Due to popular demand, I'm back to share a bit more about my experiences and lessons during my searcher journey. When I first started posting, I had no idea it would generate so much feedback and support from the SF community. I'm so grateful so many of you were able to find benefit from what I shared, and I hope you will find this post equally helpful as well. Also, I've been extremely busy and haven't been able to respond to most of the messages I've received over the last couple of years, so I apologize for that.
Before I begin, if you haven't already, I urge you to check out my previous posts, linked below. The first one was written right after I closed, and the 2nd was from a year later. They are a couple of years old at this point, but I still wholeheartedly stand behind everything I wrote in there.
Over the past several years, I've been fortunate enough to meet and talk to many members of the SF community. In particular, ^ seems to think I'm something of a Debbie Downer, and has sent many aspiring Searchers my way to get a "realistic" view of buying a small business. Ok. I am Asian after all. I was bred to be miserable. I embrace my doomsayer image.
With that said, let's begin. This will be a long post, pun intended ha ha, but hopefully will be worth the time you put into reading it.
Should I Start a Search Fund?
1. This is one of the most common questions I get asked. It's no secret there has been a huge spike in interest in search funds over the past couple of years. Business schools are pushing this concept hard amongst their student bodies, and now almost every fresh faced MBA grad has grand visions of rolling up mom and pop HVAC businesses and selling them for $50mm to PE in 5 years. On the one hand, this is great. It gives our community much greater interest, exposure, and ultimately liquidity options. On the other hand, not enough people talk about the demands and stresses of choosing this route. So let me be the one. IT IS HARD. I think I emphasized this point in both my previous posts. BUT IT IS INSANELY HARD. If you are lucky to close a deal, being a small business operator will eat you up and chew you out in ways you didn't even think could happen.
2. I spoke to one searcher who said the reason she wanted to buy a small business was that she was tired of working so much at her 50hr/week PE analyst job, and was looking forward to being a semi-absentee owner working 20hrs/week clearing 500k a year in income. Another spoke glowingly of how he planned on acquiring 5 companies a year and then retiring within 5 years on a $25mm nest egg. Countless others have preached to me the semi-absentee ethos.
3. Bottom line is, if you are a participation trophy kind of person, I would not recommend being a Searcher as a career choice. Maybe you'll get lucky, but probably not. First you'll have to deal with the search process. The interminable hours spent looking at dead end leads. The countless unreturned calls and unreplied emails. The days that bleed into weeks that bleed into months of stalled progress, making you question every decision you ever made in life. And then, right when you finally get your hopes up and you think you found something, they back out on you in the 11th hour. And that's the easy part. Then comes actually running the business. In my specific case, I worked 14 hours a day, 7 days a week for months on end. I dug every hole there was to dig, carried every rock there was to carry, and pushed every wheelbarrow there was to push. I came home every day with permanently stained fingers and countless bruises because that's what it took to keep things afloat. Now, I sure hope none of you will experience a global pandemic in the first month of your business, and many of you won't be involved in a manual labor-heavy business like mine, but landmines and obstacles abound in every industry. Ask yourself if you are willing and able to put in the time, sweat, tears, and blood it takes to keep things going no matter what.
4. Think, instead about what you want out of your life. Are you trying to leave an asset for the next generation? Are you excited and eager to learn new skills while shouldering the responsibility of running a business? Do you crave a certain level of control and actionability? Am I ok dealing with all the stress in order to achieve my goals? Hint: The answer shouldn't be "well I want to work less and make more money doing it."
How Should I Approach Funding a Deal?
Probably the questions I get asked the most all relate to funding. How should I source my funding? What should my cap table look like? I covered a lot of this in my prior posts, but the short answer is, there is no one right answer. In general, a SF deal cap table is comprised of 3 parts: equity, bank financing, seller's note. Now, it's important to note that each component of that financing is completely customizable and negotiable
1. Equity -- Most of the questions come down to the issue of a "traditional search" or a self funded search. Again, there is no right answer. If you have the economic means, and you want to retain more control over search parameters and timeline, then a self funded search is probably the better option. Especially if you are "just kind of keeping an eye open" for a good deal, a traditional search won't be suitable. The biggest drawback to a self funded search is the lack of access to expertise, advice, introductions, networking, etc that usually comes along with the dedicated traditional search fund investors. On the other hand, I've found it harder to be flexible and creative with alternative funding options if you have a large search investor as your anchor investor. But again, it's up to you to decide. Do you want the structure, stability, and knowledge that comes with working with experienced search investors? Or would you rather prefer the flexibility of working with your rich uncle and his golf buddies? Would the traditional model impose certain covenants or mandate certain performance hurdles that might be detrimental to your long term plans for the business?
