HoldCo Discussion
May 9, 2023 | Issue #84
Big Deal Small Business: HoldCo Discussion
May 9, 2023 | Issue #84
Welcome! Not sure exactly where you all came from, but we’ve added nearly 600 new subscribers in the past two weeks, so a quick intro to me:
Formerly worked in private equity (special sits & buyouts, targeting companies with $15M to $200M+ in earnings)
Decided to buy a small business via a self-funded search (using investor equity capital & SBA 7a debt financing)
Acquired a residential & commercial building contractor business in Seattle in early 2022 (soft plug — if you know homeowners or property managers in Seattle, I’d always appreciate inros, I switch to non-anon for those conversations obviously)
This newsletter aims to:
Provide a ride-along experience with my search process & now operating process
Synthesize institutional investing concepts into more practical applications in a small business investing and M&A context
(Give me a procrastination break from the day-to-day grind/emotional roller coaster of running a small business. I don’t publish on a regular schedule, just when I have time & something on my mind.)
If you’re new to the search / ETA (Entrepreneurship Through Acquisitions) world or just considering it as a career path, I’d encourage you to browse the New Searcher Reader Guide, which has a number of links to more foundational resources.
Cool! Let’s hop into today’s post, which delves into how to think about building a HoldCo as a searcher.
What is a HoldCo?
If you’re not on SMB Twitter, where HoldCos have been discussed ad nauseum — a HoldCo is a holding company that owns multiple businesses in unrelated industries.
This is not a new concept — wealthy families have operated HoldCos for generations. Berkshire Hathaway is the poster child obviously, but there are thousands of privately-held holding companies.
Here are a few examples of HoldCos whose owners are active in the SMB Twitter/ETA communities (note, they may not define themselves as HoldCos, but roughly speaking):
Major caveat to everything in this post — each HoldCo operates in a unique way. I’m speaking in rough generalities that will hold mostly true for most HoldCos.
A key concept in a HoldCo is that cash flow from each business generally floats its way to the Holding Company layer, which is where capital investment decisions get made.
So while each business is relatively standalone from an operations perspective, they often have shared leadership / decision-making from a capital perspective.
HoldCos sometimes offer more centralized operations support across their companies, such as a single bookkeeper that manages the accounting for four different companies.
You can imagine the potential benefits for small businesses that don’t have the scale to afford a full-time bookkeeper, but could definitely use a 0.25 FTE bookkeeper.
That said, the general tone from SMB HoldCos seems to be in favor of de-centralization of operations for a variety of reasons beyond the scope of this post.
Capital Allocation
As a business generates profits, it needs to do something with that profit. The decision of what to do with the profit is called “capital allocation”.
There are four standard capital allocation choices for most businesses:
Organic Growth: Invest in the business by buying new equipment, investing in marketing, etc.
Inorganic Growth: Use the capital to acquire related businesses to grow in step fashion
Pay Down Debt: Make principal payments on your debt balance (effectively creating equity value)
Return Capital to Shareholders: Send the cash to equity owners of the business
Each of those investment options has an associated return profile. If you can buy $150K of new equipment to launch a new crew, and that crew can generate $75K of incremental profit per year, that investment has a payback period of 2 years.
But more relevantly, if your business can someday be sold for 5x multiple of earnings, that $75K of earnings increases your business value by $375K…more than a 2x return on investment in a very short time-frame, plus the value of the actual cash flow.
This may seem obvious, but re-investing in the business is the often the highest return investment possible. The issue is that many businesses don’t actually need that much capital to grow, so you have to do something else with the profits.
IMC is the family office/holding company for the family that founded Golden Corral. One of their investors, Connor Leonard, talks about great businesses having a “reinvestment moat” — basically, businesses that reliable provide create opportunities to reinvest capital at a high rate of return are higher quality businesses than those that don’t.
It’s a positive feedback loop where successful businesses have the capital & the capital opportunities to grow, so eventually outstrip (via compounding) businesses that don’t have both.
By contrast to the Organic Growth investment opportunity, choosing to Pay Down Debt is generally one of the lowest return opportunities you have, as the return is fixed.
If you have debt costing you 8%/year in interest, if you pay it down, your return on investment is exactly 8%/year. The best part of this investment decision is that you know exactly what your return will be — there’s very little risk associated with that return (other than the opportunity cost of the capital).
Returning Capital to Shareholders
When a business returns capital to shareholders, it’s actually a burden for the shareholders. They need to do something with that capital to ensure it continues generating returns, otherwise it’s dead cash just being inflated away.
Redeploying capital is not trivial. For those of you in the search process, you know how hard it is to find the next business to put that capital into.
This is where HoldCos become interesting. In a holding company, the default decision at the company-level is to return capital to shareholders (which in this case, is the holding company itself).
The holding company then makes a decision along each of four options above, but across all its businesses in tandem.
In essence, for every dollar of cash your businesses generate, you’ve increased the number of investment opportunities for it. The cash flow from business A can now be used to invest in organic/inorganic growth for business B.
If you reliably have one business that generates cash with little capital needs, and another business that can use that cash to grow aggressively…that’s a dream outcome.
A well-designed holding company is a capital allocation machine, built around a core competency of figuring out what to do with the cash from each business.
You’re effectively building a reinvestment moat as a holding company.
Connecting back to Search
Running a HoldCo effectively is a difficult job. Being a capital allocator is a trade, just like being an HVAC tech. It requires constant inquisition, learning, and discipline to be an effective capital allocator. It requires deal reps & experience. You’re building a muscle over time as you hone your ability to invest capital.
But running a small business is also hard. (So hard, honestly).
It’s become cliché for searchers to say they want to build a holding company — more experienced operators & HoldCo operators generally roll their eyes when they hear that.
It’s a worthy goal, but 1) it’s generally too far down the road to be a meaningful goal while searching, and 2) requires a completely different skill set than running a small business well.
That said, I think of the HoldCo approach as an upside option on buying a small business. Having access to a differentiated, proprietary set of reinvestment opportunities is 1) really fun & cool if you’re into that kind of thing, and 2) good for your long-term wealth creation.
By choosing to go down the SMB path, you’re opening up an option that building a HoldCo is more possible down the road than if you stay in a corporate path. But it’s more of a potential upside, rather than a clear milestone-like goal.
So if you’re a searcher or early SMB operator (like me), the HoldCo outcome is aspirational, but likely not an explicit goal for now. The delayed gratification there is likely too delayed to be motivating right now anyway.
But! Your mileage may vary — I’ve seen folks execute on a second acquisition in an unrelated space in a quick time frame. I’m not capable of that, hence the general tone of caution above.
Conclusion
I’m often asked if I’m planning to build a HoldCo from my business. My answer is generally some variant of “Maybe? That’d be cool, but I have no idea if I’m going to succeed at the first business yet.”
The above post lays that out in a bit more detail. But I’d love to hear your feedback, especially if it diverges from the thoughts above.
For thoughts or feedback, just hit reply to this email or post/DM me on Twitter.
Thanks,
Guesswork Investing
P.S. I run a local building maintenance contractor in Seattle, WA that focuses on single family residential & commercial properties. To the extent you know folks in the RE industry in Seattle (both homeowners & property managers), I’d always appreciate intros.