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Buying and Selling a Small Business
By Verne A. Bunn
About This Book
Going into business for oneself can be a great adventure--or a great
disaster. Which it will be depends a great deal on how well the prospective
owner prepares through investigation and analysis of the situation he or
she is about to enter.
In some ways, the person who buys a going business has an advantage over
the one who starts from scratch. For one thing, there are more facts to
work with--if the buyer knows where to find them and how to use them.
These are the principal problems taken up in Buying and Selling a Small
Business. What should the prospective buyer of a small business--or the
seller--know before the buy-sell decision is made? Where can this
information be found? How can the buyer or seller correlate and interpret
the data? How does he or she apply the data to negotiating a buy-sell
transaction?
This volume, now in second edition, does not pretend to give complete or
specific answers. In some cases professional help is necessary, and in all
cases the answers depend on many variables. Rather this booklet is intended
to serve as a guide to areas needing investigation and to suggest some
approaches that may be helpful.
The buyer of a small business faces more problems--and more difficult
ones--than the seller. Because of this, Buying and Selling a Small Business
may appear to give more attention to the buyer than to the seller. However,
it is important for the seller to know how the buyer is likely to approach
the negotiations; and wherever specific problems for the seller do come
into the picture, they are discussed separately.
This booklet is issued as part of the management publications program of
SBA's office of Management Information and Training.
Based in SBA's Kansas City Regional Office, the author, Verne A. Bunn,
administers the Agency's management assistance programs for several states.
He acquired his wide knowledge of small business in a variety of ways,
including experience as a counselor of small business owners as well as
university research and teaching.
Contents
Part 1. The Buy-Sell Transaction
1 A Small Business Is Bought and Sold
2 The Flow of Decisions in a Buy-Sell Transaction
Part 2. Sources of Information for Buy-Sell Decisions
3 Sources of Market Information
4 Sources of Financial Information
5 Sources of Legal Information
Part 3. The Buy-Sell Process
6 Determining the Value of a Business
7 Negotiating the Buy-Sell Contract
8 Financing and Implementing the Transaction
Part 4. Using Financial Statements in the Buy-Sell Transaction
9 Income Statements and Balance Sheets
10 Adjustments to the Financial Statements
11 Analyzing the Financial Statements
Part 5. Analyzing the Market Position of the Company
12 The Market
13 The Company
14 The Sales Forecast
Part 1 The Buy-Sell Transaction
Chapter 1 - A Small Business Is Bought and Sold
IS THERE A SMALL-BUSINESS OWNER who has never considered selling his
business? Probably not. Is there an individual with some money, talent, or
an urge for independence (often only the last) who hasn't thought about
owning his own business?
The number of small businesses actually bought and sold, however,
represents only a small fraction of those who have felt these urges. To
many people, the desire to buy or sell is only a passing thought. Others
find various ways to solve their problems or satisfy their ambitions. But
sometimes an individual doesn't follow through because he finds the
prospect of buying or selling a business too baffling.
The objective of this manual is to describe the process of buying and
selling a small business and to establish some guidelines. It will not
remove the difficulties, but it will make them more manageable.
A Look at the Buy-Sell Process
It will be helpful to take a detailed look at what happens when a business
is bought or sold. First, consider some of the thoughts that go through the
minds of the buyer and seller during the decisionmaking process.
THE SELLER: (Before the transaction) Shall I sell my business? What is it
worth? How can I find a buyer? (During the transaction) How much shall I
tell this guy about my business? Will he raise his offer? What terms shall
I insist on? (After the transaction) Should I really have sold? I wonder if
I could have got more money. Wonder how the business is getting along.
THE BUYER: (During the transaction) Shall I buy this business? I wonder why
he really wants to sell. How much can I afford to pay? Where can I get the
rest? How far will he reduce his price? (After the transaction) Now that
I've bought it, which new idea shall I try first? Should I have known that
would happen? It's going to work out just fine--isn't it?
These are typical thought patterns. They mark the flow of decisions in the
transaction. They also reflect the doubts and hesitancy involved in the
decisionmaking.
A Step-by-Step Account
The following step-by-step description of buying and selling a grocery
store is basically the story of an actual case. To make it more typical of
all buy-sell transactions, some questions and problems from other cases
have been worked into the account.
Bill Smith wants to buy. Bill Smith had worked several years in grocery
stores in Whitton, a city of 400,000. He had started as a carry-out boy and
progressed through every job in a store operation.
Bill was anxious to own his own store. He and his wife were in their early
forties and eager to establish a business of their own. They had saved
about $16,000, and Bill was confident that he knew enough about grocery
stores to handle the operation. His wife planned to take care of the
bookkeeping.
The Smiths had followed up many leads from the classified section of the
newspaper. In every case, they found the business either too run down to
salvage or too large to finance. Bill had also talked to a few real estate
agents who specialized in business properties. But the agents' listings had
not turned up anything that interested the Smiths.
In August, Bill learned from a food salesman that Sam Brown was trying to
sell his store. Sam's Market was a small store on the other side of town.
It had been operating for many years.
Sam Brown wants to sell. Sam Brown had been thinking about selling his
business for several months. He was reluctant to do it because the store
had been established by his father. Yet he was finding the long hours he
had to spend in the store a real hardship.
Furthermore, during the last 4 years, business had declined from a high of
$400,000 gross sales to less than $200,000. The main reason for the decline
in sales, in Sam's opinion, was the competition from several new
supermarkets in his area.
Finally, he was concerned about a space of about 1,100 square feet at one
end of the building in which the store was located. Sam owned the entire
building and had been unable to find a tenant for this space for more than
3 months. Now a discount paint company had offered him a local franchise.
Sam believed he could use the vacant space for this operation and handle
the business with much less effort than he was putting into the grocery
store. If he could sell the grocery business and lease that part of the
building to the new owner, he would have a comfortable arrangement.
The transaction. After talking to the salesman, Bill called Sam and
expressed an interest in the store. They arranged several meetings to
discuss the situation. Bill learned that Sam wanted to sell in order to
take advantage of the paint-store opportunity. When Sam announced that he
was asking $50,000 cash and $600 a month rent, the conversation went like
this:
BILL: Could I spend some time with your books?
SAM: I can't let you do that. Most of my personal affairs are in those
books. Besides, I don't want to be giving away everything about my business
to someone who might be a competitor someday.
BILL: But I have to have something to go on!
SAM: Well, you ask me what you think you need to know, and I'll tell
you--if I can.
During the discussions that followed, Bill learned the following facts
about the store:
The modern fixtures and equipment had cost $60,000 new. Now 6 years old,
they had a depreciated value of $30,000. The inventory had a wholesale cost
of $20,000. Gross sales were running about $16,000 a month with a gross
margin between 14 and 16 percent. In the past, annual sales had been as
high as $400,000. The 3,900 square feet of store space appeared well
organized.
From this information and his observation of the store, Bill figured that
he could increase sales to $40,000 a month within a year by more aggressive
sales promotion--handbills, radio spot announcements, an extra large neon
sign, and more personal service. This meant, in Bill's opinion, that
inventory would need to be enlarged to $24,000.
To better the profit, which had been averaging 2-1/2 percent of gross sales
including Sam's salary, Bill believed the average markup should be raised
from 18 percent to 20 percent. An additional increase in profit could be
realized, according to Bill's analysis, if he reduced the staff by one
full-time and one part-time clerk.
Bill was unable to borrow the difference between his $16,000 savings and
Sam's asking price of $50,000. Several banks turned him down before one
agreed to lend him $20,000 at 11-1/2 percent interest with monthly payments
over 5 years.
Sam refused Bill's offer of $36,000 but offered to carry part of the price.
After several more discussions, agreement was reached on the following
terms:
1. $24,000 cash.
2. $22,000 unsecured note, payable monthly over 5 years at 12% interest.
3. $400 a month rent.
