I was
recently talking to an entrepreneur that passed on an investment because it
would not need yield the company at least a 10x growth opportunity. I told him those level of returns are
reasonable when investing in small businesses under $5MM, but that he should
consider lowering his ROI threshold when investing in larger companies. My logic was twofold: (1) bigger companies
are harder to grow as quickly as small businesses, so the growth percentages
will be lower; and (2) you can make “oodles” more money in dollars on the
bigger company investment, even if the ROI was only 3x-5x. This post will help you know when to focus on
percentage returns vs. dollar returns when assessing your investment
opportunities.
Path One—Invest in a Small Company for a
10x Growth Opportunity
Let’s say
you are looking to invest in a $2MM revenue business that you can grow to $20MM
in revenues (10x opportunity). That $2MM
business was generating $200K in cash flow and you purchase it at a 3x EBITDA
multiple for $600K. And, when you sell
it, the business is doing $2MM in EBITDA, and you can realistically achieve a
4x EBITDA multiple on the sale as a bigger business. So, you sell it for $8MM, which results in a
pretty 13x return on invested capital. You made $7.4MM in the process, over the
five years you owned the company—that is a whopping 68% average annualized IRR. Nice job!
Path Two—Invest in a Medium Company for a
5x Growth Opportunity
In this
case, you are investing in a $20MM revenue business that you can grow to $100MM
in revenues (5x opportunity). That $20MM
business was generating $2MM in cash flow and you purchase it at a 4x EBITDA
multiple for $8MM. And, when you sell
it, the business is doing $10MM in cash flow, and you can realistically achieve
an 8x EBITDA multiple on the sale as a materially bigger business, as private
equity investors are willing to pay a premium for high cash flowing
companies. So, you sell it for $80MM, which
results in a nice 10x return on invested capital. You made $72MM in the process, over the five
years you owned the company—that is an impressive 58% average annualized
IRR. Amazing!
Comparing Both Paths
If you were
the entrepreneur that I mentioned earlier, you would have only pursued the
first path, as that is the one that enabled the 10x growth opportunity. And, you would have been happy at the end of
the day with your 13x return on invested capital and 58% annual IRR. But, should he have been happy? If he can gone down path two instead, which
was only a 5x growth opportunity, he would have returned $64.6MM more capital,
albeit it a lower 10x return on invested capital and lower 58% annualized
IRR. He was so focused on hitting that
one 10x growth metric, that he lost sight on the big picture of there being a
ton of money left “off the table” by not investing in path two.
Key Things to Understand
One of the
key things to digest in this comparison is what happened to the business
valuation multiples as businesses get larger.
The business in path one started at 3x EBITDA multiple as a $200K EBITDA
business, and expanded to a 4x EBITDA multiple as a $2MM EBITDA business. That means 25% of the return had nothing to
do with the growth of the business, it had everything to do with how investors
value bigger businesses.
And then, if
you continue this exercise for the sale of the bigger business in path two, the
EBITDA multiple grew to 8x as a $10MM EBITDA business, after starting at a 4x
valuation. That means 50% of the return
had nothing to do with the growth of the business, it had everything to do with
how investors value even bigger businesses.
The point here, there are material economies of scale here when valuing
companies, and bigger is typically better for driving a higher sale multiple. Several roll-up stories are modeled on that
exact hypothesis: buy 10 companies at 3x and sell them at 8x without having to
do a single thing operationally. You
simply put the businesses together into one entity to create shareholder value.
Closing Thoughts
So, what
does this all mean for you? Don’t be so
focused on hitting your one single metric (10x growth in this case study), that
you lose sight of the forest of through the trees. Would you rather be bragging about your 10x
growth story that helped create $7.4MM, or your 5x growth story that helped
create $72MM. I don’t know about you,
but the latter certainly sounds a lot more appealing to me. Hopefully, you have a better grasp on when to
focus on multiples or percentages of growth, and when to focus on the dollar
growth instead. Good luck resetting your
growth and return objectives and you will be celebrating all the way to the
bank.
For future posts, please follow me on Twitter at: @georgedeeb.
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