businessduediligencechecklist

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How To Investigate Any Business Opportunity

Buying And Selling Businesses

For Maximum Profits

How To Investigate And Structure The Transaction, Negotiation and

Settlement of Any Business Opportunity

Introduction

The decision to buy or sell a business requires careful consideration of the many factors involved. If

you are a seller, these factors include preparing your business for sale and finding buyers. If you are

a buyer, they include pricing and financing your purchase.

This report presents due diligence guidelines for buying and selling a business and the various factors

as well as the necessary procedures for structuring transactions, negotiations and settlements

Following this report’s recommendations will assist you in alleviating excessive potential risks in-

volved in these types of transactions and help you maximize your profits. Knowledge is power.

But remember that investigating a business opportunity involves a team effort. Your accountant and

attorney will have roles to play, but your own understanding of the ways business interests are trans-

ferred will make your decisions informed and intelligent.

You, of course, are responsible for the decision to ultimately buy or sell. Your advisors can only rec-

ommend a course of action, not take it for you.

So let’s maximize your profits when selling or buying a business starting right now!

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How To Investigate Any Business Opportunity

1. Making The Decision To Buy Or To Sell A Business

The Decision to Sell

Business owners choose to sell for a variety of reasons:

Retirement.

Partnership dispute.

Diminished interest in the business due to boredom or frustration.

Illness or death of one of the principals.

Sales and earnings have plateaued because the company lacks the working capital or manage-

ment resources to grow.

Losing money.

Selling a business is different than selling any other asset one owns, because a business is more than

an income earning asset. It is a lifestyle as well. Therefore, the decision to part with it can be emotional.

Personal ambitions should be weighed against economic consequences to achieve a properly balanced

decision to sell or not to sell.

It is said that timing is everything, and certainly that old axiom is true as applied to the decision to sell a

business. Intelligent business owners carefully plan out the decision to sell. They recognize that a busi-

ness should be sold only after proper preparation and not because of sudden personal frustration or a

short-term downturn in business.

The Decision to Buy

It is imperative that a potential business buyer carefully think through his motives for considering the pur-

chase of a business and his criteria in selecting one. A buyer should consider his experience - both vo-

cational and avocational - what he is good at and what he enjoys. If a buyer is interested in a business

that has a product or service that is outside his area of expertise, then he should make certain that key

employees will stay on after the change in ownership or that similar expertise can be hired.

It is equally important that a buyer identify the desired location's and the amount of money willing to be

invested. If the money to be used is not in liquid form, the buyer should assess what the realistic possi-

bilities are of obtaining the funds from outside sources. One should also decide on the size of the busi-

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How To Investigate Any Business Opportunity

ness in terms of sales, profits, and the number of employees.

It is important to determine if the desired business is to be one that is profitable and stable or one that is

losing money and in need of new management. The more profitable and stable a business, the more it is

likely to cost.

2. Preparing The Business For Sale

Nearly every privately-held business is operated in a manner that minimizes the seller's tax liability. Un-

fortunately, the same operating techniques and accounting practices that minimize tax liability also mini-

mize the value of a business. As a result, there is often a conflict between running a business the way

an owner wants and preparing the business for sale. Although it is possible to reconstruct financial state-

ments to reflect the actual operating performance of the business, this process may also put the owner

in a position of having to pay back income taxes and penalties. Therefore, plans to sell a business

should be made years in advance of the actual sale. This will permit the time required to make neces-

sary changes in accounting practices that demonstrate a 3 to 5 year track record of maximum profits.

Audited statements are the best type of financial statements because they are most easily verified by

the buyer. However, it is not uncommon for a business's financial statements to be reviewed or com-

piled. Good financial statements don't eliminate the need for making the business esthetically pleasing.

The business should be clean, the inventory current, and the equipment in good working order.

Next, a valuation report should be prepared. The valuation report eliminates guesswork and the painful

trial and error method of pricing that so many owners rely on. Finally, a business presentation package

should be prepared. All facets of the business should be addressed in this document. They include:

A history of the business.

A description of how the business operates.

A description of the facilities.

A discussion of suppliers.

A review of marketing practices.

A description of the competition.

A review of personnel including an organizational chart, description of job responsibilities, rates

of pay, and willingness of key employees to stay on after the sale.

Identification of the owners.

Explanation of insurance coverage's.

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How To Investigate Any Business Opportunity

Discussion of any pending legal matters or contingent liabilities.

A compendium of 3 to 5 years' financial statements.

3. Finding Buyers And Sellers

The first step is to find a business to buy or find a buyer for the business.

Print Advertising

Business opportunity classified ads are a viable way to advertise a business for sale. Many ads are

placed by intermediaries (business brokers or merger and acquisition specialists), but some are placed

directly by business owners. The larger local newspapers are the best source of such ads for smaller,

privately-held businesses. Sundays are generally the most popular days for these ads.

Business opportunity ads, whether for small or large businesses, usually describe the business in sev-

eral short phrases, keeping its identity anonymous, and list a phone number to call or post office box for

reply. The ad should be worded to demonstrate the business's best qualities, (both financial and non-

financial) and many include a qualifying statement describing the kind of cash investment or experience

required. A telephone number in the ad will draw more responses than a post office box number, but

may not permit the anonymity of a post office box.

Trade Sources

Trade sources can be a viable source of information on businesses for sale. Key people within an indus-

try or in companies on the periphery of the industry, such as suppliers, often know when businesses

come up for sale and may be aware of potential buyers. Every industry has a trade association and

trade association publications can do a good job of communicating the sale of a business in their indus-

try. If a seller thinks a buyer is likely to come from the same industry, the trade association's publications

department should be contacted to see if classified advertising is permitted.

Intermediaries

Business opportunity intermediaries generally can be divided into two groups: ) business brokers and 2)

merger and acquisition specialists. The differences between these two groups are subtle, but in general,

business brokers primarily handle the smaller businesses, and merger and acquisition specialists handle

the larger middle-market companies. Both groups usually ask for a contract with a 180 day or more ex-

clusive right to sell the business.

Business brokers charge a fee usually as a percent of the purchase price. Merger and acquisition spe-

cialists also charge fees, although often the fee is well under 10% since the transactions they work on

are much larger. Often, a good merger and acquisition specialist receives a portion of the fee in ad-

vance, paid as either a flat fee or an hourly fee. In exchange, the intermediary performs some tangible

service such as preparing a presentation package for prospective buyers and a valuation report. Al-

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How To Investigate Any Business Opportunity

though it is sometimes paid by the buyer, it is more common for the seller to pay the intermediary's fee.

An experienced intermediary can offer assistance in (1) pricing the business, (2) setting the terms, (3)

compiling a comprehensive presentation package, (4) professionally marketing the business, (5) screen-

ing potential buyers, (6) negotiating and evaluating offers, (7) making certain that proper legal steps are

taken. The result can be a considerable saving of the business owner's or business buyer's time and ef-

fort.

4. Evaluating The Business

The first step a buyer must take in evaluating a business for sale is that of reviewing its history and the

way it operates. It is important to learn how the business was started, how its mission may have

changed since its inception and what past events have occurred to shape its current form. A buyer

should understand the business's methods of acquiring and serving its customers and how the functions

of sales, marketing, finance and operations interrelate. General information about the industry can be

obtained from trade associations.

The business's financial statements, operating documents, and practices should be reviewed. A sum-

mary of the items to be reviewed follows.

Balance Sheet

Accounts Receivable

1. Obtain an accounts receivable aging schedule and determine if there is concentration among a few

accounts.

2. Determine the reasons for all overdue accounts.

3. Find out if any amounts are in dispute.

4. Are any of the accounts pledged as collateral?

5. Is the reserve for bad debt sufficient and how was it established?

6. Review the business's credit policy.

Inventory

1. Make sure the inventory is determined by physical count and divided by finished goods, work in pro-

gress and raw materials.

2. Assess the method of valuation and why it was used. (LIFO, FIFO, etc.).

3. Determine the age and condition of the inventory.

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4. How is damaged or obsolete inventory valued?

5. Is the amount of inventory sufficient to operate efficiently and for how long?

6. Should an appraisal be obtained?

Marketable Securities

1. Obtain a list of marketable securities.

2. How are the securities valued?

3. Determine the fair market value of the securities.

4. Are any securities restricted or pledged?

5. Should the portfolio be sold or exchanged?

Real Estate

1. Obtain a schedule of real estate owned.

2. Determine the condition and age of the real estate.

3. Establish the fair market value of each of the buildings and land.

4. Should appraisals be obtained?

5. Are repairs or improvements required?

6. Are maintenance costs reasonable?

7. Do any of the principals have a financial interest in the company's) that performs) the maintenance?

8. Is the real estate required to operate the business efficiently?

9. How is the real estate financed?

10. Are the mortgages assumable?

11. Will additional real estate be required in the near future?

12. Is the real estate adequately insured?

Machinery and Equipment

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How To Investigate Any Business Opportunity

1. Obtain a schedule of machinery and equipment owned and leased.

2. Determine the condition and age of the machinery and equipment and the frequency of maintenance.

3. Identify the equipment and machinery that is state-of-the-art.

4. Identify the machinery and equipment that is obsolete.

5. Should an appraisal be obtained?

6. Will immediate repairs be required and at what cost?

Accounts Payable

1. Obtain a schedule of accounts payable and determine if there is concentration among a few accounts.

2. Determine the age of the amounts due.

3. Identify all amounts in dispute and determine the reason.

4. Review transactions to determine undisclosed and contingent liabilities.

Accrued Liabilities

1. Obtain a schedule of accrued liabilities.

2. Determine the accounting treatment of:

-unpaid wages at the end of the period

-accrued vacation pay

-accrued sick leave

-payroll taxes due and payable

-accrued income taxes

-other accruals

3. Search for unrecorded accrued liabilities

Notes Payable and Mortgages Payable

1. Obtain a schedule of notes payable and mortgages payable.

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How To Investigate Any Business Opportunity

2. Identify the reason for indebtedness.

3. Determine terms and payment schedule.

4. Will the acquisition accelerate the note or mortgage or is there a prepayment penalty?

5. Determine if there are any balloon payments to be made and the amounts and dates due.

6. Are the notes or mortgages assumable?

Income Statement

The potential earning power of the business should be analyzed by reviewing profit and loss statements

for the past 3 to 5 years. The business's earning power is a function of more than bottom line profits or

losses. The owner's salary and fringe benefits, non-cash expenses, and nonrecurring expenses should

also be calculated.

