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BUSINESSBUSINESS
VALUATIONVALUATION
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ValuationValuation
There are a number of tools available toThere are a number of tools available topredict value including complex softwarepredict value including complex softwaretools that promise to reduce valuation to atools that promise to reduce valuation to a
simple formula.simple formula.However, all of valuation comes down toHowever, all of valuation comes down tothis simple truth:this simple truth:
A business is worth what a buyer isA business is worth what a buyer iswilling to paywilling to pay..
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33
Fair Market ValueFair Market Value
Fair Market Value is defined as the valueFair Market Value is defined as the value
that athat a willingwilling seller and aseller and a willingwilling buyer, bothbuyer, both
beingbeing informedinformed of theof the relevantrelevant facts aboutfacts aboutthe company, could reasonably conduct athe company, could reasonably conduct a
buybuy--sell transaction, neither party under anysell transaction, neither party under any
compulsioncompulsion to do so.to do so.
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NonNon--quantitative Factors inquantitative Factors in
Valuing a BusinessValuing a Business
CompetitionCompetition
MarketMarket
Future CommunityFuture Community
DevelopmentDevelopmentLegal CommitmentsLegal Commitments
Union ContractsUnion Contracts
BuildingsBuildings
Product PricesProduct Prices
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What can theWhat can the
term value mean?term value mean?Fair market valueFair market value..
This is the price at which a willing seller wouldThis is the price at which a willing seller wouldsell and a willing buyer would buysell and a willing buyer would buy
every sale would ultimately constitute a fairevery sale would ultimately constitute a fair
market value sale.market value sale.
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What can theWhat can the
term value mean?term value mean?
Intrinsic valueIntrinsic value. This is perceived value arrived. This is perceived value arrivedat by interpreting balance sheet and incomeat by interpreting balance sheet and incomestatements through the use of ratios, discountingstatements through the use of ratios, discounting
cash flow projections, and calculating liquidatedcash flow projections, and calculating liquidatedasset valueasset value
Investment valueInvestment value. This is the worth of the. This is the worth of the
business to an investor and is based on thebusiness to an investor and is based on theindividual requirements of the investor as to risk,individual requirements of the investor as to risk,return, tax benefits, and so forthreturn, tax benefits, and so forth
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What can theWhat can the
term value mean?term value mean?GoingGoing--concern valueconcern value..
This is the current status of the business asThis is the current status of the business asmeasured by financial statements, debt load,measured by financial statements, debt load,
and economic environmental factors, such asand economic environmental factors, such as
government regulation, that may affect the longgovernment regulation, that may affect the long--
term continuation of the business.term continuation of the business.
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What can theWhat can the
term value mean?term value mean?Liquidation valueLiquidation value. This value assumes the. This value assumes the
selling off of all assets and calculating theselling off of all assets and calculating the
amount that could be recovered from doing so.amount that could be recovered from doing so.
Book valueBook value. This is an accounting measure of. This is an accounting measure of
value and refers to the difference between totalvalue and refers to the difference between total
assets and total liability. It is essentiallyassets and total liability. It is essentially
equivalent to shareholders or owners equity.equivalent to shareholders or owners equity.
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Why Businesses Are AppraisedWhy Businesses Are Appraised
Mergers and AcquisitionsMergers and Acquisitions
Allocation of PurchaseAllocation of PurchasePricePrice
Estate and Gift TaxesEstate and Gift Taxes
Marital DissolutionMarital Dissolution
Liquidation orLiquidation orReorganization of aReorganization of aBusinessBusiness
BuyBuy--Sell AgreementsSell Agreements
Stockholder DisputesStockholder Disputes
FinancingFinancing
Initial Public OfferingInitial Public Offering
Damages LitigationDamages Litigation
Charitable ContributionsCharitable ContributionsFinancial ReportingFinancial Reporting
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Appraisal PrinciplesAppraisal Principles
Principle of SubstitutionPrinciple of Substitution
Principle ofFuture BenefitsPrinciple ofFuture Benefits Principle of AnticipationPrinciple of Anticipation
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Standards of ValueStandards of Value
Fair Market ValueFair Market Value
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Fair Market ValueFair Market Value
...the price at which the property would
change hands between a willing buyer anda willing seller when the former is not
under any compulsion to buy and the latter
is not under any compulsion to sell, both
parties having reasonable knowledge of
relevant facts.
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Standards of ValueStandards of Value
Fair Market ValueFair Market Value
Fair ValueFair Value
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Fair Market Value v Fair ValueFair Market Value v Fair Value
1.1. Willing Buyer.Willing Buyer.
2.2. Willing Seller.Willing Seller.
3.3. Neither is under compulsion.Neither is under compulsion.
4.4. Assumes a typicalAssumes a typical hypotheticalhypothetical
buyer and seller.buyer and seller.
5.5. AA priceprice that isthat is equitable to both.equitable to both.6.6. Assumes both buyer and sellerAssumes both buyer and seller
havehave equal knowledgeequal knowledge..
7.7. AssumesAssumes reasonable knowledgereasonable knowledge
of both parties.of both parties.
1.1. Not always a Willing Buyer.Not always a Willing Buyer.
2.2. NotNot always aWilling Seller.always aWilling Seller.
3.3. Buyer may be compelled, butBuyer may be compelled, but
seller isseller is..
4.4. A concept of "fairness" to theA concept of "fairness" to theseller, considering the inabilityseller, considering the inability
to keep the stock.to keep the stock.
6.6. No such assumption.No such assumption.
7.7. No such assumptionNo such assumption
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Standards of ValueStandards of Value
Fair Market ValueFair Market Value
Fair ValueFair Value
Investment ValueInvestment Value
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Standards of ValueStandards of Value
Fair Market ValueFair Market Value
Fair ValueFair Value
Investment ValueInvestment ValueIntrinsic ValueIntrinsic Value
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Factors To ConsiderFactors To ConsiderNature of the business and history of the enterprise since itsNature of the business and history of the enterprise since its
inception.inception.