Bill planned to use the $12,000 cash left from the bank loan to increase
inventory and provide working capital.
The store changed owners about September 1. Bill discovered that the
inventory was worth only $16,000 at wholesale cost. He immediately used
$8,000 to increase his shelf stock. Sales during the first few months
increased to $30,000 a month, and Bill felt sure he could reach his goal of
$40,000 a month. Profit, however, was running only 2 percent of gross sales
in spite of Bill's attempt to increase margins and reduce costs.
A sad ending. Six months later, the doors were closed on Bill's Market. The
remaining $12,000 inventory was sold to a wholesale outlet for $10,800. The
fixtures were sold for $16,400. Bill was trying to find a way to pay his
debts and forget the loss of his life's savings.
Four months later, Sam still had not been able to rent the space formerly
occupied by the food store. He had little prospect of recovering his loan
to Bill, and he had lost over $4,000 in rental income. He was undecided
what action he should take.
The Big Question
Bill and Sam each thought he had received a fair value. But the final
result showed that neither one had made a right decision. Both lost savings
and income. What went wrong? How do you go about buying or selling a
business?
An important question? To the Bills and Sams--past, present, and
future--few questions could be more important.
A difficult question? Either buying or selling a business requires
personal, financial, and management decisions. At no steps along the way
are the decisions easy to make. But it will be helpful to establish the
basic steps or elements in a buy-sell transaction and then to examine each
of these elements.
Chapter 2 - The Flow of Decisions in a Buy-Sell Transaction
BUYERS AND SELLERS both seek answers to the same question: "What is this
business worth?" Most people see the worth of a business as the total value
of equipment and fixtures, inventory, and buildings and land. Important,
certainly, but the sum of these values does not equal the value of the
business.
Bill probably paid a fair price for equipment, fixtures, and the like. But
did his price of $40,000 reflect the value of Sam's Market? Obviously not.
What, then, is the value of a business?
For both buyer and seller finding the answer to this question is the most
difficult and at the same time the most important step in the buy-sell
process. But this final decision reflects many other decisions made while
the transaction is being considered. In other words, the buy-sell process
is a flow of decisions. It would be impossible to point out every decision
that must be made, but the basic ones are as follows:
Motivation: a decision to attempt the sale or purchase of a business.
Contact: a decision on how to find a buyer (or seller) for a business with
specified characteristics.
Information: a decision on what information must be gathered or given to
buy or sell a business.
Sources: a decision on how, where, and at what cost the needed information
can be obtained.
Analysis: a decision on the meaning, importance, and reliability of the
information gathered.
Value: a decision on what the business is worth.
Price: a decision on how much money to take or give for the business.
Financing: a decision on how to pay or receive the purchase price.
Contract: a decision on the form and content of the contractual relation.
Implementation: a decision on how and when to effect transfer of
ownership.
Motivation
What leads an owner to sell his business? It may be any of a large number
of reasons: a personal health problem, a business disagreement,
overextension of the company's activities, a desire to retire from
business. The possible reasons are many and varied.
For Sam, the motivating factor was change. He found his sales decreasing in
spite of his extra effort, competition increasing, empty building space
impossible to rent. In other words, both internal and external factors had
brought changed conditions that affected the business unfavorably.
Changed conditions should be analyzed carefully before a business owner
accepts them as reasons for selling his business. The following questions
can serve as a guideline for this analysis:
1. Have changes actually occurred in my business?
2. Are the causes of the changes beyond my control?
3. Are the causes of the changes within my control?
It would be unfortunate for a owner to sell his business because of changes
he could control if, by such control, he could recapture a successful and
satisfying operation. Every owner, therefore, should examine closely his
motives for wanting to sell the business.
What makes an individual want to buy a business? Again, motivations will
cover the whole range of human desires, from simple economic gain to social
ladder climbing.
Bill's prime motivating factor was the desire to expand a special skill
into a business of his own. Bill thought he knew enough about grocery
stores to handle one of his own. But he didn't. This factor of a special
skill represents one of the dominant reasons for wanting to buy a business.
It is a natural motive, but, perhaps because of its natural appeal, it can
be a dangerous motive.
A business must be managed. An operating skill does not always lead to
managing ability. In fact, it often encourages a business owner to spend
his time operating instead of managing. Planning for the future, organizing
resources, staffing the business with competent people, directing the
coordination of people and operations, controlling results--these are the
functions of management. Consequently, an individual with a skill seeking
to buy a business in which to apply the skill should check his motivation
by asking questions such as the following:
How important is management ability in this business?
Occasionally, a business that is unique and very simple almost manages
itself. But if the business is in a competitive field, management ability
is probably the most important requirement for success.
Do I have the ability to manage successfully?
Effectiveness with people (customers and employees), eagerness to tackle
difficult problems and make decisions, and intelligence about general
business operations are key ingredients in management ability.
Can I learn how to manage this business?
Most people can learn to manage if they recognize the need. This requires
room to make mistakes, however, and the self-discipline to undertake
self-improvement programs.
Contact
Assuming that motives have been examined and that both seller and buyer are
still interested, the next step is to get the two together. But there seems
to be no "best way" to find a seller or a buyer for a business.
From the seller's point of view, the task of finding an interested buyer is
the more difficult one, but there are many avenues to explore other than
running advertisements in newspapers. He should ask himself these questions:
Have I told my employees and other business associates that I intend to
sell the business?
Have I taken advantage of the broadcasting ability of salesmen who call on
businesses similar to mine, of association meetings, of other trade
contacts?
This informal advertising requires the same kind of information more formal
advertising does. Business associates, trade contacts, and friends should
be told the asking price, the terms, the anticipated return. Without this
knowledge, a potential buyer can hardly be expected to respond positively.
He needs to know in advance how the offer relates to his financial ability.
From the buyer's point of view, finding opportunities is relatively easy.
The difficulty lies in locating a business he can analyze confidently. When
he deals with unfamiliar firms, he is haunted by a desire for more
information and suspicious about the information he does receive. A buyer
seeking a seller should consider the following points:
Have I asked people I deal with about persons who might be considering
selling a business?
Have I considered approaching businesses with which I am familiar about the
possibility of a purchase?
Kinds and Sources of Information
At this stage, the buyer and the seller must decide what information about
the business to seek or give. In the case of Sam's Market, information was
brought out about three factors:
1. The nature of the business in the past.
2. Present condition of the business.
3. Relation of the past and present to future expectations.
Bill's approach was proper, but the information he gathered was meager
support for decision making.
Some of the information a careful buyer will want may take a lot of money
or time to gather. He must decide what sources of information are essential
and which ones he can leave untapped. Bill, for instance, might well have
inquired about local economic conditions. Full information, it is true,
would have required a costly analysis, but consider what information he
could have got from easily available sources:
1. Sales in the market had declined more than 50 percent.
2. Sam had been unable to rent commercial space in the building in which the
market was located.
3. New supermarkets were operating in the same area.
4. Banks hesitated to gamble on the future of the market.
Bill might also have developed information about the future trend of the
business, but that would have required time. He should have known the
following facts about his financial program, however:
Available funds $36,000
Use of funds:
Payment to Sam $24,000
Planned increase in inventory 4,000
Advertising 1,000
Display sign 1,000 30,000
------- -------
Available for working capital $6,000
Expected new income per month (3% of $30,000) 900
Probable expense:
Payment to bank $265
Payment to Sam 295
Sam's salary ?
Bill had enough information available to know (1) that his sales
expectations were too optimistic and (2) that even if he reached his sales
goal, he would not be able to satisfy the cash demand on the operation.
What happened could have been predicted.
Analysis
The word "predict" is important. The buyer should be able to follow through
the steps listed below and predict with some confidence the future of the
business.
What factors affect sales?
How will these market factors behave?
Therefore, what sales can I expect?
What makes up the cost of sales?
