I know I haven’t sent out an update in a while. Been very busy with a lot of things but also I use this Substack to only share thoughts when warranted. This is one of them.

Every year, I think we can all attest to some degree that we set goals for ourselves as an annual ritual to ring in the new year.

“I want to lose 10lbs.”

“I want to run a marathon.”

“I want to get a raise.”

“I want to…..” and the list goes on and on.

But what I’ve learned about goals, aside from quitting too early on, is that everyone usually only sets up one arbitrary “goal” and that’s it.

“I want to lose 10lbs” and then nothing after that.

What I use now is something that I got from Bill Girdley when it comes to assigning goals. They need to be

a) Measurable but also,

b) There needs to be more than one. Three to be exact.

This is how it works. The first goal is to set the initial benchmark that you’re trying to achieve. This should be your north star. Something that isn’t so easily obtainable but also isn’t unrealistic.

For instance, going into this year, I wanted to grow to 2,000 subscribers.

Given that I started at 1,269, a 57% y/y increase was definitely a modest goal to achieve.

But here’s the next part. What happens if you reach that goal? What’s the next stage? No one ever talks about that.

That’s when you have to great your second “goal” or “benchmark.”

It’s supposed to be something that is achievable but also requires you to put in a little more work to get there.

For me, it was to get to 2,500 subscribers by the end of the year.

A modest lift but still a lot based on the starting point.

Then comes the third goal. The, “shoot for the moon” goal in case you hit both the primary and secondary goals.

It needs to be a far out one. A, no way this would happen unless quite literally stars aligned.

For me, it was to achieve 5,000 subscribers. I definitely didn’t hit that but it’s not really supposed to be reached. It’s supposed to act as a third goal post in the event we met the first two and still needed something to “work towards.”

So to recap. I said for 2024, I want to reach 2,000 subscribers as my first (primary) goal. 2,500 as my secondary goal. And then 5,000 for my “shoot for the moon” goal.

As you think about your goals for 2025, I hope that you leverage the 3 goal structure that I use now. You can use it for literally anything that’s measurable, and that’s why it’s so great when it comes to New Year’s goals.

Losing weight.

Making money.

Growing a newsletter.

Hell, how many girl scout cookies you can help your daughter sell.

All something that’s measurable.

I hope this helps you with your 2025 goal planning and that the new year brings you everything you’ve been working hard for.

Here’s to a bright 2025. Let’s get it. 💪🏼

Best,
Paul

Do a quick search on YouTube and there’s no shortage of videos both for and against starting a Turo side hustle.

Plenty of people were able to generate enough side income to cover some basic expenses while others wanted it to become an actual business of them renting out their cars for a living.

However, the reason I’m sharing this post is that if you’re looking to make some side money and want to use your car as the underlying asset, read this quick post first.

My Why

The whole reason I chose to do Turo was because I recently bought a car to commute to my new portfolio company and living in NYC, street parking made me want to jump off a bridge and ran the risk of it getting damaged by other people. So, to pay for a monthly parking garage, I wanted to use Turo to subsidize that personal cost in my life to the tune of $400/mo.

That was the only goal. Just cover my monthly parking space. Anything above that was in theory, rolled over to the next month to get a head start on that bill.

My Earnings

Obviously, nicer cars can charge more because they’re premium, and usually, when people rent cars, they want to look good (generally) when they do.

My car is a 2019 Audi A4 Premium Turbo in all black and has all the bells and whistles. This allowed me to charge $103/day (not including tolls or tickets).

This is what allowed me to earn just over $4,000 in 8 months (pictured below).

However, while it seems like I “came out on top”, events that transpired over those 8 months made me stop doing it completely and change my mind about the whole thing.

If you’ve made it this far, go a little further and see why before you make a potential mistake yourself.

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Lessons Learned

I can label my whole experience down to three simple lessons that will cover nearly every issue with my Turo experience.

1. It’s not their car.

2. It’s not their car.

3. It’s not their car.

Literally. It’s that simple. When you’re renting or borrowing something from someone, there’s always a part of you that goes “It’s okay. It’s not mine.”

I don’t know about you guys reading this but I’ve only owned two cars my whole life. The first was when I was 16 and it cost me $1,400 and was 12 years old at the time. The second was this Audi. So, I cared a lot about it and every little ding or scratch made me want to die a little inside.

