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Buying a Business

 

Buying and Selling a Small Business Part B

It is customary to have an independent appraiser establish a value for real property. Appraisers' findings on real property are usually more acceptable to both parties than personal-property appraisals—the real property may have multiple uses, whereas personal property consists of single-purpose assets. The book value of real property will be close to the appraisal value unless the property has been held for a long period of time or unusual circumstances have caused sudden and drastic changes of real-property values.

Personal-property assets. The buyer may feel that he knows going values of the personal property and decide not to retain an independent appraiser. In addition, many individuals believe that cost or book value is a good place to begin negotiations for personal property. However, because of the many methods of computing depreciation and also because of conflicting ideas about capitalizing cost, the cost or book value may not reflect a value that is agreeable to both parties.

It is difficult to assign a value to personal property equipment because these assets have little value if the company is liquidated. Therefore, a going concern value should be determined. The price to be paid for this equipment should be somewhere within the range of the cost of new equipment or the cost of comparable used equipment. For this reason, an independent appraiser can be useful, particularly if he is acquainted with the type of equipment being sought or sold.

The seller should realize that he may own assets that do not appear on the fixed-asset schedule. Many companies have a policy of not capitalizing any assets below some arbitrary amount ($100 or $200). A complete physical inventory should be taken.

If the assets are numerous and geographically dispersed, the seller may be asked to prepare a certified list of the assets giving description and location. The buyer can then test the list by verifying only selected assets at the time of the sale, but with plans to verify all of them within a certain period of time.

The value of personal-property assets is usually decided after considerable bargaining. It is better to assign values to individual assets rather than to make a lump-sum purchase of assets. In a lump-sum purchase, there is more chance of overlooking some asset values.

The buyer should try to determine the condition of the assets as well as repair and replacement requirements. If he doesn't establish the condition of the assets individually, repair and possible replacement costs may create an unexpectedly heavy drain on his working capital.

Federal Income Tax Consequences

Federal income tax consequences of the buy-sell transaction may be an important bargaining issue if the buyer and seller are aware of them. The seller should be concerned about the amount of tax he will have to pay on his gains from the sale. The buyer should be concerned about the tax basis he will acquire as a result of the transaction. These concerns almost inevitably lead the buyer and seller into conflict in valuing the business.

The income-tax laws are highly technical, and the possible variations in a buy-sell situation are infinite. Because of this, a discussion specific enough to be really helpful is impossible here. Both buyer and seller should study the applicable sections of the IRS Tax Guide for Small Business; and if an important decision in the buy-sell agreement is to be based on Federal income-tax consequences, the advice of an income-tax expert should be sought. The key to tax savings is tax planning—before the buy-sell contract is closed.

The seller should keep in mind that he must report any income-tax liability he incurs by selling a going business. Reinvesting the sales proceeds in another business will not enable him to avoid or postpone his income-tax liability.

A Valuation Example—the Regal Men's Store

This example will help to bring the factors discussed about into better focus. It is not intended to show what should be done but to give some idea of what might be done.

The buyer and the seller. Joe Critser is interested in buying a men's clothing store. He has had nearly 25 years' experience in the men's clothing trade-first as a salesman in retail stores and more recently as a sales representative for Sentinel, a major manufacturer of men's clothing.  Now 45 years old, Critser is interested in having a store of his own.

In February 1979, Critser learns that the Regal Men's Store is for sale. James Rombaugh, owner and operator of the store, is now 67 and wants to retire, he says. He has no heirs, and no employee of the store is financially able to purchase the business. Rombaugh started the store in the late twenties and has been the sole owner during the 40 years Regal has been in operation.

The Store. Critser's early investigation convinces him that the store has the kind of possibilities he is looking for. Although it has been operated conservatively, it has a good reputation in the community and a creditable standing in the clothing trade. The store has never been particularly aggressive in advertising—the owner has relied on repeat patronage and word-of-mouth advertising.

Critser suspects that part of Rombaugh's desire to sell is due to competitive pressure from more aggressive stores in the community. Sales have continued to increase about in proportion to the market in general, but gross margin and profit have been reduced because of lower overall maintained markups and increasing costs of operation. Rombaugh owns the inventory, fixtures, equipment, and operating supplies and leases the building at 5 percent of net sales, with a minimum payment of $1,000 a month. The current lease will expire in about 4 years.

The preliminary discussion. Rombaugh has been well impressed with Critser and agrees to furnish necessary financial information. In their discussion to date, Rombaugh has stated that he feels the business is worth about $100,000 for the purchase of inventory, fixtures, equipment, and goodwill. He will retain all accounts receivable, but he is willing to allow the new owner an 8 percent fee for outstanding accounts receivable collected after the transfer of ownership has been completed.

He also wants to keep a few assets for which he has a sentimental attachment, such as a massive rolltop desk purchased when the store was first opened. Rombaugh will assume responsibility for payment of liabilities outstanding at the time of sale.

Critser, on the other hand, feels that the business is worth somewhat less than $100,000. It is obvious to him through casual inspection that some of the inventory is worth less than the original purchase price, and he doubts the value that Rombaugh would place on goodwill. He also notes that some of the display equipment is outmoded and needs replacement.

Before accepting or rejecting Rombaugh's price, Critser suggests that he be permitted to make his own evaluation of the business on the basis of past financial records and an appraisal of the assets. Rombaugh agrees.

Following are the major elements of Critser's investigation and appraisal:

Past sales

1974--$220,000

1975-- 228,800

1976-- 238,000

1977-- 247,600

1978-- 257,600

 

Forecast sales--1979

$265,000--Critser's estimate of sales, which includes a somewhat smaller increase than the average of 3.2 percent per year between 1974 and 1978.

$268,676--Rombaugh's estimate based on the average.

Five-year operating statement

1974     1975     1976     1977     1978

Sales............... $220,000  $228,800  $238,000  $247,600  $257,600

Cost of goods sold.. 139,980  146,432  159,260  160,940  167,440

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

Gross margin........   80,020    82,368    78,740    86,660    90,160

Operating expenses   62,420   66,352   62,674   70,566   74,704

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

Profit..............   17,600    16,016    16,066    16,094    15,456

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

 

Projected operating statement for 1979

                                         CRITZER   ROMBAUGH

                                         (Buyer)   (Seller)

 

Sales....................................$265,000  $268,676

Cost of goods sold....................... 172,250    174,640

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

       Gross margin......................  92,750    94,036

 

Operating expenses...................... 76,850     75,766

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

       Profit........................... 15,900     18,270

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

 

Balance sheet of Regal Men's Store as of January 31, 1979

Assets

Cash on hand and in bank....................................$20,000

Accounts receivable.............................$32,000

Less estimated uncollectible.................. 4,000

-------      28,000

Merchandise inventory....................................... 49,214

Sales and office supplies................................... 1,920

Fixtures........................................ 20,000

Less estimated depreciation................... 5,600

-------      14,400

Equipment....................................... 19,000

Less estimated depreciation................... 8,600

-------      10,400

Miscellaneous assets........................................ 1,280

                                                           --------

Total assets...........................................$125,214

 

Liabilities

Accounts payable.................................$11,000

Payroll and sales tax payable....................  1,300

                                                 -------

Total liabilities...................................... $12,300

Net worth

James Rombaugh, capital.................................... 112,914

Total liabilities and net worth........................$125,214

                                                           --------

Salable assets

Inventory at current book value............................ $49,214

Sales and office supplies..................................  1,920

Fixtures, current depreciated value........................  14,400

Equipment, current depreciated value.......................  10,400

                                                           -------

Total salable assets................................... $75,934

 

Valuation of inventory and appraisal of fixed assets

CRITZER    ROMBAUGH

Inventory by physical count.................................$47,514

90 percent valued at current prices..............$42,762

5 percent valued at 75 percent of current prices 1,782

5 percent valued at 50 percent of current prices 1,188

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

Inventory—appraised value....................... 45,732    47,514

Usable office supplies...........................  1,680     1,680

Fixtures—appraised value....................... 13,600     13,600

Equipment—appraised value......................  9,400     9,400

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

   Total assets—appraised value................$70,412    $72,194

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

 

How much to pay? If Critser feels that his return on investment should be capitalized over 5 years, his offering price, based on anticipated profits for the year ahead, would be $79,500 (5 years = 20 percent per year;

$15,900 div. by .20 - $79,500). If, on the other hand, the purchase was based on the appraised value of assets only, the purchase price would be $70,412 plus any provision for goodwill.

