UNIT 14. BUYING OR SELLING A BUSINESS

capitalisation of profits

Net Asset Backing

This method is the most popular when we don't want to pay for goodwill and it is a buyer's market. We even try to buy the business at less than its asset backing so that we can build in a prospective capital gain up front. This is one of the main motivators for companies engaging in takeovers or for another breed of investors called "asset traders".

The first step is to look at the balance sheet, which is supposed to offer a true and fair view of the value of assets and liabilities.

For example, where the market value of an asset is less than the cost we should expect to see the lower figure shown in the balance sheet. If we are buyers we cannot rely on what the seller puts in the balance sheet and so we have to independently appraise each asset and liability. This is not difficult for cash at bank but for assets like debtors, office equipment and "specialist" assets the valuation exercise is more complex.

Office equipment, for instance, may be valued at replacement cost or at going market auction value. It really depends on how desperate the seller is and the supply and demand situation for assets of that kind. If, for example, a computer is listed in the assets schedule at $50,000 and you know you can buy the same computer at auction for $20,000 then the latter figure is what you would use.

By following this approach you will invariably end up with a different figure for total assets from what is shown on the balance sheet.

Great care needs to be taken with liabilities because the risk is always that the liabilities are understated, particularly where you know the organisation has been experiencing financial strife recently. You have to guard against the balance sheet figures being "window dressed" for selling purposes.

Once you have valued the assets and liabilities objectively you subtract one from the other to arrive at "net assets". This, theoretically, is the true capital of the business. If you are buying the business in total the net asset figure is crucial in your negotiating strategy.

Capitalisation of Profits

In this approach we try to measure the future prospects of the business. The task is simply to prepare reliable Profit & Loss and Balance Sheet budgets. Great care needs to be taken to independently evaluate the sales and expense projections.

Let us assume that the net profit for the next five years is estimated to be as follows:

Year 1 $ 10,000

Year 2 20,000

Year 3 30,000

Year 4 40,000

Year 5 50,000

The average net profit expected for the five year period would be $30,000. Have a look at the average profit for the last five years. It may for example be $20,000. You have to then decide what average annual net profit figure you will assume for valuation purposes. Let's say you decide on $25,000 per annum. The next step is to work out what your ROI target is. If it is 10% you will not want to pay more than $250,000 for the business.

Let us further assume that the net assets were $200,000. You would now be paying a premium of $50,000 for goodwill. You are paying $250,000 for a set of resources capable of generating an ROI of 10% per annum. Where the agency has a reliable profit history and good future prospects with a reasonable number of prospective buyers you will expect to pay more for goodwill.

This valuation method is sometimes called the "going concern" method because it looks at the business as a going concern for the future in contrast with the net asset method which is more of a "liquidation" approach. Both methods are advisable so that you can calculate the premium you are paying for goodwill or the discount that you will enjoy.

When you are doing the income projections you must apply the same care as you would in preparing a marketing plan and budget for your own business. This analysis must not be rushed. The prospective buyer of the agency will undoubtedly be interested in key factors such as:

location

immediate competition

reliance on key customers

reliance on key staff

economic prospects

When you are doing the arithmetic for future income flows it is always advisable to use discounted cash flow analysis. This is because very often you will be comparing this investment alternative with others which may have different time periods and magnitudes of monies involved. You must remember that income in the short term is worth more to you today than income in the long term.

Sometimes it is very tempting to buy a business that has tremendous profit prospects but the only trouble is that most of the income flow is in the medium to long term. Let us use an illustration. You may invest in a block of land and plant seedlings for a forest but the trees will not be ready for harvest for 15 years. Have a look at page 54 of the McMahon text and see what $1 in 15 year's time is worth in present value terms.

Financing the Purchase

Let us use an illustration to introduce the concept of financial leverage to the investment decision. Suppose that the new agency you are planning to purchase is going to be added to your existing agency network. Let us use the following figures as an illustration.

			Combined Agencies
	Current	New	Borrow	Invest
	Business	Agency	Funds	Funds
Commission Income	$288	120	408	408
Operating Expenses
(excluding interest)	264	106	370	370
Net Income before
Interest	24	14	38	38
Interest	4	2	14	6
Net Income before Tax	20	12	24	32
Tax	8	4	8	12
Net Income after Tax	12	8	16	20
Net Income	12		16	20
Invested Capital	80		80	160
ROI	15%		20%	12.5%

The new agency is estimated to cost an additional $80,000. These funds can be provided by additional capital or by borrowing at 10%.

The illustration shows that the borrowing alternative improves the ROI, because the "denominator" of the ROI calculation stays the same.

The additional interest is offset by the tax saving of that interest whilst the taxation laws allow interest to be offset against income.

The additional capital alternative increases this denominator and though the net income after tax is slightly higher it is not enough to offset the huge increase in the denominator and so the ROI must fall.

This illustrates the concept of financial leverage on ROI. One should remember the risks involved with borrowing on the basis that the increased commitments to pay interest and principal when they fall due may be beyond the agency's capacity to pay in the event of an economic downturn or any other unforeseen circumstance.

Copyright © Bill Wright 1994

 

Copyright © 2000 Genesis Management Services Pty Ltd
Last modified: July 18, 2006