Prioritize ROI objectives

I was recently talking to an entrepreneur who walked away from an investment because he wouldn’t need to return at least a 10x growth opportunity to the company. I told him that this level of return was reasonable when investing in small companies under $5 million, but that he should consider lowering his ROI threshold when investing in larger companies . My logic was twofold: (1) large companies are harder to grow as quickly as small companies, so growth percentages will be lower; and (2) you can make a lot more money in dollars on a larger company investment, even if the ROI was only 3-5x. This article will help you know when to focus on percentage returns versus dollar returns when evaluating your investment opportunities.

Way One: Invest in a Small Business for a 10x Growth Opportunity

Let’s say you’re looking to invest in a company that generates $2 million in revenue and you can grow to $20 million in revenue (10x opportunity). This $2 million business was generating $200,000 in cash flow and you buy it at a multiple of 3x EBITDA for $600,000. And, when you sell it, the company makes $2 million in EBITDA, and you can realistically achieve a 4x EBITDA multiple when selling as a larger company. So, you sell it for $8 million, which translates to a nice 13x return on invested capital. You made $7.4 million in the five years you owned the company, which represents a whopping average annualized IRR of 68%. Well done!

Way Two: Invest in a Mid-Sized Company for a 5x Growth Opportunity

In this case, you are investing in a $20 million revenue company that you can grow to $100 million in revenue (5x opportunity). This $20 million business was generating $2 million in cash flow and you buy it at a multiple of 4x EBITDA for $8 million. And, when you sell it, the company generates $10 million in cash flow, and you can realistically achieve an 8x EBITDA multiple when selling as a significantly larger company, because the Private equity investors are willing to pay a premium for companies with high cash flow. . So, you sell it for $80 million, which translates to a nice 10x return on invested capital. You made $72 million in the five years you owned the company, which represents an impressive average annualized IRR of 58%. Amazing!

Compare the two paths

If you were the entrepreneur I mentioned earlier, you would have only followed the first path, because it was the one that enabled the 10x growth opportunity. And you would have been happy at the end of the day with your 13x ROI and 58% annual IRR. But should he have been happy? If he could have taken the second path instead, which only represented a 5x growth opportunity, he would have returned $64.6 million in additional capital, even though it was a return on 10x lower invested capital and a 58% lower annualized IRR. He was so focused on hitting that 10x growth metric that he lost sight of the bigger picture, which was that there was a ton of money left “off the table” by not investing in the second way.

Key things to understand

One of the key things to digest in this comparison is what has happened to company valuation multiples as companies have grown. The first track’s business started at a 3x EBITDA multiple as a $200,000 EBITDA business, and expanded to a 4x EBITDA multiple as a $200,000 EBITDA business. EBITDA of $2 million. This means that 25% of the return has nothing to do with company growth, but rather how investors value large companies.

And then if you continue this exercise of selling the largest company in the second path, the EBITDA multiple has increased to 8x for a $10 million EBITDA company, after starting at a 4x valuation. This means that 50% of the return has nothing to do with the growth of the company, but rather how investors value an even larger company. The point here is that there are significant economies of scale when valuing companies, and a higher value is generally better to generate a higher sales multiple. Many roll-up stories are modeled on this exact hypothesis: buy 10 companies at 3x and sell them at 8x without having to do anything operationally. Simply consolidate the companies into one entity to create shareholder value.

Final Thoughts

So what does all this mean for you? Don’t focus so much on your single metric (10x growth in this case study) that you lose sight of the forest or through the trees. Would you rather brag about your 10x growth story that helped create $7.4 million, or your 5x growth story that helped create $72 million. I don’t know about you, but the latter certainly sounds a lot more appealing to me. I hope you know better when to focus on growth multiples or percentages, and when to focus instead on dollar growth. Good luck resetting your growth and return goals and you’ll be partying all the way to the bank.

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George Deeb is a partner at Red Rocket Companies and author of 101 Startup Lessons – Entrepreneur’s Handbook.