Since both of these figures are well below the suggested price of $100,000, negotiation will be necessary. Here are some questions that might arise:

1. In light of future sales and profit possibilities, are the assets worth more than the sale price?

2. Is the risk less than Critser anticipates? To pay $100,000, he would have to reduce his risk level to between 6 and 7 years.

3. Is Rombaugh's price too high in the light of future sales and profit possibilities under new management?

4. How much confidence does Critser have in his ability to realize an acceptable return on his investment?

5. Is the actual value of this business as a going concern closer to $68,000, $80,000, or $100,000?

6. How much is the goodwill of this business actually worth to Rombaugh? To Critser?

7. What kind of compromise might be satisfactory to both the buyer and the seller?

 

Chapter 7 - Negotiating the Buy-Sell Contract

THE FINAL OBJECTIVE of the negotiation process is a written agreement covering the details of the proposed buy-sell transaction. Some of the details—price, terms of payment, price allocation, form of the transaction, liabilities, warranties—are matters over which the interests and motivations of the buyer and seller may be in sharp conflict.

The seller is interested in—

The best possible price—

Getting his money—

Favorable tax treatment of gains from the sale—

Severing liability ties, past and future—

Avoiding contract terms and conditions that he may not be able to

carry out.

In contrast, the buyer is interested in—

A good title at the lowest possible price—

Favorable payment terms—

A favorable tax basis for resale and depreciation purposes—

Warranty protection against false statements of the seller, inaccurate

financial data, and undisclosed or potential liabilities— An indemnification agreement and security deposit.

The agreement reached by the parties, if they succeed in reaching one, will be the result of bargaining. Depending on the relative bargaining position of the buyer and seller, the buy-sell contract may reflect either compromise or capitulation.

Price

The central bargaining issue in the buy-sell transaction is price. Price is what is actually paid for a business. Value, as distinguished from price, relates to what the business is worth. The decisions of the buyer and seller as to how much to pay or take for each dollar of potential profit are a basis for bargaining, but other factors affect the final price.

In the Regal Men's Store negotiations, Rombaugh was asking $100,000 for his business. Critser made his own evaluation of the business and offered $66,000. After an extended period of negotiations, Critser and Rombaugh agreed on a purchase price of $84,000.

What determined the asking and offering prices? How did they finally arrive at the figure of $84,000?

The process of price determination is sometimes described as horse trading.  This element is important, and undoubtedly both Rombaugh and Critser anticipated it in setting their asking and offering prices. But granting that tactics and compromise play a part in price determination, other explanations often account for the relative success or failure in the bargaining process.

Bargaining position. The price paid often reflects the bargaining position of one of the parties. Is the seller's desire to sell stronger than the buyer's desire to buy, or vice versa? The reason behind the decision to buy or sell is important. This would be true of a seller who must sell because of age, health, or personal financial reasons. If the buyer knows that sale of the business is urgent, the seller is less likely to get a reasonable price for his business, although the reasons bear no relation to the value of the business or the ability of the buyer to pay cash.

The seller's willingness to finance part of the price, or perhaps all of it, will also depend on the urgency of his need to sell. Sometimes a purchase price is agreed upon but later raised because the buyer is unable to get favorable tax treatment or in exchange for more favorable terms in other aspects of the contract.

The time factor. Another important factor affecting bargaining position is the time element—when to sell, when to buy. Economic conditions cannot be overlooked. The seller is more likely to gain his bargaining objectives when business conditions are good, particularly if his business is sharing the prosperity. During periods of recession—either general, local, or in a particular industry or activity—the pessimistic outlook of both buyers and sellers tends to depress prices.

The buyer. Still another important factor is, "Who is the buyer?" To a person experienced in business valuation, a business may be worth buying only at the liquidation value of the assets. To another buyer, the same business may be the answer to a long-held dream of owning his own business.

Liabilities

A buyer generally prefers to purchase assets rather than stock for tax reasons, but his preference becomes even stronger because of liability considerations. In the assets transaction, the legal continuity of the seller's business is broken. The seller's business liabilities are usually not carried over unless the buyer assumes them by agreement.

Buyers often find an advantage in assuming obligations of the seller under leases, mortgages, or installment-purchase contracts. The seller may be willing to make some financial sacrifice to the buyer in order to get out from under the payment burden—even though he remains liable for the obligation if the buyer defaults.

But these are known liabilities. It is the unknown that the buyer fears in the stock transaction. Many liabilities, both existing and potential, are unknown at the time of contracting merely because of inadequate investigation. And in any business, there are potential liabilities that neither an honest seller nor a diligent buyer can foresee at the time of the buy-sell transaction. An accident involving a company truck, the fall of a customer on the business premises, or the discharge of an employee may become the basis of a lawsuit and eventual liability, even though many months have passed since the event.

Even more elusive are liabilities that may arise from the manufacture or sale of defective products, patent or trademark infringements, or violations of statutes such as wage-and-hour laws, blue-sky laws, the Robinson-Patman Act, the Sherman Act, and so on. Tax deficiencies may arise out of tax returns filed but unaudited at the time of the buy-sell transaction.

The price agreed upon in a stock transaction will, of course, take into consideration only known liabilities. The possibility of unknown liabilities need not, however, preclude the buyer from entering into a stock transaction. Such a course of action may, in fact, be necessary in order to retain the benefits of nonassignable contracts, leases, franchises, government licenses, stock registrations, corporate name, and so on.

The buyer of stock should take precautions against unknown liabilities.  Ordinarily this would include an agreement on the part of the seller to indemnify the buyer against such liabilities and on some means for satisfying any claims against the seller. Holding part of the purchase price in escrow against such a contingency gives the buyer at least some security.

Contract Terms

A number of problems in the buy-sell transaction are brought into focus by the necessity of "writing up a contract." At this point, agreement has usually been reached on the major issue—price. Presumably, the buyer and seller have considered tax consequences, assumption of liabilities, and terms of payment in arriving at a price.

More is involved in drafting an adequate buy-sell contract, however, than mechanically reducing these oral agreements to written form. To protect the interests of both parties, the contract must cover possible problems that are often far from the minds of the buyer and seller at the time.

What if the buyer defaults on his installment payment of the purchase price? What if the seller's financial statements, which the buyer relied on, turn out to be inaccurate or false? What if the seller turns out to have liabilities that have not been taken into account in the price? What if some of the assets purchased turn out not to be owned by the seller or are subject to undisclosed liens? What if material changes in the business occur before the buy-sell transaction is closed? What if the seller opens a competing business of the same type in the immediate vicinity?

These questions reflect the uncertainty of the buyer's position. The seller knows what he is selling and what he is getting (with a possible exception in the case of seller financing). The buyer is getting an unknown quantity. Whether or not the buyer gets the protection he should have as part of the contract is a matter of bargaining.

A Typical Buy-Sell Contract

Following is a typical buy-sell contract, with comments, covering the sale of the Regal Men's Store. The contract covers the sale of a proprietorship business, but the basic content would be the same in a corporate stock transaction.

                           ------+++------

 

THIS AGREEMENT is made and entered into this 15th day of February, 1979, between James Rombaugh, hereinafter referred to as the Seller, and Joe Critser, hereinafter referred to as the Buyer.

WHEREAS the Seller is the owner of a men's clothing store using the trade name of "Regal Men's Store" in Central City, Illinois, and the Seller desires to sell to the Buyer his rights, title and interests including the goodwill therein, and the Buyer is willing to buy the same on the terms and conditions hereinafter provided, IT IS AGREED AS FOLLOWS:

(The above statements introduce the parties and the nature of the agreement. If the business is incorporated and a stock transaction contemplated, the stockholders will be identified as the sellers and stock as the item sold.)

1. Sale of business. The Seller shall sell and the Buyer shall buy, free from all liabilities and encumbrances except as hereinafter provided, the men's clothing store owned and conducted by the Seller under the trade name of "Regal Men's Store" at the premises known as 120 North Main Street, Central City, Illinois, including the goodwill as a going concern, the lease to such premises, stock in trade, furniture, fixtures, equipment and supplies, all of which are more specifically enumerated in Schedule A attached hereto.

