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Buying a Business

 

Buying and selling a small business Part A

By Verne A. Bunn

About This Book

Going into business for oneself can be a great adventure—or a great disaster. Which it will be depends a great deal on how well the prospective owner prepares through investigation and analysis of the situation he or she is about to enter.

In some ways, the person who buys a going small business has an advantage over the one who starts from scratch. For one thing, there are more facts to work with—if the buyer knows where to find them and how to use them.

These are the principal problems taken up in Buying and Selling a Small Business. What should the prospective buyer of a small business—or the seller—know before the buy-sell decision is made? Where can this information be found? How can the buyer or seller correlate and interpret the data? How does he or she apply the data to negotiating a buy-sell transaction?

This volume, now in second edition, does not pretend to give complete or specific answers. In some cases professional help is necessary, and in all cases the answers depend on many variables. Rather this booklet is intended to serve as a guide to areas needing investigation and to suggest some approaches that may be helpful.

The buyer of a small business faces more problems—and more difficult ones—than the seller. Because of this, Buying and Selling a Small Business may appear to give more attention to the buyer than to the seller. However, it is important for the seller to know how the buyer is likely to approach the negotiations; and wherever specific problems for the seller do come into the picture, they are discussed separately.

This booklet is issued as part of the management publications program of SBA's office of Management Information and Training.

Based in SBA's Kansas City Regional Office, the author, Verne A. Bunn, administers the Agency's management assistance programs for several states.  He acquired his wide knowledge of small business in a variety of ways, including experience as a counselor of small business owners as well as university research and teaching.

Contents

Part 1. The Buy-Sell Transaction

1 A Small Business Is Bought and Sold

2 The Flow of Decisions in a Buy-Sell Transaction

 

Part 2. Sources of Information for Buy-Sell Decisions

3 Sources of Market Information

4 Sources of Financial Information

5 Sources of Legal Information

 

Part 3. The Buy-Sell Process

6 Determining the Value of a Business

7 Negotiating the Buy-Sell Contract

8 Financing and Implementing the Transaction

 

Part 4. Using Financial Statements in the Buy-Sell Transaction

9 Income Statements and Balance Sheets 10 Adjustments to the Financial Statements 11 Analyzing the Financial Statements

 

Part 5. Analyzing the Market Position of the Company

12 The Market

13 The Company

14 The Sales Forecast

 

Part 1 The Buy-Sell Transaction

Chapter 1 - A Small Business Is Bought and Sold

IS THERE A SMALL-BUSINESS OWNER who has never considered selling his business? Probably not. Is there an individual with some money, talent, or an urge for independence (often only the last) who hasn't thought about owning his own business?

The number of small businesses actually bought and sold, however, represents only a small fraction of those who have felt these urges. To many people, the desire to buy or sell is only a passing thought. Others find various ways to solve their problems or satisfy their ambitions. But sometimes an individual doesn't follow through because he finds the prospect of buying or selling a business too baffling.

The objective of this manual is to describe the process of buying and selling a small business and to establish some guidelines. It will not remove the difficulties, but it will make them more manageable.

A Look at the Buy-Sell Process

It will be helpful to take a detailed look at what happens when a business is bought or sold. First, consider some of the thoughts that go through the minds of the buyer and seller during the decisionmaking process.

THE SELLER: (Before the transaction) Shall I sell my business? What is it worth? How can I find a buyer? (During the transaction) How much shall I tell this guy about my business? Will he raise his offer? What terms shall I insist on? (After the transaction) Should I really have sold? I wonder if I could have got more money. Wonder how the business is getting along.

THE BUYER: (During the transaction) Shall I buy this business? I wonder why he really wants to sell. How much can I afford to pay? Where can I get the rest? How far will he reduce his price? (After the transaction) Now that I've bought it, which new idea shall I try first? Should I have known that would happen? It's going to work out just fine—isn't it?

These are typical thought patterns. They mark the flow of decisions in the transaction. They also reflect the doubts and hesitancy involved in the decisionmaking.

A Step-by-Step Account

The following step-by-step description of buying and selling a grocery store is basically the story of an actual case. To make it more typical of all buy-sell transactions, some questions and problems from other cases have been worked into the account.

Bill Smith wants to buy. Bill Smith had worked several years in grocery stores in Whitton, a city of 400,000. He had started as a carry-out boy and progressed through every job in a store operation.

Bill was anxious to own his own store. He and his wife were in their early forties and eager to establish a business of their own. They had saved about $16,000, and Bill was confident that he knew enough about grocery stores to handle the operation. His wife planned to take care of the bookkeeping.

The Smiths had followed up many leads from the classified section of the newspaper. In every case, they found the business either too run down to salvage or too large to finance. Bill had also talked to a few real estate agents who specialized in business properties. But the agents' listings had not turned up anything that interested the Smiths.

In August, Bill learned from a food salesman that Sam Brown was trying to sell his store. Sam's Market was a small store on the other side of town.  It had been operating for many years.

Sam Brown wants to sell. Sam Brown had been thinking about selling his business for several months. He was reluctant to do it because the store had been established by his father. Yet he was finding the long hours he had to spend in the store a real hardship.

Furthermore, during the last 4 years, business had declined from a high of $400,000 gross sales to less than $200,000. The main reason for the decline in sales, in Sam's opinion, was the competition from several new supermarkets in his area.

Finally, he was concerned about a space of about 1,100 square feet at one end of the building in which the store was located. Sam owned the entire building and had been unable to find a tenant for this space for more than 3 months. Now a discount paint company had offered him a local franchise.

Sam believed he could use the vacant space for this operation and handle the business with much less effort than he was putting into the grocery store. If he could sell the grocery business and lease that part of the building to the new owner, he would have a comfortable arrangement.

The transaction. After talking to the salesman, Bill called Sam and expressed an interest in the store. They arranged several meetings to discuss the situation. Bill learned that Sam wanted to sell in order to take advantage of the paint-store opportunity. When Sam announced that he was asking $50,000 cash and $600 a month rent, the conversation went like this:

BILL: Could I spend some time with your books?

SAM: I can't let you do that. Most of my personal affairs are in those books. Besides, I don't want to be giving away everything about my business to someone who might be a competitor someday.

BILL: But I have to have something to go on!

SAM: Well, you ask me what you think you need to know, and I'll tell you—if I can.

During the discussions that followed, Bill learned the following facts about the store:

The modern fixtures and equipment had cost $60,000 new. Now 6 years old, they had a depreciated value of $30,000. The inventory had a wholesale cost of $20,000. Gross sales were running about $16,000 a month with a gross margin between 14 and 16 percent. In the past, annual sales had been as high as $400,000. The 3,900 square feet of store space appeared well organized.

From this information and his observation of the store, Bill figured that he could increase sales to $40,000 a month within a year by more aggressive sales promotion—handbills, radio spot announcements, an extra large neon sign, and more personal service. This meant, in Bill's opinion, that inventory would need to be enlarged to $24,000.

To better the profit, which had been averaging 2-1/2 percent of gross sales including Sam's salary, Bill believed the average markup should be raised from 18 percent to 20 percent. An additional increase in profit could be realized, according to Bill's analysis, if he reduced the staff by one full-time and one part-time clerk.

Bill was unable to borrow the difference between his $16,000 savings and Sam's asking price of $50,000. Several banks turned him down before one agreed to lend him $20,000 at 11-1/2 percent interest with monthly payments over 5 years.

Sam refused Bill's offer of $36,000 but offered to carry part of the price.  After several more discussions, agreement was reached on the following terms:

1. $24,000 cash.

