Big Deal Small Business: Deal Size
How large of a business should I buy? This question comes up in every conversation I have with fellow searchers.
There’s no single answer — the right size depends on your respective goals for EtA/Micro PE.
Instead of providing a definitive answer, this post talks through several key considerations around deal size.
Just so you know my bias, I’m targeting $750K to $1.5M of SDE or EBITDA.
Summary of Deal Sizes
I think of the SMB world in the following SDE buckets: <$750K, $750K to $1.5M, $1.5M to $3.0M, $3.0M+.
One note — a strategic buyer (especially one backed by PE) can usually buy at any SDE range. If a real strategic is in your deal process, just drop out.
Transaction Considerations — Smaller Deals
Smaller Deal Benefits
First, at the smaller end of the range (<$1.5M SDE), the deals are generally SBA-financed. Between 90% leverage and <5x purchase price multiples, smaller deals require equity capital of <$1M in most cases.
This makes deals viable for well-capitalized individuals or self-funded searchers (i.e. with a loose group of equity investors) as they can end up with a large % of equity with $100K to $300K checks.
Second, smaller businesses tend to have more straightforward diligence processes given business complexity is usually limited.
This translates to lower total $ deal costs (though higher as a % of deal size given certain fixed costs). It also means deals tend to close faster at higher rates of success from the LOI stage.
Third, these deals tend to be too small to move the needle for well-capitalized searchers, sponsors or strategics.
In summary:
Can buy a real business with limited capital
Deal costs, time to close deal, and odds of dead deal are lower
Less competitive deal processes
Smaller Deal Downsides
The primary issue I’ve faced is seller & broker sophistication. Messy financial records and internal systems makes diligence challenging.
Your conviction level on core diligence questions will likely be lower than in larger transactions.
Smaller deals tend to have more existential transition risk — the owner is more involved and there’s less in-place overhead. This is tough to diligence. You can put contingency plans in place, require a seller note, etc., but ultimately you have to swallow hard and take the leap.
Transaction Considerations — Larger Deals
Larger Deal Benefits
It may seem counterintuitive, but if you don’t have significant savings (~$100K to $300K of investible funds), completing a larger deal with investor equity tends to make more sense.
A larger deal ensures there’s enough “dollars to go around”. You receive a smaller share of the equity but it’s applied to a larger deal size, so the deal is still worth 5+ years of your time.
Second, larger deals tend to have sophisticated managers in place to facilitate the diligence process. A simple financial DD ask might get turned around in 2 days rather than 2 weeks.
Third, while deal costs are higher in $ terms, they are much lower as a % of deal size despite getting superior legal & financial DD support.
Larger Deal Downsides
Beside the obvious impact of higher purchase prices, larger deals tend to have more competitive auction processes. Further, a larger business tends to have more to diligence.
These two dynamics tends to result in longer, more expensive diligence processes.
Larger deals require far more capital from more parties, which adds a layer of complexity into the mix. Every document becomes harder to complete as more people (and their lawyers) get involved.
More complex deals have more reasons to die, so the overall odds of closing a deal are lower.
Overhead Dollars
Barring significant technical complexity, a larger business should have more people and processes in place, lowering the transition risk from the current owner.
Larger deals have more fixed overhead dollars in the P&L to solve issues. Suppose you have one key employee that you want to give a retention bonus as part of the acquisition. If your business does $500K of SDE, a $50K retention bonus lowers SDE by 10%. The same key employee only impacts a $1M SDE business by 5%.
One note on margins that is not big or small deal-specific. When I look at big businesses in my day job, high margins are a good thing. It implies a strong business model.
That can hold true in SMB acquisition, but there’s more nuance due to owner involvement. An SMB might run at very high SDE margins because the owner is “over-involved”.
Take two businesses with $3 million in revenue and 50% gross margins, but one at 30% SDE margin and the other at 20% SDE margin.
Business A would do $900K of SDE with $600K of overhead. Business B would do $600K of SDE but with $900K of overhead.
In reality, Business A might have an “over-involved” owner doing ~$300K worth of work in addition to core managerial responsibilities. You might come in and replace the owner as a manger, but might still need to put in $300K of additional overhead.
In that case, Business B is the better acquisition target given the transition from owner to staff has already been completed. You get to buy off of a lower SDE baseline and you have more overhead to play with to make the operations work.
Cash Buffer for Investments & Downside Protection
On the growth side, a smaller business might have more quick wins available with limited investment that a larger business solved earlier in its lifecycle.
But a larger business has cash flow to invest in larger fixed costs (say a new salesperson) to drive growth.
I’ve illustrated these cash flow dynamic below:
Think of Levered Free Cash Flow as your investment capacity or your downside buffer. As you can see above, the % of loan payment and levered FCF yields are both higher in smaller businesses.
Said differently, smaller deals generate more cash per $ of invested equity thanks to lower multiples and higher loan availability.
That can be misleading. Look at the Overhead row — a business with $1.2M in fixed overhead has more room to maneuver than a business with $300K in fixed costs.
Said differently, your annual cash buffer against breakeven is lower in $ terms for smaller businesses, but larger in % terms relative to your equity investment.
Further, even if the %s are lower for big businesses, the crucial issue is cash out of your pocket. Despite higher purchase multiples, larger businesses have more cash flow to burn through before owners need to come out of pocket to make payroll.
Conclusion
There’s no definitive answers in this post, just some frameworks to consider as you define the size you want to go after. I’m going after $750K to $1.5M+ of SDE or EBITDA, but there are clear reasons for folks to go higher or lower.
Would love to hear your thoughts. Just hit reply to this email or DM me on Twitter.
Thanks,
Guesswork Investing