Company Profile

Company Profile

Searchers often make the mistake of searching for a “great” business. The search model would classify a great business as one with 3 years of expanding profits, recurring revenues, a simple business model, low customer concentration, defensible market position, differentiated products or services, minimal capital expenditure requirements, low seasonality, little government regulation and a sound management team.

You don’t want acquire a “great” business. You will have to pay a premium for a great business and will have little opportunity to improve it. Instead, your search sweet spot should be a “not-so-great” or “good” business that you can purchase at a “great” price, and then transform into a “great” one.

In the search process, time is working against you. Later, when you own the business, time is on your side. You and your investors can work on a longer-term plan to improve, re-position and enhance the business. It does not have to be “great” at the start.

Search for a “great” foundation.

Tyler Hogan and Mike Donovan at East Range Partners found an HVAC installation and service business that was earning 10 margin points higher than the rest of their competition. They discovered a robust back office system for tracking installers and dispatching them efficiently. The owner had negotiated favorable supply contracts with vendors. Several years earlier, the owner had assessed the profitability of their customer base and made a strategic decision to focus exclusively on commercial customers, exiting its residential business entirely. This shift resulted in margin improvement, reduced SG&A ratios and EBITDA growth. The owner, in his 40’s, wanted to exit for a multiple that was more than 2 turns higher than industry comps. Tyler and Mike wondered if the business was worth the premium.

When profits are higher than industry average, the challenge is to understand whether they are sustainable. The “magic” that the owner brings to the table cannot be overestimated, or easily replicated when he or she leaves. These two searchers concluded that they would be overpaying for a business that did not have much headroom for improvement in the event of any “surprises” after closing. Instead, they focused on similar businesses in the same industry vertical that had not yet transformed their business model. Their new-found learning helped them focus on better search targets.

A Private Equity or a synergistic buyer can justified buying the “great” business by extracting savings from duplicated functions or by bringing in a seasoned CEO to maintain the “great” results. A searcher, with a portfolio of one, cannot afford to match this level of competition since there will be no efficiencies or current operation to merge into. Passing on these opportunities quickly and early saves precious search time.

Where to find a good business.

Your search process will naturally yield a number of “great” businesses. Often times, they are represented by strong and competent brokers who are able to hold an auction process to satisfy the seller’s price expectations. Since a searcher cannot afford overpay for a business, the searcher should use these auctions as an opportunity to dig deeper into the industry.

The “not-so-great” businesses aren’t likely to be found in an auction. Their owners generally don’t go to conventions or industry events; their investment in self-promotion may have waned in recent years. Perhaps their website is antiquated and needs updating. While their industry verticals may be growing, their growth lags the industry.

Sub-par profitability should not disqualify a target. In many instances, neglected businesses exhibit excessive SG&A costs that may represent long-run opportunities for EBITDA margin improvement.

Casting a wide net to locate these types of prospects is critical in the search process. Digging deeper into lists of companies and scouring for the competitors of competitors in an industry will yield these gems. Locate old directories of companies in the industry to find those faded businesses in need of an overhaul. These situations are not to be confused with turnarounds, which have a history negative EBITDA.

Examine systems and operations.

Your first instinct may be to value a “not-so-great” business based on the financial statements. That may not be possible. Poor accounting systems and the inability to provide timely and actionable financial information is frequently a challenge for a business owner. Sellers will often be told by their brokers/advisors to “clean up the books” in preparation for sale. In many instances, however, this is not done and can present another opportunity for improvement once you own the business.

During accounting due diligence, your professional advisors will be able to point out how to improve these systems. Inexpensive, web-based financial systems can replace antiquated paper-and-spreadsheet systems to make quick improvements in visibility and reporting. Oftentimes, industry-specific systems are available and well used by the “great” businesses in the industry, and can be quickly implemented after closing.

Pay attention to the people in the business.

Estimating the value and risks of a “not-so-great” business hinges quite a bit on its human capital. Many small private companies spend very little on developing systems to develop and retain their employees. Many don’t have an employee handbook for consistent and fair treatment of employees. Systems may be weak or non-existent — for setting base pay, establishing regular performance reviews, or addressing consistency in pay and benefits.