How will these cost factors apply to expected sales?
Therefore, what gross profit can I expect?
What expenses are required to run this business?
How will expenses develop under my ownership?
Therefore, what net profit can I predict?
What assets will the business need and possess?
What is the condition of these assets?
Therefore, what asset improvements will I have to make?
What credit does the business assume?
What is the condition of the credit position?
Therefore, what changes, if any, can occur in the debt structure?
How much cash do I have?
How much cash will the business generate?
Therefore, what will be my available-cash position?
What immediate cash outlay must I make?
What will be the cash needs of the business?
Therefore, what cash outgo will be necessary?
What will be my net cash position as things now stand?
What additional cash resource, if any, must I have?
Therefore, what financing plan shall I use?
Value
A business had a purpose. That purpose is to provide a satisfactory return
on the owner's investment. Consequently, determining value involves
measuring the future profit of the business being sold.
A seller often thinks of value as representing the money he has invested
through his years of ownership. A buyer is tempted to consider value as a
fair price for tangible items such as equipment and inventory. These
factors are important, but they have value only to the extent that they
contribute to future profits. An owner may have invested $40,000, the
tangible assets may have a current worth of $20,000, but it is the profit
potential that establishes the value of the total business.
Assuming that a reliable estimate of future profit is made, how much is to
be paid for each dollar of profit potential? This computation is discussed
in chapter 6, but the general approach is suggested by the following
questions:
What am I buying (or selling)? A business, or a building full of equipment
and inventory?
What return would I get if I invested my money elsewhere--in stocks, bonds,
or other business opportunities?
What return ought I get from an investment in this business?
Price
It might seem that the price to be paid or received for a business would
simply be equal to the value. However, value refers to what a business is
worth; price refers to the amount of money for which ownership is
transferred. There is usually a difference between price and value because
the buyer and seller differ as to how much the business is worth. The price
will represent negotiation and compromise. Here are two suggestions for
fruitful negotiation:
* Discussion between buyer and seller should focus on the future profit
performance of the firm. Since expected profit is basic to determining
value, it can be a valuable point for negotiation.
* Every profit projection includes some assumptions and risks. Generally,
the less firmly based the assumption and the more apparent the risk, the
less value an expected profit can support. Consequently, identifying and
analyzing risks involved in future operations can make discussions between
buyer and seller more significant.
These two points will help bring negotiations about value toward a mutually
acceptable price.
Financing
When the price has been settled, the question of how to finance it remains.
Financing a buy-sell transaction involves these five factors:
1. The amount of capital required.
2. The type of capital required.
3. The specific uses to which the capital will be put.
4. The length of time needed to pay back the capital source from
the business operation.
5. The sources of available capital.
How much? Bill's failure after buying Sam's Market illustrates a common
problem--underestimating the amount of capital required to purchase a
business. Capital must be available not only to pay the purchase price but
also for (1) funds to operate until the business is generating cash, (2)
funds to meet unexpected expenses, and (3) funds as a reserve to allow for
errors in expectations. A buyer must think beyond the purchase price to
determine the amount of capital he needs. Unless he does he will find his
resources embarrassingly and probably disastrously wanting. Here are some
questions that must be asked about his capital needs:
Do I have enough capital to pay the purchase price?
Do I have enough capital to support 1 to 3 months' operations--such as
payroll and other cash expenses--while the business reaches a
self-supporting stage?
Do I have some extra capital to cover needs I may have overlooked (perhaps
10 to 15 percent of the purchase price?
Types of capital. There are two basic types of capital: (1) equity
capital--investment in the business by the owner or owners, and (2) debt
capital--borrowed capital that must be repaid.
Equity capital is often called risk capital. Those who furnish the equity
capital are expected to take the primary risks of failure and to reap the
benefits of success. The equity capital provides a margin of safety for a
lender. The greater the amount of equity capital, other things being equal,
the easier it is to get debt capital.
The primary source of equity capital is the personal savings of the buyer
of the business. Although many small businesses are incorporated, the sale
of stock is seldom a source of capital for the small business.
Few buyers, however, have enough personal savings to finance the purchase
of a small business without any debt financing. An individual may borrow
money for the purchase of a business by obtaining a personal loan, by
borrowing against insurance policies, or by refinancing the mortgage on his
home. These debts are not direct debts of the business, but the debts of a
small business and the personal debts of the owner cannot be completely
separated. Banks are the principal institutional source of debt capital for
small businesses.
The seller as lender. In the sale and purchase of Sam's Market, the buyer's
savings plus a bank loan were not enough to finance the purchase. Bill (who
needed more financing) and Sam (who wanted to sell his business) reacted in
a manner quite common in the financing of the sale of a small business. Sam
agreed to accept payment of part of the purchase price over an extended
period of time.
The seller is sometimes a source of capital to the buyer of a small
business, as in Bill's case. A happy circumstance if it is handles
properly. Before jumping at the chance, however, the buyer should ask
himself these questions:
Is there a good reason why commercial lenders would not approve my loan
request?
Is the seller so interested in getting out from under the business that he
will take an unwise risk?
Am I sure the business is as good as it looks?
Can the business support the debt payments to which I am obligating myself?
In the light of Sam's experience, the seller, too, should pause long enough
to answer some questions before he accepts an extended payment plan.
How serious will it be if the buyer is unable to make his payments?
What security do I have to protect my position?
How capable of operating my business successfully is the buyer?
.Contract and Implementation
Every step so far in this discussion has involved forecasting. From
motivation to finance, the buyer and the seller must anticipate
characteristics, developments, and problems that may develop. The contract
between the parties embodies the resulting basic agreements about the
business and the relation between buyer and seller. A "good" contract is
meaningless if the earlier steps in the process have been carried out
carelessly or not at all.
Part 2 Sources of Information for Buy-Sell Decisions
Chapter 3 - Sources of Market Information
TWO BASIC QUESTIONS face the prospective buyer or seller of a small
business when he starts to gather information for his decisionmaking:
"What kinds of information do I need?"
"Where can I get this information?"
The information needed can be grouped into three general types: (1) market
information, (2) financial information, and (3) legal information. The
purpose of this chapter and of chapters 4 and 5 is to identify still
further, within these groups, the kinds of information the buyer or seller
should look for and some sources of that information. Not all of the
sources listed will apply equally to all kinds of businesses. The buyer or
seller will have to determine for himself the extent to which the specific
types of information will help him reach a sound decision.
Some difficulty may arise in the information-gathering stage because of
poor records, unavailability of some information, lack of cooperation, and
the like. The seller has the advantage as far as internal data are
concerned. He has free access to his own records; the buyer does not. If
the buyer needs internal information to reach a decision, it should be made
available to him. He should insist on seeing the company records and be
wary of any seller who refuses to give him the information he needs.
Either seller or buyer may have to spend considerable time and effort
digging out the information. The sources suggested below, however, should
help him gather the basic types of information needed in the decisionmaking
process.
Importance of Market Information
The first and most logical step in buying or selling a business is to
conduct a market analysis. A market analysis is a study of the present
position of the business within its market area and of probable future
patterns. It should include the growth pattern of the business being sold,
the state of the market, the nature and extent of competition--all factors,
in fact, that will show the present market position of the business or that
will affect its future.
A market analysis should indicate whether the purchase or sale of the
business should be considered further. It will help the seller decide what
valuation to place on the business for sale purposes. It will help the
buyer decide how much he should pay, and it will also give him a clearer
picture of just what he is buying. A market analysis has the added value of
making it possible to develop more accurate sales forecasts. It places
greater emphasis on fact and less on hunch and guesswork.
The specific nature of the business being bought or sold will determine
much of the market information needed. A manufacturing business with
problems of marketing and distribution will need information not
necessarily pertinent to a retail or service business, with its more
localized market. The following areas of market information are designed to
suggest sources that may be useful to the buyer or the seller in analyzing
the market of the business.
