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Small Business Management, 11th editionLongenecker, Moore, and Petty© 2000South-Western College Publishing

Chapter 4Chapter 4

Startup and Buyout Startup and Buyout OpportunitiesOpportunities

In the Spotlight:FunZonewww.choicemall.com/funzone

In the Spotlight:FunZonewww.choicemall.com/funzone

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Learning Objectives: Chapter 4Learning Objectives: Chapter 4

1. Give three reasons for starting a new business rather than buying an existing firm or acquiring a franchise.

2. Distinguish the different types and sources of startup ideas.

3. Identify five factors that determine whether an idea is a good investment opportunity.

4. List some reasons for buying an existing business.

5. Summarize four basic approaches for determining a fair value for a business.

6. Describe the characteristics of highly successful startups.

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Types of Ideas That Develop into Startups

New Market

Example:Targeting the “New Age” beverage market by selling soft drinks with nutritional value

New Technology

Example:Using high-tech computers to develop a simulated helicopter ride

New Benefit

Example:Developing a personal misting device to keep workers cool

TYPE A TYPE B TYPE C

TYPE A: Providing customers with a product or service that is not in their market but already exists elsewhere.

TYPE B: Using new technology that provides the basis for new product or service ideas.TYPE C: Performing an old function for customers but in a new and improved way.

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Sources of Startup Ideas

Prior Work Experience

45%

Family Business6%

Other4%

Chance Happening11%

Education/Courses6%

Suggestion7%

Personal Interest/Hobby16%

Friends/Relatives5%

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Examples of Startup Ideas

PersonalExperiencePersonalExperience

HobbiesHobbies

AccidentalDiscoveryAccidentalDiscovery

DeliberateSearchDeliberateSearch

• Natalie Stiles

• OCS Consulting Services

• Consulting experience with GE

• Natalie Stiles

• OCS Consulting Services

• Consulting experience with GE

• Vickie Henry

• Feedback Plus

• Shopping ability

• Vickie Henry

• Feedback Plus

• Shopping ability

• J. P. Shyu

• Hang-It Clip

• Need to hang data on wall

• J. P. Shyu

• Hang-It Clip

• Need to hang data on wall

• Bill Waugh

• Taco Bueno, Burger Street

• Extensive research in the fast-food industry

• Bill Waugh

• Taco Bueno, Burger Street

• Extensive research in the fast-food industry

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Evaluation Criteria for a Startup Venture• Marketing Factors

Need for productCustomersValue created by product for customerLife of productMarket structureMarket sizeMarket growth

• Competitive AdvantageCost structureDegrees of control over price, costs, channels of supplyBarriers to entry: regulatory protection, response/lead-time advantage, legal advantage, contacts and networks

• EconomicsReturn on investmentInvestment requirementsBreak-even point

• Management Capability

• Fatal Flaw

• Marketing FactorsNeed for productCustomersValue created by product for customerLife of productMarket structureMarket sizeMarket growth

• Competitive AdvantageCost structureDegrees of control over price, costs, channels of supplyBarriers to entry: regulatory protection, response/lead-time advantage, legal advantage, contacts and networks

• EconomicsReturn on investmentInvestment requirementsBreak-even point

• Management Capability

• Fatal Flaw

Source: Adapted from Jeffery A. Timmons, New Venture Creation (Homewood, IL: Irwin, 1999), pp. 86-87.

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CONS

• Existing problems

• Poor quality of current employees

• Poor business image

• Modernization required

• Purchase price based on inaccurate data

• Poor business location

Pros and Cons of Buying an Existing Business

PROS

• High chance of success

• Less planning

• Existing customers/suppliers

• Necessary equipment

• Bargain price

• Experienced employees

• Existing business records

+

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Income Statement as Adjusted by Income Statement as Adjusted by Prospective BuyerProspective Buyer

Original Required AdjustedIncome Statement Adjustments Income Statement

Estimated sales $172,000 $172,000Cost of goods sold 84,240 84,240Gross profit $87,760 $87,760Operating expenses:

Rent $20,000 Rental agreement will $24,000expire in six months; rent is expected to increase 20%.

Salaries 19,860 19,860Telephone 990 990Advertising 11,285 11,285Utilities 2,580 2,580Insurance 1,200 Property is underinsured; 2,400

adequate coverage will double present cost.

Professional services 1,200 1,200

Credit card expense 1,860 Amount of credit card 460expense is unreasonably large; approximately $1,400of this amount should be classifiedas personal expense.

Miscellaneous 1,250 $60,225 1,250 $64,025Net income $27,535 $23,735

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Valuation of a BusinessValuation of a BusinessAsset-BasedValuationApproach

Asset-BasedValuationApproach

Market-BasedValuationApproach

Market-BasedValuationApproach

Earnings-BasedValuationApproach

Earnings-BasedValuationApproach

Cash Flow-BasedValuationApproach

Cash Flow-BasedValuationApproach

• Examines the value of business assets taken separately

• Does not reflect the value of a going concern

• Examines the value of business assets taken separately

• Does not reflect the value of a going concern

• Looks at similar businesses sold recently• Looks at similar businesses sold recently

• Considers future earnings• Considers future earnings

• Is based on future cash flows

• Is the best theoretical method

• Requires a more complex procedure

• Is based on future cash flows

• Is the best theoretical method

• Requires a more complex procedure

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Determinants of a Firm’s Determinants of a Firm’s Capitalization RateCapitalization Rate

Risk

High

Low

High Capitalization

Rate

Low Capitalization

Rate

Low Firm Value

High Firm Value

ProjectedGrowth

High

Low

Low Capitalization

Rate

High Capitalization

Rate

High Firm Value

Low Firm Value

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Nonquantitative Factors to Consider Nonquantitative Factors to Consider in Valuing a Businessin Valuing a Business

• CompetitionCompetition

• MarketMarket

• Future Community DevelopmentsFuture Community Developments

• Legal CommitmentsLegal Commitments

• Union ContractsUnion Contracts

• BuildingsBuildings

• Product PricesProduct Prices

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Suggested Risk Premium CategoriesSuggested Risk Premium Categories

1 Established businesses with a strong trade position that are wellfinanced, have depth in management, have stable past earnings, andwhose future is highly predictable.

6 10%

2 Established businesses in a more competitive industry that are wellfinanced, have depth in management, have stable past earnings, andwhose future is fairly predictable.

11 15%

3 Businesses in a highly competitive industry that require little capital toenter, have no management depth, and have a high element of risk,although past record may be good.

16 20%

4 Small businesses that depend on the special skill of one or two peopleor large established businesses that are highly cyclical in nature. Inboth cases, future earnings may be expected to deviate widely fromprojections.

21 25%

5 Small “one-person” business of a personal services nature, where thetransferability of the income stream is in question.

26 30%

Category Description Risk Premium

Source: James H. Schilt, “Selection of Capitalization Rates--Revisited,” Business Valuation Review, American Society of Appraisers, P.O. Box 17265, Washington, DC 20041 (June 1991), p. 51.

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