QUANTUM BUSINESS HOUSE BUSINESS GUIDE 2. BUYING A BUSINESS

Transcription

1 QUANTUM BUSINESS HOUSE BUSINESS GUIDE 2. BUYING A BUSINESS

2 2 Chapter 2. Buying a Business Sometimes, it is a better way to start a business by purchasing an existing business especially when you do not have sufficient time and skill to build a business from a scratch. In this chapter, we will discuss the pros and cons of buying a business with the required procedures of business buying to minimise risks and how to value the business you want to buy. 2.1 Pros & Cons The main advantages of buying an existing business are: You will save the time and effort required to build the business and eliminate any teething problems including purchase of equipments such as computers, desks recruitment of staff and securing suitable premises. It is lower risk as supplier relationships have already been established. Existing clientele should mean that you are not exposed to a long set-up period without incoming revenue It will be considerably easier to obtain finance for a business with a track record than for a start-up. The main disadvantages of buying an existing business are: Starting from scratch can be cheaper, as you are not paying for goodwill. You may overvalue the business if you are too optimistic about the future earnings potential of the business. The previous owner may have had poor relationships with employees, customers or strategic partners. This exiting illness could be difficult to overcome. The seller may have misstated the value of the assets or the business s financial statements. You may inherit prior mismanagement such as holdings obsolete stock or software which is antiquated. 2.2 Proper Procedures of a Buying a Business Finding a business for sale Finding suitable businesses for sale is a challenging task and considerable amount of time and energy need to be taken. The most main sources of leads are: Business brokers, corporate advisory firms and merchant banks Newspapers Newsletters and magazines Word of mouth The internet

3 3 Business brokers and Corporate Advisors You will need to contact a range of intermediaries including business brokers to register your interest in acquiring a business in a certain price range, industry sector and geographical area. A business broker matches people who want to buy a business with people who are selling one. Brokers typically deal in smaller businesses such as retail, manufacturing, hospitality and professional practices. Corporate advisers tend to act in larger deals (over $5 million) and generally play a more active role in the transaction than a business broker actively finding buyers, preparation of information memorandums, setting the terms and pricing. One of the benefits of buying a business through corporate advisors is that they will generally screen the businesses for sale to determine if there are any major problems and will also help set a realistic price(humphreynicholas, 2004) Assessing Experience and Skills One of the first steps in buying a business is a thorough personal assessment of your risk profile, motives and the seriousness of your search. You also need to assess realistically the size of the financial/professional resources to which you have access. Another key assessment is to determine how closely the business matches your personal skills and interests. The closer the match, the better your chance of success. The next step is to ensure that you have the necessary experience and skills to operate the business. In addition to general business skills such as finance, marketing and operations, you will need experience and expertise in running a business of that magnitude and in that particular industry. You must ensure that you have the myriad of business and management skills required. You should also join the relevant industry association and consider undertaking a short course of study. Some industries also require business operators to have special qualifications. For example, you may need a suitable degree or diploma and relevant industry experience to hold the necessary licences or permits. Please see Licence and Permit section of this book for more information Signing a Terms Sheet Before you spend significant time conducting due diligence, you should consider signing a terms sheet with the seller. Do not sign a fully binding terms sheet unless it is conditional upon the satisfactory completion of due diligence, raising of finance and execution of legal documentation. You should also seek legal advice before signing a terms sheet. A terms sheet summarises the intentions of the parties and describes the general terms and conditions of the transaction. The terms sheet should deal with: The purchase price and how it is to be calculated;

