Is It OK to Pay Too Much for a Business? (hint: yes, and it might even be a smart thing)

When he walked into Starbucks with a big red notebook under his arm, I figured the meeting might not go as planned. I had worked with Robert (not his real name) for almost four months. We had met through a mutual friend who knew Robert and his wife were looking to leave corporate life and buy a business they could run together. Robert had contacted me to see if I had any companies he might be interested in buying.

I had been engaged by the owner of a 60 year-old business that was practically recession proof. My client’s business had a strong team and cranked out profits of almost seven figures per year. When I described this opportunity to Robert, he was very interested. He soon began to dig behind the numbers, he and his wife visited with the owners, and it wasn’t long before he had hired an attorney to write the Letter of Intent.

My client was asking a bit more than five times annual profits for the business, which was admittedly on the high end of its market value. Robert negotiated a bit on terms, but we were basically on the same page when the LOI came in. Everything was going smoothly. It looked like this was a match made in heaven.

So when Robert strolled in that day with that red notebook, I knew something was amiss. It seems Robert’s accountant had convinced him he was paying too much for my client’s business. Robert and his accountant had searched on two business-for-sale websites to see if there were comparable businesses for sale and at what price. Sure enough, he found a few ostensibly similar businesses in various parts of the United States. His red notebook was full of print outs on those businesses. He excitedly showed me how those other businesses were priced lower than my client’s business, as measured by multiple of cash flow. At that point, Robert was convinced my client had over-priced his business, so he and his wife decided to buy a similar business in Texas.

I tell this story to anyone who says they want to leave corporate life to buy a business. I tell them Robert should have bought my client’s business, even if it was over-priced relative to comparables:

  1. Leaving corporate life to become an entrepreneur, you know a lot less about running a business than you think you do. Therefore, find a business that is already well run. My client’s business was a well-oiled machine, in fact, it’d be hard to mess it up.
  2. Being an entrepreneur is more glamorous on the outside looking in, and it can be exceedingly disruptive on your personal life. Therefore, find a business that does not require a re-location (unless you’re trying to get away from something/ someone, but that’s a problem beyond the scope of my expertise).
  3. Having a long view is key to entrepreneurial success. Realize that getting a “fair price” is less important than having the right business. Therefore, find a business that throws off more cash than you need for bank debt service and your lifestyle.

To be specific about Robert’s mistake, the way we were structuring the deal, he would have had it paid off within seven to eight years. Robert was 47 years old, so by his mid-50s, he would have owned free and clear a business throwing off about $1 million per year. But, the company he ended up buying in Texas was “a better deal” because he could have it paid off within four to five years.

So isn’t a deal paid off in four to five years a better deal than one paid off in seven to eight years? Yes, in theory if all factors are equal, but all factors are never equal. In my client’s business, at the end of seven to eight years, Robert would have had TWICE the cash flow as in the business he ended up buying. I wasn’t a math major in college, but I think owning a business in seven to eight years that makes $1,000,000 per year is better than owning a business in four to five years than makes $500,000 per year.

Valuing a business is fundamentally about a projected return on investment as defined by a multiple of earnings. But, there are other factors that an entrepreneur should consider that just might make the over-priced deal the right deal.

 

JIM CUMBEE is President of Tennessee Valley Group, Inc. a retainer-based business brokerage and transition mediation firm in Franklin, TN. Cumbee is an attorney and has an MBA from Harvard Business School. He has a wide range of corporate and entrepreneurial experiences that make him one of the most sought-after business transition advisors in the state of Tennessee.

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Tennessee Valley Group

Jim Cumbee established Tennessee Valley Group to help business owners fulfill their dreams for life after business ownership. It’s a mission that his 30+ year career history had prepared him well for—in addition to being an attorney, transition mediator and business broker, Jim has been a buyer, seller, and entrepreneur. His broad range of experience gives him unique insight into how business buyers and sellers can achieve their goals.

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