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