Buying a Business

Before considering the purchase of an existing business, there are several steps to consider.  In order to insure the best decision, an entrepreneur must discover what type of business it is and become familiar with any guidelines and regulations that accompany it.  They should also analyze the current owner’s business plan and conduct their own industry analysis.  In order to validate the owner’s assumptions, they should hire a contractor to examine the site and value the standing inventory.  It would greatly benefit them as well to hire a lawyer to assist with legal issues and an independent auditor to check the business’ financials.  By talking with current employees they will be able to understand how the business works day-to-day.  After these steps are completed, all that is left is to accurately value the business and examine their own financial situation in order to determine if a purchase is possible.  If everything is completed, they will be well on their way to becoming a new business owner.

First of all, the owner must decide what type of business they are going to run. There are five types of businesses an owner can venture into.  These are Sole Proprietorships, Partnerships, Corporations, S Corporations, and the last is a Limited Liability Company. A Sole Proprietor is “someone who owns an unincorporated business by himself or herself” (IRS).  The advantages for a sole proprietorship include that it is cheap and easy to form, the government does not regulate it highly, and income taxes are lower than corporations.  The disadvantages for a sole proprietorship include unlimited personal liability, it is difficult to obtain large amounts of capital, and it is limited to the owner’s life.

A partnership is “the relationship existing between two or more persons who join to carry on a trade or business” (IRS).  The advantages and disadvantages for a partnership are similar to that of a sole proprietorship, excluding a few government regulations.  However, in a partnership, there is shared risk and financing responsibility unlike in a sole proprietorship.

When considering forming a corporation, some advantages are unlimited life, any loss is restricted to investment, and transfer of ownership is simple. The restrictions include double taxation and heavy regulation. An S Corporation is formed to avoid double taxation, which is the main advantage of forming such a corporation.  Disadvantages for an S Corporation include numerous regulations and requirements that must be upheld, including a limit on the number of shareholders, and like a C Corporation, it can be costly to set up and follow corporate formalities (All Business).

A Limited Liability Company (LLC) “is a relatively new business structure allowed by state statute” (IRS).  Advantages of a LLC include limited personal liability for the debts and actions of the owners, and there is management flexibility and benefit of pass-through taxation. However, it is more expensive to create a LLC than a partnership or sole proprietorship and state laws for creating Limited Liability Corporation may not reflect latest federal tax changes (residual-rewards).

When buying a business, probably the most important step you should take would be to determine the true value of the business. Deciding on a price for an existing business is probably the most emotionally charged decision throughout the entire process because the seller has their opinion and viewpoint of how much it is worth and the typically the buyer has another opinion. That is why when entering into negotiations, it is to the buyer’s advantage to have done research and investigations to support their counteroffer to the sellers listed price. A realistic business valuation requires more than just looking over the past year’s financials; it requires a thorough evaluation of several years of the business operations and projected future profits. There are several different ways to determine the value of a business. Most people think that a business is worth the Fair Market Value. According Ruling 59-60, the Fair Market Value is defined as, “the price at which the property would change hands between a willing buyer and willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Additional methods to determine the value include, book value, discounted cash flows, return on investment, earnings multiple, and intangible value.

The book value method is “the difference between the original acquisition cost and the amount of accumulated depreciation.” (text bk) The only problems associated with this method is that it does not take into account the present value of the original cost, depreciation expenses can transfer values at the wrong time, and intellectual property such as patents, trademarks, and trade secrets don’t have book value.

Unlike the book value method, the discounted cash flows method takes into account the present value of future cash flows. This method identifies the value of a business to be its future earnings. “Discounted cash flows are cash flows that have been reduced in value because they are to be received in the future. This requires estimating the amount and timing of future cash flows and dividing each cash flow by a required rate of return compounded by the time that will pass before the next cash flow is received.” (tx bk)

The return on investment method is the most common method in determining the value of a business. Return on investment is not profit; it is, “the amount of money the buyer will realize from the business in profit after debt service and taxes.” (entreprenure.com) A typical small business earns between 15 and 30 percent on investment. This is the average net in after-tax dollars. This method identifies the value of a business, as it’s potential to earn money in the future from the initial investment. No doubt the business should at least break even and if it can produce a 15 percent return, then it is a business worth investing in.