 

(Paragraph 1 incorporates by reference an inventory not shown here of the assets being purchased. A specific enumeration of assets being purchased is important as a basis for recourse against the seller in the event of shortage or title defects.)

2. Purchase price. The purchase price for all the assets referred to in paragraph 1 shall be $84,000 and allocable as follows:

 

    Lease.........................................     0

    Goodwill......................................$ 6,000

    Fixtures and equipment........................ 30,000

    Inventory..................................... 47,400

    Supplies......................................   600

                                             -------

$84,000

                                             -------

 

(The allocations in paragraph 2 represent compromise of the conflicting tax interests of the buyer and seller.)

3. Method of payment. The Buyer shall pay to the Seller the purchase price as stated above, in the following manner: (a) $10,000 by certified or cashier's check upon execution of this agreement, the receipt of which is hereby acknowledged by the Seller, such proceeds to be held in escrow by Paul Jones, attorney for the Seller, as provided in paragraph 13; (b) $40,000 by certified or cashier's check at the date of closing, subject to the adjustments provided for in paragraph 4; © the balance of $34,000 by a promissory note payable in consecutive monthly installments of $400 each beginning the first day of April, 1979, together with interest at 11-1/2% per annum.all contain a provision, satisfactory Such note shto the attorney for the Seller, for the acceleration of the balance remaining unpaid upon default in the payment of an installment for a period longer than thirty days. As security for the payment of any such note, the Buyer shall execute and deliver to the Seller at the closing a chattel mortgage upon the inventory, fixtures, and equipment described in paragraph 1, such mortgage to contain an after-acquired property clause and such other provisions as the attorney for the Seller may request.

 

(Paragraph 3 recognizes the financing seller's principal problem: security—or lack of it. The acuteness of the problem results from the fact that the buyer has usually exhausted all acceptable forms of security in getting the bank credit he needs.)

4. Adjustments. Adjustments shall be made at the time of closing for the following: inventory sold, insurance premiums, rent, deposits with utility companies, payroll and payroll taxes. The net amount of these adjustments shall be added or subtracted, as the case may be, from the amount due on the purchase price at the time of closing.

5. Buyer's assumption of contracts and liabilities. In the event this agreement to sell is in fact closed and the business is transferred by the Seller to the Buyer, the Buyer shall be bound by and does hereby assume the terms of the following contracts:

 

Lease of business premises dated January 1, 1976. The Buyer shall indemnify the Seller against any liability or expense arising out of any breach of such contracts occurring after the closing.

(Since a going business is being sold, the most realistic approach to the problem of outstanding liabilities may be for the buyer to assume all liabilities shown in an attached balance sheet and also liabilities that arise in the ordinary course of business after contracting but before closing. Such an agreement provides recourse by the seller against the buyer if the buyer defaults, but does not discharge the liability of the seller to the third party.)

6. Seller's warranties. The Seller warrants and represents the following:

 

    (a) He is the owner of and has good and marketable title to all the assets specifically enumerated in Schedule A, free from all debts and encumbrances.

    (b) The financial statements which are attached hereto as Schedule B have been prepared in conformity with generally accepted accounting principles and present a true and correct statement of the financial condition of said business as of their respective dates.

    (c) There are no business liabilities or obligations of any nature, whether absolute, accrued, contingent or otherwise, except as and to the extent reflected in the balance sheet of January 31, 1979.

    (d) No litigation, governmental proceeding or investigation is pending, or to the knowledge of the Seller threatened or in prospect, against or relating to said business.

    (e) The Seller has no knowledge of any developments or threatened developments of a nature that would be materially adverse to said business.

    (f) The statements made and information given by the Seller to the Buyer concerning said business, and upon which the Buyer has relied in agreeing to purchase said business, are true and accurate and no material fact has been withheld from the Buyer.

 

(Paragraph 6 is intended to protect the buyer from the unknown—title defects, undisclosed liens, false or fraudulent information, undisclosed or potential liabilities. If the buyer is becoming liable for all business liabilities through assumption or purchase of stock, he will require more extensive warranties than these.)

7. Seller's obligation pending closing. The Seller covenants and agrees with the Buyer as follows:

 

    (a) The Seller shall conduct the business up to the date of closing in a regular and normal manner and shall use its best efforts to keep available to the Buyer the services of its present employees and to preserve the goodwill of the Seller's suppliers, customers and others having business relations with it.

    (b) The Seller shall keep and maintain an accurate record of all items of inventory sold in the ordinary course of business from January 31, 1979 up until the date of closing. Such record shall be the basis for adjustment of the purchase price as provided in paragraph 4.

    (c) The Seller shall give the Buyer or his representative full access during normal business hours to the business premises, records and properties, and shall furnish the Buyer with such information concerning operation of the business as the Buyer may reasonably request.

    (d) The Seller shall comply to the satisfaction of the Buyer's attorney with all the provisions of the statute of the State of Illinois commonly known as the "Bulk Sales Act."

    (e) The Seller shall deliver to the Buyer's attorney for examination and approval prior to closing such bills of sale and instruments of assignment as in the opinion of the Buyer's attorney shall be necessary to vest in the Buyer good and marketable title to the business, assets and goodwill of the Seller.

 

8. Risk of loss. The Seller assumes all risk of destruction, loss or damage due to fire or other casualty up to the date of closing. If any destruction, loss or damage occurs and is such that the business of the Seller is interrupted, curtailed or otherwise materially affected, the Buyer shall have to right to terminate this agreement. In such event, the escrow agent shall return to the Buyer the purchase money held by him. If any destruction, loss or damage occurs which does not interrupt, curtail or otherwise materially affect the business, the purchase price shall be adjusted at the closing to reflect such destruction, loss or damage.

 

(Paragraphs 7 and 8 are concerned with the period between contracting and actual transfer of ownership. The provisions stated anticipate such risks as depletion of inventory, injury to goodwill, creditors' actions, and casualty loss. In 7 ©, the disruptive effect of a transfer of ownership is reduced by providing the buyer with the opportunity to become familiar with the details of the business operation before he assumes the responsibility of operation.)

9. Covenant not to compete. The Seller covenants to and with the Buyer, his successors and assigns, that for a period of five years from and after the closing he will not, directly or indirectly, either as principal, agent, manager, employee, owner, partner, stockholder, director or officer of a corporation, or otherwise, engage in any business similar to or in competition with the business hereby sold, within a fifty mile radius of Central City, Illinois.

 

(Paragraph 9 anticipates the possibility that the buyer would suffer a loss of the business goodwill he has purchased if the seller opened a similar business in competition with the buyer. Such provisions are enforceable if the restriction is reasonable. What is considered reasonable will depend on the circumstances of each case.)

10. Conditions precedent to closing. The Buyer's obligations at closing are subject to the fulfillment prior to or at closing of the following conditions:

 

    (a) All of the Seller's representations and warranties contained in this agreement shall be true as of the time of closing.

    (b) The Seller shall have complied with and performed all agreements and conditions required by this agreement to be performed or complied with prior to or at the closing.

 

(Paragraph 10 raises a problem that is inherent in the traditional contracting with a closing at some future date. In the period between, the buyer sometimes uncovers facts that would constitute a breach of warranty and grounds for canceling the contract. Because of this, transactions are finally closed, if at all, largely on the good faith of both parties. It is possible, if both parties work together toward the common goal, to sign the contract and close the transaction at the same time.)

11. Closing. The closing shall take place at the office of Paul Jones, 100 South Main Street, Central City, Illinois, on March 1, 1979, at 10:00 a.m.  At the time of said closing, all keys to the business premises, the bills of sale and other instruments of transfer shall be delivered by the Seller to the Buyer and the money, note and mortgage required of the Buyer shall be delivered to the Seller. Upon completion of the said payment and transfer, the sale shall be effective and the Buyer shall take possession of the said business.

12. Indemnification by the seller. The Seller shall indemnify and hold the Buyer harmless against and will reimburse the Buyer on demand for any payment made by the Buyer after closing in respect to:

 

    (a) Any liabilities and obligations of the Seller not expressly assumed by the Buyer.

    (b) Any damage or deficiency resulting from misrepresentation, breach of warranty or nonfulfillment of the terms of this agreement.

 

13. Seller's security deposit. As security for the indemnities specified in paragraph 12, the Seller's attorney, Paul Jones, shall hold in escrow, for a period of one year from the date of closing, the sum of $10,000 which has been paid by the Buyer upon execution of this agreement. Said escrow agent shall upon application of the Buyer apply all or any part of such to reimburse the Buyer as provided in paragraph 12, provided the Seller shall have been given not less than ten days' notice of such application and has not questioned its propriety.

