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By: Davis Smith and Trenton Smith
Most startups fail. According to Startup Genome’s 2019 report, 92% of startups fail. Surprisingly, only 4% of businesses in the United States exceed $1 million in annual revenue, and only 0.6% reach $10 million in revenue, according to the US Census Bureau. It’s no wonder that many would-be entrepreneurs view leaving a steady job to start a business as a significant risk.
The risks that kill
In our experience, startups face three deadly risks, and when new ventures fail, it’s almost always attributable to at least one of these risks. But we’ve learned that there is a way to dramatically reduce risk in every area.
This risk centers on the startup’s level of funding (the capital you have access to) and the funding structure (mix of equity, debt and hybrid capital). When a business starts with insufficient capital, it typically struggles to attract the right team, deliver a quality product, and compete productively.
Additionally, debt and alternative funding sources are generally not available, leaving equity as the only option. However, equity has the highest cost of capital and only 0.5% of companies receive venture capital investment, leaving most startups undercapitalized.
2. Market Acceptance
If a startup can survive capitalization risk long enough, it has a chance to face market acceptance. This risk has a single, all-powerful key performance indicator: revenue. The thing is, it’s hard to get sales.
Startups need to prove that customers should trust an unknown company, often with a new product. This challenge is often amplified by capitalization risk (i.e. underinvestment in customers and marketing). Moreover, the market rarely accepts the original form of a business model and product. This means that pivoting (often multiple times) is essential to success, but it almost always takes time and money, which are often severe constraints.
Related: Navigate a Growing Business in a Crowded Market with These 5 Tips
3. Cash flow
In cases where startups survive long enough to demonstrate market acceptance, entrepreneurs may feel they have succeeded. Then they run out of money. They are trying to raise equity under the flag of market acceptance, but it takes time and they are running out of money. They’re trying to borrow capital to provide a gateway to their next capital raise, but the lenders want to see a longer track record, so they’re running out of money. They try to meet their cash flow needs organically, but it takes too long and they run out of cash.
These three deadly risks are so deadly because they compound each other. With such seemingly insurmountable risks, it’s no wonder startup failure rates are so high. What should an aspiring entrepreneur do?
Related: Infographic: The 20 Most Common Reasons Startups Fail and How to Avoid Them
There may be an easier path to entrepreneurial success
We love entrepreneurship! Finding exciting new ways to build things while creatively managing risk is in our blood. Growing up, one of our favorite activities was playing the board game Risk. We even created rules for naval and air troops, then used a glass coffee table and a homemade map on clear plastic to add those air troops. Market acceptance by our cousins was mixed at best, but we loved it!
Davis launched his first company after undergrad, and over the past 19 years has built three companies that have generated over $150 million in revenue. Trenton has spent most of his career underwriting and financing small and medium-sized businesses. After all these years of working with startups, we recently recognized a pattern that changed the way we see them.
Last year, rather than start a business from scratch, Davis acquired a thriving small business with plans to scale it. He had never done anything like this, and what he discovered shocked him. This form of entrepreneurship was a lot easier and far less risky. His perspective was particularly insightful because the business he acquired was the one he founded in 2004 and then sold in 2010. Looking back at the risk, sacrifice and pain it took to build this company versus the relative ease of buying it; he couldn’t help but realize that there is a much easier path to entrepreneurship.
Taking a startup from 0 to 1 is high risk and tends to generate the smallest amount of wealth per year of work. Getting a business from 2 to 10 isn’t easy or guaranteed, but it does come with significantly reduced market acceptance and cash flow risk. Moreover, it often comes with access to one of the most powerful tools for creating wealth: leverage (i.e. the ability to finance the acquisition or invest in leveraged growth).
What if, instead of spending years finding market-ready products, managing losses, and raising capital, you skipped those painful early years and jumped right into building a business? What if you could use the power of leverage while doing it? If the voice in your head is saying “that’s good, but I don’t have the money, the network or the credit to buy a business”, listen to us. You may have more options than you think.
It’s easier than you think.
You might be surprised how easy it is to acquire a profitable small business. The United States Small Business Association (SBA) works with banks to fund thousands of small businesses each year. These SBA 7(a) loans have reasonable interest rates, low down payment requirements (typically 10%) and can provide up to $5 million in principal.
Over the past decade, the default rate on SBA 7(a) loans has hovered below 3.5%. Compared to the failure rate of about 90% of startups, the chances of success are considerably higher.
Related: How to Finance an Acquisition Using an SBA Loan
Where do you find this business to buy? In the United States, there are 12 million small businesses owned by baby boomers and 11,000 are retiring every day. Over the next decade, they will pass control of an estimated $10 trillion wealth to the next generation. The environment is ripe for aspiring entrepreneurs to find small businesses that would benefit from fresh thinking. To get started, check out Microacquire.com and BizBuySell.com or talk to a business broker.
