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SMB Investing for Venture Capitalists and Angel Investors

By Mainshares

Dec 28, 2024

High-growth technology startups are highly sought after by professional investors—venture capitalists (VCs)—who invest on behalf of their LPs—and angel investors—who invest their own personal capital. This asset class, especially at the earliest stages of company formation, represents a high-risk, high-reward investment opportunity where startups seek to raise subsequent rounds of venture funding, grow, and, hopefully, exit for a hefty sum. 

While there is the potential for big, power-law returns, there is also a relatively high rate of company failure compared to other private market asset classes, like small to medium-sized businesses (SMBs). If the venture capital markets taught us something from the rollercoaster of exuberance during COVID-19 and the subsequent downturn across fundraising, it’s that it doesn’t hurt to diversify your private market portfolio into asset classes that can provide a much-needed contrast to the go-big-or-go-home return profile of tech startups. 

Below, we’ll compare and contrast the venture asset class with SMB acquisitions as an asset class. 

Ownership structure of SMB acquisitions

Startup investors typically either invest directly into the startup (which is most often incorporated as a Delaware C corporation)—by purchasing preferred equity and being directly on the cap table—or through a Special Purpose Vehicle (SPV) set up to group investor checks into a single line item on the company’s cap table. In VC investing, investing in an SPV grants the investor membership interests in the LLC or LLP entity based on their pro-rata share of the investment amount relative to all other investors in the SPV. 

Similarly, investors in an SMB acquisition will most often purchase interests in an SPV entity—which is organized as an LLC or C corporation structure. The SPV will then purchase the existing stock if the acquisition is a stock sale or acquire the assets of the SMB if the transaction is an asset sale.

Sometimes, investors will purchase stock directly from the seller, but this is not very common and typically the result of an SMB that holds a designation that requires a certain ownership structure (e.g., a Service-Disabled Veteran Owned Small Business, SDVOSB).

In short, the ownership structure of SMB acquisitions vs. venture investments is quite similar.

Accessing investment opportunities in SMB acquisitions

Both asset classes experience similar characteristics when it comes to accessing investment opportunities. 

Most deal flow comes from proprietary, off-market relationships with founders—in venture capital—and operators—in SMB acquisitions. Deal flow for the best VC firms and SMB investors typically comes inbound from entrepreneurs raising capital or warm introductions from other investors in the ecosystem. For most other private market investors—whether that be VCs or SMB investors—it’s helpful to meet with other investors in the space for potential co-investment opportunities, reach out to operators who you know that may be curious about buying a business, and work on branding yourself as a value-add investor that operators want on the cap table. 

Mainshares, to this extent, is building tools to connect operators with investors and help standardize the process and relationship between operators and investors. We’re playing a similar role for SMB to what firms like Angellist, YC and Carta did for the venture asset class.

How do fees differ between SMB acquisitions and venture capital?

Investing through an intermediary 

Investors in VC funds or syndicates typically pay the manager a “2 and 20” fee. This means a 2% management fee every year (typically for a total of 7-10 years) on the amount you’ve committed to the fund or the deal and then a 20% carry based on the profits of the investment once it’s realized. 

In independent sponsor deals, a financial sponsor will organize an investment opportunity for their LPs akin to investing in a syndicate deal rather than investing directly in a startup. Independent sponsors typically charge three types of fees: 

  • Acquisition fee: 2-5% of the deal size

  • Management fee: 3-7% of EBITDA 

  • Carried interest: This can range from 15-25% on the business’s profits and is usually triggered after an investor hurdle rate has been reached. 

Most independent sponsors are doing multiple deals per year and then raise investor money to help capitalize on the deals they win. This mirrors the mechanics of venture syndicates, where a syndicate lead spends time hunting for a deal before raising equity from investors to fill the syndicate’s allocation.

The one difference is that it is less common for syndicate leads to charge acquisition and management fees than it is for independent sponsors to charge those fees for a business acquisition.

Investing directly into the company 

VCs and angels who invest directly on a company's cap table do not pay fees but rather share in the company's ownership, similar to investing directly into a self-funded search SMB acquisition.  

In self-funded search deals, the searcher doesn’t charge investors a fee but will typically pay for transaction expenses with the business’s cash flow in addition to owning most of the common equity. Their majority ownership, or implied “carry,” can be thought of as their upside for (1) personally guaranteeing the SBA debt on the deal and (2) assuming the full-time operator role to run the company. 

Similarly with investing in a startup, the founder negotiates the dilution and structure of the financing with the investor but does not charge any management or performance fees, beyond the salary they draw as an employee of the company. 

Investor rights in SMB acquisitions and venture capital deals

Venture capital has developed over the past few decades into a sophisticated asset class with fairly standardized documents and clauses. Some of the most common VC investor rights include:

Similarly, organizations such as YCombinator and the National Venture Capital Association (NVCA) developed documents that ultimately became the market standard, bringing about more transparency and trust into venture financing.

The SMB world is still a bit of the wild west in comparison. By way of analogy, it’s probably around 20-30 years behind Silicon Valley and the venture asset class in terms of its sophistication, market terms and widely used transaction documents. 

This means that each operator can set their own terms with their counsel and lead investors of the round. With that said, transaction documents will typically include liquidation preferences, information rights, and voting rights for investors.

At Mainshares, we’ve worked with some of the nation’s top law firms to develop standardized transaction documents that we provide to our operators. You can read more about some of the governance terms here.

Investing risks in SMB acquisitions and venture capital

The risk profile of investing in SMB acquisitions varies significantly from the VC asset class. 

In venture capital investing, there is a high failure rate of startups that go out of business - often cited as upwards of 75% of venture-backed companies go out of business. The past few years have been particularly ugly for the asset class, with 2023 seeing the largest percentage of shutdowns happening in the year. 