14. Arbitration of disputes. All controversies arising under or in connection with, or relating to any alleged breach of this agreement, shall be submitted to a panel of three arbitrators. Such panel shall be composed of two members chosen by the Seller and Buyer respectively and one member chosen by the arbitrators previously selected. The findings of such arbitrators shall be conclusive and binding on the parties hereto. Such arbitrators shall also conclusively designate the party or parties to bear the expense of such determination and the amount to be borne by each.

 

(Paragraph 12 obligates the seller to indemnify the buyer to the full extent of any cost or damage sustained by the buyer as a result of the seller's breach of warranty or contractual obligations. Paragraph 13 backs up this agreement with a requirement that part of the purchase price be placed in escrow as security for the seller's performance. Paragraph 14 provides a means for resolving without litigation any buyer-seller disputes that may arise from the contract.)

IN WITNESS WHEREOF, the Buyer and Seller have signed this agreement.

JAMES ROMBAUGH, Seller

JOE CRITSER, Buyer

 

------+++------

 

Chapter 8 - Financing and Implementing the Transaction

THE BUYER AND SELLER have a number of important matters to attend to before the transaction can be closed. The seller will be thinking about instruments of transfer that must be delivered at the closing, about compliance with the bulk sale act, and possibly about making financial arrangements if the buyer can't raise the purchase price. The buyer's attention will be focused on financing arrangements, organizing his business-to-be, overseeing the seller's operation of the business in the meantime, and becoming familiar with the details of the business operation.

Compliance With the Bulk Sale Act

Most States require the seller of a business to furnish a sworn list of his creditors to the buyer and the buyer to give notice to the creditors of the pending sale. The purpose of such a "bulk sale" act is to make certain that the seller doesn't sell out his stock in trade and fixtures, pocket the proceeds, and disappear, leaving his creditors unpaid. Compliance with the statute gives creditors an opportunity to impound the proceeds of the sale if they think it necessary.

Noncompliance or inadequate compliance may result in attachment of the property after the sale by creditors of the seller and voiding of the buy-sell transaction. The buyer should not close the transaction until he has made sure that all statutory requirements have been met.

Financing the Buy-Sell Transaction

In general, the buyer has two options regarding the financing of the business. The first basic method of financing is person investment of the future owner or owners of the business. The buyer may pay cash for the business out of personal resources, establish a partnership, or sell stock.  These forms of financing are commonly referred to as the use of equity or investment capital.

The other basic form of financing is through borrowing or the establishment of credit. This method of financing may or may not require the payment of interest, but it does require the borrower to repay the principal, usually over a stipulated period of time or on a specific date. This method of financing is commonly referred to as the use of debt capital. Often the purchase is made through a combination of equity and debt capital.

Equity capital. In the simplest form of purchase, the buyer pays the full purchase price in cash. The buyer's investment in the business, at least initially, is full and complete. Whether the funds come from one person or more than one, the financial nature of the transaction does not change.

The sources of equity capital are many and varied. Generally, they are in the form of bank savings. Or cash may be obtained from liquidating certain assets the buyer may own, such as surrendering life insurance policies for cash value or selling real estate, stocks and bonds, or other assets.

Before disposing of assets, however, the buyer should ask himself this question: "Do I want to buy the business more than I want to keep these assets, considering both present and future values?" For instance, if the buyer cases $16,000 worth of government bonds, there may be a possibility of his making a higher profit, but the risk of losing his investment entirely will be greater. He should be as certain as possible that the expected return is worth the risk.

An equally important question is how much the buyer should invest in the business. In general, the more he invests himself, the better chance he will have of borrowing at least part of the purchase price.

A buyer may not have the capital, however, nor perhaps the inclination, to purchase the business outright with his own personal funds. How far he goes in this respect depends on his own cash resources, his confidence in the business, and his ability to borrow money or establish credit with others.

Debt capital. In most cases, the buyer of a small business will have to borrow money or establish credit to purchase the business. Several factors will affect the use of debt capital for this purpose: the source of capital, the amount that can be borrowed, and the length of time for which the capital can be borrowed.

Commercial lending institutions are the sources to which the buyer will probably turn first. The availability of financing through these sources depends on the security that can be pledged to the loan, the profit potential of the business, the prospect of repayment of principal and interest, and the general availability of credit.

One of the major difficulties facing the buyer at this point concerns the collateral that can be pledged as security. The physical assets of the business—particularly fixtures, equipment, and land and buildings—will not be available for security unless they are free of other financial obligations. The buyer may be forced to look to his own personal assets, such as cash value of life insurance, stocks and bonds, mortgages on real property, and so on.

Less formal sources of debt capital may be open to the buyer, such as loans from friends, relatives, business associates, and the like. Many small businesses have been financed through such means.

The seller as lender. A common source of debt capital is that supplied by the seller when he lets the buyer pay for the business over time. Why should the seller finance the buyer? Probably because the desire to sell is strong enough so that the seller is willing to assume part of the risk.

As in financing from other sources, the seller usually demands that the buyer pay interest on the amount being financed and repay the principal and interest at stipulated periods. The seller usually establishes his security on the more certain assets, such as fixtures and equipment. However, he may also assume the inventory as acceptable security without placing it in a bonded warehouse.

The seller's philosophy toward financing the buyer seems to be that if the buyer should fail, the seller can take back the business. The major problem in this form of financing is that it is harder for the buyer to get additional financing from other sources when the seller has first claim on the assets of the business.

How much to borrow. As the first step toward financing the purchase of a business, the buyer has to find answers to two questions:

"How much do I need to borrow?"

"How much can I afford to borrow?"

 

The answer to the first question depends partly on how much money the buyer has and how much he is willing to invest in the business himself. The less equity capital he has, the more debt capital he needs.

How much he can afford to borrow depends on his ability to keep up principal and interest payments. If a buyer borrows from a number of sources, he may find himself committed to a repayment schedule that the profits from the business will not support. His borrowing plans should be related to the projected income statement prepared during his study of the business under consideration.

Operating capital. In addition to funds for purchasing the business, the buyer must have enough working capital to cover the cost of operation until the business itself produces enough cash. In other words, the buyer must think in terms of cash requirements and cash flow for weeks and months ahead. A common mistake in buying a business is failure to provide adequate working capital.

If sales and business costs after purchase of the business are expected to follow the pattern of the immediate past, the need for short term working capital should not be hard to estimate.

Closing the Sale of the Regal Men's Store

In the sale and purchase of the Regal Men's Store, discussed in chapters 6 and 7, Rombaugh and Critser compromised on a price of $84,000. The problem then facing the two men was how the transaction was to be financed. What were the various possibilities?

Critser could pay the entire $84,000 out of cash or negotiable assets converted to cash, providing he had that amount and was willing to invest the entire sum. Critser did not have that much cash and was not likely to be able to raise it.

Critser could pay up to the limit of his own resources and borrow the rest. Critser had been turned down by three banks—they did not consider him an acceptable credit risk. This had nothing to do with Critser's personal credit rating. It was due to concern about whether he could meet the resulting financial obligations out of profits and about the nature of the assets as a basis for security.

Rombaugh could allow Critser to assume ownership of the business and pay the amount due over several years. Whether Rombaugh would agree to such an arrangement would depend on how badly he wanted to sell to Critser, how long it would take Critser to pay off the amount due, and whether there were any other potential buyers who might be able to finance the purchase differently.

Critser might be able to get others to invest with him, forming a partnership and spreading the capital requirements among two or more owners. This arrangement would reduce Critser's ownership in the business, since the legal form would be changed from a single proprietorship to a partnership. Critser did not want this. He would rather not purchase the business than take on a partner.

Critser might form a corporation and sell stock to raise capital. This would not ordinarily be feasible for such a small business.