Financial Ratios

While analyzing the balance sheet and the income statement, sales and operating ratios should be cal-

culated in order to point out areas requiring further study. Key ratios are the current ratio, quick ratio, ac-

counts receivable turnover, inventory turnover and sales/accounts receivable. The significance of these

ratios, the methods for calculating them, and industry averages are available through Dun & Bradstreet

and Robert Morris Associates. Look for trends in the ratios over the past 3 to 5 years.

Leases

1. What is the remaining term of the lease?

2. Are there any option periods, and if so, is the option exercised only by the choice of the tenant?

3. Is there a percent of sales clause?

4. What additional fees (such as a common area maintenance or merchants association dues) are paid

over and above the base rent?

5. Is the tenant or landlord responsible for maintaining the roof and the heating and air conditioning sys-

tem?

6. Is there a periodic rent increase called for to adjust the rent for changes in the consumer price index

or for an increase in real estate tax assessments?

7. Is there a demolition clause?

8. Under what terms and conditions will the landlord permit an assumption or extension of the existing

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How To Investigate Any Business Opportunity

lease?

Personnel

1. What are the job responsibilities, rates of pay, and benefits of each employee?

2. What is each employee's tenure?

3. What is the level of each employee's skill in their position and are they employed under an employ-

ment contract?

4. Will key employees stay after the business is purchased?

5. Are any employees part of a union, or is any union organizing effort likely?

Marketing

1. Are any of the products proprietary?

2. Describe any new upcoming products and projected sales.

3. What is the business's geographic market area?

4. What is the business's percentage of market share?

5. What are the business's competitive advantages?

6. What are the business's annual marketing expenditures?

Patents

A list of trade names, trademarks, logos, copyrights and patents should be obtained, noting the period of

time remaining before each expires.

Taxes

1. Are all tax payments current?

2. What was the date and the outcome of the last tax audit?

Legal issues

1. Are there any suits now or soon to commence?

2. What government registration requirements and regulations must be met and are they currently being

met?

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How To Investigate Any Business Opportunity

3. Are all local zoning requirements being met?

4. Review the articles of incorporation, minute books, bylaws, and/or partnership agreements.

5. What are the classes of stock and the restrictions of each, if any?

6. Has any stock been canceled or repurchased?

7. Is the business a franchise? If so, review the franchise agreement.

Competitors

1. Who are the business's competitors?

2. What is their market share?

3. What are each competitor's competitive advantages and disadvantages?

All the factors identified in this section on evaluating a business have to be carefully scrutinized and

weighed. Some factors will have a positive influence on the decision to buy. Others will have a negative

influence. Seek out professional assistance if help is needed in interpreting the significance of the infor-

mation. The important thing is to obtain all the information needed to make a decision. In most in-

stances, all of the business records should be made available to the buyer. In some cases however, cer-

tain information may be withheld until a bona fide offer, contingent upon obtaining that information, has

been made. If important information is unreasonably withheld, the likelihood of making the transaction

work diminishes.

5. Financing The Purchase

A buyer's source of financing depends in part on the size of the business being purchased. The vast ma-

jority of businesses (and particularly the smaller businesses) are purchased with a significant portion of

the purchase price financed by the owner. The buyer, however, still must make a down payment and be

sure that adequate working capital sources are available.

If the funds needed for the down payment are not readily available, the buyer must look for financing

from an outside source. To grant such financing, an institutional lender is almost certain to require per-

sonal collateral for the loan as well as a compendium of financial and operating data of the business to

be acquired. It is rare indeed to be granted a loan to purchase a smaller, privately-held business when

the loan is secured only by the assets of the business. The most attractive types of personal collateral

from the lender's point of view are real estate, marketable securities and cash value of life insurance. In

addition to personal collateral, it must also be demonstrated to the lender that the buyer is of good char-

acter, has a clear source of repayment, and has a good business plan. The most common sources for

such loans are financial institutions such as banks.

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The chances of obtaining outside financing improve as the size of the business being acquired in-

creases. Not only does the willingness of the lender to participate in the transaction increase, the num-

ber of potential lenders increases as well. Banks, insurance companies, commercial finance companies

and venture capital companies all may be interested in lending money for an acquisition of some size.

Again, the borrower must be of good character, have a clear source of repayment and have a good busi-

ness plan.

Lenders for larger transactions may or may not require personal collateral from the purchaser; however,

they will require a personal guarantee. Collateral for larger loans generally will consist of a first lien secu-

rity interest in the tangible assets of the business such as accounts receivable, inventory, equipment and

real estate. The lender will set loan conditions and restrictions regarding certain activities of the busi-

ness. In the case of insurance companies and venture capitalists, the lender may insist on an equity po-

sition in the business and a role in major management decisions. Commercial finance companies make

loans on much the same basis as banks. While the interest rate such companies charge is usually

higher than that charged by a bank, they are often willing to take more risk.

It is rare for a privately-held business to be acquired without leveraging the business's assets in some

manner, pledging them as collateral for a loan made either by the owner of the business or an outside

lender. The owner has a strong incentive to provide financing if he feels it is necessary to get the price

he wants for the business and has confidence in the buyer. An outside lender must be convinced that

the loan's risk of failure is minimal and represents a profitable transaction. Institutional lenders are gen-

erally conservative and concentrate rate primarily on repayment. To obtain outside financing it is impor-

tant to be well prepared and have the information that a lender needs to make a decision.

6. Pricing the Business

Determining the value of a business is the part of the buy-sell transaction most fraught with potential for

differences of opinion. buyers and sellers usually do not share the same perspective. Each has a distinct

rationale, and that rationale may be based on logic or emotion.

The buyer may believe that the purchase will create synergy or an economy of scale because of the way

the business will be operated under new ownership. The buyer may also see the business as an espe-

cially good lifestyle fit. These factors are likely to increase the amount of money a buyer is willing to pay

for a business. The seller may have a greater than normal desire to sell due to financial difficulties or the

death or illness of the owner or a member of the owner's family.

For the transaction to come to conclusion, both parties must be satisfied with the price and be able to

understand how it was determined.

Factors That Determine Value

The topic of business evaluation is so complex that any explanation short of an entire book does not do

it justice. The process takes into account many, many variables and requires that a number of assump-

tions be made. Shannon Pratt, a noted business valuation expert, names six of the most important fac-

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tors:

Recent profit history.

General condition of the company (such as condition of facilities, completeness and accuracy of

books and records, morale and so on).

Market demand for the particular type of business.

Economic conditions (especially cost and availability of capital and any economic factors that

directly affect the business).

Ability to transfer goodwill or other intangible values to a new owner.

Future profit potential.

The six factors named above determine the fair market value. However, businesses rarely change

hands at fair market value. The reason is that three other factors often come into play in arriving at an

agreed upon price. Pratt identifies them as follows:

Special circumstances of the particular buyer and seller.

Tradeoff between cash and terms.

Relative tax consequences for the buyer and seller, which depend on how the transaction is

structured.

The definition of fair market value is the price at which property would change hands between a willing

buyer and a willing seller, both being adequately informed of all material facts and neither being com-

pelled to buy or to sell. In the market place, buyer and seller are nearly always acting under different lev-

els of compulsion.

Rule-of-Thumb Formulas

The rule for using rule-of-thumb formulas for pricing a business is don't use them. The problem with rule-

of thumb formulas is that they address few of the factors that impact a business's value. They rely on a

"one size fits all" approach when, in fact, no two businesses are identical.

Rule-of-thumb formulas do, however, provide a quick means of establishing whether a price for a certain

business is "in the ballpark." Formulas exist for many businesses. They are normally calculated as a per-

centage of either sales or asset values, or a combination of both.

Comparables

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Using comparable sales as a means of valuing a business has the same inherent flaw as rule-of-thumb

formulas. Rarely if ever are two businesses truly comparable. However, businesses in the same industry

do have some characteristics in common, and a careful contrasting may allow a conclusion to be drawn

about a range of value.

