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Buying and Selling a Business

Buying and Selling Private, Closely Held Businesses

Buying or selling a business is a complex process. Legal, tax, accounting, valuation and psychology issues are all involved. This seminar and this outline only introduce certain basic matters to you. Do not think that you can rely on this outline (or any other resource material) and go it alone. You need help from a lawyer, an accountant and if necessary, a business broker and an appraiser, all of whom must have experience in mergers and acquisitions. FINDING A BUSINESS FOR SALE / FINDING A BUYING FOR YOUR BUSINESS To find a partner, you can use a combination of the following approaches: Talk to People in the Business. You should talk to people in the industry on a constant basis. This is a particularly good way to find win-win mergers. Accountants, Attorneys and Bankers. Frequently a business owner will tell his accountant, attorney or banker of his desire to sell the business, long before making any formal attempt at sale. The accountant, attorney or banker can then introduce possible matches. Advertisements. Check out the business opportunities section of your local newspaper or trade journal. Brokers. Business brokers and realtors are possible contacts. A good business broker can be invaluable. But keep in mind: *The broker takes a fee out of the sales price (up to 10%). *Buyer beware. From buyer’s perspective, the broker’s fee means that (i) seller might increase the sales price to cover the broker’s fee, and (ii) even though buyer may have contacted the broker, the broker will still try to drive up the price. *Seller beware. Seller must be very careful when agreeing to the broker’s terms for representation. Review the contract carefully concerning the broker’s fee, and pay special attention to sliding scale fees. Watch out for administration and other fees. Be sure that you can fire the broker after 1–3 months. NON-DISCLOSURE AGREEMENT Early in the process, seller should require that buyer sign a non-disclosure agreement to protect seller’s confidential information. TIMING Most small deals take around 3 months. You will need 1 month for initial negotiations and to get to the letter of intent, 3 weeks for due diligence, then 1 month to close. Sellers usually want to speed up the process, while buyers like to slow it down. LETTER OF INTENT When buyer has identified a target and has agreed to basic terms with seller, the parties may consider entering into a letter of intent. The letter of intent should not be a binding agreement. It should only confirm the basic deal terms, and obligate seller to (i) cooperate with buyer in its due diligence, and (ii) not accept other offers for a stated period of time. DUE DILIGENCE An open, orderly and professional due diligence benefits both sides. A buyer performs due diligence to understand the business that it will buy. Seller prepares for buyer’s due diligence to mitigate (but not to hide) any problems that can reduce the purchase price. It is very important that seller determine the levels and timing of information and access that it will give to buyer. What Should Buyer Look For? First, buyer must understand what makes the business tick, and concentrate on that (whatever it is). In general, a due diligence review should focus on the following: **Why? The first question is, why is the business for sale? Seller should have a good answer, e.g. retirement or a shareholder dispute. **Goodwill and Client Base. Goodwill is seller’s (good) reputation. Buyer should be sure that seller’s goodwill and client base are not tied to personal relationships (which will vanish if seller leaves the company). Do additional due diligence on key clients and suppliers. **Employee Base. Buyer should make sure that all key employees come along, and that it can terminate unwanted employees. **Financial and Tax Review. Buyer should insist that seller produce the business’ (i) financial and business records, (ii) income tax and employment tax returns, and (iii) sales tax returns for the past few years. These documents will shed light on whether the business is and can be profitable. Both sides should use accountants. Buyer should consider having Seller sign IRS Form 2848D to authorize IRS to send tax information regarding Seller directly to Buyer. This will protect Buyer from phony tax returns. Buyer also should be wary of employee / independent contractor misclassification, because such misclassification can lead to a hefty tax bill. **Assets; Leases; Accounts. Buyer should (i) review and inspect all tangible and intangible assets including IP; (ii) review all leases and other contracts (including for third party consent requirements); and (iii) get an aging of accounts receivable. **Liabilities. Buyer should check for liens, unpaid back