Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall 7-1

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 7-2 Chapter 7

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Buying an existing business can help reduce risk for the entrepreneur  But, take your time!  Conduct a thorough analysis of the business and the opportunity it presents  Important questions:  Does the business meet your lifestyle and financial expectations?  Do you have the ability to operate the business successfully? 7-3

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Advantages of Buying an Existing Business  Business may continue to be successful  Leverage the experience of the previous owner  Owning a business guarantees a job  The turnkey business  Superior location  Employees and suppliers in place  Equipment installed with known production capacity  Inventory in place  Trade credit established  Easier access to financing  High value 7-4

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Disadvantages of Buying an Existing Business  Cash requirements  Business is losing money  Paying for “ill will”  Unsuitable employees  Unsatisfactory location  Obsolete or inefficient equipment and facilities  Customers may be loyal to previous owner  Change may be challenging to implement  Obsolete inventory  Value of accounts receivable  Business is overpriced 7-5

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 7-6 Valuing Accounts Receivable

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 7-7 Process of Buying a Business

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Four steps to conduct an effective search for the right business to buy: 1.Conduct a self-inventory 2.Develop a list of the key criteria that define the “ideal business” 3.Seek help to develop a list of potential candidates for acquisitions that meet your criteria 4.Investigate the potential acquisition targets that best meet your criteria 7-8

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 1.Self-Inventory  Conducting a self-inventory beforehand will help the entrepreneur develop a list of criteria that a company must meet before it becomes a purchase candidate 7-9

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 2.Develop a List of Criteria  Identify the characteristics of the “ideal business” to focus on the viable candidates 7-10

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 3.Potential Candidates  Begin the search using:  The Internet  Bankers  Accountants  Attorneys  Investment bankers  Trade associations  Contacting owners  Newspapers and trade journals  Networking 7-11

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 4.Investigation  Research the customer base  Existing and potential customers  Competitor analysis  Direct competitors  Level of competition  Motivation of the seller  Real reason for selling  Review finances  At least three years of performance 7-12

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  The deal stage includes:  Valuing the business  Formalizing the financing of the purchase  Negotiating details  Letter of intent  Due diligence 7-13

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Methods for Determining the Value of a Business  Assessing tangible assets is usually straightforward  Valuing intangible assets is difficult  Goodwill  No single best method for determining value  Consider using several  Deal must work for both parties 7-14

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall Selling prices of Private Companies

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Three basic techniques to determine value: 1.Balance Sheet Technique  Variation: Adjusted Balance Sheet Technique 2.Earnings Approach  Variation 1: Adjusted Earnings Approach  Variation 2: Excess Earnings Approach  Variation 3: Capitalized Earnings Approach  Variation 4: Discounted Future Earnings Approach 3.Market Approach 7-16

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 1.Balance Sheet Technique  Computes the book value of the company’s net worth or owners equity 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,

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 2.Earnings approach  Considers future income potential  Variation 1: Adjusted earnings method  Start with EBITDA 7-18

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 2.Earnings approach  Considers future income potential  Variation 2: Excess earnings method  Estimates goodwill 1.Compute adjusted tangible net worth 2.Calculate the opportunity cost of investing in the business 3.Project net earnings 4.Compute extra earning power 5.Estimate the value of intangibles 6.Determine the value of the business 7-19

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 2.Earnings approach  Considers future income potential  Variation 3: Capitalized earnings approach  Divides estimated net earnings by the rate of return that reflects the risk level 7-20

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 2.Earnings approach  Considers future income potential  Variation 4: Discounted future earnings approach 1.Project earnings for five years into the future 2.Discount these future earnings using the appropriate present value factor 3.Estimate the growth stream beyond five years 4.Discount the income estimate beyond five years using the present value factor for the sixth year 5.Computer the total value of the business 7-21

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 3.Market approach  Uses the price/earnings ratios of similar businesses to establish value 7-22

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 3.Market approach  Disadvantages:  Necessary comparisons between publicly traded and privately owned companies  Unrepresentative earnings estimates  Finding similar companies for comparison  Applying the after-tax earnings of a private company to determine its value 7-23

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  The best method?  There is no single best method  The final price will be based on the valuation used and the negotiating skills of both parties 7-24

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Negotiating the Deal  The structure of the deal – the terms and conditions of payment – is more important than the actual price the seller agrees to  The ‘art of the deal’  Both parties need to work to achieve their goals, while making concessions to keep the negotiations alive 7-25

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall Identifying the Bargaining Zone

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Negotiating tips to help reach a mutually satisfying deal: 1.Establish the proper mindset 2.Know what you want to have when you walk away from the table 3.Develop a negotiating strategy 4.Recognize the other party’s needs 5.Be an empathetic listener 7-27

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 6.Avoid seeing the other side as “the enemy” 7.Educate, don’t intimidate 8.Be creative 9.Keep emotions in check 10.Be patient 11.Don’t become a victim 12.Remember that “no deal” is an option 7-28

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  The Buyer’s 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. 7-29

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  The Seller’s 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 7-30

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  The structure of the deal  Straight business sale  Often the safest exit for an entrepreneur  Usually the most expensive option  Seller must be willing to finance part of the purchase price  Use a two-step sale  Business is purchased in two phases 7-31

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Letter of Intent  A firm commitment by both sides that they are ready to move toward closing the sale  Only 25% of deals make it from the letter of intent to the final closing 7-32

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  The Due Diligence Process  Involves investigating three critical areas of the business and the potential deal beyond those already evaluated earlier in the search and deal processes: 1.Confirming valuation: What is the real value of the business? 2.Legal issues: What legal aspects of the business are known or hidden risks? 3.Financial state: Is the business financially sound? 7-33

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 1.Confirming valuation  Are the assets really useful, or are they obsolete?  Will the assets require replacement soon?  Do the assets operate efficiently?  Book value is not the same as market value  Other factors:  Accounts receivable  Lease arrangements  Business records  Intangible assets  Location and appearance 7-34

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 2.Legal issues  Liens  Contract assignments  Due-on-sale clauses  Covenants not to compete  Ongoing legal liabilities  Physical premises  Product liability claims  Product liability lawsuits  Labor relations 7-35

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 3.Financial state  Income statement and balance sheet for at least three years  Income tax return for at least three years  Cash flow  Be wary if the seller refuses to disclose financial records! 7-36

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Closing the sale of a business is a complex legal process  Closing documents include:  Asset purchase agreement  Bill of sale  Asset list  Buyer’s disclosure statement  Allocation of purchase price  Non-compete agreement  Consulting/Training agreement  Transfer of subsidiaries associated with business 7-37

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  Transfer of utilities  Transfer of Web sites, social media addresses, and phone numbers  Documentation of new entity that will own the business and documentation of new bank account for that business  Transfer of merchant accounts  Notice to creditors  Lease assignments 7-38

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  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 7-39

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall.  To smooth the transition, a buyer should:  Concentrate on communicating with employees  Be honest with employees  Listen to employees  Devote time to selling the vision for the company to key stakeholders  Consider asking the seller to serve as a consultant until the transition is complete 7-40

Copyright © 2015 Pearson Education, Inc. publishing as Prentice Hall. 7-41