Underwriting Small Add-On Deals

Guesswork Unveiled, Issue #8

Underwriting Small Add-On Deals

Guesswork Unveiled, Issue #8

One potential value creation lever after buying a small business is to go acquire competitors. This is called “inorganic growth” (as opposed to “organic growth,” which is internally-generated).

If adding on smaller companies is the core strategy in your acquisition thesis, that can be called a “roll-up” — a popular private equity deal type.

However, even if you don’t intend to do a roll-up, you can still strategically make acquisitions from time-to-time — being in your industry will grant you access to see deals you may not see as a solo searcher. Deals may makes sense once you’re a “strategic buyer” that didn’t make sense as a searcher.

In particular, there is a specific flavor of small business that is usually too small for an individual buyer — think <$500K of revenue and <$200K of SDE. The owner is usually an industry expert and providing actual expertise or services to their clients. This kind of business is impressive in its own right, as it represents gritty entrepreneurship to build a business that provides the owner a healthy lifestyle.

But it’s hard to sell — the buyer has to be able to replace the owner with a similar level of expertise, but there’s usually not enough profit in the business to both do that and generate a return for the buyer. Simply put, you can’t really value the business on a cash flow multiple.

This is where you come in as a strategic buyer — a business with an establish client list, even with zero or only a couple employees — can be underwritten effectively without applying a cash flow multiple.

In particular, the focus of today’s post is on how to underwrite small add-on acquisitions as a client acquisition tool — a replacement for advertising spend.

This is particularly relevant for re-occurring revenue business models, which are harder to underwrite than recurring revenue business models, where there are real customer contracts to acquire. In a very small business doing re-occurring business, you are buying a client list that should reliably generate sales opportunities.

More broadly, the purpose of this post is to push your imagination to think through alternative forms of value than solely cash flow acquisition. The case study I run through below should help you think about frameworks on how to underwrite in different ways.

Let’s dive into a case study example to explain how I underwrite these types of deals. Buckle in for a longer post, with lots of numbers.