Section I - The Challenges of Entrepreneurship



Chapter 7 Buying an Existing Business

Part 1: Learning Objectives

1. Understand the advantages and disadvantages of buying an existing business.

2. Define the steps involved in the right way to buy a business.

3. Explain the process of evaluating an existing business.

4. Describe the various techniques for determining the value of a business.

5. Understand the seller's side of the buyout decision and how to structure the deal.

6. Understand how the negotiation process works and identify the factors that affect the negotiation process.

Part 2: Class Instruction

Introduction

Some entrepreneurs choose to buy existing businesses rather than start their own. In a typical year, between 500,000 to one million businesses are bought and sold. Purchasing an established business can offer many advantages—if the entrepreneur knows what they are really buying and if the business is priced right.

Buying an Existing Business LO 1

A prospective owner must ask several key questions before buying an existing business.

• Is it the right type of business for the market?

• What experience do I bring to the venture?

• What is the success potential?

• What changes are needed—and how extensive are they—to realize the full potential of the value of the business?

People buy businesses for different reasons. As described in Figure 7.1: Types of Business Buyers, we can categorize buyers into four areas:

1. Main street buyers

2. Corporate refugees

3. Serial entrepreneurs

4. Financial buyers

Figure 7.1: Types of Business Buyers on page 232 presents four profiles of main street, corporate refugees, serial entrepreneurs and financial buyers.

Advantages of buying an existing business include:

• A successful existing business may continue to be successful.

• An existing business may already have the best location.

• Employees and suppliers are established.

• Equipment is installed and productive capacity is known.

• Inventory is in place and trade credit is established.

• The new business owner hits the ground running.

• The new owner can use the experience of the previous owner.

• Easier financing.

• It's a bargain (maybe?).

Disadvantages of buying an existing business include:

• It's a loser (maybe?).

• The previous owner may have created ill will.

• The business location may have become/is unsatisfactory.

• Equipment and facilities may be obsolete or inefficient.

• Change and innovation are difficult to implement.

• Inventory may be outdated or obsolete.

• Accounts receivable may be worth less than face value. Figure 7.1

• Changes may be difficult to implement.

• Inventory may be stale.

• Accounts payable may be worth more than face value.

• The business may be overpriced.

Steps in Acquiring a Business LO 2

More than half of business acquisitions fail to meet the buyers’ expectations. The correct way to evaluate a match is to:

• Analyze your skills, abilities.

• Develop a list of criteria

• Prepare a list of potential candidates.

• Investigate and evaluate candidate businesses and evaluate the best one.

• Explore financing options—the seller is a potential source.

• Negotiate a reasonable deal with the owner

• Ensure a smooth transition—communicate with employees, listen and ask questions.

Evaluating an Existing Business: The Due Diligence Process LO 3

A potential buyer should explore a business opportunity by examining five critical areas.

1. Motivation: Why does the owner want to sell?

There are many reasons business owners plan to sell their companies and knowing that motivation will be beneficial to the buyer.

2. Asset valuation: Assess the physical condition of the business:

• Accounts receivable

• Lease arrangements

• Business records

• Intangible assets

• Location and appearance

3. Market potential: What is the potential for the company's products or services?

• Product line status

• Potential for company’s products or services

• Customer characteristics and composition

• Competitor characteristics and composition

4. Legal issues: What legal aspects should you consider?

• Liens

• Bulk transfers

• Contract assignments

• Covenants not to compete

• Ongoing legal liabilities

5. Financial condition: Is the business financially sound?

• Income statements and balance sheets for past 3-5 years

• Income tax returns for the past 3-5 years

• Owner's compensation (relatives, skimming)

• Cash flow

The acquisition process involves seven key steps as described in Figure 7.2: The Acquisition Process on page 247:

1. Identify and approach the candidate

2. Sign the nondisclosure statement

3. Sign the letter of intent (LOI)

4. Buyer’s due diligence investigation

5. Draft the purchase agreement

6. Close the final deal

7. Begin the transition

Methods for Determining the Value of a Business LO 4

Business valuation is partly an art and partly a science. Establishing a price for a privately held business may be difficult due to the nature of the business itself. Goodwill may be a key consideration.