2. $22,000 unsecured note, payable monthly over 5 years at 12% interest.

3. $400 a month rent.

 

Bill planned to use the $12,000 cash left from the bank loan to increase inventory and provide working capital.

The store changed owners about September 1. Bill discovered that the inventory was worth only $16,000 at wholesale cost. He immediately used $8,000 to increase his shelf stock. Sales during the first few months increased to $30,000 a month, and Bill felt sure he could reach his goal of $40,000 a month. Profit, however, was running only 2 percent of gross sales in spite of Bill's attempt to increase margins and reduce costs.

A sad ending. Six months later, the doors were closed on Bill's Market. The remaining $12,000 inventory was sold to a wholesale outlet for $10,800. The fixtures were sold for $16,400. Bill was trying to find a way to pay his debts and forget the loss of his life's savings.

Four months later, Sam still had not been able to rent the space formerly occupied by the food store. He had little prospect of recovering his loan to Bill, and he had lost over $4,000 in rental income. He was undecided what action he should take.

The Big Question

Bill and Sam each thought he had received a fair value. But the final result showed that neither one had made a right decision. Both lost savings and income. What went wrong? How do you go about buying or selling a business?

An important question? To the Bills and Sams—past, present, and future—few questions could be more important.

A difficult question? Either buying or selling a business requires personal, financial, and management decisions. At no steps along the way are the decisions easy to make. But it will be helpful to establish the basic steps or elements in a buy-sell transaction and then to examine each of these elements.

Chapter 2 - The Flow of Decisions in a Buy-Sell Transaction

BUYERS AND SELLERS both seek answers to the same question: "What is this business worth?" Most people see the worth of a business as the total value of equipment and fixtures, inventory, and buildings and land. Important, certainly, but the sum of these values does not equal the value of the business.

Bill probably paid a fair price for equipment, fixtures, and the like. But did his price of $40,000 reflect the value of Sam's Market? Obviously not.  What, then, is the value of a business?

For both buyer and seller finding the answer to this question is the most difficult and at the same time the most important step in the buy-sell process. But this final decision reflects many other decisions made while the transaction is being considered. In other words, the buy-sell process is a flow of decisions. It would be impossible to point out every decision that must be made, but the basic ones are as follows:

Motivation: a decision to attempt the sale or purchase of a business.  Contact: a decision on how to find a buyer (or seller) for a business with specified characteristics.

Information: a decision on what information must be gathered or given to buy or sell a business.

Sources: a decision on how, where, and at what cost the needed information can be obtained.

Analysis: a decision on the meaning, importance, and reliability of the information gathered.

Value: a decision on what the business is worth.

Price: a decision on how much money to take or give for the business.

Financing: a decision on how to pay or receive the purchase price.

Contract: a decision on the form and content of the contractual relation.  Implementation: a decision on how and when to effect transfer of ownership.

Motivation

What leads an owner to sell his business? It may be any of a large number of reasons: a personal health problem, a business disagreement, overextension of the company's activities, a desire to retire from business. The possible reasons are many and varied.

For Sam, the motivating factor was change. He found his sales decreasing in spite of his extra effort, competition increasing, empty building space impossible to rent. In other words, both internal and external factors had brought changed conditions that affected the business unfavorably.

Changed conditions should be analyzed carefully before a business owner accepts them as reasons for selling his business. The following questions can serve as a guideline for this analysis:

1. Have changes actually occurred in my business?

2. Are the causes of the changes beyond my control?

3. Are the causes of the changes within my control?

 

It would be unfortunate for a owner to sell his business because of changes he could control if, by such control, he could recapture a successful and satisfying operation. Every owner, therefore, should examine closely his motives for wanting to sell the business.

What makes an individual want to buy a business? Again, motivations will cover the whole range of human desires, from simple economic gain to social ladder climbing.

Bill's prime motivating factor was the desire to expand a special skill into a business of his own. Bill thought he knew enough about grocery stores to handle one of his own. But he didn't. This factor of a special skill represents one of the dominant reasons for wanting to buy a business.  It is a natural motive, but, perhaps because of its natural appeal, it can be a dangerous motive.

A business must be managed. An operating skill does not always lead to managing ability. In fact, it often encourages a business owner to spend his time operating instead of managing. Planning for the future, organizing resources, staffing the business with competent people, directing the coordination of people and operations, controlling results—these are the functions of management. Consequently, an individual with a skill seeking to buy a business in which to apply the skill should check his motivation by asking questions such as the following:

How important is management ability in this business?

Occasionally, a business that is unique and very simple almost manages itself. But if the business is in a competitive field, management ability is probably the most important requirement for success.

Do I have the ability to manage successfully?

Effectiveness with people (customers and employees), eagerness to tackle difficult problems and make decisions, and intelligence about general business operations are key ingredients in management ability.

Can I learn how to manage this business?

Most people can learn to manage if they recognize the need. This requires room to make mistakes, however, and the self-discipline to undertake self-improvement programs.

Contact

Assuming that motives have been examined and that both seller and buyer are still interested, the next step is to get the two together. But there seems to be no "best way" to find a seller or a buyer for a business.

From the seller's point of view, the task of finding an interested buyer is the more difficult one, but there are many avenues to explore other than running advertisements in newspapers. He should ask himself these questions:

Have I told my employees and other business associates that I intend to sell the business?

Have I taken advantage of the broadcasting ability of salesmen who call on businesses similar to mine, of association meetings, of other trade contacts?

This informal advertising requires the same kind of information more formal advertising does. Business associates, trade contacts, and friends should be told the asking price, the terms, the anticipated return. Without this knowledge, a potential buyer can hardly be expected to respond positively.  He needs to know in advance how the offer relates to his financial ability.

From the buyer's point of view, finding opportunities is relatively easy.  The difficulty lies in locating a business he can analyze confidently. When he deals with unfamiliar firms, he is haunted by a desire for more information and suspicious about the information he does receive. A buyer seeking a seller should consider the following points:

Have I asked people I deal with about persons who might be considering selling a business?

Have I considered approaching businesses with which I am familiar about the possibility of a purchase?

Kinds and Sources of Information

At this stage, the buyer and the seller must decide what information about the business to seek or give. In the case of Sam's Market, information was brought out about three factors:

1. The nature of the business in the past.

2. Present condition of the business.

3. Relation of the past and present to future expectations.

 

Bill's approach was proper, but the information he gathered was meager support for decision making.

Some of the information a careful buyer will want may take a lot of money or time to gather. He must decide what sources of information are essential and which ones he can leave untapped. Bill, for instance, might well have inquired about local economic conditions. Full information, it is true, would have required a costly analysis, but consider what information he could have got from easily available sources:

1. Sales in the market had declined more than 50 percent.

2. Sam had been unable to rent commercial space in the building in which the market was located.

3. New supermarkets were operating in the same area.

4. Banks hesitated to gamble on the future of the market.

 

Bill might also have developed information about the future trend of the business, but that would have required time. He should have known the following facts about his financial program, however:

Available funds                            $36,000 Use of funds:

Payment to Sam                 $24,000

Planned increase in inventory    4,000

Advertising                      1,000

Display sign                     1,000     30,000

                               -------     -------

Available for working capital              $6,000

Expected new income per month (3% of $30,000)  900 Probable expense:

Payment to bank                  $265

Payment to Sam                     295

Sam's salary                         ?

 

Bill had enough information available to know (1) that his sales expectations were too optimistic and (2) that even if he reached his sales goal, he would not be able to satisfy the cash demand on the operation.  What happened could have been predicted.

