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By: davis smith Y trenton smith
The majority Opening fail. According to Startup Genome’s 2019 report, 92% of startups fail. Shockingly, only 4% of companies in the United States exceed $1 million in annual revenue and only 0.6% reach $10 million in revenue. according to the US Census Bureau. It is not surprising that many aspiring entrepreneurs see leaving a steady job to start a business as a significant risk.
The risks that kill
In our experience, there are three deadly risks that start-ups face, and when they fail, it’s almost always attributable to at least one of these risks. But we have learned that there is a way to drastically reduce risk in each area.
1. Capitalization
This risk focuses on the startup funding level (how much capital you have access to) and financing structure (mix of equity, debt and hybrid capital). When a business starts with inadequate capital, it often has a hard time attracting the right team, delivering a quality product, and competing productively.
Additionally, debt and alternative sources of financing are generally not available, leaving equity as the only option. However, stocks have the highest cost of capital and only 0.5% of companies receive venture capital investmentleaving most startups undercapitalized.
2. Market acceptance
If a startup can survive capitalization risk long enough, it has a chance to face market acceptance. This risk has a single, all-powerful KPI: revenue. The thing is, getting sales is hard.
Startups must demonstrate that customers should trust an unknown company, often with a newest product. This challenge is often amplified by capitalization risk (ie, underinvestment in customers and marketing). Furthermore, the market rarely accepts the original form of a business model and product. That means that pivoting (often multiple times) is essential for success, but that almost always requires time and money, which are often severe constraints.
Related: Navigate a growing company in a saturated market with these 5 tips
3. Cash flow
In cases where startups survive long enough to demonstrate market acceptance, entrepreneurs may feel like they made it. So they run out of cash. They try to raise equity capital under the banner of market acceptance, but that takes time and they run out of money. They try to borrow capital to provide a bridge to their next capital raise, but the lenders want to see a longer track record, so they run out of cash. They try to meet their cash needs organically, but it takes too long and they run out of cash.
These three deadly risks are so deadly because they exacerbate each other. With seemingly insurmountable risks, it’s no wonder that startup failure rates are so high. What should an aspiring entrepreneur do?
Related: Infographic: The 20 Most Common Reasons Startups Fail And How To Avoid Them
There may be an easier path to business success
We love entrepreneurship! Finding new and exciting ways to build things while creatively managing risk is in our blood. Growing up, one of our favorite activities was playing the board game Risk. We even created rules for naval and air troops, then used a glass coffee table and a homemade map in clear plastic to add those air troops. Market acceptance from our cousins was mixed at best, but we loved it!
Davis started his first business right out of college and, over the past 19 years, has built three businesses that have generated more than $150 million in revenue. Trenton has spent most of his career underwriting and financing small and medium-sized businesses. After all these years of working with startups, we recently recognized a pattern that has changed the way we see them.
Last year, instead of starting a business from scratch, Davis acquired a small but thriving business with plans to scale it. He had never done anything like this, and what he discovered surprised him. This form of entrepreneurship was much easier and far less risky. His perspective was particularly insightful because the business he acquired was one he founded in 2004 and then sold in 2010. Looking back at the risk, sacrifice and pain it took to build that business compared to the relative ease of buying it back ; he couldn’t help but realize that there is a much easier path to entrepreneurship.
Taking a startup from 0 to 1 is high risk and tends to generate the least amount of wealth per year of work. Growing a business from 2 to 10 is neither easy nor guaranteed, but it does come with significantly reduced market acceptance and cash flow risk. Plus, it often comes with access to one of the most powerful wealth-building tools: leverage (i.e., the ability to finance the acquisition or invest for growth through debt).
So what if, instead of spending years finding the right product for the market, managing losses, and raising capital, you skip those painful first few years and go straight to scaling a business? What if you could use the power of leverage while doing it? If the voice in your head says, “That’s fine, but I don’t have the money, network, or credit to buy a business,” listen up. You may have more options than you think.
It is easier than you think.
You may be surprised at how easy it is to acquire a small, profitable business. The American Small Business Association (SBA) works with banks to finance thousands of small businesses each year. These SBA 7(a) Loans They have reasonable interest rates, low down payment requirements (generally 10%), and can provide up to $5 million in capital.
Over the past decade, the SBA’s 7(a) loan default rate has remained below 3.5%. Compared to the ~90% failure rate of startups, the chances of success are dramatically higher.
Related: How to finance an acquisition with an SBA loan
Where do you find that business to buy? In the United States, there are 12 million small businesses owned by baby boomers, and 11,000 retire daily. Over the next decade, they will pass control of an estimated $10 trillion of wealth to the next generation. The environment is ripe for aspiring entrepreneurs to find small businesses that would benefit from new ideas. To get started, visit Microacquire.com and BizBuySell.com or talk to a broker.
