In the business broker community there is a review process that helps
a buyer determine if a business purchase makes sense or not. This check
can be done by a Fortune 500 company where everything is figured down
to the penny and takes 1000 hours of research or it can be done by a
small main street shop buyer who figures it out in 1 hour. Each item in
this review process requires a decision. This decision can be based on
extensive research or just on a reasonable guess.

The
beauty of this process is; how long you want to spend on doing this
activity is totally up to you. As we review this process, I will explain
the variables of this system so you can make the necessary decisions
where needed. Remember, this is only a tool to help you make decisions
about a business purchase; it is not a sure-fire foolproof system. I
will just lay it out for you and you make your own decision as to the
validity of this formula for analyzing a business purchase that you may
want to make.

The Sanity check requires two mathematical formulas,
which require dollar amounts or other numbers to be entered in each
formula. The math is calculated and then the results are compared
against the purchase price. If it doesn't work out the way you wanted,
you have the option of then going back and change some of the numbers
and do the calculation a second time.

The two formulas are:

1. SP + WC - BF = CR

Sale Price + Working Capital - Borrowed Funds = Cash Requirement

2. SDE - FMW (FO) - DS - ROI = Extra Profit/Loss

Sellers
Discretionary Earnings - Fair Market Wage (for the owner) - Debt
Service - Return on Investment (Cash Requirement x Interest rate -Stated
as a Percentage) = Extra Profit/Loss

Since each item in the
formula needs to have a dollar amount determined, we will define the
terms and then discuss how the dollar amount is derived at.

Terms Definition:

Sale
Price: The price that is being asked for the business or the price the
buyer is thinking of offering. Depending on when you do this analysis.
If you are trying to determine an asking price you would calculate all
the other numbers in these two formulas to determine what should be your
offering price. We will do examples to make this clear later in this
article.

Working Capital: The short-term assets minus the
short-term liabilities is the accounting definition. The simple
explanation would be the amount of money necessary to be invested by the
buyer to run the daily operations of the business, once purchased. This
would include monies tied up in inventory, and accounts receivables.
Money invested to pay the landlord's or utility company's deposits. Also
included is the money spent on the business purchase to cover the loan
origination costs and purchase escrow fees when buying the business. It
is the total funds invested into the business to keep it running. The
down payment given to the seller is not part of this number, since it is
included as a separate item.

Calculation notes: 1. Cost of inventory: $_________________ (+) 2. Accounts receivable: $_________________ (+) 3. Landlord deposit: $_________________ (+) 4. Utility Deposits: $_________________ (+) 5. Escrow fees to purchase: $_________________ (+) 6. Loan origination costs: $_________________ (+) 7. Short term liabilities* $ _________________ (--) Total Working Capital $_________________

* Short-term
liabilities are defined as liabilities that are to be paid off within 1
year - accounts payables and the part of any notes payable that are to
be paid within 1 year.

Borrowed Funds: The loan made for a
business purchase from a bank or private party. The private party can be
the seller or some friend or relative who might be willing to make a
loan. This is borrowed money that must be paid back to someone at some
time in the future.

Cash Requirement: This is the invested cash
required to both buy a business, and working capital-to run the
business. The amount of cash needed to make the business purchase and
run the operations of the business after deducting all borrowed funds,
regardless of source.

Sellers Discretionary Earnings / Owners
Total Benefits: This is the total of all the non-business related
benefits going to a business owner or his family on an annual basis that
have been paid for, by the business. Included in this is definition are
taxable profit from operations, unreported cash income, owners salary,
salaries to non-working family members, any amount over the fair market
value of salaries paid to working family members, family auto expenses,
family telephone, family office expenses, health and life insurance for
any or all family members, pension plan/ profit sharing contributions
paid for the benefit of family members. This can also be stated as the
reason why most people go to work everyday; they get family support for
working.

