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Buying A Business

March 4, 2009

This article was contributed by SCORE Lancaster Volunteer Robert G. Parr.  Bob spent many years in the field of business acquisitions and business valuations and is an expert on the subject. He writes:

When buying or selling a business, the same basic approach is used to determine the value of the business to either party to the proposed transaction. The approach is known as establishing “Fair Market Value” … the price that a buyer could reasonably be expected to pay and a seller could reasonably be expected to accept for the business. Since most all of the businesses discussed here are small businesses, only a very few of the many subjective approaches will be explored to determine a reasonable valuation or “Fair Market Value”.

First, before letters of intent, due diligence and valuations, the prospective buyer should ask and answer some basic questions regarding the business.

*         What do I know about this business or the industry I’m going into ?
*         Do I understand the products or the service the company provides ?
*         What is my experience in management, operations, sales, finances and accounting ?
*         What do I know of the industry, the competition, and the market or customer base ?
*         What do I known about the reason for selling, relationship to employees, potential for growth ?
*         Where is the source of money, for buying, for sustaining the business, for expansion ?
*         Is the business dependent on the present owner? Will he help in a smooth transition ?
*         Can I retain the staff and key employees? Will they and the owner assist in training ?
*         Will the present owner assist or participate in the financing of the sale ?

Next, the prospective buyer should inquire as to the seller’s asking price. If after a limited appraisal, the buyer finds that the asking price is within a reasonable price range, buyers and sellers may require signatures to a Letter of Intent outlining the offer and conditional acceptance by the buyer and seller. Such buyer/seller conditions may relate to (but are not limited to) access to funding, due diligence, deposit, penalties, specified closing date and other caveats requested by either party to the sale. Seller may also ask the prospective buyer to sign a Confidentiality Agreement prior to disclosing company information necessary in the next phase of the prospective transaction. Following a signed Letter of Intent and Confidentiality Agreement, the buyer’s next step is to do something known as “Due Diligence.”

* Specify the exact dates for the “Due Diligence” period.
* Have detailed list of Company products, services and markets to be served. Ascertain the Company’s promotional and sales incentive programs or methods
* Know the Organization Form (proprietorship, partnership, LLC, Corporation)
* Company’s owner(s) (shareholders, partners and percentage of ownership), buy-sell agreements, accountant, lawyer, insurance agent and bank(s).
* Look at three years of Company’s financials and tax returns – incl. year to-date
* View three years of existing owner’s tax returns – same years as above
* Get a current credit reports on the Company and owner(s)
* Study copies of all agreements, contracts, authorities, leases, rentals, liens, loans, mortgages and all other Company obligations (on-going or committed)
* Understand existing and contingent liabilities (business and personal)
* Review insurance contracts (liability, property, automotive, comprehensive, workman’s compensation, business interruption, buy-sell agreements, bonding, umbrella, etc.)
* Review recent appraisal(s) and/or liens on any or all property or equipment to be purchased
* Study employee records indicating salaries, pay rates, contracts, agreements, benefits (vacations, medical, 401K, profit-sharing, pension plan, etc.)
* Relationships, franchises, agreements with employees, owners, shareholders, customers, suppliers, vendors, banks, competitors or other interested parties
* Understand the Accounting system, payroll and credit control (request a receivables aging list), customer and vendor payment terms and incentives.
* Review Company history, business economic outlook and management involvement
* Ask to see the Customer list (note any and all customers who exceeding 20% of Company sales)

It is the sole responsibility of the prospective buyer to obtain from the existing owner(s) the above information in order to make an intelligent and informed determination of the true valuation of the prospective sellers’ Company…regardless of whether you are contemplating an “asset-based” or “stock-based buy”. Buyers should seek assistance from qualified or certified professionals to determine a true valuation of the prospective seller’s Company.

Now, let’s examine the two most common types of small business valuations approaches.

* Asset-Based Method – This business is usually associated with the sale or service of products or goods directly to the consumer. The reason for a sale may be a desire to retire, ill heath, loss of business, family problems, divorce, moving, etc. The asset based approach derives an indication of value based on the costs to replace the tangible assets in like kind condition. If the earnings will not support a value greater than the assets, then at best, the value of the business is the value of the assets. These appraisals are generally performed (by mutual agreement of both parties) by a credible or certified property/ lease appraiser for any properties…and the equipment, inventory, tools, vehicles, etc. by a vendor(s) for those specific products.

* Income Approach – Businesses valued with this method are typically associated with providing services. These are service provided by professionals such as doctors, dentists, architects, lawyers, accountants, consultants and non-professionals whose primary asset is their customer base and the income it produces. Reasons for sale may similar to the above method. The income approach relates to cash flow or discretionary earnings from the intangible assets of the company derived from past performance and calculated into future years. Discretionary earnings are defined as reported pretax earnings, plus your salary, interest expense, depreciation and any personal expenses run through the business. The ending value is a multiple of discretionary earnings and includes all tangible assets needed to operate the business such as fixtures, furniture, equipment and inventory. Most small businesses sell in the range of 1.5 to 2.5 times the discretionary earnings. Additional value to keep or to sell is the net liquid assets (cash, accounts receivables – less payables and any non-performing assets). Valuation for this approach should made by a certified valuation appraiser (available in most cities). Two websites that provide a list of their designated business appraiser members is the American Society of Appraisers and The Institute of Business Appraisers…or a limited number of qualified CPAs.

In order for a buyer to make an informed decision as to purchasing this or any other business offered for sale, the buyer must go through a process such as outlined here to mitigate all the risks involved in owning and running a new or established business.

After the prospective buyer has completed all the steps as outlined above and the buyer and seller have generally agreed upon the price and conditions of the sale, the buyer must decide on the organizational form of the new company. In most cases the buyer should form a new company and not buy the organizational form of the existing company. In other words…an asset-buy and not a stock-buy. Under the asset-buy, only the required assets by the buyer would be listed (including company name) and no liabilities (existing or contingent) of the existing company. Additionally, there are beneficial tax benefits to the buyer under an asset-buy.

Prior to, and mandatory at this time, the buyer should enlist the help of a qualified accountant and attorney to advise in these matters.

For more information contact SCORE Lancaster at (717) 397-3092 or use the “Get Help” tab above to schedule an appointment.

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