BIO: David Barnett is the author of 21 Stupid Things People Do When Trying To Buy a Business. Presently he works as a private transaction advisor with people buying or selling a business.
STORY: We get a preview of his book as he takes us through the top 5 stupid mistakes people make when buying a business.
LEARNING: David shares a host of lessons for people trying to buy a business.
“If something looks like a really good deal and you don’t know about that industry, ask yourself why isn’t somebody else in this industry picking up this company.”
David Barnett loves to say that it took him 10 years to un-learn what he was taught in business school. University had trained him to be a middle manager in big enterprises, and he was unprepared for the realities of small business.
After a career in advertising sales, David started several businesses, including a commercial debt brokerage. Helping to finance small and medium-sized businesses led to the field of business brokerage. Over several years, he sold dozens of businesses for others while also managing his own portfolio of income properties and starting his career as a local private investor.
David regularly consults with professionals and banks on business and asset values. Presently he works as a private transaction advisor with people around the world who are buying or selling a business. Find him at Davidcbarnett.com.
Worst investment ever
In this episode, we will jump straight to the top five stupid mistakes that people make when buying a business, as explained in David’s book 21 Stupid Things People Do When Trying To Buy a Business: Learn how to avoid these awful novice mistakes. Then we will look at some of the things that Andrew takes away from the interview.
1. Failing to understand how businesses are valued
A lot of small business owners and potential buyers do not understand that it is not the business that is being bought or sold; it is the cash flow. So when purchasing a company, find out how much cash flow it is generating, then ask yourself as a buyer, what are you willing to pay for that cash flow, given your ability to run the business.
Also, when looking at growth opportunities, while there could legitimately be an opportunity, do not pay the seller for it because you are the one that has to do the work to deliver the result, not the seller.
2. Failing to account for the value of the buyer’s labor
Most people will be very optimistic about a business’s cash flow, and they will not put a high enough price on their own time when they are examining the business.
3. Failing to account for the value of capital
People always forget that they need a return on the cash they put in the deal. When you put money that you have saved up over years or decades into an acquisition, you need to get an adequate rate of return on that equity you have put in.
4. Overcommitting projected free cash flow to debt service
Go for a business with a much greater debt service coverage ratio because the last thing you want is a cash crunch that bleeds out your free money.
5. Failing to adjust for operating capital
Many small business owners are experts at what they are doing, but they are not financial professionals. So they fail to generate optimized balance sheets.
Cashflow growth depends on your effort, not the seller
When you buy a business, you buy two things; the existing cash flow and growth in that cash flow. So your job is to keep that cash flow growing.
Focus on the net profit
While other metrics can be helpful, net profit gets straight down to the bottom line.
Three ways to make money from your business
There are three ways to get money out of a business: pay yourself a salary or some type of compensation, embezzle, and dividends.
Three important components of cash flow
There are three components of free cash flow; core profitability, investment in working capital, and Capex (capital expenditures, fixed assets).
If you are selling your business, do a high degree of due diligence on whoever you will be working with to help you with the process. This is because there are a lot of really awful business brokers who are giving people bad advice. Look at the person’s history, what they’ve done, how long they’ve been in it, and talk to some of their past clients.
If you want to invest in a particular business, you should know how it works and what it is like to be in it.
No. 1 goal for the next 12 months
David’s number one goal for the next 12 months is to get another 10,000 subscribers on his YouTube channel because his mission and what drives his business is to help people avoid dumb business deals. The biggest problem is ignorance, and David can solve that just by creating awareness and teaching people.
“Business is risky, but it is still worth pursuing. Just do what you can to avoid the losses.”
Andrew Stotz 00:02
Hello fellow risk takers and welcome to my worst investment ever stories of loss to keep you winning. In our community. We know that to win in investing, you must take risk, but to win big, you've got to reduce it. And I bet you're exposed to investment risk right now. To reduce it, go to my worst investment ever.com and download the risk reduction checklist I made specifically for you my podcast listener, based on the lessons that I've learned from all of my guests. Well, fellow risk takers, this is your worst podcast host Andrew Stotz, from a starts Academy and I'm here with featured guest David Barnett. David, are you ready to rock?
David Barnett 00:42
Hey, Andrew, how you doing?
Andrew Stotz 00:44
I am Yes, I'm
David Barnett 00:45
ready to rock.