There are a few rules for establishing the value of a business:

• There is no single best method to determine a business's worth. The best way is to compute the value using different methods and choose the one that justifiably results in a realistic value.

• Both parties, buyer and seller, must be satisfied with the deal.

• Both the buyer and seller should have access to business records.

• Valuations should be based on facts, not fiction.

• Both parties should deal with one another honestly and in good faith.

Business valuation techniques include:

The basic balance sheet methods offer two techniques:

The balance sheet technique

Adjusted balance sheet technique

Earnings approach with three variations:

Variation 1: Excess earnings method

Variation 2: Capitalized earnings approach

Variation 3: Discounted future earnings approach

Market approach

We will now address each of these earnings approaches.

The balance sheet technique determines “book value” of net worth by subtracting total liabilities from total assets.

The earnings approach has three variations. The first variation, the excess earning method, includes six steps:

1. Computing the adjusted tangible net worth

2. Calculating the opportunity cost of investing

3. Projecting earnings for the next year

4. Computing extra earning power (EEP)

5. Estimating the value of the “goodwill” intangibles

6. Determining the value of the business

The capitalized earnings method is a second variation. This method is based on the net earnings after deducting the owner’s salary over the rate of return.

The discounted future earnings method is a third variation and five steps are a part of this technique.

1. Forecasts projected earnings for five years.

2. Discount these projections based on a weighted average of future earnings at the appropriate present value rate.

3. Estimate the earnings stream beyond five years.

4. Discount this estimate using the present value factor for year 6.

5. Compute the value of the business.

The market approach involves two steps:

1. Computes the average price earnings (P-E) ratio for as many similar businesses as possible.

2. Multiplies the average P-E ratio by next year’s forecasted earnings.

Understanding the Seller's Side

A recent study found that 64 percent of closely held companies expect to sell their businesses within three years.

Structuring the deal is one of the most important decisions a seller can make. Tax implications can be significant; therefore, a skilled tax planner can help.

Exit strategy options include:

• Straight business sale

• Sale of controlling interest or a variation called an earn-out

• Form a family limited partnership

• Sell a controlling interest

• Earn-out

• Restructure the company

• Sell to an international buyer

• Establish an employee stock ownership plan (ESOP)

Negotiating the Deal LO 6

Factors affecting the negotiation process involve:

• How strong is the seller's desire to sell?

• Is seller willing to finance part of purchase price?

• Must the seller close the deal quickly?

• What deal structure fits your needs?

• What are tax consequences for both parties?

• Is seller willing to stay on as a consultant?

• What general economic conditions exist in the industry?

Buyers have specific criteria they look for. They want to get the business at the most attractive price possible with favorable payment terms that minimize the amount of cash they pay up front.

Seller are seeking the highest price possible with the most desirable terms to maximize the cash they receive and minimize their tax burden.

The Five Ps of Negotiating include:

1. Preparation

2. Poise

3. Persuasiveness

4. Persistence

5. Patience

Conclusion

There are distinct advantages and disadvantages of buying an existing business. Following the appropriate steps will improve the changes of success. The valuation of the business is a critical step to negotiate an arrangement that works for both parties.

Part 3: Chapter Exercises

You Be the Consultant: “The Saga of Selling My Business: Part 1” pages 236

1. Is the deal that Brodsky and DC Ventures are working on typical of most business sales? Is it common for buyers and sellers to determine the value of a company by using a multiple of earnings? What are the advantage and the disadvantages of using this approach?

The earnings approach focuses on the future income potential of a business. Because this method assumes that a company’s value depends on its ability to generate consistent earnings over time, it may apply in situations where earnings, versus assets for example, are a key factor. Some type of earnings multiplier may be attractive to prospective business buyers because it relates to the motive to make money and achieve a satisfactory return on investment.

This method can be an advantage as it reflects earnings potential. A potential disadvantage is determining which figure is going to apply. Is it last year's earnings, this year's, next year's, or the last five-year’s earnings average? This decision drives the numbers and is a critical component to achieving the seller’s objective.

2. Brodsky says, “Therein lays the paradox? The less interest you have in doing a deal, the more likely you are to get on you’ll find difficult to refuse.” What does he mean? Do you agree?