Analysis

The word "predict" is important. The buyer should be able to follow through the steps listed below and predict with some confidence the future of the business.

What factors affect sales?

How will these market factors behave?

Therefore, what sales can I expect?

What makes up the cost of sales?

How will these cost factors apply to expected sales?

Therefore, what gross profit can I expect?

What expenses are required to run this business?

How will expenses develop under my ownership?

Therefore, what net profit can I predict?

What assets will the business need and possess?

What is the condition of these assets?

Therefore, what asset improvements will I have to make?

What credit does the business assume?

What is the condition of the credit position?

Therefore, what changes, if any, can occur in the debt structure?

How much cash do I have?

How much cash will the business generate?

Therefore, what will be my available-cash position?

What immediate cash outlay must I make?

What will be the cash needs of the business?

Therefore, what cash outgo will be necessary?

What will be my net cash position as things now stand?

What additional cash resource, if any, must I have?

Therefore, what financing plan shall I use?

Value

A business had a purpose. That purpose is to provide a satisfactory return on the owner's investment. Consequently, determining value involves measuring the future profit of the business being sold.

A seller often thinks of value as representing the money he has invested through his years of ownership. A buyer is tempted to consider value as a fair price for tangible items such as equipment and inventory. These factors are important, but they have value only to the extent that they contribute to future profits. An owner may have invested $40,000, the tangible assets may have a current worth of $20,000, but it is the profit potential that establishes the value of the total business.

Assuming that a reliable estimate of future profit is made, how much is to be paid for each dollar of profit potential? This computation is discussed in chapter 6, but the general approach is suggested by the following questions:

What am I buying (or selling)? A business, or a building full of equipment and inventory?

What return would I get if I invested my money elsewhere—in stocks, bonds, or other business opportunities?

What return ought I get from an investment in this business?

Price

It might seem that the price to be paid or received for a business would simply be equal to the value. However, value refers to what a business is worth; price refers to the amount of money for which ownership is transferred. There is usually a difference between price and value because the buyer and seller differ as to how much the business is worth. The price will represent negotiation and compromise. Here are two suggestions for fruitful negotiation:

Discussion between buyer and seller should focus on the future profit performance of the firm. Since expected profit is basic to determining value, it can be a valuable point for negotiation.

Every profit projection includes some assumptions and risks. Generally, the less firmly based the assumption and the more apparent the risk, the less value an expected profit can support. Consequently, identifying and analyzing risks involved in future operations can make discussions between buyer and seller more significant.

 

These two points will help bring negotiations about value toward a mutually acceptable price.

Financing

When the price has been settled, the question of how to finance it remains.

Financing a buy-sell transaction involves these five factors:

1. The amount of capital required.

2. The type of capital required.

3. The specific uses to which the capital will be put.

4. The length of time needed to pay back the capital source from the business operation.

5. The sources of available capital.

 

How much? Bill's failure after buying Sam's Market illustrates a common problem—underestimating the amount of capital required to purchase a business. Capital must be available not only to pay the purchase price but also for (1) funds to operate until the business is generating cash, (2) funds to meet unexpected expenses, and (3) funds as a reserve to allow for errors in expectations. A buyer must think beyond the purchase price to determine the amount of capital he needs. Unless he does he will find his resources embarrassingly and probably disastrously wanting. Here are some questions that must be asked about his capital needs:

Do I have enough capital to pay the purchase price?

Do I have enough capital to support 1 to 3 months' operations—such as payroll and other cash expenses—while the business reaches a self-supporting stage?

Do I have some extra capital to cover needs I may have overlooked (perhaps 10 to 15 percent of the purchase price?

Types of capital. There are two basic types of capital: (1) equity capital—investment in the business by the owner or owners, and (2) debt capital—borrowed capital that must be repaid.

Equity capital is often called risk capital. Those who furnish the equity capital are expected to take the primary risks of failure and to reap the benefits of success. The equity capital provides a margin of safety for a lender. The greater the amount of equity capital, other things being equal, the easier it is to get debt capital.

The primary source of equity capital is the personal savings of the buyer of the business. Although many small businesses are incorporated, the sale of stock is seldom a source of capital for the small business.

Few buyers, however, have enough personal savings to finance the purchase of a small business without any debt financing. An individual may borrow money for the purchase of a business by obtaining a personal loan, by borrowing against insurance policies, or by refinancing the mortgage on his home. These debts are not direct debts of the business, but the debts of a small business and the personal debts of the owner cannot be completely separated. Banks are the principal institutional source of debt capital for small businesses.

The seller as lender. In the sale and purchase of Sam's Market, the buyer's savings plus a bank loan were not enough to finance the purchase. Bill (who needed more financing) and Sam (who wanted to sell his business) reacted in a manner quite common in the financing of the sale of a small business. Sam agreed to accept payment of part of the purchase price over an extended period of time.

The seller is sometimes a source of capital to the buyer of a small business, as in Bill's case. A happy circumstance if it is handles properly. Before jumping at the chance, however, the buyer should ask himself these questions:

Is there a good reason why commercial lenders would not approve my loan request?

Is the seller so interested in getting out from under the business that he will take an unwise risk?

Am I sure the business is as good as it looks?

Can the business support the debt payments to which I am obligating myself?

In the light of Sam's experience, the seller, too, should pause long enough to answer some questions before he accepts an extended payment plan.

How serious will it be if the buyer is unable to make his payments?

What security do I have to protect my position?

How capable of operating my business successfully is the buyer?

.Contract and Implementation

Every step so far in this discussion has involved forecasting. From motivation to finance, the buyer and the seller must anticipate characteristics, developments, and problems that may develop. The contract between the parties embodies the resulting basic agreements about the business and the relation between buyer and seller. A "good" contract is meaningless if the earlier steps in the process have been carried out carelessly or not at all.

Part 2 Sources of Information for Buy-Sell Decisions

Chapter 3 - Sources of Market Information

TWO BASIC QUESTIONS face the prospective buyer or seller of a small business when he starts to gather information for his decisionmaking:

"What kinds of information do I need?"

"Where can I get this information?"

 

The information needed can be grouped into three general types: (1) market information, (2) financial information, and (3) legal information. The purpose of this chapter and of chapters 4 and 5 is to identify still further, within these groups, the kinds of information the buyer or seller should look for and some sources of that information. Not all of the sources listed will apply equally to all kinds of businesses. The buyer or seller will have to determine for himself the extent to which the specific types of information will help him reach a sound decision.

Some difficulty may arise in the information-gathering stage because of poor records, unavailability of some information, lack of cooperation, and the like. The seller has the advantage as far as internal data are concerned. He has free access to his own records; the buyer does not. If the buyer needs internal information to reach a decision, it should be made available to him. He should insist on seeing the company records and be wary of any seller who refuses to give him the information he needs.

Either seller or buyer may have to spend considerable time and effort digging out the information. The sources suggested below, however, should help him gather the basic types of information needed in the decisionmaking process.

Importance of Market Information

The first and most logical step in buying or selling a business is to conduct a market analysis. A market analysis is a study of the present position of the business within its market area and of probable future patterns. It should include the growth pattern of the business being sold, the state of the market, the nature and extent of competition—all factors, in fact, that will show the present market position of the business or that will affect its future.

A market analysis should indicate whether the purchase or sale of the business should be considered further. It will help the seller decide what valuation to place on the business for sale purposes. It will help the buyer decide how much he should pay, and it will also give him a clearer picture of just what he is buying. A market analysis has the added value of making it possible to develop more accurate sales forecasts. It places greater emphasis on fact and less on hunch and guesswork.

