Last week on Twitter two of my favorite new follows, Will Schoeberlein and Tim Ludwig, got into a discussion about the due diligence process when you’re buying different types of companies. I got tagged in and promised to follow up with some thoughts here on the blog.
This question basically comes down to what criteria do you use to determine if companies are similar. I actually don’t think you can get good at due diligence if you don’t do it repeatedly by buying similar companies. Looking back this is a big reason we got out of making startup investments. The startups and our control acquisitions are just too different because they have different growth objectives and co-owners with different financial motivations to be able to build a repeatable due diligence process across both categories.
There are other criteria by which we judge our companies to be similar. A mentioned a few in the tweet. There are certainly others.
Number of employees. We buy companies with <50 employees. Daryl and I have spent our careers owning companies in this size range. We’ve gotten comfortable with how this size of business operates. The job functions they combine. The things they outsource. The types of people they don’t tend to employ and the ones they do. The changes you can make in a day, a week, and a year.
% gross margin. We buy companies with a 30% or greater gross margin. They tend to be on the lighter side with tangible assets. These financial metrics are indicators of the resources available in the business. Growth can be funded out of that gross margin. There tend to be at least a few variable costs that can be adjusted towards cashflow, when needed.
In my experience the most overlooked criteria in deal flow creation and eventual due diligence is the age of the seller and the reason for them wanting to sell their business. We focus on buying from baby boomer business owners. Our ideal business seller wants to be paid for the value they created but they also value things besides just a financial payday. They’ve worked long hours for decades and they are finally ready to change their day-to-day lifestyle. They want to take care of their legacy. Employees need to have a viable future with the business. They want their reputation to be maintained or even improved in town. They can even get excited about us building on top of what they’ve built.
This is a big reason we create our own deal flow. Sellers listing with a business broker are generally trying to maximize the check they get often at the expense of other things. Our direct mailers use the language of a seasoned business owner. The conversations we have with accountants, bankers, and lawyers are designed to trigger a connection more to the personality of one of their clients than the check size we’re ready to cut. We’re already several steps into due diligence by the time we get a signed letter of intent because our deal flow funnel has filtered out businesses that don’t align.
We’ve learned this lesson the hard way. Over twelve acquisitions, the one that has gone the worst is when we deviated the farthest from the owner’s motive for selling.