Andrew Stotz 00:46
Yeah, I am. This is exciting, because we're gonna we're gonna do something a little bit different for the audience out there, get ready. But let me introduce you to the audience before we get started one second. So ladies and gentlemen, David Barnett, loves to say that it took him 10 years to unlearn what he was taught in Business School. University had trained him to be a middle manager in big enterprises, he was totally unprepared for the realities of small business. And I know that I know that pain. After a career in advertising sales, David started several businesses, including a commercial debt brokerage, helping to finance small and medium sized businesses led to the field of business brokerage, meaning the selling, buying and selling of businesses. over several years, he sold dozens of businesses for others while also managing his own portfolio of income properties. And starting his career as a local private investor. David regularly consults with professionals and banks on businesses and asset values. Presently, he works as a private transaction advisor with people around the world who are buying or selling a business. But Ladies and gentlemen, that's not all. The reason why we're here today is to talk about David's book 21 stupid things people do when trying to buy a business. And in this book, you can learn how to avoid those awful novice mistakes. You can find him at David C. Barnett Comm. David, take a minute in Philly, for tidbits about your life?
David Barnett 02:28
Well, I think he did a pretty good job of covering things off right there. I mean, basically, Andrew, I spend my time helping to teach people about how you actually do a transaction to buy or sell a business. And then people who are looking for that information who are contemplating doing an actual deal. Some of them decided to reach out and hire me to consult on their deals to make sure they're not making a mistake, it could be one of these 21 stupid mistakes. Or it could be, you know, a mistake that's very rare and hard to see. But maybe I've seen before, and I can help someone avoid something bad.
Andrew Stotz 03:01
Hmm. And that's the key to the podcast and helping our listeners, avoid mistakes and mistakes can be very expensive. And before we get into that, just a question, why would someone buy a business? I mean, all of my youth, I always thought I want to start a business, my own thing. I never even thought about the idea of buying a business until I started to grow up. So just for the listeners out there that are thinking, I'm gonna make my own business and all that. Tell us the benefits of buying business?
David Barnett 03:33
Yeah, sure. Well, you know, when you start a business, typically you have no sales, but you have expenses and maybe even have overheads. And so you get into a race to develop enough clients. And we get to make enough sales to reach that theoretical point in time called the breakeven point. And then once you get past breakeven, no, you still really haven't made money because now you're just recovering the losses you suffered in order to get to break even. And so when people get to be an adult or of a certain age, they realize, Hey, you know what, I've got children, I've got, you know, a spouse, I've got a mortgage about all these things, can I really be gambling on starting something new, and we know the stats about new businesses, the vast majority of them end up failing within a couple of years. And so the less risky move for people that want to get into businesses to simply buy one that already has customers and profits. It's a bigger investment upfront, but you're making money from that first day. And because there's already an established cash flow there, there's other resources you can bring to bear to buy the business such as borrowing from banks, etc. to a far greater degree than if you were going to try to borrow to start a business, which usually involves some sort of government guarantee, you know, depending on what country you're in, in order for a bank to be willing to lend to something that's entirely new.
Andrew Stotz 04:57
Yeah, it's interesting because you know, what we're talking about. Creating a cash flow, you know, with our with the coffee business that I have in Thailand with my best friend Dale. You know, I always say that, you know, ultimately what we're creating is a cash machine. And that's the way we have to look at every business that we're doing is if we're not creating a cash flow stream from it, you know, we're What are we doing? We're just a hobby, are we messing around? And so, you know, first of all, all of us actually are trying to create cash flow streams, how do we do it? Well, one way to do is just get a job. And you have now created a cash flow stream. And what you do with that cash flow stream, you know, spend it on all the different things you spend an arm, but a salary is a cash flow stream, when you start a business from scratch, I think the main point is that you're taking a huge amount of risk. And so yeah, it's a, it's a low cost to get into it in some way, you can say, but that's because the risk is so amazingly high. Whereas the upfront cost, as you've just described, to the listeners out there, of getting into an established business is higher. But it's also mean that you've de risked it quite considerably. So I think that really, you know, helps for all of us to think about, I guess the last question related to that is that, I think when a person listening to this podcast things, yeah, I can buy a business, but it's going to take a huge amount of money. And in fact, I was just in a deal yesterday, and the business that we were looking at buying in this case, was struggling. And so it didn't even have a cash flow, that we could go to the bank and say, hey, look, you have the cash flow. But I think traditionally, you're probably talking about not a turnaround situation. But you're talking about maybe an existing cash flow. If a company has an existing cash flow, it's expensive for you to buy, but you mentioned about like bank financing, or whatever type of thing, just help someone get over that hurdle of waiting, it's gonna take me a lot of money to buy business?