The specific nature of the business being bought or sold will determine much of the market information needed. A manufacturing business with problems of marketing and distribution will need information not necessarily pertinent to a retail or service business, with its more localized market. The following areas of market information are designed to suggest sources that may be useful to the buyer or the seller in analyzing the market of the business.

Sales Information

An investigation should be made of the sales history of the company. At least 3 years' sales should be examined and preferably 10 years'—or the entire sales history of the company if it is a new one.

The manner in which the records are kept will determine to a large extent the availability of sales information. Many small businesses keep little in the way of sales records—often only what is necessary for tax purposes.  Others have bookkeeping systems designed by business-machine manufacturers, trade associations, or professional accounting services. The more standardized the procedure, the more useful the information is likely to be for market analysis.

Most States now have sales taxes, and this may provide a useful source of information. Whether or not a business is required to keep sales-tax records depends largely on the type of business and the State requirements.  Sales-tax laws are not uniform, and what is required in one State may not be required in another.

If most of the business is done on a credit basis, accounts receivable may give useful sales information. If this source is used, the market investigation should be concerned only with the amount of credit sales and not with the effectiveness of the collection of accounts receivable.

Ingenuity and common sense can often turn up sources of sales information. In one case, for example, sales for a self-service laundry were determined by using water capacity per machine, city records of the amount of water consumed by the business, and price per load.

Regardless of where the sales information comes from, the purpose of gathering it is basically the same—to identify the pattern or trend of sales over the past and to use this information to project or estimate sales for the period ahead. Such an investigation is especially useful in determining the value of the business above the value of the assets.

Cost of Goods Sold

A study of the cost of goods sold is also important in determining the market position of the business. Cost of goods sold is the cost of merchandise purchased by the business for resale, including freight and other charges. The difference between sales and the cost of the goods sold is called gross margin or gross profit. The higher the cost of goods sold in relation to sales, the lower the gross margin—and the net profit.

Many factors, both within the company and in the market of which the business is a part, affect the cost of goods sold. An investigation should be made to determine the following:

1. Average rate of stock turnover, particularly as compared to the normal or typical rate for similar businesses.

2. Extent to which invoices are being discounted. Paying invoices in time to earn the cash discount will increase both gross margin and net profit if the discount is recorded as a reduction in the cost of goods sold. A direct increase in net profit will result if the discount is shown as "other income."

3. Freight costs to determine whether incoming transportation charges are in line.

 

Among the records to be studied are vendor invoices, records of merchandise payments to vendors, shipper receipts or bills of lading, and records of past physical inventories.

Sales-Effort Records

This information has to do with how much it costs in selling effort to produce a given volume of sales. It involves two types of costs: (1) advertising costs, from invoices and statements for various forms of advertising and promotion; and (2) salaries and wages paid for selling, from payroll or Social Security records. If the business maintains sales-people in the field, as a manufacturer might, information on reimbursable travel expenses should be included.

The purpose of gathering information on selling costs is to determine how well these costs are being utilized and to compare them with average figures for the kind of business being studied.

Personal Observation

Personal observation of the premises and personnel of the company is another source of information for the buy-sell process. Just what points should be noted will depend on the nature of the business, but the following are offered as examples:

The general appearance of the premises, both internal and external, may be important, particularly if direct customer contact is made at the place of business.

Plant layout and apparent efficiency of operation should be carefully observed if the seller is a manufacturer or otherwise engaged in processing or assembly.

Employee morale and general attitude toward the business should be noted, especially if current employees are to be retained.

Employee records, including wage-payment plans, employee-evaluation and merit rating programs, training programs, and so on should be studied.

Market Information From Outside Sources

Sources of market information outside the business fall into two general classes: (1) competing businesses, and (2) the total market of the business and the factors that enter into it. Analyzing market characteristics involves dealing with constantly changing forces. This is in contrast to the internal analysis, which concerns basically historical records.

Competition. Unless the business has a monopoly of some sort, a study of the competition should be included in the market analysis. The competition may be local and well defined, or quite generalized, depending on the nature of the business and of the market.

Trade associations and other data-gathering agencies, both governmental and nongovernmental, are sometimes helpful in this area. A good deal of the information about competition, however, must come from direct investigation, business by business.

Such factors as these are of interest: estimated sales, advertising and promotion, services offered, performance of sales personnel, businesses entering and leaving the competition recently, changes in the competitive structure through product mix or services offered, pricing policies, and other factors that form a part of the competitive patterns for specific types of businesses. A very important aspect of competition is the extent to which the total weight of competition has expanded the market for certain types of products or kinds of businesses, and the direction this is taking.

Location. In certain businesses, location may not be too important, providing the physical plant is structurally sound and suitable for the business. In other cases, location may be a vital factor. An important point that should be looked into is the status of the location and any plans for proposed changes that may have an adverse effect on the future of the business. Urban renewal programs are causing many small businesses to look for new locations. So are changes in highways and streets, flood-control programs, changes in zoning ordinances, and the like.

The buyer, whether he will own the physical plant or lease it, should look into the possibility of future expansion. Consulting a competent architect or engineer now may save trouble later on if the buyer should want to expand and leasing provisions allow him to.

Population and purchasing power. The number of people within the market area and the amount of spendable income they have are important market factors. For many kinds of businesses, the total population is less important than certain segments of the population. A business selling hearing aids, for example, will be interested only in persons who have hearing difficulties.

In gathering information on income and expenditures, three factors should be kept in mind: (1) the total purchasing power based on total population;

(2) the average or median income for the typical family unit; (3) the amount or percent of expenditures for various types of goods and services.

General population figures are obtained from Federal, State, and local government sources. The Federal census, taken every 10 years, gives not only total population figures but also breakdowns that are useful in many business situations. For most of the larger cities, census figures are further classified by sections within the city on the basis of certain population and economic characteristics. These sections are called census tracts.

Business population figures may be available from numerous sources. The Yellow Pages of the telephone directory and the city directory are local sources that are immediately available. Chambers of commerce, trade associations, and State and Federal government agencies can often be helpful.

The 10-year census reports the income for 20 percent of the total population on a National, State, county, city and census-tract basis. Other information issued by the Department of Commerce can also be useful.

Many trade associations report the results of research on consumer expenditures. Other sources of data on income include the following: (1) planning commission offices, (2) employment offices, (3) research done by newspapers, (4) building permits, especially in newly developed areas, and (5) mortgage and loan companies. Numerous fact-gathering agencies develop and publish estimates of consumer income and expenditures for various classes of goods and services.

General market conditions. A much broader yet vital part of the market analysis has to do with what might be called the general state of the market. Most of the discussion of market analysis so far has dealt with factors that have a direct influence on the business being bought or sold: company sales, location, competition, and so on. But these, in turn, are influenced by the overall economic conditions of the country and of the market area. These may be widespread movements such as national cycles of prosperity and depression, or they may be purely local conditions. The two extremes are not necessarily related.

It is to the advantage of the buyer or seller to have a clear understanding of economic factors that affect or are likely to affect the status of the business. The significance of this information becomes clearer when forecasts and estimates are made.

Some questions to be used as a guide in market analysis are given in chapter 12.

Chapter 4 - Sources of Financial Information

BOTH BUYER AND SELLER are interested in financial information, affecting the buy-sell transaction. However, since the seller already has this information, it is a major requirement for the buyer to get and make use of as much of it as possible.

The buyer can usually find financial information in the following places:

(1) financial statements, (2) income-tax returns, (3) other internal records, and (4) other external sources.

