Small Businesses on Private Equity’s Radar?
A few days ago, I chatted with a founder in the medical field who turned down a private equity offer to acquire his business. Today, a founder of an automotive business reached out to me and shared that someone in private equity inquired about buying his firm. Neither of these founders had their companies up for sale. The private equity firms found them.
These two stories are anecdotal, but they align with what I’ve been hearing from other investors. Large pools of capital have been raised by private equity to buy relatively small, profitable businesses.
Small businesses represent a great investment opportunity. Their size, usually $10m in annual revenue or less, means there’s ample room to grow revenue if their market is big. Their operations may not be very efficient and may rely heavily on the owner, so technology and better processes can enable these businesses to grow while increasing profit margins. Last, because these businesses are small, valuations are low because there are (or were) fewer potential buyers (i.e., less competition).
Why a Founder Didn’t Sell to Private Equity
I chatted with an entrepreneur in the medical field who has built a business doing seven figures in annual revenue. He built the company from the ground up over the last decade and was recently approached by a private equity firm about acquiring his business.
He wasn’t looking to sell but decided to go through the process of having the private equity firm evaluate his business. In the end, the firm gave him a thorough analysis of his company and an offer to buy the entire company. He would have had to stay on, with a high salary, to continue running the company.
The founder did his own analysis and declined the offer. His business is generating a material annual free-cash flow. He concluded he’d rather own the business for the long haul than sell for a lump sum today because he’s built an asset that’s giving him an above-average return that probably will improve over time. He’d rather own a cash-flowing asset he controls with potential for increasing returns than take a lump sum and find other assets to invest in that will likely pay a lower return.
I enjoyed talking to this founder and hearing his thought process. I like the way he views his company as a cash-flowing asset and how he factored returns of his two options into his decision-making.
Better Customer Discovery?
I caught up with a founder who updated me on his progress. His company recently launched its product and is now looking for customers. He has less than a year of runway left and understands that raising additional venture capital funds isn’t a sure bet.
During our conversation, he shared that he’s hyper-focused on getting to breakeven. He’s trying to convince customers to pay for the solution, which has him hyper-focused on creating real value for them that he can be paid for. He isn’t spending time with customers who can’t or won’t pay. He isn’t building nice-to-have features, only must-haves. He’s now open to introductions to different industries and customers that have the problem he’s solving (he used to be open only to a narrow industry and customer profile).
This founder has always been good about listening to customers and running a good customer discovery process, but it’s on steroids now. His focus on creating value, being paid for that value, and reaching breakeven has elevated his company’s customer discovery process to another level. The entire team is laser focused on iterating the solution quickly to turn it into something customers will happily pay for.
When capital was abundant, founders could always punt. They could raise another round to extend their runway if they didn’t find product–market fit. Now, with that option no longer readily available, the possibility of running out of runway and shutting down is very real. It has more founders focused on getting paying customers to extend their runway.
The current fundraising environment is tough for many founders, but an unexpected benefit of it could be a heightened focus on customer discovery. That would be a good thing because it would lead to more founders solving problems that people care about and are willing to pay for.
Free Cash Flow
An entrepreneur friend keeps close tabs on how public software businesses with recurring revenue are valued. He feels confident that in a high-interest-rate environment, free cash flow will play a bigger role in the valuation of these and other types of public companies than it has in the last decade.
It occurred to me that most people likely don’t know what free cash flow means. Free cash flow is a measure of how much cash a company generates (or consumes) that’s available for management to use at their discretion. For example, they may use it to pay dividends or for share buybacks. It’s important to note that free cash flow is different from net income (net profit)—mainly because of accounting rules. For example, some things that add to or subtract from net income don’t involve the company spending or receiving cash (e.g., depreciation). Companies can lack profitability but still generate free cash, and vice versa.
