34 Social Security Secrets You Need to Know Now

Treasury employee Linda Tarkenton of Philadelphia holds a blank U.S. Treasury check before it's run through a printer at the U.S. Treasury printing facility. Photo by William Thomas Cain/Getty Images.

Update: July 31, 2:10 p.m. | Lawrence Kotlikoff has agreed to answer your questions about Social Security and retirement. Submit yours in the comments below.

FOM$* (and sometime tennis sparring partner) Larry Kotlikoff of Boston University is a noted economist, prolific author and frequent contributor to Bloomberg and Forbes.com, among other venues. We've featured him on this page before and will again. Today, we post a recent essay of his: "34 Social Security 'Secrets' All Baby Boomers and Millions of Current Recipients Need to Know."

Be forewarned that Larry is sometimes wrong but rarely in doubt. Know, however, that he has worked for many years to fine-tune retirement software -- ESPlanner -- that is widely considered the gold standard in the online world. We've long linked to the basic free version of ESPlanner from this page. Know also that Larry is my own personal social security advisor. His advice to apply for a dependent spousal benefit while my wife and I put off full retirement benefits until age 70 has been a boon, and so impressed the woman with whom I spoke at Social Security, that she thanked me for informing her of it and said she'd advise callers about this option henceforth. Note that many of Larry's "secrets" involve the dependent spouse benefit. Be advised that the folks at Social Security with whom I've dealt have been uniformly courteous, responsive and efficient.

Editor's Note | A version of this post originally ran July 3, 2012, on Forbes.com.

34 Social Security 'Secrets' All Baby Boomers and Millions of Current Recipients Need to Know

By Lawrence Kotlikoff

The Social Security Handbook has 2,728 separate rules governing its benefits. And it has thousands upon thousands of explanations of those rules in its Program Operating Manual System, called the POMS, which provides guidance on implementing the 2,728 rules. Talk about a user's nightmare!

As a young economist, I did a fair amount of academic research on saving and insurance adequacy. At the time, I thought I had a very good handle on the rules. Then I started a financial planning software company, which makes suggestions about what benefits to take from Social Security and when to take them to get the best overall deal. (See, in this regard, www.maximizemysocialsecurity.com and www.esplanner.com.)

At that point, I realized I needed to quadruple check my understanding of Social Security's provisions. To do this, I established contacts with experts at Social Security's Office of the Actuary. I also hired a specialist whose only job is to audit my company's Social Security, Medicare premium, and federal and state income tax code.

The problem with this strategy is you can only check on things you know about. Over the years, I discovered things I had never heard of. I would then check with the Social Security actuaries who would say, "Oh yes, that's covered in the POMS section GN 03101.073!"

Mind you, a large share of the rules in the Social Security Handbook are indecipherable to mortal men, and the POMS is often worse. But thanks to patience on the part of the actuaries, I've learned things that almost no current or prospective Social Security recipient knows, but which almost all should know.

The reason is that taking the right Social Security benefits at the right time can make a huge difference to a retiree's living standard.

Unfortunately, Social Security has some very nasty "gottcha" provisions, so if you take the wrong benefits at the wrong time, you can end up getting the wrong, as in smaller, benefits forever.

Also, the folks at the local Social Security offices routinely tell people things that aren't correct, including about what benefits they can and can't receive and when they can receive them. Taking Social Security benefits -- the right ones at the right time -- is one of the biggest financial decisions you'll ever make, so you need to get it right.

Getting it right on your own, however, is neigh impossible. One of my engineers and I calculated that for an age-62 couple there are over 100 million combinations of months for each of the two spouses to take retirement benefits, spousal benefits and decided whether or not to file and suspend one's retirement benefits. There are also start-stop-start strategies to consider. Each combination needs to be considered to figure out what choices will produce the highest benefits when valued in the present (measured in present value). For some couples who are very different in age, survivor benefits also come into play. In that case, the number of combinations can exceed 10 billion!

Fortunately, www.maximizemysocialsecurity.com can help you find the right answer generally within a matter of seconds. It does exhaustive searches of all combinations of months in which you can take actions, but thanks to modern computing power and careful programming, our Maximize My Social Security program can run through millions upon millions of combinations of decisions incredibly fast.

Whether or not you use our software, it's important to have as full a handle on Social Security's provisions as possible. Listed below are 34 things I've learned over the years that you may not fully know. (The list started at 25, but I've been learning some new secrets and recalling some others.)

1. If you are already collecting your retirement benefit and are at or over full retirement age, you can tell Social Security you want to suspend further benefits and then ask them to restart your benefits at a later date, say age 70. Social Security will then apply its Delayed Retirement Credit to your existing benefit once you start collecting again. Hence, this is a means by which current Social Security recipients who aren't yet 70 can collect higher benefits, albeit at the cost of giving up their check for a while. But this trade off will, on net, often be very advantageous. For example, if you started collecting at 62 and are now at your full retirement age, i.e., 66, you can suspend benefits until 70 and then start collecting 32 percent higher benefits for the rest of your life. This benefit collection strategy can be called Start Stop Start. We are in the process of rolling out a new update of www.maximizemysocialsecurity.com, which incorporates Start Stop Start.
2. If you aren't now collecting and wait until 70 to collect your retirement benefit, your retirement benefit starting at 70 can be as much as 76 percent higher than your age-62 retirement benefit, adjusted for inflation. The reason is that your benefit is not reduced due to Social Security's Early Retirement Reduction; moreover, it's increased due to Social Security's Delayed Retirement Credit. For many people, the increase in the retirement benefit can be even higher if they continue to earn money after age 62 thanks to Social Security's Re-computation of Benefits.
3. But if you are married or divorced, waiting to collect your retirement benefit may be the wrong move. If you are the low-earning spouse, it may be better to take your retirement benefit starting at age 62 and then switch to the spousal benefit you can collect on your current or ex-spouse's account starting at your full retirement age. But beware of the Gottcha in item 5.
4. If you're married, you or your spouse, but not both, can receive spousal benefits after reaching full retirement age while deferring taking your retirement benefits and, thereby, letting them grow. This may require having one spouse file for retirement benefits, but suspend their collection. This is called the File and Suspend strategy.
5. Be careful! If you take your own retirement benefit early and are below full retirement age, you will be forced to take your spousal benefit early and at a permanently reduced level if your spouse collects his/her his/her retirement benefit before or in the month in which you apply to collect your retirement benefit. If your spouse is not collecting a retirement benefit when you apply for an early retirement benefit, you will not be deemed to be applying for your spousal benefit. Hence, you can start collecting your spousal benefit later. (See item 33)
6. Start Stop Start may also make sense for married workers who aren't already collecting and whose age differences are such they they can't take advantage of File and Suspend. Take, for example, a 62 year-old high earner, named Sally, with a 66-year old low earner spouse, named Joe. By starting retirement benefits early, Sally permits Joe to start collecting a spousal benefit immediately. The reason is that spouses aren't eligible to collect spousal benefits unless the worker is either collecting a retirement benefit or has filed for a retirement benefit, but suspended its collection. If Sally starts her retirement benefit at 62, Joe can apply just for his spousal benefit at 66 and then wait until 70 to collect his own retirement benefit, which will be at its highest possible value thanks to Social Security's Delayed Retirement Credit. As for Sally, she can suspend her retirement benefit at 66, when she reaches full retirement, and then restart it at 70, at which point her benefits will be 32 percent higher than what she was collecting. Even singles workers may opt for Start Stop Start to help with their cash flow problems.
7. If your primary insurance amount (your retirement benefit available if you wait until full retirement) is less than half that of your spouse and you take your own retirement benefit early, but are able to wait until full retirement age to collect your spousal benefit, your total check, for the rest of your life, will be less than one half of your spouse's primary insurance amount. Nonetheless, this may still be the best strategy. This reflects another Gotcha explained in 8.
8. On its website, Social Security states, "your spouse can receive a benefit equal to one-half of your full retirement benefit amount if they start receiving benefits at their full retirement age." This is true only if your spouse isn't collecting his/her own retirement benefit. If your spouse is collecting her own retirement benefit, his/her spousal benefit is calculated differently. Rather than equaling one half of your full retirement benefit, it's calculated as half of your full retirement benefit less your spouse's full retirement benefit. This difference is called the excess spousal benefit. The total benefit your spouse will receive is her retirement benefit, inclusive of any reduction, due to taking benefits early, or increment, due to taking benefits late, plus the excess spousal benefit. The excess spousal benefit can't be negative; i.e., its smallest value is zero.
   