David Barnett 06:50
Well, well, actually, let's talk about that. Because in the book 21, stupid things people do in trying to buy a business, the very first one is failing to understand how businesses are valued. So you talked about creating a cash flow. And what a lot of small business owners are potential sellers, and many buyers don't understand is that it's not really the business that's being bought or sold. It's the cash flow. And so, so, you know, you deal in investments, right? And so if you have something like a government bond, for example, with a certain, you know, interest coupon on it, you use that coupon to determine what someone's willing to pay for that bond based on what you need for a rate of return. Yep, kind of the same thing with a business except we're not dealing with, you know, a sovereign bond issuer, we're dealing with a very risky small business. And so what we need as far as a return is based on that risk. And, you know, in and I'll tell you, in a nutshell, how businesses are valued, no one's really going to be able to apply it with what I'm going to say. But here's conceptually what we do is we say, what is the cash flow of this business is generating? And as a buyer, what am I willing to pay for that cash flow, given my belief in my ability to maintain it under my own stewardship, because what what makes small businesses so radically different from publicly traded companies, is when I buy shares in Coca Cola, I also get the advantage, for example of all the managers, leaders, etc, that are in that business. And when I maybe sell those shares to you, Andrew, you know, all that leadership remains. But when we talk about small businesses, typically the seller is the concentrated leadership, human resource, you know, person that is running the thing, they're the brains of the operation, and they're making a lot of the big decisions, and they are going to exit upon the transaction. And we're gonna step into their shoes. And so this is what makes you know, the cash flow valued at a much lower price than if you were, for example, valuing something like publicly traded stock.
Andrew Stotz 09:04
So many things to talk about, but just repeat number one, like just get just repeat the number one and then we're going to go through these, but I have some, some points on that. So say it again.
David Barnett 09:13
Yeah. Number 11. is failing, failing to understand how businesses are valued. And I've seen so many people, it's stuck in so many different traps. And I'll give you one quick tidbit, okay. But here's one that many people fall into it over and over again, is, you know, buy my business. It's only two years old. It cost me a million dollars to build, but I'm ready to sell it to you for 600 grand. Right? And so there are many people out there who will be confused. Like if you said that about a house, you might be describing a good deal, right. But if the person has failed to create a necessary cash flow to make the business worth a million or even 600,000, then it's not even worth 600,000 that that business owner has suffered a loss By making the investment, but because there's no pricing mechanism, like if I bought shares in the telephone company for 100 bucks, and it went down to 80 on the market, I know I lost money, right? What happens in small businesses, there's no instantaneous pricing mechanism. People don't know they made a loss until they turn around trying to sell it. And they realize no one wants to pay for my cash flow what I need to get out of
Andrew Stotz 10:24
it. Yeah. So I think you know, one of the things that you when you bring up the comparison of coke and a private company, there's something interesting that you, you left out, when you talked about a private company, when you buy Coke, you're buying two things, just like any listed company, in particular, you're buying the existing cash flow. So you're saying, because you said maintain that cash flow, you're buying the existing maintenance of the cash flow, and then you're buying growth in that cash flow. And the growth in that, yeah, the growth in that cash flow is a function of that management team, investing in improving the marketing, improving the product, improving the distribution, all those things. So let's just say that the long term growth of a company could be let's just say 10%. As an example, it could be that, you know, 5% is just you know, there's, there's this maintenance, revenue, or let's say, maintenance profit that's coming in, let's just say it's $10 million a year. If you want to go from 10 million to 15 million, there's an investment needed to do that. Now, what you said about valuing a small business is, you know, looking at, you know, what you could put into it to maintain that. And I think the important thing is that growth is not assumed, number one, like maintenance is most important. The second thing that's most important in a transaction is that the seller does not have any rights to that future growth. So you want to go into that transaction, say, I'm just maintaining what you got 10? If, yeah, so
David Barnett 11:58
anyway, what you're describing Andrew is what we call the blue sky trap. So you will often see someone trying to sell a business where they will talk about these great potential opportunities that exist for the new owner. And this will become a reason why the business is worth maybe more than what the cashflow might indicate. And what I constantly advise buyers to do is to look for those opportunities for growth, because these are the reasons why you might want to buy that business, if you know there could legitimately be an opportunity, but you're not going to pay the seller for it, because you're the one that has to do the work to deliver the result. Yeah, and there have been many instances where I've talked with sellers, and they've talked about these opportunities, I say, Great, two years, exploit the opportunity, come back with a higher cash flow, and we'll be able to sell it for more.
