Thinking of Buying a Temporary Staffing Agency for $1.2 Million? Do you know Quality of Earnings?

So, you’re considering purchasing a temporary staffing agency with a price tag of $1.2 million. The business reports $2.5 million in revenue over the past two years and a cash flow of $350,000. It employs three seasoned staff members, and there’s an SBA loan available with 10% approved for the buyer. Sounds like a golden opportunity, right? But before you jump in, let’s unpack the details to see if this deal is as promising as it appears.  How to do a staffing company valuation?

Do You Need a Quality of Earnings (QoE) Report When Buying a Small Business? Understanding the Numbers: There’s More Beneath the Surface

At first glance, a business generating $2.5 million in revenue with $350,000 in cash flow is enticing. But here’s the crucial question: Is that $350,000 cash flow before or after the owner takes a salary? If it’s before, you’ll need to factor in what you’ll pay yourself, which could significantly reduce the net profit.

Think of it like buying a house that seems perfect until you realize it needs major repairs. Similarly, if the current owner isn’t drawing a salary from that cash flow, your take-home income might be less than you expect once you start paying yourself.

Do you know SDE (Seller’s Discretionary Earnings) ?

SDE is the preferred metric for pricing and valuing small businesses for several key reasons:

— Accounting for Owner’s Compensation: SDE includes the owner’s salary and benefits, which are often significant in small businesses.

— Reflecting True Profitability: Many small business owners minimize their reported net profit for tax purposes. SDE helps reveal the actual financial benefit of owning the business.

— Overcoming Limited EBITDA: Small businesses frequently show little to no EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) due to how they manage their finances
Comprehensive Financial Picture: SDE provides a more accurate representation of the total financial benefit a new owner could expect from the business.

— Industry Standard: SDE has become the go-to metric for valuing small businesses, especially those where the owner is actively involved in day-to-day operations.

Revenue Trends: Digging Deeper into the Financials

Looking at revenue over the last two years provides a snapshot, but it’s like reading the last chapter of a book and thinking you know the whole story. You need to delve deeper:

• Historical Revenue: What were the revenues in 2020, 2021, and 2022? How does the revenue so far in 2024 compare to previous years?
• Growth Patterns: Is revenue increasing, decreasing, or staying consistent? A sudden spike might be due to landing a large client who may not stick around.
• Client Concentration: Is a significant portion of revenue coming from one client? If so, losing that client could be like pulling a thread that unravels the entire fabric of the business.

Due Diligence: Looking Beyond the Surface

1. Financial Verification: crucial step of the quality of earnings process

• Financial Statements and Tax Returns: Request financial statements, bank records, and tax returns for the past three to five years. This will help verify the numbers and uncover any inconsistencies.
• Profit Margins and Expenses: Analyze the profit margins. Are they stable? What are the significant expenses? Understanding the financial health is crucial.

2. Legal Considerations

• Contracts and Agreements: Have a lawyer review all client contracts and employee agreements. Are there non-compete clauses? What are the terms of the client contracts?
• Regulatory Compliance: Ensure the business adheres to all industry regulations and labor laws. You don’t want any legal surprises down the road.

3. Employee Evaluation

• Staff Interviews: The employees are the heart of the company, especially those with long tenures. Talk to them to gauge their job satisfaction and intentions post-sale.
• Retention Strategies: Consider offering incentives or small raises to keep them onboard. Losing key employees could be detrimental.

Financing the Deal: The Realities of the SBA Loan

The seller mentions an SBA loan with 10% approved for the buyer. But here’s the twist: SBA loans aren’t pre-approved for buyers. You’ll need to undergo the approval process yourself, which includes a thorough evaluation of your financial standing.

Consider the following:

• Loan Terms: A $1.08 million loan with a 10% down payment over 10 years at a 10% interest rate translates to monthly payments of around $14,000, or $168,000 annually.
• Debt Service Impact: This debt service would consume over half of your free cash flow. If the $350,000 cash flow doesn’t account for the owner’s salary, paying yourself and covering the debt might leave little wiggle room.

Risk Factors: Potential Pitfalls to Consider

Purchasing this business isn’t without risks. Here are some potential red flags:

1. High Client Concentration

Relying heavily on a single client is like building a house of cards; one wrong move, and it could all collapse. If that client leaves, it could significantly impact your revenue.

2. Industry Challenges

The staffing industry has low barriers to entry, meaning new competitors can pop up overnight. Moreover, the industry currently faces challenges:

“Temporary hiring is taking a hit right now. I’ve been in this industry for 15 years, and it’s never been this tough to secure business.”

3. Employee Retention

The existing employees haven’t opted to buy the business themselves, which could be a warning sign. Are they committed to staying, or are they considering other opportunities?

4. Owner’s Role

The current owner brings over 30 years of experience and valuable relationships to the table. Without their involvement, maintaining client relationships might prove challenging.

Negotiating the Deal: Flexibility is Key

If you’re still considering buying the business, think about negotiating:

• Price Adjustment: Given the risks and financial analysis, offering a lower price might be appropriate. Some suggest a multiple of 2.5 to 3 times the net profit, especially when factoring in your salary.
• Seller Financing: Propose that the seller finances a portion of the sale price. This keeps them invested in the business’s success during the transition period.
• Earn-Out Agreements: Consider structuring the deal so that part of the payment is contingent on the business hitting specific performance targets after the sale.

Remember, it’s acceptable to walk away if the deal doesn’t make financial sense.