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Investor vs. Seller: Finding Common Ground in Small Business Sales


Since entering the world of small business investment, I have spoken to many owners, and one common area of misalignment I often come across is how the purchase of a business should be structured.


Not unexpectedly, the business owner desires an outright purchase, with dreams of selling up, driving off into the sunset the Ferrari, the new yacht or other luxury acquired from the proceeds of the sale. The investor on the other hand, seeks to spread the cost of the purchase over time and wants the owners to remain involved (for a period at least), until the business can be fully transitioned.


So why is there this disparate view and approach? It really comes down to the issue of risk and reward.


Investing in or acquiring a small business can be a highly rewarding endeavour for an investor. However, it is also accompanied by considerable risk. Unlike more traditional investment vehicles like savings accounts or government bonds, owning a small business involves navigating the unpredictable waters of market competition, operational challenges, and economic fluctuations.


In this post, I will explore the inherent risks of acquiring small businesses, the comparative options for investors, and the strategies that I, and fellow investors, use to protect ourselves.


Comparative Investment Options

To understand the higher risk associated with small business acquisitions, let's examine a table that lists various types of investments that are available to an investor, their typical returns, and their associated level of risk:

Investment Type

Typical Returns

Level of Risk

Savings Accounts

1% - 3%

Low

Treasury (Government Bonds)

3% - 4%

Low

Municipal (State) Bonds

2% - 4%

Low to Moderate

Corporate Bonds

3% - 6%

Moderate

Dividend-Paying Stocks

2% - 5%

Moderate

Index Funds

7% - 10%

Moderate

Mutual Funds

4% - 8%

Moderate

Real Estate

6% - 12%

Moderate to High

Growth Stocks

8% - 15%

High

International Stocks

8% - 12%

High

Cryptocurrencies

Highly Variable (10% - 100%+)

Very High

Private Equity

15% - 25%

Very High

Venture Capital

20% - 30%+

Very High

Owning/Investing in a Small Business

Highly Variable (0% - 50%+)

Very High

 

This table highlights the comparative risks and returns associated with various investment options. While owning or investing in a small business can potentially offer returns as high as 50% or more, it also carries very high risk, and the potential of a total loss of capital, when compared to safer investments like savings accounts, or government bonds.


So Why do Investors Choose High-Risk Small Business Acquisitions?

Despite the substantial risks, as investors we are often drawn to the potential high tangible and intangible rewards of small business acquisitions. The entrepreneurial spirit, the opportunity to have a direct impact on the business's success, and the possibility of significant financial gain are compelling reasons. However, given the volatility and unpredictability, we look for ways to protect our capital through various acquisition strategies.


Protective Strategies for Small Business Acquisitions

To mitigate the risks associated with small business acquisitions, we use several strategies designed to protect our investments. These strategies focus on linking the acquisition's success to the ongoing performance and profitability of the business. Here are some common protective structures:


  1. Earn-Outs: Earn-outs are a popular mechanism where the seller receives additional payments based on the business's future performance. This structure aligns the interests of both the buyer and the seller, as the seller has a vested interest in ensuring the business continues to perform well post-acquisition. Earn-outs typically include metrics like revenue, profit margins, or other financial milestones.

  2. Deferments: Payment deferments allow the buyer to postpone a portion of the acquisition price until certain conditions are met. This can be particularly useful in protecting the buyer against immediate operational risks and ensuring that the business maintains its value over a specified period. Deferments can be structured around achieving specific operational targets or financial thresholds.

  3. Contingent Payments: Contingent payments are like earn-outs but can be based on a broader range of criteria, such as achieving market share, customer retention rates, or successful implementation of new products or services. This approach ensures that the acquisition cost reflects the actual performance and growth of the business.

  4. Holdbacks: In a holdback arrangement, a portion of the purchase price is withheld for a specified period to cover any unforeseen liabilities or performance issues. If the business performs as expected, the holdback amount is released to the seller. If not, the buyer can use these funds to address any issues that arise.

  5. Vendor or Seller Financing: In some cases, the seller may finance a portion of the purchase price. This arrangement not only demonstrates the seller's confidence in the business's future but also provides the buyer with some financial flexibility. Seller financing can come with conditions that protect the buyer, such as performance guarantees.


Are There Situations Where Full Upfront Payment for the Business is Justified?

Yes of course. While these protective strategies are common, there are situations where as investors we might be willing to pay full value upfront for a small business, despite the high risks. These include:


  1. Favourable Market Conditions: The industry or market in which the business operates is experiencing extraordinary growth and favourable conditions.

  2. Strategic Fit: The business is a perfect strategic fit, providing synergies or cross-selling opportunities to an existing business.

  3. Urgency and Competition: There is urgency in closing the deal due to competitive pressure.

  4. Access to Capital: The investor has ample access to capital and prefers simplicity in the transaction.

  5. Seller Concessions: The seller offers significant concessions, such as warranties or post-sale support.


Conclusion

Acquiring a small business can be a lucrative investment, but it comes with inherent risks that need to be carefully managed. As investors, we use various strategies to protect our investments to ensure alignment between our interests and the ongoing profitability of the business. These protective measures help mitigate risks and increase the likelihood of a successful and profitable acquisition.


However, it is understandable that these protective strategies may not always align with the expectations of business owners. Many owners prefer an immediate exit and full payment upfront, seeking to capitalise on their hard work without any lingering obligations. While this is not an unreasonable expectation, it may not always be feasible from the investor's perspective, given the high-risk nature of small business investments. Balancing these differing priorities requires careful negotiation and a clear understanding of both parties' goals to achieve a mutually beneficial agreement.


When investors participate in a small business acquisitions, they bring not only capital but also a desire for the business legacy to continue and hopefully thrive. By understanding and implementing these protective strategies, investors hope to find that balance between risk and reward.



 
 
 

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