The challenge in acquiring founder driven start-ups

Our first exit to Agora Brands

In case you’re new to the DC Universe then it’s important to know, prior to my ongoing venture with Igloo, my partner and I were founders of a brand in the e-bike space. We were acquired by a direct-to-consumer roll-up (in layman’s terms: a holding company with multiple assets under one umbrella) called Agora Brands.

Post-exit, Alex and I were asked to consult for Agora and hangout with business owners to promote life under the Agora umbrella, in the event they decided to pull the trigger. It was during this process, that we experienced a massive scope of founder involvement, from all niche categories. Some founders were excellent delegators, while some were the beating heart of the company. But the main question should be: which founder’s ARE the business?

The risk investors face when acquiring businesses

In the direct-to-consumer (D2C) space, a brand has dozens of moving parts that must be meticulously managed by a team or an individual to keep the brand not only alive but, hopefully, scaling. Growth is the primary focus for most investors, especially during a “boom,” as they hope their portfolio will be acquired by a private equity firm or an even larger roll-up. Similar to what’s happening in the AI space, the D2C sector experienced a comparable surge from 2019 to 2021: consumer sentiment was at an all-time high (stimulus checks helped), the IPO index was peaking, and money was pouring in. Even though zero public D2C companies were profitable, investors were all-in, hoping to gamble their way to victory.

For context, an investor’s goal is, first, to keep the founder incentivized long enough to find a replacement at the end of their “earn-out” (a contractual period where the owner is obliged to continue working for the acquirer) and, second, to keep the business growing under a new CEO or director if the founder leaves. Nonetheless, if you write a founder a hefty check, you must weigh the risk that they may not be as motivated once they’ve taken a lot of chips off the table.

However, it wasn’t long into the hairpin of 2022 that investors realized their vulnerability to founder-run businesses. It goes without saying that a founder’s level of involvement is hard to gauge through due diligence (DD), and while everyone was sprinting for the finish line, aggregators suffered losses when their holdings started to tank. Investors had desperately chased higher multiples by growing through acquisition rather than by slowly acquiring sustainable businesses. Founders were incentivized to focus on revenue growth so profits became secondary. Moreover, several roll-ups found themselves overexposed to pandemic valuations tied to anomalous spending behavior (largely inflated due to shopping activity), leaving them with enormous debt stacks or LPs they needed to pay.

Latest news: SellerX, Unicorn aggregator is auctioning off their assets. Read more

How do investors keep founders incentivized?

A few common earn-out structures:

Businesses tailored to roll-ups or “aggregators” are often too large for private investors but too small for private equity (PE) firms, which typically seek businesses with higher EBITDA. These businesses generally fall within the $300K to $3M EBITDA range, give or take. This means they’re private, not public, and the deal is usually open for negotiation.

1 - Revenue method: During a growth phase, businesses are sometimes valued based on a revenue multiple instead of a profit/EBITDA multiple. This is more common in software, where exponential growth can offset fixed costs. However, in any growth market, ultra-aggressive buy-out vehicles often ignore profit (if we’re being honest) to inflate top-line valuations, often in pursuit of an IPO. In such cases, founders are typically offered a base salary of x with a bonus of y tied to revenue.

Example earn-out:

$100,000 base salary, plus 50% of revenue growth for 2 years.

2 - EBITDA method: Similar to the above, but this method is tied to profit. EBITDA is criticized by some investors (Warren Buffett included) because, as they argue, why should interest, taxes, and depreciation be excluded from a business’s costs? Nonetheless, it remains the most common multiple today, and founders on EBITDA earn-outs are incentivized to prioritize profit growth over revenue. However, savvy founders may find ways to inflate EBITDA - for example, by turning off ads or purchasing large amounts of inventory to protect sales, which, under accrual-based accounting, won’t be categorized under COGS until sold. This raises a challenge for acquirers: how can they detect these tactics before closing the deal?

Example earn-out:

$100,000 base salary, plus 50% of EBITDA growth for 2 years.

3 - “New Money” method: Simply put, this method incentivizes founders to generate new profit. For example, EBITDA growth could be contingent to inventory turnover, requiring that a certain percentage of inventory be sold within the earn-out period. The salary can then be tied to a percentage of sales, provided that the business’s profit margins remain flat or improve. This does get more complicated, but it’s essentially this in a nutshell:

Example earn-out:

$100,000 base salary if EBITDA margins grow 0% or higher, plus 50% of EBITDA growth if the EBITDA inventory turnover ratio exceeds [number].

You’re an investor, who would you rather buy?

Business A: An advertising agency that sources candidates to go in-house with other companies. They’re not managed by the agency, but the agency bills the client directly. $500K EBITDA, $3M TTM Revenue.

Business B: An advertising agency where the clients work directly with the agency founders and the team stack is managed by the agency as well. This is more hands on, and client facing. $600K EBITDA, $2M TTM Revenue.

My Answer: A

Buying companies isn’t exactly an art form, but it certainly requires clever paperwork, often accompanied by hefty legal fees. The biggest challenge aggregators, PE firms, or VCs face, assuming no macroeconomic changes like rising interest rates or a capital shortage (a crash being a valid example) - is keeping great leaders in charge. One could argue that acquiring businesses with less "founder-client interaction" could reduce risk, as some industries are purely transactional, with minimal contact between clients and founders. In other industries, however, the relationship may be much more personal and the product or service could be largely founder driven.

Is rolling up D2C businesses actually worth the risk?