Calculation notes: 1. Taxable profit from operation $_________________ (+) 2. Cash $_________________ (+) 3. Owners Salary $_________________ (+) 4. Salaries of non-working family members $_________________ (+) 5. Amount over the fair market value of wages of working Family members $_________________ (+) 6. Family Auto Expenses $_________________ (+) 7. Family Telephone Expense $_________________ (+) 8. Family Office Expense $_________________ (+) 9. Health and Life insurance of Any/all family members $_________________ (+) 10. Pension plan/profit share family members $_________________ (+) Total Seller Discretionary Earnings: $_________________Return on Investment: We need to have this stated as a dollar amount in Formula two. ROI is calculated as follows:

Cash Requirement X "a Percent" - the greater the risk, the higher the percent

First
we must determine what the interest rate return we wish on our
investment. This is a very subjective percentage and a change in this
number can change the whole result of this analysis. If it is of any
help, many financial investors in "Corporate America" feels they need to
get a 20% return on their invested capital. Companies do not always
make money and therefore the possible loses are built into the ROI. Some
of the reasons are: companies are bought and go broke, overseas
competition causing expectations of growth and income not to be met, and
lastly government regulations periodically close whole industries.
These are just some of the many risks involved in owning a business.

Putting
your money in a bank has little risk, because the Federal Government
insures your deposits in the bank. The stock market has a lot of risk
that many people do not fully understand, causing them to accept a long
term ROI of 10-13% from mutual fund investments. A 95% drop in stock
prices like the dot.com stocks or what happened when we had the oil
embargo in 1992 are indications that the stock market can be a much
higher risk than people realize.

I personally feel that owning
your own business and buying real estate are much lower risks, providing
a much higher return. The proof of this can be found in the number of
people who got rich in real estate and the over 25 million small
business owners across this country.

Figure out what ROI you want
and insert this number as .20 amount to represent 20% or .06 to
represent 6% ROI. This is an annual return on invested money.

Once
you have a percentage return on your investment we need to multiply it
by the Cash requirement in order to come up with a dollar amount return
needed. This restated is Dollars invested x percentage (stated as a
decimal) = Dollar return on investment.

Examples:

1)
Investment of $50,000.00 @ 6% Return On Investment (ROI) would be
calculated as follows: $50,000.00 X .06 = $3,000.000 (Dollars return on
investment)

2) Investment of $50,000.00 @ 20% Return On
Investment (ROI) would be calculated as follows: $50,000.00 X .20 =
$10,000.00 (Dollars return on investment)

Debt Service: The reason
we need this number is because this is a financial expense of owning a
business. It is not an operating expense of the daily business
operations but if you have debt, in your business, you must be able to
make the payments, out of the business operations profit. Usually this
payment is mostly interest and a smaller portion is the principal
reduction of the loan balance.

Most professionals deduct the whole
payment when doing this analysis, because the business must generate
enough profit to make the whole payment. My personal preference is to
just deduct the interest portion and to add the principal portion of the
payment to working capital amount needed. This counts as more money
being put into the business just like financing inventory and/or
accounts receivables.

For simple one-hour analyses it is not worth
splitting up the payment. In the case of a very large principal
reduction payment it could be unreasonable to not split it up. It is up
to you. You can always try it both ways, since this is a process to
raise your understanding, not to come up with a fixed answer of, yes! it
is a buy or no! it is not a buy.

Fair Market Wages: This is an
amount that the new or old owner would be paid, if he were an employee
not the owner. If the owner were the company salesman and also the
company bookkeeper working a total 60 hours a week, a reasonable salary
would have to be determined for each job. As an example only, lets say
that an outside salesman, in your industry, could make $40,000 per year.
And a bookkeeper usually charges $15 per hour. The salesman might very
well work 50 hours at this job to earn this salary. If a bookkeeper
would work 10 hours per week doing the bookkeeping that would mean 520
hours per year (10 hours x 52) times $15.00 per hour which comes to
$7800 per year for the bookkeeper. The two Fair Market Salaries would
come to $47,800 ($40,000 + $7,800).