   Take Sue and Sam. Suppose they are both 62 and a) Sue opts to take her retirement benefit early and b) Sam opts to file and suspend at full retirement and take his retirement benefit at 70. Between ages 62 and 66 (their full retirement age), Sue collects a reduced retirement benefit, but is not forced to take her spousal benefit (which would be reduced) because Sam isn't collecting a retirement benefit during the years that Sue is 62 to 66. Now when Sue reaches age 66, she starts to collect an unreduced spousal benefit because Sam has qualified her to do so by filing and suspending for his retirement benefit. OK, but her unreduced spousal benefit is calculated as 1/2 x Sam's full retirement benefit less Sue's full retirement benefit. Sue ends up getting a total benefit equal to her own reduced retirement benefit plus her unreduced excess spousal benefit. This total is less than half of Sam's full retirement benefit. To see this note that the total equals half of Sam's full retirement benefit plus Sue's reduced retirement benefit minus Sue's full retirement benefit. The last two terms add to something negative.
9. Are there are two different formulas for spousal benefits depending on whether the spouse is collecting his/her own retirement benefit? It sure seems that way because when the spouse is collecting a retirement benefit, the excess spousal benefit (potentially reduced for taking spousal benefits early) comes into play. And when the spouse isn't collecting a retirement benefit, the spousal benefit equals half of the worker's full retirement benefit. (Note, the spouse has to collect a retirement benefit before full retirement age if she applies for her spousal benefit.) The answer, in fact, is no. There is only one formula. The formula for the spousal benefit is always the excess benefit formula. But here's what happens to the application of that formula if the spouse is not collecting a retirement benefit. In that case, the spouse's full retirement benefit (also called the Primary Insurance Amount) is set to zero in calculating the excess spousal benefit. The reason, according to Social Security, is that a worker's Primary Insurance does not exist (i.e., equals zero) if the worker has not applied for a retirement benefit (and either suspended its collection or started to receive it). In other words, your Primary Insurance Amount is viewed as non-existant until you apply for a retirement benefit. This construct - the primary insurance amount doesn't exist until it's triggered by a retirement benefit application -- lets Social Security claim to have one formula for spousal benefits. But there are, in effect, two spousal benefit formulas and which one you -- the person who will collect a spousal benefit -- faces will depend on whether or not you take your retirement benefit early.
10. If you are divorced, both you and your ex can collect spousal benefits (on each others work histories) after full retirement age while still postponing taking your own retirement benefits until, say, age 70, when they are as high as can be. This is an advantage for divorcees. But there's also a disadvantage. A divorcee who applies for spousal benefits before full retirement age will automatically be forced to apply for retirement benefits even if her/his ex isn't collecting retirement benefits.
11. There is no advantage to waiting to start collecting spousal benefits after you reach your full retirement age.
12. There is no advantage to waiting to start collecting survivor benefits after you reach your full retirement age.
13. If you started collecting Social Security retirement benefits within the last year and decide it wasn't the right move, you can repay all the benefits received, including spousal and child benefits, and reapply for potentially higher benefits at a future date.
14. If you wait to collect your retirement benefit after you reach your full retirement age, but before you hit age 70, you have to wait until the next January to see your full delayed retirement credit show up in your monthly check.
15. Millions of Baby Boomers can significantly raise their retirement benefits by continuing to work in their sixties. This may also significantly raise the spousal, child, and mother and father benefits their relatives collect.
16. If you take retirement, spousal, or widow/widower benefits early and lose some or all of them because of Social Security's earnings test, Social Security will actuarially increase your benefits (under the Adjustment of Reduction Factor) starting at your full retirement age based on the number of months of benefits you forfeited. This is true whether the loss in benefits due to the earnings test reflects benefits based on your own work record or based on your spouse's work record. Consequently, you should not be too concerned about working too much and losing your benefits if you elected to take them early.
17. When it comes to possibly paying federal income taxes on your Social Security benefits, withdrawals from Roth IRAs aren't counted, but withdrawals from 401(k), 403(b), regular IRAs, and other tax-deferred accounts are. So there may be a significant advantage in a) withdrawing from your tax-deferred accounts after you retire, but before you start collecting Social Security, b) using up your tax-deferred accounts before you withdraw from your Roth accounts, and c) converting your tax-deferred accounts to Roth IRA holdings after or even before you retire, but before you start collecting Social Security.
18. Social Security's online benefit calculators either don't handle or don't adequately handle spousal, divorcee, child, mother, father, widow or widower benefits, or file and suspend options.
19. The default assumptions used in Social Security's online retirement benefit calculators is that the economy will experience no economy-wide real wage growth and no inflation going forward. This produces benefit estimates that can, for younger people, be significantly less than what they are most likely to receive.
20. Some widows/widowers may do better taking their survivor benefits starting at 60 and their retirement benefits at or after full retirement. Others may do better taking their retirement benefits starting at 62 and taking their widow/widowers benefits starting at full retirement age.
21. If you're below full retirement age and are collecting a spousal benefit and your spouse is below full retirement age and is collecting a retirement benefit, your spousal benefit can be reduced if your spouse earns beyond the Earnings Test's exempt amount. And it can also be reduced if you earn beyond the Earnings Test's exempt amount.
22. The Windfall Elimination Provision affects how the amount of your retirement or disability benefit is calculated if you receive a pension from work where Social Security taxes were not taken out of your pay, such as a government agency or an employer in another country, and you also worked in other jobs long enough to qualify for a Social Security retirement or disability benefit. A modified formula is used to calculate your benefit amount, resulting in a lower Social Security benefit than you otherwise would receive.
23. Based on the Government Pension Offset provision, if you receive a pension from a federal, state or local government based on work where you did not pay Social Security taxes, your Social Security spouse's or widow's or widower's benefits may be reduced.
24. If you have children, because you started having children late or adopted young children later in life, they can collect child benefits through and including age 17 (or age 19 if they are still in secondary school) if you or your spouse or you ex spouse are collecting retirement benefits.
25. If you have children who are eligible to collect benefits because your spouse or ex spouse is collecting retirement benefits, you can collect mother or father benefits until your child reaches age 16.
26. Your children can receive survivor benefits if your spouse or ex-spouse died and they are under age 18 (or age 19 if they are still in secondary school).
27. You can collect mother or father benefits if you spouse or ex-spouse died and you have children of your spouse or your ex-spouse who are under age 16.
28. There is a maximum family benefit that applies to the total benefits to you, your spouse, and your children that can be received on your earnings record.
29. If you choose to file and suspend in order to enable your spouse to collect a spousal benefit on your earnings record while you delay taking your benefit in order to collect a higher one later, make sure you pay your Medicare Part B premiums out of your own pocket (i.e., you need to send Social Security a check each month). If you don't, Social Security will pay it for you and treat you as waving (i.e., not suspending) your benefit apart from the premium and, get this, you won't get the Delayed Retirement Credit applied to your benefit. In other words, if you don't pay the Part B premiums directly, your benefit when you ask for it in the future will be NO LARGER than when you suspended its receipt. This is a really nasty Gotcha, which I just learned, by accident, from one of Social Security's top actuaries.
30. If you are collecting a disability benefit and your spouse tries to collect just his/her Social Security benefit early, she will be deemed to be filing for her spousal benefits as well. I.e., if your spouse takes his/her retirement benefit early, he/she won't be able to delay taking a spousal benefit early, which means both her retirement and spousal benefits will be permanently reduced thanks to the early retirement benefit and early spousal benefit reduction factors.
31. When inflation is low, like it is now, there is a disadvantage to delaying until, say 70, collecting one's retirement benefit. The disadvantage arises with respect to Medicare Part B premiums. If you collecting benefits (actually were collecting them last year), the increase in the Medicare premium this year will be limited to the increase in your Social Security check. This is referred to as being "held harmless." Hence, when inflation is low, the increase in your check due to the cost of living adjustment will be small, meaning the increase in your Medicare Part B premium will be limited. But, if you aren't collecting a benefit because you are waiting to collect a higher benefit later, tough noogies. You're Medicare Part B premium increase won't be limited. And that increase will be locked into every future year's Medicare Part B premium that you have to pay. You can wait to join Medicare until, say, age 70, but if you aren't working for a large employer, the premiums you'll pay starting at 70 will be higher and stay higher forever. So much for helping the government limit its Medicare spending!
32. Hold harmless -- the provision that your increase in Medicare Part B premium cannot exceed the increase in your Social Security check due to Social Security's Cost of Living Adjustment -- does not apply if you have high income and are paying income-related Medicare Part B premiums.
33. The thresholds beyond which first 50 percent and then 85 percent of your Social Security benefits are subject to federal income taxation are explicitly NOT indexed for inflation. Hence, eventually all Social Security recipients will be tax on 85 percent of their Social Security benefits.
34. If you take your retirement benefit early and your spouse takes his/her retirement benefit any time that is a month or more after you take your retirement benefit, you will NOT be deemed, at that point (when your spouse starts collecting his/her retirement benefit) to be applying for a spousal benefit. In other words, you can, in this situation, wait until your full retirement age to start collecting your unreduced excess spousal benefit. The retirement benefit collection status of your spouse in the month you file for early retirement benefits determines whether you are deemed to be also be applying for spousal benefits. This means that you should think twice about applying for retirement benefits in the same month as your spouse if one or both of you are applying early.

