How Acquisition Entrepreneurs Outsmart the Startup Game
Written by Walker Deibel. Published by Lioncrest Publishing in October 2018
Imagine navigating the business landscape without the arduous journey of a traditional startup. Forget years of bootstrapping, the anxieties of fundraising, and the uncertainty of product-market fit. Acquisition entrepreneurship offers a strategic alternative, allowing you to acquire an existing business with established infrastructure, revenue streams, and a customer base. You inherit a customer base, a track record, and a team potentially ready to embrace your vision. It’s akin to inheriting a well-oiled machine, one primed for optimization and growth under your skilled guidance.
Consider the current economic landscape. The impending retirement of the baby boomer generation presents a unique opportunity for acquisition entrepreneurs. Millions of well-established businesses are poised to change hands, creating a favorable buyer’s market and a plethora of attractive targets. According to many statistics acquisition entrepreneurship boasts a demonstrably higher likelihood of achieving consistent, sustainable growth.
Of course, this strategic approach demands its own set of skills and acumen. You must possess a keen eye for identifying undervalued businesses with latent potential, the analytical prowess to assess their financial health and growth prospects, and the negotiation skills to secure favorable acquisition terms. You must also be at ease with taking measured risks.
Acquiring a business can be more affordable than you think, despite the common misconception that it requires a large amount of personal wealth. In reality, banks offer loans for up to 90% of the purchase price, using the business’s assets as collateral, making it easier to secure financing. Additionally, raising capital for an acquisition takes less time and effort compared to raising funds for a startup. You can also retain 100% ownership of the company by using bank financing, and have the option to bring on partners, raise funds from friends and family, or pitch to angel investors or family offices. Furthermore, search funds, which are dedicated to helping acquisition entrepreneurs buy businesses, can also assist in acquiring larger companies or providing additional capital to lower debt levels.
Acquisition entrepreneurs are both investors and operators. They leverage bank loans instead of private investors, putting their own skin in the game. So, before diving in, understand the basics of investing. Think like a venture capitalist or private equity pro. The key is to find good investments with strong returns, safety nets, and growth potential.
First some basic terminology. Return on investment (ROI) is how much cash your business kicks back each year. Margin of safety is your buffer against risk. Upside potential is how much it can grow.
Remember, you’re buying cash flow, not just a business. Cash flow pays your salary, debts, and fuels growth. If a company can’t generate healthy cash, it’s probably not a good investment.
A small company generating $200,000 annual cash flow might sell for three times that, or around $600,000. This price depends on the industry, risk level, and the company’s track record.
To mitigate the risks we need to consider the “Intrinsic Value”: This subjective concept represents the true worth of a company, considering its assets, brand, and future cash flows. By understanding intrinsic value, investors can identify bargain opportunities. Then try to have good “Margin of Safety”. Only buy companies when their market price is significantly below their intrinsic value. This provides a buffer against potential losses.
While the small business market generally reflects intrinsic values, individual deals may offer wiggle room for negotiation by focusing on factors like seller’s discretionary earnings. It’s not just about finding the lowest price, but about achieving an appropriate return while protecting yourself from potential losses.
Compared to startups and venture-backed firms, which have high failure rates (90% and 75%, respectively), acquisitions have a much lower chance of failure (estimated at 2%). This is because existing businesses have a track record of earnings and tangible assets, reducing the risk of total loss. Valuations of small businesses tend to be closer to their inherent value, further lowering the risk compared to speculative valuations of startups.
Beyond the reduced risk, acquisitions offer significant potential for growth and appreciation.
Entrepreneurs can actively manage and improve the business, increasing revenue and ultimately building substantial value. This is in contrast to passive investments like real estate, where value appreciation primarily depends on market forces. Historical data shows that small businesses can achieve 10% or more annual revenue growth. This will double the value of your business in in just seven years.
For example, let’s say you purchased a company for 3.2 times the cashflow before taxes at $691,200, which included working capital, inventory, and closing costs. They put 10% down and took out an SBA loan for the balance. The buyer grew the sales of the business at 10% every year for ten years, resulting in the company generating $3.6 million in annual revenue. Assuming SDE maintains at 15% of revenue, the company is now generating $540,000 per year in owner benefit. The buyer exited the business in year eleven at a price of four times SDE, which equals $2.2 million. The exit of $2.5 million represents a 35% compounded annual interest rate on the original investment of $94,000. The total pretax compensation from the original investment, less the debt payments, is $5,747,934, representing a 45% compounded annual growth rate.
Most people start looking for a company to acquire completely the wrong way. You need to have the CEO mindset to acquire a company. Don’t start by thinking about what industry you would like to target. Successful acquisition entrepreneurs turn the traditional search process upside down. They understand correctly that the building blocks of how to build a company. A vision doesn’t come from what’s “on the menu,” but from aligning their attitude, aptitude, and action, and leveraging that alignment toward a specific opportunity.