For certain guests, they were excellent. Did everything I told them to do with no issues. Others, couldn’t care in the slightest.

I had renters

• Late for pickup

• Late for drop-off

• Not filling up the gas tank

• Leaving the inside of the car messy, sticky, and sometimes smelly

The worst of all was when they would get damage to the car because they backed into something, drove into something, got too close to some bushes, etc.

This was incredibly annoying because unless you look hard, it’s pretty easy to miss the small damage spots until after the fact. Not to mention, just like Airbnb, you’re at the mercy of your guest’s reviews to get others to book.

Some people did damage to the car and were very kind in their mistake and compensated me for the repairs. I had one guy who was so nice before dropping it off that while he was filling up the tank before drop off, he was washing it with the gas station squeegees. The problem is that the paint on my car is sensitive and it ended up leaving scratches on the hood. He paid for it.

Additionally, because people who are in need of a short-term rental car are typically people going on a trip, most weekends are taken if not all. That means if you want to do anything with your car that weekend and you didn’t block it ahead of time, you’re shit out of luck. Every time you cancel because you decided you needed the car, Turo dings you and sometimes even charges you a penalty if the reason isn’t good enough.

The other issue besides the damage is that depreciation on your car also accelerates because you’re renting to people who are usually traveling longer distances. This means that my tires, brakes, fluid, and everything else need to be replaced faster because of it all. Thus adding to the costs and reduced earnings.

Lastly, to protect your car, you need to get insurance that would cover damage and repairs should they arise. However, in order to do that, you need to basically give them a take rate and unless you get the top tier coverage (I had 2nd from the top), not everything is covered.

This means that I made less because of the insurance and not everything was covered. In certain damage circumstances, this meant that Turo insurance wouldn’t cover the damage and I would need to bank on the renter to pay me or I’d be shit out of luck. Thankfully I didn’t have any issues but otherwise, I would have had to pay for it all out of pocket.

Why It’s Not Worth It

Honestly, I’m a user of Turo (renter) but I wouldn’t offer my car again. The hassle of having to deal with people who don’t care about your care because it’s not theirs is not worth it.

To make a business out of this, I’m not sure is worth it and then again, I was doing it just to cover expenses not even make money.

There are other ways to make income on the side but I don’t think it’s it. Perhaps I didn’t go into it with the mindset of treating it as a business rather than lending out my personal belongings. I imagine the same can be said for people who want to casually rent out a room on Airbnb versus people who make Airbnb their business.

To each their own and if you’re reading this, maybe you’re in the latter camp but buyer beware, there’s a ton of headaches when it comes to this “side hustle.”

It’s something that will follow you for as long as there’s an outstanding balance no matter if the business succeeds, fails, or even if you live or die. It will follow you.

What I’m talking about is a personal guarantee.

A personal guarantee is a provision in your loan contract. When you agree to it, you’re taking personal responsibility for the loan if the business defaults and can’t repay it. In other words, if your business goes under or gets behind on loan payments, you are required to use personal assets to satisfy the debt.

So when you take out a loan from the SBA, you pledge your personal assets and yourself in order to pay back the debt that you took on in case things go south. Now in an ideal situation, you wouldn’t have to worry about this because your business is growing (hopefully) and flourishing, thus allowing you to pay back the loan over time and relinquish your obligations.

If the former is what happens, then you’re in luck. At least as a business owner, that’s one thing less to worry about which could help contribute to a good night’s sleep.

However, that’s not always the case and when we plant our feet back down to reality, businesses fail all the time. While an acquisition of an established business does reduce the risk of failing, that does not mean it completely rids buyers of that risk.

According to Lending Tree, 65.1% of businesses fail after 10 years.

The fact is that this still doesn’t deter most from going along this journey to better their financial state, personal dreams, or whatever else they might label it as. The problem lies when things go south. Reddit is filled with many who have openly shared their negative experiences with businesses going under and the personal guarantees that are attached to them.

These are people with serious loans with serious consequences. Not someone that lost a few thousand or tens of thousands buying speculative assets in the market because they’re degenerates.

Take a look at the example below.

