Buying A Business? Here’s What Investors Want
Sam Rosati has a couple analogies to explain the relationship between small business operators, investors, and the business itself.
One is a three-legged stool: Without any one of those legs, the stool can’t stand. The second analogy is that of the horse (the business), the jockey (the prospective business owner/operator or “searcher”), and the trainer (the investor). The second analogy is illuminating because it highlights Rosati’s priorities as an investor: a good jockey is important and plays a key role with guidance from the trainer. But neither are as important as the horse.
Rosati runs Pursuant Capital, a company that for the last 30 years has invested in small business acquisitions. Based in Tampa Bay, Florida, he’s invested in businesses across the U.S. and across industries, from custom trailer fabricators, to plumbing businesses, to property management firms, and accounting offices. In that time, his asset fund has generated more than 30% IRR (internal rate of return), which he says outperforms any other investment class.
In other words: the business of investing in small businesses is good, which is good news for those looking for an investor. When Rosati spoke at our 2023 #BossUp conference, he shared four key insights for searchers.
If An Idiot Can Do It, That’s A Good Sign
One of the biggest red flags for Rosati is an established business that is largely reliant on someone who has been there for many years. It means handing over the reins is much riskier. There are other revenue-related metrics they evaluate, as well as things like customer and vendor concentration, but the bottom line is “if anyone can run it, it’s a phenomenal opportunity from an investor perspective,” Rosati says.
Be Realistic with Your Assumptions
One of the key mistakes Rosati sees is searchers who are too aggressive in their assumptions for business performance.
They will look at metrics like internal rate of return (IRR) or the multiple on invested capital (MOIC) to determine if the investment is worth their while. “You can artificially inflate these to make them look too good to us,” he says. “But we’ve seen enough (transactions) to know that not everything is going to go according to plan.”
Rosati advises searchers to be conservative: your projected growth for the business should match the historical growth, you shouldn’t assume your EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) will change significantly from the EBITDA that determined the business’ value (i.e. if you bought the business for 4x EBITDA, you shouldn’t assume it’s going to be 5x or even that it’ll stay at 4x). One way to buffer these estimates is to give investors a higher step-up, which refers to the percentage ownership they get for their investment (i.e. if they pay for 10% of the business and the step-up is 1.5, it means they own 15% of the business). High “ones” is common as a starting point, but Rosati says they can range all the way up to three.
It’s also too aggressive to assume you’ll start generating significant returns for investors shortly after your purchase. “You’re going to have a lot of uses for cash that your predecessor didn’t,” he says; from servicing debts, to hiring staff, to buying equipment, to any number of other investments your predecessor didn’t make on their way out.
Turnarounds are another common pitfall. Despite the appeal of turning around a declining business and the cheap price tag, these are a non-starter for Rosati as an investor. He reasons that if the seller has been in that business for decades and hasn’t been able to turn it around with their experience and connections, it’s very aggressive to assume you’ll be able to.
“If their assumptions are way too rosy, to me that says it’s not only unlikely to happen, but that they’re either trying to fool me or themselves and that’s a quick pass from me.,” Rosati says.
Develop Your Financial Literacy
There are a few key characteristics Rosati likes to see in small business operators: integrity, grit (they’re not too afraid or too proud to do any job), and financial acumen. “They can’t lose track of what is going on with the business,” Rosati says. “A lot of searchers, if handed a financial statement, don’t really know how to use it to evaluate how well a business is doing or how to guide their business decisions.” For investors, that’s a problem.
Operating Experience Trumps Deal Experience
Rosati says that many talented searchers come from private equity background. They have a good sense of what makes a good opportunity. But these people are not necessarily the best ones to run the business. In his experience, there is one group of people that seem especially well-suited to operate small businesses: military veterans. “Even though they have no idea about deals, they know a ton about leadership and operations,” Rosati says.
Watch Rosati’s full session from #BossUp 2023 here.
Opinions expressed here by contributors are their own.
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