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Kenneth Fukuda

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Purchasing a Business - Alternative Strategies

The alternatives of asset purchase, stock transfer and various forms of merger and the variety of factors, including tax issues, corporate securities laws, accounting and contract issues, including real estate and other business arrangements, require creative planning and coordination of opposing goals.

The structure of a transaction is often the most difficult aspect of an acquisition. It is possible to combine structures so that some assets are purchased separately from the stock of the corporation which owns the remainder of the assets and immediately thereafter a merger occurs between the buyer and the selling corporation.  The transaction could involve purchase of assets of one corporation and the stock of another when both corporations are owned by the same seller.

A.  Asset Purchase
In an asset purchase, the target corporation transfers all of the assets used in the business, including real estate, equipment and inventory, as well as intangible assets such as accounts receivable, contract rights, leases, patents, trademarks, etc.  These may be all or only part of the assets owned by the selling corporation.  The target will deliver specific documents transferring title such as deeds, bills of sale and assignments.  The buyer typically assumes those liabilities which are agreed upon.

Generally, liabilities not assumed by the buyer remain as liabilities of the selling corporation, but there are important exceptions which must be understood.  Many intangible assets and leases may not be assignable without the consent of the other party to the transaction.  In the case of a lease with rent below the then market rate, the other party may consent only if significant rental increases are agreed upon.  In an asset transfer, all contracts of the business must be reviewed to determine whether an asset deal is feasible.

In an asset transaction, if the seller will realize a taxable gain from the sale, the buyer will obtain significant tax savings from structuring the transaction as an asset deal and thereby stepping up the asset basis to the purchase price.  Also, in an asset sale, the buyer generally only assumes the liabilities that it specifically agrees to assume.  In California, however, courts have required the buyer of a manufacturing business to assume the tort liabilities for defective products manufactured by the seller prior to the sale.

The target corporation and its shareholders will typically be subject to a double tax where the corporation sells its assets in a taxable transaction, the shareholders of the corporation will receive the sale proceeds through the sale of their stock in the corporation and the receipt of the proceeds will be taxable to the shareholders.  There are several exceptions to this general rule.

The shareholders of a corporation generally have significant tax incentive to avoid this double tax by selling stock instead of having the target corporation sell its assets.  A purchaser which insists on an asset purchase may be met with a demand for a higher purchase price, thereby shifting the cost of all or a substantial part of the additional tax burden to the buyer.

B. Stock Purchase
In a stock purchase of a corporation with many shareholders, one selling shareholder could refuse to close.  However, the parties could complete the transaction as a merger and avoid the need for 100% agreement by the stockholders.  A merger agreement, unlike a stock deal, is entered into with the selling corporation and generally must be approved only by a majority or super majority percentage of the stockholders.  Dissenting minority stockholders have certain dissenter’s rights which must be considered.

Lenders prefer to not make a loan to a buying corporation in a stock purchase because the lender will obtain a security interest in the stock of the target.  If the target later goes bankrupt and the lender forecloses on the stock, the lender stands in the shoes of the owner and the creditors of the target will be paid before the lender.

C. Corporate Merger
The practical benefits described above and logistical problems of dealing with asset deals or numerous shareholders make mergers an attractive acquisition vehicle.  In addition, mergers are favored by lenders because the lender lends to the surviving corporation and obtains a security interest in the assets of that corporation.  The loan proceeds are used to satisfy the obligation to pay the shareholders of the target corporation.  Institutional lenders are primarily concerned about ensuring valid security interests in the assets of the acquisition target.

Typically, the acquiring corporation will effect a reverse merger into the target corporation.  A buyer may form a holding corporation structure in which event, after the merger, the holding corporation will own the stock of the target and the buyer will own the stock of the holding corporation.

If the target owns different operating subsidiaries, it may not be advisable to merge all subsidiaries into a single entity because of the need to keep the litigation or other potential liabilities of each subsidiary separated.  This is especially relevant if the subsidiaries are involved in businesses with large litigation or environmental liabilities, such as chemical manufacturing, industrial plants or adventure parks.  If separate subsidiaries are maintained, a major loss by one entity may not jeopardize the operation of the other subsidiaries.

If the buyer acquires shares in the corporation or a corporate merger occurs, the buyer will own the corporation's assets, liabilities, receivables and payables.  The buyer will also assume any hidden liabilities such as unpaid taxes and product-liability lawsuits, unless the buyer obtains indemnities in the sales agreement.

Due Diligence
After finding a suitable business, the buyer typically will spend several months undertaking careful due diligence.  This will include analysis of the business and industry, customers, equipment, contracts, and financial and competitive position, negotiation of various issues with the seller, preparation of the acquisition agreement and associated documents and closing of the transaction.