Here’s the formula: free cash flow = operating cash flow – capital expenditures
Operating cash flow can be found on the statement of cash flows. I won’t get into the details, but it’s basically how much cash company operations generate. It’s different than capital cash generated or spent from investing and financing activities. If a company sells widgets, it measures how much cash it consumed or generated just from selling widgets, not from investing the company’s cash or raising debt or equity.
Capital expenditures can also be found on the statement of cash flows. This is usually a measure of how much capital was spent on assets that will be depreciated over a period. Think buildings or pieces of machinery. Buying assets isn’t an operating expense, but it does reduce cash available for management to use and thus reduces free cash flow.
Free cash flow is a good concept for entrepreneurs to understand.
Interesting Nuggets from First Republic Bank’s Failure
Today the FDIC announced that JPMorgan Chase Bank is assuming the deposits of First Republic Bank. The bank failed, it was seized by regulators, and the FDIC struck a deal with JPMorgan for the latter to acquire the bank. First Republic has been in the news for the last few weeks since the SVB failure, so this outcome isn’t surprising given how many weeks have passed.
Banks are complicated, and I’m not knowledgeable about the industry. But one thing caught my attention as I learned more about the First Republic situation. According to a Bloomberg article, First Republic catered to the wealthy and lured them to the bank with attractive mortgage products. It reportedly offered wealthy clients mortgages with up to 10 years of interest-only payments. Combine this with the rock-bottom interest rates of 2020 and 2021, and the bank saw a flood of wealthy clients take out mortgages. A few interesting points from the article:
- In 2020 and 2021, First Republic originated $900 million of interest-only mortgages in two small sections of Beverly Hills, California. Said differently, they originated almost a billion dollars of interest-only mortgages in one neighborhood. Beverly Hills has some of the most expensive residential homes in the country, but that’s still an incredible data point.
- First Republic originated more than $19 billion of interest-only mortgages in just three metro areas: San Francisco, Los Angeles, and New York. Again, all these areas have some of the highest prices for residential homes in the country, but $19 billion is a staggering amount of interest-only loans in three cities.
- $58 billion worth of First Republic’s loans at the beginning of the year were interest-only, and the majority don’t require principal payments until 2028 at the earliest.
- At the beginning of the year, the bank estimated that the mortgages it made were worth $19 billion less than their carrying value if sold at that time, and it had a $4.8 billion loss on its bond portfolio (bond losses sank SVB).
To be fair, there’s nothing wrong with interest-only mortgages. They’ve been around for a long time and, when used responsibly, can be a viable financing product for responsible borrowers. First Republic appears to have offered this product to borrowers with the highest credit scores who also earned high incomes. These loans may have been a great product for borrowers, but they weren’t so great for First Republic. I’m not sure about many of the details of these loans (fixed, variable, etc.), but the meeting of low rates on many of these interest-only mortgages with rising interest rates and strong deposit withdrawals appears to have contributed to a perfect storm for the bank.
Private Equity Consolidation of My Old Industry
A friend sent me an article about private equity consolidating segments of the automotive market, specifically tires and service centers. CCAW Automotive Group operated in this market, so I know it well.
I’m not surprised that private equity is targeting this market, because it’s fragmented and inefficient and requires significant capital to hold inventory. Rising interest rates are likely pressuring profitability of smaller players. This makes the market attractive to private equity funds looking to execute a roll-up strategy. In my opinion, it’s really the only viable strategy for this mature industry. Growth is slow (probably 3%–5% annually), so growing organically is hard because you mostly have to take customers from someone else. Buying smaller players and integrating them into a larger organization so economies of scale can be leveraged is a good strategy.
I wouldn’t be surprised to see private equity consolidate parts of this industry and then sell to a large upstream player (manufacturer, distributer, etc.) who could benefit strategically and financially. Then again, the consolidated segments could be taken public if market conditions are favorable. I’m curious to see how this plays out and hope the end result is a better experience for consumers.
