Tech Founders & VCs Investing In "Old Economy" SMBs? A Not So Crazy Idea...
As I believe most can tell by now, I am very bullish on the opportunity to invest in the substantial, relatively overlooked and “untapped” SMB market. As a reminder, I am specifically referring to “micro” SMBs, defined as those with $750k to $3.5M of unencumbered free cash flow (“FCF”) and acquired for 2x to 5x FCF. The purpose of today’s post though is not so much to discuss the "what", “why” or “how” in much detail, but rather more so the “who”.
To begin, let’s set the stage some. When we think about investing in SMBs today, who are the most common investors and how do they typically deploy equity capital into this space (notably, I am not as focused on the individuals executing these SMB investing strategies as I am on those financially backing & supporting said individuals)?
At a high level, I think it is fair to say that institutional investors are almost entirely absent from the "micro" SMB market today (though you could argue they can gain exposure via investing in, say, Constellation Software for example). Instead, those commonly investing in the SMB opportunity set usually have some direct or relevant experience with managing businesses and / or with the general investment strategies employed. So, former or current investment bankers or private equity professionals and experienced business owners / operators generally fit the bill. On a lesser scale, you may have the "doctors, dentists & lawyers", public equities analysts and wealth managers occasionally involved as well, while family offices are perhaps increasingly dabbling in the space. I won't dig into these investor profiles in detail, though I can confidently suggest that a proven, "lower-risk" and smaller-scale SMB investment strategy is most interesting for these groups.
As for the SMB investment strategies these investors often support, the most popular is to acquire a single, higher quality SMB with growth potential, rework the insides to improve margins, drive topline expansion and perhaps pursue some accretive “bolt-on” acquisitions. A common approach used to execute this strategy is the tried-and-true search fund. In other instances, you may find a more informal structure led by an individual who is often seeking to “acquire a job” by way of acquiring an SMB. Lastly, one may also see a more typical private equity fund approach, though these groups are usually focused on companies with FCF above $3M, so not so much in the “micro” SMB space. For each of these strategies, above-average SMBs with some basic growth potential are usually sought, there is a heavy dose of "hands-on" post-acquisition involvement & an ultimate exit is commonly necessary. All in all, the investors backing these approaches are smart and highly capable, while the strategies are proven and work well in many cases.
With that being said, as I’ve touched on in prior posts & quite often in my tweets, I strongly believe that a little creativity can go a long way, particularly in an arena not known for innovation and sparsely populated by more forward-thinking, imaginative talent. More specifically, it is my view that there are other very viable, higher-return, though far less practiced, “micro” SMB investing strategies / structures beyond those touched on above. The one in particular that I’ve previously proposed is, I will argue, most compelling to and better fitting for a different type of investor than those normally investing in "old economy" SMBs: namely, the venture capitalists & successful tech entrepreneurs pushing the frontiers of the "new economy" (worth mentioning, I am not referring to VC or Angel LP/GP investment funds, but rather the personal capital of these individuals).
Ok, so what are some commonly accepted characteristics of & realities for most VCs & successful tech entrepreneurs (i.e. those with real exits) ?
· Most often think “Yes” before concluding “No”
· Are more willing to experiment and to question the status-quo
· A higher risk tolerance, while thinking differently about the role & "shape" of risk
· Seek to bring “new” to the “old” to drive progress & improvement
· Are very supportive of & knowledgeable about the “entrepreneurial journey”
· Adhere to long-term thinking with similar duration investment time horizons
· Their personal wealth is often highly concentrated in the more risky “new economy”
· There are a lot more of them today than ten years ago. This trend will continue.
· Are very informed about how tech is & will change the world, economies & industries. They are "ahead of the curve" in this regard.
Okay, great, got it...but why would technophiles want to invest in boring “old economy” SMBs?
Alright, so let’s get into it then. As you may recall, I’ve suggested in the past that taking a buy-and-indefinitely-hold, ever-growing portfolio approach to acquiring cash-generative SMBs is a very worthwhile, though not widely practiced, strategy to SMB investing. When discussing portfolio size, mind you, I am referring to one that is much more akin to that of a VC than a PE fund - one where the Law of Large Numbers comes into play and where risk is diversified across many "bets", not just a dozen or so. So for our purposes here, let’s compare an average seed stage VC portfolio to that of a low to no-growth, buy-and-forever-hold, cash generative "micro" SMB focused investment portfolio:
In both portfolios, we assume 29 investments, we categorize them by their likely outcome type (i.e. Loss, Save, etc.), the frequency of the investments falling into those buckets and the ultimate actual ROI. Please note, of course, that this isn’t a deeply scientific, precise analysis and I am sure there are ways to tweak the numbers and structure of this approach for the better. However, this is more so meant to illuminate a reality that I believe few have deeply considered.
More specifically, that the relative & absolute returns from investing in “dead-end”, low growth SMBs (structured in the way I propose here with a portfolio like the one above) can, in fact, be not only a superior (& frankly far superior) risk-adjusted long-term investment opportunity (vs. investing in an average portfolio of early stage tech startups, as it relates to VCs & tech entrepreneurs), but also a more fitting, attractive and under-allocated investment strategy for a broader array of investors than perceived today. The key thing to remember here, however, is that it helps to assume a different, more nuanced approach to SMB investing than is most often practiced today - one designed to broaden the definition of an "investable" SMB and structured in a way that takes advantage of the inherent realities of the SMB market (low-growth, few "gems", exits are very hard, individually risky, etc.).
