Buying Small Businesses; The Most LoCo Thing You Can Do
You can help save our economy. Sound hyperbolic? By the end of this article you’ll not only see the truth behind the claim, but more importantly you may have a desire to do something about it.
Most people have a fairly consistent definition of an entrepreneur. But there is a crucial and evolving division of entrepreneurship that needs more exposure, investment, and mentoring; Acquisition Entrepreneurship. Acquisition Entrepreneurship (AE) is when you purchase and operate existing, successful businesses compared to starting something new. There are as many shapes, sizes, and types of businesses out there as there are entrepreneurs. The ones I will discuss today have some key similarities: Established for 10+ years, successful track record, low key-man risk, seller has a very good reason for selling (is looking to retire and doesn’t have any employees or family members to sell to), between $500k-$1M SDE (Seller Discretionary Earnings), mid to high barriers to entry, etc. But as you can imagine, there are businesses in a wide range of industries with an even wider range of scores in these areas.
I will discuss these specific types of businesses and how demographics are affecting the market, provide an example of the purchase finances, analyze risk v return, and lay out how you might be in a more unique situation than you thought to capitalize on AE.
Demographics & Selling
It has been said the only two things in life that are certain are death and taxes. But I’d like to add one more to Benjamin Franklin’s list; Current Demographics. We may be able to alter the distant future through birth rates, but simply put, we’re not going to create more 30 year olds. With standard death rates, the gap between business owners that are looking to exit and the number of eligible younger buyers is widening. We are starting to see how crucial demographics are in the economy of business ownership as many in the close-to-retirement generations are looking to exit, and their pool of buyers is smaller than it has ever been.
There are even instances where a business owner doesn’t understand how to sell, isn’t sure if they can, or feels like they don’t have the time to do so. Often these owners “wind down” their operation rather than prepare it for a sale. These are perfect opportunities for seasoned business people to get involved, educate the owner, and make sure they don’t just close their doors and cost the local economy jobs and revenue by losing out on transitioning the business through a sale.
In the cases where a business owner can, knows how, and wants to sell there are two similar but slightly distinct choices: Private Equity or an individual/group buyer. Depending on the size of the business there could be many private equity firms ready and willing to make those purchases. There are many forms and types of Private Equity, but a big problem is that many sellers don’t understand Private Equity, they don’t understand what to look for, know what to expect, or know the right questions to ask. They may not fully grasp the ramifications of working with these types of entities. Sometimes an owner wants top dollar, and they don’t care who, what, where, how, or anything else other than getting what they’re after. The legacy of the business, the employees, and other intangible parts of the business may not be important or an option to care about for that owner. How could this mindset affect the economy? What could be done for those that don’t want to or know how to work with PE? What if there are more important things to the owner that PE is not addressing?
What if an owner cares more for instance about the business legacy, what happens to their employees after transition, or the future goals of the next owner, than they do top dollar? What if they don’t feel a great fit with PE, what do they do? If that owner could find an individual buyer or a small group of buyers that has similar goals for the transition, they could create a unique transition where the seller gets what they deserve while still getting to see their legacy and the things they care about continue. In this latter scenario a local, younger, driven individual or group can put together a strategy that connects with the seller and understands their true desires and goals. If transitioned properly, this type of buyer keeps the middle class strong, keeps the local banking sector strong, keeps customer service as a top priority, keeps the core team and culture in place, builds new wealth for those that are operating versus a return for a fund, and keeps that wealth mostly in the local economy. There are many other seen and unseen benefits that come with local ownership and operation, these are just a few. And as a seasoned business owner, you are in a unique position to get to know the owners, to find the young and driven operator, and build a win-win scenario for all parties.
An Example
On average most small businesses sell for between 3x and 5x SDE (Seller Discretionary Earnings). The $500,000-$1,000,000 SDE range is my goldilocks size. PE tends to look north of $1M SDE as diligence tends to be similar for $1M or $4M SDE. Anything less than $500k usually doesn’t have the processes or structure necessary to facilitate a smooth transition, and many times you’d be buying a job, not a business. Businesses with this SDE range have other benefits like weeding out smaller buyers, having some processes in place, having some levels of management to avoid key man risk when the seller leaves, and still leaving some room for investment after debt servicing.
You could finance the purchase many ways. Perhaps you have a pile of cash and you’re looking to offset taxes, or perhaps you want to use a bank to finance the purchase. Either way could work great. Here is a bank financed example to show some quick numbers, knowing if you financed it yourself, it’s an even better return. Ultimately the cash on cash return is close to impossible to beat anywhere else when compared to traditional investments. Here’s an example:
Purchase Price: $2,500,000
SDE: $700,000 (3.57x multiple)
Down Payment: $250,000
Estimated Annual Debt: $325,000
Remaining SDE: $375,000
In this example, you have $375,000 post debt to keep, invest, hire a GM, grow, whatever you feel the business needs. Keep in mind the debt is Principal & Interest, so on a 10-year note, almost half of your annual debt is going to principal. Thus your balance sheet improves every year, and the business cash flow is paying off your note. You’re getting a post-debt return of 150% on your $250,000 investment; much higher if you calculate your principal payments.
Risk vs Return
In terms of investment decisions, it’s often a risk vs return calculation. The question with Acquisition Entrepreneurship is: Can you maximize your return and minimize your risk? Your banking relationships could help you finance the purchase with strong financial metrics, your business intelligence could help you create efficiencies and processes that improve the operation, your hiring and vetting experience could help you find a great operator, your local relationships could help you expand your reach and grow your sales, the list could go on depending on your specific skill set.
A Unique Situation
So you may be asking yourself, ok, this is all great, and I see the importance of it, but what can I do about this? You may already own a business so you can’t or don’t want to step in and operate it yourself. What if you looked at this more as an investor and mentor than as an operator? You have the skillset, the resources, the connections, and the business intelligence to put a hungry operator in the best possible position for success. What if you could free up enough time and resources to be involved, but most importantly, you focus on finding, growing, and mentoring the operator, thus decreasing your overall risk and creating a life-changing situation for someone else?
Buying an existing, successful, established business with your skillset could also be a great way to diversify your portfolio and offset risk by utilizing your skills and experience. Currently 5% of SBA acquisition loans default. That means you have a 95% chance of success! Although by no means a risk-free proposition, remember that with current demographics, there is a gap in the buyer market that you could help fill. Many of these SBA loans are going to owner-operators. By getting involved as an investor, owner, and operator-mentor it creates a unique mix of skill sets not frequently found in the acquisition space.
Conclusion
So I know this all sounds “loco”…And maybe that’s a good thing! The LoCo (Local Community) Think Tank is crazy about growing businesses. They exist to connect small business owners to solutions supported through perspective, accountability and encouragement from other like-minded business owners. This connection can in part be done through Acquisition Entrepreneurship! Although it is not for everyone, perhaps you feel a little different about AE than when you started reading. Chances are you know someone, either a seller, or a potential buyer, whose lives could benefit from understanding the pros and cons of AE. With the right combination of business setup, seller priorities, and buyer resources, a beautiful win-win transaction can occur. These types of transactions help the local economy, they help put new blood into the owner-operator market, and they can help all parties involved reach their desired potential. Maybe we all could be a little more LoCo!
