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In unit three we'll be talking about the material in chapter
four and chapter five.
That's the material on franchises and buyouts and the
material on family businesses.
A lot of the small businesses that we have now are family
businesses or small family businesses where we have,
sometimes, multiple generations who are involved
in the business.
So we'll talk a little bit about that.
Then we'll also talk about the very broad subject of
franchises and buyouts.
A lot of times entrepreneurs get their start from buying a
small business, particularly one that is floundering, and
turning that business around and converting it into
something that's very successful.
So we'll talk a little bit about that.
OK, students, we're now going to discuss chapter four--
franchises and buyouts.
And this will be kind of a little bit different than
starting up small businesses.
But it really falls in the same category.
And franchises are really a good way to start a business
if you want to kind of reduce your risk.
We'll talk about that more as we go through.
First, let's look at some definitions.
Franchising is a marketing system involving a legal
agreement whereby the franchisee conducts business
according to the terms specified by the franchisor.
So the franchisor owns the franchise system.
The franchisee purchases into the franchise system and
obtains a franchise from the franchisor.
We'll get into details on that in just a moment, too.
The franchisor is the party in the franchise contract that
specifies methods to be followed and terms to be met
by the other party.
Again, the franchisor owns the franchise system.
The franchisee is an entrepreneur whose power is
limited by contractual agreement with the franchisor.
And we'll talk about some considerations for the
contract in just a moment.
So the franchise contract is the legal agreement between
franchisor and franchisee.
So that's the legal agreement that binds the franchisee to
the franchisor and likewise a franchisor to the franchisee.
The franchise is the privileges conveyed in the
franchise contract.
So when I sign a franchise contract,
I now have a franchise.
So what are some types of franchising arrangements that
you can have?
Well, there's just all kinds of types of franchising
arrangements.
And you see these listed here.
You can have-- we'll start on the upper left-hand corner.
You can have a product in a trade name franchise, which
means, basically, you have contracted to use someone's
product or their trade name.
I'll give you a good example.
You walk into a Best Buy or some big electronic store.
And you'll see some TVs or electronic equipment with the
RCA label on them.
Well, RCA is a company that does not exist anymore.
And so what that company-- that electronics company-- has
done is they have purchased the right to use the RCA name.
And they're sticking it on whatever that electronic item
is that you're buying.
So that's an example.
A business format franchising is typically what we see in a
franchise operation.
If I look at a McDonald's or a Wendy's or one of the
fast-food franchises, that's called a
business format franchise.
And we'll talk more about that in a little detail.
But, typically, everything there is specified by the
franchisor--
what products you buy, what products you sell, what prices
you use, what advertising you use, what kind of facility
layout, where should it be located-- all those things are
specified there.
The master licensee is a franchisor--
I'm sorry, a franchisee who has been authorized by the
franchisor to sell licenses for the franchiser to sell
franchises.
A multiple-unit ownership is a franchise or relationship
where the franchisee might have multiple units or
multiple sites.
I have a friend who owns multiple McDonald franchises,
for example, all around the North Dallas/Richardson area.
Then you have area developers.
And these are developers who are authorized by the
franchisor to go out into an area to develop franchisees to
operate for that franchisor.
Piggyback franchising is pretty common now.
You don't really notice it when you see it.
But if you walk into Walmart and you see an optometrist
there or an optical company there, that
is a piggyback franchise.
That is a franchise operation sitting inside another
operation .
Or if I go into a Walmart I see a McDonald's food company
there-- food outlet there, that's a piggyback franchise.
If I go into a big mall and I see the little kiosk in the
little stores or shop areas out in the middle of the mall,
those are all, for the most part, piggyback franchises.
They're just sitting there.
They're sitting inside another facility.
And then I could do multi-brand franchising.
That's where I sell multiple brands for a franchisor.
I don't have any good examples on that.
But there are, I'm assuming, some situations where a
franchisee might actually have multiple franchisors operating
out of a single facility.