Rather than let these weaknesses scare you away from the business, learn to identify them as opportunities for improvement. These poor practices are relatively simple to rectify and have a strong impact on employee retention and morale. Abandoning the secrecy and mistrust between management and employees can also can have a substantial impact.

Determining where the employees come from is important. Relatives and family members may pose problems and should be investigated thoroughly for competency issues. On the flip-side, a pattern of hiring from a specific ethnic group might indicate an excellent talent pipe-line.

Establishing benchmark recruitment practices will improve the caliber of the employees in the business you acquire. There are plenty of inexpensive HR consultants to help you overhaul these systems.

Evaluate opportunities to improve prices.

Pricing products appropriately is one of a business owner’s more crucial responsibilities. Some excel at it while others often neglect this opportunity for immediate margin improvement. Asking simple questions such as, “When was the last time you raised prices?” and “Who sets the prices?” are very revealing. The more removed the seller is from these fundamental pricing policies, the better your opportunity for post-sale margin improvement.

Business owners are in a unique position to ask for more price simply by being able to commit the resources of their own company to the customer as part of the value proposition. Once you own the business, you will be able to command this “ownership premium”.

Bad businesses rarely get much better.

Beware the long-neglected or unprofitable businesses. A recent loss of major customers, declining revenue growth, commoditization of product lines, and/or margin erosion are early warning signs. Sellers will often claim a difficult past few years and promise a turnaround.

Run away quickly when the red flags are waving. The skill set required to bring a bad business back to profitability and viability is beyond the capability of most searchers. Investors and bankers are also skeptical of pouring good money after bad in these situations. Let the owner turnaround their own business, not you!

Be open to a variety of businesses.

Your search will expose you to businesses that you never imagined existed. While many will bypass these businesses as too limited or niche focused, they may sell at a discount and represent unique opportunities. Despite the general disdain for them in the search fund community, mildly capital intensive industries such as manufacturing and operationally complex industries such as consumer retail may offer ideal acquisition targets.

Be cautious about putting too much stock in feeling “passion” for the business. Your first response may be “not really”, but the business will grow on you. You will soon find that you have become the “King of Fiberglass” as one ex-Goldman Sachs Investment Banker searcher did after purchasing a specialty glass fiber manufacturer.

Since the business you purchase will not be the same 10 years later, avoid the easy tendency to project forward exactly what you see in front of you as the future of the business. Many searchers are concerned about boredom three years after buying a business. In reality, your entrepreneurial capacity to “see around corners” will drive you to new customers, markets, processes and paths that are not apparent while you are looking at a specific prospect.

In conclusion, seeking a perfect business is a recipe for a prolonged search, a high price, and reduced flexibility when the inevitable “surprise” happens after the business is yours. Focusing on the “not-so-great” companies in your search will yield sellers who will close, opportunities for early and sustained improvements as you learn the business and will help you avoid overpaying for the seller’s legacy.

Developing a deep understanding of the business can reduce your operational risk after closing. Identify opportunities for improvement while remaining flexible and receptive to the unpredictable.
Search on!

I encourage comments from readers and dialog about the topics which allows others to see the commentary and learn both from my views and the views of others; a virtuous learning cycle. Jump right in!

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  1. Chip Johns on April 7, 2015 at 10:46 am

    Great article, everyone wants the perfect business with all the boxes checked. You have clearly identified which boxes are the important ones and encouraged searchers in the process. Nice!

    • Jim Sharpe on April 19, 2015 at 8:53 pm

      Chip, indeed, searchers cannot afford to overpay for their business, with a portfolio of one, so a business with some neglect and flaws at a great price is ideal.

  2. Jason Scott Earl on May 7, 2015 at 8:49 pm

    Very insightful blog post! I am going to use this information in my next Cash & Valuation course at BYU. Thanks for getting this information out there Jim!

    Any advice that I can pass on to my students when it comes to getting access to industry multiples (i.e., EBIT, EBITDA) for private company deals?

    • Jim Sharpe on May 9, 2015 at 9:22 pm

      Jason, there are a number of annually printed guides htat are relatively inexpensive references summarized on now listed on my site under Reference Sources. Best to get the library to order for their reference section; they are always looking for suggestions from readers. In addition to EBIT and EBITDA, SDE (Sellers Descretionary Earnings) is another common base for multiples. The more these references are utilized, the better informed both sellers and searchers can be around negotiating to a “fair market value” for both parties.

