Take Five #175: "Avoiding the 4 Fatal Flaws We've Seen Across Hundreds of ETA Deals," and more
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Take Five #175: “Avoiding the 4 Fatal Flaws We've Seen Across Hundreds of ETA Deals,” and more
👉 Upcoming Event: Buy Then Build Summit | Sept 24-26
Searchers today face new challenges: high valuations, limited deal flow, and new sources of capital.
That’s what Search 2.0 is all about — evolving beyond the old playbook.
This month, Kumo CEO Jason Pratts will be speaking at the Buy Then Build Summit to share how we navigate this next chapter together.
Want in? Use discount code KUMO to get $650 off your ticket!
1. Treat early LOIs like practice runs; experience now makes the real deal smoother later
2. “Avoiding the 4 Fatal Flaws We've Seen Across Hundreds of ETA Deals”
“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” – Warren Buffett
The most prolific investor of our time, Warren Buffett, famously said this in his 1989 letter to shareholders. He’s referring to the inability of even the most extraordinary management teams to “fix” a bad business. Frankly, this is reality for some acquisition entrepreneurs—even the brightest and most enthusiastic can falter when they purchase a “bad” or “tough” business. This is especially true at the leverage levels that we use for acquisitions.To avoid this outcome, it is crucial to evaluate four key criteria when evaluating opportunities. In an ideal world, each business will have all four traits—it’s a great indicator of success. The fewer of these traits you have, the more likely it is that the acquisition will be in that first peak (or worse).
#1: Low Customer Concentration
In Grant’s case, he has personally experienced the pain of losing major customers representing 20%+ of revenue, leading to extremely painful revenue and profitability losses. Losing major customer isn’t just missing invoices and a weaker QuickBooks output—it’s a blow to your team. Major customer losses result in major cost-cutting measures, including extremely draining and difficult layoffs. Certainly not a place you want to be.
The loss of major customers is a stressor that business owners especially do not want to encounter while under a serious obligation to the SBA lender. The gold-standard lending ratio for SBA lenders is debt service coverage ratio—the ratio of cash flow to debt obligations. Losing a major customer severely limits your ability to meet that obligation. When you only have a few thousand dollars in the bank account and payment to the bank due on the first of the month, you probably won’t be sleeping at night. In the worst-case scenario, a default can lead to personal bankruptcy.
Read the rest of SMBootcamp’s post here.
3. How earnouts can help buyers and sellers meet in the middle without torching the deal
Earnout agreements require a solid financial framework that ties together payment terms, performance goals, and tax considerations. When structured effectively, they can align the financial interests of buyers and sellers while adhering to U.S. tax regulations.
Common Earnout Structures
In mid-market deals ranging from $5 million to $50 million, earnouts often account for 10% to 25% of the total purchase price. However, this percentage can vary significantly by industry. For instance, life sciences transactions frequently allocate around 61% of the total deal value to earnouts.
Earnouts can take several forms:
Fixed percentage models: Payments are tied to a set percentage of performance outcomes.
Tiered models: Payments increase as higher performance milestones are achieved.
Milestone-based models: Payments are triggered by specific events, such as gaining regulatory approval, securing a major client, or launching a new product.
Most earnout periods last about 24 months, but in industries like life sciences, they often extend to three to five years to align with longer development cycles. Payments can be made periodically or as a lump sum at the end of the earnout period. These structures provide the foundation for defining performance metrics.
Defining Performance Metrics
The success of an earnout often hinges on clear performance metrics. Common targets include revenue, earnings, or EBITDA.
Revenue-based earnouts: These are popular with sellers because they avoid adjustments tied to costs or accounting practices. For instance, an agreement might specify that the seller earns additional payments for every dollar of revenue exceeding a set threshold. It’s also common to outline how different revenue streams, like subscriptions versus one-time fees, are treated.
EBITDA-based earnouts: Buyers often prefer these metrics because they reflect operational efficiency and profitability. However, the agreement must clearly define what expenses are excluded and how one-off costs are handled.
4. Is ETA part of the new American Dream? The numbers backing it up are hard to ignore…
Investors are taking notice too. Amid downturns in the venture capital and private equity markets, search funds have emerged as an alternative asset class.
“Venture [capital] is so crowded now. Search funds still remain small, while the opportunity set is so big — it’s the only thing I want to do for the rest of my career. You look at the returns, they’ve been phenomenal. They’ve been outsized,” said Staenberg.
Stanford’s 2024 study of 681 search funds formed in the U.S. and Canada since 1984 found that their internal rate of return was 35.1%, with a 4.5 times return on investment.
“Over the last 40 years, the stock market has been somewhere [around] 8.5% annual returns ... Then you go to private equity or venture over that same 40-year period ... and the returns are somewhere around 13% to 14%. So [when] you start looking at the outsized returns of 35% for search, it’s a bit of a head scratcher,” said Staenberg.
“We live in such a tumultuous time with change happening so fast, this feels like a very safe port in a storm.”
Read CNBC’s article here.
5. Interview: Seven operators, seven local businesses, and a $34M fund built around people first
Doug Lepisto from Sleeping Giant Capital joins host @PrivateEquityGuy Mikk Markus to talk about how his team raised a $34M fund, backed seven searchers, and helped them buy seven local companies, all in their own backyard. He walks through why they always bet on operators first (not just deals), how they think about downside protection, and what makes a good long-term board. They also get into the team’s “hold forever” philosophy, the role universities play in their talent pipeline, and how they’re shaping a repeatable, place-based model for private equity.
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