Big Deal Small Business: The Math of Traditional vs Self-Funded If this was forwarded to you, check out the archive or subscribe below. 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.
Would challenge the assumption that the comp for a CEO in a 700K EBITDA and 3M EBITDA business would be the same. IMO a more proper comparison would double the CEO compensation in the funded example to 250 in line with the 2020 Stanford primer update.
Makes sense, you're right on that, thank you for the comment! Thought not sure it will change the "directionality" of the answers that much -- key point was that the big money outcome for traditional searchers is always in the exit because they have such a large pref to overcome.
Yep totally agree on that point. It was more towards the de-risking of a no-growth scenario. In the funded situation you are drawing a "market rate" salary -- which is helpful to know if you were to do cost-benefit against say a traditional post-MBA path.
I find this article and corresponding model really helpful. I don't fully understand, though. How did you arrive at the investor proceeds of $691,235 in the self-funded / no growth scenario? What are the components that went into that to calculate that number?
That's just the math of the model. The basic components are cash flow in excess of debt payments, the 8% accrued return, the exit proceeds, etc. Like the investors get their capital back, an 8% annualized return, and then 25% of the remaining proceeds, and the math worked out to the $691K figure.
That's correct. But they also receive preferred equity with a fixed rate of return. So first they get their money back + the X% return (8-12% generally), then they continue to own 25% of the common equity.
Interesting how it differs so much to traditional PE. What drives the difference so much?
Do you find that people rather want a guaranteed rate of return in search, but are still happy to take equity risk?
It seems they would get a lot less out vs being an LP for a higher risk equity investment (single SMB vs a fund)?
I haven't had a lot of conversations with smb investors so no idea what they expect, would be keen to see the structure/examples of people that have done this?
The reality is that these deals are priced so cheap (<5x EBITDA) that even with that small common equity check, the deals pencil out to 35%+ net IRRs with limited or no growth.
Of course the risk levels are high relative to regular PE, but I think SMB investors view this like angel investing but with a much tighter range of outcomes given the businesses are already cash flowing & proven at time of investment. The default case is "make money" whereas angel investing the default case is "company fails to find product-market fit".
Compared to a regular PE fund, I think the math is still quite attractive for LPs given a PE fund will target mid-20s IRRs and delivers a net teens return. This is just a higher risk-profile version of that, but if they do 10 deals that do reasonably okay, they should easily be at a net 20s IRR even if 1-2 deals blow up.
Would challenge the assumption that the comp for a CEO in a 700K EBITDA and 3M EBITDA business would be the same. IMO a more proper comparison would double the CEO compensation in the funded example to 250 in line with the 2020 Stanford primer update.
Makes sense, you're right on that, thank you for the comment! Thought not sure it will change the "directionality" of the answers that much -- key point was that the big money outcome for traditional searchers is always in the exit because they have such a large pref to overcome.
Yep totally agree on that point. It was more towards the de-risking of a no-growth scenario. In the funded situation you are drawing a "market rate" salary -- which is helpful to know if you were to do cost-benefit against say a traditional post-MBA path.
This is really great! Any chance you'd provide the excel spreadsheet? It would be really helpful.
Thank you! Honestly I think I've lost this spreadsheet into the sands of time sadly, otherwise would've been happy to share.
I find this article and corresponding model really helpful. I don't fully understand, though. How did you arrive at the investor proceeds of $691,235 in the self-funded / no growth scenario? What are the components that went into that to calculate that number?
That's just the math of the model. The basic components are cash flow in excess of debt payments, the 8% accrued return, the exit proceeds, etc. Like the investors get their capital back, an 8% annualized return, and then 25% of the remaining proceeds, and the math worked out to the $691K figure.
I'm confused by the equity splits in your table for the searcher. It says investor puts up 80% of the capital but only receives 25% of the equity?
That's correct. But they also receive preferred equity with a fixed rate of return. So first they get their money back + the X% return (8-12% generally), then they continue to own 25% of the common equity.
Interesting how it differs so much to traditional PE. What drives the difference so much?
Do you find that people rather want a guaranteed rate of return in search, but are still happy to take equity risk?
It seems they would get a lot less out vs being an LP for a higher risk equity investment (single SMB vs a fund)?
I haven't had a lot of conversations with smb investors so no idea what they expect, would be keen to see the structure/examples of people that have done this?
Lots of questions and enjoying the learnings!
The reality is that these deals are priced so cheap (<5x EBITDA) that even with that small common equity check, the deals pencil out to 35%+ net IRRs with limited or no growth.
Of course the risk levels are high relative to regular PE, but I think SMB investors view this like angel investing but with a much tighter range of outcomes given the businesses are already cash flowing & proven at time of investment. The default case is "make money" whereas angel investing the default case is "company fails to find product-market fit".
Compared to a regular PE fund, I think the math is still quite attractive for LPs given a PE fund will target mid-20s IRRs and delivers a net teens return. This is just a higher risk-profile version of that, but if they do 10 deals that do reasonably okay, they should easily be at a net 20s IRR even if 1-2 deals blow up.