Beyond key-person and concentration risk, a small-business purchase carries recurring costs and tax treatment that materially change the price a buyer can justify and the return a seller actually keeps - none of which shows up in a headline SDE multiple. This lesson is general information, not personal tax or legal advice, and rules vary by jurisdiction.
12 min read · Level 3
I would treat the purchase-price allocation as the most under-negotiated line item in small-business deals, precisely because it looks like paperwork rather than a decision. The total price gets fought over for weeks; the allocation across equipment, non-compete and goodwill often gets settled in an afternoon near closing, by whichever side's advisor happened to raise it first. That is backwards, because the allocation is where a genuinely large amount of after-tax value sits for both sides, spread quietly over fifteen years rather than delivered as one dramatic number at signing - which is exactly why it gets less attention than it deserves. The same is true of a franchise's royalty stack: it never shows up as a single frightening figure, only as a percentage subtracted every month for the entire life of the ownership, which is precisely the kind of cost human attention is worst at weighing correctly against a one-time number like the purchase price. Small, recurring and unglamorous is how the real cost of this asset class actually shows up, far more often than a single dramatic loss does.
Beyond the earnings-quality and concentration risks already covered, four further categories of risk and cost shape what a small business actually returns: continuing franchise obligations, the tax treatment of how a purchase price is allocated, transition and litigation risk carried by the deal structure, and the practical illiquidity of the exit.
Franchise costs stack, and they come straight out of the earnings before an owner ever sees them. A typical franchise agreement charges an upfront franchise-fee at signing, plus an ongoing franchise-royalty - commonly around 6% of gross revenue - plus a separate marketing-fund contribution, commonly around 2% of gross revenue. On 900,000 of annual revenue:
Ongoing royalty (6% of gross revenue) 54,000 a year Marketing fund contribution (2% of gross revenue) 18,000 a year ------------------------------------------------------------ Total ongoing franchise cost 72,000 a year, which is 8.0% of revenue
That 72,000 comes out before SDE is even calculated - it is a real, permanent operating cost, not a discretionary add-back, and it does not disappear if a new owner takes over. At a 2.6x multiple, that recurring cost is the equivalent of 72,000 x 2.6 = 187,200 of forgone enterprise value compared with an otherwise identical independent business carrying no royalty at all - the real, quantifiable price of the brand, training and system a franchise provides.
Tax treatment turns on how the purchase price is allocated across asset categories, and buyer and seller want opposite allocations. In a typical asset purchase, the price is split among tangible assets (at fair value), a non-compete clause, and a residual goodwill figure - and under United States federal tax rules, acquired goodwill and most other intangibles, including a non-compete, are amortised straight-line over 15 years, while equipment is generally depreciated faster, over its own shorter class life. Take the 364,000 purchase price from lesson two, allocated as follows:
Equipment (fair value) 80,000 Inventory 20,000 Non-compete clause 10,000 amortised over 15 years Goodwill (residual) 254,000 amortised over 15 years ---------------------------------------------------------------- Total intangibles amortisable over 15 years 264,000 Annual amortisation deduction (264,000 / 15) 17,600
For the seller, the same allocation determines how their gain is taxed: if the equipment's own adjusted tax basis on their books was only 30,000, the 50,000 difference between that basis and the 80,000 allocated fair value is depreciation recapture, generally taxed as ordinary-income, while the amount allocated to goodwill is generally taxed as a capital-gain - and these two categories are frequently taxed at very different rates. This is precisely why buyers and sellers negotiate the allocation itself, not just the total price: a buyer generally wants more allocated to equipment and inventory for faster deductions, while a seller with low-basis equipment generally wants more allocated to goodwill for capital-gain treatment. Tax rules and rates differ by jurisdiction and change over time; confirm the applicable treatment with a qualified tax professional before relying on any specific figure.
An earn-out shifts risk onto the seller's future cooperation and the business's future performance. When part of the price is structured as an earn-out - additional payments contingent on the business hitting agreed targets after closing - both sides are betting on a period during which the seller may have limited control but retains a financial stake, which has led to real disputes over how the business was run during the earn-out window.
Franchise costs matter because they are easy to under-weight when comparing a franchise listing's stated SDE against an independent business's, when in fact the SDE already reflects the royalty and marketing-fund deductions - so the honest comparison is not the SDE multiple alone, but what that same SDE would look like, and what multiple it might command, without a permanent 6-8% of revenue obligation attached to every future year of ownership, including years long after the current owner has sold and moved on. A franchise-disclosure-document, required in many jurisdictions before a franchise sale, is the place these obligations are spelled out in full, including territory restrictions, renewal terms, and the franchisor's right to approve or block a resale - reading it is not optional due diligence, it is the document that describes exactly what continuing obligations transfer with the business.
The tax allocation matters because it is frequently treated by first-time buyers as a formality to be settled by the lawyers at the last minute, when in fact it directly determines the buyer's annual tax deduction for the next fifteen years and the seller's after-tax proceeds from the sale - two numbers large enough that getting the allocation wrong, or accepting whatever the other side proposes without independent review, can cost real money on both sides of the table for years after closing.
Key-person risk resurfaces here in a specific, contractual form: the non-compete clause. Its value depends entirely on its actual scope, duration and geographic reach, and a clause that is too narrow, too short, or unenforceable in the relevant jurisdiction leaves a buyer paying for goodwill that the seller is legally free to compete against down the street six months later - which is a real, googleable risk in industries built on personal relationships, and worth a lawyer's specific attention to the clause's actual language rather than its label.
