A conundrum is defined as a confusing and difficult problem or question to solve. When assisting buyers who are purchasing very small (sometimes one-man) air conditioning and plumbing operations, arriving at a fair purchase price can be a real conundrum.
Very small and micro service businesses have a way to produce sizable salaries for their owners. This stands to reason as these businesses often operate with a reduced level of overhead (the best example is rent or lack there of). In addition, the owner often performs most of the labor by day and serves as the manager by night. It makes sense that a business producing just $400,000 annually might produce $100,000 in salary for the owner. That’s 25% of total revenue folks!
The real conundrum raises its head when that owner decides to sell his business. The first thing that typically happens is the business owner asks for a quick valuation from their tax CPA or attorney. Not knowing anything about selling contracting businesses many professionals refuse to say “I don’t know” and to protect their client whip up something quick that seems to make sense. It always seems to be based the owner’s salary. In this case let’s use $100,000. To that $100,000 the CPA or attorney applies a multiple of say 3 to 4. The justification being that if the business owner kept the business for 3 to 4 years they would make the same money. This is how very small contractors end up with hyper-inflated expectations for their business. And their hyper inflated bubble typically gets popped upon initial discussions with the first would-be buyer.
So why is a contacting business that produces $400,000 in annual revenues going to have a challenging time selling for $300,000 to $400,000? Let’s see.
Someone will have to replace the owner in performing the work that produces the $400,000. When a buyer analyzes the revenues and the expected earnings, they will factor in all of the cost of the direct labor going forward. In additon, because the overhead structure of small contracting business is so low, additional expenses will be factored in for a normal level of overhead.
Small business owners are often forced to turn to larger contractors as a means to sell their businesses. This is not always the best place to turn as most businesses owners already operating in the same space will under value these small acquisitions. However, an under valuation makes sense for the following reasons:
Esisting busiensses ownere will focus on what their business is able to earn on the $400,000 in additional revenues subsequent to a transaction. A typical range is 8% to 12%. Not 25%!
Existing business owners will not value anything but the customer database and the likely-hood that the existing customers will transfer over to the new owner. Nothing else will hold much value to an existing business owner.
Existing business owners analyzing small acquisitions often use a “what if” scenario when establishing a purchase price. What if I simply spent more money on advertsing as opposed to buying a risky customer database? Think about this, if a business spends 8% of its annual revenue on advertising, a would-be buyer might be lead to believe that an additional $400,000 in revenues can be had for an additional $32,000 in advertising expense. This theory is not always 100% accurate, but it certainly makes some senses.
The conundrum involving the sale prices of small and micro businesses is just that, sellers with expectations that can often exceed 10x what a buyer is willing to pay. As a business owner of a small contracting business, be aware of this conundrum. As a buyer, understand that many business owners of small contacting businesses may be basing their expectations on their annual salaries. If this is the case, negotiations may take some time and involve some strategy.