Buying Your Way into Entrepreneurship

Many aspiring leaders take conventional routes to the top in business: They get on a C-suite track at a large company, climb the ladder to partnership at a consulting or investment firm, or launch their own start-up. But there is another career path that has become increasingly popular in recent years: buying and running an existing operation—or what we call acquisition entrepreneurship. A record number of such transactions occurred in the United States during the first three quarters of 2016, according to BizBuySell, an online small-business marketplace. Every year, we teach a course at Harvard Business School on this kind of entrepreneurship, which dozens of students—and others—pursue. Among them are Tony Bautista, who did stints in investment management and business development before taking the helm of Fail Safe Testing, a company that tests equipment for local fire departments; Greg Ambrosia, who served as a U.S. Army officer before acquiring and leading City Wide Building Services, a commercial property window-cleaning specialist in the Dallas/Fort Worth area; and Jennifer Braus, an engineer-turned-MBA who now owns and runs Systems Design West, which manages billing for ambulances and other emergency service providers near Seattle. (Full disclosure: We are investors in and directors of all three companies.) Other students of ours have gone into home health care, exotic travel, musical instrument rental, specialized software, and manufacturing. Whether acquisition entrepreneurship is right for you depends on your preferences and temperament. But most of the individuals we’ve taught, advised, and tracked have found it to be personally, professionally, and financially rewarding. Perhaps the biggest benefit is instant impact. Instead of navigating a corporate bureaucracy or toiling away on business plans and prototypes, you’re immediately in charge of a living, breathing organization and making decisions that have consequence. That was appealing to Braus. “I’m someone who craves responsibility,” she says, “so I didn’t really like being a worker bee. I saw where I wanted to go in terms of leadership, and now I’m there.” Another plus is having a more flexible lifestyle than might be possible at a fledgling start-up or a large firm. When you’re running a stable operation, you rarely need to work nights and weekends, and as the boss, you set the rules: If you want to leave early for a family or community commitment, you can. But small-business acquisition and management is not without its challenges. That’s why you need to make sure you’re suited to it and then approach your search, deal negotiation, and transition to leadership in a systematic way. Through our research on multiple companies and their buyers, we’ve developed a road map for tackling all of these steps. Reflection To succeed at acquisition entrepreneurship, you of course need basic management skills: an understanding of finance, a knack for leading and managing others, and an aptitude for decision making. But you need other attributes, too. Confidence and persuasive ability are key; the job requires you to reach out and project optimism to people you don’t know—business brokers, investors, sellers, and the employees and customers you inherit. City Wide’s Ambrosia says he felt instantly comfortable with that part of the role, thanks to his military experience, which involved leading different groups of soldiers (including many who were older than he was) on combat missions in Afghanistan. Acquisition entrepreneurship means instant impact. You’re immediately in charge. Persistence—what Bautista describes as “thick skin and grit”—is crucial, too. When seeking a business to buy, you might find a great prospect, reach agreement with the owner on price and terms, and work for months to close the deal—only to have it fall apart at the last minute. You need the fortitude to bounce back. And once you’re an owner, it will be up to you to drive the company forward and ensure that it recovers from setbacks. Additionally, and perhaps most importantly, you should be an enthusiastic learner. Throughout your search, you’ll have to quickly get up to speed on unfamiliar industries, sectors, and companies. When you find an interesting target, you’ll need to become knowledgeable about the business. And as an owner and CEO, you must be able to develop expertise across functional areas, stay curious, and recognize that you can and should grow into the job. “Nothing can prepare you for owning a company other than owning a company,” Bautista comments. “No day is boring.” It’s also important to reflect on the trade-offs that all entrepreneurs make in choosing to go out on their own: Do you value what you’ll gain more than what you’ll lose? For example, you’ll have professional independence and the ability to make unilateral decisions, but that comes with a great deal more pressure. You’ll be giving up the comfort of working in a larger, more structured organization where you have greater access to capital, a better-known brand in which to take pride, and the support of peers, bosses, and functional groups such as HR and R&D. Yes, your pay will be directly linked to your performance, with every positive move you and your employees make benefiting you and your investors. But there is a negative flip side: Inevitable mistakes and down cycles will hit you harder than they would if you were a cog in a corporate machine. “You and the company become one, so you take both the good and the bad,” Bautista says. Ambrosia describes the job as “exhilarating” but also “stressful”—sometimes even more so than his time in the army. Leading troops, he alternated between periods of extreme challenge and rest, he explains. But in his role as CEO, that “feeling of responsibility to get it right”—for customers, employees, and investors—“doesn’t stop.” So carefully consider what you’re in for. If, after all this thinking, you determine that you