Post 18: Benefits of operational edge on the acquisition process

A good friend (building a holding company of small businesses) responded to my post last week (read here) on guardrails for acquiring small businesses, with a few thoughtful rebuttals: First, the companies that fit the criteria in the article are absolute unicorns, priced accordingly! Second, relaxing one or more of the criteria often supports a much more attractive price (e.g., what if the business is capex heavy but the price is half that of the company fitting all four criteria). That got me thinking about the concept of “investor edge” and how it could/should be incorporated in a search, given it allows for widening the aperture of businesses to evaluate (to more than unicorns!) and a longer list of attractive businesses. Let’s dig in!

Investor Edge in Evaluating Small Business Investments

The four characteristics I shared that make small businesses attractive acquisition targets are:

1. Market growth of 6%+

2. Recurring revenue of 60%+

3. Low churn (<10%)

4. Strong cash flow conversion (80%+ earnings to free cash flow conversion)

For individuals who have never operated a business before (think MBAs, former PE associates), these metrics serve as strong guardrails to identify businesses that require low ingoing operational expertise and function nearly on autopilot (good management teams with established processes, etc). However, for those with deep operational experience, there is an opportunity to showcase one’s edge—allowing them to relax some of these criteria in favor of more attractively priced businesses in which they can unlock hidden value.

The Power of an Operational Edge

Experienced operators understand that financial metrics only tell part of the story. A business with out all of the characteristics metrics listed might still be a strong acquisition if the investor brings specific competencies to the table. Searchers with an operational edge can take advantage of opportunities that others may pass on, often acquiring them at more favorable valuations.

Understanding CapEx and Cash Flow Volatility

A business with a lower free cash flow conversion rate may not necessarily be a poor investment. Many capital-intensive businesses (e.g., manufacturing, transportation, or storage) experience lumpy CapEx needs, causing cash flow conversion to appear weaker in certain periods and stronger in others. For investors with prior experience in capital-intensive industries, this isn’t necessarily a red flag—it’s a familiar pattern.

An operator who understands CapEx cycles can:

• Assess the timing and necessity of capital expenditures

• Optimize equipment replacement schedules

• Implement more effective maintenance programs to extend asset life

This deeper understanding allows them to extract value from a business that might look unattractive to an investor solely focused on smooth cash flow conversion. When accepting outside capital, it’s often important to reflect in the cashflow statement forecasts of the business the anticipated maintenance and acquisition capex needs of the business.

The Customer Acquisition Advantage

Low churn is a crucial metric for buyers unfamiliar with business operations, as high churn rates can create significant revenue instability. However, an investor with a strong marketing or sales background may be able to overlook a business with suboptimal churn if they have a superior ability to acquire new customers cost-effectively.

For example, an investor with a proven track record in:

• Performance marketing (e.g., digital ads, SEO, paid acquisition)

• Referral programs (leveraging existing customers to attract new ones)

• Strategic partnerships (co-branded marketing, affiliate programs)

can evolve a high-churn business into a profitable venture by implementing a robust and cost-effective customer acquisition system. This edge enables them to consider lower-priced businesses that others might shy away from. Upon attempting a sale of the business the cost of customer acquisition will be a core element of diligence. Demonstrating that cost-effective new customer acquisition will be a critical component of the buyer’s diligence process.

Fixing a Weak Recurring Revenue Model

A business with less than 60% recurring revenue may not meet traditional acquisition criteria, but for an investor skilled in structuring subscription models, customer contracts, long-term service agreements, or bundled services that incentivize repeat purchases. there is an opportunity to create stickier revenue streams, driving a step-change increase in sales multiple.

With the right strategy, an investor can transform a business with inconsistent revenue into one with predictable, high-margin recurring revenue, significantly increasing its enterprise value.

Spotting Growth Potential in ‘Slow’ Markets

Many investors avoid industries with sub-6% growth, assuming limited upside. However, an experienced operator can identify untapped opportunities within these markets.

For example, someone familiar with operational efficiencies, cost-cutting, or product innovation might see a path to improving profitability even in a low-growth industry. Additionally, a strategic repositioning of the company’s offering—such as targeting an underserved niche or expanding distribution channels—can unlock higher growth rates.

Who Should Stick to the Hard Criteria?

The original acquisition criteria—high recurring revenue, low churn, strong cash flow conversion, and market growth—are best suited for investors who lack operational experience and want to minimize risk. These buyers are looking for a business that can largely run itself while they learn the ropes of ownership. These businesses are underwritten with the expectation that the buyer will build the operational toolkit over time and begin to drive higher than trend performance in the latter years of ownership (years 2 onward typically)

For investors with operational expertise, however, there is room for flexibility. The ability to diagnose and solve business inefficiencies allows experienced operators to unlock value where others see risk. It also allows for multiple arbitrage, where a skilled operator can implement the operational changes that allow a company to reacquire the most attractive characteristics for searchers. Instead of viewing subpar financials as deal-breakers, these investors see them as opportunities to apply their skills and drive significant improvements.

Final Thoughts

Investor edge is about understanding where you can bring unique value to a business. While the standard acquisition criteria help ensure a business is stable and low-risk, seasoned operators can selectively relax these criteria based on their specific competencies.

If you have expertise in capital management, customer acquisition, recurring revenue models, or market repositioning, you may find significant value in businesses that others deem unattractive. The key is knowing your strengths and using them to turn overlooked businesses into high-performing assets.

For first-time business buyers, strict financial criteria provide necessary guardrails. But for experienced operators, the real edge lies in recognizing the hidden potential in businesses others pass over—and having the confidence and skill to unlock it.

Parting Thoughts

How you can engage with me

• 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

I look forward to hearing from you!