Entrepreneurship: Chapter 12 Business Buyout PDF

CHAPTER 12: THE BUSINESS BUYOUT LEARNING OUTCOMES LO1: Evaluate the option of buying an existing business by identifying the advantages and disadvantages. LO2: Conduct a self-audit as a requirement for finding a business to buy. LO3: Identify where to search for a business...

CHAPTER 12: THE BUSINESS BUYOUT LEARNING OUTCOMES LO1: Evaluate the option of buying an existing business by identifying the advantages and disadvantages. LO2: Conduct a self-audit as a requirement for finding a business to buy. LO3: Identify where to search for a business to buy. LO4: Evaluate available businesses before buying one. LO5: Apply methods for determining the value of a business. LO6: Identify important issues in the negotiation process with regard to determining the final purchase price of the business. LO7: Identify the traps to avoid when buying an existing business.  12.1 INTRODUCTION It is also not always necessary, or essential, for would-be entrepreneurs to start their new business from scratch or join a family business to be regarded as a true entrepreneur. The alternative option is to buy an existing business or a franchise – this is known as a buyout. Buyouts are transactions that transfer ownership of a business from one or more owners to a newindividual, group of individuals or business entity. Read: Existing business or franchise?  12.2 EVALUATING THE OPTION OF BUYING AN EXISTING BUSINESS 12.2.1 The advantages of buying a business Zimmerer and Scarborough (1998) list the following advantages: The business is a going concern. It is often easier to obtain finance for a going concern than it is for a start-up. A successful existing business may have a better chance of continuing to be successful. Location is of the utmost importance and critical to the success of a business, and an existing business may already have an excellent location.  12.2 EVALUATING THE OPTION OF BUYING AN EXISTING BUSINESS (continued) 12.2.1 The advantages of buying a business (continued) Experienced and reliable employees are already on the payroll of the business and can continue their services. The suppliers are also established, and the owner is spared the effort of building relationships with new suppliers. Inventory is in place. The equipment has been installed, and the production capacity is known. It is possible to buy an existing business at a bargain price.  12.2 EVALUATING THE OPTION OF BUYING AN EXISTING BUSINESS (continued) 12.2.2 The disadvantages of buying a business Zimmerer and Scarborough (1998) list the following external and internal problems or limitations: The business was never profitable, but the owner has disguised this fact by employing a “creative accounting” technique. A business can have an inadequate sales volume. A business may have a poor reputation or image. Some of the employees inherited with the business may not be suitable for the job.  12.2 EVALUATING THE OPTION OF BUYING AN EXISTING BUSINESS (continued) 12.2.2 The disadvantages of buying a business (continued) The business location may not be all that favourable The equipment, facilities and inventory may be obsolete. The business may be overpriced. Consider the disadvantage of operating in the shadow of the previous owner (Lambing & Kuehl 2007).  12.3 FINDING A BUSINESS TO BUY 12.3.1 The search for a suitable business Businesses on the market – These are businesses that are known to be for sale. They are advertised in the newspaper and through property or business brokers. In the majority of cases, the owner tries to sell the business on his or her own. Businesses not on the market – Zimmerer and Scarborough (1998: 105) regard the so-called hidden market as one of the richest sources of top-quality businesses. A very high percentage of buyout opportunities can be found in the unadvertised market. Usually these types of available business represent an attractive opportunity. Typical sources include property agents, business brokers, financial institutions, accountants and auditors.  12.4 EVALUATING AVAILABLE BUSINESSES Now that the prospective buyer has a list of available businesses, it is time to start evaluating and investigating the businesses. No matter what the source of the business opportunities, careful analysis and homework are fundamental requirements.  12.4 EVALUATING AVAILABLE BUSINESSES (continued) The following questions should be addressed: 1. Why is the business for sale? 2. Is the business profitable? 3. What skills and competencies are needed for managing the business? 4. What is the history of the business regarding its previous owners, its reputation and public image? 5. What is the physical condition of the business, its facilities and all other assets? 6. What are the degree and scope of competition? 7. What is the existing and the potential market size? 8. What important legal aspects must be considered?  12.5 METHODS FOR DETERMINING THE VALUE OF A BUSINESS Several methods can be applied to determine the value of a business. Different people will perhaps give different suggestions. Valuing a business is a complex process, but in the end it is worth the effort and expense.  