Andrew Stotz 12:51
It's a great one, when I was asked to advise a company here to help sell it. And in this case, we were selling it to a software giant in America. And the software was developed here in Thailand. And the software giant came in with a with offered 50 million US. And basically, I was hired at that point. To get that up. They said we want 100 million. And so I said All right, let me work on this. So I looked at did a lot of work on the business, understanding it building out the cash flow, saying what's the potential of what we could create. And then I went back on my first meeting with the negotiating team from the big software company in the US. They introduced me and I said I'm so I've done my work on this company, and our starting price is 200 million. And of course, jaws dropped, there was you know, a lot of anger and frustration when, you know, that doesn't bother me. And then they wanted to get on a call with me to go through it. And I went through it with them and said, well, we're going to hire sales team, and then we're going to do this, and we're going to do that. And we're going to do that. And you know, we're going to grow it up and this is going to be worth 200 million. And I said in your case, you know you guys are going to buy it. I mean, you can take this to a billion easy. I should be charging you, you know more easily, like, hold on. That's our, that's our value that we're going to create is like, okay, that's fair. And so we ended up negotiating until we got to 85 million. So that was a fair one. But the point is, is that, you know, there is future growth potential in a company, you know, not all there are some companies it's like, it's a donut shop and you're not going to expand 50 donut shops, and it does a good steady income. But for most businesses, there's a growth potential. And really you can say it's, it's a negotiation between the buyer and the seller on that, I would say would you agree with that, or?
David Barnett 14:34
Well, there's a negotiation between a buyer and a seller, but there are also a whole constellation of other people that are part of the negotiation too. So one of the one thing that sometimes happens is if a seller doesn't really understand where the price comes from, and they bump into an equally naive buyer, you could actually get a contract signed for a price that's far too high. Deal We'll never get done, because but eventually that buyer is going to get in front of a banker or an accountant or someone else who's gonna be working on this with them, who will show them that they'll never be able to pay the loan or what have you. The real danger, though, of course, is for individuals that actually happen to have the money, you know, they could write a check for far too much money and end up in a bad spot. But when I'm talking with sellers, one of the things I caution sellers against is, is not to ask for an unreasonable price, because what happens then is you scare off the reasonable buyer. Reasonable buyers have good credit, they have industry experience, they have money to make a down payment, they've already done research, they know what businesses in a particular industry of a certain size should be trading at. And if they see that that seller is kind of out to lunch, they're gonna say, it doesn't make sense for me to talk to that person
Andrew Stotz 15:50
there. And there's a lot of there's a lot more reasonable buyers and unreasonable. So if you're turning them off, you're turning really the group. Alright, what's number two, my goodness already so much value in number one.
David Barnett 16:00
So number two is failing to account for the value of the buyers labor. So here's one of the things about small companies, small businesses, is that they are often presented with a cash flow figure, that is called sellers discretionary earnings. So you go back to is basically all the money available to an owner operator that works full time. So it's EBITDA plus wages of the manager. Okay. And so people will look at that money, that cashflow figure, and they'll say, ooh, if I buy this business, I get all that money. However, they also have to work 40 hours a week to get all that money. And in the real world, Andrew, people do pay for interest in taxes. And there's a real cost to replacing stuff, which is represented with depreciation and amortization. Sometimes the depreciation on the financial statements doesn't really bear any real, you know, doesn't really anchor to reality very well, in a small business. There's all kinds of places where people accelerate depreciation and all this kind of stuff. But we need to consider what money do we need for our time that we're working in this business? What do we estimate we're going to have as far as a tax obligation? What debt service Do we have to undertake with this cash flow? And what reasonable amount of money do we have to hold in reserve for capital expenditures to replace equipment and gear. And so I see constantly time and time again, is people will be very optimistic about that cash flow, and they will not put a high enough price on their own time, when they're examining one of these businesses.
Andrew Stotz 17:41
So much, so much there, I have two points that I would make, and I'd love to hear your thoughts on it. The first thing is that I know being a financial analyst all my life, I, we have all kinds of the acronyms and you know, EBITDA is one of them. But truthfully, I care about net profit. Because the reason why I care about net profit is that, ultimately, I'm trying to understand what is available to shareholders after everything, you know, and we look at the earnings per share, and how much can be paid out. Because ultimately, most businesses are just a hobby, we've got to create a business that produces a dividend. That's my goal. So first thing is I understand all the other metrics, and I use them. But I really like net profit, because it just gets down to the bottom line. The second thing is that I sometimes I'll talk to startups and others about, you know, they want to sell their business in a couple of years, or whatever. And what would be my number one advice to increase the value since my focus is on valuation. I said, the first thing that you could do today to increase the value of your business is double your salary, and the salaries of all your staff.
