Large exit numbers get attention. It works on me just as much as the next guy. You hear some guy rolled up some auto repair shops or dental practices and after 3 years sold the company for 8 or 9 figures. Even though I know better, my first thought is always that the guy that sold for $50mm, now has $50mm in his bank account.
In reality, the sale price and the dollars hitting the owner’s bank account have fairly little correlation. Every startup founder that’s gone through a down round with structure can tell a tale of selling the business for hundreds of millions and making almost nothing.
So today, let’s talk about what actually moves the needle when it comes to the balance in your bank account and how that should drive your strategy as an owner or operator.
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The Timeless Trinity of Getting A Big Wire When You Sell
No matter what industry you are in, selling for more than you bought for depends on three drivers: (EBITDA) Organic Growth, Multiple Expansion, and Roll-Up / Acquisitions. If you have spent some time in finance, you likely know that every one is focused on Growth but until I ran some numbers it wasn’t intuitively clear to me how much it trumps everything else.
To compare the three drivers, let’s assume we have three businesses with the same financials and purchase price: $2mm EBITDA, $8mm purchase price (4.0x EBTIDA multiple)
Here’s a quick example of how each of them create a more valuable business:
EBITDA Organic Growth:
There are ton of ways to grow EBITDA by growing revenue (Underlying market growth, market share gains, new markets, new products, increase prices etc.) or reducing expenses (renegotiate supplier pricing, improve productivity, eliminate unnecessary expenses, etc.).
An investment thesis focused on EBITDA growth ranges all the way from buying in a high growth industry to buying a company with below margins for the respective industry.
So say you growth EBITDA from $2mm to $4mm, you have created $8mm of equity value.
There is really only one thesis that can achieve multiple expansion with out growth which is a turnaround / positioning play. The best example is a small business with a lack of reporting, potentially lacking tax and regulatory management. It’s a business the market will place a discount on because there is uncertainty around the numbers and sustainability of the EBITDA.
So you buy the business, put in place proper reporting, compliance and governance and now you can get market value (let’s say 6x EBITDA). So now the business is worth $12mm and you have created $4mm of equity value.
Roll-Up / Acquisitions:
Many industries are difficult to grow organically quickly. For example, lawn mowing and pest control are small ticket items so you need hundreds or thousands of customers to add meaningful revenue. So often times it’s easier to just buy a competitor for the customer base.
In this framework, the value that acquisitions create is from buying EBITDA at a lower multiple than the existing company trades for. This is the classic roll-up play. Larger companies trade at higher multiples, so you buy a bunch of small companies and sell them as one large company.
So let’s say you buy a $2mm EBITDA competitor for 3x EBITDA and your overall company is still worth 4x EBITDA, you have created $2mm of equity value through the transaction.
Organic Revenue Growth is Built Different
Obviously we can pick whatever numbers we want for each approach that would result in any of the particular drivers creating the most equity value (high growth, large multiple expansion, etc.). That’s why each of them are valid strategies that are pursued by finance professionals.
What matters here in the context of small business buying is that organic growth is structurally different from the other two strategies. Both a turnaround and a roll-up depend on the market changing it’s perception of the value of the cash flows the business generates.
For both turnarounds and roll-ups, the value usually goes up because the cash flows are more predictable. In the case of the turnaround because of better reporting and KPIs and in the case of roll-ups because larger businesses are more stable than smaller ones.
Organic revenue on the other hand leads to the business simply having more cash flows in the first place. That’s beneficial in two ways. First, the market does not have to change it’s perception of your business in your favor. Second, the business generates more cash during the hold period.
If you have made it this far into the post, you are likely thinking “Thanks Captain Obvious” - of course growing EBITDA creates a lot of equity value, that’s finance 101. But while the high level might seem obvious, most folks in the SMB and search space don’t actually prioritize accordingly.
Chasing Organic Revenue Growth Properly
My rule of thumb is that your base case when buying a small business should be organically doubling EBITDA in 5 years, which comes out to ~15% annual growth. Of course it’s not going to be a straight line, but when you look at a potential business, ask yourself what avenues you have to double EBITDA in 5 years (new markets, new products, market penetration, higher margins, etc.).
One thing you will notice is that a lot of businesses that fit the general search fund box have a lot of hurdles in the growth department. Specifically recurring revenue businesses tend to be harder to grow. If you buy a pest control business with 3,000 customers, your current business is pretty well protected, but in order to double it, you need to win 3,000 new customers, which usually either takes a lot of time or money (high customer acquisition cost).
Similar constraints apply to other recurring revenue businesses like software, home health, lawn / pool maintenance, etc. That’s why I’ve called recurring revenue overrated before. It’s a safe bet, but it’s harder to hit a home run.
But the implications go beyond what type of business to buy and extend into operational execution. Many searchers get attracted to the shiny object of doing a second deal or building a holding company once they are 1-2 years into their first deal and want to chase another deal. Often times, they would create more value for themselves and investors by chasing organic expansion rather than an add-on.
Doing more of what’s working is the best way you can create equity value for yourself and maximize the wire hitting your bank account at exit. Especially if you are coming from deal background (PE / banking), it’s easy to get deal fever once you’re 1-2 years into your first deal. Before you chase that deal, just ask yourself if it’s for ego or equity value.
Of course you should pursue all avenue at the same time to the extend possible. Grow the organic EBITDA as much as you can, improve reporting and KPIs to create better visibility and acquire add-ons where it makes sense strategically. But if you have one extra hour to work on the business, work on organic growth!