Before acquiring an existing business, a prospective buyer may negotiate to monitor the business before making a binding purchase commitment in order to obtain a more accurate appraisal of the corporation's business.  However, in many cases, this may not be permitted by the seller, particularly if the buyer is an actual or potential competitor of the business.  An appraiser may be used to evaluate the business, however, if the business is specialized or if the technology is changing in the industry, the estimate may be inaccurate.

The buyer must examine the condition of the equipment carefully.  The buyer should obtain valuations from equipment manufacturers who sell modern equipment.  There may be significant deferred maintenance which must be completed after the purchase.  The cost of this work must be factored into the purchase.  If the business has outmoded equipment, it will be in a competitive disadvantage as production quality will be inferior and the cost of repairs and production stoppages will reduce income.

Each acquisition will have different critical issues.  For instance, the target business may be a high-growth manufacturing operation with high-volume customers, thereby requiring strong technology and marketing skills.  Other acquisition targets may require strong financial management.  In such cases, the most difficult problem will involve obtaining financing.  The buyer must be capable of preparing detailed business plans and marketing them intensively to banks and other financing institutions to obtain a loan.

Tasks And Strategies
Buying a business is a time-consuming task which involves several steps, including locating, investigating, financing and closing the transaction.  Often, a buyer will examine numerous businesses and make several offers before consummating a purchase.

Prudent buyers of businesses should concentrate on cash flow instead of depending exclusively on profitability.  Prospective buyers should carefully analyze the economic value of the business, the prospect of increasing gross sales.  Businesses with strong cash flow and a large number of customers offer more potential for buyers.

Conversely, businesses in non-growth industries and businesses with a limited number of clients may be hurt severely by the decline of the industry itself or the loss of key customers.  Key customers may stop their business when the seller departs from the business.  Old customers who had long-term personal relationships with the seller may decide to move their business to competitors.  This may be protected against to some extent in the purchase agreement and during the due diligence period through close contact with key customers.

Fundamentally, a buyer of a business must avoid making hasty decisions for emotional reasons.  All details of the business must be analyzed because a problem which is ignored may result in major unexpected costs and possible destruction of the business after closing.

The buyer's attorney and accountant will review numerous documents, including the corporation's profit and loss statements and balance sheets for the past three to five years, income-tax returns, sales tax records, loan documents, bank statements, invoices, leases, patents, trademarks, licenses, incorporation papers, bylaws, title papers covering assets, documents related to lawsuits, business and employment contracts, accounting reports, documents pertaining to environmental investigations and Uniform Commercial Code filings.

The buyer should make every effort to determine why the business is being sold.  Common explanations include retirement, illness, divorce or death of the owner.  However, the buyer should also attempt to verify that the reasons given are true.  Otherwise, there may be hidden problems which the seller does not wish to disclose.  These reasons may affect the price or terms of the sale.  If the seller provides vague reasons such as the general expression that the seller wants to concentrate on other business, this expression may be concealing more serious business problem, such as a weak competitive position.

The buyer must recognize the major problems with the business and determine whether the problem is curable or not.  For example, if the business has outdated and defective equipment, the buyer must determine the costs and timing of replacement and potential business disruption.  If high employee turnover has occurred, query whether this is due to poor management or is this inherent in the type of industry.  The buyer should review whether significant employee claims for unemployment, worker’s compensation and other injury have been made.  The costs of such claims, including insurance and time spent in resolving such claims should be factored into the purchase decision.

Certain problems may be curable by new management without major expenditures or disruption, for example, employee problems arising from old management styles.  However, the buyer should understand that introduction of new management techniques will be resisted by long-term employees and will be disruptive to the business in the short to medium term.  On the other hand, it is essential that the buyer impose new management personnel and methods in order to establish control over the business and institute clear channels of communication among management and staff.

Buyers must be pragmatic regarding the prospects of a business since it is usually difficult to make immediate gains in revenues or cost reductions.  The buyer should interview suppliers, customers and employees with the owner's permission.  If the owner refuses permission to interview any key persons, the buyer should proceed very cautiously.

After agreeing on a price and terms, an experienced attorney typically drafts the purchase agreement.  The agreement should cover as many contingencies as possible.  The following are key questions to address.

Representations & Warranties & Indemnities
The buyer will normally require the seller to make several representations and warranties regarding the corporation and its business.  Since the seller has intimate knowledge of the business over a period of years, these representations should be carefully reviewed, together with the results of the due diligence study.