 

Plan for Financing the Purchase

Critser's personal investment.................................$40,000 Financed by Rombaugh.......................................... 34,000 First-year payment:

Principal at $400 a month.................$4,800

Interest at 11.5 percent.................. 3,910

------   $8,710

Financed by Hirschberger...................................... 10,000

First-year payment:

Principal.................................$3,333

Interest at 10 percent.................... 1,000

                                           ------     4,333

                                                       -----

First-year principal and interest payments...........$13,043

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

Total price............................................... $84,000

 

Regal Men's Store

Balance Sheet—February 15, 1979

Assets

Cash on hand and in bank.....................................  $4,000

Merchandise inventory........................................  47,400

Fixtures and equipment.......................................  30,000

Sales and office supplies....................................    600

Goodwill.....................................................  6,000

                                                             -------

Total assets.............................................  88,000

 

Liabilities

Notes payable................................................  44,000

Net Worth

Joe Critser, capital.........................................  44,000

                                                               ------

Total liabilities and new worth..........................  88,000

 

The cost of complying with stock registration requirements, the possibility of losing control of management, the lack of a market for such securities, and the greater relative cost of equity capital over debt capital would all work against it.

The decision. In effect, the only course of financing open to Critser was to raise as much as possible, borrow from personal sources, and enlist Rombaugh's willingness to finance the balance. Rombaugh agreed to finance the business to the extent of $34,000, accepting a chattel mortgage on inventory, fixtures, and equipment.

This is somewhat unusual, particularly as to the inventory. There was no requirement that the inventory be placed in a bonded warehouse or otherwise controlled. Rombaugh based his decision on his own knowledge of average inventory value and on his willingness to accept the risk that Critser would not tie up further purchases in accounts payable.

With Rombaugh financing $34,000, Critser now had to raise the remaining $50,000. He got $10,000 in the form of a loan from his former boss Dan Hirschberger. As security, Critser pledged some stock he owned. He agreed to repay the loan semiannually over a 3-year period at 10 percent interest.

The cash value of Critser's life insurance and his Series E Bonds brought $16,000 and $14,000 respectively. Another $10,000 came from his wife—savings she had accumulated working as a secretary. A $4,000 inheritance Critser had received several years before was to be retained for use as working capital, and this would be supplemented by the 10 percent fee he would receive from Rombaugh for collecting the accounts receivable outstanding at the time of purchase. This fee would amount to about $1,375 if all the accounts were collected.

How it all stacks up. With these arrangements, Critser's financial position with regard to the purchase of the business was as shown in the chart above. Almost everything he owned was either invested in or pledged to the business. One question remained: Would the business bring in enough cash to cover operating costs and other financial obligations?

The outcome—what will it be? Should he have bought the business? Can he meet his financial obligations? Will he be able to maintain enough working capital to replace inventory, pay his operating costs, and repay his debt capital with interest as the payments fall due?

Only time will tell how good a manager Critser is. Many businesses have been bought and operated successfully on a more precarious start than this.  Perhaps he will prove capable of meeting the challenge. Perhaps not.

If he should fail what would he lose? Practically everything—his full investment of $40,000 plus whatever else is necessary beyond the sale value of the assets to satisfy his creditors. Whether he succeeds or fails will depend on how well he can administer the financial program of the store, how well he can merchandise, how well he can keep his costs in line, how near his sales come to his earlier estimates.

Part 4 Using Financial Statements in the Buy-Sell Transaction

Chapter 9 - Income Statements and Balance Sheets

THE DISCUSSING OF FINANCIAL STATEMENTS in this chapter assumes that the statements are prepared in accordance with generally accepted accounting principles. There is a brief statement of some of the more important of these principles:

A business should have financial reports prepared at the end of each calendar or fiscal year, with interim reports during the year. Use of the "natural" business year as the formal accounting period has been increasing. The natural year is the 12-month period ending at the lowest point of business activity for the period.

Since many business transactions will be incomplete at the end of any accounting period, some estimates will be necessary. Such estimates are an acceptable part of financial reports as long as they are made according to procedures that have proved reliable in the past.

Each business is considered a separate accounting unit, with the affairs of the business kept entirely separate from the owner's personal affairs. All records and reports should be prepared on this basis.

Financial statements are prepared on the assumption that the business unit will continue to function in its usual manner.

For some accounting objectives, two or more methods are possible. For example, there are several methods of computing depreciation and also of valuing inventory. They are all valid, but once a method has been selected for use in the records of a business, it should be used consistently.

Accounting must be practical. Strict adherence to a principle is not required when the increase in accuracy is too small to justify the increased cost of compliance. A uniform policy should be adopted to guide such exceptions, however.

All assets and services required by a business should be recorded on the date they are acquired at their cost to the business. This cost includes costs incurred to procure the asset or service and to place it in position or condition for business use. Donated assets are recorded at their cash equivalent value as of the date of donation.

A major objective of accounting is to determine income by matching costs against revenue. The net income of a business is the increase in that company's net assets brought about through profitable exchanges of product and services or through sale of assets other than stock in trade.

 

What Is Being Sold

In the usual buy-sell transaction relating to a "going concern," what is being bought or sold is primarily a future stream of income. Not the assets or property of the business, but the income these assets will generate in the future. But future income is impossible to compute and hard to estimate. Therefore, the buyer and seller often ignore this unknown quantity. In trying to set the price, they concern themselves with known values relating principally to the replacement cost of the tangible assets being sold. This is a mistake.

Use of Past Financial Data in Valuing Future Income

It has been said that history repeats itself, but this is not always true of the financial history of a business. First of all, the question arises, "Why is the present owner willing to sell the business?" One reason may be that he foresees adverse change of one sort or another.

Keep in mind, too, in trying to predict the future from present results, that there will be a change of ownership. Will the new owner be able to produce the results the former owner did? Is he trained and experienced in management as well as in the mechanical or technical skills needed?

There are many reasons why past operating results may not be a good indication of future income. Still, they are at least concrete facts. They should be examined carefully for whatever insight they may provide into the future.

What Data To Expect

Most businesses will have at least two basic financial statements prepared at the end of the annual accounting period—a statement of income and a balance sheet. There may also be other statements containing important information. These might include a reconciliation of retained earnings in the business, a statement of source and application of funds, and listings of such items as inventories, accounts receivable, and accounts payable. However, the statement of income and the balance sheet are the basic financial statements. Any business can reasonably be expected to have these two available.

If they have not been prepared, it may be necessary to construct approximate statements—particularly statements of income—based on the best information available. If they are available but were not prepared in accordance with generally accepted accounting principles, they will probably have to be adjusted.

It is essential to understand what the accountant means by the amounts shown on the financial statements. The items discussed below should appear on most such statements. The listing is not all-inclusive, but most major items are discussed.

The Balance Sheet

A balance sheet lists in one section all the assets of the business as of the last day of the accounting period and in another section all claims against these assets. Claims against assets include creditors' claims, or liabilities, and owner's claims, or investment (also called equity or net worth).

Assets

Cash. This asset includes cash balances in the bank, cash on hand (including change and petty-cash funds), funds held in trust, sinking funds, and funds in time deposits. Not all the cash will necessarily be available for payment of liabilities. Change funds, for example, must be retained in order to have the change necessary for doing business.

Marketable securities. Included in this classification are such items as United States Treasury bills and perhaps stocks and bonds. These assets are most commonly shown on the balance sheet at their cost to the business or at their market value.

Accounts receivable. An entry that is identified merely as "accounts receivable" or has the designation "trade" after it refers to accounts receivable from customers only. Notes or accounts receivable from officers, employees, or owners of the business are considered nontrade receivables and should be entered as a separate item.

Allowance for bad debts. This is an account that is deducted from the accounts receivable account to give a more accurate valuation to accounts receivable. Suppose the business has accounts receivable of $100,000 and experience indicates that 5 percent of this amount will be uncollectible. There is no way of knowing which specific accounts will not be collected, but it can be estimated that $5,000 will eventually be uncollectible. To reflect this fact on the balance sheet, accounts receivable are shown at $100,000. An allowance for bad debts of $5,000 is also entered and deducted from the accounts receivable, leaving a net of $95,000 as the estimated collectible accounts receivable.

Notes receivable. This account includes the face amount of all notes that have been given the company and that are still unmatured, even those that have been discounted at the bank.

Notes receivable discounted. This is a contingent (possible) liability account. If a note receivable has been discounted at the bank, the company has had to guarantee its payment. Thus, until the maker of the note pays the bank, the company has a possible note payable.

The amount of the notes receivable discounted is entered on the balance sheet under the notes receivable entry and subtracted from the notes receivable total. An alternative method is not to include it in the notes receivable total but to show it in a footnote.