With that said, let’s return to the above charts and point out a few more things:
· The SMB table assumes an unlevered investment thesis. This is almost certainly not to be the case in practice. If we are acquiring established, cash-flowing, stable SMBs, we are either utilizing some form of leverage (i.e perpetual preferred equity) at the time of acquisition or once we’ve reached a certain portfolio size and / or level of diversification, whereby we can assume some portfolio-level leverage. Given such, one has to imagine that the return profile for equity holders in this SMB acquisition entity (not fund) holding this portfolio could arguably be many multiples higher than the currently stated 2.13x
· The returns in the SMB table are not coming through exits of those SMBs - we are holding them indefinitely. I am assuming returns are derived via the FCF each portfolio company will likely generate and am making a relatively modest assessment at that (i.e. 2.5x cost). In practice, excess FCF, from across the portfolio, is to be i) reinvested into further SMB acquisitions, to the extent necessary, ii) used to fund HoldCo operations, iii) distributed to shareholders, or iv) used for other financing activities (i.e. "debt" pay down, share repurchases).
· To remind readers, the SMBs being acquired here are low to no-growth entities, requiring little reinvestment who have been targeted specifically for their durable, consistent and enduring cash flow streams. There is little expectation of incremental post-acquisition upside or growth. We are buying steady, existing cash flow streams in the form of SMBs at very "cheap" prices (i.e. 2.0x to 5.0x FCF).
· The investing time frames of these two portfolios are almost certainly drastically different - I am not accounting for this. A seed stage VC investor will likely invest their entire fund within, say, 3 to 4 years and will look to harvest their investments from years 4 to 10. For the SMB strategy, it will likely take 10 years just to reach the 29 portfolio companies and we won't stop investing (we'll most likely accelerate).
· A further difference worth highlighting is that for the VC portfolio, I am likely deploying a full $50M of capital across all of the investments. For the SMB strategy, depending upon my initial desired growth curve, I may very well only need to deploy $5M in Year 1 to set up operations and acquire the initial portfolio company(ies). I am likely using some form of leverage to help fund ongoing acquisitions, while also increasingly utilizing the portfolio companies' (growing) aggregate FCF to finance the equity portion of additional deals - as such, this is a highly capital efficient holdco growth model where the common equity / early investors are minimally diluted and their returns are increasingly magnified with growing scale.
Alright, so we’ve shown the merit in at least considering "micro" SMBs as a viable, overlooked, potentially very high-return asset class that can be a far more scalable & widely attractive investment opportunity than otherwise perceived.
So, back to the same question, why should we target VCs and successful tech entrepreneurs as backers for this apparently "new" investment concept?
Well, for the following reasons:
· Given the inherent realities of investing in and growing entirely new companies pushing the boundaries of markets often through new business models leveraging new technologies, supporting a creative, “new” and “disruptive” approach to investing in a massive, relatively overlooked market ripe for innovation is a very familiar and attractive "thesis" for them (particularly one that is less risky with arguably just as much, if not more, upside over time than the average early stage tech startup portfolio).
· As much of their income and wealth is & will continue to be presumably tied to more risky, non-cash flowing “new economy” investments, it would be both highly compelling & very prudent to diversify a portion of their personal wealth into steady, proven, cash flowing investments relatively uncorrelated to the vagaries of the tech startup world (+ beyond public equities, real estate, art, etc. as well).
· Their expertise & know-how regarding all things technology and software is an immense value-add when looking to “retrofit” “old economy” SMBs who, in most cases, are seriously lacking in their technological sophistication. This opportunity in and of itself represents a relatively low-hanging, “untapped” source of meaningful "alpha" post-acquisition. Also, they can leverage this know-how to help assess changing "macro" dynamics across industries as technology continues to fundamentally change ways of doing business.
· Relative to more common “later stage” minded SMB investors, who are more apt to back a proven “entity” & strategy, they are very comfortable with investing early in a dedicated entrepreneur(s) & team passionately pursuing a powerful vision that looks to expand the up-until-now accepted "way of doing things".
So, in conclusion, I am suggesting two things:
First, I am further highlighting a thesis previously shared. There exists a compelling "new" approach / strategy to investing in SMBs that is inherently designed for the “micro” SMB market, that is meaningfully different than most current strategies in practice today, that loosely mimics elements of VC portfolio construction and that likely requires a different initial investor mindset. This opportunity is incredibly sizable and offers a potentially extreme upside scenario, on par with top-quintile VC returns, but with a superior risk-adjusted return profile.
Second, the “ideal” early-investor for this strategy is a venture capitalist or a successful tech entrepreneur - more risk-tolerant individuals with existing personal wealth who are eager to back earlier stage endeavors pursuing creative new approaches attacking large markets with interesting upsides.
Before closing out, I do want to stress that I am absolutely not suggesting that individuals outside of this above profile are poor investors, uncreative, or incapable of investing in something like this - that is not at all the case. What you should take from all of the above is that I believe a more creative, entrepreneurial, "VC-like" mindset is optimal when thinking about investing in SMBs in this way. This particular approach is distinctly not an SMB search fund nor a lower middle market private equity fund masquerading as an SMB investment outfit - having investors who understand this fact and, frankly, who are excited by this fact, that is the aim.
I’ll end with this...the biggest returns - in life or investing - often come from a combination of looking where & thinking how others aren’t, connecting the seemingly unrelated dots, having the courage to take educated risks (often), learning how to manage & benefit from failure + ambiguity and, lastly, being passionate about the things that drive you and make you smile.
Questions, critiques & other comments are always welcomed!