1. part 3 PowerPoint Presentation by Charlie Cook Copyright © 2003South-Western College Publishing. All rights reserved. All rights reserved. Startups and Buyouts 5 Pursuing New Venture Opportunities 12e

2. Copyright © by South-Western College Publishing. All rights reserved. 5–25–2 Looking Ahead After studying this chapter, you should be able to: 1. Identify five factors that determine whether an idea is a good investment opportunity. 2. Give three reasons for starting a new business rather than buying an existing firm or acquiring a franchise. 3. Distinguish among the different types and sources of startup ideas. 4. List some reasons for buying an existing business. 5. Summarize four basic approaches for determining a fair value for a business. 6. Describe the characteristics of highly successful startups.

3. Copyright © by South-Western College Publishing. All rights reserved. 5–35–3 Identifying and Evaluating Investment Opportunities “Startups 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.

4. Copyright © by South-Western College Publishing. All rights reserved. 5–45–4 Is an Idea a Good Investment Opportunity? Is there a clearly defined market need for the product or service, and is the timing right? Can the proposed business achieve a durable or sustainable competitive advantage? Is the venture financially rewarding, and does it have significant profit and growth potential? Is there a good fit between the entrepreneur and the opportunity? Is there a fatal flaw in the venture that could make the business unsuccessful?

5. Copyright © by South-Western College Publishing. All rights reserved. 5–55–5 Two Paths to Entrepreneurship Startup Creating a new business from scratch Buyout Purchasing an existing business

6. Copyright © by South-Western College Publishing. All rights reserved. 5–65–6 Reasons for Starting a New Business Developing a commercial market for a recently invented or newly developed product or service. Taking advantage of available resources, ideal location, advances in equipment, employees, suppliers, and bankers Avoiding precedents, policies, procedures, and legal commitments of existing firms

7. Copyright © by South-Western College Publishing. All rights reserved. 5–75–7 Evaluation Criteria for a Startup 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

8. Copyright © by South-Western College Publishing. All rights reserved. 5–85–8 Evaluation Criteria for a Startup 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

9. Copyright © by South-Western College Publishing. All rights reserved. 5–95–9 Evaluation Criteria for a Startup Economics –Return on investment?  Investment requirements  Break-even point Management Capability –Diverse skills or solo entrepreneur with no related experience Fatal Flaws

10. Copyright © by South-Western College Publishing. All rights reserved. 5–10 Basic Questions about Startups What are the different types of startups you might consider? What are some sources for new ideas? How can you identify a genuine opportunity that creates value, for both the company and the company’s owners? How should you refine your idea? What might you do to increase your chances that the business will be successful?

11. Copyright © by South-Western College Publishing. All rights reserved. 5–11 Kinds of Startup Ideas Type A –Startup ideas centered around providing customers with an existing product not available in their market Type B –Startup ideas, involving new ideas, involving new technology, centered around providing customers with a new product Type C –Startup ideas centered around providing customers with an improved product

12. Copyright © by South-Western College Publishing. All rights reserved. 5–12 Fig. 5.1 Example: Targeting the "New Age" beverage market by selling soft drinks with nutritional value New Market Type A Ideas Example: Using high-tech computers to develop a simulated helicopter ride Type B Ideas New Technology Example: Developing a personal misting device to keep workers cool Type C Ideas New Benefit Types of Ideas that Develop into Startups

13. Copyright © by South-Western College Publishing. All rights reserved. 5–13 Fig. 5-2 Family Business 6% Friends/Relatives 5% Personal Interest/Hobby 16% Suggestion 7% Education/Courses 6% Chance Happening 11% Other 4% Prior Work Experience 45% Sources of Startup Ideas Source: Data developed and provided by the National Federation of Independent Business Foundation and sponsored by American Express Travel Related Services Company, Inc.

14. Copyright © by South-Western College Publishing. All rights reserved. 5–14 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 with customers and suppliers. 3.To obtain an established business at a price below what it would cost to start a new business.

15. Copyright © by South-Western College Publishing. All rights reserved. 5–15 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

16. Copyright © by South-Western College Publishing. All rights reserved. 5–16 Investigating and Evaluating Available Businesses Due Diligence –The exercise of prudence, such as would be expected of a reasonable person, in the careful evaluation of a business opportunity Relying on Professionals –Accountants –Attorneys –Other experienced business owners

17. Copyright © by South-Western College Publishing. All rights reserved. 5–17 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 –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

18. Copyright © by South-Western College Publishing. All rights reserved. 5–18 Examining the Financial Data 1.Review financial statements and tax returns for the past five years. 2.Recognize that financial data can be misleading. 1.Assets overvalued 2.Expenses overstated/understated 3.Income underreported 4.Unrecorded debts 3.Prepare adjusted adjusted statements to reflect the true state of the business.

19. Copyright © by South-Western College Publishing. All rights reserved. 5–19 Income Statement as Adjusted by Prospective Buyer Fig. 5-3

20. Copyright © by South-Western College Publishing. All rights reserved. 5–20 Valuing 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-Comparable 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.

21. Copyright © by South-Western College Publishing. All rights reserved. 5–21 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.

22. Copyright © by South-Western College Publishing. All rights reserved. 5–22 Market-Comparable Valuation Earnings Multiple (Value-to-Earnings) Ratio –Ratio is determined by dividing the firm’s value by its earnings. –Firm’s ratio is compared to representative ratios of recently-sold similar firms.

23. Copyright © by South-Western College Publishing. All rights reserved. 5–23 Suggested Risk Premium Categories 1 Established businesses with a strong trade position that are well financed, have depth in management, have stable past earnings, and whose future is highly predictable. 6 10% 2 Established businesses in a more competitive industry that are well financed, have depth in management, have stable past earnings, and whose future is fairly predictable. 11 15% 3 Businesses in a highly competitive industry that require little capital to enter, have no management depth, and have a high element of risk, although past record may be good. 16 20% 4 Small businesses that depend on the special skill of one or two people or large established businesses that are highly cyclical in nature. In both cases, future earnings may be expected to deviate widely from projections. 21 25% 5 Small “one-person” business of a personal services nature, where the transferability of the income stream is in question. 26 30% Risk PremiumDescriptionCategory

24. Copyright © by South-Western College Publishing. All rights reserved. 5–24 Fig. 5.4 Determinants of a Firm’s Earnings Multiple

25. Copyright © by South-Western College Publishing. All rights reserved. 5–25 Cash Flow-Based Valuation 1.Estimate the firm’s expected cash flows. 2.Compute the firm’s cost of capital—the investors’/owners’ required rate of return on investments in the firm. 3.Using the cost of capital, calculate the present value of the firm’s expected cash flows—the value of the firm.

26. Copyright © by South-Western College Publishing. All rights reserved. 5–26 Nonquantitative Factors in Valuing a Business Competition Market Future Community Development Legal Commitments Union Contracts Buildings Product Prices

27. Copyright © by South-Western College Publishing. All rights reserved. 5–27 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

28. Copyright © by South-Western College Publishing. All rights reserved. 5–28 Characteristics of Successful High-Growth Startups 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