Buying existing businesses is all the rage these days. The rise of private equity which breaks records for money raised each year, the searcher movement, and just good old fashioned M&A has driven the value of private companies to unprecedented levels. The idea of starting new companies seems like something for chumps unless you are a tech driven venture capital darling.
I get it, starting a business is hard. I chose to do it in an industry (government contracting) that relies on past performance ratings that take years to build. My first five years were like chewing glass. It’s just so hard to get momentum. How long is it going to take until I have staff to do this? I’d ask myself. Answer: 3-5 years. Yuck. Thank god I was in my 30s. I’m not sure I could have done it a decade later. It makes sense that potential business owners want to skip over those steps. The buy versus build decision seems like an easy one to make.
Unfortunately everyone eventually figures out the optimal strategy especially if the optimal strategy is easier. If I had bought a company back when I was starting mine, it would have been a great decision. But a decade plus later and valuations have been driven through the roof. This is a real problem. While Dan Rasmussen now at Verdad Capital worked for Bain Capital in 2012, he worked on a study of returns from Bain and it’s top 20 competitors covering 1700 transactions from 1999-2010.
The goal was to figure out what accounted for the returns. In the end the answer wasn’t industry, management, operational improvements, or even leverage. The factor with the greatest impact on a successful outcome was the multiple of earnings the private equity firm paid for the company. Anything cheaper than 8 times EBITDA had a high chance of generating good returns. More expensive deals did not. The 25% of deals that were the cheapest generated 60% of the returns.
Most of the PE funds that have been raised during this run up in prices will have much lower returns. It’s inevitable. The result has been that firms play with the timing of cash flows to boost Internal Rates of Return (IRR), use inappropriate benchmarks like the S&P 5001, and have shifted to raising bigger funds in order to make profits on the 2% management fee rather than the 20% carry/success fee. Investors beware.
A similar though less extreme process has happened in the small buyout market populated by searchers. EBITDA multiples have steadily risen as the popularity of search has increased and as PE firms move farther downmarket in search of lower multiples. A reliance on bank financing for many acquirers has kept a partial lid on the craziest of increases in the lower end of the market but it’s certainly harder to get a good deal today than it ever has been before. Look also at the average multiples for venture capital start ups. The median early stage start up is getting a $50m valuation and the average comes out above $100m2. That’s insanity!
Clearly we need more supply. In most markets, the cure for high prices is high prices. Elevated prices attract competition and eventually supply begins to slake the thirst of demand but in our cash flush world that doesn’t seem to be happening. Business formation finally spiked during the pandemic but anemic growth has been the rule ever since the Great Financial Crisis and that spike could prove very temporary. Of course there is supposed to be a wave of baby boomer business owners looking to sell their businesses but that never quite seems to happen as quickly as buyers hope.
The problem is starting a business is hard and risky. It requires lots of hustle and many entrepreneurs who have done it once don’t want to do it again. Second time entrepreneurs try to replace their hustle with cash but that usually leads to wasted money. You have to hustle a bit with limited resources to figure out what works. There are also structural barriers to serial entrepreneurship. If you grow and sell a company in a vertical, the buyer is going to keep you from quickly starting another company in that vertical through a non-compete. The very thing you have the most experience in building is a nonstarter.
Another barrier is simply talent. One person can only run so many businesses. In some sense this was why the franchise model was created. I have a playbook I can run but I need owners to start and run locations or new businesses. That’s one way to create supply but franchising is a different business model than operating a business. I feel like you become half a law firm and half a marketing firm when you franchise.
Another interesting model to watch is what John Wilson @wilsoncompanies is doing: https://ownedandoperated.com/servstart. They are trying to incubate service companies. Aspiring home service entrepreneurs apply and get financial backing and operations help in launching. It’s a franchise light model. It’ll be interesting to see how that experiment goes.
We find ourselves in a situation where everyone wants to buy and the supply of quality companies is limited. The result is always going to be higher prices and I don’t see that changing anytime soon. In fact it will probably get worse and will further hurt returns. If you pay 3 times EBITDA and the business stays stable, you get a 33% return. At 10 times, you get a 10% return.
That is not sustainable for two reasons. First at 10% you can find other investments that require no effort on your part. Become a limited partner in a private real estate deal. Second, return is compensation for risk. At 33%, you have some cushion on the deal. At 10%, one bad thing happens; one customer leaves and you can’t service the debt or pay a return to your investors.
Given all of this, does it still make sense to buy a business? My reluctant answer is yes. I think the barriers to starting a business are so high that it still makes sense to buy at all but the craziest of prices at least for those without an existing business or those looking to buy in a different vertical than their existing business3. But rising prices call for some risk mitigation strategies you should think about employing to improve your chances.
First, if you figure out how to start businesses serially and efficiently, do it! That’s a rare skill and it will be richly rewarded in this market. For the rest of us suckers, we’ll have to try something else.
Second, I think you’ll have to buy smaller businesses. While values of $1m EBITDA companies and below are still going up, inflation is anchored. Private equity is going to struggle to move the needle with that low of a base; funded searchers who have raised money to support their search need a bigger company to have a chance of returning capital to their investors and themselves; and SBA loans cap out at $5m (with a temporary Covid exception of up to $10m). Only recurring SaaS companies will sell for much more than 5x at that level. At $3-5m in revenue you still get some management infrastructure and proven business methods to build on. You’ll still be in a scrappy phase of the company but it gives you a good head start.
Third, have an angle. For example, in my business you need to gather past performance to compete for limited spots on contract vehicles that government agencies use to acquire services. It’s similar to a master services agreement you might find at a large company. If you have an opportunity to work with an agency and don’t have the qualifications to get on that contract vehicle, you have to subcontract to a company that does and give that prime contractor a substantial proportion of the work.
I’m looking to buy small subcontracting companies that I can fold into my business and then convert their work to a prime using my vehicles. It’s a little bit of arbitrage where I can take the mark up and work the acquisition target has been giving to its prime contractor. That makes the acquisition process a little bit less risky. Additionally I am buying companies very much like mine. I know where the landmines are and what questions to ask. Other acquirers will focus on suppliers to their core business. As a customer of the target company they know how they operate and have a good idea of the competitive landscape.
Finally you have to be patient. The best deals are going to come to those who develop relationships with many potential owners, stay in the game until market conditions turn in their favor, and look for acquisition candidates consistently. This is not a sprint.
If you do not already own a business and want to buy one, my advice is to focus on a particular industry and its core suppliers. The more information you can gather, the more likely it is that you can find an angle. Trying to do that across multiple vertices is a challenge. If you already own a business start thinking about those arbitrage opportunities or angles you can bring to the acquisition. I think that’s how you prosper in the competitive acquisition market.
That’s it for this week,
Alan
PE buyout targets are far smaller and have more debt than S&P 500 firms. Small cap value companies are a better benchmark.
https://www.institutionalinvestor.com/article/b1t8lgsqcdrd00/VC-Valuations-Climb-Even-Higher
I think those who seek to grow with accretive acquisitions have a higher hurdle to get over before they buy. Increased marketing, qualified talent, better sales, etc. should be exhausted before you consider buying expensive growth.