Post 17: A deliberate approach to evaluating businesses for acquisition

Post 17: A Thoughtful Approach to Evaluating Businesses for Acquisition

Acquiring a business is a high-stakes decision that requires a structured, thoughtful approach. While every investor has their own criteria, the best opportunities tend to share a few core characteristics: a large and growing market, high levels of recurring revenue, low churn, and strong cash flow conversion. By focusing on these key attributes, you can identify businesses that have the potential to compound value over time.

Here’s a breakdown of how to systematically evaluate businesses for acquisition:

1. Start with the Market: Size and Growth Matter

Before assessing individual companies, you need to understand the market in which they operate. A great business in a stagnant or shrinking industry will face headwinds, no matter how well-run it is. Look for markets that are:

• Large: Bigger markets provide more opportunities for expansion and more acquisition targets.

• Fragmented: The more companies in a market, the more room for consolidation, which is great for acquisition strategies. Highly fragmented industries often allow buyers to execute roll-up strategies and gain market share quickly.

• Growing at 6%+ Annually: Organic revenue growth is a critical factor. Industries that grow at 6% or more tend to provide a strong tailwind for businesses, allowing them to scale naturally without relying purely on acquisitions.

If a market checks these boxes, it’s worth taking a deeper dive into the businesses operating within it.

2. Find Businesses with Recurring Revenue

One of the most powerful indicators of a great acquisition target is a high share of recurring revenue—typically 60% or more. But what exactly does that mean?

Recurring revenue refers to revenue streams that are predictable and repeatable. While SaaS businesses (software-as-a-service) with subscription contracts are an obvious example, many other industries have built-in recurring revenue models:

• Razor-and-Blades Model: Companies that sell high-margin consumables after an initial product purchase, like aircraft component manufacturers or printer companies (think HP’s printer and ink model).

• Service-Based Recurring Revenue: HVAC and elevator maintenance companies that sign long-term service contracts.

• Insurance and Financial Services: Annual premiums in the insurance industry and assets under management in financial services create consistent, repeatable revenue streams.

A business with strong recurring revenue has a built-in safety net—it’s not constantly starting from zero every year. This makes forecasting easier, stabilizes cash flows, and reduces risk.

3. Keep an Eye on Churn

High recurring revenue only matters if customers stick around. That’s where churn comes in. Ideally, you want businesses with a churn rate of less than 10%.

• Low churn means: Customers are satisfied and find value in the product or service.

• High churn is a red flag: It suggests pricing issues, competitive threats, or poor customer retention strategies.

In evaluating churn, be cautious of businesses with high revenue concentration. If a few customers account for a large percentage of sales, the loss of just one or two major clients could severely impact the business.

4. Prioritize Strong Cash Flow Conversion

High cash flow conversion is one of the most overlooked, yet crucial, aspects of evaluating a business. Companies that generate significant free cash flow offer tremendous optionality—whether for reinvestment, acquisitions, or returning capital to investors.

The best businesses tend to have:

• Low Capital Expenditures (CapEx): They don’t require massive ongoing investment to sustain operations.

• Low to Negative Working Capital: This means they collect payments faster than they pay expenses, a hallmark of great business models.

• Strong Free Cash Flow: This enables business owners to reinvest in growth, execute acquisitions, or distribute excess capital.

A business with these traits can grow without constantly needing external financing, making it more resilient during downturns.

5. Manageable Operational Complexity

Not all great businesses are easy to operate. But for an acquisition, the simpler the operations, the better. Businesses with excessive operational complexity—such as those with highly technical services, difficult-to-scale logistics, or regulatory hurdles—can become a burden for a new owner.

Look for businesses that:

• Have straightforward operations with minimal moving parts.

• Require limited oversight and can run without constant management intervention.

• Are not overly reliant on specialized knowledge that only a few employees possess.

If the business is highly complex, ensure there’s a strong team in place to manage it post-acquisition.

6. Identify and Bound Exogenous Risks

Every industry faces external risks—regulatory changes, supply chain disruptions, or shifts in consumer behavior. The key is identifying these risks before they become a problem.

Ask yourself:

• Are there regulatory risks that could change the business model?

• Is the supply chain overly concentrated in one region or vendor?

• Is the business exposed to macro risks, such as interest rate sensitivity?

While every business has some level of external risk, your goal is to ensure those risks are manageable and well understood.

The Sweet Spot: High-Growth Businesses in Small Vertical Markets

Some of the most attractive acquisition targets are high-growth businesses operating in smaller niche markets. These companies tend to:

• Be overlooked by larger competitors.

• Have strong pricing power due to specialized offerings.

• Offer opportunities for expansion without intense competition.

Finding a company in a fast-growing, underserved vertical is often a winning formula for long-term success.

Final Thoughts

Acquiring the right business requires a structured approach. Start with the market—size, fragmentation, and growth. Then, focus on recurring revenue, low churn, and strong cash flow conversion to find resilient businesses with long-term compounding potential.

How you can engage

• I’d love to hear how your acquisition search is going—feel free to leave a comment, reply directly to this email or reach out directly at [email protected]

• If you are interested in keeping up with my search, as a potential future investor, kindly fill out this form:

• If you are selling your business and would like to have a conversation, please email me with some business highlights (revenue, earnings, growth potential)

Thanks: I look forward to hearing from you!