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Please read Ch7 and Ch8 and answer e78 1. Write 600 words on this Key Points Chapters 7 and 8 For chapters 7 and 8 list: - Number and title of the chapter - Use the text and the PowerPoints are located in the readings from week  - Pick 5 key points you feel are the most important in each chapter. - 1) The most important lesson YOU learned from that chapter that you would share with a business colleague explaining your reasoning for choosing that lesson;  and 2) how you would utilize this lesson in your own work/life. This is the format you should use:  - Chapter number/ Chapter title  - Key points 1. 2. 3. 4. 5. -  PLUS, the most important lesson learned, explaining why you think so. Section 2: The Entrepreneurial Journey Begins Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. If this PowerPoint presentation contains mathematical equations, you may need to check that your computer has the following installed: 1) MathType Plugin 2) Math Player (free versions available) 3) NVDA Reader (free versions available) 1 Essentials of Entrepreneurship and Small Business Management Ninth Edition Chapter 8 Franchising and the Entrepreneur Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Learning Objectives (1 of 2) 1. Describe the three types of franchising: trade name, product distribution, and pure. 2-A. Explain the benefits of buying a franchise. 2-B. Explain the drawbacks of buying a franchise. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. In this chapter, you will: 1. Describe the three types of franchising: trade name, product distribution, and pure. 2.A. Explain the benefits of buying a franchise. 2.B. Explain the drawbacks of buying a franchise. 3 Learning Objectives (2 of 2) 3. Understand the laws covering franchise purchases. 4. Discuss the right way to buy a franchise. 5. Describe the major trends shaping franchising. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. In addition, you will: 3. Understand the laws covering franchise purchases. 4. Discuss the right way to buy a franchise. 5. Describe the major trends shaping franchising. 4 The Franchising Boom About 3,800 franchisors operate more than 750,000 outlets in the United States. Franchises generate more than $710 billion in annual sales and account for 2.3% of the U.S. GDP. Franchises employ 7.8 million workers in the United States in more than 300 major industries. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Most franchised outlets are small, but as a whole, they have a significant impact on both the U.S. and global economies. 5 Number of Franchised Outlets in the United States Figure 8.1 Number of Franchised Outlets in the United States Source: Based on data from Franchise Business Economic Outlook for 2017, IHS Economics and the International Franchise Association Educational Foundation, January 2017, p. 2. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. In the United States alone, about 3,800 franchisors operate nearly 750,000 franchise outlets, and more are opening constantly. 6 Franchised Outlets by Industry Figure 8.2 Franchised Outlets by Industry Source: Based on data from Franchise Business Economic Outlook for 2017, IHS Economics and the International Franchise Association Educational Foundation, January 2017, p. 2. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Figure 8.2 provides a breakdown of the franchise market by industry. 7 Franchising Franchising: A system in which semi-independent business owners (franchisees) pay fees and royalties to a parent company (franchiser) in return for the right to become identified with its trademark, to sell its products or services, and often to use its business format and system. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Franchising also has a significant impact on the global economy. Because the United States franchise market is the most mature in the world, U.S. franchisors are expanding globally to reach their growth targets. 8 Franchising Basics Franchisee gets the right to use all of the elements of a fully integrated business operation. Essence of what franchisees purchase from the franchisors: Experience. Key Question: “What can a franchise do for me that I cannot do for myself?” Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Franchisees do not establish their own autonomous businesses; instead, they buy a “success package” from the franchisor, who shows them how to use it. 9 The Franchising Relationship Figure 8.3 The Franchising Relationship Source: Adapted from Economic Impact of Franchised Businesses: A Study for the International Franchise Association Educational Foundation, Copyright 2004 by the International Franchise Association. eprinted with permission. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Franchising is built on an ongoing relationship between a franchisor and a franchisee. The franchisor provides valuable services, such as a proven business system, training and support, name recognition, and many other forms of assistance; in return, the franchisee pays an initial franchise fee as well as an ongoing percentage of his or her outlet’s sales to the franchisor as a royalty and agrees to operate the outlet according to the franchisor’s terms. 10 Types of Franchising Trade-Name: A franchisee purchases the right to use the franchisor’s trade name without distributing particular products exclusively under the franchisor’s name. Product Distribution: A franchisor licenses a franchisee to sell its products under the franchisor’s brand name and trademark through a selective, limited distribution network. Pure: A franchisor sells a franchisee a complete business format and system. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Three basic types of franchises operate in almost every industry: trade-name franchising, product distribution franchising, and pure franchising. 