Sales Information
An investigation should be made of the sales history of the company. At
least 3 years' sales should be examined and preferably 10 years'--or the
entire sales history of the company if it is a new one.
The manner in which the records are kept will determine to a large extent
the availability of sales information. Many small businesses keep little in
the way of sales records--often only what is necessary for tax purposes.
Others have bookkeeping systems designed by business-machine manufacturers,
trade associations, or professional accounting services. The more
standardized the procedure, the more useful the information is likely to be
for market analysis.
Most States now have sales taxes, and this may provide a useful source of
information. Whether or not a business is required to keep sales-tax
records depends largely on the type of business and the State requirements.
Sales-tax laws are not uniform, and what is required in one State may not
be required in another.
If most of the business is done on a credit basis, accounts receivable may
give useful sales information. If this source is used, the market
investigation should be concerned only with the amount of credit sales and
not with the effectiveness of the collection of accounts receivable.
Ingenuity and common sense can often turn up sources of sales information.
In one case, for example, sales for a self-service laundry were determined
by using water capacity per machine, city records of the amount of water
consumed by the business, and price per load.
Regardless of where the sales information comes from, the purpose of
gathering it is basically the same--to identify the pattern or trend of
sales over the past and to use this information to project or estimate
sales for the period ahead. Such an investigation is especially useful in
determining the value of the business above the value of the assets.
Cost of Goods Sold
A study of the cost of goods sold is also important in determining the
market position of the business. Cost of goods sold is the cost of
merchandise purchased by the business for resale, including freight and
other charges. The difference between sales and the cost of the goods sold
is called gross margin or gross profit. The higher the cost of goods sold
in relation to sales, the lower the gross margin--and the net profit.
Many factors, both within the company and in the market of which the
business is a part, affect the cost of goods sold. An investigation should
be made to determine the following:
1. Average rate of stock turnover, particularly as compared to the normal
or typical rate for similar businesses.
2. Extent to which invoices are being discounted. Paying invoices in time
to earn the cash discount will increase both gross margin and net profit if
the discount is recorded as a reduction in the cost of goods sold. A direct
increase in net profit will result if the discount is shown as "other
income."
3. Freight costs to determine whether incoming transportation charges are
in line.
Among the records to be studied are vendor invoices, records of merchandise
payments to vendors, shipper receipts or bills of lading, and records of
past physical inventories.
Sales-Effort Records
This information has to do with how much it costs in selling effort to
produce a given volume of sales. It involves two types of costs: (1)
advertising costs, from invoices and statements for various forms of
advertising and promotion; and (2) salaries and wages paid for selling,
from payroll or Social Security records. If the business maintains
sales-people in the field, as a manufacturer might, information on
reimbursable travel expenses should be included.
The purpose of gathering information on selling costs is to determine how
well these costs are being utilized and to compare them with average
figures for the kind of business being studied.
Personal Observation
Personal observation of the premises and personnel of the company is
another source of information for the buy-sell process. Just what points
should be noted will depend on the nature of the business, but the
following are offered as examples:
The general appearance of the premises, both internal and external, may be
important, particularly if direct customer contact is made at the place of
business.
Plant layout and apparent efficiency of operation should be carefully
observed if the seller is a manufacturer or otherwise engaged in processing
or assembly.
Employee morale and general attitude toward the business should be noted,
especially if current employees are to be retained.
Employee records, including wage-payment plans, employee-evaluation and
merit rating programs, training programs, and so on should be studied.
Market Information From Outside Sources
Sources of market information outside the business fall into two general
classes: (1) competing businesses, and (2) the total market of the business
and the factors that enter into it. Analyzing market characteristics
involves dealing with constantly changing forces. This is in contrast to
the internal analysis, which concerns basically historical records.
Competition. Unless the business has a monopoly of some sort, a study of
the competition should be included in the market analysis. The competition
may be local and well defined, or quite generalized, depending on the
nature of the business and of the market.
Trade associations and other data-gathering agencies, both governmental and
nongovernmental, are sometimes helpful in this area. A good deal of the
information about competition, however, must come from direct
investigation, business by business.
Such factors as these are of interest: estimated sales, advertising and
promotion, services offered, performance of sales personnel, businesses
entering and leaving the competition recently, changes in the competitive
structure through product mix or services offered, pricing policies, and
other factors that form a part of the competitive patterns for specific
types of businesses. A very important aspect of competition is the extent
to which the total weight of competition has expanded the market for
certain types of products or kinds of businesses, and the direction this is
taking.
Location. In certain businesses, location may not be too important,
providing the physical plant is structurally sound and suitable for the
business. In other cases, location may be a vital factor. An important point
that should be looked into is the status of the location and any plans for
proposed changes that may have an adverse effect on the future of the
business. Urban renewal programs are causing many small businesses to look
for new locations. So are changes in highways and streets, flood-control
programs, changes in zoning ordinances, and the like.
The buyer, whether he will own the physical plant or lease it, should look
into the possibility of future expansion. Consulting a competent architect
or engineer now may save trouble later on if the buyer should want to
expand and leasing provisions allow him to.
Population and purchasing power. The number of people within the market
area and the amount of spendable income they have are important market
factors. For many kinds of businesses, the total population is less
important than certain segments of the population. A business selling
hearing aids, for example, will be interested only in persons who have
hearing difficulties.
In gathering information on income and expenditures, three factors should
be kept in mind: (1) the total purchasing power based on total population;
(2) the average or median income for the typical family unit; (3) the
amount or percent of expenditures for various types of goods and services.
General population figures are obtained from Federal, State, and local
government sources. The Federal census, taken every 10 years, gives not
only total population figures but also breakdowns that are useful in many
business situations. For most of the larger cities, census figures are
further classified by sections within the city on the basis of certain
population and economic characteristics. These sections are called census
tracts.
Business population figures may be available from numerous sources. The
Yellow Pages of the telephone directory and the city directory are local
sources that are immediately available. Chambers of commerce, trade
associations, and State and Federal government agencies can often be
helpful.
The 10-year census reports the income for 20 percent of the total
population on a National, State, county, city and census-tract basis. Other
information issued by the Department of Commerce can also be useful.
Many trade associations report the results of research on consumer
expenditures. Other sources of data on income include the following: (1)
planning commission offices, (2) employment offices, (3) research done by
newspapers, (4) building permits, especially in newly developed areas, and
(5) mortgage and loan companies. Numerous fact-gathering agencies develop
and publish estimates of consumer income and expenditures for various
classes of goods and services.
General market conditions. A much broader yet vital part of the market
analysis has to do with what might be called the general state of the
market. Most of the discussion of market analysis so far has dealt with
factors that have a direct influence on the business being bought or sold:
company sales, location, competition, and so on. But these, in turn, are
influenced by the overall economic conditions of the country and of the
market area. These may be widespread movements such as national cycles of
prosperity and depression, or they may be purely local conditions. The two
extremes are not necessarily related.
It is to the advantage of the buyer or seller to have a clear understanding
of economic factors that affect or are likely to affect the status of the
business. The significance of this information becomes clearer when
forecasts and estimates are made.
Some questions to be used as a guide in market analysis are given in
chapter 12.
Chapter 4 - Sources of Financial Information
BOTH BUYER AND SELLER are interested in financial information, affecting
the buy-sell transaction. However, since the seller already has this
information, it is a major requirement for the buyer to get and make use of
as much of it as possible.
The buyer can usually find financial information in the following places:
(1) financial statements, (2) income-tax returns, (3) other internal
records, and (4) other external sources.
Financial Statements
The results of the financial transactions of every company should be
reflected in its periodic financial statements. These statements are
extremely important in buying or selling a small business. They were
prepared for the seller, of course, and their contents are available to
him. But the buyer, too, should be aware during the early stages of a
buy-sell transaction of the information contained in financial statements.
