How to Acquire Your First Small(er) Company
Almost every week someone contacts us at Permanent Equity asking about how to buy a business.
We got four such requests last week alone. We try to be highly responsive and helpful, pointing people to resources, answering questions, and hopping on a call to chat through some nuance when appropriate.
Because of time constraints and the path of conversation, the inevitable result is that we only shine the light on a tiny sliver of a much bigger picture. Like blind people grabbing different parts of the elephant, someone can walk away with a warped misrepresentation of reality. As an example, if we only discuss deal origination, an unsaid assumption may be that the rest is easy, or straightforward.
My hope is, unselfishly, this can help people who want to acquire a smaller company and help the families who own those companies. You both need each other. Unfortunately there’s a tremendous amount more sellers than qualified buyers, and the problem is only getting worse as Baby Boomers look to exit simultaneously.
Selfishly, I hope this is able to scale conversations in a way that I can’t do currently, freeing up my time and relieving me of the guilt I feel when a kind, thoughtful person reaches out for help and I’m already spread too thin.
Before I get started, I want to provide a loud and clear disclaimer. After a decade of being in this space, I don’t yet consider myself skilled at what I do. If I were to rate my competence level on a scale of 1-10, with 10 being a consummate pro and 1 being an ignorant disaster zone, I’m probably a 3. Each deal we do presents new challenges, setbacks, and valuable lessons. We’re not novices, but yet I find myself apologizing at some point in the process each and every time. Reader beware.
THE GATES
The path to buying a business involves seven distinct “gates,” or barriers, that must be navigated successfully to produce a meaningfully positive financial outcome: 1) Find, 2) Negotiate, 3) Diligence, 4) Document, 5) Finance, 6) Operate, and 7) Exit. Each gate carries a low probability of success and it’s a multiplicative system, meaning each probability of success must be multiplied by the other probabilities to get the odds of success. Even if each gate carried a 50% likelihood of success, which it doesn’t, your overall success rate would be about 1.5%.
I don’t say this to unnecessarily scare you, because miracles do happen. We’ve now done seven late-stage deals in 10 years at Permanent Equity. But you need to go into this space with your eyes wide open — It’s brutally hard, and for very good reason.
FIND
Without opportunities, nothing else matters. The goal is to find deals that meet your criteria and have a higher likelihood of success, and simultaneously not to waste time on things that can’t, or shouldn’t, close. While sheer volume can sound impressive, it’s a vanity metric. I’d rather have fewer, but better deals. This prioritization allows for the focus required to get an opportunity across the finish/starting line.
Each buyer’s criteria is different based on opportunity costs, skill set, capital base, time horizon, geography, and operational style. If you have $1M of equity to invest, it’s irresponsible to go after a $10M purchase, just as pouring over East Coast companies is a waste if you want to live in Colorado.
Here are the starting questions you should ask:
If I don’t buy a company, what else could I do with my time, relationships, and financial resources? This sets your opportunity cost.
What useful talents can I bring to bear on an acquisition? This is your incremental upside.
What areas of business am I inexperienced or unskilled in? Plan for help, which is usually expensive.
What is my size, source, and reliability of capital, and what are that capital source’s expectations? This provides the financial constraints.
Where do I want to live and how important is that in my decision-making process?
Remember, more constraints mean lower probability.
What types of decisions do I intend to make, and who else will make the rest of the decisions?
How long do I intend to be involved with the investment?
What does a successful “exit” look like?
Once you have a clear picture of the target, you can start finding opportunities. Deals typically follow two paths — intermediated/auctioned or direct. Especially in the beginning, the vast majority of the deals you review will be intermediated, and most of those will be open auctions.
While you’ll need to participate in auctions to see deals, the best deals never make it to auction. As a friend of mine likes to say, “If you see an oil deal out of Texas, it means I passed on it, twice.” Most quality companies care who they sell to and want to keep the process tight, which means the intermediary is contacting very few people, all of which have a prior relationship.
You must always ask yourself, “Why am I the lucky person?” If you want to get better deals, you have to form better relationships. The best path to incremental deal flow is to have 1000 phone calls and 300 steak dinners. It’s time-consuming, but I have yet to discover a short cut. You need to follow up with each intermediary and stay top of mind. I recommend setting aside 5-10 hours of your week to make phone calls and send emails to be sure they remember you exist.
The other option is to go direct, making contact with an owner and developing a relationship. For owners of more profitable businesses, the profile is older and you have to go where they are — trade shows, industry conferences, their service providers, their offices, and their homes. They’re far less likely to be on social media, which makes targeted advertising extremely challenging.
