Lesson #357: Prioritizing Investment Return Objectives

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.

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