Return On Investment And Equity Build Up
The Great American Dream...Business Ownership
According to the New York Times bestseller The Millionaire Next Door (Stanley & Danko, Pocket Books), 64% of American millionaires achieved their wealth by owning a business.
Those who own businesses usually have two financial goals...(1) A Return On Investment (ROI) that is better than the ROI that they might realize from investing in stocks, bonds, CD's, savings accounts, etc., and (2) A build up of Equity (future value) in the business, which is like a Future "Cash Out" Savings Account that owning your own business offers.
Of course, most business entrepreneurs also seek other benefits of ownership, as well, such as: (3) Wanting to work for themselves, not for someone else; (4) The chance, through owning, nurturing and hopefully growing a business, to achieve something special, and be rewarded for the effort; and (5) The satisfaction of having a career that allows you to express your creativity, ingenuity and personal potential; and (6) The opportunity to be of service to society, to your community, and to the country; and (7) the ability to provide well for your family, and build a legacy that could benefit future generations.
What can make all those exciting goals happen?...A Return On Investment through the business cash flow, and a Build Up Of Equity through ownership.
"Return On Investment" Questions
One of the most important questions to ask of every business opportunity you might consider purchasing is...What is the likely annual Return On Investment?... meaning, after you invest a down payment, arrange an acquisition loan, acquire the business, and after you pay all of the business' overhead operating expenses, and after paying for the "cost of goods" (the cost of the product or service the business sells), and after you pay the "cost of occupancy" of the premises (rent cost if you lease the premises, or cost of the mortgage principal & interest if you are buying the premises/real estate), and after paying the principal and interest cost of the business acquisitions loan you arrange, the remaining "cash flow" before income taxes should provide you with a "Return On Investment" (return on your original down payment) that is more attractive than the ROI you might receive investing that down payment in some other instrument (stocks, bonds, savings account, CD, rental real estate, or whatever).
Most business buyers insist on an ROI from buying a business that is better than alternative investments might deliver.
ABMI, having sold thousands of different businesses over the last almost 30 years, has a keen understanding of the Return On Investment (ROI) that a reasonable buyer can expect to achieve from buying a business. Although there are no guarantees, if the buyer achieves sales and operational management similar to the sales and management of the former owner, it is reasonable for the buyer to expect the ROI to be fairly predictable.
Extraordinary ROI of 25% to 200% Annually Is Achievable
Believe it or not, it is common for business buyers to achieve an ROI (Return On Investment), meaning a profit/return on their original down payment, of 25% to 200% or more.
For example, if a buyer invests $100,000 as a down payment on a business, with businesses brokered by ABMI, it is commonly achievable (after paying all the businesses expenses, and after paying the principal and interest payments on the buyer's acquisitions loan) for the buyer/operator of the acquired business to have $25,000 to $100,000 (or more) annually in "excess cash flow" from the business, without growth or improvement over the performance of the business under the previous owner's management.
In addition, the buyer should have an Equity Build Up of an additional Return On Investment factor. For example, if a buyer pays $500,000 for a business, and has a 7 year acquisition loan, the buyer is accumulating a "savings account" of 1/7th of the purchase price annually, or $71,428 (1/7th of $500,000), because, in 7 years, when the business loan is paid off, the buyer will own a debt free business asset, which the buyer could re-sell or keep. In either case, with the business "buying itself out of it's cash flow", the buyer has the benefit of this Equity Build Up, in addition to the benefit of the "excess cash flow".
If the down payment of the buyer on this $500,000 business was $100,000 and if the business makes the acquisition loan principal and interest payments for 7 years, this $71,428 per year in Equity Build Up represents an additional ROI to the buyer of 71.4% annually, in addition to the Cash Flow ROI.
ABMI offers buyers a no cost consultation, showing analysis techniques that help buyers determine the historical and future Return On Investment possibilities of a wide variety of business acquistions, for buyers buying everything from laundromats to manufacturing companies...from fast food restaurants to large distributorships...from car washes to internet service companies...from retailers of all kinds to trucking companies...from small main street businesses to large, middle market companies.
