Author Topic: Investment in Small Business  (Read 639 times)

ted1858

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Investment in Small Business
« on: August 17, 2019, 07:16:08 PM »
Looking for some advice on reasonable return expectations for an equity investment in a small business.

This is an existing business, a franchise in early childhood education (essentially a daycare). The transaction would include the real estate. The facility has been running at full capacity for years, so no real prospects of revenue growth. The seller's desired purchase price is 8.5x EBITDA (SDE). This seems high to me, even though it includes the property. Other info is that the deal will be 85% financed, and the potential buyer is an expert in this field.

In a scenario where revenues and expenses stay flat to historical, some key metrics are:
-Payout is ~5 years (~20% annualized yield)
-Initial monthly EBITDA/Debt Service is 1.3x
-Leverage at end of first year is 7x EBITDA
-IRR = 27% with a long-term hold (exit at 30 years at value equal to purchase price)

To me the problem is that with this much debt, the margins are razor thin (25% profit margin, but only 6% margin after debt service). A small drop in enrollment could lead to negative cash flow. Again, I feel the purchase price is just too high. Reducing the purchase price to achieve a 3 year payout results in 10% profit margins after debt service. Surprisingly this is still a 7.4x SDE purchase price.

Any feedback? What type of SDE multiple & payout period should be targeted?

SeattleCPA

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Re: Investment in Small Business
« Reply #1 on: August 19, 2019, 07:27:58 AM »
These three comments:

1. Yes, that multiple of SDE appears low for any business including a preschool but...
2. You maybe have a blended rate going on. E.g., a "20 SDE multiple ( same thing as a 5% cap rate) on the real estate and then maybe a 2.5 SDE multiple  (same thing as a 40% cash return) on the business.
3. This issue or question or puzzle possibly isn't the sort of thing you want to DIY or "crowdsource" to a forum of mostly anonymous folk. There are professionals who have relevant experience with preschool valuations, acquisitions, etc...

P.S. A blog post with some tips: https://evergreensmallbusiness.com/buying-a-small-business-tips/
« Last Edit: August 19, 2019, 07:29:41 AM by SeattleCPA »

ted1858

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Re: Investment in Small Business
« Reply #2 on: August 19, 2019, 08:12:01 AM »
Thanks for the reply. To clarify - the SDE multiple appears low or high? I'll see how it looks when trying to de-couple the business from the property, thanks.

I was asked for feedback by the potential buyer, it isn't actually me - they will engage local firm to help them with valuation before pulling the trigger, but have not yet because the seller is not budging on price. Just wanted to see what other experiences folks may have.
« Last Edit: August 19, 2019, 08:16:29 AM by ted1858 »

A Fella from Stella

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Re: Investment in Small Business
« Reply #3 on: August 23, 2019, 11:51:45 AM »
This is exciting. Have you always wanted to work in daycare/education?

Can you pay 5x over 10 years?

Am interested to know more.

Grafter

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Re: Investment in Small Business
« Reply #4 on: August 25, 2019, 03:01:23 PM »
Doing a quick look on bizbuysell shows a price to EBITDA of 4.2-10x (depending on state and size), for businesses where the RE is included.  Granted, that is just what they are listed at, not necessarily what they sell for.

I would walk away from this deal, as it doesn't pencil for a lot of the reasons you mention, chiefly that it is too highly leveraged, and that it would pretty much not generate any cash flow (assuming your calculation of 1.3x debt service coverage is correct, it would not leave a lot to pay the operator and cover taxes on the profit and debt service).

As well as something is really off with your calculations between debt service and EBITDA.  As if the seller wants a 8.5x multiple, but you are planning on paying them off over 5 years (assuming the 85% financing is a seller backed note), there is a mismatch.  If the EBITDA is 100k, purchase price is 850k, with debt financing of 722.5k (85% debt).  So the annual service would be at least $144.5, so your coverage ratio would be .69x, which means that the cash flow wouldn't even cover the debt.

The only potential upsides would be if there is some sort of value add play, such as being way before market rates that you could jack up, excess development land you could sell, or something of that nature.   

chasesfish

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Re: Investment in Small Business
« Reply #5 on: August 27, 2019, 05:33:55 AM »
I used to finance daycares.  What is the occupancy running on this location?  How many students are they licensed for and what was their average enrollment?  What happens if enrollment falls to 70%?  Is there ANY additional land in the area that a competing daycare could go up again.

The EBITDA multiple gets messy in a daycare because it includes the real estate.   Paying 8.5x AND borrowing 85% of the purchase price means total debt is 7.2x cash flow.   This leaves almost no margin of error.  If the buyers are asking you for equity, how much are they putting in as the operators?  How many other daycares do they own?

Personally, I would run away at this point in the economic cycle.  Daycares are tough investments, they have to run at near full capacity.   The prices are being held up by 85%+ financing supported by Small Business Administration guaranteed loans, which the SBA could easily tighten once they get a few losses (they did this in 2009-2012).

For reference, the worse daycare deal I ever watched be foreclosed on sold for $2.1mil in 2005 and the property finally sold at foreclosure for $700,000 in 2011.   New competitors opened up on existing land plus the economy got tough and churches locally started opening up their properties and running a "not for profit" daycare that took all the margins out of the business.

This is all before the regulatory/reputation risk in the business.  Let your operator hire a $12/hour employee and not figure out that him/her is nuts and make the news for an employee smacking around a child.

This is like hotel investing, but with a ton more risk.  Hard pass at that multiple, point in the economic cycle, and amount of leverage.