At what point is a small business worth purchasing?

It’s worth it whenever you can acquire the business at a fair price without buying yourself a job.

Three things are worth paying for: assets, brands, cashflow. In 95% of cases, the seller will have an inflated view of their offerings on those fronts. While I won’t get into negotiation tactics here, what matters is that you don’t get caught over-paying because the seller is including the value of their job.

Buying a job is the fool’s gold of business success. It might not make you poor, but it certainly won’t make you wealthy. Your salary will be lessened by opportunity cost, risk, and massive expenditures of energy and hours. What’s more, you’ll be robbing the business of growth capital.

To use some simple math to illustrate the point:

  • Scenario A. The business generates $1m in revenues with 10% net profits. You inherit the previous owner’s salary of $100k a year (included in the expenses). You reinvest all profits into the business, with that investment producing a 40% annual return. After five years, you’ve collected $500k in salary and the business has grown to $1.92m in revenues. Assuming a value of 12x earnings, your business is now worth $2.3m. Adding the equity increase to your salary, you’ve gained $1.6m over the five years.
  • Scenario B. You give 50% of that salary to hire a business manager, reinvesting the remainder along with your profits. You’ll have traded $500k in salary for a jump in revenue to $2.39m. When you work out the equity, you’ll have earned $1.67m over the same period. Put another way, you’ll have ended up adding $70k more to your net worth while having exchanged a 50+ hour job for a mostly passive role (i.e., having recovered 80% of your time).

You can fiddle with the numbers, but the returns will work out the same (they’re actually even more in favor of B once you factor in the tax burden on income). Provided that you can hire a business manager for about 50% of your intended salary, and that said person can do 80% of your work (very doable with the right model), the math is almost always favorable to getting yourself over instead of inside the business.

As for the rest, if you want the acquisition of the business to drive a substantial return, you need to:

  1. Not overpay on book value (assets minus liabilities).
  2. See evidence of intangible assets (brand/goodwill plus inherited talent) that you can make better use of.
  3. See evidence of capacity (the ability of the business to increase revenues at marginal cost) that you can fill.
  4. Have a plan to install systems that do not require more than 10 hours a week of your time (after the first 6-12 months).

As an important note, you want to drive a sale price that reflects 1 and some of 2. Never pay for 3 or 4, as you should own that risk and upside.

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