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Essay on Purchasing A Small Business
| Date: |
11-06-00 5:07pm |
| Subject: |
Business |
| Word Count: |
2511 |
| Page Count: |
10.04 |
Purchasing a Small Business
Purchasing a
Small Business
Outline
I. Deciding to buy
A. Why buy a small business?
B. Starting out-the nine steps
C. Initial details to consider
1. Are partners needed?
2. Economic factors
3. Is the location acceptable?
4. Tax strategy
II. Where to start
A. How much income is needed?
B. The "Thirteen Steps" to acquiring a
business
III. Locating a potential purchase
A. The Acquisition Plan
B. Beginning the search-who can help?
III. Negotiating a purchase price
A. Valuation of a small business
1. Why do a valuation?
2. Choosing the method that is best for
your situation
3. Some different methods of valuing a
business
a. Ability-To-Pay Method
b. Discounted Cash Flow Method
c. Excess Earnings Method
B. Calculating goodwill
C. Setting the purchase price
D. The letter of intent
IV. Finding the initial capital
A. Sources of financing
1. Traditional sources
2. Nontraditional sources
B. Guaranteed loan programs
V. Closing the deal
1. Get a lawyer
2. Audit review
3. The closing
VI. The rewards of working for yourself
The decision to purchase a business of
your own is not an easy task. There are many things to consider before
the final decision is made. First of all, exactly what do you want
to accomplish? To make millions of dollars, right? Or is it
to have the freedom of being your own boss? Whatever the reason,
you must be sure that it is something that you are ready to devote an exorbitant
amount of time and energy into and that it is something that you really
want. Otherwise, you might be stuck doing something that you hate.
If you are ready to commit then you must ask yourself just how far will
that commitment extend. How much of your own time, energy, and money
are you willing to sacrifice?
After the decision is made, the acquisition
of a small business can be summed-up into nine steps, in which most will
be elaborated upon later. "These are the nine steps to any business acquisition,
regardless of its size or industry:
1. The search, locating a business available
for sale.
2. Identifying alternative candidates.
3. Valuing the business.
4. Negotiating a price and terms.
5. Investigating the company.
6. Preparing the business plan.
7. Sourcing the financing.
8. Preparing the closing documents.
9. Managing the transition period." (Tuller,
10)
Some considerations that cannot be avoided
when purchasing a small business
include: the question of needing a partner,
the current economic factors, considering alternate locations, and developing
a tax strategy. When debating whether or not a partner is needed
or wanted, you need to know if you're going to need additional equity as
well as sharing the risk of failure. For these reasons, a partnership
seems to be a great idea, but there are also many cons that should be recognized.
Having too many partners can alter the ease of decision-making, shared
liability can cause obvious problems, and sharing profits means less for
you. Added to this, getting out of a partnership can be very
difficult.
Evaluating the current economic factors
simply means to know what you are getting into. Be sure to have some
knowledge about the business itself and it's market. Know how to
make and sell the product efficiently and in a service industry, be sure
to know the current and correct way things are done-sometimes they are
not one in the same.
Location is key. "Location of the
target can be a major determinate in both the financing of the deal and
probable success in managing the business after closing.There's no sense
spending time, effort, and money on a target located in the wrong place."
(Tuller, 12) Along with this, the personal strife of having to travel
a great distance to get to work can be very frustrating. So, be sure that
the location of your potential business is profitable in every way.
One the greatest minds of the 20th century,
Albert Einstein, once said, "tax is the most difficult thing in the world
to understand". Unfortunately, with the ever-changing laws, that
problem gets worse every year. This means that you should have knowledge
of the current tax laws. "'You will have a unique opportunity to
make decisions on exactly how much money will change hands, and how I will
allocated on the payment schedule."(Smorgenburg, 112) Maximizing
profit for both you and the seller can only be done through proper knowledge
of tax law, if you are not comfortable handling this alone, a consultant
might not bad a bad idea.
After all of the above is settled, the
next thing to figure is the amount of initial income is required.
Not only the income required to purchase the entity (which will be elaborated
upon later), but also the amount of money that you need to survive for
the years to come. "If you need $100,000, then don't look at smaller
companies which can only yield $30,000." (Tuller, 23)
"The following 13 steps will help to locate
a target and close the deal in the shortest possible time-and when buying
a company, time is money.
1. Define realistic parameters.
2. Prepare a reasonable Acquisition Plan.
3. Review current tax laws for structuring
the deal.
4. Develop a detailed plan for sourcing
potential targets.
5. Perform a preliminary due diligence
investigation.
6. Negotiate a price and terms based on
a realistic valuation.