Consider a hypothetical business with $1,000,000 in revenue and $100,000 in annual earnings before interest, taxes, depreciation, and amortization (EBITDA) that is for sale for $300,000 (a 3x multiple of EBITDA). You can finance the acquisition with $30,000 (from savings or from angel investors) and a $270,000 loan from the SBA. The business pays for itself only with the cash flow from its new service minus the monthly debt payment of $3,000.
What happens if you grow the business at an annual rate of 15% for 10 years? Your $30,000 investment would give you a fully paid-for company with $4,000,000 in revenue and $400,000 in EBITDA. Assuming the same 3x multiple in profit, the business would be worth $1,200,000, a 40x return on your $30,000 investment, while paying you an annual salary. This does not take into account that valuation multiples typically increase as growth rates rise and companies scale.
Related: The True Small Business Failure Rate
Three examples (medium, small and micro)
bring. This wood pellet grill company with a passionate following was started in 1985. In 2014, after nearly 30 years in business, the business was generating around $70 million in revenue. That’s when Jeremy Andrus and a private equity group acquired the company. Since then, Jeremy and his team have grown the business to approximately $700 million in revenue, adding an average of $70 million per year. A visionary entrepreneur funded an acquisition that enabled him to transform a relatively unknown company into a high-growth consumer brand.
Risk report card compared to a startup:
- Capital Structure Risk: Minor – Existing business makes PE and debt financing viable
- Market Acceptance Risk: Minor: $70 million in annual revenue, loyal customer base
- Cash Flow Risk: Minor – Proven cash flow to support organic growth and debt service
Pool tables.com. This home recreation business has been profitable since its inception in 2004, but growth stalled after Davis sold it in 2010. As of 2021, it had $12 million in twelve-month revenue and $1.2 million in EBITDA.
Due to a decade of low growth and relatively low earnings, the business traded at a low multiple of EBITDA (~3.5x). Davis obtained 10% of the purchase price and financed the remainder of the acquisition with an SBA loan. After some minor changes, sales are up 40%. EBITDA of $4-$5 million looks achievable in the next few years and is expected to lead to a much more attractive business multiple of 6-8x EBITDA.
Risk report card compared to a startup:
- Capital Structure Risk: Minor – Existing business track record makes acquisition financing viable
- Market Acceptance Risk: Minor: $12 million in annual revenue, nearly two decades of detailed direct customer demand data
- Cash Flow Risk: Minor: Established cash flow sufficient to cover current expenses, service acquisition debt, and finance growth initiatives
Equipment rental. Several of our friends have recently bought micro-businesses as sideline businesses. One business was a bouncy castle rental company with annual revenue of $90,000 and profit of about $40,000. This friend bought the business for $80,000, which the seller financed over six months. He used $20,000 in savings and $60,000 from his home equity line of credit (2.5% interest rate) to pay for the business. In the first year of ownership, he doubled revenue to $190,000 and tripled profits. It took less than a year to pay off the acquisition.
Risk report card compared to a startup:
- Capital Structure Risk – Lower – Existing cash flow reduces the risk of using personal debt, helps vendor financing, and provides a quicker path to more attractive long-term financing options [(i.e., small business loans)
- Market acceptance risk: Lower — existing client base and functional business model as proven by revenue and profitable operations
- Cash flow risk: Lower — positive cash flow services acquisition debt and repays equity investment over a short period
Related: 3 Tips to Turn Your Brand into a Religion (Jeremy Andrus)
Acquiring a business is not without risk
No matter your approach, entrepreneurship is a risky business. While we believe acquiring a small business is a less complicated way to build your own company, it is certainly not risk-free. You must be honest about your and your team’s ability to operate the business and adequately manage the risks. In addition, there are technical risks and limitations. For example, to secure an SBA loan, you must sign a personal guarantee, committing your home or other assets as collateral. Plus, such loans tend to be reserved for profitable businesses and borrowers with good credit.
Related: 7 Low-Risk Businesses You Can Start Tomorrow
Entrepreneurship is about more than a paycheck; it is also about purpose and meaning.
“The desire to create is one of the deepest yearnings of the human soul.” – Dieter Uchtdorf.
There are many paths to creating value through entrepreneurship. More than creating wealth, entrepreneurship is about purpose and meaning. As business leaders, we are responsible for caring for others and our planet and using our resources to lift our communities. Whether building something from scratch or acquiring a small business and making it your own, we wish you success in your endeavor!
This article was co-written by brothers, Trenton and Davis Smith. Davis is the founder and CEO of Cotopaxi, an outdoor brand and B-Corp backed by Bain Capital Double Impact. Davis holds an MBA from the Wharton School, an MA from the University of Pennsylvania, and a BA from Brigham Young University. Trenton is an investor specializing in private and alternative markets. He is the former head of equities and alternative investments for AAA and invested in private equity and real estate for the Dow pension plans. Trenton holds an MBA from the University of Chicago’s Booth School of Business and a BA from Brigham Young University.
