Entrepreneurship 1: Lecture 9 Buying an Existing Business Avimanyu (Avi) Datta, Ph.D.
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Transcript of Entrepreneurship 1: Lecture 9 Buying an Existing Business Avimanyu (Avi) Datta, Ph.D.
Entrepreneurship 1: Lecture 9Buying an Existing Business
Avimanyu (Avi) Datta, Ph.D.
Why buy an existing business?May continue to be successful
Best location
Equipment installed
Hit the ground running
Use previous experience
Easier financing
Why buy an existing business?Established Customer base
Established customer base at present location
Supplier relationships already in place
Experienced Employees
Inventory is in place and trade credit is established
Why buy an existing business Less Risk◦ Starting a business brings with it the possibility of a critical
element in the operation of the enterprise being overlooked or not adequately addressed.
◦ With the purchase of an ongoing business, this kind of planning omission is less likely to occur.
Less time and effort◦ For a business to establish operations requires considerable
attention to a wide range of details.◦ The management of an existing business has developed
relationships and procedures that allow the business to operate
The Possibility of Buying at a Bargain Price◦ The prospective buyer of an organization can uncover candidates
for purchase that are under priced.◦ The likelihood of finding such a bargain depends on who is doing
the selling and the conditions under which the sale is made. ◦ NOTE: Buy a great Business when they are in financial distress.
Disadvantages of Buying a BusinessThe environment
◦ Some businesses are available for sale because they face a difficult set of problems.
◦ When these problems are outside the firm, a shrinking market for example, the outlook can be quite bleak.
Departure of the Current Owner◦ Many small firms have an existence that
is closely associated with the founder.◦ These businesses may suffer greatly with
the departure of the owner.
Disadvantages of Buying a BusinessInternal Problems
◦ One thing that is likely to prompt an owner to sell his/her business is difficulty with its current operations.
◦ Anyone who intends to buy a business with internal problems would be well advised to develop the means to cope with these problems before proceeding
Disadvantages of Buying a BusinessPrevious owner may have created ill will“Inherited” employees may be
unsuitableLocation may have become
unsatisfactoryEquipment may be obsoleteChanges can be difficult to implementInventory may be staleAccounts receivable may be worth less
than face valueIt may be overpriced
Key Questions to Consider Before Buying a Business
Is the right type of business for sale in the market in which you want to operate?
What experience do you have in this particular business and the industry in which it operates?
How critical is experience in the business to your ultimate success?
What price and payment method are reasonable for you and acceptable to the seller?
Key Questions to Consider Before Buying a Business
Should you start the business and build it from the ground up rather than buy an existing one?
What is the company’s potential for success?
What changes will you have to make – and how extensive will they have to be – to realize the business’s full potential?
Will the company generate sufficient cash flow to pay for itself and leave you with a suitable return on your investment?
Five Critical Areas for Analyzingan Existing Business1. Why does the owner want to sell.... the
real reason?2. What is the physical condition of the
business?3. What is the potential for the company's
products or services?• Customer characteristics and
composition.• Competitor analysis.
4. What legal aspects must I consider?5. Is the business financially sound?
Why Does the Owner want to sell
Why does the owner want to sell.How long has the business existed?
◦Who founded it?◦How many owners has it had?◦Why have others sold out?
What is the profit record?◦Is profit increasing or decreasing?◦What are the true reasons for the increase
or decrease?What is the condition of the
inventory?◦Are the goods new or obsolete
Why does the owner want to sell.Why does the present owner want to sell?
◦Where will he or she go?◦What is he or she going to do?◦What do people (customers, suppliers, local
citizens) think of the present owner and of the business?
Are personnel satisfactory?◦Are key people willing to remain?
How does this business, it its present condition, compare with one that you could start and develop yourself in a reasonable amount of time?
Physical Conditions
Physical ConditionsIs the equipment in good condition?
◦ Who owns it?◦ Are there liens against any of it?◦ How does it compare with competitors’
equipment?How long does the lease run?
