Buyout Strategy: Advantage, Disadvantage, How It Works

buyout strategy

Buying an existing ongoing enterprise is another strategy for starting entrepreneurial ventures. Buying an existing business should be made only after carefully considering the advantages and disadvantages.

Having decided to buy out an existing business rather than start from scratch, entrepreneurs must now search for a business to buy out.

Before they do so, however, they need to define, with precision and brevity, the kind of products or services that best match their skills. This task is already completed in the earlier stage of creating a new venture.

Table of Contents

What is Buyout Strategy?

The buyout strategy is the process of acquisition, obtaining products and services through contracting. In a buyout strategy, the organization is purchasing or commissioning, rather than developing, at least some of the products, or parts of the products, that they turn out.

Advantages of Buying Strategy

The reasons for buying an existing business can be illustrated in the following manner:

Reduction of Uncertainties

A successful business has already demonstrated its ability to attract customers, control costs, and make a profit.

The need to spend time, money, and energy to do a thorough planning job for a new venture is eliminated. Profits can be earned sooner.

Proven Location

Location is the foremost criterion for the success of a new venture. An ongoing business has a proven location for successful operation.

Established Clientele

The buyer will get a ready market for his/her business. Extensive time and effort would be required to build long-standing favorable client relationships.

Buying an ongoing business would provide the entrepreneur with a built-in clientele, a set of customers that give a guarantee of ready sales and prosperity.

Built-in Inventory and Supply Chain

An ongoing business has its products shelves and established suppliers.

This eliminates the risky and hazardous exercise of selecting the most desirable and qualified supply chain.

Known Capability

An existing business has its machines and equipment as well as other resources.

The capabilities of these resources are exhibited in the statements and could be known in advance. It facilitates effective planning and returns.

Bargain Price

The buying is rested on a single purchase transaction. So there is a scope for bargaining for a set price and mode of payment.

Disadvantages of Buying Strategy

The buying strategy is not all strategy. Therefore, small potential disadvantages must be investigated thoroughly in every firm being considered for purchase.

The following are the disadvantages of buying an existing business;

  1. The buyer inherits any ill will of the existing firm.
  2. The merchandise lines are already established and may not conform to the buyer’s best judgment.
  3. Certain employees who are not assets to the firm may be inherited.
  4. The inherited clientele may not be the most desirable, and changing the firm’s image is unusually difficult.
  5. Inappropriate precedents set by the former owner are well-established and may be difficult to change.
  6. The firm’s budding and layout may not conform to modem standards and entail substantial expenditure for modernization.
  7. The landlord’s attitude and practices may not be conducive to a pleasant and profitable relationship, and lease terms may be detrimental.
  8. The purchase price may be too high and may create a burden on future profits.
  9. The value claimed for the current inventory may include slow-moving or obsolete merchandise.

Reasons for Buyout Strategy – Why Buyout an Existing Business

The buying decision is critical. The entrepreneur should develop a fairly comprehensive profile of criteria or parameters upon which the buying feasibility of a firm would be tested. Good buyout candidates are hard to find.

Experts have prescribed certain criteria for choosing the right firm for buying. From their general view, the buyout prospect should meet the following criteria or parameters;

Specific Products or Services

The prospective business firm should conform to the specific product or service and the specifications with which the buyer intends to start his/her venture.

Proved Earnings Performance

The prospective firm or firms should have at least 3 to 5 years of constant safes and profit.

An underachieving firm that is earning less than it should be could be selected if it could be infused with managerial talent that increases earnings even higher in the future.

One thing that should keep in mind is that earnings should not be too cyclical because the average earnings must, at a minimum, support debt service.

Low Capital Intensity

Any buyout that looks like it will require considerable research and development expenditures, capital equipment, or working capital to perpetuate the earnings stream is generally avoided.

Seasonal businesses that require significant working capital indices, particularly for inventory buildup, are usually avoided.

Mundane Product Line

Stay away from high-technology firms because high because it implies changing market, obsolescence, high mobility of management, and other factors that can spell disaster for a highly potential buyout.

So, look for boring and ugly firms.

Satisfactory Market Position

Asrgmircant market position serves as a strong safety factor for the buyer.

The ideal sales range should realistically fit both the buyer’s expertise and the financing available.

Quality Management Team

The buyout firm or firms may have a balance sheet loaded with debt.

So, the buyout management team must be astute enough and psychologically able to handle the pressure from the risk of a lot of debt.

Budget, planning, cash flow forecasting, and cash management are key management tools. The team must be capable of doing all these very efficiently.

