Mar 19, 2013

The 6-6-6 Rule of Thumb for Buying a Business

Before I met my wife, I dated (or went on a date with) over 823 different girls.  Patience pays off: I married the woman of my dreams and she's the total package.

In looking at my numbers for the last 12 months, it seems it takes 6 initial views of a business for me to create 1 offer.  I have to have 6 offers, to get 1 to accept.  Of those that accept my initial offer, only 1 out of 6 actually ends up selling me his or her business.

I’ve looked at 200-plus businesses, of which I’ve put offers on 36 (7 of these offers were revisions of offers, or re-offers on the same company); of these 36 offers, 6 have accepted, and only 1 of them actually successfully closed. 

Why didn’t I put offers on all 200-plus that I initially looked at?  Because after receiving the financials, it was apparent that many of these companies were simply not worth owning, for any price, or there were few creative ideas I could employe to improve the company once purchased, or I wasn’t able to find the right managing partner to joint-venture it with me.

Of the 36 offers I put in, most did not accept.  Anyone in business knows this: rejection is part of the game.

5 out of 6 refused my initial offer.  I rarely offer a 2nd offer unless I get something reasonable back from the seller that leads me to believe that creating a revised offer might produce a favorable deal.  Still, of the 6 that did accept my offer, only 1 of those 6 actually ended up in a purchase.  Why?  Because if you do your due diligence properly, you’ll almost always find skeletons in the closet.  How the buyer and seller negotiate for concessions once those skeletons are discovered is another area for further consideration and negotiation. 

You don’t want to be looking for excuses to modify your initial purchase price.  But you do want to hold the seller accountable for any deviations between the representations the seller made (of which your offer was based) and the actual truth.  If there’s a gap, then there needs to be a compensation for that gap.

For example, I made an offer for a manufacturing company that represented sales of about $1.2M and a net income of $180K.  I made a fair offer based upon the rules of thumb for this industry, which were a percentage of the equipment and inventory plus a multiple of SDE (seller’s discretionary earning) of 1.5x.  It’s been almost a year, but I believe the assets were represented as being worth $50K and the SDE was represented as $200K with the addbacks ($180K net income + $20K in seller’s personal expenses).  My offer of $350K was reasonable and fair, assuming the seller’s representations were in fact accurate.  

Turned out however that during due diligence, the net income figure was actually a loss on the tax returns, and the amount of addbacks didn’t come anywhere near $200K; it was more like $100K.  I had to revise my offer to accommodate that gap, adjusting the offer to reflect the actual SDE.  The seller refused, and last I checked, his business still hasn’t sold.  He’s still representing to the market the inflated numbers he’s already been called out on, hoping someone will pay a higher price for numbers that don’t actually exist.  

This process can be frustrating.  It may take you 300-600 hours to find one deal that works.

Moral of story: it's a numbers game.  As in dating and marriage: don't buy the first business you fall in love with.