of a company’s existing assets (less
its liabilities) and an estimate of its future earnings potential to
determine the selling price for the business.
– Goodwill: the difference between an established,
successful business and one that has yet to prove itself
that is based on the company’s reputation and its ability to
attract and retain customers.
– Opportunity cost: the cost of forgoing a choice; the cost
of the next best alternative.
– Extra earning power: the difference between a
company’s forecasted earnings and the total opportunity
costs of investing in that company.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Earnings Approach (2 of 2)
• Capitalized earnings approach: a business valuation
method that involves dividing a company’s estimated net
earnings (after subtracting a reasonable salary for the
owner) by the rate of return that reflects the risk level of
investing in the business.
• Discounted future earnings approach: a business
valuation method that involves estimating a company’s net
income for several years into the future and then discounts
these future earnings back to their present value, which
provides an estimate of the company’s worth.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Market Approach
• Market (or price/earnings) approach: a business
valuation method that involves using the price/earnings
ratios of similar publicly traded businesses to estimate the
value of a company.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Best Method?
Figure 7.7 Business Valuation Methods
Source: Based on data from Craig R. Everett, 2017 Private Capital Markets Report, Pepperdine
University, March 15, 2017, p. 55.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Deal Stage
• The structure of the deal – the terms and conditions of
payment—is more important than the price the seller
agrees to pay.
– The “art of the deal”
– The buyer’s goals
– The seller’s goals
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The “Art of the Deal” (1 of 3)
• Don’t confuse price with value.
– Value is what a business actually is worth; price is what
the buyer agrees to pay for it.
• The bargaining process may eventually lead both parties
into the bargaining zone: the area within which the two
parties can reach agreement.
– It extends from above the lowest price the seller is
willing to take to below the maximum price the buyer is
willing to pay.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Identifying the Bargaining Zone
Figure 7.8 Identifying the Bargaining Zone
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The “Art of the Deal” (2 of 3)
• Negotiating tips:
– Establish the proper mind-set.
– Know what you want to have when you walk away from
the table.
– Develop a negotiating strategy.
– Recognize the other party’s needs.
– Be an empathetic listener.
– Focus on the issue, not on the person.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The “Art of the Deal” (3 of 3)
• Avoid seeing the other side as “the enemy.”
• Educate; don’t intimidate.
• Be creative.
• Keep emotions in check.
• Be patient.
• Don’t become a victim.
• Remember that “no deal” is an option.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Buyer’s Goals
• The buyer seeks to realize the following goals:
– Get the business at the lowest price possible.
– Negotiate favorable payment terms, preferably over
time.
– Get assurances that he is buying the business he
thinks it is.
– Avoid enabling the seller to open a competing
business.
– Minimize the amount of cash paid up front.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Seller’s Goals
• The seller of the business is looking to accomplish the
following goals:
– Get the highest price possible for the company.
– Sever all responsibility for the company’s liabilities.
– Avoid unreasonable contract terms that might limit
future opportunities.
– Maximize the cash from the deal.
– Minimize the tax burden from the sale.
– Make sure the buyer will make all future payments.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Structure of the Deal
• Typical ways that parties structure business sales.
– Straight business sale
– Two-step sale
– Employee stock ownership plan (ESOP)
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Straight Business Sale
• Disadvantages:
– Usually the most expensive way to sell a business.
– Could result in a significant ax burden.
– Unattractive for owners who want to surrender control
gradually.