Buyers should obtain advice from experienced advisors regarding the prospective acquisition as early as possible for several reasons.  Past acquisition experience will allow the buyer to understand negotiate key terms.  The buyer should attempt to hold the seller liable for such liabilities through representations and warranties which may be secured by holdback of funds, seller financing offsets or other devices.

An experienced attorney and accountant should be involved before a letter of intent is signed.  If major considerations are not addressed, misunderstandings will certainly arise during the detailed agreement negotiations and the buyer will lose a negotiating edge.  For example, tax and liability considerations will be important, such as the decision to purchase the business assets or the shares  of a corporation.  In a sale of assets by a corporation, there may be a double tax , one at the corporate level and another at the shareholder level.  This will be unfavorable to the seller.

On the other hand, in a merger or purchase of shares, the purchasing corporation will inherit the historic tax basis of the assets of the transferred corporation.  Hence, the buyer may prefer an asset purchase.  These tax considerations will be important to both parties and should be addressed in the letter of intent to avoid misunderstanding.  When the buyer desires a step up in tax basis to the purchase price paid, the form of asset purchase should be disclosed in the letter of intent.  If this issue is raised at a later date by the buyer, the seller is likely to resist and at the very least extract a form of compromise on other issues in exchange for granting the buyer’s form of purchase.

Representations and warranties regarding financial statements, litigation, undisclosed liabilities and taxes are usually the most important.  The buyer should bargain heavily for protection for breaches of the representations regarding audited financial statements.  These statements usually provide the best picture of the selling company and many undisclosed problems will cause that representation to be violated.

The seller should agree to indemnify the buyer for problems that arise after the closing if the seller breached a representation or warranty.  Indemnification provisions specify the circumstances under which the buyer can claim damages or take other remedial action in the event that the seller has breached a representation or warranty or a covenant.  Procedural aspects of indemnity claims, including recovery of legal fees and expenses and the survival period of the indemnification, should be included.  The seller should indemnify the buyer for potential liabilities which have been disclosed to the buyer, such as significant potential environmental claims.

Experienced advisors can point out “red flags” to buyers which should be examined carefully during the due diligence period.  These may include potential liabilities such as tax matters, environmental liabilities, or contract or tort exposure.

Objectivity is the keynote for the buyer.  The buyer must not become emotionally committed to the purchase.  By establishing limits and parameters on the business, the buyer can avoid making an acquisition which may be regretted later.  The due diligence work and associated costs should be viewed as essential tools in the decision-making process.  If unfavorable conditions or problems are discovered, the buyer should be prepared to withdraw from the transaction and treat the fees and expenses as wisely spent to avoid an ill-advised deal.

If outside advisors expose serious or potential problems which are unacceptably risky, the buyer should be prepared to terminate the transaction because of the excessive risk level.

Steps In the Acquisition Process

Typical steps which must be followed in any acquisition include the following:

1. The buyer must focus upon the type of business to be purchased.  A budget must be established for the purchase price.  The search should be narrowed to a narrow range of industries, a limited geographical region and a specific corporation size.  The buyer should must evaluate its own strengths, weaknesses, interests and experience in order to realistically determine the likelihood of success of the acquisition.
2. The buyer must spend substantial time discovering available businesses.  Only a small fraction of the businesses for sale are advertised.  Most businesses are sold through insiders.  Professionals who work with small businesses such as accountants, lawyers, bankers, real estate brokers and insurance agents are good sources of information.  There may be trade associations, trade magazines, industry suppliers and businesses in the targeted industries.  Some buyers approach businesses directly even if they are not ostensibly for sale because they may provide information regarding other opportunities even if their own business is not for sale.
3. The buyer must retain knowledgeable advisers.  An experienced attorney should prepare the purchase agreement and related documents, review any lease and other agreements affecting assets owned or leased by the business and contracts entered into by the corporation and an experienced accountant with a business and tax background should analyze the corporation's books and records and tax considerations.
4.  Investigation of the business.  After identifying a target corporation, the buyer must examine the business, negotiate with the owner and obtain as much information as possible regarding its financial condition, assets, customers, suppliers, employees and competitive position.  If the owner refuses to provide information before submission of an offer, the buyer may be required to sign a confidentiality agreement and/or a non-binding letter of intent to purchase and make a good faith deposit.  The deposit may be refundable if the buyer decides not to proceed after the due diligence review is completed.  Also, the buyer may attempt to renegotiate an offer after the completion of the due diligence.

How To Value a Business
The buyer should attempt to discover recent sales of similar businesses to obtain guidelines for the transaction.  Trade associations may provide some information, as well as business advisors and brokers.

There are three factors which are universally used in evaluating businesses.  These factors should provide a range of values.

