Listen to This Blog Post
In this second edition of our “Myth Busters” series (the first one can be found here), I attempt to debunk a common misconception among prospective acquirors, particularly those looking to purchase a business for the first time.
This myth states that the smaller the business in question, the easier it is to purchase and operate.
In the material that follows, I will attempt to explain why the exact opposite statement is likely true: That smaller companies are actually much harder to both purchase and operate when compared to their larger peers.
What constitutes a “small” or a “large” company is of course relative, so it’s important to note that in both instances, I’m speaking of lower-middle-market businesses that typically generate anywhere between $0.5M – $4.0M of annual EBITDA (earnings before interest, taxes, depreciation and amortization). For purposes of the discussion that follows, we’ll define “small” companies as those at the low end of this range, and “large” companies as those at the high end of it.
It should further be noted that companies that generate in excess of $4.0M of annual EBITDA are both beyond the scope of this article and indeed beyond the scope of my own knowledge and experience. At some point outside of this range (or perhaps even at the high end of it), larger mid-market companies do indeed begin to present acquirors and operators with unique challenges not typically faced by those operating further down market.
Lastly, note that this post is targeted largely towards individual entrepreneurs who are seeking to purchase a company and subsequently assume the CEO role. For this reason, my findings may be less applicable to situations in which, say, one business is contemplating acquiring another much smaller one.
Challenges in Buying a Small Business
It is often said that making a small acquisition requires just as much time, effort, money and heartache as making a large acquisition. Indeed, this is one reason why mid-market private equity firms often don’t invest in companies below a certain size threshold – the potential upside relative to the size of their fund is often not worth the time and effort required to consummate and continually monitor these types of acquisitions. I would actually take this sentiment one step further and suggest that it is actually harder to make small stand-alone acquisitions than it is to make larger ones. This is so for many reasons, including those outlined below (note that these are generalizations, and of course exceptions will exist):
- Often, the financial and operational data available to an acquiror of a small company is in considerably worse shape than the information available to an acquiror of a large company. In some cases the data doesn’t exist at all, and in others it’s scattered across multiple different systems, and in others it doesn’t follow widely accepted conventions, like generally accepted accounting principles (or GAAP).
- In M&A processes, some small businesses either don’t use a transaction advisor at all, or they use one who lacks the experience and sophistication that’s required to efficiently consummate such transactions. Sometimes, this is because advisors don’t take sell-side engagements below a certain size threshold, again because of the asymmetry between the time & effort involved and the financial upside those efforts are likely to yield. Though some buyers may view an unsophisticated (or non-existent) sell-side advisor as a potential advantage to be exploited, I would instead suggest that it’s much more likely to be an impediment to getting a deal done. Unsophisticated or inexperienced advisors can be incredibly frustrating to deal with, can slow down the purchase process considerably, and can push for terms and conditions that fall well outside of those that are widely accepted as being “market”.
- Small businesses are much more likely than large ones to be run by an owner/operator who still plays an active and material role in the day-to-day operations of the company. This type of key-person risk can be very difficult for buyers to structure around, especially if they’re planning to purchase a majority interest in the company in question.
- In particularly small companies (that, almost by definition, demonstrate this type of key-person risk), buyers must gain comfort that they are indeed buying a going-concern business, as opposed to effectively just acquiring the seller’s job. The former obviously being preferable to the latter.
- Assuming that the acquiror eventually needs to realize a return on her investment through a liquidity event (as opposed to running it in perpetuity), she will need to be confident that she can eventually grow the business to a size that is large enough to attract a large universe of potential acquirors. As a (very) loose rule of thumb, many sources of traditional institutional capital tend to not entertain opportunities where the company in question generates <$10M in revenue. A $3M revenue business purchased today, even if it grows revenue at a compounded rate of 20% per year (which is quite a feat), is still only a $7.5M revenue business five years later.
Challenges in Operating a Small Business
In his book, Zero to One, PayPal co-founder and renowned venture capitalist Peter Theil differentiates between a “zero to one” business and a “1 to n” business: The former aims to create something entirely new, while the latter aims to copy or refine something that already exists. More specifically, he notes that the former is considerably more difficult than the latter (though of course both remain difficult). This may, at least in part, explain the extraordinarily low success rates of start-up companies (which are typically of the zero-to-one variety), where it isn’t uncommon to see 75% – 90% failure rates within only a few years of their founding.