But I've not seen that.
Co-branding is another way to do it-- where I'm branding,
along with my brand, another franchisor's brand.
And you see that occasionally in retail outlets, as well.
Now, what is the economic impact of franchising?
If you look at the top of this chart, you see that there's
estimated to be 901,093 establishments in franchise
systems in 2010.
So we're going onto three years from that time.
And so you have to assume that's
probably increased some.
In that 901,000 establishments, there were 9.5
or 9.6 million jobs with an output worth $868 billion.
So those are big numbers.
And so you can see the impact of franchises in our economy
and in our culture.
And literally everywhere you go, you see a franchise.
Right here on campus, if you're a student on campus,
you walk around.
You see all the different food outlets and the different
things going on.
Many of those are franchise operations.
The economic impact because of franchise businesses--
a study by PricewaterhouseCoopers.
Move down to the bottom.
You see there was 21 million jobs or 15.3% of private
sector job for franchise-related jobs, $661
billion of payroll or 12.5% of the private sector payrolls,
and $2.31 trillion of output, or again, 11.4% percent of
private sector output.
By the way, you guys need to get used to
what a trillion means.
A trillion is 1 x 10 to the 12th.
So it's 1 with 12 zeroes after it.
A billion is 1 with 9 zeroes and a million is 1 with 6
zeros after it.
So when we--
when you see the discussions on the US economy and the US
debt and all those kinds of things and people are tossing
these trillion-dollar numbers around very casually,
understand there's a lot of zeroes that go after that
first number in a trillion.
Now what are some of the pros and cons of franchising?
Pay special attention here, because one thing I want to
point out to you is that one of the big advantages of a
franchise is that it provides you with a greater chance of
success than if you were just starting up your own company.
So the probability of success is enhanced
with a franchise operation.
Why?
Because, well, I've got a proven line of business.
I have pre-qualified as a franchisee.
I've got support on the advertising side.
I've got support on the facility side.
I've got support on the marketing and the supplies and
material side.
So you've got a lot of support in a franchise.
I'm assuming you have a reliable and trustworthy and
proven franchisor.
We'll talk more about that in just a little bit.
You have training support.
You have financial assistance.
Sometimes franchisors will offer you lending for your
facility, the lending for setup and different
arrangements like that.
And they will also provide you training for your operations.
So there's a lot of advantages to the franchise.
What are the limitations?
Well, costs are big limitation.
For example, last time I checked, the cost of the
initial franchise fee for a McDonald's franchise is well
over a half-million dollars.
So that's a big, big investment.
Then you've got investment costs.
That's the cost of the facilities, the cost of just
getting everything ready to go.
Then you've got royalty payments.
Those are the recurring payments that occur every
quarter or every year that really is a percentage of
sales, not a percentage of profits.
So whatever sales you have, you're going to have to pay a
portion of those for royalties.
And then you've got advertising costs.
Even though the franchisor may be helping you with
advertising, you generally will have to put money into an
advertising pool that all franchisees have to contribute
money to for that franchisor then to execute
an advertising plan.
You also have restrictions on your business operations.
How often are you open?
When are you open?
Things like that.
You have some loss of independence.
And in some cases you have a lack of franchisor support.
So as you evaluate your franchise potential, you want
to be careful to evaluate the franchisor from the standpoint
of, are they a quality franchisor?
And so on.
So what are the advantages of the franchise model?
Here they are summarized.
Reduced risk of failure, going into business for yourself but
not by yourself-- not alone.
Use of a valuable trade name and trademark.
Access to a proven business system.
Management training, in most cases.
Immediate economies of scale, because there's multiple
franchisees.
A way for an existing business to diversify.
OK?
And we'll talk more about the advantages for the franchisor
here in just a little bit.
But one of the big advantages for the franchisor is, he can
expand his business model without having to incur large
amounts of debt, without having to raise capital
through an IPO or some other way.