Balance Sheet Methods of Valuation

This approach calls for the assets of the business to be valued. It is most often used when the business

being valued generates earnings primarily from its assets rather than the contributions of its employees

or when the cost of starting a business and getting revenues past the break-even point doesn't greatly

exceed the value of the business's assets.

There are a number of balance sheet methods of valuation including book value, adjusted book value,

and liquidation value. Each has its proper application. The most useful balance sheet method is the ad-

justed book value method. This method calls for the adjustment of each asset's book value to equal the

cost of replacing that asset in its current condition. The total of the adjusted asset values is then offset

against the sum of the liabilities to arrive at the adjusted book value.

Adjustments are frequently made to the book values of the following items:

Accounts Receivable - often adjusted down to reflect the lack of collectability of some receivables.

Inventory - usually adjusted down since it may be difficult to sell off all of the inventory at cost.

Real Estate - frequently adjusted up since it has often appreciated in value since it was placed in ser-

vice.

Furniture, Fixtures, and Equipment - adjusted up if those items in service (probably more than a few

years) have been depreciated below their market value, or adjusted down if the items have become ob-

solete.

Income Statement Methods of Valuation

Although a balance sheet formula is sometimes the most accurate means to value a business, it is more

common to use an income statement method. Income statement methods are most concerned with the

profits or cash flow produced by the business's assets. One of the more frequently used methods is the

discounted future cash flow method. This method calls for the future cash flows (before taxes and before

debt service) of the business to be calculated using the 4-step formula below.

Step #1

The historical cash flows are a good basis from which to project future cash flows. Cash flows are com-

puted to include the following:

1. The net profit or loss of the business.

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How To Investigate Any Business Opportunity

2. The owner's salary (in excess of an equivalent manager's compensation).

3. Discretionary Benefits paid the owner (such as automobile allowance, travel expenses, personal in-

surance and entertainment).

4. Interest (unless the buyer will be assuming the interest payment).

5. Non-Recurring Expenses (such as non-recurring legal fees).

6. Non-Cash Expenses (such as depreciation and amortization).

7. Equipment Replacements or Additions. (This figure should be deducted from the other numbers since

it represents an expense the buyer will incur in generating future cash flows).

While the future cash flows may be projected out for a number of years, for many small businesses it is

not possible to predict very far into the future before the projections become meaningless. Even with

somewhat larger and more substantial businesses, it is difficult to project cash flows for more than 5

years.

Step #2

Once the future cash flows have been projected, they must be discounted back to their present value.

This is done by selecting a reasonable rate of return or capitalization rate for the buyer's investment. The

selected rate of return varies substantially from one business to the next and is largely a function of risk.

The lower the risk associated with an investment in a business, the lower the rate of return that is re-

quired. The rate of return required is usually in the 20-50% range and, for most businesses, it is in the

30-40% range. The present value of the future cash flows can then be determined by using a financial

calculator or a set of present value tables that are available in most book stores. The following example

demonstrates how the conversion is made with a 40% rate of return.

Year Projected Discount Present

Cash Flow Factor * Value

Year 1 $360 .714 $257

Year 2 $383 .510 $195

Year 3 $397 .364 $145

Year 4 $413 .260 $107

Year 5 $438 .186 $ 81

_____

$785 Total**

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* -Based on 40% rate of return. The discount factor declines in each succeeding year.

* * - Present value of the sum of discounted projected cash flows. This figure is added to the residual

value of the business to arrive at the total value of the business.

Step #3

One more calculation must now be done - the residual value of the business. The residual value is the

present value of the business's estimated net worth at the end of the period of projected cash flows (in

this example, at the end of five years). This is calculated by adding the current net worth of the business

and future annual additions to the net worth. The annual additions are defined as the sum of each year's

after-tax earnings, assuming no dividends are paid to stockholders. These additions are added to the

current net worth, and that total is discounted to its present value to yield the residual value.

Step #4

The residual value is added to the present value sum of the projected future cash flows previously com-

puted to arrive at a price for the business. An example follows.

After Tax Income

Year 1 $125

Year 2 $131

Year 3 $138

Year 4 $144

Year 5 $152

______

Total Additions to net worth $690

Current net worth $910

______

Total net worth $1600

Residual Value (1600 x.186) $298* * *

*** - Multiplying the total net worth by the discount factor used in the final year of projected cash flows

yields the residual value. Adding the residual value of $298 to the present value sum of projected cash

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How To Investigate Any Business Opportunity

flows of $785 yields a value for the business of $1,083.

Although this formula is widely used, it cannot be applied in this simplistic form to arrive at a definitive

value conclusion. It fails to address issues such as the buyer's working capital investment, the terms of

the transaction, or the valuing of assets like real estate which may not be needed to produce the pro-

jected cash flows. However, it is useful in establishing a price range for negotiation purposes.

7. The Role of Advisors

A variety of resources are available for those buyers and sellers wanting to obtain professional advice.

These resources include business owners in the industry, industry consultants, professional intermediar-

ies, business valuation experts, accountants and attorneys. Each of these resources can be of assis-

tance and each has its limitations Business owners, consultants, and intermediaries are the best source

of industry information and operating suggestions. Business owners may be able to give free advice,

and they are often the best source of information. No one knows more about an industry than someone

who is successfully running a business in that industry, Business valuation experts can independently

appraise a business's value. Bear in mind, however, that they rely on the representations of the seller.

They render a conditional opinion based on the assumption that the financial statements are accurate

and complete. They will attempt to independently verify only certain information.

Accountants are best used to perform an audit (if one is needed), help interpret financial statements, or

provide advice in structuring the transaction to minimize tax consequences for the buyer and seller.

Probably the most often consulted advisor in the purchase or sale of a business is an attorney. Attor-

neys are asked to do everything from assessing the viability of a business and appraising its value to

negotiating the purchase price and preparing the necessary documents. Attorneys, however, cannot as-

sess the viability of a business undertaking. That is something only the buyer and seller can do. Attor-

neys also generally cannot value a business, but they can occasionally help negotiate a price between

buyer and seller. The involvement of an attorney (or any individual other than the principals) can, how-

ever, strain the lines of communication between buyer and seller, so they should be allowed into the ne-

gotiation process only after careful consideration.

The primary function of an attorney is to prepare the purchase and sale documents as negotiated by the

parties. It should include reasonable and balanced protections for both parties. Experience and reputa-

tion are important criteria when selecting an attorney. The attorney chosen should have experience han-

dling similar transactions. It may make sense to choose one attorney

to represent both buyer and seller. This avoids the adversarial relationship that opposing attorneys often

adopt and improves the odds of successfully completing the transaction. It also eliminates some of the

emotion in the negotiation process, improves the lines of communication between the parties, expedites

completion of the deal and is less expensive.

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8. Structuring the Transaction

Tax and other consequences of the structure of a transaction have an important effect on the overall

value of the transaction to the principals. Each type of structure carries with it different tax conse-

quences for the buyer and seller. The type of corporation owned by the seller, the size and date of the

transaction, and the type of consideration paid may all have a bearing on the tax consequences. Since

tax law is constantly changing, it is important to seek legal and tax advice in determining the best way to

structure the purchase or sale.

Asset Versus Stock transactions

The purchase and sale of a business can be structured in either of two basic formats: (1) the purchase

of the stock of the seller's corporation, or (2) the purchase of the assets of the seller's business.

Asset transactions - In an asset transaction, the assets to be acquired are specified in the contract.

Practices vary from industry to industry but, in general, all the assets of the business except cash and

accounts receivable and none of the liabilities of the business convey to the buyer. The seller uses the

proceeds from the sale to liquidate all short term and long term liabilities. This means that the buyer pur-

chases all of the business's equipment, furniture, fixtures, inventory, trademarks, trade names, goodwill

and other intangible assets.

An asset transaction generally favors the buyer. The buyer acquires a new cost basis in the assets

which may allow a larger depreciation deduction to be taken. The seller must pay taxes on the difference

between his basis in the assets and the price paid by the buyer for the business.

The buyer may also prefer an asset transaction for liability reasons. By purchasing assets, the buyer

may avoid the possibility of becoming liable for any of the seller's corporation's undisclosed or unknown

liabilities. The most common liabilities of this type are income taxes, payroll withholding taxes and legal

actions.

Stock transactions - Stock transactions generally call for all of the assets and liabilities of the seller's

corporation and the stock of the corporation to be transferred to the buyer. In some cases, the buyer and

seller may choose to exclude certain assets or liabilities from being conveyed. The seller must pay taxes

on the difference between the seller's basis in the stock and the price paid by the buyer for the stock.

Sometimes stock deals are more expedient for both parties. Stock transactions provide for continuity in

relationships with suppliers. They also preclude the necessity of obtaining a lease assignment when the

lease is held only in the name of the corporation and when there is no provision in the lease calling for

an assignment in the event of a change in the controlling interest of the corporation. The risk of inheriting

undisclosed debts of the seller in a stock transaction can be minimized by providing for the right of offset

to future payments due the seller.

Installment Sales

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It is rare for a privately-held business to change hands for an all-cash price. Almost all transactions are

structured as installment contracts which provide for the seller to receive some cash, but for the bulk of

the purchase price to be owner financed. For smaller privately held businesses, the down payment often

ranges from 10% to 40% of the selling price and the buyer executes a promissory note (secured by the

assets of the business only) for the balance. Such notes are typically for a period of 3-15 years at an in-

terest rate that varies with the prime rate.