12.5 METHODS FOR DETERMINING THE VALUE OF A BUSINESS (continued) The following methods are discussed: The asset-based method: This method can also be referred to as the balance sheet method. This is where the worth or value of the business is determined by equity – the total assets minus the liabilities. The market-based method: This technique relies on the financial markets to estimate the value of the business. The actual market prices of similar businesses that have been sold recently can be taken as an indication. Price-to-earnings ratio = Market price/After-tax earnings  12.5 METHODS FOR DETERMINING THE VALUE OF A BUSINESS (continued) The earnings-based approach: When one buys a business, one is actually buying future income. This is, in fact, what one is interested in. The earnings-based approach meets the requirement of considering the business's income potential. – The excess earnings method: A combination of the value of the existing assets of the business and an estimation of future earnings is used. This actually leads to an estimate of goodwill. – The capitalised earnings approach: It is important to determine the net earnings for the coming year by using the income statements for previous years. It is also important to determine the rate of return that the buyer requires from making the investment when buying the business. – The discounted future earnings approach: This approach assumes that a rand earned in the future will be worth less than a rand today.  12.5 METHODS FOR DETERMINING THE VALUE OF A BUSINESS (continued) Non-quantitative factors in valuing a business According to Longenecker et al. (2003), some of the non- quantitative factors for evaluating a business are: Competition. Market share is important for every business. The prospective buyer should therefore look into the extent, the intensity and also the location of competing businesses. Future community developments. It is important to research future developments in the community. Legal commitments. It is important for the prospective buyer to ensure that there are no contingent liabilities, unsettled lawsuits, etc. Employee contracts. It is important to determine what the existing employee contracts entail and the quality of the business relations with the employees.  12.6 THE NEGOTIATION PROCESS 12.6.1 The The generic stages stages in negotiation in negotiation include the following: Stage 1 – Preparation: It is important to clarify your objectives. Stage 2 – Discussion: This step starts when you begin to engage the other side, share information and explore options that address mutual interests. Stage 3 – Bargaining: Bargaining is the real "face-time" with the other party and focuses on a 'win-win' outcome where both sides feel they have gained something positive through the process. Stage 4 – Conclude: This is the point in the process when you reach an agreement. Stage 5 – Execute: It is about the implementation of the  12.6 THE NEGOTIATION PROCESS (continued) 12.6.1 The stages in negotiation (continued) These stages of negotiation can be summarised in the following steps (Zimmerer & Scarborough 1998): The business for sale must be identified and approached. Once the buyer and the 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”. This is a non-binding document. The buyer does a due diligence investigation to make sure that the business is good value for money. Once this has been done, and within the time agreed on in the letter of intent, the parties draw up the purchase agreement. When the purchase agreement has been drafted, the buyer and the 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.  12.6 THE NEGOTIATION PROCESS (continued) 12.6.2 Price vs value According to Lambing and Kuehl (2007), the value of a business is set in the marketplace and is what someone is willing to pay for it. It is ultimately set by the buyer. The seller determines a price for the business by using a computational method. When the buyer agrees that the business is worth as much as the asking price, or perhaps more, the sale is made. However, setting the price for the business does not make the business worth that amount – price and value are therefore two different things.  12.6 THE NEGOTIATION PROCESS (continued) 12.6.3 Sources of power in negotiations During the negotiation process, there are different sources of power that may come into play. Information: If the buyer does not have complete and reliable information about these factors, they are at a serious disadvantage. Timing: If the seller is in desperate need of money because they are already involved in another business, the buyer is in a favourable situation if they are the only interested buyer. Pressure: In the case of a business having more than one owner, there may be pressure from some of the owners or partners to make it a quick sale, while others may want to maximise the final agreement.  12.7 TRAPS TO AVOID WHEN BUYING AN EXISTING BUSINESS There are a few traps to avoid when buying a business (Timmons and Spinelli 2009). These traps include: – Legal circumference – Attraction to status and size – Unknown territory – Opportunity cost – Underestimation of other costs – Greed – Being too anxious and impatient