HBR Guide to Buying a Small Business

Richard Ruback & Royce Yudkoff

  • Costs
    • Deal costs for lawyers, accountants and other professionals can quickly add up to over $100k
    • When you complete a deal, these costs are rolled up in the acquisitions price, but if the deal falls through, you will be liable for the costs
    • About half of all deals fall apart, therefore, they recommend budgeting a reserve of $50k for broken deal costs
  • Tips for “selling” or pitching your search fund to investors
    • Arrive on time
    • Look the prospect in the eye
    • Tune into their language
      • If the potential investor is involved in the industry you’re targeting feel free to use specific terminology
      • If they’re not from the industry avoid using buzzwords or it will signal to them they’re getting involved in something they don’t understand
    • Time your presentation
      • Ask how much time the person has and adjust your presentation as required
    • Act like a peer
    • Tell stories
      • Many claims sound alike – “I’m going to buy low & sell high” or “I want a business that has high barriers to entry”
      • A good example – “I’m looking for a business with high margins due to the high barriers to entry. One example is a company I looked at, Castronics, threads metal pipe for oil and gas drillers. The pipe is really bulky and heavy which makes transporting it around cost about 6x how much the actual threading costs, therefore, competitors from outside the region are much more expensive. Also, it’s really important that the pipe arrives on time and the lengths fit together perfectly. For this reason, customers are really cautious about experimenting with other suppliers. That’s why the company generates such attractive margins, and its exactly the type of business I’m looking for”
    • Sales growth
      • High growth means that your new customers will quickly outnumber your existing ones. They bring new demands and have unknown loyalty
      • High growth requires great management effort and absorbs money quickly
      • Rapidly growing firms also attract competition
      • Sellers also demand a higher multiple – therefore, you work harder, have higher risk of failure and pay more
    • Skillset
      • Their experience is that most people with strong general management can thrive in a wide range of businesses
      • But match skills – if you don’t like selling, don’t buy a business that puts you in that role
      • Is there a key person?
      • Does the seller possess some rare skill that you can’t replicate?
      • Is there and essential supplier relationship?
    • Buy a business, not a job
    • Finding business brokers
    • Approaching potential sellers
      • Generic email vs personalised
      • Examples in book on page 118/119
      • Response rate for generic as low as 0.5%
    • Reputation
      • Look for indications the business has an outstanding reputation: that is the simplest reason why customers would keep returning
    • Other reasons customers stay
      • Integrated with customer systems that makes it difficult/costly to switch
      • Provide a critical product/service at a low cost to customer, reducing impetus to seek out cheaper alternatives
        • An automobile OEM is much more likely to focus on reducing its steel costs vs reworking a deal with the company that provides its postage meters
      • The importance of being unimportant: if the business provides something that only makes up a small portion of its customers expenses, then those customers are less likely to switch to other suppliers
      • Geographical advantage due to impractical shipping costs
    • Filters/traits to look for
      • Low customer concentration (top 5 less than 50%)
      • Sales growth from the right place
        • If customers are sticky then growth should be coming from market growth, price increases or new product introductions as opposed to new customers won from competitors – because it should be hard to poach customers in the industry!
      • Low cyclicality in sales
        • That small dip in sales may have been fine for the owner who likely operated on a debt free basis, but could be lethal for you
      • High EBITDA margins
      • Recurring customers
      • Fragmented customers and suppliers
      • Revenue growth from the right places
      • Low cyclicality
    • Commitment to sell
      • Ideally, something should be forcing them to sell
        • Retirement
        • Poor health
        • Divorce
        • Inability of business partners to get along
        • Death of the owner, and sale of business through estate
      • Questions to consider
        • I think the business has recurring revenues, but does it? What is the history of customer churn?
        • I think the business has good growth potential because the current owner hasn’t done much selling, but does it? How big is the market? How would the business compete for new customers?
        • I think the business is enduringly profitable with steady cash flows, but is it? How did it perform in the last recession?
        • Can I run it? Are there key relationships between owner and suppliers? Are there key employees? Is there certification or license requirements? Is there a preference for an attribute (women, veteran, minority) that I lack?
      • Decide on offer strategy
        • Bid below max you would pay and hope they accept/counter
        • Bid max you would want to pay and negotiate down as issues are discovered in DD
      • Small Business Administration loans
        • Good source of Gov backed funding offered by certain banks
      • Working capital peg
        • Deal needs to specify how much working capital is to be retained in the business post transaction – to ensure the business is not drained of capital
        • Owner will likely not understand this and feel his entitled to the receivables because they were sales made under his ownership
        • Should be set so there is not an excess or deficit of working capital on day 1
      • Proof of cash analysis
        • Confirms the revenues and expenses reported in the financial statements by comparing them to deposits and payments to and from the company’s bank account
        • Involve lawyers and accountants who specialise in the purchase of smaller firms
        • Want to look for tax liabilities, accruals and anything that could be hidden through poor accounting that could hurt future cash flows
        • Accounting due diligence $25-50k and legal ~$75k (including all doc prep)

 

  • Areas to assess during due diligence
    • The character and honesty of the seller
      • If you feel they’re not honest always pass – no matter how good your DD is, the seller is always in the position of superior knowledge
      • If a seller has covered up one thing, it is likely they have covered up others that you haven’t found
      • Ask customers and employees how they view the firms and owners integrity
      • How owners treat their customers, suppliers and employees is a good indicator
    • The company’s accounts and finances
      • No one reports a higher income to the tax office than they actually earn. Therefore, you can compare pre-tax income reported in their accounts against those in their tax return
    • The company’s contracts and legal affairs
    • Customer perspectives
    • Employee perspectives
  • Quality of earnings review
    • You’re most concerned about whether historical revenue and profits will recur in the future
    • Detailed analysis of the drivers in prior year revenue and cost fluctuations
    • Ensure sales and profitability are not concentrated in a few customers – older customers can become super profitable
    • Are the major clients steady and recurring or do they come and go?
    • Were there any large pieces of business that only happened once?
    • Did the business get a new customer or expand operations?
    • If a big portion of the cost base is in salaries, ensure they’re not getting paid below market
    • Have they reduced costs by underinvesting in machinery or postponing capital investments?
    • Check remaining terms on any leases and whether they’re likely to increase materially upon renewal
  • Customer interviews
    • What qualities do customers look for in selecting their supplier?
    • Are they satisfied with the services of the company?
    • How is the company better or worse than the competitors?
    • What causes the customers to switch suppliers?
    • Do they anticipate change in the amount of business they do with the company?
  • Employee interviews
    • What do the company’s customers care most about with regard to the service you provide?
    • How well do you think you measure up to their expectations?
    • Do you think there is anything the company could be doing better?