Balance sheet and income statement. The balance sheet is a statement of the
financial position of the business at a given moment in time. The income
statement is a summary of the revenue and expenses of the business during a
specified period of time. These financial statements show only the past
results of the company's transactions. The results of future operations may
or may not be similar.
Balance sheets and income statements in themselves contain important
information, but they are most useful when a professional accountant makes
a detailed analysis of them. A complete analysis includes a review of the
manner in which the statements were prepared, and perhaps also a review of
the records and control features of the accounting system. This is
especially important in a small business buy-sell transaction because the
financial statements of smaller companies are not usually as professionally
prepared as the statements for larger companies. An accountant should be
brought into the buy-sell transaction as early as possible by the seller as
well as by the buyer.
Audited statements. In many buy-sell transactions, the statements are
supplied by the seller, but the buyer reserves the right to conduct an
audit of the seller's records. Or the buyer insists that the seller
"warrant" his financial statements. Warranty of financial statements by the
seller should be accepted with caution, however, because there does not
seem to be any uniform definition of the term warranty.
If the seller's financial statements are prepared by an independent
accountant, the statements should show whether they were (1) prepared after
an audit of the seller's accounts, or (2) prepared from the seller's
records without verification by audit. If they were prepared without
verification by audit, they may be quite similar or even identical to
statements that would have been prepared by the seller's own bookkeeper. If
they were prepared after an audit, they should include a statement of the
accountant's opinion.
Financial statements prepared without such an audit may or may not reflect
the financial position or results of operation of the company. Most small
companies do not have their records audited annually, but without an audit
it is impossible to tell how accurate the statements really are.
Other considerations. The buyer should request balance sheets and income
statements for at least 3 and preferably 10 years. If the seller is a new
company, financial statements for the entire life of the company should be
requested.
Other financial statements are sometimes available to the buyer. These
include such items as statements of cost of goods manufactured (if the
seller is a manufacturer), application of funds, and variances from the
budget.
Another point the buyer should consider is the cutoff period for the
financial statements. The statements may have been cut off during the low
period of the sales cycle or during the high period. This has some bearing
on the financial position reflected in the statements.
More detailed information on financial statements and their analysis is
given in chapters 9, 10, and 11.
Income-Tax Returns
If independent accountants did not prepare the financial statements, the
seller may or may not have complete sets of statements. He should have at
least an annual income statement--that much is required for income-tax
purposes. If the seller is a partnership or corporation, the tax returns
should have balance sheets attached. If the seller is a sole
proprietorship, tax returns will not show balance-sheet data.
Financial statements prepared for income-tax purposes may be very different
from statements prepared in conformity with generally accepted accounting
principles. Those prepared for tax returns are designed to present the
desired tax position in compliance with the income-tax laws. Financial
statements for nontax purposes have different objectives and therefore may
reflect different financial information.
Many small companies prepare financial statements only for income-tax
purposes and use those statements for all management decisions. This may or
may not give the desired results. The parties to a buy-sell transaction are
interested in statements reflecting the tax position, but they should
concern themselves also with statements reflecting nontax items.
The buyer should request copies of tax returns for at least 3 and
preferably 10 years or, if the seller is a new company, for the life of the
company. The tax returns are more important in buying the stock of a
corporation than in buying the assets of a corporation, partnership, or
sole proprietorship.
The corporation is an income-tax entity; the partnership and sole
proprietorship are not. A partnership is required to file income-tax
information returns but does not pay income taxes as a company--the taxable
income is passed on to the partners, and they pay the tax as individuals.
No tax return is filed for a sole proprietorship, but the income statement
is included as a part of the sole proprietor's personal income-tax return.
The buyer should find out which tax returns have been examined by the
Internal Revenue Service and which have not. This is particularly important
if the buyer is purchasing the stock of a corporation. If a corporation
with an operating loss is being acquired, the loss might have value and the
buyer should satisfy himself as to whether this net operating loss can be
utilized. In many instances, the only information available to the buyer is
that found with the income-tax returns.
Other Internal Sources
The financial statements are usually supported by detailed analyses of
selected accounts. This might include some of the following items:
Sales may have been analyzed by customer, product, division, salesman, time
period, and any other classifications necessary.
Purchases may be classified according to product, time period, territory,
supplier, or other classification.
If the seller is a manufacturer, he may have cost-control reports that
include analyses of material costs, labor costs, overhead cost, scrap
sales, spoiled and defective goods, and other items.
There may be a cash-flow statement--perhaps incorporated with the analysis
of collections of accounts receivable--and even a projection of cash
requirements.
The seller may have a regular budgeting program with projections into the
near or distant future. It is common practice for the buyer to require the
seller to make a projection for at least a year from the date of the
proposed transfer. The buyer should insist on this projection.
Other External Sources
The seller's suppliers are an excellent source of information for the
buyer. They can provide records showing the volume of purchases by the
seller. This information may be difficult to get in some cases,
particularly if the seller informs his suppliers that it is proprietary
information.
Another source of data is the seller's banker. A banker can supply
information about cash position, line of credit, and other fiscal data. He
may, however, be reluctant to release this information.
The seller may have filed payroll-tax reports, sales-tax reports,
excise-tax reports, ICC reports, or any of many other government reports.
Some of this information is available to a buyer.
The buyer may seek information about the seller from credit agencies or
credit associations related to trade associations. Usually, the buyer must
have a contact with these agencies in order to get the information, but
there are many ways to get reports about the seller.
A number of organizations, including trade associations, supply information
about industry averages. These averages are very important to the buyer for
judging the effectiveness of the seller.
Advice to the Seller
The seller, for his part, should be cautious about releasing information to
the buyer. It is entirely possible that the supposed buyer is a competitor,
or may be one in the future. Often a seller is so anxious to sell that he
supplies any information requested by the buyer without even getting a
good-faith deposit. He may spend many dollars in collecting the data for
the buyer. A seller should not supply any information to anyone without
first discussing the matter with his accountant and his attorney.
Chapter 5 - Sources of Legal Information
THE PROSPECTIVE BUYER OF A BUSINESS can play an important role in the
discovery of legal problems that may affect the value of the business and
his decision on whether to buy. Legal opinions are the responsibility of
the buyer's attorney, of course. But the attorney must often rely on the
buyer as his source of internal information about the business--information
he will need in making his legal recommendations. It is therefore important
that the buyer have some idea as to what his attorney will expect of him.
As in any sales, the basic legal problem in the purchase of a business
involves the transfer of ownership or title to property. How serious the
title problem is varies from one business to another, depending on the
nature of the assets being purchased.
If the transaction involved only the transfer of good title to a single
piece of real estate, it would be a simple matter. But buying and selling a
business typically involves a conglomeration of assets--inventory,
fixtures, vehicles, and equipment, all of which are movable, and assorted
contract rights under leases, sales agreements, patent licenses, and so on,
which are intangible.
Each asset has its own ownership aspects. It is important to ask this
question about each asset: "Is the buyer getting the ownership rights he
assumes he is getting?"
An even more careful investigation from a legal point of view is called for
when the buyer either assumes liabilities or purchases the stock of a
corporation. Even the risk of potential liabilities--liabilities that may
occur in the future because of past events--may be reduced by proper
investigation.
Both internal and external sources of legal information are usually
available to the buyer and his attorney for examination. The buyer should
not rely solely on the oral statements of the seller as to important
aspects of the business. Any statements of the seller that have to be
accepted without support from other sources should be incorporated into the
buy-sell contract as warranties.
How much information should a buyer obtain about a business before legally
committing himself to purchase? There is no easy answer to this question,
but the buyer should realize that the legal risk he assumes is about
inversely proportional to the amount of information he has obtained about
the business.
Internal Sources of Legal Information
Among the internal sources of legal information are copies of contracts,
evidences of ownership, and organizational documents. Personally examining
the business premises and questioning the seller and his employees may be
the only source of information about some assets.
