The Five Red Flags That Will Prevent Your Business From Being Sold

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Josh Petrawksi Tells Us Why He’s Only Offered 2 LOI’s on 500+ Businesses

In today’s interview, we are speaking with Josh Petrawski, who operates a search fund that is actively looking to buy a business in the $4-10M revenue range.  We will cover: What your business is worth, the red flags that prevent businesses from being purchased, how to increase your businesses value, and the steps involved in due diligence.

The Five Red Flags That Keep Owners From Being Able To Sell Their Business

  1. EBITDA Under $250k – And Why This Number Matters
  2. Key Person Risk
  3. Customer Concentration Risk
  4. Non-recurring Customer Base
  5. Convoluted Revenue Streams And Overly Segmented Customers

Interview:

Chris: Josh, can you introduce yourself and what you are doing?

Josh: I’m a young entrepreneur looking to purchase a business.  I raised money from friends and family and a few high net worth individuals to help me achieve my dream of running a company.  

Chris: Almost everyone is familiar with the idea of starting your own business, but you have chosen a different path.  Can you tell us about that?

Josh: A lot of people like me find themselves in an MBA program, looking for ways to apply what you learned afterwards.  There are a few different paths that people usually follow. Some people go into corporate America, and some people end up starting something from scratch.  But the third option, which Stanford University coined, “Entrepreneurship Through Acquisition”, is where you find an existing business, raise some capital, and acquire it.  

Chris: So talk to me about why you chose door number three?

Josh: So door number three is, in my mind, the middle of the road as far as what you’re willing to risk. I would say if you’re going to start up something from scratch, there’s really high reward but there’s also like a very high level of risk. I mean, you’re going to be cash flow negative for most of the time, the decisions you make are going to be highly uncertain. You don’t have a lot to fall back on as far as stuff already figured out.  If you look at the statistics globally of all the smart people who have started businesses, there’s just a large failure rate. Compare that with corporate America, where there’s a bunch of processes and controls in place that provide more financial stability.

The idea of entrepreneurship through acquisition, which some people do in more or less risky ways, is less risky than starting from scratch because you’re buying a business that has been around for a while, has a track record of success and has been proven by time to be able to generate money.

Chris: What kind of businesses are usually being targeted by people that look to acquire businesses like yourself.  What are some of the characteristics of those businesses so owners can self identify if they might be a good fit for a search funder like you?

Josh: 90% of the time it’s something in an industry that has been around for a while, has a long track record, like 10 years plus. And the CEO is usually retiring. Most corporate America execs have a 401k, and everything set up, but these entrepreneurs that have built a company from the ground up, they don’t have a 401k. They put it all into this business and their business is their retirement.  Where we match up is that a search fund is able to give them an exit and give him or her their retirement. The search fund is also able to continue on their legacy and create value for the new investors.

Chris: Before we talk about all the things you’ve learned in due diligence that will help business owners reading this prepare to sell their business, what does financing usually look like for these transactions?

Josh: The majority of these sort of transactions are financed by an SBA loan, which can go up to $5M in funding for purchasing a company.  That $5M comes with a ton of strings attached in terms of what the business needs to look like and it is personally guaranteed. So if you buy the business, and it goes under, you owe that money.  This is why the majority of “searchers” are more on the conservative side.  

There is also usually some sort of seller’s financing as well.  This usually comes as a seller’s note and these tend not to be personally guaranteed, but instead are collateralized by the business.  These also are usually structured so that if the business hits a hiccup, those payments can go on pause but interest will still accrue.  So basically, the seller is usually looking at a sizable payout up front and then fixed income for a number of years while the seller’s note is being paid off.  This is also really nice for someone buying your business because then the seller is motivated to help the buyer have a successful transition. They will be there to answer questions when they get stuck on a problem.  

Chris: How many businesses have you contacted, looking to make a possible purchase?

Josh: At the very top of my funnel, I have business brokers, bankers, and other business owners sending me leads.  They will show me a business and I’ll make a quick decision if it’s the type of industry and size and market I’m interested in.  I’ve been shown 573 deals as of April 8th, 2020. From that initial look, usually about 20% make it to the next stage which is where I actually have a conversation with the business owner.  So I have spoken with roughly 100 business owners who were looking to sell their business.  

Chris: As small business consultants in Austin, our business owners usually want one of three things: growth, profitability, or an exit. For our business owners who are eventually looking to sell their company, what triggers or red flags come up that keep them from even getting to the conversation stage with a buyer?

Josh: The easiest filter here is that we are looking for a business that is large enough to be able to survive a minor change in it’s business operations.  A numerical way to measure this is the $250k EBITDA number.  In the mid 200’s for EBIDTA, there isn’t a lot of room or cushion for something to go wrong and still be able to pay everyone.  

