Section II - Building the Business Plan: Beginning Considerations
Chapter 5
Buying an Existing Business (PPT 5.1 thru 5.3)
Part One: Learning Objectives
1.
Understand the advantages and disadvantages of buying an existing business.
2.
Define the steps involved in the right way to buy a business.
3.
Explain the process of evaluating an existing business.
4.
Describe the various techniques for determining the value of a business.
5.
Understand the seller's side of the buyout decision and how to structure the deal.
6.
Understand how the negotiation process works and identify the factors that affect the
negotiation process.
Part Two: Lesson Plan
I.
Buying an Existing Business (PPT 5.4 thru 5.9)
A.
B.
II.
Advantages
 A successful existing business may continue to be successful.
 An existing business may already have the best location.
 Employees and suppliers are established.
 Equipment is installed and productive capacity is known.
 Inventory is in place and trade credit is established.
 The new business owner hits the ground running.
 The new owner can use the experience of the previous owner.
 Easier financing.
 It's a bargain (maybe).
Disadvantages
 It's a loser (maybe).
 The previous owner may have created ill will.
 Employees inherited with the business may not be suitable.
 The business location may have become/is unsatisfactory.
 Equipment and facilities may be obsolete or inefficient.
 Change and innovation are difficult to implement.
 Inventory may be outdated or obsolete.
 Accounts receivable may be worth less than face value.
 The business may be overpriced.
Steps in Acquiring a Business (PPT 5.10)
 Analyze your skills, abilities.
 Prepare a list of potential candidates.
 Investigate and evaluate candidate businesses and evaluate the best one.
 Explore financing options.
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
Ensure a smooth transition.
YOU BE THE CONSULTANT- Is This Any Way to Buy a Business?
David Clausen’s eagerness to buy a business got the best of him as he clearly “leaped before he
looked.” He was lucky to purchase the business for a very low price from the obviously disinterested and
ill-advised family of the deceased former owner. Clausen persevered through a rough and slow start,
updated his equipment to gain a competitive edge and turned the company into a success story. It is still
unclear as to whether Clausen has a passion for the mapmaking business.
Q1. Evaluate the way in which David Clausen went about finding a business to buy, assessing it, and
searching for financing. What did he do right? What did he do wrong?
Q2. What should Clausen have done differently?
A1. Using a broker was a good start, as was determining his own business value (apart from the owner’s
asking price). Clausen gave no thought as to the kind of business that would be compatible with his
experience or personality. He also had no systematic approach in gathering information nor did he
conduct research. An appraisal was not conducted to determine the fair market value of business assets.
A2. Clausen should have first analyzed his own skills and interests, and then proceeded to prepare a list
of potential candidates, investigate and evaluate each, explore financing options and ensure a smooth
transition through the building of a formal business plan.
III.
Evaluating an Existing Business – The Due Diligence Process (PPT 5.11)
A potential buyer should explore a business opportunity by examining five critical areas.
1.
2.
3.
4.
5.
Why does the owner want to sell?
Assess the condition of the business:
- The physical plant
- Accounts receivable
- Lease arrangements
- Business records
- Intangible assets
- Location and appearance
What is the potential for the company's products or services?
- Customer characteristics and composition
- Competitor analysis
What legal aspects should you consider? (PPT 5.12 thru 5.16)
- Liens
- Bulk transfers
- Contract assignments
- Covenants not to compete
- Ongoing legal liabilities
Is the business financially sound?
- Income statements and balance sheets for past 3-5 years
- Income tax returns for the past 3-5 years
- Owner's compensation (relatives, skimming)
- Cash flow
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YOU BE THE CONSULTANT - Escaping a High-Tech World for a Low-Tech One
The Lusby’s began their search for a new business venture in the correct manner. They took the
time to consider both their personal and lifestyle goals. They then proceeded to take a close look at their
major category options and limit those to one. This was followed by a nationwide search for the retail
establishment with living quarters that they were after.
Their search unfortunately ended too soon. They failed to properly assess the past, present and
future outlook of the business, its markets, products and finances. Those oversights caused problems that
could have been avoided. Their initial search for their best business match did come back to bless them
as they rode out the storm and now enjoy their new life.
Q1. Suppose that the Lusbys came to you for advice on buying their business. What would you have told
them?
Q2. Should the Lusbys have done anything differently in their quest to buy a business? Explain.
A1. & A2. The Lusbys should have completed the steps and the process of buying a business. They
identified the kind of business and lifestyle that they wanted, but did not properly assess the marketing,
operational and financial condition and potential of the business.
IV.
Methods for Determining the Value of a Business (PPT 5.17)
Business valuation is partly an art and partly a science. Establishing a price for a privately
held business may be difficult due to the nature of the business itself.
A.
B.
V.
