Our RiverStone Reporting team has had the opportunity to help over 25+ searchers over the past two years in diligencing unique family/founder-owned businesses, conduct extensive industry research, structure favorable LOI's, build more institutional investment memorandums and LBO models, dig into KPI's and customer trends, and ultimately close on transactions. Many of these clients we've continued to assist post-closing with monthly reporting, KPI's, value-creation plans, and quarterly board packages to ensure the investment gets off to a strong start (the first 12 months are extremely critical). Our goal is to rollover our compensation (majority of which is completely at-risk) into the searcher's deal and continue to add value post-closing at a fraction of the cost of a full-time CFO or VP of Finance. Our team comes from an institutional investment banking and private equity background deploying over $1.7 billion directly into 100+ small businesses and lower middle market funds since 2018. Through pattern recognition and evaluating over 1,400 small business investment opportunities across all subsectors over the past five years, we work with searchers to ensure they're digging into the right areas during diligence and working towards an efficient and successful closing.
As we've become more involved in the search fund space, attending various ETA conferences, chatting with prospective search clients, exchanging notes with accountants and consultants, discussing industry trends with search investors, and chatting weekly with a handful of current search fund clients, we've seen a great amount of M&A activity (both successes and failures) over the past two years in addition to small buyout private equity deal flow. After reflecting on lower middle market activity in 2023 through Q1 2024, we wanted to lay out 24 key tips for search funds in 2024 - whether you're mid-way through your search, recently launched your fund, or are contemplating a career in the space, we hope you find these tips useful in (i) answering many of the common questions we receive in the space and (ii) mitigating many of the common struggles we see from searchers. Sorry for the long read, but we hope you find these tips and pieces of advice to be helpful during your search. We look forward to assisting more searchers acquire and run niche small businesses in the lower middle market throughout 2024!
Buy a Platform, Not an Add-on We are seeing more and more searchers become 'search fatigued' and become anxious to acquire a business. As a result, many searchers, who had initial investment criteria of $2-5 million of EBITDA, are now digging into companies with $600-700K of EBITDA. Many of these EBITDA figures are highly adjusted with questionable addbacks from a broker. When the searcher adds their salary on top of EBITDA, there is very little room for error if the business were to decline 10-15% during the first 18 months of ownership. Please remain patient - a common theme throughout this post. Once you acquire a business it becomes your life for the next 5-8 years. We want to make sure searchers are acquiring a platform and not just an add-on acquisition - something that is scalable. Accretive tuck-in acquisitions of $300K-700K of EBITDA are great to create additional scale for your base business, but without an existing platform these are too small to truly generate operating leverage. With inflation, growing staffing / labor challenges, supply chain constraints, and expensive debt, there is little room for error in managing costs and margins post-closing. It is critical you understand the 'true' EBITDA of your identified target and ensure it is large enough to scale. There will of course be success stories of searchers buying breakeven companies and we understand self-funded searchers are targeting <$1 million of EBITDA companies, but please be thoughtful in the true EBITDA of the company you are acquiring and if there is enough scale to build upon and accelerate growth. Note - we touch on adjustments and addbacks later. I know there are readers pounding their heads knowing how difficult it is to find a $3-5 million EBITDA business in today's market. If you are open to beginning smaller due to the competitive nature of the market, we highly recommend doing significant upfront work around the potential buy-and-build strategy. If you're able to stitch together 2-3 companies that each have $600K of EBITDA you're likely acquiring nearly $2 million of EBITDA for far cheaper than buying the same earnings outright in an auction process, though you'll need to be up for the challenge around integration. If you're pursuing a buy-and-build strategy, organic growth or same-store growth will be a very important metric throughout your hold period to show the next buyer you're not merely 'stacking EBITDA' and the broader platform is growing.
