I just finished reading HBR Guide to Buying a Small Business.
My interest was piqued by Patrick O’Shaugnessy’s podcast episodes on permanent capital/equity (see here for example). Later on, the authors of the HBR book came on the podcast (see here). It was clear from the interview that the authors had much practical experience in the field.
The book is definitely useful for acquirers of small businesses all over the world. It had some insights for public equity investors as well. Primarily, this is because many small business investor insights are applicable to public stock investors too:
Investing is at its best when it is most businesslike. – Benjamin Graham
- a recurring statement was that small businesses (sub two million dollar in annual pre-tax income) are “generally” acquired for 3-5x EBITDA
- equity partners in small business buyers typically require +25% IRR over a ~5 year span
- small businesses are typically 60% debt financed: 35% senior bank debt, and 25% junior seller’s debt
- seller debt aligns incentives with the buyer somewhat (as earn-outs do as well). Be wary of sellers that strongly object to a proposal to at least finance a small part of the purchase with seller debt (is the business going to fare well in the near future?)
Insights with parallels to value investing in stocks
- Direct versus brokered search dilemma: just like in public equity investing, brokered search saves a lot of time in the initial phase (sell-side research) but one has to search longer before finding a cheap anomaly as the businesses are already “on the market”. Direct search might yield exclusive outliers.
- Just like sell-side research, private company brokers first send out “teaser sheets” that are built to pique interest. Still, these documents can be a useful first source of data
- Honing the skill of filtering: doing great business deals is always a trade-off between looking for more (and potentially even better) deals and doing more good deals more regularly. This ideas relates to the concept of decision making under uncertainty and bounded rationality (see here and here). In public equity investing, filtering is one of the most important skills to save money time. Investing, be it in real estate, businesses, bonds or stocks, is always primarily a negative art: avoiding losers. Having the right filters in place in each phase of investigation is very important. For example, you might want to throw 80% of teaser sheets in the bin immediately (having only lost 10 minutes per sheet). In the next phase you will invest more time calling the prospects and looking into more detailed financial data.
- focus on not wasting time in the first phase: look for reasons to disregard a deal
- each phase will become more time consuming. Make sure to not do the more time consuming detail tasks in the first phases (e.g. first call the seller, only meet in a later phase)
- good returns are possible because there are many natural sellers (death, disease, divorce, partner disagreements) but not much natural buyers (private equity and other institutionals have to large a cost base to investigate <2M pretax p.a. businesses)
- stocks: I’d like to focus on situations without natural buyers: e.g. spin-offs, post-bankruptcy equity (see You can be a Stock Market Genius for example)
- search for a business, not a job: try to find businesses that work well without a good operator
- stocks: avoid key man (employee) risk. Note that Warren Buffett has been on record to choose good businesses over good managements any day
- focus on enduring profitability:
- preference for high recurring customer base: small businesses vanish faster than large businesses. This is why this quality is even more important.
- slight yet profitable growth, avoid fast growth: it comes with new clients and these are less loyal and come with new demands which we might not understand (by definition we do not know churn rates of new clients)
- if the company is enduringly profitable due to sticky customers/industry structure, its primary growth should not come from market share gains (this contradiction should be investigated in due diligence)
- one of the first stages in due diligence is to check how much EBITDA the company is able to keep in free cash flow (i.e. cash flow conversion ability). Given two companies with identical EBITDA, the company that doesn’t need to reinvest in working capital and depreciating assets is clearly superior.
- stocks: indeed, this is one of the treats of quality companies as defined by public equity investors as well (see for example Quality Investing)
- the due diligence process has much in common with researching stocks (e.g. check accrual versus cash flow accounting for timing issues, check if company has been saving in maintenance Capex or employees in recent years to fetch a higher price). Some useful ones to add to a research checklist:
- interview customers (what causes clients to switch? satisfied? key qualities of the product?)
- interview employees: “what do you do here” (check also for capabilities)
- the debt raising process: assets with values that are easy to determine fetch cheaper asset-backed debt.
- stocks: the inability to lever up is a drawback for (typically high) ROIC service companies versus asset heavier businesses
Book examples of great small businesses
- the importance of being unimportant
- insect control chemicals provider for local governments, cost is only a couple of percent of the labor cost to spray the chemical. The cost is so small that even negotiating these deals is significant. Result: multi-year contracts.
- a company treating metal tubes: the treatment cost is 45$ versus 1000$ manufacturing cost. The tubes are so heavy that it costs six times more to transport them to the end client (or nearest competitor). Other barriers to a competitor entering their region: finding a great location that facilitates transport near a railroad and highway, licenses to treating tubes, and lastly specialized workforce in a rural environment)
- safety & reputation: a longstanding reputation is important when the service has a safety aspect or the product is crucial as an input to the client
- high-rise building window washing service (own note: this business has friendly middlemen as the building facility manager is typically not the payer, being typically either an employee of the company or a third-party company facility management company. Friendly middleman have other incentives: they prioritise their own reputation and time consumption over cash cost. This is why they will take reputable companies and prioritize customer satisfaction, low hassle and safety over costs, see also Quality Investing)
- Party equipment rental business: this is my favourite example as it is pretty counterintuitive. On first sight this looks like a commodity business. However, clients that organize 200+ people parties require speed and excellent execution for a party not to be spoiled. Spoiled parties carry immense reputational risk. Price is therefore not the prime consideration (note: this business has a local advantage as well as the parties need to be close to the base to be able to react fast to problems at a party or shortages, to minimize transport cost for heavy equipment). This business therefore has a good answer to the question: if this business is so good, then why is it so small/local?
- emotional switching costs: nurse car for elderly people. Clients become attached to their nurse.
Note that the best businesses mentioned have combinations of advantages.
- the risk-diminishing property of control: assuming you are managing your own company, there is no principal-agent misalignment of interests. I assume this is the reason that small business buyers are able to use more debt in their transaction without taking on much more risk than public equity investors. Indeed, given some common sense, grave misallocation of capital is less likely as empire building and short-termism play less of a role for an owner-operator
Lastly, the book has much more useful practical advice to actually buy small companies that is not in scope here.