Be an Ethical Entrepreneur, Marketer, and Business Builder

My best investment ever!

My best investment ever!

My best investment ever!

In less than 60 days I managed a 28% ROI netting me a quick $1400 in cash with almost no work and minimal risk.

Now of course these deals don’t come along everyday but you have to be ready for them when they do… And it wasn’t luck in the stock market, flipping a property (cause that takes lots of time and risk), or even growing my business. Nope – this investment was a motorcycle. 🙂 One that I bought, put 1444 miles on and sold for a quick profit.

Ironically, the formula I used to make this deal work has a lot of parallels to buying, building, and selling a business. Here are a few:

  1. The most important part is always the purchase. No matter how hard you work to build a business in a short time, the purchase price is what dictates your ROI.
  2. I knew a good deal when I saw one and acted quickly. Honestly, I know a lot more about motorcycles and engineering then I know about business so even though I knew the price was right, I did my homework and verified that the bike was WAY underpriced.
  3. I was in the right place at the right time. Granted, with business if you’re willing to travel you can always find the right place at the right time. If not, then sometimes you get lucky and find a no-brainer like I did with the bike.
  4. The bike required some minor maintenance and cleaning that I knew how to take care of.
  5. Selling the bike required knowing where to sell (i.e. craigslist), who the target audience was, and how to build value in the bike including negotiating a fair selling price and offering additional valuable services in addition to the bike (i.e a free helmet, thorough review of the bike, explanation, and inspection with an experienced mechanical engineer).
  6. I had to get the buyer and the seller to both like and trust me. The seller wanted cash and all I had was a personal check and a bank statement so he had to feel comfortable enough with me to accept that and let me ride off with his bike. The buyer had to trust that I was accurately representing the bike over the internet (to warrant a 3 hour drive to pick it up) and that my knowledge and experience with bikes was legitimate.

Some of those ideas may be a stretch, however I can’t emphasize enough that the most important part is the purchase price. With that in mind, you better spend time educating yourself on EBITDA and Free Cashflow calculations. EBITDA, as I’ve pointed out, is a bit of a farce, however Free Cashflow times some arbitrary multiplier is more “acceptable” though it’s not without it’s flaws.

Free Cashflow is basically your net income (or profits) with a few allowed add-backs such as 1 owner’s salary, vehicle and other perks. Interest is also an allowed add-back along with depreciation and amortization. At least with free-cashflow we all agree that everyone has to pay taxes regardless of the quality of your accountant. My issues with the free cashflow method (which are important to know when you negotiate the purchase of a business) are:

  1. Only 1 owner’s salary and perks can be an add-back, however what if the owner doesn’t take a salary because he has a great General Manager (Team Leader) in place? Isn’t that “automatic” business worth more then the one that requires the buyer to be the Team Leader?
  2. Very few people buy a business without some sort of financing whether it’s from the seller, bank, or rich uncle so completely discounting interest can be kinda silly.
  3. Depreciation as an add-back again is a bit ridiculous because those numbers represent legitimate expenses that had to occur before and will occur again (though hopefully not in the time it’ll take you to buy, build, and sell).
  4. The multiplier is “arbitrary”. As a business broker informed me a business is worth whatever a ready, willing, and able buyer is willing to pay. Most business owners think their business’ are worth 1 times revenue and, when you go to sell, if you can get somebody to believe that then more power to you. In reality most small businesses are worth 2-3 times free cashflow which means unless your business is making a NET profit margin of 33%-50% it’s probably not worth 1 times revenue.

Granted, my understanding and even experience with all of these is a bit limited, however the most important things I’m trying to stress are:

  1. Educate yourself completely
  2. Everything is negotiable (there are no hard, fast rules)
  3. Be willing to walk away if the seller doesn’t agree with your purchase price and go find another deal

To your success, Bryan

Business Valuation 2 – EBIDTA can eat my shorts…

Ok, so maybe that’s not the most professional way to title a blog… We can discuss that another time.

In the last blog we discussed the 2 main criteria a bank looks at for approving a commercial (and theoretically personal) loan.

  1. Cash Flow – do you make enough money to afford the payments?
  2. Tangible Assets – if you don’t make enough money what can we sell to pay off what you owe us?

Since that blog was written a banker educated me concerning listing revenue and a customer list as an asset “There is no way to assign a value because that customer base can decide to go away on a moment’s notice. They are not required to do business with you. So that value in the business is actually a part of the “blue sky.”” So you know I’m not making this stuff up. To think that customers are just going to disappear when, on average, each one has been with you over 8 years AND new customers are going to stop buying from you when you’ve had a successful revenue generating strategy in place for nearly 40 years is kinda silly. For most people their business’ are their lives. With that kind of track record how/why in the world would they all of a sudden sabotage it. That just seems like a ridiculously minor risk.