Additionally, there are just some businesses that are good candidates to be acquired; the ones that can survive a transition really well.  I think all businesses could survive but some do better than others. If your entire business is based on the CEO closing the next big deal, then when you lose their relationships with prospective customers, you’re in for trouble on your revenue forecast.  We refer to that as Key Person Risk.  If that person is going to stay on for a while, then it could be a different story, but if you are using SBA funding, there are rules around the old ownership not being able to stick around in a leadership position.  See “Change of Ownership” clause in the 7(a) funding program with the SBA.

Other red flags are project based work versus recurring revenue and contracts.  We are looking for businesses where the customer doesn’t have to make a big purchasing decision every time they transact with us.  We are looking for automatic, smooth recurring revenue. It’s a lot more lucrative to buy a business like this instead of a business that requires the sales staff to close the next big deal to keep the lights on.  To analyze this, I basically try to get into the mindset of the customer and walk through their buyer’s journey. Do they have to re-evaluate their options every time before choosing us or is it somewhat a given? Two types of businesses that have given big red flags to me are construction businesses and gov’t contract based businesses.  These seem to be relationship based, therefore, a large key person risk.  

Another red flag is customer concentration risk.  The way we think about it is, we think business owners can reasonably maintain very close relationships with about 15 people that they can influence to buy even if it’s not the right product or not the best service or price.  But if you have 200 customers, there is no way you’re best friends with all of them. This means businesses are choosing your product or service because of product market fit. The math behind customer concentration risk is driven by the amount of debt you take on.  If you have $5M in debt, you are going to have sizable debt payments. You need to be able to look at how many customers you could lose and still be able to comfortably make those debt payments. If the number you can afford to lose is too low for your comfort, then you have to pass or change the deal terms to get lower debt payments. 

Chris: Is selling and buying a business a zero sum game?

Josh:  Well, the seller is trying to get the highest price possible and the buyer is trying to get the lowest price possible.  But the way I look at it, I plan on being in this business, operating it for a good portion of my life. That means I’m more concerned with having a business that will be around and can handle the transition and that will provide me enough time to learn it and apply my skill set to it without it dying before that happens.  I am willing to pay a lot to protect my debt obligation and my investors money. As a result, if the seller is willing to help me de-risk the deal by sticking around, making themselves available, providing a generous seller’s note that keeps them incentivized, then I’m willing to pay a lot more.  

The last red flag I’ll point out is convoluted operations.  We are looking for businesses that are clear in their mission, their target audience(s), and how they add value.  Niches are great. However, if you have revenue from 6 different sources and you have all these revenue streams that trickle down into a bucket of net income, and there are a bunch of different business models and entities, and they all have different types of customers, then it makes me wonder if you have a sustainable product market fit or if you are just capitalizing on small trends.  For example, if you say you do IT for anyone, that’s a bit too generic for me. But if you say you do IT services for accounting firms with less than 10 employees, then I know you have a niche and you probably have a ton of expertise in exactly what that customer needs. It shows you are differentiated.  

Chris: What happens at the next stage, when you meet with management?

Josh: So I usually get a teaser of the financials but no monthly performance or anything.  Usually just annual numbers. They usually also provide customer concentration, and an executive summary of what they think is their differentiator that gives them some sort of a moat

Chris: What are you looking for in those financials?

Josh: I’m looking for consistent margins that don’t seem abnormally low or high.  I’m also looking for consistent revenues and some growth year over year. Surprisingly, I’m actually not looking for growth over 10% year over year because that level of growth is going to take a lot of expertise, energy, and money because growth consumes cash.  I need a consistent business that I can get to know before I hit the gas on it. Higher growth also creates a situation where the seller thinks that growth is going to go on forever, and I know that this is unlikely so we end up disagreeing too much on the future value of the business.

Chris: If that goes well, then I imagine you get to the detailed financials?  How many companies have made it to this stage in your funnel?

Josh: The next step is to get the financials and then try to get as much information as a I can to make an offer.  Every searcher does this differently. Some will submit LOI’s even if they aren’t sure whether they would buy the business or not.  I prefer to learn as much as I can, and then come up with a price and let them know that if everything they have told me is true and everything in these financials is true, then I will pay a fair price of $X for this business.  I’ve done this with about 20 companies. However, I’ve only submitted LOI’s for 2 of those 20.  

Chris: What are you looking for in those financials to get to the LOI stage?

Josh: Aside from the stuff we mentioned about consistent revenue growth and consistent, industry normal margins, I’m looking for consistency in other things.  For example, I’m looking for consistent sales and marketing expenses, occupancy expenses, and people costs. This consistency shows me that someone has figured out how to run this business like a well oiled machine.  