A.  Discounted cash flow 
This is the present value of future cash flows, based on forecasted revenues and expenses.

B.  Capitalized market value

The buyer should attempt to compare publicly held companies that are similar to the target corporation.  A public corporation's share price can be calculated as a multiple of its per share earnings, sales and assets.  The multiples are then multiplied by the target corporation's earnings, sales and assets.

C.  Rules of thumb
One concise method involves adding the corporation's book value (the value of its assets minus debts) and its goodwill (intangible assets that reflects the value of name-recognition, reputation, customer base and location).

Calculation of goodwill typically requires a three-step process that applies in certain cases.  First, add the corporation's net income to the owner's compensation (including salary and such perquisites as a corporation car, pension plan and insurance policy).  Secondly, subtract the salary which the owner would pay to a qualified person, other than the owner, to run the business.  Finally, the difference should be multiplied by a factor which ranging from one to five.

If the business is extremely risky or heavily dependent upon the owner’s personal services (e.g. a restaurant, consulting service or other personal service), the goodwill multiplier could be less than one.  If the corporation is more self-sufficient, e.g. such as a stable business in a prime location, the goodwill multiplier may be more than five.

The value of many businesses is based almost exclusively on the value of the physical assets such as fixtures and equipment.  This applies when most of the profit is attributable to the services and experience of the owner, not to the inherent value of the business.  In these cases, a business appraiser may be unable to provide an fair estimate of value of the business.  A highly specialized business is typically difficult for an appraiser to estimate.

The value of a business depends on the corporation's assets, the risks, the track record and the degree of management work which the owner must engage in to operate the business.  A risky business that relies heavily on the selling party’s skill and personal services, such as a restaurant or other personal service business will have a lower value to a buyer.  A less-risky business, such as a business with well-located real estate or a manufacturing operation with a modern plant and equipment and a long track record, will have a higher value.

In negotiating to acquire a business with equipment and goodwill, including a favorable lease in a prime location, quality staff and a well-established customer base, the buyer may agree to make a downpayment and to obtain seller financing.  The seller may be willing to agree to a lower price if the term of the seller financing is reasonably short.  However, a longer period may be essential because cash flow is critical after an acquisition.

In certain cases, the buyer may request the principal of the selling business to remain for a period of several months or years to take advantage of his or her goodwill, expertise and client relationships.  The former owner may agree to remain for a few months without compensation during a transition period.  Thereafter, the parties may agree that the former owner remain as an employee, although there are often incompatible goals and managerial styles.  Employment of selling parties often does not work when a corporate buyer has a different management methods which creates operational, labor and other problems.  In many cases, an entrepreneurial selling party will be unable to fit in a structured corporate environment.

After closing the purchase, it may be necessary for the buyer to reinvest all earnings in the business.  The buyer may decide to install modern, more efficient systems, including accounting systems, hire employees to work with customers and/or purchase new equipment.  Through these methods, it may be possible to increase annual revenues and/or decrease costs in anticipation of increasing profitability in the medium term.

Choice: Purchase Ongoing Business or Start Up New Business
1. Parties interested in entering into a new business should consider the purchase of an existing business which does not occasion the start-up risks associated with a new business.  However, there are other risks inherent in the purchase of an ongoing business of which the buyer should be aware.

Corporate executives who have left large corporations due to cutbacks or otherwise often review the prospect of buying small businesses.  Experience in the world of larger corporations may provide some but not all of the skills required to run a small business.

2. Recent studies have shown that 25 percent of executives who leave corporations contemplate starting or buying a business.  10-15 percent actually enter the small business world, but this is a significant increase from the historical average of 3 to 4 percent.

The majority usually start new businesses or become consultants.  The proportion who purchase existing businesses is smaller.  Most corporate executives are concerned about pre-existing liability exposure.

Many corporate executives may acquire franchises that give them access to much the same support system as a corporation.  Executives with sales experience may be interested in a business which has a strong technical operation but requires sales and marketing talents which the new owner can provide.

3. Many small-business owners are successful because they are detail-oriented, mechanically inclined and have various skills.  Diverse knowledge is often required, including knowledge of relevant laws as well as sales and employer skills.  The buyer must pay great attention to equipment appraisal.  If the equipment is outdated, major capital investment may be required in order for the business to remain competitive in the industry.

4. Business broker typically represent sellers and earn commission only if the sale is consummated.  Brokerage commission is often quite high, usually 10 percent to 12 percent of the sales price.  In California, business brokers must hold a real estate license, but there are no other licensing requirements.  Because many business brokers do not share their listings as do real estate agents, the buyer should make several contacts. Arrange financing.