 

Financial Statements

The results of the financial transactions of every company should be reflected in its periodic financial statements. These statements are extremely important in buying or selling a small business. They were prepared for the seller, of course, and their contents are available to him. But the buyer, too, should be aware during the early stages of a buy-sell transaction of the information contained in financial statements.

Balance sheet and income statement. The balance sheet is a statement of the financial position of the business at a given moment in time. The income statement is a summary of the revenue and expenses of the business during a specified period of time. These financial statements show only the past results of the company's transactions. The results of future operations may or may not be similar.

Balance sheets and income statements in themselves contain important information, but they are most useful when a professional accountant makes a detailed analysis of them. A complete analysis includes a review of the manner in which the statements were prepared, and perhaps also a review of the records and control features of the accounting system. This is especially important in a small business buy-sell transaction because the financial statements of smaller companies are not usually as professionally prepared as the statements for larger companies. An accountant should be brought into the buy-sell transaction as early as possible by the seller as well as by the buyer.

Audited statements. In many buy-sell transactions, the statements are supplied by the seller, but the buyer reserves the right to conduct an audit of the seller's records. Or the buyer insists that the seller "warrant" his financial statements. Warranty of financial statements by the seller should be accepted with caution, however, because there does not seem to be any uniform definition of the term warranty.

If the seller's financial statements are prepared by an independent accountant, the statements should show whether they were (1) prepared after an audit of the seller's accounts, or (2) prepared from the seller's records without verification by audit. If they were prepared without verification by audit, they may be quite similar or even identical to statements that would have been prepared by the seller's own bookkeeper. If they were prepared after an audit, they should include a statement of the accountant's opinion.

Financial statements prepared without such an audit may or may not reflect the financial position or results of operation of the company. Most small companies do not have their records audited annually, but without an audit it is impossible to tell how accurate the statements really are.

Other considerations. The buyer should request balance sheets and income statements for at least 3 and preferably 10 years. If the seller is a new company, financial statements for the entire life of the company should be requested.

Other financial statements are sometimes available to the buyer. These include such items as statements of cost of goods manufactured (if the seller is a manufacturer), application of funds, and variances from the budget.

Another point the buyer should consider is the cutoff period for the financial statements. The statements may have been cut off during the low period of the sales cycle or during the high period. This has some bearing on the financial position reflected in the statements.

More detailed information on financial statements and their analysis is given in chapters 9, 10, and 11.

Income-Tax Returns

If independent accountants did not prepare the financial statements, the seller may or may not have complete sets of statements. He should have at least an annual income statement—that much is required for income-tax purposes. If the seller is a partnership or corporation, the tax returns should have balance sheets attached. If the seller is a sole proprietorship, tax returns will not show balance-sheet data.

Financial statements prepared for income-tax purposes may be very different from statements prepared in conformity with generally accepted accounting principles. Those prepared for tax returns are designed to present the desired tax position in compliance with the income-tax laws. Financial statements for nontax purposes have different objectives and therefore may reflect different financial information.

Many small companies prepare financial statements only for income-tax purposes and use those statements for all management decisions. This may or may not give the desired results. The parties to a buy-sell transaction are interested in statements reflecting the tax position, but they should concern themselves also with statements reflecting nontax items.

The buyer should request copies of tax returns for at least 3 and preferably 10 years or, if the seller is a new company, for the life of the company. The tax returns are more important in buying the stock of a corporation than in buying the assets of a corporation, partnership, or sole proprietorship.

The corporation is an income-tax entity; the partnership and sole proprietorship are not. A partnership is required to file income-tax information returns but does not pay income taxes as a company—the taxable income is passed on to the partners, and they pay the tax as individuals.  No tax return is filed for a sole proprietorship, but the income statement is included as a part of the sole proprietor's personal income-tax return.

The buyer should find out which tax returns have been examined by the Internal Revenue Service and which have not. This is particularly important if the buyer is purchasing the stock of a corporation. If a corporation with an operating loss is being acquired, the loss might have value and the buyer should satisfy himself as to whether this net operating loss can be utilized. In many instances, the only information available to the buyer is that found with the income-tax returns.

Other Internal Sources

The financial statements are usually supported by detailed analyses of selected accounts. This might include some of the following items:

Sales may have been analyzed by customer, product, division, salesman, time period, and any other classifications necessary.

Purchases may be classified according to product, time period, territory, supplier, or other classification.

If the seller is a manufacturer, he may have cost-control reports that include analyses of material costs, labor costs, overhead cost, scrap sales, spoiled and defective goods, and other items.

There may be a cash-flow statement—perhaps incorporated with the analysis of collections of accounts receivable—and even a projection of cash requirements.

The seller may have a regular budgeting program with projections into the near or distant future. It is common practice for the buyer to require the seller to make a projection for at least a year from the date of the proposed transfer. The buyer should insist on this projection.

Other External Sources

The seller's suppliers are an excellent source of information for the buyer. They can provide records showing the volume of purchases by the seller. This information may be difficult to get in some cases, particularly if the seller informs his suppliers that it is proprietary information.

Another source of data is the seller's banker. A banker can supply information about cash position, line of credit, and other fiscal data. He may, however, be reluctant to release this information.

The seller may have filed payroll-tax reports, sales-tax reports, excise-tax reports, ICC reports, or any of many other government reports.  Some of this information is available to a buyer.

The buyer may seek information about the seller from credit agencies or credit associations related to trade associations. Usually, the buyer must have a contact with these agencies in order to get the information, but there are many ways to get reports about the seller.

A number of organizations, including trade associations, supply information about industry averages. These averages are very important to the buyer for judging the effectiveness of the seller.

Advice to the Seller

The seller, for his part, should be cautious about releasing information to the buyer. It is entirely possible that the supposed buyer is a competitor, or may be one in the future. Often a seller is so anxious to sell that he supplies any information requested by the buyer without even getting a good-faith deposit. He may spend many dollars in collecting the data for the buyer. A seller should not supply any information to anyone without first discussing the matter with his accountant and his attorney.

Chapter 5 - Sources of Legal Information

THE PROSPECTIVE BUYER OF A BUSINESS can play an important role in the discovery of legal problems that may affect the value of the business and his decision on whether to buy. Legal opinions are the responsibility of the buyer's attorney, of course. But the attorney must often rely on the buyer as his source of internal information about the business—information he will need in making his legal recommendations. It is therefore important that the buyer have some idea as to what his attorney will expect of him.

As in any sales, the basic legal problem in the purchase of a business involves the transfer of ownership or title to property. How serious the title problem is varies from one business to another, depending on the nature of the assets being purchased.

If the transaction involved only the transfer of good title to a single piece of real estate, it would be a simple matter. But buying and selling a business typically involves a conglomeration of assets—inventory, fixtures, vehicles, and equipment, all of which are movable, and assorted contract rights under leases, sales agreements, patent licenses, and so on, which are intangible.

Each asset has its own ownership aspects. It is important to ask this question about each asset: "Is the buyer getting the ownership rights he assumes he is getting?"

An even more careful investigation from a legal point of view is called for when the buyer either assumes liabilities or purchases the stock of a corporation. Even the risk of potential liabilities—liabilities that may occur in the future because of past events—may be reduced by proper investigation.

Both internal and external sources of legal information are usually available to the buyer and his attorney for examination. The buyer should not rely solely on the oral statements of the seller as to important aspects of the business. Any statements of the seller that have to be accepted without support from other sources should be incorporated into the buy-sell contract as warranties.

How much information should a buyer obtain about a business before legally committing himself to purchase? There is no easy answer to this question, but the buyer should realize that the legal risk he assumes is about inversely proportional to the amount of information he has obtained about the business.