-* Friend of Making Sen$e.

This entry is cross-posted on the Rundown- NewsHour's blog of news and insight. 

Consumer Guide to Buying a Franchise

Franchising can give you instant recognition of your business and the ability to obtain ongoing support from your franchiser, but be careful: Purchasing a franchise does not guarantee success.

Before you decide to become a franchisee, read this guide to become an expert on what your business will entail. The guide covers the following topics:

• Before investing in a franchise
• Selecting a franchise
• Investing in a franchise

Before Investing in a Franchise

The decision to purchase a franchise involves many factors. To help you explore if franchising is right for you, we've provided a list of important questions to answer.

Do you know how much you can invest?

Buying a franchise requires capital. Determine how much you can realistically afford.

• How much money do you have to invest?
• How much money can you afford to lose?
• Will you purchase the franchise by yourself or with partners?
• Will you need financing and, if so, where can you obtain it?
• Do you have a favorable credit rating?
• Do you have savings or additional income to live on while starting your franchise?

What are your abilities?

Consider the skills you will need for the franchise you are interested in.

• Does the franchise require technical experience or relevant education, such as auto repair, home and office decorating, or tax preparation?
• What skills do you have? Do you have computer, bookkeeping, or other technical skills?
• What specialized knowledge or talents can you bring to a business?
• Have you ever owned or managed a business?

What are your goals?

Think about the purpose of franchising and what you want out of this business experience.

• What are your goals?
• Do you require a specific level of annual income?
• Are you interested in pursuing a particular field?
• Are you interested in retail sales or performing a service?
• How many hours are you willing to work?
• Do you want to operate the business yourself or hire a manager?
• Will franchise ownership be your primary source of income or will it supplement your current income?
• Would you be happy operating the business for the next 20 years?
• Would you like to own several outlets or only one?

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Selecting a Franchise

Once you know how much you are willing to invest in your franchise, and your interests and capabilities, you're ready to explore what type of franchise is suitable for you. Don't just select the first franchise that fits your needs. This is an important decision that is life changing, so shop around. Here is just a brief list of the ways you can explore opportunities that are available.

Shop at a Franchise Exposition

Attending a franchise exposition allows you to view and compare a variety of franchise possibilities. Keep in mind that exhibitors at the exposition primarily want to sell their franchise systems. Be cautious of salespersons who are interested in selling a franchise that you are not interested in. When talking to franchise exhibitors, ask the following questions:

• How long has the franchiser been in business?
• How many franchised outlets currently exist?
• Where are they located?
• How much is the initial franchise fee and what are the additional startup costs? Are there any continuing royalty payments, and if yes, how much are they?
• What management, technical, and ongoing assistance does the franchiser offer?
• What controls does the franchiser impose?

Get the Facts about the Franchise

If you have a franchise in mind, do your homework by researching the business and what is involved.

• Get a written substantiation of any income projections, or income or profit claims. This is required by the Federal Trade Commission (FTC) when a franchisor tells you can earn from investing in their franchise. If they do not have one or refuse to provide you with this information, they may have made a false claim.
• Take notes and get contact information from the franchisor so you can contact them at a later date with more questions.
• If there are any offers from the franchiser, investigate the franchise first. Ask previous/current investors about their experiences. Remember that an attorney needs to review the offer, and a disclosure document must be provided. You will learn more about what the disclosure document tells you in the next section.

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Investing in a Franchise: Look into the Disclosure Document

Before investing in any franchise system, be sure to get a copy of the franchiser's disclosure document, also known as the Franchise Offering Circular. Under the FTC's Franchise Rule, you must receive the document at least 10 business days before you are asked to sign any contract or pay any money to the franchiser. You should read the entire disclosure document and make sure you understand all of the provisions. The following topics will help you to understand key provisions of a typical disclosure document as well as to ask questions about the disclosure. Get a clarification or answers to your concerns before you invest.

Business Background

The disclosure document identifies the executives of the franchise system and describes their prior experience. Consider not only their general business background, but their experience in managing a franchise system. Also consider how long they have been with the company. Investing with an inexperienced franchiser may be riskier than investing with an experienced one.

Litigation History

The disclosure document helps you assess the background of the franchiser and its executives by requiring the disclosure of prior litigation. The disclosure document tells you if the franchiser or any of its executive officers:

• Have been convicted of felonies, for example, fraud
• Have been convicted of any violation of franchise law
• Have been convicted of unfair or deceptive law practices
• Are subject to any state or federal injunctions involving similar misconduct

It also will tell you if the franchiser or any of its executives have been held liable or settled a civil action involving the franchise relationship.

A number of claims against the franchiser may indicate that the company has not performed according to its agreements, or, at the very least, that franchisees have been dissatisfied with the franchiser's performance. Be aware that some franchisers may try to conceal an executive's litigation history by removing the individual's name from their disclosure documents.