Leveraged Buyouts

Just as in an installment sale, a leveraged buyout uses the assets of the business to collateralize a loan

to buy the business. The difference is that the buyer in a leveraged buyout typically invests little or no

money, and the loan is obtained from a lending institution.

This type of purchase is best suited to asset rich businesses. A business that lacks the assets needed

for a completely leveraged buyout may be able to put together a partially leveraged buyout. In this struc-

ture, the seller finances part of the transaction and is secured by a second lien security interest in the

assets. Because leveraged buyouts place a greater debt burden on the company than do other types of

financing, buyer and seller must take a close look at the business's ability to service the debt.

Earn-Outs

An earn-out is a method of paying for a business that helps bridge the gap between the positions of the

buyer and seller with respect to price. An earn-out can be calculated as a percentage of sales, gross

profit, net profit or other figure. It is not uncommon to establish a floor or ceiling for the earn-out.

Earn-outs do not preclude the payment of a portion of the purchase price in cash or installment notes.

Rather, they are normally paid in addition to other forms of payment. Because the payment of money to

the seller under the provisions of the earn-out is predicated on the performance of the business, it is im-

portant that the seller continue to operate the business through the period of the earn-out.

Stock Exchanges

In some instances a business owner may want to accept the stock of a purchasing corporation in pay-

ment for the business. Typically, the stock he receives (if it is the stock of a publicly-held company) may

not be resold for two years. If the stock may not be freely traded, it is not as valuable as freely traded

stock, and its value should be discounted to allow for this lack of marketability.

There is an advantage to the seller in this kind of transaction. Taxes incurred by the seller on the gain

from the sale of the business are deferred until the acquired stock is eventually sold. There are several

tests that must be met to qualify for this tax treatment. Check with a competent accountant or tax attor-

ney.

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9. Negotiation Tactics

The art of negotiation plays an important role in buying or selling a business. Differences of opinion are

inherent in the negotiation process and only realistic negotiators can find creative solutions to such dif-

ferences.

Businesses change hands most easily when the parties assume a non-adversarial posture. It is impera-

tive that the parties know the issues that are important to one another. Each should understand the

other's position on these issues.

Price is just one aspect of the transaction to be negotiated. Terms are just as important, particularly the

period of time over which the debt is to be repaid and the allocation for tax purposes of the purchase

price.

Sellers naturally have the upper hand in negotiations since they best know the business. A seller should

make full use of that advantage. A buyer should minimize the seller's advantage by learning as much as

possible about the business. The section in this guide entitled "Evaluating the Business" identifies the

key areas to be studied.

It is important to do more than study the business to prepare for negotiations. The parties must both un-

derstand each other's motivation for wanting to buy or sell the business, and each other's plans after

transition takes place. They must also understand why the other party has taken a certain position on an

issue.

Developing a working strategy means each party must not only know the other's position, they must de-

velop their own position as well. They should prepare in writing a list of reasons that validate their posi-

tion. They should also think through possible weaknesses in their reasoning. In this way, each can an-

ticipate and respond to the objections the other party may raise.

Buyers should request that the seller not negotiate with other buyers while the specifics of the offer are

being negotiated. Sellers, on the other hand, are advantaged when they can negotiate with more than

one buyer at a time. The most important thing in negotiations is to be able to see things from the other

party's perspective.

This eliminates much of the difficulty of reaching agreement and keeps the parties from wasting time.

10. Making And Evaluating Offers

Making the Offer

Before making an offer, a buyer will typically investigate a number of businesses. At some point in the

investigation process, it may be necessary to sign a confidentiality agreement and show the seller a per-

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sonal financial statement. A confidentiality agreement pledges that the buyer will not divulge any infor-

mation about the business to anyone other than immediate advisors.

A buyer should determine a range of value for the business. An appraisal of the business as is can be

used to establish a pricing floor. A pricing ceiling can be established by using an appraisal that capital-

izes projected future cash flows under new management.

A buyer should have access to all records needed to prepare an offer. If some information is lacking, the

buyer must make a decision to either discontinue the transaction or make an offer contingent on receiv-

ing and approving the withheld information. The nature and amount of withheld information determines

which course of action to take.

An offer may take the form of a purchase and sale agreement or a letter of intent. Purchase and sale

agreements are usually binding on the parties while a letter of intent is often non-binding. The latter is

more often used with larger businesses.

Regardless of which form of the agreement is used, it should contain the following:

Total price to be offered.

Components of the price (amount of security deposit and down payment, amount of bank debt,

amount of seller financed debt).

A list of all liabilities and assets that are being purchased. The minimum amount of accounts re-

ceivable to be collected and the maximum amount of accounts payable to be assumed may be

specified.

The operating condition of equipment at settlement.

The right to offset the purchase price in the amount of any undisclosed liabilities that come due

after settlement and in the amount of any variance in inventory from that stated in the agree-

ment.

A provision that the business will be able to pass all necessary inspections.

Warranties of clear and marketable title, validity and assumability of existing contracts if any, tax

liability limitations, legal liability limitations and other appropriate warranties.

A provision (where appropriate) to make the sale conditional on lease assignment, verification of

financial statements, transfer of licenses, obtaining financing or other provisions.

A provision for any appropriate pro-rations such as rent, utilities, wages and prepaid expenses.

A non-competition covenant. This document is sometimes part of the purchase and sale agree-

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How To Investigate Any Business Opportunity

ment and is sometimes a separate exhibit to the purchase and sale agreement.

Allocation of the purchase price.

Restrictions on how the business is to be operated until settlement.

A date for settlement.

The purchase and sale agreement is a complex document and it is a good idea to get professional help

in its drafting.

Evaluating the Offer

The seller should look for all the same provisions in an offer that were enumerated in the section on

making the offer. The types of offers a seller is likely to receive depend in some measure on the size of

the business. A seller should ask for a resume and financial statement from an individual buyer and an

annual report if the buyer is another company. Find out what attributes the buyer brings. Sometimes, a

buyer with a commitment to the work ethic is all that is needed. In other cases, successful related work

experience may be important. If the acquirer is another company, look for the logic behind the acquisi-

tion. Perhaps some kind of synergy or an economy of scale is created. A buyer should prepare and

show the seller a post-acquisition business plan.

One final note - carefully study offers to determine what assets and liabilities are being purchased. An

offer for the assets of a business may be worth considerably less than an offer for its stock even though

the price offered for the assets is higher.

11. Closing the Transaction

Meeting Conditions of Sale

After buyer and seller have entered into a binding contract, there may be several conditions to be met

before the sale may be closed. Such conditions often address issues like assignment of the lease, verifi-

cation of financial statements, transfer of licenses, or obtaining financing. There is usually a date set for

meeting the conditions of sale. If a condition is not met within the specified time frame, the agreement is

invalidated.

Types of Settlements

Business settlements or closings, as they are also called, are usually done in one of two ways.

1. An attorney performs settlement. In this procedure, the attorney for the buyer, or an independent

attorney acting on behalf of both buyer and seller, draws up the necessary documents for settlement.

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Buyer and seller meet with the settlement attorney at a predetermined time (after all conditions of sale

have been met). Documents are signed at the meeting by buyer and seller.

A good settlement attorney is also a good problem solver. He can help find creative ways to resolve dif-

ferences of opinion. The settlement attorney holds money in escrow and disburses it when all the appro-

priate documents are signed.

2. Escrow. In an escrow settlement, the money to be deposited, bill of sale and other documents are

placed in the hands of a neutral third party or escrow agent. The escrow agent is usually an escrow

company or the escrow department of a financial institution. Buyer and seller sign escrow instructions

that name the conditions to be met before completion of the sale. Once all conditions are met, the es-

crow agent disburses previously executed documents and disburses funds. There usually is no formal

final meeting at which the signing of the documents takes place. Buyer and seller usually sign them in-

dependently of one another.

A lien search is also performed by the attorney or escrow agent. This determines if any liens against the

business's assets have been filed in the records of the local courthouse.

Documents

A number of documents are required to close a transaction. The purchase and sale agreement is the

basic document from which all the documents used to close the transaction are created. The documents

most often used in closing a transaction are described below. Other documents not described below

may also be needed depending on the particulars of the transaction.

Settlement Sheet: Shows, as of the date of settlement, the various costs and adjustments to be paid by

or credited to each party. It is signed by buyer and seller.

Escrow Agreement: Is used only for escrow settlements. It is a set of instructions signed by buyer and

seller in advance of settlement that sets forth the conditions of escrow, the responsibilities of the escrow

agent, and the requirements to be met for the release of escrowed funds and documents.

Bill of Sale: Describes the physical assets being transferred and identifies the amount of consideration

paid for those assets. It must always be signed by the seller and is often also signed by the buyer.

Promissory Note: Used only in an installment sale, it shows the principal amount and terms of repay-

ment of the debt by the buyer to the seller. It specifies remedies for the seller in the event of default by

the buyer. It is signed by the buyer and the buyer often must personally guarantee the debt.

Security Agreement: Creates the security interest in the assets pledged by the buyer to secure the

promissory note and underlying debt. It also sets forth the terms under which the buyer agrees to oper-

ate those assets which constitute collateral. It is used only in an installment sale. It is signed by both par-

ties.