The economic outlook in general and the condition and outlook ofThe economic outlook in general and the condition and outlook of
the specific industry in particular.the specific industry in particular.
The book value of the stock and the financial condition of theThe book value of the stock and the financial condition of thebusiness.business.
The earning capacity of the company.The earning capacity of the company.
The dividendThe dividend--paying capacity.paying capacity.
Whether or not the enterprise has goodwill or other intangibleWhether or not the enterprise has goodwill or other intangible
value.value.
The market price of stocks of corporations engaged in the sameThe market price of stocks of corporations engaged in the same
or similar line of business having their stocks actively traded in aor similar line of business having their stocks actively traded in a
free and open market, either on an exchange or overfree and open market, either on an exchange or over--thethe--counter.counter.
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Determining the Value of the BusinessDetermining the Value of the Business1.1. Discounted cash flowsDiscounted cash flows: cash flows reduced: cash flows reduced
in value because they are to be received inin value because they are to be received in
the futurethe future
3.3. Net realizable valueNet realizable value: amount for which an: amount for which an
asset will sell, less the cost of sellingasset will sell, less the cost of selling
4.4. Replacement valueReplacement value: cost to acquire an: cost to acquire an
essentially identical assetessentially identical asset5.5. Earnings multipleEarnings multiple: ratio of value of a firm to: ratio of value of a firm to
its annual earningsits annual earnings
6-18
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1919
Business Valuation StepsBusiness Valuation Steps -- 11
Define PurposeDefine Purpose
Understand size & characteristics of ClientUnderstand size & characteristics of Client
Assessment of People and MarketsAssessment of People and Markets--------------------------------------------------------------------------------------------
Gather Additional DataGather Additional Data
Recast Financial StatementsRecast Financial StatementsRatio Analysis / Industry ComparisonRatio Analysis / Industry Comparison
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2020
Business Valuation StepsBusiness Valuation Steps -- 11
Define PurposeDefine Purpose
Understand size & characteristics of ClientUnderstand size & characteristics of Client
Assessment of People and MarketsAssessment of People and Markets--------------------------------------------------------------------------------------------
Gather Additional DataGather Additional Data
Recast Financial StatementsRecast Financial StatementsRatio Analysis / Industry ComparisonRatio Analysis / Industry Comparison
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Determining the Value of a BusinessDetermining the Value of a Business
Balance Sheet TechniqueBalance Sheet Technique
Variation: Adjusted Balance SheetVariation: Adjusted Balance Sheet
TechniqueTechnique
Earnings ApproachEarnings Approach Variation 1: Excess Earnings ApproachVariation 1: Excess Earnings Approach
Variation 2: Capitalized Earnings ApproachVariation 2: Capitalized Earnings Approach
Variation 3: Discounted Future EarningsVariation 3: Discounted Future EarningsApproachApproach
Market ApproachMarket Approach
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Adjusted Book ValueAdjusted Book Value
The book value of a going concern is simply theThe book value of a going concern is simply the
owners equityowners equity, that is, the value of the assets, that is, the value of the assets
less the outstanding debts.less the outstanding debts.
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Balance Sheet TechniquesBalance Sheet Techniques
Book Value ofNetWorth = Total AssetsBook Value ofNetWorth = Total Assets -- Total LiabilitiesTotal Liabilities
Variation: Adjusted Balance Sheet Technique:Variation: Adjusted Balance Sheet Technique:
(Adjusted for negatives or positives from balance sheet in(Adjusted for negatives or positives from balance sheet ininventory, equipment, land/buildings/receivables, etc)inventory, equipment, land/buildings/receivables, etc)
The balance sheet method lets one take the perspective of "I walkedThe balance sheet method lets one take the perspective of "I walked
away from this business tomorrow, sold everything that it owns, howaway from this business tomorrow, sold everything that it owns, how
much do I get?"much do I get?"
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Income ApproachIncome Approach
Definitions of IncomeDefinitions of IncomeNet income after taxNet income after tax
Net income before taxNet income before tax
Cash flow (gross or net)Cash flow (gross or net)
Debt free net incomeDebt free net income
Debt free cash flow (gross or net)Debt free cash flow (gross or net)
EBIT, EBDIT or EBDITA (EBITDA)EBIT, EBDIT or EBDITA (EBITDA)Earnings before owners compensation,Earnings before owners compensation,
interest and taxes (owners discretionary cashinterest and taxes (owners discretionary cash
flow)flow)
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Income ApproachIncome Approach
Single Period ModelSingle Period Model
Capitalization: The process of converting abenefits stream into value by dividing the
benefits stream by a rate of return that is
adjusted for growth.
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Income ApproachIncome Approach
MultiMulti--Period ModelPeriod Model
Discounting: The process of converting a
future series of benefit streams into value by
bringing them to present value at a rate of
return that reflects the risk inherent in the
benefits stream.
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Income ApproachIncome Approach
Capitalization of benefits methodCapitalization of benefits method
Discounted future benefits methodDiscounted future benefits method
Excess earnings methodExcess earnings method
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Excess Earnings MethodExcess Earnings Method
1.1. Compute the adjusted tangible net worth of the business.Compute the adjusted tangible net worth of the business.
Tangible assets are adjusted up or down for market value; thenTangible assets are adjusted up or down for market value; then
liabilities are subtracted.liabilities are subtracted.
2.2. Compute the opportunity cost of this investment. How much wouldCompute the opportunity cost of this investment. How much wouldthe investor/buyer earn by investing the same amount in another,the investor/buyer earn by investing the same amount in another,
comparable investment?comparable investment?
3.3. Forecast net earnings. Earnings from previous income statementsForecast net earnings. Earnings from previous income statements
can provide a basis for the forecastcan provide a basis for the forecast
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Excess Earnings MethodExcess Earnings Method
4. Calculate the extra earning power, which is the difference between4. Calculate the extra earning power, which is the difference between
forecasted earnings and opportunity costs.forecasted earnings and opportunity costs.
