Acquiring SMBs; A practical approach to maximizing value (Part 1)

What are SMBs?

When people think of SMBs, they think of the mom-and-pop grocery stores down the street. While these are infact SMBs, the scope of SMBs goes way beyond your typical mom and pop stores. SMBs is an acronym for Small and medium sized businesses generally with fewer than 500 employees and less than $1bn in annual revenues.

So how do they differ from startups?

Y Combinator defines a startup as a company that is built to grow fast. They are able to grow fast because they are typically companies with novel ideas and potential to disrupt an entire industry. Industry disruption is the goal of any startup. Think of Paystack and Flutterwave in Nigeria whose ambition is to revolutionize how payments are made across Africa or a Piggyvest that facilitates automatic savings of my money straight from my bank account. The revolutionary nature of these companies might not seem pronounced until you take a step back to think about how their respective industries operated prior to the introduction of these startups. I’m old enough to remember how laborious automated savings used to be prior to the introduction of Piggyvest in Nigeria. You either had to manually transfer the desired sum into a dedicated savings account or buy a “Kolo” (Colloquial for piggybank) that you chugg with cash until it either reaches its maximum capacity or is obliterated for sapa emergency reasons.

SMBs differ because the reason d’etre of their existence isn’t disruptive in nature and they don’t prioritize rapid growth over revenues/profits. The success of SMBs isn’t necessarily predicated on growth but to consistently turn out a profit.

I give this background, so you get a sense of the rigid dichotomy between risk and return expectations from the perspective of an investor. Startups are a lot riskier as founders dedicate lots of resources to businesses that may or may not achieve a product-market fit hence Investors in startups have a higher return expectation because they ostensibly take on more risk. Since SMBs by their nature aim to churn out consistent profits, they mostly appeal to traditional investors who prioritize some form of capital preservation and receipt of consistent dividends from their investments.

Now that you get the idea...

Outside my corporate life and occasional sojourn into the financial markets, I invest in startups and SMBs through a vehicle set up with a buddy a few years ago. So far, we have invested in 8 startups and SMBs through a variety of instruments including direct Equity, Debt, and Convertibles. Lately, we have been exploring the North American and European markets to find investible SMBs to acquire and I thought to document what I think has been an interesting experience

Business Profile  

·       HVAC (Heating, Ventilation and Cooling) business that was founded in the early 2000s.

·       80% B2B and 20% B2C

·       Revenues of c.$4m, 18% EBITDA and 9% Net Income

·       Business has c.$1m cash and average Net working Capital (NWC) of $115k

·       Owners are in their 50s and frankly just need a last paycheck.

·       They have tried selling the business in the past but were unsuccessful due to certain clauses they were uncomfortable especially around post-acquisition integration

Why did i make an offer?

·       Most of their clients are large industrials tied into long term service contracts with them. In other words, the company has a high annual recurring revenue (ARR) that doesn’t require me to do much to earn.

·       Business is recession-proof and can’t be nuked by AI.

·       Low Capex. Fixed costs remain low and the same irrespective of service contracts fulfilled. Therefore, each marginal service contract fulfilled is done at lesser cost which creates potential for greater profitability and FCF.

What was my offer?

We agreed on this valuation: (2.5x weighted average SDE of the past 3 years) + Net Debt.

·       SDE stands for Sellers Discretionary Income. For the purpose of SMB acquisitions, SDEs are often used instead of EBITDA. The main difference with EBITDA is that owner’s compensation and discretionary expenses of the business are netted off the usual EBITDA computation. 2.5x because multiples of HVAC businesses have trended upward lately due to interest from large buyers of HVAC companies such as PE players. I wasn’t going to offer even 0.01 over 2.5x because I believe 2.5x+ is at the higher end of the valuation range for a company with my target profile.

·       Adjusted SDE was c$400k +/- $40k for the past 3 years and i applied a weight of 50% to the most recent year, 30% to the year prior and the remaining balance to the third most recent year.

·       Net debt. The company has no debt, but we agreed with the broker that every unpaid tax and creditor balances will be treated as debt. I also netted off the adjusted NWC of $100k per annum from the business cash of c.$1m.

Terms of payment was:

·       20% down payment locked in an escrow after submission of LOI and commencement of DD exercise  

·       Surplus cash paid upon completion of DD. Goodwill of c.$1m= 2.5x $c.$400k payable as follows; 20% down payment and the balance spread monthly over 2 years via a Sellers note. I structured it such that the monthly cashflow generated from the business is sufficient to fulfil the balance of the deferred consideration.

So, what’s the post-acquisition plan?

·       Appoint a solid guy i trust to oversee the business operations on my behalf

·       Include a 6-month handover period which will require at least one of the founders to work 1-2 days per week to ensure smooth transition and that my installed CEO and myself gain enough understanding of the complexities of the business operations.

·       Scale the business to a become a powerhouse in the North American market.

Deal is still live but will share progress of the deal, some of the bottlenecks i have faced and key lessons learned from this particular transaction in the part two of this write-up. Talk soon