Notes and accounts receivable from officers, employees, and owners. This amount will include amounts due the business from persons connected with the business in some way. Advances for employees' uniforms or cash loans may have been made, for instance.

Inventories. Inventories are the major asset in some kinds of businesses, particularly those in the merchandising field. Methods of valuing inventories are similar in manufacturing and nonmanufacturing companies, but the mechanics of computing the values differ. Therefore, valuation methods are discussed separately.

Purchased inventories. If the business buys merchandise or raw materials which it merely holds for a time and then sells with little or no alteration, the inventory is valued either at cost or at the replacement price if the latter is below cost. If the replacement price is higher than cost, the inventory should be valued at cost.

It is generally agreed that if the cost of transportation of the goods to the company is a significant item, the inventory account should include this cost. In fact, all costs involved in preparing the goods for sale could justifiably be included. Such costs might include, for example, certain costs of dividing and repackaging.

Once it has been decided what costs are to be included in the inventory account, there are at least four major methods of valuing the inventory:

1. If a business specifically identifies items in costing inventory, it must be able to tell what was paid for each item. This method is practical for items with a high unit price, such as new automobiles or major appliances. As the unit price falls, however, and the number of items in the inventory increases, this method of valuation becomes less practical.

2. First in, first out, or FIFO, is another method of costing inventory. It assumes that the first units purchased are the first units sold, that those still in inventory are the last ones purchased. Thus, the inventory is valued at the cost price of the last items purchased by the business.

3. Last in, first out, or LIFO, assumes the opposite—that the last goods purchased are the first ones sold. The inventory is thus valued at the cost of the first inventory items to be available for selling. The inventory valuation under LIFO does not necessarily correspond very closely to current replacement costs.

4. The average cost method is merely an average of FIFO and LIFO. It aims to find a middle ground between the two extremes.

 

If prices of the goods purchased have been rising, the FIFO valuation will come closest to current market prices—the use of LIFO will tend to value the inventory at less than current market prices. The choice of inventory valuation will affect the reported cost of goods sold on the income statement and also the reported net income.

Manufactured inventories. If the company manufacturers goods from purchased raw materials, the inventory costing or valuation method is somewhat different. Any raw materials on hand are valued by one of the methods described for purchased inventories. Valuation of work in process and finished goods inventories involves three elements:

1. Cost of the raw materials used. This can be computed very exactly.

2. Cost of the direct labor used in converting the raw material into its present state of completion. This, too, normally lends itself to fairly exact measurement.

3. Factory overhead, or indirect cost. These are the costs of such items as insurance, indirect materials, indirect labor, taxes, and so on. They must be allocated to the units produced on some reasonable basis.

 

Total indirect costs do not vary with the amount of goods produced, or at least not proportionately. This means that if the plant is not operated at its maximum capacity, the indirect costs per unit of production will be more than would be the case if the plant were operated at a higher level of production. Therefore, idle time or idle capacity in a plant may cause the inventory value of manufactured goods to be unrealistically high.

Prepaid and deferred items. Prepaid expenses are prepayments for goods or services that will be consumed in the near future—prepaid rent, prepaid insurance premiums, office supplies, and so on. Deferred charges are prepayments that will benefit the company over a period of years, such as the cost of moving to a new location.

Property, plant, and equipment. This classification includes all the fixed assets of the business—land, buildings, equipment, and other tangible items that will last more than a year and will be used in the normal operation of the business. These items, under generally accepted accounting principles, should be recorded at their original cost to the business.

Occasionally, a buyer may find that the seller has raised the valuation of these assets by appraisal writeups. If this has occurred, the buyer must satisfy himself that the value of the assets has in fact increased by the amount of the appraisal writeup.

Accumulated depreciation and depletion. This account shows the amount of depreciation, or loss of usefulness, that has been charged against the property, plant, and equipment while they have been held by the business. On the balance sheet, the amount in each depreciation account is deducted from the corresponding property, plant or equipment total. This leaves the net book value, or unrecovered original cost.

A depreciation account is merely a technique for distributing the cost of a fixed asset over its estimated useful life. It is quite possible for assets that are fully depreciated on the books to be still serviceable, and for assets not fully depreciated to be no longer serviceable.

There are a number of methods of figuring depreciation. Four of the most common are the straight-line method, the declining-balance method, the sum-of-the-years-digits method, and the units-of-production method.

The first three methods record depreciation on the basis of time. The straightline method records the depreciation uniformly over the years of the asset's estimated service life. It is by far the most commonly used because of its simplicity. The declining-balance and sum-of-the-years-digits methods record larger amounts of depreciation in the early years. With these two methods, increased maintenance expenses in later years are offset somewhat by the reduced charges for depreciation.  Also, there are some income-tax advantages.

The units-of-production method is based on the estimated productive capacity of the asset rather than time. It is useful where the amount of usage varies considerably form time to time.

All four methods will record the same total depreciation over the life of the asset. There may be a substantial difference in the amount recorded in any one year, however.

Intangibles. This classification includes such items as patents, trademarks, and goodwill. The value recorded is their cost to the business.  The amount entered for a patent, for example, will be either the cost of purchasing the patent right or the cost of developing the patent. Goodwill will not appear on the balance sheet unless the business purchased the goodwill and has decided to leave it on the books.

Liabilities and Owner's Equity

Accounts payable to trade. The amounts recorded in this account are the amounts owed to regular trade creditors (except notes payable) for merchandise and other items needed in operating the business.

Notes payable. This item includes all amounts owed by the business for which a formal not payable has been given if the note is due in 12 months or less from the balance-sheet date.

Accrued taxes payable. This account will show the amounts owed to various taxing authorities. It will include taxes that have been collected or withheld but not yet forwarded to the authorities—for example, sales taxes, income withholding taxes, and Federal Insurance Contribution Act (Social Security) taxes. The account may also include accruals for items such as property taxes, franchise taxes, and use taxes the business owes but has not yet been paid. The amount shown on the balance sheet should be the amount that the business is legally liable for.

Wages and salaries payable. This account will show all wages and salaries of employees earned but not paid as of the balance-sheet date. Any unclaimed wages due former employees will also be included in this account.

There are some rather rigid legal requirements about the handling of taxes collected from the employees as opposed to ordinary business liabilities.

Income taxes payable. This account may not appear on the balance sheet if the business is operated as a single proprietorship or partnership. It should be shown for a corporation. The amount may be only an estimate but will usually be quite accurate.

Unearned income. Some types of businesses receive fairly large amounts of prepaid or unearned income. The publisher of a newspaper or periodical, for instance, is paid for subscriptions before the publications are delivered.  If a business rents property to others, the rent will be received in advance. The amount of such income that has been received but not earned at the balance-sheet date is recorded here. There may or may not be a legal requirement that the unearned amounts be returned if the company fails to deliver the services or products.

Long-term liabilities. For a liability to be considered long term, its maturity date should be more than 12 months from the balance-sheet date. If unearned income is prepayment for services covering more than a year from the balance sheet date, a proportionate amount of it should be included here instead of under unearned income.

Owner's equity. Two elements enter into owner's equity: the initial investment of the owner or owners, and retained profit or loss. The computation of owner's equity is based on the recorded value of the assets and liabilities of the business—it is merely the difference between the total assets and the total liabilities. If the assets are recorded at less than their true value, the owner's equity will be understated. If the assets are recorded at an inflated value, the owner's equity will be overstated.

If the business is a corporation, the original investments of the owners will be kept in separate contributed capital accounts. The net results of operations will be summarized in one or more retained earnings accounts.  All these accounts together make up the owners' investment in the business.

If the business is a single proprietorship or a partnership, each owner will have a capital account that summarizes his investments, his share of net income or losses, and withdrawals he has made.

Income Statement

The income statement is a summary of the income and expenses of the business for the period covered. It shows the net result of operations—profit or loss—for the period.

Revenue. All income of the business from whatever source should be included. However, income from operations is usually shown separately from other income such as interest or rent. Charge sales are included in sales income at the time the sale is made, regardless of when the cash is received in payment.

Cost of goods sold. The cost of goods sold equals the cost of goods purchased during the accounting period (including transportation) plus the beginning inventory and minus the ending inventory.

Gross margin. This is the difference between income from operations and cost of goods sold. The gross margin must cover operating expenses, taxes, and profit.

