A Creative Way To Eliminate Friction & Unlock Value in "Acquiring" SMBs
A common thread in a good number of our posts touches on the concept of creativity. In our view, creativity is a skill that can be deliberately developed, yet this important "muscle" is not only frequently under-developed, but in fact often avoided by most, even if sub-consciously. This reality is somewhat understandable, as building one's "creative muscle" can be a bit uncomfortable - the process usually entails a lot of trial & error and a good dose of failure, pivoting and exploration along the way. With that in mind, we outline below a rather unique - and totally unproven - concept addressing a topic we discuss quite a bit here...acquiring small businesses. As you'll soon find however, this idea has less to do with the well trodden, arduous path typically taken when acquiring SMBs and more to do with imagining an entirely new way of unlocking value - both economic & non-economic - within the massive, illiquid SMB asset class via a lower friction, creative, non-zero-sum "acquisition" holding company based solution.
To begin, let us first list out a few of the more painful "pain-points" in executing SMB acquisitions:
Higher quality SMBs are often not for sale. Most of this type are passed along to heirs, though if sold, they usually end up with Strategics (e.x. Heico) who have the reputation, resources & experience to invest in the business over the long-term in ways a private equity firm, search fund or similar financial investor simply cannot. If not to a Strategic, well, be prepared to pay up alongside everyone else in the auction
Valuing an SMB is a process in and of itself. Not so much because this involves complex mathematics, but rather because you are acquiring an owner's "baby". So, not only is there a good bit of emotion involved, but this transaction is likely the biggest and only such financial transaction the owner will experience in her life. Given such, she very well may seek a valuation that is not often congruent with what an acquirer views as "logical"
The due diligence process can be, well, difficult. Not all SMBs have the record-keeping or organizational habits of a Fortune 500 company. Particularly as one descends "into the weeds" of SMB due diligence, higher levels of effort, uncertainty, frustration, confusion, and expense can arise...on both sides of the table
While acquiring a single or a modest portfolio of SMBs is, of course, viable (though no cake-walk), achieving any level of "scaled acquisitions" within this significant asset class is extremely difficult, yet incredibly valuable (think Constellation Software, Indutrade). It takes decades, extreme discipline, a unique culture and a dose of good fortune to achieve this, to say the least
Let's also remember that most attractive SMBs are not attractive for their presently untapped future growth potential, but rather for the stability and consistency of their cash flow. An investment model (not to mention an acquisition price) where meaningful & sustainable post-acquisition, execution-dependent upside is required to hit a desired return hurdle is increasingly risky and more difficult the smaller the company acquired. Such SMBs are not often designed, equipped, nor staffed to become growth engines. Realizing this, instead of placing the onus for growth and subsequent risk on the individual SMB(s), it is arguably more attractive to adopt a model whereby said growth and risk are more and more "pushed up" to the portfolio level...exactly as Constellation, Indutrade and many other serial SMB acquirers have done.
Okay, so what? This is the reality of buying SMBs, nothing you can do about it, right?
Sure - we won't argue with that assertion too much. However, do we need to actually acquire SMBs to effectively invest in SMBs? Is the outright acquisition model the only path through which one can gain direct exposure to SMBs? Maybe there is a different, albeit so far untested, way to tap into the massive SMB asset class that side-steps the above pain-points and, even better, introduces a number of non-zero-sum benefits for all involved parties that improve with time & scale and also leans into the desires and realities of a good number of SMB owners.
We think there is such a way.
To take a closer look at this "new way", let's first briefly revisit a recent tweet of mine where I tossed out a variant of this "new approach":
Fortunately, some of the generous, smart members of the #fintwit community on Twitter replied with several insightful push-backs. To highlight a few: adverse selection bias, complex tax issues & general bearishness of SMB owners in their view of peers' businesses all make this idea likely tough to pull off in practice. While I understand these valid points, I'm also of the belief that anything "new" or "different" is almost always going to be viewed as unlikely to succeed to begin, the first iteration of something is often never what actually "works" in the end, and a simple Twitter exchange is far from enough evidence to completely squash an idea.
