Murky Waters
Questions from a reader inspire a deep dive.
Well it was nice while it lasted. We made it three glorious weeks into the new year without a Sunk Thoughts post. No doubt this newsletter is an auld acquaintance that should be forgot, but alas, 2024 is going to be defined by all unwanted things you hoped would never be brought to mind: presidential candidates, syphilis, further Ghostbuster sequels.
We are so back.
And, in what can only be seen as an ominous sign of things to come, this is the longest Sunk Thoughts on record. For readability’s sake the best thing to do is not even bother reading. Failing that, try reading it in a new browser tab or in the Substack app.
Here’s an outline:
Needless preamble.
Eventual statement of topic. (This is a post about small business acquisition and ownership).
A discussion of that topic that starts with definitions and ends with some evasive reflections vis-à-vis my ambitions.
Links to things you should’ve read instead of this post.
Everyone has their own pet formulation of how the Internet era descended from high aspirations to lowered expectations. “We wanted flying cars, instead we got 140 characters” is a classic of the genre – and very nearly a haiku. Other retellings of the Fall favor the epic form, while still tending to place social media at the center of the story: Mark Zuckerberg as Lucifer in hoodie, choosing to reign in a hell of depressed teens and broken democracies rather than serve in the heaven that existed before.
I’m too young to remember this prelapsarian Eden, where the most highly respected and highly remunerated members of society were print journalists, where nobody ever felt bad comparing their appearances to others’, and where we didn’t spend our days staring at screens, but rather split them evenly between sleep, unionized factory work, and bowling with church friends.
The online world is the only one I’ve ever known, so I’m bound to tell its story using the native vernacular. My version goes something like this: ¯\_(ツ)_/¯
Perhaps there really was a time when the Internet was pure and good, and perhaps we’ve made some mistakes over the intervening years. But if you look at where we started (a network of connected computers created by the DOD to ensure that we could keep launching missiles at each other long after everyone was incinerated) and where we are now (all of human knowledge is instantly accessible but Twitter is less fun than it used to be), it’s reasonable to conclude that things could be worse.
I mean, even the most vile corners of the Internet will occasionally produce something worthwhile. Consider the comments sections of this blog. Start by picturing an individual desperate enough to make it all the way to the bottom of one of these screeds. Now think what might happen if you present him with a magic box into which he can pour all the dark sludge of his troubled mind and see it emerge as a string of symbols visible to the wider world. Before long, the siren song of the “Post Comment'' button will have attracted a horde of conspiracy theorists, crypto scammers, and sexual deviants - in other words, you, my core audience.
But with enough monkeys and enough typewriters …
Recently I posted a special edition of Sunk Thoughts. Recently as in several months ago, and “special” only in the sense that readers were spared the usual annoyance of having it show up in their email inbox. Fearing that the post was outside my audience’s areas of interest (see above), I chose to publish it in the dead of night, with notifications turned off.
Specifically, this post was a recap of a conference I attended in connection to an IRL professional interest: small business acquisition and entreprenuership.
So imagine my surprise when my phone pinged to notify me that not only had someone discovered this semi-hidden post, but responded with a comment that contained no abuse or requests for feet pics.
This is from Robert Long of the excellent Experience Machines Substack:
Obviously I will be ignoring his sensible suggestion to answer those questions in a comment and writing a 5,000 word essay instead.
And while I generally advise against reading Sunk Thoughts posts, a partial exception might be warranted here: if you’re interested in the answers to the questions Robert posed, the original post provides useful context.
What is self-funded search?
A self-funded search is a sort of informal investment vehicle. The goal is for a “searcher” (more on who that individual might be below) to find, acquire, and then operate an existing business (more on what that business might be below as well), producing a return for him and other investors.
The “self-funded” specification distinguishes it from a traditional search fund, where the searcher raises an initial pot of money to pay for his living and deal related expenses during the 3-24 months it might take to find and close on a suitable business.
In colloquial usage, the “self-funded” qualifier is often dropped, and the generic term “search fund” is stretched to cover scenarios where no fund is actually raised to support the search. I’ll do that here, because I’m of the belief that all soft drinks are Coke. (ETA, or “entrepreneurship through acquisition” is a pretty handy initialism that has pretty much the same meaning.)