5. Estimate the value of intangible assets or goodwill. If the business5. Estimate the value of intangible assets or goodwill. If the business
has extra earning power, that figure can be multiplied by what ishas extra earning power, that figure can be multiplied by what isknown as a yearsknown as a years--ofof--profit (YOP) figure.profit (YOP) figure.
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Earnings ApproachesEarnings Approaches
Variation 1: Excess Earnings MethodVariation 1: Excess Earnings Method
Step 1Step 1: Compute adjusted tangible net worth:: Compute adjusted tangible net worth:
Adjusted NetWorth = 2746380Adjusted NetWorth = 2746380 -- 1143250=1143250= 16031301603130
Step 2Step 2: Calculate opportunity costs of investing:: Calculate opportunity costs of investing:(25% is normal rate of return)(25% is normal rate of return)
Investment 1603130 x 25% = 400780Investment 1603130 x 25% = 400780
SalarySalary + 250000+ 250000
Total 65078
0Total 65078
0
Step 3Step 3: Project earnings for next year:: Project earnings for next year: 740000740000
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Excess Earnings MethodExcess Earnings Method
Step 4Step 4: Compute extra earning power (EEP):: Compute extra earning power (EEP):
EEP = Projected Net EarningsEEP = Projected Net Earnings -- Total Opportunity CostsTotal Opportunity Costs
= 740000= 740000 -- 650780 = 89220650780 = 89220
Step 5Step 5: Estimate the value of the intangibles (goodwill):: Estimate the value of the intangibles (goodwill):
Intangibles = Extra Earning Power x Years of Profit Figure*Intangibles = Extra Earning Power x Years of Profit Figure*
= 89220 x 3 == 89220 x 3 = 267660267660
* Years of ProfitF
igure ranges from 1 to 7; for a normal risk* Years of ProfitF
igure ranges from 1 to 7; for a normal riskbusiness, it is 3 or 4.business, it is 3 or 4.
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Excess Earnings MethodExcess Earnings Method
Step 6Step 6: Determine the value of the business:: Determine the value of the business:
Value = Tangible Net Worth + Value of IntangiblesValue = Tangible Net Worth + Value of Intangibles
= 1603130 + 267660 == 1603130 + 267660 = 18707901870790
Estimated Value of the Business = 1870790Estimated Value of the Business = 1870790
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Earnings ApproachesEarnings Approaches
Variation 2: Capitalized Earnings Method:Variation 2: Capitalized Earnings Method:
Value =Value = Net Earnings (Net Earnings (AfterAfterDeducting Owner's Salary)Deducting Owner's Salary)
Rate of Return*Rate of Return*
* Rate of return reflects what could be earned on a similar* Rate of return reflects what could be earned on a similar--riskrisk
investment.investment.
Value =Value = 74,000074,0000 -- 25,000025,0000 == 196,0000196,0000
25%25%
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Capitalization of EarningsCapitalization of Earnings
Either EBIT or EBITDA is divided by a capitalization rate,Either EBIT or EBITDA is divided by a capitalization rate,
which is the return the buyer requires on the investmentwhich is the return the buyer requires on the investment
For example, if the companys EBITDA was 500,000 andFor example, if the companys EBITDA was 500,000 andthe buyer needed a 20 percent return on investment, thethe buyer needed a 20 percent return on investment, the
price the buyer would be willing to pay would beprice the buyer would be willing to pay would be
2,500,000.2,500,000.
EBITDA / REQUIRED ROI = MAXIMUM PURCHASE PRICEEBITDA / REQUIRED ROI = MAXIMUM PURCHASE PRICE
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Capitalization ModelCapitalization Model
V = E / k-g
E = Earnings expected in next period
k = Discount rate
g = Long term sustainable growth rate
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Single Period Model ExampleSingle Period Model Example
Adjusted Net Income 1,000,000
Forecasted Growth x 1.05
Estimated Future Income 1,050,000
Capitalization Rate 25.0 %
Indicated Value from Operations 4,200,000
Add: Net Nonoperating Assets 357,350Total Enterprise Value 4,557,350
Rounded 4,600,000
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MultiMulti--Period ModelPeriod Model
E1 E2 E3 Et
V= --------- + --------- + --------- +... --------
(1 + i)1 (1 + i)2 (1 + i)3 (1 + i)t
Where
E = Benefit streami = Discount rate
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Earnings ApproachesEarnings Approaches
Variation 3: Discounted Future Earnings Method:Variation 3: Discounted Future Earnings Method:
Compute aCompute a weightedaverageweightedaverage of the earnings:of the earnings:
Step 1Step 1: Project earnings five years into the future:: Project earnings five years into the future:
Pessimistic + (4 x Most Likely) + OptimisticPessimistic + (4 x Most Likely) + Optimistic
6
$$
3 Forecasts:
PessimisticMost Likely
Optimistic
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Discounted Future EarningsDiscounted Future Earnings
MethodMethod
Step 1Step 1: Project earnings five years into the future:: Project earnings five years into the future:
Year Pess ML Opt Weighted Average Year Pess ML Opt Weighted Average
65,00065,00074,00074,000
82,00082,000
88,00088,000
88,00088,000
74,00074,00090,00090,000
100,000100,000
109,000109,000
115,000115,000
92,00092,000101,000101,000
112,000112,000
120,000120,000
122,000122,000
75,50075,50089,16789,167
99,00099,000
107,333107,333
111,667111,667
1122
33
44
55
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Discounted Future Earnings MethodDiscounted Future Earnings Method
Step 2Step 2: Discount weighted average of future earnings at the: Discount weighted average of future earnings at the
appropriate present value rate:appropriate present value rate:
Present Value Factor =Present Value Factor =(1 +k)(1 +k) tt
where...where...
