A Small Business Is Bought and Sold
Is there a small-business owner who has never considered selling his business? Probably not. Is there an individual with some money, talent, or an urge for independence (often only the last) who hasn’t thought about owning his own business?
The number of small businesses actually bought and sold, however, represents only a small fraction of those who have felt these urges. To many people, the desire to buy or sell is only a passing thought. Others find various ways to solve their problems or satisfy their ambitions. But sometimes an individual doesn’t follow through because he finds the prospect of buying or selling a business too baffling.
The Flow of Decisions in a Buy-Sell Transaction
BUYERS AND SELLERS both seek answers to the same question: “What is this business worth?” Most people see the worth of a business as the total value of equipment and fixtures, inventory, and buildings and land. Important, certainly, but the sum of these values does not equal the value of the business.
For both buyer and seller finding the answer to this question is the most difficult and at the same time the most important step in the buy-sell process. But this final decision reflects many other decisions made while the transaction is being considered. In other words, the buy-sell process is a flow of decisions. It would be impossible to point out every decision that must be made, but the basic ones are as follows:
o Motivation: a decision to attempt the sale or purchase of a business.
o Contact: a decision on how to find a buyer (or seller) for a business with specified characteristics.
o Information: a decision on what information must be gathered or given to buy or sell a business.
o Sources: a decision on how, where, and at what cost the needed information can be obtained.
o Analysis: a decision on the meaning, importance, and reliability of the information gathered.
o Value: a decision on what the business is worth. Price: a decision on how much money to take or give for the business.
o Financing: a decision on how to pay or receive the purchase price.
o Contract: a decision on the form and content of the contractual relation.
o Implementation: a decision on how and when to effect transfer of ownership.
How important is management ability in this business?
Occasionally, a business that is unique and very simple almost manages itself. But if the business is in a competitive field, management ability is probably the most important requirement for success.
Does the prospective owner have the ability to manage successfully?
Effectiveness with people (customers and employees), eagerness to tackle difficult problems and make decisions, and intelligence about general business operations are key ingredients in management ability.
Can he/she learn how to manage this business?
Most people can learn to manage if they recognize the need. This requires room to make mistakes, however, and the self-discipline to undertake self-improvement programs.
Value
A business has a purpose. That purpose is to provide a satisfactory return on the owner’s investment. Consequently, determining value involves measuring the future profit of the business being sold.
A seller often thinks of value as representing the money he has invested through his years of ownership. A buyer is tempted to consider value as a fair price for tangible items such as equipment and inventory. These factors are important, but they have value only to the extent that they contribute to future profits. An owner may have invested $40,000, the tangible assets may have a current worth of $20,000, but it is the profit potential that establishes the value of the total business.
Assuming that a reliable estimate of future profit is made, how much is to be paid for each dollar of profit potential?
What am I buying (or selling)? Is it a business or a building full of equipment and inventory?
What return would I get if I invested my money elsewhere–in stocks, bonds, or other business opportunities?
What return should I get from an investment in this business?
Price
It might seem that the price to be paid or received for a business would simply be equal to the value. However, value refers to what a business is worth; price refers to the amount of money for which ownership is transferred. There is usually a difference between price and value because the buyer and seller differ as to how much the business is worth. The price will represent negotiation and compromise.
Here are two suggestions for fruitful negotiation:
o Discussion between buyer and seller should focus on the future profit performance of the firm. Since expected profit is basic to determining value, it can be a valuable point for negotiation.
o Every profit projection includes some assumptions and risks. Generally, the less firmly based the assumption and the more apparent the risk, the less value an expected profit can support. Consequently, identifying and analyzing risks involved in future operations can make discussions between buyer and seller more significant.
These two points will help bring negotiations about value toward a mutually acceptable price.
Sources of Financial Information
BOTH BUYER AND SELLER are interested in financial information, affecting the buy-sell transaction. However, since the seller already has this information, it is a major requirement for the buyer to get and make use of as much of it as possible.
The buyer can usually find financial information in the following places: (1) financial statements, (2) income-tax returns, (3) other internal records, and (4) other external sources.
Financial Statements
The results of the financial transactions of every company should be reflected in its periodic financial statements. These statements are extremely important in buying or selling a small business. They were prepared for the seller, of course, and their contents are available to him. But the buyer, too, should be aware during the early stages of a buy-sell transaction of the information contained in financial statements.
Balance sheet and income statement. The balance sheet is a statement of the financial position of the business at a given moment in time. The income statement is a summary of the revenue and expenses of the business during a specified period of time. These financial statements show only the past results of the company’s transactions. The results of future operations may or may not be similar.
Balance sheets and income statements in themselves contain important information, but they are most useful when a professional accountant makes a detailed analysis of them. A complete analysis includes a review of the manner in which the statements were prepared, and perhaps also a review of the records and control features of the accounting system. This is especially important in a small business buy-sell transaction because the financial statements of smaller companies are not usually as professionally prepared as the statements for larger companies.
