How To Grow A Business For The Best Exit – Part Two: Understanding The Buying Universes

This is Part Two in our series, “How To Grow A Business For The Best Exit.” If you haven’t read part one, we suggest you go back and give it a read before proceeding here.

In that piece, we covered why a good company needs systems, regardless of size. However, if a company doesn’t have effective systems, their absence often affords one of the best opportunities to grow the business. That means that sometimes the best deals aren’t well-systematized companies, but companies that offer the potential to support effective systems. 

That led us to our “sweet spot” valuation, where oftentimes the best acquisition targets are companies making between $700,000 and $1.2 million. Under $700,000, you’re usually facing competition from individual buyers, while any company making over $1.2 million is liable to attract the attention of big institutional investors like private equity firms.

It's these types of businesses that can be bought for 3x of its earnings, systematized and grown to over $1 million in EBITDA, and then sold to those same private equity firms for $5 million or more. In order to accomplish that, it's important to understand who the different buyer types are, what their limitations are, and how to avoid competing with them directly for business acquisitions.

The Buying Universes

Generally speaking, there are two different types of business buyers: individuals and financial companies.

These two categories will be your stiffest competition when it comes to closing on an acquisition. 

It’s important that you understand the types of investors and their motivations so that, as a buyer, you can craft a narrative that sets you apart.

The Individual Business Buyer

Individual business buyers are usually financially secure and looking to purchase a company that they can manage themselves. More often than not, individual buyers are leaving their current jobs in order to become their own boss. 

Many of them have experience in sales, marketing, and leadership roles that allows them to be an effective manager. These buyers are usually looking for a business that aligns with their experience and interests, and that is relatively close to their home. 

While individual buyers are usually financially secure, they are often limited by the amount of personal capital they can put up and the amount of risk they’re willing to take. Because of that, they are usually scared off by companies with higher pricetags – specifically, anything above approximately $700,000.

The Financial Buyer

In many cases, financial buyers will be private equity firms. These are large institutional investors that have almost unlimited capital and resources to buy what they want.

However, just because they can snap up any company that’s turning a profit, that doesn’t mean they’re interested in all of them. To understand why, you need to understand how private equity thinks.

How Does Private Equity Think?

Private equity companies are incentivized by two pieces of economic upside. It’s an arrangement known as a 2 and 20. As Divestopedia defines it:

“The 2 and 20 fee structure is the way that most private equity firms are compensated. The 2 represents the 2% annual management fee on capital deployed that is used to pay salaries, cover overheads, and generally ‘keep the lights on.’ The 20 represents the 20% carryover of a certain return threshold that the private equity firm gets to keep.”

The vast majority of private equity firms are more concerned with the 20 percent carryover since that’s where most of their money is made. Often, private equity partnerships will stipulate a return of 8 percent. If the investment delivers returns of 14 percent, the 20 percent carryover takes effect on the additional 6 percent return.
The concept is explained well in this video from 365 Careers:

So, the private equity firm keeps 20 percent of 6 percent – which equals 1.8 percent. When large investments are being managed, this can be a significant amount of money. That’s why many private equity companies won’t think about acquiring a business that can’t guarantee to make at least $1.2 million. It’s simply not worth their time to send in a team of professionals, build out the assets, and turn the business around. It’s too risky.

Simply put, their motivation is to put as much money to work as possible that will bring investors a 20%+ IRR (Internal Rate of Return), which is why they would much rather pay 6x for a highly systematized business.

As we mentioned in Part One, private equity investors simply aren't interested in finding small companies and building them up so that they can grow under their own weight. They would much rather find a business that is already heavily systematized and can be grown through other means. For private equity, it takes the same amount of work to analyze a company's financials and re-do its operations for a company that is making $10 million per year in profit as it does to do the same work for a company that is making $1 million per year in profit.

A $1 million-per-year company is usually valued at 3x because it requires a lot of expertise to run – expertise that big buyers like private equity firms and other institutional investors don’t have and don’t want to spend time (and money) developing.

It also means that for Acquisition Entrepreneurs, flying under their radar – specifically buying a company that makes less than $1.2 million – makes for a better acquisition strategy.

Spending Your Money Wisely

Once you’ve zeroed in on the size of the company you want to buy and you’ve actually made the purchase, it’s time to start investing in growing the company. 

The best way to do this is through Empowered Stewardship, and it relates to the systems we spoke about in the last article. Investing in these systems and the people it will take to implement them is the best investment you can make. A properly systematized business will grow under its own weight.

Investing in these systems and the people it will take to implement them is the best investment you can make.

But be careful, because unexpected costs will crop up if you’re not careful. If you want to implement these systems yourself, you’re going to need to hire a good General Manager to run the company. That person’s salary and benefits alone can approach six figures if they’re talented and capable.

The ultimate goal is to buy a company at 3x of its EBITDA, systematize that company and grow it to the point where it’s attractive to sell to private equity for as much as 7x its EBITDA. 

That’s one exit strategy – another way to make a graceful exit is to grow a company through acquisitions and sell the combined portfolio for even more. The amount you can charge for six businesses that are each earning upwards of $1 million is substantially more than you can charge for one business that is earning $1 million.

Conclusion

We’ll discuss roll-up and tuck-in acquisitions more in next week’s article. For now, if you can think of anyone who would find this article useful, please share it using the links below. Check out Part Three here.

Have you had any experience with competition from private equity buyers? Let us know in the comments.

If you’re just getting started on your acquisition journey, the best place to start is our Acceleration Gauntlet. If you have any questions about the process schedule a call with us today through the form below. Someone will be in touch with you shortly.

Key Takeaways

• Private equity isn’t interested in businesses earning less than $1.2 million.
• Individual investors typically can’t buy businesses earning more than $700,000.
• By targeting the “sweet spot” in between, you will encounter less competition.
• Companies of this size are also primed for systematization.

Team Acquira

Acquira specializes in seamless business succession and acquisition. We guide entrepreneurs in acquiring businesses and investing in their growth and success. Our focus is on creating a lasting, positive impact for owners, employees, and the community through each transition.