HBR Guide to Buying a Small Business

HBR Guide to Buying a Small Business: Think big, buy small, own your own company
by Richard S. Ruback and Royce Yudkoff

This book provides a methodology to find, evaluate, finance, and acquire a small business. The autonomy of entrepreneurship is compelling to many, but the failure rate of start-ups is high—more than two-thirds of them never deliver a positive return to investors. In contrast, this approach seeks to buy and manage an existing “enduringly profitable” business. The authors teach a course in entrepreneurship through acquisition at Harvard Business School.

Desirable Characteristics

“You should buy a business that has enduring profitability, that is, an established, profitable business model… one that is more likely to continue to have a stable income over time… The essential characteristic of enduringly profitable businesses is recurring customers.”

Slow Growth. “Although high growth would seem like a wonderful characteristic of a business, it comes with high risk… It also absorbs money rapidly, and raising that money puts a strain on the business and its owner. A rapidly growing firm also attracts competitors, which see the expanding market and the opportunity to attract new customers… Slow growth businesses sell at lower prices.”

A good match. “We recommend that you stake stock of your own background, skills, strengths, and weaknesses. Limit yourself to businesses that you will have the ability to manage… Most businesses require general management skills—you’ll need to understand a bit of everything: people, marketing, production, legal, accounting, and so on. Our experience is that most people with strong general management potential can thrive in a wide range of businesses. Still, if you are allergic to fur, don’t buy a pet shop.”

Buy a business, not a job. “The earnings of any job are eventually limited by the number of hours in a day… In a successful business, customers value the products and services from the company. The company develops systems and policies so that individual providers can be substituted when one person moves on to another position. The customer recognizes the importance of the company, and that is what makes a business more than a job.”

Undesirable Characteristics

Avoid cyclical businesses. “If your customers are able to defer purchasing from you when their business gets soft, your revenues will drop like a stone. Because you will be responsible for regular payments on your acquisition debt, this volatility creates a big problem.”

Avoid turnarounds. “It is tempting to imagine buying a troubled business or one with uneven performance, because the purchase price would be very low. But we strongly advise against it, because you’ll have to reinvent the business model and doing so is a very difficult and risky endeavor.” Additionally, you may be unable to obtain a bank loan for a turnaround.

Avoid technology companies. “You’ll need to reinvent their products and find new customers frequently. If you like recurring revenue as we do, you’ll steer clear of these companies.”

Finding Companies to Buy

Using Brokers. “Sourcing through brokers is the most successful approach to overcome the problems presented by uncommitted first-time sellers. Brokers also provide organized information about the companies for sale, making it easier for searchers to quickly apply initial and deeper filters to prospects.”

Sourcing Directly. “The upside of direct sourcing is potentially better deals on better firms—because these firms generally won’t have been available to other searchers on the open market—but the downside is that direct sourcing is far more expensive.”

Filter for Profit margin

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. “EBITDA margin is simply EBITDA divided by revenue… Look for large EBITDA margins of at least 20% for manufacturing and service businesses and 15% for higher-volume businesses like wholesalers and distributors. The small-company acquisitions that we describe in this book, for example, have EBITDA margins ranging from 20% to 50%.”

Filtering for the Owner’s Commitment to Sell

“The clearest and most reliable indicator that an owner is committed to selling is an external factor that is compelling the sale [such as] retirement, poor health, divorce, inability of business partners to get along, or death of the owner and sale of business through the estate.”

Preliminary Due Diligence

“The goal of preliminary due diligence is not to learn how to operate the business; it is to efficiently get to a go/no-go decision and to shape the price and terms of your offer… To minimize the costs, you will do almost all the preliminary due diligence yourself.”

How much should you pay for a small business?

“The kind of enduringly profitable small business that we’ve described in this book—with EBITDA of between $750,000 and $2.0 million—tends to be priced between 3 and 5 times EBITDA (often expressed as 3x-5x). This means that if the most recent year’s EBITDA is $1 million, the purchase price would range from $3.0 million to $5.0 million. While not all smaller businesses sell in this range—distressed firms typically sell for less, and firms that appear to have enormous growth potential often sell for more—our experience and research indicate that this price range does apply to enduringly profitable, smaller firms in traditional industries with established business models and moderate growth prospects.”

“It is because these purchase-price multiples are so low, incidentally, that these smaller businesses provide significant financial opportunities for potential buyers. After all, buying a company at a 4x EBITDA—earning, say, $1.0 million of EBITDA annually on a purchase price of $4.0 million—provides a 25% yield on your investment every year.”

Leverage explained in a nutshell: “If, as we will recommend, you pay for your new business in part by borrowing against it and in part with equity, your return on equity will be even higher and well above investment returns available elsewhere.”

“Larger companies often cost much more—more like 6x-12x EBITDA… Larger companies attract more buyers (such as private-equity firms), and these buyers tend to bid up multiples.”

The Offer

“The offer itself takes the form of a formal letter of intent (LOI). In this document, you’ll state your proposed deal terms, including an initial offer price and the specifics of the next phase of the acquisition. Ideally, the seller will accept your LOI by formally signing it, but more often, some negotiation has to happen first.”

