Know What You're Buying When You're Buying

Al has a chance to buy a small business and wants to know what he should look for and if he should go through with it. Dave tells him how it's about more than just the numbers.

QUESTION: Al in Idaho has a chance to buy a small business and wants to know what he should look for and if he should go through with it. He gives Dave some numbers, and Dave tells him how it’s about more than just the numbers.

ANSWER: The first thing is that you have to know that every morning when you get up to go over there, it’s going to be an absolute blast because you’re so passionate about that particular line of work that you’re going to be doing every day. Your vocation needs to be a vacation. Otherwise, the small business is just too hard, and you shouldn’t do it.

If you want to buy a business to make money, you’re going to run out of steam, because there isn’t enough money in the world to make you work as hard as you’ll have to work running a small business. You have to love it, believe in it, and have a calling on your life. Spend some time around the business, see how it operates, and learn the ins and outs.

As far as buying it goes, you really want to take your time and dig into it. A business is only worth the income it creates. Just because it has a great location doesn’t mean it will cause income to happen. Who cares if they have a great name in the community if it doesn’t create an income? Same goes with having a brand that everyone knows. If they are not monetizing it, then who cares how well known it is? All it comes down to is the net profit of the business.

Sometimes you buy businesses on multiples of gross sales before expenses, because you know enough about that particular business to know that you can run the business for a certain number of percentage points of the gross, and thus you know what your profit will be. But most of the time when you’re buying a small business, especially if you’ve never bought one before, you need to concentrate on the gross revenue, on the details of the expenses, and on the profit it generates as a result.

Once you’ve done that, you want to ask what you’ll make on your money. You can make 12% with a mutual fund, so if you are going to take the risk of a small business, you want to be able to make at least 20% on it. As an example, if you take $100,000 and buy this business, it has to make at least $20,000 a year. That’s the most that a business is worth.

The least it’s worth is called book value. Once you own the business, if you collected all the receivables (which is the money owed to the business), and you sold off all the equipment and the inventory, then closed the business, what would you have in your pocket? That’s the book value. If this guy has $40,000 in inventory, $30,000 worth of equipment and $30,000 in receivables, the book value of that business is worth $100,000 just if you close it.

Those are your floor and ceiling values, and somewhere in between is a fair price. If the net profit of this business is $60,000 and they are asking $185,000 for it, then that’s not a bad buy. Really get into their books and find out if their numbers are real.

Another thing is this: If someone says his business does $65,000 a year but he only pays taxes on $40,000, then that means all he made was $40,000. If they don’t report it to the government, we don’t count it. I don’t do stuff under the table. This business is worth what is reported to the government, so look at the tax returns.

Lastly, if there is a competitor in another city that would mentor you a little bit, then it would be worth it to buy a plane ticket over there and ask them what to look for in that particular world, because they know the ins and outs.