If you’ve ever considered purchasing a business, the thought right after, “I can be my own boss!” is likely “Can I even afford it?” Business ownership is rewarding in many ways- beyond finances. But it also brings lifestyle changes that impact those around you. It’s an investment you want to be confident in.
We won’t talk in absolutes about whether or not you can afford to buy a business. But, after a decade of seeing executives buy businesses, we’ve developed two frameworks that work in tandem for helping you answer that question.
Here’s the first framework: If you can contribute 25% of the company’s equity in cash, there is a 95% probability the deal will close. (This holds true regardless of industry, collateral amounts, personal experience, etc. It applies mainly to transactions $7M and less.)
The most expensive thing you can do is chase deals you can’t close.
That’s why this framework focuses on the probability of success, of getting a deal closed.
The less equity you can contribute, the less probable a successful close will come. If you are only able to contribute 10% equity the chance of getting that deal closed is around 50%. The more you rely on other sources of funding, from the seller or outside investors, the more uncertainty and the more coordination needed. These things make it harder to get to a close.
Using frameworks help you decide what deals are worth chasing, what deals you can afford. In this second framework, we consider what you need from business you own and how that impacts what you can afford.
DVS dogma states there are three core things you need in the business you acquire.
1. Pay your desired salary
2. Service your debt
3. Provide a 20% return on your equity at 0% growth
So, doing a bit of reverse engineering, start with your desired salary. What do you need to take home?
Multiply that amount by two. That’s the amount of equity you’ll need to put into the business you acquire.
Multiply that amount by four. That’s the transaction size- or, more accurately, an estimate of the transaction size; that number is likely the higher end of the range.
Say, for example, you need to take home $500,000 as your salary. That means you should expect to invest $1,000,000 of equity in a transaction that could end up being $4,000,000. This ratio is good for the probability of a successful close – it’s 25% equity for the 95% success rate.
But what if you only had $600,000 to invest? For this example, that puts your equity investment down to 15%, which changes the probability of a successful close to 60%. Are you comfortable spending your time and money chasing a deal that has a 40% chance of not making it to the end?
That isn’t a comfortable rate of success for most people. So, go chase something else. To find a deal with a higher percentage of success, with your available investment money of $600,000, you’d need to lower your salary requirement. Or you keep your salary consistent and find more cash up front to invest in equity. All of these aspects interact with each other and, unless you somehow find yourself the perfect deal that matches all your requirements, you likely have to be flexible in one aspect or another.
Remember: The most expensive thing you can do is chase deals you can’t close.
Think about how much equity you can contribute and your required salary. Using our frameworks, you can come up with the likely transaction size and the probability of getting to a successful close.