The earnings multiple method is the, “ratio of the value of a firm to its annual earnings.” (tx bk) Most multiples aren’t based on fact, but rather an industry average. Some individuals within an industry may claim that their business should sell for three times their annual gross sales, or two times their gross sales plus their inventory. Whichever method the owner uses to determine a multiplier, that number is then multiplied by the company’s annual gross sales. When using this method it is best to calculate it for the business you are considering and a similar business that was recently sold. There is no real way to determine whether the multiplier the company used is accurate since an outside source did not perform a survey to arrive at the particular number. If the seller uses this method, it would be wise to use this price only as an estimate.

A huge advantage to buying an existing business is the established customer base and goodwill. The intangible value method is based upon the buyer buying these advantages rather than having to create and establish them. Some business owners will try and sell goodwill as an asset, even though it is not considered an asset on the financial statements. Goodwill does have value, but it is the financial value that needs to be placed on the financial statement, not the psychological value. Almost like the earnings multiple method, when valuing their business, the seller’s number is reached arbitrarily because they base it on how much they believe their goodwill and established customer base to be worth. It is important to consider these intangible assets, but it is difficult to match an exact price with it, that is why the return on investment method is the most commonly used and easiest to determine.

There are a few other factors that can affect the price of a business such as economic conditions and motivation. During economic expansions, businesses tend to sell at a higher price, and during economic recessions, businesses tend to sell at a lower price. How badly the seller wants to sell their business and how badly the buyer wants to buy the business is an important factor that can easily influence the price. If the seller is in a hurry to get out of the business, they are more likely to sell at a discounted rate in order to sell it faster. This works to the buyer’s advantage to play the waiting game for a lower price. As stated earlier, there are many different ways to determine the value of a business, but it is best to use multiple methods in order to come to the best possible value of the business.

 

The analysis of the current business plan is vital in starting a new business.  A business plan outlines the key elements of a firm.  These elements are product or service, industry, market, manner of operating (production, marketing, management), and its financial outcomes.  When starting a business, owners have to look at the current business plan that has been set in place to determine if they want to keep the original or change it to meet their standards.  A business plan is important because it surrounds the business, and engrosses them with a wealth of knowledge about the company.  Without this there would not be an opportunity to communicate effectively with your investors.  This is also important because it directs everyone to focus on the same outcome.  When there is lack of a common goal chaos and confusion can evolve within in the firm.  When the analysis of the business plan is complete, the business is clearly able to assess its opportunities, determine the amount of resources necessary, and visibly see the path of implementation.

An industry analysis is essential to complete before deciding whether or not to buy a business.  By conducting an industry analysis, potential buyers will be able to forecast the potential profitability of the business they are looking to buy.  A general external analysis and an industry competitive analysis will be sufficient for an industry external environment analysis. The general external environment includes topics such as: demographics, economic, political and legal, sociocultural, technological, and global aspects to the industry’s external environment.  The competitive analysis determines how attractive that particular industry is based on potential profitability.  The five forces that comprise the competitive analysis are threat of new entrants, threat of substitute products, bargaining power of suppliers, bargaining power of buyers/customers, and rivalry among competing firms within the industry.  The threat of new entrants is determined by barriers to entry such as economies of scale, switching costs, access to distribution channels, and government policies.  Threat of substitute products would include products with improving price or performance tradeoffs relative to the present industry products. Bargaining power of suppliers, or the threat of the supplier to raise prices or reduce quality, is determined by whether or not the supplier industry is dominated by a few firms, if suppliers’ products have few substitutes, if the buyer is not an important customer to the supplier, and if the supplier has a threat of forward integration.  Bargaining power of buyers, or the power to bargain down prices or forcing higher quality, is determined by factors such as: the product is undifferentiated, buyers face few switching costs, buyers’ industry earns low profits, buyer has full information, and buyer presents a credible threat of backward integration.  When analyzing rivalry among competing firms it is good to look at the market types, slow cycle, standard cycle, or fast cycle.  In a slow market cycle, companies are shielded by monopoly power or a strong brand loyalty which leads to a lack of inter-firm rivalry.  In a standard cycle, it is highly competitive despite world class products with companies focusing on high volume and product development in order to get on top. In a fast market cycle, sustained competitive advantage is very unlikely because of the constant rivalry among companies.  Clearly it is best to enter a slow cycle market if possible, because these markets have the least amount of rivalry among competing firms.  It is also important to research the potential opportunities that can assist a company to achieve strategic competitiveness and threats that could possibly hinder a company’s efforts to achieve strategic competitiveness within the industry.

Depending on the results of each category a potential buyer would determine if that industry would be profitable to enter.  For example, if there is high threat of new entrants, low threat of substitute products, low bargaining power of suppliers and buyers, and moderate level of rivalry, then the industry would be attractive for a potential buyer to enter because there would be high potential for profitability.  If a company enters into an industry without conducting an external or industry analysis, there is a (research) high percentage that they will not be able to sustain profitability.

