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Start for freeUnderstanding the Size Fallacy in Business Acquisitions
When it comes to buying a business, one of the most common pieces of advice you'll hear is "buy as big as you can." This sentiment often comes from a place of hindsight, with successful acquirers claiming they should have bought bigger. However, this advice may not be suitable for everyone. The size of the business you should buy depends on various factors, including your risk tolerance, financial situation, and growth objectives.
Execution Risk vs. Financial Risk
When considering the size of a business to acquire, it's crucial to understand the difference between execution risk and financial risk:
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Execution Risk: This is typically higher in smaller deals, where businesses are often owner-operated with less infrastructure and fewer employees. The workload on the acquisition entrepreneur is usually higher, and there's less risk distribution across the company.
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Financial Risk: This is generally higher in larger deals, where the financial stakes are much higher due to larger loan amounts and personal guarantees.
Both types of risk are important to consider, and your comfort level with each will play a significant role in determining the right size business for you to acquire.
Factors to Consider When Determining Business Size
1. Capital Requirements
The amount of capital you have access to will significantly impact the size of the business you can acquire. There are two main approaches to financing a business acquisition:
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Traditional Bank Financing: This is typically capped by the amount of assets you're willing to collateralize. You'll usually need about 20% down payment and be comfortable pledging assets.
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SBA Financing: This relies on the historical cash flow of the business rather than assets. The down payment is lower, usually between 10-20%, which can be split between you and the seller.
As deal sizes increase, banks may require higher down payments. For example, a $5-10 million deal might require a 10% down payment from you and 10-15% from the seller.
2. Post-Closing Liquidity
One often overlooked aspect of business acquisition is the post-closing liquidity requirement. This is the amount of money you need to have access to after closing the deal. Banks typically want to ensure you have a cushion or safety net.
The required amount can vary based on how capital-intensive the business is:
- For a capital-intensive business (e.g., a cyclical product-based business), banks might require 13% post-closing liquidity.
- For a service-based business with low overhead, it might be as low as 5%.
A good rule of thumb is to plan for 8% post-closing liquidity of the total loan cost. This doesn't necessarily have to be cash - it can be any liquid assets that you can access quickly if needed.
3. Income Replacement
Consider how much money you need the business to generate to sustain your desired standard of living or to pay an operator if you're not planning to run the business yourself.
Understanding Earnings and Cash Flow
One of the most critical aspects of determining the right size business to buy is understanding how the earnings you're acquiring will support your objectives. It's essential to recognize that earnings do not equal your take-home income.
Types of Earnings Metrics
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Seller's Discretionary Earnings (SDE): This is net income plus interest, taxes, depreciation, amortization, non-operating expenses/income, and the owner's compensation and benefits (for one owner).
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Net Income: This is the line item on financial statements - revenue minus COGS, expenses, depreciation, amortization, interest, and taxes.
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EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization.
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Adjusted EBITDA: This is often EBITDA plus the market rate compensation of the owner, providing a more accurate representation of the business's cash flow.
What Earnings Need to Cover
Earnings from the acquired business need to cover three main areas:
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Operations: This includes rebuilding operating cash, paying for health insurance if transitioning from a W2 job, and contributing to retirement.
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Growth: Funding for your growth strategies and ideas to improve the business.
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Income: What you can pay yourself to maintain your standard of living or pay an operator.
It's crucial to remember that these three areas need to be covered after accounting for debt service.
Practical Examples
Let's look at some practical examples to illustrate how to determine the right size business to buy:
Example 1: Targeting $200,000 Income
If you're looking to replace a $200,000 income, you might think targeting a business with $250,000-$500,000 in SDE would be sufficient. However, this might not be enough when you factor in debt service, growth strategies, and operational needs.
Let's break it down:
- Targeting a business with $450,000 SDE
- Purchase price: $1.5 million + $100,000 working capital = $1.6 million financed
- Monthly debt payment: $22,000 (annual debt service: $264,480)
- Growth strategies: $100,000 ($40,000 for increased ad spend, $50,000 for a new sales rep, $10,000 for CRM and customer solutions)
This leaves only $85,520 for your income and operational cushion, which is not enough to replace a $200,000 income and have any operating cushion.
Example 2: Adjusted Target for $200,000 Income
To comfortably replace a $200,000 income, you might need to target a business with around $700,000 in SDE. Here's how it could break down:
- SDE: $700,000
- Debt service: $264,480
- Growth strategies: $100,000
- Your income: $200,000
- Operational cushion: $35,520
This scenario provides a more balanced and realistic approach to achieving your income goals while also allowing for growth and operational needs.
Rules of Thumb for Targeting Business Size
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If you have low-cost growth strategies, target a business with at least 3 times the amount of earnings as the income you want to pay yourself.
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If you have high-cost growth strategies, target a minimum of 4 times the amount of earnings as your desired income.
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Always calculate debt service based on current interest rates and your expected leverage ratio.
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Don't forget to account for post-closing liquidity requirements in your calculations.
Additional Costs to Consider
When determining the size of the business you can afford, don't forget to factor in additional costs associated with the acquisition process:
Due Diligence Costs
- Financial due diligence: $6,000-$15,000 for light financial due diligence, or $20,000-$25,000 for a full quality of earnings report.
- Legal due diligence: $5,000-$20,000 for an asset sale, potentially more for a stock sale.
These costs are typically paid out of pocket before closing.
Closing Costs
- SBA guarantee fee: 3.5% on the first million of the guaranteed portion of the loan, 3.75% on the rest. Currently waived for loans under $1 million.
- Other closing costs vary based on deal size but can be roughly estimated to equal your down payment amount.
Closing costs are usually rolled into the loan amount.
Conclusion
Determining the right size business to buy is a complex decision that requires careful consideration of multiple factors. While the advice to "buy as big as you can" is common, it's not always the best approach for everyone. Consider your risk tolerance, financial situation, and growth objectives when deciding on the size of the business to acquire.
Remember these key points:
- Understand the difference between execution risk and financial risk.
- Calculate your capital requirements and post-closing liquidity needs.
- Ensure the business's earnings can cover debt service, operations, growth, and your income.
- Use realistic multiples when estimating purchase prices and debt service.
- Factor in due diligence and closing costs.
By carefully considering these factors and running thorough financial projections, you can determine the optimal size business to buy that aligns with your goals and risk tolerance. Remember, there's no one-size-fits-all answer - the right size business for you depends on your unique circumstances and objectives.
Article created from: https://www.youtube.com/watch?v=4Ni86thKK84