• May involve seller financing.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Two-Step Sale
• One option is an earn-out an agreement:
– The seller agrees to accept a percentage of the sales
price and stays on to manage the business for a few
more years under the new owner; the remaining
portion of the price is contingent on the company’s
performance; the more profit the company generates
during the earn-out period, the greater the payout to
the seller.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Employee Stock Ownership Plan
• Employee stock ownership plan (ESOP):
– A type of employee benefit plan in which a trust that is
created for employees purchases their employer’s
stock; employees do not make any out-of-pocket
payments but over time become owners in the
company that employs them, are entitled to share in its
profits, and receive sizable retirement benefits.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
A Typical ESOP
Figure 7.9 A Typical Employee Stock Ownership Plan
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Letter of Intent
• Letter of intent:
– A document that represents a firm commitment by both
sides that they are ready to move toward closing the
sale of a business.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Transition Stage (1 of 4)
• Closing documents include:
– Asset purchase agreement – the formal agreement of
the deal
– Bill of sale – transfers ownership
– Asset list – all assets that are included in the sale,
including tangible assets and intellectual property
– Buyer’s disclosure statement
– Allocation of purchase price – a formal document that
must be filed with the Internal Revenue Service at the
end of the tax year that allocates the price among the
various assets
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Transition Stage (2 of 4)
– Non-compete agreement
– Consulting/training agreement
– Transfer of subsidiaries associated with the business
– Transfer of utilities
– Transfer of Web sites, social media addresses, and
phone numbers
– Documentation of the new entity that will own the
business and documentation of the new bank account
for that business
– Transfer of merchant accounts
– Notice to creditors
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Transition Stage (3 of 4)
– Lease assignments
– Financing documents, security agreement, promissory
note, and UCC financing statement, if seller is
financing all or part of the sale
– Sales tax and payroll tax clearance
– Escrow instructions
– Closing adjustments/proration
– Transfer of any third-party contracts
– Corporate resolution authorizing sale of the corporate
assets
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
The Transition Stage (4 of 4)
• To ensure a smooth transition:
– Concentrate on communicating with employees.
– Be honest with employees.
– Listen to employees.
– Devote time to selling the vision for the company to its
key stakeholders, including major customers, suppliers,
bankers, and others.
– Consider asking the seller to serve as a consultant until
the transition is complete. The previous owner can be a
valuable resource.
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Conclusion
• The five stages of buying a business are:
1. The search stage
2. The due diligence stage
3. The valuation stage
4. The deal stage
5. The transition stage
Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved.
Copyright

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  • 1. Section 2: The Entrepreneurial Journey Begins Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved
  • 2. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Essentials of Entrepreneurship and Small Business Management Ninth Edition Chapter 7 Buying an Existing Business
  • 3. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Learning Objectives (1 of 2) 1. Describe the advantages and disadvantages of buying an existing business. 2. Explain the five stages in acquiring a business: search, due diligence, valuation, deal, and transition. 3. Explain the three steps in the search stage of buying a business.
  • 4. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Learning Objectives (2 of 2) 4. Describe the four areas involved in conducting due diligence on a business: the seller’s motivation, asset valuation, legal issues, and financial condition. 5. Explain the various methods used to estimate the value of a business. 6. Describe the basic principles of negotiating a deal to buy a business and structuring the deal. 7. Understand how to manage the transition stage when a deal is done.
  • 5. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Buying an Existing Business (1 of 2) • Before you buy, ask: – Is the right type of business for sale in a 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 to your ultimate success is experience in the business? – What is the company’s potential for success? – What changes will you have to make – and how extensive will they be – to realize the business’s full potential?
  • 6. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Buying an Existing Business (2 of 2) – What price and payment method are reasonable for you and acceptable to the seller? – Is the seller willing to finance part of the purchase price? – Will the company generate sufficient cash to pay for itself and leave you with a suitable rate of return on your investment? – Should you be starting a business and building it from the ground up rather than buying an existing one?
  • 7. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Types of Business Buyers Figure 7.1 Types of Business Buyers Source: “Meet the Buyers,” by Darren Dahl, Inc., April 1, 2008, pp. 98–99. © 2008 by Inc. Magazine. Reprinted with permission.
  • 8. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Advantages of Buying an Existing Business (1 of 2) • Successful existing businesses often continue to be successful. • Superior location. • Employees and suppliers are in place. • Installed equipment with known production capacity. • Inventory in place.
  • 9. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Advantages of Buying an Existing Business (2 of 2) • Trade credit is established. • The turnkey business. • The new owner can use the experience of the previous owner. • Easier access to financing. • High value.
  • 10. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Disadvantages of Buying an Existing Business (1 of 2) • Cash requirements. • The business is losing money. • Paying for ill will. • Employees inherited with the business may not be suitable. • Unsatisfactory location.
  • 11. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Disadvantages of Buying an Existing Business (2 of 2) • Obsolete or inefficient equipment and facilities. • The challenge of implementing change. • Obsolete inventory. • Valuing accounts receivable. • The business may be overpriced.