k = Rate of return on a similar riskk = Rate of return on a similar risk
investmentinvestment
t = Time period (Yeart = Time period (Year -- 1, 2, 3...n)1, 2, 3...n)
11
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Discounted Future Earnings MethodDiscounted Future Earnings Method
Year Weighted Average x PV Factor = Present ValueYear Weighted Average x PV Factor = Present Value
11
22
33
44
55
.8000.8000
.6400.6400
.5120.5120
.4096.4096
.3277.3277
75,50075,500
89,16789,167
99,00099,000
107,333107,333
111,667111,667
Step 2 (continued)Step 2 (continued): Discount weighted average of: Discount weighted average of
future earnings at the appropriate present value rate:future earnings at the appropriate present value rate:
60,40060,400
57,06757,067
50,68850,688
43,96443,964
36,59336,593
Total 248,712Total 248,712
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Discounted Future EarningsDiscounted Future Earnings
MethodMethodStep 3Step 3: Estimate the earnings stream beyond five years:: Estimate the earnings stream beyond five years:
Weighted Average Earnings in Year 5 xWeighted Average Earnings in Year 5 x 11
Rate of ReturnRate of Return
= 111,667 x= 111,667 x 11
25%25%
Step 4Step 4: Discount this estimate using the present value factor for: Discount this estimate using the present value factor for
year 6:year 6:446,668 x .2622 =446,668 x .2622 = 117,116117,116
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Discounted Future EarningsDiscounted Future Earnings
MethodMethodStep 5Step 5: Compute the value of the business:: Compute the value of the business:
= 248,712 + 117,116 == 248,712 + 117,116 = 365,828365,828
Estimated Value of Business = 365,828
Estimated Value of Business = 365,828
Value =Value = DiscountedDiscounted
earnings in yearsearnings in years
1 through 51 through 5
++DiscountedDiscounted
earnings in yearsearnings in years
6 through ?6 through ?
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Discounting Cash FlowsDiscounting Cash Flows
Calculating how much an investor would payCalculating how much an investor would pay
today to have atoday to have a cash flow streamcash flow stream of X rupees forof X rupees for
X number of years into the future.X number of years into the future.
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Multiple of EarningsMultiple of Earnings
Using a price/earnings (P/E) ratio to value aUsing a price/earnings (P/E) ratio to value abusiness is a common method among publiclybusiness is a common method among publiclyowned companies because its simple and directowned companies because its simple and direct
This ratio is determined by dividing the marketThis ratio is determined by dividing the marketprice of the common stock by the earnings perprice of the common stock by the earnings pershare.share.
P/E RATIO = STOCK PRICE / EARNINGS PERP/E RATIO = STOCK PRICE / EARNINGS PER
SHARESHARE
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Commonly Used MultiplesCommonly Used MultiplesPrice/net earningsPrice/net earningsPrice/prePrice/pre--tax earningstax earnings
Price/cash flowPrice/cash flow
Price/revenuesPrice/revenues
Price/dividend capacity orPrice/dividend capacity oryieldyield
Price/operating profitPrice/operating profit
Price/gross profitPrice/gross profit
Price/book valuePrice/book value
Price/EBITPrice/EBIT
Price/EBDITPrice/EBDIT
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Risk FactorsRisk Factors
Economic riskEconomic risk
Business riskBusiness risk
Operating risksOperating risks
Financial risksFinancial risksAsset risksAsset risks
Product risksProduct risks
Market risksMarket risks
Technological risksTechnological risksRegulatory risksRegulatory risks
Legal risksLegal risks
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Market ApproachMarket Approach
Step 1Step 1: Compute the average Price: Compute the average Price--Earnings (PEarnings (P--E) Ratio forE) Ratio foras many similar businesses as possible:as many similar businesses as possible:
Company PCompany P--E RatioE Ratio
11 3.33.3
22 3.83.8 Average PAverage P--E Ratio = 3.975E Ratio = 3.975
33 4.74.7
44 4.14.1
Step 2:Step 2: Multiply the average PMultiply the average P--E Ratio by next yearsE Ratio by next yearsforecasted earnings:forecasted earnings:
Estimated Value = 3.975 x 740000 =Estimated Value = 3.975 x 740000 = 29415002941500
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PRICE TO EARNINGS
After-tax earnings 959,446
Multiple x 6.20
Oper.Entity Value 5,948,565
Net Non-oper. Assets + 250,000
Total Entity Value 6,198,565
Rounded 6,200,000
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Market Approach ExampleMarket Approach Example
GUIDELINECO. DATE P/E P/S P/B
Apple Company, Inc. 12/31/95 8.70 55.30% 2.85
Bananas R Us, Inc. 10/31/95 9.30 47.43% 4.65
Fruits, Inc. 12/31/95 8.50 35.25% 3.65
Cherry Corp. 12/31/95 6.60 54.80% 3.90
Grapes Corp. 11/30/95 7.80 48.20% 4.25
Median Multiple 8.50 48.20% 3.90
Selected Multiple 6.20 44.00% 2.50
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Financial Statement AdjustmentsFinancial Statement AdjustmentsGAAP adjustmentsGAAP adjustments
NonNon--operating/nonoperating/non--recurringrecurring
adjustmentsadjustments
Discretionary adjustmentsDiscretionary adjustments
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Discretionary AdjustmentsDiscretionary Adjustments
Owner's compensationOwner's compensation
Owner's perquisitesOwner's perquisites
Entertainment expensesEntertainment expensesAutomobile expensesAutomobile expenses
Compensation to familyCompensation to familymembersmembers
Interest expenseInterest expense
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Discount and Capitalization RatesDiscount and Capitalization Rates
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Components of a Discount RateComponents of a Discount Rate
Risk free rate of returnRisk free rate of return
General or equity risk premiumGeneral or equity risk premium
Specific risk premiumSpecific risk premium
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Discount For Lack of MarketabilityDiscount For Lack of Marketability
Restricted StockRestricted Stock
IPO StudiesIPO Studies
Cost ofFloatationCost ofFloatation
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Valuing a going concernValuing a going concernThe capitalization of future maintainable earnings method is the mostThe capitalization of future maintainable earnings method is the most
common way of valuing an existing business in good ordercommon way of valuing an existing business in good order
Multiplying an estimate of future maintainableMultiplying an estimate of future maintainable
Valuing new businessesValuing new businesses
The discounted cash flowThe discounted cash flow method is usuallymethod is usually used to value new or immatureused to value new or immature
businesses or a businessbusinesses or a business
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5858
The Lack of Strategic Planning
Reasons for the Lack of Strategic Planning1. Time scarcity
2. Lack of knowledge
3. Lack of expertise/skills
4. Lack of trust and openness
5. Perception of high cost
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13135959
Figure13.3 The Entrepreneurial Strategy Matrix: Independent
Variables
Source: Matthew C. Sonfield and Robert N. Lussier, The Entrepreneurial Strategic Matrix: A Model forNew and Ongoing Ventures.
