A guy and his gadget
A searcher once told me about an opportunity he had been evaluating for the past month or so. This searcher was still employed full-time and hadn’t officially launched his full-time search yet, but he had been looking at a few deals in his spare time, hoping to come across a gem.
I could tell by his tone that he was very excited about this deal. He had met several times with the seller and was fairly sold on the upside potential of the business. In fact, he brought the deal up in two separate conversations about a month apart, so I know he was working on this deal for quite some time.
The seller was, if I recall correctly, a university professor with an engineering PhD and had started the business with three of his colleagues about five years prior. Each founder owned 25% of the business, which engineered custom devices that it sold primarily to utility companies that were expanding their infrastructure. In addition to the four owners, the business employed about 15 part-time contractors. The devices they developed were unique to the region, though there were several direct competitors in international markets. In the past year, the business had sold about US$4 million worth of these devices, generating about US$500k EBITDA. I don’t recall what the business had done in sales the prior year, but I believe it was significantly less.
The “seller” didn’t really want to sell his stake in the business. Rather, he didn’t feel his three partners were pulling their weight and wanted someone (e.g. the searcher) to buy them out. By his estimation the partners could be bought out for US$1 million each. The “seller” would stick with the business and believed that with a bit more firepower they could bring the business to US$15 million in turnover in five years. He believed this goal could be achieved by a) licensing other products and selling them into the existing customer base, b) expanding into Asia, and c) enhancing the IoT component of the business.
Given what I’ve told you so far, jot down your thoughts on the opportunity. What are its strengths? What are its weaknesses? What would be your next steps?
Let’s also take a pause to remind ourselves what the search fund model is designed to do - enable an entrepreneur, who is typically an aspiring first-time CEO, to acquire and operate a business with the support of a team of highly accomplished investors. And because we’re putting a first-time CEO at the helm, we should keep the following objectives in mind:
Limit risk.
Limit complexity.
Seek predictability.
Don’t overpay.
Can we achieve these objectives with this deal? Given my brief introduction to the opportunity, I think achieving these objectives would be quite difficult, and I therefore offered the following guidance to the searcher:
1. Too small.
$500k of EBITDA (12.5% margins) leaves little room for error or the unexpected bump in the road, and little opportunity for the incoming CEO to reinvest in the business. Also, it’s difficult to argue based on one year of $4 million of revenue that this is a truly proven and steady business.
2. Too immature.
A five-year history is quite brief in search fund terms, and the company’s youth is evident in its org structure: we essentially have one active executive managing a bunch of contractors. Ideally a searcher wants to buy a company with reliable processes and a middle management team in place and willing to stay post-sale. With very limited team and infrastructure, this company fits the “guy and his gadget” profile we often see in smaller businesses.
The company’s relative immaturity also produces significant key-man risk. Once the three other founders exit the business, the company’s IP rests almost entirely in the head of the remaining owner rather than distributed throughout the organization. If that owner is hit by a bus, loses motivation, or needs to be removed from the business for any other reason, much of the company’s value leaves with him.
3. Too expensive.
The implicit valuation is $4 million, valuing the company at about 8x EBITDA. This is generally far too much for a business of this size, and while overpaying may get you the deal, you’ll likely have to spend years post-acquisition digging yourself out of that hole before creating any real value for shareholders.
4. Too unpredictable.
The revenue is entirely project-based. When the customer decides to invest in an expansion project, the company can sell a bunch of devices. However, there is no ongoing revenue from that customer after that initial sale of the devices, and the company’s future revenue from that customer is entirely dependent upon the customer’s expansion strategy. $1 million of sales to a customer this year says little about our revenue from that customer next year. If the customer doesn’t expand, the company’s revenue from that customer drops to zero. This makes it difficult for the searcher-CEO to budget and allocate resources effectively.
5. Uncompelling value creation strategy
The goal of boosting revenues by licensing other products may be achievable, but it doesn’t build much equity value and margins might take a hit. The business’ margins aren’t great even as an OEM, and becoming a distributor for other products puts the company at an uncomfortable part of the value chain, leaving it vulnerable to pressure from both customers and the OEM. The company could offer some consulting services as part of their value-add, but again, that’s more project-based revenue.
The opportunity to expand overseas sounds great, but it’s very complicated. While overseas expansion can eventually be part of the growth story, it typically shouldn’t be in the near-term plan for a first-time CEO, especially with a business this small. If a $4m business needs to go overseas to grow, especially to a culturally dissimilar market, then its domestic addressable market likely just isn’t big enough.
If, however, the company were able to develop a recurring service offering that would generate recurring revenue post-installation, that could build some equity value. But really, a searcher is looking for a business that has already figured this out, rather than one that requires an immediate reinvention of the business model.
Given this analysis, why was the searcher so excited about this opportunity? Unfortunately, as is often the case with novice searchers, the answer is likely that the opportunity was one of the first doable deals the searcher had encountered. The seller liked him, and the idea of transitioning straight from his corporate job to running this business, without having to go through a full search process, was quite appealing.
In the end I recommended the searcher keep looking. This is always difficult for a searcher to hear after falling in love with a business. But when the searcher hasn’t seen many opportunities, especially early in the search, she often doesn’t know where to set the bar, and the idea of doing any doable deal is quite exciting. However, once this searcher is deeper into the search and has seen some higher-quality deals, I’m quite confident he will be grateful for not having spent the next 5-10 years of his life on this one.
Action Items
In your next conversation with a searcher, ask about the first few companies the searcher looked at. Ask where those deals rank relative to the best opportunities they’ve seen to date, or to the company they ended up acquiring.
Type up a short list of qualifying questions to ask yourself about each deal and put it on the wall. This was actually a suggestion from one of my interns, and whenever I started getting attached to a deal, the interns would point to the wall and we’d go through the list. The process was a very helpful sanity check.