Bankruptcy

The disclosure document tells you if the franchiser or any of its executives have recently been involved in a bankruptcy. This will help you to assess the franchiser's financial stability and general business acumen as well as predict if the company is financially capable of delivering promised support services.

Costs

The disclosure document tells you the costs involved to start one of the company's franchises. It will describe any initial deposit or franchise fee, which may be nonrefundable, and costs for initial inventory, signs, equipment, leases or rentals. Be aware that there may be other undisclosed costs. Use the following checklist to help inquire about potential costs to you as a franchisee.

• Continuing royalty payments
• Advertising payments, both to local and national advertising funds
• Grand opening or other initial business promotions
• Business or operating licenses
• Product or service supply costs
• Real estate and leasehold improvements
• Discretionary equipment such as a computer system or business alarm system
• Training
• Legal fees
• Financial and accounting advice
• Insurance
• Compliance with local ordinances, such as zoning, waste removal, and fire and other safety codes
• Health insurance
• Employee salaries and benefits

It may take several months or longer to get your business started. Consider in your total cost estimate for operating expenses for the first year and personal living expenses for up to two years. Compare your estimates with what other franchisees and competing franchise systems have paid. Perhaps you can get a better deal with another franchiser. An accountant can help you to evaluate this information.

Restrictions

Your franchiser may restrict how you operate your outlet. The disclosure document tells you if the franchiser limits:

• The supplier(s) of goods that you may purchase from
• The goods or services you may offer for sale
• The customers to whom you can offer goods or services
• The territory in which you can sell goods or services

Understand that restrictions may limit the way you want to do your business.

Terminations

The disclosure document tells you the conditions under which the franchiser may terminate your franchise and your obligations to the franchiser after termination. It also tells you the conditions under which you can renew, sell or assign your franchise to other parties.

Training and Other Assistance

The disclosure document will explain the franchiser's training and assistance program. Make sure you understand the level of training offered. The following checklist will help you ask the right questions.

• How many employees are eligible for training?
• Can new employees receive training and, if so, is there any additional costs?
• How long are the training sessions?
• How much time is spent on technical, business management and marketing training?
• Who teaches the training courses and what are their qualifications?
• What type of ongoing training does the company offer and at what cost?
• Whom can you speak to if problems arise?
• How many support personnel are assigned to your area?
• How many franchisees will the support personnel service?
• Will someone be available to come to your franchised outlet to provide more individual assistance?

The level of training you need depends on your own business experience and knowledge of the franchiser's goods and services. Keep in mind that a primary reason for investing in the franchise, as opposed to starting your own business, is training and assistance. If you have doubts that the training might be insufficient to teach you how to handle day-to-day business operations, consider another franchise opportunity more suited to your background.

Advertising

You often must contribute a percentage of your income to an advertising fund even if you disagree with how these funds are used. The disclosure document provides information on advertising costs. The checklist below will help you assess whether the franchiser's advertising will benefit you.

• How much of the advertising fund is spent on administrative costs?
• Are there other expenses paid from the advertising fund?
• Do franchisees have any control over how the advertising dollars are spent?
• What advertising promotions has the company engaged in?
• What advertising developments are expected in the near future?
• How much of the fund is spent on national advertising?
• How much of the fund is spent on advertising in your area?
• How much of the fund is spent on selling more franchises?
• Do all franchisees contribute equally to the advertising fund?
• Do you need the franchiser's consent to conduct your own advertising?
• Are there rebates or advertising contribution discounts if you conduct your own advertising?
• Does the franchiser receive any commissions or rebates when it places advertisements?
• Do franchisees benefit from such commissions or rebates, or does the franchiser profit from them?

Current and Former Franchisees

The disclosure document provides important information about current and former franchisees.

• Determine how many franchises are currently operating (a large number of franchisees in your area may mean increased competition)
• Pay attention to the number of terminated franchisees (a large number of terminated, canceled, or non-renewed franchises may indicate problems)

Be aware that some companies may try to conceal the number of failed franchisees by repurchasing failed outlets and then listing them as company-owned outlets. If you buy an existing outlet, ask the franchiser how many owners operated that outlet and over what period of time.

Having a number of different owners over a short period of time may indicate that the location is not a profitable one or that the franchiser has not supported that outlet with promised services.

Use the following questions to help you ask current and former franchisees for valuable information.

• How long has the franchisee operated the franchise?
• Where is the franchise located?
• What was their total investment?
• Were there any hidden or unexpected costs?
• How long did it take them to cover operating costs and earn a reasonable income?
• Are they satisfied with the cost, delivery, and quality of the goods or services sold?
• What were their backgrounds prior to becoming a franchisee?
• Was the franchiser's training adequate?
• What ongoing assistance does the franchiser provide?
• Are they satisfied with the franchiser's advertising program?
• Does the franchiser fulfill its contractual obligations?
• Would the franchisee invest in another outlet?
• Would the franchisee recommend the investment to someone with your goals, income requirements, and background?

Be aware that some franchisers may give you a separate reference list of selected franchisees to contact. Be careful. Those on the list may be individuals who are paid by the franchiser to give a good opinion of the company.

Earnings Potential

You will want to know how much money you can make if you invest in a particular franchise system. Be careful; earnings projections can be misleading. Insist upon written substantiation for any earnings projections or suggestions about your potential income or sales.

Franchisers are not required to make earnings claims, but if they do, the FTC's Franchise Rule requires franchisers to have a reasonable basis for these claims and to provide you with a document that substantiates them. This substantiation includes the bases and assumptions upon which these claims are made. Make sure you get and review the earnings claims document. Consider the following when reviewing any earnings claims.

• Sample Size. A franchiser may claim that franchisees in its system earned, for example, $50,000 last year. This claim may be deceptive, however, if only a few franchisees earned that income and it does not represent the typical earnings of franchisees. Ask how many franchisees were included in the number.
• Average Incomes. A franchiser may claim that the franchisees in its system earn an average income of, for example, $75,000 a year. Average figures like this tell you very little about how each individual franchisee performs. Remember, a few very successful franchisees can inflate the average. An average figure may make the overall franchise system look more successful than it actually is.
• Gross Sales. Some franchisers provide figures for the gross sales revenues of their franchisees. These figures, however, do not tell you anything about the franchisees' actual costs or profits. An outlet with a high gross sales revenue on paper actually may be losing money because of high overhead, rent and other expenses.
• Net Profits. Franchisers often do not have data on the net profits of their franchisees. If you do receive net profit statements, ask whether they provide information about company-owned outlets. Company-owned outlets might have lower costs because they can buy equipment, inventory and other items in larger quantities, or may own, rather than lease, their property.
• Geographic Relevance. Earnings may vary in different parts of the country. An ice cream store franchise in a southern state, such as Florida, may expect to earn more income than a similar franchise in a northern state, such as Minnesota. If you hear that a franchisee earned a particular income, ask where that franchisee is located.
• Franchisee's Background. Keep in mind that franchisees have varying levels of skills and educational backgrounds. Franchisees with advanced technical or business backgrounds can succeed in instances where more typical franchisees cannot. The success of some franchisees is no guarantee that you will be equally successful.

Financial History

The disclosure document provides you with important information about the company's financial status, including audited financial statements. Be aware that investing in a financially unstable franchiser is a significant risk; the company may go out of business or into bankruptcy after you have invested your money.

Hire a lawyer or an accountant to review the franchiser's financial statements. Do not attempt to extract this important information from the disclosure document unless you have considerable background in these matters. Your lawyer or accountant can help you understand the following.

