Question:
I’m interested in buying a business some day, but I have a question about return on investment calculations. When calculating owner benefit/cash flow, do you subtract out a reasonable salary for the owner first and keep everything else that flows to the owner (assuming your position as an owner is a full-time job) or does the total owner benefit calculation typically include owner salary?
If you don’t subtract out a reasonable owner salary aren’t you really calculating a return on your capital investment plus your time investment, and not a true ROI. Put another way, comparing small business multiples of owner benefit with that of publicly traded companies would be apples to oranges because you don’t need to give up your current job and income to invest in the stock market. If owner salary is not typically subtracted out, why isn’t it?
Answer:
This is a very perceptive question/observation and there are two schools of thought. Before discussing them, you should be aware that calculating your ROI is not to be confused with determining the business valuation (we’?ll discuss that in a moment).
In the first approach, from strictly an investment point of view, it would seem to make sense to deduct a salary for a manager from the Owner?s Benefit and therefore determine your ROI compared to other potential investments.
The second approach looks at this from the individual?s perspective, meaning that you as the buyer and future owner/operator do not reduce the Owner?s Benefit for a manager and rather evaluate this as an opportunity compared to other ?job? opportunities that you can consider.
Personally, I am a firm believer in the second approach because buying a business is your chance to forever say goodbye to working for someone else, growing the business, and ultimately, selling it one day for a multiple of the Owner Benefit. Add to that the fact that you will clearly control your own destiny far more than any impact you could have investing in a public company.
Having said that, I do recommend that you evaluate your ROI including a manager?s salary to be certain that it fits within the acceptable boundaries based on your cash investment. For example, let?s say you that you are looking at a business that is generating $100,000 of Owner Benefit, and selling for $250,000 with $125,000 of seller financing (this scenario requires a $125,000 down payment from you). Assuming you hire a manager for $40,000, this will leave you with $60,000 to service the debt and pay yourself. Assuming a five year seller note at 8% including Principal and Interest, the annual debt payment will be around $30,000, leaving you $30,000. Calculating the ROI on your cash investment (of $125,000) this will provide you with a 24% return, which is just slightly below the targeted 25% – 33% desired return for buying a business. However, once the debt is paid, and assuming all things remain equal, you?ll generate $60,000 against your $125,000 cash investment which brings a 48% ROI.
In summary, you simply need to evaluate the risk versus other investment possibilities.
That aside, let me restate that you will be buying a business to build YOUR future and while you may wish to calculate your ROI by including a manager?s salary, I do not feel it is appropriate to conduct your valuation with this net number. The valuation of a small business should be done based on the buyer replacing the seller and therefore having the benefit of the entire Owner Benefit figure (assuming all things remain the same after the purchase). While your point about investing in a business versus getting a job makes sense at the surface, I know that it is rare to have a job where you have absolutely no limit to the potential upside like you will have as the owner of a good business.
Your point about public companies is correct: you cannot compare multiples to those of a small business. However, the interesting thing about the huge gap between these two scenarios is that should you grow the business to a point that it may be attractive to be purchased one day by a public company, you can hopefully obtain a much higher multiple through the accretion that the buyer will achieve.