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Test of Reasonableness When Selling A Business

Ready to sell your business?

When Selling a business, you have to make sure the sales price passes the “Test of Reasonableness”.

There are a lot of Sellers who believe their business is worth more than it is. Or they believe someone will pay more than the valuation price because of reason X or Y or Z. One of the best ways to figure out if a sales price make sense is doing a simple calculation.

Our goal with this calculation is to determine what the potential business owner would make if they financed the business through traditional means. In order to do this calculation, you will need to know the sales price, the Seller’s Discretionary Earnings, and have a calculator and loan calculator handy.

Here is the calculation:

Sales Price – Down Payment (for SBA 7a is usually 10-15% of Sales Price) = Approximate Loan Amount (excluding closing costs and working capital).

Then you take the Loan Amount and calculate the monthly payments for the expected terms. For example, most SBA backed loans if there is no Real Estate, usually are 10 years in length and about 2.75% above prime. I would use a simple Loan Calculator to calculate the monthly debt service.

From there, I would multiply the monthly payment by 12 to determine the yearly obligation. Then I would subtract it from the owner’s earning to get an approximate yearly income a new buyer could expect if they bought the business and it performed similar to past ownership.

Depending on the results, common sense will tell you if it passes the test. For example, if the calculation reveals $45,000 expected earnings for a new buyer and in order for the new buyer to buy the business he or she would have to spend $300,000, then it doesn’t pass for several reasons. There are other businesses out there that offer a better opportunity, the risk is too great for that level of earnings, and sometimes the potential buyer can get jobs that pay similar without risking a $1.

If the sales price was $25,000 and the earning potential was $45,000, then the risk is worth the reward. Or even if the earning potential was $450,000 and the sales price was $3.5M, it would still pass, because $450,000 is a good living. So there is no exact science to what passes, therefore we use our best judgement. If the business has contracts for 20 years and the sales price is $500,000 and the earnings are $25,000 a year, it may pass because of the re-occurring revenue. Use your best judgement. 

Here are a few examples:

EXAMPLE ONE WITH INVENTORY

High End Average Low End
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 7.75% rate)$135,756 ($11,313 monthly)$122,940 ($10,245 monthly)$103,704 ($8,642 Monthly)
New Owner’s Expected Yearly Income After Debt Service ($183,000-Yearly Debt Service)$47,244$60,060$79,296

 

EXAMPLE TWO

High End Average Low End
Sales Price$299,000$267,000$165,000
10% Down Payment (Min. Required For SBA Loans)$30,000$26,700$16,500
Amount To Be Financed$269,000$240,300$148,500
Yearly Total Debt Payments For SBA Loan (10 year note at 7.75% rate)$39,156 ($3,263 monthly)$34,596 ($2,883 monthly)$21,384 ($1,782 Monthly)
New Owner’s Expected Yearly Income After Debt Service ($110,000 – Yearly Debt Service)$70,884$75,404$88,616

 

EXAMPLE THREE

High End 2017 Sales PriceHigh End

Three Year Sales Price

Average End Three Year Sales Price
Sales Price$2,950,000$2,990,000$2,490,000
10% Down Payment (Min. Required For SBA Loans)$295,000$299,000$249,000
Amount To Be Financed$2,655,000$2,691,000$2,241,000
Yearly Total Debt Payments For SBA Loan (10 year note at 7.75% rate)$378,180

($31,515 monthly)

$383,304 ($31,942 monthly)$319,212

($26,601 Monthly)

New Owner’s Expected Yearly Income After Debt Service Assuming Three Year Average SDE ($752,179  – Yearly Debt Service)$373,999$368,875$432,967

Please remember, as with many things, selling businesses are not an exact science. It is part art and part science. A good business broker will use many tools to determine a valuation and marketing plan to sell a business. I recommend finding a broker who doesn’t mislead you, can back up all his recommendations, and is fluid in his process.

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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