  • 12. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Stages in Acquiring a Business Figure 7.2 The Acquisition Process Sources: Based on Buying and Selling: A Company Handbook (New York: Price Waterhouse, 1993), pp. 38–42; Charles F. Claeys, “The Intent to Buy,” Small Business Reports, May 1994, pp. 44–47.
  • 13. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Five Stages of Buying a Business Figure 7.3 The Five Stages of Buying a Business
  • 14. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Search Stage • There are three steps in conducting an effective search for the right business to buy: 1. Conduct a self-inventory, objectively analyzing skills, abilities, and personal interests to determine the type(s) of business that offer the best fit. 2. Develop a list of the criteria that define the “ideal business” for you. 3. Prepare a list of potential candidates that meet your criteria.
  • 15. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Step 1: Self-Inventory (1 of 2) • What business activities do you enjoy most? Least? Why? • Which industries or markets offer the greatest potential for growth? • Which industries interest you most? Least? Why? • What kind of business would you enjoy running? • What kinds of businesses do you want to avoid? • What do you expect to get out of the business? • How much time, energy, and money can you put into the business?
  • 16. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Step 1: Self-Inventory (2 of 2) • What business skills and experience do you have? Which ones do you lack? • How easily can you transfer your skills and experience to other types of businesses? In what kinds of businesses would that transfer be easiest? • How much risk are you willing to take? • Are you willing and able to turn around a struggling business? • What size company do you want to buy? • Is there a particular geographic location you desire? What business skills and experience do you have? Which ones do you lack?
  • 17. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Step 2: Develop a List of Criteria • The goal is to identify the characteristics of the “ideal business” for you so that you can focus on the most viable candidates as you wade through a multitude of business opportunities. • These criteria will provide specific parameters against which you can evaluate potential acquisition candidates.
  • 18. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Step 3: Prepare a List of Potential Candidates • Many businesses that can be purchased are not publicly advertised but are available either through the owners themselves or through business brokers and other professionals. – Hidden market: low-profile companies that might be for sale but are not advertised as such.
  • 19. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Business Purchases by Type of Business Figure 7.4 Business Purchases by Type of Business Source: Based on data from “BizBuySell’s 2016 Report: Why Buying or Selling a Business Is Becoming a Big Deal,” BizBuySell, 2017, http://www.bizbuysell.com/htmlmail/2017/content/BizBuySell-Small-Business-Infographic- 2016.pdf?utm_source=bizbuysell&utm_medium=blog&utm_campaign=infographicarticle021417.
  • 20. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Due Diligence Stage (1 of 2) • Once you have a list of prospective companies, ask: – What are the company’s strengths? Weaknesses? – Is the company profitable? What is its overall financial condition? – What is its cash flow cycle? How much cash will the company generate? – Who are its major competitors? – How large is the customer base? Is it growing or shrinking?
  • 21. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Due Diligence Stage (2 of 2) – Are the current employees suitable? Will they stay? – What is the physical condition of the business, its equipment, and its inventory? – What new skills must you learn to be able to manage this business successfully?
  • 22. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Due Diligence Process • Due diligence: the process of studying, reviewing, and verifying all the relevant information concerning an acquisition. 1. Motivation. Why does the owner want to sell? 2. Asset valuation. What is the real value of the company’s assets? 3. Legal issues. What legal aspects of the business are known or hidden risks? 4. Financial condition. Is the business financially sound?
  • 23. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Motivation • Why does the owner want to sell? – The most common reasons business owners give for selling their businesses are:  Planned retirement (40%)  Burnout (21%)  Desire to own a bigger business (20%)
  • 24. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Asset Valuation • What is the true nature of the firm’s assets? – Are the assets really useful, or are they obsolete? – Will the assets require replacement soon? – Do the assets operate efficiently? • Investigate: – Accounts recievable – Lease arrangements – Business records – Intangible assets – Location and apperance
  • 25. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Legal Issues (1 of 2) • Liens: claims by creditors against a company’s assets. • Due-on-sale clause: a clause that requires the buyer to pay the full amount of the remaining loan balance or to finance the balance at prevailing interest rates, thus preventing the buyer from assuming the seller’s loan at a lower interest rate.