11 Franchise Business Index Figure 8.4 Franchise Business Index Source: Franchise Business Economic Outlook for 2017, IHS Economics and International Franchise Association Educational Foundation, January 2017, p. 4. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Figure 8.4 shows the International Franchise Association’s Franchise Business Index, a composite measure of the economic health of the franchise industry that includes six different indicators. 12 Benefits of Franchising (1 of 3) A business system Management training and support Start-up Ongoing Brand name appeal “Cloning” Standardized quality of goods and services Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. For many first-time entrepreneurs, access to a business model with a proven track record is the safest way to own a business. 13 Benefits of Franchising (2 of 3) National advertising programs Franchisees contribute 1% to 5% of sales. Financial assistance About 20% of franchisors offer direct financial assistance to franchisees. SBA – Franchise Registry Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. An effective advertising program is essential to the success of every franchise operation. A basic principle of franchising is to use franchisees’ money to grow their businesses, but some franchisors realize that because start-up costs have reached breathtakingly high levels, they must provide financial help for franchisees. 14 Benefits of Franchising (3 of 3) Proven products and business formats Centralized buying power Site selection and territorial protection Important issue: Territorial encroachment Greater chance for success Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. A franchise owner does not have to build the business from scratch. 15 Drawbacks of Franchising (1 of 3) Franchise fees and ongoing royalties Average upfront franchise fee = $25,147 Royalties range from 1% to 11% of franchisees’ sales Average royalty = 6.7% of sales Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Prospective franchisees must understand the disadvantages of franchising before choosing this method of doing business. Perhaps the biggest drawback of franchising is that a franchisee must sacrifice some freedom to the franchisor. 16 Planned Sources of Financing for Prospective Franchisees Figure 8.5 Planned Sources of Financing for Prospective Franchisees Source: Prospective Franchisee Survey Results, FranchiseDirect, 2016, www.franchisedirect.com/information/prospectivefranchiseesurveyresults2016/?r=5380. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Franchisees use many of the same sources to finance franchises that independent entrepreneurs use to finance start-up companies. 17 Franchise Royalty Fees Figure 8.6 Franchise Royalty Fees Source: Based on 2015 Franchise Sales Trends Report, FranConnect, 2015, p. 6. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. This figure shows a breakdown of franchise royalty fees. 18 Drawbacks of Franchising (2 of 3) Strict adherence to standardized operations Restrictions on purchasing Approved suppliers only Limited product line Contract terms and renewal Average term = 10.5 years Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Although franchisees own their businesses, they do not have the autonomy that independent owners have. To protect its image, a franchisor requires that franchisees maintain certain operating standards. 19 Drawbacks of Franchising (3 of 3) Unsatisfactory training programs Market saturation Less freedom “No independence” “Happy prisoners” Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Before signing on with a franchise, it is wise to find out the details of the training program the franchisor provides to avoid unpleasant surprises. 20 Franchise Breakdown by Number of Outlets Figure 8.7 Franchise Breakdown by Number of Outlets Source: Based on 2015 Franchise Sales Trend Report, FranConnect, 2015, p. 3. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Figure 8.7 shows a breakdown of the number of outlets operated by U.S.-based franchises. 21 Ten Myths of Franchising (1 of 2) Franchising is the safest way to go into business because franchises never fail. I’ll be able to open my franchise for less money than the franchiser estimates. The bigger the franchise organization, the more successful I’ll be. I’ll use 80 percent of the franchiser’s business system, but I’ll improve upon by substituting my experience and know-how. All franchises are the same. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Many myths surround franchising. 22 Ten Myths of Franchising (2 of 2) I don’t have to be a hands-on manager. I can be an absentee owner and still be very successful. Anyone can be a satisfied, successful franchise owner. Franchising is the cheapest way to get into business for yourself. The franchiser will solve my business problems for me; after all, that’s why I pay an ongoing royalty fee. Once I open my franchise, I’ll be able to run things the way I want to. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Franchising and the Law Franchise Disclosure Document (FDD) Established in 2008 to replace the Uniform Franchise Offering Circular (UFOC) Requires franchisors to disclose to potential franchisees information on 23 important topics Objective: To give franchisees the information they need to protect themselves from dishonest franchisees and to make good investment decisions. Joint Employer Liability Browning-Ferris Industries (BFI) decision Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The FDD applies to all franchisors, even those in the 35 states that lack franchise disclosure laws. The purpose of the regulation is to assist potential franchisees’ investigations of a franchise deal and to introduce consistency into the franchisor’s disclosure statements. In a recent decision known as Browning-Ferris Industries (BFI), the National Labor Relations Board (NLRB) overturned more than 30 years of regulatory practice and franchise law by declaring that franchisors are considered “joint employers” with their franchisees. Even though franchisees make decisions about hiring, paying, scheduling, and firing their employees, the ruling holds franchisors jointly responsible for those decisions. 