Audited statements. In many buy-sell transactions, the statements are supplied by the seller, but the buyer reserves the right to conduct an audit of the seller’s records. Or the buyer insists that the seller “warrant” his financial statements. Warranty of financial statements by the seller should be accepted with caution, however, because there does not seem to be any uniform definition of the term warranty.
If the seller’s financial statements are prepared by an independent accountant, the statements should show whether they were (1) prepared after an audit of the seller’s accounts, or (2) prepared from the seller’s records without verification by audit. If they were prepared without verification by audit, they may be quite similar or even identical to statements that would have been prepared by the seller’s own bookkeeper. If they were prepared after an audit, they should include a statement of the accountant’s opinion.
Financial statements prepared without such an audit may or may not reflect the financial position or results of operation of the company. Most small companies do not have their records audited annually, but without an audit it is impossible to tell how accurate the statements really are.
Another point the buyer should consider is the cutoff period for the financial statements. The statements may have been cut off during the low period of the sales cycle or during the high period. This has some bearing on the financial position reflected in the statements.
Risk and Return on Investment
If a buyer wants to invest money in a business that is being sold, he should be concerned about receiving a fair return on his investment. Many businesses can make a profit for a short time (1 to 5 years); not so many operate profitably over a longer period of time.
From the buyer’s point of view, what is a fair rate of return from an investment in a small business? The rate of return is usually related to the risk factor–the higher the risk, the higher the return should be. United States Government bonds are the safest investment–the rate of return ranges from 5-1/2 to 6 percent. Blue-chip stocks and corporate bonds usually give the investor a return of 4 to 10 percent if both dividends or interest and increase in market value are considered. Speculative stocks may have a higher return, but they also have a higher risk factor.
The buyer of a small business should try to determine the risk factor of the new business, though this is difficult at best and in many cases impossible. In attempting to assess the risk factor, the buyer should project the profits of the business as far into the future as possible. He should ask himself how high the risk should be normally and look for conditions that would be likely to affect the sales and profit-making capability of the business.
Financing and Implementing the Transaction
THE BUYER AND SELLER have a number of important matters to attend to before the transaction can be closed. The seller will be thinking about instruments of transfer that must be delivered at the closing, about compliance with the bulk sale act, and possibly about making financial arrangements if the buyer can’t raise the purchase price. The buyer’s attention will be focused on financing arrangements, organizing his business-to-be, overseeing the seller’s operation of the business in the meantime, and becoming familiar with the details of the business operation.
Compliance With the Bulk Sale Act
Most States require the seller of a business to furnish a sworn list of his creditors to the buyer and the buyer to give notice to the creditors of the pending sale. The purpose of such a “bulk sale” act is to make certain that the seller doesn’t sell out his stock in trade and fixtures, pocket the proceeds, and disappear, leaving his creditors unpaid. Compliance with the statute gives creditors an opportunity to impound the proceeds of the sale if they think it necessary.
Noncompliance or inadequate compliance may result in attachment of the property after the sale by creditors of the seller and voiding of the buy-sell transaction. The buyer should not close the transaction until he has made sure that all statutory requirements have been met.
Financing the Buy-Sell Transaction
In general, the buyer has two options regarding the financing of the business. The first basic method of financing is person investment of the future owner or owners of the business. The buyer may pay cash for the business out of personal resources, establish a partnership, or sell stock. These forms of financing are commonly referred to as the use of equity or investment capital.
The other basic form of financing is through borrowing or the establishment of credit. This method of financing may or may not require the payment of interest, but it does require the borrower to repay the principal, usually over a stipulated period of time or on a specific date. This method of financing is commonly referred to as the use of debt capital. Often the purchase is made through a combination of equity and debt capital.
Equity capital. In the simplest form of purchase, the buyer pays the full purchase price in cash. The buyer’s investment in the business, at least initially, is full and complete. Whether the funds come from one person or more than one, the financial nature of the transaction does not change.
The sources of equity capital are many and varied. Generally, they are in the form of bank savings. Or cash may be obtained from liquidating certain assets the buyer may own, such as surrendering life insurance policies for cash value or selling real estate, stocks and bonds, or other assets.
Before disposing of assets, however, the buyer should ask himself this question: “Do I want to buy the business more than I want to keep these assets, considering both present and future values?” For instance, if the buyer cases $16,000 worth of government bonds, there may be a possibility of his making a higher profit, but the risk of losing his investment entirely will be greater. He should be as certain as possible that the expected return is worth the risk.
An equally important question is how much the buyer should invest in the business. In general, the more he invests himself, the better chance he will have of borrowing at least part of the purchase price.
A buyer may not have the capital, however, nor perhaps the inclination, to purchase the business outright with his own personal funds. How far he goes in this respect depends on his own cash resources, his confidence in the business, and his ability to borrow money or establish credit with others.
