Ways to Participate in ETA: Self Funded Search

This is newsletter is the third in a multi-part “ETA Fundamentals” series that covers the following questions:

1. What is Entrepreneurship Through Acquisition?

2. What are the key activities in ETA?

3. What are the the different ways to participate in ETA?

Ways to Participate in ETA

Let’s say you’re sold on the idea of buying a company rather than building one from scratch. I was leaning this way in late 2022, but I realized I had deeper choices to make around how I buy a company. There were different “models” or methods, for buying a company, and I considered the following:

1. Self funded search

2. Search fund

3. Independent Sponsor

This newsletter double-clicks into self funded search.

SELF FUNDED SEARCH

If you hear someone talking about ETA, search, or buying a company, it’s most likely they’re talking about self funded search. It’s also likely they’re expecting to use a SBA 7(a) loan to fund the acquisition.

Activities - what you’ll do if you choose self-funded search

Search: this is where the “self-funded” comes in: searchers are paying for the search costs out of pocket. Because of this, some people choose to do self-funded search while working at a full-time job. If you’re searching full time, you don’t just incur the opportunity costs of not drawing an income, you’re also paying for diligence costs out of pocket. These include travel, legal, and accounting due diligence costs. Because of the high degree of cash burn, many self funded searchers work exclusively with business brokers and don’t conduct proprietary outreach. This approach ensures they are only evaluating businesses that are truly for sale. Businesses in self funded search tend to be more “old school,” lower growth and highly stable. Think: nursing homes, landscaping services, etc. Asset-lite businesses like software companies have a harder time securing SBA 7(a) loans.

Acquire: The SBA 7(a) loan defines much of what’s possible and standard in the Acquire phase. The SBA loan is government-backed and allows up to 90% leverage. However, with 2023 interest rates it’s more common to see 70-80% leverage and a seller note. Because the SBA 7(a) loan is capped at $5mm, self funded searchers are generally looking for a TEV (Total Enterprise Value) of $7mm and below. A key feature of the SBA 7(a) loan is that owners with >20% of equity need to provide a personal guarantee on the loan. Meaning, if the business fails, the owner’s personal assets (house, etc.) can be seized to make interest payments.

Equity for the deal can be raised from outside investors and does not have to come from the searcher’s pocket. For example, if a business is purchased for $5mm and 90% SBA debt is used, the $500k in equity can come entirely from outside investors rather than the self funded searcher.

Operate: The acquirer typically operate the company. However, the acquirer also has the option of hiring a CEO / GM for the business, assuming the business can afford the CEO / GM salary after meeting debt obligations.

Resources: what you’ll need to participate

You’ll need to have the financial resources to fund the search. Again, this is not just the lost salary costs. Need to hop on a plane to meet a business owner? That’s on you. Many of the deal-related costs like legal and accounting can be rolled into the transaction, but only if the deal closes. Imagine you spend $20,000 on a Quality of Earnings (QoE) report to verify the accuracy of financial statements. If the QoE report report shows the numbers were inaccurate, you might choose to pull out of the deal. However, you still have a $20,000 QoE invoice to pay. If you end up buying the company, that $20,000 (and other expenses) are rolled into the transaction and not paid out of your pocket. If you’re doing self-funded search, ensure you can absorb broken deal costs and loss of salary.

Other “soft” resources required: grit and determination. There’s a lot of competition for $500k - $2mm EBITDA businesses that can be purchased with an SBA loan. Ability to focus and differentiate from other buyers is also key.

Upside: what you can potentially earn

The upside is more limited - but still very attractive - with self-funded search. You’ll own a large percentage of the company (between 70-100%, depending on whether you raise outside capital for the equity), and it’s up to you whether to reinvest cash flow or put it into your pocket. Using a high percent of leverage creates strong returns on the equity invested.

However, the size of the business you can buy is limited by the SBA 7(a) loan maximum, and the business you’re buying probably won’t have the growth potential of some businesses that could be purchased without an SBA 7(a) loan.

Hot takes (aka, inflammatory things you might hear people on Twitter saying about doing self funded search)

• Positive: I’m a true owner - no one can tell me what to do! The cashflow from the business is mine, and I’ll never get fired.

• Negative: By buying such a small business, you bought yourself a job, not a company. Have fun running a septic tank cleaning business.

Please let me know if there are aspects of self-funded search you’d like me to double-click into in future newsletters.

ETA Course

If you’re interested in going deeper on Entrepreneurship Through Acquisition, I’ll be teaching a course in November. The goal of the course is to deeply understand the different methods of participating in ETA and choose the one that’s best for you. It’s a live, cohort-based class where you’ll have a peer group to learn with and learn from.

You can learn more about the course and sign up for updates here.

If you have questions about the course, you can set up time to discuss with me here.