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When To Think About The Seller’s Point of View
By Quiet Light
It never ceases to amaze me how often I’ll speak to a buyer who will go through a 10 minute explanation about how he/she arrived at a valuation for a listing, but how that person often doesn’t consider the seller’s point of view.
Example: Suppose there’s a listing that generates $300k/year in cash flow for the owner. The owner works 30 – 40 hours/week and the business has been consistent for five years. It’s not unusual to hear buyers say that they discount the $300k/year for this reason or that reason, that they expect the seller to carry a note for half the purchase price for three years and that overall they value the business at 2x earnings, or $600k. That’s well and good for the buyer, but would any rational seller consider such an offer?
How Would a Seller View Such a Deal
Let’s take a minute and figure out how the seller would likely view such a deal. If he holds the business and maintains it, he’ll earn $300k/year. In the first year, he’ll earn the total amount of cash being offered to him, or $300k. In the next year he’ll earn the total value of the note. (Instead of waiting 3 years for payout.) Finally, at the end of these two years, he’ll still own 100% of the business, and will still be able to get some cash value for it, rather than owning none of it. When looking through the eyes of the seller, he’d be an idiot to take such an offer unless he’s either highly motivated (due to a family situation, need for capital for another project or utter and complete burn out) or if the business is in serious decline.
From the buyer’s point of view, he’s essentially trying to get a 67% cash on cash return on investment per year for the first three years, then 100% thereafter. (For the first three years he’ll earn back $200k/$300k = 67% which represents the cash flow less the loan payments. Thereafter he’ll earn $300k per year which represents 100% on his initial $300k cash investment.)
The Actual Payout
I plugged these numbers into the compound return calculator and found that earning a 66% return on $300k for 5 years (there was no option for 67% return) in a taxable account with combined 34% annual federal / state tax bill would leave the buyer with $2,500,000 after five years assuming he reinvested the profits at the same rate. So do you think it’s realistic and plausible that you can earn eight times your money every five years? If so, give me a call because I’ll invest all my cash with you. For most of us mortals, however, this is a pipe dream and in no way realistic. Sellers are not stupid. They’re not going to hand you such a goldmine unless you’re willing to pay a fair price.
I freely acknowledge that my scenario leaves a lot out of the typical buyer equation. Buyers need to consider:
- Any work needed for the website.
- Whether the earnings will continue in the future as they have in the past.
- The tax consequences of any money they invest.
Regarding #1, usually buyers tend to overestimate this in my experience. They look at a site and decide it needs a $40k overhaul, but completely neglect to notice that it’s current earnings are derived from the current (ugly) website.
Regarding #2, this is a real concern and all buyers should consider it, but remember, the multiples of today’s listings already factor in the fact that these are risky investments. That’s why they typically sell for 2x – 3x in cash at closing.
Regarding #3, I find buyers usually place too much emphasis on this. If I could get a consistent 20% or 30% annual return, I wouldn’t care if I’m paying ordinary income tax rates vs. capital gains rates.
So before getting too creative with an offer, please stop and consider whether you would even consider your offer if you were the seller. When looking at my stats, 75% of the deals I’ve closed were 100% cash at closing. The other 25% usually had relatively small amounts of seller carry. If you want to get a deal done, cash is king to a seller.