Royce Yudkoff and Rick Ruback

Supported by Greenhaven Road Capital, finding value off the beaten path.

On Invest Like the Best Patrick O’Shaughnessy talked to Royce Yudkoff and Rick Ruback about the course they teach at HBS (and their book) that gives students the tools to find, buy, and run small businesses.

These businesses (750k-2M EBITA) are plentiful because there is an imbalance between the people running them now and those willing or able to run them in the future. Unlike Brian Scudamore’s companies, Uber, or HackerOne – there isn’t a marketplace to match buyers and sellers. Instead, the forty or so searchers a year that come out of places like HBS browse in a bare-bones manner.

People interested in investing in this situation would do best to connect with one of the dozen or so colleges that have programs like this, talk to a small business broker, or connect with one of the five hedge funds that make these types of investments.

Students who go through HBS (or the other schools) will typically bootstrap the search themselves. This takes about twelve months. At HBS they teach students to look for businesses with these characteristics:

  1. Recurring customers bases who have high switching costs. “Ideally over 90% but certainly over 80.”
  2. Low cyclicality. While the seller probably doesn’t have debt the buyer will. Cyclicality/seasonality can make debt service painful, or even fatal.
  3. Low customer concentration.
  4. Good free cash flow characteristics. “Almost all of EBITA is available for debt service, acquisitions, or distributions to equity.”
  5. Business that can be transferred away from selling owner with a big step-up for performance. Founders usually excel at working in the business and buyers should find instances where they can grow things by working on the business.

There are also a few negative screens:

  1. Technology companies.
  2. Stroke of pen risk. Someone can just change the reimbursement rates for medical expenses and — poof.
  3. Hobby businesses. Avoid, “I’ve always wanted to do X” situations.

The ideal small business will be “enduringly profitable business” in a boring domain with minimal go-to-zero risk.

Of course, no company will satisfy all the parts of this checklist. “In the real world you need to compromise, you just don’t get everything…as a searcher, you need to decide what’s good enough for you.”

Once a buyer/student finds a business, they typically finance half by borrowing from a commercial bank, a quarter from the seller, and a quarter from their investors. Each group will be paid back, then earn 7-10% returns, and appropriate levels of common stock. The limited investor base and permanency of them can allow for long-term orientations and decision making.

This sort of debt structure makes the “go-to-zero” risk of these businesses low. Or, in internet form:

Businesses sell for 3-5X EBITA. Even though the seller borrowed money, they probably didn’t overpay.

These businesses can be great for the buyer and their investors and it’s not likely Wall Street will start to sniff around for these returns. The amount of work in just the board meetings and calls to LPs for a one million dollar investment isn’t worth it. Also, these businesses are hard to find. A lot of times the people that live in towns with the business seller don’t even know what kind of cash is generated.


Thanks for reading,

PS. This is another experiment at short, more direct, less linky posts. Did you like what you read or do you like this:

Once a buyer/student finds a business, they typically finance half by borrowing from a commercial bank, a quarter from the seller, and a quarter from their investors. This allows plenty of skin-in-the-game for everyone involved. Harry Snyder created a profit sharing system at In-N-Out. Investors like Ian Cassel look for large ownership stakes. SITG makes people have a larger stake in the outcomes, but sometimes people don’t want this.  “At one meeting (soccer coach) Anson Dorrance proposed a resolution that every administrator who appoints a coach should be fired when that coach is fired. Nobody seconded the motion.” 

Along with SITG, investors need to keep a long-term mindset for decision making. Patrick Collison said that he’s kept Stripe private so long because this is a hard hat to wear in the winds of the public markets. Long-term thinking, wrote Sam Hinkie has other benefits, “to take the long view has an unintuitive advantage built in – fewer competitors.” But this isn’t easy. In the Steven Pressfield post we saw how to switch from short-term to long-term thinking. 

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