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Covenant not to compete: Protects the buyer and his investment from immediate competition by the

seller in his market area for a limited amount of time. The scope of this document must be reasonable in

order for it to be legally enforceable. The covenant not to compete is sometimes included as a part of

the purchase and sale agreement and is sometimes written as a separate document. It is signed by both

parties. It is not required in every transaction.

Employment Agreement: Specifies the nature of services to be performed by the seller, the amount of

compensation, the amount of time per week or per month the services are to be performed, the duration

of the agreement and often a method for discontinuing the agreement before its completion. Employ-

ment agreements are not required in all transactions, but they are used with great frequency, It is not

uncommon that the seller remain involved with the business for periods of as little as a week or as much

as several years. The length of time depends on the complexity of the business and the experience of

the buyer. For periods of more than 2-4 weeks, the seller is often compensated for his services. It is

signed by both the buyer and the seller.

Contingent Liabilities

Contingent liabilities must be taken into account and provided for when a business is sold. They most

often occur because of pending tax payments, unresolved lawsuits or anticipated but uncertain costs of

meeting regulatory requirements. Contingent liabilities can be handled by escrowing a portion of the

funds earmarked for disbursement to the seller. The sum escrowed then can be used to pay off the li-

ability as it comes due. Any remaining money can then be disbursed to the seller.

The Buy-Sell Process

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 section is to describe the process of buying and selling a small business and to es-

tablish some guidelines. It will not remove the difficulties, but it will make them more manageable.

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An Overview of the Buy-Sell Process

It will be helpful to take a detailed look at what happens when a business is bought or sold. First, con-

sider some of the thoughts that go through the minds of the buyer and seller during the decision-making

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 transac-

tion ) 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 decision-making.

Case Study of A Potential Deal

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 carryout 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

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How To Investigate Any Business Opportunity

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 announce-

ments, 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 2.5 percent of gross sales including Sam's salary, Bill be-

lieved 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.

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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 11.5 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 percent 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 inven-

tory 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 Regarding Fair Value

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, preset, 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.

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The Flow Of Decisions In a Buy-Sell Transaction

Buyers and sellers both seek answers to the same question: "What Is the business worth?" Most people

see the worth of a business as the total value of equipment and fixtures, inventory, and buildings and

land. Important, certainly, but the sum of these values does not equal the value of the business.

Bill probably paid a fair price for equipment, fixtures, and the like. But did his price of $40,000 reflect the

value of Sam's Market? Obviously not. What, than, is the value of a business?

For both buyer and seller finding the answer to this question is the most difficult and at the same time

the most important step in the buy-sell process. But this final decision reflect many other decisions made

while the transaction is being considered. In other words the buy-sell process is a flow of decisions. It

would be impossible to point out every decision that must be made, but the basic ones are as follows:

Motivation: a decision to attempt the sale or purchase of a business.

Contact: a decision on how to find a buyer (or seller) for a business with specified characteristics.

Information: a decision on What information must be gathered or given to buy or sell a business.

Sources: a decision on how, where, and at what cost the needed information can be obtained.

Analysis: a decision on the meaning, importance, and reliability of the information gathered.

Value: a decision on what the business is worth.

Price: a decision on how much money to take or give for the business.

Financing: a decision on how to pay or receive the purchase price.

Contract: a decision on the form and content of the contractual relation.

implementation: a decision on how and when to effect transfer of ownership.

Motivation Of The Seller

What leads an owner to sell his business? It may be any of a large number of reasons : a personal

health problem, a business disagreement, over-extension of the company's activities, a desire to retire

from business. The possible reasons are many and varied.

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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 exter-

nal 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 exam-

ine 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 hu-

man 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 of-

ten encourages a business owner to spend his time operating instead of managing. Planning for the fu-

ture, 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 abil-

ity.

Can I learn how to manage the business?

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Most people can learn to manage if they recognize the need. This requires room to make mistakes,

however, and the self-discipline to undertake self-improvement pogroms.

Initial Contact Between Buyer and Seller

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 busi-

ness.

From the seller's point of view, the task of finding an interested buyer is the more difficult one, but there

are many avenues to explore other than running advertisements in newspapers. He should ask himself

these questions :

Have I told my employees and other business associates that I intend to sell the business?

Have I taken advantage of the broadcasting ability of sales men who call on businesses similar to mine,

of association meetings, or other trade contacts?

This informal advertising requires the same kind of information more formal advertising does. Business

associates, trade contacts, and friends should be told the asking price, the terms, the anticipated return.

Without this knowledge, a potential buyer can hardly be expected to respond positively. He needs to

know in advance how the offer relates to his financial ability.

From the buyer’s point of view, finding opportunities is relatively easy. The difficulty lies in locating a

business he can analyze confidently. When he deals with unfamiliar firms, he is haunted by a desire for

more information and suspicious about the information he does receive. A buyer seeking a seller should

consider the following points;

Have I asked people I deal with about persons who might be considering selling a business?

Have I considered approaching businesses with which I am familiar about the possibility of a purchase?

Kinds and Sources of Information To Obtain

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.

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How To Investigate Any Business Opportunity

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 de-

cide 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 net income per month ( 3% of $30,000 ) 900

Probable expense :

Payment to bank $265

Payment to Sam 295

Sam's salary ?

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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 opera-

tion.

What happened could have been predicted.

Analysis and Due Diligence

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?

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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?

Valuing A Business Opportunity

A business has a purpose. That purpose is to provide a satisfactory return on the owner's investment.

Consequently, determining value involves measuring the future profit of the business being sold.

A seller often thinks of value as representing the money he has invested through his years of ownership.

A buyer is tempted to consider value as a fair price for tangible items such as equipment and inventory.

These factors are important, but they have value only to the extent that they contribute to future profits.

An owner may have invested $40,000, the tangible assets may have a current worth of $20,000, but it is

the profit potential that establishes the value of the total business.

Assuming that a reliable estimate of future profit is made, how much is to be paid for each dollar of profit

potential? This computation is discussed later in this section, but the general approach is suggested by

the following questions:

What am I buying (or selling)? A business, or a building full of equipment and inventory?

What return would I get if I invested my money elsewhere - in stocks, bonds, or other business opportu-

nities?

What return ought I get from an investment in this business?

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What a Business Is Worth

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 owner-

ship 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 discus-

sions between buyer and seller more significant.

These two points will help bring negotiations about value toward a mutually acceptable price.

Financing The Acquisition

When the price has been settled, the question of how to finance it remains. Financing a buy-sell transac-

tion 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 pur-

chase price but also for

(1) Funds to operate until the business is generating cash,

(2) Funds to meet unexpected expanses, and

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How To Investigate Any Business Opportunity

(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 ques-

tions that must be asked about his capital needs:

Do I have enough capital to pay the purchase price?

Do I have enough capital to support 1 to 3 months' operation - such as payroll and other cash ex-

penses - 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 with-

out any debt financing. An individual may borrow money for the purchase of a business by obtaining a

personal loan, by borrowing against insurance policies, or by re-financing the mortgage on his home.

These debts are not direct debts of the business, but the debts of a small business and the personal

debts of the owner cannot be completely separated. Banks are the principal institutional source of debt

capital for small businesses.

The seller as lender. In the sale and purchase of Sam's Market, the buyer’s savings plus a bank loan

were not enough to finance the purchase. Bill (who needed more financing) and Sam (who wanted to

sell his business) reacted in a manner quite common in the financing of the sale of a small business.

Sam agreed to accept payment of part of the purchase price over an extended period of time.

The seller is sometime a source of capital to the buyer of a small business, as in Bill’s case. A happy cir-

cumstance if it is handled properly. Before jumping at the chance, however, the buyer should ask him-

self these questions:

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How To Investigate Any Business Opportunity

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?

Contracts 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 be-

tween buyer and seller. A "good" contract is meaningless if the earlier steps in the process have been

carried out carelessly or not at all.

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.

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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 in-

vestment.

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 bushiness. 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 bushiness 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 in-

cur if he invested in a small business with a doubtful future.

Financial statements and their analysis and market analysis are discussed elsewhere in this section.

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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 sys-

tematic 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 possi-

ble 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 in-

ternal 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 invest-

ment. 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 econ-

omy 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 mar-

ket 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 than 3, and 10 is better than 5.

Perhaps the simplest method is to assume that the percentage increase (or decrease) in sales will con-

tinue 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 in-

crease at about 4-percent level? Each additional year into the future reduces the certainty of the predic-

tions.

If these negative influences limit the accuracy to such an extent, why try to forecast beyond the immedi-

ate 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

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How To Investigate Any Business Opportunity

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 guaran-

tee that these conditions will carry over into the future with the same relative significance. Nevertheless,

their possible influence should be considered.

Risk and Return on Investment

If a buyer wants to invest money in a business that is being sold, he should be concerned about receiv-

ing 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.

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 as-

sets, Profits are made by utilizing assets, of course, but actually the assets purchased are only inciden-

tal 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

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How To Investigate Any Business Opportunity

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 compensation 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 Government bonds that yields 6 percent, the buyer should be willing

to pay 333,000 ($ 20,000 / 0.06 ). If the investment is considered as safe as an investment in an excel-

lent corporate stock that earns 10 percent in dividends and price increases, the buyer should be willing

to pay $200, 000 ( $ 20,000 / 0.10 ).

