By Walker Deibel, author of Buy Then Build
There is a persistent misconception that you have to be rich to buy a business. It turns out, this isn’t the case. In today’s market, you can buy a business with as little as 10 percent down and 90 percent leverage. According to Verne Harnish’s book “Scaling Up,” only four percent of businesses generate more than $1 million in revenue annually. That means an entrepreneur’s capital injection is in line with a 20% down payment on the average home in America.
If you want to acquire a company, I believe access to capital is not an obstacle. With private capital markets flooded with cash for investment, the proliferation of search funds and the banking industry strong, more capital is available for acquisition entrepreneurs today than ever before. Further, in contrast to a startup capital raise, you can be preapproved, then close six to eight weeks after your offer is accepted.
That said, the most common objection I get in my work as an acquisition entrepreneur and advisor is that I’m an advocate for “heavy leverage.” There is a difference between acknowledging that capital is accessible and how much you should actually take on. So, what is the right amount of leverage for a business acquisition?
More Leverage Means More Risk
The more leverage you take on when buying a business, the riskier the investment becomes. As entrepreneurs, we like to think we can control outcomes, but this control is limited to within our business. We can’t predict when an event like the housing crisis or the tech-bubble burst will happen. We can only know that something like this will happen at some point.
When disaster strikes, it’s preferable your company is not “over-leveraged.” This is when your business’s cash flow tightens and subsequently threatens your ability to make loan payments -- or stay in business at all.
When capital is easy to access and banks take a liberal approach to lending, businesses tend to get acquired for as little of the buyer’s money as possible and end up over-leveraged as the markets turn. Today, the standard in private equity is putting 40 to 60 percent equity into a deal.
Balancing Safety With Growth Potential
There is no right amount of leverage. Rather, you want to get the balance right between how much risk to take on, and how much protection you have in the event of a downturn.
If you’re looking to minimize risks, you should look for what Richard Ruback and Royce Yudkoff from Harvard Business School describe as an “eternally profitable” business in their book, “HBR Guide to Buying a Small Business: Think Big, Buy Small, Own Your Own Company.” This would be something that largely lacks technological innovation, like commercial window washing or a snow-plow business.
However, many entrepreneurs prefer to maximize their growth opportunity, which means finding a business providing a growth opportunity that matches your skill set. When you do, the risk no longer sits with the business, but with your ability to execute on that growth opportunity. This is a “platform business” for the acquisition entrepreneur.
Let’s play out a scenario. You see a business you’re confident you can double in size in 24 months. You put 10 percent equity into the deal. Now, by growing the business, you’re increasing the cash flow of the business in relation to the principal and interest payments that are due. In doing so, you make the debt payments smaller in comparison to the cash flow, which is the equivalent of putting more equity down.
In other words, putting more equity into the deal or growing the company faster has the same beneficial outcome. Ultimately, it’s up to you as the entrepreneur to decide which route makes the most sense for you.
The Right Amount of Leverage for You
As an entrepreneur, your first step is to find the right business for you. The next step is making sure you take on a level of debt that you’re comfortable with. What should make you comfortable is that this is your business and, as the CEO, you will have more control over the direction and decisions made within the company. An investment in your company is an investment in yourself.
Using an acquisition return on invested capital calculator, you can see that the point of diminishing returns in terms of taking on less debt is 40 to 60 percent equity. I built this spreadsheet calculator, which has been helpful to me in calculating ROIC. Check it out and plug in your numbers -- price, earnings, management fee, term, interest rate -- to get a return on invested capital versus an earning drawdown safety.
In the end, you must look in the mirror and ask yourself: What can I bring to this business to take it to the next level?
Walker Deibel is the author of Buy Then Build: How Acquisition Entrepreneurs Outsmart the Startup Game.