I also will apply just about every financial ratio that exists to it to see how it stacks up to the industry and whether they have gotten better or worse over time.  

Ultimately, I want to get the story of the business from the CEO, and then I want to see the finances tell me the same story.  Usually, some things match up really well, and some things don’t. A common thing I see with business owners who know they are going to sell soon is that their labor costs go down but revenue stays about the same so profitability and cash flows go up. Optimistically, I want to believe that they are just getting their stride and finally have this business figured out and it’s getting more efficient.  However, pessimistically, I think a lot of people stop doing repairs on older stuff and decide to do more work themselves instead of hiring someone new and retraining them. So you see this hockey stick of profit but revenues are unchanged. I’ve seen it almost every time.  

Chris: You mentioned that most of these business owners are actively looking to sell their business.  Why don’t you go after business owners who aren’t actively looking to sell?

Josh: There are a few schools of thought on this.  Some searchers like to find owners and try to convince them to sell.  Then you can skip the business broker who takes 10% which can benefit both the buyer and seller.  Unfortunately, some of those searchers are also looking to take advantage of a business and trying to offer a price without them speaking to a broker or an M&A advisor who can tell you what you business is worth.  Assuming you are ethical and offer a fair price, it still takes a lot of time and a lot of owners will back out at the last minute.  

The process of diligence is fatiguing and takes so much energy.  It’s a huge mental barrier to let go of what you’ve been working on and having to think about what you will do next.  Ultimately, I don’t want to pay under market for a business. I want to pay a fair price and I want to work with an owner who is excited about a transition, so I prefer to speak with owners who have already made this decision.  I want them to be excited about the price they got so that they are excited to help me take it to the next stage.  

Chris: What business size range are you looking at and what price are you seeing people pay for these businesses?

Josh: I’m looking in the $500k-$1.5M of EBITDA range.  I can go a bit outside of those ranges but it would have to be for the right fit.  These businesses are usually doing between $4M and $10M in revenue annually. I am usually looking for a higher margin business as well.  

As far as prices, the more EBITDA and earnings you have, the higher a price those earnings can command.  This is called multiple expansion.  It’s rooted in the fact that the bigger your business, the more your middle management is carrying the business.  That means the CEO can step down or go on vacation and things don’t fall apart. The smaller you are, the more hats the CEO is wearing, and that means you’re buying more of a job than a business.  

“The longer you can step away, and the exact same financial results exist, the more money I’m willing to pay for the business.”

I like to get my comparable data from the Business Reference Guide.  This is what all the business brokers use to price a business.  It’s a compilation of all the deals that business brokers self report with the listing price and the price they actually sold at along with the range for that industry, and what characteristics businesses that had higher valuations had versus lower valuations.  The only thing missing is deal terms, which are pretty important.  

Ultimately, if you’re below $1M in EBITDA, you’re probably going to get 3-5X, and if you’re above $1M in EBITDA, you’re looking at 5x plus.  

Chris: Are there any deal term mechanisms being employed to deal with the uncertainty of the pandemic and the 2020 recession?

Josh: I think that buyers and sellers are going to disagree on the future more than ever.  I feel like there is a 50% chance things go back to normal and a 50% chance they go to recessionary levels.  To solve for this, I’m seeing working capital terms for the supply chain in case it gets interrupted.  If the business ends up requiring more working capital to run because you have to hold more inventory, then you will have some clawback provisions added for that instance.  More commonly, I’m seeing some sort of earn out that de-risks it entirely.  These terms say something along the lines of, if everything goes back to normal, I’ll pay you full price, otherwise, I have to get some discount that can sit in escrow.  

Chris: Our small business consultancy in Austin has spend a lot of time with owners who are considering selling. Any final thoughts for business owners who want to sell and what they should be prepared for?

Josh: The due diligence process is very taxing.  It’s emotionally draining and it takes a lot of time.  I’m basically going to ask for every document and piece of information about your business that has ever existed and you have 30-60 days to get it to me.  No one documents all this stuff perfectly so it’s hard to find most of the time. Then we are probably going to disagree on what you think it’s worth. Finally, you have to think about letting go of something you built and what you’re going to do next.  It’s a very draining process so be prepared for a marathon!

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Christopher Sica

Christopher Sica

We are passionate about helping business owners feel confident so they can enjoy the journey of entrepreneurship and create value for themselves and their communities. Understanding the steps required to scale a business helps empower business owners. That’s why I work in finance now. We are here to help in any way we can. Check out one of our workshops where we can help each other down the path.

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