Contracts. The buyer and seller are both concerned with the rights and
obligations created by outstanding contracts with suppliers, customers,
creditors, employees, lessors, and so on. The seller is concerned with his
liability for any breach of contract that may result from sale of the
business. He should know that ordinarily only contract rights, and not
contract obligations, may be transferred to a third party without the
consent of the other party to the original contract. Sublease arrangements
and mortgage assumptions are examples of this. The seller remains liable
even though the buyer takes over the lease or mortgage as part of the
buy-sell contract.
Here is an example involving a lease. A food merchant sold one of his
smaller stores at what he considered a good profit. The sale price covered
inventory, fixtures, and goodwill, for which the seller received $56,000.
He had purchased the business 2 years before for $30,000.
The building was leased, and the seller was not able to assign the lease to
the new owner of the business. He was, however, permitted to sublease the
building for the remainder of the lease. The lease amounted to $1,300 a
month.
Recently, sales have been decreasing to the point where the present owner
has threatened to give up the business and take his loss. If he should do
so, the former owner will be liable for the remaining 2 years' lease.
Unless he can find another tenant, he may lose all he gained from the sale
and more.
Assignment of contracts. The buyer often wants any contractual rights of
the seller that are needed in order to maintain the business as a going
concern. In legal terminology, the transfer of contractual rights is called
an assignment. Generally, a contractual right is assignable, but the
original contract may expressly prohibit its assignment.
Such negative provisions are common in printed forms of leases. Loan
agreements may prohibit the sale or other change in ownership of
substantially all the business assets. Or they may call for speeding up
payment of the principal if the assets do change hands. The buyer should
get copies of important contracts and review them to determine whether they
have nonassignment clauses.
A contract may be nonassignable, however, even without such a provision.
This would be true if the contract rights are coupled with obligations of a
personal character. For example, the seller's credit arrangements with a
supplier are not assignable because they are based on the seller's
reputation as a credit risk. A contract for the manufacture of certain
goods may not be assignable because the customer, when he signed the
contract, knew and was relying on the superior workmanship of the seller.
Likewise, a supplier's agreement to supply the seller's manufacturing
requirements of certain raw materials may not be assignable because the
requirements of the new owner are uncertain.
Both buyer and seller should remember that third parties will, in all
probability, have to be reckoned with in carrying out the buy-sell
transaction. If the buyer must have a contract that is nonassignable and
the seller is not a corporation, the only solution is to renegotiate the
contract. In the case of a corporate seller, it may be possible to make the
transaction a purchase of stock rather than assets.
Types of contracts. Following are some recommendations to the buyer about
specific types of contracts:
Copies of real-estate leases should be obtained from the seller and
examined for provisions relating to amount of rent, terms of payment,
expiration, renewal, subleasing, repair, improvement, insurance, and so on.
The buyer should pay special attention to the duration of the lease. If the
term remaining is too short, either the lease should be renegotiated before
the purchase or an option should be obtained to renew for an additional
period. Leases for a specific term are often misleading because of
provisions granting to one or both of the parties the right to terminate
the lease by giving a stated period of notice.
Copies of patent, trademark, trade-name, and copyright registrations should
be obtained in order to determine the legal status of the right and whether
it can be transferred.
The principle subject of the buy-sell transaction may be a contract right
to be the exclusive agent, dealer or distributor of a product or line of
products, or the right under license to use a patented process, trade name,
or trademark. Copies of such contracts should be obtained to determine the
precise nature of the right, its limitations, and the seller's power to
transfer. Particular attention should be given to the exclusiveness of the
right.
Copies of employment contracts and union agreements should be studied for
terms relating to compensation, working conditions, duration of employment,
termination, pension and profit-sharing plans, stock option, insurance
programs, and so on. The buyer should find out whether key employees will
remain with the company if the ownership changes hands. If the employees
have not been organized, he should inquire about possible activities of
union organizers among them.
The buyer should study outstanding sale and purchase contracts. Particular
attention should be given to trade-credit, discount, installment payment,
attention should be given to trade-credit, discount, installment payment,
and security requirements. The buyer should get from the seller copies of
conditional-sale contracts, purchase-money chattel mortgages, chattel
leases, lease-purchase agreements, consignment contracts, and
sale-on-approval and sale-or-return contracts to which the seller is a
party.
The buyer should also get from the seller copies of financing agreements
between the seller and commercial banks, finance companies, and other
third-party lenders. Attention should be given to the term of the loan,
repayment provisions, interest rate, finance charges, insurance
requirements, acceleration provisions, security requirements, and recourse
rights. The buyer will generally have to make his own financing agreements,
but the seller's experience in financing the business will often suggest
what the buyer can expect if he purchases the business.
A buyer's willingness to purchase accounts receivable, apart from his
financial ability to do so, should depend on their apparent collectibility.
The buyer should require the seller to submit a complete list according to
the age of the accounts. Inquiry may disclose factors other than the
statute of limitations that would prevent collection.
A study of the seller's insurance policies may give the buyer some insight
into the availability, adequacy, and cost of coverage of such risks as
liability arising from manufacture or sale of defective products, liability
to customers for injuries sustained on the premises, liability for property
damage and bodily injury arising from negligent operation of company
vehicles, liability to employees for injury under workmen's compensation
laws, and property hazards such as fire, windstorm, and theft. The buyer
should be aware, however, that premium rates based on the seller's
experience may not be available to him.
Evidences of Ownership. The buyer should get from the seller a certified
abstract of title for each parcel of real estate involved in the
transaction. The abstract should be examined by the buyer's attorney. In
addition to disclosing any defects in the title, examination of the
abstract and the abstractor's certificate will usually show whether there
are any unreleased mortgages, judgment liens, mechanics' liens, tax liens,
or unpaid real-estate taxes and special assessments.
The seller should be asked to show evidence of his ownership of principal
items of personal property in the form of bills of sales, receipts,
assignments, motor-vehicle title certificates, and so on. Such evidence
will not prove that there are no recorded liens against the property, but
lack of it should alert the buyer to the possibility that personal property
in the physical possession of the seller is rented, leased, borrowed, or
delivered on consignment.
Organizational documents. If the seller is a partnership, the buyer should
get a copy of the partnership agreement. If there is no written agreement,
he should find out who the partners are and whether authority exists to
sell the business assets.
If the seller is a corporation, the buyer should get a certified copy of
the resolution of the shareholders authorizing the sale of the corporate
assets. In a corporation stock transaction, he should get a copy of all
organizational documents. These documents include the articles of
incorporation and amendments to it, the corporate bylaws, stock-transfer
books, and minutes of shareholders' and directors' meetings.
Observation and inquiry. Certain types of legal problems can be uncovered
only by observation and inquiry. This is true of mechanics' liens. The
basis for mechanics' liens against real estate may exist even though no
lien is on file. If the buyer learns that there has been repair or
construction within the allowable period for filing mechanics' liens, he
should check with the contractors and suppliers to find out whether they
have been paid.
The real estate should be examined to make sure that it complies with
building codes and other ordinances. It is advisable also to have the real
estate surveyed to determine whether buildings are located within
boundaries in compliance with setback lines, whether adjoining buildings or
driveways are encroaching upon the property, and so on.
External Sources of Legal Information
Among the more common external sources of legal information are public
records, government agencies, and third parties with whom the seller has
had dealings.
Office of record. A down-to-date abstract of title will ordinarily disclose
the existence of liens against a particular panel of real estate, but liens
against personal property of the seller can be discovered only by a search
of the office of record. Separate filing systems may exist for chattel
mortgages, conditional sales contracts, trust receipts, assignment of
accounts receivable, and so on. Each of these files must be checked.
A record search will not disclose what items of personal property in
possession of the seller have been rented, leased, borrowed, or delivered
on consignment. Also, lien notations on motor-vehicle title certificates
may take precedence over recording--it depends on State statutes.
