Beyond the capital markets and startups, I’ve been exploring buying a suitable small business to invest in and operate. To inform myself with the process of searching and valuing privately-held establishments, I recently perused Richard Ruback and Royce Yudkoff‘s resourceful HBR Guide to Buying a Small Business: Think Big, Buy Small, Own Your Own Company (2017.)
The authors of this HBR Guide teach a popular Harvard Business School class on “acquisition entrepreneurship.” Their curriculum trains self-employment-inclined MBA students to search, negotiate, and buy an established business and become an entrepreneur-CEO within a year or two.
According to the authors, MBA students are drawn to their class by the prospect of a meaningful leadership responsibility earlier in their careers, as opposed to slowly climbing the corporate ladder or taking on the great risk of starting a company from scratch and establishing a viable business model.
The first section of the HBR Guide to Buying a Small Business can help you decide if entrepreneurship is a good match to your temperament, lifestyle, work-experience, and career ambitions. The largest part of the book provides a comprehensive roadmap for all aspects of acquiring a business—bankrolling the search process, deal-sourcing, managing risk, organizing equity- and debt-financing, running due diligence processes, structuring the purchase, and closing the deal. The final section of the book discusses changing the leadership over and transitioning into operating management.
Reflection: Is Acquisition Entrepreneurship Right for You?
- Self-employment is not for everyone. Entrepreneurs need to be smart, driven, business-savvy, self-motivated, strategic, resilient, persuasive, and be able to deal with uncertainty.
- On top of the challenges of self-employment, acquiring and operating a small-business will require reaching out, projecting self-confidence, and persuading people you don’t know—business brokers, financiers, investors, regulators, sellers, employees, and customers.
- During your exploration of what business to buy, you’ll have to quickly learn about unfamiliar industries, markets, and companies. As a leader, you must be able to develop cross-functional expertise quickly.
Searching: A Full-time Job in Itself
- Plan to commit full-time for six months to two years to raise funds from financiers, identify and vet potential acquisition targets, and negotiate with sellers on a realistic purchase price. Afterward, plan for no less than three more months to perform due diligence and complete the transaction.
- “When you are seeking out a business to buy, you might face months when you work 12 hours a day and simply not find a desirable prospect. It’s a frustrating experience with lots of effort and no reward.”
- Arrange for debt and equity financing from potential backers and risk-sharing partners. Contact affluent folks in your network and investors who specialize in small-businesses. The networks of people you bring together to help your mission can also lend a hand during the deal making and the due diligence processes.
- To find potential businesses to buy, try reaching out directly to businesses whose owners may be inclined to sell. Engage small business brokers (there’re some 3,000 small business brokers and intermediaries in North America,) or comb through databases of small businesses for sale.
- For potential sellers, look for business owners who, after building their firms over the decades, are approaching retirement and don’t have an inheritor interested in running the business. Many aging business owners are determined to ensure that their businesses live on.
Seek Enduringly Profitable Businesses: Recurring Customers and Predictable Revenue
- Look for “enduringly profitable businesses”—stable, slow-growth companies in dull-and-boring industries (such as sandblasting, equipment maintenance, industrial repair and overhaul, window-cleaning, service-providers) in small, defensible niche markets.
- Seek businesses whose business-to-business customers are unlikely to switch vendors because the product or service their customers buy isn’t a big part of the costs of their business. Consequently, they’re not motivated to shop around for lower-cost vendors and squeeze margins.
- Focus on businesses with yearly revenues of $5 million to $15 million and cash flows of $750,000 to $3 million.
- Avoid promising start-ups and risky turnaround opportunities; “it is tempting to imagine buying a troubled business or one with uneven performance, because the purchase price would be very low. But we strongly advise against it, because you’ll have to reinvent the business model and doing so is a very difficult and risky endeavor. Instead, buy a profitable business with an established model for success—one that is profitable year after year.”
