Study the hard numbers before becoming an absentee owner

A couple of days ago, we had a prospective buyer come by our office who was interested in buying a business.

He had become frustrated with how his stocks and real estate holdings had performed and felt that a local business would generate far better returns.

He was very qualified financially and held a nice job that paid him handsomely that he had no intention of leaving.

He also was an educated buyer who discovered that most businesses in the local market sell for two to four times the businesses’ annual net cash flow.

What he initially didn't understand was that these multiples are based on a buyer purchasing a business where they become the owner operator. This would mean that a business with an annual net cash flow of $200,000 might sell for $600,000 with a $200,000 down payment.

After factoring in debt service payments, his annual net cash flow would be $150,000 as an owner operator and he’d realize a 75% return on investment of his cash investment. This is a considerable improvement over the performance of his current investments.

However, since he had no intention of leaving his current employment, as an absentee owner, he was going to incur the additional expense of hiring a manager to run the operation.

In this case, a manager in this type of business would cost at least $50,000 annually, hence his annual net cash flow would drop to $100,000 after debt service payments and generate a 50% ROI.

Although the returns would not be as great as in the example above where the buyer became an owner operator, they would be better than what he has seen with his stocks and real estate investments.

From a “multiple” perspective, what this means is that he's gone from paying a three times multiple to a five times multiple. Fortunately, this buyer has the wisdom to see that it still would generate a far better return on his investment.

Unfortunately, not all buyers see it this way. Many get caught up in the “multiple” and don't look at the hard numbers associated with the investment.

To me, it is logical that a buyer who is going to invest in a business where they are not going to be working on a daily basis should expect a smaller return than the buyer who is going to work in it five days a week.

For business sellers, the good news is that there are many buyers who fit both profiles in our market right now. The majority are still those who are going to roll up their sleeves and become active in the day-to-day operations.

However, with the current economic state of stock and local real estate markets, we are seeing more buyers who are trying to purchase businesses as absentee owners.