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Buying and Selling a Small Business - Chapter 2 - The Flow of Decisions in a Buy-Sell TransactionBUYERS 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. Bill probably paid a fair price for equipment, fixtures, and the like. But did his price of $40,000 reflect the value of Sam's Market? Obviously not. What, then, is the value of a 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:
MotivationWhat leads an owner to sell his business? It may be any of a large number of reasons: a personal health problem, a business disagreement, overextension of the company's activities, a desire to retire from business. The possible reasons are many and varied.For Sam, the motivating factor was change. He found his sales decreasing in spite of his extra effort, competition increasing, empty building space impossible to rent. In other words, both internal and external factors had brought changed conditions that affected the business unfavorably. Changed conditions should be analyzed carefully before a business owner accepts them as reasons for selling his business. The following questions can serve as a guideline for this analysis:
What makes an individual want to buy a business? Again, motivations will cover the whole range of human desires, from simple economic gain to social ladder climbing. Bill's prime motivating factor was the desire to expand a special skill into a business of his own. Bill thought he knew enough about grocery stores to handle one of his own. But he didn't. This factor of a special skill represents one of the dominant reasons for wanting to buy a business. It is a natural motive, but, perhaps because of its natural appeal, it can be a dangerous motive. A business must be managed. An operating skill does not always lead to managing ability. In fact, it often encourages a business owner to spend his time operating instead of managing. Planning for the future, organizing resources, staffing the business with competent people, directing the coordination of people and operations, controlling results--these are the functions of management. Consequently, an individual with a skill seeking to buy a business in which to apply the skill should check his motivation by asking questions such as the following: How important is management ability in this business?
Do I have the ability to manage successfully?
Can I learn how to manage this business?
ContactAssuming that motives have been examined and that both seller and buyer are still interested, the next step is to get the two together. But there seems to be no "best way" to find a seller or a buyer for a business.From the seller's point of view, the task of finding an interested buyer is the more difficult one, but there are many avenues to explore other than running advertisements in newspapers. He should ask himself these questions: Have I told my employees and other business associates that I intend to sell the business? Have I taken advantage of the broadcasting ability of salesmen who call on businesses similar to mine, of association meetings, of other trade contacts? This informal advertising requires the same kind of information more formal advertising does. Business associates, trade contacts, and friends should be told the asking price, the terms, the anticipated return. Without this knowledge, a potential buyer can hardly be expected to respond positively. He needs to know in advance how the offer relates to his financial ability. From the buyer's point of view, finding opportunities is relatively easy. The difficulty lies in locating a business he can analyze confidently. When he deals with unfamiliar firms, he is haunted by a desire for more information and suspicious about the information he does receive. A buyer seeking a seller should consider the following points: Have I asked people I deal with about persons who might be considering selling a business? Have I considered approaching businesses with which I am familiar about the possibility of a purchase? Kinds and Sources of InformationAt this stage, the buyer and the seller must decide what information about the business to seek or give. In the case of Sam's Market, information was brought out about three factors:
Some of the information a careful buyer will want may take a lot of money or time to gather. He must decide what sources of information are essential and which ones he can leave untapped. Bill, for instance, might well have inquired about local economic conditions. Full information, it is true, would have required a costly analysis, but consider what information he could have got from easily available sources:
Available funds $36,000 Use of funds: Payment to Sam $24,000 Planned increase in inventory $4,000 Advertising $1,000 Display sign $1,000 ------------------------------------ $30,000 Available for working capital $6,000Expected new income per month (3% of $30,000) 900 Probable expense: Payment to bank $265 Payment to Sam 295 Sam's salary ? Bill had enough information available to know (1) that his sales expectations were too optimistic and (2) that even if he reached his sales goal, he would not be able to satisfy the cash demand on the operation. What happened could have been predicted. AnalysisThe word "predict" is important. The buyer should be able to follow through the steps listed below and predict with some confidence the future of the business.What factors affect sales?How will these market factors behave?Therefore, what sales can I expect? What makes up the cost of sales? How will these cost factors apply to expected sales? Therefore, what gross profit can I expect? What expenses are required to run this business? How will expenses develop under my ownership? Therefore, what net profit can I predict? What assets will the business need and possess? What is the condition of these assets? Therefore, what asset improvements will I have to make? What credit does the business assume? What is the condition of the credit position? Therefore, what changes, if any, can occur in the debt structure? How much cash do I have? How much cash will the business generate? Therefore, what will be my available-cash position? What immediate cash outlay must I make? What will be the cash needs of the business? Therefore, what cash outgo will be necessary? What will be my net cash position as things now stand? What additional cash resource, if any, must I have? Therefore, what financing plan shall I use? ValueA business had 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? This computation is discussed in chapter 6, but the general approach is suggested by the following questions: What am I buying (or selling)? 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 ought I get from an investment in this business? PriceIt 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: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. 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. FinancingWhen the price has been settled, the question of how to finance it remains. Financing a buy-sell transaction involves these five factors:
Do I have enough capital to pay the purchase price? Do I have enough capital to support 1 to 3 months' operations--such as payroll and other cash expenses--while the business reaches a self-supporting stage? Do I have some extra capital to cover needs I may have overlooked (perhaps 10 to 15 percent of the purchase price? Types of capital. There are two basic types of capital: (1) equity capital--investment in the business by the owner or owners, and (2) debt capital--borrowed capital that must be repaid. Equity capital is often called risk capital. Those who furnish the equity capital are expected to take the primary risks of failure and to reap the benefits of success. The equity capital provides a margin of safety for a lender. The greater the amount of equity capital, other things being equal, the easier it is to get debt capital. The primary source of equity capital is the personal savings of the buyer of the business. Although many small businesses are incorporated, the sale of stock is seldom a source of capital for the small business. Few buyers, however, have enough personal savings to finance the purchase of a small business without any debt financing. An individual may borrow money for the purchase of a business by obtaining a personal loan, by borrowing against insurance policies, or by refinancing the mortgage on his home. These debts are not direct debts of the business, but the debts of a small business and the personal debts of the owner cannot be completely separated. Banks are the principal institutional source of debt capital for small businesses. The seller as lender. In the sale and purchase of Sam's Market, the buyer's savings plus a bank loan were not enough to finance the purchase. Bill (who needed more financing) and Sam (who wanted to sell his business) reacted in a manner quite common in the financing of the sale of a small business. Sam agreed to accept payment of part of the purchase price over an extended period of time. The seller is sometimes a source of capital to the buyer of a small business, as in Bill's case. A happy circumstance if it is handles properly. Before jumping at the chance, however, the buyer should ask himself these questions: Is there a good reason why commercial lenders would not approve my loan request? Is the seller so interested in getting out from under the business that he will take an unwise risk? Am I sure the business is as good as it looks? Can the business support the debt payments to which I am obligating myself? In the light of Sam's experience, the seller, too, should pause long enough to answer some questions before he accepts an extended payment plan. How serious will it be if the buyer is unable to make his payments? What security do I have to protect my position? How capable of operating my business successfully is the buyer? Contract and ImplementationEvery step so far in this discussion has involved forecasting. From motivation to finance, the buyer and the seller must anticipate characteristics, developments, and problems that may develop. The contract between the parties embodies the resulting basic agreements about the business and the relation between buyer and seller. A "good" contract is meaningless if the earlier steps in the process have been carried out carelessly or not at all. |