- Good evening everyone,
and thank you for joining
tonight's webinar,
Entrepreneurship Through Acquisition 301.
I'm Joe Cortese.
I'm co-president of the Chicago
Booth Alumni Club of Chicago
and a principle and senior consultant
with DiMeo, Schneider & Associates.
With me again this
evening is Brian O'Connor,
adjunct associate professor
of entrepreneurship at Booth,
and founder and managing principal
of NextGen Growth Partners.
So this is our third webinar
in the Entrepreneurship Through
Acquisition or ETA series.
We were joking before the call.
We're two-for-two on my internet crashing
during these webinars.
So hopefully we don't
make it three-for-three.
But if that does happen,
rest assured I'll get back
on as soon as possible.
Brian's good at carrying the load,
so he can just continue on without me
until I'm able to join.
But in our first conversation
around ETA, we discussed,
you know, ETA generally what
it is, how it works, et cetera,
sort of the basics.
In the second webinar,
we talked about the search process,
how it's conducted, and
important considerations
to ensure the efficiency
and the effectiveness
of a potential search.
By the way, links to
the previous recordings
are available on the
Chicago Booth Alumni Club
of Chicago's website.
So if anybody's interested
in looking at those,
feel free to jump on the webpage
and you can get the links there.
In this third iteration,
we will focus on pre-acquisition
valuation considerations,
mainly valuation.
We'll talk about the relative importance
of different business criteria,
as well as a few important considerations,
as it relates to valuing,
and acquisition target
in structuring a deal.
We'll take questions along the way.
You should all see the
question and answer box
on the Zoom screen there.
If you have a question, feel
free to type it in the box
and we'll pick those up as we go.
Lastly, I'll mention,
we will have at least one
more webinar in this series.
The next one, which will be our fourth,
we'll invite one of the
entrepreneurs in residence
from Brian's firm to talk to us
about their firsthand experience
going through the search process
and actually transacting
on an acquisition.
So we'll save that one
for September or October.
So with that, let's dive in.
Brian, great to see you again.
Thanks so much for joining
us, really appreciate it.
- Hey, thanks, Joe.
Thanks for having me and thanks
everybody for dialing in,
for those of you that I haven't scared off
in 101 or 201.
Good to be here, thanks
for having me back.
- Great.
So Brian, let's start
tonight with, you know,
just sort of like, okay,
you see the business that
you would like to acquire.
Take us through that process
of how you begin the process.
What sort of information
do you wanna get upfront?
How do you request it?
Just sort of start from the beginning
moving us down the acquisition path.
- Yeah, so Joe, I think it
starts with usually in ETA,
and we've talked about
it in a prior session,
the notion of proprietary sourcing
versus intermediary
driven sourcing, right?
And so I think the next step in that path
is going to look a little bit different
based on whether there's
an intermediary involved
in the transaction or the
potential deal or not.
And I would say in either case,
you're gonna wanna start
to develop a relationship
and build trust with the business owner.
And it's very likely the owner
operator of that business.
Typically that is the
case with the smaller
or privately held companies.
Sometimes they're multi-generational,
family-owned and operated companies.
And so I would say that there's
an intermediary involved,
or you're dealing directly
with a business owner operator
about the purchase of his or her business.
You know, I think it starts
with a high degree of trust and respect.
Sometimes it's going to require,
a lot of times it's going to require
the execution of a nondisclosure agreement
or a confidentiality agreement,
just to make sure that you do have
that baseline understanding
that their information
that they share with you
that might not be publicly available
is going to be treated with
sensitivity and confidentiality.
So it would seem that's a first step
is to execute those documents
to basically in writing confirm
that you're a good person
and you're not gonna use their information
in any way than can any way harm them,
or share with competitors,
or go after employees or
customers or that sort of thing.
So I would say that in all cases,
it starts with building a
trust in a relationship,
and then you're going
to move down the path
into information requests.
And we can talk a little bit about
some of the pieces of information
that you're gonna wanna
understand early on
and request from the seller,
or from the seller in
conjunction with the intermediary
that they've decided to
hire to represent them
in the potential sale of their business.
But, you know, it really does start
with a respect and a trust
with the business owner
that you're the right person for them
to be communicating with
about something as serious
and sensitive as the potential sale of,
in a lotta cases, their life's work.
- So yeah, it sounds like
it really is developing a relationship,
probably like you have to develop
most relationships in business,
I would assume, right?
- I liken it to a very
large strategic sale
with a very long sales cycle (laughing).
And so critical in a sale like that,
in this situation you're
actually purchasing,
but you are selling yourself
as a potential buyer
and a future operator of that
business in the ETA model.
