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Buying and Selling a Small Business
By Verne A. Bunn
About This Book
Going into business for oneself can be a great adventure--or a great
disaster. Which it will be depends a great deal on how well the prospective
owner prepares through investigation and analysis of the situation he or
she is about to enter.
In some ways, the person who buys a going business has an advantage over
the one who starts from scratch. For one thing, there are more facts to
work with--if the buyer knows where to find them and how to use them.
These are the principal problems taken up in Buying and Selling a Small
Business. What should the prospective buyer of a small business--or the
seller--know before the buy-sell decision is made? Where can this
information be found? How can the buyer or seller correlate and interpret
the data? How does he or she apply the data to negotiating a buy-sell
transaction?
This volume, now in second edition, does not pretend to give complete or
specific answers. In some cases professional help is necessary, and in all
cases the answers depend on many variables. Rather this booklet is intended
to serve as a guide to areas needing investigation and to suggest some
approaches that may be helpful.
The buyer of a small business faces more problems--and more difficult
ones--than the seller. Because of this, Buying and Selling a Small Business
may appear to give more attention to the buyer than to the seller. However,
it is important for the seller to know how the buyer is likely to approach
the negotiations; and wherever specific problems for the seller do come
into the picture, they are discussed separately.
This booklet is issued as part of the management publications program of
SBA's office of Management Information and Training.
Based in SBA's Kansas City Regional Office, the author, Verne A. Bunn,
administers the Agency's management assistance programs for several states.
He acquired his wide knowledge of small business in a variety of ways,
including experience as a counselor of small business owners as well as
university research and teaching.
Contents
Part 1. The Buy-Sell Transaction
1 A Small Business Is Bought and Sold
2 The Flow of Decisions in a Buy-Sell Transaction
Part 2. Sources of Information for Buy-Sell Decisions
3 Sources of Market Information
4 Sources of Financial Information
5 Sources of Legal Information
Part 3. The Buy-Sell Process
6 Determining the Value of a Business
7 Negotiating the Buy-Sell Contract
8 Financing and Implementing the Transaction
Part 4. Using Financial Statements in the Buy-Sell Transaction
9 Income Statements and Balance Sheets
10 Adjustments to the Financial Statements
11 Analyzing the Financial Statements
Part 5. Analyzing the Market Position of the Company
12 The Market
13 The Company
14 The Sales Forecast
Part 1 The Buy-Sell Transaction
Chapter 1 - A Small Business Is Bought and Sold
IS THERE A SMALL-BUSINESS OWNER who has never considered selling his
business? Probably not. Is there an individual with some money, talent, or
an urge for independence (often only the last) who hasn't thought about
owning his own business?
The number of small businesses actually bought and sold, however,
represents only a small fraction of those who have felt these urges. To
many people, the desire to buy or sell is only a passing thought. Others
find various ways to solve their problems or satisfy their ambitions. But
sometimes an individual doesn't follow through because he finds the
prospect of buying or selling a business too baffling.
The objective of this manual is to describe the process of buying and
selling a small business and to establish some guidelines. It will not
remove the difficulties, but it will make them more manageable.
A Look at the Buy-Sell Process
It will be helpful to take a detailed look at what happens when a business
is bought or sold. First, consider some of the thoughts that go through the
minds of the buyer and seller during the decisionmaking process.
THE SELLER: (Before the transaction) Shall I sell my business? What is it
worth? How can I find a buyer? (During the transaction) How much shall I
tell this guy about my business? Will he raise his offer? What terms shall
I insist on? (After the transaction) Should I really have sold? I wonder if
I could have got more money. Wonder how the business is getting along.
THE BUYER: (During the transaction) Shall I buy this business? I wonder why
he really wants to sell. How much can I afford to pay? Where can I get the
rest? How far will he reduce his price? (After the transaction) Now that
I've bought it, which new idea shall I try first? Should I have known that
would happen? It's going to work out just fine--isn't it?
These are typical thought patterns. They mark the flow of decisions in the
transaction. They also reflect the doubts and hesitancy involved in the
decisionmaking.
A Step-by-Step Account
The following step-by-step description of buying and selling a grocery
store is basically the story of an actual case. To make it more typical of
all buy-sell transactions, some questions and problems from other cases
have been worked into the account.
Bill Smith wants to buy. Bill Smith had worked several years in grocery
stores in Whitton, a city of 400,000. He had started as a carry-out boy and
progressed through every job in a store operation.
Bill was anxious to own his own store. He and his wife were in their early
forties and eager to establish a business of their own. They had saved
about $16,000, and Bill was confident that he knew enough about grocery
stores to handle the operation. His wife planned to take care of the
bookkeeping.
The Smiths had followed up many leads from the classified section of the
newspaper. In every case, they found the business either too run down to
salvage or too large to finance. Bill had also talked to a few real estate
agents who specialized in business properties. But the agents' listings had
not turned up anything that interested the Smiths.
In August, Bill learned from a food salesman that Sam Brown was trying to
sell his store. Sam's Market was a small store on the other side of town.
It had been operating for many years.
Sam Brown wants to sell. Sam Brown had been thinking about selling his
business for several months. He was reluctant to do it because the store
had been established by his father. Yet he was finding the long hours he
had to spend in the store a real hardship.
Furthermore, during the last 4 years, business had declined from a high of
$400,000 gross sales to less than $200,000. The main reason for the decline
in sales, in Sam's opinion, was the competition from several new
supermarkets in his area.
Finally, he was concerned about a space of about 1,100 square feet at one
end of the building in which the store was located. Sam owned the entire
building and had been unable to find a tenant for this space for more than
3 months. Now a discount paint company had offered him a local franchise.
Sam believed he could use the vacant space for this operation and handle
the business with much less effort than he was putting into the grocery
store. If he could sell the grocery business and lease that part of the
building to the new owner, he would have a comfortable arrangement.
The transaction. After talking to the salesman, Bill called Sam and
expressed an interest in the store. They arranged several meetings to
discuss the situation. Bill learned that Sam wanted to sell in order to
take advantage of the paint-store opportunity. When Sam announced that he
was asking $50,000 cash and $600 a month rent, the conversation went like
this:
BILL: Could I spend some time with your books?
SAM: I can't let you do that. Most of my personal affairs are in those
books. Besides, I don't want to be giving away everything about my business
to someone who might be a competitor someday.
BILL: But I have to have something to go on!
SAM: Well, you ask me what you think you need to know, and I'll tell
you--if I can.
During the discussions that followed, Bill learned the following facts
about the store:
The modern fixtures and equipment had cost $60,000 new. Now 6 years old,
they had a depreciated value of $30,000. The inventory had a wholesale cost
of $20,000. Gross sales were running about $16,000 a month with a gross
margin between 14 and 16 percent. In the past, annual sales had been as
high as $400,000. The 3,900 square feet of store space appeared well
organized.
From this information and his observation of the store, Bill figured that
he could increase sales to $40,000 a month within a year by more aggressive
sales promotion--handbills, radio spot announcements, an extra large neon
sign, and more personal service. This meant, in Bill's opinion, that
inventory would need to be enlarged to $24,000.
To better the profit, which had been averaging 2-1/2 percent of gross sales
including Sam's salary, Bill believed the average markup should be raised
from 18 percent to 20 percent. An additional increase in profit could be
realized, according to Bill's analysis, if he reduced the staff by one
full-time and one part-time clerk.
Bill was unable to borrow the difference between his $16,000 savings and
Sam's asking price of $50,000. Several banks turned him down before one
agreed to lend him $20,000 at 11-1/2 percent interest with monthly payments
over 5 years.
Sam refused Bill's offer of $36,000 but offered to carry part of the price.
After several more discussions, agreement was reached on the following
terms:
1. $24,000 cash.
2. $22,000 unsecured note, payable monthly over 5 years at 12% interest.
3. $400 a month rent.
Bill planned to use the $12,000 cash left from the bank loan to increase
inventory and provide working capital.
The store changed owners about September 1. Bill discovered that the
inventory was worth only $16,000 at wholesale cost. He immediately used
$8,000 to increase his shelf stock. Sales during the first few months
increased to $30,000 a month, and Bill felt sure he could reach his goal of
$40,000 a month. Profit, however, was running only 2 percent of gross sales
in spite of Bill's attempt to increase margins and reduce costs.
A sad ending. Six months later, the doors were closed on Bill's Market. The
remaining $12,000 inventory was sold to a wholesale outlet for $10,800. The
fixtures were sold for $16,400. Bill was trying to find a way to pay his
debts and forget the loss of his life's savings.
Four months later, Sam still had not been able to rent the space formerly
occupied by the food store. He had little prospect of recovering his loan
to Bill, and he had lost over $4,000 in rental income. He was undecided
what action he should take.
The Big Question
Bill and Sam each thought he had received a fair value. But the final
result showed that neither one had made a right decision. Both lost savings
and income. What went wrong? How do you go about buying or selling a
business?
An important question? To the Bills and Sams--past, present, and
future--few questions could be more important.
A difficult question? Either buying or selling a business requires
personal, financial, and management decisions. At no steps along the way
are the decisions easy to make. But it will be helpful to establish the
basic steps or elements in a buy-sell transaction and then to examine each
of these elements.
Chapter 2 - The Flow of Decisions in a Buy-Sell Transaction
BUYERS AND SELLERS both seek answers to the same question: "What is this
business worth?" Most people see the worth of a business as the total value
of equipment and fixtures, inventory, and buildings and land. Important,
certainly, but the sum of these values does not equal the value of the
business.
Bill probably paid a fair price for equipment, fixtures, and the like. But
did his price of $40,000 reflect the value of Sam's Market? Obviously not.
What, then, is the value of a business?
For both buyer and seller finding the answer to this question is the most
difficult and at the same time the most important step in the buy-sell
process. But this final decision reflects many other decisions made while
the transaction is being considered. In other words, the buy-sell process
is a flow of decisions. It would be impossible to point out every decision
that must be made, but the basic ones are as follows:
Motivation: a decision to attempt the sale or purchase of a business.
Contact: a decision on how to find a buyer (or seller) for a business with
specified characteristics.
Information: a decision on what information must be gathered or given to
buy or sell a business.
Sources: a decision on how, where, and at what cost the needed information
can be obtained.
Analysis: a decision on the meaning, importance, and reliability of the
information gathered.
Value: a decision on what the business is worth.
Price: a decision on how much money to take or give for the business.
Financing: a decision on how to pay or receive the purchase price.
Contract: a decision on the form and content of the contractual relation.
Implementation: a decision on how and when to effect transfer of
ownership.
Motivation
What leads an owner to sell his business? It may be any of a large number
of reasons: a personal health problem, a business disagreement,
overextension of the company's activities, a desire to retire from
business. The possible reasons are many and varied.
For Sam, the motivating factor was change. He found his sales decreasing in
spite of his extra effort, competition increasing, empty building space
impossible to rent. In other words, both internal and external factors had
brought changed conditions that affected the business unfavorably.
Changed conditions should be analyzed carefully before a business owner
accepts them as reasons for selling his business. The following questions
can serve as a guideline for this analysis:
1. Have changes actually occurred in my business?
2. Are the causes of the changes beyond my control?
3. Are the causes of the changes within my control?
It would be unfortunate for a owner to sell his business because of changes
he could control if, by such control, he could recapture a successful and
satisfying operation. Every owner, therefore, should examine closely his
motives for wanting to sell the business.
What makes an individual want to buy a business? Again, motivations will
cover the whole range of human desires, from simple economic gain to social
ladder climbing.
Bill's prime motivating factor was the desire to expand a special skill
into a business of his own. Bill thought he knew enough about grocery
stores to handle one of his own. But he didn't. This factor of a special
skill represents one of the dominant reasons for wanting to buy a business.
It is a natural motive, but, perhaps because of its natural appeal, it can
be a dangerous motive.
A business must be managed. An operating skill does not always lead to
managing ability. In fact, it often encourages a business owner to spend
his time operating instead of managing. Planning for the future, organizing
resources, staffing the business with competent people, directing the
coordination of people and operations, controlling results--these are the
functions of management. Consequently, an individual with a skill seeking
to buy a business in which to apply the skill should check his motivation
by asking questions such as the following:
How important is management ability in this business?
Occasionally, a business that is unique and very simple almost manages
itself. But if the business is in a competitive field, management ability
is probably the most important requirement for success.
Do I have the ability to manage successfully?
Effectiveness with people (customers and employees), eagerness to tackle
difficult problems and make decisions, and intelligence about general
business operations are key ingredients in management ability.
Can I learn how to manage this business?
Most people can learn to manage if they recognize the need. This requires
room to make mistakes, however, and the self-discipline to undertake
self-improvement programs.
Contact
Assuming that motives have been examined and that both seller and buyer are
still interested, the next step is to get the two together. But there seems
to be no "best way" to find a seller or a buyer for a business.
From the seller's point of view, the task of finding an interested buyer is
the more difficult one, but there are many avenues to explore other than
running advertisements in newspapers. He should ask himself these questions:
Have I told my employees and other business associates that I intend to
sell the business?
Have I taken advantage of the broadcasting ability of salesmen who call on
businesses similar to mine, of association meetings, of other trade
contacts?
This informal advertising requires the same kind of information more formal
advertising does. Business associates, trade contacts, and friends should
be told the asking price, the terms, the anticipated return. Without this
knowledge, a potential buyer can hardly be expected to respond positively.
He needs to know in advance how the offer relates to his financial ability.
From the buyer's point of view, finding opportunities is relatively easy.
The difficulty lies in locating a business he can analyze confidently. When
he deals with unfamiliar firms, he is haunted by a desire for more
information and suspicious about the information he does receive. A buyer
seeking a seller should consider the following points:
Have I asked people I deal with about persons who might be considering
selling a business?
Have I considered approaching businesses with which I am familiar about the
possibility of a purchase?
Kinds and Sources of Information
At this stage, the buyer and the seller must decide what information about
the business to seek or give. In the case of Sam's Market, information was
brought out about three factors:
1. The nature of the business in the past.
2. Present condition of the business.
3. Relation of the past and present to future expectations.
Bill's approach was proper, but the information he gathered was meager
support for decision making.
Some of the information a careful buyer will want may take a lot of money
or time to gather. He must decide what sources of information are essential
and which ones he can leave untapped. Bill, for instance, might well have
inquired about local economic conditions. Full information, it is true,
would have required a costly analysis, but consider what information he
could have got from easily available sources:
1. Sales in the market had declined more than 50 percent.
2. Sam had been unable to rent commercial space in the building in which the
market was located.
3. New supermarkets were operating in the same area.
4. Banks hesitated to gamble on the future of the market.
Bill might also have developed information about the future trend of the
business, but that would have required time. He should have known the
following facts about his financial program, however:
Available funds $36,000
Use of funds:
Payment to Sam $24,000
Planned increase in inventory 4,000
Advertising 1,000
Display sign 1,000 30,000
------- -------
Available for working capital $6,000
Expected new income per month (3% of $30,000) 900
Probable expense:
Payment to bank $265
Payment to Sam 295
Sam's salary ?
Bill had enough information available to know (1) that his sales
expectations were too optimistic and (2) that even if he reached his sales
goal, he would not be able to satisfy the cash demand on the operation.
What happened could have been predicted.
Analysis
The word "predict" is important. The buyer should be able to follow through
the steps listed below and predict with some confidence the future of the
business.
What factors affect sales?
How will these market factors behave?
Therefore, what sales can I expect?
What makes up the cost of sales?
How will these cost factors apply to expected sales?
Therefore, what gross profit can I expect?
What expenses are required to run this business?
How will expenses develop under my ownership?
Therefore, what net profit can I predict?
What assets will the business need and possess?
What is the condition of these assets?
Therefore, what asset improvements will I have to make?
What credit does the business assume?
What is the condition of the credit position?
Therefore, what changes, if any, can occur in the debt structure?
How much cash do I have?
How much cash will the business generate?
Therefore, what will be my available-cash position?
What immediate cash outlay must I make?
What will be the cash needs of the business?
Therefore, what cash outgo will be necessary?
What will be my net cash position as things now stand?
What additional cash resource, if any, must I have?
Therefore, what financing plan shall I use?
Value
A business had a purpose. That purpose is to provide a satisfactory return
on the owner's investment. Consequently, determining value involves
measuring the future profit of the business being sold.
A seller often thinks of value as representing the money he has invested
through his years of ownership. A buyer is tempted to consider value as a
fair price for tangible items such as equipment and inventory. These
factors are important, but they have value only to the extent that they
contribute to future profits. An owner may have invested $40,000, the
tangible assets may have a current worth of $20,000, but it is the profit
potential that establishes the value of the total business.
Assuming that a reliable estimate of future profit is made, how much is to
be paid for each dollar of profit potential? This computation is discussed
in chapter 6, but the general approach is suggested by the following
questions:
What am I buying (or selling)? A business, or a building full of equipment
and inventory?
What return would I get if I invested my money elsewhere--in stocks, bonds,
or other business opportunities?
What return ought I get from an investment in this business?
Price
It might seem that the price to be paid or received for a business would
simply be equal to the value. However, value refers to what a business is
worth; price refers to the amount of money for which ownership is
transferred. There is usually a difference between price and value because
the buyer and seller differ as to how much the business is worth. The price
will represent negotiation and compromise. Here are two suggestions for
fruitful negotiation:
* Discussion between buyer and seller should focus on the future profit
performance of the firm. Since expected profit is basic to determining
value, it can be a valuable point for negotiation.
* Every profit projection includes some assumptions and risks. Generally,
the less firmly based the assumption and the more apparent the risk, the
less value an expected profit can support. Consequently, identifying and
analyzing risks involved in future operations can make discussions between
buyer and seller more significant.
These two points will help bring negotiations about value toward a mutually
acceptable price.
Financing
When the price has been settled, the question of how to finance it remains.
Financing a buy-sell transaction involves these five factors:
1. The amount of capital required.
2. The type of capital required.
3. The specific uses to which the capital will be put.
4. The length of time needed to pay back the capital source from
the business operation.
5. The sources of available capital.
How much? Bill's failure after buying Sam's Market illustrates a common
problem--underestimating the amount of capital required to purchase a
business. Capital must be available not only to pay the purchase price but
also for (1) funds to operate until the business is generating cash, (2)
funds to meet unexpected expenses, and (3) funds as a reserve to allow for
errors in expectations. A buyer must think beyond the purchase price to
determine the amount of capital he needs. Unless he does he will find his
resources embarrassingly and probably disastrously wanting. Here are some
questions that must be asked about his capital needs:
Do I have enough capital to pay the purchase price?
Do I have enough capital to support 1 to 3 months' operations--such as
payroll and other cash expenses--while the business reaches a
self-supporting stage?
Do I have some extra capital to cover needs I may have overlooked (perhaps
10 to 15 percent of the purchase price?
Types of capital. There are two basic types of capital: (1) equity
capital--investment in the business by the owner or owners, and (2) debt
capital--borrowed capital that must be repaid.
Equity capital is often called risk capital. Those who furnish the equity
capital are expected to take the primary risks of failure and to reap the
benefits of success. The equity capital provides a margin of safety for a
lender. The greater the amount of equity capital, other things being equal,
the easier it is to get debt capital.
The primary source of equity capital is the personal savings of the buyer
of the business. Although many small businesses are incorporated, the sale
of stock is seldom a source of capital for the small business.
Few buyers, however, have enough personal savings to finance the purchase
of a small business without any debt financing. An individual may borrow
money for the purchase of a business by obtaining a personal loan, by
borrowing against insurance policies, or by refinancing the mortgage on his
home. These debts are not direct debts of the business, but the debts of a
small business and the personal debts of the owner cannot be completely
separated. Banks are the principal institutional source of debt capital for
small businesses.
The seller as lender. In the sale and purchase of Sam's Market, the buyer's
savings plus a bank loan were not enough to finance the purchase. Bill (who
needed more financing) and Sam (who wanted to sell his business) reacted in
a manner quite common in the financing of the sale of a small business. Sam
agreed to accept payment of part of the purchase price over an extended
period of time.
The seller is sometimes a source of capital to the buyer of a small
business, as in Bill's case. A happy circumstance if it is handles
properly. Before jumping at the chance, however, the buyer should ask
himself these questions:
Is there a good reason why commercial lenders would not approve my loan
request?
Is the seller so interested in getting out from under the business that he
will take an unwise risk?
Am I sure the business is as good as it looks?
Can the business support the debt payments to which I am obligating myself?
