Test of Reasonableness When Selling a Business
Are you ready to sell your business?
When selling a business, the sales price must pass the “Test of Reasonableness.”
The Test of Reasonableness is a formula we use at Texas Business Brokers during the Business Valuation process to ensure the business’s sales price makes sense from a Buyer’s perspective. After performing the test, if it doesn’t seem to make sense for a buyer (risk to reward), then it is likely not going to sell or will take an extended amount of time to sell.
Unfortunately, many Sellers often overestimate the value of their business, believing it to be worth more than its actual valuation or expecting that someone will pay a premium for various reasons. To ascertain whether a sales price is reasonable, a simple yet effective calculation can be conducted.
The purpose of this calculation is to determine the potential earnings of a prospective Buyer if they were to purchase the business and finance the purchase through traditional methods. To perform this calculation, you will need the sales price, the Seller’s Discretionary Earnings, a basic calculator, and a loan calculator. Below is the calculation and some examples.
Basic Calculation Guide
1. Determine the Loan Amount:
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- Formula: Sales Price – Down Payment (typically 10-15% for SBA 7a loans) = Approximate Loan Amount (excluding closing costs, any additional inventory, and working capital).
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2. Calculate Monthly Payments:
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- Use the Loan Amount to determine the monthly payments based on expected terms. For instance, most SBA-backed loans without Real Estate are generally 10 years in length with an interest rate about 2.75% above prime.
- Utilize a simple Loan Calculator to compute the monthly debt service.
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3. Determine Yearly Obligation:
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- Multiply the monthly payment by 12 to find the yearly debt obligation.
- Subtract this amount from the current owner’s Seller’s Discretionary Income to estimate the yearly income a new buyer might expect if the business performs similarly to past ownership.
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4. Evaluate the Results:
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- Apply common sense to interpret the results. For example, if the calculation indicates $45,000 in expected earnings for a new buyer who needs to invest $300,000, the investment might not be justifiable due to the high risk and availability of better opportunities.
- Conversely, if the sales price is $25,000 and the earning potential is $45,000, the risk may be worthwhile. Similarly, a business priced at $3.5M with potential earnings of $450,000 could be considered a good investment, as $450,000 is a substantial income.
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There is no exact science to determining what “passes” as a good investment. It will vary from person to person, but whether you are a buyer or seller, this should help give you an idea if a Business sales price makes sense.
Below are a couple of sample calculations. You can also use our Business Valuation Calculator to get an approximate Business Valuation. Please feel free to call or email us with any questions. Our trusted local Business Brokers are happy to help in any way we can. We serve all of Texas.
A Few Examples
- Example 1 - Business with $750,000 In Seller Discretionary Earnings
- Example 2 - Business with Inventory
Aggressive Sales Price |
Average Sales Price |
Conservative Sales Price |
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Sales Price |
$3,950,000 | $2,990,000 | $2,490,000 |
10% Down Payment (Min. Required For SBA Loans) |
$395,000 | $299,000 | $249,000 |
Amount To Be Financed |
$3,555,000 | $2,691,000 | $2,241,000 |
Yearly Total Debt Payments For SBA Loan (10-year note at 9% rate) |
$540,396 ($45,033 monthly) | $409,056 ($34,088 monthly) | $340,656 ($28,388 Monthly) |
New Owner’s Expected Yearly Income After Debt Service ($750,000 – Yearly Debt Service) |
$210,000 | $340,944 | $409,344 |
Aggressive Sales Price |
Average Sales Price |
Conservative Sales Price |
|
Sales Price |
$599,000 | $499,000 | $349,000 |
Total Inventory That Needs To Be Purchased |
$460,000 | $460,000 | $460,000 |
Total Loan Amount |
$1,059,000 | $959,000 | $809,000 |
10% Down Payment (Min. Required For SBA Loans) |
$105,900 | $95,900 | $80,900 |
Amount To Be Financed |
$953,100 | $863,100 | $728,100 |
Yearly Total Debt Payments For SBA Loan (10 year note at 9% rate) |
$144,876 ($12,073 monthly) | $131,196 ($10,933 monthly) | $110,676 ($9,223 Monthly) |
New Owner’s Expected Yearly Income After Debt Service ($183,000-Yearly Debt Service) |
$38,124 | $51,804 | $72,324 |
Please note:
Please keep in mind that selling businesses is both an art and a science, and not an exact one. A skilled Business Broker employs a variety of tools to determine a business’s valuation and develop a marketing strategy. It is advisable to find a broker who is transparent, can substantiate all their recommendations, and is adaptable in their approach.
If you have any questions, please do not hesitate to call or email one of our Business Brokers today. We have local business brokers in Austin, Dallas, Houston, and San Antonio.
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