It's very much a strategic
sale with a long,
often long sales cycle associated with it.
So it starts with the
relationship and trust.
And then I would say
you then get into effectively
striking a balance
between getting information that you need
to evaluate the
attractiveness and the price
that you're willing to pay
and the structure at which
you're willing to pay for that business
with not overwhelming (laughing)
a business owner, right?
In this in this part of the market,
it's not as clean and as straightforward
as having, you know, a very well appointed
confidential information
memorandum, often,
or a data room with all the information
that you could ever want
to know about a business
for you to be able to evaluate that
as a potential investment.
So it's striking a balance
and a level of respect
and understanding for that business owner
that may not have the
systems readily available
or the information at their disposal
to share with you that
you might, as a Booth MBA,
be accustomed to evaluating
when determining the price,
and valuation, and structure
for a potential acquisition.
I put those things in a
couple different categories.
I mean, first, and probably obviously
to a lotta people on this call,
you're gonna want to understand
the financial performance
of the company, right?
So, historical financial
statements, income statement,
balance sheet, statement of cash flows
as far back as you can get them.
And again, it's striking a balance
between not overwhelming a business owner,
but getting the information that you need
to evaluate to understand
how has this business performed
over long periods of time,
and on as granular level
as you can get it, right?
Monthly is better than quarterly.
Quarterly is better than annual.
You know, granularity around
the expense light items
that get you down to sorta
your gross profit line,
and then down to operating
income and EBITDA,
and then ultimately free cash flow,
which I would argue is the most important.
So, you know, it is gonna be around
trying to get your hands on
as much financial information
out of probably systems
that are less than perfect
at the target company.
We can talk a little bit about the systems
and how you get that information
as we move on in the conversation.
But, I would say it kinda starts there.
And then, you know, you are gonna want
as much information as you
can get on customers, right?
Is this a business
that is a recurring
revenue business model,
which we've talked
about in prior sessions.
Or is it highly repeat?
Or is it more one-time
or episodic in nature?
And that customer data
is going to tell you
about those customer behaviors and trends
and revenue profile over
long periods of time,
hopefully, if you can get
your hands on the data.
And then the third
category that I would say,
and there are many others,
but the ones that come to mind
are around the employees, right?
What does the organization look like?
What's the org chart?
What are the compensation
levels of certain people?
And what are the potential gaps?
And where are there maybe, you know,
the wrong people in certain positions?
And these are all things
that you're going to need to understand
from the information that a business owner
is going to provide to you, hopefully,
and ultimately factor into the decision.
One, whether or not it's a business
or an asset you wanna pursue.
And then two, if it is, how you wanna
think about valuation and
structure for that business.
- And I wanna drill down a little bit,
and we've actually got a
couple of questions here
that speak to where I
think we should go next.
Ann Kit asks, you know,
"Is there a repository of standard docs
"that are used in the process?"
Or maybe said differently, you
know, is there a checklist,
like, do you have a checklist?
Are there resources out there
that provide a checklist?
Because I have to imagine
you can't just have one standard checklist
and apply it to every situation, right?
I mean, these businesses are
gonna be different enough
that you're gonna need different things
depending on the situation.
But are there some
resources that you know of
that someone could use to kinda make sure
they're getting all the
check-the-box items?
- Yeah, so it's a great question.
There are a lot of resources available.
One of the texts that we
assigned in the course
that I teach at Booth
is the HBR Guide to
Buying a Small Business.
There's a number of good resources
and examples in that book.
Stanford published and continues to update
and publish their Search Fund Primer.
And then the periodic
updated survey that they do
around search fund investing.
And that's all available on Stanford's
Center for Entrepreneurial
Studies website.
That has, one of the
indices to that document
is a very thorough and comprehensive
due diligence questionnaire and checklist.
You know, we at our firm at
NGP have developed our own.
I think that, you know,
and, and several others,
I mean, even if you did something
probably as simple as a Google search
of due diligence checklist or
due diligence questionnaire,
you'd probably come up with
a whole host of examples.
I think that the real trick in crafting
that right curated list
for each situation,
that's really where you need
to spend your time, right?
Again, getting back to the point of
not wanting to overwhelm a business owner
with requests that might not be relevant
for this particular industry
or this particular business model,
or frankly, they're just
things that, you know,
it's not reasonable to assume
might exist or be readily available
from an information or data standpoint
within a business that
generates two, three, four,
or $5 million in annual EBITDA.
- Question from Lavash.
"With regard to financials,
"how often are they certified or audited
"in this market segment?"
Or, do you find that there are,
and then where I was gonna go next is,
What happens if you can't get great data?