Consider a hypothetical business with $1,000,000 in revenue and $100,000 in annual earnings before interest, taxes, depreciation, and amortization (EBITDA) that is for sale for $300,000 (a 3x multiple of EBITDA). You can fund the acquisition with $30,000 (from savings or angel investors) and a $270,000 SBA loan. The business pays for itself with the cash flow from your new service minus the monthly debt payment of $3,000.
What if you grew the business at an annual rate of 15% for 10 years? Your $30,000 investment would net you a fully profitable business with $4,000,000 in revenue and $400,000 in EBITDA. Assuming the same 3x multiple on revenue, the business would be worth $1,200,000, a 40x return on your $30,000 investment, while paying you an annual salary. This ignores the fact that valuation multiples generally increase as growth rates increase and companies evolve.
Related: The true failure rate of small businesses
Three examples (medium, small and micro)
Trager. This wood pellet grill company with a passionate customer base was started in 1985. In 2014, after nearly 30 years of work, the company was making approximately $70 million in revenue. That’s when Jeremy Andrus and a private equity group acquired the company. Since then, Jeremy and his team have grown the business to around $700 million in revenue, adding an average of $70 million per year. A visionary entrepreneur has funded an acquisition to transform a relatively unknown company into a hyper-growth consumer brand.
Risk Report Card compared to a startup:
- Capital structure risk: lower—existing business makes private equity and debt financing viable
- Market acceptance risk: lower: $70 million annual revenue, loyal customer base
- Cash flow risk: lower — proven cash flow to support organic growth and debt service
PoolTables.com. This home entertainment business has been profitable since its inception in 2004, but its growth stalled after Davis sold it in 2010. In 2021, it had $12 million in year-over-year revenue and $1.2 million of EBITDA.
Due to a decade of low growth and relatively low revenues, the company traded at a low EBITDA multiple (~3.5x). Davis offered 10% of the purchase price and financed the rest of the acquisition with an SBA loan. After a few minor changes, sales increased by 40%. An EBITDA of $4-5 million seems achievable in the coming years and should lead to a much more attractive trading multiple of 6-8x EBITDA.
Risk Report Card compared to a startup:
- Capital structure risk: lower—existing business history makes acquisition financing viable
- Market Acceptance Risk: Lower: $12 million in annual revenue, nearly two decades of detailed direct customer demand data
- Cash flow risk: lower — established cash flow sufficient to cover ongoing expenses, service acquisition debt and funding growth initiatives
Equipment rental. Several of our friends have recently purchased micro-enterprises as side businesses. One was a bouncy house rental company with annual sales of $90,000 and profits of around $40,000. This friend bought the business for $80,000, which the seller financed over six months. He used $20,000 in savings and $60,000 from his home equity line of credit (2.5% interest rate) to pay for the business. In the first year of ownership, he doubled his revenue to $190,000 and tripled his profit. It took less than a year to pay for the acquisition.
Risk Report Card compared to a startup:
- Capital structure risk: Lower — existing cash flows reduce the risk of using personal debt, make it easier to fund service vendors, and provide a faster path to more long-term financing options interesting [(i.e., small business loans)
- Market acceptance risk: Lower — existing client base and functional business model as proven by revenue and profitable operations
- Cash flow risk: Lower — positive cash flow services acquisition debt and repays equity investment over a short period
Related: 3 Tips to Turn Your Brand into a Religion (Jeremy Andrus)
Acquiring a business is not without risk
No matter your approach, entrepreneurship is a risky business. While we believe acquiring a small business is a less complicated way to build your own company, it is certainly not risk-free. You must be honest about your and your team’s ability to operate the business and adequately manage the risks. In addition, there are technical risks and limitations. For example, to secure an SBA loan, you must sign a personal guarantee, committing your home or other assets as collateral. Plus, such loans tend to be reserved for profitable businesses and borrowers with good credit.
Related: 7 Low-Risk Businesses You Can Start Tomorrow
Entrepreneurship is about more than a paycheck; it is also about purpose and meaning.
“The desire to create is one of the deepest yearnings of the human soul.” – Dieter Uchtdorf.
There are many paths to creating value through entrepreneurship. More than creating wealth, entrepreneurship is about purpose and meaning. As business leaders, we are responsible for caring for others and our planet and using our resources to lift our communities. Whether building something from scratch or acquiring a small business and making it your own, we wish you success in your endeavor!
This article was co-written by brothers, Trenton and Davis Smith. Davis is the founder and CEO of Cotopaxi, an outdoor brand and B-Corp backed by Bain Capital Double Impact. Davis holds an MBA from the Wharton School, an MA from the University of Pennsylvania, and a BA from Brigham Young University. Trenton is an investor specializing in private and alternative markets. He is the former head of equities and alternative investments for AAA and invested in private equity and real estate for the Dow pension plans. Trenton holds an MBA from the University of Chicago’s Booth School of Business and a BA from Brigham Young University.
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