Deal Origination Math Needs to Add Up

A big myth in dealmaking is that you can randomly find one deal and close it…

And that THAT deal will be the PERFECT fit for you.

That’s why I always cite the 1 in 20 rule for closing deals…

On average, if you originate 20 quality deals you are likely to close at least one.

I was recently asked on a podcast if I pulled that number out of thin air.

Nope. There’s some math and science (and psychology behind it) — backed by my 28 years of experience in the acquisition business.

Let me prove it to you…

As you know there are three major variables that go into finding the perfect deal:

(For more on this concept check out my post explaining the perfect deal triad.)

Now let’s play the numbers game…

EVERY business is essentially for sale; it just comes down to price and deal structure.

If you have $2 billion dollars, you could buy Apple. So believe me when I tell you every business is for sale depending on where the buyer’s and seller’s motivation meet.

It’s like the bid-ask spread for the price of a company’s share on the stock market. The small business buying market is no different, except the gap is far less transparent.

Let’s say you found 100 small businesses in the IT sector, each with revenue between $1 million and–$5 million, and a profit margin of 15%.

The $1M business with $150K of EBITDA (earnings before taxes, depreciation and amortization) might be worth a 3X multiple or $450K.

The $5M business with $750K of EBITDA might be worth a 5X multiple — the higher the EBITDA, the higher the multiple. So that business is worth $3.75M.

So we have a valuation range between $450K and $3.75M across your 100 target deals.

OK, let’s keep going…

Let’s say you had $10M in cash burning a hole in your bank account.  With unlimited cash and an appetite to “spend whatever it takes,” you could buy ANY of those 100 businesses.

But that’s not where we’re at.

Let’s pass the 100 deals through the three primary filters of the deal triad referenced above, in addition to a fourth filter…

Can it be purchased at a sensible price? (Let’s get this one out of the way first.)

Assume 50% of the deals can be purchased sensibly — within market average multiples with win-win deal structures. Discard the 50% that cannot.

Next, assume 75% of the remaining 50 deals are firmly in your wheelhouse… or you can partner to get there. Discard the remaining 25% — another 12 deals gone.

Of the remaining 38 deals, assume 50% of sellers are motivated and the other 50% are not. That’s another 19 deals gone with 19 left.

And assume that ONLY one-third of the deals left have financial attributes that will facilitate an LBO. (If you can’t finance them, you must discard them.)

This leave us with just six potentially viable deals — 6% of the 100 you started with.

Put another way, you need to find at least 17 deals before you can confidently close one of them using all the odds and variables above.

For some sectors, it may be 1 in 10 (engineering, manufacturing, etc.).

For others, it may be more than 1 in 17 (e-commerce, pharma, etc.).

I find that 1 in 20 as a comfortable barometer.

This is why your deal origination machine and filtering process are CRITICALLY important.

Deal origination is a numbers game — the math has to add up.

Until next time, bye for now.

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