The Rise of Finance Bros buying Small & Medium sized Businesses (SMBs)

Welcome back everyone! Time to dive into another controversial topic among the FinTwit community - whether buying SMBs/blue collar businesses is the way to go or significantly riskier than Twitter folks may let on.

First, a message from our Sponsor - BetterPitch.Com 

Are you looking to create a deck for a debt or equity raise, market research, investor reporting, or an offering memorandum? You can outsource your deck building solutions to BetterPitch. Let a team that understands building private equity quality decks build your marketing materials. Focus on your deal, not your deck.

Learn more here.

Now to today’s piece:

If you’ve been on Twitter you’ve seen this trend – several SMB focused entrepreneurs (business builders, lawyers, operators, finance guys, etc.) make their pitch on why it’s a great path for people to escape the shackles of a W-2.

I firmly believe this is broadly a low interest rate phenomenon and when pursuing this avenue, one should think significantly about the cyclical nature of the financing markets and how much harder it is to operate in a downturn. Looking into whether I could/should buy a small business someday is actually something I contemplated, researched and interviewed/asked people about extensively. While there will be some people who pull this off, due to a strong a blue collar background, an expertise in a hands on industry, or just through true grit, it didn’t take me long to realize that there are easier ways to make money than buying a blue collar business.

The issues an SMB can deal with are AMPLIFIED from the same type of issues McDonald’s, or a large publicly traded company, may deal with. A massive, large blue chip company may only see a -1% EBITDA decline in a recession, a broadly syndicated loan level company may only see a -10% EBITDA decline, a middle market loan may see a -15% to -20% EBITDA decline, while an SMB should not be shocked to see a -30% to -40% EBITDA decline. Every negative impact businesses face is AMPLIFIED the smaller the company is. There’s more customer/supplier concentration, more “key man” or key executive/worker risk, less diversification, significantly less operating leverage than companies with true scale, fewer levers to pull to optimize your cost structure, fewer available financing partners, and usually less sophistication in operating a business across the board.

I think SMB Twitter is full of some nice people who are very successful in their own right and are very accomplished entrepreneurs. However, a lot of the discussion of SMB Twitter is often overlooking the significant challenges that come with operating businesses. Some of SMB Twitter has been getting COOKED lately – as Cam went in on below:

Over a million impressions – Jesus.

A lot of the members of SMB Twitter have posted tweets that “look down” at people with W-2s: It’s one of the most absurd things a lot of SMB Twitter does. There obviously isn’t much sense in screwing around with your career and finding yourself in a position where you’re barely saving any money (a potential issue if you stay in NYC too long without really growing your net worth), but there are so many people with W-2s that live a great life. There is a lot more bloat in many organizations than a targeted 5% headcount reduction will ever find. You can chill at a Fortune 500 Company, probably do under 40 hours a week, and find yourself in a great spot climbing up the ladder in a lower-cost-of-living area. This tradeoff is even better for people that find themselves in more bureaucratic or middle-office-styled roles at banks or asset managers – IYKYK. Sometimes it pays well to be a paper pusher! Even with continuous risks of outsourcing abroad, automation, or AI, you’d be surprised how entrenched so many white-collar jobs are.

Additionally, the W-2 Hate is a ridiculous thing to say in the finance community. In Private Equity or Credit you don’t need to go out and make a new fund to try to be the new Blackstone – you’re totally fine if you climb the ladder, get an increasing amount of carried interest or other equity interests, and strike gold if one of your funds makes a killing. This is why so many Private Equity peeps are “cash poor” because the bulk of their upside is coming from exiting some great deals and clipping a nice carry coupon that’s treated as capital gains as opposed to ordinary income. So ya, saying “you need to quit your W-2 and go buy a HVAC company” is a ridiculous proposition for well-tenured finance professionals.

Like I said, the risks at the SMB level are amplified relative to a larger institution. In Credit, you are trained to zone in on predicting the downside, something other career paths don’t really teach.

Here’s some of the increased risks when closing a deal that some prospective SMBs buyers may not truly grasp:

1. First, it may take forever to close a deal to begin with. Not forever, but like 12-24 months to find the Company you want to buy. Private equity firms and established lenders have a very established funnel. Due to scale and business relationships, it’s incredibly easy to see abundant and high-quality new deal flow. When starting out on your own, it’s very hard to get this sort of deal flow. Why would a banker reach out to you when they can talk to Sponsors they know can quickly raise the equity and debt capital? You would need to hustle and find off-markets deals in order to find the right deal. Or it would need to be so small that no one else would touch it.