“This is all so stressful. I’ve had 4 panic attacks in the past 6 months because of all this pressure.”

An all too real feeling for many who are going through the same thing. Something like that is why you lose out on sleep.

Others who have succumbed to the anxiety of having to deal with this situation, unfortunately, believe that “opting out” would rid them of the obligations and won’t put risk on their families. However, this is not the case.

A personal guarantee given to cover business debts will survive your death and is a prior charge on your estate. This means to you that your estate probate cannot be completed until such guarantees have been cancelled. This could take many months and could possibly put assets of the estate and your family at risk.

While it’s treated differently upon death, it just doesn’t go away. Your family through your estate will now have to go through all the issues and deal with the fallout. It’s so fucked up that lenders often make borrowers take out life insurance just in case in the event of death, they still get paid out.

It’s a very morbid reality in the world of small business financing.

When it comes to running a business, not only will you have to worry about the day-to-day operations, making payroll, and taking care of yourself and your family, but then truly understanding that there’s really no “optimal” way out.

I’ve personally had plenty of nights with a loss of sleep due to running a business and the feeling you get from knowing that a massive weight is on your shoulders at all times, day or night is completely and utterly terrifying.

It’s something that I want to stress to all investors that you NEED to understand what you’re getting into before “potentially” signing your life away.

There are plenty of other ways to raise capital that do not require you to get a personal guarantee and they might not keep you up at night as well.

As for me, with my personal experience and like many of those in the above image, the cost of a true night’s sleep is too expensive if not done right. The older you get too, the more you understand just how important that is.

I hope you enjoyed today’s post. If you have any general comments that you’d like me to expand on, please do so by clicking the button below and I’ll happily answer.

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Until next time,

Paul Cerro | Cedar Grove Capital

Personal Twitter: @paulcerro

For today’s post I actually made it an audio post only. I felt like this topic was one where you would rather listen to the conversation instead of reading a bunch of text.

I go over the top 5 things to keep in mind when buying a business and give examples for each. While this is not an exhaustive list by any means, the list is incredibly important when you’re conducting due diligence on the business and frankly, yourself.

If you have comments or questions, please write them out below so I can answer them for you.

Cheers.

Paul Cerro

However, there’s one business that in theory I would love to own but I know I never will. Not because of market dynamics but purely by choice.

The #1 business I would never own is 🥁🥁🥁…….restaurants.

Don’t get me wrong I love going out to eat and trying new foods and cuisines from different parts of the world. It’s a great feeling. But just because it’s a great feeling doesn’t mean that it makes sense.

I mean, the stats for starting a restaurant are pretty terrible. The failure rate is at 60% in the first year. And 80% of restaurants don’t make it past year 4.

Additionally, most businesses typically sell at a multiple to cash flow between around 2-4x, excluding software/internet companies.

Restaurants, however, don’t always fit that bill. Giving some examples below, some trade below even 2x cash flow and even worse, 1x cash flow.

This is not a “good deal” because of the multiple but because the businesses come with an incredible number of risks which I’ll explain below.

In general, and I tell this to everyone, you need to figure out the answer to one very important question when you’re looking to buy a business.

That question is, how am I going to or how could I get fucked by this deal?

One way or another, you’re going to get fucked and you need to understand where the weak points are so that you can determine if they’re worth handling.

In restaurants, they’re everywhere. Let me explain first by working backward before I get granular.

Groupthink here, what makes a restaurant successful? I can categorize it into a few buckets that are NOT mutually exclusive.

1. Consistently great tasting food.

2. Consistently great service.

3. Pricing fit for location.

4. Location.

5. Cleanliness and ambiance.

That’s obviously not all of them but those 5 round out almost everything that it takes to make a restaurant successful.

But here’s the problem with those. They’re all attached to things that I feel are just too difficult for me to want to take the plunge and own a restaurant. Many of these reasons can also be translated into other lines of business so don’t think this is just an isolated list.

I’ve listed them below in no particular order.

#1 Competition

Competition is always hard in the food space. It relies heavily on consumer tastes, trends, and cravings that fluctuate on a daily basis. To make matters worse, in a given area there are only so many people that can actually come into your restaurant. Scaling is a problem.

