Phenomenal Returns, Step-By-Step Plan

How-To-Private-Equity

A Summary of the Harvard Business Review’s Guide to Buying a Small Business.

The Harvard Business Review’s Guide to Buying a Small Business is a fantastic book written by Richard S. Ruback and Royce Yudkoff, and throughout the book, it takes you through the steps of buying a small business from searching to operating after closing, and why it is such a good potential opportunity.

The method they teach in this book is to raise a search fund, with a partner or without one, search for a business, then buy the business. After you buy the business, you operate it for some amount of time, and then you sell the business, which will net you and your investors a healthy margin of return, ideally 25% CAGR (compound annual growth rate) or more for your investors, and as much as you possibly can for yourself. The terms they recommend will be generally outlined below so you can raise money successfully and know which deals to avoid.

There are many pros to buying a small business. The most prominent reason is, you can buy a very profitable small business for much lower earnings multiples than you could buy a public stock or a larger business. For example, a business doing 1–5 million in EBITDA (earnings before income taxes, depreciation, and amortization) will typically sell for 3–5 times this EBITDA number, which is MUCH cheaper than the public traded stocks, currently.

The Process

The process generally looks like this:

  1. Save/Raise money to search
  2. Search for Business
  3. Due Diligence
  4. Close
  5. Post-Closing

Essentially, in this business-buying model you want to buy a business that fits your lifestyle desires, is enduringly profitable, is a business and not a job, and is a good deal in terms of returns.

In this post I’m going to go over the general process from start to finish of searching, acquiring, and then selling a business, because I would do the entire book, but it would end up being a 2-hour long read. I’m going to gauge interest with this post, and then I can go into much deeper specifics if people want it. Again — all of this knowledge is in the HBR Guide to Buying a Small Business, it’s a fantastic read, and goes into much more detail than I ever could in a single blog post.

Saving/Raising Money to Find a Business

Your first step towards buying a business is to raise some money. No — you don’t have to buy a business with all cash, and I wouldn’t recommend it, but you do need to raise or have some money to search for a business before you acquire one. It’s a full-time job. If you try and search for a business to buy part-time, it simply won’t work, there is too much to be done.

There are two ways in which you can finance your search for a business. This is separate from raising money to acquire the business, because, in order to find a great business, you have to search for a while.

There are metric shitloads of businesses in the United States, and not a ton of them are fantastic businesses. I’ll detail later what your needle in this haystack should look like, but the point I’m trying to make here is that you need money to finance your search.

You have two options when it comes to getting money for financing your search. You will need around $50,000 two $200,000 for your search, and if you have a partner, double that number. You can either save this money up over a number of years, or you can go out and raise the money in a search fund. This search fund will provide you with the capital, and it will provide the investors in this fund with an equity stake in the business you eventually require. There are pros and cons to both — search fund allows you to potentially close a deal faster, because you can spend money and have access to better resources, and self-funding your search will allow you to have more equity in the acquisition.

NOTE: If there is anything online that says you can buy a business with no money down — yes that is technically true, but a situation where a seller would give you 100% seller finance for a great business is so ungodly unlikely that if somebody tells you that you can do this, they are selling you something. It’s bullshit.

Now that you have the money saved or raised with or without a partner — here’s how you find a business to buy!

Searching for an Acquisition Target

When it comes to acquisitions, you need to know what you’re looking for, and be looking for reasons to remove a target at first. What you’re looking for is not a hot-shot growth company, not a potential turnaround, but an enduringly profitable business.

What is an enduringly profitable business? It is a business that doesn’t grow too much year-over-year, but has strong recurring revenue, a strong competitive advantage, and has prospects that are unlikely to change in its industry. Essentially — what you’re looking for is strong predictability.

Other things that you want:

  1. You want an owner who is NOT the main salesperson or operator.
  2. You do NOT want a business that is entirely based around the personal relationships with the current owner.

During the search process, you are going to need a boatload of leads. Every single day. And you can source them from various places.

There are on-market leads and off-market leads. On-market leads are where the owner has listed a business for sale on a website or with a business broker. These are good because they provide leads for owners who are already very interested in selling.

The other approach is to use database lists and websites like LinkedIn to prospect for business owners who are interested in selling their business. Off-market deals are where you can get some seriously lucrative deals, often because of somebody’s urgent need to sell. The best leads like this you can find are people who are old and have no succession plan and want to fund their retirement through the sale of their business.

