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PURCHASING A COMPANY
A. WHETHER TO BUY OR NOT
1. The closer you get to a project, the better it might appear simply as a result of
your increased familiarity. After obtaining a lot of information it is often useful
to stand back and evaluate the company from a more objective perspective.
2. It is important to be aware that the targeted company’s management team might have selectively
revealed information instead of showing both the good and bad parts with equal emphasis.
3. It is important to use an attorney during legal negotiations so as to keep a record of what is
being said and remember that a misrepresentation of the truth is different from only answering
the questions that have been asked.
4. During negotiations always ask specific and non-threatening questions and persist until you
get a satisfactory answer.
5. It is a good idea to write down a list of the primary reasons to purchase another company and the
value of that purchase to your company.
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B. COMPANY VALUATION
1. It is a good idea to work with an accountant when performing a detailed valuation analysis as it
will keep your figures consistent and provide independent verification.
2. There are several different methods available for determining the price of an asset such as a
company which provides a certain amount of income.
3. Three such pricing models are described below:-
- Calculating the equivalent current value
of all projected future incomes and expenses.
- Comparative pricing when the targeted
companies price is based on the selling price of other companies
sold within the industry.
- Rule of thumb formulas where a given parameter is multiplied by a factor which then
determines the right price.
4. It is very important to understand the expenses and assumptions associated with the numbers
reported on the financial statement.
5. It is important to realize that money promised tomorrow is not as sure as money in your hand today.
Consequently lenders require that you pay a “risk premium” for any money loaned today that will
be repaid with future money.
6. A discounted cash flow analysis is said to determine the amount of money, if in your hand today,
that would equal all of future money amounts you expect to receive.
7. A discounted cash flow analysis requires 3 basic components:-
- The expected future cash flow, whether
treated as negative flows (expenses) or positive flows (income).
- The amount of time between today and when
the future cash amounts under analysis are obtained, or spent.
- The discount factor applied to the future cash flows that bring it back to the current day, providing an
equivalent value today.
8. An important concept to understand is that the more risk associated with the actual receipt of future payments
the greater the discount that must be applied to this future money when bringing it to a present value.
In addition, the further out this amount is in the future the less impact it will have on the present
value of that money.
9. The Capital Asset Pricing Model (CAPM) method of determining the discount rate is probably the most
commonly accepted in the valuation of larger companies.
10. A formula used for calculating the CAPM factor is as follows:-
Expected Return (ER) = Risk Free (RF) Return + [(Beta(ERM)) – RF]
11. Where ER, expected return represents the expected future return that the stock should provide,
which also becomes the discount rate.
12. Risk Free (RF) Return represents the return you would expect if you put the money into a risk free
investment, such as a bank saving account.
13. Beta is a factor calculated by industry analysts that tracks the deviation of stock or other investments
as compared to the overall market as a whole. It measures the volatility of stocks which also represents
its risk with respect to the rest of the market.
14. Another useful method for determining a purchase price is to base the price on other comparable company sales.
This is called the comparable transaction valuation method, since you are basing your price from another
comparable transaction.
15. Another method mentioned previously is the rule of thumb valuation technique. This method takes an easily
obtained and substantiated number, such as the annual sales figures and multiplies it by a specific factor.
16. A business appraiser can be used in much the same way as a house appraiser to place a value on a business.
Members of the American Society of Appraisers act as consultants who give highly recommended and accurate
business appraisals. The Institute of Business Appraisers is a newer organization whose members also provide
appraisals but at a lower cost.
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C. FINANCING
1. Most people do not have enough cash to buy a company outright. In other words people don’t have enough liquidity for
purchases, or if they do they decide not to spend all of it on one purchase. Consequently we can use the banks financial
power to help us purchase the company.
2. The first place to look for financing is a commercial lending bank, especially if the company has an established
relationship with the bank, so allowing credit to be obtained more easily.
3. Banks will loan money based on a loan to value ratio. this means that the total percentage of an assets value against
which a loan will be provided. In other words an asset worth of $10000 against which the bank will loan up to 50% loan
to value ratio, means that you can borrow up to $5000 using this asset as collateral.
4.
It may be possible for the company to repay a loan to help finance a portion of the purchase price if it has an adequate positive
cash flow. This type of funding has a potential downside in that it uses up the companies financial resources to
help fund the purchase. If the loan is too large and the company experiences difficult times it could loan itself out
of business.
5. It is common when purchasing a small company for the seller to retain an active interest in the future operation of the
company, especially if the founder/owner was an integral part of the companies past success.
6. There are a number of ways to retain the sellers presence, to prevent a serious decrease in the future
value of the company.
- The sellers could provide a buyer with a
loan, which keeps the seller interested because future performance
will pay off the loan whilst poor performance will put the loan in
jeopardy.
- Employment agreements are set up between
the seller and the buyer, where the seller receives a set income
for a period of say 2 years, which can often be higher than the
sellers previous salary.
- The seller should be allowed to keep a
minor percentage of the selling company’s stock so that the seller
will have a vested interest in the companies future performance.
- The seller could also be given contingent
payments of higher sums of money if the newly sold company meet or
exceeds certain performance criteria.
- The seller could also be asked to provide a loan in exchange for convertible securities, which provide a fixed return over a specified period
of time and can later be converted into common stock.
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