The idea of running a small business appeals to many would-be entrepreneurs. But the fantasy often loses its allure when faced with the realities of dealing with business plans, investors, branding and legal issues. For those disheartened by such risky undertakings, buying an existing business is often a viable alternative.
One of the issues faced by the would-be entrepreneur is that most business brokers or agents represent the seller. Additionally valuating the business is a confusing issue to most and a mistake when purchasing can prove very costly.
It is imperative that potential business buyers carefully think through their motives for considering the purchase of a business and their criteria in selecting one. A buyer should consider his experience – both vocational and avocational – what he is good at and what he enjoys. If a buyer is interested in a business that has a product or service that is outside his area of expertise, then he should make certain that key employees will stay on after the change in ownership or that similar expertise can be hired. It is equally important that a buyer identify the desired location(s) and the amount of money willing to be invested. If the money to be used is not in liquid form, the buyer should assess what the realistic possibilities are of obtaining the funds from outside sources. One should also decide on the size of the business in terms of sales, profits, and the number of employees. It is important to determine if the desired business is to be one that is profitable and stable or one that is losing money and in need of new management. The more profitable and stable a business, the more it is likely to cost.
Determining the value of a business is the part of the buy-sell transaction most fraught with potential for differences of opinion. Buyers and sellers usually do not share the same perspective. Each has a distinct rationale, and that rationale may be based on logic or emotion.
The buyer may believe that the purchase will create synergy or an economy of scale because of the way the business will be operated under new ownership. The buyer may also see the business as an especially good lifestyle fit. These factors are likely to increase the amount of money a buyer is willing to pay for a business. The seller may have a greater than normal desire to sell due to financial difficulties or the death or illness of the owner or a member of the owner’s family.
For the transaction to come to conclusion, both parties must be satisfied with the price and be able to understand how it was determined.
The topic of business valuations is quite complex. The process takes into account many, many variables and requires that a number of assumptions be made. Shannon Pratt, a noted business valuation expert, names six of the most important factors:
Recent profit history
The six factors named above determine the fair market value. However, businesses rarely change hands at fair market value. The reason is that three other factors often come into play in arriving at an agreed upon price.
They are as follows:
The definition of fair market value is the price at which property would change hands between a willing buyer and a willing seller, both being adequately informed of all material facts and neither being compelled to buy or to sell. In the market place, buyer and seller are nearly always acting under different levels of compulsion.
The rule for using rule-of-thumb formulas for pricing a business is “do not use them”. The problem with rule-of thumb formulas is that they address few of the factors that impact a business’s value. They rely on a “one size fits all” approach when, in fact, no two businesses are identical.
Rule-of-thumb formulas do, however, provide a quick means of establishing whether a price for a certain business is “in the ballpark.” Formulas exist for many businesses. They are normally calculated as a percentage of either sales or asset values, or a combination of both.
Using comparable sales as a means of valuing a business has the same inherent flaw as rule-of-thumb formulas. Rarely if ever are two businesses truly comparable. However, businesses in the same industry do have some characteristics in common, and a careful contrasting may allow a conclusion to be drawn about a range of value.
This approach calls for the assets of the business to be valued. It is most often used when the business being valued generates earnings primarily from its assets rather than the contributions of its employees or when the cost of starting a business and getting revenues past the break-even point does not greatly exceed the value of the business’s assets.
There are a number of balance sheet methods of valuation including book value, adjusted book value, and liquidation value. Each has its proper application. The most useful balance sheet method is the adjusted book value method. This method calls for the adjustment of each asset’s book value to equal the cost of replacing that asset in its current condition. The total of the adjusted asset values is then offset against the sum of the liabilities to arrive at the adjusted book value.
Adjustments are frequently made to the book values of the following items:
4. Furniture, Fixtures, and Equipment – adjusted up if those items in service (probably more than a few years) have been depreciated below their market value, or adjusted down if the items have become obsolete.
Although a balance sheet formula is sometimes the most accurate means to value a business, it is more common to use an income statement method. Income statement methods are most concerned with the profits or cash flow produced by the business’s assets. One of the more frequently used methods is the discounted future cash flow method. This method calls for the future cash flows (after taxes and before debt service) of the business to be calculated.