He raises capital through his franchisees.
So what are some government concerns about franchising?
These are all valid concerns.
And I'm just going to kind of tick down through these.
Exaggerated claims by the franchisor--
a big deal.
False advertising, basically, is what we're talking about.
The opportunity behavior by the franchisor becomes a
competitive threat to franchisees.
In some franchise operations, the franchisor may own some
operations that could conceivably compete with your
franchise operation.
So this is a big concern.
Restrictions on franchisees who desire to
liquidate their holdings.
So what we're talking about here is, a franchisor has
certain rules written into the contract that limits what you
can do if you want to get out of the franchise.
Let's say your franchise contract expires and you want
to liquidate what you own there in your facility.
Then you want to make sure that your contract that you
signed doesn't constrain you there.
Conflicts of interest--
such as when the franchisor forces franchisees to be
captive outlets for other suppliers owned by the
franchisor.
Here's a good example.
I own a fast-food restaurant under a franchise.
I operate that fast-food restaurant.
I am compelled to purchase supplies from a
franchisor-owned supplier.
So that can be a problem, as well.
Churning is a problem.
This also ties in with number nine.
And to a lesser extent, number ten.
But number nine-- if you look at number nine, you'll see a
similar thing here.
Churning is where a franchise operation agreement or a
franchise agreement is terminated in order to resell
it and gain additional franchise fees.
So what happens here is, I'm operating a franchise under a
franchise agreement.
And there's a clause in the franchise agreement that
allows the franchisor to terminate under certain
conditions.
The franchise is becoming more valuable.
The franchise is making quite a bit of money.
And so if I terminate that contract, I can then force you
into a negotiation to obtain that
franchise at a higher fee.
Or I can bring in another owner to take that franchise
at a higher fee.
So I'm churning.
I'm churning the franchise and forcing you to either pay
higher fees or to get out.
And number nine is the same thing-- the imposition of new
restrictions is a requirement for contract renewal.
So my contract renewal date is coming up.
All of a sudden the franchisor is putting new constraints or
new restrictions in that contract to force me to comply
or to get out.
That could be a forced exit in order to churn that franchise.
I can impose noncompete clauses on my franchisees.
This is another concern-- one-sided contracts devised
for franchisors.
Always the case.
By the way, just a piece of advice.
Any time that you're asked to sign a contract by another
party, you must assume that contract is written to favor
the other party.
So it's important that you read any contract that you
sign in order to find out exactly how big of impact do
these favorite constraints have?
What are the things that will bother me the
most in this contract?
And don't be afraid to revise terms and
conditions of contracts.
A favorite comment of bankers and other people who have
quote unquote "standard contracts' is, this is our
standard contract.
You'll need to sign it.
And that may well be their standard contract.
But you don't have to sign it until you're satisfied with
all the terms and conditions.
And if you want to revise them, please
feel free to do so.
I do that routinely.
I review contracts that people ask me to sign.
And if I don't like a term or a condition of the contract,
I'll either cross it out and delete it or cross it out and
revise it and initial it and turn it in to whoever's
offering it to me to have them sign it.
Sometimes they don't check it.
Sometimes they will check it.
And sometimes they will sign it.
Sometimes they won't.
So don't sign contracts that you're not comfortable with.
OK.
Number 10.
The franchisor intimidation of franchisees who attempt to
form franchisee associations to seek alternative sources
for products or make other efforts to create a more level
playing field.
That's an area the government tries to watch, as well, as
they look at franchises.
OK.
So here's an example.
A clean home center-- this is a franchise.
The business was established in 1963.
Oreck is a vacuum-cleaning company.
They've been franchising since I was six.
They have 330 franchise units--
company-owned units, 98.
Here is a potential problem right there of competition
with their franchisees.
Startup costs-- $30,000.
Total investment--
somewhere between $84,600 and $221,000.
Notice the notes here.
The initial investment is different for each situation,
but is approximately 84 to 221.