It is also worth highlighting that the very successful early stage venture capital firm, First Round Capital, explored this same general concept among their portfolio companies. Ultimately, it did not gain traction due in large part to the extreme dispersion of economic outcomes among tech startups. More specifically, while the Founder of a bottom quartile startup in the fund's portfolio - one almost certain to fail - would love the opportunity to swap equity with the Founder of a top quartile startup in the fund, the opposite is effectively a non-starter.
Notably, this is not so much the case among more stable, mature, cash generative, lower growth small businesses. The dispersion of future economic outcomes across a portfolio of SMBs is far more condensed, and even more so with a team of investment professionals ensuring this to be the case by identifying & actively assessing only top-quartile SMBs - more on this later.
Okay, so, very quickly back to the above Tweet. In it, we suggested that SMB owners basically swap a minority portion of their respective SMB's equity for a dollar-equivalent amount of equity in a Holdco, which itself holds a growing portfolio of these SMB minority equity stakes. After having given this proposal some more thought, swapping equity, while likely viable, doesn't really address the pain-points we outlined above. More specifically, we still need to conduct top-to-bottom, in-depth due diligence on each SMB, we still need to arrive at an agreed upon valuation so as to know how much of Holdco equity a given SMB owner deserves, and we are still requiring SMB owners to in effect "sell" their equity. Adding all of this up doesn't really help the whole "concept scalability" piece either.
Hm...alright, well, what about committing a portion of their free cash flow to the Holdco?
Potentially...though tying to free cash flow still requires us to work all the way down the income and cash flow statements (i.e. we need in-depth, top-to-bottom diligence). So, the same issues we faced above with the equity swap all still largely apply with an added risk that SMB owners can "game" their free cash flow potentially. Ultimately, this basically has all of the burdens of owning equity, without actually owning any equity.
So, if not equity nor free cash flow, then what else works here?
Great question, glad you asked...revenue.
Why revenue? Well, for all of the reasons we detailed above as to why equity and cash flow aren't optimal. We can be more focused and efficient in our due diligence as we are predominately (though not entirely) concerned with just the revenue quality & sustainability - a top-line financial metric, we need not negotiate on valuation, the owner need not sell any equity and revenue is more difficult to "game". Eliminating these frictions, in theory, allows for a more scalable and higher-tempo "acquisition engine".
To ground us some here, let's quickly introduce the publicly listed Canadian company, Alaris Royalty. In short, Alaris provides small and medium-sized companies with a non-dilutive, "permanent" and flexible revenue royalty based financing. This financing strategy is most often used within the mining, music and other similar "recurring income stream" industry verticals to the tune of tens of billions of dollars a year. Alaris has taken this tried and true investment instrument and applied it to successful, stable, higher margin, cash generative businesses across a range of industries.
In practice, Alaris provides a company with, say, $50M, today in exchange for a small percentage (<10%) of its monthly revenue, indefinitely (note: there are take-out clauses, royalty adjustments & a bunch of other important nuances we are glossing over here). Basically a hybrid of debt and equity. Now, as the focus of this post is not Alaris, we'd encourage readers to check out their website to learn more. Our main purpose in introducing this company is to highlight the proven nature of their investment strategy / financing instrument and their existence as a successful publicly listed entity.
Alright, so now on to the big reveal!
As we often find ourselves better able to grasp more conceptual topics when expressed in numbers, we've shared below a very basic numbers-based overview of the broader concept we are proposing. Please note that this is for illustrative purposes only - we are ignoring things like taxes (which are important here) and making several other blanket assumptions:
Before translating the above into English, let us make clear a few things:
First, in attempting this concept, we will need to focus on a subset of the more attractive SMBs out there. One, because we want direct exposure to these otherwise hard-to-invest-in top SMBs, and, two, because this proposed "revenue royalty instrument" requires a certain type of business. More specifically, one with little to no existing debt, an "adequate level" of margin, meaningful revenue stability, etc. Put another way, the type of company most search funders and lower middle market PE firms would ideally love to acquire, though often cannot (because the "best businesses are not often up for sale").
