Trying to determine a price you are willing to pay for a small business is much more an art than a science – there is no sure-fire formula or foolproof rule-of-thumb.  There is one thing, however, that every buyer should consider – we call it the “Buyer’s Test”.

The Buyer’s Test is simply the analysis of the business’ cash flow to see if it is adequate to allow the business and the new owner to be successful.  There is a caution: it really only works for stable, going concerns; it really isn’t applicable to distressed or turnaround situations.

Buyer’s Test – will the cash flow  from the business:

  1. Provide a reasonable salary for the owner/operator
  2. Provide a reasonable return on invested capital
  3. Provide for capital expenditures for maintaining and growing the business
  4. Cover debt service with a reasonable debt coverage ratio

What’s a reasonable salary is fairly subjective, but should reflect the skill and training required to successfully operate the business.  The salary level required to hire a qualified, working general manager would be a good starting point.

Since most buyers do not pay all cash, financing is nearly always involved either from a commercial lender, or more likely from the seller.  Down payments of 25-50% are common.  Rate of return on the down payment typically in the range of 20-40%; lower for larger/lower-risk businesses, higher for smaller/higher-risk businesses.  For very small businesses where the buyer is essentially buying a job and not really making an investment, return on down payment may be close to zero.

Capital expenditure requirements vary greatly depending on the nature of the business, the potential for growth, and the condition of the fixed assets at the time of sale.  It’s safe to assume that some capital expenditures will be required each year.

The debt coverage ratio is simply the business’s cash flow less a provision for the owner/operator’s salary (including taxes) less required capital expenditures all divided by the debt service (principal and interest) required by the loan.  The ratio is calculated on an annual basis.  Depending on the nature of the business, banks will usually require a minimum ratio of 1.3 to 1.5.  A seller may accept a somewhat lower ratio.

If the price paid for a business passes the Buyer’s Test (adequate salary for the owner, return on invested capital, cash for capital expenditures, and some cushion to handle debt payments), it is a good indication that the price is reasonable for the cash flow the business produces.  Passing the Buyer’s Test doesn’t insure that the price is right; but failing the test is a good indication that the price under consideration is too high.

A note for sellers: You should look at your business through a buyer’s eyes and apply the Buyer’s Test.  If your asking price doesn’t pass the Buyer’s Test and provide enough cash flow for a buyer to earn a living, reinvest in the business, and make his/her payments, you will have a very difficult time consummating a sale.