Expect student to appreciate the fact that the seller’s motivation – or lack or – has on the sale of the business. An unmotivated or disinterested seller may experience a higher price from the buyer. This lack of interest plays an influential role in negotiations when the seller does not have a stake in closing the deal. Look for students to support of their chosen position.

3. Brodsky also says, “One thing I can be pretty sure of: I will never get a deal like this again.” How does that mindset affect an entrepreneur’s decision to sell his or her company?

This may be an influencing factor to make the deal happen and not miss this once-in-a-lifetime opportunity. This factor may increase the interest and motivation to sell.

4. Is it typical for a business owner to ask a prospective buyer to sign a confidentiality agreement before opening up his or her business to the buyer? Explain.

It is wise for the business owner to require a confidentiality agreement before sharing internal business information. The potential owner may become a new competitor. The deal may not come to fruition and the former buyer may be taking with competitors in the near future.

You Be the Consultant: “The Saga of Selling My Business: Part II” pages 248

1. Why is it important for business buyers to be thorough when conducting their due diligence of a company they are considering purchasing?

Business buyers must know as much as possible about the business. For most entrepreneurs, the purchase of the business will become a key part of their life. Knowledge before the purchase will help to assess expenses, revenues, current value, business potential, and better equip them to understand the commitment ahead.

2. Brodsky followed a “wart and all” policy with CD Ventures and Nova Records Management during due diligence. How typical is his approach among business sellers? Explain your reasoning.

Brodsky demonstrates an “honesty is the best policy” approach. Expect some students to consider that Brodsky’s transparency may be unusual while in the “selling mode.” Most may expect that a “put your best foot forward” approach emphasizing only the positive attributes may lead to a higher purchase price. Brodsky demonstrates that full disclosure builds trust before, during, and after the transaction.

3. Often deal such as the one Brodsky is involved in fall through at the end and are never completed. Do you see any potential deal breakers in the sale of CitiStorage?

Potential deal breakers may include:

• Lack of financing

• A downturn in the market

• Competitive actions that pose a substantial threat

• Key personal transitions on either they buyer or seller’s side of the deal

• A radical change in earning that may impact the perceived value of the venture

You Be the Consultant: “The Saga of Selling My Business: Part 3” pages 265-266

1. How important is the ability to trust the other party in a business sale? Why?

Trust is critical in a transaction of this nature. Even with full disclosure, being able to trust information and the future actions of those involved is critical before, during, and after the transaction.

2. One negotiating expert advises, “Never try to extract the last drop of blood in a negotiation. Do not leave the other person feeling as if they have been cheated. Did Nova violate this negotiation principle? If so, what repercussions did doing so have on the final deal?

Nova’s action to cut the price was unexpected and not appreciated by Brodsky. Regardless of its intent, Brodsky considers the lower offer as a negotiation tactic. It is advantageous for all to feel that they have experience a “fair” deal. In this case, the Nova's tactic resulted in Brodsky losing trust and the ultimate demise of the deal

3. What emotional issues do entrepreneurs face after they sell the companies the founded? What advice would you give Brodsky to fill the hole in his life after selling his company?

Many entrepreneurs develop an emotional connection with their businesses. The business may become more than just their professional identity, but a part of their personal identity as well. The entrepreneur may find this a difficult transition, regardless of the monetary rewards they realize.

Expect student to provide a variety of options for Brodsky. For example, students may advise Brodsky to take some time away from a work setting, appreciate and enjoy the conclusion of the accomplishment, and then map out what may be next in his personal and business life.

Part 4: Chapter Discussion Questions

1. What advantages can an entrepreneur who buys a business gain over one who starts a business “from scratch”? (LO 1)

The advantages of buying an existing business may include:

• A Successful Existing Business May Continue to Be Successful: Buying a thriving business increases the likelihood of success building upon an established customer base, supplier relationships, and business system. The new owner benefits from these important business factors already in place.

• An Existing Business May Already Have the Best Location: If the location of a business is critical to its success, it may be wise to purchase a business that is already strategically located.

• Equipment Is Installed and Productive Capacity Is Known: The buyer does not have to invest in equipment, and the previous owner may have established an efficient production operation. Thus, the new owner can use these savings in time and money to improve and expand the existing equipment and procedures.

