Failed businesses always have both myth and logic around the reasons for their failure. This is even more true for a failed business acquisition because there are the elements of the transaction added onto the elements of the business itself. The reality is always complicated, never one thing, and sometimes unavoidable. My friend Ben Kessler put together an analysis of failed business acquisitions purchased by search funds — in an effort to help himself do a better job with his search for a new business acquisition. Ben is an entrepreneur from Janesville, Wisconsin, looking to acquire a privately held enterprise in the Midwest. His website is here. His paper on this topic is located here on the Stanford Graduate School of Business website.
Nine Themes Identified by Ben Kessler in Failed Search Fund Business Acquisitions
Ben worked with a Stanford professor, Jim Ellis, who is a frequent investor in search funds, including some investments in amazingly successful companies. They identified nine common themes in failed search funds and the themes are listed in order of frequency found in unsuccessful searches. In my opinion, the themes resonate to all business acquisitions — beyond just search funds.
- Low or negative industry growth. This was defined as a growth rate of less than 5%. It is hard to earn good returns on an investment when the growth is so low. Growth is best in the middle — not too slow, and not too rocket fast. With low growth, it leaves little margin for error by the management.
- Complex operations. In business, there are no extra style points for degree of difficulty. Simple is better. Ben identified a few examples of what he meant by complex operations. These included: a) the complexity of combining multiple organizations in a roll-up strategy, b) complexity of acquiring and maintaining retail spaces, c) geographic distance between important sites, and d) specific technical expertise required for a manufacturing or business service companies.
- Troubled dynamics between searcher and board of directors. Drama is to be avoided whenever possible. High conflict doesn’t help anyone. Having people around you that you trust and working constantly to strengthen those relationships are both important.
- Low gross margin. This was defined as a gross margin below 20% in any industry, or a gross margin below average for the industry. The corollary of this is true as well: it is so much easier to be successful in a business that has a high gross margin. This is because you can often adjust the other expenses if necessary, and a high gross margin gives you the ability to invest in sales and marketing which can often be a key lever for smaller businesses.
- Execution failure. Ben said this often went hand-in-hand with complex operations. In many cases, the new manager did not master the operations of the business quickly enough.
- Customer concentration. This is defined as one customer being more than 25% of revenue. In my opinion, this is the classic situation to avoid for all investors in private companies. It is simply inevitable that large customers will modify their strategy, and this often happens at the most inopportune time for your business. There is a time to take these risks, but investors need to have their eyes wide open to this and know that they are gambling when they do so.
- Restrictive capital structure. In the research, the companies that had debt at more than 60% of their total capital ran into more problems. Leverage is a great tool to be used sparingly, but it has also been described as “a knife attached to the steering wheel” so that any slight bump in the road can be deadly.
- Conflict with previous owner. With smaller businesses, it is easier to see how previous owners can meddle (even with good intentions) or command influence beyond what is healthy.
- Inability to retain or hire adequate talent. For young search fund buyers, I can see how they may not have the ability and experience to retain middle management or to recruit new talent.
Independent sponsors (acquirers with informal funding commitments) and search funds (please see Axial.net recent post on search funds and my prior post on search funds) are becoming more common in the lower middle market for business acquisitions. This is a good thing. There are many business acquisitions to be done, and many of them will be done by independent sponsors and search funds. For sellers, this trend provides them many more buyer candidates. As Kessler wrote, “The Search Fund concept was first conceived in 1984 when Professor Irving Grousbeck and searcher Jim Southern formed the first Search Fund. This model, in which an entrepreneur raises capital from a group of investor to cover expenses related to searching for a business to acquire, has gained popularity at many top MBA programs since its inception.”
- Accounting and reporting pay off when buying and/or selling
- Investment returns are not greener by changing industries
- Investments need to balance discipline and flexibility