Gut Reaction Deal Math

March 29, 2023 | Issue #82

Big Deal Small Business: Gut Reaction Deal Math

March 29, 2023 | Issue #82

A big thank you to the folks who made intros last week to people involved in Seattle area real estate. The B2B and “non-scalable” sales work grind is off to a good start — the idea is figure out an outbound sales systems that works, systematize it with me as the sales rep, write it all down, and then hire someone to run the playbook.

We’ve got a golf outing for the Seattle SMB/ETA scene set up for May 11th at a golf course on the Eastside. Lisa Forrest at Live Oak is kindly sponsoring the 19th hole as well, so thank you to her & LOB! Please sign up at this link.

Let’s dive in today’s post. But first — this post borrows heavily on concepts around SDE, EBITDA and Cash Flow. I wrote a full intro to how to define these terms specifically in the context of SMBs — I’d suggest reading that first.

---

What is Gut Reaction Deal Math?

When I was early in private equity, I was blown away by how fast the senior partners could determine if a deal made sense or not. They could look at a basic set of figures, do some mental math (informed by years of pattern recognition), and just know the multiple we could pay for the business.

As a searcher, you want to develop a sixth sense for “does this deal pencil?” as well. And it doesn’t have to take years or hundreds of deal reps because SMB deals are much simpler to underwrite.

This is primarily because lower price expectations + attractive debt financing via SBA means you only have to underwrite to the business not blowing up. Your underwriting can afford to be more downside-oriented than NEEDING the growth levers to work.

So you sign the NDA, get the CIM (confidential information memorandum) (or maybe a crappy one-pager), and you see a breakdown of SDE (seller discretionary earning).

Based on the numbers in front of you, you should be able to very quickly tell if the numbers make any sense between deal structure, cash flow, and price expectations.

This post will hopefully help you develop that sense faster than having to go through a hundred deal reps.

To do so, I’ve created a Google Sheet that walks through basic deal math. I’ve broken it out step by step below so it’s easier to digest, but you can also review the full spreadsheet if that’s easier for you to work with.

Step 1: Get to Buyer’s EBITDA

You should receive some kind of financial disclosure in the CIM that spits out a Net Income or SDE.

You want to lay out the math to Buyer’s EBITDA as follows (depending on your email settings, you may have to allow pictures to load):

More on how to do this in the SDE vs EBITDA vs Cash Flow post. If there were interest expense, D&A, or income taxes included in the seller’s P&L, I would have added those back also, but left them off above to keep the math simple.

Note that a searcher operator salary of $125K is really $110K base + payroll taxes + benefits. Don’t forget payroll taxes & benefits when thinking about any replacement hires as well.

Step 2: Set up your basic deal structure

I’m setting this up as a typical self-funded deal structure — 80-90% leverage (primarily SBA), 10-20% equity, and working capital not included.

I didn’t include a seller note just to make the table simpler, but you could add that in easily.

Note that working capital requirements will change on every deal.

This deal structure should be based on how you’re planning to fund the deal — if you’re going all-equity with your rich uncle, obviously very different set of limits.

Step 3: Set up the rest of your cash flow statement

With Buyer’s EBITDA and deal structure in place, you can calculate the rest of the cash flow statement pretty easily as follows:

In the above, I’m assuming:

• 10% interest rate on the SBA 7(a) loan (P+200 as Prime is 8% right now)

• D&A is 1/15th of purchase price: realistically, most search deals have very high D&A in the first year because you can write off most fixed assets from the acquisition in year one. The goodwill from the transaction (purchase price above the fixed asset value) is generally amortized over 15 years. So the above table just assumes there were no fixed assets (not unusual for say a digital marketing agency), so 100% of the purchase price is goodwill, amortized over 15 years.

• Taxed on a pass-through basis with the LLC making distributions to the owners to cover taxes in the amount of 40% of taxable income.

• $50K in maintenance capex — obviously this varies massively based on the deal.

Step 4: Assess the Deal

So, you now have the deal laid out — what does it tell you?

One important thought upfront that I alluded to earlier — most SBA-financed deals will show a really high equity return because of how much debt is on the deal.

In the example above, we are generating $99K of excess cash each year and paying down $179K of debt in the first year. This means we’re generating ~$278K of equity value in the first year relative to an equity investment of $504K — 55% return out the gate!

So I wouldn’t focus on your equity return — it’ll probably show a good deal everytime.

The “game” is really surviving that debt profile, which is more about your margin for error. If you can survive, the math will work for the equity.

So what’s the math for surviving? Two ways I like to think about it are Debt Service Coverage Ratio (DSCR) and Hirable FTEs.

DSCR can be defined in different ways, but a reasonably conservative definition I like is Unlevered Free Cash Flow (defined above) divided by Debt Service (mandatory interest + principal payments).

Hirable FTEs is a way to contextualize how you could use your Usable (or “Distributable”) Cash Flow to invest in the business. At $100K/FTE, that’s roughly $85K base + payroll taxes & benefits.

So if you have 1.0x Hirable FTEs, that means the deal has enough room for you to take on one person worth of overhead before running out of cash.

Given that most search deals have unexpected tasks that the owner did that they forgot to tell you about, having some room for additional hires (or even just software investments) is a very practical margin for error.

Note that this is also a very practical limitation on your ability to grow the business given that costs will come before revenue.

Step 5: Build the Muscle

Above, I’ve clearly laid out all the numbers. But the goal is internalize the math & ratios so that you can just look at a deal and intuit if the numbers would work once laid out.

So I’ve laid that all out in a Google Sheet for you with three different columns so you can compare the math at different purchase multiples. It’s set to view-only, but you should be able to copy it into Excel or a fresh Google Sheet so you can mess with it.

Spend time with this sheet — tweak the assumptions, move the multiples around, change the deal structure, etc.

You should start to pick up on how the math changes as your multiple changes. Suddenly, a “3.5x SDE” deal doesn’t seem so good when it turns out to actually be a 4.25x EBITDA deal with high capex, meaning a very low DSCR.

Internalize that math — it will save you so much time when assessing deals as it’ll allow you to kill deals quickly. Your time is valuable as a searcher, so don’t waste it pursuing deals that have a massive gap between seller’s expectations & what the math allows for.

Yes, you can structure around a small gap using forfeitable seller notes, but a large gap just isn’t worth the time usually.

Conclusion

That was a lot of numbers — hopefully it wasn’t too much. Hopefully there are no errors in that spreadsheet, I’m not quite as detail-oriented as my private equity days.

I’m also happy to answer questions in writing if you want to reply to this email, I usually get back to folks within a week.

Otherwise, happy hunting out there! And sign up for golf (link at the top) if you’re in the Seattle area!

Best,

Guesswork Investing

P.S. I run a local contractor service business serving residential, commercial and municipal properties in the Greater Seattle Area. To the extent you have personal connections to local property owners (including single family homes), I’d always appreciate introductions.