Reprinted with permission from Business Horizons, May/June 1997, by the trustees at Indiana University, Kelley School of Business.
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13136060
Figure13.4 The Entrepreneurial Strategy Matrix: Appropriate
Strategies
Source:Matthew C. Sonfield and Robert N. Lussier, The Entrepreneurial Strategic Matrix: A Model forNew and Ongoing Ventures.
Reprinted with permission from Business Horizons, May/June 1997, by the trustees at Indiana University, Kelley School of Business.
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13136161
Venture Development StagesVenture Development Stages
LifeLife--Cycle Stages of an EnterpriseCycle Stages of an Enterprise(Chandler)(Chandler)
1.1. Initial expansion and accumulation ofInitial expansion and accumulation of
resourcesresources2.2. Rationalization of the use of resourcesRationalization of the use of resources
3.3. Expansion into new markets to assure theExpansion into new markets to assure the
continued use of resourcescontinued use of resources4.4. Development of new structures to ensureDevelopment of new structures to ensure
continuing mobilization of resourcescontinuing mobilization of resources
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13136262
Figure13.5 A Ventures Typical Life Cycle
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6363
The Entrepreneurial CompanyThe Entrepreneurial Company
in the Twentyin the Twenty--F
irst CenturyF
irst Century Major Challenges:Major Challenges:
Building dynamic capabilities that areBuilding dynamic capabilities that are
differentiated from those of emergingdifferentiated from those of emergingcompetitorscompetitors
InternalInternalutilization of the creativity andutilization of the creativity and
knowledge from employeesknowledge from employees
ExternalExternalthe search for externalthe search for external
competencies to complement the firmscompetencies to complement the firms
existing capabilities.existing capabilities.
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13.6 The Entrepreneurial Mindset
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Table13.2 The Managerial versus the Entrepreneurial Mind-Set
Managerial Mind-SetE
ntrepreneurial Mind-Set
Decision-makingassumptions
The past is the best predictor of the future.Most business decisions can be quantified.
A new idea or an insight from a uniqueexperience is likely to provide the bestestimate of emerging trends.
Values
The best decisions are those based onquantitative analyses.Rigorous analyses are highly valued for
making critical decisions.
New insights and real-world experiencesare more highly valued than results basedon historical data.
BeliefsLaw of large numbers: Chaos anduncertainty can be resolved bysystematically analyzing the right data.
Law of small numbers: A single incident orseveral isolated incidents quickly becomepivotal for making decisions regardingfuture trends.
Approach to problems
Problems represent an unfortunate turn ofevents that threaten financial projections.
Problems must be resolved withsubstantiated analyses.
Problems represent an opportunity todetect emerging changes and possibly new
business opportunities.
Source: MikeWright, Robert E. Hoskisson, and LowellW. Busenitz, Firm Rebirth: Buyouts as
Facilitators of Strategic Growth and Entrepreneurship, Academy of Management Executive 15(1): 114.
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Building the Adaptive FirmBuilding the Adaptive Firm
An AdaptiveF
irmAn AdaptiveF
irm One that Increases opportunity for its employees, initiatesOne that Increases opportunity for its employees, initiates
change, and instills a desire to be innovative.change, and instills a desire to be innovative.
How to remain adaptive and innovative:How to remain adaptive and innovative:
Share the entrepreneurs visionShare the entrepreneurs vision
Increase the perception of opportunityIncrease the perception of opportunity Institutionalize change as the ventures goalInstitutionalize change as the ventures goal
Instill the desire to be innovative:Instill the desire to be innovative:
A reward systemA reward system
An environment that allows for failureAn environment that allows for failure
Flexible operationsFlexible operations
The development of ventureThe development of venture teamsteams
Flexibility, innovation, speed, strategic leadership are importantFlexibility, innovation, speed, strategic leadership are important
for growing businessfor growing business
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The Transition from an Entrepreneurial Style to aThe Transition from an Entrepreneurial Style to a
Managerial ApproachManagerial Approach
Impediments to Transition:Impediments to Transition:
A highly centralized decisionA highly centralized decision--making systemmaking system
An overdependence on one or two keyAn overdependence on one or two key
individuals,individuals,
An inadequate repertoire of managerial skillsAn inadequate repertoire of managerial skills
and trainingand training
A paternalistic atmosphereA paternalistic atmosphere
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Table13.3 The Entrepreneurial Culture versus the Administrative
Culture
Entrepreneurial Focus Administrative Focus
Characteristics Pressures Characteristics Pressures
StrategicOrientation
Driven byperception ofopportunity
Diminishing opportunitiesRapidly changing technology, consumereconomics, social values, and politicalrules
Planning systemsand cycles
Social contractsPerformance measurementcriteria
Commitmentto SeizeOpportunities
Revolutionary, withshort duration
Action orientationNarrow decision windows
Acceptance of reasonable risksFew decision constituencies
Evolutionary, withlong duration
Acknowledgement of multipleconstituenciesNegotiation about strategiccourseRisk reduction
Coordination with existingresource base
Commitmentof Resources
Many stages, withminimal exposureat each stage
Lack of predictable resource needsLack of control over the environmentSocial demands for appropriate use ofresourcesForeign competitionDemands for more efficient use
A single stage,with completecommitment out ofdecision
Need to reduce riskIncentive compensationTurnover in managersCapital budgeting systemsFormal planning systems
Control of
Resources
Episodic use orrent of requiredresources
Increased resource specializationLong resource life compared with needRisk of obsolescence
Risk inherent in the identified opportunityInflexibility of permanent commitment toresources
Ownership oremployment of
requiredresources
Power, status, and financialrewardsCoordination of activity
Efficiency measuresInertia and cost of changeIndustry structures
ManagementStructure
Flat, with multipleinformal networks
Coordination of key noncontrolledresourcesChallenge to hierarchyEmployees desire for independence
Hierarchy
Need for clearly definedauthority and responsibilityOrganizational cultureReward systemsManagement theory
Source:Reprinted by permission of the HarvardBusiness Review. An exhibit from The Heart of Entrepreneurship, by Howard H. Stevenson
and David E. Gumpert, March/April 1985,
89. Copyright 19
85 by the President and
Fellows of Harvard College; all rights reserved.
