A lot of people have emailed me saying that my article about taking a 30% loan sounds pretty crazy. I appreciate the feedback so much that I decided to explain why 30% is quite alright for a loan depending on the income of the business, repayment period, and down payment required.
If you think a 30% percent loan is always a bad idea, then there’s some good news and bad news about this article…
First, the bad news: To explain this properly, this article is going to be pretty math filled and dry.
Second, the good news: Your mind is going to be blown in less than the 5 minutes it takes to read this.
We’re simplifying things a bit (eg. excluding variables like buying undervalued businesses, which is quite possible to make a tremendous amount of money in this industry), but a business’ ROI is determined by the net profit divided by the asking price.
So, let’s pretend we have a business making $250k a year, and they’re asking a 3x multiple, so they’re asking for $750k. Since $250k divided by $750k is equal to 0.33, or 33%, we can state that for every dollar you paid into the business, it makes back $0.33, and thus gives an ROI of 33%.
Now, a net income figure which should already have taken out all expenses is all that should matter since that’s the actual definition of net income. This is precisely why in this industry I’ll never look at gross figures, and in many cases, you need to ignore that “Check out our weekly sales of $8,000 a week!” for bread routes or whatever absurdly high gross revenue figure FedEx routes can produce. If you just look at that figure alone, you’re likely going to get screwed…but this is a bit off topic for ROI.
Going back to ROI, if I’m making 33% for every dollar into that business, I’m willing to take out a hefty loan percentage. While loans for FedEx routes do happen, they’re considerably rarer than loans for a bread route. Due to leverage issues you’ll see in Pepperidge Farm, which you don’t get hardly in other industries besides real estate, you pump up your ROI substantially. Let’s check some math:
For the FedEx or bread route (or any business for that matter) that is asking $750k that produces $250k of net income, let’s imagine that this loans wants 10% down (a common loan down payment amount for a Pepperidge Farm and other bread routes). In this case, that’d be $75k as a down payment.
So now you’re actually only expending $75k of your money to make $250k (250k / 75k = 3.33 or 333%). Your ROI for your dollars spent are 333% due to the leverage, since every $1 you personally put into this business, you get back $3.33 for it.
Now, it doesn’t work quite like this, since a loan will have interest payments to it which will decrease your net profit substantially.
This is where a lot of people will move on to something else, but stay with me and you’ll see why that’s a bad idea.
So, let’s pretend you got a term for 10 years (common in the route industry for loan terms), at 30% interest, for a loan of $675k (remember you put down $75k down payment). An amortization calculator will show the monthly payment as being $17,794. For the moment, I’m going to ignore any principle repayment where you’re building equity in this, but the equity repayment gets to be substantial after 5 years. The monthly payments add up to $213,538 in payments over the year.
I just convinced you to pay $2,135,380 over the course of 10 years for only borrowing $750,000. Bad idea!? Not quite.
If you’re making $250k, which is $36,462 of profit left over ($250,000 income minus $213,538 of loan repayments), it’s still not very convincing you’ve done the right thing, but stay with me.
Amortization tables get crazy with how much equity you’re repaying, so I’m going to pretend that you keep the route for 10 years to pay it off, and the route somehow magically didn’t appreciate at all (unlikely, as many routes are growing to some degree) and is still worth $750,000 at the end of that 10 year period.
So, you spent $75,000 to initially get an income of $36,462, which is still a hefty 48% ROI (36,462 / 75,000 = 48.6% ROI) but a lack luster income and I get that. But then at the end of the 10 years, you sell your route and get your equity out of the route of $750,000. You’re basically almost a millionaire in 10 years with $750,000 in your pocket. So overly simplify things, if we just divided up the $750,000 equity you have amassed over a 10 year period, then you get $75,000 of equity you’ve built per year PLUS the $36,462 that you made during the payoff period which totals $111,462 a year.
Hmm…maybe this loan isn’t looking so bad?
The ROI math gets strange here, so you can look at it a couple different ways…if you spent $75,000 and got back $111,462 in that first year, your ROI is 148% for that one year (it doesn’t quite work like that, since your equity built in year 1 isn’t $75,000, but bear with me here). Now, of course you don’t have to keep putting in $75k each year though and it still produces that income year after year.
To simplify further, perhaps try to look at it as if it were an annuity based solely upon you putting in $75k and getting out $750,000 + $364,620 (the $36k * 10 years) to total $1,114,620 of profits generated over 10 years based on $75k.
So the ROI is 1,486% over the entire 10 year term…that’s with me paying 30% interest.
That’s a significant statement, so here it is again reworded…
Your $75,000 just made you over a million dollars, and you were even paying 30% interest on a short term loan.
See why I wouldn’t mind paying on a high interest loan? People are stuck in a mindset of not wanting to pay high interest and I get that. But most people have never bought an income producing asset like a business in their life. They’re used to computers, cars, and TVs that not only don’t make a dime but depreciate into garbage rapidly. Also, people that don’t see the light yet will often look at what they’re making today and saying things like, “After my loan payments I’ll only make $36k a year?! Pfft…I should be making $250k like the ad states! That interest rate is too high! I’ll pass and keep working my day job.”
This is a myopic outlook, because the major money in the route industry is made at 2 points:
- The entry – making sure you get a good route, pay the right price, know what you’re really going to net for your income, and understand how much time it’ll really take.
- The exit – making sure you get the most amount for your route when you sell it. Unlike real estate where you only need to contact a broker or consultant when you sell, you need to get consultation to begin preparing to maximize the value of your business starting on day one.
Other people that aren’t as experienced with business acquisitions will focus too much in the middle – the income while owning the route. This is just the leftovers of an employee mindset thinking about what their weekly paycheck is going to be. There’s obvious value in knowing what this figure is (definitely more so if no loans are involved), but it’s a problem of being far too focused only on that, when you need to focus on an intelligent and informed entry and exit of this business.
It’s time for you to get trained personally on how to evaluate these routes.