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)
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.
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.
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.
This figure shows a profile of the four major categories of buyers and their characteristics that business brokers have identified.
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.
Keep in mind that despite the advantages of buying an existing business, there are some disadvantages to the strategy.
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.
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.
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.
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.
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.
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.”
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.
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.
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?
Every prospective business buyer should investigate the real reason the business owner wants to sell.
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.
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
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.
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.
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.
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.
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.
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.
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.
The final deal a buyer strikes depends, in large part, on his or her negotiating skills.
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.
These negotiating tips can help parties reach a mutually satisfying deal.
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.
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.
To make a negotiation work, the two sides must structure the deal in a way that is acceptable to both parties.
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.
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.
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).
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.
Once the buyer and seller have negotiated a deal, they put the details of the structure of the sale into a letter of intent.
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.
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.
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.