How to earn passive income from SMB ownership

As entrepreneurship through acquisition has become more popular over the years, many have started to look towards buying an SMB as a means of generate passive cash flow. While some are looking to own and operate, others are looking for a way to earn cash flow while remaining passive. 

The SMB M&A space has attracted passive investors ranging from family offices and HNW individuals to hobbyist RE investors looking for better returns than their market can offer today.

This article breaks down the common methods to passively own an SMB and includes the pros and cons of each path.

Buying an Absentee Business

An absentee business is a business where the day-to-day operations are not run by the owner of the business. The owner has typically delegated himself out of a job, by putting in place a general manager or president to run day-to-day operations. This allows the owner to focus his time on other pursuits, whether it’s starting another business, working as a W-2 employee, or enjoying semi-retirement. 

For first-time SMB investors, absentee businesses are typically the first method they look to for getting into the space and owning a piece of an SMB.

However, it’s often not as simple as it looks. Very few small businesses are truly absentee. Many owners are involved in sales, finances, and management, to varying degrees. It’s hard for even a business broker to truly know how passive the business is, opening up the potential buyer to risk that it is more active than they can support.

For the businesses that truly are passive, they are such a hot commodity that they trade at much higher multiples and prices than a typical owner-operated business. 

Lastly, a business can transition from “absentee” to “owner-operated” very quickly. All it takes is the key manager leaving the business. This means the owner needs to have the manager on a strong incentive plan, build a good relationship with him or her, and have a contingency plan if something happens.

For finding an absentee business, the best approach is to use listing sites like BizBuySell and build relationships with brokers to get notified of when something is about to hit the market.

Buy a Business and Staff an Operator

One option is for an investor to buy an actively managed business and convert it into an absentee one by hiring an operator. This avenue is best for hands-on investors who know how to get deals done. These investors want quite a bit of control and to own a majority of the business. In order to execute well, these investors typically have operating experience themselves and know how to structure deals, hire, and manage.

Typically, there are a few approaches to buying a business and transitioning it from active to passive ownership:

1. Meet an operating partner and search for a business to buy together, leaning into businesses where the operating partner is well suited.

2. Go under contract and find a GM to staff at, or shortly after, closing of the deal.

3. Operate the business for a few months before hiring a GM.

Aside from path 1, this approach requires the investor to have the flexibility to act as the operator for a period of time until the GM comes on.

However, the upside is that there are many more businesses that can be bought with this approach compared to looking for businesses that are already absentee.

For investors interested in this approach, please reach out to our team. We can support you in finding an operating partner as well as seeing if a searcher wants to operate a deal you have under contract. 

Invest in a Self-Funded Searcher

Self-funded searchers are individuals who look for a business to buy on their own dime but then raise from passive investors to help fund the acquisition. In other words, they “self-fund” the search but then use a mix of debt and investor equity to fund the deal.

Unlike an operator that an investor hires, these entrepreneurs are more tightly aligned with investors. Typically they have a personal guarantee as part of the SBA loan, which includes a lien on their house. Additionally, they often draw a below-market salary and are looking towards future distributions and an exit to make the acquisition worth their time and money.

The downside of backing self-funded searchers is that the market is competitive for investors and the universe of deals is smaller than if you bought a business and staffed an operator. Additionally, investors typically have less control over self-funded deals. They will have voting power over key issues but day-to-day operations are fully left to the self-funded searcher.

To access self-funded deals, sign up as an investor on Mainshares. Separate from Mainshares, you can search out dealflow by visiting self-funded conferences, networking with searchers on Searchfunder, and building your rolodex of other investors for referrals.

Back a Search Fund

Search funds are what most people think about when it comes to investing in a business acquisition. The first ever search fund was founded out of Stanford Graduate School of Business in 1984. Unlike a self-funded deal, search fund operators raise capital before a deal is under contract. The investors then get a step-up when that raised capital converts into equity in the acquired business. 

While search funds are quite popular in business schools and target larger businesses, they do have some downsides. Some search funds will never identify a target and need to return capital to investors. Additionally, because their target deal size is much higher, investors need to put in larger checks. Lastly, they typically take a longer time to return capital than other deals, as they are looking to grow the equity value and then generate returns through an exit. 

However, search funds offer attractive IRRs as evidenced by the Stanford survey and they provide more control than a self-funded deal, which may have no formal board.

For investors interested in backing search funds, the Searchfunder network is a great place to start. Similar to self-funded ecosystem, there are a number of search fund conferences at business schools across the country each year.

Managed Fund

For investors that are looking to benefit from the returns of SMBs but are not looking for as much involvement in sourcing, structuring and managing deals, there are a number of new managed funds that have launched in the past two years.

These funds offer investors diversification while taking on the burden of sourcing and diligencing deals as well as contributing to the operator’s management of the business. 

Many of the GPs of these funds are previous searchers or search fund investors who have deep experience in SMB deals. They charge management and performance fees in exchange for offering investors a more lightweight way to get involved in SMB deals.

While there is no aggregator of these funds, there are a few worth reviewing: Feta Fund, FruitionCap, and Slackwater Capital. We’re happy to introduce to the GPs if you are interested, just shoot us a note.

Comparing Ways to Passively Own an SMB

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.