  • 26. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Legal Issues (2 of 2) • Covenant not to compete (or restrictive covenant): an agreement tied to the sale of a business in which the seller agrees not to open a competing business within a specific time period and geographic area of the existing one. • Product liability lawsuit: a lawsuit which claims that a company is liable for damages and injuries caused by the products or services it sells.
  • 27. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Financial Condition • Is the business financially sound? – Examine:  Income statements and balance sheets for at least three years  Income tax returns for at least three years  Cash flow
  • 28. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Valuation Stage • Non-disclosure agreement (NDA): a legal contract that requires a prospective buyer to maintain the confidentiality of the business, its owner, and any information, financial and otherwise, that the buyer sees as part of the due diligence process. • Methods for Determining the Value of a Business – Business valuation is partly an art and partly a science.  Balance sheet method  Earnings approach  Market approach
  • 29. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Balance Sheet Method • Net worth (or owner’s equity): – Net worth = Assets − Liabilities
  • 30. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Earnings Approach (1 of 2) • Excess earnings method: a business valuation method that combines both the value of a company’s existing assets (less its liabilities) and an estimate of its future earnings potential to determine the selling price for the business. – Goodwill: the difference between an established, successful business and one that has yet to prove itself that is based on the company’s reputation and its ability to attract and retain customers. – Opportunity cost: the cost of forgoing a choice; the cost of the next best alternative. – Extra earning power: the difference between a company’s forecasted earnings and the total opportunity costs of investing in that company.
  • 31. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Earnings Approach (2 of 2) • Capitalized earnings approach: a business valuation method that involves dividing a company’s estimated net earnings (after subtracting a reasonable salary for the owner) by the rate of return that reflects the risk level of investing in the business. • Discounted future earnings approach: a business valuation method that involves estimating a company’s net income for several years into the future and then discounts these future earnings back to their present value, which provides an estimate of the company’s worth.
  • 32. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Market Approach • Market (or price/earnings) approach: a business valuation method that involves using the price/earnings ratios of similar publicly traded businesses to estimate the value of a company.
  • 33. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Best Method? Figure 7.7 Business Valuation Methods Source: Based on data from Craig R. Everett, 2017 Private Capital Markets Report, Pepperdine University, March 15, 2017, p. 55.
  • 34. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Deal Stage • The structure of the deal – the terms and conditions of payment—is more important than the price the seller agrees to pay. – The “art of the deal” – The buyer’s goals – The seller’s goals
  • 35. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The “Art of the Deal” (1 of 3) • Don’t confuse price with value. – Value is what a business actually is worth; price is what the buyer agrees to pay for it. • The bargaining process may eventually lead both parties into the bargaining zone: the area within which the two parties can reach agreement. – It extends from above the lowest price the seller is willing to take to below the maximum price the buyer is willing to pay.
  • 36. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Identifying the Bargaining Zone Figure 7.8 Identifying the Bargaining Zone
  • 37. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The “Art of the Deal” (2 of 3) • Negotiating tips: – Establish the proper mind-set. – Know what you want to have when you walk away from the table. – Develop a negotiating strategy. – Recognize the other party’s needs. – Be an empathetic listener. – Focus on the issue, not on the person.
  • 38. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The “Art of the Deal” (3 of 3) • Avoid seeing the other side as “the enemy.” • Educate; don’t intimidate. • Be creative. • Keep emotions in check. • Be patient. • Don’t become a victim. • Remember that “no deal” is an option.
  • 39. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Buyer’s Goals • The buyer seeks to realize the following goals: – Get the business at the lowest price possible. – Negotiate favorable payment terms, preferably over time. – Get assurances that he is buying the business he thinks it is. – Avoid enabling the seller to open a competing business. – Minimize the amount of cash paid up front.
  • 40. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Seller’s Goals • The seller of the business is looking to accomplish the following goals: – Get the highest price possible for the company. – Sever all responsibility for the company’s liabilities. – Avoid unreasonable contract terms that might limit future opportunities. – Maximize the cash from the deal. – Minimize the tax burden from the sale. – Make sure the buyer will make all future payments.