There are a few rules for establishing the value of a business:
 There is no single best method to determine a business's worth. The best way
is to compute the value using different methods and choose the best one.
 Both parties, buyer and seller, must be satisfied with the deal.
 Both the buyer and seller should have access to business records.
 Valuations should be based on facts, not fiction.
 Both parties should deal with one another honestly and in good faith.
Business valuation techniques
1.
The Basic Balance Sheet Methods (PPT 5.18)
a. The Balance Sheet Technique
b. Adjusted Balance Sheet Technique
2.
Earnings approach (PPT 5.19 thru 5.29)
a. Variation 1: Excess Earnings Method
b. Variation 2: Capitalized Earnings Approach
c. Variation 3: Discounted Future Earnings Approach
d. Market Approach
Understanding the Seller's Side (PPT 5.30 thru 5.33)
A.
B.
Structuring the Deal: This is one of the most important decisions a seller can
make. Tax implications can be significant; therefore, a skilled tax planner can
help.
Exit Strategy Options:
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






*Straight business sale
*Form a family limited partnership
*Sell a controlling interest
*Restructure the company
*Sell to an international buyer
*Use a two-step sale
*Establish an employee stock ownership plan (ESOP)
YOU BE THE CONSULTANT – A Seller’s Tale
The owner of the magazine Dive Travel made the decision to sell his business. That was the easy
part. It took more than a year to locate a serious and qualified buyer and another six months to finalize
the deal. After a sometimes-heated negotiation process, a short- and long-term agreement was reached to
the satisfaction of both parties.
Q1. Why is the process of valuing a business so difficult for the entrepreneur who founded it?
Q2. Which method(s) of valuing a business do you think would be most appropriate in placing a realistic
value on Dive Travel? Explain.
Q3. Evaluate the final deal the parties struck from both the buyer's and the seller's perspectives. Do you
think the deal was “fair”?
A1. It is relatively easy to place a value on the physical plant assets of a business. Placing a value on the
name, reputation and standing of the business (goodwill) is much more difficult. The seller will often
have a much higher value in mind than the buyer.
A2. Buyers should always run as many pricing models and pro-forma spreadsheets on a business as
possible in order to collectively and carefully determine a fair price.
A3. The buyer and seller were both satisfied with the deal in the end.
VI.
Negotiating the Deal (PPT 5.34)
A.
Factors Affecting the Negotiation Process
- How strong is the seller's desire to sell?
- Is seller willing to finance part of purchase price?
- Must the seller close the deal quickly?
- What deal structure fits your needs?
- What are tax consequences for both parties?
- Is seller willing to stay on as a consultant?
- What general economic conditions exist in the industry?
B.
The Negotiation Process
- Refer to figure 5.6
Part Three: Suggested Answers to Discussion Questions
1. What advantages can an entrepreneur who buys a business gain over one who starts a business
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“from scratch”?
The advantages of buying an existing business may include:
a. A Successful Existing Business May Continue to be Successful: Buying a thriving business
increases the likelihood of success. Former owners have already established a customer base, built
supplier relationships, and set up a business system. With these in place, the new owner has an
advantage over one who is starting from scratch.
b. An Existing Business May Already Have the Best Location: If the location of a business is
critical to its success, it may be wise to purchase a business that is already strategically located.
c. Equipment is Installed and Productive Capacity is Known: The buyer does not have to invest in
equipment, and the previous owner may have established an efficient production operation. Thus,
the new owner can use these savings in time and money to improve and expand the existing
equipment and procedures.
d. Inventory is in Place and Trade Credit is Established: Establishing the right amount of inventory
can be costly. If there is too little inventory, customer demand cannot be satisfied. If too much is
available, excessive capital is tied up, costs are increased, and profits decrease. There is a
tremendous advantage if previous owners have established a balance in inventory. In addition, a
proven track record gives the new owner leverage in negotiating credit concessions.
e. Experience of Previous Owner: If the previous owner is around, the new owner can benefit from
his/her expertise. Even if the owner is not present, business records can guide the new owner.
f. It's a Bargain: If the owner needs to sell on short notice, wants a substantial down payment in
cash, or the business requires special skills, the number of buyers will be small, which may lead the
owner to sell at a lower price.
2.
How would you go about determining the value of the assets of a business if you were unfamiliar
with them?
When evaluating an existing business, a potential buyer should assemble a team of specialists to
help in determining the potential business opportunity. The team is usually composed of a
banker, an accountant familiar with the industry, an attorney, and perhaps a small business
consultant or business broker. Company records, interviews with management, and particularly
financial statements will help the potential owner and the team of specialists to identify the
assets. Once the assets are identified, it may be necessary to hire a professional to assess value to
the major components of the building -- structure, plumbing, heating and cooling system, as well
as inventory.
