Startups And Buyouts

part

3

Pursuing New Venture Opportunities

Buyouts

PowerPoint Presentation by Charlie Cook

12e

Copyright © 2003South-Western College Publishing. All rights reserved.

Two Paths to Entrepreneurship

Startup Creating a new business from scratch

Copyright © by South-Western College Publishing. All rights reserved.

Buyout Purchasing an existing business

5–2

Reasons for Starting a New Business Developing a commercial market for a recently invented or newly developed product or service. Taking advantage of available resources, ideal location, advances in equipment, employees, suppliers, and bankers Avoiding precedents, policies, procedures, and legal commitments of existing firms

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5–3

Reasons for Buying an Existing Business 1. To reduce some of the uncertainties and unknowns that must be faced in starting a business from the ground up. 2. To acquire a business with ongoing operations and established relationships with customers and suppliers. 3. To obtain an established business at a price below what it would cost to start a new business.

Copyright © by South-Western College Publishing. All rights reserved.

5–4

Pros and Cons of Buying an Existing Business • Pros – High chance of success – Less planning – Existing customers/ suppliers – Necessary equipment – Bargain price – Experienced employees – Existing business records

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• Cons – Existing problems – Poor quality of current employees – Poor business image – Modernization required – Purchase price based on inaccurate data – Poor business location

5–5

Investigating and Evaluating Available Businesses • Due Diligence – The exercise of prudence, such as would be expected of a reasonable person, in the careful evaluation of a business opportunity

• Relying on Professionals – Accountants – Attorneys – Other experienced business owners

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5–6

Finding Out Why the Business Is For Sale • Owner’s reasons for selling the business – Old age or illness – Desire to relocate in a different section of the country – Decision to accept a position with another company – Unprofitability of the business – Discontinuance of an exclusive sales franchise – Maturation of the industry and lack of growth potential

Copyright © by South-Western College Publishing. All rights reserved.

5–7

Examining the Financial Data 1. Review financial statements and tax returns for the past five years. 2. Recognize that financial data can be misleading. • Assets overvalued • Expenses overstated/understated • Income underreported • Unrecorded debts

•

Prepare adjusted adjusted statements to reflect the true state of the business.

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5–8

Income Statement as Adjusted by Prospective Buyer Original Income Statement

Required Adjustments

Adjusted Income Statement

Estimated sales $172,000 $172,000 Cost of goods sold 84,240 84,240 Gross profit $87,760 Operating expenses: Rent $20,000………………….Rental agreement will $24,000 expire in six months; rent is expected to increase 20%. Salaries 19,860 19,860 Telephone 990 990 Advertising 11,285 11,285 Utilities 2,580 2,580 Insurance 1,200………………….Property is underinsured; 2,400 adequate coverage will double present cost. Professional services 1,200 1,200 Credit card expense

Miscellaneous Net income

1,860………………….Amount of credit card expense 460 expense is unreasonably large large; approximately $1,400 of this amount should be classified as personal expense. 1,250 $60,225 1,250 $27,535

$87,760

$64,025 $23,735 Fig. 5-3

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5–9

Valuing the Business • Asset-Based Valuation – Estimates the value of the firm’s assets; does not reflect the value of the firm as a going concern.

• Market-Comparable Valuation – Considers the sale prices of comparable firms; difficulty is in finding comparable firms.

• Cash-Flow-based Valuation – Compares the expected and required rates of return on the amount of capital to be invested in the business.

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5–10

Asset-Based Valuation • Modified Book Value Technique – Historical value of firm’s assets is adjusted to reflect current market values.

• Replacement Value Technique – Value of firm’s assets is adjusted to reflect current costs to replace the assets.

• Liquidation Value Technique – Value of firm’s assets is adjusted to reflect their value if the firm ceased operations and disposed of the assets. Copyright © by South-Western College Publishing. All rights reserved.

5–11

Market-Comparable Valuation • Earnings Multiple (Value-to-Earnings) Ratio – Ratio is determined by dividing the firm’s value by its earnings. – Firm’s ratio is compared to representative ratios of recently-sold similar firms.

Firm value Earnings multiple = Earnings Firm value = Ratio × Earnings Copyright © by South-Western College Publishing. All rights reserved.

5–12

Suggested Risk Premium Categories Category

Description

Risk Premium

1

Established businesses with a strong trade position that are well financed, have depth in management, have stable past earnings, and whose future is highly predictable.

2

Established businesses in a more competitive industry that are well financed , have depth in management, have stable past earnings, and whose future is fairly predictable.

11 15%

3

Businesses in a highly competitive industry that require little capital to enter, have no management depth, and have a high element of risk, although past record may be good.

16 20%

4

Small businesses that depend on the special skill of one or two people or large established businesses that are highly cyclical in nature. In both cases, future earnings may be expected to deviate widely from projections.

21 25%

5

Small “one-person” business of a personal services nature, where the transferability of the income stream is in question.

26 30%

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6 10%

5–13

Determinants of a Firm’s Earnings Multiple

High Firm

Low Earnings Multiple

Risk Low

High Firm

High Earnings Multiple

High Earnings Multiple

Growth Low

Low Firm Value

High Firm Value

High Firm Value

Low Earnings Multiple

Low Firm Value

Fig. 5.4 Copyright © by South-Western College Publishing. All rights reserved.

5–14

Cash Flow-Based Valuation 1. Estimate the firm’s expected cash flows. 2. Compute the firm’s cost of capital—the investors’/owners’ required rate of return on investments in the firm. 3. Using the cost of capital, calculate the present value of the firm’s expected cash flows—the value of the firm.

Copyright © by South-Western College Publishing. All rights reserved.

5–15

Nonquantitative Factors in Valuing a Business • Competition • Market • Future Community Development • Legal Commitments • Union Contracts • Buildings • Product Prices Copyright © by South-Western College Publishing. All rights reserved.

5–16

Negotiating and Closing the Deal • Terms of Purchase – Assets purchase or total entity – Indemnification clause – Payment in full or partial payments over time

• Closing the sale – Best handled by a third party Bill of sale Tax certifications Payment-to-seller agreements and guarantees

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5–17

Characteristics of Successful High-Growth Startups • Begin as a team effort • Are in service and manufacturing industries • Have competent founders who: – have related experience. – have started other businesses. – share in ownership of business.

• Are somewhat better financed • Do not limit themselves to local markets Copyright © by South-Western College Publishing. All rights reserved.

5–18