Sector-Focused Search Many prospective search clients ask us the same question: "should I specialize and only focus on a single industry for my search?". I have a couple of takeaways on this topic that I feel strongly about. In private equity, there are many data points that sector-focused funds outperform generalist funds. It makes sense - investors generate stronger returns investing in companies and industries they know extremely well or specialize in. Back in the 1990's and early 2000's any major private equity fund would have multiple M&A divisions or teams: consumer & retail, healthcare, industrials, business services, special situations / turnarounds, and aerospace & defense. Bring in a new C-suite, implement an ERP system, acquire your top competitor, and flip the investment in five years. Those days are largely behind us. Many private equity spinouts and emerging managers target one industry (i.e. food & beverage fund, healthcare fund, etc.). Another interesting data point on this - one of our search clients was reaching out to any small business with a pretty generic, templated email with little industry focus. She eventually chatted with a female owner in the women's health space and did not move forward with diligence. Separately, our RiverStone Team helps with sourcing, and we happened to connect with the same business owner. I asked the owner about their conversation with the searcher and why it did not seem to be a strong fit. The owner transparently mentioned the searcher had no experience or knowledge of the specific niche within women's health and that the searcher seemed to be open to acquiring 'any' small business. The owner was very willing to transact and sell, however, did not believe their employees (whom they care deeply about) would be in good hands with a young, inexperienced searcher who knew nothing about the segment. Had the searcher done some homework and been able to rattle off (i) total addressable market and growth trends, (ii) recent M&A activity in the space as well as talk knowledgeably about larger strategics in the space, and (iii) be able to relate to the owner and discuss likely challenges around provider staffing, inflation, and supply chain constraints in purchasing healthcare equipment the searcher would've likely resonated with the owner's objectives to sell and gone on to have multiple conversations and potentially even transact. I know searchers are likely pursuing all sorts of niches and subsectors which is great, but please come across as a sector-focused / targeted searcher to the business owner and show you are passionate and have done your homework. Your conversation will go much further. The takeaway: we recommend searchers pick 3-4 subsectors that they are interested in (i.e. 3PL logistics, physical therapy, commercial roofing). This way, you can identify and pursue a blanket of targets within one niche and your industry research and data points can be leveraged across multiple conversations.
If a Lender Can't Underwrite Putting Debt on a Business, Maybe You Shouldn't Put Equity on it Either There are good companies to run and then there are good companies to buy. Many searchers have come to us with a unique, niche opportunity to acquire a small business in an obscure field. The kicker always goes something like this: "I'm really excited about this opportunity and the owner likes me; however, lenders are not comfortable providing debt on the business. Should I dig in further?". We get this question from searchers monthly. Our belief is if a lender is not willing to put debt on a business you shouldn't put equity on the business and buy it. While search transactions are very small and leverage is not the main driver of returns, lenders come from a very conservative viewpoint. However, if a business is cyclical, seasonal, generates little to no margins, has choppy financial performance, or operates in an incredibly niche sector that demonstrates uncertainty and lack of pattern recognition, our viewpoint is life is too short. For example, many searchers, independent sponsors, and family offices have bought an HVAC business over the past decade - these companies are easy to understand and underwrite, fairly recession-resistant, and incredibly easy to receive debt reads from lenders. Say you're looking at a contract manufacturer that produces holiday decorations and products. The business is pretty niche, and you'll likely encounter significant seasonality with little cash generation during the first half of the year and strong performance during the second half of the year. This dynamic can make it very difficult to properly manage cash over a 12-month period as well as meet interest payments and debt covenants if the business generates little to no revenue for a period of time. While we encourage searchers to construct a niche thematic sourcing approach in buying a differentiated business (not every transaction needs to be an HVAC or MedSpa business), debt is an important element of the cap table (and returns). If a lender can't provide you with a conservative debt read (1.5-3.0x leverage) we recommend moving on. If you are deploying a buy-and-build strategy, we also encourage searchers to minimize the debt utilized upfront and as the business scales and performs in the right direction, layer in incremental debt over time to create a flexible, conservative capital structure.
Always Ask for the Latest Monthly or LTM Financials It is surprising the number of searchers who forget to ask for the latest monthly financials when trying to close a transaction. You sign an LOI and the seller is slow to reply with diligence requests. All of a sudden three months have gone by and you're looking to close in three weeks. You should always ask the owner / broker for the latest monthly financials, understanding that there is likely as ~30-day lag in reporting. Again, many sophisticated investment banks would show searchers the latest LTM trends and higher EBITDA figure to push for a higher valuation for their client. That is not the case in the micro-PE end of the market. Say you're buying a business for a $10 million enterprise value or a 5x valuation based on $2 million of LTM EBITDA. Three months have passed, and you are finally making progress on third-party diligence streams and looking to close at month-end. You request P&L's for the past three months and realize that LTM EBITDA has increased to $2.3 million - you're now really buying the business for 4.3x. In addition, the slight increase in EBITDA could mean the lender is open to providing more debt at closing thus minimizing your equity need upfront. On the flipside, say EBITDA declined to $1.7 million - you may want to discuss the recent financial decline with the owner and potentially look to negotiate a small purchase price reduction or shift a portion of cash proceeds to an earnout if the trend continues. In general, real-time financial performance is important to assess the current trajectory of the business, regardless of if it may or may not impact your valuation.