The estimate includes a franchise
fee, which is $30,000.
And Oreck offers third-party financing.
So let's talk about all this just for a little.
What does all that involve?
Well, you've got a $30,000 fee upfront you'll have to pay.
Then you'll have to pay for your facilities.
And so your total cost can be as much as $84,600 all way up
to $220,000 for just getting the business started.
Then they have special incentives for VetFran.
I'm not sure what that is, unless it's a veteran.
You're coming in for a repeat franchise.
And then for franchise resell opportunities.
So that's kind of a summary of one type
of franchise offering.
You will see another one here in just a little bit.
So what are the controls that a franchisor has on a
franchisee?
Well, first you can restrict the sales territory.
You can require site approval, imposing a requirement on the
outlet's appearance and their floor plan
and everything else.
Restricting the goods and services that can be sold.
Requiring specific operating hours.
Controlling advertising.
Those are all common, normal controls that a franchisor has
on a franchisee.
Now let's look at how we evaluate the franchise
opportunities just for a little bit.
First of all, you've got to select a franchise.
And then you've got to do some sort of investigation or due
diligence of the franchise to see if that's something that
you could match up with.
In selecting a franchise, you want to make sure that you
really have a franchise that you can be comfortable with.
And so how do you do that?
Well, you observe them.
You observe an operation.
You look at advertisements.
You look at any kind of reviews that have
been done on them.
You go down through--
due diligence to the extent that you try to ask every
question you have.
One of the things that you want to do is, you want to
select a franchise that's doing something that you think
you might like it.
So that's one question you need to ask
yourself right upfront.
So then as you begin to investigate the franchise, you
want to look at all kinds of information.
Look at independent third-party sources like the
Federal Trade Commission.
Go on the internet and do a Google search.
Look at a franchise and talk to franchise consultants.
Be a little bit careful there, because franchise consultants
obviously are looking for some money.
Talk to franchisors themselves.
Ask them questions.
Ask them for their disclosure documents.
They all have to file disclosure documents, which
discloses what their business really is.
And then probably the best source is to talk to existing
and previous franchisees.
You're looking at a--
I'm going to bring up McDonald's again-- you're
looking at a McDonald's franchise.
Go talk to the guy that operates the local McDonald's.
He's a franchisee himself.
And ask him, hey, how is it to work with McDonald's?
Or how is it to work with Wendy's?
Or how is it to work with whichever franchise that
you're looking at?
So here's some steps or some questions you can always ask.
You can kind of cycle down through these questions.
I won't cover all of these.
Look at number three, for instance.
Does the franchisor enjoy a favorable reputation and broad
acceptance in the industry?
So that's a question you need to answer for yourself.
You've got to do some research to do that.
Look at the last one.
Does the franchisor have a history of attractive earnings
by his franchisees?
Very important question.
If I'm looking at a franchise operation and I'm going to
talk to some of their franchisees, I want to know,
are you making any money in this operation?
How hard is it to make a profit in this operation?
So that's one of things--
that's a big question.
You really need to ask that question.
And again, go back to the existing franchisees and talk
to them about the franchise opportunity.
Here's another example.
This is Glass Doctor.
It comes from the International Franchise
Association.
Glass Doctor-- here's all the details on Glass Doctor.
You see the startup costs are anywhere
from $20,000 to $125,000.
The total investment is $107,000.
So that says then that my fee is probably going to be around
$80,000 to $90,000 franchise fee, which is an upfront fee
that everybody has to pay.
So that's just kind of a brief insight
into that one franchise.
Here's some details on it.
Tells you who Glass Doctor is.
It's the largest chain in full-service glass frame sizes
in the nation.
And it goes down all the way through in a lot of detail.
Now, what is it that the company does?
What kind of training do they provide?
What kind of qualifications are required of franchisees?
And you could probably, if you contact the franchisor, you
can get more details about how they really like to operate
with their franchisees.
Who are the top 10 fastest-growing
franchises for 2010?