Asset-based Firm

The prospective firm should be a dull manufacturer of a proprietary product that is a leader in its industry with a physical plant far below its real market value and at least ten years of remaining useful life.

A distribution firm must have a recognized stable product line, strong market positions, tight credit and collection policies, and high inventory turnover.

Since firms are the hardest to leverage because their primary asset other than accounts receivable is usually goodwill, assuming they have any goodwill.

Strong Balance Sheet

The buyout firm or firms should have a clean balance sheet which means an abundance of good and adequate hard assets for collateral for loans and a high degree of liquidity.

Hard assets refer to accounts receivables, inventories, machinery and equipment, and real property.

They should not be pledged to lenders or third parties.

Excess and Hidden Assets

The assets of the firm should have the prospect of redevelopment.

These assets are real estate, excess machinery and equipment, obsolete and excess inventories, product lines, divisions, etc.

You should not count on hidden assets to make the deal but look for them, and if they exist, convert them to cash.

Resolvability

The firm can be such that it can be resold. The assets should haw a resale value. One should keep in mind that the exit path must keep open before chirring into a deal.

Size

The buyout firm’s size depends on an entrepreneur’s vision and the depth of his/her pocket.

Location

personal preference of the entrepreneur about the location of the firm. He/she may have any particular choice for a particular geographical area.

So. the firm should be located in that area specification.

Seller’s Presence

The buyer may want the seller to stay on for at least three months after the buyout to help the buyer over the rough edges of the transition.

Evaluating an Opportunity to Buy an Existing Business

The right assessment of an existing venture business is pivotal for a successful buyout. It will take time to have the required documents and other information to evaluate the firm’s worthiness for buying.

But the entrepreneur should take time and be ready to engage efforts and talents to find out the appropriate firm. It is a tedious process, but one has to go through it to identify the right firm to buy from.

The following facts are needed to have the right assessment of a buyout firm;

Review the trend of profits of the firm.

Ask for audited reports of income statements and balance sheets for at least five years.

Review the firm’s books of accounts. Study the copies of bank deposits for a specific period. Study the copies of income tax returns for the past five years too.

You will have a dear picture of profit trends and will understand the profit potentials shortly.

The prime measure of the business trend is sales volume. Check the sales records and verify the cash and credit sales.

Find out the trends regarding growing, declining, or relatively stable sales. The authenticity of sales claims should be verified.

Check the consistency of profits with sales volume

See the variations of actual profits with standard profits and identify whether the result is upward or downward.

Review the motive of the owner of the business behind selling the firm

The reasons must be sound. Among the valid reasons why owners are willing to sell are the following;

  • Personal and career reasons. Owners may want to convert their holdings in a family-held business to cash. Old age or illness. The decision to accept a position with another company.
  • Management succession problems. Owners may doubt the ability of younger men and women in the business to carry on profitable in the future.
  • One-person management. Owners may realize that their business is getting too big for them and that they cannot continue strengthening themselves because of their managerial shortcomings.
  • Relocation the business m a different section of the country.

However, sellers commonly hide their true motives for selling.

So, buyers must search out the real reasons.

Otherwise, they may lack any basis for deciding whether they can solve the problems of the business to be acquired.

The following are the motives for selling;

  • Fear about the financial future of their business.
  • Fear that the technology is now too complex to cope with.
  • Fear that the product or service is outdated.
  • Fear that the wealth built up over a lifetime would be lost due to a declining trend.

Checking financial condition

The solvency ratio, ownership ratio, accounts receivable age and turnover rate, inventory conditions and turnover, etc., will indicate the soundness or unsoundness of the firm’s financial position.

Valuate the fixed assets.

First, check that the conditions of the fixed assets are good and they are a modem.

You should check that the shown values of the assets in the balance sheet are proper and realizable under the present market condition.

Value the firm and compare it with the market of such ether firms. The value of the firm can be assessed with various methods.

  • Asset-based valuation
  • Market-based Valuation
  • Earning-based Valuation
  • Cash flow-based valuation

Asset-based valuation

The asset-based valuation approach assumes that the value of the firm can be determined by estimating the value of its underwing assets. These different methods are used under this approach:

The modified book value method. It takes the firm’s book value as shown in the balance sheet and adjusts it to reflect any obvious differences between the historical cost of an asset and its current value.

The replacement value method attempts to determine what it would cost to replace each of the firm’s assets.

The liquidation value method estimates the amount of money that would be received if the firm ended its operations and liquidated the individual assets.

