No Man’s Land

October 20, 2020


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Recently I have been working on the purchase of a SMB – the business has $1.5M of annual profit, two offices and 35 employees. The process reminds me why SMBs of this size and scope – what I’ll call the micro middle market – are “no man’s land” for M&A.

This is compared to the $250k-$750k Seller Discretionary Earnings market, where buyers are generally buying a job as much as they are buying a business. And also compared to the $2-2.5M+ of EBITDA market, where PE buyers become very interested and competition/multiples increase.

But it also reminded me why SMBs with $1-2M of annual profit are attractive opportunities for the capable SMB buyer. Might the micro middle market see less competition, lower valuations and more buyer-friendly terms in the near term? I’ll explain …

Deal terms on this transaction are relatively straightforward: purchase price for 100% of the business is $6M (4x) with a $650k subordinated seller note (11% of PP). Seller is providing a 6-month transition period before retiring. 

This business didn’t have many natural buyers. It’s a small, geographically focused, old economy business … not a great combo for PE firms. So, the other options were “strategics” (e.g. competitors) and individuals looking to exit the corporate world and “buy a job”. 

Let’s start with the “Job Buyer” … how would she or he finance the purchase? The obvious answer is an SBA loan. After adding $250k of deal expenses (SBA fee, lawyer, CPA, etc.) and $250k of working capital to the $6M PP, the project cost is $6.5M. 

Subtract the $650k seller note and $5M max SBA loan and the deal requires an $850k cash injection. It doesn’t all need to come from the Job Buyer – in fact she or he can raise all of it from investors and still retain a significant portion of the equity. 

But imagine your friends in the corporate world…could they write an $850k check themselves or find investors to do so on their behalf? It’s tougher than it sounds. And the Job Buyer still must sign a PG for the loan. FWIW, it’s doable and many have done this (myself included).

Even a smaller deal is tough for Job Buyers. A $1M profit SMB at 4x is $4M with a min $400k injection. And the SBA has pulled back on “airball” deals (little collateral) in today’s COVID world. So, the Job Buyer is mostly eliminated from these SMB deals in the micro middle market.

What about PE firms? Even the smallest shops have EBITDA minimums (for platform co’s) that are well above the micro middle market. Pre-COVID, some firms would go “down market” to SMBs with $1-2M of annual profit, but in recent convo’s w/ PE friends, that has largely changed. 

PE shops see micro deals as riskier, more operationally challenging and less economically meaningful. So, they’ve retreated back “up” to $3-5MM+ of EBITDA. And bolt-on activity has slowed b/c of COVID uncertainty plus PE firms are focused on their current co’s more than buying.

Independent sponsors would struggle to finance this deal in the COVID world. The SBA is a non-starter due to the PG. And the non-recourse cash flow lenders, “micro mezz” and SBIC shops have retreated upmarket, tightened their credit standards and/or stayed on the sidelines. 

So that leaves good old-fashioned equity from family offices, HNW folks and other equity backers. But “too much” equity means lower returns for typically structured (i.e. quick flip incentive) sponsor deals…and lower returns means worse economics to those sponsors.

Strategic buyers – especially those that are aggressive in M&A, move quickly and pay cash – are extremely competitive SMB buyers. Say what you will about their “synergies” and speed … experienced strategic buyers are our nightmare when it comes to competitive SMB M&A.

But many strategic buyers are too slow and too big to focus on growth via SMB M&A. Add COVID to the mix, and strategics are far more focused on keeping their own boats afloat than aggressively pursuing growth through M&A in the micro middle market.

Interestingly, in the micro middle market, sellers often get nervous about marketing their businesses to strategic buyers – the fear of disclosing key info to other industry players is too much to overcome (even with iron-clad NDAs in place). So many sellers self-select to non-strategic buyers.

So, who buys micro middle-market SMBs in a COVID world? And how do those buyers finance their deals with the usual sources retreating or poorly suited for the particular buyer or deal? “Over equitizing” is one answer, but rarely the one that works for most buyers. 

Here are my takeaways. These are obvious. And we’ve read about them all before. But for the first time in 10 years we are seeing this play out in the SMB M&A world … and maybe less competition, lower valuations, and more buyer-friendly terms are on the horizon.

  1. For the natural buyers of micro middle-market SMBs, debt is the primary form of financing. It juices returns, is the lowest cost of capital and, for the past 10 years, has been readily available. But when debt dries up, SMB deals are harder to get done.

  2. If SMB M&A deals are harder to get done, something will (must?) change so they do get done. SMBs still have to transact. Retiring owners cannot work forever – and they won’t just shut their co’s down. The community needs to get paid (brokers, CPAs, lawyers, etc.)

I think (and hope) the answer is lower valuations and more buyer-favorable terms. For example, in our deal described above, the Job Buyer could much more easily get the deal done with a SBA loan at a 3x purchase price ($4.5M) multiple and 20% seller note.

  1. If you are an “all-cash” (equity) buyer in the micro middle market, your advantage is enormous!! I hear about this dynamic in real estate, and debt financing in the RE world is WAY easier to get compared to the SMB M&A world … and that was pre-COVID!


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