In the light of Sam's experience, the seller, too, should pause long enough
to answer some questions before he accepts an extended payment plan.
How serious will it be if the buyer is unable to make his payments?
What security do I have to protect my position?
How capable of operating my business successfully is the buyer?
.Contract and Implementation
Every step so far in this discussion has involved forecasting. From
motivation to finance, the buyer and the seller must anticipate
characteristics, developments, and problems that may develop. The contract
between the parties embodies the resulting basic agreements about the
business and the relation between buyer and seller. A "good" contract is
meaningless if the earlier steps in the process have been carried out
carelessly or not at all.
Part 2 Sources of Information for Buy-Sell Decisions
Chapter 3 - Sources of Market Information
TWO BASIC QUESTIONS face the prospective buyer or seller of a small
business when he starts to gather information for his decisionmaking:
"What kinds of information do I need?"
"Where can I get this information?"
The information needed can be grouped into three general types: (1) market
information, (2) financial information, and (3) legal information. The
purpose of this chapter and of chapters 4 and 5 is to identify still
further, within these groups, the kinds of information the buyer or seller
should look for and some sources of that information. Not all of the
sources listed will apply equally to all kinds of businesses. The buyer or
seller will have to determine for himself the extent to which the specific
types of information will help him reach a sound decision.
Some difficulty may arise in the information-gathering stage because of
poor records, unavailability of some information, lack of cooperation, and
the like. The seller has the advantage as far as internal data are
concerned. He has free access to his own records; the buyer does not. If
the buyer needs internal information to reach a decision, it should be made
available to him. He should insist on seeing the company records and be
wary of any seller who refuses to give him the information he needs.
Either seller or buyer may have to spend considerable time and effort
digging out the information. The sources suggested below, however, should
help him gather the basic types of information needed in the decisionmaking
process.
Importance of Market Information
The first and most logical step in buying or selling a business is to
conduct a market analysis. A market analysis is a study of the present
position of the business within its market area and of probable future
patterns. It should include the growth pattern of the business being sold,
the state of the market, the nature and extent of competition--all factors,
in fact, that will show the present market position of the business or that
will affect its future.
A market analysis should indicate whether the purchase or sale of the
business should be considered further. It will help the seller decide what
valuation to place on the business for sale purposes. It will help the
buyer decide how much he should pay, and it will also give him a clearer
picture of just what he is buying. A market analysis has the added value of
making it possible to develop more accurate sales forecasts. It places
greater emphasis on fact and less on hunch and guesswork.
The specific nature of the business being bought or sold will determine
much of the market information needed. A manufacturing business with
problems of marketing and distribution will need information not
necessarily pertinent to a retail or service business, with its more
localized market. The following areas of market information are designed to
suggest sources that may be useful to the buyer or the seller in analyzing
the market of the business.
Sales Information
An investigation should be made of the sales history of the company. At
least 3 years' sales should be examined and preferably 10 years'--or the
entire sales history of the company if it is a new one.
The manner in which the records are kept will determine to a large extent
the availability of sales information. Many small businesses keep little in
the way of sales records--often only what is necessary for tax purposes.
Others have bookkeeping systems designed by business-machine manufacturers,
trade associations, or professional accounting services. The more
standardized the procedure, the more useful the information is likely to be
for market analysis.
Most States now have sales taxes, and this may provide a useful source of
information. Whether or not a business is required to keep sales-tax
records depends largely on the type of business and the State requirements.
Sales-tax laws are not uniform, and what is required in one State may not
be required in another.
If most of the business is done on a credit basis, accounts receivable may
give useful sales information. If this source is used, the market
investigation should be concerned only with the amount of credit sales and
not with the effectiveness of the collection of accounts receivable.
Ingenuity and common sense can often turn up sources of sales information.
In one case, for example, sales for a self-service laundry were determined
by using water capacity per machine, city records of the amount of water
consumed by the business, and price per load.
Regardless of where the sales information comes from, the purpose of
gathering it is basically the same--to identify the pattern or trend of
sales over the past and to use this information to project or estimate
sales for the period ahead. Such an investigation is especially useful in
determining the value of the business above the value of the assets.
Cost of Goods Sold
A study of the cost of goods sold is also important in determining the
market position of the business. Cost of goods sold is the cost of
merchandise purchased by the business for resale, including freight and
other charges. The difference between sales and the cost of the goods sold
is called gross margin or gross profit. The higher the cost of goods sold
in relation to sales, the lower the gross margin--and the net profit.
Many factors, both within the company and in the market of which the
business is a part, affect the cost of goods sold. An investigation should
be made to determine the following:
1. Average rate of stock turnover, particularly as compared to the normal
or typical rate for similar businesses.
2. Extent to which invoices are being discounted. Paying invoices in time
to earn the cash discount will increase both gross margin and net profit if
the discount is recorded as a reduction in the cost of goods sold. A direct
increase in net profit will result if the discount is shown as "other
income."
3. Freight costs to determine whether incoming transportation charges are
in line.
Among the records to be studied are vendor invoices, records of merchandise
payments to vendors, shipper receipts or bills of lading, and records of
past physical inventories.
Sales-Effort Records
This information has to do with how much it costs in selling effort to
produce a given volume of sales. It involves two types of costs: (1)
advertising costs, from invoices and statements for various forms of
advertising and promotion; and (2) salaries and wages paid for selling,
from payroll or Social Security records. If the business maintains
sales-people in the field, as a manufacturer might, information on
reimbursable travel expenses should be included.
The purpose of gathering information on selling costs is to determine how
well these costs are being utilized and to compare them with average
figures for the kind of business being studied.
Personal Observation
Personal observation of the premises and personnel of the company is
another source of information for the buy-sell process. Just what points
should be noted will depend on the nature of the business, but the
following are offered as examples:
The general appearance of the premises, both internal and external, may be
important, particularly if direct customer contact is made at the place of
business.
Plant layout and apparent efficiency of operation should be carefully
observed if the seller is a manufacturer or otherwise engaged in processing
or assembly.
Employee morale and general attitude toward the business should be noted,
especially if current employees are to be retained.
Employee records, including wage-payment plans, employee-evaluation and
merit rating programs, training programs, and so on should be studied.
Market Information From Outside Sources
Sources of market information outside the business fall into two general
classes: (1) competing businesses, and (2) the total market of the business
and the factors that enter into it. Analyzing market characteristics
involves dealing with constantly changing forces. This is in contrast to
the internal analysis, which concerns basically historical records.
Competition. Unless the business has a monopoly of some sort, a study of
the competition should be included in the market analysis. The competition
may be local and well defined, or quite generalized, depending on the
nature of the business and of the market.
Trade associations and other data-gathering agencies, both governmental and
nongovernmental, are sometimes helpful in this area. A good deal of the
information about competition, however, must come from direct
investigation, business by business.
Such factors as these are of interest: estimated sales, advertising and
promotion, services offered, performance of sales personnel, businesses
entering and leaving the competition recently, changes in the competitive
structure through product mix or services offered, pricing policies, and
other factors that form a part of the competitive patterns for specific
types of businesses. A very important aspect of competition is the extent
to which the total weight of competition has expanded the market for
certain types of products or kinds of businesses, and the direction this is
taking.
Location. In certain businesses, location may not be too important,
providing the physical plant is structurally sound and suitable for the
business. In other cases, location may be a vital factor. An important point
that should be looked into is the status of the location and any plans for
proposed changes that may have an adverse effect on the future of the
business. Urban renewal programs are causing many small businesses to look
for new locations. So are changes in highways and streets, flood-control
programs, changes in zoning ordinances, and the like.
The buyer, whether he will own the physical plant or lease it, should look
into the possibility of future expansion. Consulting a competent architect
or engineer now may save trouble later on if the buyer should want to
expand and leasing provisions allow him to.
Population and purchasing power. The number of people within the market
area and the amount of spendable income they have are important market
factors. For many kinds of businesses, the total population is less
important than certain segments of the population. A business selling
hearing aids, for example, will be interested only in persons who have
hearing difficulties.
In gathering information on income and expenditures, three factors should
be kept in mind: (1) the total purchasing power based on total population;
(2) the average or median income for the typical family unit; (3) the
amount or percent of expenditures for various types of goods and services.
General population figures are obtained from Federal, State, and local
government sources. The Federal census, taken every 10 years, gives not
only total population figures but also breakdowns that are useful in many
business situations. For most of the larger cities, census figures are
further classified by sections within the city on the basis of certain
population and economic characteristics. These sections are called census
tracts.
Business population figures may be available from numerous sources. The
Yellow Pages of the telephone directory and the city directory are local
sources that are immediately available. Chambers of commerce, trade
associations, and State and Federal government agencies can often be
helpful.
The 10-year census reports the income for 20 percent of the total
population on a National, State, county, city and census-tract basis. Other
information issued by the Department of Commerce can also be useful.
Many trade associations report the results of research on consumer
expenditures. Other sources of data on income include the following: (1)
planning commission offices, (2) employment offices, (3) research done by
newspapers, (4) building permits, especially in newly developed areas, and
(5) mortgage and loan companies. Numerous fact-gathering agencies develop
and publish estimates of consumer income and expenditures for various
classes of goods and services.
General market conditions. A much broader yet vital part of the market
analysis has to do with what might be called the general state of the
market. Most of the discussion of market analysis so far has dealt with
factors that have a direct influence on the business being bought or sold:
company sales, location, competition, and so on. But these, in turn, are
influenced by the overall economic conditions of the country and of the
market area. These may be widespread movements such as national cycles of
prosperity and depression, or they may be purely local conditions. The two
extremes are not necessarily related.
It is to the advantage of the buyer or seller to have a clear understanding
of economic factors that affect or are likely to affect the status of the
business. The significance of this information becomes clearer when
forecasts and estimates are made.
Some questions to be used as a guide in market analysis are given in
chapter 12.
Chapter 4 - Sources of Financial Information
BOTH BUYER AND SELLER are interested in financial information, affecting
the buy-sell transaction. However, since the seller already has this
information, it is a major requirement for the buyer to get and make use of
as much of it as possible.
The buyer can usually find financial information in the following places:
(1) financial statements, (2) income-tax returns, (3) other internal
records, and (4) other external sources.
Financial Statements
The results of the financial transactions of every company should be
reflected in its periodic financial statements. These statements are
extremely important in buying or selling a small business. They were
prepared for the seller, of course, and their contents are available to
him. But the buyer, too, should be aware during the early stages of a
buy-sell transaction of the information contained in financial statements.
Balance sheet and income statement. The balance sheet is a statement of the
financial position of the business at a given moment in time. The income
statement is a summary of the revenue and expenses of the business during a
specified period of time. These financial statements show only the past
results of the company's transactions. The results of future operations may
or may not be similar.
Balance sheets and income statements in themselves contain important
information, but they are most useful when a professional accountant makes
a detailed analysis of them. A complete analysis includes a review of the
manner in which the statements were prepared, and perhaps also a review of
the records and control features of the accounting system. This is
especially important in a small business buy-sell transaction because the
financial statements of smaller companies are not usually as professionally
prepared as the statements for larger companies. An accountant should be
brought into the buy-sell transaction as early as possible by the seller as
well as by the buyer.
Audited statements. In many buy-sell transactions, the statements are
supplied by the seller, but the buyer reserves the right to conduct an
audit of the seller's records. Or the buyer insists that the seller
"warrant" his financial statements. Warranty of financial statements by the
seller should be accepted with caution, however, because there does not
seem to be any uniform definition of the term warranty.
If the seller's financial statements are prepared by an independent
accountant, the statements should show whether they were (1) prepared after
an audit of the seller's accounts, or (2) prepared from the seller's
records without verification by audit. If they were prepared without
verification by audit, they may be quite similar or even identical to
statements that would have been prepared by the seller's own bookkeeper. If
they were prepared after an audit, they should include a statement of the
accountant's opinion.
Financial statements prepared without such an audit may or may not reflect
the financial position or results of operation of the company. Most small
companies do not have their records audited annually, but without an audit
it is impossible to tell how accurate the statements really are.
Other considerations. The buyer should request balance sheets and income
statements for at least 3 and preferably 10 years. If the seller is a new
company, financial statements for the entire life of the company should be
requested.
Other financial statements are sometimes available to the buyer. These
include such items as statements of cost of goods manufactured (if the
seller is a manufacturer), application of funds, and variances from the
budget.
Another point the buyer should consider is the cutoff period for the
financial statements. The statements may have been cut off during the low
period of the sales cycle or during the high period. This has some bearing
on the financial position reflected in the statements.
More detailed information on financial statements and their analysis is
given in chapters 9, 10, and 11.
Income-Tax Returns
If independent accountants did not prepare the financial statements, the
seller may or may not have complete sets of statements. He should have at
least an annual income statement--that much is required for income-tax
purposes. If the seller is a partnership or corporation, the tax returns
should have balance sheets attached. If the seller is a sole
proprietorship, tax returns will not show balance-sheet data.
Financial statements prepared for income-tax purposes may be very different
from statements prepared in conformity with generally accepted accounting
principles. Those prepared for tax returns are designed to present the
desired tax position in compliance with the income-tax laws. Financial
statements for nontax purposes have different objectives and therefore may
reflect different financial information.
Many small companies prepare financial statements only for income-tax
purposes and use those statements for all management decisions. This may or
may not give the desired results. The parties to a buy-sell transaction are
interested in statements reflecting the tax position, but they should
concern themselves also with statements reflecting nontax items.
The buyer should request copies of tax returns for at least 3 and
preferably 10 years or, if the seller is a new company, for the life of the
company. The tax returns are more important in buying the stock of a
corporation than in buying the assets of a corporation, partnership, or
sole proprietorship.
The corporation is an income-tax entity; the partnership and sole
proprietorship are not. A partnership is required to file income-tax
information returns but does not pay income taxes as a company--the taxable
income is passed on to the partners, and they pay the tax as individuals.
No tax return is filed for a sole proprietorship, but the income statement
is included as a part of the sole proprietor's personal income-tax return.
The buyer should find out which tax returns have been examined by the
Internal Revenue Service and which have not. This is particularly important
if the buyer is purchasing the stock of a corporation. If a corporation
with an operating loss is being acquired, the loss might have value and the
buyer should satisfy himself as to whether this net operating loss can be
utilized. In many instances, the only information available to the buyer is
that found with the income-tax returns.
Other Internal Sources
The financial statements are usually supported by detailed analyses of
selected accounts. This might include some of the following items:
Sales may have been analyzed by customer, product, division, salesman, time
period, and any other classifications necessary.
Purchases may be classified according to product, time period, territory,
supplier, or other classification.
If the seller is a manufacturer, he may have cost-control reports that
include analyses of material costs, labor costs, overhead cost, scrap
sales, spoiled and defective goods, and other items.
There may be a cash-flow statement--perhaps incorporated with the analysis
of collections of accounts receivable--and even a projection of cash
requirements.
The seller may have a regular budgeting program with projections into the
near or distant future. It is common practice for the buyer to require the
seller to make a projection for at least a year from the date of the
proposed transfer. The buyer should insist on this projection.
Other External Sources
The seller's suppliers are an excellent source of information for the
buyer. They can provide records showing the volume of purchases by the
seller. This information may be difficult to get in some cases,
particularly if the seller informs his suppliers that it is proprietary
information.
Another source of data is the seller's banker. A banker can supply
information about cash position, line of credit, and other fiscal data. He
may, however, be reluctant to release this information.
The seller may have filed payroll-tax reports, sales-tax reports,
excise-tax reports, ICC reports, or any of many other government reports.
Some of this information is available to a buyer.
The buyer may seek information about the seller from credit agencies or
credit associations related to trade associations. Usually, the buyer must
have a contact with these agencies in order to get the information, but
there are many ways to get reports about the seller.
A number of organizations, including trade associations, supply information
about industry averages. These averages are very important to the buyer for
judging the effectiveness of the seller.
Advice to the Seller
The seller, for his part, should be cautious about releasing information to
the buyer. It is entirely possible that the supposed buyer is a competitor,
or may be one in the future. Often a seller is so anxious to sell that he
supplies any information requested by the buyer without even getting a
good-faith deposit. He may spend many dollars in collecting the data for
the buyer. A seller should not supply any information to anyone without
first discussing the matter with his accountant and his attorney.
Chapter 5 - Sources of Legal Information
THE PROSPECTIVE BUYER OF A BUSINESS can play an important role in the
discovery of legal problems that may affect the value of the business and
his decision on whether to buy. Legal opinions are the responsibility of
the buyer's attorney, of course. But the attorney must often rely on the
buyer as his source of internal information about the business--information
he will need in making his legal recommendations. It is therefore important
that the buyer have some idea as to what his attorney will expect of him.
As in any sales, the basic legal problem in the purchase of a business
involves the transfer of ownership or title to property. How serious the
title problem is varies from one business to another, depending on the
nature of the assets being purchased.
If the transaction involved only the transfer of good title to a single
piece of real estate, it would be a simple matter. But buying and selling a
business typically involves a conglomeration of assets--inventory,
fixtures, vehicles, and equipment, all of which are movable, and assorted
contract rights under leases, sales agreements, patent licenses, and so on,
which are intangible.
Each asset has its own ownership aspects. It is important to ask this
question about each asset: "Is the buyer getting the ownership rights he
assumes he is getting?"
An even more careful investigation from a legal point of view is called for
when the buyer either assumes liabilities or purchases the stock of a
corporation. Even the risk of potential liabilities--liabilities that may
occur in the future because of past events--may be reduced by proper
investigation.
Both internal and external sources of legal information are usually
available to the buyer and his attorney for examination. The buyer should
not rely solely on the oral statements of the seller as to important
aspects of the business. Any statements of the seller that have to be
accepted without support from other sources should be incorporated into the
buy-sell contract as warranties.
How much information should a buyer obtain about a business before legally
committing himself to purchase? There is no easy answer to this question,
but the buyer should realize that the legal risk he assumes is about
inversely proportional to the amount of information he has obtained about
the business.
Internal Sources of Legal Information
Among the internal sources of legal information are copies of contracts,
evidences of ownership, and organizational documents. Personally examining
the business premises and questioning the seller and his employees may be
the only source of information about some assets.
Contracts. The buyer and seller are both concerned with the rights and
obligations created by outstanding contracts with suppliers, customers,
creditors, employees, lessors, and so on. The seller is concerned with his
liability for any breach of contract that may result from sale of the
business. He should know that ordinarily only contract rights, and not
contract obligations, may be transferred to a third party without the
consent of the other party to the original contract. Sublease arrangements
and mortgage assumptions are examples of this. The seller remains liable
even though the buyer takes over the lease or mortgage as part of the
buy-sell contract.
Here is an example involving a lease. A food merchant sold one of his
smaller stores at what he considered a good profit. The sale price covered
inventory, fixtures, and goodwill, for which the seller received $56,000.
He had purchased the business 2 years before for $30,000.
The building was leased, and the seller was not able to assign the lease to
the new owner of the business. He was, however, permitted to sublease the
building for the remainder of the lease. The lease amounted to $1,300 a
month.
Recently, sales have been decreasing to the point where the present owner
has threatened to give up the business and take his loss. If he should do
so, the former owner will be liable for the remaining 2 years' lease.
Unless he can find another tenant, he may lose all he gained from the sale
and more.
Assignment of contracts. The buyer often wants any contractual rights of
the seller that are needed in order to maintain the business as a going
concern. In legal terminology, the transfer of contractual rights is called
an assignment. Generally, a contractual right is assignable, but the
original contract may expressly prohibit its assignment.
Such negative provisions are common in printed forms of leases. Loan
agreements may prohibit the sale or other change in ownership of
substantially all the business assets. Or they may call for speeding up
payment of the principal if the assets do change hands. The buyer should
get copies of important contracts and review them to determine whether they
have nonassignment clauses.
A contract may be nonassignable, however, even without such a provision.
This would be true if the contract rights are coupled with obligations of a
personal character. For example, the seller's credit arrangements with a
supplier are not assignable because they are based on the seller's
reputation as a credit risk. A contract for the manufacture of certain
goods may not be assignable because the customer, when he signed the
contract, knew and was relying on the superior workmanship of the seller.
Likewise, a supplier's agreement to supply the seller's manufacturing
requirements of certain raw materials may not be assignable because the
requirements of the new owner are uncertain.