Does anyone know if banks are “forced” to not consider revenue or customer base as an asset because of some strange banking or FDIC regulations?

At any rate, we’ve spent enough time on valuing a business based on tangible assets so let’s consider valuing a business based on EBITDA. Firstly, EBITDA and cashflow are NOT the same thing. If you’re buying a business, you should always value it by looking at profits. Secondly, EBITDA in no way approximates or represents profits. I only point that out because if you’re trying to buy a business and someone tells you that it’s worth $1 million because EBITDA is $200k and the standard multiplier is 5 then you should indicate that EBITDA doesn’t tell you anything about the business and you need to look at profits instead. Let’s look at each piece piece of EBITDA so we can see why its only helpful when you sell your business (because it’ll drastically inflate the business’ value).

  1. Earnings – depending on who’s doing the evaluation this can be either Net Operating Income or Net Income. In essence, this is your “book” profits. Except there’s one problem. If your business is based on Accrual accounting (which over 95% are) then earnings are based on sales, not on deposits. Just because I made a $1000 sale, doesn’t mean I’ve actually collected $1000 and have that cash in my bank account to spend. In other words, this tells me what earnings should be but not how much of that is cash in my pocket.
  2. Interest – The theory goes that when you buy a business you’re not buying the business’ debt so you have to pull out its interest. That makes sense as long as you add back in the interest you’ll now be paying for whatever loan you need. If you’re just using EBITDA to measure “free cashflow” in a public company, you definitely don’t want to pull out interest because they have to pay that every month and that certainly affects their cashflow.
  3. Depreciation – The basic idea is that if you buy a truck, car, building, computer, or office equipment for your business, you can’t write-off that expense all at once and so have to depreciate it over 3,5,7, or 21 years depending on what it is. Well you had to pay for it upfront, so now you have a non-cash expense (i.e. an expense that shows up on your income statement that isn’t a part of payables) and more cash in your pocket every month, right? There are 2 problems with that.
    1. You generally still have mortgage or car payments to make that don’t show up on your Income Statement. So in this instance some portion of that depreciation IS actually decreasing your cash flow every month.
    2. Depreciation is designed to expense an item over it’s lifetime. However, at some point you’ll have to replace that item again. If its your habit to pay for everything up front without a loan then every month you’ll have to be setting some cash aside to replace that item when its useful life expires.
  4. Taxes – This one is similar to Interest in that when you buy the business you’ll have a new accountant and and so the amount you pay in taxes is going to be different. That sounds reasonable to me. So figure out how much in taxes your super-accountant will be able to save you and subtract that. Don’t just assume taxes are going to disappear and base your business valuation on that assumption. One way or another you will pay taxes – or end up like Al Capone.
  5. Amortization – The whole concept of amortization is probably the one I understand the least but here’s my explanation anyway. Admittedly, this one can be a very legitimate non-cash expense. I’ve discussed this one with business owners, accountants, lawyers, and bankers and, though they all seem to have a slightly different explanation, from what I can tell, it’s a GREAT accounting gimmick. Here’s how it works, it’s basically the same as depreciation except for non-tangible assets. For instance, let’s say you pay $1 million for a business but through certain accounting practices you can show the business is worth $600k. You now may have the ability to amortize that $400k “blue sky” asset, that has no “tangible” value, over the next 15-20 years. Now, if you are the one who is making payments on a $1 million loan then the amortization is just like the depreciation. It’s not really a non-cash expense since you’re making loan payments against it. However, if you buy a business where the previous owner was amortizing from his purchase, now you could potentially have 10-15 years left of that non-cash expense to write-off. This is most common when the previous owner bought the business when it was losing money (if you pay any money for a business that is losing money you should have some “blue sky” to amortize) and then made it profitable and sold it to you.

The Bottom Line

EBITDA has it’s place. In fact, it’s great when you want to sell your business. Most people in the business and banking world use EBITDA multiplied by some arbitrary number (generaly 3-9) to come up with the value of a business. Since that value will always be higher than valuing the business based on profitability, then why wouldn’t you try to sell your business based on that?

On the other hand, I’m not sure I can think of one solid business reason to evaluate a business based on an EBITDA, EBITA, or EBIT number. Maybe that’s why EBITDA is not a GAAP (generally approved accounting practice) calculation.

Nonetheless, you have to give it to the first guy who invented EBITDA by highlighting it in a corporate report to show how well his business was doing. We all bought into it and now he even has the banks and accountants using his inventive, creative, and pointless calculation.

Just make sure the next time you’re looking to buy a business or just some stocks, you’re not spending too much time on EBITDA.

To your success, Bryan