CHAPTER 6

Identifying the Characteristics You Want in Your Business

As you begin your search for a smaller company to buy, you might be tempted to think big thoughts about the future of humankind to identify the shifting sands of the business environment. You’ll wonder, What is the next big thing? Where are the opportunities for big growth and fabulous profits? These kinds of musings make for wonderful conversations but rarely lead to good business decisions. In fact, we’ll explain in this chapter that you should look for what may seem to be a dull business: one that has the same customers from year to year and is growing slowly—a business that is what we call enduringly profitable.

In this chapter, we will describe the kind of business we think you ought to buy and the characteristics you should consider.

An Established and Profitable Firm

As mentioned above, you should buy a business that has enduring profitability, that is, an established, profitable business model. A business is profitable when its customers are willing to pay more for its products or services than what the company must spend to provide them. It is that simple. What isn’t so simple is why some businesses are profitable, year after year, while others struggle. Some struggling businesses were once profitable but are no longer. Others approach profitability but never achieve it, and some never enjoy even a glimmer of success. It is tempting to imagine buying a troubled business or one with uneven performance, because the purchase price would be very low. But we strongly advise against it, because you’ll have to reinvent the business model and doing so is a very difficult and risky endeavor. Instead, buy a profitable business with an established model for success—one that is profitable year after year.

The essential characteristic of enduringly profitable businesses is recurring customers. There are, of course, many factors that make smaller businesses enduringly profitable. These include some important, basic management best practices such as treating employees and customers well, being honest, and keeping expenses low. Managing well every day is essential to building a good business. But a business that has enduring profitability is more than that. It is able to attract and keep the right customers, those who highly value its product or service and will purchase year after year.

When the ownership of a business changes hands, some customers may consider other choices, and competitors will quickly pounce on the opportunity. Buying a business and then losing customers is a nightmare. Our experience, however, is that recurring customers persist even when the ownership of the business changes. Customer retention is critical for a successful transition from the existing owner to a new owner. Those recurring customers provide the foundation for a great small business.

Slow Growth

Although high growth would seem like a wonderful characteristic of a business, it comes with high risk. High growth means that your new customers will quickly outnumber your existing ones. Because new customers bring new demands, there are many ways to get in trouble. New customers are, well, new; they have no loyalty to the company and no history. High growth requires great management effort. It also absorbs money rapidly, and raising that money puts a strain on the business and its owner. A rapidly growing firm also attracts competitors, which see the expanding market and the opportunity to attract new customers. So, in a high-growth business, you could work hard and still fail if you cannot keep pace with your competitors. And even if your business survives, you might find that competition has forced you to sell at low prices, so you enjoy little financial reward after all. Making this all the harder, the seller will demand a much higher price for a business that has the potential to grow quickly. Buy a high-growth business, and you’ll work harder, face a bigger risk of failure, and pay more for the opportunity.

Low growth, in contrast, means low risk. And low risk is great because it is your money at stake. If you are like most small-business owners, all of your wealth will be tied to the company. Want to avoid worrying about paying college tuition for your kids? Buy a dull business. Want to work less than a dozen hours a day, seven days a week, every week, every year? Buy a dull business. You will still work hard and worry. But you should be able to have dinner with your family and sleep most nights. Why? Low growth doesn’t put strain on management and doesn’t require a lot of additional money. Things just move slower in an established business that is growing slowly. And in a slow-growing business, you’ll have time to build lasting relationships with your customers. You’ll learn what they value, and you’ll adapt to provide products and services that they will appreciate. They will buy from you every year, and you’ll learn to cherish that recurring revenue. It reduces your marketing and sales costs, but more importantly, it makes the sales next year less risky and far more predictable. That means fewer surprises and a much easier management challenge. Also, slow-growth businesses sell at lower prices.

As described in chapter 1, “The Opportunity: Entrepreneurship Through Acquisition,” both Greg Ambrosia and Tony Bautista purchased seemingly dull businesses that grew slowly. Greg’s business, a commercial window-washing service in Dallas, grows slowly because new high-rise buildings are added to the Dallas skyline slowly. His existing customers appreciate his good service and often use his company year after year, generating a stream of steady, recurring revenue. Tony’s business, testing fire hoses, is similar; there is little organic growth in the market, but his customers almost always purchase his company’s services year after year. Of course, both Greg and Tony can grow by expanding their service area and by attracting the customers from competitors by providing higher-quality services. But attracting new customers is often very difficult in businesses with repeat customers because the same economic forces that keep your customers buying from you keep your competitors’ customers buying from them. Because gaining market share by winning over the competition’s customers is so tough, your growth is likely to be slow but steady.