Operating expenses. Types of operating expenses vary with the type of business, but all businesses have some—building expenses, utilities, wages, supplies, some kinds of taxes, insurance, and so on. These expenses for the accounting period are subtracted from the gross margin to give the net income (before income taxes).

Auditing of Financial Statements

If the buyer in a buy-sell transaction asks an accountant to audit the financial statements of the seller, the accountant will want to make a "purchase investigation." A purchase investigation is a normal audit with intensified examination of certain items critical in a buy-sell situation. The accountant may go to greater lengths, for example, to make sure that the physical plant and all equipment are present and in serviceable condition.

There is no required form an accountant must use in certifying financial statements, but the following standard certificate has evolved:

We have examined the balance sheet of the __________________ Company as of December 31, ____ and the related statement of income and surplus for the year then ended. Our examination was made in accordance with generally accepted auditing standards and accordingly included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances.

In our opinion the accompanying balance sheet and statement of income and surplus present fairly the financial position of the ____________________ Company at December 31, ____ and the results of its operations for the year then ended, in conformity with generally accepted accounting principles applied on a basis consistent with that of the preceding year.

If the accountant cannot use this certificate as it is, he will do one of two things. He will either qualify his certification, or state that he is unable to render an opinion regarding the financial statements. This might happen if he were unable to comply with generally accepted auditing standards, or if the accounting records were not prepared in conformity with generally accepted accounting principles.

What If There Are No Financial Statements?

The buyer may find, in a very small business, that the owner has never prepared financial statements. Furthermore, there may be no records available from which to prepare them.

There is no realistic way to determine the results of past operations without financial statements. However, there are a few records that even the smallest, most poorly run business must have. The buyer should try to construct from these records as realistic as possible an income statement and balance sheet. Here are some of these records:

The seller will have had to file Federal income-tax returns that include an income statement for the business. At least part of this income statement will probably have been prepared on a cash basis and will not reflect the results of operations as accurately as a statement prepared on an accrual basis would. However, it is a fairly safe bet that the seller has not overstated the receipts from the business on his income-tax return. He may have tended to overstate expenses, though, particularly by including some personal expenses as expenses of the business.

If the seller has a retail store and make sales in a State that has a sales tax, he has had to file sales-tax returns. The buyer should examine these returns to determine the amount of gross sales during the period covered.

If the business has employees, the seller will have made deductions from the employees' pay for income taxes and Social Security. The returns prepared for the Director of Internal Revenue covering these deductions will show the wages paid.

Almost any business will have certain types of expenses such as property taxes and insurance. The buyer can call the County Treasurer and the insurance agent to learn the amounts of these expenses.

A fairly good evaluation of the financial position of the business can be made by talking to the seller's principal suppliers and to his bank to determine the amounts owed by the seller and the credit standing of the business.

 

Chapter 10 - Adjustments to the Financial Statements

IT IS IMPORTANT TO KNOW what the accountant who audits and certifies the financial statements is saying. He is not saying that there is no possibility of error in the financial statements. He is saying that the financial statements substantially reflect the correct financial position of the business. His certificate on a set of financial statements is the buyer's assurance that he can rely on the statements without further investigation to determine that they were prepared correctly. Some adjustments may be needed, however, to make the statements more useful in valuing the business.

Assets

Cash. No revaluation of this item is likely to be needed unless the business has deposits in foreign currencies. In that case, a revaluation may be necessary for possible loss in conversion of foreign currencies into United States dollars.

The buyer should also be aware that some of the cash may not be available to pay current debt and operating expenses. For example, some cash may have to be kept in change and petty-cash funds.

Marketable securities. Marketable securities are often recorded on the balance sheet at their cost, which may be below current market value. These assets should be stated at market value. Short-term Treasury notes or bonds that will mature shortly after the sale of the business could be valued at their maturity value. There would probably be little difference between this and their market value.

Accounts receivable and allowance for bad debts. These two accounts must be examined together. The buyer should make certain that the net receivables on the balance sheet are really collectible.

The most common way to do this is to prepare an aging of the accounts receivable to show how old each account is. Thus, if the business normally sells merchandise on 30 days' credit and many of their accounts receivable are more than 90 days old, it is doubtful that these accounts can be collected.

If there are large accounts due from individual customers, the buyer might be wise to correspond directly with the customers to verify the amounts receivable. At the very least, invoices and signed shipping receipts should be studied to make sure that the customers have received the merchandise and have not yet paid for it.

The objective of the valuation of the accounts receivable is to state them at the true net collectible amount.

Notes receivable and notes receivable discounted. These two accounts must also be examined together. Unless the business normally receives a note at the time of a sale, a note from a customer usually means that the customer was unable to pay his account when it was due. The customer has, therefore, already shown some financial weakness, and the number of notes that will prove uncollectible may be fairly high. The buyer should try to find out whether notes still held by the business are likely to be paid at maturity.

The objective is to state the notes at their estimated collectible value and the amounts the business is likely to have to pay on default of discounted notes.

Accounts receivable and notes receivable from officers, employees, and owners. Since these items represent amounts due from people who have an inside interest in the business, there may be a serious question as to whether they will be collectible. Care should be taken to see that they are stated at their realizable value to the business.

Inventories. If inventories are stated on the balance sheet at cost, this cost may be what was paid recently, or it may be only indirectly related to the present value of the inventory. If the buyer does not feel competent to appraise the condition of the inventory, he should obtain the services of someone who is. He should not rely on the valuation of the seller.

One way to verify or correct the inventory value in a small business is to get the company's supplier to value the inventory. This is especially suitable if one principal vendor supplies the business. Since he or his representative will have to visit the business regularly in the future, it will be to his advantage to make sure that the valuation is fair. Also, the suppliers know the value of their own goods. The valuation should allow for all trade discounts and damaged or obsolete stock should be rejected.

Prepaid and deferred items. These items will be valued at their unrecovered cost to the business. They buyer should make sure that he can use any prepaid items he buys. Suppose, for example, that the business has recently purchased substantial quantities of stationery and other printed office supplies bearing the name of the present owner. Unless the name of the business is to be carried over, any amount that appears in the prepaid items for these supplies should be removed.

The buyer should also make sure that any prepaid insurance premiums and the insurance policies to which they apply can be transferred to him without loss of coverage or requirement for additional premium payments. He should be aware that premiums on workmen's compensation insurance are subject to later adjustment. Any insurance the buyer doesn't want, of course, will be canceled, and the balance sheet should be adjusted to show this.

Property, plant, and equipment. A professional appraisal of buildings, plant, and equipment may be useful, but many intangibles enter into a selling price. The fact that the building is appraised at $100,000 doesn't necessarily mean that the building is worth that much to the buyer. On the other hand, it may be worth more.

Another common way to value an asset of this kind is to establish a replacement value, allow depreciation for the length of time the asset has been held, and use the remainder as the value of the asset. The main problem in using replacement value is that fixed assets are seldom replaced with identical assets. A 20-year-old building is not likely to be replaced with a building just like it. Building methods change and needs of the business change. Therefore, it is unrealistic to think in terms of replacement cost for an asset that would never be replaced.

The seller of the business may want to value these fixed assets on the basis of values established by the insurance company in determining the amount of fire and extended-coverage insurance. The buyer should realize that these values are not necessarily equal to sale or market values. There is probably no one good way to value assets of this kind. Their true value will depend on the amount of income that can be generated through their use.

Intangibles. Intangible assets are recorded on the balance sheet at their cost to the business less any amounts written off. The buyer is mainly concerned with whether the intangibles really exist and will benefit the business in the future. Patents and trademarks may have a market value and could, in some cases, be sold. But their market value is very hard to determine until they are sold.

The buyer may recognize that patents and trademarks will benefit the business but be unable to determine the degree of usefulness with any accuracy. He should at least recognize that patents have a limited life, and he should find out how much time is left before the patent expires. A trademark, if registered, is not limited and may benefit the business indefinitely.

Any goodwill on the balance sheet reflects an amount paid at some time in the past, less what has been charged off. There is no assurance that any goodwill still attaches to the business.

In the case of liquidation, intangibles are usually of no value. Anything paid for them is not likely to be recoverable.

Claims Against Assets

Accounts payable to trade. If the business is in financial difficulties, the creditors may be willing to adjust downward the amounts due them. In that case, the balance-sheet item should be adjusted to show only the amount required to satisfy the creditors' adjusted claims.