7. Perform a thorough due diligence investigation.
8. Prepare a complete business plan.
9. Develop sources for at least three
alternative financing structures.
10. Arrange for the final updated due
diligence investigation.
11. Write the Buy/Sell Agreement and negotiate
the final contract language.
12. Plan how you will operate the company
after closing.
13. Attend the closing.
Yet another crucial instrument in the
purchase of any business is the Acquisition
Plan. This document lists every
step and detail leading to the closing of the deal. Starting with
the industry survey, it lists the start date, the finish date, and the
cost of each of these processes. Following the survey is the target
search, then on to the due diligence investigations. The importance
of this plan revolves around the organization of a solid purchase.
With this, you are able to enact the purchase at the right moment for you,
this time being a buyer's market. If you need to wait out the bear
market, you can do it much easier with everything laid out in front of
you. Hence, the Acquisition Plan does the job.
All of the above steps and considerations
are a waste if you are unable to find a business for sale. The difficulty
of finding the type of business that you will purchase is put to ease through
an M & A consultant, accountant, or simply browsing the Wall Street
Journal. A smaller gas station or party store-type business can usually
be found in the local paper. On the other hand, if you are looking
for a larger company, an M & A consultant may be pricey (2-15,000 dollars
for a retainer), but this is probably the best way to go. Be sure
to ask the consultant many questions regarding his or her creditability.
For instance, get a list of references and ask about the number of deals
he closed in the past 12 months.
Negotiating a purchase price involves a
thorough valuation of the projected purchase. Evaluation of a business
is essential because you need to know what you are paying for and how much
you should pay. " If you are a buyer, your valuation will also be helpful
to you when you meet with lenders, so that you can help justify the mount
you are asking to borrow. For this purpose alone, however, a valuation
is not generally worth the effort." (Horn, 20) There are many different
methods that you can use to properly determine the value of the entity.
The most common methods are as follows: the Ability-To-Pay Method, this
method is used in almost all buy/sell cases. It makes clear whether
the acquisition can pay for itself out of its own cash flow. The
Discounted Cash Flow Method is most often used when the company is going
to be purchased as an investment and held for a limited number of years.
It is also used in high-risk situations, such as highly leveraged deals
that have more of a proportion of debt than usual. The third method
is the Excess Earnings Method, used to value any profitable company.
The Excess Earnings method "assumes that a business is worth the market
value of its tangible assets, plus a premium for 'goodwill' if the earnings
are high enough."(Horn, 51)
Another area that must be calculated is
goodwill. "Goodwill is not an operating cost and cannot be depreciated.
It does not provide you with tax relief."(Smorenburg, 114) Since there
is no record of the worth of goodwill, it can be fairly difficult to determine
an accurate buying price. Usually the seller will set the price based
on their knowledge of the company. The set price, however, should
be reasonable. Negotiations can be made to produce an agreeable price.
The next step is to set a purchase price.
"There is no right or wrong way to value a business. Each company
has different characteristics. Obviously, the seller will argue that
the net asset value method is right because that's what he invested in
the business."(Tuller, 103) You should consider all factors in the
P/E/ ratios, liquidation value, net asset value, and historic and projected
cash flow. After analyzing these aspects of the business, you should
be able to determine a fair price for the entity.
"The letter of intent is a document that
aims to formalize the terms around which a later negotiation will revolve.
As such, the letter is primarily a tentative offer that remains subject
to further negotiations and confirmation of material facts through a process
of due diligence.By offering a letter of intent, you tangibly solidify
your resolve and thereby make the seller understand that you are a serious
buyer."(Smorenburg, 126)
The letter of intent covers the precise
terms of the deal, the payment details, and management and other issues
involving the transfer. You need to give your accountant and lawyer
a draft of the letter for review. This way, you are protected from
any loopholes that can harm you. It proves that you are a serious buyer
and entices the seller to more openly discuss sensitive aspects of the
business. The letter is a written contract that can be legally cancelled
at any time without the consent of the other party, so be sure that you
and the seller are in agreement.
Once everything is settled and you and
the seller are in agreement to the term of the letter of intent, the next
task you face is finding the initial capital. Using other people's
money to finance a purchase is a key ingredient if business success.
Financing falls into two separate categories: debt and equity.
Debt financing is the most elementary of
the two. It is basically taking a loan from a lender and paying it
back with interest. It is reliant on the business or individual's
ability to pay the loan off. Usually, collateral will be made available
to the source of the loan in the case that you cannot continue to make
payments. A good credit history and reputation is another aspect
that financing is reliant upon. With these, a loan is much easier
to get.