Market-based Valuation

The market-based valuation approach relies on financial markets to estimate a firm’s value. This method looks at the actual market prices of firms that are similar to the one being valued and that have been recently sold or is traded publicly on a stock market.

Earning-based Valuation

The earning-based valuation approach determines the value- of a firm based on future returns from the investment. That is the estimated value is based on its ability to produce future income or profits.

The technique is; Firm’s Value = Normalized Earning / Capitalization Rate.

Normalization earnings are earnings that have been adjusted for any unusual items. It is the average income of the firm for a few years.

On the other hand, the capitalization rate is determined by the level of risk involved in the business and the expected growth rate of future earnings used to assess a business’s earnings-based value.

Generally, it is the expected rate of return or an effective rate of going interested.

Cash flow-based valuation

The cash flow-based valuation approach values a firm on the amount and timing of its future cash flows.

Two steps are involved in measuring the present value of a firm’s future cash flows;

  1. Estimation of the future cash flows that the investor can expect, and
  2. The decision as to the investor’s required rate of return.

The future cash flows are discounted by the required rate of return to arrive at the present value.

Cheek the nature of the lease if the business is rented. The lease deed and its provisions regarding the lease period, renewability, and the landlord’s attitude toward the business.

The quality of the buildings housing the business should be checked with particular attention paid to any fire hazards, any restrictions on access in the building, the life of the building, etc.

How To Evaluate Businesses in a Buyout Strategy Decision?

If the participants have successfully cleared all the hurdles and dealt with all the unexpected surprises, the day they have all been waiting for finally arrives. It usually takes about five to six months from inception to the close of the transaction.

By then, everyone is generally tired of the deal but very happy to finally see some tangible results from the intensive efforts.

The attorneys usually orchestrate the closing session with many documents requiring appropriate signatures. The terms of the contract are of utmost importance to a solid, problem-free transfer of ownership.

The old adage “good paper makes good deals” is true in a buyout transaction.

What assets are to be sold?

The asset description should be detailed so that no confusion or misunderstanding exists as to what is being acquired. For example, an itemization may include merchandise inventory at the time of sale; furniture and fixtures, equipment, tools, signs, supplies; and customer lists.

What assets are to be retained by the seller?

Frequently, these include cash in hand and on deposit at the time of transfer, personal vehicles, j tax rebates, insurance proceeds, prepaid deposits, and so forth.

How will accounts receivable be handled?

If the buyer is to acquire accounts receivable, their valuation must be decided. Rather than arbitrarily discounting older receivables, acquiring them at face value is best.

Those uncollected after a specific time should be transferred back to the seller for full payment.

What is the purchase price?

Allocate the total purchase price among the sold assets to establish the acquisition price of depreciable assets. The buyer aims to place as much of the purchase price as possible on depreciable assets, such as furniture and fixtures, vehicles, equipment, etc.

How will the purchase price be paid?

This should be spelled out in the financing package. Counsel should prepare all finance documents such as notes, assumption of liabilities, amounts, hens, and so forth, and make their exhibits to the contract.

How will the inventory adjustment be made?

The valuation of inventory should be conducted by physical tabulation immediately before the sale.

Both parties should agree on a professional inventory tabulation firm to tabulate and value the inventory impartially. The objective is to buy at the seller’s net acquisition price. All unsalable items should be rejected.

What about other adjustments?

Hems adjusted and prorated include insurance premiums, rent, deposits, payroll, fuel oil, inventory sold after tabulation, and prepayments.

What about the seller’s liabilities?

Suppose the buyer is to acquire the assets without assuming seller debt. In that case, the agreement will expressly state, “assets are being sold free and clear of all liens, encumbrances, and liabilities or adverse claims.’

Examples of additional protection include notification to the seller’s creditors of the intended sale not less than 10 days before the sale, a check of mortgages and liens, obtaining tax waivers, insistence on an indemnity agreement whereby the seller will pay or protect the buyer from any claims made by the seller’s creditors and additionally requiring the seller to place a sufficient portion of the purchase price in escrow as security to protect against unsettled creditor claims.

What other warranties should the seller make to the buyer?

A buyer should insist on each of these additional warranties:

  1. The seller owns and has a good and marketable title to all the assets to be sold. (If any items are not owned but leased and held on consignment, on loan, or on conditional sale, they should be set forth on a disclaimer list attached to the contract.)
  2. The seller has full authority to sell and transfer the assets and to undertake the transaction.
  3. The financial statements (or lax returns) shown to the buyer are accurate in all material respects. The tax returns or statements should be attached to the agreement.
  4. No litigation, governmental proceedings, or investigation against the business is known to be pending.
  5. The seller does not know of any developments that would materially affect the business.