have the skills and the appetite to become a small-business owner, you’re ready to begin your search. The Search Although would-be entrepreneurs often worry about making mistakes once they take over a business, it’s actually much earlier that many falter. According to research by a team at Stanford University, about a quarter of acquisition searches end without a successful purchase. In other cases, people let emotion or a desire for expediency lead them into buying bad businesses (or the wrong ones for them) or overpaying. We’ve focused on avoiding these outcomes in our work advising former students and in making investments ourselves. Here’s what we suggest. Whether you’re working alone or with a partner, you need to commit to searching full-time for six months to two years. This may sound extreme, but an extended period is necessary to raise funds from investors, identify potential acquisition prospects, thoroughly vet the best of them, negotiate with sellers, and, eventually, find one that agrees to sell at a reasonable price. Then it will take at least three more months to perform due diligence and complete the transaction. Establishing a search fund is the most popular way to raise enough capital for out-of-pocket expenses and your cost of living during this time. The process involves approaching potential backers (wealthy individuals in your network or those in the small-business-acquisition community) and offering them a first look at investing in an eventual acquisition at favorable terms. Bautista, Ambrosia, and Braus all went about their searches this way. Their aim was to acquire not just money but also advisers who could help them through the deal process, since none of them had M&A experience. An alternative is to self-finance. To make this realistic, you should try to keep expenses down—one of our students spent only $25,000 over his 14-month search, in part because he was able to live with his in-laws—and limit the number of prospects you consider. The advantage of this route is that you can strike a better deal with investors when you raise money at the acquisition stage. The search begins by sourcing and filtering prospects. We recommend focusing on companies with annual revenues of $5 million to $15 million and annual cash flows of $750,000 to $3 million. In this range, there are high-quality small businesses available for prices low enough that you and your investors can earn an excellent return even if the business grows only slowly. Forget rapidly evolving start-ups and risky turnaround opportunities; you should look for steady (often unglamorous) enterprises that are profitable year after year and likely to remain so—what we call enduringly profitable. While these are strong businesses, you can still add a lot of value by applying best management practices that the current owners might not know about or have the energy to pursue. In a typical search you’ll encounter acquisition prospects every day—through referrals from your network or brokers or through your own direct outreach to business owners. These prospects might total in the thousands over a year or two, so you will need to dismiss most of them very quickly. We recommend that you evaluate each using five criteria: Is it profitable? Is it an established business? Are its revenues and cash flows in the desired range? Do you have the skills to manage it? Does it suit your lifestyle (location, hours, need for travel, and so on)? If you can answer yes to all of the above, ask two additional questions that take a bit more time to investigate: How enduringly profitable is the business? Is the owner serious about selling it? Markers of enduring profitability include a steady, loyal customer base; a strong reputation; deep integration with customers’ systems; large switching costs; and few or no competitors. Examine the financials carefully and look for strong margins and low customer churn. (For more details, see our HBR Guide to Buying a Small Business.) Over a 12-month period, Ambrosia considered approximately 7,500 businesses, from a slaughterhouse to a confectionary company. He indicated interest in 26 and received favorable responses from two before he entered into exclusive negotiations with the seller from whom he eventually purchased his company. Bautista looked at hundreds of prospects (often pestering brokers for details on promising ones), created a short list of 15, and visited five or six before settling on his target. As for Braus, she acknowledges that she “came across a lot of garbage” before finding one candidate that “stood out.” If a business owner has engaged a broker, it’s a good sign that he or she is ready to sell. But it’s not uncommon for people to back out at the last minute. To counter this risk, spend time with potential sellers as early as possible to investigate their motives. Are they retiring? Have they had a life change that requires them to give up the business? Are they just testing the waters? Consider their expectations: What price do they want? Are they just looking to turn a big profit—or perhaps get rid of a bad apple? And be sure that you’ve talked to all the owners; someone else with a share may be less interested in selling than the person with whom you’ve been dealing. Even as you dig more deeply into businesses that make it past your initial filters, you should continue to review new prospects in case your desired deal falls through. Negotiating a Deal You may have spent only a day or so on the prospect thus far, but if it’s still of interest, you should now devote substantially more time to preliminary due diligence: a focused period of rapid learning in preparation for making an offer. This is when you’ll test the seller’s initial claims and verify the information that has made the business appealing to you. You believe the company has many devoted customers because it reported a low churn rate—but are those customer businesses themselves healthy? You think cash flows are steady—but