2. Let’s say you have no search fund, it’s just you going out and buying a Company with zero money. You’ll need to find a debt partner and an equity partner AND they’ll all need to get along. Maybe you can give yourself a transaction fee in the sources & uses section and then roll that fee into the deal to get an equity %. My point being though, if you’re tackling a larger SMB deal and have ZERO money – it means you’re only going to end up with a 5%-20% equity position tops which isn’t super compelling? If you’re in a situation where you need to take on a high LTV to complete a transaction, then certainly your capital structure can go upside down pretty quickly if FCF shakes around or interest rates jump up significantly. I mean, this is why I think it’s a low interest rate phenomenon right? Because when you’re making a convoluted capital structure it works better when debt and equity financing is cheaper. When it’s more expensive, you’re looking at a potentially over-levered deal where a lot more of your bridge from EBITDA to FCF is going towards interest.

   Another non-traditional financing mechanism is through sale-leasebacks. This means you buy a business and the real estate from the Seller and then to finance the transaction you sell the real estate to a third party. This CAN work - but it also means hoodwinking a blue collar Seller which isn’t the coolest thing to do. It’s a nice way to guarantee that they’ll never trust you again. Also, you need the sale-leaseback market to be there for you. In a higher rate environment or a recession, you may not get the valuation or bid needed to complete the overall transaction. This adds just another layer of execution risk among another financing source. Lastly, the more concerning part is that you’re levering the business and finding a new and creative way to reduce FCF. Before, the business didn’t pay rent - now they do! Better update your model and see how your FCF is looking. Now that you don’t own the property, the valuation you’ll want to exit at will be lower too. Sure, it’s a way to raise $ for your deals, but for most parties, this is a morally ambiguous transaction that thrives on lower interest rates and decreases your FCF and exit valuation.

   The Twitter User known as RVC said it best below.

3. Deal quality is probably poor. So you’ve sourced for an off-market deal – maybe the deal is okay and the Seller just doesn’t know any bankers/doesn’t understand M&A and you find a gold mine, or maybe the deal got banked around and a buyer couldn’t be found or the deal isn’t worth the time and effort for banks. Think about it – if you’re a first-time SMB buyer looking for a business, there’s probably better odds that someone with more experience or a larger platform would’ve come across this company before right? Maybe you did find a little gold mine, but make sure it isn’t fool’s gold. When you sign up a deal, you may be disappointed with how poor the internal processes may be within a small business. This may be an opportunity for you as a buyer, but it makes the diligence process a lot more challenging. What if there are limited (or no) KPIs, weak accounting functions, and not the right internal resources that can take the business to the next level? What if there structurally isn’t a next level for this business? Every MM PE guy knows how big of a pain it is to try to implement a new ERP system. Imagine how bad it can be at an even more poorly disorganized level. An MBA who worked at a larger platform shouldn’t be shocked that this is a lot trickier than executing a middle market tuck-in acquisition.

4. Execution risk – time can kill all good deals. While there is an opportunity within SMBs due to sellers being less sophisticated about the M&A process (like Twitter people openly talking about fleecing Sellers with sale-leasebacks), there is also significant risk. Sure, there can be a lot of negotiation tactics (sellers threatening to walk or getting emotional in order to negotiate on a point or drive more value – you see this constantly in Succession btw) there is also a lot more hot-headedness within the SMB space. What if you were pressing on diligence, or the transaction was taking an extra month to close and the Seller got fed up with you and decided to stop the transaction? Or what if the Seller decides “I’m not ready to retire yet, I don’t want to lose my baby just yet” and walks away? There are a million reasons why a transaction could fall apart, while at least in larger deals there’s less emotion tied to closing a deal and fewer reasons why a larger, more sophisticated deal may fall apart. Obviously, when a deal falls apart there is usually a decent level of sunk costs associated with the collapsed transaction. What if you racked up a massive legal bill? Or paid consulting fees for market research? Or an accountant to conduct a quality of earnings (QoE)? Those are all costs that need to be eaten by someone and at a minimum you could be responsible for eating all the costs on your side. Maybe there’s a way to recoup some $ if the Seller walks, but that’s more legal expenses needed if the situation becomes prolonged. It’s not a great scenario and you could possibly be looking at a bill that hits 6 FIGURES!!! Just for a deal that broke! The bill could be a lot lower depending on the legal team and the people you pay, but you can’t just go into a deal without paying for outside counsel and verifying financials right? It’s a tough situation and gets me back to my overarching point – every risk you experience in the SMB space is AMPLIFIED relative to if you were at Blackstone/BlackRock etc.