We’re not talking about huge businesses here. A $5 million purchase price would be relatively large for a self-funded search, whereas the tiniest company in the S&P 600 index of small cap stocks has a market cap of $235 million. Still, $5 million is a lot more than most people have lying around, so even “self-funded” searchers will typically take out loans and raise money from outside equity investors to complete an acquisition.
Who does this sort of thing?
Let’s distinguish again. If we refer to a “searcher,” we’re probably talking about someone a little different from other sorts of business acquirers. Say, from an existing small business owner looking to expand or diversify his operation. Or an “institutional buyer” - a private equity fund, which might be attempting to “roll up” several similar businesses and then sell (or even publicly list) the combined entity a few years later.
No, our searcher is more likely to resemble a criminal suspect you hear described on the six o’clock news: young, male, unemployed, willing to do things for money that others won’t.
That is to say this searcher is probably/stereotypically in his early to mid thirties (the median age is 32 - 34, per two recent surveys), male (87% are, according to the same), and, if not quite unemployed, then maybe going through an employment transition of sorts: he’s very possibly just graduated from an MBA program,1 or decided to leave the white collar world of finance or consulting for something (anything!) different.
That last part is significant. For all of his talents, experiences, and ambitions, a searcher is almost by definition hoping to take over a business he has no background in. The whole endeavor is premised on finding an opportunity that has been in some sense overlooked or undervalued: doing so successfully requires casting a wide net, or, to mix surf and turf metaphors, roaming onto unfamiliar grounds if that’s where the most promising hunting is.
Caveats abound. I’ve met lots of smart and creative people who run a tightly focused search informed by their former careers: a mechanical engineer who acquires a specialty manufacturer, CPAs who take over an accounting practice, even a doctor who went on to run a healthcare software business. It’s also very common for searchers to target a specific industry that they don’t have past experience in, but believe has attractive characteristics.
What sort of attractive characteristics?
Caveats again - it depends on the searcher, his or her investors, the current state of the macroeconomy, etc. 2
That being said, everyone’s sort of looking for the same thing? I’ll subject you to some more of my thoughts on contrarianism vs. conformity as investing and life principles later in this Q&A. For now, here are a few of the most commonly cited characteristics of businesses that searchers might be drawn to.
These are quite different from the attractive characteristics that startup founders and venture capitalists covet, like a large total addressable market, cutting edge technology, or the potential for network effects. A startup that checks these boxes might be able to raise many millions of dollars and be valued in the billions. Or it might fail before getting a single paying customer. A searcher / acquisition entrepreneur trades the possibility of a 100x home run for an improved likelihood of making contact with the ball.
Predictable Cash Flow
This one is important because virtually all searchers plan on using debt to finance their acquisitions, which means they’ll have to make payments to their lenders each month. Faced with the absolute certainty of this cash leaving your business, you want to have as much certainty as you can about the cash that will be coming in.
Revenue from contracted subscriptions is the ideal in this regard.3 Some examples of businesses that commonly feature subscription models include enterprise software, facilities maintenance, and outsourced HR services (e.g. PEOs).
Next best would be offering a product or service for which there’s consistent demand. Seasonal businesses aren’t off limits (air conditioning repair is an extremely popular search vertical) but do entail more complexity compared to those with year-round demand (say, plumbing). Highly cyclical industries (e.g. anything oil and gas related, much of the construction industry) are also tough to operate within, and generally difficult to get financing for in the first place.
In this world, there’s an inverse relationship between how sticky a businesses’ offering is and how exciting it sounds. Here are some examples of businesses I’ve gotten very excited about:
A portable toilet rental company that contracted mostly to army bases.
An elevator inspection and repair company.
A company that makes software public school districts use to complete compliance training required to be eligible for one specific federal funding program.
A chimney sweeping company.
Document storage, as in boxes of paper that for reasons regulatory or otherwise certain organizations will pay to have indefinitely retained in a warehouse.4
Low Customer Concentration
A corollary to the above. It’s always a source of fragility when a large percentage of a company’s revenue comes from a small percentage of customers. For a searcher looking to take over a small business, where customer relationships often overlap with personal ones, there’s an added risk that key accounts could disappear with the previous owner.