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 con-

sidered adequate. This means that the buyer should pay between $80,000 and $100,000 for this busi-

ness. If it earns the projected $20,000 a year, the buyer will recover his initial investment in 4 or 5 years.

This time will be extended by income taxes to be paid on the income, but this would also be the case for

most alternative investments except nontaxable 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 consid-

ered. 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 sup-

plies 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 guaran-

tee should be established.

The assets most commonly purchased in a small business buy-sell transaction are merchandise inven-

tory, 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 concerns

good name, capable staff and personnel, high financial standing, reputation for superior products and

customer services, and favorable location.

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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 com-

puted 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 contri-

butions. 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 consid-

ered 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 capitali-

zation 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 busi-

nesses that are for sale do not have excess profits. They usually show nominal profit or none at all. Of-

ten 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 estab-

lished 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 / 0.10 ). Capitalizing the same excess profits

at 20 percent gives a goodwill value of $20,000 ( $4,000 / 0.20 ).

Though 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 finished goods -

and each of them presents different problems in valuation. The distributive company has only one inven-

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How To Investigate Any Business Opportunity

tory, 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 chose 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 proce-

dures 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 items

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 inven-

tory. 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 team individu-

als 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 re-

corded 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 in-

ventory is taken and priced like the merchandise inventory of a distributive business. The work-in-

progress 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 situa-

tion 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

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How To Investigate Any Business Opportunity

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 costs, 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 ($200 or $300). 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 se-

lected 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 as-

sign values to individual assets rather than to make a lump-sum purchase of assets. In a lump-sum pur-

chase, 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 require-

ments. 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.

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Income Tax Consequences

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 valu-

ing 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 tax laws ; and if an important decision in the buy-sell agreement is to

be based on 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 postpones

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, 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 fi-

nancially able to purchase the business. Rombaugh started the store in the late sixties and has been the

sole owner since than.

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 advertis-

ing, 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 aggres-

sive stores in the community. Sales have continued to increase about in proportion to the market in gen-

eral, but gross margin and profit have been reduced because of lower overall maintained markup and

increasing costs of operation. Rombaugh owns the inventory, fixtures equipment, and operating supplies

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How To Investigate Any Business Opportunity

and leases the building at 5 percent of net sales, with a minimum payment of $ 1,000 a month. The cur-

rent 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 busi-

ness 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 roll-

top 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. Rom-

baugh agrees. Following are the major elements of Critser's investigation and appraisal :

Past sales

XXX1 - $220,000

XXX2 - 228,800

XXX3 - 238,000

XXX4 - 247,600

XXX5 - 257,600

Forecast sales - XXX6

$265,000 - Critser's estimate of sales, which includes a somewhat smaller increase than the average of

3.2 percent per year between XXX1 and XXX5.

$268,676 - Rombaugh's estimate based on the average.

Five-year operating statement

XXX1 XXX2 XXX3 XXX4 XXX5

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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

* Includes owner's salary.

Projected operating statement for XXX6

CRITSER 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

* Includes estimate of owner's salary.

Balance sheet of Regal Men's Store as of January 31, XXX6

Assets

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Cash on hand and in bank $20, 000

Accounts receivable $32, 000

Less estimated un-collectible 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

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James Rombaugh, capital 112, 914

Net worth

________

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

CRITSER 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

________ ________

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Total assets-appraised value $70, 412 $72,194

* Independent appraiser. Excludes assets to be retained by Rombaugh.

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 /

0.20=$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 neces-

sary. 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 manage-

ment?

4. How much confidence does Critser have in his ability to realize an acceptable return on his invest-

ment?

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?

Negotiating The Buy-Sell Contract

The final objection 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 transac-

tion, liabilities, warranties - are matters over which the interests and motivations of the buyer and seller

may be in sharp conflict.

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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 undis-

closed 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

other compromise or capitulation.

Price

The central bargaining issue in the buy-sell transaction is price. Price is what is actually paid for a busi-

ness. 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 bargain-

ing, 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, Crit-

ser 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?

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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 deci-

sion 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 f or 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 un-

able to get outside financing. The price may also be adjusted in order 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 property. 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 business.

Liabilities

A buyer generally refers to purchase assets rather than stock for tax reasons, but his preference be-

comes 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 install-

ment 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 li-

abilities, both existing and potential, are unknown at the time of contracting merely because of inade-

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quate 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 cus-

tomer 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, pat-

ent or trademark infringement, or violations of statutes, and so on. Tax deficiencies may arise out of tax

returns filed but audited at the time of the buy-sell transaction.

The price agreed upon in a stock transaction will, of course, take into consideration only known liabili-

ties. 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

non-assignable 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 con-

tingency 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, assumptions 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 undis-

closed liens?

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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 un-

known 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 cor-

porate stock transaction.

______________

THIS AGREEMENT is made and entered into this 15th day of February, XXX6, between James Rom-

baugh, 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, 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 incorpo-

rated 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 encum-

brances except as hereinafter provided, the men’s clothing store owned and conducted by the Seller un-

der the trade name of "Regal Men's Store" at the premises known as 120 North Main Street, Central

City, including the goodwill as a going concern, the lease to such premises, stock in trade, furniture, fix-

tures, 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 f or 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:

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Lease 0

Goodwill $6, 000

Fixtures and equipment 30, 000

Inventory 47, 400

Supplies 600

_________

$84, 000

( 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 fol-

lowing 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;

each beginning the first day of April, XXX6, together with interest at 6.5 % per annum. Such note shall

contain a provision, satisfactory to the attorney for the Seller, for the acceleration of the balance remain-

ing 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 chat-

tel 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, in-

surance 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 pur-

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How To Investigate Any Business Opportunity

chase 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, XXX6. 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 liabili-

ties 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.

or otherwise, except as and to the extent reflected in the balance sheet of January 31, XXX6.

(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

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shall use its best efforts to keep available to the Buyer the services of its present employees and to pre-

serve 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, XXX6 up until the date of closing. Such record shall be the basis

for adjustment of the purchase price as provided in paragraph 4.

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 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 the 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 owner-

ship. 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 as-

sumes 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 princi-

pal, agent, manager, employee, owner, partner, stockholder, director or officer of a corporation, or other-

wise, engage in any business similar to or in competition with the business hereby sold, within a fifty

mile radius of Central City.

(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 circum-

stances 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

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How To Investigate Any Business Opportunity

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 fu-

ture 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, on March 1, XXX6, at10: 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 non-fulfillment of

the terms of this agreement.

13. Seller's security deposit. As security for the indemnities specified in paragraph 12, the Seller's at-

torney, 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' no-

tice 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 al-

leged 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 sus-

tained 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 secu-

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How To Investigate Any Business Opportunity

rity 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, SeIIer

JOE CRITSER, Buyer

Analyzing the Company's Marketing Performance

Just as important as a study of the market as a whole is a study of the position in that market of the

company under consideration and how well it has performed under existing conditions.

Location

When a brand new business is being opened, the prospective owner has some choice about location. In

buying a going concern, this is seldom possible. The seller is not likely to sell the assets of the firm with

the understanding that the buyer will find other premises. Neither is it likely that the buyer will acquire the

assets and then seek other quarters in which to operate.

Location, then, remains as it is at the time of the buy-sell transaction. The buyer should give careful

thought to the location of the business he is considering, particularly in relation to the market of which it

is a part.

Questions in the Analysis of Location

1. Is there any possibility that the status of this location will change in the foreseeable future?

Urban renewal programs, for example, have a direct effect on business locations as well as on residen-

tial buildings. The buyer should look carefully into the possibility that the area will become a target for

urban development that would require him to vacate the premises. The same investigation should be

made in connection with other forms of development that might cause land condemnation or change of

status highways, flood-control projects, military uses, rezoning, and the like.

2. What specific factors should be examined in determining the desirability of the location?

The following outline suggests points that should be considered in evaluating the location of a retail

store. It can be adapted for use with other types of businesses.

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Checklist for Locating a Store

City or Town

1. Economic considerations:

Industry: Farming, Manufacturing, Trading,

Trend: Highly satisfactory, Growing, Stationary, Declining

Permanency: Old and well established, Old and reviving, New and promising, Recent and un-

certain

Diversification: Many and varied industries, Many of the same type, Few but varied, Dependent

on one industry

Stability: Constant, Satisfactory, Average, Subject to wide fluctuations,

Seasonally: Little or no seasonal change, Mild seasonal change, Periodic - every few years,

Highly seasonal in nature

Future: Very promising, Satisfactory, Uncertain, Poor outlook

2. Population

Income distribution: Mostly wealthy, Well distributed, Mostly middle income, Poor

Trend: Growing, Large and stable, Small and stable, Declining

Living status: Own homes, Pay substantial rent, Pay moderate rent, Pay low rent

3. Competition

Number of competing stores: Few, Average, Many, Too many

Type of management: Not progressive, Average, Above average, Alert and progressive

Presence of chains: No chains, Few chains, Average number, Many well established,

Type of competing stores: Unattractive, Average, Old and well established, New and modern

4. The town as a place to live

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Character of the city: Are homes neat and clean, or run down and shabby? Are lawns, parks,

streets, and so on neat, modern, and generally attractive?