It's also worth noting that with the explosion in interest in search funds, so has the increase in funding options. More and more institutions and individuals are now familiar with the concept of a search fund, and to be honest many of them just treat it as micro-PE, which it effectively is. This means you are much more likely to quickly get post deal funding, straightforward equity investment terms, etc. So as a searcher today you really have many options when it comes to raising capital. Make sure you cast a wide net to see what is available to you.2. Bank Financing -- Traditionally, SBA loans have been the default option and they are still great. Nowadays, there are more alternative/private lenders so you have more options to explore, especially if you are wary of the personal guarantee imposed on SBA loans. Just make sure, where rates are now, to be comfortable with the economics in a 10%+ interest rate environment. My SBA loan started off @ 5%, but now it's at 10%. This has added a couple thousand to my monthly debt payments. Make sure your business can handle the added interest expense.
3. Seller's Note -- I get a lot of questions about this one, but again this is completely negotiable. Seller's notes can vary in maturity, interest rate, payment form, etc. Make sure you spend plenty of time discussing and cementing the details of the seller's note earlier in your negotiations so don't find yourself fighting over this when you are at the finish line. As an example, my first seller's note was 5 years at 5%, with the first year being IO. The one I'm negotiating right now is 3 years @ 8%, starting 1 year after close. So again, you can really negotiate this however you want to.
Still with me? Awesome! Let's keep going.
You can write a Stephen King novel about this topic, but I'm going to skip all the obvious things (profitability, etc) and focus on some of the things I would have drilled into deeper knowing what I know now. Again, I touched on a lot of these points in my previous posts, but I'm going to add a couple more.
Things to be Aware of During the Due Diligence Process
1.. Whenever anyone asks me "What would you have spent more time on in during due diligence?", my answer is always unequivocally "Understanding the labor situation." It doesn't matter if you're in a labor intensive business like mine, or some kind of SaaS company, as a new business owner you're only going to get as far as your existing employees can take you. Make sure you understand what the owner's duties are (and how hard they would be to be replaced), and how reliably you can count on the existing employee base to stay through the transition. How much labor turnover is there annually? How difficult is it to hire? Do employees need licenses? Wall Street guys and MBAs never talk about labor when analyzing companies on a spreadsheet, but I promise you it will be the single most important factor to your business's success.
2. "Excellent Staff in Place. Managers and key employees have all been with the company for 30 years." I see this a lot, especially on brokered deals, as a way to tout the attractiveness of the company. And in many ways, yes, that's a great thing. However, to me, that is a BIG potential red flag. Firstly, someone that has been working for 30+ years, by definition, would be expected to have fewer working years remaining. That means you will have to replace him sooner rather than later. Secondly, if all the key employees have been there for so long, if/when they retire or quit, how can you replace him? The guy who knows all your processes intimately, the guy who knows all your customers and vendors, the guy who the customer calls up and says "Oh, mention it to Bill. I've been dealing with him for so long, he knows what I'm talking about" -- how do you replace THAT guy? It's kind of like you're running an army. The front line infantry, when they fall, you just replace them with some fresh faced cadets and it's pretty much all the same. But the colonels? The 5 star generals? They don't grow on trees. When they fall, it throws your army into disarray. If all you have in your army are 5 key people, it puts you in a precarious spot should they leave. Think about that when you're doing the DD. Ask what the ages of the key employees are.