  3. Harry Shah on September 6, 2018 at 10:17 pm

    Great article! My interpretation of buying a business after reading “HBR Guide to Buying a Small Business” was to buy a great business. But this article provided me with another point of view in evaluating businesses with great customers but not so great internal operations that supports the business. A agree that fixing non-critical operational issues will lower SG&A, hence, increase profitability resulting in better upside upon exit.

    • Jim Sharpe on September 29, 2018 at 2:09 pm

      Harry, Thanks for the kind words. Indeed, I feel you may find yourself “overpaying” for a great business and with a portfolio of one, this is very risky for a first time searcher/CEO. Instead, acquiring a “good” business at a “great” price is a much better focus. Your ability to improve operational performance and then focus on profitable growth gives you time to learn the business and initiate the cultural changes you will need to scale. Also, the “great” businesses tend to be picked off fairly quickly by financial or strategic buyers who can afford the portfolio risk.

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Posts – Contemplating a Search

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Posts – Conducting your Search

Posts – Being CEO/Owner

Random Quote

45-“Strategic partners” are very important to the business searchers.You want to rely on some trusted providers to support your business, you can’t do everything yourself!(See Blog Post-Strategic Partnerships)

42-Start early on legal documents, they often delay closings while under LOIBoth the searcher and the seller are plowing new ground and it takes a while to comprehend the meaning of all of the legal details .(See Blog Post-Getting to closing)

63 Searchers make promises they can meet to build trust with sellers. It is important to provide incremental opportunities to show that you can be counted on to deliver.(See Blog Post-Building Trust with Sellers)

34 Searchers who get access to employees before closing are more likely to close. Once the seller begins to confide in their employees about the sale of the business and introducing you as the “new owner”, they are more likely to proceed to finalize the transaction than to change their mind at the last minute.(See Blog Post-Getting to Close)

07-You are not a PE firm, don’t act like one!
Potential sellers resonate with your taking over their legacy, a PE firm is simply adding to their portfolio. Make sure your website looks personal and non-intimidating.

04-Fight Seller Fatigue in Due Diligence!
Sellers get worn out in this process. It is highly emotional for them, probably their first time at relinquishing their “baby” to someone else. During LOI stage, make it a practice to communicate with them, in person or by phone, every 2 days.

53-Holding monthly “all-hands” meetings indicates your transparency. Trust employees with what is going on with the business and they will trust you more .(See Blog Post-Communicating with Employees)

06-Use metrics to drive decisions
Track what is most important for your search – getting in front of prospective sellers to make offers to buy their business. Track the number prospects, IOI’s, LOI’s and set goals for yourself! If you measure it, you can improve it.

22-When in conflicts arise, remind professional advisors they work for you.
Inevitably, you will disagree with some advice you are getting. After checking multiple sources, do what feels right to you and move forward. You will have to “live” with your own choices, not the professionals!(See Blog Post-Professional Support)

18-Every day that goes by during Due Diligence raises the chance that you won’t close!
Time is of the essence when it comes to moving from a signed LOI to closing on your business. Seller fatigue sets in as the closing date gets extended and the seller constantly re-evaluates their motivation to sell. Only you can push the process along.(See Blog Post-Due Diligence)

44-Plan ahead, give thought to the small details of how you present yourself as the new owner. The first introduction to the employees of the business has a huge impact so you want every word to be rehearsed!(See Blog Post-Taking over the business)

50-Don’t expect immediate “loyalty”, the previous owner earned it, it takes time. You will need to earn the trust of your employees by your actions, not your words. (See Blog Post-Seller Tranisition)

35-Searcher CEO’s need to be prepared to walk away from volume orders if margins will decline. It takes a forward thinking CEO to seek out higher margin, value added opportunities to grow profits, not revenue.(See Blog Post-Wearing the sales hat)

09-Learn from others – read case histories
Over 40 case histories have been written about funded and self funded searchers in a variety of industries and historical settings. Each have great “lessons learned” and are worth the $10 cost to read them. Searchers are learners!

39-The business seller is “hiring” you to run their business. The owner trusts you enough to turnover the “legacy” of their business to you. (See Blog Post-Searcher Profile)

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