- Avoid high-growth businesses because “high growth means that your new customers will quickly outnumber your existing ones. Because new customers bring new demands, there are many ways to get in trouble. New customers are, well, new; they have no loyalty to the company and no history. High growth requires great management effort. It also absorbs money rapidly, and raising that money puts a strain on the business and its owner. A rapidly growing firm also attracts competitors, which see the expanding market and the opportunity to attract new customers. So, in a high-growth business, you could work hard and still fail if you cannot keep pace with your competitors. And even if your business survives, you might find that competition has forced you to sell at low prices, so you enjoy little financial reward after all. Making this all the harder, the seller will demand a much higher price for a business that has the potential to grow quickly.”
- Avoid technology-driven companies (they face shifting customer needs and therefore demand constant reinvention,) cyclical business, and businesses with well-established competitors.
- Small business-owners usually don’t hire large consulting firms or investment banks to sell their businesses. Their businesses are too small to appeal to private equity firms. “We think it makes sense to buy a business with between $750,000 and $2.0 million in annual pretax profits. … At the upper end of our size range—$2 million or more in profitability—we find that institutional investors, like smaller private-equity firms, start to become interested and that competition raises the purchase price, reducing the financial benefits of owning the business.”
- “EBITDA margin (EBITDA/revenue) ≥ 20% for services and manufacturing or 15% for distribution and wholesale”
A Checklist for Enduringly Profitable Businesses
- Is the prospect consistently profitable?
- Is it an established business instead of a startup or turnaround?
- Is it in the right size range?
- Is it located in a place you are willing to live?
- Do you have the skills to manage it?
- Does it fit your lifestyle?
- Is the prospect enduringly profitable?
- Is the owner serious about selling the business?
Valuing the Company and Negotiating a Deal
- Use the company’s past financial information to project future earnings and your return on investment. Then decide on how much you should pay for a small business: “You’ll need to base the offer price on the general range of 3x–5x EBITDA.” Adjust the multiple for profit margins and growth prospects.
- Run a primary due diligence—“a focused period of rapid learning in preparation for making an offer. This is when you’ll test the seller’s initial claims and verify the information that has made the business appealing to you. … You’re looking for any reason that you might not want to acquire this business.”
- Finance using equity and debt. “Visit banks and approach your investor network to raise money for the acquisition. You should be prepared to provide information about the business and its industry, details on the due diligence that you’ve done, your financial projections, and the deal terms that you are proposing.”
- Once your offer has been accepted after negotiations, run a confirmatory due diligence “in which the company’s records will be fully open to you. You will typically have around 90 days to work with your accountant and attorney to check for any inconsistencies and red flags. … This can be an extremely nerve-racking time for both the buyer and the seller, so it’s important to be patient and calm.”
Transitioning into Leadership and Emphasizing Business-as-Usual
- As part of the negotiated deal, try to get the seller to stick around for 3 to 6 months to help you in the transition.
- “After closing the sale, you should focus on four tasks: introducing yourself to all your managers and employees, meeting with external stakeholders, communicating the transition plan to everyone, and taking control of your cash flow.”
- “The most common trouble for small firms under new owners is running out of cash. … So set up a process whereby you approve all payments before they go out, and review your accounts-receivable balances at least weekly. You should also implement a 90-day rolling cash-flow forecast.”
- Meet with all the constituencies and reassure them that they won’t see any immediate changes. Lay emphasis on “your overarching goals for the company—for example, excellent customer service, commitment to quality, a satisfying work environment—and encourage people to stay focused on their work.”
- Visit every major customer as soon as you can. Keep your ears open for ideas to improve your product- and service-offerings.
- Don’t make any big changes early on, get to know the business, and be very respectful of all the constituents—they know more about the business than you do.
Recommendation: Read ‘HBR Guide to Buying a Small Business’ for a Very Good Introduction on How to Buy and Organize Finance for a Business
Richard Ruback and Royce Yudkoff’s HBR Guide to Buying a Small Business is excellent manual for prospective entrepreneurs, employees of small businesses, financiers, and value-seeking investors. You will also become acquainted about interactions with bankers, brokers, sellers, accountants, and attorneys you meet while searching for a business to buy.