SelfInformed

September 2016


The Benefits Of Buying A Business

Thursday, September 29, 2016

BACK TO BASICS, The Benefits Of BuyingABusiness

Buying a business provides a tremendous money making opportunity because it combines six factors that make it far superior to any other form of investment.

These six factors are:
- Appreciation
- Leverage
- Depreciation
- Amortization
- Conversion
- Cash Flow

Let us analyze each of these from the view of the business owner.

APPRECIATION
Appreciation is the increase of the value of the business over time. The selling price for a business is determined to a large extent by the sales and profit generated. If the sales and profits grow over time so does the value of that business.

Example: Bob’s Bagel Shop has yearly sales of $300K and yearly profit of $100K. The buyer Joe purchases Bob’s Bagel for 2.5 times yearly profit (a good price), He pays $250k for the business. Joe brings new blood to the business. He energizes advertising and customer service. Joe increases sales by 10% per year. After 5 years his yearly sales have increased to $402K and his yearly profit to $133K. His business is now saleable for $332K (assuming the same 2.5 times profit). Joe’s business has appreciated by 33%.

LEVERAGE
Leverage is a marvelous tool that allows a business buyer to purchase a business by financing a percentage of the purchase price. The average purchase price of a business is financed from thirty to fifty percent.

Financing sources can be the business seller, the SBA (Small Business Administration), a local bank, or family and friends.

Obtaining financing from the seller carries the added benefit of his commitment to helping make sure the buyer is successful in the running of the business.

Example: Joe was able to get the seller of Bob’s Bagel to finance 50% of the purchase price of $250k over 5 years at 5%. Joe purchased Bob’s bagels for $125K cash down.

DEPRECIATION
Depreciation describes an accounting method that allows the value of certain assets to be allocated over a number of years. A large benefit of investing in a business is depreciation.

When a business is purchased, a large portion of the purchase price will be allocated to assets (including goodwill). Tax laws will allow deductions on income on the amount depreciated. Depreciation periods vary, but usually are three or five years for fixtures and equipment and fifteen years for goodwill.

Example: Joe allocates the purchase price of Bob’s Bagels to be 30% on equipment and 70% on goodwill. Assuming the purchase price of $250k, and that his equipment is depreciated on a three-year basis and his goodwill on a 70% basis, Joe will be able to use a depreciation deduction on his taxes of $37K ($25K for equipment, $12K for goodwill) for the first three years, and $12K per year after.

AMORTIZATION
Amortization describes the principal payment of the purchase loan. The purchased business will generate the funds that allow for the monthly payments. Hence the business is being used to pay for itself. The principal payments become equity for the buyer.

Example: Joe’s debt to the seller of Bob’s Bagels is $125K, payable over 5 years at 5%. His monthly payment to the seller will be $2,400 of which initially $1,800 is principal and $600 is interest. The interest portion is a tax deductible expense, and the principal adds to Joe’s equity in Bob’s Bagels.

CONVERSION
Conversion is the transition of ordinary income into long term capital gain's income. If a business that has been owned for over a year, is sold, the increase in value will be taxable at the lower capital gains tax rate. The realized profit from the sale of the business is not taxed as regular income. For businesses that are held for many years and have increased their value in large amounts, the tax savings can be dramatic.

CASH FLOW
Cash flow refers to the deficits or surpluses of money after all expenses. Positive cash flow, indicates a situation where the business supports itself without additional cash allocations.

When a buyer is considering a business purchase, one of his first tasks should be to determine how much money he needs to live on. He must then start looking for a business that will give him at least that amount. National statistics indicate that the average small business is sold for 3.07 times owner benefit.

Owner benefit is a key term when analyzing and evaluating a business purchase. Owner benefit is described as the amount of money that goes to the owner of the business, and not necessarily what is reflected as the net profit in the tax returns.

Example: The tax filing of Bob’s Bagels, provided to Joe as part of the due diligence, reflected several allowable expense deductions. Joe prepared the owner benefit calculation for Bob’s Bagels as follows:

Tax Statement Net Profit

$20,000

Owner Salary

$40,000

Personal Phone

$1,000

Personal auto

$4,000

Personal travel and entertainment

$2,000

Interest

$3,000

Depreciation

$13,000

Total Owner Benefit

$ 83,000

With this owner benefit, Joe felt comfortable paying $250K for Bob’s Bagels Shop.

CONCLUSION
When evaluating buying a business, common sense can be the buyer’s best ally. The amount of money a buyer makes in running the business will be greatly determined by how these factors are evaluated.

If the business buyer is looking to make his first business purchase, support from a business friendly attorney and accountant are strongly encouraged. Business brokers can be invaluable at filtering through hundreds of businesses to find a select few that meet the required profile and type. The business broker fees are generally paid by business sellers, so this resource can be an excellent element for the ground work.

An experienced business broker will ask the following questions as part of finding a list of good candidate businesses:

- How much cash is available to put down as down payment?
- What type of business is of interest or does the buyer have experience in?
- What types of business does the buyer definitely not want?
- Who will run the business on a daily basis?
- How much additional cash does the buyer have to cover new capital needs and start-up expenses?
- What minimum cash flow does the buyer need from a business to cover his current living expenses?
- How soon does the buyer want to be in business?
- Does the buyer have any location preferences?

Finding the right business will take time and effort. The best businesses sell fast and when the right business is found the buyer should have his team in place to move quickly and do the due diligence.

The benefits of buying the right business can give the buyer many years of profitable enjoyment.

Authors Note: Antonio Paez has over 20 years of experience in business brokerage, business valuations, business coaching, and mergers and acquisitions.

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