It is just simple logic: a new restaurant in your neighborhood is not giving birth to 100 new customers. It is simply taking away 100 customers from the restaurant next door. But when you have 10 new restaurants fighting for that same 100 customers, you can imagine just how difficult it can get to stay in business!

I don’t want to be at the mercy of consumers’ tastes for the day when it comes to making a food decision nor do I want to be attached to discretionary spending as well.

#2 Food Costs

Food cost weighs heavily on operating expenses and you’re really not in control of much when it comes to that. Food cost generally makes up around 28% to 35% of a restaurant’s ongoing expenses. The cost can also differ based on what type of menu items you plan to serve. For example, a steakhouse may run up to 40% in food costs, while an Italian restaurant may run closer to 28%. 

Food costs are volatile. A bad weather event like a hurricane or other natural disaster can quickly throw everything into flux. You’re also at the mercy of trends driving up demand and, therefore, costs. If avocados, for example, become a hot item on the market, you are vulnerable to supply-and-demand issues, which may drive up food costs. 

Vendor relationships are also crucial to keeping food costs low so if you’re not the type that’s good at negotiating, this can really bite you in the ass. And finally, food waste. A difficult balance exists between not having enough of an item and having too much. One study found that 58% of restaurants struggle to manage their inventory properly and end up ordering too much food, resulting in wasting money and food.

Something that as an owner, I wouldn’t want to deal with and actually would feel bad about personally. Spoilage and waste just suck.

#3 Labor

Simply, hourly employees are tough to manage for a whole list of reasons. Labor makes up a large slice of operating costs and includes hourly wages, vacation pay, sick days, employee benefits, payroll tax, and more. 

Restaurants attempt to keep labor costs at around 25% to 30%. Quick-service restaurants are at the lower end of the range, while casual dining is at the upper end.

But aside from the payroll, you still have to deal with the employees themselves. Calling out sick, not showing up, abruptly quitting, pissing off your customers. For the cooks, if your menu is dependent on skilled labor then you’re kinda up shits creek if they leave or decide not to put passion behind their creations.

We talk about being a strong athlete, and use athletic terms because you have to have the mindset and the physical energy. It's physically demanding. You have to be on your feet and mentally engaged to make the guest happy.

It's the hardest job in the world.

We have 30 people on staff tonight. 30 different personalities. Everyone either had a good day, an okay day, or a sh*tty day. We're about to open up the doors and say hello to 200-250 people all in the same boat. It's show business every day. It's playoffs that never end. It never ends. It's the Super Bowl every day.

This applies to most smaller businesses but you don’t want to be at the whim of your employees if you can’t do the job yourself. I.e. if you can’t get back there and cook, perhaps having that employee leverage over you might not be the best especially when you have bills to pay.

The headaches and drama with managing different staff levels just aren’t worth the squeeze to me.

#4 Quality Control

This one is easy in practice but tying it back to your employees, it can be one that can go south quickly. This means keeping the restaurant clean with no dust, trash, or anything that’s not supposed to be there from being there.

The quality of service is important as well. Greeting customers quickly and with a happy personality and that they’re seated and attended to. Something that does matter to many because if people have a bad experience, more often than not they won’t say anything to you and just not come back.

The last portion is with food quality. All food needs to go out perfectly every time or you have the waste that I talked about above or you have angry customers that could leave bad reviews.

Not being mostly in control of all these aspects of quality is tough and something that I know would irk me unless I’m there 100% of the time.

Bottom line

Running a restaurant is hard and I have incredible respect for those who end up taking that plunge. There are just too many factors that can make or break a concept that ironically we all need in order to survive.

There’s a fun fact about the restaurants in NYC. It’s said that you can eat at a different restaurant for every meal for the rest of your life and never come full circle. That’s because so many open and close that it’s impossible to complete that task.

If you enjoyed today’s post, please consider sharing it with others and subscribe below.

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Paul Cerro | Cedar Grove Capital

Personal Twitter: @paulcerro

Disclaimer

All information provided herein by Cedar Grove Capital Holdings, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.

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With that said, let’s get into today’s post.

Compensation is, of course, more than money. It includes other aspects such as: how much you enjoy your career, whether it provides fulfillment, how much flexibility you get and how much influence you have over what you do and when you do it.