A Debt and Equity Partner for an Early-Stage Traditional Business
Today I talked with a founder looking to start a new brick-and-mortar business. His model is interesting. He’s renting out space in a building designed to cater to an overlooked segment of entrepreneurs. It’ll be recurring revenue, and he already has a few customers committed once he launches. We talked through capital for his project. The revenue potential of the business is capped based on the square footage of the real estate, so it won’t be high-growth. He wants to do debt, but he’s faced some hurdles in getting financed with banks because their underwriting is more conservative. Venture capitalists would love to invest in him, but that isn’t an option because the company isn’t high-growth.
We started talking about the perfect situation for him, and it ended up being a mix of equity and debt. The equity would be permanent capital, meaning the investor isn’t targeting to sell in a certain number of years like a PE or VC fund. They would plan to be an owner and receive profit distributions in perpetuity. The debt would be normal term debt with fair terms. The kicker is that he’d like to do this type of deal with a single person or capital partner.
The more we talked about it, the more I thought about how big the market is. Many entrepreneurs building traditional businesses would probably benefit from a capital partnership like this, especially if interest rates stay at current levels or go higher.
Breakeven: Another Way to Extend Your Runway
Early-stage founders have been asking for advice about their fundraising plans lately. Many are planning to raise this year after avoiding a difficult fundraise environment in the second half of last year. Many of these companies don’t have runway past 2023. They’re looking to raise venture capital to extend their runway.
If last year taught us anything, it’s that the availability of venture capital funding isn’t a given; it’s heavily impacted by macro conditions. Venture capitalists themselves were impacted by macro conditions and had a difficult time raising capital from their limited partners in the second half of last year.
Raising capital isn’t the only way to extend a start-up’s runway. Increasing revenue and reducing expenses are also levers founders can pull to extend runway. Expenses can be cut only so much, but revenue growth is limitless (hypothetically).
In today’s environment, I’m a fan of founders with limited runway taking control of their destiny by trying to get their companies to breakeven. It’s not possible for all founders, but if it is a possibility (even a slim one), it makes sense to work toward it if you have limited runway. It reduces or eliminates cash burn, extending runway. If venture capital is still an objective, it puts the founder in a better position because they don’t “need” the investment to survive. This approach has its downside, too. It could negatively impact growth. That’s not ideal, but a slower growing company is better than a dead company. If a founder achieves breakeven and manages to show growth (even slightly), it’s a good signal to investors and could increase their desire to invest.
If you’re a founder running out of runway, consider the option of moving the company toward breakeven.
Founder Hack: Treat Sweat Equity and Financial Equity Differently
Some founders seed their companies with their personal capital in the early days. There are a variety of ways to handle this, with a loan from the founder as a shareholder being the one I’ve seen most. When a founder plans to grow their company quickly and raise venture capital, they have another option: they can classify their capital as an investment in the company. The easiest way to do this is through a convertible note or simple agreement for future equity (SAFE).
Why would a founder want to do this? For many reasons. One is that it helps to separate sweat equity from financial equity. If a founder must leave the company for some reason and their equity as a founder doesn’t vest, they still have their financial equity. The founder will own a percentage of the company based on their investment, regardless of what happens with the equity tied to their employment.
There are other benefits too, such as owning—for the financial equity—preferred equity versus common equity.
Start-up Bank Failure
This week’s Silicon Valley Bank (SVB) failure was unexpected and happened in less than 48 hours. I’ve chatted with a few founders and venture capitalists whose companies have assets with SVB. As of Friday afternoon, SVB accounts were frozen, meaning customers couldn’t add or withdraw any funds. Most of the people I talked with were busy establishing relationships with other banks in anticipation of being able to move their funds. The venture capital firms were assessing their own exposure and the exposure of their portfolio companies and updating limited partners on the situation.
The FDIC insures deposits up to $250 thousand. Insured deposits will be available Monday morning. Anything above $250 thousand likely won’t be available until the FDIC sorts through everything, which could take time. My gut tells me that SVB customers will likely get most of their money back, but when that will happen isn’t clear. The longer it takes, the more difficult decisions there will be for SVB customers to make.
I’ll be watching this closely as it unfolds.