Business Owners As High Income Earners And Wealth Holders
Business owners are more likely than wage earners to be in households classified as high income earners and wealth holders, according to a study released by the Office of Advocacy of the U.S. Small Business Administration.
“Business ownership has traditionally been a route to prosperity for Americans,” said Dr. Chad Moutray, Chief Economist for the Office of Advocacy.
The report, How Did Small Business-Owning Households Fare During the Longest U.S. Economic Expansion?, written by Dr. Charles Ou, Economist for the Office of Advocacy, and Dr. George Haynes is a follow-on to the study Wealth and Income: How Did Small Businesses Fare from 1989 to 1998?.
The study finds that in 2001 small business-owning households were more than twice as likely as non-owning households (57.1 percent to 25.5 percent) to be high income, and over eight times more likely (21.2 percent to 2.5 percent) to be high wealth households.
The study also examines the changes in the demographic characteristics of high income and high wealth households over the 1992-2001 period.
The Office of Advocacy, the “small business watchdog” of the government, examines the role and status of small business in the economy and independently represents the views of small business to federal agencies, Congress, and the President. It is the source for small business statistics presented in user-friendly formats and it funds research into small business issues.
Entrepreneurs who would like to arrange a no cost, no obligation consultation with an ABMI agent/consultant/advisor, to discuss the wealth possibilities of business ownership may register with this ABMI web site and we will contact you.
How To Conservatively Analyze The Cash Flow And Return On Investment (ROI) Of Any Business
In order to review financial data in a consistent manner the financial/investment industry has developed a standard process called Recasting, Normalizing, or Stabilization. This concept has been adopted by the appraisal industry, CPA’s, attorneys, bankers, the International Business Brokerage Association (IBBA), and the Small Business Administration (SBA) as the accepted approach to standardizing financial information.
Expenses that typically are adjusted/recast/stabilized/normalized and taken out of the Profit & Loss statement, to arrive at the "true cash flow", include owners salary, owners benefits (owner's life insurance, health insurance, pension plan), debt service, depreciation (non-cash expense), and charitable contributions. Other expenses may be adjusted based the unique business owners accounting methods.
The adjusted (stabilized) expense information is integrated with the original cash flow of the business to arrive at an adjusted cash flow (see examples below). This is the actual net cash benefit to the business owner. This adjusted number is referred to as Net Owner Benefit (NOB) and/or Sellers Discretionary Cash Flow (SDCF).
Most objective advisors agree that a business is only worth what it can produce in terms of current cash flow and future returns to the owner...not worth what a seller might want or need, nor what a buyer wishes it could be purchased for, nor worth what an advisor (attorney, accountant, brother in law, next door neighbor, etc) might "guess" it's worth...but is actually worth a multiple of the historical cash flow and the potential return on investment to whoever owns the business.
Buyers and lenders look at the ability of the business to earn a realistic salary for the owner for operating the business, while producing enough cash flow to comfortably cover debt service, and generating a fair return on invested capital (ROIC).
A common way to determine the Seller's Discretionary Cash Flow (SDCF) is by using an analysis known as EBITDA (Earnings of the business Before expensing the seller's Interest, corporate income Taxes, Depreciation and Amortization). Also deducted from the business expenses is any owner's compensation or benefits the company paid. The result of this analysis is to leave in the expenses any recurring, non-elective "core" expense that the buyer is likely to also experience when the buyer takes over the operations of the business.
The resulting Seller's Discretionary Cash Flow then represents the factor that then is usually used as a multiple in determining what the business is "worth", based not on the assets present in the business, nor on it's potential, nor on it's history/reputation/good will, nor on any factor but on it's ability to generate cash flow.
Multiples (or ratios) can be derived by comparing selected variables such as annual sales, gross profit and SDCF to the Sales Price. Due in part to the volume of transaction information, applied to businesses in similar industries, these multiples can provide a very accurate picture of valuation (as defined by the marketplace).