“If you go forward with the acquisition, the LOI will be succeeded by a much more detailed and binding purchase agreement. But the LOI [ensures] that there is mutual understanding of the key terms before everyone does a lot more work… Keep in mind that an LOI typically runs 4 pages long; your binding purchase agreement is about 40 pages long.”

Deal Breakers

“Some estimates suggest that about half the deals for smaller firms fall apart for one reason or another… There are two common deal terms that often confuse owners and cause them to abandon the acquisition late in the process.”

“Working capital is the amount of money needed to run the business… When you agree on a price… you specify an amount of working capital that will stay with the business. In many small businesses, this amount is substantial, sometimes in the millions of dollars, but more often in the hundreds of thousands. The buyer includes the working capital because it is, effectively, an operating asset of the business. The seller, however, has a different view, and deals often break down over this issue.”

In a debt-free, cash-free acquisition, “the seller gets to keep the cash in the business but also must pay any outstanding debt of the business… If there is a $1.0 million loan, perhaps related to the purchase of a building or a piece of machinery, the seller needs to pay off that loan; the buyer doesn’t have this liability, even though the buyer gets the building or the machine the borrowed money was used to purchase. Some sellers misunderstand this term, and one very disappointed searcher reported that a seller abandoned an acquisition within a few weeks of the scheduled close even after multiple discussions about pricing.”

Confirmatory Due Diligence

The confirmatory due diligence “phase is the most time-intensive portion of the search and acquisition… You’ll want an accountant to review the financials and to prepare a quality-of-earnings report so that you can be sure that the company has been paying its bills and taxes and is likely to be profitable in the future. There might be other outside professionals you’ll need to consult (and pay) to learn about, for example, environmental liabilities or labor issues.”

Raising capital

The capital structure of your acquisition might consist of:  senior loan 40% + seller debt 25% + equity 35%.

Senior loan. “Local and regional banks are a good source of senior loans, as are nonbank lenders.”

“SBA loans are a great choice, if you qualify,” for three reasons. First, “the SBA will allow you to borrow up to 80% of the acquisition cost of qualifying small businesses up to a maximum loan size of $5 million. (Conventional lenders typically lend 40% to 50% of the acquisition cost.) Second, because three-quarters of the loan is guaranteed by the SBA [Small Business Administration], it is less expensive than other bank debt. Third, the loan is long term, typically ten years… Most banks (outside of the SBA loan program) try to keep the term of their loans to smaller firms to five years or less to limit the banks’ risk.”

“Almost all senior loans come with covenants, or specific promises you make to your lender. If you violate a covenant, the loan becomes due immediately.”  Additionally, senior loans typically require the borrower to sign a personal guarantee, making them personally liable for repayment. “All SBA-guaranteed loans require a personal guarantee.”

Seller debt. “Most buyers finance about one-third of the cost of their acquisition directly from the seller.”

“Earn-outs are similar to seller notes in that in these arrangements, part of the sales price is paid on a deferred basis. But in the case of earn-outs, that payment is pegged to company performance. It enables the seller to be paid a higher price if future company performance hits certain targets, while the buyer has the protection of only paying more if the company demonstrates this additional success. An earn-out is a good way to resolve different views of a company value during a purchase negotiation.”

Equity. “There are many more people trying to invest capital than there are good investments… That means there are investors interested in providing equity to fund about one-third of your total purchase price—as long as the promised payoffs are high enough to reward them for the risks and illiquidity inherent in that type of investment. In our experience, the payoffs need to provide investors with at least an annual rate of return around 25%.”

Final thoughts

The obvious primary target reader is someone interested in buying and managing a small business. But even if the reader doesn’t end up pursuing an acquisition, learning the perspective of a buyer helps an executive to understand what drives value in a small business. It might also be useful for prospective sellers to read this book in order to understand the process, price considerations, as well as common terms and conditions of a transaction.

The authors presume the reader has a basic understanding of how to read financial statements. I highly recommend two HBR books for readers who want to brush up on fundamental accounting and finance concepts: Financial Intelligence and How Finance Works. I also recommend Small Business Finance and Valuation.

The authors teach a course on small business acquisition at Harvard Business School. It would be interesting if they conducted a follow-up study of their students who purchase small businesses: How many deals fell through (and why)? What are some of the noteworthy snags in the transition as a new owner? What percentage of acquisitions achieve or exceed the 25% ROE objective in the years following the acquisition? What percentage of them fail within 5 years? Did any of the entrepreneurs run into trouble with bank loan covenants or have to make good on the personal guarantee of senior debt? This would make an interesting Harvard Business Review article or addendum to a future edition of the book.

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Ruback, Richard S., and Royce Yudkoff. HBR Guide to Buying a Small Business: Think Big, Buy Small, Own Your Own Company. Boston, Massachusetts: Harvard Business Review Press, 2017. Buy from Amazon.com

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Disclosure: As an Amazon Associate I earn from qualifying purchases. I received a review copy of this book.