BRUCE'S BLOG - A retreat from rational?
Bruce Sheppard
BRUCE SHEPPARD examines the motives that drive people to pay too much for businesses.
Have you ever wondered what drives small business values and small residential lot values?
Let us start with a scenario of what would be rational with, for example, buying a section for development.
You would start with:
* what you think the sale price of the completed dwelling is likely to be after deducting the full costs of improvements
* a return for risk and the amount left over is the value of the land
In essence, if you are rational, when you buy land in such circumstances, you are buying an opportunity to improve it for - and this is important - profit.
How about a small owner-operated business?
You are buying it as a bundled proposition - to get a job and to make a return on your capital. So, what is such an enterprise in theory worth? Clearly the asset, which is the opportunity to profit, is worth the super profits you think it will make.
Imagine your business making $150,000 before you pay yourself to run it.
Should you value the business on the $150,000 or a lesser number of, say $75,000, being the profits after you pay yourself to run it or work in it?
It’s clearly the latter, right?
Not so. When a small business is presented to you for sale, the brokers will present the number before interest, tax, and depreciation and proprietor remuneration. In the example above, that is what the $150,000 will be. Assuming it is moderately decent, the asking price will be between $300,000 and $600,000.
As an example, take the mid-point, which is a multiple of three. Assume you pay cash for this business, it is stable, and makes $150,000 each year for the years you own it. Assume, for simplicity, no depreciation either.
In the first year you make $150,000, you pay yourself $75,000 before tax, which you need to live, and you pay tax on the remaining $75,000. The tax comes to $24,750, leaving you $50,250. It takes you nine years to get your money back.
Now, if you are lucky and in nine years time you can get your capital back as well (because the buyers are just as irrational as you), you will have surrendered your capital for nine years, and made a 16.66% return on it in the interim, and that’s before tax. Is this enough for the risk and aggravation of running a small business? Is it enough for surrendering nine years of your life? Guess what? Most buyers will answer the question in the affirmative.
Now if you, as a non-builder, have ever done the mathematics on a building, house or townhouse, it usually works out the same. I’ve done it on a spare section I have owned for 20 years. No matter when I do it, the math ends up saying I am better to just sell the section. Why? Why do small builders not price in profit and, more often than not, their labour as well? How do they not go broke?
The builder scenario is a bit easier to understand. They know it takes six to nine months to build and sell a house and they assume house prices will rise and fix the problem. During most of the past decade, that has been a pretty safe assumption. But I wouldn’t bet on it today. Even with inflation the builder, at best, only gets back his wages. Why would such people put their capital at risk to just make wages? Why do small business buyers not value their labour and, in a sense, pay a high price to buy a job?
Well, instead of considering the cost of paying someone to do the job, they consider their own opportunity loss of buying the land or the business, rather than doing their next best alternative activity. This is actually rational on their part. So, what is your opportunity loss? Is your next most viable alternative unemployment or stocking shelves in the supermarket? It isn’t $75,000 that is for sure.
How come there are people that think they can run a business, that are confronted with the next best alternative of being unemployed or in minimum wage jobs? Now that is easy to answer. We are in a recession, middle management jobs have been slashed, higher paid jobs have disappeared and mostly the 50-year-old pluses in middle management are taking the hit. They also have some capital, thus the thought of buying a job makes sense to them. But should it?
In the example above they will earn a wage and get their capital back over nine years and they will be 60 and looking to sell their business to the next guy who wants to buy a job. Their gamble is that in 10 years time the opportunity loss they had to confront will still be a real feature of the employment market. That is a very risky bet. The reality is this bubble of 50-year-old pluses is going to pass through as the baby boomer bubble passes on.
Assume the economy is recovering. Assume that buyers become rational again and only value super profits. They will end up selling the business for half what they paid for it, and the return on their investment will be a paltry 8%pa before tax over the time they owned it.
Why would buyers of small business pay so much for so little? Are they being just dumb?
Before you answer that question, because I don’t intend to, consider one other factor: In a discussion with a senior company director asking "why be a director in an environment where, for inadvertent errors of judgment, you face double bunking in Mt Eden Prison", he replied they do it to “remain relevant”.
To a point this is what drives a builder to pay too much for land and a middle-class middle-aged family to pay too much for a business. If the alternative is the scrap heap, how much will you pay to avoid it and remain connected to those yet to face the disconnection from being productive and relevant?
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