Analysis of a potential business acquisition

Per my previous posts I’ve been looking at acquiring a small business. A combination of factors are at play: wanting to deploy capital productively, my previous private equity experience, and the challenge. All of this is motivating me to do some due diligence on a potential acquisition.

The particular business I’m looking at is in the services sector particularly in fire suppression equipment. These are the guys you call to service your fire extinguishers and to check that everything is in place as per the regulations around buildings and fire protection.

Why do I like this industry?

  • Annuity/sticky income as customers need to do annual and biannual checks on their equipment.
  • Mandated by law.
  • Small expense for a customer relative to maintenance of their property as a whole.
  • Diversified customer base as it applies across any sector that has a building.

What do I like about this particular fire suppression business?

  • Has been around for decades and highly profitable.
  • Long customer list.
  • Low tech and has room to be improved via better technology implementation in quotes, invoicing, CRM and servicing.
  • Management team in place.
  • Owner is retiring hence needs to sell.

What are the risks to the investment?

  • Covid is causing office/government/university workers to work from home. Is this a permanent feature, and how should historical earnings be adjusted to reflect this. However, this isn’t the US where everyone can move online, so I expect a lot of the earnings will come back.
  • Services businesses are more difficult to get debt funding as there are few to no assets to fund – it’s all on forecast earnings. The fire suppression equipment they have will form a fraction of the overall value.
  • Pricing and inflation – the business has been running for decades, the barriers to entry are not massive and the market is commoditized and saturated. Therefore there is little pricing power to increase service prices in the market, no growth and no new technology. Margins could get squeezed.

Let’s have a look at the high level numbers:

  • Sale price: $800k
  • EBITDA: $300k
  • Sale multiple: 2.6x
  • Assets: $200k

If you acquired the business on a combination of debt and equity, say at 50/50. Then the investor’s check would need to be $400k, along with bank debt of $400k. At 10% per annum you’re looking at profit before tax of around $250k/$180k of PAT.

If the acquisition debt is to be repaid over 5 years, then with just inflationary increases your equity value will grow from the $400k investment to around $1m (pre-tax) over 5 years if you use the same exit multiple as entry with an IRR of 40% pre-tax (30% post tax).

The return on equity is similarly impressive at around 30% in the first year, on a levered basis. For a business that has been around for decades, the returns look very attractive.

Closing comment on the price

The sale price is on the high range of affordability, mainly due to my discomfort around the size of the debt. However, once I’ve spoken to a few banker colleagues, perhaps I’ll be able to acquire it without needing too many personal guarantees.

If I can get the majority of the funding against the business (difficult due to low assets), there’s a chance of proceeding on this one and diving into the detail.

Or, I need to get a co-investor to split some risk – depends on the terms and their involvement, but there are some folks that might be interested.

Overall, a sustainable-type business, mandated by law, at a 2.7x multiple, is looking very attractive as a small business acquisition. It definitely warrants additional work to have a look.

4 Replies to “Analysis of a potential business acquisition”

  1. Hey Charlie,

    Loved this post and congratulations on finding something you might be able to get your teeth into.

    My instinct is you’ve found a good market niche. When I moved to SA I was blown away by the lacklustre approach to HSE (although the UK does get called a nanny state). That changed massively in the last few years and I suspect you would see significant growth if you can simplify and optimise the process as you describe. I also think there would be opportunity to diversify into something like PAT testing. Not sure if that’s a “Thing” here in SA but it’s massive in the UK and is equally low tech and if you’re already at the building, would be no more effort.

    One request, I wasn’t able to fully follow how you got to your 30-40% IRR calculation and I suspect most of us readers would struggle (you clearly have the math down from your Private Equity days) so I would love it if you would do a post on how you do a high level financial assessment of a business for us dummies!

    1. Thanks MrH! Fingers crossed!

      PAT testing sounds interesting, I’m not aware of any such service in SA for consumers. It’s obviously big in the industrial space with calibration and machine maintenance etc. but not at the level you’ve described. We do seem to love cutting corners in SA, so I would like to see much more HSE in place. The first place that everyone can start is holding public contractors to account in terms of roads and sidewalks haha. I grumble about it to my wife every time I go for a walk or a drive.

      Thanks for the request, it’s a good idea! I’ll definitely have a look at doing an explanatory post on deriving the IRR and return numbers. It’s quite straightforward and an incredibly important metric. For me it’s one the first point when I evaluate investment options so I can compare returns amongst asset classes. It also lets you see how someone else is thinking about returns, is it all in fantasy land where the exit number is some astronomical value or is the return plausible with cash flow along the way.

  2. Hi,

    It would be interesting to hear how you found the business. Are you working with a broker or do you know the owner who wants to retire?

    I’ve also thought about doing something similar, but can never find a business for sale that I want to own, priced right and is in a niche like this.

    1. This particular one came through a broker. Not one I’ve dealt with before, but well known in the equity industry. The investment is in a similar space to a deal I did before so I do know what the levers are and what things result in a no deal.

      From my private equity days there were loads of ways to get leads, if people knew that you were in the business acquisition game. They mainly want to know that you will execute on a deal if it fits your parameters. So if you’re serious about acquiring a business at some stage, then define the equity cheque size you’d like and speak to the brokers, lawyers, bankers, accountants and direct contacts (founders/management). It’s obviously different in the pe game because you have a fund to deploy, but even for smaller investors there’s a lot of looking and groundwork to be done before you execute. I would say the screen 100 deals to find 10 worth investing and executing finally on 1 is still the right ratio, so it’s about looking and finding. It’s not a problem to keep saying no until you find something interesting. The biggest difference is operational involvement and where I need to find comfort this is something I can actually do.

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