Industry’s Continental Divide: Where Small Business Ends and the Middle Market Begins

It’s arguably the most highly debated line of demarcation in business today, but just what separates a small business from a middle-market one is more a mind-set than a revenue threshold. Or so Brendan Anderson explains. As cofounder and managing partner of Evolution Capital Partners, Anderson spends his days helping small business owners to navigate the territory between start-up and large firm.

MME: What do most small businesses lack when compared to middle-market firms?

Anderson: A business operating system is something that you use to run and grow your business. What you find is that most entrepreneurs feel that if they put in enough hours and hustle, they will be successful. What they don’t fully comprehend is that when you are out hustling, you are not necessarily creating a boatload of value for the company. You may be successful, but you are not teaching your organization how to make decisions and how to grow and how to run the organization using data instead of the gut. We watch how small businesses run, and in the successful ones we find that the single biggest factor is an entrepreneur who is willing to embrace an operating system. These people are highly successful; however, they’re not always being held accountable for things that they’re saying or doing. The downside of an operating system for some entrepreneurs is that you have to be accountable.

MME: What else is often missing in an entrepreneur-led firm?

Anderson: I would say that the number one pillar of business that we almost never find is great financial statements. By this, I’m referring to the quality and timeliness of the financials and daily data that are being generated. If you go back in the history of a small business, you’ll find that the entrepreneur often has the data in his or her head and they can keep people moving, but at some stage in the game and for many entrepreneurs, a breakdown happens at about 25 employees, and here’s where the operating system must be added.

MME: When does Evolution like to sell? Do you require a threshold of, say, $5 million in EBITA?

Anderson: Our goal is to create businesses that will continue to grow long after our ownership, and a lot of times we’d love to own a little piece going forward. We’re in the business of trying to transform the lives of the employees, families, and communities of the businesses in which we invest, and it just so happens that $5 million of free cash flow brings in lots of buyers. If you take a sample of the private equity funds out there that are paying good multiples, you’ll find that $5 million is often the bottom end of their range. Now, having said this, it seems like everyone is now coming down market a little bit, and I think that the world has gotten much more competitive at the $2.5 million to $4 million EBITA range.

MME: How low are buyers willing to go?

Anderson: If you go out and try to sell your business with $600,000 or $800,000 of EBITA, there is a small subset of buyers that may or may not be willing to invest in it. It’s likely that 100 percent of them will want you to stick around for 2 to 5 years anyway. The payday will be in some sort of earn-out. What we’re offering at times is to allow the entrepreneur to take some cash off the table now, reduce their risk, and then get back to growing the business for a number of years so that when we make that transition and the firm has $5 million of EBITA, there will be lots more buyers and the multiples will rise.

MME: What does the role of a finance leader resemble in these organizations?

Anderson: One of our biggest inefficiencies over the past 20-something years has to do with the fact that almost none of the businesses we work with have a top finance leader, and there’s a good reason. Seasoned finance leaders can go just about anywhere that they want to. To work for a business run by an entrepreneur who doesn’t use a process or rely on financial data — well, it becomes almost impossible to attract these people. Even when we come in and put in the process and the financial statements, it’s still very difficult. What we have found is that you almost have to use a temporary, business-savvy CFO who can handle more than one business at a time.