Well, look at them.
JenPro franchising--
commercial cleaning.
Subway--
you see them everywhere.
Stratus Building Solutions--
I'm not really familiar with them, but
that's commercial cleaning.
By the way, commercial cleaning is a big business if
you want to get into that business.
Very competitive, though, but just think about it.
Every major government facility, every major company,
every major office building-- they all have to
have cleaning services.
Some of them even do more than that.
They have cleaning services and maintenance services.
Look at number five.
Number four--
Dunkin' Donuts.
Number five--
Anago Cleaning Systems-- another
commercial cleaning company.
Big franchise operation.
Look at number seven, number eight, number ten.
Lots of commercial cleaning companies' franchises in the
top ten there.
So if you like to clean, get you a
commercial cleaning franchise.
So becoming a franchisor--
what are the considerations you have to make?
You have to look at their business model.
How do they operate?
The business model tells you, this is what we sell to
generate revenue.
And that's what you want to look at is, what do you do to
generate revenue?
Because if you can't understand what the
revenue-generating model is in a company, you will not be
able to do well in that company.
So you've got to understand that.
What kind of assistance is required?
What kind of government regulations impact what I'm
trying to do?
What kind of financial considerations impact what I'm
trying to do?
Is an operations manual either developed or already
developed that I--
I'm sorry, either in development or already
developed that I can use?
And then, does the franchise add a long-term value?
Is the franchisor adding a long-term value to what I'm
trying to do with my franchisee?
What do we mean by that?
Let's just give an example.
Let's go back once again to McDonald's.
McDonald's is continually upgrading their products.
They are continually trying to allow their franchisees to get
long-term value out of their franchise operations.
That's what we mean by adding long-term value.
Is the company changing with the time or are they changing
products as they need to?
OK.
So if you want to become a franchisor, well, there's some
real benefits to being a franchisor.
It reduces your capital requirements because you're
using other people's money--
notably, your franchisees.
It increases your management motivation.
And it allows you to expand very rapidly.
So the benefits of a franchise operation-- if you're a small
company, you want to look into it--
is, it allows you to basically raise capital very cheaply and
very rapidly and allows you to expand your brand very
rapidly, as well.
It's a smart thing to do, but requires a lot more management
than what you might normally do.
What are the drawbacks?
Well, you lose some control, because now I've got a lot of
different people operate my stores or
whatever franchise I have.
A lot of different people are sharing in my profits.
And it's going to increase my operational support costs.
All those things go up.
But there's some real benefits to it, as well.
Well, here's the rub, the legal issues,
the franchising contract.
I would recommend that any time you're thinking
considering a franchise operation, you get the
contract, the written contract, from the franchisor.
You read it carefully.
You do not sign it unless you have legal counsel looking
over your shoulder.
You ask your friendly attorney-- and by the way, I
always advise every entrepreneur to have two close
friends in your business startup activity--
your trusted accountant and your trusted attorney.
I recognize that word "trusted," it is kind of
counter to what we normally think.
But trust me, there are people that you will bring on board
to serve as your counsels who are good, trusted accountants
and good, trust attorneys.
So have those two best friends as you move forward.
So have your trusted attorney read this contract and
advise you on it.
Change any clauses that you want to change, because
really, you're starting a negotiation process.
Make sure it contains a termination transfer provision
clause in the contract.
And make sure it contains a statement of rights to renew
the contract.
So those are two basics that you want to think about if
you're doing a franchising contract.
Well, here's some franchise disclosure requirements.
This is rule 436 of the Federal Trade Commission--
the FTC.
It places certain constraints upon the franchisor as far as
what he must disclose, and in fact requires that the
franchisor have a franchise disclosure document which you
should be able to read.
Now let's shift the focus just a little bit to buying an
existing business.
That's called an acquisition.
So we're talking about--
we first talked about franchises.
Now we're going to talk about buying an existing business.