Internal Sources of Legal Information

Among the internal sources of legal information are copies of contracts, evidences of ownership, and organizational documents. Personally examining the business premises and questioning the seller and his employees may be the only source of information about some assets.

Contracts. The buyer and seller are both concerned with the rights and obligations created by outstanding contracts with suppliers, customers, creditors, employees, lessors, and so on. The seller is concerned with his liability for any breach of contract that may result from sale of the business. He should know that ordinarily only contract rights, and not contract obligations, may be transferred to a third party without the consent of the other party to the original contract. Sublease arrangements and mortgage assumptions are examples of this. The seller remains liable even though the buyer takes over the lease or mortgage as part of the buy-sell contract.

Here is an example involving a lease. A food merchant sold one of his smaller stores at what he considered a good profit. The sale price covered inventory, fixtures, and goodwill, for which the seller received $56,000. He had purchased the business 2 years before for $30,000.

The building was leased, and the seller was not able to assign the lease to the new owner of the business. He was, however, permitted to sublease the building for the remainder of the lease. The lease amounted to $1,300 a month.

Recently, sales have been decreasing to the point where the present owner has threatened to give up the business and take his loss. If he should do so, the former owner will be liable for the remaining 2 years' lease.  Unless he can find another tenant, he may lose all he gained from the sale and more.

Assignment of contracts. The buyer often wants any contractual rights of the seller that are needed in order to maintain the business as a going concern. In legal terminology, the transfer of contractual rights is called an assignment. Generally, a contractual right is assignable, but the original contract may expressly prohibit its assignment.

Such negative provisions are common in printed forms of leases. Loan agreements may prohibit the sale or other change in ownership of substantially all the business assets. Or they may call for speeding up payment of the principal if the assets do change hands. The buyer should get copies of important contracts and review them to determine whether they have nonassignment clauses.

A contract may be nonassignable, however, even without such a provision. This would be true if the contract rights are coupled with obligations of a personal character. For example, the seller's credit arrangements with a supplier are not assignable because they are based on the seller's reputation as a credit risk. A contract for the manufacture of certain goods may not be assignable because the customer, when he signed the contract, knew and was relying on the superior workmanship of the seller. Likewise, a supplier's agreement to supply the seller's manufacturing requirements of certain raw materials may not be assignable because the requirements of the new owner are uncertain.

Both buyer and seller should remember that third parties will, in all probability, have to be reckoned with in carrying out the buy-sell transaction. If the buyer must have a contract that is nonassignable and the seller is not a corporation, the only solution is to renegotiate the contract. In the case of a corporate seller, it may be possible to make the transaction a purchase of stock rather than assets.

Types of contracts. Following are some recommendations to the buyer about specific types of contracts:

Copies of real-estate leases should be obtained from the seller and examined for provisions relating to amount of rent, terms of payment, expiration, renewal, subleasing, repair, improvement, insurance, and so on.  The buyer should pay special attention to the duration of the lease. If the term remaining is too short, either the lease should be renegotiated before the purchase or an option should be obtained to renew for an additional period. Leases for a specific term are often misleading because of provisions granting to one or both of the parties the right to terminate the lease by giving a stated period of notice.

Copies of patent, trademark, trade-name, and copyright registrations should be obtained in order to determine the legal status of the right and whether it can be transferred.

The principle subject of the buy-sell transaction may be a contract right to be the exclusive agent, dealer or distributor of a product or line of products, or the right under license to use a patented process, trade name, or trademark. Copies of such contracts should be obtained to determine the precise nature of the right, its limitations, and the seller's power to transfer. Particular attention should be given to the exclusiveness of the right.

Copies of employment contracts and union agreements should be studied for terms relating to compensation, working conditions, duration of employment, termination, pension and profit-sharing plans, stock option, insurance programs, and so on. The buyer should find out whether key employees will remain with the company if the ownership changes hands. If the employees have not been organized, he should inquire about possible activities of union organizers among them.

The buyer should study outstanding sale and purchase contracts. Particular attention should be given to trade-credit, discount, installment payment, attention should be given to trade-credit, discount, installment payment, and security requirements. The buyer should get from the seller copies of conditional-sale contracts, purchase-money chattel mortgages, chattel leases, lease-purchase agreements, consignment contracts, and sale-on-approval and sale-or-return contracts to which the seller is a party.

The buyer should also get from the seller copies of financing agreements between the seller and commercial banks, finance companies, and other third-party lenders. Attention should be given to the term of the loan, repayment provisions, interest rate, finance charges, insurance requirements, acceleration provisions, security requirements, and recourse rights. The buyer will generally have to make his own financing agreements, but the seller's experience in financing the business will often suggest what the buyer can expect if he purchases the business.

A buyer's willingness to purchase accounts receivable, apart from his financial ability to do so, should depend on their apparent collectibility.  The buyer should require the seller to submit a complete list according to the age of the accounts. Inquiry may disclose factors other than the statute of limitations that would prevent collection.

A study of the seller's insurance policies may give the buyer some insight into the availability, adequacy, and cost of coverage of such risks as liability arising from manufacture or sale of defective products, liability to customers for injuries sustained on the premises, liability for property damage and bodily injury arising from negligent operation of company vehicles, liability to employees for injury under workmen's compensation laws, and property hazards such as fire, windstorm, and theft. The buyer should be aware, however, that premium rates based on the seller's experience may not be available to him.

Evidences of Ownership. The buyer should get from the seller a certified abstract of title for each parcel of real estate involved in the transaction. The abstract should be examined by the buyer's attorney. In addition to disclosing any defects in the title, examination of the abstract and the abstractor's certificate will usually show whether there are any unreleased mortgages, judgment liens, mechanics' liens, tax liens, or unpaid real-estate taxes and special assessments.

The seller should be asked to show evidence of his ownership of principal items of personal property in the form of bills of sales, receipts, assignments, motor-vehicle title certificates, and so on. Such evidence will not prove that there are no recorded liens against the property, but lack of it should alert the buyer to the possibility that personal property in the physical possession of the seller is rented, leased, borrowed, or delivered on consignment.

Organizational documents. If the seller is a partnership, the buyer should get a copy of the partnership agreement. If there is no written agreement, he should find out who the partners are and whether authority exists to sell the business assets.

If the seller is a corporation, the buyer should get a certified copy of the resolution of the shareholders authorizing the sale of the corporate assets. In a corporation stock transaction, he should get a copy of all organizational documents. These documents include the articles of incorporation and amendments to it, the corporate bylaws, stock-transfer books, and minutes of shareholders' and directors' meetings.

Observation and inquiry. Certain types of legal problems can be uncovered only by observation and inquiry. This is true of mechanics' liens. The basis for mechanics' liens against real estate may exist even though no lien is on file. If the buyer learns that there has been repair or construction within the allowable period for filing mechanics' liens, he should check with the contractors and suppliers to find out whether they have been paid.

The real estate should be examined to make sure that it complies with building codes and other ordinances. It is advisable also to have the real estate surveyed to determine whether buildings are located within boundaries in compliance with setback lines, whether adjoining buildings or driveways are encroaching upon the property, and so on.

External Sources of Legal Information

Among the more common external sources of legal information are public records, government agencies, and third parties with whom the seller has had dealings.

Office of record. A down-to-date abstract of title will ordinarily disclose the existence of liens against a particular panel of real estate, but liens against personal property of the seller can be discovered only by a search of the office of record. Separate filing systems may exist for chattel mortgages, conditional sales contracts, trust receipts, assignment of accounts receivable, and so on. Each of these files must be checked.

