Badly want to get in the game, would you do this deal at 61% ownership?

June 04, 2024

by a searcher from University of Southern California in San Francisco, CA, USA

I've been working on a deal that's a health/wellness spa franchise in the Bay Area - it’s unique in that the owner has been trying to work with me to do the deal, but she’s not flexible on the purchase price.

It does $500k EBITDA, she opened it in Sept ‘22, and after speaking with a bunch of franchisees, it seems like she’s selling because it takes up more of her time to run than she initially anticipated (she owns a bunch of other franchises and is on the older side).

She initially wanted 5x, non negotiable. She was ok with a $500k seller note, but just this week she came back and said she wants $2.3M cash at close, no seller note. After SBA appraisal (which would likely come in below that) I’d probably need to raise additional equity on top of the SBA loan and I’d end up with 61% ownership.

If you were 25 and badly wanted to get in the game, would you be ok with that ownership given the PG risk?

Reply by an investor
from Massachusetts Institute of Technology in Boston, MA, USA

Few things here: 1. $500K EBITDA on a business started 2022 is impressive for that business model. This suggests quick ramp-up and potentially a really strong location/operating model. 2. You've done the right thing and your due diligence talking to the franchisees. If you purchase this and your goal is to grow the brand and their experience is positive it does help de-risk the operations and standardizes support. Have to take this into consideration too. 3. She seems motivated, but changing deal structure at the last minute has it's own underlying red flags, it may be her age, may be she's too busy, but it could also be a cash flow issue on her end too. There's often valid reasons for asking for the cash, then there's reasons for it relating to distress. 4. Getting your foot in the ETA door at 25 is a positive thing to do to learn and motivate you to keep going. With a real business under management is extremely valuable for long-term trajectory and credibility. If you can keep growing it you'll be golden and the 5x won't be as painful in the long-run as you potentially could exit it for the same later down the line for a lot more but more on this 5x below. 5. 5x for a single location health/wellness spa is aggressive. It's a service business and can be construed as a "fad" right now. Being a service business this should be more within line of probably 2-3x, maybe 4x EBITDA. Unless there's a strong brand equity or significant growth upside potential. 6. Thought it's got a good EBTIDA growth, is it repeatable, recurring, or one time fees. It's a young business with limited operating history. That's a major risk in underwriting as well as within any venture raise. One good year doesn't guarantee sustainability. 7. With her removing the seller note again at the last minute would be a red flag for me. It reduces alignment on the deal and shifts all the risk onto you. If she at the last minute removes the seller note, there could be some underlying reason as to why she doesn't believe or want to support the business any longer, and my gut would tell me it's not cause she's too busy. She would be a silent and/or passive investor at that point really, being busy has nothing to do with that. 8. For the cash issue, you'll most likely need a $1.6-$2M SBA loan (depending on appraisal), then $300K - $700K in equity. If you only reatin 61% you're doing all the personal guarantee risk and operating risk, but giving up 39% of upside to passive investors is a heavy dilution considering you're also the operator. 9. At 25, signing a personal guarantee on a $1.5M+ SBA loan while only owning 61% is something to seriously think about. You'll bear 100% of the downside risk (default, bankruptcy, lawsuits, etc.) but only 61% of the equity upside. Yes, overpaying a little bit on your first one to get into the game can be fine, but not without terms that protect you. With no seller note and high price, you're taking on a lot of front-loaded risk. 61% ownership isn't necessarily bad, but the math needs to work. If you can increase EBITDA to $750K - $1M in###-###-#### months which is hopefully doable, the dilution might be worth it. But if the business stalls, and you start churning customers, you're under water quick with investors looking for returns and a personal guarantee hanging over your head. I may be too conservative here, and others may disagree with me, but everyone in this game has different aspects they focus on. For me, at your age just getting into this, you're close to a deal, but this needs rebalancing. Push back on price, or demand a seller note or earnout. If she refuses you can walk. Your first deal shouldn't saddle you with outsized risk and minimal flexibility to where it could hinder your future searches. Again, this is just my perspective, everyone may have other opinions. Happy to discuss more if you'd like.

Reply by a searcher
from University of Oregon in Portland, OR, USA

I think Greg’s thoughts are spot-on. She can have price or structure, but not both. You can get to the same place at full price with the right structure. I’d model a home run scenario and then consider what I would pay if that came to pass. Then I’d offer something like the home run price contingent on your success, and write those terms into the note. Home run=1.x what she’s asking and she shares the upside. A single? Maybe only her asking price with repayment terms that let me make that adjustment later after you’ve had some time to prove the model. One other thought: if she knew of an adverse event on the horizon, what might it be? If it’s a highly localized business, or if the customers are concentrated amongst a couple of employers, I’d look into the health of those employers. This includes-sad to say – political risk, which used to not be a thing in the United States, but which very much is right now. By way of example, if I had a service business in Beaverton, Oregon, I would be very tuned to what was going on at Intel and Nike. If either of those companies hiccups it would be challenging. If they both caught a cold together, it could do serious damage to the geographic area because together they employ a lot of people in the region. Perhaps most of her customers are Apple employees and she is concerned about our president‘s latest threat to hit Apple with a 25% tariff on every iPhone not manufactured in the US. Hopefully this is just an academic thought exercise, but it is healthy to think about the downside risk before you write the check.

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