CHAPTER 4 BUYING AN EXISTING BUSINESS

CHAPTER OVERVIEW

 

Buying an existing business is an option into entrepreneurship chosen by many people. Relative to the alternative of starting a business, buying offers an identifiable set of advantages and disadvantages. The chapter examines these advantages and disadvantages, explains the determinants of price, and then explores negotiations as an aspect of the purchasing process.

 

 

LEARNING OBJECTIVES

 

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 Buying an existing business has several important advantages over starting one, including less risk, less time and effort, and the possibility of getting a bargain.

 

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Finding a business to buy should not be confined to the standard channels where businesses for sale are advertised.

 

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Determining the value of the business requires taking into account both the assets the company has and the earnings it is likely to achieve in the future.

 

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In order to negotiate effectively, the entrepreneur must gather as much information about the company and the industry as possible.

 

 

CHAPTER OUTLINE

 

I.          Advantages of Buying a Business

 

A.        Less Risk

 

1.         Starting a business brings with it the possibility of a critical element in the operation of the enterprise being overlooked, or not adequately addressed.

 

2.         With the purchase of an ongoing business, this kind of planning omission is less likely to occur.

 

B.        Less Time and Effort Required

 

1.         For a business to establish operations requires considerable attention to a wide range of details.

 

2.         The management of an existing business has developed relationships and procedures that allow the business to operate.

 

C.        The Possibility of Buying at a Bargain Price

 

1.         The prospective buyer of an organization can uncover candidates for purchase that are underpriced.

 

2.         The likelihood of finding such a bargain depends on who is doing the selling and the conditions under which the sale is made.

 

II.        Disadvantages of Buying a Business

 

A.        The Environment

 

1.         Some businesses are available for sale because they face a difficult set of problems.

 

2.         When these problems are outside the firm, a shrinking market for example, the outlook can be quite bleak.

 

B.        Internal Problems

 

1.         One thing that is likely to prompt an owner to sell his/her business is difficulty with its current operations.

 

2.         Anyone who intends to buy a business with internal problems would be well advised to develop the means to cope with these problems before proceeding.

 

C.        Departure of the Current Owner

 

1.         Many small firms have an existence that is closely associated with the founder.

 

2.         These businesses may suffer greatly with the departure of the owner.

 

III.       Finding the Business

 

A.        Businesses that Are on the Market

 

1.         There is an active market for the sale and purchase of small businesses.

 

2.         Among the more prominent channels for these businesses to use are business brokers and the classified ads of many newspapers.

 

B.        Businesses that Are Not on the Market

 

1.         According to the view of some people, the best opportunities for acquisition of a business are those that are not on the market.

 

2.         This reasoning leads to the recognition of the importance of finding the right one from among those in operation, without restricting the search.

 

3.         The direct and indirect methods of locating a business are both available and should be considered for use.

 

IV.       Determining the Price of a Business

 

A.        Anyone considering the purchase of a business must recognize and understand the difference between price and value.

 

B.        Any system of evaluation of a business should incorporate the value of the firm’s assets and its expected flow of future earnings.

 

V.        The Negotiating Process

 

A.        The way in which the process leading to a deal proceeds affects the satisfaction experienced by both the buyer and the seller.

 

B.        Price Versus Value

 

1.         Many business owners do not know the value of the business but must nonetheless set the price when it is time to put it on the market.

 

2.         The price of the business is whatever the owner chooses; its value, however, is established in the market only when a buyer agrees to pay the price.

 

VI.       Sources of Power in Negotiations

 

A.        Among the sources of power held by the parties in negotiations, the most important is probably information.

 

B.        Other factors affecting the power of the parties are timing and the availability of alternatives.

 

 

SUGGESTED RESPONSES TO DISCUSSION QUESTIONS

 

1.         Why is buying a business a less risky proposition than starting one?

 

Buying a business means buying something that has been established. Starting one means dealing with a variety of details, all of which must be taken care of in a careful, sometimes exhaustive, way.

 

2.         How would you go about finding a business to buy if you didn’t see anything in the classified ads that you liked?

 

If a prospective buyer did not find an acceptable business through the use of conventional channels, he or she could explore the prospects that exist among other firms. To do so, he or she could contact them directly or go through bankers, accountants, lawyers, and others who serve small business, in hopes of finding an owner who, despite not having put the business on the market, may entertain the idea of selling.

 

3.         Why is the negotiating process important in the purchasing a business?

 

The negotiating process determines both the final price and the way in which that price is reached. The process therefore plays an important role in determining the satisfaction experience by both parties.

 

4.         What are the two major determinants of the value of a business? Explain each of them.

 

The two determinants of value are the firm’s assets and its projected future earnings. The assets may be evaluated in four ways: using book value, replacement value, liquidation value, and an appraisal value. The value of a company’s future earnings must be adjusted using interest levels and the period of time before the earnings materialize.

 

5.         Distinguish between price and value. What does it mean to say that the owner sets the price of a business, but the buyer sets the value?

 

Price is what the seller wants it to be; value is determined in the market. When an owner puts the business up for sale the price must be set, but the response of the prospective buyers will determine whether that price matches value.

 

6.         Explain the sources of power for the parties in negotiations.

 

Information is typically the most important source of power during negotiations and is usually held by the seller. Consequently the buyer must go to great lengths to gather and analyze information in order to keep from being at a disadvantage. Another source of power is the set of alternatives available to each of the participants. If the owner must sell for some reason, the prospective buyer may be able to extract better terms. If, on the other hand, the owner is content staying with the business for the foreseeable future and the buyer has concluded that this business is the only acceptable one, the power is clearly in the hands of the owner.

 

 

LINK TO THE BUISNESS PLAN

 

A business plan is just as necessary when buying an existing business as when starting one.   However, some of the questions will be different.  The need for the business is generally demonstrated by good sales and profit. For this reason, the last three years of financial statements should be included in the business plan along with projections for the next three years.  If the company does not have good sales and profit levels, the buyer must state what will be done to turn the company around.  The business plan must also include the sales price of the company and how that price was determined.  Bankers and investors will most likely want an appraisal of tangible assets to compare to the selling price. Any changes in company operations or personnel should also be included.

 

The business plan will require the entrepreneur to answer:

 

Why is this business for sale?   Why do you want to buy it?

 

What is the selling price and how was it determined?  Do you have an appraisal of the     tangible assets?

 

Will the seller be available after the sale to answer questions and give advice?

 

HELPFUL WEBSITES

 

http://asbdc.ualr.edu/bizfacts/

This is the site of the Arkansas Small Business Development Center. It offers guidelines on virtually every aspect of entrepreneurship, including buying a business. It provides a useful and easy-to-follow method for valuation of the business being considered for purchase.

 

http://www.business.gov/phases/launching/buy_business/index.html

 Included here are topics including purchase research, determining value, sales agreement, due diligence, and a closing checklist.

 

http://sbinfocanada.about.com/cs/buysellabiz/a/buybusinessstep_p.htm

This is a short and practical description of what the process of purchasing a business should look like. The author, Susan Ward who wrote “Your Guide to Small Business: Canada,” provides an interesting comparison of locating and deciding on a business with what is involved in buying a used car.