One challenge is timing, mixed with expectations. Most owners are open to selling if they’d get higher than their “number,” and usually their expectations start in the stratosphere. As with anything, if you haven’t done it before, it’s going to look simple and country club bravado is always about “the multiple.”
It’s easy to laugh off, but the struggle is real. Put yourself in their shoes: Two of your buddies have “sold out” in the past couple years. One claimed a 6X multiple and the other claimed an 8X multiple. Let’s assume both friends were both being completely truthful and had big, moated businesses. Do you think someone coming along offering less is going to sweep the owner off his feet? Not so much.
The reality is that multiples, as I’ll go into during the negotiation section, are an approximation for valuation and nothing more. But, people get fixated on it and use it as a proxy for fairness. Like hearing about people’s salary at a bar, multiples get inflated, twisted, and confused in discussion. If someone has unreasonably high expectations, try to give them a little education, then leave them alone. The sharp rocks of reality eventually hit.
The bottom line is that you need to look at lots of deals before buying your first company. There’s no substitute for practice — yes, I’m talking about practice — and you want to avoid the “fool and his money are invited everywhere” syndrome. I recommend keeping track of your expectations. For every 50 deals you see, write down what you thought was the best one and why. By the time you see your 500th deal, you’ll be shocked at what initially looked attractive.
NEGOTIATE
To be successful long-term, you need to create a win-win deal and not make the negotiation zero sum. The goal is to get creative in how risk and reward are shared in various scenarios. Price is just one of the tools in your toolbox. Here are a few more:
Seller Debt: The seller helps finance a portion of the purchase price. It’s like any other debt, with a size, term, interest rate, security, and covenants. Depending on the situation, you can delay the amortization, or make it a bullet payment. If you don’t know many of these terms, start Googling.
Example: $3M seller note at 5% interest, on a six-year term. The first three years are interest-only, with it fully amortizing thereafter. The loan is recourse to the buyer’s equity interest in the company and subordinate to senior debt, including a working capital line of credit.
Earn-Out: Payments to the seller are based on performance. Pretty much whatever you can dream up can be done. But a warning: the more complicated, the less likely you’ll get the deal done, and if you do, the more likely you’ll have major conflict with the seller post-close.
Example: There will be a $2M payment after year two and a $3M payment after year five, as long as the company’s gross profit levels remaining at greater than $10M in every year after the transaction. So if in year 4, the gross profits drop below $10M, the final $3M payment isn’t earned.
Executive Compensation: Most sellers will continue working for the business post-close. You can adjust their compensation and the term of employment up/down as a deal tool.
Example: Seller will get a base salary of $200,000 and customary benefits, plus a bonus of $50,000 based on performance benchmarks. The initial employment contract will be for three years, but the company can buy out the contract at any time for 50% of the remaining salary.
Consulting: It’s not unusual for a seller to be associated with the business in an advisory capacity for a considerable period of time upon leaving their full-time role. Usually this comes with a smaller amount of compensation.
Example: After full-time employment ends, the seller will become Board Chairman and will be paid $50,000 per year.
Management Fee: If you’re buying 100% of a company, the management fee is irrelevant. Otherwise, it’s important. Determine how much and what it covers. The more specific, the better.
Example: Buyer will receive a monthly management fee equal to 3% of TTM EBITDA, which covers all oversight and travel expenses. Extraordinary work within the company will be mutually agreed upon and separately compensated.
Real Estate: Oftentimes, the seller will own the primary piece(s) of real estate. The terms of use can be an important piece to the deal.
Example: Buyer will agree to a 10-year triple-net lease at $17,000/month with a 2% per year escalator. Buyer gets an option to renew the lease for an additional 10 years at the same terms. At any point during the first lease term, the buyer may purchase the property for an 8% cap rate.
Preferred Equity: Classes of equity can be created that come with features.
Example: Preferred A shares receive an 8% coupon that is received yearly as a payment-in-kind and get a 2X liquidation preference.
Senior Debt: The senior most position on a company’s cap table, usually occupied by a bank. If you’re not buying 100% of the company, this can be a discount mechanism because the company is assuming the debt.
Example: Buyer’s offer for 70% equity interest includes $6M of senior debt provided by Regional Bank.
Subordinate Debt: Debt that sits below the senior debt. Also called mezzanine financing.
Example: In addition to the $6M of senior debt, buyer will employ $5M of mezz debt.
The ways these tools interact with all the parties and with each other is important to consider. $20M deals can function in wildly different manners, which is why the headline price/multiple is so deceiving. Oftentimes a $20M offer with a preferred equity structure, employing multiple tranches of debt, can be far less valuable to a seller than a more simplistic $15M offer. But, it doesn’t always feel that way.