David Barnett 18:53
Well, you want to get them to fair market wages, because I run into this all the time to Andrew, where people will underpay themselves, because they can make their choice. If they own the business. They can choose to do that. And they think that they're magnifying the bottom line. And this will add value to the business. But the very first thing that a buyer does is normalize for the fair market value of labor that's going on in the business. It doesn't fool anyone. Yep. And so, you know, if you're going to work full time, as a, you know, software developer or even just as the manager of the restaurant, you should pay yourself what you would be paid if you did that for somebody else. And, you know, in a lot of the stuff that I do I talk I don't like the word business necessarily, because I find is too general. I like to say that if you have some kind of economic entity going on, and you're able to earn an amount of money in excess of what you would be paid to do that work in another business, then you have a business. If you're just bringing home the same amount of money that you would earn working someplace else doing the same work, then you don't own a business. It's called a job. You own In a job, and if you bring home less than you'd be paid to do it somewhere else, then it's that h word you just used, it's a hobby.
Andrew Stotz 20:08
Alright, number three. Now, we're not gonna be able to get to all of these, but Ladies and gentlemen, just go to Amazon, go to the show notes, just type in 21 stupid things. And before, you know, you're gonna get all of them. So what do you got?
David Barnett 20:21
So the next one, number three is failing to account for the value of capital. So I just described that out of that sellers, discretionary earnings, cash flow level, I tell people, they need to bring home money for themselves, they need to pay debt service, they need to pay taxes, they need to account for any kind of equipment or material that needs to be replaced. The thing that people always forget, is they need a return on the cash to put in the deal. Like it's an, it's amazing how people will budget for the bank's earnings, called the interest rate, you know, they're gonna pay the bank. But if they put money that they've saved up over years or decades into this acquisition, they need to get an adequate rate of return on that equity they've put in,
Andrew Stotz 21:08
you mean, the return is not the salary that I'm taking out of the business?
David Barnett 21:11
No, no, no, no, that the salary is for your labor, right. And so this is how businesses end up getting overpriced is when people look at business broker, for example, will try to add back every kind of adjustment they can to grow that sellers, discretionary earnings to those big numbers they can, and they'll put some kind of multiplier on it, and they'll try to justify it to a buyer. So buyers have to be smart enough to take apart all of their needs out of that number to really see what it is that they're buying over and above what their other alternative is, which is maybe to go work somewhere and keep their money in the bank, or invested in simply other place, right?
Andrew Stotz 21:55
So I'm going to come back to the net profit. And you know, as an analyst, we look at free cash flow as an example free cash flow to the firm and all that. But as I say, in my valuation masterclass, I say, you know, free cash flow is a theoretical number, based upon lots of estimates, and it's possibly what the company could pay out in dividends. And if everything's right, Yes, it can. But the reality is, is that, that net profit is the most real number that, you know, from my perspective, I can get dividend out of that. And I think that dividend, I know, is the ultimate return. It is the only and I think this is an important point. For people that don't understand business or finance that well is that there's really three ways to get money out of a business, one, pay yourself a salary or some type of compensation to embezzle. There's many, many people that pad payments and they get, you know, there's all kinds of crap that goes on, that's illegally siphoning money out of a business, which I choose not to do, and I recommend people don't do. And then the third way that an investor can get money out of a business, and the only way that an investor alone can get money out of a business is dividend. And a great example of this is Dale, my business partner, who is the managing director of coffee works. And me. I'm a shareholder, and we're both equal shareholders. There's zero opportunity for me to take any money out of the company as a salaried employee or in any other way like that. But he could do a lot of sneaky tricky things that could get money into his account. Luckily, he doesn't, you know, and we've got trust. But the point is for a shareholder, that dividend is all gone.
David Barnett 23:41
Great points. You know, I and I'd like to point out something else about that second one, you mentioned embezzlement. Because the reason why though in the world of small business, we use that sellers, discretionary earnings cashflow level, is for just that reason. And it has to do with the way that a lot of small business people will manage their personal benefit from owning the business. So when people think of the word embezzlement, they think about somebody sneaking off with, you know, envelopes full of cash and stuff like that. But the the actual way that it looks when it's done, you know, day to day experience, is that you've got this company that has a cell phone plan, and the owner's teenage daughter has a company cell phone, right, or the owner spouse is filling their vehicle with fuel using a company gas card. And so all of these little perks start to percolate within the business. And then the goal of this of course is to reduce the net income so they pay a lower tax burden. But then when they want to sell the business, then they want to add back all these things. You the true net benefit. And this really bites a lot of sellers in the butt and here's the biggest thing that happens is when they do this very aggressively, Andrew they I end up with tax returns that have no profits. And so they may personally be enjoying a very, very great lifestyle from everything that the business is providing to them. But when the potential buyer shows those tax returns and financial statements to a bank, they're not getting alone. Yep. And so they actually the seller will undermine the buyers ability to purchase the business by doing that kind of thing.