The Three A’s to evaluate in your target company. They will help identify the right parameters for your search and allow you to move forward with conviction. :
- Attitude: The culture, values, and potential for growth.
- Aptitude: The company’s operational efficiency, market fit, and financial stability.
- Action: The leadership’s capabilities, existing strategies, and potential synergy with your goals.
The mindset of a CEO should encompass a variety of traits and skills, including strategic thinking, interpersonal skills, intellectual ability, industry experience, the ability to deal with ambiguity, tenacity, organization, being laser-focused, achievement-oriented, thick-skinned, risk-tolerant, self-confident, creative, optimistic, assertive, decisive, methodical, and perfectionistic. You also need to have a growth mindset and be flexible to embrace challenges and learn from failures. Identify your 3 As of Attitude, Aptitude, and Action.
How to find a good company to buy? Either look for stable businesses with minimal growth potential but consistent cash flow (e.g., snow removal, plumbing). Or for high growth companies with high valuation but also higher risk.
You can also search for high turnaround potential and find companies in poor financial health that can be restored to profitability through operational improvements. Or you can find companies where your specific skills and goals align with the growth opportunity (e.g., building a sales team, improving marketing).
To increase chances of success finding the right company to acquire, it’s important to ignore common approaches such as committing to one broker and not considering all available options. Instead, define your process and be open to various tools and resources.
Don’t solely rely on internet listings like bizbuysell.com. They’re good for learning, but most aren’t great deals. You need to get out and meet business brokers, intermediaries, I-bankers, and M&A Advisors. They usually find the deals in the first place, and only post them online when they can’t find a buyer in their network. You probably will find them on LinkedIn.com. Explain what your target is, review their current offerings, and get on their email list for new listings. Get vetted and upstreamed to the deal flow in your area.
Businesses that are not listed can also be acquired if you approach them strategically. Intermediaries like brokers make it easier to connect. Sellers often need time and guidance to accept the valuation and emotional aspects of selling their “baby.” Direct outreach to companies you’d like to acquire can pay off, even if they’re not actively looking to sell.
Persistence and relationship building can lead to opportunities over time.
Now, let’s discuss deal making, specifically focusing on the importance of preparation and managing various stakeholders. It’s not a linear process and requires laying the groundwork early on to ensure success. It’s helpful to have a team, including bankers, brokers, sellers, and possibly partners, to simultaneously review the acquisition targets and to manage relationships with these stakeholders. Making a deal is an art that involves creating value where it didn’t previously exist, and requires careful planning and execution.
It’s possible to acquire a company with 90 percent debt. It can maximize ROI but also significantly increases risk. Private equity firms typically use 30-60% equity for leveraged buyouts (LBOs) for more stability. Paying all cash maximizes safety but minimizes ROI. Most acquisitions involve some debt financing, even by wealthy individuals. Aim for the maximum loan possible from the bank to maximize potential ROI. It’s good to recover your 10% equity investment within the first year for future profits as your payback goal.
So you should have $150,000. If not then maybe you shouldn’t do acquisitions, or you could find angel investors.
It’s better to meet banks when still searching. Avoid delays by establishing relationships before needing immediate financing. It’s even advisable to become pre-qualified.
Prepare the paperwork like your personal balance sheet and tax returns. Check your creditworthiness. Also focus on banks actively involved in business loans and SBA programs. Highlight your experience and acquisition goals clearly. You can also ask your bank manager for introductions to potential sellers and M&A advisors.
Banks look for a good debt-to-earnings ratio with a minimum of 1.25, to ensure the company can repay the loan. Then the pre-tax cash flow should be enough to cover debt service and leave room for operating expenses and reinvestment.
Banks obviously also like hard assets (e.g., buildings) for collateral, especially for low-asset businesses like software companies. For low-asset businesses, banks may require a higher down payment (cash equity) to mitigate risk.
Partnerships can be beneficial for entrepreneurs, but it’s essential to establish clear roles, responsibilities, and expectations to avoid conflicts and misalignment. Determine early the amount of capital each partner will contribute to the venture. Clearly outline what each partner expects from the collaboration. Link compensation to performance rather than ownership to maintain motivation and fairness. Consider implementing buy-sell agreements to protect both parties in case of unexpected events. Regular communication and addressing conflicts promptly can help prevent misunderstandings and strengthen the partnership.
The bank will require you to carry key-man insurance for the amount and term of the unsecured portion of your loan. This insurance will be important for both the bank and your family. If something happens to you, the insurance will pay off the uncollateralized portion of the debt, allowing the business to be operated or sold without worrying about the loss of your involvement. If your family chooses to operate the business, the total cash flow will increase either by eliminating the need for monthly loan payments or through increasing the cash benefit at exit with the equity buildup provided by the insurance.