Fragmented Industry
The more businesses operating in an industry, the more likely it is to find one that is available for acquisition. This is especially important to searchers planning to pursue multiple acquisitions - the roll up strategy mentioned above.
Fragmentation also means competition, which is a good thing for society but not necessarily for someone looking to earn supernormal profits. The lower the barriers to entry in an industry, the wider the gap between the least and the most efficient firms. Consolidation follows; out of chaos comes opportunity. That is to say, even when the business in question is small, an owner can create meaningful value by improving operations and improving its market power relative to competitors.
Seller’s Circumstance
If the modal searcher is a former investment banker in his mid-30s, then his counterpart in the sale would be a 65 year old who’s owned and operated the business for decades and is now looking to retire.5 The search investment thesis is in part motivated by the “Silver Tsunami,” or aging of the population, which will see 2.3 million Baby Boomer small business owners reach the end of their working years
I’ve written about this before. Demographics may be destiny, but netting out the effects of an aging population will still be tricky.6 Suffice it to say here that while a small business owner may be intrigued by the idea of selling his company to someone from the next generation who’s committed to building it for decades more, he’s under no obligation to do so. The transaction still has to make sense, financially and otherwise. This isn’t like getting a great deal on a vintage credenza at an estate sale.
Nonetheless, an owner’s retirement at least offers a satisfactory answer to the question of “if this business is so great, why are you selling it?” Adverse selection is not the searcher’s friend!
(Relatively) Low Complexity
There’s a lot that can and will go wrong when running a business. That’s doubly true when the business undergoes an ownership change - triply so if the new owner is a first time operator. The fewer potential points of failure, the better. Not only does this increase the probability that the business continues to function, it also allows for an outsider to better understand and value the business before submitting an offer.
Still one man’s complexity is another’s competitive advantage. A lot of the things that can break a business if done poorly are the same things that create strategic moats for others - high volume production, complex inventory management, R&D expenditure, etc. So it’s not exactly right to say that searchers run away from the challenges and opportunities that come with complexity, just that they tend to move toward them incrementally. This leads to a general tilt towards labor and service oriented businesses (e.g. home health care) over capex heavy manufacturing ones (e.g. producing advanced medical equipment), where it’s possible to develop an operating playbook for the unit level, then increase the number of units through follow on acquisitions or geographic expansion.7
A digression about valuation
Let’s say that our searcher finds a business available for sale that meets all his target criteria. What is that worth?
An unhelpful thing that people in finance sometimes say is that any asset is worth the present value of all its future cash flows. They might then elaborate:
“An asset is something that has value. Value is a measure of benefit; cash is the unit of account that allows for comparison. One way to get cash is selling the asset. Another is to use that asset to produce a good or service and sell that instead.8 Since cash is a unit of exchange as well as a unit of account, it can be used to do all sorts of things that other, more particular assets cannot. This means there’s a compounding opportunity cost to owning an asset instead of doing all those other things instead. This is the cost of capital- 5%, 10%, 50%, whatever - that means $X of cash produced by an asset today is worth more to you than $X of cash produced tomorrow, and even more than $X produced the day after that.9 Take all the cash produced by an asset in the future, discount each dollar to account for the cost of capital and timing effects, add it all together, and that’s how much I’m willing to pay for the asset today.”
More likely though, the finance person will just give you a second to nod in acknowledgment of your mutual sophistication before saying a number that’s equal to however much the asset earned this year times like, I don’t know, 20?
Maybe the number is higher if the finance person thinks that the asset will earn a lot more in future years than this past one. Maybe the number is lower if he thinks earnings will grow less than for alternatives, or even if he thinks this asset’s earnings are especially hard to predict.10
This “multiples” based approach has some obvious limitations, but it does lend itself to quick comparisons between the companies. The number “20” mentioned above is arbitrary, but it also happens to be around the current price to earnings ratio for the S&P 500 index of the largest US stocks. Is this a lot? A little? Who knows.11 But what’s more apparent is that 20 is higher than, say 4, which would be a reasonable multiple of earnings a searcher might hope to pay for an acquisition target.12
In a stylized sense this gap is telling us that a dollar of income produced by the small, privately owned business could be purchased for 80% less than a dollar of income produced by a collection of large, publicly traded ones.