taxes, current and potential lawsuits, unpaid bills, unfunded pension liability, unpaid vacation liability, and environmental issues. **Capitalization. For a stock sale, buyer should make sure that it will receive clean title to a majority (if not 100%) of the company’s stock. Buyer will need to know of all outstanding securities for seller, and the existence of any disputes concerning such securities. **Government Issues. Buyer should check into any problems that seller may have with the government, e.g. zoning or environmental cleanup. VALUATION Most private companies are valued using the discounted cash flow method, with comparable transactions used as a reference point. Seller should hire a professional appraiser early on in the process to put a value on the company. A bare bones appraisal will cost around $5,000. PURCHASE PRICE The purchase price should take taxes into account, because it is your after-tax (not pre-tax) purchase price that counts. This is one of the reasons why the legal structure of a deal is so important. After fixing a purchase price, the next question is how will buyer pay it? Buyer (and seller if it takes a deferred purchase price) must be sure that financing the acquisition will not dangerously reduce buyer’s liquidity. FORM OF PUCHASE PRICE You have 4 choices: cash up-front, a promissory note, stock in the buyer or an earn-out. From the seller’s perspective, cash is king. When a seller accepts a promissory note, stock in buyer or an earn-out, seller essentially becomes an investor in buyer. THE TRANSACTION Even though you may have settled on a purchase price, negotiations are not over. The structure of the transaction and the purchase agreement directly affect the bottom line risks and after-tax price of the deal. Structure Rule of thumb: buyers buy assets and sellers sell stock. **Stock Sales. Here buyer purchases the stock of seller’s shareholders. Each shareholder makes its own decision whether or not to sell. Buyer assumes all liabilities of the company. Buyer gets a carry-over basis in seller’s assets (usually lower than a stepped-up basis). Seller’s shareholders pay taxes on the appreciation in their shares (with no double-tax). For these reasons, sellers prefer stock sales. **Asset Sales Here buyer purchases seller’s assets, and assumes only those liabilities that it agrees to assume. Seller’s company remains liable for its obligations. Seller dividends up to its shareholders the proceeds of the sale. This causes the double tax problem — seller’s company pays taxes on the asset sale, then its shareholders pay taxes on the dividend to them (exception for pass-through entities). Buyer gets a stepped-up basis in seller’s assets (consisting of the purchase price plus assumed liabilities plus transaction expenses). For these reasons, buyers prefer asset sales. **Mergers. Although there are different forms of mergers, the end result is that buyer will convert the stock owned by seller’s shareholders into the consideration given for the merger. For more on mergers and acquisitions, see Business Mergers **Tax-Free Reorganizations. The basic concept of a tax-free reorganization is that buyer pays the purchase price by using buyer’s own securities as consideration. The transaction frequently looks like an exchange of stock between buyer and seller. The transaction is tax free, except for any “boot” received by seller’s shareholders. Representations Seller will make extensive representations about its affairs. This allows buyer to recover back some of the purchase price if any of the representations is materially misleading, for example, seller did not disclose certain liabilities. Representations are not a substitute for due diligence, but they do provide additional security. Holdbacks Buyer should try to holdback a portion of the purchase price, in case seller has made false representations. Holdbacks can be structured as a promissory note, an escrow or an earn-out (which is a purchase price that is paid over time based on the company’s post-closing performance). Post-Closing Adjustments Sometimes the parties agree that buyer may adjust the purchase price before or after the closing. Buyer usually makes adjustments based on an accounting and inventory that it performs after it takes over the business, or for the gap period between the signing of the sale agreement and closing. NON-COMPETITION AGREEMENTS Buyer should receive non-competition agreements from seller. Otherwise, buyer is at risk that seller will set up a competing shop across the street. EMPLOYMENT AGREEMENTS Buyer should receive employment agreements from the key employees of the company that buyer wishes to retain. PSYCHOLOGY Ego drives deals. Be sensitive to your own and the other side’s psychology. For more on mergers and acquisitions, see Business Mergers, and Valuation Issues in Buying and Selling a Business.