  • 41. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Structure of the Deal • Typical ways that parties structure business sales. – Straight business sale – Two-step sale – Employee stock ownership plan (ESOP)
  • 42. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Straight Business Sale • Disadvantages: – Usually the most expensive way to sell a business. – Could result in a significant ax burden. – Unattractive for owners who want to surrender control gradually. • May involve seller financing.
  • 43. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Two-Step Sale • One option is an earn-out an agreement: – The seller agrees to accept a percentage of the sales price and stays on to manage the business for a few more years under the new owner; the remaining portion of the price is contingent on the company’s performance; the more profit the company generates during the earn-out period, the greater the payout to the seller.
  • 44. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Employee Stock Ownership Plan • Employee stock ownership plan (ESOP): – A type of employee benefit plan in which a trust that is created for employees purchases their employer’s stock; employees do not make any out-of-pocket payments but over time become owners in the company that employs them, are entitled to share in its profits, and receive sizable retirement benefits.
  • 45. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. A Typical ESOP Figure 7.9 A Typical Employee Stock Ownership Plan
  • 46. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Letter of Intent • Letter of intent: – A document that represents a firm commitment by both sides that they are ready to move toward closing the sale of a business.
  • 47. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Transition Stage (1 of 4) • Closing documents include: – Asset purchase agreement – the formal agreement of the deal – Bill of sale – transfers ownership – Asset list – all assets that are included in the sale, including tangible assets and intellectual property – Buyer’s disclosure statement – Allocation of purchase price – a formal document that must be filed with the Internal Revenue Service at the end of the tax year that allocates the price among the various assets
  • 48. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Transition Stage (2 of 4) – Non-compete agreement – Consulting/training agreement – Transfer of subsidiaries associated with the business – Transfer of utilities – Transfer of Web sites, social media addresses, and phone numbers – Documentation of the new entity that will own the business and documentation of the new bank account for that business – Transfer of merchant accounts – Notice to creditors
  • 49. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Transition Stage (3 of 4) – Lease assignments – Financing documents, security agreement, promissory note, and UCC financing statement, if seller is financing all or part of the sale – Sales tax and payroll tax clearance – Escrow instructions – Closing adjustments/proration – Transfer of any third-party contracts – Corporate resolution authorizing sale of the corporate assets
  • 50. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Transition Stage (4 of 4) • To ensure a smooth transition: – Concentrate on communicating with employees. – Be honest with employees. – Listen to employees. – Devote time to selling the vision for the company to its key stakeholders, including major customers, suppliers, bankers, and others. – Consider asking the seller to serve as a consultant until the transition is complete. The previous owner can be a valuable resource.
  • 51. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Conclusion • The five stages of buying a business are: 1. The search stage 2. The due diligence stage 3. The valuation stage 4. The deal stage 5. The transition stage
  • 52. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Copyright

Editor's Notes

  1. If this PowerPoint presentation contains mathematical equations, you may need to check that your computer has the following installed: 1) MathType Plugin 2) Math Player (free versions available) 3) NVDA Reader (free versions available)
  2. In this chapter, you will: 1. Describe the advantages and disadvantages of buying an existing business. 2. Explain the five stages in acquiring a business: search, due diligence, valuation, deal, and transition. 3. Explain the three steps in the search stage of buying a business.
  3. In addition, you will: 4. Describe the four areas involved in conducting due diligence on a business: the seller’s motivation, asset valuation, legal issues, and financial condition. 5. Explain the various methods used to estimate the value of a business. 6. Describe the basic principles of negotiating a deal to buy a business and structuring the deal. 7. Understand how to manage the transition stage when a deal is done.
  4. When considering purchasing a business, the first rule is, “Do not rush into a deal.” Taking shortcuts when investigating a potential business acquisition almost always leads to nasty – and expensive – surprises.
  5. This figure shows a profile of the four major categories of buyers and their characteristics that business brokers have identified.
  6. A survey by Securian Financial Services reports that 60% of small business owners plan to exit their businesses by 2024 and that their most likely exit strategy is selling the business to someone. Over the next decade, as these small business owners decide to retire and sell, entrepreneurs looking to buy existing businesses will have ample opportunities to consider. Those who purchase an existing business may reap these benefits.
  7. Keep in mind that despite the advantages of buying an existing business, there are some disadvantages to the strategy.
