The Messy Middle of Small Business
December 7, 2023 | Issue #94
Big Deal Small Business: The Messy Middle of Small Business
December 7, 2023 | Issue #94
This is a newsletter written by Guesswork Investing about acquiring & operating small businesses. If you are a new reader / new searcher, I recommend starting with the New Searcher Reader Guide. If you are looking for a deal team to support your transaction, I have recommendations for you.
There’s been lots of talk on Twitter/X recently about how hard SMB operating and Entrepreneurship Through Acquisition (“ETA”) can be. There’s also been plenty of massive upside stories.
But there’s another possible outcome. Today’s post tells the story of an ETA operator who is living in “The Messy Middle” – a term he’d heard on podcasts that describes the situation well.
Let’s dive in.
Background
Patrick (fake name) acquired a residential contractor business in North Carolina in Fall 2022. Unlike many searchers, he actually had relevant industry experience – he had worked for a national construction company, managing commercial development projects. He had experience running a small book of business for them, not so different from running a small contractor business.
The business he acquired did about $2.4 million of revenue and $250K of Seller Discretionary Earnings (“SDE”). He took on about $500K in debt (SBA + seller note) to get the deal done, leaving him with about $90K/year in payments. Based on that, he was expecting to clear ~$160K/year in owner distributions before tax – not a bad starting point to grow from.
The former owner was effectively the estimator/project manager – Patrick felt confident he could take on that role given his experience. And once he grew the business, he’d be able to hire for that role given he has experience both hiring & managing PMs.
Initial Transition
Right out the gate, everything went smoothly – the seller was a good person, he completed his transition properly and continues to provide occasional support. There were no skeletons in the closet that were missed during due diligence.
In the first four months, Patrick did about $800K in revenue, putting him on track to meet the prior year’s $2.4 million in full-year revenue.
The business operated with two crews – Crew A, the more efficient crew, did about 2/3rd of the revenue, and Crew B, the less efficient crew, did about 1/3rd of the revenue.
Crew Issue
Around the four-month mark, the foreman of Crew B decided he wanted to a different role, one that Patrick couldn’t provide at the same salary. So as the foreman lost motivation, his crew slowly just went away.
Given they were the less productive crew, Patrick is still on track to do $1.75 million in revenue this year, and he’s managed margins up, so he should still land at ~$200K in SDE. But rates have gone up, so his payments are closer to $100K/year.
All of a sudden, $160K/year in owner distributions looks more like $100K/year.
With an infant at home and a second on the way, this means that his wife has started working part-time and they’ve eliminated extraneous expenses in order to balance their personal budget.
Now, this all works – Patrick actually has way more time flexibility than ever given the business is a bit smaller, so he doesn’t have to do nearly as many estimates. They’re not spending out of their savings and they’re making their monthly debt payments.
The Messy Middle
But here’s the rub – in theory, the next step is clear. Hire a second crew and get the business back to its former revenue level.
The issue is that Patrick knows the lifeblood of his inbound leads is his Google profile, especially in a one-time revenue business. There’s not a lot of room for a bad review pushing him down the Google rankings.
Hiring a new crew is real risk – he would have to eat some payroll while bidding on jobs to fill their time, and then ensure they do high enough quality work to avoid bad reviews.
Patrick isn’t risk-avoidant – he bought a small business after all. But the weight of the SBA debt & personal guarantee is real. It impacts his ability to take on the risk of the second crew.
Patrick feels stuck right now – yes, his work hours are very manageable, but he doesn’t feel like he has enough margin for error to take the risk of adding the second crew. He knows what he needs to do, but the monthly debt service acts like a pair of handcuffs.
Given that, he’s stuck at this size of business for now as the business keeps cash flowing and paying down debt slowly.
This is the “Messy Middle” – the business is okay, debt payments are getting made, but there’s not enough excess cash flow to reinvest for growth or to pay down debt faster. There’s too much debt to take growth risks. But there’s 8.75 years of debt payments left — that’s a long time.
It’s hard to convey in writing how heavy the debt & monthly debt service can feel to an ETA entrepreneur. When your cash flow and debt service converge, you feel trapped by your business.
Importantly, if you’re the type of person craving the freedom of “being your own boss,” this type of trapped feeling is extremely hard to stomach - it’s antithetical to why you may have gotten into ETA in the first place.
Patrick and I wanted to share this story to highlight that SMB/ETA isn’t a binary outcome of success or failure. There’s a wide range of outcomes between those two ends, which can lead to owners feeling stuck, potentially for years.
How do you avoid these situations?
Buy bigger – Yes, you take on more debt, but you also have more margin for error. If you have 5 crews and lose one, the impact is lower than if you have 2 crews and lose one. Also, if you need to make one new hire at $65K, that’s 26% of a $250K profit business. It’s only 10% of a $650K profit business – making that one new hire is less risky in that sense.
Have more money set aside – You don’t want your last dollars going into your SMB deal as the downpayment. You may still need that money for the business later. Put it this way – if you have a $100K downpayment requirement, but $200K in the bank, you may not want to put all $200K in as a downpayment. The extra $100K of SBA debt costs you ~$16K/year in extra debt payments. Setting that extra $100K aside effectively covers that extra debt for 6 years! And it gives you the option to use it for growth investments or to cover debt payments in the short-run.
Buy cheaper – This is pretty obvious, but the cheaper price you pay (multiple of cash flow), the more cash flow you’ll have to play with as the operator. This is because the debt service will take a smaller slice of your cash flow than if you paid a higher multiple.
Buy based on EBITDA, not SDE – Budget in a reasonable salary for yourself to live your life, then see if the deal makes sense AFTER that expense is taken out. Read this post to learn about EBITDA vs SDE vs Cash Flow.
A big thank you to Patrick (again, fake name) for sharing his story so candidly with me – it’s a service to the broader ETA community.
Feel free to reply to this newsletter if you’d like to connect with him, whether to provide support, ideas, or just general commiseration – I’ll connect you to him.
For general thoughts or feedback, you can always reply to this email or post/DM me on Twitter. And quick reminder — if you need deal team recommendations for your deal, here’s my Trusted Deal Team list.
Thanks,
Guesswork Investing