• Does the franchiser have steady growth?
• Does the franchiser have a growth plan?
• Does the franchiser make most of its income from the sale of franchises or from continuing royalties?
• Does the franchiser devote sufficient funds to support its franchise system?

You can also find more advice on how to avoid costly pitfalls before buying a franchise at the Federal Trade Commission's Consumer Guide to Buying a Franchise.

Starting vs. Buying a Business
Each path has its own set of advantages and disadvantages

By The BizQuest Staff

Every year thousands of people consider entrepreneurship. The two primary routes people use are starting their own business or buying an existing one. Each path to business ownership has a variety of advantages and disadvantages that the would-be entrepreneur should consider.

Starting a Business
Starting your own business can be very rewarding, but generally requires an idea or concept that revolves around a unique product, technology, or marketing plan. Developing a business idea from scratch will usually involve less up front costs compared to buying a business, and can frequently be tested from a home or small office. You also won't have to pay someone for goodwill. Keep in mind though that researching a new business idea is extremely important because frequently, ideas that seem to make initial sense do not after a detailed investigation. There may be little or no demand for the product or service, or competition may be so fierce that a profit cannot be made. Thorough research should tap as many resources as possible, such as the Small Business Administration, other business owners, the Internet, your local library, and relevant trade associations.

There are usually a number of disadvantages to starting your own business. You will need to attract customers, which can involve quite a bit of time and effort. Because there may be months or even years of few, if any, profits from the business, you may need to support yourself with personal savings. Financing a new business can also be very difficult. Most people rely on their family, friends, and personal funds to get them through the rough times until profitability. Another important factor to consider is the risk. The chances of survival for a start up business are very low. Some surveys indicate up to a 75% failure rate.

Buying a Business
Buying a business can be a more effective way to business ownership, but is frequently more costly. Existing business owners will expect you to pay a premium for providing you with an existing customer base and location. In addition, there can be contingent liabilities associated with buying an existing business, although structuring the transaction as an asset purchase can usually protect you from these liabilities.

The advantages to buying an existing business typically outweigh the disadvantages. Existing businesses can usually obtain financing from financial institutions because they have an established history, assets, and a proven idea. Or, the seller of the business will provide a portion of the financing in the form of a loan. Established businesses are less risky because there is an existing customer base, relationships with suppliers, operating processes, a known location, and employees have already been hired and trained. In addition, there is existing cash flow which will likely provide some immediate income to the buyer.

Experts generally agree that, in most cases, paying the extra cost for an existing business will outweigh the risks of starting one from scratch

How to Buy a Business

Starting from scratch isn't the only way to get started. Buying an existing business can help you hit the ground running. Here's what you need to know to find a great deal.

September 6, 2005

URL: http://www.entrepreneur.com/article/79638

When most people think of starting a business, they think of beginning from scratch--developing your own ideas and building the company from the ground up. But starting from scratch presents some distinct disadvantages, including the difficulty of building a customer base, marketing the new business, hiring employees and establishing cash flow...all without a track record or reputation to go on.

Buying an Existing Business
In most cases, buying an existing business is less risky than starting from scratch. When you buy a business, you take over an operation that's already generating cash flow and profits. You have an established customer base, reputation and employees who are familiar with all aspects of the business. And you don't have to reinvent the wheel--setting up new procedures, systems and policies--since a successful formula for running the business has already been put in place.

On the downside, buying a business is often more costly than starting from scratch. However, it's easier to get financing to buy an existing business than to start a new one. Bankers and investors generally feel more comfortable dealing with a business that already has a proven track record. In addition, buying a business may give you valuable legal rights, such as patents or copyrights, which can prove very profitable. Of course, there's no such thing as a sure thing--and buying an existing business is no exception. If you're not careful, you could get stuck with obsolete inventory, uncooperative employees or outdated distribution methods. To make sure you get the best deal when buying an existing business, be sure to follow these steps.

The Right Choice
Buying the perfect business starts with choosing the right type of business for you. The best place to start is by looking at an industry with which you're both familiar and which you understand. Think long and hard about the types of businesses you're interested in and which best match your skills and experience. Also consider the size of business you are looking for, in terms of employees, number of locations and sales. Next, pinpoint the geographical area where you want to own a business. Assess labor pool and costs of doing business in that area, including wages and taxes, to make sure they're acceptable to you. Once you've chosen a region and an industry to focus on, investigate every business in the area that meets your requirements. Start by looking in the local newspaper's classified section under "Business Opportunities" or "Businesses for Sale". You can also run your own "Want to Buy" ad describing what you are looking for. Remember, just because a business isn't listed doesn't mean it isn't for sale. Talk to business owners in the industry; many of them might not have their businesses up for sale but would consider selling if you made them an offer. Put your networking abilities and business contacts to use, and you're likely to hear of other businesses that might be good prospects.

Contacting a business broker is another way to find businesses for sale. Most brokers are hired by sellers to find buyers and help negotiate deals. If you hire a broker, he or she will charge you a commission--typically 5 to 10 percent of the purchase price. The assistance brokers can offer, especially for first-time buyers, is often worth the cost. However, if you are really trying to save money, consider hiring a broker only when you are near the final negotiating phase. Brokers can offer assistance in several ways.

• Prescreening businesses for you. Good brokers turn down many of the businesses they are asked to sell, whether because the seller won't provide full financial disclosures or because the business is overpriced. Going through a broker helps you avoid these bad risks.
• Helping you pinpoint your interest. A good broker starts by finding out about your skills and interests, then helps you select the right business for you. With the help of a broker, you may discover that an industry you had never considered is the ideal one for you.
• Negotiating. The negotiating process is really when brokers earn their keep. They help both parties stay focused on the ultimate goal and smooth over any problems that may arise.
• Assisting with paperwork. Brokers know the latest laws and regulations affecting everything from licenses and permits to financing and escrow. They also know the most efficient ways to cut through red tape, which can slash months off the purchase process. Working with a broker reduces the risk that you'll neglect some crucial form, fee or step in the process.

A Closer LookWhether you use a broker or go it alone, you will definitely want to put together an "acquisition team"--your banker, accountant and attorney--to help you. These advisors are essential to what is called "due diligence", which means reviewing and verifying all the relevant information about the business you are considering. When due diligence is done, you will know just what you are buying and from whom. The preliminary analysis starts with some basic questions. Why is this business for sale? What is the general perception of the industry and the particular business, and what is the outlook for the future? Does--or can--the business control enough market share to stay profitable? Are raw materials needed in abundant supply? How have the company's product or service lines changed over time?

You also need to assess the company's reputation and the strength of its business relationships. Talk to existing customers, suppliers and vendors about their relationships with the business. Contact the Better Business Bureau, industry associations and licensing and credit-reporting agencies to make sure there are no complaints against the business.

If the business still looks promising after your preliminary analysis, your acquisition team should start examining the business's potential returns and its asking price. Whatever method you use to determine the fair market price of the business, your assessment of the business's value should take into account such issues as the business's financial health, its earnings history and its growth potential, as well as its intangible assets (for example, brand name and market position).

To get an idea of the company's anticipated returns and future financial needs, ask the business owner and/or accountants to show you projected financial statements. Balance sheets, income statements, cash flow statements, footnotes and tax returns for the past three years are all key indicators of a business's health. These documents will help you conduct a financial analysis that will spotlight any underlying problems and also provide a closer look at a wide range of less tangible information.