Secondly, the Holdco entity will be initially staffed by a small team of entrepreneurial investment professionals. These individuals will set up the Holdco entity, handle all legal & tax issues, source, assess & diligence compelling SMB "investment candidates", introduce to and educate SMB owners on the ins and outs of this concept and provide on-going oversight & reporting across the growing portfolio. Over time, this Holdco team will grow and begin to facilitate non-economic value-adds such as intra-portfolio executive networking & potential cross-selling opportunities, extensive knowledge sharing, executive recruiting support and perhaps even group-wide conferences and collective investment opportunities outside of SMBs (i.e. startups, real estate, etc.). Of course, to accomplish all of this and for being the inertia putting all of this together, the Holdco team will be paid salaries and have some modest percentage ownership stake in the Holdco. Point being, there is a cost here to SMB owners, though there is also a lot of immediate and growing non-economic value accruing to them as well.
Okay, so let's now put the above spreadsheet into words:
First, and most obviously, the above mentioned Holdco team will aim to build out a portfolio of SMBs adhering to this model. We don't see why this portfolio can't number in the 100s of SMBs over the course of a decade or two.
On to the specifics...in exchange for 2.5% of revenue, paid monthly / quarterly to Holdco, the SMB owner receives an economic equivalent number of shares in Holdco that provide her with direct exposure to a growing portfolio of other highly vetted, high quality, industry diverse SMB revenue streams...an effective "SMB index fund dividend stream", if you will. On a dollar-for-dollar basis, she is indeed "losing" money (i.e. her dividend only equals 72% of the revenue she is contributing, not accounting for taxes), but as briefly touched on above and more below, there are numerous non-economic benefits (i.e. wealth diversification, access to a built-in, engaged peer network, ongoing knowledge-sharing, etc.) that are increasingly valuable over time and otherwise impossible to benefit from without participating in such an "SMB owners' club".
Before we dig deeper into why exactly Ms. SMB owner would be interested in participating in this concept, let us first realize her likely situation (and that of our "target" SMB owner more broadly):
She loves her business & it is a "beautiful" business that many a buyers would covet...but, she isn't interested in selling any time soon, if ever..not even a single share
However, much of her wealth is currently concentrated in this single asset...her beloved, stable, cash machine of an SMB. The small percentage of her total net worth that is liquid is invested in an S&P500 index fund and in local real estate. Now, while she appreciates the idea of diversification into other asset classes, she knows SMBs the best, having built hers from the ground up, and thus would prefer to diversify some of her wealth into other SMBs. She feels comfort in truly understanding what exactly she is investing in. The problem is, she can't moonlight as an SMB PE investor while running her SMB and isn't too keen about a highly concentrated portfolio of maybe a handful of SMB investments in a single geography and of varying levels of quality. Instead an "S&P 500-like index fund" of nation-wide SMBs would be ideal....unfortunately, nothing really exists like this today
Given how laser-focused and busy she has been growing her SMB over the years, she has also never really had the chance to expand her professional network outside of her immediate stakeholders and local community, let alone learn from other successful SMB owners. This is something she increasingly values as her business has scaled, her time is a bit more of her own and her awareness of what she can both share and learn from others is becoming more apparent with time
Well, lucky for her, the Holdco team is building something that checks all of these boxes! Maybe not with 500 "index constituents", but 10, 25, 100 SMB "index constituents" over the course of a few years to a decade and beyond.
So, let's now return to why Ms. SMB owner may be interested in herself joining this "index":
No need to sell any equity nor have any onerous covenants, outside interference, etc.