LinkedIn is Fun, But Not Reality I love how collaborative the search community is through Searchfunder, conferences, LinkedIn, clubs, and the openness to network. LinkedIn has become a hotspot to share successes, closed deals, new customer wins, and positive news. But what is also refreshing are the quiet conversations behind closed doors and 1-on-1 calls with our search clients. For example, we're engaged with a highly impressive female searcher from a blue-chip university who acquired a declining healthcare business three years ago and the company was too difficult of a turnaround. She ultimately had to walk away from the business and is now launching search #2 after spinning wheels on a difficult prior transaction (although great learnings). Another duo-HBS self-funded search team was about to acquire a $4 million EBITDA business in the home services segment for <4x EBITDA and three weeks before closing the deal fell apart due to the cash to accrual conversion and accounting principles regarding overstating the completion of projects, hence inflating EBITDA. All of the work the past five months is down the tubes and completely back to square one to network with business owners and source a new platform. While there are great learnings in dead deals, diligence can be time consuming. We had been in conversations with another traditional searcher (many familiar search investors on cap table) for six months about potentially assisting with diligence. After recently checking in, the searcher notified us that they have shut down their search and moved on to another career path. For every 'success' search story posted on LinkedIn there are bound to be multiples of searchers struggling on the other side of the spectrum. Do not be discouraged if you see posts of others' success in the space - usually the 'failures' and 'struggles' remain hidden and believe me there are dozens of other searchers in the exact same boat as you. We applaud the success so many searchers and investors have found in the space, but it's important to be reminded that not every searcher will successfully close a deal and not every closed deal generates a 5.0x cash-on-cash return. Hang in there read one of our later tips - remain patient.
Only Work with Motivated Sellers We are seeing many searchers proprietarily source interesting leads for high-quality businesses, however, the owner appears they are not ready to sell. The Company is growing, the transaction has few EBITDA adjustments, the business continues to win new customers and has been operational for 30+ years (time-tested and recession-resistant). It checks all of the boxes. Except one. If an owner is truly not interested in a transaction or has extremely high valuation expectations, feel free to maintain an open dialogue with the owner every quarter, but move on. The owner is likely fishing for valuation guidance to understand how their business is currently perceived in the marketplace, but has no intention to sell today. We've seen searchers get sucked into diligencing companies that are not for sale and it will utilize a significant amount of your time. RiverStone assists all sorts of healthcare CEOs with financial reporting and KPI metrics. There were business owners back in 2021 that seemed as though they were ready to retire and finally sell their company. We've stayed in touch with the owner or conducted light reporting work with the business over the past three years to strengthen the relationship. Finally, in February 2024, the owner of a $3 million EBITDA business has expressed an interest in selling their business, which we've introduced to one of our search clients after being ghosted for 3.5+ years. The takeaway is despite your salesy tactics and prestigious logos on your resume, you may not be able to convince the owner that now is the right time to sell. In this particular example, it took the business owner 3.5 years to ultimately come to the conclusion that 'now' is the right time for liquidity and taking a step back. We encourage searchers to have a rating system to track their deal flow. Have a separate tab / section for unmotivated sellers and set reminders to check back in with them every 4-6 months to stay top of mind, but don't force continued conversations if the owner is clearly not ready. We don't encourage spending any more time on these targets until you have clarity that the seller is ready to have a more formal discussion around a transaction.