Both buyer and seller should remember that third parties will, in all
probability, have to be reckoned with in carrying out the buy-sell
transaction. If the buyer must have a contract that is nonassignable and
the seller is not a corporation, the only solution is to renegotiate the
contract. In the case of a corporate seller, it may be possible to make the
transaction a purchase of stock rather than assets.
Types of contracts. Following are some recommendations to the buyer about
specific types of contracts:
Copies of real-estate leases should be obtained from the seller and
examined for provisions relating to amount of rent, terms of payment,
expiration, renewal, subleasing, repair, improvement, insurance, and so on.
The buyer should pay special attention to the duration of the lease. If the
term remaining is too short, either the lease should be renegotiated before
the purchase or an option should be obtained to renew for an additional
period. Leases for a specific term are often misleading because of
provisions granting to one or both of the parties the right to terminate
the lease by giving a stated period of notice.
Copies of patent, trademark, trade-name, and copyright registrations should
be obtained in order to determine the legal status of the right and whether
it can be transferred.
The principle subject of the buy-sell transaction may be a contract right
to be the exclusive agent, dealer or distributor of a product or line of
products, or the right under license to use a patented process, trade name,
or trademark. Copies of such contracts should be obtained to determine the
precise nature of the right, its limitations, and the seller's power to
transfer. Particular attention should be given to the exclusiveness of the
right.
Copies of employment contracts and union agreements should be studied for
terms relating to compensation, working conditions, duration of employment,
termination, pension and profit-sharing plans, stock option, insurance
programs, and so on. The buyer should find out whether key employees will
remain with the company if the ownership changes hands. If the employees
have not been organized, he should inquire about possible activities of
union organizers among them.
The buyer should study outstanding sale and purchase contracts. Particular
attention should be given to trade-credit, discount, installment payment,
attention should be given to trade-credit, discount, installment payment,
and security requirements. The buyer should get from the seller copies of
conditional-sale contracts, purchase-money chattel mortgages, chattel
leases, lease-purchase agreements, consignment contracts, and
sale-on-approval and sale-or-return contracts to which the seller is a
party.
The buyer should also get from the seller copies of financing agreements
between the seller and commercial banks, finance companies, and other
third-party lenders. Attention should be given to the term of the loan,
repayment provisions, interest rate, finance charges, insurance
requirements, acceleration provisions, security requirements, and recourse
rights. The buyer will generally have to make his own financing agreements,
but the seller's experience in financing the business will often suggest
what the buyer can expect if he purchases the business.
A buyer's willingness to purchase accounts receivable, apart from his
financial ability to do so, should depend on their apparent collectibility.
The buyer should require the seller to submit a complete list according to
the age of the accounts. Inquiry may disclose factors other than the
statute of limitations that would prevent collection.
A study of the seller's insurance policies may give the buyer some insight
into the availability, adequacy, and cost of coverage of such risks as
liability arising from manufacture or sale of defective products, liability
to customers for injuries sustained on the premises, liability for property
damage and bodily injury arising from negligent operation of company
vehicles, liability to employees for injury under workmen's compensation
laws, and property hazards such as fire, windstorm, and theft. The buyer
should be aware, however, that premium rates based on the seller's
experience may not be available to him.
Evidences of Ownership. The buyer should get from the seller a certified
abstract of title for each parcel of real estate involved in the
transaction. The abstract should be examined by the buyer's attorney. In
addition to disclosing any defects in the title, examination of the
abstract and the abstractor's certificate will usually show whether there
are any unreleased mortgages, judgment liens, mechanics' liens, tax liens,
or unpaid real-estate taxes and special assessments.
The seller should be asked to show evidence of his ownership of principal
items of personal property in the form of bills of sales, receipts,
assignments, motor-vehicle title certificates, and so on. Such evidence
will not prove that there are no recorded liens against the property, but
lack of it should alert the buyer to the possibility that personal property
in the physical possession of the seller is rented, leased, borrowed, or
delivered on consignment.
Organizational documents. If the seller is a partnership, the buyer should
get a copy of the partnership agreement. If there is no written agreement,
he should find out who the partners are and whether authority exists to
sell the business assets.
If the seller is a corporation, the buyer should get a certified copy of
the resolution of the shareholders authorizing the sale of the corporate
assets. In a corporation stock transaction, he should get a copy of all
organizational documents. These documents include the articles of
incorporation and amendments to it, the corporate bylaws, stock-transfer
books, and minutes of shareholders' and directors' meetings.
Observation and inquiry. Certain types of legal problems can be uncovered
only by observation and inquiry. This is true of mechanics' liens. The
basis for mechanics' liens against real estate may exist even though no
lien is on file. If the buyer learns that there has been repair or
construction within the allowable period for filing mechanics' liens, he
should check with the contractors and suppliers to find out whether they
have been paid.
The real estate should be examined to make sure that it complies with
building codes and other ordinances. It is advisable also to have the real
estate surveyed to determine whether buildings are located within
boundaries in compliance with setback lines, whether adjoining buildings or
driveways are encroaching upon the property, and so on.
External Sources of Legal Information
Among the more common external sources of legal information are public
records, government agencies, and third parties with whom the seller has
had dealings.
Office of record. A down-to-date abstract of title will ordinarily disclose
the existence of liens against a particular panel of real estate, but liens
against personal property of the seller can be discovered only by a search
of the office of record. Separate filing systems may exist for chattel
mortgages, conditional sales contracts, trust receipts, assignment of
accounts receivable, and so on. Each of these files must be checked.
A record search will not disclose what items of personal property in
possession of the seller have been rented, leased, borrowed, or delivered
on consignment. Also, lien notations on motor-vehicle title certificates
may take precedence over recording--it depends on State statutes.
Tax authorities. Investigation is especially important where the buyer is
purchasing the stock of the seller or assuming liability for the payment
status of Federal, State, and local income taxes, Social Security and
income withholding taxes, Federal excise taxes, State and local taxes,
license taxes, and real- and personal-property taxes. Have tax returns been
reviewed and approved by the taxing authority?
Zoning ordinances, planning agencies, building codes. The buyer should
check zoning ordinances and building codes to determine the existence of
nonconforming land uses or violations of building codes. Comprehensive
zoning plans may provide for steps to be taken toward elimination of
nonconforming uses. This can be done by prohibiting alteration or enlarging
of buildings or by requiring liquidation of nonconforming use within a
prescribed period of time.
City, county, or metropolitan planning agencies and engineering departments
should be consulted about the existence of master plans for future
rezoning, redevelopment, and street or highway changes. Highway relocation,
limited street or highway access, elimination of on-street parking, or
changes in the composition of the immediate market area may be enough to
destroy the business as a going concern. City annexation policies may be
important to businesses located in the suburbs. The cost of planned
improvements may affect the buyer's decision.
Court records. The buyer should find out from court records whether
judgment liens exist against real estate involved in the buy-sell
transaction and whether lawsuits are pending that may retroactively result
in the attachment of liens. This is of particular concern to the buyer who
either assumes business liabilities or purchases the stock of a
corporation. Not only litigation costs and liability must be considered but
also the impact of the publicity on the goodwill of the business.
Even if a court record search is negative, future litigation may arise out
of events of the past several years, such as motor-vehicle accidents,
manufacture or sale of defective products, accidents on the premises
involving customers or employees, breach of contract, violations of
wage-and-hour laws, and so on. The best protection is to inquire of the
seller and of employees who have been intimately concerned with the
business.
Part 3 The Buy-Sell Process
Chapter 6 - Determining the Value of a Business
THE MOST DIFFICULT STEP in buying or selling a small business is probably
determining what the business is worth as a going concern. Many judgment
decisions must be made. Yet before negotiations can continue successfully,
a value must be established. The value must be acceptable to both buyer and
seller, or further negotiation is fruitless. It must result from the
logical and objective efforts of all the parties involved.
Valuation Methods
There are two basic methods of determining the value of a business. The
first is based on expectations of future profits and return on investment.
This method is preferable by far. It forces the buyer and seller to give at
least minimum attention to such factors as trends in sales and profits,
capitalized value of the business, and expectancy of return on investment.
The second method is based on the appraised value of the assets at the time
of negotiation. It assumes that these assets will continue to be used in
the business. This method gives little consideration to the future of the
business. It determines asset values only as they relate to the present. It
is the more commonly used, not because it is more reliable, but because it
is easier. The projections needed to value the business on the basis of
future profits are difficult to make.
Looking Ahead
Whichever method is to be used to value the business, the buyer should ask
the seller to prepare a pro forma, or projected, statement of income and
profit or loss for at least the next 12 months. For this, the seller will
prepare a sales estimate for this period along with a matching estimate of
the cost of goods sold and operating expense.
The projected statement will reflect the net profit the seller believes
possible. The buyer should then make his own estimate of sales, cost of
goods sold, operating expenses, and net profit for the next year at least,
and as far into the future as possible.
In preparing these statements, the buyer should start by analyzing the
actual statements of profit and loss for at least 5 years back. He should
be sure that the past and projected statements provided by the seller are
correct and are consistent with the buyer's proposed future operation. He
should also study general and local economic changes that will affect
future business. This includes competition.
If the buyer is not qualified to prepare projected financial statements, he
should consult an independent accountant. This will involve some expense,
but the cost will be small compared to the loss he might incur if he
invested in a small business with a doubtful future.
Financial statements and their analysis are discussed in part 4; market
analysis in part 5.
Forecasting Sales
The most important projection to be determined in the projected income
statement is the sales figure. After this number has been established, the
cost, expense, and profit figures are easier to acquire. The data for
projecting sales will come from past sales records of the business. The
more accurate and systematic these records are, the more confidently they
can be used in estimating future sales.
How long a forecast? A basic question is this: "Over how long a period of
time is it necessary or possible to forecast sales?" Any forecast is
uncertain, and the farther a forecast is projected into the future, the
greater the uncertainty. While it may be possible to exercise at least
reasonable control over the internal operation, the external economic and
market factors make forecasting difficult because of lack of control.
Perhaps the best way to approach the length of the forecast is in terms of
the expected return on investment. Suppose it is estimated that the
business should bring a 20 percent return on initial investment. The
investment, then should be returned in 5 years. At this point, the owner
would just break even on his original investment. It seems logical to
project sales and profits over a span of time comparable to that estimated
for return on investment--in the above illustration, 5 years.
Any such forecast, however, should give careful consideration to expected
changes either in the economy or in the industry market that might affect
the pattern of sales change. Mathematically, it is possible to forecast
sales with some precision. Realistically, however, this precision is dulled
because vital market and economic factors cannot be controlled.
Methods of forecasting sales. There are numerous methods by which sales
forecasts can be made. Most of them take their lead from the past sales
performance of the company. For establishing trends or averages, 5 years of
sales history is better then 3, and 10 is better than 5.
Perhaps the simplest method is to assume that the percentage increase (or
decrease) in sales will continue and that no market factors will influence
sales performance more in the future than in the past. Suppose, for
example, that the rate of yearly average increase for the past 5 years has
been 4 percent, and that each year has shown about this rate of increase.
Then it might be assumed that sales for the next year will be 4 percent
greater than the current or most recent year.
But what about the year following? The year after that? Can it be assumed
that these years will also increase at about 4-percent level? Each
additional year into the future reduces the certainty of the predictions.
If these negative influences limit the accuracy to such an extent, why try
to forecast beyond the immediate future (1 year)? Because such a forecast
forces the person making it to give at least a little attention to economic
and market factors that might influence the future operation--that might,
in fact, indicate that the purchase or sale of the business would not be
wise.
With forecasts covering more than 1 or 2 years, a more detailed forecasting
technique is needed. Such technique should be designed to weight out
extreme variations in year-to-year sales and to give a trend or level of
sales change that is more realistically oriented to probable future sales
patterns.
No method of forecasting can set any value on external market conditions,
because there is no guarantee that these conditions will carry over into
the future with the same relative significance. Nevertheless, their
possible influence should be considered.
Some simple methods of short-term forecasting are described in chapter 14.
Risk and Return on Investment
If a buyer wants to invest money in a business that is being sold, he
should be concerned about receiving a fair return on his investment. Many
businesses can make a profit for a short time (1 to 5 years); not so many
operate profitably over a longer period of time.
From the buyer's point of view, what is a fair rate of return from an
investment in a small business? The rate of return is usually related to
the risk factor--the higher the risk, the higher the return should be.
United States Government bonds are the safest investment--the rate of
return ranges from 5-1/2 to 6 percent. Blue-chip stocks and corporate bonds
usually give the investor a return of 4 to 10 percent if both dividends or
interest and increase in market value are considered. Speculative stocks
may have a higher return, but they also have a higher risk factor.
The buyer of a small business should try to determine the risk factor of
the new business, though this is difficult at best and in many cases
impossible. In attempting to assess the risk factor, the buyer should
project the profits of the business as far into the future as possible. He
should ask himself how high the risk should be normally and look for
conditions that would be likely to affect the sales and profit-making
capability of the business.
In any event, he should consider carefully the minimum return on investment
that he is willing to accept. This concept of risk is important in valuing
the business by capitalization of future earnings.
Valuing the Business by Capitalizing Future Earnings
The price to be paid by the buyer should be based on the capitalized value
of future earnings. Instead, however, in most small business buy-sell
transactions, price is based on the purchase and sale of assets. Profits
are made by utilizing assets, of course, but actually the assets purchased
are only incidental to the future profits of the new business.
Capitalized value is the capital value that would bring the stated earnings
at a specified rate of interest. The rate used is usually the current rate
of return for investments involving a similar amount of risk. The
capitalized value is found by dividing the annual profit by the specified
rate of return expressed as a decimal.
Assume for the moment that the future profits of a business have been
projected for the next 5 years and are estimated to average $20,000 a year.
(This is in addition to compensations for the services of the buyer and any
members of his family.) What should be the sales price for the buy-sell
transaction?
If this investment were as safe as U.S. Government bonds, the buyer should
be willing to pay $333,000 ($10,000 divided by .06). If the investment is
considered as safe as an investment in an excellent corporate stock that
earns 10 percent in dividends and price increases, the buyer should be
willing to pay $200,000 ($10,000 divided by .10).
Very few small businesses, however, have as low a risk factor as these two
investments. What rate, then, should be used in capitalizing the earnings
of a small business? Usually, 20 to 25 percent is considered adequate. This
means that the buyer should pay between $80,000 and $100,000 for this
business. If it earns the projected $20,000 a year, the buyer will recover
his initial investment in 4 to 5 years. This time will be extended by
Federal and State income taxes to be paid on the income, but this would
also be the case for most alternative investments except nontaxable
municipal securities.
In using a computation such as this, the importance of long-run profits
should be kept in mind. Unless profits are possible over a long period of
time (10 to 15 years), investment in a small business may be a poor
decision. The trend of profits is also important. If all other factors are
the same, a company whose profits are declining is worth less than one
whose profits are increasing.
Valuing the Business on the Basis of Asset Appraisal
The majority of buy-sell transactions are based on a value established for
the assets of the company. This approach is not recommended, but if it is
to be used, the suggestions that follow should be considered.
A most important point is to find out early in the transaction just what
assets are to be transferred. Usually, the seller has some personal items
that he does not wish to sell. Prepaid insurance, some supplies and the
like, in addition to cash, marketable securities, accounts receivable, and
notes receivable usually are not sold. If the buyer does purchase the
receivables, the seller may guarantee their collection, but such a
guarantee should be established.
The assets most commonly purchased in a small business buy-sell transaction
are merchandise inventory, sales and office supplies, fixtures and
equipment, and goodwill.
Evaluating goodwill. One of the assets that must be considered in a
buy-sell transaction is goodwill. Goodwill, in a general sense, arises from
all the special advantages connected with a going concern--its good name,
capable staff and personnel, high financial standing, reputation for
superior products and customer services, and favorable location.
From the accounting point of view, goodwill is the ability of a business to
realize above-normal profits as a result of these factors. By above-normal
profit is meant a higher rate of return on the investment than that
ordinarily necessary to attract investors to that type of business.
The value of goodwill can be computed in either of the following ways:
1. Capitalization of average net earnings. As explained above, the amount
to be paid for a business may be determined by capitalizing expected future
earnings at a rate that represents the required return on investment. The
difference between this amount and the appraised value of the physical
assets may be considered the price of goodwill.
This method uses only earnings in computing the price to be paid for the
business. For that part of the calculation, it ignores the appraised value
of the assets.
2. Capitalization of average excess earnings. This method recognizes both
earnings and asset contributions. It starts with the appraised value of the
assets and computes what would be a fair return on that value. If the
estimated future earnings are higher than this "fair return," the
difference between the two figures--the "excess earnings"--is capitalized
at a higher rate, and the amount thus obtained is considered the goodwill
value. This figure is added to the appraised value of the assets to give a
price for the business.
Payment of excess earnings is often stated in terms of "years of purchase"
instead of in terms of capitalization at a certain interest rate.
Capitalization of average earnings at 20 percent is the same as payment for
5 years' excess earnings.
As the above discussion shows, the determination of goodwill usually
reflects the value of profits that will be realized by the buyer above the
normal rate of return; that is, the excess profits. But most small
businesses that are for sale do not have excess profits. They usually show
nominal profits or none at all. Often the seller makes an offer that seems
quite good, but the buyer must be able to eliminate the seller's emotions
and reduce all facts to workable relationships.
If there are excess profits, goodwill is usually valued by capitalizing
them at a fixed percentage established by bargaining between the seller and
the buyer. The capitalization percentage needs to be high because profits
higher than a normal return are difficult to maintain. Excess profits of
$4,000 capitalized at 10 percent will give a goodwill value of $40,000
($4,000 divided by .10). Capitalizing the same excess profits at 20 percent
gives a goodwill value of $20,000 ($4,000 divided by .20).
Although goodwill valuation is the first asset valuation to be discussed
here, it is normally the last to be computed. Since few small businesses
being sold are producing excess profits, the problem of goodwill value is
not a pressing one in most buy-sell transactions.
Merchandise inventory. In a service business, placing a value on the
inventories is a minor problem; but in distributive and manufacturing
businesses, the inventory is likely to be the largest single asset. A
manufacturer, for example, has three inventories--raw material, work in
process, and fixed goods--and each of them present different problems in
valuation. The distributive company has only one inventory, called
merchandise inventory.
The financial statements presented by the seller will probably reflect an
inventory value different from the one assigned in a buy-sell transaction.
Inventories are usually carried on the books either at cost or at the lower
of cost or market. Market is defined as the current replacement cost to the
seller.
In determining the value of inventories, the seller has to choose a method
of arriving at cost. The most common costing methods are first-in-first-out
(FIFO), last-in-first-out (LIFO), and average cost. These methods may give
very different values and the buyer and seller must arrive at some value
agreeable to both. The most common methods used in valuing inventories for
buying and selling small businesses are cost of last purchase and current
market price.
The quantity of the inventory is usually determined by a physical count.
The physical inventory procedures should be decided before the count, and
each inventory team should include one representative from the buyer and
one from the seller. It is easy to omit items from the inventory count, and
here the seller is usually in a more vulnerable position than the buyer.
There is more danger of omitting item from the count than of double
counting them.
It may be that some items of inventory are not to be sold. If so, these
items should be segregated before the count begins. Another problem is
determining what quality of items are to be included in the inventory. The
buyer needs to be cautious when examining the inventories--in most buy-sell
situations there is some inventory that is not salable.
This is one reason why the buyer should employ as his representatives on
the inventory teams individuals who are acquainted with that type of
inventory. If the buyer and the seller disagree on the value of certain
items, the seller will remove these items from the list of inventory for
sale.
When the inventory is being priced, be very careful in matching price to
quantity. Be sure that the units in which the quantity is recorded and the
units priced are the same. The physical count should be recorded in
duplicate so that buyer and seller can each make separate extensions after
all prices have been listed. After independent extensions, the two
inventories should be reconciled.
Manufacturer's inventory. When a manufacturing company is being exchanged,
the raw materials inventory is taken and priced like the merchandise
inventory of a distributive business. The work-in-process and
finished-goods inventories may present a problem. Usually, there is no
market price or cost of last purchase to relate to these inventories;
consequently, the seller's cost is generally used for establishing prices.
If the seller has unused plant capacity or if his plant is inefficient, his
costs may be inflated. Such a situation requires the help of an accountant
with a good knowledge of cost accounting.
Store supplies and office supplies. These two items are usually quite
small. They should present no problem, though some of them may have no
value to the buyer if the name of the company is to be changed. After the
usable supplies have been determined, a physical inventory should be taken
and priced as in the case of the merchandise inventory.