  8. Roughly 500,000 businesses change ownership each year, although about one-third of all business sales that are initiated fall through. The main reason is an unreasonable demand unrelated to the price of the business by either the buyer or the seller. This figure summarizes the steps in the acquisition process.
  9. Purchasing an existing business can be a time-consuming process that requires a great deal of effort is often difficult to complete, and can be risky if approached haphazardly. Repeated studies report that more than half of all business acquisitions fail to meet the buyer’s expectations; therefore, buyers must conduct a systematic and thorough analysis prior to negotiating any deal. The remainder of this chapter examines the five stages that entrepreneurs go through when buying a business: (1) search stage, (2) due diligence stage, (3) valuation stage, (4) deal stage, and (5) transition stage.
  10. When buying a business, entrepreneurs must search for a business that fits best with their background and personal aspirations. There are three steps in conducting an effective search for the right business to buy.
  11. The primary focus is to identify the type of business that you will be happiest and most successful owning. Answering the following questions can help.
  12. Based on the answers to the self-inventory questions, the next step is to develop a list of criteria that a potential business acquisition must meet.
  13. When you know what your goals are for acquiring a business, you can begin your search. Do not limit yourself to only businesses that are advertised as being “for sale.”
  14. The more opportunities an entrepreneur has to find and evaluate potential acquisitions, the greater the likelihood of finding a match that meets his or her criteria. This figure shows the types of businesses that aspiring entrepreneurs purchase through the Web site BizBuySell, the Internet’s largest business-for-sale marketplace.
  15. Finding the right company requires patience. Although some buyers find a company after only a few months of looking, the typical search takes much longer, sometimes as much as two or three years. Once you have a list of prospective candidates, it is time to do your homework, learning about the company, analyzing financial statements, making certain that the facilities are structurally sound, and exploring other details by asking questions such as these.
  16. The goal of the due diligence process is to discover exactly what the buyer is purchasing and avoid any unpleasant surprises after the deal is closed. The due diligence process involves investigating four critical areas of the business and the potential deal beyond those already evaluated earlier in the search and deal processes: Motivation. Why does the owner want to sell? Asset valuation. What is the real value of the company’s assets? Legal issues. What legal aspects of the business are known or hidden risks? Financial condition. Is the business financially sound?
  17. Every prospective business buyer should investigate the real reason the business owner wants to sell.
  18. A prospective buyer should evaluate the business’s assets to determine their true value. The buyer bases the valuation used to negotiate the deal on the financial statements provided by the seller. The buyer and the advising team must verify the actual value of the business through careful inspection of the business and its assets. Questions to ask about assets include these questions.
  19. Business buyers face myriad legal pitfalls. The most significant legal issues involve liens, contract assignments, covenants not to compete, and ongoing legal liabilities. The prospective buyer also should evaluate the terms of other contracts the seller has, including: Patent, trademark, or copyright registrations Exclusive agent or distributor contracts Insurance contracts Financing and loan arrangements Union contracts
  20. Any investment in a company should produce a reasonable salary for the owner and a healthy return on the money invested. Otherwise, purchasing the business makes no sense. Therefore, every serious buyer must analyze the records of the business to determine its true financial health.
  21. After conducting due diligence on a target business, an entrepreneur moves into the valuation stage. The valuation stage includes not only a valuation of the business but also signing a nondisclosure agreement.
  22. The balance sheet method establishes the value of a company by computing the book value of its net worth, or owner’s equity (Net worth = Assets − Liabilities. A common criticism of this technique is that it oversimplifies the valuation process. The problem with this technique is that it fails to recognize reality: Most small businesses have market values that exceed their reported book values.
  23. The earnings approach is an approach to valuation that finance professionals and experienced entrepreneurs prefer because it considers the future income potential of the business. That is what an entrepreneur really is buying with an existing business – its ability to generate returns on the investment into the future.
  24. The market (or price/earnings) approach uses the price/earnings ratios of similar businesses to estimate the value of a company. The buyer must use businesses whose stocks are publicly traded to get a meaningful comparison. A company’s price/earnings ratio (P/E ratio) is the price of one share of its common stock in the market divided by its earnings per share (after deducting preferred stock dividends). To get a representative P/E ratio, the buyer should average the P/Es of as many similar businesses as possible.
