Chapter 22-1 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Family Enterprise, Start-up, and Buyout Opportunities 2 PowerPont prepared by Thomas M c Kaig, Ryerson University

Chapter 22-2 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Looking Ahead After studying this chapter, you should be able to: 1.Give three reasons for starting a new business rather than buying an existing firm or acquiring a franchise. 2.Distinguish the different types and sources of start-up ideas. 3.Identify five factors that determine whether an idea is a good investment opportunity. 4.List some reasons for buying an existing business. 5.Summarize four basic approaches for determining a fair value for a business.

Chapter 22-3 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Looking Ahead 6.Describe the factors that make a family business unique. 7.Identify the management practices that enable a family business to function effectively. 8.Describe the process of managerial succession in a family firm. 9.Analyze the major issues involved in the transfer of ownership to succeeding generations. 10.Describe the characteristics of highly successful start-up companies.

Chapter 22-4 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Two Paths to Entrepreneurship Start-up Creating a new business from scratch Buyout Purchasing an existing business

Chapter 22-5 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Alternative Routes to Small Business Ownership Figure 2-1

Chapter 22-6 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Types of Ideas that Develop into Start-ups Figure 2-2

Chapter 22-7 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Kinds of Start-up Ideas Type A  Start-up ideas centered around providing customers with an existing product not available in their market Type B  Start-up ideas, involving new ideas, involving new technology, centered around providing customers with a new product Type C  Start-up ideas centered around providing customers with an improved product

Chapter 22-8 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Sources of Start-up Ideas Figure 2-3

Chapter 22-9 Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Identifying and Evaluating Investment Opportunities “ Start-ups with products that do not serve clear and important needs cannot expect to be ‘discovered’ by enough customers to make a difference.”—Amar Bhide Infatuation with an idea may lead to an underestimation of the difficulty of developing market receptivity and building a firm to capture the opportunity. …continued

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Identifying and Evaluating Investment Opportunities 1.There must be a clearly defined market. 2.Proposed business must be able to achieve durable or sustainable competitive advantage. 3.Economics of the venture must be rewarding. 4.Good fit between entrepreneur and opportunity. 5.There must be no fatal flaw in the venture.

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Evaluation Criteria for a start-up Marketing Factors  Need for product Identified or unfocused  Customers Reachable or not, brand loyal  Value created for customer Significant or insignificant  Life of product Recovery of cost by customer …continued

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Evaluation Criteria for a Start-up Marketing Factors (cont’d)  Market structure Emerging or mature  Market size (known or unknown?)  Market growth (how fast?) Competitive Advantage  Cost structure  Degree of control over: price, costs, channels of supply  Barriers to entry: regulatory protection, response/lead- time advantage, legal, contacts and networks

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Refining a Start-up Idea Start-up ideas require an extended period of time for refinement and testing Most new business ideas deserve careful study and typically require modification. The need to refine an idea is the basis for small business incubation centres.

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Reasons for Buying an Existing Business 1.To reduce some of the uncertainties and unknowns that must be faced in starting a business from the ground up. 2.To acquire a business with ongoing operations and established relationships. 3.To obtain an established business at a price below what it would cost to start a new business.

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Finding an Existing Business to Buy Relying on Professionals  Matchmakers  Accountants  Lawyers  Other experienced business owners

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Pros and Cons of Buying an Existing Business Pros  High chance of success  Less planning  Existing customers/ suppliers  Necessary equipment  Bargain price  Experienced employees  Existing business records Cons  Existing problems  Poor quality of current employees  Poor business image  Modernization required  Purchase price based on inaccurate data  Poor business location

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Finding Out Why the Business Is For Sale Owner’s reasons for selling the business  Old age or illness  Desire to relocate in a different section of the country  Opportunity to start another business  Decision to accept a position with another company  Unprofitability of the business  Discontinuance of an exclusive sales franchise  Maturation of the industry and lack of growth potential

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Examining the Financial Data 1.Review financial statements and tax returns for the past five years. 2.Recognize that financial data can be misleading.  Assets overvalued  Expenses overstated/understated  Income underreported  Unrecorded debts

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Income Statement as Adjusted by Prospective Buyer Fig. 2-4 Figure 2-4

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Valuation of the Business Asset-Based Valuation  Estimates the value of the firm’s assets; does not reflect the value of the firm as a going concern. Market-Based Valuation  Considers the sale prices of comparable firms; difficulty is in finding comparable firms. Cash-Flow-Based Valuation  Compares the expected and required rates of return on the amount of capital to be invested in the business.

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Asset-Based Valuation Modified Book Value Technique  Historical value of firm’s assets is adjusted to reflect current market values. Replacement Value Technique  Value of firm’s assets is adjusted to reflect current costs to replace the assets. Liquidation Value Technique  Value of firm’s assets is adjusted to reflect their value if the firm ceased operations and disposed of the assets.