Andrew Stotz 25:27
So I guess mom was right. Honesty is the best policy.
David Barnett 25:33
If you want to get paid and have a buyer that can borrow money.
Andrew Stotz 25:37
That's true. Yeah, I think if you're selling a business, and you can assure the people that there's really is no bombs that are going to go off when they buy it, you know, valuable, that's valuable. All right, next.
David Barnett 25:47
All right. Number four, is overcoming projected free cash flow to debt service. Which I think you just mentioned about right. Yeah. So So here's the trap, is that businesses are asymmetric systems. And so what that can mean is that a depending on, you know, the cost of goods sold and the fixed overheads of the business, you can have a business with in which a 10% decline in revenue could be a 35%, decline in profit. Right. And so the, you know, on the upside, a 10%, increase in sales can be a 30% increase in profit, and everyone likes to look at the upside, right? The reason people want to get into an operating business over say, buying a piece of investment, real estate, is that there's greater potential to leverage up and grow profits if you can grow revenue. And so when people go into this stuff, I always make the case for looking at realistic downside scenarios. I've Andrew, I mean, I've been looking at small business financial statements for decades. And I can tell you when you lay five years out, and they bumped around by eight or 10%, a year, up and down, that's actually called flat. Because that's just normal for a lot of these types of businesses. Yeah, especially if it's an industry that might be driven by a really big project work of some kind, you know, you can have these great years, and then you have a dry year, right? And so when people look at that sellers, discretionary earnings, and they read somewhere, that a debt service coverage ratio of 1.25 is adequate, then the very first thing I asked them is, well, did you figure what you need to take home getting back to point number one point number one, but but I say, that's crazy, that 1.25 debt service coverage ratio to me is for a small apartment block, which, as you know, may have some vacancies in the air, but it's not gonna be 100%, empty, you know, at any given point. And so I, my rule of thumb is you want a much greater debt service coverage ratio, because the last thing you want is a cash crunch that bleeds out your free money. And, you know, I mean, you've probably seen this before, right?
Andrew Stotz 28:06
So, a couple of things about that, first of all, what what you're talking about in the technical world of finance we call operating leverage, and that is imagine that we have a small we have two businesses, you know, or let's just look at one one business, five employees, and they have a huge rent payment. And if the revenue goes up, Hey, no problem. You know, it's just same rent. But if that revenue goes down, oh, no problem, same rent, all of a sudden, the operating the impact on the profit can be massively negative. Compare that to a company that, let's say outsources their most of their business to outsourcers, like we do these days with delivery services and stuff. And as soon as the revenue goes down, those costs go down. Those are variable costs. So it's the relationship between fixed and variable number one that helps us understand what's going to happen to that business, when it's simple enough to just look at a business's change in revenue and change in let's say, profit or EBIT da or something like that. So that's the first part. The second part is it for the audience out there that doesn't understand free cash flow? Let me just explain that there's three components to in my description of free cash flow that I talked about, there's three components, the first one is what you could call core profitability. And the second one is investment in working capital. And the third one is investment in capex meaning capital expenditures, fixed assets. And so basically, those three things come together. The core profitability is a positive number, and the investment in inventory or let's say, accounts receivable, these are net working capital items, and then there's the capex. So a good story from my own business in coffee works when we set up the business. We knew we bought this huge piece of equipment to do the roasting many years ago. And then what We kind of forgot about was that, oh yeah, we still need to buy inventory. And we still need to give our customers credit. And all of a sudden we realized Holy crap, and working capital, and we didn't get credit from our suppliers. So we had to finance inventory and accounts receivable. And what we realized was it isn't working capital is an investment. And so now I just look at really two items. What's the core profitability? And what's the level of investment? And remember that that investment number that you're going to forecast? Is your assumption of what's going to be required to either maintain or grow the business?
