Pursuing New

part
3 Venture
Opportunities

Buyouts

PowerPoint Presentation by Charlie Cook

12e Copyright © 2003South-Western College Publishing.
All rights reserved.
 Two Paths to Entrepreneurship

Startup
Creating Buyout
a new Purchasing
business an existing
from business
scratch

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 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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 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.

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 Pros and Cons of Buying an
Existing Business
• Pros • Cons
– High chance of success – Existing problems
– Less planning – Poor quality of current
– Existing customers/ employees
suppliers – Poor business image
– Necessary equipment – Modernization required
– Bargain price – Purchase price based on
– Experienced employees inaccurate data
– Existing business records – Poor business location

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 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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 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

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 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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 Income Statement as Adjusted by Prospective Buyer

Adjusted
Original Required Income
Income Statement Adjustments Statement

Estimated sales $172,000 $172,000

Cost of goods sold 84,240 84,240
Gross profit $87,760 $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 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.
Miscellaneous 1,250 $60,225 1,250 $64,025
Net income $27,535 $23,735

Fig. 5-3
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 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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 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.

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 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

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 Suggested Risk Premium Categories

Category Description Risk Premium

1 Established businesses with a strong trade position that are well 6 10%
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 11 15%

financed
, have depth in management, have stable past earnings, and
whose future is fairly predictable.

3 Businesses in a highly competitive industry that require little capital to 16 20%

enter, have no management depth, and have a high element of risk,
although past record may be good.

4 Small businesses that depend on the special skill of one or two people 21 25%
or large established businesses that are highly cyclical in nature. In
both cases, future earnings may be expected to deviate widely from
projections.

5 Small “one-person” business of a personal services nature, where the 26 30%

transferability of the income stream is in question.

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 Determinants of a Firm’s Earnings Multiple

Low
High Low Firm Value
Earnings Multiple
Firm
Risk
High
Low High Firm Value
Earnings Multiple

High
High High Firm Value
Earnings Multiple
Firm
Growth
Low
Low Low Firm Value
Earnings Multiple

Fig. 5.4
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 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.

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 Nonquantitative Factors in
Valuing a Business

• Competition
• Market
• Future Community
Development
• Legal Commitments
• Union Contracts
• Buildings
• Product Prices

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 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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 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

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