On the other hand, SMB acquisitions target tenured, stable operating companies with positive EBITDA margins and free cash flow. While self-funded search acquisitions are levered with SBA debt, it’s reported that the probability of default on an SBA loan is just 2.25%. That’s to say, the percentage of SMBs that go out of business after an acquisition is far lower than the number of venture-backed startups that go out of business after raising capital from investors. 

Additionally, since most venture-backed companies rely on an exit to return capital to investors, investors typically see no financial return if the company fails. On the other hand, SMB investors are typically entitled to cash distributions during the life of the business, which provides investment returns during the holding period, reducing the risk that investors see no return at all in the case of the company failing. 

Still, some key risks exist, such as the operator’s or management team's abilities to run the business effectively through adversity, such as competition and market conditions, as well as liquidity, legal, and regulatory risks—many of which are found in both venture capital opportunities and small business acquisitions. 

Return profile of SMB acquisitions and venture capital

The return profile of investing in an SMB acquisition also varies widely from the VC asset class—in terms of structure, type, and consistency. 

In venture capital, the potential investment returns are commensurate with the risk at each stage of a startup’s life. For this reason, investors in early-stage startups target significant power law returns because the risk of a shutdown is so high at the earliest stage. 

Early-stage VC investors may benchmark their target returns as much as 100x multiple on invested cash (MOIC) or 35%+ internal rate of return (IRR). As startups mature, their relative risk of shutdown tends to decrease, and as a result, investor return expectations also decrease. A late-stage startup investor may target 1.5-5x MOIC or 20% IRR. 

Investment returns in SMB acquisitions are different for two reasons:

  1. Risk profile

  2. Investor distributions. 

Each SMB acquisition will have different financial projections, but it’s common to see issuers projecting a 3-4x+ MOIC on a 5-year exit and 25-35%+ IRR. These expectations are lower than those of early-stage VC deals because the risk of investing in this asset class is much lower. However, SMB return expectations are typically greater than late-stage venture capital. 

Compare this to venture capital, where a 3x MOIC on a fund is very good—reportedly, only 10% of VC funds achieve it.

As a reminder, SMB acquisitions typically occur in tenured companies with years of profitable operating experience and proven systems in place. SMB investors usually receive a waterfall return structure that prioritizes their return on investment and a preferred investor return. These deals can do so because of their available free cash flow. This stands in contrast to VC deals, where companies often do not distribute cash and only realize investor returns—based on seniority, multiple, and participation—when there is an exit opportunity. 

A comparison of holding time horizons 

Most venture capital investments have a holding time horizon between 3-10+ years. In the earliest stages, investors should expect a 10+ year time horizon, while growth and later-stage investments will have a shorter time horizon given the shorter time frame to an expected exit. 

Venture capital funds typically have a 10-year horizon before they need to shut down—either by selling their positions and distributing cash to LPs or transferring shares in-kind to LPs.  

When you invest in an SMB acquisition, your position is typically considered illiquid, similar to venture capital investment.

SMB operators may consider a few key exit opportunities (which we’ll discuss below) that may materialize in 5-7 years. Private companies' ownership stakes, whether small businesses or venture-backed startups, do not trade on a public exchange like publicly traded stocks.

Exit opportunities for SMB investors 

VCs and angel investors typically expect one of a few potential outcomes to realize their investments—initial public offering (IPO), acquisition, or secondary sale.

On the other hand, because of their size and growth potential, SMBs rarely go public and trade on a stock exchange. The nature of these companies means most SMBs will not become billion-dollar companies and IPO and investors are unlikely to find a developed secondary market for their equity holdings.

The most common exit opportunities for SMB investors occur when the business is sold to a strategic or financial buyer. This could be an investment fund, company, or individual purchasing the business for financial reasons or a competitive or synergistic company wanting to add its operations to its existing company. 

Based on the terms of the acquisitions, investors would be entitled to their pro-rata share of the net transaction proceeds. 

It’s also possible that the operator would recapitalize the company, cashing out existing investors or purchasing investor shares back after a pre-determined time or return hurdle. In this case, investors would walk away with their pro-rata share of the value of their membership interests.

Each SMB acquisition is unique, and it’s important to review the financial models to understand how the deal sponsor anticipated investor distributions and exit scenarios.   

Dilution

Finally, an investor’s equity dilution looks very different whether you’re investing in an early-stage startup or an SMB acquisition. 

In venture capital, high-growth startups typically need to raise several funding rounds to grow, hire team members, and expand into new markets. Each time a startup issues more shares to new investors, the percentage of ownership that every existing investor has decreased. This is called dilution, resulting from more pieces of the same pie being created over time. While there are mechanisms, like pro-rata rights, to avoid equity dilution, it is common for VCs—especially early-stage investors—to have their ownership percentage reduced significantly as the company continues to grow and raise capital. 

When operators raise capital to buy a business, they typically only need to raise capital once to fund the acquisition. Since most SMBs aren’t high-growth startups, they typically do not raise dilutive equity capital to fund future operations. If anything, operators may raise debt capital for certain working capital or expansion needs but rarely take on additional equity unless they are running a roll-up strategy.

Therefore, an investor in an SMB acquisition, for example, who purchased 10% of the transaction's value, would normally keep their 10% ownership of the company until an exit.

Why we think investing in SMBs is an attractive opportunity for venture capitalists and angel investors 

Venture capital and SMB investing share many similarities within the private markets but differ across meaningful factors, such as risk and reward expectations, exit opportunities, and governance structures. 

Investing in SMB acquisitions can provide VC and angel investors with an attractive opportunity to diversify against systematic risks associated with the VC asset class, trading some of the power-law upside potential for more consistent distributions and better downside protection.


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.


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