Deals Fall Apart. Your Pipeline of Opportunities Should Not I'm starting to see this situation more and more. A searcher is feeling lukewarm about an opportunity, but their investors encourage them to submit an LOI. A week later the local broker responds that the owner is excited to move forward, and you've just signed into 90-day exclusivity. You've done it. You're about to acquire a business and become an operator, ending the long and tedious search process. Many searchers completely discontinue conversations with other business owners in their pipeline, stop new lead generation, and focus 100% of their efforts on the business under LOI. We always recommend our searchers continue a 'light touch' model of lead generation even when they have a deal under LOI (at least initially). We are seeing more and more dead deals and dead ends with sellers getting cold feet, valuation expectations being too high, inability to agree on a re-negotiated valuation due to recent business trends, or QoE findings coming back negatively. Deals fall apart. We've all heard the metrics at a search conference that states the average searcher will sign 3 LOI's before ultimately successfully acquiring a small business. While your LOI will tell the owner you are looking to close in 90 days the average LOI period is over 5 months. Chances are your first LOI will not be your last (despite your confidence). Keep this in mind - if you have 90 days of exclusivity we recommend still searching for new opportunities and generating new leads during the first half of this exclusivity period. Chances are the financial trajectory / profile of the target could shift somewhat materially during a 4-5 month span under LOI. You never know when a good deal will blow up. Once you are in the final 30 days to closing you should then focus 100% of your time on the transaction ensuring legal, accounting, tax, insurance / benefits and other third-party workstreams are all checking out in addition to continuing to build a strong relationship with the seller. You should be highly in the weeds on reps & warranty insurance, the net working capital peg, and tax structuring in the final innings before closing. In the event your deal falls apart, you will still have gained strong reps / experience in buying a business and learnings for a future diligence process. While it wasn't a complete waste of time, you are likely going back to ground zero. It is important to keep other leads or helpful business brokers close to home so you can act on another business immediately and avoid starting completely from scratch. Do not let your pipeline of near-term opportunities dry up just because you're under LOI with a business. Deals will die, but your pipeline of opportunities should not.
Preserve Cash and Monitor Debt Covenants We've all heard 'cash is king' but what does that really mean when you're operating a business? This tip is particularly important with where interest rates are today. A couple of years ago if you acquired a small business you may have received terms of SOFR + 500. This equated to about 7.5% all-in. Say the company generates $4 million of LTM EBITDA and you utilized a $10 million loan (2.5x leverage) to acquire the company. You'll be paying $750K of annual interest expense. I always recommend searchers evaluate their fixed charge coverage ratio and ability to meet amortization and interest payments. With the debt market scare during 2022, that same loan is now likely SOFR + 650. The issue is not only is the lender proposal more expensive, but interest rates have doubled. That same offer will now cost you approximately 11.5% per annum, increasing your annual interest expense by $400K to $1.15 million. This is a significant reduction in cash for the business, reducing your ability to re-invest into the team and operations. RiverStone works with searchers to evaluate both levered and unlevered free cash flow. A friendly reminder that EBITDA does not equal cash. You must diligence a company's net working capital, tax structure, and maintenance / growth capital expenditures as well as understand its amortization and interest payments per year. We always recommend funding a small portion of cash to the balance sheet at closing so you are not too tight on payroll, SG&A expenses and near-term capital expenditures for the first couple of months of ownership.
Remain Patient We've engaged with some searchers who are 9-15 months into their search and seem to be losing steam or becoming anxious. The quality of CIMs and poorly constructed broker teasers may seem to be declining, however, the searcher may be more willing to dig into a low-quality pipeline because they've been at their search for over a year. Stay disciplined and patient. You will be better off spending 18 months during your search to buy one high-quality business than 5 months to buy one low-quality business and will thank yourself years down the road. It can be especially hard to spend months on a single deal, build the relationship with the seller and have ongoing conversations with investors and lenders only for the deal to fall apart. It is okay to pivot and deep-dive into a completely new sector or business. In some ways, digging into a completely new sector creates a fresh start and new energy. Convincing an owner to sell will likely take multiple discussions or a period of 'ghosting' before they determine you are the right buyer and now is the right time. Remain patient.
Network with Individuals that Complement Your Skillset and Experiences The search space is highly collaborative. I love it. The search network is incredibly powerful and open / transparent compared to most subsectors and searchers want to help searchers. One piece of advice - find experienced help and mentors or advisors that complement your skillset and background. One of the biggest drawbacks of the search model is giving a 25-35-year-old $15 million of capital to buy a business. What does a searcher with no operational experience and likely little to no experience navigating an economic recession know better than the current CEO of a business, who is likely 55-65 years old and run their company in a specific industry for 20-30 years? It's a crazy idea and energy can only get you so far. Industry-specific experience is incredibly important and running a business day-to-day is different than investing in companies or providing accounting or legal advice. We always recommend our searchers find outside perspectives. Be best friends with retired operators who have previously run multiple companies and lived through both successes and failures. At RiverStone, we believe in the 'power of 10' and typically partner with other operators who are 10 years older and 10 years younger. One of our revenue cycle management deals back in 2020 was a combination of operating partners aged 28, 38, and 48 (actually happened to be exactly 10 years apart). Different generations bring valuable different perspectives and experienced advisors can ensure you're not missing something during diligence. It's great most searchers have built vast networks with MBA classmates and fellow searchers, but look to network outside of the box and even outside of the search space. There are many former board members and operating partners who have retired from private equity, but would be happy to chat with you for 30 minutes. Take them up on it.