25 Things to Consider

Following is a checklist of items you should evaluate to verify the value of a business before making a decision to buy:

1. Inventory. Refers to all products and materials inventoried for resale or use in servicing a client. Important note: You or a qualified representative should be present during any examination of inventory. You should know the status of inventory, what's on hand at present, and what was on hand at the end of the last fiscal year and the one preceding that. You should also have the inventory appraised. After all, this is a hard asset and you need to know what dollar value to assign it. Also, check the inventory for salability. How old is it? What is its quality? What condition is it in? Keep in mind that you don't have to accept the value of this inventory: it is subject to negotiation. If you feel it is not in line with what you would like to sell, or if it is not compatible with your target market, then by all means bring those points up in negotiations.

2. Furniture, fixtures, equipment and building. This includes all products, office equipment and assets of the business. Get a list from the seller that includes the name and model number of each piece of equipment. Then determine its present condition, market value when purchased versus present market value, and whether the equipment was purchased or leased. Find out how much the seller has invested in leasehold improvements and maintenance in order to keep the facility in good condition. Determine what modifications you'll have to make to the building or layout in order for it to suit your needs.

3. Copies of all contracts and legal documents. Contracts would include all lease and purchase agreements, distribution agreements, subcontractor agreements, sales contracts, union contracts, employment agreements and any other instruments used to legally bind the business. Also, evaluate all other legal documents such as fictitious business name statements, articles of incorporation, registered trademarks, copyrights, patents, etc. If you're considering a business with valuable intellectual property, have an attorney evaluate it. In the case of a real-estate lease, you need to find out if it is transferable, how long it runs, its terms, and if the landlord needs to give his or her permission for assignment of the lease.

4. Incorporation. If the company is a corporation, check to see what state it's registered in and whether it's operating as a foreign corporation within its own state.

5. Tax returns for the past five years. Many small business owners make use of the business for personal needs. They may buy products they personally use and charge them to the business or take vacations using company funds, go to trade shows with their spouses, etc. You have to use your analytical skills and those of your accountant, to determine what the actual financial net worth of the company is.

6. Financial statements for the past five years. Evaluate these statements, including all books and financial records, and compare them to their tax returns. This is especially important for determining the earning power of the business. The sales and operating ratios should be examined with the help of an accountant familiar with the type of business you are considering. The operating ratios should also be compared against industry ratios which can be found in annual reports produced by Robert Morris & Associates as well as Dun & Bradstreet.

7. Sales records. Although sales will be logged in the financial statements, you should also evaluate the monthly sales records for the past 36 months or more. Break sales down by product categories if several products are involved, as well as by cash and credit sales. This is a valuable indicator of current business activity and provides some understanding of cycles that the business may go through. Compare the industry norms of seasonal patterns with what you see in the business. Also, obtain the sales figures of the 10 largest accounts for the past 12 months. If the seller doesn't want to release his or her largest accounts by name, it's fine to assign them a code. You're only interested in the sales pattern.

8. Complete list of liabilities. Consult an independent attorney and accountant to examine the list of liabilities to determine potential costs and legal ramifications. Find out if the owner has used assets such as capital equipment or accounts receivable as collateral to secure short-term loans, if there are liens by creditors against assets, lawsuits, or other claims. Your accountant should also check for unrecorded liabilities such as employee benefit claims, out-of-court settlements being paid off, etc.

9. All accounts receivable. Break them down by 30 days, 60 days, 90 days and beyond. Checking the age of receivables is important because the longer the period they are outstanding, the lower the value of the account. You should also make a list of the top 10 accounts and check their creditworthiness. If the clientele is creditworthy and the majority of the accounts are outstanding beyond 60 days, a stricter credit collections policy may speed up the collection of receivables.

10. All accounts payable. Like accounts receivable, accounts payable should be broken down by 30 days, 60 days, and 90 days. This is important in determining how well cash flows through the company. On payables more than 90 days old, you should check to see if any creditors have placed a lien on the company's assets.

11. Debt disclosure. This includes all outstanding notes, loans and any other debt to which the business has agreed. See, too, if there are any business investments on the books that may have taken place outside of the normal area. Look at the level of loans to customers as well.

12. Merchandise returns. Does the business have a high rate of returns? Has it gone up in the past year? If so, can you isolate the reasons for returns and correct the problem(s)?

13. Customer patterns. If this is the type of business that can track customers, you will want to know specific characteristics concerning current customers, such as: How many are first-time buyers? How many customers were lost over the past year? When are the peak buying seasons for current customers? What type of merchandise is the most popular?

14. Marketing strategies. How does the owner obtain customers? Does he or she offer discounts, advertise aggressively, or conduct public-relations campaigns? You should get copies of all sales literature to see the kind of image that is being projected by the business. When you look at the literature, pretend that you are a customer being solicited by the company. How does it make you feel? This can give you some idea of how the company is perceived by its market.

15. Advertising costs. Analyze advertising costs. It is often better for a business to postpone profit at year-end until the next year by spending a lot of money on advertising during the last month of the fiscal year.

16. Price checks. Evaluate current price lists and discount schedules for all products, the date of the last price increase, and the percentage of increase. You might even go back and look at the previous price increase to see what percentage it was and determine when you are likely to be able to raise prices. Here again, compare what you see in the business you are looking at, with standards in the industry.

17. Industry and market history. You should analyze the industry as well as the specific market segments of the business targets. You need to find out if sales in the industry, as well as in the market segment, have been growing, declining, or have remained stagnant. This is very important to determine future profit potential.

18. Location and market area. Evaluate the location of the business and the market area surrounding it. This is especially important to retailers, who draw the majority of their business from the primary trading area. You should conduct a thorough analysis of the business's location and the trading areas surrounding the location including economic outlook, demographics and competition. For service businesses, get a map of the area covered by the business. Find out, based on the locations of various accounts, if there are any special requirements for delivering the product, or any transportation difficulties encountered by the business in getting the product to market.

19. Reputation of the business. The image of the business in the eyes of customers and suppliers is extremely important. As we mentioned, the image of the business can be an asset, or a liability. Interview customers, suppliers and the bank, as well as the owners of other businesses in the area, to determine the reputation of the business.

20. Seller-customer ties. You must find out if any customers are related or have any special ties to the present owner of the business. How long has any such account been with the company? What percentage of the company's business is accounted for by this particular customer or set of customers? Will this customer continue to purchase from the company if the ownership changes?

21. Inflated salaries. Some salaries may be inflated or perhaps the current owner may have a relative on the payroll who isn't working for the company. All of these possibilities should be analyzed.

22. List of current employees and organizational chart. Current employees can be a valuable asset, especially key personnel. Evaluate the organizational chart to understand who is responsible to whom. You must also look at the management practices of the company and know the wages of all employees and their length of employment. Examine any management-employee contracts that exist aside from a union agreement, as well as details of employee benefit plans; profit-sharing; health, life and accident insurance; vacation policies; and any employee-related lawsuits against the company.

23. OSHA requirements. Find out if the facility meets all occupational safety and health requirements and whether it has been inspected. If you feel that the seller is "hedging" on this and you see some things you feel might not be safe on the premises, you can ask the Occupational Safety and Health Administration (OSHA) to help you with an inspection. As a prospective buyer of a business that may come under OSHA scrutiny, you need to be certain that you are not buying an unsafe business. Some sellers may perceive your asking for OSHA's help as a dirty trick. But you must realize that as a prospective, serious buyer, you need to protect your position.

24. Insurance. Establish what type of insurance coverage is held for the operation of the business and all of its properties as well as who the underwriter and local company representative is, and how much the premiums are. Some businesses are underinsured and operating under potentially disastrous situations in case of fire or a major catastrophe. If you come into an underinsured operation, you could be wiped out if a major loss occurs.