Owners of small businesses can set their own hours, make their own management decisions, and take pride in the ownership of their work.

I’ve had to personally deal with this conflict as I started off my career in Wall Street chasing money and now I’ve been earning and burning through sweat equity.

The real question that I’m answering in this post is whether or not it’s more lucrative to pursue a traditional career path in investment banking, consulting, or private equity or to put skin in the game and make it that way.

The data is quite surprising so let’s look into the numbers.1

To start, let’s assume that the alternative to being a small firm CEO is to follow a traditional post-MBA career and recognize that, at best, we can only compare expected paths because everyone’s experience will be different.

So, we begin by assuming that the traditional path offers cash compensation equal to the average starting salary. (It might be tempting to turn to the highest starting salary paid, which typically goes to the graduate with the most experience in the most competitive market, who often earns crazy money their first year. But these are rare occurrences, and we believe that using the average yields a more accurate outcome.)

That average is actually hard to nail down, however. Some large sample surveys report that MBAs nationwide have an average starting salary of about $100K. Graduates from so-called elite schools make more, with some estimates of elite school average starting salaries in the $150K range. 

The relative compensation of a traditional career and entrepreneurship through acquisition hinges on salaries in the next 10 years and the carry from deals with investors who provided money to acquire the business. These are of course unknown and highly dependent on the job and the success of the small business itself.  But here is a sketch based on the information we have at hand.

We’ll assume the salary in a traditional post-MBA job grows at a 12% compound annual growth rate (CAGR) so that it more than triples in the first 10 years. 

We’ll also assume the cash compensation for a new CEO of a small business starts off at the average post-MBA salary, and its growth is generally tied to the performance of the company — both of which are typical. 

Harvard Business Review argues that those searching for a small business to buy should target slow-growing dull businesses, so we’ve put this at 5% per year. The chart below shows that over the first 10 years of employment, the cash compensation from the traditional job dominates.

But the annual cash compensation only provides part of the pecuniary payoffs of the purchase of a small business because the entrepreneur also has a significant ownership interest in the company. The size of that ownership interest varies on how they structured their funding throughout the process, but for now let’s assume the entrepreneur has a 20% carried interest in the acquired company. (That means that the CEO keeps 20% of any cash distribution after the investors’ investment is returned and they are paid a preferred dividend.)

The value of that carried interest, of course, depends on the performance of the business, its size, amount of debt used to finance the acquisition and the eventual pricing of a subsequent sale.

To make the analysis tractable, we’ll make some simplifying conservative assumptions: we’ll assume no growth in the business and, because there is no growth, we’ll assume that the selling multiple exactly equals the purchase multiple. We’ll also assume the entrepreneur acquired a $1.5 million EBITDA company for 4x paying $6 million and using 50% debt financing.

To keep things simple, we’ll take advantage of our assumptions of no growth and a constant multiple and ignore the actual timing of the cash flows. That means that, in this example, the purchase price and the eventual selling price will be the same so that the debt and the equity investment can be assumed to be repaid at the sale. This leaves us only with the cash flows that occur between the purchase and the eventual sale.

In this example, the annual cash flow is $1.5 million; the debt is half of the purchase price, or $3 million; and the interest on that debt (assuming a 5% interest rate) is $150,000 annually. This leaves $1,350,000 to be split 80%/20% between the investors and the CEO. The CEO’s implicit annual cash flow from the carried interest is therefore 20% of $1,350,000, or $270,000.

Add this to the cash salary and the entrepreneurship through acquisition path dominates the traditional post-MBA career path, as shown in the chart below.

What happens if we take into account the timing of the cash flows?

The usual timing of cash flows is that the debt gets repaid first, then the equity investors get their investment plus preferred return second, next the entrepreneur gets paid 20% of the preferred return, and lastly, the remaining cash flows are split 80% for the investor and 20% for the CEO.

The bank and investors get paid off before the CEO gets any cash for the carried interest. But the advantage to the traditional path in the early years is very much offset by the impressive EtA cash flows that occur once the carry starts getting paid and even more so upon exit (which we’ve assumed in year 10 in this example).  Here is the revised comparison:

Analytical readers may think this is a great opportunity to compute the present values of the two paths, perhaps using different discount rates the reflect the perceived risks of the two paths (the present values are close at 15% for the traditional path and 25% for the EtA path) in hopes of determining which path offers the highest compensation. (HBR recognizes that some believe that the EtA path is riskier and thus would assign a higher discount rate.) We don’t advise that approach.