EBITDA Adjustments are Not Cash Flow We can't stress this enough. EBITDA adjustments are adjustments - many of these do not correspond directly into cash flows or may take 6-12 months to actually convert into meaningful cash to the company. A typical rule of thumb with lenders or credit firms in private equity is adjustments should not make up more than 20-25% of EBITDA. This figure can vary greatly by type of business, situation, and industry, however, there are search deals I've seen where 85-95% of the EBITDA is strictly based on adjustments. Shareholder distributions or excess CEO compensation is the best addback as it means the owner is taking home cash. I've seen healthcare companies try to get credit for adding back a practice management software (PMS) system, despite knowing the PMS is critical to day-to-day operations and the cost is not going away (may in fact increase) post-closing. Work with your investors, advisors, and QoE provider to really dig into what a normalized EBITDA looks like and be wary of too many addbacks. If your EBITDA is full of adjustments, you may be better off looking for the next opportunity.
Ask for Historical Financials Pre-Pandemic Many operating companies have been around for 30-80+ years. Unless you're acquiring a recently founded high-flying tech or software business, there is so much to learn from past financial performance during downturns. It is shocking the number of deals I see marketed with financials only going back the past 1-2 years. The two main categories we suggest our searchers request from the owner or broker are financials during the global financial crisis (GFC) and financials pre-COVID. Financials from 2007-2011 when a business operated during the GFC can provide valuable insights into client churn, pricing power, operational inefficiencies, the strength in management (if still active in the business), and cyclical characteristics of the end market. The business' profile and size has likely changed over the past 15 years, but it can be incredibly insightful to evaluate actual company performance during an economic downturn. On a more recent note, most brokers or investment banks only show historical financials going back to 2020 or 2021. It is very helpful to evaluate 2018-2019 financials vs. today to see how the business' revenue and margin profile has shifted pre-pandemic to today. It's easy to accept 'no' for an answer from a lazy broker, but we push searchers to gain additional visibility into the last 5-10 years of financial performance (even just revenue) to validate the company's growth trajectory and stability during various economic cycles.
Who Will Buy Your Business in 5 Years? A common question private equity firms ask themselves is who will buy their portfolio company in five years and work backwards. Will a middle market PE firm pay-up for the asset to bolt on to an existing platform or expand geographies? Will a strategic pay a market-clearing price for a must-have asset or blue-chip customer base? Some niche company types that may be difficult to find a future buyer include FedEx routes, construction businesses, asset-heavy companies, restaurants, and anything you'll find on 'Shark Tank'. Start-ups and creative entrepreneurs are great, but we typically advise our searchers to go find the boring family/founder-owned business that has been around for 20-30+ years and throws off cash vs. the new shiny object founded during COVID with little operating history. You want to acquire a business that will be garnering attention from private equity firms and receiving inbound interest after 12 months of ownership. Longevity is very important - buy a business that will continue to be around and garner interest from sophisticated capital. Be thoughtful in the subsectors you pursue and always ask yourself who would buy this company in five years?
We Hate 'SDE' Our team had not heard of the term 'seller discretionary earnings' until the search space. SDE is essentially net income or EBITDA plus adding back the owner's salary to show the seller's total take-home pay. Many broker listings and small, unsophisticated bankers will utilize SDE as the earnings figure that searchers and independent sponsors should bid on. The issue is that 99% of the time SDE adds back the full amount of the current owners' compensation. Let's say a small business generated $700K of total earnings in 2023, which includes the current owner's salary of $250K. You, the searcher, are planning to submit an LOI of 4x based on the $700K of SDE presented by the broker. However, you forgot that this figure includes 100% of the owner's standard annual compensation. You plan to pay yourself a $200K salary post-closing as CEO. Your prior 4x offer means your $2.8 million enterprise value is really overpaying by $800K. Or said differently, if true earnings are actually $500K after being fully burdened by your salary, you're actually paying a 5.6x valuation on a $2.8 million enterprise value. Adding back owner or shareholder distributions is completely different and fair game as those distributions will now be retained in the business going forward and become a true addback. Adding back an owner's salary is not an adjustment. Sophisticated private equity firms will view these transactions much differently / more aggressively and actually further reduce EBITDA saying, 'you haven't invested into proper infrastructure and we'll be forced to hire on a COO and Controller to bolster the team which will reduce go-forward earnings'. Do not be tricked into adding back an owner's salary if you plan on taking a salary yourself.