You may also want to consider getting a Home Equity Line of Credit (HELOC) before closing on an SBA loan. A HELOC is a loan on the equity portion of your home. Once you have an SBA loan in place, you’re unable to be approved for a HELOC, which ties up that equity until the SBA is paid back.
Your Certified Public Accountants (CPAs) play a crucial role in the acquisition process. They can provide immense value by understanding a business, identifying potential problems, and assisting with due diligence. When selecting a CPA for an acquisition, it’s important to ensure they have experience in business transactions and are familiar with the specific complexities of M&A deals. Additionally, it’s advisable to discuss their fee structure, experience on both sides of the table, and their availability during the due diligence period.
Lawyers can be “deal breakers” as they prioritize client protection over closing the deal.
The buyer (you) should ultimately decide on acceptable risk and desired protections, not solely rely on your lawyer’s judgment. Try to save money with boilerplate standard templates for legal agreements. Set the agenda: Clearly communicate your goals and desired outcomes to your lawyer.
Limit direct lawyer-to-lawyer communication: Encourage negotiations to flow through you to maintain control and focus.
When reviewing Listings try to quickly identify potential good fits and rule out irrelevant ones.
Get a general overview of what’s available. Use your pre-defined criteria (SDE, revenue, industry, etc.) to efficiently decide on listings. Be respectful of confidential information.
Be prepared to sign a non-compete agreement to receive an Offering Memorandum (OM). The OM will provide in-depth details about the business and its financials. If the OM shows promise, move quickly to further assessment and due diligence.
The question “Why are they selling?” is over-weighted and often asked too early by potential buyers. Most of the time they’re just ready to retire or to move on. But it is possible that the business is about to decline. Through due diligence, research, and conversations with the seller, you can identify the risks inherent to the opportunity and what your strengths can bring to the table. Ultimately, it’s up to the acquisition entrepreneur to decide whether the opportunity is right for them.
If you like a listing, it’s important to act quickly, as great listings often result in a bidding war or high interest from potential buyers. Buyers must convince the intermediary that they’re a solution-focused CEO who can execute on their acquisition plans.
The next step is understanding, analyzing, and projecting financial performance of your potential acquisition(s). Analyze the revenue, profit, operational efficiency, cash flow, and the total Owner Benefit (the SDE). The balance sheet, in particular, offers insights into a company’s assets, liabilities, and owner’s equity at a specific point in time. The financial statements of publicly traded companies can serve as a useful reference point for comparison. Consider the price-to-earnings (PE) ratio when evaluating a lower middle-market company.
All of this information can be found in their financial statements provided in the Offering Memorandum (OM). Keep in mind that most companies keep accrual-based records internally but cash basis when filing taxes.
On a balance sheet there are current assets and long-term assets. Current assets include items like cash, accounts receivable, and inventory, while long-term assets include items like fixed assets, intangible assets, and goodwill. Deduct depreciation. Estimate the value of the intellectual property and goodwill, which can be difficult to value since they don’t generate revenue directly.
Liabilities include debts such as bank loans, equipment purchases, and accounts payable, while owner’s equity is calculated by subtracting total liabilities from total assets. Also analyze ratios such as Return on Equity (ROE) and debt to equity to gauge the company’s financial health.
The income statement, your monthly, quarterly, or annual financial scorecard, reveals if they’re making or losing money. Gross margin, your profit per sale after subtracting product costs, shows how effectively you turn materials into profit. Margins differ across industries, so compare apples to apples when analyzing company health.
Running a business involves expenses beyond production costs, and these show up as operating expenses. Think marketing, office rent, and staff salaries. Subtract them from your gross margin, and you get your net income – the profit available for reinvestment or owner payouts. Don’t get fooled by fancy numbers, though. Depreciation and amortization, non-cash expenses like equipment wear and tear, are included here and don’t reflect actual cash flow. To see that, add them back to net income. Remember, loan repayments aren’t expenses – they’re just returning borrowed money.
There are three asset-based valuation methods for businesses: book value, fair market value, and liquidation value. Book value is the net worth of the company as reported on its financial statements, but it is not always accurate as it does not account for the exponential depreciation of assets. Cash flow is ultimately what matters for a business, and these asset-based valuation methods do not necessarily reflect that.
Validating the accuracy of financial information is an essential part of the due diligence process, but it’s equally important to keep in mind that numbers can be manipulated, and it’s crucial to evaluate how the numbers were arrived at. Scrutinize those add-backs! Watch out for perks disguised as business expenses, or non-recurring events inflated for advantage. Trust, but verify – ensure each add-back aligns with your future vision for the business.