Which is all to set up the question, “how could that be?” Plenty of people ask themselves that when they first discover the world of small business acquisition after spending time in parts of the financial universe where loftier valuations prevail (e.g. public equities, large scale private equity, venture capital).
Answers will vary. As a searcher, it’s tempting to believe that there’s a host of investable SMBs that are screamingly cheap because no one but you is clever enough to find them. That’s arguably a lot less crazy than overriding the collective wisdom of millions of market participants representing trillions of dollars of deployable capital by making a buy/sell call on a stock. Nonetheless, there are reasons beyond potential market inefficiency why a company’s earnings might be priced at notably low multiples. The two broad explanations for small businesses are that small businesses are:
Riskier - This is true in an operational and analytical sense. The loss of a single customer, much less a single employee, is probably not going to sink Microsoft.13 For a small business, there’s less margin for error when managing those sorts of routine disruptions. Likewise, large corporations produce standardized, audited financial statements that allow outsiders to form an accurate view of their performance. Small ones generally don’t, making them harder to evaluate.
Less Liquid - That’s to say, there are fewer potential buyers and transactions are relatively costly (in time and money). Lest there be any confusion about how this works, whichever lucky guy it is who ends up being the high bidder for a small business has just bought himself several months of negotiations/due diligence/loan applications that, if he’s lucky, will result in a closed deal/an indefinite obligation to keep the business from running into the ground. Which is a lot harder than logging into Fidelity to check your AAPL shares. While there are institutional investors (i.e. private equity funds, family offices) and corporate acquirers that have the expertise to do all those things, they might find businesses below a certain size don’t move the needle enough to justify the deal costs.
The only justification I can offer for this long digression about valuation is that it’s hard to convey how incredibly dense the aggregation of information we know as price is. It’s like a black hole, and what you see when you stare into the fathomless darkness reveals as much about your belief in whatever’s down there as it does the objective quality of the thing itself.
I’ll follow this line of thinking to its natural conclusion and say that what you see when you look at a price implicitly reveals your beliefs about everything. Because a price is a cost, and cost should account for all the foregone alternative uses of time and money and energy. When you buy or sell; when you do something; when you don’t do something: what’s really happening here is that you’re murdering every version of the future except one, and also all the ones that come after it.
Noted investor Fred Nietzsche discussed this in The Gay Science: Principles and Techniques for Securities Analysis:
What if some day or night a demon were to steal after you into your loneliest loneliness, and say to you, "This life as you now live it and have lived it, you will have to live once more and innumerable times more; and there will be nothing new in it, but every pain and every joy and every thought and sigh and everything unutterably small or great in your life will have to return to you, all in the same succession and sequence" ... Would you not throw yourself down and gnash your teeth and curse the demon who spoke thus? Or have you once experienced a tremendous moment when you would have answered him: "You are a god and never have I heard anything more divine."
Call it eternal recurrence or margin of safety, what Nietzsche’s describing is conviction, something you can’t put a price on, and something that you better have before deciding to pursue a small business acquisition.
Some days I have that conviction, other days I top out at idle curiosity.
“What’s the latest on your work?” / “What are your plans?”
What that means in practice is that I’ve frittered away over a year now theorizing about the conditions that would have to hold for small business acquisition to offer a superior risk adjusted return to other investment strategies and career paths.
This is not optimal. Rumination is worse than alternative activities such as, for example, literally anything else. I see this as clearly as I see the irony that my clarity was only achieved after much ruminating. And at the end of all the rumination – which hasn’t really ended, only taken written form in this post – I’m left feeling like Borges’ Pierre Menard, who believed that if he learned Spanish, converted to Catholicism, and somehow forgot the last three hundred years of history, he would be capable of writing an original version of Don Quixote, perfectly independent of but identical to the one that already existed. Everyone has their own process. Mine is that I spend vast amounts of time doing things other than the things I should be doing, and in doing so, come to viscerally understand the meaning of “opportunity cost.”
Opportunity cost is the fundamental idea in economics, and - returning to the topic that this post has intermittently been about - a decent shorthand for why the entrepreneurship through acquisition path makes sense for some people, maybe even for me.