Are adequate facilities available? Banking, Transportation, Professional services, Utilities, Schools

Amusement centers, Medical and dental services

Is the climate satisfactory for the type of business you are considering?

The Site

1. Competition:

Number of independent stores of the same kind as yours: Same block, Same side of the

street, Across the street

Number of chain stores: In the same block, Same side of the street, Across the street

Kind of stores next door

Number of vacancies: Same side of the street, Across the street, Next door

Dollar sales of your nearest competitor

2. Traffic flow:

Sex of pedestrians

Age of pedestrians

Destination of pedestrians

Number of passersby

Automobile traffic count

Peak hours of traffic flow

3. Transportation

Transfer points

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Highway

Kind ( bus, streetcar, auto, railroad )

4. Parking facilities

Large and convenient

Large enough but not convenient

Convenient but too small

Completely inadequate

5. Side of street

6. Plant

Frontage and depth in feet

Shape of building

Condition

Heat type, air conditioning

Light

Display space

Front and back entrances

Display windows

7. Corner location - if not, what is it?

8. Unfavorable characteristics

Fire hazards

Cemetery

Hospital

Industry

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Relief office

Undertaker

Vacant lot - without parking possibilities

Garages

Playground

Smoke, dust, odors

Poor sidewalks and pavement

Unsightly neighborhood buildings

9. Professional men in block

Medical doctors and dentists

Lawyers

Veterinarians

10. History of the site

Sales Effort

The discussion here concerns the nature of the company's sales effort and measurement of its cost

against the resulting sales. For practical purposes, selling effort can be classified as indirect and direct.

Indirect sales effort includes all forms of non-personal customer-oriented advertising and promotion.

Direct sales effort is the performance of persons directly engaged in selling the merchandise or services

offered.

Questions in the Analysis of Sales Effort

1. How much was spent for advertising during the past year? How much per year for the past 10

years?

These figures should be reduced to percent of change so that the results over time can be studied.

2. What advertising media were used and what percent or estimated percent of the total advertis-

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ing expenditures went to each medium?

Newspapers?

Trade papers?

Magazines - kinds of magazines?

Broadcast media - radio, television?

Other forms of advertising?

The question is whether the media being used are a reasonable choice considering the amount that can

be spent.

3. What changes have been made in the use of advertising media? Is the company relying more

on one form of advertising than in the past? If so, why the change?

No one advertising medium is best for all types of businesses. There is sometimes a tendency, however,

to switch media too often, without giving any medium enough time to show its real value.

4. How does the cycle of advertising vary in relation to seasonal sales fluctuations? As sales in-

crease, do advertising costs increase in about the same proportion? What is the pattern?

Dollar advertising expenditures usually rise as sales volume rises but not as fast percentage-wise. When

sales drop, there is a tendency to spend either too much or too little in relation to normal seasonal

changes, depending on the urgency felt by the advertiser.

5. If advertising allowances are available from vendors or sources of supply, is the company tak-

ing advantage of them? What kinds are available?

Advertising allowances, if properly used, make it possible to do more advertising with less money. An

alert advertiser will take advantage of all advertising allowances he feels to be reasonable and useful to

his business.

6. Is the company taking advantage of other available promotional services such as newspaper

mats and so on?

Many suppliers offer advertising services that help improve the quality of the advertising, reduce the

cost, or perhaps both. The company's use of all advertising and promotional helps should be analyzed.

7. What percent of sales was spent on advertising last year? For the past 10 years? Is this in-

creasing? Decreasing?

It is important to know not only changes in the pattern of advertising expenditures, but the relation be-

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tween these changes and changes in sales volume.

8. How do the advertising and promotion costs of this business compare with typical or average

figures for this kind of business? Higher? Lower? A bout the same?

Figures are available from trade sources and other reporting agencies that will give a standard of com-

parison.

9. Are other forms of promotion being used effectively? Window display? Interior layout and dis-

play?

For many kinds of businesses, other promotion methods may be as important as media advertising, or

even more so. All possibilities should be studied as to their importance in the business under considera-

tion.

10. Is the company capitalizing on all special promotion events suitable to the business?

This point covers a wide range of activity. Examples might be maximizing sales effort at the seasonal

peak or peaks of the business, using premiums, participating with sources of supply in special promo-

tions, and so on.

11. What percent of sales has gone into selling-payroll costs for the past 10 years? What has

been the trend? Are selling costs increasing, decreasing, remaining about the same?

Changes in selling costs should be studied singly, in comparison to changes in sales volume, and in

comparison to standards or averages for businesses of the same kind.

12. What is the quality of the selling effort of this company as shown by such factors as training,

sales attitude, methods of compensation, and the like?

Selling-payroll costs as a measure of sales effort do not reveal the forces at work behind this effort and

affecting its quality. Motivation of sales personnel through training, method and amount of compensa-

tion, and sales management should also be considered.

Past Sales

The history of sales growth within the company and in relation to similar businesses is considered the

principal measure of company progress. The buyer or seller should note three types of variations that

influence sales and how each may affect the buy-sell transaction.

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Seasonal fluctuations. All businesses are affected to some extent by seasonal variations in the de-

mand for goods or services, These variations may be the result of numerous factors - buyer motivation,

weather, specific events. Their nature, causes, and extent should be identified as fully as possible.

Some are reasonably predictable; others are not.

All businesses are affected to some extent by seasonal variations in the demand for goods or services,

These variations may be the result of numerous factors - buyer motivation, weather, specific events.

Their nature, causes, and extent should be identified as fully as possible. Some are reasonably predict-

able; others are not.

The prospective buyer of a business should think in terms of completing the purchase just before the

maximum seasonal peak of the company. This will give him the greatest possible short-term gain and

return on investment. Buying a business immediately after the maximum seasonal peak puts an addi-

tional burden on short-term working capital.

The seller is likely to take the opposite view. He is most likely to want to sell immediately after the sea-

sonal peak of the company, thus realizing the best possible profit. (It is assumed here that time in rela-

tion to sales peaks and valleys would have no appreciable effect on the market or replacement value of

assets other than merchandise.)

Cyclical fluctuations. Cyclical fluctuations are changes that occur over a longer period of time but tend

to appear somewhat regularly. Periods of depression and prosperity will obviously affect the future of a

business. The major difficulty is to determine what effect such fluctuations will have on the businesses

being bought or sold.

Cyclical fluctuations are changes that occur over a longer period of time but tend to appear somewhat

regularly. Periods of depression and prosperity will obviously affect the future of a business. The major

difficulty is to determine what effect such fluctuations will have on the businesses being bought or sold.

Long-range trends. Long-range patterns of change in an industry or a given business fall within this

classification. The interplay of forces creating such trends is extremely complex, but the buyer in particu-

lar should be alert for changing patterns in his industry or market that are likely to affect the future of the

business. Long-range patterns of change in an industry or a given business fall within this classification.

The interplay of forces creating such trends is extremely complex, but the buyer in particular should be

alert for changing patterns in his industry or market that are likely to affect the future of the business.

Questions in the Analysis of Sales

1. What has been the year-to-year change in dollar sales?

The length of time to use is largely a matter of judgment. If the figures are later to be used to make pro-

jections, a 10-year period or more is not unreasonable if the company has been in business that long.

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Converting the dollar figures to yearly percent of change and plotting them on a graph makes them eas-

ier to interpret.

2. Using a given year in the past as a base, what has been the cumulative rate of change up to

the present?

Again, plotting the figures on a graph helps to visualize the changes.

3. What has been the percent of change in sales, year-to-year and cumulative, for this kind of

business on a national or other basis?

The years should be comparable to those used in questions 1 and 2 so that the pattern of change for the

company can be compared with that for like businesses.

4. How much of the increase or decrease in sales can be attributed to increasing or decreasing

prices and how much to real sales?

The fact that sales have shown an increase may lead to a false conclusion that the company has shown

good growth. In some types of businesses, merchandise costs have increased rapidly. An average in-

crease of 2 percent per year in sales over 5 years changes in significance when it is known that prices

have increased 8 percent during the same period. Consumer and wholesale price indexes should be

checked, as well as other factors that may indicate rising prices.

5. Have prices in this company increased more rapidly, less rapidly, or at about the same rate as

those in this kind of business generally?

It is important to know how the business compares in this respect with similar firms. If it is out of line,

what is the reason?

6. Over a period of years, what has been the change in the level of sales for this business as

compared to all businesses of this type? Are sales-

Increasing percentage-wise more than normal?

Increasing at about the same rate?

Increasing less than normal?

Showing no increase at all?

Decreasing less than normal if like businesses are decreasing?

Decreasing at about the same rate?

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Decreasing more than normally?

7. What is causing the increase or decrease in sales (a) for this company and ( b ) for similar

businesses?

This point may prove to be the one that basically determines the decision to buy or sell the business.

8. Has the rate of change in sales been increasing?

Are sales increasing more rapidly now than, say, a year or two ago? Are sales increasing less rapidly

now? If sales are decreasing, has the rate of decrease increased or lessened?

9. At the time of the study, where does the business stand seasonally?

Is this normally the low point for sales in this kind of business?

Is it the high point? Somewhere in between?

Is seasonal variation so minor as to have little or no significance?

Are seasonal variations predictable?

Seasonal variations may have a strong bearing on when the buyer is willing to purchase, when the seller

is willing to sell, and the price.