3. "Oh I'll Just Hire Someone." This is another common response I hear when talking to searchers who downplay the importance of labor. "I plan on being an absentee owner after a couple months -- I'll just hire a manager." or "Yea I'll just hire 5 new salesmen and 10 crews and triple my revenue in 2 years." Yea no. Sorry. It doesn't work like that, especially when it comes to hiring a manager. You have to find someone that is competent, hardworking, honest, AND comes at a reasonable salary. Believe me when I say, the super ambitious Harvard grads are not going to run your $2mm car wash or medical billing company for $75k a year. Same goes for any other potential employee. It takes a long time (and costs a lot of money) to identify, vet, try out, fire, and rehire good employees. There just aren't many of them around. So again, don't try to paper over any potential holes in the employee base by assuming you can just replace them. If you find a key employee is about to retire, or a skilled tradesmen is likely to quit, you need to discuss with the seller beforehand, and have a plan other than "oh I'll just hire someone to replace him."
4. On Fragmented and Niche Markets The canonical Search Fund text highly espouses businesses that are in highly fragmented and/or niche markets. I'm very fortunate to have had multiple conversations with Royce Yudkoff (of HBR Guide to Buying a Small Business fame), and he in particular champions looking for "niche, boring" companies. I agree with those sentiments, but let me add a wrinkle. There is such a thing as too fragmented and too niche. When that happens, it makes acquisitive growth extremely difficult. The Lawn Maintenance Business I'm in, for example, is too fragmented. The vast vast majority of companies consist of a dude and his cousin, driving his pickup around cutting lawns. Mom and Pop HVAC companies, are exactly that - husband and wife (and maybe a couple other employees) working in their local neighborhood. The problem is that most of these companies cannot be bought. Maybe the owner makes a decent living, but that's it. They are too small to be acquired. So you are left with only a small handful of actual buyout targets, and that severely limits your rollup/addon potential. Similarly, an industry that is too niche also leaves with you few acquisition targets because, well, literally there aren't any. It's too niche. If you bought the one water treatment company servicing Manhattan water tanks, that's it. You're done. Great business, but you can never add to it. You just bought the medical billing provider to regional hospitals and fire depts in greater Chicago? Congratulations! You're your only competitor. So when thinking about what kind of business/industry is right for you, make sure you think about what your long term plans are. Are you hoping to buy a company, and run it until you retire and maybe pass off to your children? If so, great! But in that case, if you're going to go the niche route, it might be best to wait to buy as big of a company as you can, so that cash flow will be large enough for you even in year 20. If your plan is to initiate with a starter company, and then plan to constantly do rollups/addons, then a highly fragmented / niche industry may not be the best fit for you.
5. SDE vs EBITDA So this is a point of contention that's pretty much guaranteed to come up in your valuation negotiations. What to make of an appropriate owner/manager/CEO salary? For those not familiar, SDE stands for Seller's Discretionary Earnings, and pretty much the main difference between SDE and EBITDA is that SDE includes owner's salary. On virtually every brokered deal, the asking price will be based on the SDE, while all you discerning MBAs cry out in unison "but that's not the correct number!" I know a lot of people, even on this forum, insist and stick to their belief that they will only give a 4x multiple on true EBITDA and not SDE. After all, when Apollo goes to buy Arconic, Leon Black isn't personally going to be running the company and so has to hire a CEO; that CEO's salary is a fixed cost of the company and the price of the company should be discounted to reflect that. In reality, this question is a bit hard to answer. Generally, I find that the smaller the company (EBITDA < $600k say), the harder it is to value on EBITDA, because it just makes the valuation too low. As the buyer of a small business, you have to assume that you will, in fact, be personally running the business for quite some time, and so SDE is in fact a more accurate representation of the true profitability to you. Again, this is something that you have to discuss with the seller, maybe your investors, and even internally to see where you stand. Again, I think it gets pretty hard to stick to the pure EBITDA viewpoint because you will just be so far apart on every potential deal.
6. Day 1 PPE Expenditures I think it's important to do a thorough inspection of everything you're getting in a deal, before you sigh. I think it goes without saying you should never do a deal without a site visit and close inspection of the equipment/property/capital assets. Just getting a vehicle list isn't enough. There is a big difference between a 2015 Ford Pickup with 200k miles that's only being driven by salesmen on sales calls, and a 2018 Ford Pickup with 100k miles that hauls loose rocks and snow plows for 500 hours every winter (hint, the 2nd one is not pretty). Does the roof of the building have a leak and need to be fixed? Is your onsite gas tank leaching into the ground? Is the camera/security system fully functional? Make sure you don't get blindsided by any unforeseen large expenses because you didn't do a thorough inspection of the PPE.