The basic insight here is that starting anything from scratch is incredibly difficult. When purchasing a small business, though you won’t necessarily need to create the business itself from scratch, chances are you’ll need to create several components of it from scratch. Though this of course can be done, I would argue that it’s far easier to refine or improve existing teams, tools, processes and systems than it is to create them from nothing. Larger companies tend to already have many of these things in place, and as a result, your job as the new owner will be to optimize and improve them as opposed to building them from the ground up.
I learned this the hard way when I purchased my own company in 2014, where we had to build both a Sales and a Marketing team (among several other departments) from what was effectively a non-existent state. Before purchasing the company, we viewed the absence of these departments as a positive – our rationale was that the company was likely to grow much faster once we did put properly functioning sales and marketing capabilities in place. While this thesis eventually did come to pass, building these two departments from scratch was much harder than we could have ever anticipated. It took many mistakes, much more time, and much more money than we had originally thought.
(It’s worth noting here that many proposed acquisitions in the SMB ecosystem share a very similar investment thesis. Though the thesis can and often does have merit, it’s almost always much more difficult, time consuming, and expensive than any investment memo would have you believe)
In addition to the fundamental “zero to one” risk, several other operating challenges may present themselves inside of very small companies:
- Even if the company in question has high cash flow margins, because of their small size these companies often present a dollar value of annual cash flow that can be insufficient to finance future growth initiatives. For example: If your company only produces $400K of cash flow annually, unless you have easy access to other sources of capital (debt, equity, or cash on hand), you won’t have much money to finance the various growth initiatives that you’re likely interested in pursuing as a new owner. Indeed, as few as two senior management hires can consume the entirety of your annual operating cash flow at these levels, leaving nothing left over for other growth initiatives
- Sometimes, small companies are still small for a reason. Though it is possible that the previous owner was satisfied with the previous size of the company, it is equally possible that the market is small, competitive, saturated, or contracting. It is similarly possible that true product/market fit hasn’t yet been achieved, again limiting future growth opportunities
- You’ll want to have a thorough understanding of where future growth is likely to come from in a small business, because all sources of growth are not created equally. For example, in some industries, penetration of the type of product being sold is low, so most sales opportunities can be “greenfield” in nature, meaning that there is no need to replace an incumbent provider of a competing product (this is preferable). In other instances however, the market may be more saturated, meaning that any new sale will require a customer to replace the product of an existing provider (this is much less preferable)
- Though some element of concentration is common to many small businesses, concentration (which can become a single point of failure, depending on its magnitude) is, by definition, much more common in smaller businesses than in larger ones. This can leave a new owner effectively beholden to a single employee, supplier, or customer, whose actions are largely outside of their control.
- Small companies often (though not always) under-invest in internal tools, processes and systems, and even if they haven’t done so historically, they’re reasonably likely to outgrow the ones that they currently have in place. For companies like these, the profitability profile on their current set of financial statements may not represent the true profitability profile that the business will yield under your ownership, which may in turn leave you with even fewer dollars to pursue new growth initiatives
- Another reason why historical margins often don’t represent go-forward margins is because in many small businesses, the founder/CEO gladly occupies several roles that would otherwise require 1-4 incremental hires under a new owner. Founders are often able to simultaneously play these roles due to their decades of company and industry experience, but expecting a new owner (especially if that new owner is a single individual) to do something similar is very often unrealistic
- Lastly, a small quantum of EBITDA provides new owners with much less “cushion” against the operating mistakes that they will inevitably make, particularly if the new owner is occupying the CEO seat for the first time. In a $2M EBITDA business, a $250K mistake is painful but ultimately very survivable. In a $500K EBITDA business, that same mistake not only cuts EBITDA in half, but could also put the company’s liquidity position in meaningful peril. To put this number into context, it’s worth reminding you that a single hiring mistake can easily cost a company $250K, if not much more. And if you’re a first time CEO, it is a virtual guarantee that you will make a hiring mistake as you build out your management team (more likely, you’ll make several of them, as I did, explained in further detail here)
When a young entrepreneur sets out to purchase a small business with a view towards assuming the CEO role, she almost certainly feels some level of insecurity and uncertainty about her ability to actually do the job successfully, even if only at a subconscious level (in my case, it was at a very conscious level).
In response to these understandable insecurities, she may look for ways to make the task seem less daunting, and too often these entrepreneurs think that buying and running a smaller business is one way to do just that. Unfortunately, these entrepreneurs are mistaken. Within the lower-middle-market, in my opinion, smaller companies are actually much harder to both purchase and operate when compared to their larger peers.
In most cases, it’s far easier to take a business from “1 to n” than it is to take a business from “zero to one”.