Debt capital. In most cases, the buyer of a small business will have to borrow money or establish credit to purchase the business. Several factors will affect the use of debt capital for this purpose: the source of capital, the amount that can be borrowed, and the length of time for which the capital can be borrowed.
Commercial lending institutions are the sources to which the buyer will probably turn first. The availability of financing through these sources depends on the security that can be pledged to the loan, the profit potential of the business, the prospect of repayment of principal and interest, and the general availability of credit.
One of the major difficulties facing the buyer at this point concerns the collateral that can be pledged as security. The physical assets of the business–particularly fixtures, equipment, and land and buildings–will not be available for security unless they are free of other financial obligations. The buyer may be forced to look to his own personal assets, such as cash value of life insurance, stocks and bonds, mortgages on real property, and so on.
Less formal sources of debt capital may be open to the buyer, such as loans from friends, relatives, business associates, and the like. Many small businesses have been financed through such means.
The seller as lender. A common source of debt capital is that supplied by the seller when he lets the buyer pay for the business over time. Why should the seller finance the buyer? Probably because the desire to sell is strong enough so that the seller is willing to assume part of the risk.
As in financing from other sources, the seller usually demands that the buyer pay interest on the amount being financed and repay the principal and interest at stipulated periods. The seller usually establishes his security on the more certain assets, such as fixtures and equipment. However, he may also assume the inventory as acceptable security without placing it in a bonded warehouse.
The seller’s philosophy toward financing the buyer seems to be that if the buyer should fail, the seller can take back the business. The major problem in this form of financing is that it is harder for the buyer to get additional financing from other sources when the seller has first claim on the assets of the business.
How much to borrow. As the first step toward financing the purchase of a business, the buyer has to find answers to two questions:
1) How much do I need to borrow?”
2) “How much can I afford to borrow?”
The answer to the first question depends partly on how much money the buyer has and how much he is willing to invest in the business himself. The less equity capital he has, the more debt capital he needs.
How much he can afford to borrow depends on his ability to keep up principal and interest payments. If a buyer borrows from a number of sources, he may find himself committed to a repayment schedule that the profits from the business will not support. His borrowing plans should be related to the projected income statement prepared during his study of the business under consideration.
Operating capital. In addition to funds for purchasing the business, the buyer must have enough working capital to cover the cost of operation until the business itself produces enough cash. In other words, the buyer must think in terms of cash requirements and cash flow for weeks and months ahead. A common mistake in buying a business is failure to provide adequate working capital.
If sales and business costs after purchase of the business are expected to follow the pattern of the immediate past, the need for short term working capital should not be hard to estimate.
Putting a Value on Goodwill
Goodwill, when it exists, is a valuable asset. It may result from a good reputation, a convenient location, efficient and courteous treatment of customers, or other causes. However, because it is intangible and difficult to measure, goodwill is sometimes recorded when it does not exist.
From the accountants’ standpoint, goodwill should be recorded only when it is purchased. It should not be recorded otherwise, they believe, because of the difficulty of placing a fair value on it.
As a practical matter, above-average earnings are normally considered the best evidence of the existence of goodwill, and the value placed on the goodwill at the time of its sale is often determined by capitalizing these extra earnings. Take, for example, a business in a field in which the normal return on investment is 10 percent. Suppose the business has a capital investment of $200,000 and an annual return of about $24,000. The average return on $200,000 for this type of business would be $20,000 a year. Therefore, the business has above-average earnings of $4,000 yearly.
Capitalizing these above-average earnings at 10 percent ($4,000 div. by .10) gives $40,000 as the investment needed to earn the $4,000. Therefore $40,000 may be taken as the value of the goodwill of this firm.
Many people feel that unless a business has above-average earnings, it does not have goodwill. Thus, a business might appear to have an excellent location, enlightened customer policies, and a superb product; yet this business will not have goodwill attaching to it unless its earnings exceed the normal earnings for that type of business.
The measurement of goodwill has many pitfalls. To begin with, a decision must be made as to what normal earnings are. (Industry averages will probably be available, but average earnings for the industry aren’t necessarily normal earnings.) And once this decision has been made, the percent at which the above-normal earnings will be capitalized must be decided. In the example given, 10 percent was used. This means that the buyer should recover his investment in 10 years. If he wants to recover his investment more quickly, he will want to use a higher percent, which will give a lower capitalized value. If he is willing to wait longer, he will accept a lower percent, which will raise the capitalized value.
Goodwill is simply a bookkeeping device to represent the value of one part of a business when that business is valued as a whole. In most cases, the total value of the business is decided without a detailed calculation of the goodwill figure–in many cases, without even detailed consideration of the value of the other assets.
In the ensuing chapters, we will develop an in-dept strategy to find, value and acquire a business using as little of our cash as possible. This is not a book that you read and put down. This is a workbook, a work-in-progress type manual. We recommend that the reader takes action as he/she goes through the information enclosed. That is the only way to successfully become a small business owner. And by duplicating your efforts, you can repeat the process outlined in this book to build a small empire.