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Understanding the Growth StageUnderstanding the Growth Stage
KeyF
actors During the Growth StageKeyF
actors During the Growth Stage ControlControl
Does the control system imply trust?Does the control system imply trust?
Does the resource allocation system imply trust?Does the resource allocation system imply trust?
ResponsibilityResponsibility
Creating a sense of responsibility that establishes flexibility,Creating a sense of responsibility that establishes flexibility,innovation, and a supportive environment.innovation, and a supportive environment.
Tolerance of failureTolerance of failure
Moral failureMoral failure
Personal failurePersonal failure
Uncontrollable failureUncontrollable failure
ChangeChange
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Understanding the Growth StageUnderstanding the Growth Stage
Managing Paradox and ContradictionManaging Paradox and ContradictionBureaucratization versus decentralizationBureaucratization versus decentralization
Environment versus strategyEnvironment versus strategy
Strategic emphases: Quality versus costStrategic emphases: Quality versus costversus innovationversus innovation
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Confronting the GrowthWallConfronting the GrowthWall
Successful growthSuccessful growth--oriented firms have exhibitedoriented firms have exhibitedconsistent themes:consistent themes:
The entrepreneur is able to envision and anticipate the firm as aThe entrepreneur is able to envision and anticipate the firm as a
larger entity.larger entity.
The team needed for tomorrow is hired and developed today.The team needed for tomorrow is hired and developed today.
The original core vision of the firm is constantly and zealouslyThe original core vision of the firm is constantly and zealously
reinforced.reinforced.
BigBig--company processes are introduced gradually ascompany processes are introduced gradually as
supplements to, rather than replacements for, existingsupplements to, rather than replacements for, existing
approaches.approaches.
Hierarchy is minimized.Hierarchy is minimized.
Employees hold a financial stake in the firm.Employees hold a financial stake in the firm.
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Unique Managerial Concerns of Growing VenturesUnique Managerial Concerns of Growing Ventures
PressuresPressures-- p ip, donationp ip, donationCommunityCommunity
PressuresPressures-- participation, leadership, donationparticipation, leadership, donation
DistinctionDistinction
of Small Sizeof Small SizeOneOne--PersonPerson--BandBand
SyndromeSyndrome
asas tete
TimeTime
ManagementManagement--assess,assess, prioritise,procedures,delegateprioritise,procedures,delegate
GrowingGrowingVentureVentureGrowingGrowingVentureVenture
ContinuousContinuousLearningLearning
Th Hi h f B i O tTh Hi h f B i O t
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The Hierarchy of Business OutcomesThe Hierarchy of Business Outcomes
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Business life cycleBusiness life cycle
Several models, with sameSeveral models, with same general ideasgeneral ideas::
Multiple stagesMultiple stages
Key issues, lessons, and actions at each stageKey issues, lessons, and actions at each stage
Level of risk business faces changes from stage toLevel of risk business faces changes from stage to
stagestage
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1.1. EmergenceEmergence: person thinks and takes: person thinks and takes
action towards starting a firmaction towards starting a firm
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2.2. ExistenceExistence: having the business in: having the business in
operation, but not yet stableoperation, but not yet stable
Risk is highRisk is high
Owners lack key informationOwners lack key information
3.3. SuccessSuccess: develop information, skills,: develop information, skills,
and routines to grow the businessand routines to grow the business
profitsprofits This is a stage that lasts a long timeThis is a stage that lasts a long time
20-77
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4.4. Resource maturityResource maturity: stable level of: stable level of
sales and profitssales and profits
Functional areas, the market, andFunctional areas, the market, andthe products or services are beingthe products or services are being
dealt with consistently and efficientlydealt with consistently and efficiently
Challenge is to avoid complacencyChallenge is to avoid complacency
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3 key components3 key components to staving offto staving off
customer complacency:customer complacency: RecencyRecency: be among the people your: be among the people your
customers have seen in the last few dayscustomers have seen in the last few days
FrequencyFrequency: stay in touch with customers on: stay in touch with customers on
a frequent basis (visits, phone calls, emails,a frequent basis (visits, phone calls, emails,etc.)etc.)
