Understanding ROI in Business Acquisition.

When thinking about buying a business, one key concept you need to understand is Return on Investment (ROI). A common question that comes up is whether you should subtract a reasonable salary for yourself as the owner when calculating the owner's benefit or cash flow. This question touches on some fundamental principles of business evaluation, and it's crucial to understand the different perspectives.

 Two Schools of Thought on ROI Calculation

  Investment Perspective

From a strict investment viewpoint, it makes sense to subtract a manager's salary from the owner's benefit. This approach helps you evaluate the ROI in comparison to other investments, like stocks or real estate. By deducting a manager’s salary, you can see what the business would generate purely as an investment, separate from your role as an operator.

  Owner-Operator Perspective

On the other hand, some people prefer to evaluate the business from the perspective of an owner-operator. In this view, you don’t deduct a manager’s salary because you’re considering the business as your job and investment combined. This approach aligns with the idea that you’re not just buying a business for passive income but also for the opportunity to run and grow it.

 Example: Calculating ROI

Let's break down an example to understand these concepts better.

Imagine you're considering buying a business that generates $100,000 in owner benefit and is selling for $250,000. The seller is willing to finance $125,000, so you need to put down $125,000 in cash.

Now, let's calculate the ROI in two scenarios:

1. **Without Deducting Owner's Salary**:

   - Owner Benefit: $100,000

   - Purchase Price: $250,000

   - Down Payment: $125,000

   - Seller Financing: $125,000

   In this scenario, you get to keep the full $100,000 as the owner benefit. If we consider the seller financing with a five-year note at 8% interest, the annual debt payment is approximately $30,000. After paying the debt, you are left with $70,000.

   ROI Calculation:

ROI = (Net Income / Initial Investment) * 100 = (70,000 / 125,000) * 100 = 56%

2. **With Deducting Owner's Salary**:

   - Assume you would hire a manager for $40,000 per year.

   - Adjusted Owner Benefit: $100,000 - $40,000 = $60,000

   - After debt payment: $60,000 - $30,000 = $30,000

   ROI Calculation:

ROI = (Net Income / Initial Investment) * 100 = (30,000 / 125,000) * 100 =24%

Why Not Deduct the Owner's Salary?

Deducting the owner's salary can give you a clear picture of the business as a passive investment. However, not deducting it can highlight the business’s potential as your primary source of income and growth opportunity. It’s essential to understand that when you buy a business, you are not just investing money; you are also investing your time and effort.

 Valuation vs. ROI

It’s crucial to distinguish between calculating ROI and determining business valuation. The business valuation typically includes the full owner's benefit because it assumes that you, as the new owner, will replace the seller. Therefore, the owner's benefit represents the total financial benefit you would receive from running the business.

 Public Companies vs. Small Businesses

Comparing the ROI of a small business to investing in public companies is like comparing apples to oranges. Public companies offer passive investment opportunities without requiring you to give up your current job. In contrast, buying and running a small business often requires your full-time commitment but provides the potential for unlimited growth and control over your destiny.

When evaluating a business for purchase, consider both perspectives on ROI. Calculate the ROI with and without a manager's salary to understand the full scope of your investment. Remember, buying a business is not just about the financial return; it’s also about the lifestyle and personal goals you wish to achieve. By considering these factors, you can make a well-informed decision that aligns with your long-term objectives.