4 4 Whether the sale is by shares or assets; The assets and liabilities to be transferred and excluded. Terms sheets are usually non-binding. However, the no-shop or exclusivity clause and the confidentiality provisions should be binding. The no-shop clause protects the buyer by stating that the seller will not negotiate with other potential buyers for a period of time. Tips for drafting Typically, the terms sheet is drafted b the buyer. It is better if the first draft is prepared by the principals, rather than the lawyers. Focus on the major points; do not go into the details. The letter should be short three or four pages at most. State expressly which terms are meant to be legally binding and which are not. Specify what conditions must be satisfied before the transaction is completed. State expressly that the investment, sale of purchase depends upon the execution of a definitive agreement. 2.3 Due Diligence The legal adage of caveat emptor or let the buyer aware applies when you purchase a business. Before you buy the business, you must satisfy yourself as to the prospects and viability of the business. You should undertake extensive due diligence into the business you are purchasing. You should also seek appropriate professional advice from legal, tax and accountants. Your investigations should focus on the following things: What are the maintainable earnings of the business? Is there potential to improve sales/earnings? Is the asking price justified by the value of the assets and the past and potential profits? Is there sufficient working capital to operate the business (i.e. will additional funding be required)? Will the potential profits provide you with an adequate salary plus a return on your capital? Is the cash flow predictable? Are the sales and revenues growing, stagnant or declining? Have adequate financial records been kept over the life of the business? Is there any capacity to reduce the level of overheads? Are key personnel locked in? Ensure you review all major contacts (customers, suppliers and personnel). You should ensure that there are no termination provisions which are triggered by a change of control or assignment, that proper arrangements are in place for fees payments, and there is no excessive exposure to liability or indemnities. Note any key performance indicators (KPIs) which must be met and assess if they are achievable (industry benchmarks) How long has the business been on the market? Clearly, the longer it has been for sale the more bargaining power you are likely to have.

5 5 Why are the owners selling? Part of your due diligence enquiries should be to establish why the current owners are selling. Are they simply getting out before the business goes into insolvency? Most sellers will offer a range of seemingly valid reasons for disposal. An individual seller may be sick or planning to retire. A corporate seller may explain the division is no longer part of the overall group s strategic focus or no longer has support from head office. You need to find out the real reason they are selling. An analysis of external threats may highlight the real reason. For example: Demographics changing demographics in the market may mean the long-term prospects of the business are not viable. Regulation the government may be planning to introduce new legislation which will hamper the industry. The local council may be planning to rezone the area, restricting your ability to carry on the business, or it may be planning to change regulations such as traffic flow or parking which may also be detrimental to the business. Competition a new well-funded competitor may be launching. Consider the impact of the introduction of Coles Supermarket nearby a small family owned grocery shop. Trade and industry associations are good place to gain intelligence on new competitors. Obsolescence Are the products or services sold by the business about to become obsolete through the introduction of new technology? It is also worth checking on the seller s intentions after the sale. Are they simply moving down the road to a more prominent location or cheaper premises? A restraint of trade provision is important in any business purchase. Below is the sample check lists for due diligence process. A. Organization and Good Standing. The Company's documents of incorporation and all amendments thereto. The Company's constitution, and all amendments thereto. The Company's minute book, including all minutes and resolutions of shareholders and directors, executive committees, and other governing groups. The Company's organizational chart. The Company's list of shareholders and number of shares held by each. Copies of agreements relating to options, voting trusts, warrants, calls, subscriptions, and convertible securities. Annual reports for the last three years. A list of all states or countries where the company owns or leases property, maintains employees, or conducts business. A list of all of the Company's registrations of business names and copies of registrations thereof.