Entrepreneurs often overvalue their babies (i.e., companies). So the asking price could be fair. Don’t be fooled by “get-rich-quick” brokers promising miracles; rely on your analysis and walk away if the math doesn’t add up. Remember, you’re not buying the past, you’re betting on the future. Base your offer on the business’s potential for growth, not just its historical performance.
If the price aligns with your calculations, then meeting the seller is the next step.
Now you can start designing the Future. Create a plan for acquisition and value creation in your new company. You can understand the industry and business model with Porter’s Five Forces: Analyze industry threats, competition, power dynamics, and company strengths.
Gauge where the company and its industry is (introduction, growth, maturity, decline) to inform strategy.Just like our lives have stages, so do industries. They go through birth (introduction), growth (adolescence), maturity (adulthood), and decline (old age). Understanding this cycle helps you choose the right strategy for acquiring a company.
Develop a business plan by identifying the business driver. Determine the core factor fueling profit and growth. Should you focus on innovation or market consolidation? Reduce risk by knowing the industry’s potential challenges and opportunities.
There are planning tools and frameworks to help you with that. Study high-growth frameworks: Learn from success stories and envision bold possibilities. Set ambitious goals.
The process of acquiring a business involves several stages, including commitment, preparation, search, and making an initial offer. The offer is made in the form of a Letter of Intent to Purchase (LOI), which outlines the price, structure, and terms of the deal. Although similar to a binding contract, an LOI is non-binding and serves as a starting point for negotiations. Non-binding except for the exclusivity period, during which the seller cannot market the company to other buyers. Common elements of an LOI include the type of purchase, purchase consideration, proposed closing date, contingencies, agreement to sign a future asset purchase agreement, escrow deposit, and division of expenses. Additionally, confidentiality and exclusivity are often required. Have only one LOI at a time, similar to being engaged or making an offer on a house.
The two types of sales are asset and stock sales. Asset sales are more common in lower middle-market transactions and involve the buyer acquiring the assets of the company and forming a new legal entity, which is not liable for the seller’s past activities or liabilities. Stock sales involve buying the actual legal entity and are less common, but might be necessary if the company has valuable contracts or licenses that cannot be transferred.
When buying a business, the seller’s goal is to reduce inventory and minimize accounts payable (AP) while converting accounts receivable (AR) into cash. As a buyer, this is beneficial because it reduces short-term debt and increases working capital. The key assets being acquired are those necessary for the business’s operations and cash flow. Real estate is a separate consideration, and it’s generally preferred to keep it separate from the business investment.
The deal structure can be all cash, an earnout, or a purchase with a seller note, depending on the circumstances. An all-cash offer may be made if the buyer has confidence in the business’s future and wants to negotiate a lower purchase price, or if there is competition from other buyers. Make sure you do enough due diligence in case of a bidding war.
There are various strategies for buying a business with no money down, including using an SBA loan, seller financing, and earnouts.
The bank will require an appraisal of the company, and if there is real estate involved, it will also need to be appraised. Full disclosure of any known litigation or significant changes in the business is necessary before closing. The equipment should be in good working order as it is essential for the company’s operations. A finalized and binding purchase agreement is needed before closing, which helps avoid last-minute surprises.
Include contingencies in the Letter of Intent (LOI). Contingencies are conditions that must be met before the sale can be finalized, including:
- Buyer’s ability to obtain financing.
- Satisfactory completion of due diligence.
- Access to contracts.
- Tax returns.
- Non-compete clause.
- Seller training:.
- Interviews with employees, suppliers, or customers.
It’s advised to offer a price based on your own valuation of the company, rather than a lowball offer to maintain a positive relationship between the buyer and seller.
Once the Letter of Intent has paved the way, the acquisition phase commences. This dynamic, and often emotional stage involves several crucial steps happening in parallel, all geared towards the the Purchase Agreement. This legal framework of the deal takes shape through meticulous drafting and diligent negotiation.
- The buyer needs to form a suitable legal entity.
- The buyer secures the financing.
- The seller settles all contingencies in the agreement. This might involve resolving legal matters, finalizing audits, or fulfilling specific closing requirements, ensuring a clean path forward.
- Due diligence continues
- Final inventory, and then the acceptance of the Bill of Sale. The paperwork can last a whole day amd will probably be led by an attorney.
The two main reasons why a buyer might not close in the end are a material adverse change in business performance or incomplete due diligence.
The first ninety days are critical for the new CEO to establish themselves within the company. Meet with employees, suppliers and clients. Set specific and achievable goals, assessing the company’s strengths and weaknesses, improving internal systems, and maybe even initiating a clean-up of the facility. The transition period with the seller should be not too short and not too long for a smooth transition.