So how often do you run across a situation
where the data is good,
and then if it isn't,
what do you do?
- Yeah, I chuckled a little bit
when the question was asked,
how often are they audited?
'Cause the honest answer
is it's like never.
Certified and reviewed,
probably more than, you know,
the instances that I've
seen audited financials
in this part of the market.
But the reality is,
is you're dealing with
imperfect information
coming from imperfect systems
and you have to make do.
And I've seen, you know,
and at least one of these
we like to do at our firm here,
is we have the capability
to request source files.
If they're running on QuickBooks,
we request QuickBooks source files
and build our own set of financials
based on gap, you know,
accrual accounting,
as opposed to some of these
that you see different methodologies,
cash based or otherwise used.
So it's always messy.
It's always imperfect.
I think you have to be patient.
You have to be understanding.
You have to realize the
limitations associated
with the information that
you're gonna be provided
and the systems with which you're pulling
that information and data from.
And in some cases it's gonna
be a little bit frustrating
for the Booth MBA that's used to having
a lot of information, a lot of data,
a lot of research, a lot of analysis.
It might not exist,
and you might need to
make some assumptions.
And then I think that as
you advance an opportunity,
and we can get to this maybe
later on in the conversation,
but you very well are going to likely
point to hire a consultant.
Like we had accounting service provider
to do a quality of earnings.
Unlikely that you do sort of a full audit.
But you need to do the quality of earnings
to really dig in and verify
that the numbers that you're looking at
are in fact, legitimate,
and the right numbers to be looking at.
And there's probably gonna
be some changes that are made
in arriving at the EBITDA or the earnings,
or ultimately free cash flow
that you as the buyer of the business
are going to be using
to value the business.
The only constant is that
it's always imperfect.
It's always messy.
And, you know, just to varying degrees.
- So have you ever come
across a situation where,
or what would you do in a situation
where you found an attractive business,
you really wanna pursue it,
but the data is just terrible?
I mean, can you move forward,
or would you recommend like
cut bait and look for something else?
- Yeah, I think you can move forward.
I think it requires a lot of patience.
It may require you spending time onsite
or gaining the trust
of the business owner,
such that you've got an inside look
or access into some of the systems
so that you might be able to suss out
some of the things that
you need to evaluate
the attractiveness and evaluation
and ultimately the structure,
the price that you're willing
to pay for that company.
I would say that the one situation
where it does become just kinda walk away
is if you have good reason to believe
that you're being misled.
If you're getting information
that is just grossly
inconsistent with, you know,
your own findings and your own
research that you're doing,
and your trust in the information
that you've been given is shaken,
and you believe that you're
being misrepresented in any way,
then you walk away.
Or, I suppose the
situation where, you know,
it truly is so difficult or impossible
to get any information as it relates
to the financial
performance of the company,
financial stability of the company.
Then I suppose that would
be another situation
where it'd be very difficult
to assess the value of that business.
- Got it, thank you. That's great.
So let's move on and talk about
some of the important considerations
that you're gonna look to
evaluate in these businesses.
You mentioned if you, you
know, source of revenue
and how, if revenue is recurring
or those sorts of things.
If you could just talk a little
bit more about some of the,
I know they're all different,
but I'm sure there's a few key things
that you're looking for and
that you want to evaluate.
And then how do you sort of,
how do you place relative importance,
or how do you determine
relative importance
of those different factors
in making your overall determination?
- Yeah, Joe, I think last time
we had one of these sessions,
we talked about the use
of an industry scorecard
when evaluating objectively
the relative attractiveness
of one particular niche
that you might focus
on to source deal flow
versus another versus another.
I think the same applies here.
My advice is develop a scorecard
based on your own goals
for this acquisition
and those of your investors.
If you're raising, you know,
some outside equity
capital to get a deal done,
it's gonna be important to understand,
and bake into your scorecard
and your evaluation,
how important to me and to
my investors is things like,
you know, lack of customer concentration
and, you know, the revenue model, right?
Recurring versus repeat
versus onetime or episodic.
And we can kinda go down
the list a little bit,
but I would start by just saying,
develop a framework that allows you
to quantifiably and objectively say
this business scores, you
know, an 8.2 on my 10 scale,
based on these following criteria
at these weightings and objectively,
that compares to a 7.1 of this business
and a 9.2 in this business, right.
I think that's the first step.
And not messing around too
much with your weightings
or those criteria to tell a story
that you want the data or your
scorecard to support, right?
So just being dispassionate and objective
about the things that are important to you
and their relative importance
in their weighting,
and the things that are
important to the investors
that will ultimately be backing you
in the pursuit of this acquisition.
