| In the business broker community there is a review | | | | Once you have a percentage return on your |
| process that helps a buyer determine if a business | | | | investment we need to multiply it by the Cash |
| purchase makes sense or not. This check can be | | | | requirement in order to come up with a dollar amount |
| done by a Fortune 500 company where everything is | | | | return needed. This restated is Dollars invested x |
| figured down to the penny and takes 1000 hours of | | | | percentage (stated as a decimal) = Dollar return on |
| research or it can be done by a small main street | | | | investment. |
| shop buyer who figures it out in 1 hour. Each item in this | | | | Examples: |
| review process requires a decision. This decision can | | | | 1) Investment of $50,000.00 @ 6% Return On |
| be based on extensive research or just on a | | | | Investment (ROI) would be calculated as follows: |
| reasonable guess. | | | | $50,000.00 X .06 = $3,000.000 (Dollars return on |
| The beauty of this process is; how long you want to | | | | investment) |
| spend on doing this activity is totally up to you. As we | | | | 2) Investment of $50,000.00 @ 20% Return On |
| review this process, I will explain the variables of this | | | | Investment (ROI) would be calculated as follows: |
| system so you can make the necessary decisions | | | | $50,000.00 X .20 = $10,000.00 (Dollars return on |
| where needed. Remember, this is only a tool to help | | | | investment) |
| you make decisions about a business purchase; it is | | | | Debt Service: The reason we need this number is |
| not a sure-fire foolproof system. I will just lay it out for | | | | because this is a financial expense of owning a |
| you and you make your own decision as to the validity | | | | business. It is not an operating expense of the daily |
| of this formula for analyzing a business purchase that | | | | business operations but if you have debt, in your |
| you may want to make. | | | | business, you must be able to make the payments, out |
| The Sanity check requires two mathematical formulas, | | | | of the business operations profit. Usually this payment |
| which require dollar amounts or other numbers to be | | | | is mostly interest and a smaller portion is the principal |
| entered in each formula. The math is calculated and | | | | reduction of the loan balance. |
| then the results are compared against the purchase | | | | Most professionals deduct the whole payment when |
| price. If it doesn't work out the way you wanted, you | | | | doing this analysis, because the business must |
| have the option of then going back and change some | | | | generate enough profit to make the whole payment. |
| of the numbers and do the calculation a second time. | | | | My personal preference is to just deduct the interest |
| The two formulas are: | | | | portion and to add the principal portion of the payment |
| 1. SP + WC - BF = CR | | | | to working capital amount needed. This counts as |
| Sale Price + Working Capital - Borrowed Funds = | | | | more money being put into the business just like |
| Cash Requirement | | | | financing inventory and/or accounts receivables. |
| 2. SDE - FMW (FO) - DS - ROI = Extra Profit/Loss | | | | For simple one-hour analyses it is not worth splitting up |
| Sellers Discretionary Earnings - Fair Market Wage (for | | | | the payment. In the case of a very large principal |
| the owner) - Debt Service - Return on Investment | | | | reduction payment it could be unreasonable to not split |
| (Cash Requirement x Interest rate -Stated as a | | | | it up. It is up to you. You can always try it both ways, |
| Percentage) = Extra Profit/Loss | | | | since this is a process to raise your understanding, not |
| Since each item in the formula needs to have a dollar | | | | to come up with a fixed answer of, yes! it is a buy or |
| amount determined, we will define the terms and then | | | | no! it is not a buy. |
| discuss how the dollar amount is derived at. | | | | Fair Market Wages: This is an amount that the new or |
| Terms Definition: | | | | old owner would be paid, if he were an employee not |
| Sale Price: The price that is being asked for the | | | | the owner. If the owner were the company salesman |
| business or the price the buyer is thinking of offering. | | | | and also the company bookkeeper working a total 60 |
| Depending on when you do this analysis. If you are | | | | hours a week, a reasonable salary would have to be |
| trying to determine an asking price you would calculate | | | | determined for each job. As an example only, lets say |
| all the other numbers in these two formulas to | | | | that an outside salesman, in your industry, could make |
| determine what should be your offering price. We will | | | | $40,000 per year. And a bookkeeper usually charges |
| do examples to make this clear later in this article. | | | | $15 per hour. The salesman might very well work 50 |
| Working Capital: The short-term assets minus the | | | | hours at this job to earn this salary. If a bookkeeper |
| short-term liabilities is the accounting definition. The | | | | would work 10 hours per week doing the bookkeeping |
| simple explanation would be the amount of money | | | | that would mean 520 hours per year (10 hours x 52) |
| necessary to be invested by the buyer to run the daily | | | | times $15.00 per hour which comes to $7800 per year |
| operations of the business, once purchased. This | | | | for the bookkeeper. The two Fair Market Salaries |
