How much equity can I get?
July 15, 2024 | Issue #100
Big Deal Small Business: How much equity can I get?
July 15, 2024 | Issue #100
How much equity can I get? This is one of the most common questions I receive from prospective searchers, and one of the most misunderstood.
But first — this is Issue #100 of this newsletter! As you know, everything about search & small business ownership is about slow, steady progress.
Growing my small business continues to be a challenging grind, and my faith in the “compound growth” gods is shaky at best these days. But this newsletter has served as a reminder to me of how compounding works. I picked a couple random data points to illustrate that:
Issue #28 was sent to 576 recipients.
Issue #78 was sent to 2,863 recipients: ~2,300 new recipients in 50 issues
Issue #99 was sent to 6,300 recipients: ~3,400 new recipients in 21 issues
If you’ll forgive the nerdy finance segue into today’s newsletter topic — potential compounded growth of capital (aka projected IRR) is how you figure out how much equity you can get as a searcher. I dive into that in detail below.
(P.S. Soft hook to read this whole piece — I built a companion Google Sheets model to allow you to model basic investment scenarios…more on that later down!)
How much equity can I get?
Variations on this question are “what kind of step-up should I ask for?” or “how much carry can I get” or “how much sweat equity should I ask for?”…there are a dozen different ways to ask the same question.
But how much equity you can get is an ANSWER — not the question you should be asking. It’s the answer to how much Equity IRR your deal can generate, and how that IRR gets shared around investors and you. I’ll define IRR and Equity IRR in a moment, but let’s set a core foundation first.
There are three fundamental ways to generate Equity IRR:
Reducing the Amount of Equity Capital by Adding Debt Capital (aka Leverage)
Growing the Business (aka Increasing Cash Flow)
Reducing Cost of Capital (aka Increasing the Business Valuation Multiple)
That’s it — just about any deal can be boiled down to those three levers.
So how does that help you answer How Much Equity Can I Get?
The list above can be turned into a series of preceding questions — I’ll walk you through each one below, with a link to a Google Sheet at the end to let you play with various scenarios.
Question 1: How much total capital return can this deal generate?
Question 2: How can I reduce the amount of equity capital needed for my deal?
Question 3: How much can I grow the business?
Question 4: How much can I de-risk the business or make it stronger?
Question 5: How much of the resulting capital return needs to go to my investors (aka cost of equity capital)?
Answer: Once you answer the above questions, it’s just math to solve to how much equity I get to keep as the searcher.
Key intuition point: Your job as the searcher/operator is to generate Equity IRR that is higher than Equity Cost of Capital…the difference between the two is what you get to take home as the searcher. But because you have to decide on the equity splits upfront, your searcher equity terms are actually based on you & your investors agreeing on a reasonable projected Equity IRR, given you don’t know what the actual Equity IRR will be yet.
Question 1: How much capital return can this deal generate?
IRR: IRR stands for Internal Rate of Return. It’s an answer to “what was the compounded growth rate of your invested capital?”
It accounts for inflows & outflows, in case you had to put more money into your investment along the way. Think of it as a more all-encompassing measure of “annualized rate of return” to account for compounding and cash coming in & out of an investment. The expected IRR of an investment is a proxy for measuring your expected capital return from the investment.
You have IRR for the whole deal — total IRR paid out to your debt & equity sources combined. But what we care the most about as a searcher is equity IRR — what return can we generate for our shareholders.
So first, what is our expected capital return?
Capital Return
Here’s a simple example where you never grow the business, so you sell it for the same value in the future:
Deal 1: You can buy a business with $450,000 in cash flow (true cash flow, after taxes, after searcher salary, etc). You can buy it for $3,000,000, and assume you can sell it in the future for $3,000,000 as well.
$450,000 / $3,000,000 = 15% expected cash flow return every year from the deal.
Deal 2: Same terms, but it only generates $300,000 of cash flow per year — that’s a 10% expected cash flow return.