Now, there are all kinds of considerations when you're
getting ready to buy a business.
And we'll talk about these some as we go through this
short lecture.
But the basic thing is, you want to make sure you've
checked it out thoroughly.
And we'll talk about that in a little bit more detail.
What kind of risk are you taking on?
Is your price really a fair price?
Are you losing key people?
All these things you have to ask yourself as you begin to
think about starting a--
I'm sorry, acquiring a business.
So first thing you've got to do is, you've got to find a
business to buy.
And you have to be thinking about-- it's very much like
buying anything else.
What kind of commitment do you have to it?
What can you afford?
What kind of skills do you have that might
apply in this business?
And what kind of impact would it make on your lifestyle?
There's a lot of other questions that go
along with this, too.
But these are the basic starting questions.
What is it that I'm mostly interested in?
What can I afford to do?
What kind of skills do I have to bring to the business?
And how's it going to impact my lifestyle?
So here are the pros and cons of
buying an existing business.
Well, the pros are, you have a better chance of success.
So the risk of failure is less.
You have less planning to do.
You have existing customers and suppliers and so forth.
You go right on down the list.
But what are the cons?
Existing problems--
oftentimes concealed existing problems.
Example--
I've looked at companies before.
One of the first questions I'll ask a company or a CEO
owner when I'm looking at a company is, what kind of--
and this is before we get into any offer or negotiation,
contract of sale, things like that.
This is right up front.
What kind of problems are you having with the EPA?
I'll never forget.
I asked this of a small manufacturer one time I was
looking at.
His eyes got big.
He said, "It's interesting you should ask that question.
I've got this leak out here on a hydraulic press that's been
bugging us.
And the EPA is after me.
I've got to clean it up.
It's going to cost me about $1,000 to clean it up." So
those are the type of things that will bubble up if you ask
the right questions.
So never be afraid to ask questions about businesses.
What are the quality of the employees?
What kind of image do they have?
And so forth and so on.
All those things, as you tick down that list, are things
that you need to look at if you're going to look into
acquiring a business.
Now how do we find it?
Well, the best way to find it is to look around.
That's the best thing I can say.
Look around at people who are offering
businesses up for sale.
There's two or three best ways to do that.
There are a number of business brokers around the country who
handle nothing but the brokering--
the buying and selling of businesses.
In fact, I am affiliated with a good friend of mine in
Atlanta, Georgia, right now who owns a business brokerage
and just asked me to affiliate with him.
And so when necessary, I will consult with him or I will
hook people up with him in order to either
buy or sell a business.
Two other sources are--
really three other sources are your accountants, your
accountant and his firm, any attorney
friends that you have.
Because these people are constantly running into small
businesses are wanting to sell.
And then another source is your bank.
A lot of times, bankers will know about businesses that
they either are financing or have
financed who are for sale.
And they'll be glad to pass it on to you.
That's the way to do it.
Now let's go back to the top of this chart.
You see the due diligence?
That's the definition of a very important term that
you've got to become familiar with.
It's the exercise of the prudence expected of a
reasonable person in the careful evaluation of the
business opportunity.
So due diligence is the careful evaluation of a
business opportunity.
When I go to buy a business, I have to go through a period of
due diligence.
And that is a very well-respected term.
It's a term that all buyers and sellers of businesses
understand.
And we'll talk more about that later as we get into this.
So here's some due diligence for purchasing a business.
Once you've found a business that you'd like to buy, then
there's a lot of things that you need to do.
And I'll just give you kind of a brief example of the steps
you go through when you're getting
ready to buy a business.
You meet with the owners.
You find out the business is for sale.
You meet with the owners or the CEOs or whoever is
representing the owners and CEOs.
And you begin to ask questions.
And you begin to kind of formulate a relationship.
And then at some point in time, after you've had a
chance to visit, you get the company's sales pitch on the
business or the broker's sales pitch on the business, you get
some financial statements to look at, some kind of
high-level stuff that you begin to look at.
