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Businesses valued on profits to a working owner

on September 17, 2019 / by Tom Beswick

Part of the business buying process involves understanding what the financials shown in the Information Memorandum (“IM”) are telling you about the profitability of the company. A key financial item to understand is how pay to a working owner has been treated, as not all businesses for sale are created equal.
Businesses valued on profits to a working owner

Some IMs will have no allowance for the pay of a working owner or management.

What this means is that the business profit isn’t really that real – there is another worker (or two) required to earn that level of profit.

Some businesses will have management costs already built into the valuation – and this makes them more valuable as it widens the prospective buyer pool.

With a good manager in place, potentially anyone can be a buyer – rather than maybe needing industry experience if you need to be hands on.

Clearly, lower staff cost assumptions cause higher profits, which leads to a higher potential business value and sale price.

So, there is an incentive in selling a business to not allow for the true costs of management when the owner has previously been doing this work.

Are you buying a job?

This can lead to people paying good money just to effectively buy a job.

Let’s say Dave is selling his electrical business. He’s finally decided to retire and sell his baby of the last 20 years.

Dave works in the business full time and he pays himself a wage of $75,000, which reduces company profit to nil. On paper the business has zero profit.

Now Dave talks to his business broker and they prepare the IM which says “Profit of $75,000 to a working owner.” Which is true.

But where I have trouble is when that $75,000 is then multiplied, by say 3x to arrive at the business value.

Quite often that business would get listed for sale at $225,000.

Is that business worth that money? Maybe, maybe not. Dave knows that if he wasn’t running the business, he’d have to pay that profit to any manager that he got in to do it for him.

There wouldn’t be much profit left over for any shareholders.

I argue that if all the profits of a business go to pay for a manager to run it – then that business isn’t really making any money.

One step further (and slightly tongue in cheek) – if said business isn’t making money, then it may not be worth anything.

Cue general outcry from many business owners.

To me a business should ideally be valued based on what a shareholder can earn without having to lift a finger.

Now of course there are many valid reasons that people pay the prices they do for businesses that are not related to the profits of the company i.e. lifestyle opportunities, value of working for yourself, the ability to add value to the business, synergies with other businesses they own etc.

These reasons are all valid. I just like to be clear to my clients what they are paying for when they buy a business.

Of course, most SME businesses will have mum and dad involved in the business in some shape or form. Usually very heavily.

Most of them won’t be able to afford to take a manager on. That’s all totally fine.

I just don’t want my clients to overpay by paying an asking price that doesn’t factor in the real costs of running the business.

It is crucial to ask the right questions before you buy a business – always seek professional, independent advice.