David Barnett 30:36
Did you read this book, because item number five is failing to adjust for operating capital. And so for everyone listening, you know, we talked about that cash flow, and then we multiply it by some number. And it's different by industry and size of business. And, you know, there's research that can be done, there's databases available for even these very small, small businesses and what they've sold for. So what an unsophisticated seller or business broker will do is they'll determine that cash flow that sellers, discretionary earnings, they'll figure out a number and they'll multiply it. And they'll say, this is what the assets of the business are worth. And they'll present it as an asset sale, where the seller keeps, you know, cash receivables, and takes care of his payables. And it's a very simplistic understanding of a business because when we multiply cash flow by that number, whatever it is, we get something called the enterprise value. And the enterprise value is inclusive of something called the net normal position and working capital. And so small business owners, you know, a lot of them are expert at what they're doing, you know, for example, roasting coffee or what have you. But they're not finance professionals. And one of the things that is pretty consistent, and every business I look at is it doesn't have an optimized balance sheet. So a really profitable business over time, they'll pay off all their debts. And then they suffer a lower return on equity, because they've got a ton of equity. Right? But their goal is always been to maximize profit, which means not paying interest, right? So when we look at a business like that, we have to normalize the balance sheet, we have to say, look, what would be normal in this business, some kind of line of credit that might support receivables and inventory, if it's a fungible inventory, you know, what kinds of inventory are financing many are many art, right? And so we look at normalizing it. And we say, under normal conditions for a business like this, what kind of cash does the owner of the business have to have to grease the wheels of this machine and make it go that net normal position and working capital is just as critical as the forklift that unloads the goods off the truck, and it's part of what the buyers buying when they buy this business? And so Andrew, I probably met 200 people who didn't understand this, and overpaid for a business by the amount of the net position and working capital. Yep. Looks like you have a prop there. But
Andrew Stotz 33:18
yes, I just grabbed a prop off my shelf. But before I do, I think, um, as far as going through the 21, those top five are already golden value. And I just want to tell the listeners out there, just go, you can come to the show notes and click on the links, you can go directly to Amazon, and you know, just type in 21 stupid things people do. But the point is, is that there's a lot of a lot of knowledge you have from David and also you can go to his website, David C. Barnett comm and sign up for you know, his email his newsletter and see his blog. But also I just it's kind of it's interesting, because I wrote a book called nine valuation mistakes and how to avoid them, which I also have on Amazon and I'm, I'm, I'm approaching it from a little bit different as an analyst. Although I'm a business owner, I've spent my time as an analyst looking at, you know, 1000s of companies. And then I've spent 30 years teaching finance and teaching valuation. So I have the benefit of and then I have the valuation masterclass where I'm watching my students do valuation. And I came up with, with nine mistakes that people make. But, you know, I looked through it, and I just looked at Mistake number six is under estimating working capital investment. You know, and so we're, we're talking about so many of the same things. That that, you know, just very common. In fact, I wrote a course called finance made ridiculously simple because I wanted to help people really start to understand their balance sheet, their income statement ratios, and that type of thing. So I think I want to wrap up by asking you, instead of asking you kind of my traditional questions, I want to ask You this the question I often ask at the end of my interviews is, what one action would you recommend our listeners take to avoid suffering the same fate? We're talking about making a mistake. But I think in this case, what what maybe a good way to say, for what is your one piece of advice, one for a seller, and your one piece of advice for buyer, let's say there's two people listening to this, someone wants to sell in the next year, or two, or three, or whatever, and someone wants to now you know, buy a business, what would be your one piece of advice for each of these people.
David Barnett 35:33
So my one piece of advice for someone who's going to sell is to really do a high degree of diligence on whoever they're going to be working with to help themselves. There's practically no barrier to entry into the professional business broker in most jurisdictions around the world. And so people get attracted to the industry, because the commission rates seem high in comparison to things like being a real estate agent. And so I've run into a lot of really awful Business Brokers who are giving people bad advice. In fact, I use the term qualified business broker, because I don't like to use the blanket term anymore, I people need to do some work into looking at the person's history, what they've done, how long they've been in it, they need to talk to some of their past clients. Because setting the price and adequately setting the sellers expectation is the most key thing that any kind of professional is going to do. The saddest thing that I run into is sellers, Andrew, is when they've had their business for sale for two years. And they can't understand why they can't get it sold. They go on YouTube, and they find me. And then they hire me to look over the package that their broker has been using. And I asked them for some additional information. And I'll say, Well, the reason your business hasn't sold is that you're asking 40 or 50% too much? And do you understand that in your particular industry, under these circumstances, it will never be a cash deal. This is the kind of deal you're looking at, you know, a certain amount down, maybe the buyer can borrow a certain amount from a bank. And then you're probably looking at a note with payments over three or five years. Very often, when I have these clients and I go through this exercise, they'll say to me, some variation of this. They'll say, Oh my god, a few months into trying to sell my business, somebody made an offer like that. And they missed their chance to exit. Yep. Because they didn't know what a reasonable offer was going to look like. Yep. And I remember, you know, back in my business broker days, when I had a full time office, and I was doing this all the time, I would tell sellers, this is what a deal looks like, we hardly ever do all cash deals, you're gonna end up holding paper, you're gonna have to choose the right buyer there have to be qualified. And people will say, I don't like that. And they leave. And they go find someone else. And they come back a year later, when their contract expired. And they would say, I really need to sell a house. And I know that you were telling me the truth. So that's kind of for sellers. Yep. For buyers, my biggest piece of advice is you need to know something about the industry you're looking at. And and, you know, if something looks like a really good deal in an industry, and you don't know about that industry, you should be asking yourself, why isn't somebody else in this industry picking up this company? Right, there's something the insiders know, that is making this deal look unpalatable. And even the smallest businesses, you know, I've had civil servants, middle managers at banks, you know, different people come and look at things like fast food restaurants and pizzerias and stuff like this. And I'll say to them, like, have you ever worked in a business like this? No. And I'll say, Well, why don't you go work at McDonald's? You know, if you're willing to work Saturday night, they'll hire you because that teenagers don't want to work on Saturday night either.
