Ch. 6 - Buying an Existing Business

First rule when considering purchasing a business

"do not rush into a deal"

Buying a franchise or existing business is an approach that can

reduce the risk for an entrepreneur rather than start a new venture

Opportunity cost

the cost of forgoing a choice; the cost of the next best alternative.

Extra earning power

the difference between a company's forecasted earnings and the total opportunity costs of investing in that company

Goodwill

the difference between an established, successful business and one that has yet to prove itself that is based on the company's reputation and its ability to attract and retain customers.

Define the due diligence stage

The process of studying, reviewing, and verifying all the relevant information concerning an acquisition. Four areas: the seller's motivation, asset valuation, legal issues and financial condition.

Liens

claims by creditors against a company's assets

The main reason that buyers purchase existing businesses

to get their future earning potential

Product liability lawsuit

- a lawsuit which claims that a company is liable for damages and injuries caused by the product or services it sells.

Covenant not to compete (or restrictive covenant)

- an agreement tied to the sale of a business in which the seller agrees not to open a competing business within a specific time period and geographic area of the existing one.

what is the acquisition process

1. Identify and approach 2. Sign nondisclosure statement 3. Sign letter of intent 4. Buyers due diligence investigation 5. Draft the purchase agreement 6. Close the final deal 7. Begin the transition

The five stages of buying a business:

1. Search stage 2. Due diligence stage 3. Valuation stage 4. Deal stage 5. Transition stage

Types of business buyers:

Main street buyers - wants a business that is manageable and easy to run alone or with a small group of people Corporate refugees - wants a service business with commercial clients and existing contract revenue Serial entrepreneurs - wants profitable companies with sound management in place Financial buyer - wants profitable companies that offer "hot" products or services and are ready to grow rapidly

How many businesses change ownership each year.

Roughly 500,000

Advantages of buying an existing business

Successful existing businesses often continue to be successful Superior location Employees and suppliers are in place Installed equipment with known production capacity Inventory in place Trade credit is established The turnkey business The new owner can use the experience of the previous owner Easier access to financing High value

Closing documents include:

· Asset purchase agreement - formal agreement of the deal · Bill of sale - transfers ownership · Asset list - all assets that are included in the sale, including tangible assets and intellectual property · Buyers disclosure statement · Allocation of purchase price - a formal document that must be filed with the IRS at the end of the tax year that allocates the price among the various assets · Non-compete agreement · Consulting/training agreement · Transfer of subsidiaries associated with the business · Transfer of utilities · Transfer of web sites, social media addresses, and phone numbers · Documentation of the new entity that will own the business and documentation of the new bank account for that business · Transfer of merchant accounts · Notice to creditors · Lease assignments · Financing documents, security agreement, promissory note, and UCC financing statement, it 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

What are 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

Define the search stage

Entrepreneurs must search for a business that fits best with their background and personal aspirations. 1. Conduct a self-inventory, objectively analyzing skills, abilities, and personal interests to determine the type of business that offer the best fit. 2. Develop a list of the criteria that define the "ideal business" for you. 3. Prepare a list of potential candidates that meet your criteria.

Capitalized earnings approach

a business evaluation method that involves dividing a company's estimated earnings (after subtracting a reasonable salary for the owner) by the rate of return that reflects the risk level of investing in the business.

List the four key areas to explore in the due diligence stage

1. Why does owner want to sell? Look for real reason. 2. Asset valuation- accounts receivable, lease arrangements, business records, intangible assets, location and appearance 3. Legal issues - liens, contract assignments, due-on-scale clauses, covenants not to compete, ongoing legal liabilities 4. financial condition - income statements and balance sheets for at least three years, income tax returns for at least three years, cash flow

A survey by Securian Financial Services reports that

60 percent of small business owners plan to exit their businesses by 2024 and that their most likely exit strategy is selling the business to someone.

Disadvantages of buying an existing business

Cash requirements The business is losing money Paying for ill will Employees inherited with the business may not be suitable Unsatisfactory location Obsolete or inefficient equipment and facilities The challenge of implementing change Obsolete inventory Valuing accounts receivable The business may be overpriced

The primary motivation for business buyers purchasing an existing business

is the same as it is for entrepreneurs: the desire to be their own bosses.

Analyzing a target company's history and track record of sales and earning helps a business buyer assess

its likelihood of success in the future.

Hidden market

low-profile companies that might be for sale but are not advertised as such

Net worth (or owner's equity)

net worth = assets - liabilities

The due diligence process that involves analyzing and evaluating an existing business for possible purchase is

no less time-consuming than the process of developing a comprehensive business plan for a start-up.

Define the valuation stage

non-disclosure agreement, determining the value of a business Many buyers rely on multipliers of earnings before interest, taxes, depreciation, and amortization to estimate a company's value. Other methods include balance sheet techniques, earnings approaches, and the market approach.

Excess earnings method

a business valuation method that combines both the value of a company's existing assets (less it liabilities) and an estimate of its future earnings potential to determine the selling price for the business

Discounted future earning approach

a business valuation method that involves estimating a company's net income for several years into the future and then discounts these future earnings back to their present value, which provides an estimate of the company's worth.

Market (or price/earnings) approach

a business valuation method that involves using the price/earnings ratios of similar publicly traded businesses to estimate the value of a company.

Due-on-sale clause

a clause that requires the buyer to pay the full amount of the remaining loan balance or to finance the balance at prevailing interest rates, thus preventing the buyer from assuming the seller's loan at a lower interest rate.

Letter of intent

a document that represents a firm commitment by both sides that they are ready to move toward closing the sale of a business.

Non-disclosure agreement

a legal contract that requires a prospective buyer to maintain the confidentiality of the business, it owner, and any information, financial and otherwise, that the buyer sees as part of the due diligence process.

Employee stock ownership plan

a type of employee benefit plan in which a trust that is created for employees purchases their employer's stock; employees do not make any out-of-pocket payments but over time become owners in the company that employs them, are entitled to share in its profits, and receive sizable retirement benefits.

Earn-out

an agreement in which the seller agrees to accept a percentage of the sales price and stays on to manage the business for a few more years under the new owner; the remaining portion of the price is contingent on the company's performance; the more profit the company generates during the ear-out period, the greater the payout to the seller.

About one-third of all business sales that are initiated fall through. What is the main reason?

an unreasonable demand unrelated to the price of the business by either the buyer or the seller.

Buying an existing business requires a great deal of

analysis and evaluation to ensure that entrepreneurs actually are getting what they think they are buying and that the business meets their needs and expectations

Done correctly, the due diligence process reveals

both the negative and positive aspects of an existing business.

Define the transition stage

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 seller.

Define the deal stage

the structure of the deal - the terms and conditions of payment- is more important that the price the seller agrees to pay. The buyer's primary concern is making sure that the terms of the deal do not endanger the company's future financial health and that they preserve the company's cash flow.

What are 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

Unprofitable business often result from at least one of the following problems:

· Inefficient operating systems · High inventory levels · Excessively high wage and salary expenses due to excess pay or inefficient use of personnel · Excessively high compensation for the owner · Inadequate accounts-receivable collection efforts · Excessively high rental or lease rates · High-prices maintenance costs or service contracts · Poor location or too many locations for the business to support · Inefficient equipment · Intense competition from rivals · Prices that are too low · Low profit margins · Losses due to employee theft, shoplifting, and fraud

What are the basic principles of negotiating a deal to buy a business and structuring a deal

· Never confuse price with value · Best deals result from a cooperative relationship between the parties based on trust · Parties may structure a deal in many ways, including a straight business sale, a two-step sale, and an employee stock ownership plan