6 6 B. Financial Information. Audited financial statements for three years, together with Auditor's Reports. The most recent unaudited statements, with comparable statements to the prior year. Auditor's letters and replies for the past five years. The company's credit report, if available. Any projections, capital budgets and strategic plans. Analyst reports, if available. A schedule of all indebtedness and contingent liabilities. A schedule of inventory. A schedule of accounts receivable. A schedule of accounts payable. A description of depreciation and amortization methods and changes in accounting methods over the past five years. Any analysis of fixed and variable expenses. Any analysis of gross margins. The company's general ledger. A description of the company's internal control procedures. C. Physical Assets. A schedule of fixed assets and the locations thereof. All leases of equipment. A schedule of sales and purchases of major capital equipment during last three years. D. Real Estate. A schedule of the company's business locations. Copies of all real estate leases, deeds, mortgages, title policies, surveys, zoning approvals, variances or use permits. E. Intellectual Property. A schedule of domestic and foreign patents and patent applications. A schedule of trademark and trade names. A schedule of copyrights. A description of important technical know-how. A description of methods used to protect trade secrets and know-how. Any "work for hire" agreements. A schedule and copies of all consulting agreements, agreements regarding inventions, and licenses or assignments of intellectual property to or from the company. Any patent clearance documents. A schedule and summary of any claims or threatened claims by or against the company regarding intellectual property. F. Employees and Employee Benefits.

7 7 A list of employees including positions, current salaries, salaries and bonuses paid during last three years, and years of service. All employment, consulting, nondisclosure, nonsolicitation or noncompetition agreements between the company and any of its employees. Resumes of key employees. The company's personnel handbook and a schedule of all employee benefits and leave entitlements. Copies of collective bargaining agreements, if any. A description of all employee problems within the last three years, including alleged wrongful termination, harassment, and discrimination. A description of any labour disputes, requests for arbitration, or grievance procedures currently pending or settled within the last three years. A list and description of benefits of all employee health and welfare insurance policies or self-funded arrangements. A description of worker's compensation claim history. Copies of all stock option and stock purchase plans and a schedule of grants thereunder. G. Licenses and Permits. Copies of any governmental licenses, permits or consents. Any correspondence or documents relating to any proceedings of any regulatory agency. H. Environmental Issues. Environmental audits, if any, for each property leased by the company. A listing of hazardous substances used in the company's operations. A description of the company's disposal methods. A list of environmental permits and licenses. Copies of all correspondence, notices and files related to Federal, State, or local regulatory agencies. A list identifying and describing any environmental litigation or investigations. A list identifying and describing any contingent environmental liabilities or continuing indemnification obligations. I. Taxes. Company income tax returns for the last three years. GST & FBT returns for the last three years. Any audit and revenue agency reports. Any tax settlement documents for the last three years. Employment tax filings for three years. Any tax liens. J. Material Contracts. A schedule of all subsidiary, partnership, or joint venture relationships and obligations, with copies of all related agreements.

8 8 Copies of all contracts between the company and any officers, directors, shareholders or affiliates. All loan agreements, bank financing arrangements, line of credit, or promissory notes to which the company is a party. All security agreements, mortgages, indentures, collateral pledges, and similar agreements. All guaranties to which the company is a party. Any instalment sale agreements. Any distribution agreements, sales representative agreements, marketing agreements, and supply agreements. Any letters of intent, contracts, and closing transcripts from any mergers, acquisitions, or divestitures within last five years. Any options and stock purchase agreements involving interests in other companies. The company's standard quote, purchase order, invoice and warranty forms. All nondisclosure or noncompetition agreements to which the company is a party. All other material contracts. K. Product or Service Lines. A list of all existing products or services and products or services under development. Copies of all correspondence and reports related to any regulatory approvals or disapprovals of any company's products or services. A summary of all complaints or warranty claims. A summary of results of all tests, evaluations, studies, surveys, and other data regarding existing products or services and products or services under development. L. Customer Information. A schedule of the company's twelve largest customers in terms of sales thereto and a description of sales thereto over a period of two years. Any supply or service agreements. A description or copy of the company's purchasing policies. A description or copy of the company's credit policy. A list and explanation for any major customers lost over the last two years. All surveys and market research reports relevant to the company or its products or services. The company's current advertising programs, marketing plans and budgets, and printed marketing materials. A description of the company's major competitors. M. Litigation. A schedule of all pending litigation. A description of any threatened litigation. Copies of insurance policies possibly providing coverage as to pending or threatened litigation. Documents relating to any injunctions, consent decrees, or settlements to which the