25. Product liability. Product liability insurance is of particular interest if you're purchasing a manufacturing company. Insurance coverage can change dramatically from year to year, and this can markedly affect the cash flow of a company.

Determining a Fair Price

No decision is more emotionally charged than deciding upon a price for an existing business. The owner has one idea of how much the business is worth, while the buyer will typically have another viewpoint. Each party is dealing from a different perspective and usually the one who is best prepared will have the most leverage when the process enters the negotiating stage.

Keep in mind that most sellers determine the price for their business arbitrarily or through a special formula that may apply to that industry only. Either way, there usually aren't very many solid facts upon which to base their decisions.

Price is a very hard element to pin down and, therefore, is for the buyer to assess. There are a few factors that will influence price, such as economic conditions. Usually, businesses sell for a higher price when the economy is expanding, and for a much lower price during recessions. Motivation also plays an important factor. How badly does the seller want out? If the seller has many personal financial problems, you may be able to buy the business at a discount rate by playing the waiting game. On the other hand, you should never let the seller know how badly you want to buy the business. This can affect the price you pay adversely.

Beyond these factors, you can determine the value of a business using several different methods discussed below.

Multipliers
Simply put, some owners gauge the value of their business by using a multiplier of either the monthly gross sales, monthly gross sales plus inventory, or after-tax profits. While the multiplier formula may seem complex and quite accurate to begin with, if you delve a little deeper and look at the components used to arrive at the stated value, there is actually very little to substantiate the arrived at price.

Most of the multipliers aren't based on fact. For example, individuals within a specific industry may claim that certain businesses sell at three times their annual gross sales, or two times their annual gross sales plus inventory. Depending on which formula the owner uses, the gross sales are multiplied by the appropriate number, and a price is generated.

For instance, if the business was earning $100,000 a year and the seller was using a formula in which the multiple of gross sales was 30 percent based on industry averages, then he or she would generate a price using the following equation:

100,000 x .30 = $30,000

Of course, you can check the monthly sales figure by looking at the income statement, but is the multiplier an accurate number? After all, it has been determined arbitrarily. There usually hasn't been a formal survey performed and verified by an outside source to arrive at these multipliers.

In addition, even if the multiplier was accurate, there is such a large spread between the low and high ends of the range that it really just serves as a ballpark figure. This is true whether a sales or profit multiplier is used. In the case of a profit multiplier, the figure generated becomes even more skewed because businesses rarely show a profit due to tax reasons. Therefore, the resulting value of the business is either very small or the owner has to use a different profit factor to arrive at a higher price.

Don't place too much faith in multipliers. If you run across a seller using the multiplier method, use the price only as an estimate and nothing more.

Book Values This is a fairly accurate way to determine the price of a business, but you have to exercise caution using this method. To arrive at a price based on the book value, all you have to do is find out what the difference is between the assets and liabilities of a company to arrive at its net worth. This has usually been done already on the balance sheet. The net worth is then multiplied by one or two to arrive at the book value.

This might seem simple enough. To check the number, all you have to do is list the company's assets and liabilities. Determine their value, arrive at the net worth, and then multiply that by the appropriate number.

Assets usually include any unsold inventory, leasehold improvements, fixtures, equipment, real estate, accounts receivable, and supplies. Liabilities can be anything. They might even include the business itself. Usually, though, you want to list any unpaid debts, uncollected taxes, liens, judgments, lawsuits, bad investments--anything that will create a cash drain upon the business.

Now here is where it gets tricky. In the balance sheet, fixed assets are usually listed by their depreciated value, not their replacement value. Therefore, there really isn't a true cost associated with the fixed assets. That can create very inconsistent values. If the assets have been depreciated over the years to a level of zero, there isn't anything on which to base a book value.

Return on Investment
The most common means of judging any business is by its return on investment (ROI), or the amount of money the buyer will realize from the business in profit after debt service and taxes. However, don't confuse ROI with profit. They are not the same thing. ROI is the amount of the business. Profit is a yardstick by which the performance of the business is measured.

Typically, a small business should return anywhere between 15 and 30 percent on investment. This is the average net in after-tax dollars. Depreciation, which is a device of tax planning and cash flow, should not be counted in the net because it should be set aside to replace equipment. Many novice business owners will look at a financial statement and say, "There's $5,000 we can take off for depreciation." Well, there's a reason for a depreciation schedule. Eventually equipment does wear out and must be replaced, and it sometimes has to be replaced much sooner than you expect. This is especially true when considering a business with older equipment.

The wisdom of buying a business lies in its potential to earn money on the money you put into it. You determine the value of that business by evaluating how much money you are going to earn on your investment. The business should have the ability to pay for itself. If it can do this and give you a return on your cash investment of 15 percent or more, then you have a good business. This is what determines the price. If the seller is financing the purchase of the business, your operating statement should have a payment schedule that can be taken out of the income of the business to pay for it.

Does a 15-percent net for a business seem high? Everybody wants to know if a business makes two, three, or 10 times profit. They hear price-earning ratios tossed around, and forget that such ratios commonly refer to companies listed on the stock exchange. In small business, such ratios have limited value. A big business can earn 10 percent on its investment and be extremely healthy. The big supermarkets net two or three percent on their sales, but this small percentage represents enormous volume.

Small businesses are different. The small business should typically earn a bigger return because the risk of the enterprise is higher. The important thing for you, as a buyer of a small business, is to realize that regardless of industry practices for big business, it's the ROI that you need to worry about most. Is it realistic? If the price is realistic for the amount of money you have to invest, then you can consider it a viable business.

Capitalized Earnings Valuing a business based on capitalized earnings is similar to the return-on-investment method of assessment, except normal earnings are used to estimate projected earnings, which are then divided by a standard capitalization rate. So what is a standard capitalization rate?

The capitalization rate is determined by learning what the risk of investment in the business would be in comparison to other investments such as government bonds or stock in other companies. For instance, if the rate of return on investment in government bonds is 18 percent, then the business should provide a return of 18 percent or better on the investment into it. To determine the value of a business based on capitalized earnings, use the following formula:

Projected Earnings x Capitalization Rate = Price

So, after analyzing the market, the competition, the demand for the product, and the organization of the business, you determine that projected earning could increase to $25,000 per year for the next three years. If your capitalization rate is 18 percent, then the value of the business would be:

$25,000 / .18 = $138,888

Generally, a good capitalization rate for buyouts will range between 20 to 40 percent. If the seller is asking much more than what you've determined the capitalized earnings to be, then you will have to try and negotiate a lower price.

Intangible Value
Some business owners try to sell goodwill as an asset. Normally, in everyday accounting procedures, most companies put down perhaps one dollar as the value of goodwill. There is no doubt that goodwill has value, particularly if the business has built up a regular trade and a strong base of accounts. But it is the financial value of the accounts, not their psychological value, that should be placed on any financial statements.

Goodwill as such is not an asset. You as a buyer would assess the business based on the return on investment. Certain rules of the game may change when you enter the fields of acquisition and merger. Suppose you buy out your competition, merge all your facilities, and double your volume. Now the labor and overhead factors are much lower. Thus, even if the seller was losing perhaps 5 percent a year, if you bring them into your company, which is making 15 percent a year, it might allow you to increase sales and end up making 20 percent.

The Art of the Deal

Deciding on a price, however, is just the first step in negotiating the sale. More important is how the deal is structured. David H. Troob, chairman of Geneva Companies, a national mergers and acquisitions services firm, suggests that you should be ready to pay 30 to 50 percent of the price in cash, and finance the remaining amount.