5. Small business acquisitions may be financed partly by the seller.  The buyer may make a downpayment of 30 to 50 percent of the purchase price, and the seller may finance the balance over three years to five years at an interest rate at or below the market interest rate.  As the amount and duration of seller financing increase, the higher the price the seller will ask for the business because the seller will be relying on the buyer to continue the success of the business over a longer period.

A bank loan may be available if the corporation owns hard assets such as real estate, inventory or equipment.  The buyer may be able to obtain a Small Business Administration guarantee.  To obtain an SBA guarantee, you must pay a minimum of one-third of the purchase price in cash and the business must have sufficient cash flow to repay the loan.  The SBA also requires the buyer to pledge business assets or personal assets, such as a home, as collateral.

Non-compete agreement
The buyer typically requires the seller to agree not to compete with the business within a certain geographical area for a reasonable period of time and to not disclose confidential information regarding the business.  The buyer may also require the seller to remain in the business for a certain transitional period until the buyer gains knowledge of the business.  If there are key employees, the buyer may require them to sign employment contracts.

Allocation of assets
For tax purposes, the buyer must allocate the purchase price among different asset categories, such as inventory, machinery and goodwill.  Machinery is depreciable and is tax deductible.  Goodwill is deductible over a much longer period.

For example, if a corporation has gross income of $2,000,000 and a 10 percent pre-tax net profit after paying a $50,000 salary to the owner.  If it is a risky business that relies heavily on the owner's skill and personal services, such as a restaurant or auto-repair shop it may have a value of only $500,000.  A less-risky business, such as a mini-warehouse with real estate and a track record, might have a value of $1,000,000.  A manufacturing operation with substantial plant and equipment could have a value over $2,000,000.

Let us take an example of a retail business purchased for $500,000, with $250,000 allocated for equipment and $250,000 for goodwill, including a favorable lease in a prime location, quality staff and a well-established customer base.  The buyer pays one-third in cash and the seller finances the balance under a 10-year note paying 8% interest annually.  The buyer could have negotiated a lower price if the term of the seller financing were shorter.  However, a longer period may be essential because cash flow is critical to a new business.

For example, assume that the selling corporation has a book value of $750,000 and generates $250,000 net income.  The owner receives $150,000 per year in salary and perks.  If the corporation would pay a new president $100,000, the value of the goodwill would be $900,000 ($250,000 plus $150,000 less $100,000 multiplied by a factor of 3).  By adding the $750,000 book value and goodwill, the total value of the business would be $1,650,000.  The threefold goodwill multiplier is merely an example.  The appropriate multiplier depends on the degree of risk and nature of the business.Benefits And Drawbacks Of


A franchise involves components of both large corporate business and small business.
Franchisors are companies that sell business concepts to independent business owners "franchisees".  Franchisors provide many support systems to the franchisee.  These include a business plan, marketing strategies, advertising campaigns, training and assistance with site selection, lease negotiation and equipment purchase.

Franchisees also have a peer group they may call for consultation.  Most importantly, their businesses benefit from the goodwill and name recognition that franchises own.

Franchisees pay a high price for these advantages.  Franchisors typically obtain a royalty fee of 5 percent to 15 percent of sales from each unit.  Franchise fees typically average 7 percent to 8 percent, irrespective of whether the franchisee makes a profit.  Many franchisors levy an additional fee for advertising, and may require the franchisor to purchase equipment and. supplies from them at a price that may be higher than the franchisee could obtain independently.

Most franchisors also place strict constraints on the operation of the business.  Franchisees often complain that the franchisor does not deliver provide the agreed upon support or that the franchise format is unfair to the franchisees.

The franchisee may take disputes with the franchiser to arbitration, rather than to court, which could limit the amount of damages which the franchisee may collect.  When the franchisee decides to sell his unit, he will probably have to offer it first to the franchisor, which may pay less than market value  It is often quite difficult to sell a franchise.

There are many example of franchises which are very successful.  On the other hand, there are many which do not succeed.

A franchise may be appropriate for a person with limited marketing or sales skills  However, after five years in a franchise, the franchisee will probably learn all of the details of the business.  The franchisee fee will remain the same even when the value of the royalties to the franchisee have been reduced substantially.

The purchase of a franchise will require the same steps involved in buying any small business.  In addition, the franchisee should obtain the franchisor's disclosure document, which will give you pertinent financial data about the corporation and disclose any litigation between it and the franchisees.

Also, the franchisor should provide names of franchisees who are satisfied as well as some who are dissatisfied.  The prospective franchisee should interview both the contented and discontented franchisees to discover their views from actual experience.


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Purchasing a Business – Alternative Strategies

Selling a Business – Alternative Strategies