Property assets and accumulated depreciation. The property-asset account
normally reflects the cost of the assets reduced by a provision for
depreciation. In many small business buy-sell transactions, no real
property is exchanged, because the plant site is leased. The problem of
establishing a value on real estate is not as acute, anyway, since the
market value for real property does not fluctuate as widely as the market
value for personal property.
It is customary to have an independent appraiser establish a value for real
property. Appraisers' findings on real property are usually more acceptable
to both parties than personal-property appraisals--the real property may
have multiple uses, whereas personal property consists of single-purpose
assets. The book value of real property will be close to the appraisal
value unless the property has been held for a long period of time or
unusual circumstances have caused sudden and drastic changes of
real-property values.
Personal-property assets. The buyer may feel that he knows going values of
the personal property and decide not to retain an independent appraiser. In
addition, many individuals believe that cost or book value is a good place
to begin negotiations for personal property. However, because of the many
methods of computing depreciation and also because of conflicting ideas
about capitalizing cost, the cost or book value may not reflect a value
that is agreeable to both parties.
It is difficult to assign a value to personal property equipment because
these assets have little value if the company is liquidated. Therefore, a
going concern value should be determined. The price to be paid for this
equipment should be somewhere within the range of the cost of new equipment
or the cost of comparable used equipment. For this reason, an independent
appraiser can be useful, particularly if he is acquainted with the type of
equipment being sought or sold.
The seller should realize that he may own assets that do not appear on the
fixed-asset schedule. Many companies have a policy of not capitalizing any
assets below some arbitrary amount ($100 or $200). A complete physical
inventory should be taken.
If the assets are numerous and geographically dispersed, the seller may be
asked to prepare a certified list of the assets giving description and
location. The buyer can then test the list by verifying only selected
assets at the time of the sale, but with plans to verify all of them within
a certain period of time.
The value of personal-property assets is usually decided after considerable
bargaining. It is better to assign values to individual assets rather than
to make a lump-sum purchase of assets. In a lump-sum purchase, there is
more chance of overlooking some asset values.
The buyer should try to determine the condition of the assets as well as
repair and replacement requirements. If he doesn't establish the condition
of the assets individually, repair and possible replacement costs may
create an unexpectedly heavy drain on his working capital.
Federal Income Tax Consequences
Federal income tax consequences of the buy-sell transaction may be an
important bargaining issue if the buyer and seller are aware of them. The
seller should be concerned about the amount of tax he will have to pay on
his gains from the sale. The buyer should be concerned about the tax basis
he will acquire as a result of the transaction. These concerns almost
inevitably lead the buyer and seller into conflict in valuing the business.
The income-tax laws are highly technical, and the possible variations in a
buy-sell situation are infinite. Because of this, a discussion specific
enough to be really helpful is impossible here. Both buyer and seller
should study the applicable sections of the IRS Tax Guide for Small
Business; and if an important decision in the buy-sell agreement is to be
based on Federal income-tax consequences, the advice of an income-tax
expert should be sought. The key to tax savings is tax planning--before the
buy-sell contract is closed.
The seller should keep in mind that he must report any income-tax liability
he incurs by selling a going business. Reinvesting the sales proceeds in
another business will not enable him to avoid or postpone his income-tax
liability.
A Valuation Example--the Regal Men's Store
This example will help to bring the factors discussed about into better
focus. It is not intended to show what should be done but to give some idea
of what might be done.
The buyer and the seller. Joe Critser is interested in buying a men's
clothing store. He has had nearly 25 years' experience in the men's
clothing trade-first as a salesman in retail stores and more recently as a
sales representative for Sentinel, a major manufacturer of men's clothing.
Now 45 years old, Critser is interested in having a store of his own.
In February 1979, Critser learns that the Regal Men's Store is for sale.
James Rombaugh, owner and operator of the store, is now 67 and wants to
retire, he says. He has no heirs, and no employee of the store is
financially able to purchase the business. Rombaugh started the store in
the late twenties and has been the sole owner during the 40 years Regal has
been in operation.
The Store. Critser's early investigation convinces him that the store has
the kind of possibilities he is looking for. Although it has been operated
conservatively, it has a good reputation in the community and a creditable
standing in the clothing trade. The store has never been particularly
aggressive in advertising--the owner has relied on repeat patronage and
word-of-mouth advertising.
Critser suspects that part of Rombaugh's desire to sell is due to
competitive pressure from more aggressive stores in the community. Sales
have continued to increase about in proportion to the market in general,
but gross margin and profit have been reduced because of lower overall
maintained markups and increasing costs of operation. Rombaugh owns the
inventory, fixtures, equipment, and operating supplies and leases the
building at 5 percent of net sales, with a minimum payment of $1,000 a
month. The current lease will expire in about 4 years.
The preliminary discussion. Rombaugh has been well impressed with Critser
and agrees to furnish necessary financial information. In their discussion
to date, Rombaugh has stated that he feels the business is worth about
$100,000 for the purchase of inventory, fixtures, equipment, and goodwill.
He will retain all accounts receivable, but he is willing to allow the new
owner an 8 percent fee for outstanding accounts receivable collected after
the transfer of ownership has been completed.
He also wants to keep a few assets for which he has a sentimental
attachment, such as a massive rolltop desk purchased when the store was
first opened. Rombaugh will assume responsibility for payment of
liabilities outstanding at the time of sale.
Critser, on the other hand, feels that the business is worth somewhat less
than $100,000. It is obvious to him through casual inspection that some of
the inventory is worth less than the original purchase price, and he doubts
the value that Rombaugh would place on goodwill. He also notes that some of
the display equipment is outmoded and needs replacement.
Before accepting or rejecting Rombaugh's price, Critser suggests that he be
permitted to make his own evaluation of the business on the basis of past
financial records and an appraisal of the assets. Rombaugh agrees.
Following are the major elements of Critser's investigation and appraisal:
Past sales
1974--$220,000
1975-- 228,800
1976-- 238,000
1977-- 247,600
1978-- 257,600
Forecast sales--1979
$265,000--Critser's estimate of sales, which includes a somewhat smaller
increase than the average of 3.2 percent per year between 1974 and 1978.
$268,676--Rombaugh's estimate based on the average.
Five-year operating statement
1974 1975 1976 1977 1978
Sales............... $220,000 $228,800 $238,000 $247,600 $257,600
Cost of goods sold.. 139,980 146,432 159,260 160,940 167,440
-------- -------- -------- -------- --------
Gross margin........ 80,020 82,368 78,740 86,660 90,160
Operating expenses 62,420 66,352 62,674 70,566 74,704
-------- -------- -------- -------- --------
Profit.............. 17,600 16,016 16,066 16,094 15,456
-------- -------- -------- -------- --------
Projected operating statement for 1979
CRITZER ROMBAUGH
(Buyer) (Seller)
Sales....................................$265,000 $268,676
Cost of goods sold....................... 172,250 174,640
-------- --------
Gross margin...................... 92,750 94,036
Operating expenses...................... 76,850 75,766
-------- --------
Profit........................... 15,900 18,270
-------- --------
Balance sheet of Regal Men's Store as of January 31, 1979
Assets
Cash on hand and in bank....................................$20,000
Accounts receivable.............................$32,000
Less estimated uncollectible.................. 4,000
------- 28,000
Merchandise inventory....................................... 49,214
Sales and office supplies................................... 1,920
Fixtures........................................ 20,000
Less estimated depreciation................... 5,600
------- 14,400
Equipment....................................... 19,000
Less estimated depreciation................... 8,600
------- 10,400
Miscellaneous assets........................................ 1,280
--------
Total assets...........................................$125,214
--------
Liabilities
Accounts payable.................................$11,000
Payroll and sales tax payable.................... 1,300
-------
Total liabilities...................................... $12,300
Net worth
James Rombaugh, capital.................................... 112,914
Total liabilities and net worth........................$125,214
--------
Salable assets
Inventory at current book value............................ $49,214
Sales and office supplies.................................. 1,920
Fixtures, current depreciated value........................ 14,400
Equipment, current depreciated value....................... 10,400
-------
Total salable assets................................... $75,934
-------
Valuation of inventory and appraisal of fixed assets
CRITZER ROMBAUGH
Inventory by physical count.................................$47,514
90 percent valued at current prices..............$42,762
5 percent valued at 75 percent of current prices 1,782
5 percent valued at 50 percent of current prices 1,188
------- -------
Inventory--appraised value....................... 45,732 47,514
Usable office supplies........................... 1,680 1,680
Fixtures--appraised value....................... 13,600 13,600
Equipment--appraised value...................... 9,400 9,400
------- -------
Total assets--appraised value................$70,412 $72,194
------- -------
How much to pay? If Critser feels that his return on investment should be
capitalized over 5 years, his offering price, based on anticipated profits
for the year ahead, would be $79,500 (5 years = 20 percent per year;
$15,900 div. by .20 - $79,500). If, on the other hand, the purchase was
based on the appraised value of assets only, the purchase price would be
$70,412 plus any provision for goodwill.
Since both of these figures are well below the suggested price of $100,000,
negotiation will be necessary. Here are some questions that might arise:
1. In light of future sales and profit possibilities, are the assets worth
more than the sale price?
2. Is the risk less than Critser anticipates? To pay $100,000, he would have
to reduce his risk level to between 6 and 7 years.
3. Is Rombaugh's price too high in the light of future sales and profit
possibilities under new management?
4. How much confidence does Critser have in his ability to realize an
acceptable return on his investment?
5. Is the actual value of this business as a going concern closer to
$68,000, $80,000, or $100,000?
6. How much is the goodwill of this business actually worth to Rombaugh? To
Critser?
7. What kind of compromise might be satisfactory to both the buyer and the
seller?
Chapter 7 - Negotiating the Buy-Sell Contract
THE FINAL OBJECTIVE of the negotiation process is a written agreement
covering the details of the proposed buy-sell transaction. Some of the
details--price, terms of payment, price allocation, form of the
transaction, liabilities, warranties--are matters over which the interests
and motivations of the buyer and seller may be in sharp conflict.
The seller is interested in--
The best possible price--
Getting his money--
Favorable tax treatment of gains from the sale--
Severing liability ties, past and future--
Avoiding contract terms and conditions that he may not be able to
carry out.
In contrast, the buyer is interested in--
A good title at the lowest possible price--
Favorable payment terms--
A favorable tax basis for resale and depreciation purposes--
Warranty protection against false statements of the seller, inaccurate
financial data, and undisclosed or potential liabilities--
An indemnification agreement and security deposit.
The agreement reached by the parties, if they succeed in reaching one, will
be the result of bargaining. Depending on the relative bargaining position
of the buyer and seller, the buy-sell contract may reflect either
compromise or capitulation.
Price
The central bargaining issue in the buy-sell transaction is price. Price is
what is actually paid for a business. Value, as distinguished from price,
relates to what the business is worth. The decisions of the buyer and
seller as to how much to pay or take for each dollar of potential profit
are a basis for bargaining, but other factors affect the final price.
In the Regal Men's Store negotiations, Rombaugh was asking $100,000 for his
business. Critser made his own evaluation of the business and offered
$66,000. After an extended period of negotiations, Critser and Rombaugh
agreed on a purchase price of $84,000.
What determined the asking and offering prices? How did they finally arrive
at the figure of $84,000?
The process of price determination is sometimes described as horse trading.
This element is important, and undoubtedly both Rombaugh and Critser
anticipated it in setting their asking and offering prices. But granting
that tactics and compromise play a part in price determination, other
explanations often account for the relative success or failure in the
bargaining process.
Bargaining position. The price paid often reflects the bargaining position
of one of the parties. Is the seller's desire to sell stronger than the
buyer's desire to buy, or vice versa? The reason behind the decision to buy
or sell is important. This would be true of a seller who must sell because
of age, health, or personal financial reasons. If the buyer knows that sale
of the business is urgent, the seller is less likely to get a reasonable
price for his business, although the reasons bear no relation to the value
of the business or the ability of the buyer to pay cash.
The seller's willingness to finance part of the price, or perhaps all of
it, will also depend on the urgency of his need to sell. Sometimes a
purchase price is agreed upon but later raised because the buyer is unable
to get favorable tax treatment or in exchange for more favorable terms in
other aspects of the contract.
The time factor. Another important factor affecting bargaining position is
the time element--when to sell, when to buy. Economic conditions cannot be
overlooked. The seller is more likely to gain his bargaining objectives
when business conditions are good, particularly if his business is sharing
the prosperity. During periods of recession--either general, local, or in a
particular industry or activity--the pessimistic outlook of both buyers and
sellers tends to depress prices.
The buyer. Still another important factor is, "Who is the buyer?" To a
person experienced in business valuation, a business may be worth buying
only at the liquidation value of the assets. To another buyer, the same
business may be the answer to a long-held dream of owning his own business.
Liabilities
A buyer generally prefers to purchase assets rather than stock for tax
reasons, but his preference becomes even stronger because of liability
considerations. In the assets transaction, the legal continuity of the
seller's business is broken. The seller's business liabilities are usually
not carried over unless the buyer assumes them by agreement.
Buyers often find an advantage in assuming obligations of the seller under
leases, mortgages, or installment-purchase contracts. The seller may be
willing to make some financial sacrifice to the buyer in order to get out
from under the payment burden--even though he remains liable for the
obligation if the buyer defaults.
But these are known liabilities. It is the unknown that the buyer fears in
the stock transaction. Many liabilities, both existing and potential, are
unknown at the time of contracting merely because of inadequate
investigation. And in any business, there are potential liabilities that
neither an honest seller nor a diligent buyer can foresee at the time of
the buy-sell transaction. An accident involving a company truck, the fall
of a customer on the business premises, or the discharge of an employee may
become the basis of a lawsuit and eventual liability, even though many
months have passed since the event.
Even more elusive are liabilities that may arise from the manufacture or
sale of defective products, patent or trademark infringements, or
violations of statutes such as wage-and-hour laws, blue-sky laws, the
Robinson-Patman Act, the Sherman Act, and so on. Tax deficiencies may arise
out of tax returns filed but unaudited at the time of the buy-sell
transaction.
The price agreed upon in a stock transaction will, of course, take into
consideration only known liabilities. The possibility of unknown
liabilities need not, however, preclude the buyer from entering into a
stock transaction. Such a course of action may, in fact, be necessary in
order to retain the benefits of nonassignable contracts, leases,
franchises, government licenses, stock registrations, corporate name, and
so on.
The buyer of stock should take precautions against unknown liabilities.
Ordinarily this would include an agreement on the part of the seller to
indemnify the buyer against such liabilities and on some means for
satisfying any claims against the seller. Holding part of the purchase
price in escrow against such a contingency gives the buyer at least some
security.
Contract Terms
A number of problems in the buy-sell transaction are brought into focus by
the necessity of "writing up a contract." At this point, agreement has
usually been reached on the major issue--price. Presumably, the buyer and
seller have considered tax consequences, assumption of liabilities, and
terms of payment in arriving at a price.
More is involved in drafting an adequate buy-sell contract, however, than
mechanically reducing these oral agreements to written form. To protect the
interests of both parties, the contract must cover possible problems that
are often far from the minds of the buyer and seller at the time.
What if the buyer defaults on his installment payment of the purchase
price? What if the seller's financial statements, which the buyer relied
on, turn out to be inaccurate or false? What if the seller turns out to
have liabilities that have not been taken into account in the price? What
if some of the assets purchased turn out not to be owned by the seller or
are subject to undisclosed liens? What if material changes in the business
occur before the buy-sell transaction is closed? What if the seller opens a
competing business of the same type in the immediate vicinity?
These questions reflect the uncertainty of the buyer's position. The seller
knows what he is selling and what he is getting (with a possible exception
in the case of seller financing). The buyer is getting an unknown quantity.
Whether or not the buyer gets the protection he should have as part of the
contract is a matter of bargaining.
A Typical Buy-Sell Contract
Following is a typical buy-sell contract, with comments, covering the sale
of the Regal Men's Store. The contract covers the sale of a proprietorship
business, but the basic content would be the same in a corporate stock
transaction.
------+++------
THIS AGREEMENT is made and entered into this 15th day of February, 1979,
between James Rombaugh, hereinafter referred to as the Seller, and Joe
Critser, hereinafter referred to as the Buyer.
WHEREAS the Seller is the owner of a men's clothing store using the trade
name of "Regal Men's Store" in Central City, Illinois, and the Seller
desires to sell to the Buyer his rights, title and interests including the
goodwill therein, and the Buyer is willing to buy the same on the terms and
conditions hereinafter provided, IT IS AGREED AS FOLLOWS:
(The above statements introduce the parties and the nature of the
agreement. If the business is incorporated and a stock transaction
contemplated, the stockholders will be identified as the sellers and stock
as the item sold.)
1. Sale of business. The Seller shall sell and the Buyer shall buy, free
from all liabilities and encumbrances except as hereinafter provided, the
men's clothing store owned and conducted by the Seller under the trade name
of "Regal Men's Store" at the premises known as 120 North Main Street,
Central City, Illinois, including the goodwill as a going concern, the
lease to such premises, stock in trade, furniture, fixtures, equipment and
supplies, all of which are more specifically enumerated in Schedule A
attached hereto.
(Paragraph 1 incorporates by reference an inventory not shown here of the
assets being purchased. A specific enumeration of assets being purchased is
important as a basis for recourse against the seller in the event of
shortage or title defects.)
2. Purchase price. The purchase price for all the assets referred to in
paragraph 1 shall be $84,000 and allocable as follows:
Lease......................................... 0
Goodwill......................................$ 6,000
Fixtures and equipment........................ 30,000
Inventory..................................... 47,400
Supplies...................................... 600
-------
$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 following manner: (a) $10,000 by certified or
cashier's check upon execution of this agreement, the receipt of which is
hereby acknowledged by the Seller, such proceeds to be held in escrow by
Paul Jones, attorney for the Seller, as provided in paragraph 13; (b)
$40,000 by certified or cashier's check at the date of closing, subject to
the adjustments provided for in paragraph 4; (c) the balance of $34,000 by
a promissory note payable in consecutive monthly installments of $400 each
beginning the first day of April, 1979, together with interest at 11-1/2%
per annum.all contain a provision, satisfactory Such note shto the
attorney for the Seller, for the acceleration of the balance remaining
unpaid upon default in the payment of an installment for a period longer
than thirty days. As security for the payment of any such note, the Buyer
shall execute and deliver to the Seller at the closing a chattel mortgage
upon the inventory, fixtures, and equipment described in paragraph 1, such
mortgage to contain an after-acquired property clause and such other
provisions as the attorney for the Seller may request.
(Paragraph 3 recognizes the financing seller's principal problem:
security--or lack of it. The acuteness of the problem results from the fact
that the buyer has usually exhausted all acceptable forms of security in
getting the bank credit he needs.)
4. Adjustments. Adjustments shall be made at the time of closing for the
following: inventory sold, insurance premiums, rent, deposits with utility
companies, payroll and payroll taxes. The net amount of these adjustments
shall be added or subtracted, as the case may be, from the amount due on
the purchase price at the time of closing.
5. Buyer's assumption of contracts and liabilities. In the event this
agreement to sell is in fact closed and the business is transferred by the
Seller to the Buyer, the Buyer shall be bound by and does hereby assume the
terms of the following contracts:
Lease of business premises dated January 1, 1976. The Buyer shall indemnify
the Seller against any liability or expense arising out of any breach of
such contracts occurring after the closing.
(Since a going business is being sold, the most realistic approach to the
problem of outstanding liabilities may be for the buyer to assume all
liabilities shown in an attached balance sheet and also liabilities that
arise in the ordinary course of business after contracting but before
closing. Such an agreement provides recourse by the seller against the
buyer if the buyer defaults, but does not discharge the liability of the
seller to the third party.)
6. Seller's warranties. The Seller warrants and represents the following:
(a) He is the owner of and has good and marketable title to all the assets
specifically enumerated in Schedule A, free from all debts and encumbrances.
(b) The financial statements which are attached hereto as Schedule B have
been prepared in conformity with generally accepted accounting principles
and present a true and correct statement of the financial condition of said
business as of their respective dates.
(c) There are no business liabilities or obligations of any nature, whether
absolute, accrued, contingent or otherwise, except as and to the extent
reflected in the balance sheet of January 31, 1979.
(d) No litigation, governmental proceeding or investigation is pending, or
to the knowledge of the Seller threatened or in prospect, against or
relating to said business.