3.
Why do so many entrepreneurs run into trouble when they buy an existing business? Outline the
steps involved in the right way to buy a business.
Buying an existing business can be risky if approached haphazardly. To avoid costly mistakes, an
entrepreneur should follow a logical, methodical approach:
 Analyze your skills, abilities and interests: Consider what business activities you enjoy most,
what kind of business you want to buy, what you expect from the business and how much time
and energy you have to invest.
 Prepare a list of potential candidates: Examine businesses for sale, as well as those that may
be in the "hidden market."
 Investigate and evaluate candidate businesses and choose the best one: Investigate potential
candidates in more detail. Perform a SWOT analysis on each. Examine company financial
statements.
 Explore financing options: Consider the options for financing. Often, financing for an existing
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
4.
business is easier than for a new one. Although many traditional lenders shy away from deals
involving purchases of existing business and others only lend a portion of the assets, most
buyers still have access to a ready source of financing-- the seller. Many times, the seller will
finance anywhere from 30 to 80 percent of the purchase.
Ensure a smooth transition: To avoid a bumpy transition, the business buyer should:
concentrate on communicating with employees, be frank, open, and honest with employees,
listen to employees-- they have knowledge of the business, consider asking the seller to serve as
a consultant until the transition is complete.
When evaluating an existing business that is for sale, what areas should an entrepreneur
consider? Briefly summarize the key elements of each area.
When evaluating an existing business, a potential buyer should explore a business opportunity by
Answering these five critical questions.
1.
Why does the owner want to sell? Every prospective business buyer should
investigate the real reason the owner wants to sell.
2.
What is the physical condition of the business?
3.
What is the potential for the company's products or services?
4.
What legal aspects should you consider?
5.
Is the business financially sound?
5.
How should a buyer evaluate a business's goodwill?
Goodwill is a financial term for the reputation of the business and its ability to attract customers
based on that reputation. Goodwill has a value, but it is very difficult to determine in a precise
manner. The earnings approach to the valuation of a firm offers some help on valuing goodwill.
One measure of goodwill is the difference between a reasonable expected return on investment and
what you purchase the business for. Another measure if the difference between the value of the
assets of the business and what you pay for it.
6.
What is a restrictive covenant? Is it fair to ask the seller of a travel agency located in a small
town to sign a restrictive covenant for one year covering a twenty-square-mile area? Explain.
Under a restrictive covenant, the seller agrees not to open a new competing store within a specific
time period and geographic area. The covenant must be negotiated with the owner and not the
corporation to bind the owner. The covenant must be part of a business sale and must be reasonable
in scope in order to be enforceable. As for the restrictive covenant of a travel agency in a small
town, the answer depends on several factors. If this is the only travel agency, it appears that
restricting a new one would create a monopoly, thus, the covenant probably would not be
reasonable. In addition, while the term of one-year seems to be reasonable, the term of the twentysquare-mile area may or may not be reasonable depending on the size of the town, and the
possibilities of a new travel agency being built in the next town.
7.
How much negative information can you expect the seller to give you about the business? How
can a prospective buyer find out such information?
Although the seller cannot lie about the facts or mislead the seller, do not expect the seller to
disclose anything negative about the business. The sale of a business is based on the old concept of
"buyer beware." Two key steps a potential buyer should take in order to find out such "negative"
information are reviewing business records and interviewing/questioning management, legal
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council and others.
8.
Why is it so difficult for buyers and sellers to agree on a price for a business?
The negotiation process between the buyer and seller appears to be adversarial. The selling party
usually wants the "maximum" financial gain from his business; on the other hand, while the buyer
wants to buy a good business, he wants to pay the "minimum." These two forces pull against one
another.
9.
Which method of valuing a business is best? Why?
There is no “best” method for determining the value of a business; each method has advantages and
disadvantages and some are more appropriate than others under different circumstances. All
available methods should be considered as an aid to determining a truly fair price.
10.
Outline the different exit strategy options available to a seller.
Existing strategy options include:
Straight Business Sale: selling a business outright.
Form a Family Limited Partnership: entrepreneur takes the role of general partner with the children
becoming limited partners in the business.
Sell a Controlling Interest: sell majority interest in companies to investors, competitors, suppliers,
or large companies with an agreement they will stay on after the sale as managers or consultants.
Restructure the Company: replace the existing corporation with a new one, formed with other
investors.
Sell to an International Buyer: sell to foreign buyer(s).
Use a Two-Step Sale: allows the buyer to purchase the business in two phases -- getting 20%-70%
today and agreeing to buy the remainder within a specific time period. Until the final transaction
takes place, the entrepreneur retains at least partial control of the company.
Establish an Employee Stock Ownership Plan: a plan in which a trust is created for employees to
purchase their employers' stock.