• Inventory Is in Place and Trade Credit is Established: Establishing the right amount of inventory can be costly. If there is too little inventory, customer demand cannot be satisfied. If too much is available, excessive capital is tied up, costs are increased, and profits decrease. There is a tremendous advantage if previous owners have established a balance in inventory. In addition, a proven track record gives the new owner leverage in negotiating credit concessions.

• Experience of Previous Owner: If the previous owner is around, the new owner can benefit from his/her expertise. Even if the owner is not present, business records can guide the new owner.

• It's a Bargain: If the owner needs to sell on short notice, wants a substantial down payment in cash, or the business requires special skills, the number of buyers will be small, which may lead the owner to sell at a lower price.

2. How would you go about determining the value of the assets of a business if you were unfamiliar with them? (LO 3)

When evaluating an existing business, a potential buyer should assemble a team of specialists to help in determining the potential business opportunity. The team is usually composed of a banker, an accountant familiar with the industry, an attorney, and perhaps a small business consultant or business broker. Company records, interviews with management, and particularly financial statements will help the potential owner and the team of specialists to identify the assets. Once the assets are identified, it may be necessary to hire a professional to assess value to the major components of the building—structure; plumbing, heating, and cooling system; as well as inventory.

3. Why do so many entrepreneurs run into trouble when they buy an existing business? Outline the steps involved in the right way to buy a business. (LO 2)

Buying an existing business can be risky if approached haphazardly. To avoid costly mistakes, an entrepreneur should follow a logical, methodical approach that may include the following:

• Analyze your skills, abilities, and interests: Consider what business activities you enjoy most, what kind of business you want to buy, what you expect from the business, and how much time and energy you have to invest.

• Prepare a list of potential candidates: Examine businesses for sale, as well as those that may be in the “hidden market.”

• Investigate and evaluate candidate businesses and choose the best one: Investigate potential candidates in more detail. Perform a SWOT analysis on each. Examine company financial statements.

• Explore financing options: Consider the options for financing. Often, financing for an existing business is easier than for a new one. Although many traditional lenders shy away from deals involving purchases of existing business and others only lend a portion of the assets, most buyers still have access to a ready source of financing—the seller. Many times, the seller will finance anywhere from 30 to 80 percent of the purchase.

• Ensure a smooth transition: To avoid a bumpy transition, the business buyer should: concentrate on communicating with employees; be frank, open, and honest with employees; listen to employees—they have knowledge of the business—and consider asking the seller to serve as a consultant until the transition is complete.

4. When evaluating an existing business that is for sale, what areas should an entrepreneur consider? Briefly summarize the key elements of each area.

(LO 3)

When evaluating an existing business, a potential buyer should explore a business opportunity by answering these five critical questions.

1. Why does the owner want to sell? Every prospective business buyer should investigate the real reason the owner wants to sell.

2. What is the physical condition of the business? What are the current conditions of the businesses assets, their expected life, and/or anticipated maintenance costs of the building and equipment.

3. What is the potential for the company's products or services? Does the business offer the promise of greater potential once you have control?

4. What legal aspects should you consider? Are there potential future legal concerns that you may need to address?

5. Is the business financially sound? What do their financial statements tell you about the venture and do they seem to be accurate?

5. What is goodwill? How should a buyer evaluate a business's goodwill? (LO 4)

Goodwill is a financial term for the reputation of the business and its ability to attract customers based on that reputation. Goodwill has a value, but it is very difficult to determine in a precise manner. The earnings approach to the valuation of a firm offers some help on valuing goodwill.

One measure of goodwill is the difference between a reasonable expected return on investment and what you purchase the business for. Another measure is the difference between the value of the assets of the business and what you pay for it.

6. What is a restrictive covenant? Is it fair to ask the seller of a travel agency located in a small town to sign a restrictive covenant for one year covering a twenty-square-mile area? Explain. (LO 5)

Under a restrictive covenant, the seller agrees not to open a new competing store within a specific time period and geographic area. The covenant must be negotiated with the owner and not the corporation to bind the owner. The covenant must be part of a business sale and must be reasonable in scope in order to be enforceable. As for the restrictive covenant of a travel agency in a small town, the answer depends on several factors. If this is the only travel agency, it appears that restricting a new one would create a monopoly, thus, the covenant probably would not be reasonable. In addition, while the term of one year seems to be reasonable, the term of the twenty-square-mile area may or may not be reasonable depending on the size of the town, and the possibilities of a new travel agency being built in the next town.