◦ Is it a satisfactory lease?◦ What are its conditions?◦ Can it be renewed?
What is the condition of the area around the business?◦ Are traffic routes or parking regulations likely to
change
Physical ConditionsBuildingInventoryAccounts receivableLease arrangementsBusiness recordsIntangible assetsLocation and appearance
Potential for Company’s products and Services
Potential for Company’s products and ServicesCustomer characteristics and composition-
who, why, how often, loyalty, new customers, well-defined, growing?
Competitor analysis-number and intensity, saturation point reached, reason for survival, sales comparison, uniqueness?
Are there dependable sources of supply?◦Are any franchises or other special
arrangements expiring soon?What about present and future
competition?◦Are new competitors or substitute materials or
methods visible on the horizon?
Legal Aspects
Legal AspectsLiensBulk TransfersContract assignmentsCovenants not to compete Ongoing legal liabilities
Legal Aspects: What are involved?Lien - creditors’ claims against an
asset.Bulk transfer - protects business
buyer from the claims unpaid creditors might have against a company’s assets.
Contract assignment - buyer’s ability to assume rights under seller’s existing contracts.
Bulk Transfer Seller must give the buyer a list of creditors.
Buyer and seller must prepare a list of the property included in the sale.
Buyer must keep the list of creditors and property for six months.
Buyer must give notice of the sale to each creditor at least ten days before he takes possession of the goods or pays for them (whichever is first).
Contract AssignmentRestrictive covenant - contract in
which a business seller agrees not to compete with the buyer within a specific time and geographic area.
Ongoing legal liabilities - physical premises, product liability, and labor relations.
Financial Matters
Financial Matters
Value of Tangible AssetsValue of Tangible Assets
Value of Intangible AssetsValue of Intangible Assets
Profit PotentialProfit Potential
Purchase PricePurchase Price
+
+
Tangible AssetsThe inventory
◦timely, fresh, and well balancedThe equipment
◦current, usable machines and equipment
Intangible AssetsGoodwill
◦enables a business to earn a profit in excess of the normal rate of return earned by other businesses of the same kind
Leases and Other Contracts◦a lease on a favorable location is a valuable business asset
Patents, Copyrights, and Trademarks◦intellectual property can be a valuable intangible asset
Financial Matters: Determining the Price of a Business Anyone considering the
purchase of a business must recognize and understand the difference between price and value.
Any system of evaluation of a business should incorporate the value of the firm’s assets and its expected flow of future earnings.
Financial Matters: Calculating the purchase price for an existing business
1. Adjusted value of tangible net worth $224,000
2. Earning power at 15% $33,600
3. Reasonable salary for owner or manager 40,000
$73,600
4. Average annual net earning before subtracting owner’s salary
(83,600)
5. Extra earning power of business $10,000
6. Value of intangibles, using four-year profit figure for moderately well- established firm (4 x line 5)
40,000
7. Offering price 264,000
Determining Value of Business
Balance Sheet Technique ◦Variation: Adjusted Balance Sheet Technique.
Earnings Approach◦Variation 1: Excess Earnings Approach.◦Variation 2: Capitalized Earnings Approach.
◦Variation 3: Discounted Future Earnings Approach.