When buying a business, there is most likely always left over inventory that the seller has bought but has not sold yet.  It is important to meet with the seller to go through and examine the entire inventory.  When examining the inventory, the buyer should find out how much is on hand at the present time and how much will be on hand at the end of the fiscal year.  Since inventory is listed as an asset on the financial statements, it is also good to get the inventory appraised to make sure depreciation is listed correctly.  Depending on the type of business it is depends on the importance of investigating the current inventory and the current inventory method.  If it is a service business, the inventory is not as big of an issue as it is in a manufacturing business.  A manufacture’s inventory is the business’ most important asset because they have three different types of inventory, raw materials, work-in process, and finished goods to evaluate.  When evaluating the inventory, manufactures have two different methods to choose from, LIFO, which stands for last-in first-out, or FIFO, first-in first-out.  Also when figuring the value of the inventory, the buyer and seller must be able to come to an agreement on which method they will use, because these two methods can produce very different numbers.  The most common method though used in valuing inventories for buying and selling small businesses are cost of last purchase and current market price.  When the inventory is being priced, be very careful in matching price to quantity.  It is important to make sure that the units in which the quantity was recorded matches the units priced.  Also if the inventory does not meet the buyer’s quality standards, the buyer can always reject the inventory and discuss this in the negotiations of the price.

When starting a business there are two concerns an owner must confront.  Where will the business be run, and will building be bought or built.  These decisions are important because they will affect the feelings of future customers.  Customers like comfort and convenience.  These decisions also affect the employees of the company. Employees prefer to work in a safe environment that is not too far from home.

If a business owner decides to buy a pre-existing building, the conditions of the building should be examined to see if it meets certain governmental regulations and if there are needed repairs. For example if the building looks damaged, it is not up to code in food areas, and the environment feels unsafe then this will create a possible lawsuit from employees and customers. In the beginning, make sure a building inspector and a health inspector come out to check the building and the property. If the owner is building it is still a safe practice to have the property inspected as well. This will benefit the company in the future.  The main goal of these two decisions is to make the customer want to come back.

If the entrepreneur decides to buy a company an abundant resource for information about the interworking of the organization is its current employees.  Current employees of a similar organization are also very useful as well.  They know firsthand what it is like to be a part of the company and how it gets along day-to-day.  It is important to tread lightly as to not make current employees feel that the new owner is there to only disrupt the pattern they have.  An effective way to gather all of the information that an owner needs is to set up a private interview with one or two employees from each part of the business.  For example, if you were considering purchasing a restaurant, you would want to discover the facts from the point of view of a manager, as well as a member of the wait staff.  It is very important to talk to the members of the staff that have direct contact with the customers because they will be able to tell you what comments the customers may have had about the business and what you can expect from the typical customer base.  This technique will best ensure that the owner does not have too many biased opinions in your information pool.  Another way to go about gathering information from the employees is to hold a sort of focus group.  This would include a gathering of all of the key employees together to answer questions.  This method would definitely be less time consuming, but may not lead to as many truthful answers because of the presence of other employees.  There are a few questions that it would most benefit the owner to know the answer to.  One is to find out what they would do if they were given the chance to run things.  What would they do differently?  Another is to find out what they like the most about the current business.  The owner should want to know what they definitely do not want changed and what techniques and practices that they think are working and not working.  The entrepreneur will also want to find out if any of the employees would be inclined to leave the organization if it were to be sold to new management.  Overall, there are many clues to the efficiency of the organization that the owner will only be able to discover by talking to its current employees.

Another important step is to hire a competent independent auditor to make sure that the seller is accurately representing the financial state of his business.  These auditors are completely independent and will give the owner an unbiased evaluation of your potential business’ financials.  Their principle role is to give the owner an opinion on whether the information they were given was free of misrepresentation.  This is imperative because the owner needs accurate financial information to even consider purchasing an existing business.  The auditor the entrepreneur chooses should be certified as a public accountant.  Before hiring, it would be in the best interest of the future owner to review his/her references and discuss work that has been done for past clients.  They will be in charge of going over all of the organization’s accounting information and checking for accuracy.  At the end of their study, they will be able to communicate to the future owner any discrepancy in the organization’s accounting principles, the clarity and completeness of all of their financial statements, and “Any items that have a significant impact on the representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements” (aicpa.org).  Another important method they should be able to discover is the one that the current management of the company used in formulating certain estimates in their accounting.  All of this information will prove vital in the future owner’s decision-making process on whether or not to purchase the business.  The American Institute of Certified Public Accountants makes a great resource for finding answers to any more questions and assistance in finding a quality auditor.