9 9 company is a party. N. Insurance Coverage. A schedule and copies of the company's public liability, personal and real property, product liability, errors and omissions, key-man, directors and officers, worker's compensation, and other insurance. A schedule of the company's insurance claims history for past three years. O. Professionals. A schedule of all law firms, accounting firms, consulting firms, and similar professionals engaged by the company during past five years. P. Articles and Publicity. Copies of all articles and press releases relating to the company within the past three years. 2.4 Business Valuation The principles of valuing a business and components of a business are well established. The seller wants to get as much as possible, the buyer wants to pay as little as possible, and the value lies somewhere in between. Business valuation methods are different in today s market place depending upon size, profitability and nature of the business. However there are five generally accepted methods for business valuation. Ultimately, the ultimate goal for business valuation is value the future maintainable profits of a business. Price / Earnings method The capitalisation of future maintainable profits method is the most common way of valuing an existing business in good order, as it usually aligns reasonably well with the expectations of potential purchasers. This involves multiplying an estimate of future maintainable earnings by the capitalisation rate. The capitalisation rate differs between industries and businesses and is usually expressed as a multiple of price / earnings ratio (PE). EBIT method This is the most common method of valuing private businesses worth around $2 million and above. Relatively few add-backs are made to the book profit when valuing a large business. Interest is added back and depreciation in some cases. Owner s wages not added back (but may be adjusted to bring them in line with commercial rates) as these businesses are valued as running under management. EBIT earnings before interest and tax EBITDA earnings before interest, tax, depreciation and amortisation.

10 10 The EBIT figure is used in valuation calculations, although the EBITDA can be used. The EBIT method is simply calculated by the following formula: Value of business = EBIT EBIT multiple For example, if the EBIT is $2.5 million and the multiple is four, the value is $10 million. This is the value of the business assets comprising stock, plant & equipments and goodwill. Debtors and creditors are not usually included. It is becoming increasingly common for the purchaser to buy the entire company by way of purchase of the shares in the company. In this case, the final price is adjusted to reflect the other items on the balance sheet, including debtors, creditors, accruals for staff entitlements and perhaps company debt. The EBIT multiple to be applied to value a business can vary from around two up to around six, and sometimes higher, depending upon a number of factors, including: The total EBIT figure (the higher the EBIT figure, the higher the multiple) The quality of the management team Stability of sales and profits The type of industry Barriers to entry The ability of the business to generate profits without the owner s involvement Growth potential Market dominance. Discounted cash flow method This method is based on the concept that the value of a business depends on the future net cash flow of the business discounted back to present value at an appropriate discount rate. The discounted cash flow method is usually used to value new or immature businesses or a business in which there is considerable variation in income or expenditure expectations. This discount rate increases with the level of risk and the estimated time taken for the business to reach maintainable earnings. It could also be used where small or medium company has long term contracts for the supply of goods and services or where the company has a history of regular cash flows. Asset valuation method Under-performing businesses are valued according to the asset valuation method. There is no goodwill component and the value of the business is derived solely from the value of the plant and equipment (usually at current market price) and inventory.

11 11 This method is used when other valuation methods give a value that is less than the net tangible assets of a business. This is based on the concept that a business owner is highly unlikely to sell his business less than he can receive by way of an ordinary disposal of the business assets. Inventory is valued at invoice cost, but may be discounted depending upon the amount of slowmoving or obsolete stocks. Return on Investment (ROI) method This is the most common method applicable to value businesses worth up to about $2 million. It reflects the percentage returns to an owner on his capital investment in the business. The net profit used in the calculation is not the same as shown on the Profit & Loss Statement. A number of adjustments and add-back are made to the P & L statement to reflect the return to an owner and to add back non-business expenses and one-off expenses. For further information please contact our team: Website: info@quantumhouse.com.au Phone: Fax: Disclaimer: Although the views expressed in this document represent the general views of Quantum Business House, readers must rely on their own professional advice in respect of specific circumstances.