There are many terms and adaptations to an acquisition strategy focused on acquiring smaller businesses, e.g. acquisition entrepreneurship, search funds, or micro private equity. At Bifrost Studios, we have been successful with majority investments in companies with enterprise values below $5 million, leveraging our experiences as entrepreneurs to propel the company further. Extending on these successes, we are extremely bullish on a micro-acquisition strategy, in which we buy and build, infusing ways of working and capabilities from the startup studio.
Studio partnering
If you think about entrepreneurship as the process of taking a company from zero to one, the startup studio facilitates that process with a structured and sequential path. The Bifrost Studios micro-acquisition strategy is centered around buying promising businesses and partnering with a vertically focused studio to infuse the structure, capabilities, and resources that take the business from 0.5 to 1. For instance, one of our studios excels at business operations for fashion companies and has proven its ability to quickly turn around an early-stage brand, doubling revenues and reaching profitability after saving the company from bankruptcy. This is just one example of how the private equity playbook can be applied to smaller companies with great success.
Playing where PE can’t
What sets micro-acquisitions apart from conventional private equity is, of course, size, however, that causes a much more important dynamic of buying smaller businesses. The price you pay, measured by the EBITDA multiple or profit multiple in micro acquisitions is significantly lower than what private equity firms pay for a mature business. Where a PE firm will often pay more than 10X EBITDA, micro-acquisitions regularly trade for 2-5X EBITDA.
We argue that a simple supply and demand relationship explains this. Firstly, there are more small businesses than large businesses. Secondly, there are fewer investors willing to invest below $10 million in enterprise value. While the first is intuitive, the second is a product of the private equity business model, in which GPs make a living from management fees and carried interest from LPs, creating a strong incentive for larger funds, and by extension investing in larger companies. It is simply not worth it for PE funds to invest in small companies, but we do not have LPs and do not face this challenge.
Solid fundamentals, solid returns
Let us review the economics of micro-acquisitions. Suppose you can buy a business for $1 million, that does $250 thousand in annual net profit. At a four times profit multiple this is on the higher end of what businesses are selling for, but it should suffice to showcase the point. The return on equity is 25% per annum, far outperforming public indices. Remember, that this is before making any improvements to the business.
Now, let’s decrease our risk by introducing debt to the equation. Wait a minute, do banks actually underwrite loans to buy startups? Well, in this case we are buying a profitable business with a history of resilient revenue, so yes, you can definitely use debt. In the United States, the SBA fosters stellar conditions for micro acquisitions, allowing for leverage up to 90% of the acquisition. In this case, let us assume 40% leverage.
Having secured a loan to acquire the business, you now only need $600 thousand, the annual profit is $218 thousand after subtracting interest expenses at 8% of $400 thousand. Your annual return on equity is now 36%. The investment pays itself back in about 2 years and 10 months, after which you can continue to harvest dividends or buy another business.
To calculate the sensitivity of the investment from taking on debt, the debt service coverage ratio (DSCR) is helpful. The DSCR indicates how many times the operating income covers debt service. In this case, let’s assume that the firm does $300 thousand in EBITDA. With $32 thousand in interest expenses, this is a DSCR of 9.4 times. This implies that EBITDA would have to decrease with 89%, before the company defaults on the business loan.
