STUDY UNIT 12: The business buyout

Nieman, G. & Nieuwenhuizen, C. 2014. Entrepreneurship: A South African Perspective. 3rd Edition. Pretoria: Van Schaik.

12.1 Evaluating the option of buying an existing business

The entrepreneur must first decide why he or she wishes to buy a business. He or she should be aware of the advantages and disadvantages of buying an existing business.

Why would an entrepreneur want to buy an existing business?

  • Reduce some of the uncertainties that must be faced when starting a business from scratch
  • Buy ongoing operations and established relationships with customers and suppliers
  • Obtain an established business at a price below what it may cost to start a new business

The advantages of buying a business:

  • Business is a going concern, this will save time and money and energy that is usually required when planning.
  • May have a better chance of being successful. Already producing a known income and profit, already has an established customer base that will carry the new owner.
  • Location is of utmost importance, there already may be an existing location for the business.
  • Experienced and reliable employees are already on the payroll of the business and continue their services.
  • Suppliers are established
  • Inventory is in place
  • Equipment has been installed, and the production capacity is known
  • Possible to buy an existing business at a bargain price

The disadvantages of buying a business:

  • The business was never profitable and the previous owner disguised it “creative accounting”
  • Inadequate sales volume
  • Poor reputation of business
  • Employees inherited may not be suitable
  • Location may not be favorable
  • Equipment, facilities and inventory may be obsolete
  • Business may be overpriced
  • Consider the disadvantage of operating in the shadow of the previous owner

12.2 Finding a business to buy

Before buying an existing business the entrepreneur must answer the following questions:

•What business activities do you enjoy the most and why?

•What kind of business do you want to buy/avoid?

•How much time, energy and money are you willing to put into the business?

•How many risks are you willing to take?

• How do we find a business that is on the market?

Name some sources of information on businesses that are for sale but that are not advertised.

  • How do we find businesses that are not on the market?
  • Property agents
  • Financial institutions
  • Business brokers
  • Accountants and auditors
  • Suppliers
  • Friends and relatives
  • Knocking on the door of businesses on is interested in
  • Trade organizations eg. South African Business Chamber
  • Business chambers

12.3 Evaluating available businesses

  • Why is the business for sale?
  • Is the business profitable?
  • What skills and competencies do I need to manage the business?
  • What is the history of the business in terms of its previous owners, its reputation and its public image?
  • What is the physical condition of the business, its facilities and all its other assets?
  • What are the degree and scale of competition?
  • What is the existing and potential market size?
  • What important legal aspects must be considered?
  • What is the situation regarding employees when a new owner takes over?
  • What are the legal obligations in relation to matters like ongoing contracts and liabilities?

12.4 Methods for determining the value of the business

When the process is completed, you will be at the higher end of the continuum of making rock-solid decisions. The benefits of such a valuation are:

  • A business loan is more easily secured with a quality business valuation.
  • Understanding the true value of the business spares one financial loss and perhaps also a deflated ego.
  • Costs to be incurred later to rectify a situation may be prohibited

Asset-based method/balance sheet method

  • The value of the business is determined by subtracting total liabilities from total assets
  • Market-based method
  • This valuation technique relies on the financial markets to estimate the value of the business
  • Actual market price of similar businesses is used as a yardstick, while making provision for differences like location, size, quality of service and image
  • Can also calculate the value of the business using the price-tot earnings ratio by taking market price divided by after-tax earnings
  • Earnings-based method

Explain why the excess earnings approach may be the best method to use in determining the value of a business.

  • Excess earnings method
  • This method uses a combination of the value of the business’ existing assets and an estimation of the future earnings
  • Calculate the value of the business by adding the value of tangible net worth to goodwill
  • See page 21 in textbook for example
  • calculate the opportunity cost by:
  • return on investment % x adjustable tangible net worth of business
  • person will also forego salary, so add that to above calculation to determine opportunity cost
  • Capitalized earnings approach
  • Determine the net earnings for the coming year by using the income statements of previous years
  • Value of the business is calculated as:

Net earnings (after deducting the owner’s salary

Value =rate of return

  • the higher the risk, the lower the value of the business
  • Discounted future earnings approach
  • Value of a business is based on the present value of its future earnings
  • Refer to page 222 of textbook for practical example

Thesecond step is to discount these future earnings at the appropriate present value rate.

The future net earnings are R119 040 (after one year), then the present value of this amount at a discounted rate of 20% will be R99 200.

This rate of 20% is again the rate that a buyer could have earned on a similar risk investment.

The third step involves the estimation of the income stream beyond 5 yrs. and then discounting this income stream again, using the present value factor.

The last step involves the adding up of all these discounted values. This total will then be the value of the business.

Identify qualitative factors should be considered when evaluating an existing business.

  • Non-quantitative factors in evaluating a business (qualitative factors)
  • Competition
  • Future community developments
  • Legal commitments
  • Employee contracts

12.5 The negotiation process

  • The final price of the business is determined through negotiations between the buyer and the seller
  • The complete negotiation process includes the following steps:
  • The identification and approach of the business for sale
  • After the buyer and seller are satisfied with their preliminary research, they are ready to begin serious negotiations.
  • Before the buyer makes a legal offer to buy the business, he or she will sign a letter of intent.
  • The buyer does his “homework” to make sure that the business is good value for money.
  • After the buyer does his “homework”, the parties draw up the purchase agreement.
  • After drafting of the purchase agreement, the buyer and seller close the deal by signing the necessary documents
  • The real challenge now begins for the buyer, who has to make the transition to being a successful business owner.
  • The following elements is important:
  • Price versus value
  • Value of a business in the market place is what somebody is willing to pay for it, and is ultimately determined by the buyer
  • Value does not always reflect the full potential of the business
  • Seller uses one of the computational methods discussed above to determine a price for the business, and if the buyer agrees, the price is set
  • Price is only one of the factors that make up the total sale package – also includes rate of payment and other non-financial arrangements
  • Price can also be below the actual value of the business, but it business is in non-desirable location, the calculated price may be higher than the actual value
  • Sources of power in negotiation
  • Various sources of power:
  • Complete and reliable information about the elements of the external environment i.e. market, competition, social, economic, political and technological environments
  • Timing. The party with the most time available to strike the deal (thus not desperate) has the advantage in terms of timing as a negotiation power
  • Pressure from other people. If the business has more than one owner, there might be pressure to make a quick sale, which proves to be an advantage for the buyer.

12.6 Traps to avoid when buying an existing business

  • Legal circumference
  • Buyer must ensure that he fully understands the terms of the contract of purchase. Get an attorney to pay attention to the details of the transaction
  • Attraction to status and size
  • Not all big and prestigious businesses are good investments
  • Unknown territory
  • There must be a fit between the business and the entrepreneur’s skill, experience and interests. Buyer must know the detail of the specific industry and the specific type of business.
  • Opportunity cost
  • Look at all the opportunity costs involved. The new owner may have to go without a salary for a couple of months, until the business settles, work long hours etc.
  • Underestimation of other costs
  • Don’t forget about costs like payments to auditors, insurance and legal fees
  • Greed
  • Make sure your actions are based on fundamentals and not on greed
  • Being too anxious and impatient
  • Make sure that as a prospective new owner, you know everything about the business.