I have been asked this question quite a bit. The question almost always assumes a private equity type of purchase, as opposed to buying a venture-backed or backable company. These are a few comments on the major questions that people seem to ask about this process.
I’d like a business that has good cash flow, a retiring owner with an at-or-below market price expectation, and the willingness to finance the purchase for me.
Everyone – well, a lot of people, anyway – are looking for this business that doesn’t seem to exist very frequently. They want the proverbial retiring owner with an at market or below market price expectation who will help finance the sale (by giving the buyer an attractive loan to reduce the buyer’s need for a cash infusion) and wait patiently to be paid. I haven’t seen this happen much. I’ve seen retiring owners sell at attractive prices in all cash deals, or for very attractive prices and some subordinated debt, but not all of these factors together. Often an owner holding debt will use all of the buyer’s equity as collateral. In other words, don’t pay and he gets the company back.
What are the hot industries I should look at?
I wonder if this is the criteria to use. It seems to me that the potential buyer has a higher chance of success if they can describe the business they want from an industry or expertise point of view.
If you, as the buyer, have deep knowledge of an industry, this is a great place to start. (If you’re in an industry that you don’t like, or that has no future, perhaps getting some experience in another industry might be a reasonable starting point prior to making an acquisition.)
If you do understand an industry, you might start your search by talking to business owners who have businesses that you understand and would be interested in.
If your industry skills are directly applicable to many markets, even better. (For example, if you are a seasoned manager of an e-commerce business with P/L responsibility, you may well be capable of moving to a different market within the e-commerce industry, as long as you have a keen awareness of what you do not know about the new market and provide yourself with expertise to bridge the knowledge gap.)
Prepare yourself for the conversation. Look up the ownership structure and identify the owners before you call. (You’ll find all of that with the state office that keeps corporate records, usually online. In Wisconsin, it is the Department of Financial Institutions. Some other states have Secretaries of State.)
See if you can get an understanding of the market structure by competitors that the business operates in. (Michael Porter’s Five Forces is an excellent place to begin.) Draw a market map. Examine it for opportunities.
If you find an interesting opportunity, do ask yourself the innovation question as it relates to purchase price. That is, can you innovate in a way that reduces the time it will take to repay the debt by increasing sales, reducing expenses, acquiring other companies, combining with new partners, etc.
What can you do for the owner/seller beyond the purchase price if anything? Would the selling owner like to stay on in some capacity? Would this add to your ability to succeed in the business?
If I am going to require more capital than I have, where will it come from?
The investor who is helping you buy this business will have an expected outcome.
If it is a bank – should you be able to acquire a business that can utilize debt – they want cash flow coverage and guarantees of repayment. (“We don’t make investments, we lend money that we expect to be repaid,” they say.) And, fair enough. The interest rates banks typically get are substantially less than what an investor expects.
If you cannot use bank debt, - or if you can use some but still need substantial equity – where will you get it and under what terms?
None of us would go to buy a car not knowing where we might get the money, or if anyone would lend it to us. Said another way, we understand bank debt, but we need to consider the same kind of questions for equity investors. What rate of return do they expect? Is their IRR goal 25%? Less? More? Does the nature of the business generally provide these types of returns?
What else might they want? (From a financial “want” point of view, some investors – especially private equity investors who are not VCs – may want you to be an LLC and assign them all of the early tax losses. Under the correct circumstances, that can be a bonus for you.)
It is true, it seems to me, that nothing really comes together until there is a real business to consider, but that first opportunity may not have much chance of success without a pretty good answer to this question.
If a business has cash flow, how do I figure out if I can finance it?
Start with the basics of debt flow coverage ratios and see if the funds you have for equity will be enough when combined with the company’s cash flow, to support debt.
As an example, if you can come up with $1Million in equity on your own, that might mean that you could (in a really rough estimate sort of a way) look at opportunities with cash flow at market caps of about $5MM. By “with cash flow” I mean with adequate cash flow to support $4MM in debt on common commercial terms. Of course, in the real transaction, debt structure is going to be a lot more complex than a single term loan, and may well include separate a real estate transaction as well as lines of credit, debt subordinated to the bank, and so forth. But it is important for the potential buyer to be able to get to a “back of the envelope” calculation that helps limit the breadth of the search.
A business selling for $5MM with adequate debt coverage ratio cash flow may sell for somewhere in the 3-7 times EBIT range. At an assumed blended interest rate of 8% and a 7 year amortization, with 20% down, an EBIT of 6 will generate a cash flow coverage ratio of about 1.11. It won’t work at an EBIT of 7.
What if I have to get an equity investor as well as debt financing?
An investor is going to want either some sort of cash-flow based return (For instance, 95% of the free cash flow until 2X the investment, with a two year period, with a penalty for not making the number) or a sale-of-the-company event to return the investment, or some sort of minimum repurchase price based on the entrepreneur’s ability to do a recapitalization at a market value attractive to the buyer. And, of course, the bank will want to be paid or refinanced before your investor is paid out.
What if I don’t have bank financing, but only an equity partner?
The structure as to how the investor gets paid remains the same. It is important, however, to figure out exactly how the investor will be paid off. I think a necessary part of this process is building actual examples of payouts on spreadsheets that you – the business buyer – can use to decide if what is being proposed can be done by the business being considered. Sounds obvious. I’m amazed how often it is not.
People get into deals that wind up badly not because the business fails, but because it went more slowly than planned and this was not foreseen in the investment agreement.
On the other hand, deals constructed by advisors that put total control as to amount and timing of payouts in the hands of the entrepreneur will be avoided by smart investors. These risk turning into lifestyle businesses that pay a nice salary to the owner who works in the business and not much to investors.