Ultimately, the goal is to set up the deal for success. You have to be able to close it and structure it appropriately to meet your post-close objectives. The more decision-makers in the process, the less likely the deal is to close. And if you layer on exotic debt on a highly cyclical business, it will usually fail.
Process-wise, you’ll want to communicate your offer in a term sheet or an indication of interest, followed by a letter of intent. The only binding aspects of the letter of intent are typically non- disclosure and exclusive dealings for a period of 60-120 days. It’s not uncommon to go through 2-3 term sheets and 3-4 drafts of a letter of intent before signing. The more detail you get in your letter of intent, the less negotiation you’ll have during due diligence.
EXPLORATORY DUE DILIGENCE
Once you’ve gotten under an LOI, now begins due diligence, which is jargon for: 1) verifying the facts as presented, and 2) exploring the company’s risk/return profile. At Permanent Equity, we have a 23-page checklist of things we need to understand, which ranges from financial systems controls and insurance levels to environmental issues and customer histories. My guess is that on an average deal we collectively spend 500 hours on this exploration.
The bottom line is that someone must do the work and you, as the buyer, must understand it. I could go into tremendous detail here about the ways to gather and organize information, but as a first-time buyer, you’ll just have to apply brute force and hope you’ve hired talented advisors (mostly lawyers and accountants). Plan to spend at least $150,000 on outside advisors during the deal process. That may seem expensive — until you get through it. Then you’ll say, “Ahh, totally makes sense.”
DOCUMENTATION
There are two seasons to every due diligence period: exploratory diligence and documentation. After you’ve determined you want to move forward with the deal, you’ll need to start drafting the purchase agreement, operating agreement, leases, employment agreements, and any other controlling documents. The last deal we did had over sixty closing documents, which were mostly schedules and exhibits.
With a good deal attorney, the initial drafts shouldn’t take more than two weeks. The challenge is negotiating the different “what if” scenarios. There will be upwards of 300 features that you, or your lawyer, will have to negotiate. If that sounds outrageously complicated, it is. You have to put in the work, try to keep your cool, and manage the relationship with the seller during a time of tremendous stress.
FINANCING
Simultaneous to making your offer, diligencing/documenting the deal, and closing, you’ll have to secure equity and debt financing. Every time you make the deal contingent on another person/group, you’re dramatically lowering the chances of closing. And if you’re planning to find the perfect deal, then “figure it out,” you’re living in fantasyland. Get all your financing lined up in advance, including fully negotiated terms on a dummy deal that will be in the ballpark of what you will actually get done.
On the equity side, there are a number of outside sources. You can raise a dedicated fund, but it would be almost impossible without a track record of doing successful deals. You can launch a search fund. You could go “in-house” at a family office. Or, you can go down the fundless sponsor route, where you try to gain backing on a deal-by-deal basis.
Whatever the path, do more work upfront to completely understand the constraints of your capital. Here are some questions:
What size range of deals can I do?
What is my time horizon for returning the capital?
What is my target return on an IRR and ROIC basis?
How is that return achieved and how do I build the return profile based on leverage, entry multiple, operational improvement, and exit multiple?
How does the fee arrangement work, including on-going cash flow and carry?
How do I fund the search and expenses, including dead deal fees?
Who needs to approve the terms of the deal and/or the final purchase?
What authority do I have to make decisions post-close?
What happens when my strategy conflicts with the provider of capital?
As for debt, there’s every flavor imaginable. It just depends on what you’re trying to achieve, and under what conditions. The lowest-cost and most risk averse debt will usually come from banks, which will take a senior position and usually require a personal guarantee, especially on your first deal. Currently, you can expect 5-8% interest rates on a fully amortizing 5-year term, with a longer term and higher rates if you get backstopped by the SBA/USDA. The highest-cost and most risk-tolerant debt is mezzanine debt, which will carry interest rates of 15-25%, with the ability to get some equity under certain circumstances. Senior and mezzanine debt can be stacked together, creating a high-levered capital structure.
It’s important to remember that debt doesn’t create returns, but merely amplifies the underlying performance. A good outcome will get better with debt. A mediocre outcome will get worse with debt. To figure out your ideal mix, you should answer the following:
What am I trying to achieve that I can’t accomplish without debt?
How much debt do I think the business can handle today and next year?
Where do we think we are in the economic cycle and could the business handle the debt load if there was a downturn?
If the business were to experience a temporary downturn, how would the debt holders respond?
