The following is adapted from Buy Then Build: How Acquisition Entrepreneurs Outsmart the Startup Game
The majority of people who set out to buy a company never complete their purchase. In fact, as many as 90 percent of people give up along the way. Why does this happen? A lot of the time, it’s because they simply don’t know what they’re looking for.
For example, they may try to find a company in a specific industry, without considering their personal strengths and weaknesses or the value particular companies offer as investments and entrepreneurial vehicles. This is a grave error.
The smart way to go about looking for a company is to generate a target statement before you start, so that you understand what will make a company valuable to you and match your skills and inclinations. A good target statement looks something like this:
I am looking for a [choose product, distribution, or service] company with [enter the type of growth opportunity], generating [define size by seller discretionary earnings (SDE) range], with [enter any limiters].
The order isn’t critical and you can eliminate any part that doesn’t apply to you, but it’s important that you consider all aspects of the statement. The question is, how can you determine which factors are most important to you? In this article, I’ll show you.
Product, Distributor, or Service?
All business can probably be identified as offering a product, acting as a distributor, or providing a service. These are the main industry types you should use to structure your target statement. The choice of which one fits you best may be obvious already, or it may require some consideration on your part.
If you are looking for a product, do you want to be a manufacturer or simply a reseller of that product? A product company could be a manufacturing company, or one that simply owns the right to the brand, manufactures the product from a supplier, and manages the sales channels.
Distribution companies can source, manage inventory, coordinate international logistics, or be a reseller of a product. A core competency in distribution could be applied to logistics management, channel management, supply chain efficiencies, or product reselling.
The service industry employs more than 33 percent of the world’s labor force. It includes all professional services like legal and accounting, banking, advertising, software engineering, IT, medicine, nonprofit activity, education, and retail or custom light-manufacturing.
These three industry types of product, distribution, or service stand as three different offerings, or values, to the market. Make a decision to anchor your statement in one or two of these industry types in order to bring a little focus to a broad description. We want your description to be specific enough that people understand what you are looking for, but not so specific that the opportunity never turns up. Getting the balance right may require further reflection on your part to identify the specific industry drivers you prefer.
Four Different Opportunity Profiles
Broadly, speaking, there are four different types of company you may be interested in purchasing. The first is the eternally profitable business. This is a business that serves a need that is very unlikely to go away.
The eternally profitable business is a “cash cow” with very small growth opportunity, but also small threat of industry disruption. It’s a stable and dependable business that you can count on. It may also be assumed from a business like this that the customer relationships have been long established and the company has a dependable track record.
The second type of opportunity is the turnaround business. A turnaround describes the acquisition of a company that has fallen on hard times, with the goal of improving operations, building efficiencies, and strengthening the value that the company provides to its customers. It’s the company version of the “fixer-upper.” Often, however, the best opportunities are with companies in pretty bad shape, even bankrupt.
These companies typically have complicated messes to work out. Still, for the operational expert, these opportunities can be the diamond in the rough. The point is that the assets of the company are discounted from a typical selling valuation— sometimes as low as liquidation value—due to the underperformance of the company.
Another type of company you may choose to seek out is the high growth company. A company coming off, say, three years of significant revenue growth is exciting and attractive for many buyers. After all, these are the types of companies making the current owners healthy sums of money.
The good news behind high growth is that there is clearly demand for the product or service, and the company is doing well at delivering it. The bad news is that because revenue and earnings growth drive value, you will be paying more for prior performance. This is worth it as long as the growth rate continues under your leadership, but if you use significant debt in the acquisition process, paying a higher multiple introduces added risk to your company.
The final profile I want to discuss is the platform company. This is not to say that these are the only possible types of company, but these categories describe most organizations. In acquisition entrepreneurship, a platform company is one where the buyer of the company is typically the one who will be operating within the company themselves as the CEO.
A platform company could have any kind of profile. It could be an eternally profitable, high growth, or turnaround. More likely, it’s somewhere in the middle. A nice, “good” company with some aspects of stability and some of risk.
When you understand the different types of company profile, and you know which type is likely to suit you best, you have information that most potential buyers blithely ignore. Categorizing companies in this way is far more useful than simply choosing an industry and hoping for the best.
