Building an Investor Base

October 7, 2021 | Issue #45

Big Deal Small Business: Building an Investor Base

October 7, 2021 | Issue #45

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Self-funded search doesn’t mean 100% self-funded search. In my case, it means I fund the transaction costs (legal, quality of earnings, etc.) myself and put in a good chunk of the equity injection.

But I will likely raise 50-80% of the equity from investors, depending on how large the deal is.

As a result, I’ve put together an group of prospective investors who I plan to ask for equity once I find a good deal.

This post talks about how I put my investor list together and how I communicated my vision to ensure philosophical alignment.

(By the way, I spent a great ~10 days in Austin & Salt Lake City visiting SMB operators and ETA folks — stay tuned for learnings & reflections on my trip in the coming weeks.)

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Putting The Investor List Together

I started putting the investor list together when I was getting serious about my first deal. That’s probably not the best way to do it — most searchers are a bit more proactive than that.

The benefit of waiting until a deal is in hand or close to in hand is that it gives you something specific to talk about with prospective investors, even if it’s early days. You can talk specifics on strategy & vision (more on vision later in this post).

That said, if I were starting over, I would have done more early leg work around building relationships and getting to know folks ahead of discussing a deal.

I ended up in that spot because my deal died, so my investor relationships have been well-seasoned at this point, but that was a happy accident of a dead deal.

Setting that aside, I started out by listing every single person in my personal & professional network I could think of who:

• is likely an accredited investor

• understands small business and / or private business investing

• is an individual investor with indefinite/unlimited holding period

The first is a legal requirement.

The second specifically excludes my affluent friends who work in tech, medical, etc. While they may be accredited investors, I did not feel comfortable educating them on the risk profile of a leveraged buyout of a small business.

As a result, it didn’t feel right to take their money if I didn’t think they were fully up to speed on what they were getting into.

The third is a function of investor alignment, which I’ll discuss further below.

This very simple 3-step qualification test is an effective initial filter for building your list. It’s effectively filtering for investor education/sophistication and long-term alignment.

For me, I first came up with ~40 individuals. The initial list was primarily my private equity/hedge fund network, plus my friends from college who ended up in finance.

I then added on a few folks I’d met from SMB Twitter/Searchfunder (though I’ve since met many more). Guys like Steve Ressler & Sam Rosati can be super-connectors to other self-funded search investors.

The final list, once I included the self-funded search investor community was right around 50 people.

The makeup of your investor group is important, but I don’t think it’s the primary driver. I’m planning to include several SMB operators in order to have folks to call when shit hits the fan.

That said, the reality is that the checks they write into your deal likely won’t be material enough to change their skin-in-the-game incentives meaningfully.

Instead, I would optimize for who you think will care about the deal, who you have the strongest relationship with, and who you have the best long-term philosophical alignment with.

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Communicating the Vision

As a searcher, you have to lay out a clear vision for your deal. If investors don’t understand that vision, they either 1) won’t invest or 2) will invest and find themselves at odds with your vision in the future.

Outcome #2 is a worse place to be than Outcome #1.

Taking an investor into your deal is a 3-5 year relationship at a minimum, but it could be a 10+ year relationship. Governance rights can solve some issues, but a solid foundation built on philosophical alignment is where a good relationship starts.

To give you a concrete example of deal vision, I will lay mine out below (this is more or less verbatim what I told my prospective investors):

Start:

First, I have no idea what things will look like 2 years into the deal. I will have a thesis and a value creation plan, which I will lay out in an investment memo. But if there’s anything I’m certain on, it’s that the investment memo will be obsolete roughly 1 hour after closing.

As a result, we will be fluid and adaptive.

Years 1-2 of the investment will be focused on stabilization. Learn the business, generate some cash, make debt payments, hire more staff as required. Don’t break things.

After 2 years, we will all sit down with a blank sheet of paper and decide where we see opportunity.

We will end up going down one or more of 3 paths (they are not mutually exclusive):

• We see significant organic growth potential in the business. We’re going to plow cash flow (if required) back into the company and focus on growing it.

• We love the sector, but have hit a wall on this specific business due to service area limitations or otherwise. We’re going to take cash flow and buy similar businesses to grow inorganically.

• We don’t see a real organic or inorganic growth story, so we need to focus on generating cash, paying down debt, and returning cash to shareholders. This may culminate in a sale after a few years, or in the installation of a manager to run a steady ship.

Lastly, my goal is to own the business for 30+ years. Any of the 3 paths laid out above can end up in a 30+ year hold.

I plan on making decisions with a 30-year holding period in mind, which may mean using cash flow today to generate share value in the future.

While I do intend to return your capital & pref return sooner (ideally within 5 years), my priority is building long-term equity value for all of us, not cash distributions today.

End

That’s a bit long-winded, but the key messages are as follows:

• I have ideas, but ideas are cheap. It will take me 2 years into the business to have a solid grasp on what the real opportunity is.

• We are in this for the long haul. This is not a quick flip to make short-term cash. I want to build an institution with staying power, happy employees, long-term customers. That translates to shareholder returns, but on a decades time scale.

When I showed investors my first deal, some people said no. Lots of people said yes. So it goes, but I felt confident that all the people in the deal knew what they were getting into from a risk perspective and a partnership perspective.

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Conclusion

While I’ve written about equity deal structures & investor selection in the past, hopefully this was a helpful foray deeper into the beast of equity raising.

If you’re a searcher who wants to bounce your vision off of someone, shoot it my way, happy to provide an opinion.

If you just disagree with my vision or have feedback on it, I’m all ears.

Either way, hit reply to this email or find me on Twitter.

Thanks,

Guesswork Investing

P.S. I’d always appreciate introductions to potential acquisition targets or brokers (primarily targeting $750K-$1.5M+ of SDE or EBITDA, located in Seattle or the Bay Area).