In your search, you want to have in mind that you have a runway, which is your search fund, or the amount you have saved up, and that runway is finite. Every single second, that runway gets shorter. The number one reason why acquisitional entrepreneurs fail is because they either run out of money or they give up. Searching is a long, grueling, and unrewarding process until it finally works, and you must be very, very attentive to your usage of funds while searching.

Due Diligence

Now, when you are searching you are going to want to have a few layers of due diligence. Think of these layers as filters for sifting out the gold from the garbage in your list of leads. With each business you look at, give it a pre-screen, and if it passes that, it moves onto the next step, if it makes it through that step it goes to the next one and so-on and so-on.

This approach allows you to spend as little time on shitty businesses as possible and dedicate your focus only to the ones with high potential. Time is of the utmost importance during the search phase.

In your initial screen you want to find out:

  1. Where the company is located
  2. Where the operations of the company are
  3. What the size of the company is
  4. Do you have the skills to manage it?
  5. Is this company consistently profitable? (last 5 years steadily profitable)
  6. Is it an established business or a turnaround/startup?
  7. Does this fit your desired lifestyle?

Now if the answers to those questions are all good — then you go into more, deeper due diligence.

  1. Is this prospect enduringly profitable?
  2. Is the owner serious about selling this business?

Now just some things to know — when you are sourcing with brokers, you are going to get a teaser of businesses, and this will show some preliminary information, and if you don’t weed the business out at that point — get something called a Confidential Information Memorandum (CIM), and this is like a 40-page document detailing much more about the business. I would take this mostly as truth — but not as absolute truth, because it’s the business broker’s job to get you to buy the business, and this CIM is marketing material and you have to sign an NDA to get it.

Through your deeper due diligence, you find out if a business is enduringly profitable by really studying it. You deeply analyze why the business is profitable, why customers keep coming to this business, if it’s hard to switch from using this business as a provider, etc. You need to study it.

Secondly, the reason why you want to figure out how serious the owner is about selling a business is because it’s not easy to tell. They aren’t trying to lead you on, but because the process is so long, so tiring, and often-times, they are not getting as much cash upfront as they would like, so they decide to bag it. This is why it is important to sus out how committed they are to selling.

Those questions will be answered after turning over every stone.

NOTE: Your due diligence never stops. Assume that the owner, if they are intensely motivated, will not tell you the truth. When they stand to make millions of dollars, they will lie to you in order to get more. Turn over every single stone you can. If you see red flags — either get out, or investigate further and possibly, renegotiate if you have already agreed on a satisfactory price.

Closing

Lots more goes into closing or purchasing than one might think, and there are LOTS of terms to agree upon.

In addition, in order to get to this phase, you need to have an Indication of Intent (IOI) signed, and then you send a Letter of Intent (LOI) to be signed. In the LOI you have these terms that are specified and agreed upon, then on closing day you make it all happen:

  1. Price — you need to agree on the price, and you need to agree on a price that will allow you and your investors to see substantial enough returns.
  2. Type of Purchase — is this an asset purchase, where you purchase the assets of a business, or is this a stock purchase where you purchase the stock of the existing entity? This has to be determined.
  3. Working Capital — you need to determine how much working capital the business will have post-purchase, because if it doesn’t have enough, that is more money coming out of your pocket, and this can be in the hundreds of thousands of dollars, even if the business only does 2 million in EBITDA.
  4. Capital Structure — this is how you finance the deal. This will be the amount of commercial debt, equity, and potentially, seller’s debt. You would prefer seller’s debt over commercial debt just because it’s less of a hassle, but you will want to finance a good chunk of it with debt.
  5. Time Frame — lastly, you want the time frame for the closing. Usually this is 90 days, but often runs longer.

The way you establish the right purchase price is through some negotiation. Usually this price will be 3–5 times the EBITDA, which we’ve mentioned, but what’s really most important here is the highest price you can pay. So, in order to get that desired return, you’re going to have to model out what you predict the businesses prospects to be.

If you can pay a price such that you can have your investors receive a 25% or greater CAGR, and you can have a nice, healthy return for yourself, as well as any debt service you can cover with the income very handsomely (debt service coverage ratio of ~2 or greater), then you can pay that price. That’s the maximum — but you want to pay lower than that obviously.

