The Math of Traditional vs Self-Funded

Big Deal Small Business: The Math of Traditional vs Self-Funded

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I’m running a self-funded search.

But today I wanted to lay out some simple math comparing a traditional search deal versus a self-funded deal. There are significant qualitative differences as well (investor type, M&A support, governance rights, etc.) but today’s post focuses on the quantitative outcomes.

The goal of this post is to help prospective searchers think about what model would fit them best — both have pros & cons.

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Deal Set-Up

The below compares a typical self-funded search deal with a traditional search deal in terms of size, capitalization, and equity splits. I ignored seller note / rollover equity / earnout to simplify the analysis.

Note there tends to be more variance in self-funded deal terms, but what I showed is reasonable. For traditional deals, I took what is listed as common in the Stanford search primer, but assumed a simple 8% pref to make the deals more easily comparable.

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Returns

I ran two simple cases — one at 0% EBITDA growth, one at 20% EBITDA growth per year. The upside case translates to 5-year EBITDA growth from $750K to $1.6M in the self-funded deal or $3M to $6.2M in the traditional deal.

I assumed parity multiple on exit as entry and 2% in deal fees at exit.

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Discussion

The above shows middling to successful outcomes — even at 0% growth, investors earn 2x+ their money in either deal. But let’s not forget the downside case, where the business goes bankrupt.

Downside Case: A downside case is significantly worse for a self-funded searcher than a traditional searcher because they have personally guaranteed the debt. A traditional searcher may spend years trying to turn the business around to save their investors’ money, but their quantitative downside is capped at $0. A self-funded searcher’s downside is only capped at the debt balance.

0% Growth Case: The 0% growth case does not turn into a life-changing outcome in traditional search. The majority of their financial return comes from the exit. It would take many more years to pay down their pref before they start to take a share of cash flows. Until exit, they’re only making their $125K/year salary and very slowly building equity value given the pref is accruing at 8%. Most MBAs would make more than that in their first job out of an MBA program.

By contrast, in a self-funded deal, the pref is still paid off within 4 years (thanks to low multiple on entry). So from year 4+, the searcher is earning $80K+ in equity cash flow per year on top of a $125K salary. The equity cash flow increases by another $250K+/year once the debt is paid off. In other words, a self-funded searcher could maintain a low/no growth business and eventually generate nearly $500K/year between equity & salary, without even considering the equity value in the business.

Upside Case: In an upside case, there are simply more dollars at work in a traditional deal, so the small 25% equity stake translates into big, life-changing dollars for the searcher. That said, the traditional searcher still needs to sell the business to realize that upside outcome.

A self-funded upside case can translate to significant annual cash flow even if the business is never sold. However the total dollars you’ll earn are probably never quite as high as starting with a bigger business in the first place.

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Other Considerations

As mentioned above, a self-funded searcher has a PG on the debt — this is a big, big deal. That can be impossible to stomach if you have a spouse & kids and the bank requires you put your home on the line.

Further, there are meaningful pre-closing costs to being a self-funded searcher. You eat dead deal costs along the way, you pay your own salary out of your savings, etc.

In traditional search, you receive real M&A support from traditional investors or search fund accelerators — if you’re a self-funded searcher, you’re figuring that out as you go. Feel free to reach out to me if you have questions on that front, happy to help out.

The one big offset to the above points is control. Control rights deserve a post of their own, but in a self-funded search, you control your destiny for better or worse. In traditional search, your board can fire you or they can say no to every deal you find interesting.

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Conclusion

I think there are great reasons to do either a traditional search or a self-funded search. Both have meaningful cons as well.

They have very different payoff profiles for searchers, so you should be aware of that going in and make sure you buy a business that fits the payoff you’re optimizing for.

If deploying capital & growing a business is your jam, a traditional search is probably a better fit. If buying a cash-flowing, old-school small business for a low multiple and trying to eke out a bit of growth each year sounds exciting, a self-funded approach may yield better results.

Similarly, you should pick an exit strategy that fits what you’re looking for — if you’re interested in a 30-year hold and living the lifestyle of a small business owner, you’re likely better off in a self-funded search even if it’s tougher upfront and requires big personal risk. If you want to test your mettle as an executive and grow into a larger, capital allocator role over time, a traditional search might be best.

Hope this was useful! If you think this post would be helpful to prospective searchers you know, please share with them.

As always, would welcome your thoughts & feedback — hit reply to this email or find me on Twitter.

Thanks,

Guesswork Investing