Overview

Entrepreneurship through acquisition has evolved significantly over the past decade, with a clear market bifurcation between funded searchers targeting larger deals (~$20M enterprise value) and self-funded searchers focusing on smaller businesses (under $1M EBITDA), with the latter often achieving higher returns through SBA financing.

The most attractive acquisition targets share key characteristics: recurring revenue (80-90% repeatability), low customer/vendor concentration, non-cyclical business models, and manageable operations that don't require deep prior expertise—with the "magic" being in the low purchase multiples (typically 3-8x).

Typical sellers are 65-year-old founders without clear succession plans who have "more money than time," creating opportunities for MBA graduates and increasingly diverse entrepreneurs (veterans, engineers) who value independence over traditional corporate careers.

Despite compelling returns (IRRs in the 30%+ range compared to private equity's teens), only a small fraction of business school graduates pursue this path, as it requires significant independence, personal financial risk, and the ability to manage an entire business rather than work within structured corporate environments.

Post-acquisition performance typically follows a pattern: 5-10% losses in year one during the transition, with strong performance emerging around year three and substantial growth opportunities in years 7-12 as new owners expand service offerings and reinvest in previously undercapitalized businesses.

Content: Entrepreneurship Through Acquisition - A Decade of Evolution

Introduction and Context

This episode of "Invest Like The Best" hosted by Patrick O'Shaughnessy features Harvard Business School professors Rick Ruback and Royce Yudkoff
The professors teach students about searching for, acquiring, and running small businesses
The conversation explores entrepreneurship through acquisition, with the host noting their previous discussion remains remarkably relevant even a decade later
The episode aims to share wisdom about what makes a company worth buying, the importance of business acquisition multiples, and how their students achieve impressive returns through patient, value-oriented approaches

Evolution of the Small Business Acquisition Space

Significant bifurcation has occurred in the market over the past decade:

- Funded searchers now target larger deals (around $20 million enterprise value) - Unfunded searchers focus on smaller businesses (under $1 million EBITDA) - Acquisition multiples have widened to a range of 3-8x

Key developments enabling this evolution:

- SBA loan programs allow acquisitions with high leverage (80-90%) - Entrepreneurs can own 70-80% of a business with minimal upfront capital - "Independent sponsors" have emerged who aim to acquire multiple businesses without directly running them - The career path has transitioned from "quirky" to more mainstream and accepted

Emerging trends in the space:

- Some searchers pursuing roll-up strategies - Increasing diversity of backgrounds among acquisition entrepreneurs (veterans, English majors, engineers) - Growing number of success stories making the path more attractive

Risk and Return Dynamics

Deal failure rates vary significantly:

- Funded searches now experience failure rates over 50% - Unfunded searches have much lower failure rates (less than 25%)

Reasons for deal failure include:

- Unsuccessful due diligence - Sellers changing their minds - Business performance decline - Increased competition with strategic buyers and private equity

Return profiles are compelling:

- Funded Search: Average IRR in low 30% range (significantly higher than private equity's low-to-mid teens) - Self-Funded Search: Even higher returns due to low purchase multiples (4x), high leverage (80%), with investors targeting 35% return while searchers retain 60-70% of common stock

Risk mitigation factors:

- Low purchase multiples help quickly pay down debt - Difficult to completely lose invested capital - The model increasingly resembles venture capital portfolio strategy - Differs from traditional private equity risk distribution

Investment Landscape

Funded search is increasingly dominated by small private equity funds investing at a portfolio level
More investors are interested in talented searchers than there are well-prepared searchers
The market remains illiquid, with difficulty finding good companies to acquire

Key Acquisition Target Criteria

1. Recurring Revenue - High-quality, predictable revenue (80-90% repeatability) - Allows offensive marketing strategies - Pairs well with financial leverage

2. Low Customer/Vendor Concentration - Avoid businesses overly dependent on single legacy clients or vendors

3. Avoid Economic Cyclicality - Cyclical businesses pair poorly with financial leverage

4. Manageable Business - Searcher must be able to learn and operate the business - Not necessarily an expert, but capable of developing necessary skills

Additional insights:

- Multiples remain attractive, especially for smaller businesses ($750k EBITDA) - Growth is not a primary criterion - "The magic is in the multiples" in this market - Newly minted MBAs can successfully operate businesses outside their original experience

Business Selection and Management Approach

Students carefully select businesses they believe they can effectively manage
Military veterans (captains/lieutenants) often buy blue-collar businesses, viewing management similar to running a military platoon
Physical presence and in-person management are considered crucial, especially for inexperienced leaders
Remote business management is viewed skeptically

Educational approach to selection:

- Students examine 100+ companies for potential acquisition - They work in groups to evaluate and select potential businesses - No consensus emerges on "the best" company - selection is highly subjective - The goal is to develop judgment about "how good is good enough"

Key selection factors:

- Business location matters significantly to potential buyers - Personal ability to manage the business is critical - No single company will perfectly meet all desired criteria - Developing judgment comes from extensive exposure to "deal flow"

Funding and Investor Dynamics

Funding sources are relatively open and diverse
Students can secure funding from section mates, family friends, and other networks
Academic institutions like Harvard have strict rules preventing faculty from investing in students during their studies
Post-graduation, investment opportunities become more accessible

Typical investor structure:

- Searchers typically prefer a diversified cap table with 10-12 different investors - Investors want variety in advisors and ownership distribution - The search fund model has expanded beyond Harvard and Stanford MBA programs

Expansion Beyond Traditional MBA Programs

The self-funded search model now dominates outside MBA ecosystems
Many searchers use SBA loans to acquire smaller businesses ($750K-$1M EBITDA)
The model has become mainstream as an alternative career path

Motivations driving this expansion:

- Searchers are attracted by independence and control over their professional trajectory - Many see corporate employment as increasingly risky and unstable - Baby boomer business owners are a key source of acquisition targets

Typical Seller Profile

Often 65-year-old business founders who:

- Built business over 20-25 years - Lack a clear internal successor - Need professional management as business has grown - Have reached a point where they have "more money than time"

Businesses typically require a trained manager rather than an expert artisan
Sellers seeking someone who can both finance and run the business

COVID-19 Impact and Market Dynamics

Many business owners delayed selling during COVID due to business disruption and uncertainty
Owners have been "waiting for next year" to sell, creating potential pent-up supply
Prediction of a potential surge in business sales over the next 3-4 years as owners reach their patience limit

Business Types Attractive to Searchers

Preferred businesses have specific economic characteristics:

- Recurring/reoccurring revenues - Diverse customer and vendor bases - Non-cyclical service needs - Examples: roofing, HVAC, veterinarian services, overhead garage doors, automotive repair

Software business acquisition trends:

- Searchers tend to buy niche software businesses serving specific markets (e.g., software for podiatrists, small municipalities) - Look for stable underlying markets with potential for incremental improvement - Avoid volatile, trendy software or tech businesses

Business Strategy and Roll-Ups

Discussion of roll-up strategy in auto repair facilities
The strategy involves centralizing management while allowing mechanics to focus on technical work
This approach can be applied across various service industries (veterinary, medicine, HVAC)

Investment characteristics:

- Lower middle market investments typically yield consistent returns - Typical return pattern: multiple 3X investments, occasional 8X or 10X, with some 1X mixed in - Private equity firms find these returns attractive

Unique market dynamics:

- Lower middle market is unique because top talent consistently "graduates" to larger investment opportunities - Unlike other industries, successful teams naturally move to larger fund sizes and bigger company investments

Red Flags and Due Diligence

Key warning signs in potential investments:

- "It's a job, not a company" - Over-reliance on personal relationships/expertise of a single owner - Multiple owners with different motivations can complicate deal closure - Need to carefully understand sellers' true motivations for selling

Small firm acquisition insights:

- In small firms, owners often run personal expenses through the business (typically around $100,000) - Buyers must carefully assess the extent of these personal expenses and the owner's ethical standards - Large personal expense add-backs (e.g., 50% of EBITDA) can signal potential risks

Due diligence considerations:

- Build in a margin of safety when pricing the deal to account for potential surprises - Small firms often have incomplete or inaccurate documentation about contracts, recurring revenue, licenses, sales tax payments, and employee compensation

Transaction Closing Strategies

Recommended practices for increasing deal closure probability:

- Conduct weekly meetings (preferably on Wednesdays) - Maintain consistent communication - Track progress and outstanding deliverables

Negotiation challenges:

- Sellers typically plan spending of the entire anticipated sale price in advance - Price renegotiations can become emotionally charged and potentially derail the deal - Competitive bidding processes make price concessions difficult

Post-Acquisition Growth and Performance

Typical first-year performance:

- Most businesses experience 5-10% losses initially - Reasons include seller's timing, learning curve, customer relationship transitions - Year three often represents the first strong performance year

Growth opportunities:

- New owners often discover additional service opportunities by directly engaging with customers - Sellers may have previously been reluctant to pursue these opportunities - Younger, more energetic new owners are more likely to expand service offerings - Successful businesses often compound growth in years 7-12

Capital allocation in small businesses:

- The professors guide students toward capital-light businesses with strong free cash flow - Capital investment decisions in these businesses are typically straightforward and episodic - Most small businesses are undercapitalized and must carefully ration capital - They advise caution with IT investments, recommending simple, low-cost solutions initially

Teaching Approach and Philosophy

The professors have developed a highly-rated, impactful business class through:

- Extreme practicality, focusing on real-world lessons - Bringing case protagonists to class to help students answer: "Do I want to be this person?" and "Can I do what this person does?"

Teaching methodology:

- They teach theory, but always contextualized through concrete, meaningful examples - The goal is to help students evaluate and prepare for a potential profession - They use real business cases to illustrate complex concepts - They emphasize pattern recognition in learning, particularly through case-based education

Favorite teaching cases:

1. Nashton Partners - About two HBS graduates who bought a municipal extermination company 2. Capital Digital - Purchased by student Nick Anderson, highlighting challenges of small business information systems 3. Brian Bonk case - A PhD biology student who purchased the largest rabbit slaughterhouse in the US

Why More Graduates Don't Choose Search Funds

Despite the attractive returns, only 20-25 out of 920 annual graduates enter search funds
Graduates often prefer traditional career paths in private equity, corporations, or consulting

Motivations for choosing corporate paths:

- Desire to work in enterprises with substantial resources - Want to be surrounded by highly educated colleagues - Seek to be part of something larger (e.g., working for a major brand) - Prefer structured work environments

Challenges of search fund entrepreneurship:

- Requires significant independence - Involves creating one's own to-do list - Requires managing entire business strategy - Involves personal financial risk - Can be emotionally frustrating

Personal Reflections from Royce

Co-founded Abri Partners with Andrew Banks in late 80s/early 90s
After 25 successful years, questioned long-term professional fulfillment
Key motivations for leaving:

- Desire to explore different life experiences - Confidence in next generation of partners - Recognition of having "more money than time"

Found new partnership with Rick Ruback, which he considers fortunate

Closing Thoughts

The speakers have a deep respect and appreciation for their students
They view their work as meaningful, helping students find new career paths
They believe they're improving the world through supporting small business entrepreneurship
The conversation concludes with reflections on how this discussion compares favorably to a similar one from 10 years ago

Royce Yudkoff & Rick Ruback - Entrepreneurship Through Acquisition - [Invest Like the Best, EP.423]