A common question from first-time buyers is: If I buy a business, what down payment is required and how much can I pay myself? We are going to attempt to answer the very difficult question of how much a buyer might expect to earn annually from an acquired business. To do so we have to make three assumptions to enable a computation.
Business Down Payment Assumptions
The assumptions are as follows:
- The business and buyer are able to qualify for a SBA loan with the following terms:
- a 25% down payment on the purchase price is required
- a 6.5% interest rate
- a 10 year amortization
- The buyer’s advisors have determined that the buyer should count on reinvesting approximately 20% of the business’ cash flow back into the business.
- The business is acquired at a reasonable price based on the assumed levels of cash flow used in the four scenarios shown below.
Seller’s Discretionary Earnings Explained
The valuation of a small business is usually determined by its level of Seller’s Discretionary Earnings (SDE), which is often informally referred to as “cash flow”, to which a multiple is applied to establish the valuation. Because buyers are willing to pay a higher multiple for businesses that generate more income, the larger the value of SDE, the higher the multiple that is applied to the SDE figure. (To fully understand this very important concept, read this article: How Small Businesses Are Valued Based on Seller’s Discretionary Earnings (SDE)).
SDE is really a calculation of the amount of cash generated by the business which is available to the buyer for three purposes:
- to pay debt service on the acquisition
- to reinvest in the business
- to pay the buyer for his/her efforts in managing the business.
Reinvestment Required When Buying a Business
Obviously, debt service must be paid before cash can be used to compensate the new owner. The amount required for reinvestment can vary significantly from business to business and different owners may make significantly different decisions about how to utilize the available cash after debt service. For purposes of this article, as stated above, we are assuming the buyer’s advisors have recommended reinvesting 20% of the cash flow back into the business.
Scenarios of Buying a Business
Following are calculations that conclude, under the stated assumptions, that a buyers might be able to pay themselves approximately 40% – 50% of the SDE that was used to establish the valuation of the business (assuming the business SDE is stated correctly and the business is acquired at a reasonable multiple of the SDE).
|Senario #1||Senario #2||Senario #3||Senario #4|
|SDE (cash flow)||$100,000||$250,000||$350,000||$500,000|
|Business Purchase Price||$270,000||$750,000||$1,190,000||$2,000,000|
|25% down payment||$67,500||$187,500||$297,500||$500,000|
|SDE (cash flow, from above)||$100,000||$250,000||$350,000||$500,000|
|Annual debt service based on 6.5% over 10 years||$27,591||$76,642||$121,606||$204,379|
|Cash flow after debt service||$72,409||$173,358||$228,394||$295,621|
|20% of SDE (cash flow) reinvested in business||$20,000||$50,000||$70,000||$100,000|
|Amount available to compensate new owner for their time in managing the business||$52,409||$123,358||$158,394||$195,621|
|Compensation/SDE % calculation||52.41%||49.34%||45.26%||39.21%|
When Buying a Business: the Relationships Between Down Payment, Seller’s Discretionary Earnings and Personal Earnings
So what can we conclude? Under the assumptions, if you have a minimum amount of annual personal income that you must earn to maintain your lifestyle, you should be searching for businesses to acquire that have SDE (cash flow) which is at least 2 – 2.5 times the amount you need to pay yourself. Following is a written interpretation of the above chart:
- If you need personal earnings of $50,000, look for businesses earning at least $100,000 of SDE. If you find a business with $100,000 of SDE and it qualifies for an SBA loan, your required down payment will be in the area of about $70,000 (based on approximately 25% of a $270,000 purchase price).
- If you need personal earnings of $125,000, look for businesses earning at least $250,000 of SDE. If you find a business with $250,000 of SDE and it qualifies for an SBA loan, your required down payment will be in the area of about $190,000 (based on approximately 25% of a $750,000 purchase price).
- If you need personal earnings of $150,000, look for businesses earning at least $350,000 of SDE. If you find a business with $350,000 of SDE and it qualifies for an SBA loan, your required down payment will be in the area of about $300,000 (based on approximately 25% of a $1.200,000 purchase price).
- If you need personal earnings $200,000, look for businesses earning at least $500,000 of SDE. If you find a business with $500,000 of SDE and it qualifies qualifies for an SBA loan, your required down payment will be in the area of about $500,000 (based on approximately 25% of a $2,000,000 purchase price).
Looking at this interpretation, you might also conclude there is a quantifiable relationship between the required down payment and SDE for businesses with valuations of $2,000,000 or less (assuming the buyer and business qualify for a SBA loan). The estimated down payment could roughly be computed as 75% – 100% of the SDE of the business being acquired. That will also be an important factor in determining which businesses you are capable of acquiring.
For buyers entering the business acquisition market for the first time, we are simply trying to help you set expectations.
As you begin your search to acquire a company, because so many businesses are overpriced (for so many reasons beyond the scope of this article) on the internet listing websites, it is best to focus on SDE (cash flow) numbers rather than the asking price.
This series of articles will continue with Want to Buy a Business? How and Where to Begin.