• Will

Buying Steady Cash Flows In The Form of Small Businesses

On the topic of small businesses (“SMBs”), I will propose below a way of thinking about acquiring SMBs that I anticipate will get plenty of pushback. I encourage that of course, however, I would also point readers to several multi-billion dollar public companies in existence today who are executing this general strategy with great success. With that disclaimer out of the way, let’s get to it!


As a reminder, we are defining SMBs as those with $500k to $2.5M in “free cash flow”.


To begin, I have outlined below several maxims that underpin this broader thesis of sorts:


General


The Law of Large Numbers is real - the average of a sample tends to approach the expected value as the size of the sample increases: the more bets you make, the more your average outcome looks like the average of the distribution itself


Predictions & future-state assumptions are most often wrong. Minimizing the range of probable future outcomes is a more compelling way to control risk / increase conviction


Populated by humans - complex, emotional beings - most companies, both big & small, old & young, are messy inside. We shouldn’t expect much else in many cases


SMBs


SMBs are small for a reason. Most SMBs should remain small


Growth is expensive & difficult...and downright destructive if achieved unintelligently


A distinct subset of SMBs should be valued not for their potential future growth, but rather for their consistent, reliable streams of steady cash flow 


Obtaining external financing for SMBs is a cumbersome, drawn out, distracting process


While individually risky, a growing portfolio of SMBs can become an increasingly less risky, valuable, differentiated & expanding cash flow stream


A global wave of liquidity-seeking SMBs, numbering in the trillions of dollars, is upon us. Most acquirers, however, are incapable of participating & instead fight over bigger, more richly valued, “needle-moving” deals


M&A


Integrations are hard & fraught with risk, while synergies are often unattained and packed with deleterious second-order side-effects


A significant percentage of investors & businesses ultimately overpay


Next up, a brief, closer look at the private equity industry will be helpful to further set the stage. 


Not surprisingly, a majority of the most lucrative private equity deals that have ever occurred happened during the 1980’s & 1990’s, when competition was less intense and deal sizes were smaller, among other supporting factors. Most every successful deal at that time had the following characteristics: small, cheap & levered.


Bargain Purchases Above All Else


<$200M in size & acquired for less than 7.0x EBITDA 


The chief driver of investment success (and failures) was the purchase price


The cheapest 25% of PE deals accounted for 60% of the industry’s profits


The most expensive 60% of PE deals accounted for 10% of the industry’s profits


High Relative, Low Absolute Leverage on Simple, Cash-Generative Businesses


Debt often equaled >70% of deal financing, though only 2x to 4x EBITDA


Stable, “boring” businesses with proven, consistent cash flows were prized


A significant % of returns came from simple deleveraging


Cost reduction / containment, not growth or operational prowess, drove cash flow & returns


Source: data & insights gleaned from general research and interviews of professionals from Verdad Capital


So, in considering the above, I will suggest a broader investment strategy focused exclusively on SMBs that has the following components & characteristics:


Establish a permanent capital acquisition holding company 


Buy-and-indefinitely-hold a growing portfolio of low to no-growth, cash generative SMBs 


- Acquire SMBs for <5.0x “free cash flow” multiples

- Focus on durability & longevity of existing cash flows

- Deprioritize organic growth & limit portfolio SMB reinvestment 

- Allocate most all excess cash into new acquisitions


Adhere to a highly decentralized & focused portfolio operating strategy 


- Portfolio SMBs remain independent, stand-alone entities

- Focused, though highly minimized post-acquisition activities

i) Free cash flow & working capital optimization

ii) Compensation & incentive structuring

iii) Introduction of value-add technology & software

- Empower & compensate portfolio SMB leaders to drive deal sourcing


Utilize a revenue-linked, high-yield, preferred equity-like instrument to fund growth 


- Non-dilutive, scalable & very business-friendly

- Allows exposure to an otherwise inaccessible, illiquid, differentiated asset class

- More to come in a future post, though, in short, it is successfully in use today


As we look to launch such a vehicle in the U.S. & Japan, for those interested in discussing further, I welcome the chance to chat directly - please don’t hesitate to reach out at will@goldsoutheast.com!


I’ll leave you with a quote from one of my favorite thinkers & investors, Josh Wolfe of Lux Capital:


“The greatest entrepreneurs are risk killers. They think about killing failure paths. They also understand that risk and value can change form. When risk has been killed then value has been created and a subsequent investor should pay a higher price for a percentage ownership interest in a business.”

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