Almost everything written concerning the business world is about large, publicly-traded companies, multi-million dollar venture-funded start-ups, and billion dollar IPOs. Despite all this digital ink, small and mid-sized businesses still remain the engine of our economy.
Depending on how you define small and mid-sized, these businesses represent one half to two thirds of our economy. Two thirds to three quarters of all working Americans are employed by these businesses.
How to define “small”?
The term “small business” has most people thinking about very small businesses. Sole proprietors and Mom-and-pop businesses. The local dry cleaner, plumber, or consignment shop. But in reality, small businesses cover a large range of sizes. From the self-employed person working from home all the way to multi-million dollar enterprises.
Federal and state governments like to categorize businesses by their number of employees. I prefer using revenue (annual sales). It’s the simplest and most market-oriented way I know to categorize a business as small, medium, or large. More or less, this is how the business transaction community (of investors, intermediaries and advisers) view it:
As you can see, there is a lot of room between $100,000 and $5 million.
How many small businesses are there?
According to the U.S. Census Bureau, there are about 5.8 million U.S. businesses with paid employees. Of these, about 76% have sales under $1 million. They don’t break out $5 million and up, but I suspect 95% of businesses have sales under $5 million. So, as far as I can tell, the number of small businesses outweighs the number of medium businesses by a ratio of about 20 to 1.
As a whole, small businesses make up a large part of our economy and American jobs. So the next time you read about another billion dollar internet company (with no paying customers or profits), just take a moment to remember the contribution of small and mid-sized businesses. They are the ones providing most of the jobs in America, and driving the real economy.
The National Federation of Independent Business (NFIB) has released their latest survey of business owner confidence. It shows a continuing trend of improvement, though it remains stubbornly low.
We suspect that there is correlation between this sentiment and the lack of businesses on the market. Of course, since the supply is low, and demand remains high (especially from private equity investors), owners of solid, growing businesses have some pricing power in an otherwise tepid market.
Companies with $1 million or more in EBITDA (earnings before interest, taxes, depreciation and amortization) are considered middle market businesses (or lower middle market businesses). Middle market business are large enough to attract the interest of institutional investors (as opposed to individual investors). The most common of these are private equity firms. In a nutshell, private equity firms use investor money to buy private businesses, and sell them at a profit in the future…returning the original capital, plus a profit, to their investors. The private equity fund gets a share of the profit as their reward for making a good investment. This profit is called carried interest, and it has received some attention lately for the manner (rate) in which it is taxed. The video below does a good job in explaining carried interest. Enjoy!
According to Axial Market, private equity firms continue to put more of their money to work down south. In 2012, 1,931 deals were originated in the Southern US, versus only 759 in the Northeast, and 843 Midwest.
This mirrors the general economic growth trends across the country. The costs of starting and growing a business are lower in the south and west, versus the northeast and midwest, generally speaking. And taxes are also generally lower, leaving more capital available for owners to plow back into growing their businesses.
Having served clients in 47 states, and from an anecdotal perspective, we have seen similar trends with our clients. There are substantial differences in costs, taxes and regulations among regions, states, and cities, and we expect these differences to widen over the near term.
Private equity activity has slowed substantially in the first half of 2012, according to industry sources. Lots of excuses are used to explain the decline…economic headwinds, the upcoming presidential election, tax and regulatory uncertainty, etc. However, it really all boils down to this: good businesses are getting harder and harder to find.
So what is a “good” business? We’ll discuss that in our next post. Stay tuned…
According to Pitchbook, more than half of the private equity deals in Q1 2012 were add-on acquisitions to existing portfolio companies. This may suggest that the PE companies are relying ever more heavily on acquisitions to grow their platform companies…perhaps finding organic growth more challenging in the current economic environment.
In any event, the trend has been continuing for some time, and seems unlikely to abate anytime soon. It also suggests that timing one’s sale is even more critical than ever, as the opportunity to “bolt-on” to existing private equity platform companies offers the chance for a more lucrative exit.
A professional adviser can help business owners navigate these waters effectively. Knowing how and when to exit is a critical decision process that shouldn’t be taken lightly.
The current low interest rate environment is attracting lots of capital to private equity, with the intent of realizing higher yields. Earlier this month, Bain & Company put out a report detailing the extent of the Private Equity’s biggest problem….too much capital chasing too few deals. While it seems counterintuitive to have too much money at one’s disposal…nearly a trillion dollars industrywide, the fact is that investors in private equity expect that their money will be put to work. Unfortunately for investors in private equity and the private equity firms themselves, much of this “dry powder” has been sitting on the sidelines for a relatively long time, and must be used soon. If this investment capital can’t be put to work, it must be returned to the investor…a result that is anathema to private equity firms.
One person’s problem is another person’s opportunity…and opportunity is knocking for owners of middle market enterprises. Of course, opportunity knocks loudest for those who are the most prepared.
Private equity funds were able to borrow more easily to finance acquisitions in 2011. Across all size categories, debt leverage increased. Total Debt/EBITDA increased from 3.0 in 2010, to 3.3 in 2011. This also marks the second straight year of increases for all transactions under $100 million.
Pension funds are searching for yield in a low-yield environment. It’s a tough task for sure. However, many are turning to private equity. Private equity funds offer the potential for much higher yields…a necessity to close the gap between the yield pension funds are currently getting and the yield they need to meet their goals. While many pension funds already allocate a small percentage to private equity, most of these pension funds have already increased or are considering increasing their private equity allocation.
While this is good news for the private equity industry, it is even better news for business owners looking to sell. Simply put…there is more money chasing fewer businesses. It is basic supply and demand. And the better news is that the current low-yield environment looks like it is here to stay…at least for 2 or 3 more years.
More money to invest, and lower acceptable yields, mean private equity can afford to pay more for privately-held businesses. Business owners would be wise to take advantage of these circumstances while they last.
Over 25 years ago, my father told me “long sickness, sure death.” He was talking about deals…any kind of deal…business or personal. The longer a negotiation drags on, he said, the less likely it is to close.
Regarding the sale of a business, no truer words were spoken. Negotiations that linger on, almost never result in a completed sale. And for those few that do, it is typically because the seller/owner has made substantial concessions to maintain the buyer’s interest. This is no way to sell a business.
The key to getting to the closing table is dealing with “problems” before going to market…and fixing them (or at least mitigating the ones that can’t be fixed). This is where detailed exit planning can be most beneficial to a business owner. Problems are identified and dealt with in a deliberate manner….not in “crisis mode” during the due diligence period.
Unfortunately, too many business owners learn this lesson the hard way. No business sale ever goes completely smoothly, but the best way to make it to the closing table, on your terms, is to plan it that way.