What Investors Actually Check Before Backing a Small Business Acquisition

This is a guest article written for Baton by Grant Hensel, Managing Partner of Entrepreneurial Capital.

At Entrepreneurial Capital, we see hundreds of small business acquisitions a year, most of them brought to us by self-funded searchers and independent sponsors looking for an equity partner. We run every one through the same 13-point checklist.

The checklist is a starting point. The diligence we do before making a soft commitment on a deal is only the tip of the iceberg, and the heavy lifting comes after. So we want that initial yes to be as straightforward as possible, and the checklist keeps us from falling in love with a great story before we've asked the right questions.

If you're a searcher raising capital, this is representative of what many investors are looking at. If you're an owner thinking about selling, it's what the buyer across the table needs to answer before they can close. Here's the list, grouped by what each question is really asking.

The Business Itself

1. Revenue quality. Recurring revenue (contracts, subscriptions) or re-occurring revenue (customers who come back on their own, like service and maintenance work) is best. Project-based, lumpy revenue is worst, because last year's number tells you very little about next year's.

2. Stroke of pen risk. This could come from customer concentration, channel concentration or other single points of failure. How much of the business can walk out the door with a single signature? Less is better. When concentration is too high, it's very hard to structure around, and for us it's almost always a dealbreaker.

3. EBITDA and margins. Two questions here: What scale is the business operating at? And is it a low-margin, normal-for-the-industry, or high-margin operation? The answer shapes how much room there is for things to go wrong after close.

4. Capital intensity. A business that has to keep sinking money into equipment and inventory, as a percentage of revenue, turns less of its earnings into cash the new owner can actually use. That's a negative.

5. Cash conversion cycle. Related to the above: how long does it take the business to collect cash, and how much inventory does it need to hold, compared with how long it has to pay its own bills? A profitable business can still run short on cash when that gap is wide.

6. Industry and regulatory risk. Businesses that rise and fall with new construction cycles, natural resource prices, or interest rates are less attractive to us. Even a great operator can't manage their way out of a cycle.

The Price and the Structure

7. Entry multiple. We're looking for below 5x. Price is the one thing nobody can fix after close, and a good business bought at too high a multiple leaves very little margin for error. We're comfortable passing on trending businesses that trade at higher multiples and sticking to those at 5x or lower.

8. Deal structure. The more skin in the game the seller keeps – whether through a seller note, earnout, or rolled equity – the better. It keeps the seller invested in a smooth transition and signals that they believe in the numbers they're selling.

9. Investor terms. Are the terms in line with market norms, or maybe even attractive for being slightly above them? Searchers who offer reasonable terms make it easy for good investors to say yes.

The People

10. Transition and key person risk. Small businesses are famously run by a handful of people in the know. Can the searcher fill the gaps if one or more key people leave?

11. Seller motivation. The best answer is “I'm 80 and it's time to retire.” The worst is “I'm 25 and have other projects I want to focus on.” Why a seller is selling tells you a lot about how they'll show up in diligence, how committed they'll be to the transition, and whether the deal closes at all.

The Things That Change the Shape of the Deal

12. Real estate. Not necessarily good or bad, but important to understand if it's present. How expensive is the real estate relative to the operating business? Is there a sale-leaseback? Property can quietly turn a business acquisition into a much bigger, and very different, transaction.

13. Franchise or union. Both change the nature of the business. A franchise brings fees, approvals, and rules you don't control. A union contract shapes labor costs and how much flexibility the new owner has. Neither is a dealbreaker on its own, but both are crucial to note up front.

A Checklist, Not a Verdict

Plenty of good deals miss on a criterion or two. The real question is whether the miss can be priced or structured around. High customer concentration is the rare one that usually can't.

For sellers, the takeaway is simple: the cleaner your answers to these 13 questions, the faster a buyer and their investors can get to yes. For searchers, walk your investors through this list before they ask. It's the fastest way to show them you've done the hard thinking on your deal.

About Entrepreneurial Capital

Entrepreneurial Capital partners with self-funded searchers and independent sponsors through minority equity investments in small business acquisitions. Founded by Grant Hensel, a successful searcher, we are passionate about investing not just in companies, but in their people.

Additionally, we produce a free weekly newsletter for acquisition entrepreneurs and operators: This Week in ETA. If we can support you in your acquisition, please reach out.