How do you decide on target deal size as a self-funded searcher?

January 08, 2020

by a searcher from INSEAD in Sydney NSW, Australia

This may be a bit of an ignorant question, but would appreciate some views:

Do you use your own available equity as a basis and apply leverage (e.g###-###-#### %), then see what the business can afford in terms of pay-down at that level of debt, to come up with total target EV?

Or do you choose a wider range and fill the gap with outside equity as the need arises during/after LOI?

What process / thinking should I use to decide what business size I should have in my target statement as a self-funded searcher?

Is the first-order question "what business would provide me with the right return, at the lowest risk, regardless of size" or is it "what business can I afford to buy"?

Thank you!

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Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

My thoughts:
1) First get comfortable with the long-term demand side of the product/services of target. Failure risk is high with demand problem. And, also with over leverage. Oervaluation reduces IRR but does not cause failure. Experienced guys focus on demand; newbies focus on IRR.
2) Are you capabale of running the target and will you enjoy running the target?
3) Reagrding size: Assume no growth. You have 100. Borrow 400. EV is 500. After few years, say 5, debt is paid off. Your 100 has become 500. Now assume you buy a larger business. Bring additional capital of 900. Equity is 1000, debt is###-###-#### After 5 years 1000 becomes###-###-#### Your share 1000 is 10% because your capital is 100. In th elarger size, your 100 becomes 500, same as before if you had bought a small business. So, in this simpplified scenario you are indifferent between a small and large.
4) So you have to look at other factors for small vs. large. With large you may be able to negotiate to split the gain disprpoprtanate to your investment to your side due to your effort; small does not afford this economic opportunity. Small may be easier, larger will require a pool of investors. With larger, you will have investors to answer to, but then they can provide value added guidance (unless they are just capital providers). With large, you will have more competition from funded and more experienced buyers. These are just few of the non-economic factors.
5) As others have said, cast a broad net, but not too broad.

Reply by a searcher
from Brown University in Boston, MA, USA

I have also been wrestling with this question. The way I have approached this range question is two ways. On the low end of the size range, you are looking for a company that is aligned what you believe is large enough that it would fully consume your time as an owner/operator and but small enough that you might be able to fund it yourself with some outside financing. On the high end of the range, you want a company that you still feel that can manage on your own but may have to tap into a core group of investors that would help you bridge the gap in capital. While you can control the industries where you concentrate your search, it is hard to completely control the size of companies available in that industry. Therefore, I think you have to have some flexibility. One way to do this to have outside capital that you can tap into if you come across something that is outside what you can afford personally.

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