You know, again, you asked about
some of those things, right?
I rattled off a few of
them, like, you know,
you wanna avoid customer concentration.
I won't rehash a lot of the
industry ones like, you know,
cyclicality and industry growth.
I mean, that's really a separate scorecard
than when you're talking
about the scorecard
associated with evaluating
a particular business.
So, you know, you might
have things on there,
like bench strength and,
you know, customer churn.
If it's a recurring or highly
repeat service revenue model,
you wanna understand how often
you're churning those customers
versus how much stability
year in and year out
there is in the account base, right?
There's things like history
of profitability and growth.
The longer this company has been around
and heading in the right direction
and generating attractive EBITDA
and free cashflow margins,
I would argue that the
less risky that business is
when you're stepping in
as a new owner operator
and expecting to have
that business continue
on that same trajectory,
or ideally at an increased
growth trajectory
under your leadership, right?
Those are a couple of ideas.
Competitive advantage, you know,
does this business relative to its peers
have some sort of special sauce
that's gonna allow you to be effective
in gaining share or winning new accounts
when you're the leader of
the business, you know.
Is the industry...
Or I'm sorry, does this
business play in a space
that's fragmented or is it
highly consolidated, right?
That might weigh into how you think about
this business's attractiveness
vis-a-vis some of the other peers
that might be offering similar
type products or services.
- I've got a couple of
questions about, you know,
sort of the current market.
Let's hold off on that one a little bit.
More toward the end we'll get to that.
A question from Audrey,
"how often are ETAs funded
through outside investors,
"and who are the targeted investors,
"and what incentivizes them?"
I think we've covered some
of this, but you know,
you as a founder of an
ETA firm's search firm,
how would you describe
just the competitive landscape out there?
Are you bumping into, you know,
the same competitors over and over again?
Do you think it's a fairly, you know,
an attractive market at this point?
Or what are your just
general thoughts there?
- Yeah, I think I've
sort of made this joke
in one of our prior sessions, but like,
let's keep this market
a secret between this,
amongst us in this group,
because relative to the number of targets,
the level of competition
chasing after these deals
represents tremendous opportunity
to those that are pursuing the ETA path
vis-a-vis say what I would describe
as the opposite dynamic that exists
in mid market or upper middle market,
private equity, where, you know,
you've got a finite number of targets
and a tremendous amount
of capital and buyers
chasing after that finite pool of targets.
Really the opposite dynamic
is just in this part of the market.
You know, the breakdown
between the different models
that we talked about, you
know, earlier in ETA 101,
sort of this self-funded approach
versus a traditional search fund
versus partnering with
a private equity fund
like NextGen.
You know, I don't know
that the exact breakdown,
but suffice it to say is that
there's a broad enough universe
of these opportunities,
that the models don't very
often bump into each other.
And that tends to be a good
thing for participants,
whether you're pursuing
a self-funded acquisition
or one through a search
fund, or one in a, you know,
sponsored or private
equity backed setting.
- Sticking with sort of the data topic
for one more question here.
First of all, how do you, or do you,
look to compare the target that
you're working on to other,
you know, clearly other
businesses within the industry?
Can you find good data?
I mean, there's this end of the market.
Is there good enough data
that you can do meaningful
relative comparisons?
And how much of a role does that play,
you know, as you're
evaluating a potential target.
- Yeah.
Like my answer to the information
that you're trying to
extract from the company,
I would say a very similar response
to that across the market, right.
It's imperfect, right?
So, it's not like you can subscribe
to a research resource
and get all of the company's
public filings, right?
These aren't publicly traded companies
that have to disclose a
certain amount of information
every quarter, right.
And typically business owners
are quite secretive about,
you know, because they don't
have disclosure requirements,
they are quite secretive about, you know,
things like revenue and
margins and earnings levels
and even employee counts
and that sort of thing.
So you have to do a lot of digging
and you have to do a lot
of primary research, right?
You have to find industry river guides
and you have to attend trade shows
back when people used
to do that in person.
Now sort of figuring out
this new normal, right.
But I think it's, it's
really kind of scrappy
and boots on the ground
and having conversations
with industry experts
and navigating that way.
Now, there are some research
resources that report on,
and I know we're gonna
talk a little bit later
in this about, you know, market valuations
and that sort of thing.
You know, there are some
groups that are out there
that report on transaction multiples
and that sort of thing.
But, information on a
comp set, if you will,
for a target you might
be looking to acquire
that generates 20 million in revenue
and four million in annual EBITDA,
you're probably not gonna get a ton of
just readily available
information on it's comp set
to evaluate if that's a good margin level
or a bad margin level for that industry.
