Opinions expressed by Entrepreneur contributors are their own.
By: Davis Smith and Trenton Smith
Most startups fail. According to the Startup Genome’s 2019 report, 92% of startups fail. Surprisingly, only 4% of businesses in the United States ever exceed $1 million in annual revenue, and only 0.6% reach $10 million in revenue, according to the US Census Bureau. It’s no wonder that many would-be entrepreneurs see quitting a stable job to start a business as a significant risk.
The risks that kill
In our experience, there are three deadly risks startups face, and when new businesses fail, it is almost always attributable to at least one of these risks. But we’ve learned there’s a way to dramatically reduce risk in each area.
1. Capitalization
This risk centers on the startup’s funding level (how much capital you have access to) and funding structure (mix of equity, debt, and hybrid capital). When a business starts with inadequate capital, it generally struggles to attract the right team, deliver a quality product and compete productively.
Additionally, debt and alternative financing sources are generally unavailable, leaving equity as the only option. However, equity has the highest cost of capital, and only 0.5% of businesses receive venture capital investment, leaving most startups undercapitalized.
2. Market acceptance
If a startup can survive capitalization risk long enough, it gets the chance to face market acceptance. This risk has a single, all-powerful key performance indicator: revenue. The thing is, getting sales is hard.
Startups must prove that customers should trust an unknown company, often with a novel product. This challenge is frequently amplified by capitalization risk (i.e., underinvestment in customers and marketing). In addition, the market rarely accepts the original form of a business model and product. That means pivoting (often multiple times) is essential to success, but that almost always takes time and money, which are often severe constraints.
Related: Navigate a Growing Company in a Crowded Market With These 5 Tips
3. Cash flow
In cases where startups survive long enough to demonstrate market acceptance, entrepreneurs may feel they’ve made it. Then they run out of cash. They try to raise equity capital under the flag of market acceptance, but that takes time, and they run out of money. They try to borrow capital to provide a bridge to their next equity raise, but lenders want to see a longer track record, so they run out of cash. They try to meet their cash needs organically, but it takes too long, and they run out of cash.
These three killer risks are so deadly because they exacerbate each other. With such seemingly insurmountable risks, it is no wonder startup failure rates are so high. What is an aspiring entrepreneur to do?
Related: Infographic: The 20 Most Common Reasons Startups Fail and How to Avoid Them
There may be an easier path to entrepreneurial success
We love entrepreneurship! Finding new and exciting ways to build things while creatively managing risk is in our blood. Growing up, one of our favorite things to do was play the board game Risk. We even created rules for naval and aerial troops, then used a glass coffee table and homemade map on clear plastic to add those aerial troops. Market acceptance from our cousins was mixed at best, but we loved it!
Davis started his first business out of undergrad, and over the last 19 years, he has built three businesses that have generated over $150 million in revenue. Trenton has spent most of his career underwriting and funding small and midsize companies. After all these years working with startups, we recently recognized a pattern that has changed how we see them.
Last year, rather than starting a business from scratch, Davis acquired a small but thriving business with plans to scale it. He had never done anything like this, and what he discovered shocked him. This form of entrepreneurship was much easier and far less risky. His perspective was particularly insightful because the business he acquired was one he founded in 2004 and then sold in 2010. Looking back at the risk, sacrifice, and pain it took to build that business compared to the relative ease of repurchasing it; he couldn’t help but realize there is a much easier path to entrepreneurship.
Taking a startup from 0 to 1 is high risk and tends to generate the smallest amount of wealth per year of work. Growing a company from 2 to 10 is neither easy nor guaranteed, but it comes with significantly reduced market acceptance and cash flow risk. Plus, it often comes with access to one of wealth creation’s most powerful tools: leverage (i.e., the ability to finance the acquisition or invest in growth through debt).
So what if, instead of spending years finding product-market fit, managing losses and raising capital, you skipped those painful early years and went straight into scaling a business? What if you could use the power of leverage while doing so? If the voice in your head is saying, “that’s nice, but I don’t have the money, network or credit to buy a business,” hear us out. You may have more options than you realize.
It is easier than you think.
You might be surprised at how easy it is to acquire a small, profitable venture. The United States Small Business Association (SBA) works with banks to fund thousands of small businesses annually. These SBA 7(a) loans have reasonable interest rates, low down payment requirements (generally 10%) and can provide up to $5 million in capital.
Over the last decade, SBA 7(a) loan default rate has hovered below 3.5%. Compared to the ~90% failure rate of startups, the chances of success are dramatically higher.
Related: How to Finance an Acquisition Using an SBA Loan
Where do you find that business to buy? In the United States, there are 12 million small businesses owned by baby boomers, and 11,000 retire daily. Over the next decade, they will pass control of an estimated $10 trillion wealth to the next generation. The environment is ripe for aspiring entrepreneurs to find small businesses that would benefit from fresh thinking. To start, check out Microacquire.com and BizBuySell.com or talk to a business broker.
