Before committing funds to acquire an SME, investors assess certain internal and external metrics to determine whether it would be a good buy. These range from financial parameters reviewed through due diligence to competitive advantages, including barriers to entry, the leadership team's track record, and the potential of the sector the company operates in.
Here's a summary of the five areas they focus on:
Growth potential
This is the company's ability to expand and increase its value in the future. The keys to measuring that potential are cash flow generation and ROCE (return on capital employed). The first tells us whether the company will need to seek alternative financing to make investments, which could mean higher leverage and financing costs. The second tells us how efficiently a company uses capital to generate profits; it's calculated by dividing EBIT (earnings before interest and taxes) by capital employed.
A potential investor will also look into the following factors:
- Target market: they assess its size, growth outlook, demand for the products or services, and any untapped market opportunities.
- Competitive advantages that help the company stand out and win more market share: these include innovative technology, intellectual property, and strong relationships with customers and suppliers, among others.
- Scalability of the business model: the company's ability to grow without a proportional increase in costs.
- Innovation and adaptability: this shows whether the company can anticipate and respond to emerging trends or customers' changing needs.
A solid business model
This means a clear, viable structure for generating revenue, creating value, and staying profitable over the long term. What interests investors here is the SME's ability to innovate, lead, and stay competitive in a constantly evolving market. To gauge this, they'll look at whether it solves customers' problems or meets their needs better than the competition.
Other aspects to analyze include:
- A sustainable revenue model: they examine every revenue stream. That includes sales of products or services, subscriptions, advertising, licensing, etc.
- Effective distribution channels: they assess the company's sales and distribution strategy, such as direct sales, retail stores, e-commerce, etc.
- Barriers that keep competitors out: they weigh patents and intellectual property, exclusive relationships with suppliers or customers, economies of scale, etc.
A capable management team
This is another key indicator of the company's ability to reach its goals and overcome challenges. In general, investors look for a capable management team that inspires confidence in its ability to lead and grow the company. They therefore also look at employees' experience and training, as well as their complementary skills. This matters because it makes the SME more efficient: it avoids having to outsource certain services, which means significant savings.
Investors also look for evidence of a strong track record in executing past strategies, achieving key milestones, and meeting stated goals.
Finally, the team's culture and values can also matter to investors. Ethics, transparency, and accountability can be seen as a very valuable asset.
Profitability and return on investment
These are fundamental aspects when evaluating an SME. They provide valuable insight into the company's ability to generate profits and reward investors. There are many ratios you can use to measure a company's financial health. Here are a few:
- EBITDA: earnings before interest, taxes, depreciation, and amortization is one of the most widely used gauges of whether a company is profitable.
- Profit margin: the amount of net profit earned relative to the revenue generated. A healthy profit margin signals that the company is profitable enough to cover its costs and reward investors.
- Historical results: these include revenue, profits, and margins over time. This shows whether the company has achieved profitable growth in the past and whether it has been able to generate consistent profits.
- Financial projections: these show expected future revenue and profits. They must be realistic and based on reasonable data and assumptions. An investor will consider whether the projections point to sustainable growth and improving profitability over time.
- Return on investment (ROI): the ratio between the gain obtained and the investment made. Investors may also consider the expected time frame to achieve it and whether there are exit opportunities, such as an acquisition or an initial public offering (IPO).
Risk assessment
Risks are events that can cause losses or significantly affect any business venture. Here are some of them:
- Operational risks: these are tied to the company's day-to-day activities, such as risks arising from the supply chain, product quality, data security, or business interruption. An investor analyzes whether the SME has adequate policies, procedures, and systems to mitigate these risks.
- Financial risks: these assess the company's financial health and its ability to meet its obligations. Investors look at its debt level, profit margin, liquidity, etc.
- Competitive risks: the company's ability to compete in its target market. These cover the presence of strong competitors, the risk of products or services becoming obsolete, barriers to entry, etc.
- Legal risks: the existence of legal disputes, administrative penalties, data protection and privacy issues, etc.
- Strategic risks: the company's ability to adapt to changes in the business environment and seize emerging opportunities.
- Sustainability risks: investors check the company's carbon footprint and how it applies ESG (environmental, social, and governance) criteria.
An investor's goals when assessing whether an SME is a good fit for investment vary. They depend on the situation, the sector, and even the preferences of whoever is putting up the money. However, there's a set of characteristics a company must meet so the investor has no doubt that investing in it is the right move.