Instead, we think you should recognize that there are a lot of differences that we haven’t fully modeled. On one side of the coin, there are likely tax advantages from the EtA payouts and increases from growing the acquired business.

On the traditional path side of the coin, there might be pensions or bonuses that we’ve not captured.

Bottom line

There’s a lot more that goes into owning a business aside from just the different types of compensation that you can get from it. This inherently turns many away aside from the obvious that not all can afford a takeover or have the managerial acumen to be an operator.

However, the numbers speak for themselves. If you put in the work, you can really reap the rewards.

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Until next time,

Paul Cerro | Cedar Grove Capital

Personal Twitter: @paulcerro

Fund Twitter: @cedargrovecm

HoldCo Twitter: @cedargrovech

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Disclaimer

All information provided herein by Cedar Grove Capital Holdings, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.

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With that said, let’s get into today’s post.

Attention Grabbing Headlines

Have you started your acquisition journey and come across headlines for listings that immediately sound good so you click through to read more?

Yeah, usually, but not always, those are too good to be true. Let me give you an example of just this without giving too much information because I did sign an NDA.

I came across a business with a headline that read

Fitness Franchise with over 6-Figure Net Income!

I’m paraphrasing the title so that you can’t just go ahead and google it but this headline alone covers three main points.

1. It’s a franchise business so you’re under the assumption that you’ll be getting corporate support for a fee

2. It’s fitness so could be capital intensive (get an uptick in depreciation in asset purchase) or some type of low capital intensity studio

3. Six-figure net income sounds great!

There really wasn’t anything that threw off a worrying feeling. The multiple was ~3x SDE which is the average for most fitness businesses being sold and the sales seemed high enough that the margin made sense.

However, the problem is when you start to look under the hood during diligence which changed the whole thing completely. It’s still up for sale by the broker today even though I started talking to them in August of last year if that paints you any picture.

Diligence Discovery

So like most fitness businesses during COVID, there were obviously tough times that needed a lot of effort to generally survive. The owner stated just how much memberships dipped because of state-wide closures and how they had to give discounts in order to get people back quickly.

This didn’t really bother me because that made intuitive sense. In the back of my mind though I was already thinking about how margins were getting hit because of that.

But then again, the business is making over six-figure net income so it had to have bounced back meaningfully.

But just like most people, numbers can’t lie. You can try to finesse the numbers but eventually, everything comes out.

This brings me to the chart in the CIM that basically told me everything I needed to know in about 30 seconds.

I’m going to let you analyze the above chart and see how many things you can determine from it and if you think it makes sense to pursue the opportunity.

After you’ve done that (or not), take a look at all the reasons why I passed on it.

1) Memberships

When I say memberships, I don’t mean the absolute number of memberships, I mean the revenue of the memberships.

In 2019, 291 members equated to ~$475k in sales, or ~$1,632/member for the year.

In 2021, that same equation resulted in ~$1,265/member, or a decrease of ~22%.

Not good but I get it, it’s an uphill battle getting people back.

2) Officer Salary

For those that don’t know, the “officers” line item refers to owners’ compensation. The jump from 2019 to 2020 is understandable because at the run rate, the owner could have afforded to pay herself more.

However, this is BS in my mind because we went into lockdown in March and many states didn’t come back online until summer or even after that for fitness centers.

That >100% increase wasn’t warranted and thus really put the company in the red. Even in 2021, the owner only dialed it back a few thousand after losing ~$29,000 at the company level.

I understand there are tax implications of that but still, you’d rather not see that especially if you’re trying to convince a bank to give you a few hundred thousand dollars to buy the company.

They want to back less risky, financially stable businesses whose owner isn’t milking it for self-gain to prop up numbers.

3) Company Profit/Net Income

It’s pretty obvious but the company isn’t making money, the owner is. The owner makes out with over $100,000 a year but at the expense of the company.

While this technically isn’t “wrong”, it’s not optimal since the obvious goal is to make as much as you can to pay yourself a nice salary while tucking away money for the business as well.