| would include monies tied up in inventory, and accounts | | | | would come to $47,800 ($40,000 + $7,800). |
| receivables. Money invested to pay the landlord's or | | | | Sometimes the market salaries are not so easy to |
| utility company's deposits. Also included is the money | | | | figure. Lets take an owner who owns a 99-cent |
| spent on the business purchase to cover the loan | | | | discount type store. This shopkeeper works 70 hours |
| origination costs and purchase escrow fees when | | | | per week behind a counter in the store. You can hire a |
| buying the business. It is the total funds invested into | | | | counter person for $7.00 per hour so this becomes |
| the business to keep it running. The down payment | | | | (70 hrs x $7.00 per hour x 52 weeks). |
| given to the seller is not part of this number, since it is | | | | Then you start discussing that this $7.00 per hour |
| included as a separate item. | | | | counter person would not be able to do the buying. |
| Calculation notes: | | | | You might want to figure a purchasing agent's salary. |
| 1. Cost of inventory: $_________________ (+) | | | | This can be done or you can just do simple numbers, |
| 2. Accounts receivable: $_________________ | | | | leaving the salary only based on a counter person's |
| (+) | | | | wages. |
| 3. Landlord deposit: $_________________ (+) | | | | DOING THE MATH |
| 4. Utility Deposits: $_________________ (+) | | | | By now you have the information to come up with |
| 5. Escrow fees to purchase: | | | | numbers to put into the formula. Let us create a |
| $_________________ (+) | | | | scenario. This was a transmission shop. The |
| 6. Loan origination costs: $_________________ | | | | customers pay COD-upon pick up of the car. The |
| (+) | | | | parts inventory is from old transmissions and show on |
| 7. Short term liabilities* $ _________________ (--) | | | | the books as worth nothing. The seller-owner is asking |
| Total Working Capital $_________________ | | | | $75,000 for this business that he is able to takes out |
| * Short-term liabilities are defined as liabilities that are to | | | | $50,000 in profit or benefits. In an interview, the owner |
| be paid off within 1 year - accounts payables and the | | | | mentioned that if a buyer will put $40,000 as a down |
| part of any notes payable that are to be paid within 1 | | | | payment he would carry the $35,000 balance at 5% |
| year. | | | | interest for 5 years. By observation, we can see that |
| Borrowed Funds: The loan made for a business | | | | the current owner sits in the office and does the |
| purchase from a bank or private party. The private | | | | bookkeeping, orders parts and makes bank deposits. |
| party can be the seller or some friend or relative who | | | | He has a manager who bids jobs and handles |
| might be willing to make a loan. This is borrowed | | | | production. No one is going out and calling on |
| money that must be paid back to someone at some | | | | prospective business, which is one thing the owner |
| time in the future. | | | | should be doing with his time, but he is not doing. Lets |
| Cash Requirement: This is the invested cash required | | | | go through what the numbers are with this example. |
| to both buy a business, and working capital-to run the | | | | Math Formula #1: Sale Price + Working Capital - |
| business. The amount of cash needed to make the | | | | Borrowed Funds = Cash Requirement |
| business purchase and run the operations of the | | | | Sales Price: $75,000 |
| business after deducting all borrowed funds, regardless | | | | Working Capital: The business requires $10,000 cash |
| of source. | | | | infusion upon close of escrow, mostly to pay the |
| Sellers Discretionary Earnings / Owners Total Benefits: | | | | landlords deposits and start a new marketing |
| This is the total of all the non-business related benefits | | | | campaign. |
| going to a business owner or his family on an annual | | | | Borrowed Funds: $35,000 |
| basis that have been paid for, by the business. Included | | | | So, the calculation for formula #1 looks like this: |
| in this is definition are taxable profit from operations, | | | | Sales Price: $75,000 |
| unreported cash income, owners salary, salaries to | | | | Working Capital (+) $10,000 |
| non-working family members, any amount over the fair | | | | Borrowed Funds (-) $35,000 |
| market value of salaries paid to working family | | | | =Cash Requirement: $50,000.00 |
| members, family auto expenses, family telephone, | | | | Math Formula #2: Sellers Discretionary Earnings - Fair |
| family office expenses, health and life insurance for | | | | Market Wages For Owner - Debt Service - Return on |
| any or all family members, pension plan/ profit sharing | | | | Investment (Cash Requirement x Percentage) = Extra |
| contributions paid for the benefit of family members. | | | | Profit/Loss |
| This can also be stated as the reason why most | | | | Seller Discretionary Earnings in this case is, let us say, |
| people go to work everyday; they get family support | | | | $50,000.00. |
| for working. | | | | Fair Market Wage: You can calculate what you |
| Calculation notes: | | | | consider fair or you can put all of the other numbers |
| 1. Taxable profit from operation | | | | into the equation and see what is left for salary. If you |
| $_________________ (+) | | | | like the salary you buy the business, if not you do not. If |
