Capturing Multiple Expansion in SMB Roll-ups
Capturing Multiple Expansion in SMB Roll-ups
Why being a small acquiror can be advantageous for the ambitious
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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.
There are many theories around why smaller businesses trade for such low multiples, but one main argument is that they're subject to larger risks if a key customer, supplier or employee departs, while larger businesses can absorb these risks better.
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:
Investing too much of their money in one target (too much risk without diversification)
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.
Entrepreneurs who've built large companies have little trouble finding institutional or strategic buyers. Owners of small and mid-sized companies don't have the same luxury. Although private equity investors pay multiples of 15 to 20 times a company's profits (EBITDA) to acquire large firms, they only pay multiples of five to 10 times for smaller companies.
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.
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Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
HoldCo Twitter: @cedargrovech