Let’s say you have equity investors who are willing to finance your whole deal for only a 10% equity return. No debt. In that case, Deal 1 works — you as the searcher can negotiate to keep the difference between 10% equity cost of capital and 15% expected return to equity.
Deal 2 doesn’t work — even though you have capital to match the 10% expected return, that leaves nothing for you to eat as the searcher.
Cash flow is just one form of capital return — the other is from the actual sale of the business — in the above example, we assumed that is zero, because the sale only generates enough to pay back the initial capital.
But if you increase the value of the business (by growing the business or increasing its multiple), there’s more capital to go around. More on that later.
Key Intuition Point: The inverse of 15% return is a multiple. $3,000,000/$450,000 = 6.7x. Business acquisition prices are quoted as multiples, real estate acquisition prices are quoted as “cap rates,” such as 15%. If you can buy a small business for a 4x multiple of cash flow, that’s the equivalent of a 25% cap rate or cash flow return.
Question 2: How much can I reduce the amount of equity capital needed for my deal?
Okay — let’s add some debt to improve our equity IRR.
You may know this intuitively, but let’s spell it out — debt capital is cheaper than equity capital.
Equity capital is generally your most expensive form of capital. By adding debt (or “leverage”) to your deal, you need less equity capital.
Same deal scenarios as above — let’s say you can layer on $2.5 million of SBA debt that costs 11% per year onto Deal 1 — now, instead of needing $3 million of equity capital from investors, you only need $500K.
Here’s the math (and link to Google Sheet, tab “Simple Cap”):
As you add debt to a deal, you make it riskier. So let’s say now your cost of equity capital for this deal structure is 25% — this deal works great! That difference between 25% cost of equity of capital and 35% expected equity capital return is what you get to eat as the searcher (we will translate that into your actual equity % later on in this post).
But what if the SBA lender doesn’t like the nature of the business very much — too project-based, too much customer-concentration, etc. They only approve $2,000,000 in debt financing. Here’s what your capital structure looks like now:
Shoot — now you only have a 23% return for investors. Maybe they have a slightly lower return requirement as there’s less debt on the deal, but even if it was 20%, it only leaves the gap between 20% and 23% for you to eat as the searcher.
Hopefully this explains the intuition behind why companies that can support higher debt loads (or cheaper cost of debt) are fundamentally more valuable — they require less equity to operate and have a lower weighted average cost of capital.
Does debt solve every deal? What if we added debt to that 10% expected return deal we discussed above?
Debt doesn’t solve all problems. The cost of debt capital is simply too high. A 10% return deal, financed with $2.5 million of SBA debt, leaves only 5% in return for equity capital.
Intuition Point: You may have noticed the deal scenarios I used are 10% and 15% expected capital return, which is the equivalent of 10x and 6.7x purchase multiples, respectively. If you’ve researched SMB buying, you’ll know that you should be able to buy in the 3-5x range, which is the equivalent of 20%-33% capital return. That’s why there’s SO much equity available to searchers — if the deal generates a 20-33% capital return, and you can finance it with 90% debt at ~11% cost of debt capital…there’s a HUGE gap between equity cost of capital and equity expected IRR — the searcher gets to eat that. I’ll walk through this in detail later in this post.
Question 3: How much can I grow my business?
I’ll spend the least amount of time here — hopefully this is fairly obvious — if you can grow your business, that generates a capital return.
If you bought a business with $300K of cash flow for 5x ($1.5 million), and then you grow it to $600K over 5 years and sell it for 5x ($3.0 million), you’ve generated an additional $1.5 million in capital returns. This all goes into the expected equity IRR of the deal.
There’s no guarantees here — this is all projected growth of course. When putting together the projected investment case for your pitch to investors, it’s completely reasonable to include growth — you generally wouldn’t be buying the business if you didn’t think you could grow it, after all.