(e) The Seller has no knowledge of any developments or threatened
developments of a nature that would be materially adverse to said business.
(f) The statements made and information given by the Seller to the Buyer
concerning said business, and upon which the Buyer has relied in agreeing
to purchase said business, are true and accurate and no material fact has
been withheld from the Buyer.
(Paragraph 6 is intended to protect the buyer from the unknown--title
defects, undisclosed liens, false or fraudulent information, undisclosed or
potential liabilities. If the buyer is becoming liable for all business
liabilities through assumption or purchase of stock, he will require more
extensive warranties than these.)
7. Seller's obligation pending closing. The Seller covenants and agrees
with the Buyer as follows:
(a) The Seller shall conduct the business up to the date of closing in a
regular and normal manner and shall use its best efforts to keep available
to the Buyer the services of its present employees and to preserve the
goodwill of the Seller's suppliers, customers and others having business
relations with it.
(b) The Seller shall keep and maintain an accurate record of all items of
inventory sold in the ordinary course of business from January 31, 1979 up
until the date of closing. Such record shall be the basis for adjustment of
the purchase price as provided in paragraph 4.
(c) The Seller shall give the Buyer or his representative full access
during normal business hours to the business premises, records and
properties, and shall furnish the Buyer with such information concerning
operation of the business as the Buyer may reasonably request.
(d) The Seller shall comply to the satisfaction of the Buyer's attorney
with all the provisions of the statute of the State of Illinois commonly
known as the "Bulk Sales Act."
(e) The Seller shall deliver to the Buyer's attorney for examination and
approval prior to closing such bills of sale and instruments of assignment
as in the opinion of the Buyer's attorney shall be necessary to vest in the
Buyer good and marketable title to the business, assets and goodwill of the
Seller.
8. Risk of loss. The Seller assumes all risk of destruction, loss or damage
due to fire or other casualty up to the date of closing. If any
destruction, loss or damage occurs and is such that the business of the
Seller is interrupted, curtailed or otherwise materially affected, the
Buyer shall have to right to terminate this agreement. In such event, the
escrow agent shall return to the Buyer the purchase money held by him. If
any destruction, loss or damage occurs which does not interrupt, curtail or
otherwise materially affect the business, the purchase price shall be
adjusted at the closing to reflect such destruction, loss or damage.
(Paragraphs 7 and 8 are concerned with the period between contracting and
actual transfer of ownership. The provisions stated anticipate such risks
as depletion of inventory, injury to goodwill, creditors' actions, and
casualty loss. In 7 (c), the disruptive effect of a transfer of ownership
is reduced by providing the buyer with the opportunity to become familiar
with the details of the business operation before he assumes the
responsibility of operation.)
9. Covenant not to compete. The Seller covenants to and with the Buyer, his
successors and assigns, that for a period of five years from and after the
closing he will not, directly or indirectly, either as principal, agent,
manager, employee, owner, partner, stockholder, director or officer of a
corporation, or otherwise, engage in any business similar to or in
competition with the business hereby sold, within a fifty mile radius of
Central City, Illinois.
(Paragraph 9 anticipates the possibility that the buyer would suffer a loss
of the business goodwill he has purchased if the seller opened a similar
business in competition with the buyer. Such provisions are enforceable if
the restriction is reasonable. What is considered reasonable will depend on
the circumstances of each case.)
10. Conditions precedent to closing. The Buyer's obligations at closing are
subject to the fulfillment prior to or at closing of the following
conditions:
(a) All of the Seller's representations and warranties contained in this
agreement shall be true as of the time of closing.
(b) The Seller shall have complied with and performed all agreements and
conditions required by this agreement to be performed or complied with
prior to or at the closing.
(Paragraph 10 raises a problem that is inherent in the traditional
contracting with a closing at some future date. In the period between, the
buyer sometimes uncovers facts that would constitute a breach of warranty
and grounds for canceling the contract. Because of this, transactions are
finally closed, if at all, largely on the good faith of both parties. It is
possible, if both parties work together toward the common goal, to sign the
contract and close the transaction at the same time.)
11. Closing. The closing shall take place at the office of Paul Jones, 100
South Main Street, Central City, Illinois, on March 1, 1979, at 10:00 a.m.
At the time of said closing, all keys to the business premises, the bills
of sale and other instruments of transfer shall be delivered by the Seller
to the Buyer and the money, note and mortgage required of the Buyer shall
be delivered to the Seller. Upon completion of the said payment and
transfer, the sale shall be effective and the Buyer shall take possession
of the said business.
12. Indemnification by the seller. The Seller shall indemnify and hold the
Buyer harmless against and will reimburse the Buyer on demand for any
payment made by the Buyer after closing in respect to:
(a) Any liabilities and obligations of the Seller not expressly assumed by
the Buyer.
(b) Any damage or deficiency resulting from misrepresentation, breach of
warranty or nonfulfillment of the terms of this agreement.
13. Seller's security deposit. As security for the indemnities specified in
paragraph 12, the Seller's attorney, Paul Jones, shall hold in escrow, for
a period of one year from the date of closing, the sum of $10,000 which has
been paid by the Buyer upon execution of this agreement. Said escrow agent
shall upon application of the Buyer apply all or any part of such to
reimburse the Buyer as provided in paragraph 12, provided the Seller shall
have been given not less than ten days' notice of such application and has
not questioned its propriety.
14. Arbitration of disputes. All controversies arising under or in
connection with, or relating to any alleged breach of this agreement, shall
be submitted to a panel of three arbitrators. Such panel shall be composed
of two members chosen by the Seller and Buyer respectively and one member
chosen by the arbitrators previously selected. The findings of such
arbitrators shall be conclusive and binding on the parties hereto. Such
arbitrators shall also conclusively designate the party or parties to bear
the expense of such determination and the amount to be borne by each.
(Paragraph 12 obligates the seller to indemnify the buyer to the full
extent of any cost or damage sustained by the buyer as a result of the
seller's breach of warranty or contractual obligations. Paragraph 13 backs
up this agreement with a requirement that part of the purchase price be
placed in escrow as security for the seller's performance. Paragraph 14
provides a means for resolving without litigation any buyer-seller disputes
that may arise from the contract.)
IN WITNESS WHEREOF, the Buyer and Seller have signed this agreement.
JAMES ROMBAUGH, Seller
JOE CRITSER, Buyer
------+++------
Chapter 8 - Financing and Implementing the Transaction
THE BUYER AND SELLER have a number of important matters to attend to before
the transaction can be closed. The seller will be thinking about
instruments of transfer that must be delivered at the closing, about
compliance with the bulk sale act, and possibly about making financial
arrangements if the buyer can't raise the purchase price. The buyer's
attention will be focused on financing arrangements, organizing his
business-to-be, overseeing the seller's operation of the business in the
meantime, and becoming familiar with the details of the business operation.
Compliance With the Bulk Sale Act
Most States require the seller of a business to furnish a sworn list of his
creditors to the buyer and the buyer to give notice to the creditors of the
pending sale. The purpose of such a "bulk sale" act is to make certain that
the seller doesn't sell out his stock in trade and fixtures, pocket the
proceeds, and disappear, leaving his creditors unpaid. Compliance with the
statute gives creditors an opportunity to impound the proceeds of the sale
if they think it necessary.
Noncompliance or inadequate compliance may result in attachment of the
property after the sale by creditors of the seller and voiding of the
buy-sell transaction. The buyer should not close the transaction until he
has made sure that all statutory requirements have been met.
Financing the Buy-Sell Transaction
In general, the buyer has two options regarding the financing of the
business. The first basic method of financing is person investment of the
future owner or owners of the business. The buyer may pay cash for the
business out of personal resources, establish a partnership, or sell stock.
These forms of financing are commonly referred to as the use of equity or
investment capital.
The other basic form of financing is through borrowing or the establishment
of credit. This method of financing may or may not require the payment of
interest, but it does require the borrower to repay the principal, usually
over a stipulated period of time or on a specific date. This method of
financing is commonly referred to as the use of debt capital. Often the
purchase is made through a combination of equity and debt capital.
Equity capital. In the simplest form of purchase, the buyer pays the full
purchase price in cash. The buyer's investment in the business, at least
initially, is full and complete. Whether the funds come from one person or
more than one, the financial nature of the transaction does not change.
The sources of equity capital are many and varied. Generally, they are in
the form of bank savings. Or cash may be obtained from liquidating certain
assets the buyer may own, such as surrendering life insurance policies for
cash value or selling real estate, stocks and bonds, or other assets.
Before disposing of assets, however, the buyer should ask himself this
question: "Do I want to buy the business more than I want to keep these
assets, considering both present and future values?" For instance, if the
buyer cases $16,000 worth of government bonds, there may be a possibility
of his making a higher profit, but the risk of losing his investment
entirely will be greater. He should be as certain as possible that the
expected return is worth the risk.
An equally important question is how much the buyer should invest in the
business. In general, the more he invests himself, the better chance he
will have of borrowing at least part of the purchase price.
A buyer may not have the capital, however, nor perhaps the inclination, to
purchase the business outright with his own personal funds. How far he goes
in this respect depends on his own cash resources, his confidence in the
business, and his ability to borrow money or establish credit with others.
Debt capital. In most cases, the buyer of a small business will have to
borrow money or establish credit to purchase the business. Several factors
will affect the use of debt capital for this purpose: the source of
capital, the amount that can be borrowed, and the length of time for which
the capital can be borrowed.
Commercial lending institutions are the sources to which the buyer will
probably turn first. The availability of financing through these sources
depends on the security that can be pledged to the loan, the profit
potential of the business, the prospect of repayment of principal and
interest, and the general availability of credit.
One of the major difficulties facing the buyer at this point concerns the
collateral that can be pledged as security. The physical assets of the
business--particularly fixtures, equipment, and land and buildings--will
not be available for security unless they are free of other financial
obligations. The buyer may be forced to look to his own personal assets,
such as cash value of life insurance, stocks and bonds, mortgages on real
property, and so on.
Less formal sources of debt capital may be open to the buyer, such as loans
from friends, relatives, business associates, and the like. Many small
businesses have been financed through such means.
The seller as lender. A common source of debt capital is that supplied by
the seller when he lets the buyer pay for the business over time. Why
should the seller finance the buyer? Probably because the desire to sell is
strong enough so that the seller is willing to assume part of the risk.
As in financing from other sources, the seller usually demands that the
buyer pay interest on the amount being financed and repay the principal and
interest at stipulated periods. The seller usually establishes his security
on the more certain assets, such as fixtures and equipment. However, he may
also assume the inventory as acceptable security without placing it in a
bonded warehouse.
The seller's philosophy toward financing the buyer seems to be that if the
buyer should fail, the seller can take back the business. The major problem
in this form of financing is that it is harder for the buyer to get
additional financing from other sources when the seller has first claim on
the assets of the business.
How much to borrow. As the first step toward financing the purchase of a
business, the buyer has to find answers to two questions:
"How much do I need to borrow?"
"How much can I afford to borrow?"
The answer to the first question depends partly on how much money the buyer
has and how much he is willing to invest in the business himself. The less
equity capital he has, the more debt capital he needs.
How much he can afford to borrow depends on his ability to keep up
principal and interest payments. If a buyer borrows from a number of
sources, he may find himself committed to a repayment schedule that the
profits from the business will not support. His borrowing plans should be
related to the projected income statement prepared during his study of the
business under consideration.
Operating capital. In addition to funds for purchasing the business, the
buyer must have enough working capital to cover the cost of operation until
the business itself produces enough cash. In other words, the buyer must
think in terms of cash requirements and cash flow for weeks and months
ahead. A common mistake in buying a business is failure to provide adequate
working capital.
If sales and business costs after purchase of the business are expected to
follow the pattern of the immediate past, the need for short term working
capital should not be hard to estimate.
Closing the Sale of the Regal Men's Store
In the sale and purchase of the Regal Men's Store, discussed in chapters 6
and 7, Rombaugh and Critser compromised on a price of $84,000. The problem
then facing the two men was how the transaction was to be financed. What
were the various possibilities?
* Critser could pay the entire $84,000 out of cash or negotiable assets
converted to cash, providing he had that amount and was willing to invest
the entire sum. Critser did not have that much cash and was not likely to
be able to raise it.
* Critser could pay up to the limit of his own resources and borrow the
rest. Critser had been turned down by three banks--they did not consider
him an acceptable credit risk. This had nothing to do with Critser's
personal credit rating. It was due to concern about whether he could meet
the resulting financial obligations out of profits and about the nature of
the assets as a basis for security.
* Rombaugh could allow Critser to assume ownership of the business and pay
the amount due over several years. Whether Rombaugh would agree to such an
arrangement would depend on how badly he wanted to sell to Critser, how
long it would take Critser to pay off the amount due, and whether there
were any other potential buyers who might be able to finance the purchase
differently.
* Critser might be able to get others to invest with him, forming a
partnership and spreading the capital requirements among two or more
owners. This arrangement would reduce Critser's ownership in the business,
since the legal form would be changed from a single proprietorship to a
partnership. Critser did not want this. He would rather not purchase the
business than take on a partner.
* Critser might form a corporation and sell stock to raise capital. This
would not ordinarily be feasible for such a small business.
Plan for Financing the Purchase
Critser's personal investment.................................$40,000
Financed by Rombaugh.......................................... 34,000
First-year payment:
Principal at $400 a month.................$4,800
Interest at 11.5 percent.................. 3,910
------ $8,710
Financed by Hirschberger...................................... 10,000
First-year payment:
Principal.................................$3,333
Interest at 10 percent.................... 1,000
------ 4,333
-----
First-year principal and interest payments...........$13,043
------- -------
Total price............................................... $84,000
-------
Regal Men's Store
Balance Sheet--February 15, 1979
Assets
Cash on hand and in bank..................................... $4,000
Merchandise inventory........................................ 47,400
Fixtures and equipment....................................... 30,000
Sales and office supplies.................................... 600
Goodwill..................................................... 6,000
-------
Total assets............................................. 88,000
-------
Liabilities
Notes payable................................................ 44,000
Net Worth
Joe Critser, capital......................................... 44,000
------
Total liabilities and new worth.......................... 88,000
------
The cost of complying with stock registration requirements, the possibility
of losing control of management, the lack of a market for such securities,
and the greater relative cost of equity capital over debt capital would all
work against it.
The decision. In effect, the only course of financing open to Critser was
to raise as much as possible, borrow from personal sources, and enlist
Rombaugh's willingness to finance the balance. Rombaugh agreed to finance
the business to the extent of $34,000, accepting a chattel mortgage on
inventory, fixtures, and equipment.
This is somewhat unusual, particularly as to the inventory. There was no
requirement that the inventory be placed in a bonded warehouse or otherwise
controlled. Rombaugh based his decision on his own knowledge of average
inventory value and on his willingness to accept the risk that Critser
would not tie up further purchases in accounts payable.
With Rombaugh financing $34,000, Critser now had to raise the remaining
$50,000. He got $10,000 in the form of a loan from his former boss Dan
Hirschberger. As security, Critser pledged some stock he owned. He agreed
to repay the loan semiannually over a 3-year period at 10 percent interest.
The cash value of Critser's life insurance and his Series E Bonds brought
$16,000 and $14,000 respectively. Another $10,000 came from his
wife--savings she had accumulated working as a secretary. A $4,000
inheritance Critser had received several years before was to be retained
for use as working capital, and this would be supplemented by the 10
percent fee he would receive from Rombaugh for collecting the accounts
receivable outstanding at the time of purchase. This fee would amount to
about $1,375 if all the accounts were collected.
How it all stacks up. With these arrangements, Critser's financial position
with regard to the purchase of the business was as shown in the chart
above. Almost everything he owned was either invested in or pledged to the
business. One question remained: Would the business bring in enough cash to
cover operating costs and other financial obligations?
The outcome--what will it be? Should he have bought the business? Can he
meet his financial obligations? Will he be able to maintain enough working
capital to replace inventory, pay his operating costs, and repay his debt
capital with interest as the payments fall due?
Only time will tell how good a manager Critser is. Many businesses have
been bought and operated successfully on a more precarious start than this.
Perhaps he will prove capable of meeting the challenge. Perhaps not.
If he should fail what would he lose? Practically everything--his full
investment of $40,000 plus whatever else is necessary beyond the sale value
of the assets to satisfy his creditors. Whether he succeeds or fails will
depend on how well he can administer the financial program of the store,
how well he can merchandise, how well he can keep his costs in line, how
near his sales come to his earlier estimates.
Part 4 Using Financial Statements in the Buy-Sell Transaction
Chapter 9 - Income Statements and Balance Sheets
THE DISCUSSING OF FINANCIAL STATEMENTS in this chapter assumes that the
statements are prepared in accordance with generally accepted accounting
principles. There is a brief statement of some of the more important of
these principles:
* A business should have financial reports prepared at the end of each
calendar or fiscal year, with interim reports during the year. Use of the
"natural" business year as the formal accounting period has been
increasing. The natural year is the 12-month period ending at the lowest
point of business activity for the period.
* Since many business transactions will be incomplete at the end of any
accounting period, some estimates will be necessary. Such estimates are an
acceptable part of financial reports as long as they are made according to
procedures that have proved reliable in the past.
* Each business is considered a separate accounting unit, with the affairs
of the business kept entirely separate from the owner's personal affairs.
All records and reports should be prepared on this basis.
* Financial statements are prepared on the assumption that the business
unit will continue to function in its usual manner.
* For some accounting objectives, two or more methods are possible. For
example, there are several methods of computing depreciation and also of
valuing inventory. They are all valid, but once a method has been selected
for use in the records of a business, it should be used consistently.
* Accounting must be practical. Strict adherence to a principle is not
required when the increase in accuracy is too small to justify the
increased cost of compliance. A uniform policy should be adopted to guide
such exceptions, however.
* All assets and services required by a business should be recorded on the
date they are acquired at their cost to the business. This cost includes
costs incurred to procure the asset or service and to place it in position
or condition for business use. Donated assets are recorded at their cash
equivalent value as of the date of donation.
* A major objective of accounting is to determine income by matching costs
against revenue. The net income of a business is the increase in that
company's net assets brought about through profitable exchanges of product
and services or through sale of assets other than stock in trade.
What Is Being Sold
In the usual buy-sell transaction relating to a "going concern," what is
being bought or sold is primarily a future stream of income. Not the assets
or property of the business, but the income these assets will generate in
the future. But future income is impossible to compute and hard to
estimate. Therefore, the buyer and seller often ignore this unknown
quantity. In trying to set the price, they concern themselves with known
values relating principally to the replacement cost of the tangible assets
being sold. This is a mistake.
Use of Past Financial Data in Valuing Future Income
It has been said that history repeats itself, but this is not always true
of the financial history of a business. First of all, the question arises,
"Why is the present owner willing to sell the business?" One reason may be
that he foresees adverse change of one sort or another.
Keep in mind, too, in trying to predict the future from present results,
that there will be a change of ownership. Will the new owner be able to
produce the results the former owner did? Is he trained and experienced in
management as well as in the mechanical or technical skills needed?
There are many reasons why past operating results may not be a good
indication of future income. Still, they are at least concrete facts. They
should be examined carefully for whatever insight they may provide into the
future.
What Data To Expect
Most businesses will have at least two basic financial statements prepared
at the end of the annual accounting period--a statement of income and a
balance sheet. There may also be other statements containing important
information. These might include a reconciliation of retained earnings in
the business, a statement of source and application of funds, and listings
of such items as inventories, accounts receivable, and accounts payable.
However, the statement of income and the balance sheet are the basic
financial statements. Any business can reasonably be expected to have these
two available.
If they have not been prepared, it may be necessary to construct
approximate statements--particularly statements of income--based on the
best information available. If they are available but were not prepared in
accordance with generally accepted accounting principles, they will
probably have to be adjusted.
It is essential to understand what the accountant means by the amounts
shown on the financial statements. The items discussed below should appear
on most such statements. The listing is not all-inclusive, but most major
items are discussed.
The Balance Sheet
A balance sheet lists in one section all the assets of the business as of
the last day of the accounting period and in another section all claims
against these assets. Claims against assets include creditors' claims, or
liabilities, and owner's claims, or investment (also called equity or net
worth).
Assets
Cash. This asset includes cash balances in the bank, cash on hand
(including change and petty-cash funds), funds held in trust, sinking
funds, and funds in time deposits. Not all the cash will necessarily be
available for payment of liabilities. Change funds, for example, must be
retained in order to have the change necessary for doing business.