Risks after closing a deal:

There’s significant risk upon closing a smaller deal that there were some items or nuances that the Seller (who was highly motivated to get their exit check) failed to mention. They might’ve Scooby-Dooed you, and not told you about the ghost in the attic.

Also – is there still skin in the game for the Seller? Do they still have equity or a seller note? If the Seller wanted to take all their cash out that’s probably not great right? Hopefully, the Seller is still there as a resource that can be reached as needed and more importantly hopefully the team there doesn’t quit two weeks after a new owner joins. Continuity is important and it’s nice having around people who actually understand the business right? Because here's the thing – a lot of the buyers of these businesses are highly educated individuals who don’t really come from a blue-collar background. So if you’re a 29-year-old who doesn’t really understand the business you’re buying….that’s not really a great recipe. Even if you went to Wharton, don’t be stupid, understand your limitations and understand that you probably don’t understand the business you just bought and will get rocked along the way.

If you don’t have a sense of how you would rightsize the business if needed, gain new clients, effectively manage working capital, or potentially not take a paycheck for a few years, then you could put yourself into a bad situation. Every risk in the SMB world is greater relative to bigger, more fluid businesses.

The potential positives of owning an SMB:

Okay, I’ll highlight some bright spots.

You might actually know the space: If your dad was an auto mechanic and you helped him around the shop as a kid, and now you want to buy an auto shop, this makes A LOT more sense than an ivy leaguer born in CT buying an auto shop. If you have a deep knowledge of a particular industry, then hey F-it, go for it man. Just know the risks, but this is a lot better than someone who doesn’t really get the industry blowing themselves up. If you can marry blue collar and white collar knowledge, you could be a perfect candidate. Hell, I’d even throw some bucks in equity in for someone who really has that dog in them and knows the space. Especially if it’s their second rodeo.

You’re the boss, you have the equity: It’s a grind – but you have equity ownership and don’t have a “boss”: Naturally, there is more upside (but more risk) to having an equity position over a salaried position. Positioning yourself to take a salary + have equity upside is a good potential avenue to wealth creation, so long as you can exit. Once you exit one deal you can walk away with a bit of a sigh of relief, knowing you executed successfully, rode off with a nice check, and now can be known as someone who was able to buy and operate a business successfully.

The SMB market being less sophisticated is also a Pro: As I mentioned, this can also be a con. But it’s also a nice way to garner some pretty solid terms relative to negotiating a sale with a seasoned private equity partner. You can acquire an asset for a low multiple and beyond that, you might have some quick synergies and strategies that make sense, can address low-hanging fruit and can quickly improve performance.

There will be winners – people with that dog in them who bet on themselves and made a killing. It doesn't mean you'll necessarily be a billionaire, but you can build your own healthy pile of cash.

It can pay dividends – literally. There can be a point where you scale your SMB and then all of a sudden produce an extra $1mm in FCF a year. What if you don’t really need to spend that $1mm to grow the business? Well, you can just dividend that out to yourself at favorable taxable rates. There was an NYT piece (which I initially couldn’t find but a follower sent me later - here it is) that laid out how a surprising amount of the wealthiest people in America are “mom and pop” business owners that run a modest neighborhood business but are able to rake in a lot of $$$ while appearing to live pretty modest lives.

The Secret CFO, a FinTwit account and a good dude, bought a business recently and laid out his framework for how he thought about the acquisition. The framework is helpful. He completed a deal where the Seller took a Seller Note that had no interest or security. There was also no personal guarantee signed or a $ of capital put into the business at this time. Pretty impressive and favorable structuring. This is an example of someone more seasoned who knows how to source and structure favorably.

Here’s two more pretty sharp SMB people: On the entrepreneurial side, Michael Girdley, a well-known Twitter profile who owns a $100mm+ Holdco full of 11 businesses. On the legal side, is Eric Pacifici who runs the SMB Attorney Twitter account.

Concluding thoughts:

Look in conclusion – this strategy does work for some people – but it feels like there are significantly more people that this doesn’t work for and who don’t fully understand the risks (especially now that rates are higher and the economy is expected to slow). Additionally, a lot of the people that entered and tried in this market are newer entrants who haven’t been recession tested yet. Given the high failure of blue collar small businesses and a higher interest rate environment, it’s hard to imagine exceedingly positive outcomes for most people. But if you know intrinsically you’re the exception, then go for it.

That’s all for this piece - thanks again to our Sponsor BetterPitch - definitely check out their private equity quality pitch deck solutions.

Until next time.

Best,

HYH