24 The Right Way to Buy a Franchise (1 of 3) Evaluate yourself: What do you like and dislike? Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. By asking the right questions and resisting the urge to rush into an investment decision, potential franchisees can avoid being taken by unscrupulous operators. 25 Are You Franchise Material? Successful franchise owners have: Commitment A willingness to work with others A positive attitude Leadership ability Solid people skills Adequate capital Compatible values A learning attitude Patience General business skills Coachability Adequate capital A willingness to follow the system Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Do you have what it takes to be a successful franchise owner? 26 The Right Way to Buy a Franchise (2 of 3) Evaluate yourself: What do you like and dislike? Research your market. Consider your franchise options. Get a copy of the Franchisor’s FDD – and read it! Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. 27 Factors that Make a Franchise Appealing Unique concept or marketing approach Profitability Registered trademark Business system that works Solid training program Affordability Positive relationship with franchisees Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The Right Way to Buy a Franchise (3 of 3) Evaluate yourself: What do you like and dislike? Research your market. Consider your franchise options. Get a copy of the Franchisor’s FDD – and read it! Talk to existing franchisees. Ask the franchiser some tough questions. Make your choice. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Trends Shaping Franchising (1 of 6) Changing face of franchisees Minorities own 31.2% of all franchises compared to 14.6% of independent businesses. Modern franchisees are also better educated, more sophisticated, more financially secure, and have more business acumen compared to just 20 years ago. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Franchising has experienced three major growth waves since its beginning. The first wave occurred in the early 1970s, when fast-food restaurants used the concept to grow rapidly. The second wave took place in the mid-1980s, as the U.S. economy shifted heavily toward the service sector. A third wave began in the early 1990s and continues today. It is characterized by new low-cost franchises that focus on specific market niches. In the wake of major corporate downsizing and the burgeoning costs of traditional franchises, these new franchises allow would-be entrepreneurs to get into proven businesses faster and at reasonable costs. Franchisees today are a more diverse group than in the past. 30 Age Distribution of Franchisees Figure 8.8 Age Distribution of Franchisees Source: Based on “Prospective Franchisees Survey 2016,” FranchiseDirect, July 5, 2016, www.franchisedirect.com/information/prospectivefranchiseesurvey2016/?r=5380. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. People of all ages and backgrounds are choosing franchising as a way to get into business for themselves. 31 Trends Shaping Franchising (2 of 6) International opportunities Many franchises are focusing on international markets as a source of growth. McDonald’s earns 67% of its sales internationally. Yum! Brands has more than 14,000 restaurants outside the United States. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. One of the major trends in franchising is the internationalization of American franchise systems. Franchising has become a major export industry for the United States, with franchises focusing on international markets to boost sales and profits as the domestic market has become saturated. 32 Top 10 Franchise Markets Table 8.4 Top 10 Franchise Markets Rank Country 1 Canada 2 Australia 3 China 4 Indonesia 5 South Africa 6 Mexico 7 India 8 Vietnam 9 Colombia 10 Brazil Source: 2016 Top Markets Report: Franchising, U.S. Department of Commerce, International Trade Administration, 2016, pp. 2–3. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. This table shows the top 10 countries that present the greatest potential for franchisors, according to a cross-country analysis of five factors, including the availability of business infrastructure and a suitable labor force, sufficient market size, and the government regulatory environment. . 33 Trends Shaping Franchising (3 of 6) Mobile Franchises Putting businesses on wheels. Smaller, nontraditional locations Intercept Marketing: putting a franchise’s products or services directly in the paths of potential consumers, wherever they may be. Conversion Franchising Owners of independent businesses become franchisees to gain the advantage of name recognition. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Mobile franchising is one of the fastest-growing segments in the franchise market because mobile franchises typically have lower capital requirements than brick-and-mortar businesses, and they offer a marketing advantage: the ultimate in convenience for customers because the product or service comes to them. As the high cost of building full-scale locations continues to climb, more franchisors are searching out nontraditional locations in which to build smaller, less expensive outlets. It is not unusual for entrepreneurs who convert their independent stores into franchises to experience an increase of 20% or more in sales because of the instant name recognition the franchise offers. 34 Trends Shaping Franchising (4 of 6) Refranchising Franchisors sell their company-owned outlets to franchisees. Multi-unit franchising IFA: 20% of franchise owners are multiple-unit owners. Typical multiple-unit franchises own five outlets. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Refranchising not only increases franchisors’ profitability because it generates more royalty income for franchisors but also provides capital to finance international expansion. Franchisors are finding that multi-unit franchising is an efficient way to do business. For a franchisor, the time and cost of managing 10 franchisees each owning 10 outlets are much less than managing 100 franchisees each owning 1 outlet. A multi-unit strategy also accelerates a franchise’s growth rate. Not only is multiple-unit franchising an efficient way to expand quickly, it also is effective for franchisors who are targeting foreign markets, where having a local representative who knows the territory is essential. 35 Trends Shaping Franchising (5 of 6) Area development and master franchising Area Development: the franchisee earns the exclusive right to open multiple units in a specific territory in a specific time. Master Franchise: franchisee has the right to create a semi-independent organization in a particular territory to recruit, sell, and support other franchisees. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Driving the trend toward multiple-unit franchising are area development and master franchising. 36 Trends Shaping Franchising (6 of 6) Co-Branding Aka piggyback or combination franchising: Two or more franchises team up to sell complementary products or services under one roof. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. This “buddy-system” approach works best when the two franchise ideas are compatible and appeal to similar customers. 37 Conclusion Franchising: Is a key part of the small business sector Increases the chance of business success for the entrepreneur Growth continues Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Copyright Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. 39 Section 2: The Entrepreneurial Journey Begins Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. If this PowerPoint presentation contains mathematical equations, you may need to check that your computer has the following installed: 1) MathType Plugin 2) Math Player (free versions available) 3) NVDA Reader (free versions available) 1 Essentials of Entrepreneurship and Small Business Management Ninth Edition Chapter 7 Buying an Existing Business Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Learning Objectives (1 of 2) Describe the advantages and disadvantages of buying an existing business. Explain the five stages in acquiring a business: search, due diligence, valuation, deal, and transition. Explain the three steps in the search stage of buying a business. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. In this chapter, you will: 1. Describe the advantages and disadvantages of buying an existing business. 2. Explain the five stages in acquiring a business: search, due diligence, valuation, deal, and transition. 3. Explain the three steps in the search stage of buying a business. 3 Learning Objectives (2 of 2) Describe the four areas involved in conducting due diligence on a business: the seller’s motivation, asset valuation, legal issues, and financial condition. Explain the various methods used to estimate the value of a business. Describe the basic principles of negotiating a deal to buy a business and structuring the deal. Understand how to manage the transition stage when a deal is done. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. In addition, you will: 4. Describe the four areas involved in conducting due diligence on a business: the seller’s motivation, asset valuation, legal issues, and financial condition. 5. Explain the various methods used to estimate the value of a business. 6. Describe the basic principles of negotiating a deal to buy a business and structuring the deal. 7. Understand how to manage the transition stage when a deal is done. 4 Buying an Existing Business (1 of 2) Before you buy, ask: Is the right type of business for sale in a market in which you want to operate? What experience do you have in this particular business and the industry in which it operates? How critical to your ultimate success is experience in the business? What is the company’s potential for success? What changes will you have to make – and how extensive will they be – to realize the business’s full potential? Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. When considering purchasing a business, the first rule is, “Do not rush into a deal.” Taking shortcuts when investigating a potential business acquisition almost always leads to nasty – and expensive – surprises. 5 Buying an Existing Business (2 of 2) What price and payment method are reasonable for you and acceptable to the seller? Is the seller willing to finance part of the purchase price? Will the company generate sufficient cash to pay for itself and leave you with a suitable rate of return on your investment? Should you be starting a business and building it from the ground up rather than buying an existing one? Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. 6 Types of Business Buyers Figure 7.1 Types of Business Buyers Source: “Meet the Buyers,” by Darren Dahl, Inc., April 1, 2008, pp. 98–99. © 2008 by Inc. Magazine. Reprinted with permission. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. This figure shows a profile of the four major categories of buyers and their characteristics that business brokers have identified. 7 The Advantages of Buying an Existing Business (1 of 2) Successful existing businesses often continue to be successful. Superior location. Employees and suppliers are in place. Installed equipment with known production capacity. Inventory in place. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. A survey by Securian Financial Services reports that 60% of small business owners plan to exit their businesses by 2024 and that their most likely exit strategy is selling the business to someone. Over the next decade, as these small business owners decide to retire and sell, entrepreneurs looking to buy existing businesses will have ample opportunities to consider. Those who purchase an existing business may reap these benefits. 8 The Advantages of Buying an Existing Business (2 of 2) Trade credit is established. The turnkey business. The new owner can use the experience of the previous owner. Easier access to financing. High value. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. 9 The Disadvantages of Buying an Existing Business (1 of 2) Cash requirements. The business is losing money. Paying for ill will. Employees inherited with the business may not be suitable. Unsatisfactory location. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Keep in mind that despite the advantages of buying an existing business, there are some disadvantages to the strategy. 10 The Disadvantages of Buying an Existing Business (2 of 2) Obsolete or inefficient equipment and facilities. The challenge of implementing change. Obsolete inventory. Valuing accounts receivable. The business may be overpriced. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. 11 The Stages in Acquiring a Business Figure 7.2 The Acquisition Process Sources: Based on Buying and Selling: A Company Handbook (New York: Price Waterhouse, 1993), pp. 38–42; Charles F. Claeys, “The Intent to Buy,” Small Business Reports, May 1994, pp. 44–47. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Roughly 500,000 businesses change ownership each year, although about one-third of all business sales that are initiated fall through. The main reason is an unreasonable demand unrelated to the price of the business by either the buyer or the seller. This figure summarizes the steps in the acquisition process. 12 The Five Stages of Buying a Business Figure 7.3 The Five Stages of Buying a Business Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Purchasing an existing business can be a time-consuming process that requires a great deal of effort is often difficult to complete, and can be risky if approached haphazardly. Repeated studies report that more than half of all business acquisitions fail to meet the buyer’s expectations; therefore, buyers must conduct a systematic and thorough analysis prior to negotiating any deal. The remainder of this chapter examines the five stages that entrepreneurs go through when buying a business: (1) search stage, (2) due diligence stage, (3) valuation stage, (4) deal stage, and (5) transition stage. 13 The Search Stage There are three steps in conducting an effective search for the right business to buy: Conduct a self-inventory, objectively analyzing skills, abilities, and personal interests to determine the type(s) of business that offer the best fit. Develop a list of the criteria that define the “ideal business” for you. Prepare a list of potential candidates that meet your criteria. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. When buying a business, entrepreneurs must search for a business that fits best with their background and personal aspirations. There are three steps in conducting an effective search for the right business to buy. 14 Step 1: Self-Inventory (1 of 2) What business activities do you enjoy most? Least? Why? Which industries or markets offer the greatest potential for growth? Which industries interest you most? Least? Why? What kind of business would you enjoy running? What kinds of businesses do you want to avoid? What do you expect to get out of the business? How much time, energy, and money can you put into the business? Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The primary focus is to identify the type of business that you will be happiest and most successful owning. Answering the following questions can help. 15 Step 1: Self-Inventory (2 of 2) What business skills and experience do you have? Which ones do you lack? How easily can you transfer your skills and experience to other types of businesses? In what kinds of businesses would that transfer be easiest? How much risk are you willing to take? Are you willing and able to turn around a struggling business? What size company do you want to buy? Is there a particular geographic location you desire? What business skills and experience do you have? Which ones do you lack? Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. 16 Step 2: Develop a List of Criteria The goal is to identify the characteristics of the “ideal business” for you so that you can focus on the most viable candidates as you wade through a multitude of business opportunities. These criteria will provide specific parameters against which you can evaluate potential acquisition candidates. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Based on the answers to the self-inventory questions, the next step is to develop a list of criteria that a potential business acquisition must meet. 17 Step 3: Prepare a List of Potential Candidates Many businesses that can be purchased are not publicly advertised but are available either through the owners themselves or through business brokers and other professionals. Hidden market: low-profile companies that might be for sale but are not advertised as such. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. When you know what your goals are for acquiring a business, you can begin your search. Do not limit yourself to only businesses that are advertised as being “for sale.” 18 Business Purchases by Type of Business Figure 7.4 Business Purchases by Type of Business Source: Based on data from “BizBuySell’s 2016 Report: Why Buying or Selling a Business Is Becoming a Big Deal,” BizBuySell, 2017, http://www.bizbuysell.com/htmlmail/2017/content/BizBuySell-Small-Business-Infographic-2016.pdf?utm_source=bizbuysell&utm_medium=blog&utm_campaign=infographicarticle021417. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The more opportunities an entrepreneur has to find and evaluate potential acquisitions, the greater the likelihood of finding a match that meets his or her criteria. This figure shows the types of businesses that aspiring entrepreneurs purchase through the Web site BizBuySell, the Internet’s largest business-for-sale marketplace. 19 The Due Diligence Stage (1 of 2) Once you have a list of prospective companies, ask: What are the company’s strengths? Weaknesses? Is the company profitable? What is its overall financial condition? What is its cash flow cycle? How much cash will the company generate? Who are its major competitors? How large is the customer base? Is it growing or shrinking? Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Finding the right company requires patience. Although some buyers find a company after only a few months of looking, the typical search takes much longer, sometimes as much as two or three years. Once you have a list of prospective candidates, it is time to do your homework, learning about the company, analyzing financial statements, making certain that the facilities are structurally sound, and exploring other details by asking questions such as these. 20 The Due Diligence Stage (2 of 2) Are the current employees suitable? Will they stay? What is the physical condition of the business, its equipment, and its inventory? What new skills must you learn to be able to manage this business successfully? Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. 21 The Due Diligence Process Due diligence: the process of studying, reviewing, and verifying all the relevant information concerning an acquisition. Motivation. Why does the owner want to sell? Asset valuation. What is the real value of the company’s assets? Legal issues. What legal aspects of the business are known or hidden risks? Financial condition. Is the business financially sound? Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The goal of the due diligence process is to discover exactly what the buyer is purchasing and avoid any unpleasant surprises after the deal is closed. The due diligence process involves investigating four critical areas of the business and the potential deal beyond those already evaluated earlier in the search and deal processes: Motivation. Why does the owner want to sell? Asset valuation. What is the real value of the company’s assets? Legal issues. What legal aspects of the business are known or hidden risks? Financial condition. Is the business financially sound? 22 Motivation Why does the owner want to sell? The most common reasons business owners give for selling their businesses are: Planned retirement (40%) Burnout (21%) Desire to own a bigger business (20%) Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Every prospective business buyer should investigate the real reason the business owner wants to sell. 23 Asset Valuation What is the true nature of the firm’s assets? Are the assets really useful, or are they obsolete? Will the assets require replacement soon? Do the assets operate efficiently? Investigate: Accounts recievable Lease arrangements Business records Intangible assets Location and apperance Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. A prospective buyer should evaluate the business’s assets to determine their true value. The buyer bases the valuation used to negotiate the deal on the financial statements provided by the seller. The buyer and the advising team must verify the actual value of the business through careful inspection of the business and its assets. Questions to ask about assets include these questions. 24 Legal Issues (1 of 2) Liens: claims by creditors against a company’s assets. Due-on-sale clause: a clause that requires the buyer to pay the full amount of the remaining loan balance or to finance the balance at prevailing interest rates, thus preventing the buyer from assuming the seller’s loan at a lower interest rate. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Business buyers face myriad legal pitfalls. The most significant legal issues involve liens, contract assignments, covenants not to compete, and ongoing legal liabilities. The prospective buyer also should evaluate the terms of other contracts the seller has, including: Patent, trademark, or copyright registrations Exclusive agent or distributor contracts Insurance contracts Financing and loan arrangements Union contracts 25 Legal Issues (2 of 2) Covenant not to compete (or restrictive covenant): an agreement tied to the sale of a business in which the seller agrees not to open a competing business within a specific time period and geographic area of the existing one. Product liability lawsuit: a lawsuit which claims that a company is liable for damages and injuries caused by the products or services it sells. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. 26 Financial Condition Is the business financially sound? Examine: Income statements and balance sheets for at least three years Income tax returns for at least three years Cash flow Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Any investment in a company should produce a reasonable salary for the owner and a healthy return on the money invested. Otherwise, purchasing the business makes no sense. Therefore, every serious buyer must analyze the records of the business to determine its true financial health. 27 The Valuation Stage Non-disclosure agreement (NDA): a legal contract that requires a prospective buyer to maintain the confidentiality of the business, its owner, and any information, financial and otherwise, that the buyer sees as part of the due diligence process. Methods for Determining the Value of a Business Business valuation is partly an art and partly a science. Balance sheet method Earnings approach Market approach Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. After conducting due diligence on a target business, an entrepreneur moves into the valuation stage. The valuation stage includes not only a valuation of the business but also signing a nondisclosure agreement. 