Be Selective with your Cap Table and Board I'm encountering more and more searchers where the limited partners on the cap table all are very similar in terms of expertise, consulting, industry backgrounds and value-add. Try to build a diverse cap table or board of directors - it's always helpful to receive capital and help across a wide array of experiences including traditional operators / CEO's, prior searchers, former private equity / investment banking professionals, accounting / CPA advisors, legal / tax advisors, and software / tech professionals. There are some excellent value-additive search investors out there - find them. Just because someone previously was successful with one search 10 years ago does not mean they're an ideal candidate for your cap table or has maintained an in-depth understanding of current private equity trends. Do your own homework and assemble an A-team with a diverse skillset. It will serve you well not only during diligence but post-closing. The more momentum and connections you build during your search, the greater ability you'll have to be selective in who you partner with on your multi-year journey. Private equity leans heavily on boards and operating partners to drive industry-specific expertise, value-creation plans, customer introductions, and ultimately shareholder value. While you may not have the budget or network to recruit former CEOs of Fortune 500 companies or massive CPG brands, it is important to leverage board members who have an outside, fresh, and unbiased perspective.
Make Sure Your Business has a Moat One of the most important questions we ask in private equity is 'does the business have a reason to exist?'. Will it be around tomorrow? In 10 years? The company's differentiation or competitive moat is extremely important. Focus your search efforts on buying a long-lasting business with a moat, whether it be IP-driven, high capex upfront, sticky customer relationships, or pricing power, you want barriers to entry that another business can't replicate overnight. Each sector will have its own barriers which are important to identify and examine during diligence and conversations with the seller. We work with searchers on competitive landscape benchmarking to ensure your company is well-positioned for sustainable growth. Identifying moats for companies that have been around for decades is much easier than the high-risk, high-flying new start-up founded in 2019.
Be Persistent It's hard. You just tee'd up 500 emails to send out, 100 bounced back, and 390 did not reply. Stay on top of the 10 proprietary leads / responses you did generate and be persistent (but not annoying) in sending 1-2 follow-ups to owners that responded. You'd be surprised at the number of business owners who were on vacation or too busy to respond, but see the second email two months later and are willing to hop on an intro call. RiverStone is becoming more involved in sourcing and believe me when we say we understand how daunting it can be to send out hundreds of emails without a response. Sourcing is the hardest part of the job and it is becoming increasingly competitive. This ties back to our prior tip around sector specialization. The more you can position yourself to be a sector expert and the perfect match to acquire a business from an owner the better as it will help to separate you from the competition. I'm increasingly seeing mini brokered deals and even some proprietary deals where our searcher is told that the owner is contemplating 2-3 other offers including engagement from an independent sponsor (unfunded private equity firms) and other search funds. Be persistent, persuasive, and stand out. It only takes one email response to change the trajectory of your search.
Self-Funded Searchers: Understand the Terms with Your Investors I'm increasingly seeing self-funded searchers raise capital at pretty poor terms or not fully understanding the terms they are agreeing to with investors. I always encourage self-funded searchers to raise capital from friends and family, prior colleagues, and professionals within their network first prior to sourcing outside capital. Most self-funded search deals are largely funded through SBA loans, seller rollover and seller notes, leaving the required equity to be fairly minimal. Many self-funded investors in the space have extremely high hurdle rates and preferred equity terms with kickers. Some of these terms can result in the investor requiring a search to achieve a minimum of 2.0-3.0x MOIC prior to the searcher having a split in the equity waterfall, which is fairly egregious compared to a private equity's standard 8% preferred return. The quick math in private equity is an 8% compounded minimum return threshold equates to approximately a 1.5x MOIC hurdle - anything above this amount and the private equity firm will take 20% carry and share in the upside. If your hurdle is 2.5-3.0x MOIC this means you could achieve a fairly decent outcome and still not make any promote or carry, providing the investor with huge downside protection. I understand some self-funded searchers may become desperate to raise capital or want to close a transaction, but please be mindful what kind of terms you are signing up for and how it impacts your returns in different scenarios. Many times, business owners do not understand preferred vs. common equity and PIK interest or preferred hurdle rates and as the searcher who will be full-time in the business as CEO for the next 5+ years you must understand what you're signing up for. If you are comfortable taking on unfavorable terms or limiting your upside in order to close a deal then go for it, but do your diligence first and know what you're getting into.