Tax authorities. Investigation is especially important where the buyer is
purchasing the stock of the seller or assuming liability for the payment
status of Federal, State, and local income taxes, Social Security and
income withholding taxes, Federal excise taxes, State and local taxes,
license taxes, and real- and personal-property taxes. Have tax returns been
reviewed and approved by the taxing authority?
Zoning ordinances, planning agencies, building codes. The buyer should
check zoning ordinances and building codes to determine the existence of
nonconforming land uses or violations of building codes. Comprehensive
zoning plans may provide for steps to be taken toward elimination of
nonconforming uses. This can be done by prohibiting alteration or enlarging
of buildings or by requiring liquidation of nonconforming use within a
prescribed period of time.
City, county, or metropolitan planning agencies and engineering departments
should be consulted about the existence of master plans for future
rezoning, redevelopment, and street or highway changes. Highway relocation,
limited street or highway access, elimination of on-street parking, or
changes in the composition of the immediate market area may be enough to
destroy the business as a going concern. City annexation policies may be
important to businesses located in the suburbs. The cost of planned
improvements may affect the buyer's decision.
Court records. The buyer should find out from court records whether
judgment liens exist against real estate involved in the buy-sell
transaction and whether lawsuits are pending that may retroactively result
in the attachment of liens. This is of particular concern to the buyer who
either assumes business liabilities or purchases the stock of a
corporation. Not only litigation costs and liability must be considered but
also the impact of the publicity on the goodwill of the business.
Even if a court record search is negative, future litigation may arise out
of events of the past several years, such as motor-vehicle accidents,
manufacture or sale of defective products, accidents on the premises
involving customers or employees, breach of contract, violations of
wage-and-hour laws, and so on. The best protection is to inquire of the
seller and of employees who have been intimately concerned with the
business.
Part 3 The Buy-Sell Process
Chapter 6 - Determining the Value of a Business
THE MOST DIFFICULT STEP in buying or selling a small business is probably
determining what the business is worth as a going concern. Many judgment
decisions must be made. Yet before negotiations can continue successfully,
a value must be established. The value must be acceptable to both buyer and
seller, or further negotiation is fruitless. It must result from the
logical and objective efforts of all the parties involved.
Valuation Methods
There are two basic methods of determining the value of a business. The
first is based on expectations of future profits and return on investment.
This method is preferable by far. It forces the buyer and seller to give at
least minimum attention to such factors as trends in sales and profits,
capitalized value of the business, and expectancy of return on investment.
The second method is based on the appraised value of the assets at the time
of negotiation. It assumes that these assets will continue to be used in
the business. This method gives little consideration to the future of the
business. It determines asset values only as they relate to the present. It
is the more commonly used, not because it is more reliable, but because it
is easier. The projections needed to value the business on the basis of
future profits are difficult to make.
Looking Ahead
Whichever method is to be used to value the business, the buyer should ask
the seller to prepare a pro forma, or projected, statement of income and
profit or loss for at least the next 12 months. For this, the seller will
prepare a sales estimate for this period along with a matching estimate of
the cost of goods sold and operating expense.
The projected statement will reflect the net profit the seller believes
possible. The buyer should then make his own estimate of sales, cost of
goods sold, operating expenses, and net profit for the next year at least,
and as far into the future as possible.
In preparing these statements, the buyer should start by analyzing the
actual statements of profit and loss for at least 5 years back. He should
be sure that the past and projected statements provided by the seller are
correct and are consistent with the buyer's proposed future operation. He
should also study general and local economic changes that will affect
future business. This includes competition.
If the buyer is not qualified to prepare projected financial statements, he
should consult an independent accountant. This will involve some expense,
but the cost will be small compared to the loss he might incur if he
invested in a small business with a doubtful future.
Financial statements and their analysis are discussed in part 4; market
analysis in part 5.
Forecasting Sales
The most important projection to be determined in the projected income
statement is the sales figure. After this number has been established, the
cost, expense, and profit figures are easier to acquire. The data for
projecting sales will come from past sales records of the business. The
more accurate and systematic these records are, the more confidently they
can be used in estimating future sales.
How long a forecast? A basic question is this: "Over how long a period of
time is it necessary or possible to forecast sales?" Any forecast is
uncertain, and the farther a forecast is projected into the future, the
greater the uncertainty. While it may be possible to exercise at least
reasonable control over the internal operation, the external economic and
market factors make forecasting difficult because of lack of control.
Perhaps the best way to approach the length of the forecast is in terms of
the expected return on investment. Suppose it is estimated that the
business should bring a 20 percent return on initial investment. The
investment, then should be returned in 5 years. At this point, the owner
would just break even on his original investment. It seems logical to
project sales and profits over a span of time comparable to that estimated
for return on investment--in the above illustration, 5 years.
Any such forecast, however, should give careful consideration to expected
changes either in the economy or in the industry market that might affect
the pattern of sales change. Mathematically, it is possible to forecast
sales with some precision. Realistically, however, this precision is dulled
because vital market and economic factors cannot be controlled.
Methods of forecasting sales. There are numerous methods by which sales
forecasts can be made. Most of them take their lead from the past sales
performance of the company. For establishing trends or averages, 5 years of
sales history is better then 3, and 10 is better than 5.
Perhaps the simplest method is to assume that the percentage increase (or
decrease) in sales will continue and that no market factors will influence
sales performance more in the future than in the past. Suppose, for
example, that the rate of yearly average increase for the past 5 years has
been 4 percent, and that each year has shown about this rate of increase.
Then it might be assumed that sales for the next year will be 4 percent
greater than the current or most recent year.
But what about the year following? The year after that? Can it be assumed
that these years will also increase at about 4-percent level? Each
additional year into the future reduces the certainty of the predictions.
If these negative influences limit the accuracy to such an extent, why try
to forecast beyond the immediate future (1 year)? Because such a forecast
forces the person making it to give at least a little attention to economic
and market factors that might influence the future operation--that might,
in fact, indicate that the purchase or sale of the business would not be
wise.
With forecasts covering more than 1 or 2 years, a more detailed forecasting
technique is needed. Such technique should be designed to weight out
extreme variations in year-to-year sales and to give a trend or level of
sales change that is more realistically oriented to probable future sales
patterns.
No method of forecasting can set any value on external market conditions,
because there is no guarantee that these conditions will carry over into
the future with the same relative significance. Nevertheless, their
possible influence should be considered.
Some simple methods of short-term forecasting are described in chapter 14.
Risk and Return on Investment
If a buyer wants to invest money in a business that is being sold, he
should be concerned about receiving a fair return on his investment. Many
businesses can make a profit for a short time (1 to 5 years); not so many
operate profitably over a longer period of time.
From the buyer's point of view, what is a fair rate of return from an
investment in a small business? The rate of return is usually related to
the risk factor--the higher the risk, the higher the return should be.
United States Government bonds are the safest investment--the rate of
return ranges from 5-1/2 to 6 percent. Blue-chip stocks and corporate bonds
usually give the investor a return of 4 to 10 percent if both dividends or
interest and increase in market value are considered. Speculative stocks
may have a higher return, but they also have a higher risk factor.
The buyer of a small business should try to determine the risk factor of
the new business, though this is difficult at best and in many cases
impossible. In attempting to assess the risk factor, the buyer should
project the profits of the business as far into the future as possible. He
should ask himself how high the risk should be normally and look for
conditions that would be likely to affect the sales and profit-making
capability of the business.
In any event, he should consider carefully the minimum return on investment
that he is willing to accept. This concept of risk is important in valuing
the business by capitalization of future earnings.
Valuing the Business by Capitalizing Future Earnings
The price to be paid by the buyer should be based on the capitalized value
of future earnings. Instead, however, in most small business buy-sell
transactions, price is based on the purchase and sale of assets. Profits
are made by utilizing assets, of course, but actually the assets purchased
are only incidental to the future profits of the new business.