Tax and other consequences of the structure of a transaction have an important effect on the overall value of the transaction to the principals. Each type of structure carries with it different tax consequences for the buyer and seller. The type of corporation owned by the seller, the size and date of the transaction, and the type of consideration paid may all have a bearing on the tax consequences. Since tax law is constantly changing, it is important to seek legal and tax advice in determining the best way to structure the purchase or sale.
The purchase and sale of a business can be structured in either of two basic formats: (1) the purchase of the stock of the seller’s corporation, or (2) the purchase of the assets of the seller’s business.
Asset transactions – In an asset transaction, the assets to be acquired are specified in the contract. Practices vary from industry to industry but in general, all the assets of the business except cash and accounts receivable and none of the liabilities of the business convey to the buyer. The seller uses the proceeds from the sale to liquidate all short term and long-term liabilities. This means that the buyer purchases all of the business’s equipment, furniture, fixtures, inventory, trademarks, trade names, goodwill and other intangible assets.
An asset transaction generally favors the buyer. The buyer acquires a new cost basis in the assets, which may allow a larger depreciation deduction to be taken. The seller must pay taxes on the difference between his basis in the assets and the price paid by the buyer for the business.
The buyer may also prefer an asset transaction for liability reasons. By purchasing assets, the buyer may avoid the possibility of becoming liable for any of the seller’s corporation’s undisclosed or unknown liabilities. The most common liabilities of this type are income taxes, payroll withholding taxes and legal actions.
Stock transactions – Stock transactions generally call for all of the assets and liabilities of the seller’s corporation and the stock of the corporation to be transferred to the buyer. In some cases, the buyer and seller may choose to exclude certain assets or liabilities from being conveyed. The seller must pay taxes on the difference between the seller’s basis in the stock and the price paid by the buyer for the stock.
Sometimes stock deals are more expedient for both parties. Stock transactions provide for continuity in relationships with suppliers. They also preclude the necessity of obtaining a lease assignment when the lease is held only in the name of the corporation and when there is no provision in the lease calling for an assignment in the event of a change in the controlling interest of the corporation. The risk of inheriting undisclosed debts of the seller in a stock transaction can be minimized by providing for the right of offset to future payments due the seller.
It is rare for a privately held business to change hands for an all-cash price. Almost all transactions are structured as installment contracts, which provide for the seller to receive some cash, but for the bulk of the purchase price to be owner financed. For smaller privately held businesses, the down payment often ranges from 10% to 40% of the selling price and the buyer executes a promissory note (secured by the assets of the business only) for the balance. Such notes are typically for a period of 3-15 years at an interest rate that varies with the prime rate.
Just as in an installment sale, a leveraged buyout uses the assets of the business to collateralize a loan to buy the business. The difference is that the buyer in a leveraged buyout typically invests little or no money, and the loan is obtained from a lending institution.
This type of purchase is best suited to asset rich businesses. A business that lacks the assets needed for a completely leveraged buyout may be able to put together a partially leveraged buyout. In this structure, the seller finances part of the transaction and is secured by a second lien security interest in the assets. Because leveraged buyouts place a greater debt burden on the company than do other types of financing, buyer and seller must take a close look at the business’s ability to service the debt.
An earn-out is a method of paying for a business that helps bridge the gap between the positions of the buyer and seller with respect to price. An earn-out can be calculated as a percentage of sales, gross profit, net profit or other figure. It is not uncommon to establish a floor or ceiling for the earn-out.
Earn-outs do not preclude the payment of a portion of the purchase price in cash or installment notes. Rather, they are normally paid in addition to other forms of payment. Because the payment of money to the seller under the provisions of the earn-out is predicated on the performance of the business, it is important that the seller continue to operate the business through the period of the earn-out.
In some instances, a business owner may want to accept the stock of a purchasing corporation in payment for the business. Typically, the stock he receives (if it is the stock of a publicly-held company) may not be resold for two years. If the stock may not be freely traded, it is not as valuable as freely traded stock, and its value should be discounted to allow for this lack of marketability.
