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The Buyer's Perspective: Risk and Reward


Welcome to the third installment of our "Seller vs. Buyer" blog series, where I examine the buyer's perspective in small business acquisitions. As an experienced investor, I've seen firsthand the allure and challenges that come with purchasing a small business. While sellers often dream of an immediate financial windfall, buyers are focused on balancing the potential for high returns with the inherent risks.


In this post, I will explore why investors like me are drawn to high-risk small business acquisitions, the comparative options available, and the strategies we use to mitigate risks.


The Appeal: Potential for High Rewards

Investing in or acquiring a small business can be incredibly rewarding, not just financially but also in the satisfaction that comes from helping small business owners transition to a better life and helping their businesses continue to thrive. The potential returns often surpass those of more traditional investment vehicles (as shown in the the diagram below), making small business acquisitions an attractive option for investors willing to take on higher risk. Some of the attractions for investors are:


  • High Returns: Small businesses can offer returns as high as 50% or more, significantly outpacing traditional investments like savings accounts or government bonds.

  • Tangible Impact: Investors often find satisfaction in having a direct impact on the business's success, which is not possible with passive investment vehicles.

  • Entrepreneurial Spirit: The chance to be actively involved in the business and contribute to its growth appeals to many investors with an entrepreneurial mindset.



Comparative Investment Options: Lower Risk Alternatives

Investors have a wide array of lower-risk investment options that don't come with the inherent risks of owning a small business. These investments are typically more stable and predictable, offering security at the cost of lower, but more stable, returns. Examples include:


  • Savings Accounts: These offer minimal risk with steady, albeit low, returns. In Australia, investors can obtain 5% - 5.75% for term deposits. They are ideal for preserving capital but not for significant growth.


  • Government and State Bonds: Bonds provide low to moderate returns with relatively low risk. They are backed by government or local state entities, making them a relatively secure investment. These returns range from 3% - 5% currently.


  • Stocks ( Shares) / Mutual Funds and ETFS: All are equity based options offering moderate risk and returns. Equities have a higher degree of volatility but over the longer terms  providing a balance between growth and stability. For instance, ASX has historically provided average returns of 13% per annum over the past 100+ years.


  • Commercial Real Estate: Real estate investments can offer moderate to high returns with varying degrees of risk, depending on the market conditions and property type. This sector has shown an average total return of 10%, with relatively stable annualised income returns averaging 7.5%.


Why are these returns important? Simplistically it’s that there needs to be a compelling reason for an investor to expose their capital when other lower-risk investments are available. For instance, a business that has an underlying profit margin of 15% - 20% is only producing a 5% - 10% higher return than what could be achieved with substantially lower risk. It therefore needs to make strong commercial sense to an investor before they will risk their capital in that business.


The Risks of Small Business Investments

Despite the higher potential returns, investing in small businesses comes with significant risks that investors must carefully manage. These risks include:


  • Market Competition: Small businesses face intense competition, which can impact profitability and growth.

  • Operational Challenges: Managing daily operations can be complex and demanding, with risks related to staffing, supply chain, and regulatory compliance.

  • Economic Fluctuations: Small businesses are more vulnerable to economic downturns, which can severely affect their performance.

  • Liquidity Risk: Unlike stocks or bonds, small businesses are not easily liquidated. This lack of liquidity can pose challenges if the investor needs to exit the investment quickly.

  • Total Loss of Capital: There's always a risk that the business may fail, resulting in a complete loss of the invested capital.

  • Owner Dependence: Many small businesses are heavily reliant on the owner's relationships with customers and suppliers. If the business's success is closely tied to the owner's involvement, transitioning to new ownership can be particularly challenging.


Importance of Risk Management

Given these risks, it is crucial for investors to implement protective strategies to safeguard our investments. The way we achieve this is by spreading the purchase cost of the investment over time. This approach has several fundamental benefits:


  • It reduces the exposure to a loss of upfront capital.

  • It helps to de-risk the investment by linking payments to the business's continued performance.

  • It provides an alignment between the buyer and seller.


In general, most investors will not look to commit more than 30% - 40% of their capital upfront on an investment. However, this depends on the business and the manner in which revenue is derived. For instance, businesses with solid annuity-style revenues not linked to an owner may attract a higher upfront payment.


The typical ways in which the balance of payments are spread include:

  • Deferred Payments: Payments are postponed until certain conditions are met.

  • Earn-Outs: Additional payments are based on future performance.

  • Contingent Payments: Payments depend on achieving specific criteria.

  • Holdbacks: A portion of the purchase price is withheld for a period.

  • Vendor or Seller Financing: The seller finances a portion of the purchase price.


By spreading out payments, investors can protect against immediate operational risks, ensure the business meets performance metrics, and align the seller's interests with the ongoing success of the business.


Case Studies: Real-World Examples

To illustrate these strategies, let's look at a couple of real-world examples.


  1. Case Study: A Successful Earn-Out

  • Background: Sarah acquired a local fitness studio for $1 million. She made an initial down payment of $300,000. The business was producing $400,000 in annual profits, so Sarah included an agreement with an earn-out of $200,000 per annum for four years based on membership growth. The agreement also allowed Sarah to pay out the owner earlier should increased profits allow it.

  • Details: The earn-out agreement was structured to incentivise the former owner to assist in driving new memberships and improving overall business performance. Metrics such as member retention rates and revenue growth were used to determine the earn-out payments.

  • Outcome: The earn-out motivated the former owner to help drive new memberships, resulting in a thriving business. Profits increased by 15% per annum, allowing Sarah to provide the seller with a full payout within three years.


2. Case Study: A Strategic Deferment


  • Background: Mark purchased a small manufacturing business for $2 million. The business had stable revenues but was underperforming in terms of operational efficiency. Mark made an initial down payment of $500,000, with the remaining $1.5 million deferred over five years, contingent on the business meeting specific operational efficiency targets.

  • Details: The deferment agreement included quarterly performance reviews, focusing on metrics such as production costs, waste reduction, and process improvements. This structure incentivised the seller to ensure a smooth transition and maintain operational standards.

  • Outcome: The deferments motivated the former owner to assist in optimising operations. Over the five years, the business achieved a 20% reduction in production costs and a significant improvement in overall efficiency. As a result, Mark was able to meet the payment obligations comfortably, and the business's profitability increased, making the acquisition a success.


Conclusion: Balancing Risk and Reward

For investors, acquiring a small business is a calculated risk with the potential for significant rewards. By understanding the inherent risks and employing protective strategies, buyers can mitigate these risks and increase their chances of a successful acquisition. Clear communication, thorough due diligence, and strategic planning are essential to navigating this complex process.


As we continue this series, I'll explore more aspects of the seller and buyer dynamic, providing valuable insights for both parties involved in small business acquisitions. Stay tuned for my next post, where we'll dive into the intricacies of negotiating a win-win deal.



 
 
 

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