I’m not trying to be self-deprecating or to insult the eighth most populous country on earth when I compare myself to Bangladesh: we’re relatively young, got lots of potential, but are a little uncertain how to chart a course for ourselves in the global knowledge economy of the 21st century. It’s not that tearing apart ships for scrap metal is all we’re capable of, but for now that’s our comparative advantage. Attempting to acquire and grow a small business is infinitely preferable to ship breaking, but it is in its own way hard work, and the yield is frankly too small for many to bother in the first place. Prohibitively high opportunity cost for some creates opportunities for others.
There’s another way that opportunity cost informs my moderately bullish view of ETA. It relates to the cost of capital concept tediously explained above.14 Capital costs are just a type of opportunity cost - the rate of return investors require to fund one company instead of the best alternative.15 Without getting into details here or conscripting any more developing economies into questionable analogies, I’ll just note that the cost of capital is high for a searcher looking to acquire a small business - minority equity partners might expect something on the order of a 25% IRR,16 while the bank loan used to fund the majority of the deal’s value would carry an interest rate of over 10% in today’s market.
High cost of capital makes life harder, and that makes me sad. But it also clarifies the challenge in a way that I find reassuring. A lot of what you can find online about small business entrepreneurship has the feel of those “One Weird Trick to Cut Belly Fat” ads. My weird trick for cutting through the BS is imagining a scenario where a searcher earned above his cost of capital and asking myself what would have had to go right.
He’d have had to pick a good industry and exert discipline on the acquisition price. He’d have to have avoided or overcome the loss of key personnel and customers in the transition period. He’d have had to manage high levels of leverage, and eventually find one or two growth channels. None of that is unprecedented, nor is any of it easy. On balance I’d say it’s a plausibly difficult undertaking for someone inclined to take it on.
Careful readers will have noticed that at no point in the preceding 600+ word section did I address Robert’s questions about the current status of my work and plans for the future. I fear the absence of an answer above is more eloquent of where things stand at the moment than anything written below, but for the benefit of the more literal minded, here’s an summary.
The “idle” curiosity I mentioned has proven to be persistent. Though this post has laid out something of a conceptual framework for thinking about the potential returns from entrepreneurship through acquisition, I’m aware that it would be insane to make a major life decision because you have some half-baked ideas about CAPM. I do get a kick out of solving puzzles - finding an attractive business, valuing it, negotiating a purchase, and implementing a strategy to help it thrive.17 But I’m under no illusion that small business ownership is an intellectual exercise, and in fact I know I’d find the messy and often quite menial aspects to be gratifying. I’m the sort of person who likes mowing my own yard, and I think this might be a weirdly important predictor of success as a small business owner.
I’m also under no illusion that I’ve done nearly enough to convert curiosity into action. Some of that can be chalked up to prudence. I’ve kept my full time job and plan on keeping it even as I ramp up the search intensity. One motivation is to build savings for the purchase. Another is that I don’t want to feel like I can’t walk away from a deal.18 However, aside from prudence, a lot of the inaction has to be chalked up to passivity - an unwillingness to set clear goals and hold myself accountable for meeting them.
I spend 5-10 hours each week researching industries, reviewing business listings, contacting brokers and business owners. That will have to increase by a factor of at least three (and I’m hopeful that some things at my job are changing so that I can make that happen). I’ve set up a website and use a dedicated email address that helps me appear a little less like just some guy. I have a much better sense now than when I started of what’s required on a daily basis to conduct a successful search (a topic for a future post perhaps).
Returning yet again to the idea of opportunity costs, I know that none of this is without tradeoffs. Inconceivable as it might sound, the quality of this newsletter could fall even further as I prioritize search activities. Churning out convoluted nonsense takes me longer than I care to admit. It would be an elegant solution if Sunk Thoughts proved useful for connecting with like-minded entrepreneurs and potential investors, but that’s not my primary goal here. I value the freedom that comes with writing about anything I want and not having to mean everything I write.
The more notable tradeoff is between pursuing entrepreneurship and looking for other job opportunities that excite me. Partially this is a question of time - there are only so many hours in the day. The real limiting factor, however, is commitment. It’s difficult to appear credible as a potential buyer unless you can say that you are 100% focused on getting the deal done. And it’s difficult to believe that when you say it if you’re busy trying to check whether the grass is greener on the other side of a proverbial career fence.