Also, the net income is indicative of add-backs that we don’t necessarily see based on this preliminary chart. While we do see the salary, there’s another ~$27,000 not fully accounted for.

I could tell it partially comes from travel and interest/depreciation but where is the rest? Probably something that would have to be an expense anyways.

Un-Underwritable

Yeah, I just made up that word but it sounds good for this example. If a company doesn’t make enough money to make a bank feel that the investment has enough margin of error for an acquisition to be sound, it won’t fund it.

Let’s see why in my napkin math.

So taking the table above and applying my own rationale, I could ascertain that a lot of the expenses in order to bridge the gap between what was given and the company profit came from traditional things like; employee salaries, misc stuff like accounting, etc., and a simple franchise fee.

The wages come from paying six workers an average wage of $17.50, for 40 hours a week, for 52 weeks a year. Yes, I understand that can vary widely but the point of this simple math is to pressure test it with simple parameters.

For 2022, the owner let me know that they’re on track to do ~12% y/y sales growth. I factored in zero growth for owner wages and depreciation/interest.

Amortization I wrote off to be conservative.

I calculated a new franchise cost based on the fee that they told me and then held margins steady for the other items. Again, to be conservative.

Presto! We have company profit, but not much.

While now the company is making more money, here comes the problem with funding.

Now the benefits of the SBA are that you can get some serious benefits when it comes to the term length on the loan. Typically, it’s 10 years which means that a fully amortized loan can be good since you can lower your monthly payments since the duration is better than traditional 3-year notes.

For the equity, you can put as little as 5% down for some deals but since this company is in the best financial health, I marked it at 20% which will help cover all the misc fees.

But, the problem is the debt rate. SBA loans run off of the WSJP rate plus a spread. Typically this spread is 2 - 300 bps.

If you factor in a terminal rate of 11%, this debt gets expensive but not out of the ordinary for deals nowadays.

However, with the benefit of a 10-year amort, the 11% on 80% LTV makes the annual payment ~$68,000.

That immediately wipes away any gains that you could expect from the business. So while in the second table, I modeled improved company profitability, the summation of my model (~$130,000 in “cash”) gets cut in half with the debt that you’d take out to fund the deal.

No bank and I mean no bank will underwrite that. Hence, why the business still hasn’t sold.

Bottom line

While headlines might be good for attention grabbers, once you peel back the onion, you really find out what stinks.

Always remember to pressure test the math!

If you enjoyed today’s post, please hit the subscribe button below.

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Until next time,

Paul Cerro | Cedar Grove Capital

Personal Twitter: @paulcerro

Fund Twitter: @cedargrovecm

HoldCo Twitter: @cedargrovech

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Disclaimer

All information provided herein by Cedar Grove Capital Holdings, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.

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With that said, let’s get into today’s post.

Multiple Arbitrage in SMBs

I originally talked about small businesses and our first Pet Services acquisition on the Chit Chat Money podcast which you can find below.

But what do I mean by multiple arbitrage when it comes to SMBs?

Well first off, in layman's terms, it’s being able to value a business at a higher multiple than what you paid for it.

Many can relate to this when they invest in the stock market because you paid 5x sales for something a year ago and now it’s worth 10x sales. Granted a multiple is just a ratio so you’re hoping that when it goes up that the underlying metric isn’t deteriorating.

Nonetheless, you can achieve multiple arbitrage when you’re looking to roll up SMBs.

This will specifically revolve around the time you’re looking to sell and want a premium on what you’ve built/created.

Now in the episode above, I explained that when you sell a small business to another owner, there is indeed a multiple on earnings but they really stay within a range. Owners of small businesses tend to use that small business to actually live and pay bills. They need the earnings now and not 10 years from now.

This is why DCFs and other financial valuations don’t typically work when you’re buying a small business because it most likely won’t leave much for the new owner to live off of if they pay too much.

Hence, why they usually don’t move from the “range”.

Pet services for instance typically trade between 2-3x SDE. Software companies can go well above that. Capital-intensive companies can go for less. It all depends.

Though this is the typical way of doing things, here’s where the arbitrage comes into play. I will admit, this is

• Not easy

• Not quick

• Not for everyone

You need to understand that before you read the rest. For those of you that are thinking about doing this, let’s continue.