Be Scrappy with Off-List Reference Calls Some searchers do an outstanding job with off-list cold calls whether it be regarding competitors, potential large customers, new client wins, the current CEO or its key employees, and better understanding a sector or business. While you need to be careful not to poke around too much, some searchers dig up very insightful information regarding a company or an industry through off-list networking. Whether you're trying to get comfortable with an investor, a new C-suite hire, customer concentration, or competitive landscape, I advise searchers to be scrappy. You'll often be handed a list of references who have already been educated to read a script and say positive things about the person or company of interest, however, chatting with off-list references is where you'll find the real story whether it be a new entrant that is disrupting the market or a large customer that is unhappy and may bring production in-house vs. outsource. Be scrappy - it will pay off and provide you with valuable insights.
Don't 'Just Submit an LOI' I'm hearing this more and more. A searcher isn't thrilled about a business but their network, whether a large investor on their cap table, friend or family member, mentor, or fellow searcher, is trying to convince you to 'just submit an LOI'. "It can't hurt". Reasons could be to get light experience with the LOI submission / diligence process or 'toss in a high valuation which you can always re-trade closer to closing'. Business owners don't want to be toyed with. Most searchers have two years to buy a business. Why waste the next three months digging into a company if you aren't excited about the growth prospects. One of the most difficult parts of the search journey is understanding where to allocate your time and what to dig into. You may generate 20-30 leads per month through CIMs / teasers and proprietary calls with owners, but you can't possibly dig in-depth into every opportunity. Be smart with where you allocate your time and only submit LOI's on companies you are serious about acquiring. I've never been a fan of submitting a high valuation with the intent to re-trade in the ninth inning before closing and you don't want to gain the reputation similar to certain PE firms that are known for fishing around for information and re-trading at the last minute. Not to mention it isn't a good use of your capital or resources. Find a business you like and run at it hard - leave the others on the wayside.
Not Every Lead Needs to be Proprietary As M&A becomes significantly more efficient, generating a truly proprietary transaction can be very challenging. With that being said, there are many business owners that are 'represented' by unsophisticated brokers, lawyers, consultants, family friends, and mini listing brokers. It is difficult to reach out to a stranger and acquire their business in four months. It is much easier to jump into a mini brokered process and build a relationship with a willing seller who is already looking to retire or sell. Many of these mini auction processes are not like a traditional investment bank and you can still gain access to management, spend time with the owner, and acquire companies for compelling valuations. Limited auctions through unsophisticated brokers can be a great way to generate high-quality deal flow - we encourage searchers to find a unique angle to become the preferred buyer and build a direct relationship with the seller, who will ultimately select the buyer.
Forgivable Earnouts Are Great (but Probably Not Market) I had not heard of a 'forgivable' earnout until digging into the search world. Private equity leverages earnouts to award owners for upside performance or beating budget over the next 12 months. By comparison, most searchers have sellers provide a seller note that is forgivable if the business' performance declines by a specific metric during a period of time. For example, the seller may provide a $5.0 million note that generates 8% cash interest paid quarterly with a balloon payment owed in year four. The searcher may structure the note where if the company's revenue declines by 15% from the threshold at closing at any time during the hold period, the note is 'forgiven' and the searcher will not need to pay the remaining balance to the owner. It's amazing downside protection, but in my viewpoint not market. I think it is difficult to get an owner to be willing to take on operational risk in year three or four of your investment period when they're no longer in the business. Why should a seller be penalized if the searcher is inefficiently running the company or lost a major customer? I always tell searchers to attempt a forgivable earnout structure, but that it is a fairly aggressive ask. I'm typically moreso focused on cash preservation and the ability to potentially reduce the seller note interest rate, maturity / balloon payment date, or convert the rate from cash interest to PIK interest. In summary, I'd say a forgivable earnout is a nice to have, but not a need to have. If revenue has declined by 20%+ in your business, you likely have far greater problems with the cost structure and operations and more to worry about than paying off the seller note.