PotencyPotency: be remembered for the right: be remembered for the right
reasonsreasons
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5.5. TakeoffTakeoff: a period of exceptional growth: a period of exceptional growth
Might come from landing an unexpectedlyMight come from landing an unexpectedly
gigantic contractgigantic contract,, expandingexpanding into multipleinto multiple
locations, or just being in thelocations, or just being in the right place atright place atthe right timethe right time
Most small businesses never go through theMost small businesses never go through the
taketake--off phaseoff phase
20-80
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Types ofFirmsTypes ofFirms
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Sales Growth:Sales Growth: comes from several wayscomes from several ways
Increasing sales to existing steady customersIncreasing sales to existing steady customers
Make occasional customers into steadyMake occasional customers into steady
customerscustomers
Expand areas where you have smallExpand areas where you have smallcustomer basecustomer base
Technological growth:Technological growth: can take two formscan take two forms
Use technology to Improve efficiencies andUse technology to Improve efficiencies and
profitsprofits
Use it to create new products or servicesUse it to create new products or services
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Closing the Small BusinessClosing the Small Business
Every year, nearly 4 million go through changesEvery year, nearly 4 million go through changes
in ownership and existencein ownership and existence
HarvestHarvest: get maximum value they can for the: get maximum value they can for thebusinessbusiness
Initial public offering (IPO)Initial public offering (IPO): selling stock to: selling stock to
public on major stock exchangepublic on major stock exchange
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484
Methods for Harvesting a BusinessMethods for Harvesting a Business
After value creationAfter value creation
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After value creationAfter value creation
Harvesting the BusinessHarvesting the Business
What is harvesting?What is harvesting?It is the sale of some or all of the equity of a company.It is the sale of some or all of the equity of a company.
A number of possible exit routes:A number of possible exit routes:1.1. A trade sale to another companyA trade sale to another company
2.2. The sale of the investment to another corporate investorThe sale of the investment to another corporate investor
such as a venture capitalistsuch as a venture capitalist
3.3. The sale of equity to another individualThe sale of equity to another individual such as asuch as a
business angel or a fellow shareholderbusiness angel or a fellow shareholder or throughor throughmanagement busymanagement busy--out or buyout or buy--inin
4.4. The sale of equity to the public through an IPO (initialThe sale of equity to the public through an IPO (initial
public offering) on a stock exchange.public offering) on a stock exchange.
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The Importance of the ExitThe Importance of the Exit
Harvesting (or Exiting)Harvesting (or Exiting)
The process used by entrepreneurs andThe process used by entrepreneurs and
investors to reap the value of a business wheninvestors to reap the value of a business when
they get out of it.they get out of it.
The process involves:The process involves:
Capturing value (cash value)Capturing value (cash value)
Reducing riskReducing risk
Creating future optionsCreating future options
Releasing the Firms CashReleasing the Firms Cash
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Releasing the Firm s CashReleasing the Firm s Cash
FlowsFlowsHarvesting by Withdrawing Firms CashHarvesting by Withdrawing Firms Cash
Advantages:Advantages:
Retain control of firm while harvesting investment.Retain control of firm while harvesting investment.
No need to seek a buyer or incur expensesNo need to seek a buyer or incur expenses
associated with sale of businessassociated with sale of business
DisadvantagesDisadvantages
Loss of development potential and opportunitiesLoss of development potential and opportunities
Tax disadvantages of cash withdrawalTax disadvantages of cash withdrawal
Requires patience to siphon off cash slowlyRequires patience to siphon off cash slowly
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Harvesting: Going PublicHarvesting: Going PublicInitial Public Offering (IPO)Initial Public Offering (IPO)
Benefits of the sale of shares of stock to theBenefits of the sale of shares of stock to the
public:public:
1.1. Signals to investors that a firm is a qualitySignals to investors that a firm is a quality
business and will likely perform well in the future.business and will likely perform well in the future.2.2. Provides access to more investors when the firmProvides access to more investors when the firm
needs to raise capital to grow the business.needs to raise capital to grow the business.
3.3. Helps create ongoing interest in the companyHelps create ongoing interest in the company
and its continued development.and its continued development.4.4. Makes firms stock more attractive as incentiveMakes firms stock more attractive as incentive
pay to key personnel.pay to key personnel.
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Harvesting: UHarvesting: Using Private Equitysing Private Equity
Private Equity (Capital)Private Equity (Capital)
Money provided by venture capitalists orMoney provided by venture capitalists or
private investors.private investors.
Factors in the Transfer ofFamilyFactors in the Transfer ofFamily--OwnedOwned
FirmsFirms
Liquidity for exiting family membersLiquidity for exiting family members
Continued financing for company growthContinued financing for company growthMaintenance of family control of the firmMaintenance of family control of the firm
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TransfersTransfers: ownership is moved from: ownership is moved from
one person or group to anotherone person or group to another
2003: around2003: around 860,000 firms860,000 firms werewere
transferred within the familytransferred within the family
NearlyNearly 1 million1 million business sales took placebusiness sales took place
Occur only among the largest smallOccur only among the largest small
businessesbusinesses
20-90
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TransfersTransfers::
One key goal is minimizing theOne key goal is minimizing the tax effectstax effects
of the transferof the transfer
Business can lose as much asBusiness can lose as much as halfhalfof itsof its
value to the governmentvalue to the government Pass offPass off: owner gives the firm to someone: owner gives the firm to someone
as a gift, without compensation; 38% useas a gift, without compensation; 38% use
thisthis
Sell offSell off: everything is sold to another: everything is sold to anotherbusiness, with proceeds paying offbusiness, with proceeds paying off
remaining debtsremaining debts
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TerminationsTerminations: more likely for young firms: more likely for young firms
1.8 million per year1.8 million per year
Three types of terminations:Three types of terminations:
WalkawaysWalkaways closing the firm and quickly paying offclosing the firm and quickly paying off
any debts.any debts.
WorkoutsWorkouts-- when the debt cant quickly be paid off,when the debt cant quickly be paid off,
but the owner can make arrangements to pay itbut the owner can make arrangements to pay it
off over timeoff over time
BankruptciesBankruptcies-- for the firm, the owner, or both.for the firm, the owner, or both.