Buying a dull business doesn’t mean your career as a CEO or owner is at all dull. Greg and Tony are fully engaged in a whirlwind of activities that make use of all their talents. Both men find that just running the business is hard work, with a myriad of challenges such as hiring employees, revamping the company’s information technology systems, scheduling crews, improving the quality of their offerings, and professionalizing the business. And while growth is slow and steady, both Greg and Tony have expanded their capacity and are focusing on enlarging their company’s customer base. Both often visit with customers to learn more about how to improve their offerings, and the two frequently meet with employees to improve safety, quality, and efficiency. Greg and Tony describe themselves as completely engaged, very busy, and constantly challenged because they know that they are ultimately responsible for their company’s success.

Appropriate Size

We think it makes sense to buy a business with between $750,000 and $2.0 million in annual pretax profits. A few considerations should guide you. Because smaller businesses are usually less expensive to buy relative to their profits, they are more attractive. But you also want a business that is big enough to financially reward you for your efforts, and those rewards often depend on the profitability of the business, making larger prospects more attractive. At the upper end of our size range—$2.0 million or more in profitability—we find that institutional investors, like smaller private-equity firms, start to become interested and that competition raises the purchase price, reducing the financial benefits of owning the business. And finally, there is the practical consideration of how much equity funding you can raise. Generally, about one-third of your purchase will be funded by equity, and smaller firms often sell at roughly four times their pretax profits. So, at the low end of the range, you’ll need to raise $1.0 million in equity, and at the upper end, almost $2.7 million. We’ll explain how to do that later in this book, but if your personal network is small, it probably makes sense to focus on the lower end of the range.

A Good Match with Your Skills

Our suggestions so far—look for an established, profitable business with low growth, recurring revenue, and steady cash flow—leave hundreds of thousands of businesses for you to consider. But not all of those will make sense for you. We recommend that you take stock of your own background, skills, strengths, and weaknesses. Limit yourself to businesses that you will have the ability to manage.

Most businesses require general management skills—you’ll need to understand a bit of everything: people, marketing, production, legal, accounting, and so on. Our experience is that most people with strong general management potential can thrive in a wide range of businesses. Still, if you are allergic to fur, don’t buy a pet shop. Many businesses will require its owner to be its chief salesperson. If you hate selling or are not very good at it, don’t buy a business that requires you to fill that role. Some businesses have facilities, customers, or suppliers widely dispersed around the world. If you are unwilling to travel, look elsewhere. If you don’t like to manage people, don’t buy a business with hundreds of employees.

You should know how a business works before you buy it. Investigate how the company makes its products or conducts its services and what these offerings depend on. Is there a key person? Does the seller possess some rare skill that you will have a hard time replacing? Is there an essential supplier relationship? You should also understand the customers. Why do they buy from the company? And you should know the industry. Are there competitors? What are the company’s strengths and weakness relative to the competitors? You don’t need to know all of this in the first encounter with the company; you will learn a great deal about a business throughout your search and when you give a particular company a closer look before buying it. But you do need to learn about it and understand why it is profitable before you close the deal. And there are, of course, some businesses that you will find easier to understand than others. But if you dig deep into the due-diligence process and the company’s profile still seems like smoke and mirrors—and you can’t get a clear vision of its strengths and weaknesses—don’t buy it.

A Good Match with Your Lifestyle

There are also lifestyle considerations in your search. Make sure that you and your family are willing to move to the location of the business and can be part of the community. It is impossible to manage a small business successfully without being at the business almost every working day. At the same time, as you decide on the geographical scope of your search, don’t put too-strict limits on where you want to live and work. We don’t think it is sensible to look for a business in a narrow region—for example, a particular city or state is too restrictive. So, if your family refuses to live in North Dakota, don’t look for a business in North Dakota. But if your family refuses to live anywhere outside of the western suburbs of Boston, perhaps instead of looking for a business, you should find a job nearby.

We emphasize your family’s tastes for a reason: Running a business is all-absorbing. You have to put all of your efforts into making it a success. Your future and your family’s financial security depend on it. You will not have the time to manage both the business and an unhappy family.

You also need to have the energy and focus to manage the business you buy. If you or your family has health restrictions or lifestyle preferences that will keep you from working long hours, you should be realistic about these limitations when searching. One of the great things about owning your own company is that you get to make your own trade-offs about how hard you work and how much money you make. You can choose to make less and spend more time with your family without having to ask anybody’s permission or apologize to anyone. Business owners are in the unique position of being able to structure their professional life in a way that suits them and their families. We know of people who decided to become business owners because they could run their businesses successfully while still having the flexibility to pursue other commitments or passions. This flexibility is one of the most wonderful things about being a business owner. Think about those preferences as you are searching to make sure the business you choose allows you to pursue them.

