Post 14: Derisking an Acquisition - Buying Smart

Buying Smart: Why it Matters

I would argue that business and market selection are the most important strategic elements when acquiring a business. Potential investors and entrepreneurs must carefully evaluate the market and its headroom for growth to pinpoint opportunities that have a high likelihood of steady growth and profitability. Attractive characteristics include inherent structural demand that only a small number of companies can address, recurring purchases from a small set of operators, and increasing demand for the service(s) as time progresses (e.g., additional seats for a software package or components for more airplanes for an industrial manufacturer)

Choosing the Right Business

The process of identifying a suitable business goes beyond aligning personal interest with professional expertise; it demands a strategic assessment of the industry’s growth potential and the specific business's market position. Ideally, businesses should be situated in markets exhibiting rapid growth—typically exceeding twice the GDP—and a fragmented competitive landscape. These conditions not only support organic growth but also create attractive opportunities for accretive strategic acquisitions.

Despite extensive private equity consolidations in sectors like veterinary care, HVAC, and dental practices, these industries continue to present a number of viable businesses for acquisition. This indicates enduring market dynamics where growth potential remains substantial despite previous investment and consolidation efforts.

Advantages of Acquiring an Existing High-Performing Business

Acquiring an existing performing business offers a foundation of established operations and customer relationships, which allows the new owner to concentrate on understanding business and industry specifics instead of dealing with underperformance. The CEO can identify take the position of listener to their management team without making any changes, while the business continues to perform to due its attractive market positioning.

Over an initial assessment period, typically spanning 9-12 months, the CEO can transition from listener to execution-oriented executive, making the operational adjustments necessary to capture faster growth.

Financial Health and Cash Flow Considerations

From a financial perspective, as long as the commercial elements are strong, you typically are rewarded with attractive financials for no additional effort. The main characteristic to evaluate is the free cash flow generation of the business. Typically it means taking the EBITDA or Seller Discretionary Earnings (SDE) and subtracting the usage of cash due to working capital and capital expenditures. Robust free cash flow indicates that a considerable portion of the revenue is being converted into cash that is available for reinvestment, debt reduction, or distribution to owners, thus providing a financial cushion during economic downturns and funding for growth initiatives.

Identifying Value in Underperforming Companies in attractive markets

Opportunities often arise from acquiring businesses that are underperforming relative to their market potential. These businesses might include under-resourced subsidiaries of large corporations or holding companies, businesses involved in manageable legal issues with limited financial risk, or family-owned businesses that have not maximized operational efficiency. These scenarios often allow for strategic improvements that can significantly enhance value. They also tend to present attractive scenarios for acquisition due to their low price relative to their pro forma earnings potential. An underperforming business with 10% margin will trade for half or less than half of a similarly sized business with 20% margin, despite the ability to achieve or exceed that profitability profile.

Conclusion

The decision to acquire and manage a small business should be supported by a thorough analysis of market conditions, financial stability, and growth potential. Selecting a business in a high-growth market with strong cash flow characteristics is crucial, particularly in an industry a CEO has not operated in before. Particularly when backed by investors, keeping room for mistakes in the acquisition process is critical. While obtaining any business at a really good price is useful, I argue that the primary goal, particularly when looking to build a business over decades, should be on riding the tailwinds of the inherent market growth potential and cashflow conversion potential of the business. This level of strategic focus is helpful in increasing the likelihood of long-term success and profitability.

Tweets from the Streets

• On thinking outside the box: https://tinyurl.com/post11tweetone

• On marketing: https://tinyurl.com/post11tweettwo

• On the worst case scenario: https://tinyurl.com/post11tweetthree

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• On compounding over long time horizons: https://tinyurl.com/tikisnewsletterpost10

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Parting Thoughts

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Until next time…Keep building!