Capitalized value is the capital value that would bring the stated earnings
at a specified rate of interest. The rate used is usually the current rate
of return for investments involving a similar amount of risk. The
capitalized value is found by dividing the annual profit by the specified
rate of return expressed as a decimal.
Assume for the moment that the future profits of a business have been
projected for the next 5 years and are estimated to average $20,000 a year.
(This is in addition to compensations for the services of the buyer and any
members of his family.) What should be the sales price for the buy-sell
transaction?
If this investment were as safe as U.S. Government bonds, the buyer should
be willing to pay $333,000 ($10,000 divided by .06). If the investment is
considered as safe as an investment in an excellent corporate stock that
earns 10 percent in dividends and price increases, the buyer should be
willing to pay $200,000 ($10,000 divided by .10).
Very few small businesses, however, have as low a risk factor as these two
investments. What rate, then, should be used in capitalizing the earnings
of a small business? Usually, 20 to 25 percent is considered adequate. This
means that the buyer should pay between $80,000 and $100,000 for this
business. If it earns the projected $20,000 a year, the buyer will recover
his initial investment in 4 to 5 years. This time will be extended by
Federal and State income taxes to be paid on the income, but this would
also be the case for most alternative investments except nontaxable
municipal securities.
In using a computation such as this, the importance of long-run profits
should be kept in mind. Unless profits are possible over a long period of
time (10 to 15 years), investment in a small business may be a poor
decision. The trend of profits is also important. If all other factors are
the same, a company whose profits are declining is worth less than one
whose profits are increasing.
Valuing the Business on the Basis of Asset Appraisal
The majority of buy-sell transactions are based on a value established for
the assets of the company. This approach is not recommended, but if it is
to be used, the suggestions that follow should be considered.
A most important point is to find out early in the transaction just what
assets are to be transferred. Usually, the seller has some personal items
that he does not wish to sell. Prepaid insurance, some supplies and the
like, in addition to cash, marketable securities, accounts receivable, and
notes receivable usually are not sold. If the buyer does purchase the
receivables, the seller may guarantee their collection, but such a
guarantee should be established.
The assets most commonly purchased in a small business buy-sell transaction
are merchandise inventory, sales and office supplies, fixtures and
equipment, and goodwill.
Evaluating goodwill. One of the assets that must be considered in a
buy-sell transaction is goodwill. Goodwill, in a general sense, arises from
all the special advantages connected with a going concern--its good name,
capable staff and personnel, high financial standing, reputation for
superior products and customer services, and favorable location.
From the accounting point of view, goodwill is the ability of a business to
realize above-normal profits as a result of these factors. By above-normal
profit is meant a higher rate of return on the investment than that
ordinarily necessary to attract investors to that type of business.
The value of goodwill can be computed in either of the following ways:
1. Capitalization of average net earnings. As explained above, the amount
to be paid for a business may be determined by capitalizing expected future
earnings at a rate that represents the required return on investment. The
difference between this amount and the appraised value of the physical
assets may be considered the price of goodwill.
This method uses only earnings in computing the price to be paid for the
business. For that part of the calculation, it ignores the appraised value
of the assets.
2. Capitalization of average excess earnings. This method recognizes both
earnings and asset contributions. It starts with the appraised value of the
assets and computes what would be a fair return on that value. If the
estimated future earnings are higher than this "fair return," the
difference between the two figures--the "excess earnings"--is capitalized
at a higher rate, and the amount thus obtained is considered the goodwill
value. This figure is added to the appraised value of the assets to give a
price for the business.
Payment of excess earnings is often stated in terms of "years of purchase"
instead of in terms of capitalization at a certain interest rate.
Capitalization of average earnings at 20 percent is the same as payment for
5 years' excess earnings.
As the above discussion shows, the determination of goodwill usually
reflects the value of profits that will be realized by the buyer above the
normal rate of return; that is, the excess profits. But most small
businesses that are for sale do not have excess profits. They usually show
nominal profits or none at all. Often the seller makes an offer that seems
quite good, but the buyer must be able to eliminate the seller's emotions
and reduce all facts to workable relationships.
If there are excess profits, goodwill is usually valued by capitalizing
them at a fixed percentage established by bargaining between the seller and
the buyer. The capitalization percentage needs to be high because profits
higher than a normal return are difficult to maintain. Excess profits of
$4,000 capitalized at 10 percent will give a goodwill value of $40,000
($4,000 divided by .10). Capitalizing the same excess profits at 20 percent
gives a goodwill value of $20,000 ($4,000 divided by .20).
Although goodwill valuation is the first asset valuation to be discussed
here, it is normally the last to be computed. Since few small businesses
being sold are producing excess profits, the problem of goodwill value is
not a pressing one in most buy-sell transactions.
Merchandise inventory. In a service business, placing a value on the
inventories is a minor problem; but in distributive and manufacturing
businesses, the inventory is likely to be the largest single asset. A
manufacturer, for example, has three inventories--raw material, work in
process, and fixed goods--and each of them present different problems in
valuation. The distributive company has only one inventory, called
merchandise inventory.
The financial statements presented by the seller will probably reflect an
inventory value different from the one assigned in a buy-sell transaction.
Inventories are usually carried on the books either at cost or at the lower
of cost or market. Market is defined as the current replacement cost to the
seller.
In determining the value of inventories, the seller has to choose a method
of arriving at cost. The most common costing methods are first-in-first-out
(FIFO), last-in-first-out (LIFO), and average cost. These methods may give
very different values and the buyer and seller must arrive at some value
agreeable to both. The most common methods used in valuing inventories for
buying and selling small businesses are cost of last purchase and current
market price.
The quantity of the inventory is usually determined by a physical count.
The physical inventory procedures should be decided before the count, and
each inventory team should include one representative from the buyer and
one from the seller. It is easy to omit items from the inventory count, and
here the seller is usually in a more vulnerable position than the buyer.
There is more danger of omitting item from the count than of double
counting them.
It may be that some items of inventory are not to be sold. If so, these
items should be segregated before the count begins. Another problem is
determining what quality of items are to be included in the inventory. The
buyer needs to be cautious when examining the inventories--in most buy-sell
situations there is some inventory that is not salable.
This is one reason why the buyer should employ as his representatives on
the inventory teams individuals who are acquainted with that type of
inventory. If the buyer and the seller disagree on the value of certain
items, the seller will remove these items from the list of inventory for
sale.
When the inventory is being priced, be very careful in matching price to
quantity. Be sure that the units in which the quantity is recorded and the
units priced are the same. The physical count should be recorded in
duplicate so that buyer and seller can each make separate extensions after
all prices have been listed. After independent extensions, the two
inventories should be reconciled.
Manufacturer's inventory. When a manufacturing company is being exchanged,
the raw materials inventory is taken and priced like the merchandise
inventory of a distributive business. The work-in-process and
finished-goods inventories may present a problem. Usually, there is no
market price or cost of last purchase to relate to these inventories;
consequently, the seller's cost is generally used for establishing prices.
If the seller has unused plant capacity or if his plant is inefficient, his
costs may be inflated. Such a situation requires the help of an accountant
with a good knowledge of cost accounting.
Store supplies and office supplies. These two items are usually quite
small. They should present no problem, though some of them may have no
value to the buyer if the name of the company is to be changed. After the
usable supplies have been determined, a physical inventory should be taken
and priced as in the case of the merchandise inventory.
Property assets and accumulated depreciation. The property-asset account
normally reflects the cost of the assets reduced by a provision for
depreciation. In many small business buy-sell transactions, no real
property is exchanged, because the plant site is leased. The problem of
establishing a value on real estate is not as acute, anyway, since the
market value for real property does not fluctuate as widely as the market
value for personal property.
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
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$84,000
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(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; (c) 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 (c), 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
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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 |