What are the rights of the seller to compete?

The seller’s covenant not to compete should define a geographic radius and duration. It’s enforceable to the extent that it is reasonable to protect the goodwill.

For businesses where specific customers can be defined, the covenant should prohibit the solicitation of these customers by the seller.

What if there is a casualty to the business before the closing?

The contract should provide that on any casualty (fire, water, or sprinkler damage, and so on) to the premises or to any material) part of the assets, the buyer should have the right to rescind (he agreement.

The casualty clause should extend to the shopping center or other major adjoining tenants relied on to draw customers.

What restrictions should be imposed on the seller in operating the business before closing?

The minimum conditions should be that the seller will do the following;

  1. Maintain customary business hours.
  2. Not change prices beyond the ordinary course of business.
  3. Not terminate employees without good cause.
  4. Not conduct a going-out-of-business or liquidation sale.
  5. Not discontinue charge accounts, deliveries, or other existing service policies.
  6. Not terminate relations with suppliers.
  7. Preserve the goodwill of the customers, suppliers, and others having business relations with it.

What conditions should attach to the agreement?

The buyer should make the agreement conditional on any external factor on which full performance is dependent. The most common examples are these:

Lease

The buyer would make the obligation to close conditional on his or her obtaining an acceptable lease for the premises. The proposed lease terms should be negotiated with the landlord before the closing and even in advance of the negotiations.

Therefore, a copy of the intended or required lease should be appended. The seller would agree to terminate his or her present lease on sale, with acceptance of termination by the landlord.

If the seller’s lease is to be assigned, the contract would be conditional on the landlord’s assent to the assignment and acknowledgment that the lease is in good standing.

Financing

The proposed financing terms should be spelled out if the buyer relies on outside financing to fund the acquisition.

The seller should insist that the condition be satisfied by a certain time before the sale, or the contract may be voided. This protects a seller from waiting until the closing date to find out that the financing condition hasn’t bcm satisfied.

License transfers:

If the buyer is obligated to obtain new licenses tv operate the business, the contract should be conditional on the buyer’s obtaining the licenses. As with all conditions, the buyer should agree to use best efforts.

Transfer of contract rights

If the buyer is relying on a transfer of contract rights (franchises, distributorships, or other third-party) contracts). the agreement should be conditional on acceptance of the transfer.

What happens to the books and records of the business on dosing?

Under a transfer of assets, the financial and lax records would remain the seller’s property. Records relating to the business’s goodwill should be transferred to the buyer.

These include customer lists, trade secrets, pricing information, catalogs, and invoices relating to assumed liabilities. The seller should deliver am warranties on any equipment being transferred.

How should disputes under the agreement be resolved?

The American Arbitration Association, with offices in every major city, will hear and resolve disputes within months. Their findings have the same authority as a court judgment if the parties agree to it in the contract.

When should the dosing be?

Buyers should be aware that even when a contract specifics a closing date, the parties have a reasonable period after that to perform. The bus er should insert a provision stating the time for performance is of the essence if he or she intends to hold the seller to the exact closing date.

The two extremes of going into business are the buyout and the start-up.

In buyouts, many advantages exist for the would-be entrepreneur; consequently, this way of going into business should be seriously considered. The key advantage of a buyout is that all components are in place and operating. The main disadvantage is that the buyer may be acquiring a loser.

An attractive way for an entrepreneur to acquire a company is by using the leveraged buyout method. The simple formula of a leveraged buyout is this: leverage a lot of debt, and generate cash flow to support it.

Write up assets and lake depreciation to reduce taxes, use the selection criteria and company profile that give downside protection, and bring on board the kind of management that can run highly leveraged company management with good cash-flow skills.

No matter how one acquires a firm, the buyer must have something to contribute to it. Hunting for and buying a business may resemble a dog chasing a car. What is the dog going to do if he catches it?

To help find the “right” company, the buyer should establish a list of selection criteria that meet his or her needs to find the target firm. Finding the firm in a reasonable time requires developing a search strategy.

The key to negotiating a buyout price and determining if it can meet its debt service is its value, especially from earnings and cash-flow viewpoints.

Both determining value and negotiating a price require applying quantitative and qualitative methods. If the deal is closed, the buyer must be sure that a number of protections are written into the contract.