Another important issue for an owner to consider when starting a business is investing into a lawyer.  An owner may need a lawyer for multiple situations such as government law and regulations, contracts, and other specific situations when starting a business as well after the business has been established.  As stated previously there are five different types of businesses that an owner can embark upon.  Each of these businesses requires permission of establishment from the government, some being more complicated than others.  Lawyers are helpful in smoothing out the process.  Once an owner has decided to purchase an existing building or build from the ground up there are stipulations that have to be met.  A few of these requirements are permission from the government to build on the land, test the land for any hazardous materials that could be in or under the soil, as well as many other requirements.  Lawyers that specialize in small businesses assist in making sure all requirements are met and there are no legal issues that may hinder the growth of the organization.

Contracts can be very specific depending on the arrangement being made, and can sometimes manipulate words to create a different meaning.  Before signing agreements with vendors, contractors or other necessary companies that the owner will do business with, it is important for a lawyer to look through the contract for any hidden meanings.  Contracts are binding agreements that can sometimes be impossible to get out of should the covenant go sour. Lawyers can reassure that the deal between the owner and the other party are fair and beneficial.

According to a book, Entrepreneurial Small Business, one in ten small businesses will inevitably go through some type of lawsuit.  A small business can be sued by employees, customers and suppliers.  In these situations it is almost impossible to survive without a lawyer’s assistance and representation.  Whether the owner settles or goes to court the best way to get through a traumatizing situation is to rely on a lawyer.

Once an owner has decided to obtain representation there are two options.  The first option is to retain a lawyer, meaning the owner pays a specific amount every month to the lawyer regardless of the workload for that month (Green 590).  The second option is to hire a lawyer upon condition.

When hiring a lawyer the best resource to find a lawyer is by referral.  Other small business owners that have used a specific lawyer in the past can give positive or negative testimonials to aid you in the search (Lewis).  Other resources are web sites such as the Small Business Administration website, other government sponsored websites, or web searches.  These sites can assist in finding a local lawyer that can assist in the specific need of the small business owner.

Once the owner has found a lawyer there are some basic questions that can assist in discovering if the specific lawyer is the best fit for the owner and the business.  A few of these questions are: does the lawyer provide a free consultation, can their fee be negotiated, have they handled similar cases or needs, can they provide references from other clients, will the lawyer personally work on the case or will others work on it also, what is the lawyers current case load (www.smallbusinesslawfirms.com).  When the owner is discussing the fee it is important to note the type of payment the lawyer requires.  Do they charge by the hour, a flat rate or is the payment contingent (Green 590).  A flat rate is a fixed amount paid for a certain task. Contingency is fee paid by a client to an attorney for legal services that is dependent upon the outcome of a case (Green 590).  In anyway situation it is wise for a small business to research a lawyer and perhaps talk to one before, during and after the establishment of the business.

Last but not least it is important for any business owner to know where their finances are going to come from.  Savings, out of pocket, family investment, and loans are a few ways that owners can finance their business.  Any of these options can be matched together. If an owner should take out a loan it is important to know ahead of time what their credit score is.  This can be found by one of the three credit agencies; Equifax, TransUnion, and Experian.  The entrepreneur(s) can get a free credit report by going to http://www.annualcreditreport.com.  At this site it is safe, easy and free to find information on what liabilities are out and what debt a person has under their name.  Knowing this type of information is excellent to know if the owner has to take a loan out from a bank or outside lender.  The credit report lets lenders and other investors know the history of the owner; if they have a history of skipping payments is a good example.  Family is another source of finding funding.  Family members can be very involved in opening an organization and can be helpful not only in assisting with capital but also support of starting a business.  Also loans from family members can be a more lenient in repayment than a bank or other outsider lenders.  Out of pocket and savings is another way to finance starting a business.  It is not uncommon for an owner to be a part-time entrepreneur.  Working a full time job and starting a business on the side helps continue a steady income during the beginning stages of a business.  Whichever way the owner decides to finance their business it is important to have an idea beforehand.

In conclusion, the above ten things are only a few steps an owner needs to take when starting their own business. Know the type of business to enter, make a business plan, know the industry, know location, if it is going to be in an existing building or new one, know what inventory is needed, talk to current employees, have an auditor, a lawyer, and know the finances to start the business of. Although there is much more information to getting started, these ten are steps in the right direction to becoming the new owner of a business.


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