So after intentionally taking a step away from anything having to do with a business search this past month, I’ve decided to get back at it - smarter and harder than I have done up to this point. The goal would be to close on a purchase within the next twelve months, which is just under the median search duration within the self-funded space. I have some KPIs that should let me know if I’m on track. If I’m not on track at the end of each three month interval, I’ll ask myself if there’s a good reason why not. And if it turns out there’s no good reason, that’ll be a sign that I need to consider closing shop.
What should I have read on this topic instead of this post?
Many people first learn about this world by reading The Harvard Business Review’s Guide to Buying a Small Business or Walker Deibel’s Buy Then Build. Both are practical introductions to the why/what/how of ETA: the HBR guide focuses on traditional search funds, Deibel on less formal, self-funded variants.
The Stanford Graduate School of Business conducts a biannual survey of search funds to collect information on searcher demographics, deal terms, and operating results. (The accompanying primer is useful too.) Last year Search Investment Group produced a similar survey of self-funded searchers, data from which informed this post.
Searchfunder.com is an amazingly active and constructive community of people pursuing entrepreneurship through acquisition. The Big Deal, Small Business Substack is excellent as well. There are numerous podcasts about small business entrepreneurship: Acquiring Minds and Think Like an Owner are two I especially enjoy. I’ve reached out to quite a few entrepreneurs after hearing them be interviewed on these shows. Their thoughtfulness, energy, and willingness to give advice to a stranger like me has been genuinely inspirational.
Finally, since Robert’s questions are what set this post in motion, I’ll link to a relevant essay from another Substack that he’s recommended before on Experience Machines (subscribe!) Sasha Chapin’s concept of the low status moat is integral to my understanding of how it can be rewarding on many levels to work in areas where others don’t want to. All the resources linked above are evidence that small business entrepreneurship has attracted plenty of attention from highly capable people. The low status moat is getting filled in rapidly, so the hipster in me wants to say this opportunity is “over.” But I think it’s worth it to fight that instinct.
The first search funds grew out of elite MBA programs like Harvard and Stanford. Professors, many of whom are investors or corporate managers as well, will back a student with funding, then serve on the acquired company's board.
The local economy too, as many/most businesses at this scale operate in a small geographic area. On the topic of geography, it's worth noting that some people limit their search to a particular city/state/region, while others look nationwide. All things being equal, flexibility is valuable. Businesses in remote areas have fewer potential acquirers, so they often are priced lower relative to their earnings producing potential than businesses in cities. And for some businesses, remote geography acts as a competitive moat: the Harvard Business Review's Guide to Buying a Small Business profiles one search group that acquired an industrial pipe threading company in a rural Nebraska oil patch that could price its services above that of competitors because it offered proximity / lower transportation costs.
Ideal for the business at least. Customers on the other end of the subscription proliferation trend might feel more ambivalent. Cloud enabled SaaS? Sure, yes, makes sense. But BMW charging a monthly fee for heated seats? A topic for a future Sunk Thoughts rant perhaps.
AJ Wassertstein, a Yale professor who is the leading academic studying the world of search funds, was himself the CEO of one such company.
It's only a slight caricature to say the seller is someone who worked tirelessly to put his daughter through law school only to learn that she’s not all that interested in moving home to take over the family septic tank pumping businesses.
From a searcher's perspective, the main positive would include more businesses available for sale. Against this you have to weigh the negatives: a shrinking labor force, lower propensity to consume for older households, maybe even higher interest rates as the largest generation in history moves out of its working/saving years.
Franchising would be the paradigmatic example.
Technically converting your asset - say, raw cotton and looms - into another kind of asset - clothe - and then selling that. This schematic applies even when nothing tangible is being produced. Say, when that cotton loom is pledged as collateral to a bank in exchange for a loan.
This also known as the discount rate, which is sort of like the inverse of an interest rate. You're willing to put dollar in your savings account today at a 5% interest rate because in one year you'll get back $1.05, or, $1 * (1 +.05). The bank is willing to pay $1.05 for the right to use your dollar because it thinks that whatever it uses the dollar for will return some X number of dollars where X / (1 +.05) is greater than 1.
