Interested in learning about business buyer types? Download our small business sale guide for a detailed discussion on the topic.
What is ETA?
At 10 syllables the phrase “entrepreneurship through acquisition” is a mouthful. Fortunately, the pronunciation drawback stands in contrast to the benefits offered by this form of entrepreneurship. ETA, for short, entails buying and operating an existing business, typically from an owner who seeks to exit the business but who may continue to serve as an advisor or board member. ETA activity is primarily directed towards small businesses, defined generally as those companies that are valued at $50 million or less, with most transactions taking place below $20 million.
Although entrepreneurship is often associated with starting new businesses, the reality is that there are a variety of paths to owning and operating a business. Depending on the desired level of financial risk, or an individual’s skill set, ETA may be a more suitable path for an entrepreneur than a startup. The difficult reality of starting a business is that the failure rate is high, which limits the accessibility of startups for those who need a stable path, but who desire to pursue entrepreneurship.
Furthermore, as we noted in a prior post, there are hundreds of thousands of businesses that are well beyond the startup phase and that are on the cusp of facing succession challenges. Succession challenges refer to the need for business owners to tap a new generation of operators to step in and run the business so that owners can successfully exit. Businesses that face succession challenges employ millions of people and represent a sizable percentage of the economy.
ETA Creates Value for Buyers and Sellers
ETA creates value for both parties in an acquisition, the buyer of a business and the seller of a business. For buyers who aspire to operate a business but who want to shift the odds of success favorably relative to a startup, acquiring an existing company may be a good fit. And for business owners who seek liquidity and a new generation of leadership, ETA fills an important void by providing qualified buyers.
Two Types of ETA
The two most common forms of ETA are self funded search and funded search. Let’s discuss the differences between these two types of ETA.
Self Funded Search
Self funded search is performed by an individual, or partners, who desire to find and acquire a business and who are comfortable paying their own way during the search phase. Self funded searchers must cover their expenses while looking for a business to acquire. For some, this means searching for businesses while maintaining employment, while for others this may entail setting aside enough savings to cover living expenses for a defined period of search time.
Small Business Administration (SBA) loans have become a common form of financing for self funded search. SBA loans enable business acquisitions with minimal equity down payments. Banks that underwrite SBA loans are guaranteed by the government to recover up to 75% of the loan value. If a $1 million business is purchased with an SBA loan covering 75% of the purchase price, a self funded searcher would need to produce $250,000 of equity to purchase the business, with the SBA loan funding the remaining $750,000.
High net worth individuals, experienced entrepreneurs, or aspiring entrepreneurs are examples of individuals comprising the self funded category of acquirer. Anecdotally, this group is typically seeking acquisition targets under $5 million in enterprise value.
Funded Search
Unlike self funded searchers, funded searchers will raise capital from investors to cover operating costs during a search period. Commonly this search period is 24 months. Funded search has been around for nearly 40 years, and there are established investors that focus exclusively on backing individuals, or partners, who desire to acquire and operate a business.
Once a business is identified, the funded searchers will raise acquisition equity from the investors who funded the 24 month search period. In exchange for backing the search period, investors receive a first look at deals before the searcher can show the deal to non-search-phase investors. Search investors also commonly receive an investment step up, which means that every dollar invested during the search period will go into the acquired company at a value greater than one dollar. This step up is compensation for the risk an investor takes during the search period. According to data from a 2022 study conducted by Stanford, 34% of funded searches do not result in an acquisition.
Funded searchers come from a variety of backgrounds, but usually have operating experience, or have worked in professional services, such as consulting or banking. Target deal size for funded search is generally $5 million to $50 million in enterprise value.
ETA Value Creation is Greatest for Stable Businesses
Regardless of whether a searcher pursues the self funded or funded path, ETA is best suited for businesses that have profitable operations and that have been in operation for three years or more. While three years is not a rule, companies that have operated for a period of at least 3 to 5 years tend to have a higher probability of continuing to operate than businesses that have operated for three years or less. Data show that the odds of business survival increase with the age of the business.
The Bureau of Labor Statistics (BLS) tracks the formation of private businesses in a given year, and continues to track which of those businesses are operating 12 months after formation, then 24 months after formation, and so forth. For instance, in the twelve months ending March 2010 there were 560,391 private establishments formed. Fast forward 12 months to March 2011 and 440,245 of the 560,391 establishments were still operating, implying that 21% of businesses ceased to operate after 12 months. After five years, 49% of the 560,391 firms were no longer operating. And by year ten, nearly 65% of the businesses started in 2010 were no longer operating. Based on this cohort, the ten year survival rate of private establishments in the US is about 35%. This high failure rate highlights why startups are an untenable path for some entrepreneurs.
In addition to business survival rates, the BLS data show an interesting trend in employment, and one that highlights why ETA should continue to be an appealing path for both buyers and sellers. Among the 560,391 businesses established in the 12 months ending March 2010, average employee count per business was 4.5 individuals at founding. By 2020, average employment of the surviving businesses was 11.3 individuals. Although 65% of businesses that started in 2010 were no longer operating by March 2020, the businesses that continued to operate realized average employee count growth of 51% from 4.5 employees per business to 11.3 employees per business. According to BLS data, there is a positive correlation between time and employee count growth.
The key takeaway is that starting and scaling a business is very challenging, but when a company finds the right fit in the market to warrant continued operations for a period of five years or more, that company serves an important role in creating value for an economy, including much needed job opportunities. Thus, as owners of companies with five years or more of operating history contemplate an exit, ETA offers a path for an owner to realize liquidity and to transition a business to an operator who will continue to drive growth. The new operator then contributes positively to the employment trend, while also offering the buyer a path to entrepreneurialism with a significant reduction in risk relative to startups.
ETA Offers Owners A Path to Smooth Employee Transition
There are a myriad of reasons private equity firms, “industry buyers”, and search funds target stable business. The longer a business exists, the less likely it is to fail. The Bureau of Labor Statistics supports this intuition with data. Unsurprisingly, the longer a business survives and thrives, the more people the business employs. Buyers favor businesses that have a track record of success, but some may not value the employee growth.
Good employees are difficult to find. Most owner/founders spend years developing a stable of talent, often from within the company. These employees know the business, know the owner, understand internal operations, and often have been key to the sustained success and survival of the company. As an owner contemplating a sale to an unknown buyer, it’s natural to fear for tenured employees, especially if they won’t receive any cash from the change in control (which is usually the case).
Sadly, acquiring entities may not share this concern. Private equity buyers may aim to extract value from their portfolio companies through cost cutting (and often expect the owner to continue to run the business which is a subject for a separate blog post). Personnel costs are typically the largest expense on the income statement and are the natural place for some institutional investors to start cutting. Industry buyers (also known as “strategic acquirers”) may want the acquired company to alter operations to fit their model, or may want only a piece of the acquired company (intellectual property, customer base, etc.). The resulting company may not resemble the legacy an owner envisions.
ETA Depends on Successful Employee Transitions
Searchers seeking to acquire, operate, and grow one great company, like the searchers at 37th & Moss, want to keep existing teams intact and empower that team to achieve new levels of professional growth. Practitioners of ETA aren’t looking to extract value from a company by cutting costs and eliminating roles. In fact, experienced employees who know and understand the business are much needed in the ETA model. The more experienced the workforce, the more likely entrepreneurship through acquisition will succeed. When owners beat the odds and build a great company with great people, it’s natural that during a transition the owners will seek fluidity of transition for the team. If owners are contemplating a change in control, ETA is a great model for those owners who desire to pass the reins to a like-minded entrepreneur who cares about the people in the business the owner has built.