And earn-outs matter because they change the nature of the relationship after closing from a clean transfer into an ongoing, financially entangled one - which can align incentives well when both sides act in good faith, and can produce genuine, expensive disputes when the buyer's operating decisions during the earn-out period affect the metrics the seller's remaining payments depend on.
This is educational information, not tax or accounting advice. Rules differ by country and change — get advice from a qualified professional in your jurisdiction before acting.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
Sources: U.S. IRS - official tax information; U.S. SEC - Investor.gov; UK Government - Capital Gains Tax guidance; OECD - tax policy and statistics
A franchised sandwich shop, purchased for 364,000 at a 2.6x multiple on 140,000 SDE, generating 900,000 in annual revenue, illustrating three of these risks together.
The royalty stack. Royalty at 6% of gross revenue is 54,000 a year; the marketing fund at 2% is 18,000 a year; total 72,000 a year, or 8.0% of revenue - already subtracted before the 140,000 SDE figure was even calculated, and unavoidable for as long as the franchise agreement runs.
The tax allocation, buyer's side. The purchase price is allocated 80,000 to equipment, 20,000 to inventory, 10,000 to a non-compete, and the 254,000 residual to goodwill. The non-compete and goodwill combined - 264,000 - are amortised straight-line over 15 years under the general federal rule for acquired intangibles, producing an annual tax deduction of 264,000 / 15 = 17,600 for each of the next fifteen years, a real and predictable reduction in the buyer's taxable income that a stock purchase of the same business would generally not have provided in the same way.
The tax allocation, seller's side. The seller's adjusted basis in the equipment was 30,000; the 80,000 allocated fair value creates 50,000 of depreciation recapture, generally taxed at ordinary-income rates, while the 254,000 allocated to goodwill is generally taxed at capital-gains rates - two very different tax outcomes on two portions of the same total price, which is exactly why sellers frequently push to allocate more of the price to goodwill and less to equipment.
The non-compete's real scope. The clause covers a five-mile radius for eighteen months. In a dense urban market, five miles might cover the entire realistic customer base; in a sparse rural one, it might leave the seller free to open a nearly identical shop just outside the line the day after the eighteen months end - the same clause, wildly different practical protection, depending entirely on geography the headline number does not capture.
None of this changes the 364,000 price or the 140,000 SDE. It changes what that price and that SDE actually mean once the recurring franchise cost, the after-tax proceeds on each side, and the real strength of the non-compete are accounted for - which is the whole point of a lesson that comes after the price has already been agreed rather than before it.
Comparing a franchise's SDE multiple directly against an independent business's without remembering that the franchise SDE already carries a permanent 6-8% of revenue royalty and marketing obligation, one that transfers to every future owner for as long as the franchise agreement runs.
Treating the purchase-price allocation as a closing-day formality rather than a genuine negotiation with real, multi-year tax consequences for both sides.
Assuming a non-compete clause provides real protection without reading its actual radius, duration and enforceability in the relevant jurisdiction - some jurisdictions restrict non-compete enforceability significantly, which can make a clause worth far less than its wording suggests.
Agreeing to an earn-out structure without spelling out, in the contract itself, exactly which operating decisions during the earn-out period are within the buyer's discretion and which require the seller's input, since ambiguity here is where most earn-out disputes actually originate.
Confirm the exact royalty percentage, marketing-fund contribution, remaining term of the franchise agreement, renewal conditions, territory protection, and the franchisor's rights over any future resale - all of which affect what the business is actually worth to a future buyer, not just to you.
Understand how each category - equipment, inventory, non-compete, goodwill - will be taxed on your side as a buyer over the amortisation period, and ask a qualified tax professional to model the after-tax impact of the seller's proposed allocation before agreeing to it.
Confirm its geographic radius, duration, and whether it is likely to be enforceable in the applicable jurisdiction. A non-compete that looks reassuring on the page but is legally unenforceable, or geographically too narrow, is not the protection its presence suggests.
Define, in writing, which decisions the buyer controls unilaterally during the earn-out period and which require the seller's consultation, along with exactly how the earn-out metric will be measured and audited, before either side signs.
This lesson explains general mechanics; actual rules, rates and enforceability vary by jurisdiction and change over time. A qualified professional working from your specific numbers and location is the only reliable source for what applies to your transaction.
Whenever evaluating a franchised business specifically, whenever negotiating the final purchase agreement's price allocation, and whenever any part of the price is proposed as an earn-out rather than paid in full at closing.
Do not treat this lesson's specific figures - the 15-year amortisation period, the royalty percentages, the tax characterisations - as universal or current for your own jurisdiction and situation. Tax rules and rates change, differ by country, and depend on facts specific to each transaction; verify the current rules with the sources below and a qualified professional before relying on any number here.
In transactions where the buyer and seller have negotiated the total price amicably for weeks, it is a recurring pattern for real friction to appear suddenly at the purchase-price-allocation stage, once each side's tax advisor explains what a given split actually costs or saves their own client. A buyer who has spent no time understanding the seller's basis in their own assets, or a seller who has spent no time understanding a buyer's amortisation preferences, is frequently surprised that a topic which felt like paperwork becomes the last real point of contention before closing.
Discuss the purchase-price allocation, and each side's basis position, early in the negotiation rather than leaving it for the final week - it is a genuine negotiation, not a formality.
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