Consider a hypothetical business with $1,000,000 in revenue and $100,000 in annual earnings before interest, taxes, depreciation and amortization (EBITDA) that is for sale for $300,000 (a 3x multiple of EBITDA). You can finance the acquisition with $30,000 (from savings or angel investors) and a $270,000 SBA loan. The business pays for itself with the cash flow from your new service minus the $3,000 monthly debt payment.
What if you grow the business at an annual rate of 15% for 10 years? Your $30,000 investment would net you a fully paid-off company doing $4,000,000 in revenue and $400,000 in EBITDA. Assuming the same 3x multiple on earnings, the business would be worth $1,200,000, a 40x return on your $30,000 investment, while paying you an annual salary. This does not consider that valuation multiples typically increase as growth rates rise and businesses scale.
Related: The True Failure Rate of Small Businesses
Three examples (mid-sized, small and micro)
Traeger. This wood-pellet grill company with a passionate following was started in 1985. In 2014, after nearly 30 years of work, the business was doing about $70 million in revenue. That’s when Jeremy Andrus and a private equity group acquired the firm. Since then, Jeremy and his team have grown the business to approximately $700 million in revenue, adding an average of $70 million per year. A visionary entrepreneur financed an acquisition allowing him to transform a relatively unknown company into a hyper-growth consumer brand.
Risk Report Card compared to a startup:
- Capital structure risk: Lower — existing business makes PE and debt financing viable
- Market acceptance risk: Lower — $70 million in annual revenue, loyal customer base
- Cash flow risk: Lower — proven cash flow to support organic growth and debt service
PoolTables.com. This home recreation business has been profitable since its inception in 2004, but growth stagnated after Davis sold it in 2010. In 2021, it had $12 million trailing twelve months’ revenue and $1.2 million in EBITDA.
Due to a decade of low growth and relatively low earnings, the business traded at a low multiple of EBITDA (~3.5x). Davis came up with 10% of the purchase price and financed the remainder of the acquisition with an SBA loan. After some minor changes, sales have increased by 40%. An EBITDA of $4- $5 million appears achievable in the coming years and is expected to lead to a much more attractive trading multiple of 6-8x EBITDA.
Risk Report Card compared to a startup:
- Capital structure risk: Lower — existing business track record makes acquisition financing viable
- Market acceptance risk: Lower — $12 million in annual revenue, nearly two decades of detailed direct customer demand data
- Cash flow risk: Lower — established cash flow sufficient to cover current expenses, service acquisition debt, and finance growth initiatives
Equipment rental. Several of our friends have recently bought micro businesses as side hustles. One business was a bounce-house rental company with $90,000 in annual revenue and profits of about $40,000. This friend bought the business for $80,000, which the seller financed over six months. He used $20,000 in savings and $60,000 from his home equity line (2.5% interest rate) to pay for the business. In the first year of ownership, he doubled revenues to $190,000 and tripled profits. It took less than a year to pay for the acquisition.
Risk Report Card compared to a startup:
- Capital structure risk: Lower — existing cash flow reduces the risk of using personal debt, helps service seller financing and provides a faster path to more attractive long-term financing options [(i.e., small business loans)
- Market acceptance risk: Lower — existing client base and functional business model as proven by revenue and profitable operations
- Cash flow risk: Lower — positive cash flow services acquisition debt and repays equity investment over a short period
Related: 3 Tips to Turn Your Brand into a Religion (Jeremy Andrus)
Acquiring a business is not without risk
No matter your approach, entrepreneurship is a risky business. While we believe acquiring a small business is a less complicated way to build your own company, it is certainly not risk-free. You must be honest about your and your team’s ability to operate the business and adequately manage the risks. In addition, there are technical risks and limitations. For example, to secure an SBA loan, you must sign a personal guarantee, committing your home or other assets as collateral. Plus, such loans tend to be reserved for profitable businesses and borrowers with good credit.
Related: 7 Low-Risk Businesses You Can Start Tomorrow
Entrepreneurship is about more than a paycheck; it is also about purpose and meaning.
“The desire to create is one of the deepest yearnings of the human soul.” – Dieter Uchtdorf.
There are many paths to creating value through entrepreneurship. More than creating wealth, entrepreneurship is about purpose and meaning. As business leaders, we are responsible for caring for others and our planet and using our resources to lift our communities. Whether building something from scratch or acquiring a small business and making it your own, we wish you success in your endeavor!
This article was co-written by brothers, Trenton and Davis Smith. Davis is the founder and CEO of Cotopaxi, an outdoor brand and B-Corp backed by Bain Capital Double Impact. Davis holds an MBA from the Wharton School, an MA from the University of Pennsylvania, and a BA from Brigham Young University. Trenton is an investor specializing in private and alternative markets. He is the former head of equities and alternative investments for AAA and invested in private equity and real estate for the Dow pension plans. Trenton holds an MBA from the University of Chicago’s Booth School of Business and a BA from Brigham Young University.