How to Avoid Successor Liability When Buying a Business

In this article, I explain how to avoid successor liability when buying a business. It’s a nasty surprise to discover, after you’ve paid the purchase price for the business, that you must pay the seller’s debts and liabilities from before the closing. RULE OF THUMB: BUYER ASSUMES LIABILITIES IN A STOCK DEAL, NOT AN ASSET DEAL The structure of the purchase initially determines whether the buyer will assume the liabilities of the seller. As a rule of thumb, the buyer assumes liabilities in a stock deal, but not an asset deal. ** In a stock deal, you buy the stock of the target corporation. The corporation does not change, other than getting you as the new owner. The corporation and all its assets and liabilities remain in place. This means the corporation keeps all liabilities that it had before you purchased it. In sum, you become the shareholder of the target corporation, which keeps its assets and liabilities in place. ** In an asset deal, your shell corporation buys the assets of the target company, and your shell only assume the liabilities and debts that you want. The buyer can pick and choose among the assets and liabilities of the seller. Hence you do not buy the target corporation; instead your shell corporation buys its assets, but leaves unwanted liabilities behind in the target company. After the deal, the seller still owns the target corporation, which keeps its debts and liabilities. Most deals are structured as asset purchases to avoid the automatic assumption of unwanted debt. You only do a stock deal if you need the target company itself. For example, the target company might have contracts that you can’t get assigned over to your shell corporation, or you need its tax ID number. WHEN BUYERS AUTOMATICALLY ASSUME LIABILITY IN AN ASSET PURCHASE The general rule is that, in an asset purchase, the buyer doesn’t automatically assume the liabilities of the purchased business. Here are some exceptions to the rule, where the buyer assumes, by operation of law, certain liabilities of the seller. Doctrine of Successor Liability. The buyer will assume liabilities if the sale was “unfair” to the creditors of the purchased business. The doctrine of successor liability protects creditors in the following scenario: the buyer takes all assets out of the business, but pays an unreasonably small price for the assets. This leaves the creditors with no assets in the business on which to foreclose. In successor liability, you also frequently see the buyer continuing the business without substantial change in its directors, employees, name and location. No one on the outside would even know there was a sale. Add up all of these factors, and it looks like a fraud on the creditors. Bulk Sales. The CA bulk sales law applies to companies for which the principal business is the sale of inventory, including restaurants. Service businesses, or businesses in which the sale of merchandise is only incidental, are not subject to the bulk sales requirements. If you acquire a business that is subject to the bulk sales law, then you must notify the creditors of the purchased business. Failure to provide notice permits the creditors to sue you for the debts owed by the business. Again, this law protects the creditors of the purchased business. Taxes. Taxes are a big exception to the general rule that, in an asset purchase, the buyer does not automatically assume the seller’s debts. The buyer corporation (and even you, its shareholder, personally) can be liable, by operation of law, for a number of the target corporation’s tax obligations. Remember that the king writes the law, and the king gets paid his taxes no matter what, even by making the buyer responsible for the seller’s taxes. Here is a list of the primary taxes for which successor liability applies: ** Federal income and social security taxes. ** CA sales taxes, both for the target corporation’s prior sales to customers, and for the sale of assets in the acquisition deal. ** CA payroll taxes including unemployment insurance contributions. You, the buyer should perform an extensive due diligence on the purchased business, and demand represenations in the purchase agreement for problem areas. Consider getting bulk sale clearances and tax clearances. Lastly, the buyer can leave a portion of the purchase price in escrow, or can pay a portion of the price via promissory note, to ensure that funds are available to cover any undisclosed liability flowing through seller.