And so in the course of these discussions, you decide you
really would like to make a run on this business as
far as buying it.
And so you then make a contingent offer to the owner
of the business.
And the contingent offer will read something like this.
After careful examination, my firm has decided that it would
like to acquire your company.
And this is a contingent offer.
We are willing to offer you $100,000 for your business.
And that sales price is contingent upon satisfactory
completion of due diligence.
And oh, by the way, here is a list of due diligence
questions that we would like for you to answer in writing
before we come in to visit with you certain week with my
attorney and my accountant and myself to
investigate your records.
OK.
So that's a typical first offer-- a contingent offer.
Everything is contingent upon satisfactory due diligence.
So after I've done my due diligence, what do you think
is going to happen to that offering price?
It's going to come down.
The owners understand that.
The brokers understand that.
The bankers understand that.
After I've completed due diligence, there's a good
chance that my initial offer is going to come down, because
I've had to adjust for things that I
found during due diligence.
So here is kind of a list.
It's a very short list of the things that you would want to
look at in due diligence contracts and these
agreements--
customer list, supplier/purchaser list.
You want to look at financial statements.
Another thing to look at is travel and expense reports,
your org charts, how much you're paying the
employees, on and on.
I have a list of over 100 due diligence questions that can
be asked of a company.
So there's a lot of questions.
This is a very small list right here that
you're looking at.
This is kind of the basic list of due diligence.
So you see, you can get into a lot of detail.
For a large company, due diligence may take several
weeks or months to complete.
For small companies, it might take a week of you and your
accountant and your attorney sitting in their offices going
through records and asking questions of the company.
It's amazing what you find when you go
through that process.
Of the first things I do is, I try to find out why a business
is for sale.
I typically will sit down with the owner and
ask him that very--
I've asked that very question.
Why are you selling?
And oftentimes it will be because the
owner wants to retire.
He's ready to get out of the business.
Sometimes the owner just wants to get the business out so he
can start another business.
He wants to move to another part of the country.
The business is not making him any money.
All kinds of reasons for selling.
But you want to figure that out.
Why is the owner wanting to sell?
This previous business example I was giving you, I sat down
with the owner and I asked him that question.
Why do you want to sell?
Well, it's time to retire for me.
I want to retire.
I got some traveling and other things I want to do.
And my children are not interested in this business.
So I really don't have anybody to carry on the business.
And I noticed that the office next to him was a person by
the same name as his.
I said, is the office next door-- is that one of your
children or a relative of some sort?
He said, oh, yes, that's my son.
That's his office.
And so he already told me that there was no real interest in
the business by his children.
And so I just kind of observed, as I was there for
that meeting, I was in there for several hours walking
around with him, whatnot.
And I noticed that Junior didn't come in
until almost noon.
And in some further discussion and questions I found out
Junior's busy doing a lot of other things.
He's coaching a Little League team.
He's doing this.
He's doing that.
So Junior is not really plugged into the business.
And so what's happened here is, the old man has come to
the point and he's figured out Junior is not going to run
this business successfully.
If I sell it to him, I will never see my retirement value
coming out of that.
I might have to sell it to somebody that's going to
generate me some cash that I can live on.
And so that was his decision process.
Everybody's got a reason for selling their business.
Now look at the little bullet down at the
bottom of this chart.
Beware of sellers who may have cooked the books to make the
business more attractive.
That's one of the purposes of due diligence is to dig in and
see if the books have been cooked.
One of the questions or one of the things I look for in small
business is travel expense statements.
Who's been traveling for the company?
I noticed that this company here, that whenever they
traveled, that the owner took his wife with him.
And his chief engineer took his wife with him.
And they traveled together.
And so there's some expenses there being taken that
probably are questionable as to whether they're really
valid travel expenses for the company.
And so you'd go through and adjust things for those kinds
of things you find in the books of the company.
See, this is what we're talking about.
Examining the financial data.