Company Size
When it comes to buying a company, size matters. Typically, the size of the target is identified by revenue but then valued on a multiple of SDE or cash flow. Now that you know which type of company profile you want to purchase, you’ll need to identify the target SDE.
As a result, defining what you are looking for by revenue is just the wrong metric. What if you find a software-as-a-service company with 70 percent net income to revenue? Or a metal-trading company with 1 percent net income? Defining by revenue doesn’t define your target by the thing you are buying in the first place: the cash flow.
Instead, define the target by the amount of SDE. Briefly, seller discretionary earnings (SDE), is a measure of how much total cash flow the seller of the firm has been enjoying. It is calculated by taking the pre-tax earnings of a company, then adding back any interest and non-cash expenses like amortization and depreciation (which will give you earnings before interest, taxes, depreciation, and amortization). Finally, adding in any seller benefit such as salary, personal insurance and vehicles, and any one-time expenses the company had during that time.
As listings move from Main Street to middle market, a definition largely defined by size, you’ll likely see Adjusted EBITDA as the metric used instead of SDE. They typically refer to the same thing. The difference is often that Adjusted EBITDA is the term largely used for passive ownership, while SDE refers to active ownership.
Despite all the complicated valuation calculations that can be done to calculate value, the typical transaction just comes down to identifying the SDE (or Adjusted EBITDA) number by a fair multiple. The smaller the firm, the smaller the multiple. Typically, you’ll see good companies under $700,000 in SDE trading at two and a half to three and a half times SDE, and companies over $700,000 at north of that.
As a result, I have found that the most “affordable” acquisitions for financial buyers and acquisition entrepreneurs can be had in the $250,000 to $700,000 SDE range. The multiples remain lower, at two and a half to three and a half, but can push toward four if the revenue and earnings have experienced strong growth.
By no means am I suggesting you focus on this same segment. Larger companies equate to increased stability of cashflow. If you are in a position to acquire a more solidly middle-market firm, you should explore that option.
In addition, many acquisition entrepreneurs starting out might not go it alone. They can bring in partners with capital to invest or apply for backing by the many search funds that are supporting these entrepreneurs with training, search efforts, and financial backing. The size you are looking for can change quickly with the involvement of partners or investors.
The size of firm you choose to target will depend on your personal situation and preferences. The key is to understand those variables and to target companies accordingly.
Important Limiters
The final step prior to forming your target statement is to apply a bit of the process of elimination. You need to identify any limiters that apply to your search, anything that you absolutely don’t want to consider. This will bring focus to your activity by filtering out anything not worth considering.
The top limiter is geographic preferences. Are you okay moving wherever the best opportunity is? Or do you want to stay in the same location? If you need to work around where you are, how far are you willing to commute? Or, are you looking for an online business where the company is often completely relocatable?
Are there any industries you absolutely will not work in? How would you define those in the most general way? What if purchasing real estate isn’t available? What if it is required? Take some time to reflect and decide how you think about these things so that you are prepared when they get introduced later.
Defining Your Target Statement
Now that you’ve considered all the relevant factors, you’re in a position to put together your target statement. As a reminder, it should be in the format:
I am looking for a [choose product, distribution, or service] company with [enter the type of growth opportunity], generating [define size by seller discretionary earnings (SDE) range], with [enter any limiters].
To get you started, here are a few examples:
“I am looking for a distribution company with strong sales and marketing processes but needing operational excellence, generating $300,000 to $400,000 in Seller Discretionary Earnings, in or around the Chicago area.”
“I am looking for a manufacturing company with no current eCommerce presence, generating $250,000 to $300,000 in SDE.”
“I’m looking for a commercial IT service business with solid operations but lacking a strong B2B sales effort, generating between $750,000 and $1,000,000 in SDE in the regional southwest.”
“I am looking for any service company tied to real estate with a direct sales effort needed as the driver for growth, generating between $400,000 and $500,000, located in the greater Portland area.”
Use the template of the target statement and the examples above to create your own. When you do this, you will instantly place yourself head and shoulders above 90 percent of people with an interest in acquisition entrepreneurship.
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For more advice on creating a target statement, the benefits of acquisition entrepreneurship, and finding the right business, you can find Buy Then Build on Amazon.
