Justifying the purchase price of a business
Buying a business is probably one of the most difficult decisions someone has to make. Buying a car and buying a house certainly rank up high with them because we need to have a car and we need to have a house but we don’t need to buy a business as we can go a get a job. Perhaps deciding to ask or accepting an invitation for marriage and buying a business are the most difficult decisions to make as the decision stays with us a long time and there is a tremendous amount of emotion invested; especially if the answer is yes.
The buying decision making process generally covers many months. It includes initial high level decisions to determine if the business feels right and whether it makes sense to continue through the demanding processes of negotiating the deal, worrying about how to fund and buy the business, if the buyer has the skill set to be successful, getting all the right legal documents and agreements in place and so much more.
The financial viability is a critical aspect for the buyer and seller. The seller has gone through their process to know what price they are willing to accept to sell the business. For the buyer, this can be a difficult process as they can be comparing Business A with Business B, deciding how much risk they could take and more.
The following suggestion is to provide a buyer with a way to decide if their justification of the purchase price of the business makes it a good decision. This is a fairly simple tool and like all tools, does not provide all the answers to all questions but I think helps guide a buyer about whether their initial investment makes any sense.
Purchase Price Justification formulaThe Purchase Price Justification formula goes as follows: Your numbers will be different to my example but simply get out a calculator and use this to analyze your numbers.
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.tftable tr:hover {background-color:#ffffff;}Business purchase price$600,000Buyer downpayment (33.67% of the purchase price = $200,000)Net Profit or Sellers Discretionary Earnings of the business$200,000Minus annual Debt of $400,000 (For example, a 10 years SBA loan @6.75%)$56,297Minus current interest a buyer could earn on their downpayment$2,000Minus Buyers salary for owning and operating the business$75,000Minus any annual costs to replace capital equipment, for example$5,000Remaining cash flow for buyer$61,703Final Purchase Price Justification.tftable {font-size:12px;color:#333333;width:100%;border-width: 1px;border-color: #729ea5;border-collapse: collapse;}
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.tftable tr:hover {background-color:#ffffff;}Return on downpayment if getting interest at a bank (currently 1%)$2,000Remaining cash flow for buyer per the above$61,703Average equity return ($400,000 divided by 10 years)$40,000Total$103,703
To calculate the annual Return On Investment simply divide the $200,000 into $103,703 and then divide by 100 = 51.85%. That is, if a buyer uses a downpayment of $200,000 to buy this business and is able to maintain the existing cash flow and repay the SBA loan after 10 years they will get a 51.85% annual Return On Investment; which is pretty impressive.
If the buyer wants to be aggressive and repay the SBA loan after 5 years the annual Return on Investment jumps to 71.85%. There are very few places to earn that sort of Return On Investment.
If you would like more information about buying a business please visit my webpage Buy a business or buy a copy of my book Successfully buy your business.
For more immediate help with buying a business you are welcome to send an email to Andrew Rogerson or give me a call on 916 570-2674.