Guidelines on Building a Base Case Investment Model:
You should use reasonable growth projections backed up by an actual game plan. You don’t want to just show a straight 15% revenue growth each year, with steady EBITDA margins.
I believe it’s more reasonable to show EBITDA margin declines in the first year or two (as you build your operating platform aka the J-curve), and then start to see growth in the later years.
When I get pitches from searchers, that’s one of the first things I check — does the model assume 15% growth per year, or did they actually model a realistic base case scenario.
Intuition Point: Growth is reasonable to assume in your expected equity IRR. But don’t assume an unreasonable amount and back up the growth assumption with a clear plan to drive that growth. Otherwise your model is fairly meaningless to investors.
Question 4: How much can I de-risk the business or make it stronger?
This fundamentally comes down to lowering the company’s cost of capital. As we discussed earlier, the inverse of cost of capital is valuation multiple — the lower the cost of capital, the higher the valuation multiple.
Very, very simple example: Let’s say you buy a project-based business with $2 million of revenue and $500K of cash flow for 3x EBITDA multiple, so you paid $1.5 million. The cost of capital of this business is 33% (inverse of 3x is 1/3, or $500K per year on $1.5 million).
Let’s say the business continues to do projects, but they have a ton of repeat customers that are willing to sign actual contracts with a minimum annual spend of $1 million per year, in exchange for a 5% price discount.
So now, $1 million of revenue is discounted to $950K, generating only $200K of EBITDA (assuming fixed costs). The other $1 million of revenue continues to generate $250K of of EBITDA. (Gross oversimplification, I know.)
A new buyer will look more favorably at the $200K of EBITDA that is contractual as it is lower risk — they may be willing to earn only a 20% return on that capital, while still demanding a 33% return on the project-based EBITDA:
20% return = 5x valuation multiple, times $200K = $1.00 million of value
33% return = 3x valuation multiple, times $250K = $0.75 million of value
Total business value = $1.75 million, an increase of $250K from your initial purchase
So despite your business size declining by $50K/year in EBITDA, you increased its value by $250K by de-risking the business and lowering its cost of capital.
Other forms of de-risking that are common in search deals:
Lowering owner/employee dependence: By transitioning the business from an owner to a management staff, the business has less key person risk.
Lowering customer concentration: When searchers grow a business, they have the added benefit of lowering customer concentration (assuming the growth doesn’t come from the large existing customers).
Improving revenue quality: Example above
Improving systems: This relates to lower key employee dependence, but building the business into a functional set of systems & processes improves its overall stability.
Improving Size: Obviously this is a double whammy as you also get the benefit of more earnings, but larger businesses tend to be more stable and have a lower cost of capital.
Improving financial sophistication: Having clean accounting books and easy-to-understand financials/KPIs will make it easier for future investors & lenders to underwrite your business. This in turn lowers your cost of capital as you have a more competitive “auction” for accessing capital. Basically, you want to make it easier for your next buyer to raise debt & equity capital than it was for you.
Question 5: How much of the resulting capital return needs to go to my investors (aka equity cost of capital)?
As I mentioned previously, the key concept for searchers to understand is the gap between projected Equity IRR and equity cost of capital — that gap is the “excess” profits that you get to take home.
The first four questions above answered how to calculate projected Equity IRR and how to maximize that number.
But what is the baseline equity cost of capital?
I want you to think of deals as a marketplace — you are offering investors a product (an opportunity to generate a return). They are offering you capital to finance your deal.
If more capital is available than deals, then the cost of capital goes down. If there are more deals chasing less capital, the cost of capital goes up. It’s no different than if you were selling bread or Beanie Babies.
“Deals” as I used above constitutes the entirety of places for investors to put their capital. That’s why it’s easier to fund deals with interest rates are low — if putting cash into a savings account yields 0% interest, there are more investors (and capital) willing to invest in small business acquisition deals, so the cost of that capital goes down.
