Big Deal Small Business: Pro Forma Payroll in SMB
November 20, 2022 | Issue #75
Owner dependence is one of the most common risks to overcome when buying a small business, especially <$1.5 million in EBITDA.
My deal was no different, with two owners (and one owner’s wife) heavily involved in day-to-day operations. But setting aside the risk element for a moment (i.e. feasibility of replacing them), today’s post walks through my approach to figuring out the costs required to replace the owners.
I recently wrote about how to bridge from SDE to Buyer’s EBITDA to Cash Flow. One of the key line items in that bridge is “Replacement Hires” – this post basically dives into how I come up with the number to plug into that line.
Note there are some Excel screenshots in this post, so please click on “download images” if your email client is blocking them from loading.
Process Mapping
Before figuring out how to replace the owners, you need to (deeply) understand what everyone even does at the business.
In any deal, figuring out how "how they make money" is my first priority for the first meeting - I wrote it about this nearly 18 months ago.
When you're post-LOI in particular, this should become very granular. Here are some examples of process steps for a typical service contractor, along with questions you should be able to answer:
Customer finds them (Through what channels? All organic, some paid, mostly paid, etc? Who manages marketing?)
Customer contacts them (How? Web? Phone call? Text? Email? How fast do they respond?)
Quoting process (In-person / online / over phone? Who is capable of giving quotes? How are they delivered?)
Customer accepts quote (How do they accept? Deposit taken?)
Job is scheduled (Who does this? How many service visits per customer? What factors go into scheduling? Who handles staffing for jobs?)
Job Prep (Do client reminders go out? Do supplies need to be ordered? What prep work is needed? Who does all this?)
Job Day (How does dispatch work? Who talks to client? Who confirms work is completed properly?)
Invoicing (Who sends invoices? What are payment options & terms?)
Collections (Who handles collections? How common are non-paying customers?)
Admin & Bookkeeping (Who ensures accounting is correct? Who deposits checks? Who does taxes? Who maintains business licenses, sales taxes, etc.? Who handles payroll?)
Obviously simplified, but applicable for most local service businesses. Going through this investigation will probably kick up ideas for optimization or growth.
At the end of this step, you should have a very clear understanding of the customer lifecycle and the list of tasks & roles required to make the whole thing happen.
People Mapping
The next step is to map the company's people against those roles & tasks to make sure you understand who does what.
I try to set it up based on hours per week, recognizing that may not line up perfectly with real life - for example, the Seller may do 8 hours of bookkeeping at the end of each month, which averages to ~2 hours per week.
Below is a simplified, generic example (click download images if table doesn't load):
The totals along the right give you a sense for Full-Time Equivalent of each person. It's common for this to add up to >50 for the seller.
The Seller's Wife (or spouse in general, but most SMB deals I saw were an older male seller with his wife running the office) will be marketed as <10 hours/week, but is usually more like 20-30 hours/week, if not more.
The totals along the bottom give you a sense of the various hour capacities it takes to operate the business.
Here's an example of one "Post-Close" set up that you could create as your transition plan:
Couple notes here:
You as the buyer will not be as efficient as the seller & seller's spouse initially. There is a learning curve, so don't be overconfident on that front.
You won't be able to replace hours 1:1 -- if you need to replace 8 hours of sales work/week, it is highly unlikely you can hire a salesperson working 1 day/week. So your ending org chart may end up with way more capacity than you need (not necessarily bad depending on your company's growth potential).
This example assumes Lead Tech #1 is capable (and willing) to move one day of service work to one day of sales work. That assumption has to be tested with the seller and ideally the employee to see if that actually makes sense.
This example assumes you can hire a new Lead Tech to take over direct service work from the seller - this may not be true if the Seller is doing the most specialized work.
Some of the work may be outsourceable, such as taking in-house bookkeeping to outsourced bookkeeping.
If not clear from above, the MAJOR caveat is that people are not numbers on a spreadsheet. Moving hours around like I did above is very hard to do in practice, and needs to be tested as feasible during diligence and with the seller.
The goal is to come up with an ending list of people & tasks that is actually feasible to implement & execute.
Cost Pro Forma
The last step is to recalculate payroll costs based on your pro forma org chart, which is hopefully pretty straightforward.
Couple tips:
To estimate new hire costs, you can look at existing payroll and job openings at competitors.
Don't forget to factor in raises, especially for folks who will have to take on more responsibility (like Lead Tech #1 in the example above)
Get quotes from outsourced providers during diligence if possible to avoid big misses on your cost estimates.
Don't forget to include benefits, 401K match, payroll taxes, workers comp, etc. when calculating new employee costs; these add-on costs can be an additional 8-20%+ on top of payroll and may not be incurred on the sellers' personal income depending on their tax structure.
Lastly, this exercise is designed to figure out who you need to achieve current earnings level. NOT to grow it. In practice, it'll likely make sense for your replacement hires to have excess capacity that you can grow into, but that's not the point of this process.
Based on that, I wouldn't "burden" your pro forma earnings with the full cost of hires that are partially replacements, partially growth. I would just allocate the share that is replacement-related. BUT - when you build your model for next year, you have to burden it with their full cost given costs usually precede revenue growth.
Anyway, here's the continuation of our example scenario:
As you can see in the above example, if you add back sellers' earnings and then reduce by buyer's salary & replacement hires, the net decline in earnings is ~$150,000.
That's a big deal. If you're paying ~4x earnings, that's a $600K price difference if you don't understand this concept.
Said differently, if you think you're paying 4x SDE of $800K, you're actually paying 4.9x Buyer's EBITDA of $650K. That could be the difference between your debt service coverage being very comfortable to being very dicey.
Conclusion
This was a pretty simple example, but hopefully you can see how to apply it in real life to your deals; it's more or less what I did while diligencing my business.
The most challenging aspect is figuring out what skills you can hire for and in what capacity; you can't generally hire a 0.25 FTE, for example.
Feel free to reach out if anything is unclear or seems off to you! Just reply to this email or find me on Twitter.
Happy Thanksgiving! And a major, major thank you to everyone that donated to the Hatch School after my last post. I can't tell exactly who all came through this newsletter unless I already know you personally, so apologies if I don't send you a direct thank you note!
Thanks,
Guesswork Investing