Regardless of the formal approach to valuation, and the calculated value of a specific business, the business is only worth what it can produce in terms of current cash flow and future returns to the buyer. Buyers and lenders look at the ability to earn a realistic salary for operating the business while producing enough cash flow to comfortably cover debt service, and generating a fair return on invested capital (ROIC).
Return On Investment Analysis For An Absentee Owner
Actual Case Studies of Recent Acquisitions of Businesses That Buyers Will Operate Absentee/Part Time
|Item||Business Example (A)||Business Example (B)||Business Example (C)||Business Example (D)|
|Buyer's Down Payment||(50,000)||(65,000)||(125,000)||(250,000)|
|Buyer's Acquisition Loan||150,000||260,000||325,000||750,000|
|Business Cash Flow*||70,000||145,000||160,000||315,000|
|Less Buyer's Annual Loan Payments**||(27,000)||(46,800)||(67,500)||(135,000)|
|Buyer's Annual Cash Flow After Loan Pmts||43,000||98,200||92,500||180,000|
|Less Manager's Salary||(30,000)||(20,000)||(30,000)||(50,000)|
|Buyer's Absentee Cash Flow||13,000||78,200||62,500||130,000|
|Absentee Cash Flow For 7 Years***||91,000||547,400||437,500||910,000|
|Plus Value Of Business After 7 years****||200,000||325,000||500,000||1,000,000|
|Total Financial Benefits To Buyer*****||291,000||872,400||937,500||1,910,000|
|Less Buyer's Original Down Payment Investment||(50,000)||(65,000)||(125,000)||(250,000)|
|Net Financial Gain To Buyer, 7 years||241,000||807,400||812,000||1,660,000|
|Return On Investment (ROI) During 7 Years******||482%||1,242%||650%||664%|
|Annual Average Return On Investment (ROI) Counting Cash Flow Benefits and Equity Return||68%||177%||93%||95%|
* Annual Business Cash Flow using EBITDA Analysis
** Buyer's annual Principal & Interest Payments, 7 Year Loan, Assumes About 7% Interest
*** Cash Flow After Paying Manager To Operate Business, So Buyer/Owner Can Be Absentee/Part Time
**** Assumes Business Will Be Worth No Less In 7 Years Than the Price Buyer Originally Paid. Assumes the PriceBuyer Might Sell the Business For After 7 Year's Ownership, and/or Value Of Debt Free Business After 7 Year's Ownership
***** Adds (a) Absentee Cash Flow For 7 years and (b) Value Of Debt Free Business After 7 Years
****** Return On Buyer's Original Down Payment Investment Over 7 Year's Ownership
This analysis is based on the current owner's results. A different owner may experience different results due to different management practices.
This analysis is for absentee owners who hire a manager to operate the business. An owner-operator who serves as his/her own manager would not have the manager expense.
Information and data about the businesses, including financial records, are the representations of the buyer and seller. Broker disclaims any responsibility for its accuracy.
This analysis assumes that the buyer/acquirer will achieve sales and profits that are no less than the previous owner's sales and profits. If the buyer/acquirer of the business has less sales and profits, and/or if the buyer/acquirer increases the cost of the goods and services, and/or if the buyer/acquirer spends more on overhead operating costs, and/or if the buyer/acquirer does not maintain a mark-up on goods/services equal to the former owner, the above ROI conclusions would not be accurate.
If the buyer/acquirer achieves sales and profits that are more than the previous owner's sales and profits, and/or if the buyer/acquirer decreases the cost of goods, and/or if the buyer/acquirer spends less on overhead costs, and/or if the buyer increases the mark-up on goods/services, it's possible the buyer/acquirer could realize an ROI that is more than the conclusions shown above.
If the buyer/acquirer operates the business as an owner-operator, instead of paying a manager to manage the business, this "hands on" buyer/acquirer would likely have higher SDCF (Seller's Deiscretionary Cash Flow), higher total (ROI) Return On Investment, annually, and over the life of ownership.