I'm using earnings and cash flow interchangeably here. For stocks the most commonly discussed earnings multiple is price-to-earnings, or P/E. This is market cap (i.e. the company's equity value) divided by net income, or equivalently, share price divided by earnings per share.
But one of Robert's questions was about the definition of EBITDA. This is "Earnings Before Interest, Taxes, Depreciation, and Amortization" and is often used as a proxy for the amount of cash a business is capable of producing from its operations. In other contexts (private equity transactions, or for that matter, small business acquisitions) EBITDA is generally the "earnings" number in the denominator of a multiple. The "price" number in the numerator is Enterprise Value (EV), which is the equity value of a company PLUS the value of its debt (minus cash holdings).
Legendary cable entrepreneur John Malone usually gets credited for popularizing EBITDA as a measure. He argued that net income (the accounting definition which earnings per share is based on) gave a misleading picture of performance, particularly for companies like his that used debt to fund serial acquisitions.
A lot of this has to do with tax treatment of interest and depreciation expenses. The more fundamental insight though is you can sometimes understand the long term value of a business better by looking beyond 1) the stylized conventions of Generally Accepted Accounting Principles (GAAP), and 2) Shorter term decisions related to capital structure (i.e. debt vs. equity mix).
Earnings multiples can be inverted (E/P) to give some sense of the company's earnings yield, analogous to the yield on a bond. So a P/E of 20 gives an earnings yield of 1/20, or 5%. That's not much better than the current yield on an basket of large corporate bonds, which could be a sign stocks are relatively expensive.
Cheating here a little by mixing multiples. See the above footnote re. P/E vs. EV/EBITDA. This post has more on the common definitions of earnings and cash flow seen in small business acquisitions.
Perhaps we could carve out an exception for employees named Satya (and/or Sam, depending on you view Microsoft's relationship to OpenAI).
There are other, other ways. Most literally, the opportunity cost of leaving my current job and career path, while not zero, is pretty far from golden handcuffs, seven figure bonus and expensed dinners at Per Se levels. There's also something to be said about the advantage of aligned incentives and holding periods that make a young and not especially wealthy person uniquely committed to maximizing the long term value of a business as majority shareholder.
The weighted average cost of capital, or WACC, takes into account that a company can have multiple sources of capital, like debt and equity, and that each has its own required rate of return (typically lower for debt than equity). Companies use their WACC when analyzing whether an internal investment offers sufficient return to justify its costs. In this context you'll hear it referred to as the "hurdle rate."
IRR is internal rate of return. It's sort of a measure of annual return, but really it's discount rate that would make the present value of future cash flows from an investment equal to the cost of making that investment today.
The 25% IRR for equity investors mentioned is around the median reported by one survey of self funded search acquisitions. Typically these investors would be given preferred equity, a quasi-debt like instrument that promises to pay a certain rate of return (10-15% annualized would be plausible today) before any proceeds are distributed to common equity shareholders, including the searcher. Preferred shares in these deals can themselves convert to common equity, allowing the outside investors to participate in upside scenarios and receive a form of downside protection. The point here is that the common cost equity cost of capital” is actually higher than 25%. Common equity is riskiest (the last to get paid), preferred equity a little less so.
One of Robert's questions was "how did you get into this?" I read some books on the subject and talked to some people I really respect who did it, but thinking back further, I see I've always been interested in businesses that occupy weird and durable niches. This profile of the guy who runs floppydisk.com is an example of the sort of thing I'd find myself thinking about long after encountering it.
Searchers talk a lot about the full vs. part time decision. I know that going full time significantly increases the probability of acquiring a business (by something on the order of 30% if I had to handicap it). The expected value calculation has to consider foregone wages and the quality of the eventual acquisition, which should be higher in a scenario where you aren't constrained by cash burn.
That weighs heavily on me. The market for small business acquisition targets is a bit like the housing market right now. Interest costs make financing difficult, potential sellers would rather wait than reduce their price expectations, and no one can seem to convince themselves that a recession isn't imminent. It's not that deals can't get done in this environment, or even that my assessment is 100% accurate, but right now I don't have high enough confidence that I would be able to find and close on a good business to burn my job boat.