Marketable securities. Included in this classification are such items as
United States Treasury bills and perhaps stocks and bonds. These assets are
most commonly shown on the balance sheet at their cost to the business or
at their market value.
Accounts receivable. An entry that is identified merely as "accounts
receivable" or has the designation "trade" after it refers to accounts
receivable from customers only. Notes or accounts receivable from officers,
employees, or owners of the business are considered nontrade receivables
and should be entered as a separate item.
Allowance for bad debts. This is an account that is deducted from the
accounts receivable account to give a more accurate valuation to accounts
receivable. Suppose the business has accounts receivable of $100,000 and
experience indicates that 5 percent of this amount will be uncollectible.
There is no way of knowing which specific accounts will not be collected,
but it can be estimated that $5,000 will eventually be uncollectible. To
reflect this fact on the balance sheet, accounts receivable are shown at
$100,000. An allowance for bad debts of $5,000 is also entered and deducted
from the accounts receivable, leaving a net of $95,000 as the estimated
collectible accounts receivable.
Notes receivable. This account includes the face amount of all notes that
have been given the company and that are still unmatured, even those that
have been discounted at the bank.
Notes receivable discounted. This is a contingent (possible) liability
account. If a note receivable has been discounted at the bank, the company
has had to guarantee its payment. Thus, until the maker of the note pays
the bank, the company has a possible note payable.
The amount of the notes receivable discounted is entered on the balance
sheet under the notes receivable entry and subtracted from the notes
receivable total. An alternative method is not to include it in the notes
receivable total but to show it in a footnote.
Notes and accounts receivable from officers, employees, and owners. This
amount will include amounts due the business from persons connected with
the business in some way. Advances for employees' uniforms or cash loans
may have been made, for instance.
Inventories. Inventories are the major asset in some kinds of businesses,
particularly those in the merchandising field. Methods of valuing
inventories are similar in manufacturing and nonmanufacturing companies,
but the mechanics of computing the values differ. Therefore, valuation
methods are discussed separately.
Purchased inventories. If the business buys merchandise or raw materials
which it merely holds for a time and then sells with little or no
alteration, the inventory is valued either at cost or at the replacement
price if the latter is below cost. If the replacement price is higher than
cost, the inventory should be valued at cost.
It is generally agreed that if the cost of transportation of the goods to
the company is a significant item, the inventory account should include
this cost. In fact, all costs involved in preparing the goods for sale
could justifiably be included. Such costs might include, for example,
certain costs of dividing and repackaging.
Once it has been decided what costs are to be included in the inventory
account, there are at least four major methods of valuing the inventory:
1. If a business specifically identifies items in costing inventory, it
must be able to tell what was paid for each item. This method is practical
for items with a high unit price, such as new automobiles or major
appliances. As the unit price falls, however, and the number of items in
the inventory increases, this method of valuation becomes less practical.
2. First in, first out, or FIFO, is another method of costing inventory. It
assumes that the first units purchased are the first units sold, that those
still in inventory are the last ones purchased. Thus, the inventory is
valued at the cost price of the last items purchased by the business.
3. Last in, first out, or LIFO, assumes the opposite--that the last goods
purchased are the first ones sold. The inventory is thus valued at the cost
of the first inventory items to be available for selling. The inventory
valuation under LIFO does not necessarily correspond very closely to
current replacement costs.
4. The average cost method is merely an average of FIFO and LIFO. It aims
to find a middle ground between the two extremes.
If prices of the goods purchased have been rising, the FIFO valuation will
come closest to current market prices--the use of LIFO will tend to value
the inventory at less than current market prices. The choice of inventory
valuation will affect the reported cost of goods sold on the income
statement and also the reported net income.
Manufactured inventories. If the company manufacturers goods from purchased
raw materials, the inventory costing or valuation method is somewhat
different. Any raw materials on hand are valued by one of the methods
described for purchased inventories. Valuation of work in process and
finished goods inventories involves three elements:
1. Cost of the raw materials used. This can be computed very exactly.
2. Cost of the direct labor used in converting the raw material into its
present state of completion. This, too, normally lends itself to fairly
exact measurement.
3. Factory overhead, or indirect cost. These are the costs of such items as
insurance, indirect materials, indirect labor, taxes, and so on. They must
be allocated to the units produced on some reasonable basis.
Total indirect costs do not vary with the amount of goods produced, or at
least not proportionately. This means that if the plant is not operated at
its maximum capacity, the indirect costs per unit of production will be
more than would be the case if the plant were operated at a higher level of
production. Therefore, idle time or idle capacity in a plant may cause the
inventory value of manufactured goods to be unrealistically high.
Prepaid and deferred items. Prepaid expenses are prepayments for goods or
services that will be consumed in the near future--prepaid rent, prepaid
insurance premiums, office supplies, and so on. Deferred charges are
prepayments that will benefit the company over a period of years, such as
the cost of moving to a new location.
Property, plant, and equipment. This classification includes all the fixed
assets of the business--land, buildings, equipment, and other tangible
items that will last more than a year and will be used in the normal
operation of the business. These items, under generally accepted accounting
principles, should be recorded at their original cost to the business.
Occasionally, a buyer may find that the seller has raised the valuation of
these assets by appraisal writeups. If this has occurred, the buyer must
satisfy himself that the value of the assets has in fact increased by the
amount of the appraisal writeup.
Accumulated depreciation and depletion. This account shows the amount of
depreciation, or loss of usefulness, that has been charged against the
property, plant, and equipment while they have been held by the business.
On the balance sheet, the amount in each depreciation account is deducted
from the corresponding property, plant or equipment total. This leaves the
net book value, or unrecovered original cost.
A depreciation account is merely a technique for distributing the cost of a
fixed asset over its estimated useful life. It is quite possible for assets
that are fully depreciated on the books to be still serviceable, and for
assets not fully depreciated to be no longer serviceable.
There are a number of methods of figuring depreciation. Four of the most
common are the straight-line method, the declining-balance method, the
sum-of-the-years-digits method, and the units-of-production method.
The first three methods record depreciation on the basis of time. The
straightline method records the depreciation uniformly over the years of
the asset's estimated service life. It is by far the most commonly used
because of its simplicity. The declining-balance and
sum-of-the-years-digits methods record larger amounts of depreciation in
the early years. With these two methods, increased maintenance expenses in
later years are offset somewhat by the reduced charges for depreciation.
Also, there are some income-tax advantages.
The units-of-production method is based on the estimated productive
capacity of the asset rather than time. It is useful where the amount of
usage varies considerably form time to time.
All four methods will record the same total depreciation over the life of
the asset. There may be a substantial difference in the amount recorded in
any one year, however.
Intangibles. This classification includes such items as patents,
trademarks, and goodwill. The value recorded is their cost to the business.
The amount entered for a patent, for example, will be either the cost of
purchasing the patent right or the cost of developing the patent. Goodwill
will not appear on the balance sheet unless the business purchased the
goodwill and has decided to leave it on the books.
Liabilities and Owner's Equity
Accounts payable to trade. The amounts recorded in this account are the
amounts owed to regular trade creditors (except notes payable) for
merchandise and other items needed in operating the business.
Notes payable. This item includes all amounts owed by the business for
which a formal not payable has been given if the note is due in 12 months
or less from the balance-sheet date.
Accrued taxes payable. This account will show the amounts owed to various
taxing authorities. It will include taxes that have been collected or
withheld but not yet forwarded to the authorities--for example, sales
taxes, income withholding taxes, and Federal Insurance Contribution Act
(Social Security) taxes. The account may also include accruals for items
such as property taxes, franchise taxes, and use taxes the business owes
but has not yet been paid. The amount shown on the balance sheet should be
the amount that the business is legally liable for.
Wages and salaries payable. This account will show all wages and salaries
of employees earned but not paid as of the balance-sheet date. Any
unclaimed wages due former employees will also be included in this account.
There are some rather rigid legal requirements about the handling of taxes
collected from the employees as opposed to ordinary business liabilities.
Income taxes payable. This account may not appear on the balance sheet if
the business is operated as a single proprietorship or partnership. It
should be shown for a corporation. The amount may be only an estimate but
will usually be quite accurate.
Unearned income. Some types of businesses receive fairly large amounts of
prepaid or unearned income. The publisher of a newspaper or periodical, for
instance, is paid for subscriptions before the publications are delivered.
If a business rents property to others, the rent will be received in
advance. The amount of such income that has been received but not earned at
the balance-sheet date is recorded here. There may or may not be a legal
requirement that the unearned amounts be returned if the company fails to
deliver the services or products.
Long-term liabilities. For a liability to be considered long term, its
maturity date should be more than 12 months from the balance-sheet date. If
unearned income is prepayment for services covering more than a year from
the balance sheet date, a proportionate amount of it should be included here
instead of under unearned income.
Owner's equity. Two elements enter into owner's equity: the initial
investment of the owner or owners, and retained profit or loss. The
computation of owner's equity is based on the recorded value of the assets
and liabilities of the business--it is merely the difference between the
total assets and the total liabilities. If the assets are recorded at less
than their true value, the owner's equity will be understated. If the
assets are recorded at an inflated value, the owner's equity will be
overstated.
If the business is a corporation, the original investments of the owners
will be kept in separate contributed capital accounts. The net results of
operations will be summarized in one or more retained earnings accounts.
All these accounts together make up the owners' investment in the business.
If the business is a single proprietorship or a partnership, each owner
will have a capital account that summarizes his investments, his share of
net income or losses, and withdrawals he has made.
Income Statement
The income statement is a summary of the income and expenses of the
business for the period covered. It shows the net result of
operations--profit or loss--for the period.
Revenue. All income of the business from whatever source should be
included. However, income from operations is usually shown separately from
other income such as interest or rent. Charge sales are included in sales
income at the time the sale is made, regardless of when the cash is
received in payment.
Cost of goods sold. The cost of goods sold equals the cost of goods
purchased during the accounting period (including transportation) plus the
beginning inventory and minus the ending inventory.
Gross margin. This is the difference between income from operations and
cost of goods sold. The gross margin must cover operating expenses, taxes,
and profit.
Operating expenses. Types of operating expenses vary with the type of
business, but all businesses have some--building expenses, utilities,
wages, supplies, some kinds of taxes, insurance, and so on. These expenses
for the accounting period are subtracted from the gross margin to give the
net income (before income taxes).
Auditing of Financial Statements
If the buyer in a buy-sell transaction asks an accountant to audit the
financial statements of the seller, the accountant will want to make a
"purchase investigation." A purchase investigation is a normal audit with
intensified examination of certain items critical in a buy-sell situation.
The accountant may go to greater lengths, for example, to make sure that
the physical plant and all equipment are present and in serviceable
condition.
There is no required form an accountant must use in certifying financial
statements, but the following standard certificate has evolved:
We have examined the balance sheet of the __________________ Company as of
December 31, ____ and the related statement of income and surplus for the
year then ended. Our examination was made in accordance with generally
accepted auditing standards and accordingly included such tests of the
accounting records and such other auditing procedures as we considered
necessary in the circumstances.
In our opinion the accompanying balance sheet and statement of income and
surplus present fairly the financial position of the ____________________
Company at December 31, ____ and the results of its operations for the year
then ended, in conformity with generally accepted accounting principles
applied on a basis consistent with that of the preceding year.
If the accountant cannot use this certificate as it is, he will do one of
two things. He will either qualify his certification, or state that he is
unable to render an opinion regarding the financial statements. This might
happen if he were unable to comply with generally accepted auditing
standards, or if the accounting records were not prepared in conformity
with generally accepted accounting principles.
What If There Are No Financial Statements?
The buyer may find, in a very small business, that the owner has never
prepared financial statements. Furthermore, there may be no records
available from which to prepare them.
There is no realistic way to determine the results of past operations
without financial statements. However, there are a few records that even
the smallest, most poorly run business must have. The buyer should try to
construct from these records as realistic as possible an income statement
and balance sheet. Here are some of these records:
* The seller will have had to file Federal income-tax returns that include
an income statement for the business. At least part of this income
statement will probably have been prepared on a cash basis and will not
reflect the results of operations as accurately as a statement prepared on
an accrual basis would. However, it is a fairly safe bet that the seller
has not overstated the receipts from the business on his income-tax return.
He may have tended to overstate expenses, though, particularly by including
some personal expenses as expenses of the business.
* If the seller has a retail store and make sales in a State that has a
sales tax, he has had to file sales-tax returns. The buyer should examine
these returns to determine the amount of gross sales during the period
covered.
* If the business has employees, the seller will have made deductions from
the employees' pay for income taxes and Social Security. The returns
prepared for the Director of Internal Revenue covering these deductions
will show the wages paid.
* Almost any business will have certain types of expenses such as property
taxes and insurance. The buyer can call the County Treasurer and the
insurance agent to learn the amounts of these expenses.
* A fairly good evaluation of the financial position of the business can be
made by talking to the seller's principal suppliers and to his bank to
determine the amounts owed by the seller and the credit standing of the
business.
Chapter 10 - Adjustments to the Financial Statements
IT IS IMPORTANT TO KNOW what the accountant who audits and certifies the
financial statements is saying. He is not saying that there is no
possibility of error in the financial statements. He is saying that the
financial statements substantially reflect the correct financial position
of the business. His certificate on a set of financial statements is the
buyer's assurance that he can rely on the statements without further
investigation to determine that they were prepared correctly. Some
adjustments may be needed, however, to make the statements more useful in
valuing the business.
Assets
Cash. No revaluation of this item is likely to be needed unless the
business has deposits in foreign currencies. In that case, a revaluation
may be necessary for possible loss in conversion of foreign currencies into
United States dollars.
The buyer should also be aware that some of the cash may not be available
to pay current debt and operating expenses. For example, some cash may have
to be kept in change and petty-cash funds.
Marketable securities. Marketable securities are often recorded on the
balance sheet at their cost, which may be below current market value. These
assets should be stated at market value. Short-term Treasury notes or bonds
that will mature shortly after the sale of the business could be valued at
their maturity value. There would probably be little difference between
this and their market value.
Accounts receivable and allowance for bad debts. These two accounts must be
examined together. The buyer should make certain that the net receivables
on the balance sheet are really collectible.
The most common way to do this is to prepare an aging of the accounts
receivable to show how old each account is. Thus, if the business normally
sells merchandise on 30 days' credit and many of their accounts receivable
are more than 90 days old, it is doubtful that these accounts can be
collected.
If there are large accounts due from individual customers, the buyer might
be wise to correspond directly with the customers to verify the amounts
receivable. At the very least, invoices and signed shipping receipts should
be studied to make sure that the customers have received the merchandise
and have not yet paid for it.
The objective of the valuation of the accounts receivable is to state them
at the true net collectible amount.
Notes receivable and notes receivable discounted. These two accounts must
also be examined together. Unless the business normally receives a note at
the time of a sale, a note from a customer usually means that the customer
was unable to pay his account when it was due. The customer has, therefore,
already shown some financial weakness, and the number of notes that will
prove uncollectible may be fairly high. The buyer should try to find out
whether notes still held by the business are likely to be paid at maturity.
The objective is to state the notes at their estimated collectible value
and the amounts the business is likely to have to pay on default of
discounted notes.
Accounts receivable and notes receivable from officers, employees, and
owners. Since these items represent amounts due from people who have an
inside interest in the business, there may be a serious question as to
whether they will be collectible. Care should be taken to see that they are
stated at their realizable value to the business.
Inventories. If inventories are stated on the balance sheet at cost, this
cost may be what was paid recently, or it may be only indirectly related to
the present value of the inventory. If the buyer does not feel competent to
appraise the condition of the inventory, he should obtain the services of
someone who is. He should not rely on the valuation of the seller.
One way to verify or correct the inventory value in a small business is to
get the company's supplier to value the inventory. This is especially
suitable if one principal vendor supplies the business. Since he or his
representative will have to visit the business regularly in the future, it
will be to his advantage to make sure that the valuation is fair. Also, the
suppliers know the value of their own goods. The valuation should allow for
all trade discounts and damaged or obsolete stock should be rejected.
Prepaid and deferred items. These items will be valued at their unrecovered
cost to the business. They buyer should make sure that he can use any
prepaid items he buys. Suppose, for example, that the business has recently
purchased substantial quantities of stationery and other printed office
supplies bearing the name of the present owner. Unless the name of the
business is to be carried over, any amount that appears in the prepaid
items for these supplies should be removed.
The buyer should also make sure that any prepaid insurance premiums and the
insurance policies to which they apply can be transferred to him without
loss of coverage or requirement for additional premium payments. He should
be aware that premiums on workmen's compensation insurance are subject to
later adjustment. Any insurance the buyer doesn't want, of course, will be
canceled, and the balance sheet should be adjusted to show this.
Property, plant, and equipment. A professional appraisal of buildings,
plant, and equipment may be useful, but many intangibles enter into a
selling price. The fact that the building is appraised at $100,000 doesn't
necessarily mean that the building is worth that much to the buyer. On the
other hand, it may be worth more.
Another common way to value an asset of this kind is to establish a
replacement value, allow depreciation for the length of time the asset has
been held, and use the remainder as the value of the asset. The main
problem in using replacement value is that fixed assets are seldom replaced
with identical assets. A 20-year-old building is not likely to be replaced
with a building just like it. Building methods change and needs of the
business change. Therefore, it is unrealistic to think in terms of
replacement cost for an asset that would never be replaced.
The seller of the business may want to value these fixed assets on the
basis of values established by the insurance company in determining the
amount of fire and extended-coverage insurance. The buyer should realize
that these values are not necessarily equal to sale or market values. There
is probably no one good way to value assets of this kind. Their true value
will depend on the amount of income that can be generated through their use.
Intangibles. Intangible assets are recorded on the balance sheet at their
cost to the business less any amounts written off. The buyer is mainly
concerned with whether the intangibles really exist and will benefit the
business in the future. Patents and trademarks may have a market value and
could, in some cases, be sold. But their market value is very hard to
determine until they are sold.
The buyer may recognize that patents and trademarks will benefit the
business but be unable to determine the degree of usefulness with any
accuracy. He should at least recognize that patents have a limited life,
and he should find out how much time is left before the patent expires. A
trademark, if registered, is not limited and may benefit the business
indefinitely.
Any goodwill on the balance sheet reflects an amount paid at some time in
the past, less what has been charged off. There is no assurance that any
goodwill still attaches to the business.
In the case of liquidation, intangibles are usually of no value. Anything
paid for them is not likely to be recoverable.
Claims Against Assets
Accounts payable to trade. If the business is in financial difficulties,
the creditors may be willing to adjust downward the amounts due them. In
that case, the balance-sheet item should be adjusted to show only the
amount required to satisfy the creditors' adjusted claims.
If some of the accounts are past due, it may be found that some of the
creditors have mechanics' liens against assets of the business. This is
primarily a legal matter. The buyer should consult his lawyer about this
possibility.
Notes payable. It is possible that substantial interest accrued on notes
payable has not been entered in the accounts of the business. This account
should be valued at the face amount of the notes plus interest accrued up
to the date of the buy-sell agreement. If some of the notes are past their
maturity dates, the buyer should consult his lawyer about the possibility
of pending legal action against the business.
Accrued taxes payable. These amounts due are subject to audit by the taxing
authority concerned. It is entirely possible that past discrepancies or
failure to report taxes due might result in substantial penalties,
interest, and back tax payments.
The buyer should try to ensure that a clear distinction is made between the
seller's responsibility for taxes collected in the past and the buyer's
responsibility for future tax liabilities. He must make certain that the
account properly reflects all sales taxes collected and not yet remitted to
the taxing authorities; all withholding and FICA taxes collected and not
yet remitted; all unemployment taxes; all franchise taxes; and all excise
taxes. He should also make certain that the business is not liable for any
taxes it has failed to collect in the past.
Federal and State income taxes payable. A business organized as a single
proprietorship or partnership does not pay income taxes as a business and
therefore will not have this account. If the business is a corporation, the
buyer should see that Federal and State income taxes of the business have
been paid and that there is an adequate income tax accrual in the books for
current income taxes payable. If income taxes have been improperly reported
in past years, the corporation, even if it has changed hands, will have to
pay any back taxes, penalties, and interest assessed against it.
Unearned revenues. The principal concern here is to make certain that all
unearned revenues that have been collected are included in this account.