Market Approach - Willing buyer & willing seller
Determining Value of Business: Balance Sheet Technique
Book Value of Net Worth = Total Assets - Total Liabilities = $266,091 - $114,325 = $151,766 (value)
Variation: Adjusted Balance Sheet Technique: (Adjusted for negatives or positives from balance sheet
in inventory, equipment, land/buildings/receivables, etc)
Adjusted Net Worth = $274,638 -
$114,325
= $160,313 (value)
Determining Value of Business: Earnings Approach
Step 1: Compute adjusted tangible net worth
Adjusted Net Worth = =$274,638 - $114,325
= $160,313
Step 2: Calculate opportunity costs of investing
Investment =$160,313 x 25%
= $40,078
+ Salary =$25,000
Total =$65,078
Step 3: Projected earnings for next year: $74,000
Step 4: Compute extra earning power =Projected Net Earnings - Total Opportunity Costs
=Step 3 - Step 2
=$74,000 - 65,078
== $8,922
Determining Value of Business: Earnings Approach
Step 5: Estimate the value of the intangibles ("goodwill"):
Intangibles = Extra Earning Power x "Years of Profit Figure*"
= 8,922 x 3 = $26,766
Step 6: Determine the value of the business:
= $160,313 + 26,766
= $187,079
Estimated Value of the business = $187,079
* Years of Profit Figure ranges from 1 to 7; for a normal risk business, it is 3 or 4.
Determining Value of Business: Capitalized earning method
Variation 2: Capitalized Earnings Method:
Value = Net Earnings (After Deducting Owner's Salary)
Rate of Return*
* Rate of return reflects what could be earned on a similar-risk investment.
Value = $74,000 - $25,000 = $196,000
25%
Determining Value of Business: Discounted earning method
Variation 3: Discounted Future Earnings Method:
Compute a weighted average of the earnings:
Step 1: Project earnings five years into the future:
Pessimistic + (4 x Most Likely) + Optimistic 6
$$
3 Forecasts:PessimisticMost LikelyOptimistic
Determining Value of Business: Discounted earning method
Step 1: Project earnings five years into the future:
$65,000
$74,000
$82,000
$88,000
$88,000
$74,000
$90,000
$100,000
$109,000
$115,000
$92,000
$101,000
$112,000
$120,000
$122,000
$75,500
$89,167
$99,000
$107,333
$111,667
1
2
3
4
5
Year Pess ML Opt Weighted Average
Determining Value of Business: Discounted earning method
(continued)
Step 2: Discount weighted average of future earnings at the appropriate present value rate:
Present Value Factor = (1 +k)
twhere...k = Rate of return on a similar risk
investmentt = Time period (Year - 1, 2, 3...n)
1
Determining Value of Business: Discounted earning method
Year Weighted Average x PV Factor = Present Value
1
2
3
4
5
.8000
.6400
.5120
.4096
.3277
$75,500
$89,167
$99,000
$107,333
$111,667
Step 2 (continued): Discount weighted average of future earnings at the appropriate present value rate:
$60,400
$57,067
$50,688
$43,964
$36,593
Total $248,712
Determining Value of Business: Discounted earning method
Step 3: Estimate the earnings stream beyond five years:
Weighted Average Earnings in Year 5 x 1 Rate of Return
= $111,667 x 1
25%
Step 4: Discount this estimate using the present value factor for year 6:
$446,668 x .2622 = $117,116
Determining Value of Business: Discounted earning method
Step 5: Compute the value of the business:
= $248,712 + $117,116 = $365,828
Estimated Value of Business = $365,828
Value =
Discounted earnings in years 1 through 5
+ Discounted
earnings in years 6 through ?
Determining Value of Business: Market Approach
Step 1: Compute the average Price-Earnings (P-E) Ratio for as many similar businesses as possible:
Company P-E Ratio1 3.3 2 3.8 Average P-E Ratio =
3.9753 4.74 4.1
Step 2: Multiply the average P-E Ratio by next year’s forecasted earnings:
Estimated Value = 3.975 x $74,000 = $294,150
Negotiation
Negotiations ProcessThe way in which the process leading to a
deal proceeds affects the satisfaction experienced by both the buyer and the seller.
Price Versus Value Many business owners do not know the
value of the business but must nonetheless set the price when it is time to put it on the market.
The price of the business is whatever the owner chooses; its value, however, is established in the market only when a buyer agrees to pay the price.
Sources of Power in NegotiationsAmong the sources of power held
by the parties in negotiations, the most important is probably information.
Others factors affecting the power of the parties are timing and the availability of alternatives.