"Equity financing means obtaining funds
in exchange for selling or giving up a part of interest in the business.
Equity financing is not a loan; rather, it is the sale of a part of you
business."(Fallek, 82) The popularity of equity financing has increased
in the high tech industries in the past few years. However, selling
a part of your newly purchased business may not be your cup of tea, so
choose your type of financing wisely.
Some traditional sources of capital include
yourself, family and friends, commercial banks, loan companies, insurance
companies, credit unions and private investors. The old saying, "don't
mix business with pleasure" is applicable when dealing with family and
friends. Taking a loan from these sources can cause turmoil if the
loan cannot be paid back. Banks are the standard for business lending.
"The amount they charge is based on two factors: the size and history of
the customer and the risk the bank will take in providing the loan."(Fallek,
85) If you are able to decrease the bank's risk and have a standing
credit line, you will get the most out of your loan. The other types
of traditional lenders are less frequently used, but are also good sources
of capital.
"Nontraditional money sources are unlimited
in number and type, but you need to be creative to acquire the necessary
funds from them."(Fallek, 89) These sources include customers, suppliers,
leasing companies, local development companies, and advertising for money.
Customers or potential customers are often great sources of funding, as
well as suppliers. Suppliers will furnish you with the necessary
equipment and product. Leasing companies and local development companies
are also good nontraditional sources of capital. "You can actively
seek funding by running a display advertisement in the business section
under the appropriate heading in the classified ads of your local newspaper.
Specify the amount of money needed and the type of business for which it
will be used."(Fallek, 91)
Yet another source for funding might be
through the Small Business Administration. They offer different types
of loan programs to small businesses. The SBA Guaranteed Loan Program
grants a loan on the basis that the individual needs more time than allotted
by other lenders to pay back the loan, has insufficient credit, or lack
business experience. "There are no restrictions as to the number
of SBA loans a company or individual may have, as long as the SBA's exposure
does not exceed $750,000."(Fallek, 96)
The final step in acquisition of a business
is the closing. You will need a lawyer if you don't currently have
one. The search for the right lawyer requires certain questions to
be answered. For instance, you want to find out the lawyer's hourly
rates, experience, availability, if there is any conflict of interest between
the lawyer and the seller, and any other applicable questions. The
best way to find a lawyer is word of mouth, ask friends and family for
references. When a lawyer is located, you must then begin the audit
review.
"Even thought most buyers work with their
local CPA in preparing the business plan and counsel with him on tax matters
relative to the acquisition, the audit review should be preformed by an
independent CPA firm in the same city as the target company; preferably
on of the 'Big-5' firms. The audit review consists of a comprehensive look
at business since the last audit with particular emphasis on determining
the adequacy of internal controls and internal reports."(Tuller, 192)
Be sure to take this step, it examines all aspects of the business and
insures that it is a safe investment. After this is complete, it's
time to close the deal.
The documents generally needed for proper
closure are: a buy/sell agreement, an earn out agreement, a promissory
note terms and conditions agreement, title search and title insurance,
lease agreements, employment contracts, personal guarantees, and an equity
agreement with the lender. These documents are dealt with and an
announcement should be made to the employees, customers, and vendors of
the change in ownership. "There is a mood of anticipation, of excitement,
and even-if the truth be know-of fear. Of all the events which take
place in the business world, nothing can match an acquisition closing for
pure excitement and thrill."'(Tuller, 203) the actual signing of
the transfer documents will not usually take more than an hour. The
key is not to worry about what you are signing, that's what your lawyer
is for. After all the money spent, the time devoted and the effort
put forth, the business is finally yours.
Running your own business can be very
rewarding. You don't have anyone to answer to besides the government.
You are in complete control. Along with this the ability to write
off certain expenses is enough of a reward in itself. The effort
you put forth is completely up to you. The life and death of the
business is in your hands.
Bibliography
1. Fallek, Max (1994). Finding
Money for Your Small Business
Enterprise-Dearborn:
USA
2. Fluery, Robert (1995). The Small
Business Survival Guide
Sourcebooks, Inc.: Naperville, IL
3. Horn, Thomas (1990). Business
Valuation Manual
Charter Oak Press: Lancaster PA
4. Peterson, C.D. (1990). How To
Leave Your Job and But A Business of Your Own
SVS, Inc. (Video)
5. Smorenburg, Michael (1998) Business
Buyer's Kit
Career Press: Franklin Lakes, NJ
6. Tuller, Lawrence (1990) Buying In: A
Complete Guide to Acquiring a Business or
Professional Practice
Liberty Hall Press: Blue Ridge Sumit, PA
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