7. Status of Contracts I think most people are aware of this, but I'll just put it here. Make sure you understand how your customer contracts are signed and structured. How do you win them? How do they renew? Especially if you are a B2B company, I would expect many of your contracts are RFQ'd out. That means they are all bid based, and you win only because you are the lowest bidder. That inherently makes your revenue stream less predictable. How many contracts are "won" in such a manner? When are they coming up for renewal? Does most of your business derive from 5 year contracts that are all coming up for re-bidding in the next year? What happens if you don't win them again? If the contracts aren't publicly bid but privately negotiated, is it because the seller has a personal connection/relationship with the customer? What happens when he's no longer there?
8. Covid Adjustment In normal circumstances, I think 3-5 years of financials gives you pretty good visibility and confidence into a company's operations. The last 3 years, however, have been anything but normal. COVID and inflation has distorted many numbers. Some for the better, others for the worse. Because of this, make sure you get pre-pandemic numbers and talk through any changes from###-###-#### Are the jumps in revenue sustainable? Are the declines truly transitory? This business I'm currently looking to acquire, for example, saw 35% total growth from###-###-#### However, 2023 YTD is comping negative and we both expect 2024 to be sequentially down again. We are both on the same page about the sustainability of pandemic driven growth, so there are realistic expectations of valuation. Make sure you get pre-pandemic numbers to compare.
9. Read the Google Reviews This is self explanatory. If possible, read the google reviews. See what they do right, what they do bad. Bring up the bad reviews with the seller.
10. Check out the Seller This is something that I like to do as a kind of back of the envelope check on a seller. If a seller is claiming that his SDE is, say, $1mm a year, then he really ought to live like a millionaire. What car does he drive? What car does his wife drive? How nice is his house? Do his kids go to fancy private schools? Did he pay for their college tuition out of pocket? Ok maybe he's a Warren Buffet disciple and isn't ostentatious with his wealth. Does he have a big art collection? Wine Collection? Likes to vacation in French Riviera 2 months a year? In your conversations with him, try to tease out what his hobbies / interests are. I'd be very very wary of a seller proclaiming a $750k SDE when he lives in a 1 story ranch rental with a Civic and a Mazda parked in the driveway. Something seems off there.
11. Rudimentary Business Tools Don't be immediately put off the business doesn't seem "fancy." It's perfectly normal for small businesses to not utilize advanced software and systems, and even what you may think as basic business tools like Quickbooks or even a website! The fact is, most small businesses don't need them and not having them doesn't make the seller duplicitous. In fact, in may even be a potential area for efficiency gains. Instead, focus on your relationship with the seller. As I said in my prior posts, no one knows the details of that company better than him. Your relationship with him, and his level of trustworthiness, are going to get you very far in terms of getting over the finish line.
Ok Whew. If you've made it this far, I applaud and thank you. Verbal diarrhea is both a gift and a curse of mine, though if you ask my friends it's all curse and no gift. Thank you all for making this community so helpful and collaborative. I hope you guys will be able to derive value from what I've posted here. Again, feel free to reach out / connect, but don't be offended if I take forever to respond! Best would be if you dropped your phone in the chat and I'll try to give a quick call when I can.
I'll leave you with this last thought. Buying a small business is terrifying. It truly is. You're risking so much -- your savings, your family time, perhaps even your sanity and health -- to embark on a journey with no guaranteed results. Because of that, we naturally want to find that perfect situation, to buy the perfect business for the perfect price. But as they say, perfection is the enemy of progress. Sometimes, you just have to take a leap of faith, dive in, and trust that the kinks will be worked out. I'm sure everyone on this forum has their own war stories and lived to tell the tale, so you've got a supportive community right alongside you. And if it doesn't, I've got about 500 bottles of alcohol we can ruminate over. Good luck.