Yeah, and you good opportunity. You know, you learn in there,
David Barnett 39:10
see what it's really like, see what that kind of business is like, what the environments like what the customers are, like, what the staff issues are like, right? And then you can know if you really want to own this business. You think many people would have done that? Of course not. No, no, right? They, they, they look at the numbers and you know, people who are going to invest in a certain business should have some idea of how that business works and what it's like to be in
Andrew Stotz 39:38
it. I can't remember the name of this movie, but it was Robert Redford was the star of it. And he basically went in, he was going to be the new prison warden of a prison in Ohio. And what they did is nobody knew this. Just him and the governor of Ohio and He went in as a prisoner. And he spent three months in the jail, you know, a month and a half, until there was a situation, you know, really drastic, drastic situation. And basically, he, you know, was in the middle of the situation and you looked at the guard, he says, Call the governor. And at that moment, everything flipped, and all of a sudden, he knew all the bad, bad stuff that was going on in there. And it was just, it was a great movie, it was a great kind of turnaround movie. Alright, so let me ask you. Last question, what's your number one goal for the next 12 months? For me personally,
David Barnett 40:35
it's, it's to get another 10,000 subscribers on my YouTube channel. Because my mission, what drives me my business today is to help people avoid dumb business deals. And basically, the problem is ignorance. And I can solve that just by creating awareness and teaching people. So my big goal is to continue to spread that message. So that, you know, I've got hundreds of videos on the channel about buying and selling businesses, it's all there for people who consume, there's no cost or anything. And so, you know, I want people to come and learn from this stuff. They avoid these bad mistakes. And if you find a deal that looks like it's the good a good deal, and it's the right deal for you, then maybe you want to get me to help look at it as well. Because there's, you know, you see things through your career that are amazing. And then, amazingly, a year or two later, you see it again. Yep. And so someone who looks at this stuff all the time is going to be able to spot things that you know, even the best CPA in your town isn't going to spot because they don't look at these deals all the time in the same way. Beautiful.
Andrew Stotz 41:48
All right. And listeners, there you have it. Now, that wasn't a story of loss. That was a discussion about how to avoid loss. My number one goal for the next 12 months is to help you, my listener to reduce risk in your life. I mean, that's what the whole podcast is about. So go to my worst investment ever.com right now and download the risk reduction checklists and see how you measure up. As we conclude, David, I want to thank you again for coming on the show. And on behalf of a Stotz Academy, I hereby award you alumni status, returning your fantastic experience into your best teaching moment. Do you have any parting words for the audience?
David Barnett 42:34
No, I just business is risky. It's still worth pursuing. No, do what you can to avoid the losses. And I think that's what's great about your show.
Andrew Stotz 42:48
Yeah, that's fantastic. All right. That's a wrap on another great story to help you create, grow, and most importantly, protect your well fellow risk takers. This is your worst podcast host Andrew Stotz saying. I'll see you on the upside.
Connect with David Barnett
- How to Start Building Your Wealth Investing in the Stock Market
- My Worst Investment Ever
- 9 Valuation Mistakes and How to Avoid Them
- Transform Your Business with Dr.Deming’s 14 Points
Andrew’s online programs
- Valuation Master Class
- How to Start Building Your Wealth Investing in the Stock Market
- Finance Made Ridiculously Simple
- Become a Great Presenter and Increase Your Influence
- Transform Your Business with Dr. Deming’s 14 Points