Review financial statements and tax returns for the past
five years.
Now that's an important statement right there.
You want to look at their financial statements.
But also look at their tax returns.
Because their financial statements should correlate
with the tax return.
The differences being whatever deductions and whatever claims
with the IRS that are legal claims.
So you want to look at that.
You want to look to see if their assets are overvalued.
The equipment that they're carrying on the books may be
25 years old.
It may not be totally depreciated.
Who knows?
You have to find out.
Has it been depreciated?
What would it cost to replace it?
All those things you've got to look at.
And another thing to look at-- this last little bullet here
on the green bullet.
Unrecorded debts.
Are there are some off-book debts that will come along
with this business if I buy this business?
You've got to find that out.
Because you don't want to wake up and find out, I bought a
business that's carrying a big debt here that I now own.
And I didn't know I was going to own it.
Because it wasn't being carried on the books.
So how do you value the business?
Well, there's three basic ways.
I can do an asset-based valuation, which means I can
basically either estimate or look at their books to
determine what is the value of all the
assets the company owns?
This is what a banker would look at--
the value of assets.
I can look at a market-comparable evaluation.
This considers the sales price of other businesses like this
in the market.
Now there's a problem with that type of valuation.
Because oftentimes, businesses are totally unique.
It's hard to find a business that will exactly compare to
this business that I'm interested in that has been
sold recently or within the last year.
So that's a hard--
market comps are hard to obtain for small businesses
that are meaningful.
Then the cash-flow-based valuation.
This is when I do an expected return from the company over
the next, say, four or five years.
What will be my rate of return in the next four, five years?
What will be the cash flow?
Can I turn that into a number that will represent what this
company is worth?
I'm going to give you another kind of quick and dirty way to
value a business.
It's very, very quick.
And it has room for a lot of error.
But typically it's pretty close.
If I take the EBITDA of the company--
E-B-I-T-D-A, earnings before interest, taxes, depreciation
and amortization, EBITDA--
if I take the EBITDA of the company and multiply it by a
ratio typically from four to six or seven, that will give
me a quick and dirty value of that company.
Most of the time, the ratio will be around five or six.
And so if I've got a company with $100,000 EBITDA, I
multiply that by five.
That gets me $500,000.
That tells me that is a reasonable
value of that company.
I should pay something in that ballpark for the company.
So that's kind of a quick and dirty way to do it.
But it works.
So what are some nonquantitative factors in
valuing a business?
You've got to look at the competition, the market, where
they're located in the future community, any legal
commitments.
Union contracts--
a big deal, you've got to look for those.
It can have a major impact on loan term or your company.
Buildings--
what kind of facilities do they have?
What kind of pricing environment are they in?
All those things are nonquantitative things
you can look at.
So now I've done all these things.
I've made the contingent offer.
I've done my due diligence.
I've done all the examination.
I've asked all the questions.
So now I want to negotiate and close the deal.
So I have to come up with a specific set of terms of
purchase, which means, what kind of assets am I buying?
What is the total entity?
Is there an indemnification clause?
I'll come back to that.
Am I making payment in full or partial payments over time?
Along that same thing, I will always ask an owner of a
business, would you be willing to finance a
portion of this sale?
Most of the time, they will, which means that previous
owner will take a note on the sale of the business that you
can take and use that to help finance your business.
Now, let's look at indemnification.
Very important concept here.
What indemnification clause does is, it says all things
that happen after the signing of this contract are the
responsibility of the new owners.
All liabilities that have occurred prior to the signing
of this contract are the
responsibility of the old owners.
That's indemnifying you from prior liabilities that pop up
after you have bought the company.
Very important.
You don't want something that happened not on your watch to
come back and be a liability you have to deal with.
Closing the sale is best handled by a third party.
Your attorney, your trusted attorney, can handle it for
you, make sure everything is closed properly.
OK.
This concludes chapter four.
And this should well support the reading of
your chapter four.