A record search will not disclose what items of personal property in possession of the seller have been rented, leased, borrowed, or delivered on consignment. Also, lien notations on motor-vehicle title certificates may take precedence over recording—it depends on State statutes.

Tax authorities. Investigation is especially important where the buyer is purchasing the stock of the seller or assuming liability for the payment status of Federal, State, and local income taxes, Social Security and income withholding taxes, Federal excise taxes, State and local taxes, license taxes, and real- and personal-property taxes. Have tax returns been reviewed and approved by the taxing authority?

Zoning ordinances, planning agencies, building codes. The buyer should check zoning ordinances and building codes to determine the existence of nonconforming land uses or violations of building codes. Comprehensive zoning plans may provide for steps to be taken toward elimination of nonconforming uses. This can be done by prohibiting alteration or enlarging of buildings or by requiring liquidation of nonconforming use within a prescribed period of time.

City, county, or metropolitan planning agencies and engineering departments should be consulted about the existence of master plans for future rezoning, redevelopment, and street or highway changes. Highway relocation, limited street or highway access, elimination of on-street parking, or changes in the composition of the immediate market area may be enough to destroy the business as a going concern. City annexation policies may be important to businesses located in the suburbs. The cost of planned improvements may affect the buyer's decision.

Court records. The buyer should find out from court records whether judgment liens exist against real estate involved in the buy-sell transaction and whether lawsuits are pending that may retroactively result in the attachment of liens. This is of particular concern to the buyer who either assumes business liabilities or purchases the stock of a corporation. Not only litigation costs and liability must be considered but also the impact of the publicity on the goodwill of the business.

Even if a court record search is negative, future litigation may arise out of events of the past several years, such as motor-vehicle accidents, manufacture or sale of defective products, accidents on the premises involving customers or employees, breach of contract, violations of wage-and-hour laws, and so on. The best protection is to inquire of the seller and of employees who have been intimately concerned with the business.

Part 3 The Buy-Sell Process

Chapter 6 - Determining the Value of a Business

THE MOST DIFFICULT STEP in buying or selling a small business is probably determining what the business is worth as a going concern. Many judgment decisions must be made. Yet before negotiations can continue successfully, a value must be established. The value must be acceptable to both buyer and seller, or further negotiation is fruitless. It must result from the logical and objective efforts of all the parties involved.

Valuation Methods

There are two basic methods of determining the value of a business. The first is based on expectations of future profits and return on investment. This method is preferable by far. It forces the buyer and seller to give at least minimum attention to such factors as trends in sales and profits, capitalized value of the business, and expectancy of return on investment.

The second method is based on the appraised value of the assets at the time of negotiation. It assumes that these assets will continue to be used in the business. This method gives little consideration to the future of the business. It determines asset values only as they relate to the present. It is the more commonly used, not because it is more reliable, but because it is easier. The projections needed to value the business on the basis of future profits are difficult to make.

Looking Ahead

Whichever method is to be used to value the business, the buyer should ask the seller to prepare a pro forma, or projected, statement of income and profit or loss for at least the next 12 months. For this, the seller will prepare a sales estimate for this period along with a matching estimate of the cost of goods sold and operating expense.

The projected statement will reflect the net profit the seller believes possible. The buyer should then make his own estimate of sales, cost of goods sold, operating expenses, and net profit for the next year at least, and as far into the future as possible.

In preparing these statements, the buyer should start by analyzing the actual statements of profit and loss for at least 5 years back. He should be sure that the past and projected statements provided by the seller are correct and are consistent with the buyer's proposed future operation. He should also study general and local economic changes that will affect future business. This includes competition.

If the buyer is not qualified to prepare projected financial statements, he should consult an independent accountant. This will involve some expense, but the cost will be small compared to the loss he might incur if he invested in a small business with a doubtful future.

Financial statements and their analysis are discussed in part 4; market analysis in part 5.

Forecasting Sales

The most important projection to be determined in the projected income statement is the sales figure. After this number has been established, the cost, expense, and profit figures are easier to acquire. The data for projecting sales will come from past sales records of the business. The more accurate and systematic these records are, the more confidently they can be used in estimating future sales.

How long a forecast? A basic question is this: "Over how long a period of time is it necessary or possible to forecast sales?" Any forecast is uncertain, and the farther a forecast is projected into the future, the greater the uncertainty. While it may be possible to exercise at least reasonable control over the internal operation, the external economic and market factors make forecasting difficult because of lack of control.

Perhaps the best way to approach the length of the forecast is in terms of the expected return on investment. Suppose it is estimated that the business should bring a 20 percent return on initial investment. The investment, then should be returned in 5 years. At this point, the owner would just break even on his original investment. It seems logical to project sales and profits over a span of time comparable to that estimated for return on investment—in the above illustration, 5 years.

Any such forecast, however, should give careful consideration to expected changes either in the economy or in the industry market that might affect the pattern of sales change. Mathematically, it is possible to forecast sales with some precision. Realistically, however, this precision is dulled because vital market and economic factors cannot be controlled.

Methods of forecasting sales. There are numerous methods by which sales forecasts can be made. Most of them take their lead from the past sales performance of the company. For establishing trends or averages, 5 years of sales history is better then 3, and 10 is better than 5.

Perhaps the simplest method is to assume that the percentage increase (or decrease) in sales will continue and that no market factors will influence sales performance more in the future than in the past. Suppose, for example, that the rate of yearly average increase for the past 5 years has been 4 percent, and that each year has shown about this rate of increase.  Then it might be assumed that sales for the next year will be 4 percent greater than the current or most recent year.

But what about the year following? The year after that? Can it be assumed that these years will also increase at about 4-percent level? Each additional year into the future reduces the certainty of the predictions. If these negative influences limit the accuracy to such an extent, why try to forecast beyond the immediate future (1 year)? Because such a forecast forces the person making it to give at least a little attention to economic and market factors that might influence the future operation—that might, in fact, indicate that the purchase or sale of the business would not be wise.

With forecasts covering more than 1 or 2 years, a more detailed forecasting technique is needed. Such technique should be designed to weight out extreme variations in year-to-year sales and to give a trend or level of sales change that is more realistically oriented to probable future sales patterns.

No method of forecasting can set any value on external market conditions, because there is no guarantee that these conditions will carry over into the future with the same relative significance. Nevertheless, their possible influence should be considered.

Some simple methods of short-term forecasting are described in chapter 14.

Risk and Return on Investment

If a buyer wants to invest money in a business that is being sold, he should be concerned about receiving a fair return on his investment. Many businesses can make a profit for a short time (1 to 5 years); not so many operate profitably over a longer period of time.

From the buyer's point of view, what is a fair rate of return from an investment in a small business? The rate of return is usually related to the risk factor—the higher the risk, the higher the return should be. United States Government bonds are the safest investment—the rate of return ranges from 5-1/2 to 6 percent. Blue-chip stocks and corporate bonds usually give the investor a return of 4 to 10 percent if both dividends or interest and increase in market value are considered. Speculative stocks may have a higher return, but they also have a higher risk factor.

The buyer of a small business should try to determine the risk factor of the new business, though this is difficult at best and in many cases impossible. In attempting to assess the risk factor, the buyer should project the profits of the business as far into the future as possible. He should ask himself how high the risk should be normally and look for conditions that would be likely to affect the sales and profit-making capability of the business.

In any event, he should consider carefully the minimum return on investment that he is willing to accept. This concept of risk is important in valuing the business by capitalization of future earnings.