There is an advantage to the seller in this kind of transaction. Taxes incurred by the seller on the gain from the sale of the business are deferred until the acquired stock is eventually sold. There are several tests that must be met to qualify for this tax treatment.
The art of negotiation plays an important role in buying or selling a business. Differences of opinion are inherent in the negotiation process and only realistic negotiators can find creative solutions to such differences.
Businesses change hands most easily when the parties assume a non-adversarial posture. It is imperative that the parties know the issues that are important to one another. Each should understand the other’s position on these issues.
Price is just one aspect of the transaction to be negotiated. Terms are just as important, particularly the period of time over which the debt is to be repaid and the allocation for tax purposes of the purchase price.
Sellers naturally have the upper hand in negotiations since they best know the business. A seller should make full use of that advantage. A buyer should minimize the seller’s advantage by learning as much as possible about the business. It is important to do more than study the business to prepare for negotiations. The parties must both understand each other’s motivation for wanting to buy or sell the business, and each other’s plans after transition takes place. They must also understand why the other party has taken a certain position on an issue.
Developing a working strategy means each party must not only know the other’s position, they must develop their own position as well. They should prepare in writing a list of reasons that validate their position. They should also think through possible weaknesses in their reasoning. In this way, each can anticipate and respond to the objections the other party may raise.
Buyers should request that the seller not negotiate with other buyers while the specifics of the offer are being negotiated. Sellers, on the other hand, are advantaged when they can negotiate with more than one buyer at a time. The most important thing in negotiations is to be able to see things from the other party’s perspective. This eliminates much of the difficulty of reaching agreement and keeps the parties from wasting time.
Making and Evaluating Offers
Before making an offer, a buyer will typically investigate a number of businesses. At some point in the investigation process, it may be necessary to sign a confidentiality agreement and show the seller a personal financial statement. A confidentiality agreement pledges that the buyer will not divulge any information about the business to anyone other than immediate advisors.
A buyer should determine a range of value for the business. An appraisal of the business as is can be used to establish a pricing floor. A pricing ceiling can be established by using an appraisal that capitalizes projected future cash flows under new management.
A buyer should have access to all records needed to prepare an offer. If some information is lacking, the buyer must make a decision to either discontinue the transaction or make an offer contingent on receiving and approving the withheld information. The nature and amount of withheld information determines which course of action to take.
An offer may take the form of a purchase and sale agreement or a letter of intent. Purchase and sale agreements are usually binding on the parties while a letter of intent is often non-binding. The latter is more often used with larger businesses.
Regardless of which form of the agreement is used, it should contain the following:
The seller should look for all the same provisions in an offer that were enumerated in the section on making the offer. The types of offers a seller is likely to receive depend in some measure on the size of the business. A seller should ask for a resume and financial statement from an individual buyer and an annual report if the buyer is another company.
Find out what attributes the buyer brings. Sometimes, a buyer with a commitment to the work ethic is all that is needed. In other cases, successful related work experience may be important. If the acquirer is another company, look for the logic behind the acquisition. Perhaps some kind of synergy or an economy of scale is created. A buyer should prepare and show the seller a post-acquisition business plan.
One final note – carefully study offers to determine what assets and liabilities are being purchased. An offer for the assets of a business may be worth considerably less than an offer for its stock even though the price offered for the assets is higher.
After buyer and seller have entered into a binding contract, there may be several conditions to be met before the sale may be closed. Such conditions often address issues like assignment of the lease, verification of financial statements, transfer of licenses, or obtaining financing. There is usually a date set for meeting the conditions of sale. If a condition is not met within the specified period, the agreement is invalidated.
Business settlements or closings, as they are also called, are usually done in one of two ways.
There usually is no formal final meeting at which the signing of the documents takes place. Buyer and seller usually sign them independently of one another. The attorney or escrow agent also performs a lien search. This determines if any liens against the business’s assets have been filed in the records of the local courthouse.
A number of documents are required to close a transaction. The purchase and sale agreement is the basic document from which all the documents used to close the transaction are created. The documents most often used in closing a transaction are described below.
Other documents not described below may also be needed depending on the particulars of the transaction.