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.
Founders Are Shifting Their Focus
Over the last year, I’ve watched a number of founders I’m close to go from “what traction do I need to show to raise my next round” to “how can I get to breakeven?” The time it’s taken to make this mental shift has varied, usually based on how much cash they had in the bank. The less cash, the quicker the realization.
I’m a fan of this mindset change. Focusing on reducing cash burn can change a culture in a positive way. The team realizes that resources are scarce and becomes more efficient in using them. People stop throwing money at problems and start coming up with creative, out-of-the-box solutions and ideas. All of this increases the probability that the company will create a solution that customers want and will pay for continually.
One of my closest friends put it best: “I’ve done my best work when running out of money was a real possibility.”
Share Your Early Ideas
This week I caught up with a lawyer friend. We touch base regularly to catch up. I tell him what I’m working on and thinking about (personally and professionally), and he does the same.
During our recent chat, I shared some early ideas that weren’t fully fleshed out. My expectation was that he’d ask a few questions and we’d move on to what was going on in his world. To my surprise, he quickly caught on to what I was thinking and agreed with part of my hypothesis. In fact, not only did he get it, he pointed me to a little-known database that could provide valuable information to help me execute this idea. He walked me through how to navigate the database and understand the information returned as results.
This meeting was a reminder to share your ideas with people. Doesn’t matter if they’re rough or half-baked; share them anyway. You never know what someone knows or who someone knows that could help you. There’s way more to gain from sharing than not sharing your ideas.
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.
Unwilling to Relocate
A Bloomberg article today reported that 1.6% of job seekers relocated to take a new job in the first quarter of 2023. According to the article, that’s “the lowest level on record.”
That statistic really jumped out at me. That means people are now choosing where they live based on factors other than their work. I’m sure other things, such as low unemployment making competition for talent fierce and high interest rates making buying a new home more expensive and less appealing, are playing into this. But it still says a lot about the shift in employee psychology.
I don’t think this change is limited to employees. I suspect founder psychology has also changed. Founders are choosing where to build companies based on personal factors like quality of life—not proximity to investors or traditional tech talent pools.
If this dispersion of founders continues, I’m curious to see how seed-stage venture capital funds adjust their sourcing strategies.
Overcome Uncertainty by Figuring Things Out
I was chatting with a family member about something I want to accomplish. They started asking questions about how I was going to do it. “I don’t know,” I repeatedly said. They were puzzled. They couldn’t understand why I was okay not knowing how I was going to accomplish my goal. This intrigued me, so I began asking them questions. I eventually learned that they associate a clear path to a goal with a high likelihood of success. Said differently, if you know what steps to take ahead of time, you’re likely to be successful (if you put in the work).
No clear path means uncertainty, which scares many people. That’s understandable. In my experience, an unclear path can be scary but isn’t insurmountable. If you can figure things out as you go, you drastically improve your probability of success.
I first realized I could figure things out when I was a kid. I tried to convince my parents to let me do some hairbrained side hustle. They reluctantly agreed, to my surprise. That’s when I realized I had to figure out a lot of stuff to make the side hustle work. I had no idea what to do or how to do it. Eventually, I figured it out by talking to people and doing research. There were some bumps along the way. But to my parents’ and my surprise, it worked out. I made some money and learned how to figure things out.
The ability to figure things out is key to dealing with uncertainty. If it isn’t a skill you were born with, it can be learned. All you need to do is practice by . . . trying to figure something out.
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.
Apple Sees $1 Billion in Deposits in 4 Days
A few weeks ago, I wrote about Apple having launched a new savings account product. The product was interesting for a few reasons:
- It offered a competitive 4.15% APY when it launched, which is higher than many other institutions’ accounts.
- The iPhone gives Apple a huge distribution advantage in a changing banking landscape.
- The Silicon Valley Bank (SVB) failure and First Republic Bank failure put uninsured deposits top of mind for depositors. People are moving deposits to mitigate this risk, which is shifting the banking landscape. Banks must now compete for deposits and reward savers.
- Given these facts, Apple’s announcement seems well timed. It may have decided to not let a good crisis go to waste.
I’ve been curious how successful this product would be. This week, I read a Forbes article that answered that question. According to the article, Apple’s new savings accounts saw inflows of almost $1 billion in deposits in just four days. That’s astonishing. If it’s accurate, it signals, to me, that there’s an huge amount of pent-up demand because of an unmet need. Talk about product–market fit and perfect timing. I can’t wait to see how Apple’s savings accounts do over time and what their next banking move will be.
iBank coming soon?
More Demand for Disciplined Founders?
I founder friend I’ve known for years reminded me that bootstrapping my company forced me to apply discipline in building my company differently than other founders who were focused on growth (and raising capital from investors). I’ve thought about this a bit, and he’s right.
The margin of error was much smaller for my company. If we ran out of cash, that was it. Game over. Paranoia forced me to dive into learning the numbers early in the company’s life cycle and focus on adding to our cash (i.e., turning a profit).
This type of management style wasn’t always in favor when profitability was less of a priority than growth. After my conversation with my buddy, I’m wondering if that will change. Will founders with a more disciplined approach to running and growing companies be more in demand?