When Investing in a Company, Chasing Growth Might Cost You Millions Maximizing ROI is always a nice goal, but it's not the only one you should consider.
By George Deeb
Opinions expressed by Entrepreneur contributors are their own.
I was recently speaking with an entrepreneur who'd passed on an investment because it would not need yield the company at least a 10x growth opportunity. I told him those returns might be reasonable when investing in small businesses (under $5 million) but that he should consider lowering his ROI threshold when investing in larger ones.
My logic was twofold: First, bigger companies are harder to grow as quickly as small ones, so the growth percentages will be lower; and second, there's the potential to make substantially more money on a bigger company investment, even if the ROI was only 3x to 5x.
Here's how to know when it's better to focus on percentage returns vs. dollar returns when assessing your investment opportunities.
Path one: investing in a small company for a 10x growth opportunity
Let's say you are looking to invest in a business that has $2 million in revenue that you can grow to $20 million in revenue (10x opportunity). That $2 million business was generating $200,000 in cash flow, and you purchase it at a 3x EBITDA (earnings before interest, taxes, depreciation and amortization) multiple for $600,000. When you sell it, the business is doing $2 million in EBITDA, and you can realistically achieve a 4x EBITDA multiple on the sale as a bigger business. So, you sell it for $8 million, which results in a very nice 13x return on invested capital. You made $7.4 million in the process (over the five years you owned the company) — a whopping 68% average annualized IRR. Nice job!
Related: 5 Important Factors Novice Entrepreneurs Must Consider Before Buying a Business
Path two: investing in a medium company for a 5x growth opportunity
In this scenario, you are investing in a $20 million revenue business that you can grow to $100 million in revenue (5x opportunity). That $20 million business was generating $2 million in cash flow, and you purchase it at a 4x EBITDA multiple for $8 million. When you sell it, the business is doing $10 million in cash flow, so you can realistically achieve an 8x EBITDA multiple on the sale as a materially bigger business (as private equity investors are willing to pay a premium for high cash-flowing companies). So, you sell it for $80 million, which results in a 10x return on invested capital. You made $72 million in the process (again, over the five years you owned the company) — a 58% average annualized IRR. Amazing!
Comparing both strategies
If you were the entrepreneur I mentioned earlier, you would have only pursued the first path, as that's the one with a 10x growth opportunity. And you would have been happy at the end of the day with your 13x return on invested capital and 58% annual IRR.
But should you have been happy?
If path two had been chosen instead, which was only a 5x growth opportunity, you would have returned $64.6 million more capital, albeit it a lower 10x return on invested capital and a lower 58% annualized IRR. The point is not to be so focused on hitting that 10x growth metric that you lose the big picture and miss out on a ton of money.
Related: Turn Crisis into Profit — Why You Should Invest in Distressed Businesses in this Economy
Other considerations
One pivotal factor to be aware of in this comparison is what happens to valuation multiples as businesses get larger. Path one started at a 3x EBITDA multiple as a $200,000 EBITDA business, then expanded to a 4x EBITDA multiple as a $2 million EBITDA business. That means 25% of the return had nothing to do with growth but everything to do with how investors value bigger enterprises.
Additionally, if you continue this exercise for the sale of the bigger business in path two, the EBITDA multiple grew to 8x as a $10 million EBITDA business after starting at a 4x valuation. That means 50% of the return had nothing to do with the growth of the business but everything to do with how investors value even bigger businesses. The takeaway is that there are material economies of scale when valuing companies, and bigger is typically better for driving a higher sale multiple. Several roll-up stories are modeled on that exact hypothesis: Buy 10 companies at 3x and sell them at 8x without having to do a single thing operationally. You simply put the businesses together into one entity to create shareholder value.
Related: The 4 Biggest Red Flags to Look for When Buying a Business
Closing thoughts
So, what does this all mean for you? Put simply, it's vital to avoid being so fixated on hitting one single metric (10x growth in this case study) that you lose sight of potentially higher returns. Would you rather be bragging about your 10x growth story that helped create $7.4 million or a 5x growth story that helped create $72 million? I don't know about you, but the latter sounds a lot more appealing to me.