This may happen if a lot of money was investedThis may happen if a lot of money was invested
and the company never hit the successful stageand the company never hit the successful stage
20-92
Selling the Firm: BuyersSelling the Firm: Buyers
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93
93
Selling the Firm: BuyersSelling the Firm: Buyers
Reasons for Purchasing a FirmReasons for Purchasing a FirmSales to EmployeesSales to Employees
Employee Stock Ownership Plan (ESOP)Employee Stock Ownership Plan (ESOP)
A method by which a firm is sold either in part or inA method by which a firm is sold either in part or in
total to its employees.total to its employees. Employees retirement contributions are used to purchaseEmployees retirement contributions are used to purchase
shares in the firm.shares in the firm.
Frequently is the exit method of last resort.Frequently is the exit method of last resort.
Motivates the employeeMotivates the employee--ownersowners
to perform.to perform.
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Harvesting the BusinessHarvesting the Business
For the entrepreneur or venture capitalist:For the entrepreneur or venture capitalist:
-- find the right time to sellfind the right time to sell
-- decide on the exit routedecide on the exit route
-- agree a price with the purchaseragree a price with the purchaser
However, in a private company, there may beHowever, in a private company, there may berestrictions on the ability to sell: e.g.restrictions on the ability to sell: e.g.
OwnerOwner--manager may be required to offer to the existingmanager may be required to offer to the existingshareholders (who cannot/will not buy)shareholders (who cannot/will not buy)
May only be a minority shareholder without power to sell the entireMay only be a minority shareholder without power to sell the entireventureventure
Minority shareholding may be worthless to potential buyer althoughMinority shareholding may be worthless to potential buyer althoughan agreed, and binding, exit mechanism with pricing formula mayan agreed, and binding, exit mechanism with pricing formula mayalready exist.already exist.
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Harvesting the BusinessHarvesting the Business
For the entrepreneur or venture capitalist:For the entrepreneur or venture capitalist:
-- find the right time to sellfind the right time to sell
-- decide on the exit routedecide on the exit route
-- agree a price with the purchaseragree a price with the purchaser
However, in a private company, there may beHowever, in a private company, there may berestrictions on the ability to sell: e.g.restrictions on the ability to sell: e.g.
OwnerOwner--manager may be required to offer to the existingmanager may be required to offer to the existingshareholders (who cannot/will not buy)shareholders (who cannot/will not buy)
May only be a minority shareholder without power to sell the entireMay only be a minority shareholder without power to sell the entireventureventure
Minority shareholding may be worthless to potential buyer althoughMinority shareholding may be worthless to potential buyer althoughan agreed, and binding, exit mechanism with pricing formula mayan agreed, and binding, exit mechanism with pricing formula mayalready exist.already exist.
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Harvesting the BusinessHarvesting the Business
Hence, questions for the entrepreneur:Hence, questions for the entrepreneur:
Do I wish to realize all or only part of my investment?Do I wish to realize all or only part of my investment?
Do I wish to continue to be associated with the company after theDo I wish to continue to be associated with the company after the
sale?sale?
What form of payment do I want from the saleWhat form of payment do I want from the sale equity in anotherequity in another
company, cash on deferred terms. A pension, a consultancy retainer?company, cash on deferred terms. A pension, a consultancy retainer?
Which exit route will give me the greatest returns?Which exit route will give me the greatest returns?
IfI decide to float, what will it cost and who will help me?IfI decide to float, what will it cost and who will help me?
IfI decide to seek a trade sale or sale to a third party, how do I find aIfI decide to seek a trade sale or sale to a third party, how do I find abuyer?buyer?
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The NotThe Not--SoSo--Secret Secrets of SuccessSecret Secrets of Success
Critical Success Factors (CSF):Critical Success Factors (CSF): processes,processes,
benchmarks, or components of the business that arebenchmarks, or components of the business that are
essential for the business to be profitable andessential for the business to be profitable andcompetitivecompetitive
Come from sources external to entrepreneursCome from sources external to entrepreneurs
Fall into two categoriesFall into two categories
Outside helpOutside helpEntrepreneurial experienceEntrepreneurial experience
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Entrepreneurial ExperienceEntrepreneurial Experience
Being incorporatedBeing incorporated: a lawyer is likely to give small: a lawyer is likely to give small
business owners advice and help them avoid some ofbusiness owners advice and help them avoid some of
the major pitfalls of a new firmthe major pitfalls of a new firm
EmployeesEmployees: get more done, appeal to a larger market,: get more done, appeal to a larger market,
source of expertisesource of expertise
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Entrepreneurial ExperienceEntrepreneurial Experience
Extreme startExtreme start--up capitalup capital: business starting with no start: business starting with no start--
up capital, and those starting with more than 50,000,up capital, and those starting with more than 50,000,
are among those most likely to survive long termare among those most likely to survive long termProtectable intellectual propertyProtectable intellectual property: patents or trademarks: patents or trademarks
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Entrepreneurial ExperienceEntrepreneurial Experience
Brand name affiliations or partnersBrand name affiliations or partners: have been: have been
checked out and found to be acceptablechecked out and found to be acceptable
Optimal strategiesOptimal strategies: picking and starting a business in: picking and starting a business in
a growing industrya growing industry
PresalesPresales: pilot test through contracts, orders, or: pilot test through contracts, orders, or
letters of interestletters of interest
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Measuring Success with Four BottomMeasuring Success with Four Bottom
LinesLines
The FirmThe Firm::
Define the level of profit that they seekDefine the level of profit that they seek
Leadership of the industryLeadership of the industry
Employee satisfaction and wellEmployee satisfaction and well--beingbeing
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CommunityCommunity: how the business relates: how the business relatesto the communityto the community
Community impactCommunity impact
Building trustBuilding trust Promoting a positive culturePromoting a positive culture
Enhancing flexibilityEnhancing flexibility
Fostering innovationFostering innovation
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FamilyFamily: spend the time with your family: spend the time with your family
Leave personal time to make the transitionLeave personal time to make the transition
from work to familyfrom work to family
Clear your work list and your mindClear your work list and your mindYourselfYourself: personal returns: personal returns
Variety of expectations, dreams, and goalsVariety of expectations, dreams, and goals
Keeping the dreams aliveKeeping the dreams alive
20-103
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