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Earnings-Based Valuation Earnings Multiple (Value-to-Earnings) Ratio  Determine normalized earnings, and  Divide this amount by a capitalization rate.  Normalized earnings are earnings that have been adjusted for any usual items such as fire damage. Capitalization Rate Normalized Earnings Firm’s Value =

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Risk High Low High Capitalization Rate Low Firm Value High Firm Value Projected Growth High Low High Firm Value Low Firm Value Determinants of a Firm’s Capitalization Rate High Capitalization Rate Low Capitalization Rate Low Capitalization Rate Figure 2-5

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Cash Flow-Based Valuation 1.Estimate the future cash flows that can be expected by the investor. 2.Decide on the investor’s required rate of return.

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Risk Premium The difference between the required rate of return on a given investment and the risk-free rate of return Required rate of return =  Risk free rate of return + Risk Premium Table 2-2 lists suggested risk premium categories

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Nonquantitative Factors in Valuing a Business Competition Market Future Community Development Legal Commitments Union Contracts Buildings Product Prices

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Negotiating and Closing the Deal Terms of Purchase  Assets purchase or total entity  Indemnification clause  Payment in full or partial payments over time Closing the sale  Best handled by a third party Bill of sale Tax certifications Payment-to-seller agreements and guarantees

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. What Is a Family Business? Family Business  A company in whose ownership and/or functioning two or more members of the same family are directly involved.  A firm whose ownership passes from one generation of a family to another Smith Family Hardware Est Welcome

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Family and Business Overlap Family Concerns  Care and nurturing of family members  Employment and advancement in the firm  Loyalty to the family Business Concerns  Production and distribution of goods and/or services  Need for professional management  Effective and efficient operation of the firm

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Concerns The Overlap of Family and Business Concerns Figure 2-6

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Special Features of Family Firm Management Family concerns  Nurturing  Development Business concerns  Profitability  Survival

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. The Culture of a Family Business Organizational Culture  Patterns of behaviours and beliefs that characterized a particular firm Cultural Configuration  The total culture of a family firm, consisting of the firm’s business, family, and governance patterns

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Founder’s Imprint on Culture The distinctive values that motivate and guide an entrepreneur in the founding of a firm may help to create a competitive advantage for the new firm.  For example, the founder could have a special way of delivering customer service.  The founder’s core values and business ethics will likely permeate the growing organization.

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. The Need for Good Management A family firm must be able to rely on competence of its professional and managerial personnel Favouritism in personnel decisions must be avoided Plans for succession, steps in professional development, and intentions regarding changes in ownership must be discussed openly.

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Nonfamily Employees in a Family Firm The issue for a parent is to decide if an outsider will be promoted over a family member The potential for promotion for an outsider could be limited, and they may experience a sense of unfairness and frustration. …continued

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Nonfamily Employees in a Family Firm  Hazards: Competition with family members for advancement Getting caught in the crossfire and politics of family competition within the firm  Solution: Identify family-only reserved positions in advance. Treat both family and nonfamily employees fairly in matters of reward and promotion.

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Family Councils An organized group of family members who gather periodically to discuss family-related business issues Function as the organization and strategic planning arm of a family Family members discuss values and policies and directions for the future

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. CAFE Canadian Association of Family Enterprise (CAFE) is a national not-for-profit association dedicated to research, education, and assistance for family businesses. CAFE has local chapters in most Canadian cities

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. The Process of Leadership Succession Available Family Talent  Mentoring Guiding and supporting the work and development of a new or less- experienced organization member.  Allowing only qualified competent family members to assume leadership roles in the firm increases the value of the firm for all who have an ownership interest in it.

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Source: Adapted from Justin G. Longenecker and John E. Schoen, “Management Succession in the Family Business,” Journal of Small Business Management, Vol. 16 (July 1978), pp. 1–6. A Model of Succession in a Family Business Figure 2-7

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Transfer of Ownership The final step in conveyance of power from parent to child is distribution of ownership of the family business. In distributing their estate, parent-owners typically wish to treat all their children fairly, both those involved in the business and those on the outside.

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Conditions Favouring Successful Leadership Succession in a Family Firm A sound, profitable business Stable, healthy family relationships Advance planning for leadership succession Positive family leadership and a team-oriented management structure Presentation of career opportunities without pressure Open communication on family business issues

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. Characteristics of Successful High-Growth Start-ups Begin as a team effort Are in service and manufacturing industries Have competent founders who:  have related experience.  have started other businesses.  share in ownership of business. Are somewhat better financed Do not limit themselves to local markets

Chapter Copyright © 2003 by Nelson, a division of Thomson Canada Limited. 10 Lessons for Growing Companies “Never settle for second best” “Use relationships to tap export markets” “Play to win, win, win” “Beg, borrow, or steal” “Create product synergies” “Ride the edge” “Let your employees do the thinking” “Raise the barriers” “Never stand still” “Look five years out”