You can either purchase the stock of a company or you can purchase the assets of the company. You want professionals on your team because they will tell you which one is more tax-advantageous for your situation, which you can then go and do in order to save some money on taxes.

If the business needs a certain amount of working capital in order to work, you want that working capital to be there and stay in the business when you take it over. Typically what you want is for the owner to pay down all current debts so that you can take over the business without any large notes overhanging you — good news on this is, most business owners who started it operate their business with little debt.

In your agreement you need to have the specific capital structure of how you are financing this deal. This will look something like:

- 80% commercial debt from ____ bank, senior position

- 10% equity down-payment

- 10% seller debt, secondary position

All this means is that — the commercial debt will be paid back in full before the seller debt can be paid back, as it’s in the “secondary” position.

The capital structure should be agreed upon in the LOI stage, and you should’ve been talking to bankers during this entire process so that they are more comfortable with you, they really trust you, and so that you know best how to get your deal financed.

This is pretty self-explanatory, it’s just setting the closing date.

NOTE: During the time between the signing of the documents and the date of the closing, you still want to be doing confirmatory due diligence. If a problem comes up, halt the process, and renegotiate. It’s MUCH better to make no deal than to make a bad deal.

Additionally, you are going to have some money in escrow before you buy this thing, and if the deal goes south, you have a right to claim some of it. Essentially, what you want is something that’s like a “safety” clause, which is, if for some reason you find some damning evidence or reason why you really can’t buy this business and you decide to back out — you want THEM to pay YOU for taking all the time to go through the process just to have it not work out in the end.

Now on closing day, you come in with both sets of lawyers, you sign the documents, there’s a handshake, and boom. Now you’re the owner of a business! The authors describe it as a relatively anti-climactic day, but hey — you now own a business!

Post-Closing

Now that you own this sucker — you have to run it. During this time, you usually keep the old owner onboard in a sort of conciliatory fashion for about 3 to 6 months. This is just so they can help you run this thing. What you want to focus on when you are operating this business is to make it more valuable for when you eventually sell it in the end.

So how do you make the business more valuable? That’s a tough question — and it pretty much revolves around making it consistently, enduringly profitable, and that it can run without you there. There is a book I’m currently reading called: Expensive Mistakes When Buying and Selling Companies, and it’s going over all of that. So stay tuned!

Important to know: You likely aren’t going to be able to sell the company for a much higher multiple than you got it for. If you buy the company for 4xEBITDA, put into your financial model that you’ll sell the business in 5–10 years for 4xEBITDA.

Conclusion

All in all — it seems a very, very exciting prospect to buy and operate your own business. It’s very profitable, and allows you flexibility with your lifestyle, and you don’t have to go through the pain of establishing a business from scratch. Personally, it’s what I plan to do — but I plan on doing a consolidation play, rather than a small-business private-equity fund style.

The opportunities are so rich because these companies sell for lower multiples than real estate and public companies do. Most real estate won’t sell for less than 12x their NOI (net operating income) which is essentially the EBITDA, and the average P/E of the S&P 500 is about 17 right now, granted that isn’t EBITDA, but STILL. 17????

That’s insane. That means, if you took every penny of the net income generated by the business, you would have to wait 17 years before you broke even. 17 years. So that is one reason why buying small businesses is a very exciting sort of prospect.

If you want more specifics on any section, like the raising of funds, the terms in the investment memorandum, the closing, the pricing, the financial modeling, the accounting analysis, any sort of things along those lines, comment below, and I will do them next time.

I know this was a long read — but thank you for sticking with me. There is too much information in this book for me to put into one post, really. This is a lot of information, and I already cut out at least 50% of it. This is the bird’s-eye view of going from 0 to a full-blown acquisition.

I highly recommend, if this is something you’re interested in, you go and buy the HBR Guide to Buying a Small Business. It’s a 300-page book, and it’s jam-packed with information. The authors, Richard S. Ruback and Royce Yudkoff are insanely intelligent, kickass writers and educators. Their book is so unbelievably useful.

I wish I could do their work justice in one blog post — but I just can’t. There’s too much info. So I will be posting more and more about financial modeling, financial analysis, small business acquisitions, and more practical things. This book is insanely practical, and it goes over every detail so finely that I actually understand all the fancy terms used.

Go pick it up — and go gimme a clap. See y’all next time.

Phineas Pambianchi

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I believe in taking care of others first. I study Economics and Business at Cornell University, and I’m shooting for the big B.

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