Make no doubt about it: buying a business is risky.
Even though common advice says that diversification is the safest route to financial success, great wealth often comes not from diversification but from concentration.
As Warren Buffett famously said, “Put all your eggs in one basket and watch that basket like a hawk.” Billionaires typically build their fortunes by focusing intensely on one area, usually their businesses.
So although diversification is a nice thought, when it comes to acquiring a business, it isn’t an option. You’re focused on one company, one valuation on the day of closing, and you’re making a commitment with very concrete terms.
In fact, I almost didn’t publish Buy Then Build after spending four years writing it because I realized people might actually take my advice and buy a business!
Fast forward a few years, I did publish the book and I even started teaching others how to successfully buy and build businesses because of the overwhelming opportunity present.
That said, there’s a fine line to walk between the level of risk and the level of opportunity an acquisition presents. Luckily for you, walking that line doesn’t have to be a skill that only develops after decades of mistakes.
Over the last 18 years, I’ve developed a risk-opportunity heuristic that’s allowed me to successfully buy, operate, and sell multiple companies. Hopefully in sharing it with you, you’re able to use this to more rationally determine if the opportunities of an acquisition you’re considering outweighs the risk.
Using the Risk-Opportunity Heuristic to Evaluate Risk
The most common question I get is, “Is this a good deal or not?”
To answer this question, we use a variety of tools in the Acquisition Lab to evaluate deals effectively, and this risk-opportunity heuristic is one of those many tools.
The risk-opportunity heuristic has six factors that allow you to objectively weigh the risks against the opportunities of a deal.
1. Likelihood of Downside Occurring
When assessing risk, first determine the likelihood of a downside event occurring. You’re basically asking yourself, “What are the chances that this could fail?”
Certain red flags can make this risk more apparent. For example, take customer concentration – if 90% of a company’s revenue comes from a single customer, the downside risk is significantly higher. If that customer decides to leave or goes out of business, the impact could be catastrophic.
For other potential downside factors to consider, check out my previous articles on Porter’s Five Forces and doing a SWOT analysis on a potential acquisition.
2. Average Occurrence of Downside Event
After assessing the likelihood of a downside event, the next step is to consider the average impact if that downside occurs. In other words, instead of asking, “What could go wrong?” Now we’re asking, “How often does it go wrong?” This is why, in the Acquisition Lab, we focus on “breaking” companies on paper – so you can fully understand the worst-case scenarios before they happen.
Interestingly, the most common downside in small business acquisitions isn’t outright failure.
In search funds, for example, one of the major risks businesses face is underperformance more than anything else. Of the 67% of search funds that successfully acquire a business, 1 of 4 of those operate at a loss.
Source: 2020 Search Fund Study | Stanford GSB
Instead of being cash cows, they become financial drains. The owner might not earn the salary they originally anticipated and may end up funneling all their income into equity buildup just to pay off the acquisition loan. This is the typical downside scenario in small business transactions and one you’ll want to gauge when evaluating a deal.
After all expenses and fees are taken into consideration, can you afford the business and then some? Will the cash flow have enough buffer to weather storms and any temporary setbacks you might face when transferring the business?
3. Extreme Downside
For the last downside consideration, you want to ask yourself: what’s the worst-case scenario?
What’s the absolute worst thing that can happen to your business?
A lot of what we discuss in Buy Then Build involves acquiring small businesses with SBA loans, which often come with personal guarantees. If you’re serious about buying a business, a personal guarantee is something you’ll likely need to accept, unless you have other means of financing your business.
When you sign a personal guarantee, you’re essentially telling the lender that you’re fully responsible for the money – so much so that you’re willing to put your assets on the line.
Although the acquired business should generate more than enough income to cover that loan, the worst-case scenario is that everything falls apart, you’ll default on your loan, and you’ll face personal bankruptcy.
That’s the extreme downside risk.
This is why in Buy Then Build, I emphasize the importance of the prep funnel and structuring your entire search around your unique strengths. Why? Because finding a business that’s aligned with your specific strengths and skill set turns the acquisition into a disproportionately greater opportunity and can offset some of the inherent risks the business has.
4. Likelihood of Upside Occurring
Luckily, being an acquisition entrepreneur isn’t just about spotting the flaws in every acquisition.
On the other side of the risk-opportunity heuristic is the upside. When evaluating a deal, you need to determine the likelihood of an upside, or in other words, “What are the chances this deal could be successful?”
