The reading level for this article is Expert
Note: If you have not read section one and two of the buying a business series, some of the anecdotal references below may be new to you. As such, it is suggested that you read the previous two sections prior to this section.
Buyers and sellers both seek answers to the same question: “What is the 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, than, 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 reflect 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.
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, over-extension 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:
Have changes actually occurred in my business?
Are the causes of the changes beyond my control?
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 the 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 pogroms.
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 sales men who call on businesses similar to mine, of association meetings, or 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:
The nature of the business in the past.
Present condition of the business.
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:
Sales in the market had declined more than 50 percent.
Sam had been unable to rent commercial space in the building in which the market was located.
New supermarkets were operating in the same area.
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
Available for working capital $6,000
Expected net 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
that his sales expectations were too optimistic, and
that even if he reached his sales goal, he would not be able to satisfy the cash demand on the operation.
What happened (as stated in section 2, he soon went out of business) could have been predicted.
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?
A business has 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 later in this section, 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?
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.
When the price has been settled, the question of how to finance it remains. Financing a buy-sell transaction involves these five factors:
The amount of capital required.
The type of capital required.
The specific uses to which the capital will be put.
The length of time needed to pay back the capital source from the business operation.
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
Funds to operate until the business is generating cash,
Funds to meet unexpected expanses, and
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’ operation – 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:
Equity capital – investment in the business by the owner or owners, and
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 re-financing 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 sometime a source of capital to the buyer of a small business, as in Bill’s case. A happy circumstance if it is handled 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 p ayments?
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.