The Seduction of High ROI
In the example provided by the book, here’s the hypothetical setup:
Seller’s Discretionary Earnings (SDE): $216,000
Valuation Multiple: 3.2x = Purchase price of $691,000
Additional Costs: $200,000 for inventory and working capital, plus $50,000 in closing costs = Total acquisition cost of $941,000
Down Payment: 10% of $941,000 = $94,120 (with the rest financed through an SBA loan)
The author of the book claims this deal yields a staggering 229% ROI annually, painting it as an unbeatable opportunity. But let’s dig deeper.
ROI vs. ROE: The Hidden Distinction
The first red flag is the misuse of ROI (Return on Investment). What’s described in the book is actually ROE (Return on Equity)—the return on the buyer’s cash investment, not the entire cost of the deal.
By focusing solely on the $94,120 down payment, the calculation ignores the fact that $847,000 is financed through debt. When you account for the total acquisition cost, the actual ROI plummets to 12%. While 12% is still a respectable return, it’s a far cry from the flashy 229% initially advertised.
The “Return” Illusion
Another misleading aspect is treating SDE as pure profit. In reality, SDE includes the owner’s salary, which means part of that "return" is compensation for the buyer’s work.
If we subtract a reasonable owner salary—say $100,000—the normalized EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) drops to just $116,000.
Now, factor in the annual debt payments on an SBA loan, estimated at $120,000. Suddenly, the business is operating at a loss before even considering taxes, reinvestment needs, or unexpected expenses. This isn’t financial freedom; it’s a high-stakes balancing act.
The Risks of Overleveraging
This deal exemplifies several risks that make it a potential trap for inexperienced buyers:
Overpaying for the Business: With a 3.2x multiple plus inventory and working capital, the purchase price is inflated compared to industry norms.
No Margin for Error: A small dip in revenue could spell disaster, leaving no room to cover debt payments or unforeseen costs.
Inadequate Reserves: The lack of cash reserves means any unexpected expense—like replacing equipment or navigating an economic downturn—could cripple the business.
These risks highlight the dangers of overleveraging and emphasize the need for cautious, informed decision-making.
Why the Hype?
So why are deals like this framed as golden opportunities? The answer lies in psychology. These inflated ROI claims are designed to appeal to those new to business buying, positioning acquisition entrepreneurship as a low-risk, high-reward venture. But the reality of running a business is far more complex. It requires skills, dedication, and a realistic understanding of the financial landscape—not just optimism and a willingness to sign on the dotted line.
How to Protect Yourself
If you’re considering buying a business, here’s how to safeguard your investment:
Master the Numbers: Learn how to analyze financial statements and calculate realistic ROI. Don’t rely on SDE alone; focus on normalized EBITDA and cash flow.
Be Skeptical: Treat promises of extraordinary returns with caution. If it seems too good to be true, it probably is.
Invest in Education: Take courses or work with experts to build your understanding of cash flow, debt management, and market valuation.
Prioritize Reserves: Ensure any deal leaves room for operational challenges and economic fluctuations.
Conclusion:
Buying a business can indeed be a path to financial freedom, but only when approached with a clear understanding of the risks and realities. Flashy ROI figures and overly optimistic projections can lead you into financial trouble if you don’t take the time to dig deeper.
By sharpening your critical thinking skills and focusing on sustainable deals, you can position yourself for long-term success—not just short-term excitement.
Check out my book 21 Stupid Things People Do When Trying to Buy a Business: Learn How to Avoid These Awful Novice Mistakes https://a.co/d/2Ud3FT5
And be sure to join my email list if you’re not on it already at https://www.DavidCBarnettList.com
Cheers!
Dave