Sometimes the market salaries
are not so easy to figure. Lets take an owner who owns a 99-cent
discount type store. This shopkeeper works 70 hours per week behind a
counter in the store. You can hire a counter person for $7.00 per hour
so this becomes (70 hrs x $7.00 per hour x 52 weeks).

Then you
start discussing that this $7.00 per hour counter person would not be
able to do the buying. You might want to figure a purchasing agent's
salary. This can be done or you can just do simple numbers, leaving the
salary only based on a counter person's wages.

DOING THE MATH

By
now you have the information to come up with numbers to put into the
formula. Let us create a scenario. This was a transmission shop. The
customers pay COD-upon pick up of the car. The parts inventory is from
old 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 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 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 and does the
bookkeeping, orders parts and makes bank deposits. He has a manager who
bids jobs and handles production. No one is going out and calling on
prospective business, which is one thing the owner should be doing with
his time, but he is not doing. Lets go through what the numbers are with
this example.

Math Formula #1: Sale Price + Working Capital - Borrowed Funds = Cash Requirement

Sales Price: $75,000

Working Capital: The business requires $10,000 cash infusion upon close of escrow, mostly to pay the landlords deposits and start a new marketing campaign.

Borrowed Funds: $35,000

So, the calculation for formula #1 looks like this:

Working Capital: The business requires $10,000 cash infusion upon close of escrow, mostly to pay the landlords deposits and start a new marketing campaign.

Borrowed Funds: $35,000

So, the calculation for formula #1 looks like this:

Sales Price: $75,000

Working Capital (+) $10,000

Borrowed Funds (-) $35,000

=Cash Requirement: $50,000.00

Math
Formula #2: Sellers Discretionary Earnings - Fair Market Wages For
Owner - Debt Service - Return on Investment (Cash Requirement x
Percentage) = Extra Profit/Loss

Seller Discretionary Earnings in this case is, let us say, $50,000.00.

Fair
Market Wage: You can calculate what you consider fair or you can put
all of the other numbers 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 we were to calculate what the owner's salary should be I would not
pay much for what he does. Even though he puts in 50 hours a week he
really only works 15 hours a week of true production. I am figuring 5
hours for bookkeeping and banking and 10 hours for 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 52 weeks comes to $11,700
per year.

Debt Service: My financial calculator says that if you
borrow $40,000 for 5 years (60 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 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 of the payment as is generally accepted in the industry.

Return
on Investment: We are going to use the 20% figure we discussed above.
Formula one determined that $50,000 was needed as an investment which is
multiplied by 20% (.20) = $10,000 per year return on investment.

Formula #2 (Sellers Discretionary Earnings - Fair Market Wages (For Owner) - Debt Service - Return on Investment (Cash Requirement x Percentage) = Extra Profit/Loss) would the look like this:

Formula #2 (Sellers Discretionary Earnings - Fair Market Wages (For Owner) - Debt Service - Return on Investment (Cash Requirement x Percentage) = Extra Profit/Loss) would the look like this:

Seller Discretionary Earnings: $50,000.00

- Fair Market Wages: $11,700.00 (-)

- Debt Service: $ 7,925.00 (-)

- Return on investment: $10,000.00 (-)

= Extra Profit/Loss: $20,375.00

This
means that after deducting from the income, wages, financing costs and a
return on your cash investment the business still generates $20,375
more profit. Now would you buy this business under these circumstances?
It would appear, yes! Of course this is based on a few assumptions,
which might not be true. Lets look at them again.

The owner is
only working 15 hours a week or he is only doing 15 hours of real work
even though he is sitting around all day. The other assumption is that a
20% return on your investment is a sufficient return for the risk.

We
can also consider that if the new owner puts in an extra 25 hours a
week doing productive sales the business should be able to afford to pay
him another $20,375 for the first year. It would appear that if the
sales work was done then the profit should greatly increase in the
second year or maybe even the second month.