Owners of a business would usually set a price at which they are willing to sell their business. However, entrepreneurs interested in purchasing that business must ensure that the business is worth the price being charged.
When evaluating a business to purchase, there are several things that must be given due consideration. Among important considerations include:
(a) Reason for Sale
Businesses that seem successful upfront may be plagued with problems such as legal suits, dwindling sales, increased competition and so on. Some owners may resort to hiding the reason for sale in their attempt to get rid of the problematic business in hand. Therefore, it is always important to scrutinise the reason why the owner is selling the business. One should be careful not to purchase a business with serious underlying problems that can be detrimental for the new owner.
(b) History of Business
It is crucial to thoroughly review the history of the business before deciding to purchase it. Past events usually pave the path for the future. A business that has been doing well will usually continue to perform well. Similarly, businesses with a dark history may not hold much value as claimed by the owner. Some essential information needed to evaluate the business includes:
(i) When was the business founded?
(ii) How has it grown?
(iii) What were the problems faced?
(iv) How were these problems handled?
(v) Has it been making profit?
6.3
Suggest ways to look for businesses to purchase. Where can we find such information?
ACTIVITY 6.1
(vi) Has the profit been increasing over the years?
(vii) Were the competitive strategies employed to get to this position ethical and so on.
(c) Determine CompanyÊs Net Worth
In determining the companyÊs net worth, the buyer needs to find the difference in the assets and liabilities of a company to arrive at its net worth. Lambing and Kuehl (2007) stated that assets can be valuated based on the book value (original cost of assets minus depreciation), replacement value (market price of asset if purchased), liquidation value (value if assets are sold), or appraised value (value determined by industry expert). It is important to also include the value of intangible assets such as goodwill.
Usually, it is recommended that the purchaser buys only the assets and let the owner take care of the liabilities. Determining the values of the businessÊ assets and liabilities sets the ground for comparison with the price set by the owner.
(d) Current Status of the Business
Buyers should ensure that they are well informed about the current situation of the business. They should thoroughly investigate if the business is performing well financially, has met legal requirements (e.g. payment of income taxes, oblige contracts and agreements, comply with the Environment Protection Laws and OSHA guidelines), the business competitive situation, employee morale and other important factors.
(e) Future Earning Potential of the Business
Although the current standing of the business seems great, it is advisable to always analyse the future potential of the business. Is there a market for the business in years to come? Is the market growing? Are the expected future earning worthwhile?
One common method of evaluating expected future earnings is discounting future cash flow. This method calculates the present value of the future cash value by taking into consideration the time value of money.
Simply put, the expected RM50,000 in the future, for example in 5 years time is worth less than the same sum of money today.
Therefore, although the business is expected to generate a certain amount of income over the years, when evaluating the business, the value is discounted to reflect the present value of the earnings.
Once these factors have been thoroughly scrutinised, the buyer can then determine the price of the business. There are various method of evaluation. A simple method to evaluate the business is depicted in Figure 6.3.
Figure 6.3: Determining the value of the business
With reference to Figure 6.3, there are four basic steps in estimating the market value of the business.
(i) STEP 1: Determining a companyÊs net worth
The first step is to estimate the net worth of the business. Basically, this step deducts liabilities from tangible and intangible assets (e.g. goodwill).
(ii) STEP 2: CompanyÊs past earnings
The next step is to determine the past earnings of the business. It is expected that if a business has been performing well, it will usually continue to perform accordingly. The business annual earning (past year) is multiplied by a rating of the business performance. Lambing and Kuehl (2007) outlined that the usual ratings range from 5 to 10. The ratings are estimated based on the company track record. If the business is doing well with established market, less intense competition, loyal customers, popular product and so forth, the ratings would be generally higher.
(iii) STEP 3: CompanyÊs discounted future earnings
The future earnings of the business is calculated using the discount factor.
(iv) STEP 4: Value of the business
The value of the business is determined by summing up the above three values. Weights are estimated depending on the importance assigned on those values. For example, in an industry which undergoes dynamic changes, past earnings will be assigned smaller weightage as it may no longer be accurate in predicting the future.