Alignment of Interest is So Important People act based on incentives. You see it all of the time whether at a private equity firm or on a C-suite management team. Always keep incentives and alignment of interest in-mind when structuring a deal. 'Earnouts' can be very love-hate. On one hand, earnouts can push a team to perform and achieve new heights or thresholds and create operational momentum. On the other hand, if structured poorly, earnouts can be detrimental to the long-term health of your business. Owners may look to 'stuff' revenue or new customer wins in the current year's budget vs. next year to ensure they achieve certain thresholds and lock in a big payday. I've never been a fan of earnouts based on revenue as the owner could sacrifice pricing / margins in order to win new business and achieve the earnout, which does not make the company better off. An entirely different end of the spectrum regarding alignment of interest is within physician practice management (PPM) roll-ups in healthcare. If you're buying an oral surgery business from a lead dentist who is making $1 million per year operating the company as-is, the alignment of interest is going to be difficult to achieve post-closing. The owner will receive a large pay day at close, their motivation is likely to decline, yet they're clinically involved and a big part of the business' production, patient volumes, and brand / reputation. Acquiring a business where the owner is vital to operations creates misalignment. They will likely be less motivated post-closing due to their big pay day and want to move on to another company / role or demand more compensation for sticking around as they know how important they may be to operations. Always think through alignment of interest with the seller, even if there is meaningful rollover or a seller note. The more alignment, the more the entire team is working towards a common goal, which will drive success.
Post-Close 12-Month Performance is Critical There are all sorts of metrics that a Company's ability to get off to a strong start during the first year of ownership leads to strong returns for investors. Companies that are slower out of the gates or run into issues, whether operational challenges, a lost customer, or labor constraints, become much harder to turn back into growing companies (businesses typically stay in motion). Turnarounds are much harder than a searcher may realize. You want to ensure your first 12 months is focused on growth, rather than mitigating operational challenges, negotiating with lenders, and potentially injecting additional capital via an equity cure. A difficult first year can allow for problems to snowball leading to longer hold periods, more equity, and a lower IRR. When RiverStone works with searchers throughout diligence, the bulk of the investment memorandum becomes the backbone of the 100-day value creation plan - we want you to hit the ground running post-closing. We always encourage searchers to be one step ahead so once you have officially closed your transaction, you're off to the races to accelerate growth. Monthly financial reporting, visibility into performance with top customers, and tracking key performance indicators is extremely important to have real-time insights into the business' financial well-being. We always encourage searchers to leverage the majority of the work completed post-LOI as a base for a first 100-days as you look to familiarize yourself with the business, its customer base, and its employees.
Bonus Tip: Think Outside of the Box Thematic sourcing can be very tricky. You are trying to thread the needle in acquiring a small business at an attractive valuation while simultaneously getting both investors and lenders comfortable with the operating model and structure as well as convincing a business owner to sell. This can be a lot. You don't need to buy an HVAC, roofing, or MedSpa business just because everyone else is showing interest in a subsector. Be willing to think outside of the box and evaluate niche sectors where nobody else is looking. Focus on companies that meet your investment criteria - if your investors expect recurring revenue then stick to the plan. If you want a business with at least $2 million of EBITDA don't stretch for the smaller $600K EBITDA company, despite the cheap valuation. But if your investment criteria boxes are checked be creative with your own search as it is not 'one size fits all' and you will eventually be the one to run the day-to-day operations.
We hope you found these search tips to be relevant and helpful as you pursue acquiring a small business! If you believe you could benefit from private equity consulting and hands-on advisory during diligence please feel free to reach out to our RiverStone Team: Eric@RiverStoneReporting.com. We assist both self-funded and traditional search funds with conducting industry research, evaluating broker CIMs / teasers, structuring favorable LOI's, constructing more institutional, neatly formatted investment memorandums, evaluating customer cohort and retention trends, digging into company and industry-specific KPI's, and building LBO models (with upside, downside, and base case scenarios). We often rollover nearly 100% of our compensation (which is largely at-risk and only paid out if a deal successfully closes) into your transaction and will continue to assist searchers post-closing with monthly financial reporting, quarterly customer and KPI dashboards / metrics, 100-day value-creation plans, and quarterly board packages. We are always happy to provide references of other searchers and independent sponsors we've assisted historically. As noted in our tips above, alignment of interest is everything and we always look to be aligned with our search clients. Onwards and upwards in 2024!
- Eric
RiverStone Reporting
Willing to Work Harder