In twenty years of helping people buy and sell Main Street businesses, that is to say, owner-operated businesses, the fact is that almost all of them are purchased by a new owner-operator. From that work, the rule of the three-slice pie is sacrosanct and inviolable. This rule must prove true, or a sale can’t in good conscience be consummated.  

The pie that the rule refers to is what is known as Seller’s Discretionary Earnings (SDE). We have other blogs that dive into SDE, but as a quick reminder, SDE is the total amount of financial reward available to a single human engaged full-time in the operation of the business, no matter how that reward is dispensed to the owner by the business. Included but not limited to salary, dividends, health benefits, personal insurance policies, and perks of all manner, from car expenses to dinners out. If it is not required for the successful operation of the business, it is probably part of SDE.

The three-slice pie rule states that when an individual purchases a business, they need to achieve three things from the SDE of the business. One is a living wage. Two is the servicing of any debt incurred to buy the business. Three is a Return on Invested Capital for the money that they shook out of their piggy bank to make the transaction happen. Let’s look at each piece of pie a little closer. 

1. A Living Wage

From the first slice of the SDE money pie, a buyer needs to realize a personal income. They still have rent or a mortgage, groceries, and all the other necessities of life. At this stage, it is not about what they want to make but rather what they need to make. I counsel my buyer clients that their living wage should be enough so that they are not always short of money. That is wearing on the psyche. You want to be in your best mental state when you show up for work. What they want to make comes later when we take away the second slice of our pie. Right now, we need a living wage, more than a struggling wage but less than an opulent wage. 

2. Service the Debt Incurred to Buy the Business

Most business acquisitions are financed in some way, typically with a combination of money from the purchaser and debt from various sources, most commonly an institution (bank) and the seller of the business. 

The easy way to understand this is that financing is available to purchase a profitable business. The purchaser can then take the money they have available to make the purchase and leverage that into the purchase of a larger business. The advantages of this are too numerous to explore in this blog, but suffice it to say that in the hundreds of transactions that I have been a part of over 20 years, I can count on one of the ones that did not have some sort of debt as part of the purchase price. 

Therefore, the second slice the purchaser takes from the SDE pie is debt service. The key concept that underlies this exploration of the SDE pie is that it is enough to fund the entirety of the business purchase. If the purchaser had to bring in more money to pay for any and all loans they took on to buy the business, that would constitute a higher selling price. I should also be clear that this is both principal and interest.

3. A Suitable Return on Invested Capital (ROIC)

Finally, the buyer wants to see an appropriate return on the money they shook out of their proverbial piggy bank to initiate the purchase. We hear stories of people buying business with no money of their own. These are stories that I would say could be classified as fantasy. My partner likes to remind us that no one has to buy a business. They could continue to stay in their current employ and look for an investment for their savings. The buyer has used personal savings or other financial resources to finance the acquisition (either in part or fully); they want to make sure the business generates returns that are proportional to the risks and opportunity costs involved in the investment.

The third piece of the SDE pie is used to calculate the ROIC. As an example, let’s say that a business had an SDE of $250,000 and purchased the business for $625,000 with a $400,000 loan from the bank at 9% over 7 years and $260,000 of their own money to make up the balance of the business price and $35,000 for closing costs. The purchaser needs to gross $120,000 to use as a living wage, slice number one. The debt servicing has an annual cost of $77,228. That leaves $40,682 after two slices and an estimated corporate tax; the third slice. Earning the purchaser $40,682 from the $260,000 their piggy bank gave up, which is a 15.6%. That seems like a pretty good third slice. But wait, some is hiding a part of that third slice. The slice is bigger than what we see on the surface. Under the table, if you will, is the rest of that slice. The debt servicing is paying both interest and principal. The $260,000 will also be returned to the purchaser, the principal portion of the loan, which will be $400,000 over 7 years. That is another $57,143 on average per year. That makes the ROIC 37.6%. All of these calculations do not take into account any growth the business will probably experience, a fine slice of the pie by any measure. 

I have always believed that the perceived risk of purchasing a business is inflated past reality. New businesses have a tough go, absolutely. Nevertheless, this is what the market dictates and getting a piece of the ownership pie, in fact three, is, in my mind, one of the best things any human can do. I think the three-slice pie rule is such a helpful concept for both buyers and sellers. The seller can get help with understanding the range of a likely selling price, and the purchaser can ensure that the purchaser can put a deal together that will put them in a good position for a successful outcome with the business they have purchased to take care of them and their family.

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