7. How much negative information can you expect the seller to give you about the business? How can a prospective buyer find out such information? (LO 5)

Although the seller cannot lie about the facts or mislead the seller, do not expect the seller to disclose anything negative about the business. The sale of a business is based on the old concept of “buyer beware.” Two key steps a potential buyer should take in order to find out such “negative” information are reviewing business records and interviewing/questioning management, legal council, and others.

8. Why is it so difficult for buyers and sellers to agree on a price for a business? (LO 5)

The negotiation process between the buyer and seller appears to be adversarial. The selling party usually wants the “maximum” financial gain from his business; on the other hand, while the buyer wants to buy a good business, he wants to pay the “minimum.” These two forces pull against one another. It may require making concessions and take time to find an acceptable price for both.

9. Which method of valuing a business is best? Why? What advice would you offer someone who is negotiating to buy a business about determine its value? (LO 5)

There is no “best” method for determining the value of a business; each method has advantages and disadvantages and some are more appropriate than others under different circumstances. All available methods should be considered as an aid to determining a truly fair price.

Potential areas of advice may include:

• Compute the value using different business valuation methods – based on information – and choose the method that justifiably results in a realistic value.

• Inquire about access to business records and is access is too limited, that will be a deal breaker.

• Determine if both parties, buyer and seller, will be potentially satisfied with the deal and can deal with one another honestly and in good faith

10. Outline the different exit strategy options available to a seller. (LO 5)

Existing strategy options include:

• Straight business sale: Selling a business outright.

• Form a family limited partnership: Entrepreneur takes the role of general partner with the children becoming limited partners in the business.

• Sell a controlling interest: Sell majority interest in companies to investors, competitors, suppliers, or large companies with an agreement they will stay on after the sale as managers or consultants.

• Restructure the company: Replace the existing corporation with a new one, formed with other investors.

• Sell to an international buyer: Sell to foreign buyer(s).

• Use a two-step sale: Allows the buyer to purchase the business in two phases. For example, getting 20 percent-70 percent today and agreeing to buy the remainder within a specific time period. The entrepreneur retains at least partial control of the company until the final transaction take place.

• Establish an employee stock ownership plan: A plan in which a trust is created for employees to purchase their employers' stock.

11. What tips would you offer someone about to enter into negotiations to buy a business? (LO 6)

Students may take an approach to develop recommendations that may include these ideas.

• Enlist the skills of a professional to establish a value for the business before negotiations begin.

• Bring in a third party to moderate the negotiation and transaction.

• Explore all financing options with the mutual goals of the buyer and seller in mind.

• Outline a transition plan that will be optimal for seller, the buyer, and employees.

• Document the terms and conditions of the sale.

Another response is to apply the five Ps of a successful negotiation process. This includes:

1. Poise: Remain clam during the negotiation

2. Patience: Don’t be such in a hurry to close the deal that you end up giving up much of what is important to you.

3. Persuasiveness: Know what your most important positions are, articulate them and offer support for your position.

4. Preparation: Examine and appreciate the needs of both parties

5. Persistence: Don’t give in at the first sign of resistance to your position, especially if it is an issue that ranks high in your list of priorities.

12. One entrepreneur who recently purchased a business advises buyers to expect some surprises in the deal no matter how well prepared they may be. He says that every potential buyer must build some “wiggle room” into their plans to buy a company. What steps can a buyer take to ensure that he has sufficient “wiggle room”? (LO 6)

With sufficient planning and time, the five P’s of negotiations should create the opportunity and enough" room" to successfully negotiate and resolve concerns in the buyer’s favor. This approach optimizes the ability for both parties the chance to find a satisfactory solution.

Part 5: Case Studies

The following text case may be used for lecture and assignments for topics presented in this chapter.

• Case 9: Our Town America

Part 6: Online Videos and Podcasts

These online videos may enhance class discussion and provide additional insight for the chapter topics.

• 5 Questions to Ask Before Buying a Business 5:34 minutes



• Buying a Business 1:42 minutes



• Buying a Business – Bill Bartmann 5:31 minutes



• Buying an Existing Small Business 1:04 minutes



Links to additional online resources are available on the companion Web site at scarborough.

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