Home run or base hit?
The other day a searcher described to me a dilemma she’s facing. After being priced out of a few attractive deals recently, she’s re-evaluating her sourcing approach, particularly when it comes to industry.
These deals were very attractive - great growth, good margins, fantastic scalability, good ratio of customer acquisition costs to lifetime value, multi-year contracts, capable team… the works. She could see herself in the business, she had a value creation strategy sketched out, and she had investors who could see the vision.
Just one problem: she couldn’t afford the asking price.
This was a software business, and as the valuation of SaaS businesses is often calculated as a multiple of revenue, the searcher was offering $7-10 million for a business with $3.6m in annual recurring revenue (ARR). Unfortunately, the business wouldn’t consider less than $15 million.
And here’s the thing - someone might end up paying $15 million. For the right buyer, especially a strategic buyer who can realize material synergies, this is an opportunity to buy additional ARR without adding much to the cost base, as well as to potentially expand the product line or geographic footprint, offering new growth or value creation opportunities not available through organic means. In addition, that buyer might bump its own valuation multiple in the process, making the ROI of the deal quite attractive even at over 4x ARR. (Of course, in order to realize those synergies, the strategic buyer may have to gut the acquired business. But for the seller who just wants cash, that’s not such a big deal.)
Unfortunately for the searcher, there are no synergies to realize, which means she must evaluate the business as a stand-alone entity. She should look at the existing cash flow, existing team, existing customers, existing product line... and calculate the price she’s willing to pay based on those factors. Naturally, the price she arrives at should be lower than that offered by the strategic acquirer.
Her spirits crushed by several similar losses in recent months, the searcher is considering whether she should continue pounding the pavement in software, or whether she should pivot to other less sexy industries. When asked why she chose to focus on software, she gave two answers:
She thinks running a software business will better hold her interest than running a non-software business.
She wants this deal to be a huge success, and she thinks buying a software business is the best way to put herself on that path.
I partially addressed #1 in a post a few months ago, so let’s focus on #2. The question at hand is whether to swing for the fences or get on base. (For those unfamiliar with baseball, the question is whether to swing big and risk missing, or swing more conservatively for a smaller, but higher-probability, result.)
I love discussing this dilemma, because I faced it in my own search as well. I began my search thinking that I wanted the search fund project to be at least a moderate success, because that would then set me up well for whatever I wanted to do next. Then, somehow, over the course of my search that mentality changed to “I want a massive home run.” That latter mentality ultimately caused problems in my search. I became greedy, both in terms of which deals I would even consider and in the offers I made.
Searchers I meet can be found anywhere on this spectrum, sometimes oscillating between extremes, and their confusion is not helped by the diversity of opinions in the investor base, some of whom push for more high-risk, high-reward deals, while others are more conservative.
I feel for them, and though there is unfortunately no easy answer to this dilemma, I did offer some guidance to the searcher mentioned above. I asked her to remember why she embarked upon this process. What do you really want out of it? For how long? What is the minimum financial outcome for you that will help you meet your short- and long-term objectives? What other outcomes are you looking for?
Armed with these answers, a searcher can begin to narrow the universe of sourcing strategies and target industries. It is also important to remember that a searcher can do very well for herself and her investors by bringing a $2m EBITDA company to a $6m EBITDA company, paying down debt, and finding an attractive liquidity event for investors, and that there are many companies that can be bought for reasonable valuations and that can set a searcher up for such a story. Whether such a path constitutes success for the searcher is ultimately up to the searcher herself.