If the downturn was more permanent, how would you respond and work it out with the debt holders?
How much does bringing in debt holders lower your odds of completing the deal?
OPERATING
Congrats, you’ve closed your first deal. Now what?
Operating style, reporting cadence, decision-making, hiring/firing responsibilities, and reinvestment are all critical issues to understand. Without complete clarity, the company will suffer. And remember, someone has to do the work.
There are two clear paths to post-close operations and a very messy middle. The first path is a hands-off approach where a leadership team is empowered and you’re only involved to set incentives and check off on major decisions. There’s a clear reporting structure, generally including weekly/monthly calls and quarterly in-person meetings. This path scales nicely, but requires a talented and trusted operating team to be in place, with aligned incentives. If you wrongly assess the situation, and have a team that needs constant direction, makes unwise decisions, or creates a bad culture, you’re screwed. After a crash, it’s nearly impossible to get the train back on the tracks.
The other path is to get your hands dirty and start making changes. You assume the CEO role, call the shots, and go to work for 5-10 years. If you know what you’re doing, you can “tune” the company and dramatically increase the value. This is also the quickest path to a detonation if you start pulling on strings that are connected to other strings. The whole ball of yarn can unravel, fast. This path doesn’t scale and requires a long-term commitment, but is the most direct route to high returns.
There’s a very messy third option between these two path. You sometimes intervene, but usually don’t. You want to make “the big decisions,” but don’t have the day-to-day muscle memory. You occasionally override the management team and get involved in the minutia because “things need to be done with excellence.” You take on a few side projects for the company, then try to hand them off to someone else. You “do deals” on behalf of the company, sidestepping company procedures because you’re a guy who “gets stuff done.”
For goodness sake, don’t do this. Full stop.
The “messy middle” will turn out poorly for you and will destroy the company’s leadership team. No one will understand who has authority, how decisions should be made, or what should take priority. No one will take responsibility and everyone will be discouraged. The eventual result will be binary between the two paths previously discussed. You will either rebuild the management team and take a more hands-off approach, or you’ll become the CEO and spend the next 5-10 years rebuilding the company.
Pick one of the two paths and own it.
EXITING
Since we never invest with an intention to exit, this is the area I’m least versed in. So instead of theorizing about the practicality of what others do, I’ll just say this — make sure you understand how you sell. I’d ask these questions:
Who buys companies like this?
What do they normally pay and under what terms?
What will be the transaction costs associated with the sale?
Who will do the work to sell the company?
What happens if the company can’t be sold?
Q&A
Q: So you’re telling me I can buy a $1M in annual cash flow for $3M-$4M? What’s the catch?
A: If you can find a nicely run small company with a defensible market position and run it with excellence, there is no catch. But those companies are few and far between. Most small companies are complete disasters that are held together with bailing wire and duct tape by the owner who works 60-80 hour weeks and knows the business inside-out. If it looks too good to be true, it probably is. Find the catch.
Q: How hard will I have to work?
A: Harder than you’ve ever worked before. As the old adage goes, the opportunity in the small business market is dressed in overalls and looks like hard work. Plan on consistently working 60 hours/week, and more in spurts. You’ll call the shots, but you won’t have much flexibility.
Q: What if I don’t want to “run it?”
A: You better buy right and treat the leadership team exceedingly well. Small businesses don’t run themselves and need constant attention from someone with a deep expertise and aligned incentives. If you’re not willing to step in and do that work, I’d question if you’re a good fit for this segment of the market.
Q: How long will it take to get my first deal done?
A: If you’re doing it alone, I’d budget three years of full-time effort. The first year is all about planting seeds. The second year you might get lucky, but you’ll likely be nurturing opportunities. If you have a timeline and start pushing hard, you’ll usually lose the deal. Besides your own living expenses, you’ll need to budget for subscriptions, travel, and advisory fees. Conservatively, I’d want at least $500,000 of budget outside my living expenses.
Q: Where should I live?
A: There’s no right answer. I’m a big fan of keeping my burn rate as low as possible and avoiding perceived conflicts. Outside the coasts, most people are skeptical of people from “the big city.” I’d pick a place like Kansas City, Denver, or Phoenix, where you get access to direct flights, have a relatively cheaper cost of living, and is less intimidating to sellers.
Q: What’s my value proposition to sellers?
A: I’m not sure. It depends on your background, skill set, and intentions. I’d advise that you under-promise and over-deliver. It’s easy to make big promises about increasing sales and launching a new technology platform. In reality, there’s a good reason why the person who founded the company and has been running it for 20 years can’t do it.