Valuing the Business by Capitalizing Future Earnings

The price to be paid by the buyer should be based on the capitalized value of future earnings. Instead, however, in most small business buy-sell transactions, price is based on the purchase and sale of assets. Profits are made by utilizing assets, of course, but actually the assets purchased are only incidental to the future profits of the new business.

Capitalized value is the capital value that would bring the stated earnings at a specified rate of interest. The rate used is usually the current rate of return for investments involving a similar amount of risk. The capitalized value is found by dividing the annual profit by the specified rate of return expressed as a decimal.

Assume for the moment that the future profits of a business have been projected for the next 5 years and are estimated to average $20,000 a year. (This is in addition to compensations for the services of the buyer and any members of his family.) What should be the sales price for the buy-sell transaction?

If this investment were as safe as U.S. Government bonds, the buyer should be willing to pay $333,000 ($10,000 divided by .06). If the investment is considered as safe as an investment in an excellent corporate stock that earns 10 percent in dividends and price increases, the buyer should be willing to pay $200,000 ($10,000 divided by .10).

Very few small businesses, however, have as low a risk factor as these two investments. What rate, then, should be used in capitalizing the earnings of a small business? Usually, 20 to 25 percent is considered adequate. This means that the buyer should pay between $80,000 and $100,000 for this business. If it earns the projected $20,000 a year, the buyer will recover his initial investment in 4 to 5 years. This time will be extended by Federal and State income taxes to be paid on the income, but this would also be the case for most alternative investments except nontaxable municipal securities.

In using a computation such as this, the importance of long-run profits should be kept in mind. Unless profits are possible over a long period of time (10 to 15 years), investment in a small business may be a poor decision. The trend of profits is also important. If all other factors are the same, a company whose profits are declining is worth less than one whose profits are increasing.

Valuing the Business on the Basis of Asset Appraisal

The majority of buy-sell transactions are based on a value established for the assets of the company. This approach is not recommended, but if it is to be used, the suggestions that follow should be considered.

A most important point is to find out early in the transaction just what assets are to be transferred. Usually, the seller has some personal items that he does not wish to sell. Prepaid insurance, some supplies and the like, in addition to cash, marketable securities, accounts receivable, and notes receivable usually are not sold. If the buyer does purchase the receivables, the seller may guarantee their collection, but such a guarantee should be established.

The assets most commonly purchased in a small business buy-sell transaction are merchandise inventory, sales and office supplies, fixtures and equipment, and goodwill.

Evaluating goodwill. One of the assets that must be considered in a buy-sell transaction is goodwill. Goodwill, in a general sense, arises from all the special advantages connected with a going concern—its good name, capable staff and personnel, high financial standing, reputation for superior products and customer services, and favorable location.

From the accounting point of view, goodwill is the ability of a business to realize above-normal profits as a result of these factors. By above-normal profit is meant a higher rate of return on the investment than that ordinarily necessary to attract investors to that type of business.

The value of goodwill can be computed in either of the following ways:

1. Capitalization of average net earnings. As explained above, the amount to be paid for a business may be determined by capitalizing expected future earnings at a rate that represents the required return on investment. The difference between this amount and the appraised value of the physical assets may be considered the price of goodwill.

 

This method uses only earnings in computing the price to be paid for the business. For that part of the calculation, it ignores the appraised value of the assets.

2. Capitalization of average excess earnings. This method recognizes both earnings and asset contributions. It starts with the appraised value of the assets and computes what would be a fair return on that value. If the estimated future earnings are higher than this "fair return," the difference between the two figures—the "excess earnings"—is capitalized at a higher rate, and the amount thus obtained is considered the goodwill value. This figure is added to the appraised value of the assets to give a price for the business.

 

Payment of excess earnings is often stated in terms of "years of purchase" instead of in terms of capitalization at a certain interest rate. Capitalization of average earnings at 20 percent is the same as payment for 5 years' excess earnings.

As the above discussion shows, the determination of goodwill usually reflects the value of profits that will be realized by the buyer above the normal rate of return; that is, the excess profits. But most small businesses that are for sale do not have excess profits. They usually show nominal profits or none at all. Often the seller makes an offer that seems quite good, but the buyer must be able to eliminate the seller's emotions and reduce all facts to workable relationships.

If there are excess profits, goodwill is usually valued by capitalizing them at a fixed percentage established by bargaining between the seller and the buyer. The capitalization percentage needs to be high because profits higher than a normal return are difficult to maintain. Excess profits of $4,000 capitalized at 10 percent will give a goodwill value of $40,000 ($4,000 divided by .10). Capitalizing the same excess profits at 20 percent gives a goodwill value of $20,000 ($4,000 divided by .20).

Although goodwill valuation is the first asset valuation to be discussed here, it is normally the last to be computed. Since few small businesses being sold are producing excess profits, the problem of goodwill value is not a pressing one in most buy-sell transactions.

Merchandise inventory. In a service business, placing a value on the inventories is a minor problem; but in distributive and manufacturing businesses, the inventory is likely to be the largest single asset. A manufacturer, for example, has three inventories—raw material, work in process, and fixed goods—and each of them present different problems in valuation. The distributive company has only one inventory, called merchandise inventory.

The financial statements presented by the seller will probably reflect an inventory value different from the one assigned in a buy-sell transaction. Inventories are usually carried on the books either at cost or at the lower of cost or market. Market is defined as the current replacement cost to the seller.

In determining the value of inventories, the seller has to choose a method of arriving at cost. The most common costing methods are first-in-first-out (FIFO), last-in-first-out (LIFO), and average cost. These methods may give very different values and the buyer and seller must arrive at some value agreeable to both. The most common methods used in valuing inventories for buying and selling small businesses are cost of last purchase and current market price.

The quantity of the inventory is usually determined by a physical count. The physical inventory procedures should be decided before the count, and each inventory team should include one representative from the buyer and one from the seller. It is easy to omit items from the inventory count, and here the seller is usually in a more vulnerable position than the buyer.  There is more danger of omitting item from the count than of double counting them.

It may be that some items of inventory are not to be sold. If so, these items should be segregated before the count begins. Another problem is determining what quality of items are to be included in the inventory. The buyer needs to be cautious when examining the inventories—in most buy-sell situations there is some inventory that is not salable.

This is one reason why the buyer should employ as his representatives on the inventory teams individuals who are acquainted with that type of inventory. If the buyer and the seller disagree on the value of certain items, the seller will remove these items from the list of inventory for sale.

When the inventory is being priced, be very careful in matching price to quantity. Be sure that the units in which the quantity is recorded and the units priced are the same. The physical count should be recorded in duplicate so that buyer and seller can each make separate extensions after all prices have been listed. After independent extensions, the two inventories should be reconciled.

Manufacturer's inventory. When a manufacturing company is being exchanged, the raw materials inventory is taken and priced like the merchandise inventory of a distributive business. The work-in-process and finished-goods inventories may present a problem. Usually, there is no market price or cost of last purchase to relate to these inventories; consequently, the seller's cost is generally used for establishing prices.

If the seller has unused plant capacity or if his plant is inefficient, his costs may be inflated. Such a situation requires the help of an accountant with a good knowledge of cost accounting.

Store supplies and office supplies. These two items are usually quite small. They should present no problem, though some of them may have no value to the buyer if the name of the company is to be changed. After the usable supplies have been determined, a physical inventory should be taken and priced as in the case of the merchandise inventory.

Property assets and accumulated depreciation. The property-asset account normally reflects the cost of the assets reduced by a provision for depreciation. In many small business buy-sell transactions, no real property is exchanged, because the plant site is leased. The problem of establishing a value on real estate is not as acute, anyway, since the market value for real property does not fluctuate as widely as the market value for personal property.