Increasing wealth diversification within an asset she knows well: high-quality SMBs
Extensive personal & business networking with successful, experienced peers
Revenue royalty has minimal impact on her business' fundamentals / financials
Access to a growing body of SMB "best practices" sourced from across the group
Ongoing Holdco team support (i.e. sales & marketing, IT, recruiting, strategy, etc.)
Opportunity to co-invest with peers in otherwise inaccessible, non-SMB investments
Holdco as a comfortable, logical acquirer of her SMB, should that day ever come
Most certainly there are more benefits we could add here, but I think you get the picture. There is a lot of non-economic upside value / optionality baked into this concept, with a bit of wealth diversification alone being perhaps powerful enough on its own.
Now, will every SMB owner find this opportunity to be of interest or value? No. However, we don't need every SMB owner to feel so. We only need a few core "early adopters" who, quite frankly, help us build this entity early on & act as self-interested, authentic, powerful "super fans". With their support, recruiting other top-quality SMB owners into our "network" should increasingly become a self-reinforcing "fly-wheel" of sorts over time. An "elite club" of top-flight SMB owners who, instead of restricting membership, actively seek to expand it with a strong desire to "invite" only those who have built the best of breed SMBs.
So, at this point, I suspect readers are in one of two buckets. Either the "this is ridiculous, have fun & good luck" group OR the "I'm intrigued, please continue..." group....or maybe the "I stopped reading after the first paragraph, I am not even reading this" group. Well, this next segment is specifically geared for those in the second bucket...
To add another "wildcard" element here...we would add that there is the possibility, though not the requirement, to publicly list this Holdco vehicle. In doing so, this would open up a very attractive economic value-add in support of this concept. Remember, Alaris Royalty and others just like them are publicly listed in Canada, the UK and elsewhere around the globe, so IPO'ing this entity isn't totally far-fetched. Admittedly, though, we are thinking about this idea more so in its execution in Japan, where small IPOs are the norm and frictions within the typical SMB M&A process are more pronounced:
The below "add-on" to our above spreadsheet will hopefully make our point a bit more clear in this regard. Again, this is a highly simplified model, not necessarily a perfect representation of reality:
So, assuming an IPO is viable - and we would argue it is at least possible in Japan - the added economic value to SMB owners in "joining this club" is significant...in this scenario, their publicly traded shares are valued at over 4x the value of their contributed revenue royalties, all the while never having to sell any equity in their "babies". We think this is viable as public market investors today, particularly in Japan, crave yield, growth and an efficient, low-cost way to tap into the otherwise illiquid, difficult-to-access SMB asset class. For example, high margin publicly listed SMB focused M&A brokers in Japan - such as Nihon M&A Center or Strike Company - trade at seemingly unsustainable (though surprisingly sustainable) EBITDA multiples of ~30x to ~50x. Structured as an effective "SMB REIT", we would suspect similar levels of public investor interest (and hopefully similar valuation levels as well).
Let us also not forget some of the benefits for "us" - the investment team managing Holdco:
While there may be some "startup costs", there is no real need for investment capital
Direct exposure to higher quality SMBs, something otherwise difficult to achieve, particularly "at scale"
No need to haggle with SMB owners over business valuation
A more focused, streamlined due diligence process given revenue-focused instrument
Access to a growing network of successful SMB business owners
Potential to outright acquire some of the existing portfolio companies over time
Opportunity to build a large, entirely new, unique, non-zero-sum business
Offer a ton of net-new value to entrepreneurs powering the back-bone of the economy
Since we are hitting short-story level here with this post, let's look to tie things up.
Please remember that this is an unproven concept at the moment. No doubt there are holes, open questions and other aspects we haven't addressed (i.e. taxes, dealing with owners who want to exit / terminate their royalties, etc.). While we more than welcome constructive criticism and pointers about where this idea falls flat on its face, we would just as much love to hear from anyone a bit more optimistic on the approach, who may have some thoughts about how this concept could be tweaked to become more actionable, optimal, etc.