When savings account 4% interest, some amount of the capital is happy to sit there, making less capital available to searchers, making the cost of the capital that is available higher.
Okay, theoretical finance diatribe over — here’s the actual answer — based on my experience, search investors are looking for a ~30-35% projected equity IRR in search deals with high leverage (>80% of the capital is funded by debt). I honestly haven’t seen it move much with rates moving up over the past 2 years.
Achieving a 30-35% projected IRR is based on a reasonable base case as discussed earlier — reasonable growth, minor assumed multiple expansion (not more than 1x, such as buying a business for 3x and selling it for 4x).
Investors are primarily heavily betting on the searcher — if the deal goes sideways, it’s unlikely they can step in to take over. So they will key in heavily on you — your background, your commitment level, your fit to the business, etc.
For more on investor selection & building an investor base:
Answer: So how much equity can I get?
Okay, I get it, that was a really, really long way to get to the question you actually want answered. Congrats on making it this far, this was a slog of a post.
First, the simple answer — most good self-funded search deals that are bought for 3-5x EBITDA and 90% leverage allow the searchers to retain ~65-80% of the common equity. (That’s the TLDR, but I didn’t want to put that upfront and not explain the WHY behind it.)
It’s more important to understand how you actually answer the key question! Once you’ve modeled out your deal, you get to keep as much equity as still allows your investors to earn a projected equity IRR in line with their equity cost of capital.
In order to help you calculate this, I’ve made a full deal model laying out how searcher equity works. If you click on File > Make A Copy, you can make an editable version for yourself to play around with.
Here’s the intuition behind the spreadsheet:
I tried to show you returns for the same deal set-up, but across all three key IRR levers: debt (leverage), growth, and multiple.
Deal Set-Up Tab:
These are all the key deal set-up assumptions. Only change cells in yellow.
I set it up showing the exact same searcher equity terms whether the deal has debt or not. As a result, the Returns tab shows the difference in investor equity IRR.
Alternatively, you could keep lowering the searcher equity terms until the investor equity IRR looks similar in levered or unlevered deals — that will give you an idea of how important the leverage is to your searcher equity %.
Returns Tab:
This shows investor equity IRR across all the IRR generation levers.
Scenarios:
You can change what Low Growth & High Growth operating scenarios look like in their respective tabs.
Price Impact tab:
This is a standalone example meant to show the importance of entry price on searcher economics. This gets captured in expected equity IRR of course, but I wanted to create a clear visual for it.
I may eventually need to create an anonymous Loom video or an FAQ to explain this model in more detail, so if anything is unclear, please reply to this email and I will try to compile answers into one document.
One note…it was always terrifying to show a model to investment committee when I worked in PE. The idea of sending even a very simple model to 6K+ readers is brutal — I’m sure there are errors, but hopefully no major busts. If you do find an error, please let me know and I’ll correct it on the fly!
Conclusion
How much equity you can get as a searcher relies on some core theoretical finance concepts of cost of capital and expected returns. In writing this piece, I struggled to find the line between going too basic or assuming too much knowledge, so it’s possible this missed the mark. To the extent you need more explained, please don’t hesitate to ask and hopefully it’ll turn into future posts (or just long email replies).
My response times are slow, as my actual business remains my priority. But I will get back to you!
Thank you again for reading & supporting this newsletter across 100 posts! As always, if you’ve got thoughts or feedback just hit reply to this email or post/DM me on Twitter.
Thanks,
Guesswork Investing
FYI: I’m investing small amounts (~$10K) in self-funded search deals, especially when I get to back searchers who I’ve witnessed go through the search process. I can’t promise to look at every deal, it tends to be bandwidth-reliant, but I am a pretty quick yes or no. So to the extent having a current small business owner at the bottom end of your cap table is appealing, please feel free to reach out.
Thank you for spending the time to continue to put out incredibly helpful content.
Took me a while to dig into this, but very useful! Thank you for putting it together and publishing it.