10. What percentage of the year. What percentage of the years business is done each month? What is

the monthly average over the past several years?

Monthly sales averages help to determine immediate working capital requirements and to plan sales for

the months ahead. They are especially important when the sales of a given month as a percent of the

year's total do not vary greatly from year to year. If there has been considerable variation, the reasons

for it should be identified if possible.

11. Do there appear to be any changes in the seasonal pattern of sales? If so, what appears to be

causing these changes?

Changes in consumer buying habits, the pressure of increased competition, governmental regulations,

and the like create changes over time that may affect the short-term sales cycle of the business.

12. If a change in the seasonal pattern is occurring, does it tend to increase total sales or merely

shift the volume from one month to another?

A comparison of several years' sales may show that the overall effect is not a proportionate gain in total

business but a readjustment of sales from month to month throughout the year.

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13. If cyclical changes have any effect on this kind of business, what is the nature of the fluctua-

tions?

How often do they occur?

With what intensity?

14. Have sales of this business in the past tended to show the effect of these cyclical fluctua-

tions? To what extent? Intensity?

Knowing the effect of cyclical changes on the business may give some idea of what can be expected

from the standpoint of intermediate-range planning and forecasting.

15. If the business is influenced by cyclical fluctuations, at what stage is the cycle at the time of

the study?

Cyclical fluctuations may be the result of broad-scale economic circumstances, but the intermediate ef-

fect on a given business may not be in proportion to normal economic indicators.

16. What is the ratio of operating expenses to sales in the most recent operating statement?

A comparison of these costs with ratios or averages of similar businesses should give an indication of

the operating efficiency.

l7. Which has been the year-to-year and average ratio of operating expenses to sales for past

years?

Have operating expenses tended to increase, decrease, or remain about the same in relation to sales?

Has the relative change in operating expenses been about equal to, greater than, or less than the rela-

tive change in sales?

On a cumulative basis, what has been the change in the pattern of operating expenses over the past

years?

18. Are selling costs (sales, salaries, advertising, delivery) increasing, decreasing, or remaining

the same in relation to sales?

If selling costs are increasing faster than sales, each dollar spent on selling effort is bringing in a smaller

return. This information may suggest possible ways of increasing the efficiency of the company's sales

effort,

19. What is the ratio of net sales to gross sales and what has been the trend of this ratio over the

past years?

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An increase in the difference between net and gross sales may indicate weaknesses within the company

in policy, sales effectiveness, merchandising, quality control, or a combination of two or more of these

factors.

20. What are the reasons for customer returns and allowances and what action is being taken to

reduce them, if reduction is possible?

Care should be taken in analyzing the sales of a company to see that gross sales are not taken as net

sales, particularly if lenient returns and allowances have been a part of the sales program.

21. What has been the pattern in the value of the average transaction over the past years?

Sales may be stationary, but the number of transactions may increase or decrease, thus changing the

value of the average sale. Or sales may be changing but disproportionately to transactions. The ideal to

be sought is an increase both in the value of the transactions and in their number.

22. How do transactions in this business compare in average value and number with those of

similar businesses throughout the industry or market area?

This will give a standard comparison to show how well the company has been able to realize an average

sale in terms of what it would be normal to expect.

23. What are the current sales per square foot of floor space for the business? What has been

the trend in sales per square foot for the past several years? How does this compare to known

averages or ratios for other businesses of this type?

The purpose of this analysis is to estimate how efficiently space is being used for sales purposes. It may

be figured on the basis of total gross footage, including area used for other than selling purposes, or it

may be limited to the space devoted primarily to selling and merchandising.

The Sales Forecast

When the business and the market have been analyzed, the probable sales volume of the business can

be forecast. This forecast should be a simple projection of the business involved; it should not be an at-

tempt to forecast or project the total state of the market.

The variables that influence the market are too vast and complex for a small businessman to do any-

thing about. It will have to be assumed that what has happened to establish the condition of the market

as it is, will continue to have the same general effect, at least for the period just ahead.

This is a dangerous assumption - markets and the economy are dynamic, not static - but from the practi-

cal point of view, there is little choice. In any case, it is usually over longer periods of time that changing

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market factors make themselves felt.

Sales Forecast vs. Sales Potential

A distinction is necessary here between making a sales forecast and estimating sales potential. A sales

forecast is based on past sales performance and a reckoning of known and anticipated market condi-

tions.

From these, the expected sales level is determined.

Sales potential, on the other hand, is a measure of the capacity of the business to reach a certain volume

of sales. It is based on knowledge of the total market and the extent of competitive influence, and it in-

volves the use of strategy through sales effort.

Past sales performance may bear little or no resemblance to sales potential. In general, sales potential is

likely to represent a higher sales level than a sales forecast.

Length of the Forecast

For the purposes of a buy-sell transaction, a short-term or at most an intermediate-term forecast is all

that should be attempted. Short-term forecasts cover a few months - seldom more than a year. Interme-

diate-term forecasts should be limited to 1 or 2 years.

The Information Needed

Since the forecast is based on past sales of the company, it is necessary to know the dollar sales volume

of the firm for the past several years. If not enough sales data have been recorded, it may be necessary

to improvise.

In one instance, the prospective buyer of a self-service laundry was unable to get sales figures. He con-

tacted the manufacturer of the washing machines to determine the amount of water used per machine

load.

He then learned from the water company the amount of water consumed by the business. Using these

two figures and making allowances for water used for drinking, rest room, and so on, he computed the

number of loads washed per month. This figure multiplied by the price charged per load gave him a rea-

sonably accurate figure for the sales volume.

Short-Term Sales Forecasting

For a short-term forecast, it is usually enough to know the sales for the past few weeks or months in

comparison with the corresponding period of the year before. If sales for the past 4 weeks were 8 percent

more than the corresponding 4 weeks of the preceding year, sales for the next few weeks can reasona-

bly be expected to be 8 percent ahead of the corresponding period a year ago.

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Adjustments have to be made, of course, for any known or predicted conditions that will change this rate

of increase - conditions such as unusual weather, short-lived labor disputes, changes in the dates of

events such as Easter, and so on.

Distribution of sales by months. A longer method of forecasting is based on the distribution of sales by

months. This method works best if the monthly variations over a period of years have been small.

Suppose, for instance, that a short-term forecast is being made in June. For the past several years, sales

in July have been between 11 and 13 percent of annual sales, with an average of 12.5 percent. During

the same period, May sales have averaged 10 percent of annual sales. Sales during the May just past

were $16,000. Then $ 6,000 : 0.10 = $160,000, the estimated annual sales. Projected sales for July will

be 12.5 percent of $160,000, or $20,000. Sales for other months can be forecast in the same way.

Cumulative percents. Another method of short-term forecasting is the cumulative-percent method. The

percent of total sales is figured for each week during the past year and added to the percent for preced-

ing weeks, as shown in this example :

Weeks Weekly percent Cumulative percent

1 0.9 0.9

2 1.1 2.0

3 1.4 3.4

4 1.7 5.1

5 1.9 7.0

6 2.4 9.4

7 2.6 12.0

8 2.9 14.9

9 3.1 18.0

If sales during the first 4 weeks amount to $8,000, the annual total will be estimated at $8,000 : 0.051, or

$156,862. To forecast sales for the next 4 weeks, add the percentages for those weeks and multiply the

annual estimate by the result ($156,862 X 0.098 = $15,372. This method works best for goods or ser-

vices that are not subject to wide variations in sales volume and whose prices do not fluctuate greatly.

Number of sales transactions. Where prices tend to vary, the number of sales transactions may show

a steadier trend than dollar sales do.

An increase in dollar sales without an increase in the number of transactions means that the average dol-

lar value per transaction has gone up. This increase in the amount of the average sale may mean (1) that

customers are buying higher-quality goods, (2) that they are buying in larger quantities, or (3) that prices

have increased.

If the level of transactions is steadier than the dollar sales, the forecast tends to be more conservative. A

study of the transactions may bring to light factors not revealed by total dollar sales.

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Intermediate-Term Sales Forecasting

Because of the combination of variables at work in the market, the techniques used in the short-term

forecast are not reliable when applied to the longer periods covered by intermediate-term forecasting. In

the longer forecast, two methods of measurement are generally used: the long-term trend method and

the correlation method. Correlation analysis requires data usually beyond the reach of the small busi-

nessman, but the long-term trend as determined by the least squares method may be useful. This

method will not be taken up here, but an explanation of its use can be found in any introductory book on

statistical methods.

Effect of Changing Market Factors

It must be reemphasized that a trend is determined from past data and from the total market as reflected

in company sales. Insofar as these conditions remain in about the same state of balance, a projection of

the trend into the future has some value; but the more dynamic these market factors are, the less reliable

trend lines become.

The investigator must give careful thought to how changing market factors will affect his forecast. Al-

though he cannot have precise knowledge of these factors, he must decide how influential they are likely

to be and adjust his forecast accordingly.

Conclusions on Forecasting

The reliability of a forecast is always uncertain. Past performance is no guarantee of the future. The basic

value in making a forecast is that it forces the buyer or seller to look at the future objectively. A forecast

does not eliminate the need for value judgments, but it does require the forecaster to identify elements

influencing the future. It may act as a damper on the buyers unbounded faith in his own managerial abil-

ity.