Business Mergers

In this article I discuss business mergers, from a legal perspective. LEGAL STRUCTURE OF THE MERGER There are a number of possible legal structures for a merger, but usually the choice is either the classic merger or the newco merger. You choose based on the facts of your merger. Classic Merger Here you merge Corp 1 into Corp 2. Corp 2 is the surviving corporation. Corp 2 takes the assets of both Corps 1 and 2, and it carries on their combined operations. Corp 1 dissolves not long after the merger. The shareholders of Corps 1 and 2 divide up ownership of Corp 2. [Corp = corporation or LLC] Corp 2 inherits all contracts and liabilities of Corp 1 and keeps its own old contracts and liabilities. This creates risk for each merger side that it takes on the unknown liabilities of the other. The parties mitigate the risk through pre-merger due diligence on Corps 1 and 2. The shareholders of Corp 1 also indemnify the shareholders of Corp 2 for pre-merger liabilities, and vice-versa. The IRS treats a classic merger as a tax-free reorganization, which is good. Regarding valuable contracts (e.g. contracts with clients), Corp 2 automatically takes over the contracts without need for the consent of the other contracting party. Note: look for “buy on sale” clauses in certain contracts, e.g. leases and loan documents – you might need the landlord’s or bank’s consent for these contracts. Newco Merger The alternative to a classic merger is to start a new company, called Corp 3 (aka Newco). Corps 1 and 2 transfer their assets (but not their receivables or liabilities) to Corp 3. This transfer can be direct to Corp 3 or via an intermediary distribution to the shareholders, who then contribute the assets to Corp 3. The shareholders contribute cash to Corp 3 to cover its startup period until post-merger receipts come in. The shareholders divide up ownership in Corp 3. The primary benefit of the Newco is limited liability. Corps 1 and 2 dissolve, giving Corp 3 and the shareholders an argument that old liabilities died with the old Corps. These liabilities might include, for example, bad contracts, tax audits, employment law claims, etc. If this argument holds, the shareholders of Corps 1 and 2 can feel safe that the new venture doesn’t take on old liabilities, including the liabilities of the other Corp to the merger. This limited liability benefit is not full-proof, however, and the creditors have a counter-argument. The creditors can sue Corp 3 for liabilities of Corps 1 and 2 on grounds that Corp 3 is the successor to Corps 1 and 2. The facts of the merger will tell you the strength of the creditors’ argument. As for taxes, the IRS can characterize as a taxable sale the transfer to Corp 3 of assets out of old Corps 1 and 2. This can be painful. Corps 1 and 2 also must assign their client contracts and other valuable contracts to Corp 3, which can be painful depending on the number and nature of the contracts. CONTRIBUTIONS TO OWNERSHIP The hardest part of a merger is figuring out how the shareholders of Corps 1 and 2 divide up ownership of the new, merged business. In any merger, expect to spend a majority of the negotiation on this problem. The problem is accounting for differences in value between Corp 1 and 2 so that you divide ownership of the new business in a fair way. It’s rare that Corps 1 and 2 are so equal in value that shareholdings translate directly across from the old to the new. One way to solve this dilemma is to put a dollar value on all assets to be contributed to the new business, and base new shareholder percentages directly on the dollar values. The parties can use cash to equal out the asset values / shareholder percentages. EXIT CLAUSE Sometimes a party to a merger wants an exit clause in case the merger isn’t working out, usually within the first year. With the exit, the party receives the return of its assets, plus customer lists, phone numbers, office leases, staff, equipment, and corporate name and entity. Note that items acquired jointly (post-merger) need a special mechanism to ensure a buy-out at fair value. MISCELLANEOUS ISSUES Some additional issues to consider in the merger: * How to divide corporate control, including membership on the board of directors, veto rights and super-majority votes. * How to set the formula for compensation of the shareholders, including salary. * Drafting a Buy-Sell Agreement for the shareholders. * Transferring insurance from the old corps to the new business. * Transferring licenses to the new business. I hope this article helps you. For more on mergers and acquisitions, see Buying and Selling a Business, and Valuation Issues in Buying and Selling a Business. Remember this is complex stuff. Before you do anything, get competent legal counsel to help you.