  25. This figure shows the most common valuation methods that business brokers use. Which of these methods is best for determining the value of a small business? Simply stated, there is no single best method. These techniques yield a range of values, but usually several of the values cluster together, giving the buyer useful guidance in determining an offering price. The final price will be based on both the valuation used and the negotiating skills of the parties.
  26. Once an entrepreneur has established a reasonable value for the business, the next step in making a successful purchase is negotiating a suitable deal. Most buyers do not realize that the price they pay for a company often is not as crucial to its continued success as the terms of the purchase.
  27. The final deal a buyer strikes depends, in large part, on his or her negotiating skills.
  28. This figure is an illustration of two individuals prepared to negotiate for the purchase and sale of a business. The buyer and seller both have high and low bargaining points in this example: The buyer would like to purchase the business for $900,000 but would not pay more than $1,300,000. The seller would like to get $1,500,000 for the business but would not take less than $1,000,000. If the seller insists on getting $1,500,000, she will not sell the business to this buyer. Likewise, if the buyer stands firm on an offer of $900,000, there will be no deal.
  29. These negotiating tips can help parties reach a mutually satisfying deal.
  30. The buyer seeks to realize the following goals: Get the business at the lowest price possible. Negotiate favorable payment terms, preferably over time. Get assurances that he is buying the business he thinks it is. Avoid enabling the seller to open a competing business. Minimize the amount of cash paid up front.
  31. The seller of the business is looking to accomplish the following goals: Get the highest price possible for the company. Sever all responsibility for the company’s liabilities. Avoid unreasonable contract terms that might limit future opportunities. Maximize the cash from the deal. Minimize the tax burden from the sale. Make sure the buyer will make all future payments.
  32. To make a negotiation work, the two sides must structure the deal in a way that is acceptable to both parties.
  33. A straight business sale may be best for a seller who wants to step down and turn over the reins of the company to someone else. A study of small business sales in 60 categories found that 94% were asset sales. In an asset sale, the seller keeps all liabilities – those that are on the books and any that might emerge in the future due to litigation. That is why buyers favor asset sales. The remaining 6% involved the sale of stock. About 22% were for cash, and 75% included a down payment with a note carried by the seller. The remaining 3% relied on a note from the seller with no down payment. When the deal included a down payment, it averaged 33% of the purchase price. Only 40% of the business sales studied included covenants not to compete.
  34. For owners wanting the security of a sales contract now but not wanting to step down from the company’s helm for several years, a two-step sale may be ideal. The buyer purchases the business in two phases, getting 20 to 70% immediately and agreeing to buy the remainder within a specific time period. Until the final transaction takes place, the original owner retains at least partial control of the company.
  35. Some owners who want to sell their businesses but keep them intact cash out by selling to their employees through an employee stock ownership plan (ESOP).
  36. This figure shows how a typical employee stock ownership plan works. The company transfers shares of its stock to the ESOP trust, and the trust uses the stock as collateral to borrow enough money to purchase the shares from the company. The company guarantees payment of the loan principal and interest and makes tax-deductible contributions to the trust to repay the loan (see Figure 7.9). As the company repays the loan, it distributes the stock to employees’ accounts, based on a predetermined formula.
  37. Once the buyer and seller have negotiated a deal, they put the details of the structure of the sale into a letter of intent.
  38. Once the deal stage is completed, the transition stage begins with the actual closing of the purchase. Closing the sale of a business is a complex legal process. Many deals fall apart at the closing table due to unforeseen surprises or last-minute legal maneuvering by either the buyer or the seller.
  39. Once the parties finalize the closing, the challenge of facilitating a smooth transition is next. No matter how well planned a sale, there are always surprises. To avoid a bumpy transition, a business buyer should do try these strategies.
  40. Rather than start a business “from scratch,” some entrepreneurs choose to take a faster, more direct route and purchase an existing business. The process is fraught with pitfalls, but a wellprepared entrepreneur can avoid them. Following the five-stage process described in this chapter increases the odds that an entrepreneur will find an existing business that suits his or her needs and be able to successfully negotiate an outstanding deal to purchase it.