As a finance guy, I tend to be conservative when investing. It's in my DNA. I spent 22 years in corporate finance ending with a CFO role with Universal Music Group, the largest music recording company in the world. So numbers and risk adverseness define me.
When people talk of leverage, it can have various meanings, and to me prior to great recession, I avoided debt due to the risks and high rates.
The purpose of this article is to show you the math related to leveraging and why there has never been a better time to leverage your business purchase.
The economy is finally heating up! After 8 years of over regulations and that small business killer banking regulation called Dodd-Frank,we're seeing optimism entering the business sales market with sales hitting records! This means demand for small businesses are increasing, this drives multiples higher.
CASH FLOW MULTIPLES BEAT DOWN
The cash flow multiples are driven by buyer perception of the future. When the future looks grim, people believe cash flow will decrease, as a result they reduce the multiples they're willing to pay for a business. Said another way a buyer may say "yeah that's good and dandy that you made $100,000 last year, but because of the slow economy, I think you're only going to make $70,000 next year." This has a result of lower the multiple paid for the business. The buyer may be willing to pay 2.5 times, but it is 2.5 times for what he or she expects, which is $70,000 a year which is $175,000. But the seller is thinking 2.5 times $100,000 or $250,000. In essence the real multiple is $175,000/$100,000 in this case or 1.75 times. We saw this behavior during 2008 through 2013 economy.
And when the economy is weak, sales tend to decrease and costs tend to increase unless margins are well managed. Again, as illustrated above, the buyer knows this and is thinking $75,000 while the owner is thinking $100,000 of cash flow. But if the seller wants to sell, then he or she must come to reality of the situation and price the business accordingly.
THE MATH IN MORE DETAIL
Let me illustrate this with some more numbers. Let's assume a business before the slow economy was earning $150,000 a year owner cash flow. And because people's expectations when the economy was strong were good, they would pay 2.7 time or more for a good business with good books and records. At SellingStores we sold hundreds of businesses at those multiples from 2004 to 2008. This business is then worth about $405,000.
Let's fast forward. Today the market has beat down the cash flow multiples because the buyer's expectations of the future is weak, and the way they reduce risk is by reducing the cash flow multiple they're willing to pay. So today the multiple could be closer to 2.2 times and at one point the multiples were below 2 times (keep in mind each region in the U.S. and international countries commands different multiples). To make matters worse, since sales are down and costs are up, the owner's cash flow for the same business is now $100,000. So the value of the restaurant today is $220,000, a significant decrease of $185,000.
Now imagine the opposite today as the economy is heating up. No one can call the top, but we're certainly in a hotter market than just a couple years ago!
EFFECTS OF LEVERAGE
So keep up with me here. You buy this business for $220,000 with an SBA loan and a total of 20% down plus closing costs. That would be about $58,000 down in total out of your pocket cash. After debt payments of principal and interest you'd net about $77,000 a year from this business.
Here is where it gets fun and interesting. Let's say the economy turns-up, as many are finally saying it is. This allows you to raise prices. It will drive more traffic to your business if you're doing a good job of providing great service and good prices. So now the business earns $150,000. And more important, the buyers are more optimistic and the cash flow multiples have been driven-up to the 2.7 times again. The value of the business is now $405,000.
So with $58,000 out of pocket investment, you've not only increase your equity by $185,000 or 3.2 times what you put down, you've also increased you income by $50,000 and the restaurant after debt service is now returning you $127,000 ($185,000 less $58,000) on a $58,000 investment. More than a 200% return on investment. Of course, some would pay themselves a fair wage and reduce that number by that amount, but it would still be more than a 100% return!
THAT'S LEVERAGE! IT'S A BEAUTIFUL THING IN AN UP ECONOMY!
We at SellingStores feel obligated to educate the public, our customers and our clients with information that can help them make more intelligent buying and selling decisions.
Mel Jones is one of the premier restaurant brokers in the nation having published hundreds of articles on buying and selling a restaurant and bar business, selling thousands of restaurants in CA., WA and AZ and building one of the most copied business models in the brokerage industry. Mel started SellingStores in 2004 with the one simple concept, give the buyers the information they need to make intelligent buying decisions without being pestered by a broker or hiding information, prepare the business for market by researching key details that make or break deals and educate the buyer on the buying process to create an intelligent buyer. Prior to SellingStores, Mel was a Chief Financial Officer for Universal Music Group, the largest music company in the world. There he participated in more than $11.5 billion of merger and acquisition transactions. He also work for top companies such as Nestle Foods, USA. He hold a Bachelors in Business Administration Finance as well as attended Law School at Gonzaga University. Give Mel a call at 480.274.7000 or e-mail him at [email protected] if you have any questions.