If some of the accounts are past due, it may be found that some of the creditors have mechanics' liens against assets of the business. This is primarily a legal matter. The buyer should consult his lawyer about this possibility.

Notes payable. It is possible that substantial interest accrued on notes payable has not been entered in the accounts of the business. This account should be valued at the face amount of the notes plus interest accrued up to the date of the buy-sell agreement. If some of the notes are past their maturity dates, the buyer should consult his lawyer about the possibility of pending legal action against the business.

Accrued taxes payable. These amounts due are subject to audit by the taxing authority concerned. It is entirely possible that past discrepancies or failure to report taxes due might result in substantial penalties, interest, and back tax payments.

The buyer should try to ensure that a clear distinction is made between the seller's responsibility for taxes collected in the past and the buyer's responsibility for future tax liabilities. He must make certain that the account properly reflects all sales taxes collected and not yet remitted to the taxing authorities; all withholding and FICA taxes collected and not yet remitted; all unemployment taxes; all franchise taxes; and all excise taxes. He should also make certain that the business is not liable for any taxes it has failed to collect in the past.

Federal and State income taxes payable. A business organized as a single proprietorship or partnership does not pay income taxes as a business and therefore will not have this account. If the business is a corporation, the buyer should see that Federal and State income taxes of the business have been paid and that there is an adequate income tax accrual in the books for current income taxes payable. If income taxes have been improperly reported in past years, the corporation, even if it has changed hands, will have to pay any back taxes, penalties, and interest assessed against it.

Unearned revenues. The principal concern here is to make certain that all unearned revenues that have been collected are included in this account.  Some businesses may record unearned revenues as earned revenues at the time of receipt.

Long-term liabilities. Most long-term liabilities will be evidenced by a formal agreement such as a note payable or a mortgage payable. They should be valued at the total amount owed, including interest.

Unrecorded liabilities. It is always possible that some notes payable, accounts payable, or accrued liabilities have not been included in the sellers' latest balance sheet. The buyer should be aware of this possibility and make at least a reasonable search for unrecorded liabilities such as these.

Contingent liabilities. This broad group includes a number of items that may become liabilities to the business even after it changes hands. Usually few, if any, contingent liabilities appear on the seller's balance sheet.

For example, a delivery truck owned by the business may have been involved in a serious accident. If the business had inadequate insurance protection, there is a very real possibility that the business will have to pay substantial claims. Or perhaps warranties, express or implied, go with the merchandise or services sold. Future costs may be involved in honoring warranties already given by the seller. Such items could conceivably have an appreciable impact on the future profitability of the business.

The searching out of contingent liabilities is difficult. In fact, there may be no way to discover some of them. But any prospective buyer should search out whatever information he can about contingent liabilities of the business he is considering. Some of these investigations might best be done by the buyer's attorney. If the buyer knows the real answer to the question "Why is the seller willing to sell?" he may decide the business is not a good investment.

Owner's equity. If the above examination of the balance sheet has resulted in any changes in assets or liabilities, the owner's equity will have to be adjusted. It must equal the difference between total assets and total liabilities.

Income Statement

The buyer should examine the income statement closely to make certain that it gives a reasonably accurate picture of the results of past operations. He should determine that the revenues reported on the income statement were earned in the period covered by the statement. No prepaid or unearned revenues should be included in the income reported, and no revenue items that properly apply to the period should be omitted.

Expenses. Expenses should be examined to determine that all have been included and that all items included are proper expenses of the business.  If any personal living expenses of the owners have been paid by the business and included as business expense, these items should be eliminated.

Owner's salary. The amount of salary paid the owner is always a troublesome area. It may appear too high—or completely inadequate. The buyer should know the market value of his services. If the business will not provide him an adequate salary plus a satisfactory return on the capital he invest, he may be better off financially to work as an employee and invest his money elsewhere.

Depreciation. The buyer should pay close attention to any writeoff for depreciation expense. The amount of depreciation expense claimed is basically a decision based on the judgment of the seller and his accountant as to which method to use in computing depreciation.

Common ownership. In some cases, the buyer may find that the business is one of a group of businesses under common ownership. If this is the case, the buyer should make certain that the business has been charged for all expenses that should be attributed to it. For example, has the business been charged for its clerical and bookkeeping services, or have these been supplied by the parent company at a nominal charge or no charge at all? If they have been supplied by the parent company, the income statement should be adjusted to include this expense.

Occupancy charge. Another item about which the buyer should be concerned is the occupancy charge. Is it unusually low? This might happen for any of several reasons. Probably the most common reason is that the seller owns the property and, once it had been fully depreciated, entered no charge for rent or depreciation. If this happens, an unrealistically high net income may be reported.

Another possibility is that the business may have been paying an abnormally high or low rent for the real property occupied. This situation often occurs when the business is one of a group of businesses with common ownership.

The buyer should take care that a realistic charge for occupancy of real property is included in the adjusted income statement.

Notes to Financial Statement

A financial statement may or may not have accompanying notes. If there are notes, they should be considered an integral part of the statement and read carefully. Often important contingent liabilities or contractual obligations are described in such notes. Unless the notes are read and interpreted, the analysis of the financial statements will be incomplete.

Incorrectly Prepared Financial Statements

Many financial statements prepared by small businesses are not prepared in conformity with generally accepted accounting principles. Often no clear distinction is made, for example, between the operations of the business and the owner's personal business affairs. Such items as gasoline and car expenses that are actually personal living expenses of the owner of the business may be recorded as a business expense. The balance sheet may include as an asset the personal residence of the owner of the business. There may also be some items of business expense that were not recorded in the financial statements.

The buyer should keep in mind that the statements are only as reliable as the information that went into them. If the information is only estimated or is overstated or understated, the statements will reflect the inaccuracy. They should be adjusted to bring them as nearly as possible into line with accepted accounting principles.

Accrual Method of Accounting

If financial statements were prepared strictly on a cash basis, all cash inflow would be revenue and all cash paid out would be expense. Even fixed plant and equipment assets would be recorded as expense items at the time they were paid for instead of being charged off over the life of the assets through depreciation charges. Under the accrual method, all items of income are included in gross income when earned, even though payment is not received at that time. Expenses are deducted as soon as they are incurred, whether or not they are paid for at that time.

Normally, the accrual method of accounting is the only one that shows results of past operations accurately. If the seller's financial statements have been prepared on a cash basis, the buyer should make whatever adjustments are necessary to convert the statements to an accrual basis.

Chapter 11 - Analyzing the Financial Statements

WHEN THE FINANCIAL STATEMENTS have been made as accurate as possible, the buyer or his accountant should analyze the information they contain. Some comparisons and ratios that can be used to bring out trends and relations are discussed in this chapter.

Probably the first analysis to be made is to compare financial statements for the past 10 years or as close to that length of time as possible. Has the trend over the years been up or down, or has there been no significant change? All items on the statements should be studied.

The changes from one year to another will be more helpful if they are stated in percentages. On each year's income statement, the net sales figure is taken as 100 percent and each other item is stated as a percent of net sales. On the balance sheet, total assets are taken as 100 percent and other items are stated as percents of total assets. Such statements are called "common size" statements. Typical comparative statements covering 2 years, with common-size percents, are shown in schedules 1 and 2 below.

Ratios and Other Analyses

Certain ratios and other expressions showing relations between items on the financial statements are also helpful in interpreting the statements.  Schedule 3 illustrates several commonly used formulas based on the 1978 figures in schedules 1 (below) and 2. Each of them is discussed briefly following schedules 1, below,  2, and 3.

Schedule 1

Comparative Balance Sheet

December 31, 1978 and December 31, 1977

                                     Amount              Percent

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

                               1978        1977       1978    1977

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

ASSETS

Current assets:

  Cash.....................  $ 28,000    $178,000     2.64   18.43

  Marketable securities....        0      160,000         0   16.56

  Accounts receivable (net)  136,000      128,000     12.83   13.25

  Notes receivable.........    8,000        3,000     0.76     0.31

  Inventories..............  380,000      368,000     35.86   38.10

  Prepaid expenses.........    11,600      12,000     1.09     1.24

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

Total current assets.......  563,600      849,000     53.18   87.89

Property, plant, and

equipment (net)............  396,200      77,000     37.38     7.97

Intangibles................  100,000      40,000     9.44     4.14

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

Total assets...............$1,059,800    $966,000   100.00   100.00