| 2. Cash $_________________ (+) | | | | we were to calculate what the owner's salary should |
| 3. Owners Salary $_________________ (+) | | | | be I would not pay much for what he does. Even |
| 4. Salaries of non-working family members | | | | though he puts in 50 hours a week he really only |
| $_________________ (+) | | | | works 15 hours a week of true production. I am figuring |
| 5. Amount over the fair market value of wagesof | | | | 5 hours for bookkeeping and banking and 10 hours for |
| working Family members $_________________ | | | | ordering parts and answering phone calls. At $15.00 |
| (+) | | | | per hour he is earning $225.00 a week ($15.00 x 15 |
| 6. Family Auto Expenses $_________________ | | | | hours) and that multiplied times 52 weeks comes to |
| (+) | | | | $11,700 per year. |
| 7. Family Telephone Expense | | | | Debt Service: My financial calculator says that if you |
| $_________________ (+) | | | | borrow $40,000 for 5 years (60 months) at 5% and |
| 8. Family Office Expense $_________________ | | | | the balance at the end of the 60-month is zero, the |
| (+) | | | | monthly payments come to $660.49. Since the formula |
| 9. Health and Life insurance of | | | | requires yearly figures we multiply by 12 and get |
| Any/all family members $_________________ | | | | $7,925.92. Most of this payment is principal reduction |
| (+) | | | | but we are going to just deduct all of the payment as |
| 10. Pension plan/profit share family members | | | | is generally accepted in the industry. |
| $_________________ (+) | | | | Return on Investment: We are going to use the 20% |
| Total Seller Discretionary Earnings: | | | | figure we discussed above. Formula one determined |
| $_________________ | | | | that $50,000 was needed as an investment which is |
| Return on Investment: We need to have this stated as | | | | multiplied by 20% (.20) = $10,000 per year return on |
| a dollar amount in Formula two. ROI is calculated as | | | | investment. |
| follows: | | | | Formula #2 (Sellers Discretionary Earnings - Fair |
| Cash Requirement X \"a Percent\" - the greater the | | | | Market Wages (For Owner) - Debt Service - Return |
| risk, the higher the percent | | | | on Investment (Cash Requirement x Percentage) = |
| First we must determine what the interest rate return | | | | Extra Profit/Loss) would the look like this: |
| we wish on our investment. This is a very subjective | | | | Seller Discretionary Earnings: $50,000.00 |
| percentage and a change in this number can change | | | | - Fair Market Wages: $11,700.00 (-) |
| the whole result of this analysis. If it is of any help, | | | | - Debt Service: $ 7,925.00 (-) |
| many financial investors in "Corporate America" feels | | | | - Return on investment: $10,000.00 (-) |
| they need to get a 20% return on their invested capital. | | | | = Extra Profit/Loss: $20,375.00 |
| Companies do not always make money and therefore | | | | This means that after deducting from the income, |
| the possible loses are built into the ROI. Some of the | | | | wages, financing costs and a return on your cash |
| reasons are: companies are bought and go broke, | | | | investment the business still generates $20,375 more |
| overseas competition causing expectations of growth | | | | profit. Now would you buy this business under these |
| and income not to be met, and lastly government | | | | circumstances? It would appear, yes! Of course this is |
| regulations periodically close whole industries. These | | | | based on a few assumptions, which might not be true. |
| are just some of the many risks involved in owning a | | | | Lets look at them again. |
| business. | | | | The owner is only working 15 hours a week or he is |
| Putting your money in a bank has little risk, because | | | | only doing 15 hours of real work even though he is |
| the Federal Government insures your deposits in the | | | | sitting around all day. The other assumption is that a |
| bank. The stock market has a lot of risk that many | | | | 20% return on your investment is a sufficient return for |
| people do not fully understand, causing them to accept | | | | the risk. |
| a long term ROI of 10-13% from mutual fund | | | | We can also consider that if the new owner puts in an |
| investments. A 95% drop in stock prices like the | | | | extra 25 hours a week doing productive sales the |
| stocks or what happened when we had the oil | | | | business should be able to afford to pay him another |
| embargo in 1992 are indications that the stock market | | | | $20,375 for the first year. It would appear that if the |
| can be a much higher risk than people realize. | | | | sales work was done then the profit should greatly |
| I personally feel that owning your own business and | | | | increase in the second year or maybe even the |
| buying real estate are much lower risks, providing a | | | | second month. |
| much higher return. The proof of this can be found in | | | | Conclusion: |
| the number of people who got rich in real estate and | | | | This is a tool to help you analyze a business. It is not |
| the over 25 million small business owners across this | | | | the end-all of a business appraisal or evaluation. Just a |
| country. | | | | tool to help increase your understanding of a |
| Figure out what ROI you want and insert this number | | | | business's value that you may be seeking to purchase. |
| as .20 amount to represent 20% or .06 to represent | | | | Have fun with it. |
| 6% ROI. This is an annual return on invested money. | | | | |