28 Balance Sheet Method Net worth (or owner’s equity): Net worth = Assets − Liabilities Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The balance sheet method establishes the value of a company by computing the book value of its net worth, or owner’s equity (Net worth = Assets − Liabilities. A common criticism of this technique is that it oversimplifies the valuation process. The problem with this technique is that it fails to recognize reality: Most small businesses have market values that exceed their reported book values. 29 Earnings Approach (1 of 2) Excess earnings method: a business valuation method that combines both the value of a company’s existing assets (less its liabilities) and an estimate of its future earnings potential to determine the selling price for the business. Goodwill: the difference between an established, successful business and one that has yet to prove itself that is based on the company’s reputation and its ability to attract and retain customers. Opportunity cost: the cost of forgoing a choice; the cost of the next best alternative. Extra earning power: the difference between a company’s forecasted earnings and the total opportunity costs of investing in that company. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The earnings approach is an approach to valuation that finance professionals and experienced entrepreneurs prefer because it considers the future income potential of the business. That is what an entrepreneur really is buying with an existing business – its ability to generate returns on the investment into the future. 30 Earnings Approach (2 of 2) Capitalized earnings approach: a business valuation method that involves dividing a company’s estimated net earnings (after subtracting a reasonable salary for the owner) by the rate of return that reflects the risk level of investing in the business. Discounted future earnings approach: a business valuation method that involves estimating a company’s net income for several years into the future and then discounts these future earnings back to their present value, which provides an estimate of the company’s worth. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. 31 Market Approach Market (or price/earnings) approach: a business valuation method that involves using the price/earnings ratios of similar publicly traded businesses to estimate the value of a company. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The market (or price/earnings) approach uses the price/earnings ratios of similar businesses to estimate the value of a company. The buyer must use businesses whose stocks are publicly traded to get a meaningful comparison. A company’s price/earnings ratio (P/E ratio) is the price of one share of its common stock in the market divided by its earnings per share (after deducting preferred stock dividends). To get a representative P/E ratio, the buyer should average the P/Es of as many similar businesses as possible. 32 The Best Method? Figure 7.7 Business Valuation Methods Source: Based on data from Craig R. Everett, 2017 Private Capital Markets Report, Pepperdine University, March 15, 2017, p. 55. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. This figure shows the most common valuation methods that business brokers use. Which of these methods is best for determining the value of a small business? Simply stated, there is no single best method. These techniques yield a range of values, but usually several of the values cluster together, giving the buyer useful guidance in determining an offering price. The final price will be based on both the valuation used and the negotiating skills of the parties. 33 The Deal Stage The structure of the deal – the terms and conditions of payment—is more important than the price the seller agrees to pay. The “art of the deal” The buyer’s goals The seller’s goals Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Once an entrepreneur has established a reasonable value for the business, the next step in making a successful purchase is negotiating a suitable deal. Most buyers do not realize that the price they pay for a company often is not as crucial to its continued success as the terms of the purchase. 34 The “Art of the Deal” (1 of 3) Don’t confuse price with value. Value is what a business actually is worth; price is what the buyer agrees to pay for it. The bargaining process may eventually lead both parties into the bargaining zone: the area within which the two parties can reach agreement. It extends from above the lowest price the seller is willing to take to below the maximum price the buyer is willing to pay. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The final deal a buyer strikes depends, in large part, on his or her negotiating skills. 35 Identifying the Bargaining Zone Figure 7.8 Identifying the Bargaining Zone Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. This figure is an illustration of two individuals prepared to negotiate for the purchase and sale of a business. The buyer and seller both have high and low bargaining points in this example: The buyer would like to purchase the business for $900,000 but would not pay more than $1,300,000. The seller would like to get $1,500,000 for the business but would not take less than $1,000,000. If the seller insists on getting $1,500,000, she will not sell the business to this buyer. Likewise, if the buyer stands firm on an offer of $900,000, there will be no deal. 36 The “Art of the Deal” (2 of 3) Negotiating tips: Establish the proper mind-set. Know what you want to have when you walk away from the table. Develop a negotiating strategy. Recognize the other party’s needs. Be an empathetic listener. Focus on the issue, not on the person. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. These negotiating tips can help parties reach a mutually satisfying deal. 37 The “Art of the Deal” (3 of 3) Avoid seeing the other side as “the enemy.” Educate; don’t intimidate. Be creative. Keep emotions in check. Be patient. Don’t become a victim. Remember that “no deal” is an option. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. 38 The Buyer’s Goals The buyer seeks to realize the following goals: Get the business at the lowest price possible. Negotiate favorable payment terms, preferably over time. Get assurances that he is buying the business he thinks it is. Avoid enabling the seller to open a competing business. Minimize the amount of cash paid up front. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The buyer seeks to realize the following goals: Get the business at the lowest price possible. Negotiate favorable payment terms, preferably over time. Get assurances that he is buying the business he thinks it is. Avoid enabling the seller to open a competing business. Minimize the amount of cash paid up front. 39 The Seller’s Goals The seller of the business is looking to accomplish the following goals: Get the highest price possible for the company. Sever all responsibility for the company’s liabilities. Avoid unreasonable contract terms that might limit future opportunities. Maximize the cash from the deal. Minimize the tax burden from the sale. Make sure the buyer will make all future payments. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. The seller of the business is looking to accomplish the following goals: Get the highest price possible for the company. Sever all responsibility for the company’s liabilities. Avoid unreasonable contract terms that might limit future opportunities. Maximize the cash from the deal. Minimize the tax burden from the sale. Make sure the buyer will make all future payments. 40 The Structure of the Deal Typical ways that parties structure business sales. Straight business sale Two-step sale Employee stock ownership plan (ESOP) Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. To make a negotiation work, the two sides must structure the deal in a way that is acceptable to both parties. 41 Straight Business Sale Disadvantages: Usually the most expensive way to sell a business. Could result in a significant ax burden. Unattractive for owners who want to surrender control gradually. May involve seller financing. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. A straight business sale may be best for a seller who wants to step down and turn over the reins of the company to someone else. A study of small business sales in 60 categories found that 94% were asset sales. In an asset sale, the seller keeps all liabilities – those that are on the books and any that might emerge in the future due to litigation. That is why buyers favor asset sales. The remaining 6% involved the sale of stock. About 22% were for cash, and 75% included a down payment with a note carried by the seller. The remaining 3% relied on a note from the seller with no down payment. When the deal included a down payment, it averaged 33% of the purchase price. Only 40% of the business sales studied included covenants not to compete. 42 Two-Step Sale One option is an earn-out an agreement: The seller agrees to accept a percentage of the sales price and stays on to manage the business for a few more years under the new owner; the remaining portion of the price is contingent on the company’s performance; the more profit the company generates during the earn-out period, the greater the payout to the seller. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. For owners wanting the security of a sales contract now but not wanting to step down from the company’s helm for several years, a two-step sale may be ideal. The buyer purchases the business in two phases, getting 20 to 70% immediately and agreeing to buy the remainder within a specific time period. Until the final transaction takes place, the original owner retains at least partial control of the company. 43 Employee Stock Ownership Plan Employee stock ownership plan (ESOP): A type of employee benefit plan in which a trust that is created for employees purchases their employer’s stock; employees do not make any out-of-pocket payments but over time become owners in the company that employs them, are entitled to share in its profits, and receive sizable retirement benefits. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Some owners who want to sell their businesses but keep them intact cash out by selling to their employees through an employee stock ownership plan (ESOP). 44 A Typical ESOP Figure 7.9 A Typical Employee Stock Ownership Plan Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. This figure shows how a typical employee stock ownership plan works. The company transfers shares of its stock to the ESOP trust, and the trust uses the stock as collateral to borrow enough money to purchase the shares from the company. The company guarantees payment of the loan principal and interest and makes tax-deductible contributions to the trust to repay the loan (see Figure 7.9). As the company repays the loan, it distributes the stock to employees’ accounts, based on a predetermined formula. 45 Letter of Intent Letter of intent: A document that represents a firm commitment by both sides that they are ready to move toward closing the sale of a business. Copyright © 2019, 2016, 2014 Pearson Education, Inc. All Rights Reserved. Once the buyer and seller have negotiated a deal, they put the details of the structure of the sale into a letter of intent. 46 The Transition Stage (1 of 4) Closing documents include: Asset purchase agreement – the formal agreement of the deal Bill of sale – transfers ownership Asset list – all assets that are included in the sale, …