Buying a Business, Not a Job

There are all kinds of ways to become your own boss, and the life you lead is clearly dependent on the path you choose. Some people accomplish professional independence by owning a business; others through self-employment—they are independent salespeople, business brokers, literary agents, electricians, interior decorators, freelance consultants, or any of hundreds of other professions. But the earnings of any job are eventually limited by the number of hours in a day. There are only so many customers that an individual can serve. You can add assistants who might extend your reach, but as long as the customers value most the contributions of a particular person (you), it is a job, not a business. In a successful business, customers value the products and services from the company. The company develops systems and policies so that individual providers can be substituted when one person moves on to another position. The customer recognizes the importance of the company, and that is what makes a business more than a job.

There are surely some jobs that are much better than some businesses. We know of two interesting examples—a computer services company and a website design firm. Both companies had a common operating philosophy of not having a central office and keeping overhead extraordinarily low. The CEOs were the nexus of their businesses and assigned tasks to employees and subcontractors directly. These executives were also the primary sales people and financial managers of their companies. There was no level of middle management. The streamlined chain of command helped make both of these businesses very profitable, and both CEOs earned more money than they had before they became CEOs. But did they have great businesses—or great jobs? Different people might see the answer to that question differently, and it could be the subject of a lively debate. But, sadly, in these cases, we know the answer. The CEO of the computer service company was in a serious auto accident, and the CEO of the website design company had a personal health crisis. Both were unexpectedly and completely away from their companies for months. When they returned, their businesses were a shell of what they had been: Most employees had left, clients had not paid, and almost no new work had been sold. Without the CEOs, there were no businesses. These executives had had jobs—great jobs, but still just jobs.

There is, of course, nothing wrong with buying a great job. But this book focuses on buying great businesses that are more than jobs because we think owning a great business is much better than having a great job. We have two reasons for thinking this is so.

First, when you are the owner of a smaller firm, your earnings are unhitched from the hours you work. This makes you different from craftspeople or other professionals who essentially bill by the day or the hour; ownership gives you the potential to earn much, much more. Your reward is tied to the management structure that you create and that enables others—hopefully, many others—to deliver the products and services that your customers value. Such a structure potentially gives you not only larger monetary rewards but also a more flexible lifestyle.

Second, when you own a business, you get paid in two ways. You are paid for being the manager—think of this as the annual salary you would make if you performed this same job at someone else’s company—and you also earn a return on the money, time, and energy you have invested in the company. If you are successful, the sale of your business will be an important part of your wealth. When most professionals retire, their income stream rapidly comes to an end. They have no ongoing business to sell; they work to make money, and when the work stops, so does the money. Successful craftspeople sell their tools upon retirement for less than they paid for them; a successful company will sell for much more than the amount that was put into it.

So when searching, look for a business, not a job. Avoid companies in which the owner has an essential role in the delivery of the business. It is common for owners to be the company’s primary salesperson, but be wary when the owner is involved in the delivery of every product or service the company provides. If you cannot imagine a smooth transition from the seller to yourself because the seller seems so irreplaceable, you might be looking at a job, not a business. Avoid businesses in which your work would be so irreplaceable that the company would be worth nothing when you decide to leave.

What to Ignore

Our shopping list of the desirable features of a suitable business acquisition excludes some items that you might have expected. We did not suggest, for example, that you restrict your prospects to businesses that you are passionate about. Wooden boats. Old cars. Windmills. Music. Rare books. Fine foods. Wine. The list is long and different for each of us. Some searchers believe that the business they run should have a social purpose, for example, reducing carbon emissions. We appreciate all of these desires to mix a professional career with a larger passion, but passion for a business is an elusive concept at best and, at worst, will cause you to overlook problems with a business and overpay. You should be passionate about making money and building the professional life that you desire. Hobbies and social causes rarely make good businesses. It doesn’t make sense to require that you love the products or services of the company you buy. Remember: Dull is good. We also excluded price from the shopping list. The price of the business you buy isn’t restricted to the amount of cash you have in the bank.

Next Steps

As we will explain later, there are many ways to finance an acquisition, including traditional sources such as borrowing money from a bank and less traditional sources such as funding from outside investors who will share the risks and rewards of the business with you. So, there is no meaningful price limit on the company you buy—though, obviously, the higher the purchase price, the less of the company you will own personally. And while you can buy a company that far exceeds your personal wealth, the company has to be a good value. The next few chapters are devoted to helping you recognize a good value in a potential acquisition.