The more you can grow the business, the more you protect yourself from downside risks. Growth fuels safety: by expanding the company, generating more cash, and building a robust balance sheet, you significantly reduce potential downsides.
Even private equity firms only invest 30-40% equity in a deal. By doing so, they’re able to safeguard against losses by ensuring a strong financial foundation from the start, even if they have access to ample cash and debt.
Although you’re not a private equity firm and don’t have the same leeway to only invest a fraction of the deal, you can still take note and build a strong financial base by maximizing cash flow and growing the business as quickly as reasonably possible.
5. Average Growth Potential
Next, you have to consider the average growth potential – how often do things go well?
Many people talk about buying “boring” businesses (I used to say “unsexy” because I don’t like the idea of being bored in my business, but that’s a different conversation). The appeal of so-called boring businesses, such as laundromats or car washes, is they have minimal operational demands.
The average growth in these types of small businesses tends to be low, often ranging from 2% to 10% annually, occasionally reaching 20% or more.
However, when it comes to other small business acquisitions, average growth will be roughly 20%, especially if you’re dealing with companies valued at a million dollars or more.
Research the market of your particular industry and see what the historic and projected annual growth rate is.
6. Extreme Upside
Then there’s the question of extreme upside – what’s the potential for extraordinary growth?
When I was recently asked how to make a million or five million dollars in three to five years, my answer was straightforward: buy a business, double it, and then sell it.
Doubling a business in a short time creates significant value. While you can choose to keep the business, selling it and reinvesting tends to be a more effective strategy than buying and holding.
When evaluating the upside of an acquisition, ask yourself these two questions:
- Can I realistically double the business and, if so, how long will it take?
- Can I recoup my investment within three to five years?
If you can say “yes” to both of these questions, you’ve got yourself a winning deal.
Remember, the trick to capturing this extreme upside lies less in the business itself and more in the synergy between you, your skills, and the business you’re looking to acquire.
How to Balance Risk and Opportunity
So with all that being said, now that you’ve evaluated the likelihood and degree of risk and opportunity in a given deal, what do you do now?
How do you manage the risks? How much risk is too much risk?
First, understand that downside risks are almost always external. These could include factors like market shifts, a major customer leaving, or a key employee walking away after the acquisition. These are often outside your control.
On the other hand, the potential for upside growth is entirely within your control.
As Stephen Covey’s The 7 Habits of Highly Effective People teaches us, focus on what you can control, not on what you can’t.
Source: Discovery in Action
Focus on the factors you can control and manage the downside risks accordingly.
If you only focus on potential risks, you might hesitate and never make the move. Instead, concentrate on what you can influence: growing the business and strengthening its position.
Secondly, you want to fully consider the risks of a business before you submit a letter of intent (your offer). Risks aren’t something to start managing after you’ve taken over.
That said, don’t think you need to search for the perfect business, because such a business doesn’t exist. If you’re looking for one that’s flawless before you acquire it, you’ll never find one (in fact, whether or not you realize it, you’re likely using your perfectionism as an excuse to not buy a business).
Lastly, remember that a deal is negotiable. In the Acquisition Lab, we use the Venn Deal Diagram as a guide to structure deals. The idea is that once you’ve identified the risks, you can negotiate deal terms and deal structure to balance those downsides.
A participant in the Lab once said, “You tell me the price, and I’ll tell you the terms.” Although tongue-in-cheek, this highlights the leeway you have in negotiating terms and structuring deals to ensure it’s ultimately a win-win for both you and the seller.
Learn From My Experience
The first time I bought a business, it took me two years of searching.
The second time, nearly a year.
But by the third through seventh businesses, I was able to identify an opportunity and be under contract within three days.
It came down to experience, getting the reps in, and understanding exactly what I was looking for so I could act quickly when the right opportunity arose. Fast forward to today, a big part of my ability to reliably evaluate deals is the risk-opportunity heuristic I shared with you in this article.
Acquiring a business can be risky, but there are also substantial rewards. You don’t want to avoid risk, but you want to approach it intelligently instead.
If you want to better quantify the risk of a deal while focusing on what will tangibly drive growth, use the risk-opportunity heuristic on your next deal. This is how you’ll build wealth long-term – one smart acquisition at a time.
Ready to acquire a business in the next 12 months? The Acquisition Lab is your first stop. Reach out to us today and get on the fast track to becoming an acquisition entrepreneur.