Some businesses may record unearned revenues as earned revenues at the time
of receipt.
Long-term liabilities. Most long-term liabilities will be evidenced by a
formal agreement such as a note payable or a mortgage payable. They should
be valued at the total amount owed, including interest.
Unrecorded liabilities. It is always possible that some notes payable,
accounts payable, or accrued liabilities have not been included in the
sellers' latest balance sheet. The buyer should be aware of this
possibility and make at least a reasonable search for unrecorded
liabilities such as these.
Contingent liabilities. This broad group includes a number of items that
may become liabilities to the business even after it changes hands. Usually
few, if any, contingent liabilities appear on the seller's balance sheet.
For example, a delivery truck owned by the business may have been involved
in a serious accident. If the business had inadequate insurance protection,
there is a very real possibility that the business will have to pay
substantial claims. Or perhaps warranties, express or implied, go with the
merchandise or services sold. Future costs may be involved in honoring
warranties already given by the seller. Such items could conceivably have
an appreciable impact on the future profitability of the business.
The searching out of contingent liabilities is difficult. In fact, there
may be no way to discover some of them. But any prospective buyer should
search out whatever information he can about contingent liabilities of the
business he is considering. Some of these investigations might best be done
by the buyer's attorney. If the buyer knows the real answer to the question
"Why is the seller willing to sell?" he may decide the business is not a
good investment.
Owner's equity. If the above examination of the balance sheet has resulted
in any changes in assets or liabilities, the owner's equity will have to be
adjusted. It must equal the difference between total assets and total
liabilities.
Income Statement
The buyer should examine the income statement closely to make certain that
it gives a reasonably accurate picture of the results of past operations.
He should determine that the revenues reported on the income statement were
earned in the period covered by the statement. No prepaid or unearned
revenues should be included in the income reported, and no revenue items
that properly apply to the period should be omitted.
Expenses. Expenses should be examined to determine that all have been
included and that all items included are proper expenses of the business.
If any personal living expenses of the owners have been paid by the
business and included as business expense, these items should be eliminated.
Owner's salary. The amount of salary paid the owner is always a troublesome
area. It may appear too high--or completely inadequate. The buyer should
know the market value of his services. If the business will not provide him
an adequate salary plus a satisfactory return on the capital he invest, he
may be better off financially to work as an employee and invest his money
elsewhere.
Depreciation. The buyer should pay close attention to any writeoff for
depreciation expense. The amount of depreciation expense claimed is
basically a decision based on the judgment of the seller and his accountant
as to which method to use in computing depreciation.
Common ownership. In some cases, the buyer may find that the business is
one of a group of businesses under common ownership. If this is the case,
the buyer should make certain that the business has been charged for all
expenses that should be attributed to it. For example, has the business
been charged for its clerical and bookkeeping services, or have these been
supplied by the parent company at a nominal charge or no charge at all? If
they have been supplied by the parent company, the income statement should
be adjusted to include this expense.
Occupancy charge. Another item about which the buyer should be concerned is
the occupancy charge. Is it unusually low? This might happen for any of
several reasons. Probably the most common reason is that the seller owns
the property and, once it had been fully depreciated, entered no charge for
rent or depreciation. If this happens, an unrealistically high net income
may be reported.
Another possibility is that the business may have been paying an abnormally
high or low rent for the real property occupied. This situation often
occurs when the business is one of a group of businesses with common
ownership.
The buyer should take care that a realistic charge for occupancy of real
property is included in the adjusted income statement.
Notes to Financial Statement
A financial statement may or may not have accompanying notes. If there are
notes, they should be considered an integral part of the statement and read
carefully. Often important contingent liabilities or contractual
obligations are described in such notes. Unless the notes are read and
interpreted, the analysis of the financial statements will be incomplete.
Incorrectly Prepared Financial Statements
Many financial statements prepared by small businesses are not prepared in
conformity with generally accepted accounting principles. Often no clear
distinction is made, for example, between the operations of the business
and the owner's personal business affairs. Such items as gasoline and car
expenses that are actually personal living expenses of the owner of the
business may be recorded as a business expense. The balance sheet may
include as an asset the personal residence of the owner of the business.
There may also be some items of business expense that were not recorded in
the financial statements.
The buyer should keep in mind that the statements are only as reliable as
the information that went into them. If the information is only estimated
or is overstated or understated, the statements will reflect the
inaccuracy. They should be adjusted to bring them as nearly as possible
into line with accepted accounting principles.
Accrual Method of Accounting
If financial statements were prepared strictly on a cash basis, all cash
inflow would be revenue and all cash paid out would be expense. Even fixed
plant and equipment assets would be recorded as expense items at the time
they were paid for instead of being charged off over the life of the assets
through depreciation charges. Under the accrual method, all items of income
are included in gross income when earned, even though payment is not
received at that time. Expenses are deducted as soon as they are incurred,
whether or not they are paid for at that time.
Normally, the accrual method of accounting is the only one that shows
results of past operations accurately. If the seller's financial statements
have been prepared on a cash basis, the buyer should make whatever
adjustments are necessary to convert the statements to an accrual basis.
Chapter 11 - Analyzing the Financial Statements
WHEN THE FINANCIAL STATEMENTS have been made as accurate as possible, the
buyer or his accountant should analyze the information they contain. Some
comparisons and ratios that can be used to bring out trends and relations
are discussed in this chapter.
Probably the first analysis to be made is to compare financial statements
for the past 10 years or as close to that length of time as possible. Has
the trend over the years been up or down, or has there been no significant
change? All items on the statements should be studied.
The changes from one year to another will be more helpful if they are
stated in percentages. On each year's income statement, the net sales
figure is taken as 100 percent and each other item is stated as a percent
of net sales. On the balance sheet, total assets are taken as 100 percent
and other items are stated as percents of total assets. Such statements are
called "common size" statements. Typical comparative statements covering 2
years, with common-size percents, are shown in schedules 1 and 2 below.
Ratios and Other Analyses
Certain ratios and other expressions showing relations between items on the
financial statements are also helpful in interpreting the statements.
Schedule 3 illustrates several commonly used formulas based on the
1978 figures in schedules 1 (below) and 2. Each of them is discussed
briefly following schedules 1, below, 2, and 3.
Schedule 1
Comparative Balance Sheet
December 31, 1978 and December 31, 1977
Amount Percent
--------------------- --------------
1978 1977 1978 1977
-------- -------- ----- -----
ASSETS
Current assets:
Cash..................... $ 28,000 $178,000 2.64 18.43
Marketable securities.... 0 160,000 0 16.56
Accounts receivable (net) 136,000 128,000 12.83 13.25
Notes receivable......... 8,000 3,000 0.76 0.31
Inventories.............. 380,000 368,000 35.86 38.10
Prepaid expenses......... 11,600 12,000 1.09 1.24
-------- -------- ----- -----
Total current assets....... 563,600 849,000 53.18 87.89
Property, plant, and
equipment (net)............ 396,200 77,000 37.38 7.97
Intangibles................ 100,000 40,000 9.44 4.14
-------- -------- ------ -----
Total assets...............$1,059,800 $966,000 100.00 100.00
---------- -------- ------ ------
LIABILITIES AND OWNERS' EQUITY
Current liabilities:
Accounts payable......... $100,800 $120,000 9.51 12.42
Notes payable............ 0 20,000 0 2.07
Accrued taxes payable.... 1,600 2,400 0.15 0.25
Unearned revenues........ 6,000 0 0.57 0
--------- -------- ------ ------
Total current liabilities.. 108,400 142,400 10.23 14.74
Mortgage payable........... 120,000 20,000 11.32 2.07
--------- -------- ------ ------
Total liabilities.......... 228,400 162,400 21.55 16.81
--------- -------- ------ ------
Owners' equity:
Original investment...... 500,000 500,000 47.18 51.76
Retained earnings........ 331,400 303,600 31.27 31.43
--------- -------- ------ ------
Total owners' equity....... 831,400 803,600 78.45 83.19
--------- -------- ------ ------
Total liabilities and
owners' equity...........$1,059,800 $966,000 100.00 100.00
---------- -------- ------ ------
Schedule 2
Comparative Income Statement
Years ended December 31, 1977 and 1978
Amount Percent
----------------------- ---------------
1978 1977 1978 1977
---------- ---------- ------ ------
Gross sales................$1,947,000 $1,706,000 101.41 101.21
Sales returns.............. 27,000 20,400 1.41 1.21
---------- ---------- ------ ------
Net sales.................. 1,920,000 1,685,600 100.00 100.00
Less cost of goods sold.... 1,430,000 1,245,000 74.48 73.86
---------- ---------- ------ ------
Gross margin............... 490,000 440,600 25.52 26.14
---------- ---------- ------ ------
Operating expenses:
Wages paid............... 282,800 243,000 14.72 14.41
Taxes.................... 65,000 62,000 3.38 3.68
Insurance................ 48,000 48,000 2.50 2.85
Telephone................ 4,800 4,400 0.25 0.26
Miscellaneous............ 10,800 5,500 0.58 0.33
---------- --------- ------ ------
Total operating expenses... 411,400 362,900 21.43 21.53
---------- --------- ------ ------
Net income before taxes.. $78,600 $77,700 4.09 4.61
---------- --------- ------ ------
Schedule 3
Current ratio
Current assets, $563,600
----------------------------- = 5.2 to 1.
Current liabilities, $108,400
Acid test or "quick ratio"
Cash plus assets near cash, $172,000
------------------------------------ = 1.6 to 1.
Current liabilities, $108,400
Days' sales uncollected
Accounts receivable, $136,000
----------------------------- x 365 = 25.5 days' sales uncollected.
Charge sales, $1,947,000
Turnover of merchandise inventory
Cost of goods sold, $1,430,000
--------------------------------------- = 3.82 times, merchandise turnover.
Average merchandise inventory, $374,000
Return on owners' investment
Net income, $78,600
---------------------------------- = 0.0987, or 9.78 percent, return on
Beginning owners' equity, $803,600 investment.
Return on total assets invested
Net income, $78,600
------------------------ = 0.0742, or 7.42 percent, return on assets
Total assets, $1,059,800 invested.
Owners' percentage equity in business
Owners' equity, $831,400
------------------------ = 0.7845, or 78.45 percent.
Total assets, $1,059,800
Creditors' percentage equity in business
Creditors' equity, $228,400
--------------------------- = 0.2155, or 21.55 percent.
Total assets, $1,059,800
Current ratio. This ratio compares current assets to current liabilities.
In the example shown in schedule 3 above, there is $5.20 in current assets
for every $1 of current liabilities.
The current ratio establishes an important relation between the business'
current debt and its ability to pay the debt. The assumption is that a
company should be comfortably able to pay current debts from current assets
if necessary. In many businesses, however, especially service businesses,
current assets are proportionately smaller because there is little
inventory. In these businesses, the relation of current assets to current
liabilities may be less important.
Acid test or quick ratio. This ratio points out the relation between the
current assets that can be most quickly converted into cash and current
liabilities. It is similar to the current ratio except that it uses only
assets that are just one step away from being cash.
"One step away from cash" means that only one additional transaction is
needed to convert the asset into cash. For example, accounts receivable
only have to be collected and marketable securities sold. Merchandise
inventories that are normally sold on credit, on the other hand, are two
steps away from cash. The inventory will first be sold and accounts
receivable created. Then the accounts receivable must be collected before
cash is realized from the inventory.
Days' sales uncollected. Days' sales uncollected shows how fast a business
collects its accounts receivable. One way to find this figure is to divide
the year-end accounts receivable by the total charge sales for the year and
multiply the results by 365.
For this computation to be valid, the accounts receivable must be fairly
constant throughout the year. In most businesses, however, sales--and
therefore accounts receivable also--tend to be higher at certain times of
the year. It is better to use an average if possible.
Turnover of merchandise inventory. The turnover of merchandise inventory is
the number of times the average inventory is sold during an accounting
period. To find it, divide the cost of goods sold during the period covered
by an average merchandise inventory at cost. A high turnover is usually a
mark of good merchandising; but if the business only computes its inventory
once a year, and that at the low point of the business's cycle, the
turnover may appear better than it really is.
Return on owner's investment. The ratio of net income to proprietorship
measures the owner's success in making a profit on the money he has
invested in the business. Usually, net income after taxes and owner's
equity as of the beginning of the year are used. (The beginning figure for
any year is the December 31 figure for the year before.) If the owner's
equity fluctuated greatly during the period, an average owner's equity
should be used.
Return on total assets. This shows the return on the total investment of
all who have a stake in the business, creditors as well as the owners.
Owner's percent of equity. For this percent, the year-end owner's equity is
divided by the total assets. The share of the assets of a business
contributed by the owner is always of interest to anyone trying to analyze
the business. Creditors like to see a high proportion of ownership
equity--the greater the owner's equity in proportion to that of the
creditors, the greater the losses that can be absorbed by the owner before
the creditors begin to suffer a loss.
Creditors' percent of equity. The ratio of creditor's claims to total
assets is always 100 percent minus the owner's percent of equity.
Interpretation of Ratios and Percentages
The value of these ratios and percentages lies mainly in their use as tools
of comparison rather than in their absolute values. Thus, a consistent
increase or decrease in the current ratios of a business over a 5-year
period establishes a pattern that may be significant. Suppose the current
ratios for the 5 years are 7 to 1, 5 to 1, 4 to 1, 3 to 1, and 2 to 1.
Clearly, the ability of the business to meet its current debt is declining.
Another important use of ratios is to compare the company's performance
with that of similar businesses. For almost every size and type of
business, there are published ratios of expenses to sales that are accepted
throughout the industry. A comparison between the ratios of the business
offered for sale and averages for the trade will bring out any
discrepancies. Some of the discrepancies may be due simply to poor
management, but each one should be investigated.
Evaluation of Past Years' Profits
In using a net-profit figure for past years to project the future earning
potential of the business, the buyer or seller should exclude the profit of
any year that is unusually high or low because of exceptional
circumstances. It may also be wise to use a weighted average for the past
years' profits.
Assume, for example, that two similar businesses are to be compared. Their
profits for the past 5 years have been as follows:
Year Company A Company B
1.................................$18,000 $2,000
2................................. 14,000 6,000
3................................. 10,000 10,000
4................................. 6,000 14,000
5................................. 2,000 18,000
------- ------
Total........................$50,000 $50,000
------- ------
Average...........................$10,000 $10,000
Both businesses show the same average profits over the 5 years and would
therefore, on the basis of a simple average, be valued at the same figure.
But while company A has been declining, company B has been growing. Some
method is needed that will give more emphasis to the profits of the later
years.
A weighted average can have this effect. How much the later profits are
emphasized over the earlier years will depend on what multiplier is used,
and the choice of multiplier is a matter of personal opinion. Here is an
example of how a weighted average could be used to give effect to trends in
comparing companies A and B:
Year Company A Company B
1..............$18,000 X 1 = $18,000 $2,000 X 1 = $2,000
2.............. 14,000 X 2 = 28,000 6,000 X 2 = 12,000
3.............. 10,000 X 3 = 30,000 10,000 X 3 = 30,000
4.............. 6,000 X 4 = 24,000 14,000 X 4 = 56,000
5.............. 2,000 X 5 = 10,000 18,000 X 5 = 90,000
-- -------- -- --------
Total........ 15 $110,000 15 $190,000
-- -------- -- --------
Weighted
av.....$110,000 div. by 15 = $7,334 $190,000 div. by 15 = $12,667
In assessing the future of the business, the buyer must take into
consideration any changes he plans to make in the basic financial structure
of the business, such as putting in additional capital or not buying all
the assets. However, he should not pay for future profits he is going to
earn by reason of his own special skills or additional investment. In
determining the future income he is purchasing, therefore, he must rely
largely on past results of the business operation.
Effect of Changes in Price Levels
When the buyer is analyzing several years' financial statements, he must
keep in mind the effect on the statements of changes in price levels; that
is, in the purchasing power of money. He should consider the possibility of
converting the amounts on the financial statements to a base year.
Putting a Value on Goodwill
Goodwill, when it exists, is a valuable asset. It may result from a good
reputation, a convenient location, efficient and courteous treatment of
customers, or other causes. However, because it is intangible and difficult
to measure, goodwill is sometimes recorded when it does not exist.
From the accountants' standpoint, goodwill should be recorded only when it
is purchased. It should not be recorded otherwise, they believe, because of
the difficulty of placing a fair value on it.
As a practical matter, above-average earnings are normally considered the
best evidence of the existence of goodwill, and the value placed on the
goodwill at the time of its sale is often determined by capitalizing these
extra earnings. Take, for example, a business in a field in which the
normal return on investment is 10 percent. Suppose the business has a
capital investment of $200,000 and an annual return of about $24,000. The
average return on $200,000 for this type of business would be $20,000 a
year. Therefore, the business has above-average earnings of $4,000 yearly.
Capitalizing these above-average earnings at 10 percent ($4,000 div. by
.10) gives $40,000 as the investment needed to earn the $4,000. Therefore
$40,000 may be taken as the value of the goodwill of this firm.
Many people feel that unless a business has above-average earnings, it does
not have goodwill. Thus, a business might appear to have an excellent
location, enlightened customer policies, and a superb product; yet this
business will not have goodwill attaching to it unless its earnings exceed
the normal earnings for that type of business.
The measurement of goodwill has many pitfalls. To begin with, a decision
must be made as to what normal earnings are. (Industry averages will
probably be available, but average earnings for the industry aren't
necessarily normal earnings.) And once this decision has been made, the
percent at which the above-normal earnings will be capitalized must be
decided. In the example given, 10 percent was used. This means that the
buyer should recover his investment in 10 years. If he wants to recover his
investment more quickly, he will want to use a higher percent, which will
give a lower capitalized value. If he is willing to wait longer, he will
accept a lower percent, which will raise the capitalized value.
Goodwill is simply a bookkeeping device to represent the value of one part
of a business when that business is valued as a whole. In most cases, the
total value of the business is decided without a detailed calculation of
the goodwill figure--in many cases, without even detailed consideration of
the value of the other assets.
Checklist
1. Get financial statements for the past 10 years or as long as the business
has been in operation.
2. Make whatever revaluations of the financial statements are necessary to
make the statements realistic.
3. Prepare ratios and percentages as needed.
4. Compare results of the company's operations from year to year in the
past and with results in the industry at large.
Questions To Be Considered by the Buyer
1. What will happen to the profit when I take over the business?
2. How good is the accounting system that has been used?
3. How good is the cost system?
4. How realistic are the budgets?
5. How much owner's personal expense has been charged
to or absorbed by the business?
6. Is there an equipment record--for insurance and to tell me what it costs
to maintain various types of machinery?
7. Is the insurance adequate?
8. What have the financing arrangements been, particularly if sources other
than a bank were used?
9. What is the rate of return on capital invested and what rate of return
do I want for my capital investment?
Part 5 Analyzing the Market Position of the Company
The Market
Introduction: Market Analysis
EVERY BUYER, and indeed every seller, should have some measurement of what
the future will offer. This includes not only the possibility of
maintaining the same volume of sales as in the past, but also the
opportunity to increase sales.
The buyer must have some idea of what he is acquiring besides the physical
assets of the business. He is, in fact, investing in or obligating himself
to the continued operation of the business. The true value to him lies in
the ability of the business to generate sales at lease equal to its current
position in the market. This calls for a careful investigation and analysis
of two factors: (1) the past growth of the company within the market of
which it is a part, and (2) a forecast of the future sales pattern.
The seller also needs a market analysis for the business he proposes to
sell. He wants the best possible price for the business--and the better the
outlook, the more likely the buyer is to agree to the asking price.
Who Does the Work?
Will a single market analysis fill the needs of both buyer and seller?
Separate studies are probably better. The seller has access to data about
the business that are not available to the buyer. Unless the buyer has had
wide and recent experience in the same kind of business, he may--rightly or
wrongly--tend to rely on the seller's statement of the market position of
the company.
No two studies of the same company will produce exactly the same results.
The buyer's analysis is almost certain to be on the conservative side, and
a compromise will be necessary.
Another question is whether the buyer and seller should conduct their own
market studies or hire specialists to do it. The detailed and complex type
of investigation conducted by a professional market analyst is valuable, of
course, but the cost is considerable.
The basic purpose of a market analysis in the buy-sell situation is to get
a clearer picture of the company in the marketing scheme and some
indication of the general direction in which it is moving. The buyer and
seller should be able to gather and analyze the basic data they need for
this purpose--if they avoid a highly statistical approach.