Business Joint Ventures

In this article, I explain business joint ventures. A joint venture exists when two or more businesses team up to engage in a limited activity, for example, one business has customer relationships in a particular market while the other has back-end personnel, so they team up to offer a vertically integrated service in that market. There are four basic concepts in structuring your joint venture: corporate structure, control, money, and exit: (1) Choose a structure for the JV, perhaps a corporation or a partnership. (2) Decide who will control the venture, including the votes needed to make decisions, and day-to-day operational control. (3) Decide how you will split the profits of the venture, and which partner will initially receive and hold the money from customers. (4) Create an exit – before you enter any business relationship, you need to prepare your exit. CORPORATE STRUCTURE You can form a new corporation or LLC to operate the joint venture. Usually I advise clients to form a JV corporation or LLC because it gives limited liability protections to the JV members. In the alternative, you can operate the JV without a legal entity, in which case you are partners in a general partnership. The primary drawback here is that partnerships don’t have limited liability, that is, all partners are liable for the partnership’s debts. In some cases, however, keeping it simple makes sense, for example if JV activities have little risk of liability. You should talk with your attorney about whether or not to form a corporation or LLC for the JV. Note: Irrespective of the JV’s corporate structure, all JVs need a Joint Venture Agreement. CONTROL Control means voting rights and veto rights. Voting is a positive form of control, in that you make decisions about projects and other matters based on the affirmative vote of members. Do not assume that a JV will have simple 50/50 voting for all matters, because there might be 3 or more members in the JV or one member might have a greater voting interest. Also identify the JV managers who will control day-to-day operations. Veto rights are a negative form of control. A veto right lets you stop certain JV actions. For example, you might require that a 75% vote approve the sale of the JV or the purchase or sale of JV property. Veto rights generally protect minority owners from the actions of the majority. MONEY Clearly state how the members will share in the profits. Consider such factors as money and other resources invested, and time and labor spent in operations. An ancillary requirement is to map out how money flows into the JV and into what account. For example, if money flows through one member’s website and into its account, the other member will need accounting rights and other protections. Keep your eyes on who employs the personnel that carry out JV activities – a member or the JV itself? The employing member must receive reimbursement for all related expenses and perhaps indemnity for employment law disputes. Be careful also if a member can use JV assets to its personal benefit, for example through the use of JV equipment or through related party contracts. EXIT All business partnerships end sometime, usually sooner than you think. You need a structure that permits an economic divorce among the members. The Joint Venture Agreement should provide this structure, which will consist of a trigger event followed by the separation. I write about this topic a lot, see for example, Buy-Sell Agreements. A common trigger event is irreconcilable dispute among the members. If the members can’t get along, then one or more of them can require the economic divorce. In the divorce, each member should receive a fair division of the JV’s assets. The easiest way to separate the members is for each member to take back the assets it brought to the JV. The division is harder for assets that the JV itself acquired, like the JV’s name, website, goodwill, customer relationships, and software developed for the JV. Consider also an allocation of JV obligations, such as taxes, lease rentals, guaranties and litigation related liabilities. You need special drafting in the Joint Venture Agreement to handle these more troublesome assets and liabilities. The goal is always the same, however: an efficient separation through the fair division of assets and liabilities.