Getting the Multiple Uplift

It starts with you. What do I mean by that? Well, you as an individual whether you are self-funded or a searcher, can really only do small-sized deals.

I say small but “small” is a relative term so don’t get held up by that. However, because you’re “small”, that means you have to operate within the world of SMB valuations, not general M&A valuations.

This means that you’re going to most likely buy and later sell your business for roughly the same multiple you bought it for.

No multiple expansion.

On the flip side of this, a larger player, like a strategic or a PE fund, pay bigger multiples for businesses that already have scale and a decent amount of cash flow.

The reason for this.

Limitations of PE

Funds have two mandates. The first mandate is to earn money (i.e. Return on Invested Capital) and deploy the funds under their management.

It is important to understand the second mandate: deploying funds. Funds want to avoid two problems:

1. Investing too much of their money in one target (too much risk without diversification)

2. Investing too little money in too many targets

Let’s put this logic into an example.

A business with $1m in EBITDA has an average equity check of $600,000. If a $100m fund were to target $1m EBITDA businesses, then they would need to buy 166 businesses.

Put another way they would have to buy 160 businesses more than the average fund. Until the economics of funds significantly shift, funds cannot acquire small businesses.

With increased competition, funds are increasingly going to small businesses, but most funds can’t dip below $5m EBITDA threshold. Most businesses they acquire at the $5m EBITDA threshold are add-ons or businesses they are combining with another company.

Because of this, PE funds aren’t going to want to buy out a business that only has a few locations (unless it’s a great concept or the few locations are big enough). I.e. they won’t buy a business with two car wash locations but they would buy a business with 10 car wash locations.

This need to purchase a bigger, existing business is why they’ll pay up but won’t do so until the business being mentioned gets to that point.

This is where you come in.

Your ability to buy small businesses, roll them up, and scale them can eventually attract the attention of PE funds looking to take it to the next level when you’re looking to cash out.

Here’s an easy way to look at this.

Let’s say that you buy car washes that trade for 3x earnings. You pay $900,000 for a business that generates $300,000 in earnings. Simple.

Now over time, you buy enough of the exact same size business and even maybe open some yourself.

So in 10 years, you have 10 car washes that generate over $10 million in sales (each car wash does $1 million in sales) and $3.5 million in earnings (each car wash now does $350,000 in earnings because of economies of scale).

Not bad and honestly, there are many factors that could probably improve all this but for the sake of this post, we won’t go into that level of detail.

So now you’re not a little business owner anymore. You’re a local (potentially regional) car wash tycoon! With all your hard work, you want to cash out.

If we stayed at the SMB sales level, you’d most likely sell at 3x earnings for an individual who wants to get into the space. That means you’d be getting ~$10.5 million for your 10 years of blood sweat and tears.

Again, not bad, but you’re not some small time one store Joe. You think you can entice a PE fund, which might already specialize in car washes, to buy your business.

For argument’s sake, let’s say they're interested. Because you’re playing at a new level that means that you can capture a higher multiple for moving “upstream” in the business size range.

Now this PE fund decides that comparable comps for a business of your size go for 6x earnings.

💥 BOOM! 💥 You just achieved multiple expansion.

One of the best parts about this is that you just spent the last 10 years of your life building a business, getting paid to do so by means of salary + SDE, and now you can cash out.

10 years of salary and business earnings and now you get a 6x multiple on adjusted earnings which equates to a $21 million payday.

Rolling up and getting to a big enough size to attract a different kind of investor gets you the higher multiple, and in the example above, rewards you an extra $10.5 million!

And that is the ~7-minute 50,000ft view on how you can get multiple expansion when it comes time to sell by rolling up SMBs.

If you enjoyed today’s post, please hit the subscribe button below. If you’d like to chat through SMB acquisitions, diligence, and improving your own business operations, I offer a consulting service that assists with that.

SMB Consultations

Until next time,

Paul Cerro | Cedar Grove Capital

Personal Twitter: @paulcerro

Fund Twitter: @cedargrovecm

HoldCo Twitter: @cedargrovech

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Disclaimer

All information provided herein by Cedar Grove Capital Holdings, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.