Buying a business in the small business M&A space is a process that involves a lot of friction. This makes it seem difficult and unapproachable. The good news is that there are plenty of resources available to newcomers in the field. Those who master the process can achieve strong returns. The 2022 Search Fund Study published by Stanford University reported a median aggregate pre-tax internal rate of return for investors of 35.3%, with reported returns as high as 10x.
The first step in this process involves getting acquainted with key industry terms. When comparing this industry’s terminology to vocabulary from more well-known areas of finance such as Private Equity, a few notable differences emerge.
“ETA” is the standard abbreviation for “Entrepreneurship Through Acquisition”, which describes the practice of buying and growing an established small or medium business (SMB).
Buyers can be individuals or small groups, organized into “search funds”. This term refers to an investment vehicle usually formed by one or several individuals (the “searchers”), together with a small group of aligned investors to find, acquire, and lead a privately-held company.
The financial metrics used by search funds to evaluate potential deals also have their own peculiarities. For example, SDE, or “Seller’s Discretionary Earnings”, is a concept we really only see in this space. While SDE is similar to EBITDA, there are a few important differences related to the specifics of a small business acquisition. For instance, with SDE, the manager’s salary is added back, assuming that the buyer might replace the seller as the owner/operator of the business.
Additionally, sellers in the ETA space are usually represented by business brokers rather than investment bankers. Notably, brokers frequently do not have the resources (or name recognition) of investment bankers from large institutions. Elements of the business broker’s role mirror that of a real estate agent, whereby brokers directly manage a business listing placed online. Additionally, because the scope of potential buyers consists of individuals rather than a set group of known corporate options, business brokers end up spending a good portion of their time evaluating buyers and their ability to complete the transaction.
Buyers acquire companies using a variety of distinct strategies. In the “traditional” model, search funds take money from investors, buy bigger companies, and hold less equity compared to the self-funded search funds, which primarily use SBA loans to cover the majority of the acquisition costs in a more leveraged transaction. While these are the primary search fund strategies, additional methods are gaining popularity, including a co-op strategy, whereby the seller’s employees gain ownership over a company and run it through cooperative governance.
How to Get Started Looking for Businesses to Buy
There are several strategies searchers can use to find deals. On-market deals are typically either represented by brokers or FSBO (“for sale by owner”). These opportunities are considered “on-market” because they can be found on listings aggregators, broker websites, and broker newsletters. Often, brokers will market a deal quietly to their internal contacts prior to placing them online. Buyers should try and access these so-called “pocket listings” before they hit the market by building relationships with brokers that are likely to represent deals in their areas of interest. Contact brokers directly, and earn their trust by being prepared, transparent, and willing to share information about financing sources. In the non-brokered universe, buyers can find off-market deal opportunities, where the buyer cold-calls the seller directly. These kinds of transactions can sometimes be more favorable to the buyer than an on-market deal due to less competition and potentially less seller support in the transaction, though industry data shows that these deals are less-likely to close.
A top piece of advice we offer to the beginners in the ETA field is to start with a defined list of search criteria. A thoughtful investment thesis can incorporate factors such as geographical area, industry, product type, SDE margin, operational model etc.
Try to define your search criteria well, but keep in mind that flexibility is the key throughout the search. Ask yourself questions such as: “Am I willing to go smaller in size (or SDE margin) to find a business in the right industry?” or “Can I be more flexible on industry and location so that I can find a cleaner deal (or a deal with higher margins)?”
Beginners’ list of ETA resources
With so much information out there, finding the right resources to support an SMB acquisition can be tricky. Here’s a good place to start: we outlined the fundamental process for buying a small business by starting with our primer about the 42 Steps to Acquiring a Small Business.
After that, here are some of our favorite additional sources:
- Twitter – here are some great starting points SMB, SMBTwit Thought Leaders;
- Websites – Searchfunder, Searchfund;
- Podcasts – Think Like an Owner, Acquisitions Anonymous, Private Market Insights;
- ETA events and conferences – the big ones include conferences at Harvard, Stanford, Chicago/Northwestern, MIT, and the Southeast ETA conference.
Searching to buy a business is not a straightforward process, and there is no single recipe for success. Like all forms of entrepreneurship, ETA requires both discipline and creativity. We at Private Market Labs are here to offer entrepreneurs the tools they need to find the right deal and then put together your acquisition team. Please reach out to us for questions and suggestions about how to improve the platform.