11.
Explain the 5 Ps of a successful negotiation process. What tips would you offer someone about
to enter into negotiations to buy a business?
The 5 P's of a successful negotiation process include:
1.
Poise
2.
Patience
3.
Persuasiveness
4.
Preparation
5.
Persistence
12.
One entrepreneur who recently purchased a business advises buyers to expect some surprises in
the deal no matter how well prepared they may be. He says that every potential buyer must build
some “wiggle room” into their plans to buy a company. What steps can a buyer take to ensure
that he has sufficient “wiggle room”?
If the 5 P’s of negotiations are addressed, there should be enough room to negotiate and resolve
concerns in the buyer’s favor since planning and sufficient time have been given.
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Part Four: Lecture or Critical Thinking Case Studies-Not In Student Text
DETERMINING THE VALUE OF A SERVICE BUSINESS
DETERMINING THE VALUE OF A SERVICE BUSINESS
Art McDonald was a pioneer of the prisons-for-profit concept. His company, Eclectic
Communications, Inc., was one of the first to enter into the private prison industry, housing and feeding
prisoners in California.
McDonald had never been a financial wizard, and he knew he needed help when a competitor,
Corrections Corporation of America, offered to buy his company for $10.5 million. McDonald wondered
what his company was worth. Clouding the valuation issue was the fact that Eclectic is a service business
with few tangible assets. Most of its worth lies in hard-to-value intangibles such as managerial talent,
quality services, and reputation. So McDonald called in Bonnie Niten Baha, a business valuation expert,
who established a value for Eclectic using three different approaches: market, cost, and income.
The market approach uses the value of a comparable public company as a model for determining
the worth of a business. Baha found three public companies in the private prison business, but didn't
consider them comparable; too much of their revenues came from non-prison operations. She did,
however, have the value that Corrections Corporation of America placed on Eclectic-- their $10.5 million
offer two years earlier. That offer was 1.37 times Eclectic's sales revenue and 61 times its net profit.
Applying those figures to Eclectic's current sales and profits, Baha found: Sales revenue of $11 million x
1.37 = $15.1 million and Net profit of $181,550 x 61 = $11.1 million.
The cost approach values a business at what it would cost to duplicate it. When Baha applied this
method, it produced the lowest value for Eclectic.
The income-approach views a business as an income-generating entity. Its value is determined by
the profits that it will produce in the future, discounted back to their present value. First, McDonald, his
accountant, and Baha forecast every item on Eclectic's income statement for the next five years. Then
they came up with a discount rate that accurately reflected the risks and returns associated with running
the company.
Baha calculated that Eclectic's rate of return on equity was 17.41 percent. She considered it to be
an extremely well managed, established company, but to reflect the risks of running a business, she
raised the discount rate to 18 percent. Putting that figure into perspective, Baha says, "I've used discount
rates that are as high as 40 or 50 percent," when valuing some small businesses. The resulting discounted
future value was $10,755.534. Her pricing model, however, assumed only minority ownership in the
business. She adjusted the value to reflect majority ownership of Eclectic--called a control premium. To
find it, she evaluated two studies of company sales involving control premiums; one showed an average
premium of 38.3 percent, and the other reported 58.6 percent. Baha pinned a 35 percent premium on
Eclectic, making the total estimated value $14,519,971.
What did McDonald learn about the value of his company? Baha's final report included an
estimated range of $11 million and $15 million. That was good enough for McDonald, who has decided
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to keep Eclectic for now. "If I can continue to have fun and make the business grow rapidly," he says,
"we can sell it for a tremendous amount in the future."
1. Why didn't Baha use any of the balance sheet techniques to value Eclectic Communications, Inc.?
2. Find examples in this case that illustrate the statement "Business valuation is partly art and partly
science”?
3. Do you agree with the methods that Baha used to value the company? Why did she use more than one
method?
Source: Adapted from Ellya E. Spragins, “Locking Up Good Value,” Inc., November 1989, pp. 157-158.
Part Five: Supplemental Readings
Stern, and Wilma Randle. "The best way to start a business...may to be buy one." Working Woman. March
1996 v21 n3 p33(3).
Price, Courtney. "The pros and cons of buying a business." Black Enterprise. Nov. 1994 v25 n4 p143(6).
Harrison, Chris. "Timing and tenacity in a business sale." The Financial Times. Feb. 3, 1997 pFTS4(2).
Miracle, Barbara. "Buy a business, buy a job." Florida Trend. Jan. 1997 v39 n9 p30.
"Quality supplants "bid-and-buy" tradition." Industrial Distribution. Oct. 1996 v85 n10 pF10(3).
Narva, R., and Ira Bryck. "Case study: keep the firm in the family?" Nation's Business. May 1996 v84 n5
p60(1).
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