You can finance through a traditional lender, or sellers may agree to "hold a not," which means they accept payments over a period of time, just as a lender would. Many sellers like this method because it assures them of future income. Other sellers may agree to different terms--for example, accepting benefits such as a company car for a period of time after the deal is completed. These methods can cut down the amount of upfront cash you need; Troob advises, however, that you should always have an attorney review any arrangements for legality and liability issues.

An individual purchasing a business has two options for structuring the deal (assuming the transaction is not a merger). The first is asset acquisition, in which you purchase only those assets you want. On the plus side, asset acquisition protects you from unwanted legal liabilities since instead of buying the corporation (and all its legal risks), you are buying only its assets.

On the downside, an asset acquisition can be very expensive. The asset-by-asset purchasing process is complicated and also opens the possibility that the seller may raise the price of desirable assets to off-set losses from undesirable ones.

The other option is stock acquisition, in which you purchase stock. Among other things, this means you must be willing to purchase all the business assets--and assume all its liabilities.

The final purchase contract should be structured with the help of your acquisition team to reflect very precisely your understanding and intentions regarding the purchase from a financial, tax and legal standpoint. The contract must be all-inclusive and should allow you to rescind the deal if you find at any time that the owner intentionally misrepresented the company or failed to report essential information. It's also a good idea to include a no compete clause in the contract to ensure the seller doesn't open a competing operation down the street.

Remember, you have the option to walk away from a negotiation at any point in the process if you don't like the way things are going. "If you don't like the deal, don't buy," says Troob. "Just because you spent a month looking at something doesn't mean you have to buy it. You have no obligation."

Alternatives to Cash Short on cash? Try these alternatives for financing your purchase of an existing business:

• Use the seller's assets. As soon as you buy the business, you'll own the assets--so why not use them to get financing now? Make a list of all the assets you're buying (along with any attached liabilities), and use it to approach banks, finance companies and factors (companies that buy accounts receivable).
• Buy co-op. If you can't afford the business yourself, try going co-op--buying with someone else that is. To find a likely co-op buyer, ask the seller for a list of people who were interested in the business but didn't have enough money to buy. (Be sure to have your lawyer write up a partnership agreement, including a buyout clause, before entering into any partnership arrangement.)
• Use an Employee Stock Ownership Plan (ESOP). ESOPs offer you a way to get capital immediately by selling stock in the business to employees. If you sell only non-voting shares of stock, you still retain control. By offering to set up an ESOP plan, you may be able to get a business for as little as 10 percent of the purchase price.
• Lease with an option to buy. Some sellers will let you lease a business with an option to buy. You make a down payment, become a minority stockholder and operate the business is if it were your own.
• Assume liabilities or decline receivables. Reduce the sales price by either assuming the business's liabilities or having the seller keep the receivables.

Common Mistakes to Avoid

Don't be too anxious when you're looking to buy a business. As we've mentioned already, if you're too anxious, this can affect the price.

Tremendous mistakes are made by people who are anxious. Business consultants called in by anxious buyers can sometimes salvage the situation, but oftentimes consultants are not called until a deal has been closed. And once your signature goes on that dotted line, you're stuck with the purchase. So keep in mind that anxiety or impatience isn't going to help you buy a business. Take your time. Recognize that there's always time to reflect on the business that's for sale. No matter what a business broker, a business seller, or any other person may tell you, there's always time. Nine times out of 10, the business that's up for sale is going to be around for awhile. And if it's not, then it's the seller who is going to be the anxious one; and the seller's anxiety, of course, is something that can be manipulated to your advantage as buyer.

Some of the more common mistakes are:

• Buying on price. Buyers don't take into account ROI. If you're going to invest $20,000 in a business that returns a five-percent net, you're better off putting your money in stocks and commodities, the local S&L, or municipal bonds. Any type of intangible security is going to produce more than five percent.
• Cash shortage. Some buyers use all their cash for the down payment on the business, though cash management in the startup phase of any business, new or existing, is fundamental to short-term success. They fail to predict future cash flow and possible contingencies that might require more capital. Further, there has to be some revenue set aside for building the business via marketing and PR efforts. So, if you have $20,000 to invest, make sure you don't invest the entire amount. Keep some of the capital. Though figures vary from industry to industry, a common contingency is 10 percent. Additionally, you may want to set aside a sum that you regard as your working capital, which in a number of businesses is enough to cover about three months' worth of expenses.
• Buying all the receivables. It generally makes good sense to buy the receivables, except when they are 90 or 120 days old, or older. Too often buyers take on all the receivables, even those beyond 90 days. This can be very risky because the older the account, the more difficult it'll be to collect against. You can protect yourself by having the seller warrant the receivables; what's not collectible can be charged back against the purchase price of the business. For receivables beyond 90 days, give those to the owner, and see if he or she can collect.
• Failure to verify all data. Most business buyers accept all the information and data given to them by the seller at face value, without the verification of their own accountant (preferably a CPA, who can audit financial statements). Most sellers want to get their cash out of the business as soon as possible, and buyers frequently allow them to take all the quick assets such as receivables, cash, and equipment inventories, and sometimes bring in equipment. The seller talks the buyer into virtually anything, knowing that the buyer wants the business badly.
• Heavy payment schedules. Novice business owners often overestimate their revenue during the first year and take on unduly large payments to finance the buyout. Generally, however, revenue rarely pans out. During the first year of any operation, the owner experiences numerous non-recurring costs such as equipment failures, employee turnover, etc. For this reason, it makes sense to have a payment schedule that begins fairly light, then gets progressively heavier. This is something that can be negotiated with a seller and should not be difficult to arrange.
• Treating the seller unfairly. People think that, because they are buying a business, the seller is at their mercy. All too often, the buyer will be cold, rigid and hard-headed. Sellers with savvy will throw such people out and tell them not to come back. Just because you have some money and may be interested in purchasing the business, that doesn't meant that you aren't going to have to give a little in the process of negotiation.

Transition Time
The transition to new ownership is a big change for employees of a small business. To ensure a smooth transition, start the process before the deal is done. Make sure the owner feels good about what is going to happen to the business after he or she leaves. Spend some time talking to key employees, customers and suppliers before you take over; tell them about your plans and ideas for the business's future. Getting these key players involved and on your side makes running the business a lot easier.

Most sellers will help you in a transition period during which they train you in operating the business. This period can range from a few weeks to six months or longer. After the one-on-one training period, many sellers will agree to be available for phone consultation for another period of time. Make sure you and the seller agree on how this training will be handled, and write it into your contract.

If you buy the business lock, stock and barrel, simply putting your name on the door and running it as before, your transition is likely to be fairly smooth. On the other hand, if you buy only part of the business's assets, such as its client list or employees, then make a lot of changes in how things are done, you'll probably face a more difficult transition period.

Many new business owners have unrealistically high expectations that they can immediately make a business more profitable. Of course, you need a positive attitude to run a successful business, but if your attitude is "I'm better than you," you'll soon face resentment from the employees you've acquired.

Instead, look at the employees as valuable assets. Initially, they'll know far more about the business than you will; use that knowledge to get yourself up to speed, and treat them with respect and appreciation. Employees inevitably will feel worried about job security when a new owner takes over. That uncertainty is multiplied if you don't tell them what your plans are. Many new bosses are so eager to start running the show, they slash staff, change prices or make other radical changes without giving employees any warning. Involve the staff in your planning, and keep communication open so they know what is happening at all times. Taking on an existing business isn't always easy, but with a little patience, honesty and hard work, you'll soon be running things like a pro.

This how-to was excerpted from Start Your Own Business and Entrepreneur Magazine's Small Business Encyclopedia.