Valuation in Buying or Selling a Business

Both the buyer and the seller should value the seller’s business (the target). Buyer does so for obvious reasons, and target does so to determine the asking price for the business. In buying a service industry business, there are 2 common methods for valuing the business: discounted earnings, and comparable change of control transactions. To the extent both methods are available, buyer will use both. Usually, however, buyer will rely more on the discounted cash flow method, because insufficient market information will be available to fully use the comparable sales method. You ordinarily don’t buy a business as an “investment” (you invest in the public markets instead). You buy a business because you want to run the business or you see a special fit between the business and your current operations. Now, the basic question for buyer is, given its projected uses for target and its objectives in acquiring target, what is target worth to buyer? The earnings method explained below helps make more clear target’s intrinsic worth, and the comparable sales method helps buyer know that it’s in the right ballpark. Although both valuation methods can assist buyer, the real analysis for buyer will concern buyer itself – what are buyer’s objectives for the acquisition, and what does buyer hope to obtain by virtue of the acquisition? Target should know buyer’s objectives as well, because target will receive a premium purchase price to the extent it can help buyer meet those objectives. DISCOUNTED CASH FLOW METHOD In valuing a service firm, the No. 1 factor is determining the earnings potential of the firm. There is no magic formula, buyer simply takes earnings and multiplies it by a factor that takes into account risk and premiums. In other words, buyer bases price on a multiple of EBIT, and to determine the multiple, buyer considers factors like the stability and skills of the worker base, the stability and attractiveness of the customer base, and market penetration. In the end, buyer wants a firm with an established client base, a proven revenue stream, and a stable core of employees. That said, I do have a model for valuation that helps you see the factors and how they fit in. Real world valuation is much more complex than my model, however. Use the model only to see how the pieces of a valuation analysis can fit together. Basic Principal: Value a business at the present value of the expected income stream over a term of years. That is, quantify the future income stream, then discount for risks and add in for premiums, then calculate present value. V = [Earnings X Number of years (base the number of years on employee and client stability)] X [Risk discounts and premiums (expressed as a percentage)] X [Present value discount] — STEP#1: Calculate Earnings. Start with complete financial statements for the past 3 years, the owners’ tax returns for the past 3 years, and current agings of accounts receivable and accounts payable. [EBIT (operating profit)] = Gross sales — Cost of sales + selling/admin expenses — EBIT does not take into account how target’s financing, leverage and taxes have affected its earnings. Now adjust EBIT, because service firms usually are smaller companies that can and will be flexible in financial matters. For example, the owner may have been anticipating a sale of the business, and therefore may have been pumping up earnings by not making needed capital expenditures. Reduce EBIT for capital expenditures that should have been made. Also reduce EBIT to account for the cash needed to bring working capital up to a secure level. On the other hand, owners try not to show a profit for tax purposes. Instead they expense out profits in the form of salary and perks. Increase earnings to the extent paid out as extra salary and perks. STEP#2: Project Over a Term of Years. Next, estimate the duration of the EBIT income stream. For a service firm, you can base the duration of income stream on the average retention of each client, where you weight the clients based on their dollar billings, and on the average retention of billing employees. Because a stable client stream and a stable employee base are difficult to build, buyer might consider applying a multiple to the average retention. STEP#3: Calculate a Projected Income Stream. The result of the above calculation is a number that reflects target’s projected income stream: “EBIT X years.” STEP#4: Discount for Risks. Here you express risk as a capitalization rate, that is, you express each risk as a percentage and apply it to the “EBIT X years” number. Client Loyalty to Individual Principals. It’s not easy replacing an owner / operator. Target can mitigate this risk by having the principal stay on as a consultant, retaining the principal as an employee and using no-compete agreements. Employee Mobility. Target and buyer can work together to see that key employees will remain with the firm after the transaction. Corporate / Legal Issues. All shareholders should have clear title to their shares, and be willing to sell. Target should have cleared up all litigation and other claims against it. Earnout. Because it’s so difficult to quantify risk, most buyers adjust for risk by using an earnout. Target should take all measures possible to mitigate risk prior to negotiations. Target’s preparation can reduce or eliminate the earnout. STEP#5: Add in Premiums. Just as with risks, you express reward as a capitalization rate. Target gets the maximum purchase price by showcasing its value. Different buyers will see different values in a company, and will be willing to pay different amounts. For example, a buyer that only wants the hard assets of a business will pay a low, liquidation value price. Buyer will pay a premium if it wants to take over target’s business and income stream, or if it sees a critical fit between target and buyer’s future growth. Attractive targets have a value that is hard to replicate. Buyer will buy target to get the value, that is, buyer cannot practically or quickly develop the value on its own. Examples of factors that create a premium purchase price include: Synergies between Buyer and Target **Special Expertise. A service firm’s primary income generating asset is its skilled, billing employees. The question is, how much are the people in the firm worth in terms of their ability to generate income? Typically, the more specialized and technical the skills of the employees, the more valuable the firm is. **Turnkey Operations. Look for a stable employee base and stable operations. **Attractive Client Base. Look for stable “institutionalized” clients, with cross-selling opportunities. **Good, Long Term Lease. As for finding a buyer that is willing to pay a premium, target’s best hope is its own hard work. Well in advance of the estimated time of sale, target’s principals should be out talking to friends and competitors in the industry. The subject of conversation is not target’s impending sale (which should not be revealed), but rather about the industry itself and how a firm can grow to best take advantage of opportunities. Merger and acquisition ideas will naturally come up, based on strategic fits. And now target has found its premium. STEP#6: Calculate Present Value. Calculate the sum of money that today would equal the total purchase price calculated above over the term of years. The discount rate can be the 1-year Treasury Constant Maturity. COMPARABLE SALES METHOD The market / comparable sales method for valuation requires an active, transparent market, and an exchange of comparable businesses. The best example is the home real estate market, where comparable sales exist just down the street. Unfortunately, for us, no two firms are the same, buyers have different purposes for the acquisitions, and the market is not transparent. In sum, it is very risky to base a purchase price on a comparable sale. That said, however, we recently have seen and heard 2.5X (more or less, but prior to the recent downturn) as a common multiple over EBIT for the sale of an IT firm. You also can use the following websites for transaction data and comparable prices: FACTORS IN COSTS OF FINANCING THE ACQUISION Buyer should take into account its costs of financing the acquisition. That is, the expected rate of return from the acquisition should well exceed its costs (such as interest or equity dilution) in obtaining the funds used for the purchase price. ADDITIONAL CALCULATIONS FOR PURPOSES OF COMPARISONS WITHIN YOUR INDUSTRY Once you have the basic measuring stick (EBIT), you can do more calculations. First determine the service firm’s profit margin. Use profit margin for comparisons with target’s prior years to see if it is getting more profitable, not just bigger. Also use profit margin to compare with other service firms in the industry. You are looking at profitability and operational efficiency. Profit margin = EBIT / Gross sales Next, use EAIT (earnings after interest and taxes) to get to target’s bottom line. Here determine taxes at the standard rate, not target’s actual rate. EAIT (true net profit) = EBIT — Interest — Taxes Finally, determine the service firm’s net profit margin. Net profit margin shows how much profit buyer can expect to derive from target on a yearly basis. Net profit margin = EAIT / Gross sales

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