The Smaller End of the Scale

As I continue talking to business owners and learning from other small business acquirers, I’ve realized there’s an unloved area that’s perfect for searchers with a self-funded mentality: so-called “buying-a-job” sized service businesses.

When I first started searching in earnest about eight months ago, I followed the playbook of traditional search funds: niche business-to-business services with $1 million to $2 million in EBITDA. I still think those are frequently great businesses and, especially at a fair price, good investments. Traditional searchers (i.e. searchers with a number of outside investors) may still have to focus on those kinds of businesses because, at a smaller scale, there’s not enough profit to justify the investment across the outside investors. And, with private equity supposedly moving into smaller and smaller deals at what seems like any price, it may be becoming so competitive that a traditional searcher’s margin of safety shrinks significantly. There are only so many $1MM to $2MM companies for sale.** Still, I respect the heck out of traditional searchers who can make such a deal work!

Fortunately, I’m fortunate because I don’t have to only look at businesses in a narrow price range. And I’ve begun to appreciate just how fortunate after listening to Nick Haschka of Cub Investments and Nick Huber of The Sweaty Startup. The traditional search fund advice is that, below a certain scale, you’re buying a job. The two Nicks say, and I’m synthesizing here, that buying a job isn’t a bad thing. There can be lots of advantages to paying $600K for a $200K SDE business compared to paying $6MM for a $1MM SDE business.

  • No large strategic acquirers or private equity funds bidding prices into the stratosphere. The lower profitability multiples on small acquisitions acts as a risk-reducer in themselves.
  • Many listed businesses = short search. There are a ton of ~$150k-$350k SDE businesses for sale on brokerage sites. Of course, most of the businesses in the ~$150k-$350k SDE range aren’t going to be good candidates (e.g. nightclubs and restaurants, at least for my search). Anecdotally, I’ve heard that fewer than six months from search start to acquisition is a typical timeline because of the number of available businesses.
  • Easier to understand the business. You might still be learning the payroll software 6 months into operating with a bigger business. You might still be forgetting the names of employees. In contrast, a smaller business has fewer moving parts. You might be digging ditches yourself when you first start, but you’re likely going to have a comprehensive view of the business early on.
  • Lower impact on you in the event of business failure. I’m inspired by Mohnish Pabrai’s The Dhando Investor. Pabrai talks about “Dhando” as a way of thinking about risk, a philosophy of high returns and low risk. He uses the example of the Indian Patel clan acquiring motels in the US. The Patels came from virtually nothing to owning half of America’s motels. In the 1970s, with inflation and high oil prices, motels were selling cheap. Patels could acquire a motels with relatively little money that they’d scrounge together by pooling savings and getting a loan collateralized by the real estate. Pabrai assumes there’s a 90% chance that motel succeeds and a 10% chance the motel goes to zero (with an expected value that’s positive even when including the 10% chance of failure). The Dhando element is that, in the event of total loss, the Patel clan member would just have to go back to a low-wage job for a couple years and repeat the process. The chance of failure happening twice is one in a hundred. But the important Dhando element is that the initial failure doesn’t prevent the Patel from trying a second time. Smaller acquisitions have this Dhando element. A huge acquisition with a 90% chance of success doesn’t because, if that big acquisition fails, it might take many more years to recover. In a small acquisition, I can pick myself up and try again. It’s the difference between betting 99% of your net worth on a lottery ticket and 20% of your net worth on a lottery ticket (not that I’d recommend doing either, lottery tickets are money-losing propositions). At 99% of my net worth, I’m risking just about everything. At 20% of my net worth, I could have a very painful loss, but not one that would stop me from buying a second lottery ticket. You live to fight/bet/invest/operate another day.
  • Higher upside from multiple expansion. If you buy a company at a low multiple due to its small size then grow it, you can often sell it at a higher multiple. So if I buy a business that makes $200,000 for its owner at a 3x seller discretionary earnings (SDE) multiple, grow SDE by $100,000 each year for the following three years, then sell it at the end of year three for 6x SDE, that’s an aggregate 733% return on investment in about four years ($200k+$300k+$400k+$500k+$3,000K)/($600k)! A business that’s larger when you purchase it initially, unless you’re able to turn it into an Asurion, is probably going to grow more slowly and not have a margin expansion anywhere near as striking.

I’m keeping my eyes and ears open for anything from HVAC to plumbing to landscaping businesses at the $200K SDE mark. In fact, I’d say it’s slowly becoming my primary focus.

-Charles

** I don’t think searchers looking in the $1MM – $2MM EBITDA range are the only people in a crowded acquisition field. I’d argue that anyone who invested in a pre-acquisition SPAC at a multiple of trust value (e.g. paying $30 a share for a SPAC with a cash/trust value of $10… which means that if the SPAC doesn’t find an acquisition candidate, the investor will lose about $20 instead of getting their principal back) is in a much, much worse position. SPACs are searching an even more crowded field because (1) there are so many SPACs now, (2) there aren’t enough acquisition targets of sufficient size, and (3) there is heavy competition from non-SPAC acquirers like so-called “strategic” buyers. Contrast the SPAC situation with Berkshire Hathaway: Berkshire’s universe of appropriately-sized acquisition candidates is indeed smaller since Berkshire is so big (Buffett talks about searching for an “elephant sized” acquisition) but Berkshire has less competition from other acquirers and, critically, Berkshire isn’t under much pressure to make an acquisition in a limited time period.