Organizing the Study
Part 5 includes five series of questions and a checklist to guide the buyer
or seller in his analysis of the market position of the business.
Sample rating charts
+-------------------------------------------------------------------+
¦COMPANY SALES: ¦
¦ Dollar Percent ¦
¦ Year sales change ¦
¦ ¦
¦1974.................................. $__________ ___________ ¦
¦1975.................................. ___________ ___________ ¦
¦1976.................................. ___________ ___________ ¦
¦1977.................................. ___________ ___________ ¦
¦1978.................................. ___________ ___________ ¦
¦Dollar increase 1978 over 1974........ $__________ ___________ ¦
¦Percent increase 1978 over 1974.................... ___________ ¦
¦How satisfactory? 1 2 3 4 5 ¦
¦ ¦
¦SHARE OF MARKET: ¦
¦ Share of ¦
¦ Industry Company market ¦
¦ Year sales sales (percent) ¦
¦ ¦
¦1974................ $____________ $______________ ___________ ¦
¦1975................ _____________ _______________ ___________ ¦
¦1976................ _____________ _______________ ___________ ¦
¦1977................ _____________ _______________ ___________ ¦
¦1978................ _____________ _______________ ___________ ¦
¦Change in share of market 1978 over 1974............ ___________ ¦
¦How satisfactory? 1 2 3 4 5 ¦
+-------------------------------------------------------------------+
The list of questions is not complete, and not all of those given will be
equally useful for all types of businesses. The nature of the business
determines what kind of information is needed and in what detail. The
questions will, however, call attention to some aspects of the market that
might otherwise be overlooked.
Determining how important to the business a specific market characteristic
is presents a problem. What is vital to one company may be unimportant to
another. And some system should be worked out for rating each
characteristic.
A possible method for this is to list the major subject areas in the study,
showing their relative importance, and then to rate them according to a
uniform system--a rating scale using numbers, for instance, or words such
as "high," "medium," "low," and "not significant."
An example of how a
numbered scale might work in rating the company's sales over time (one of
the characteristics most likely to be studied) is shown in the box above.
Chapter 12 - The Market
THE STRENGTH OF A MARKET depends on three elements: population, income, and
motivation or attitude. The first two can be measured with some accuracy
and predicted statistically. Motivation, being subjective, cannot be easily
observed and is largely unpredictable.
Population in the Market Area
Population, particularly the pattern within the given market, is a dominant
element in the market prospects of a business. Changes in age distribution
of the population will be important to some types of businesses. Migratory
factors such as shifts from rural to urban and from urban to suburban may
determine the future growth of others.
Many businesses, such as food stores, will be influenced principally by the
total growth in population. Others will feel the impact of structural
changes--the older group with its special requirements, the increase in the
infant market.
Rapidly growing communities show a larger-than-normal proportion of young
families; areas with a static or declining population, a larger-than-normal
proportion of older families. How permanent the population in the market is
must be considered. In areas where employment is seasonal or cyclical, a
large part of the population may be only semipermanent.
An analysis of population consists of more than simply counting noses. It
requires a careful study of both qualitative and quantitative
characteristics.
Questions in the Analysis of Population
1. What has been the change in total population in this market area over
the past 10 years?
A comparison of census figures will show these changes. The use of census
tracts in major metropolitan market areas is helpful. Many city and county
government units compile population figures on various geographical bases.
2. Using a given year in the past as a base, what has been the annual and
cumulative percent of change in population in this market area?
The cumulative percent of change is found by dividing each succeeding year
by the first year. It shows as a percent how each year up to the present
compares with the base year. Plotting the figures on a graph helps to
visualize the progressive change.
3. What is the average family size? Has this been increasing or decreasing?
In many consumer-goods businesses, the size of the average family unit may
be more important than total population, particularly where there are
observed changes in family size. Increase in the size of the family unit
has had a profound effect on many classes of consumer goods, from station
wagons to outdoor gym sets.
4. What is the population in this market measured in family units?
The rate of change in family units will not be the same as the rate of
change in total population if the size of the average family unit is
changing.
5. What is the current distribution by age groups in the market? How has
this distribution changed in the past 10 years?
Nationwide, the age distribution of the population is not the same as it
was a few years ago. The under-5 and over-65 groups probably show the
greatest rate of change. The buyer should know whether the seller has been
alert to these changing patterns and is taking advantage of them.
6. What percent of the population in this market can be classified as
urban, suburban, rural? How has this changed over the past 10 years?
Changing living patterns and habits change the demand patterns for various
types of goods and services. If population shifts are changing the market
or shows signs of being about to do so, the businessman must try to
determine how much effect this has or is likely to have on his operation.
7. What percent of the family units in this market have only one person?
Two? Three? Four? More?
A breakdown of family units by number of persons in the family has value
for businesses whose sales volume is at least somewhat related to family
size. A manufacturer of outdoor portable swimming pools, for instance,
would be interested in family sizes because this would influence the
production of various sizes of pools.
8. What percent of the total population or family units are potential
customers for this kind of business?
This is particularly important for businesses whose goods or services are
related to the way people live. The demand for three-horsepower garden
tractors will depend on the number of families living on small acreages.
Septic tank sales will depend on the families not eligible for public
sewerage services. An analysis of the market for specialized goods and
services may be the key to evaluating the future of the business.
9. How has the total population been changing over the past 10 years? Is
it--
Increasing at an increasing rate?
Increasing at a decreasing rate?
Showing no change?
Decreasing at a decreasing rate?
Decreasing at an increasing rate?
Population may be continuing to increase, but at a slower rate. This would
probably suggest less in-migration and more out-migration, or perhaps a
reduced birth rate, though this would probably occur over a fairly long
period of time. Analysis of vital statistics of the market (births over
deaths) is advisable.
10. What is the level of education in the market? Is it increasing? What is
the rate of increase? What is the level of education by age groups in the
adult population? Education of the male population? Female population?
Generally, the higher the education level, the higher the income level is
likely to be, with correspondingly greater capacity for goods and services.
Trends in the level of education, particularly when correlated with income,
may indicate future potential.
Income in the Market Area
Income as used here refers to net spendable income rather than gross
earnings. Of the spendable income, the primary concern is with that which
remains after fixed or relatively fixed obligations have been met--rent or
home payments, utility payments, insurance premiums, and the like. The
amount left is the income over which the consumer has some control--whether
to spend all of it or some.
How each consumer spends this income is largely a matter of personal
motivation. The total amount available for consumption in the market,
however, depends on the economic factors influencing income. Variations in
total income and the resulting purchasing power stem largely from two
sources: (1) changes in the average income of the family unit, with the
same general level of employment prevailing; and (2) changes in the level
of employment with the average income constant.
The difference between earned income and real income must also be
recognized. If the cost of living is increasing at a rate about equal to
the purchasing power, there is no gain in purchasing power. Dollar
purchases may increase, but each dollar buys less. The net difference
between the increase in income and the increase in prices reflects the true
gain or loss in income converted to purchasing power.
Some classes of goods and services show no positive relation between demand
and income levels. For example, when incomes rise, more dollars are spent
for food, but the percent of income channeled into these goods is smaller.
Income is important in market analysis because changes in income are
reflected in the demand patterns for goods and services. No business is
free from this effect. As barbershop prices increase, the interval between
haircuts increases and the sale of hair clippers for home use rises. The
demand for funerals in a rising market does not change, but the degree of
ornateness in the casket or services decreases.
Questions in the Analysis of Income
1. What is the total spendable income within the market area? What is the
average per capita income? Average per family income?
2. What has been the rate of change in income (per capita, per family) over
the past 10 years on both a year-to-year basis and a cumulative basis?
Changes in income reflect the changing status of the market. The change is
most likely to be an increase, but the extent of the increase should be
known.
3. How does the rate of change in income in this market compare with
changes in the Nation as a whole and in similar markets?
The economic factors affecting the income status of a given market may
differ from those at work in the economy as a whole, but it is helpful to
know how changes in this market compare with trends in other markets.
4. What is the distribution of income and purchasing power by income class
in the market?
A frequency distribution such as this can be used to analyze income and
purchasing power:
Percent of Percent of total
Distribution family units purchasing power
$0 to $4,999 ______________ ________________
$5,000 to $7,999 ______________ ________________
$8,000 to $13,999 ______________ ________________
$14,000 to $19,999 ______________ ________________
$20,000 and over ______________ ________________
The $8,000 to $13,999 income group, for instance, might represent 32
percent of all family units and 38 percent of the purchasing power; the
$20,000-and-over group, 5 percent of the family units and 11 percent of the
purchasing power. The higher-income groups will ordinarily be smaller, but
they will have a higher-than-proportionate purchasing power.
5. How has the distribution of income and purchasing power by income
classes changed over the past 10 years?
This information should be reduced to year-to-year and cumulative
percentages.
6. What are the types of employment and the percentage of the working force
in each class?
Here, again, changes over time should be studied.
7. Have there been any significant changes in the forms of employment in
this market over the past 10 years? What changes in industry and employment
in this market are foreseeable?
8. What is the level of unemployment in this market area? Is unemployment
increasing? Decreasing? Showing no appreciable change?
Knowledge of the unemployment trend is important because of the direct
effect it has on purchasing power and the psychological effect of the
threat of unemployment.
9. How much do consumers typically spend for various classes of goods and
services in this kind of market?
Competition in the Market Area
The buyer of a business not only acquires the physical property of the
company; he also inherits its competition. He will probably be able to do
little or nothing to lessen the competitive pressure operating against him,
but he can develop a clear working knowledge of what he will face--the
state of competition, the relative strength of the business within the
market, the general patterns of development and change. A detailed analysis
of the competition is highly desirable in deciding whether to buy an
existing business.
Attention should be given first to competitors of about the same type and
size as the business in question, since they are on a more realistic level
of competition. A small clothing store would be wise to concern itself with
other small clothing stores rather than with a high-volume department
store. In time, a small operation might grow to the point of competing
successfully with major firms, but the immediate pull of competition will
come from other businesses of about the same size and description.
Investigation of large businesses, if any is made, should concern the
extent to which they enlarge the total market, stimulate demand, or
otherwise open up market possibilities to the smaller business.
Questions in the Analysis of Competition
1. How many competitive businesses are there within the market area of this
business? Where are they located? What can be found out about them? From
whom?
The market area in this sense is the trade area in which the business
operates. In a retail, wholesale, or service business, this trade area may
be rather narrowly defined. In a manufacturing or mail-order business,
there may be a number of markets--regional, national, and perhaps even
international.
Markets can be further defined as either consumer-goods markets or
industrial goods markets, depending on the nature of the business and the
goods or services with which it deals. The market or markets must be
carefully identified to avoid any waste of time and effort in making the
analysis.
2. How many competitive businesses have gone out of business or moved out
of the market area within the past year?
If there has been a decline in the number of competitors, an attempt should
be made to find out why. If the decline has been significant, it may
indicate that there are too many businesses of that type for the potential
sales volume. If other areas of the analysis tend to indicate a declining
market, exodus of competing businesses may help support those findings.
3. How many competitive businesses have opened in this market area within
the past year?
Is this increase in competition more than should normally be expected? What
circumstances have been responsible for the increase in competition? Can
the market support all these businesses?
Unless the market grows in proportion to new competitive entries, the net
result is a smaller share for each competitor.
4. What is the total known or estimated volume of competitive business
within the market area?
This should give a cross-check on the volume of business done by the
company up for sale. The total sales estimate for the market less that done
by the company gives a reasonably accurate estimate of the volume going to
the competition. Or the sales of the company can be estimated by
subtracting competitors' sales from total sales in the market.
5. What sort of sales effort does the competition make?
How do the competitors advertise, promote? What advertising media are used?
How much?
What is the quality of competitors' sales forces? Could business be drawn
from competitors by improving on their sales ability?
There is likely to be considerable variation in the level of sales effort
between competitors in the same market, from those who are highly
aggressive to those who simply "follow the crowd." The person investigating
the market should analyze competition from this point of view as
intensively as possible.
6. What is the total footage of all competitive businesses within the
market area?
From the total gross footage and total estimated volume, it is possible to
get an overall sales-per-square-foot average to compare with the company
under consideration.
7. What is the general physical appearance of competitive establishments in
the market area?
Generally speaking, alert, progressive firms present an up-to-date physical
appearance and use the newest techniques of operation. A generally high
level of overall appearance gives some indication of the aggressiveness of
the competition.
8. What other competitive businesses are known to be for sale within the
market area?
If general business conditions are such that other competitors are seeking
to get out of the market, the prospective buyer should know it. It may
signify that the area is not a good one for entering business. On the other
hand, a lessening of competition leaves to the business in question a
larger potential volume. The reasons why competitors have left the market
area should be learned. A decision to purchase assumes economic health in
the market.
9. What other kinds of businesses are in indirect competition--that is,
deal at least to some extent in the same kinds of goods or services as the
business being considered for sale or purchase?
Businesses are constantly adding lines of merchandise, expanding services
offered, and creating new products. As a result, the pattern of competition
changes rapidly. The buyer, and presumably the seller, should be aware of
these changes and their likely effect on the business in question.
10. Can the competitive businesses be rated, taking all factors into
account, from the strongest or most dominant to the weakest?
What characteristics of the strongest competitors should be studied with an
eye to improving the business being bought or sold? What weaknesses of the
competition might the buyer or seller be able to capitalize on?
11. What kinds of services to customers are competitors offering that this
business does not?
Customer services are becoming a dominant force in attracting and holding
customers. Services offered to customers by competitors should be
investigated carefully to determine the effect these have on attracting
sales volume.
12. What are the general pricing policies of competitors?
An actual price comparison of specific products or services should be made.
Attention should be concentrated on general price levels rather than
specific items--the purpose is to compare this company and its competition,
taking into account cost of merchandise, relation with sources of supply,
cost of operation and so on.
13. How influential has the competition been in enlarging the overall
market?
Demand is classified in two ways: primary demand, which is the demand for
certain kinds of goods or services, and selective demand, which is demand
for a given brand or desire to purchase from a specific company.
Competition, through promotion and sales effort, must be able to enlarge
market capacity for a product by type or class. The combined sales effort
of all appliance stores in a market, for example, will expand the primary
demand for air conditioning. Thus the separate but total force of
competition may have the positive effect of expanding the basic market.
14. How does the competition compare with the business in the buy-sell
transaction as to the amount apparently spent on sales effort?
The nature and extent of advertising and promotion is often a strong
indicator of the competitive intensity of business within a market. As the
market becomes more competitive, sales-effort costs as a percentage of
sales tend to rise. A study of competitive advertising and promotion--the
media and methods used, the form the promotion follows--would be of value
in the market analysis.
15. Is there evidence of concerted or cooperative effort on the part of the
competition to increase the total market?
Through trade associations? Joint promotional programs? How effective does
the effort appear to be?
Chapter 13 - The Company
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 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 from
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 the relation to the
market of which it is 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 residential 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 point that should be considered in
evaluating the location of a retail store. It can be adapted for use with
other types of businesses.
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 receiving
New and promising
Recent and uncertain
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
Seasonality
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
Are many people shopping outside the community?
4. The town as a place to live
Character of the city
Are homes neat and clean, or run down and shabby?
Are lawns, parks, streets and so neat, modern, and generally
attractive?
Are adequate facilities available?
Banking
Transportation
Professional services
Utilities
Schools
Churches
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
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
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
Others
10. History of the site
Sales effort
The discussion here concerns the nature of the company's 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 nonpersonal 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 advertising 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 the past? If so, why
the change?
No one advertising medium is best for all types of business. 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 increase, 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 taking 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 increasing? Decreasing?
It is important to know not only changes in the pattern of advertising
expenditures, but the relation between 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? About
the same?
Figures are available from trade sources and other reporting agencies that
will give standard of comparison.
9. Are other forms of promotion being used effectively? Window display?
Interior layout and display?
For many kinds of 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
consideration.
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 trading
stamps or other premiums, participating with sources of supply in special
promotions, 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, 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 effecting its quality. Motivation of sales
personnel through training, method and amount of compensation, 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 effect the buy-sell transaction.
Seasonal fluctuations. All businesses are affected to some extend 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 predictable; 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
additional 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 seasonal peak of the company, thus realizing
the best possible profit. (It is assumed here that in relation 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.
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 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 judgement. If the figures
are later to be used to make projections, a 10-year period or more is not
unreasonable if the company has been in business that long. Converting the
dollar figures to yearly percent of change and plotting them on a graph
makes them easier 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 year 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 increase 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 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?
Decreasing more than normal?
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 same 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 variation 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's 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.
13. If cyclical changes have any effect on this kind of business, what is
the nature of the fluctuations? 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 fluctuations? 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 effect 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.
17. What 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 relative 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?
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 the 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 in
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 of 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.
Chapter 14 - 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 attempt 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
anything 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 practical point of view, there is little choice. In any
case, it is usually over longer periods of time that changing 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 conditions.
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 market and the extent of competitive influence, and it involves 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. Intermediate-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 contacted 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 reasonably
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 reasonably be expected to be 8 percent ahead of the corresponding
period a year ago.
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, sale 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 $16,000 div. by .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 preceding weeks, as
shown in this example:
Weekly Cumulative
Weeks percent percent
1 .9 .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 div. by .51, or $156,682. To forecast sales for the
next 4 weeks, add the percentages for those weeks and multiply the annual
estimate by the result ($156,862 div. by .098 = $15,372). This method works
best for goods or services 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 dollar 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.
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 businessman, 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. Although 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 buyer's unbounded faith in his own managerial ability.
Can You Make Money with Your Idea or Invention?
By John Tavela, Editor
Management Publications
U.S. Small Business Administration
Summary
Innovative ideas are essential to business progress. It is very difficult,
however, for innovators to get the kind of financial and management support
they need to realize their ideas.
This Aid, aimed at idea people, inventors, and innovative owner-managers of
small companies, describes the tests every idea must pass before it makes
money.
You've Got an Idea? Great!
So, you've had an idea for an invention or an innovative way of doing
something that will boost productivity, put more people to work, and make
lots of money for you and anyone who backs you? As you've probably heard,
you're the kind of person your country needs to compete in world markets
and maintain its standard of living. You're the cutting edge of the future.
You are another of those individuals on whom progress has always depended.
We all know that it hasn't been huge corporations that have come up with
the inventions that have revolutionized life. As the discoverer of
penicillin, Sir Alexander Flemming, said, "It is the lone worker who makes
the first advance in a subject: The details may be worked out by a team,
but the prime idea is due to the enterprise, thought and perception of an
individual." Innovators like you are business's lifeblood.
Owner-managers who have started companies on new ideas know first hand
about the innovation process. They also know that you can expect to hear....
You've Got an Idea? So What?
In the first place, the chances that you are the first to come up with a
particular innovation are somewhere between slim and none. Secondly, even
if you have come up with the better mouse trap, nobody--but nobody--is
going to beat a path to your door. In fact, in the course of trying to
peddle your BMT, you'll beat up plenty of shoe leather wearing paths to
other people's doors. You'll stand a good chance of wearing out your
patience and several dozen crying towels as well.
Why is it so hard to find backers for your brainchildren? One consultant
put it: "Nobody wants unproven ideas. Nobody wants to be first. Everybody
wants to be second." Why this fear of the new?
Well, new product failure rates are estimated conservatively to be between
50 and 80 percent. One survey of major companies with millions of dollars
to spend on R & D, market research, and product advertising, and with
well-established distribution systems found that of 58 internal proposals
only 12 made it past initial screening. From these 12 only one successful
new product emerged.
Another group set up to help innovators has found that of every 100 ideas
submitted 85 have too many faults to bother with. They can be eliminated
immediately. Of the remaining 15, maybe five will ever be produced. One of
those might--only might--make money.
With odds like 99 to 1 against an idea being a monetary success, is it any
surprise that your idea is greeted with a chorus of yawns?
People--companies, investors, what have you--are basically conservative
with their money. Ideas are risky.
Does that mean you should forget about your idea? Of course not. It merely
means that now you're beginning to see what Edison meant, when he said,
"Genius is one per cent inspiration and ninety-nine percent perspiration."
Again, those of you who own small firms started on innovations are well
aware of the truth of Edison's words. You've been through the hard work.
Can You Exploit Your Idea?
Although coming up with what you think is a sure-fire idea is the biggest
step, it's still only the first one. You've got the other thousand miles of the journey to
success still ahead of you.
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