what did the books look like during the last recession? And how sound are the company’s current business practices (regarding quality control, billing, refunds, pay, and benefits)? You’re looking for any reason that you might not want to acquire this business. Use the company’s historical financial data to project future earnings and your return on investment. These calculations will allow you to value the firm as accurately as possible—and thus to arrive at an offer price, typically between three and five times the current EBITDA. Visit banks and approach your investor network to raise money for the acquisition. You should be prepared to provide information about the business and its industry, details on the due diligence that you’ve done, your financial projections, and the deal terms that you are proposing. Especially if you’re competing against other interested parties, this is also the time to persuade the seller that you are the right buyer. Bautista was up against private equity funds willing to spend more money on Fail Safe than he and his investors were, but he won out by emphasizing that he really cared about the business and would continue the owner’s legacy. If your offer is accepted—or accepted after negotiations—you’ll enter a period of confirmatory due diligence in which the company’s records will be fully open to you. You will typically have around 90 days to work with your accountant and attorney to check for any inconsistencies and red flags. (It’s a good idea to wait until this stage before bringing in these outside professionals so that you don’t have to pay them should the deal fail, as is more likely earlier in the process.) This can be an extremely nerve-racking time for both the buyer and the seller, so it’s important to be patient and calm. “I was always trying to communicate that progress was being made,” Ambrosia recalls. Braus’s seller threatened to back out when the company signed a big new client 10 days before their deal was scheduled to close, but she and her investors pulled the seller back by renegotiating some of the terms. “Living with the uncertainty during that period was a difficult thing to do,” she says, “but we weren’t willing to lose the business over it.” Transitioning into Leadership After closing the sale, you should focus on four tasks: introducing yourself to all your managers and employees, meeting with external stakeholders, communicating the transition plan to everyone, and taking control of your cash flow. The most common trouble for small firms under new owners is running out of cash. As you meet your new colleagues, reassure them that they won’t see any immediate changes. Instead, share your overarching goals for the company—for example, excellent customer service, commitment to quality, a satisfying work environment—and encourage people to stay focused on their work. Also give them an opportunity to ask you questions, but don’t feel as if you should have definitive answers for everything: “I want to learn more about that issue before I make a decision” is a fine response. On the day Ambrosia announced his purchase of City Wide, he stood up in front of his 50 or so employees and delivered a three-part message: He’d bought the business because it was already a great one, everyone’s job was secure, and he looked forward to learning from them. He then met with his managers, laying out his expectations for them (mainly codifying existing responsibilities) and telling them what to expect from him. He also made sure to “lead from the front” in his first few weeks—rolling up his sleeves to clean windows with both day and night crews. You’ll need to take the same proactive approach with customers, suppliers, and your new community. All these stakeholders will want to meet the new boss, and many will offer useful ideas about how to improve your offerings. Two other acquisition entrepreneurs we know made a point of visiting every major customer as soon as they could; they told us that all their new product and service ideas in the subsequent months came out of those early meetings. If you have a management transition arrangement with the former owner, be clear with both employees and customers about how it will work. Explain how decisions are now going to be made and whom to approach with certain types of questions or requests. Along with relationships, cash flow should be a top priority. The most common trouble for small firms under new owners is running out of cash; after all, they are likely to have acquisition debt to service. So set up a process whereby you approve all payments before they go out, and review your accounts-receivable balances at least weekly. You should also implement a 90-day rolling cash-flow forecast. The weeks after closing will be exciting, busy, and filled with learning. You’ll be pulled in more directions than even an extended business day can accommodate. “It’s a shock to everyone,” Bautista explains. “You’re afraid all your employees are going to quit, and they’re all worried you’re going to fire them. And you’re responsible for everything right away. I remember thinking ‘I’m a 28-year-old now running a 50-person company.’” Ambrosia and Braus also admit to unexpected early challenges. In the first few months of their tenures, both senior and junior employees left, voluntarily and not, in part because the new owners were bringing more discipline and accountability to their companies. Bautista says he had to drop a few longtime customers that were not actually profitable, and the company experienced a payroll snafu that upset both him and his staff. But these types of growing pains are inevitable. If you have approached the acquisition process thoughtfully and begun to apply good management, things will soon settle down. And then you’ll be able to focus on growing your small business into a successful medium-sized—or even large—one.

Buying Your Way into Entrepreneurship

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