Or if that level of, you know,
the level of customer concentration
that exists in that business is normal
and to be expected, or, you know,
you should be scared
of, that sort of thing.
It's really hard, and
I think it's gonna come
from a lot of hard work and scrappiness
and boots on the ground
and primary research
to get at some of that information
as you're evaluating potential acquisition
of one of these businesses.
- Right, makes a lotta sense.
It's a great segue.
I wanna move out and talk about valuation
and valuation considerations.
And maybe we could start by,
and the question that
came in also talks about
how do you think about valuation
in the context of COVID-19
and what we've been through over the last,
you know, six months or so?
So let's start there.
Kind of maybe take us
through sort of pre-COVID,
kind of what you saw valuation.
I know, you know, it's hard
to make generalizations,
but if you could just sort
of help us understand.
And then how are you
thinking about valuation
in the context of a COVID world?
- Yeah, I mean, I think
that pre-COVID, you know,
the market for these smaller businesses,
and let's describe them as
being two to five million
in annual EBITDA, plus or minus,
maybe down to one million in EBITDA
and up to seven million in EBITDA.
I think for good business
models, you know,
you've seen those assets
historically trade.
If it's the first sort
of institutional capital,
I'll use air quotes for
institutional capital,
but it's the first sort of capital event
for a privately held
family owned and operated
type of business,
You know, those businesses
have historically traded
at four to six times TTM EBITDA
and give or take, right.
And it's very industry specific.
It's very business model specific.
That's kind of the zone.
And if you think about that zone,
and let's just use for a minute,
EBITDA is proxy for free
cash flow, you know,
before leverage, you're
effectively buying that business
at, you know, at those multiples
at 17 to 25% un-levered
free cash flow yield,
which is pretty darn interesting, right?
And then you apply some leverage
likely in the capital
structure and you, you know,
and that's just to keep holding.
It doesn't grow, so you
assume a little bit of growth.
And then if you're lucky
enough to realize some,
you know, multiple expansion
from where you bought it
to where you ultimately sold it,
all of a sudden you've generated
a really interesting return.
So there's a nice, what I would argue,
a really attractive risk
adjusted return opportunity
in this type of model,
and at those valuations.
Now in this environment that we're in,
things have changed.
I think that, you know,
availability of
third-party debt financing,
it used to be pretty readily available
for these types of businesses,
is not what it was kind of
pre, you know, March of 2020.
So that's gonna have an influence
on what you can ultimately,
the capital that you can come up with
to finance these deals, and ultimately
the competitiveness around
a potential acquisition.
I think that good businesses
that have performed,
you know, in line with how
they were performing pre-COVID,
are probably still, and
we've seen anecdotally,
I think the data is
still a little bit early
to draw any conclusions around this.
But we see, you know, pretty
well in line with that zone.
And in some cases, COVID has
benefited some business models
and they're sort of
commanding a higher valuation
than sort of that range, right.
And the businesses that
have really suffered,
I think it's too early to tell, right?
I mean, you're dealing with a situation
where understanding the
new earnings profile
of that business is gonna be tricky.
Evaluating a TCM period
may not be representative
of how this business
over long periods of time
is actually going to perform.
You know, what does that
do to the purchase multiple
that should be applied to those
or any historical earnings streams?
I think that's still all a
little bit to be determined.
And for me to share anything
insightful on this call
would really be too early and anecdotal.
What we're kind of seeing
and doing at our firm,
which is not sort of yet comprehensive
or illustrative of kinda what's going on
in the broader market.
- Yeah, got it.
How is, I mean, I assume
transaction activity
has likely slowed down.
I, in other areas of
markets that I studied
I've definitely seen, you
know, grind to a halt.
But it seems like it's starting
to slowly come back online here.
What's your experience in
your end of the market?
- Yeah, Joe.
I don't know that I'd
see it any differently
than how you categorized it
for other parts of the market.
I think that, you know, in April and May,
business owners, would-be sellers,
and potential buyers alike
just kind of were a little
bit shocked, you know.
And so when that happens,
I think that, you know,
it creates real large bid ask spreads
and nothing really gets done.
I think you've seen that
cool off a little bit.
At our firm, we just closed
an investment two weeks ago.
The business has been
performing extremely well
throughout the recent sort
of turmoil and pandemic.
And, you know, and we were
able to come to an agreement
around, you know, price and structure
and all those sorts of things.
So deals are happening.
And I would say that it's
definitely coming back
in a way relative to kind of April and May
is encouraging and positive.
I would say that it's still
not back at the levels
that it was in, you know,
late 2019 or this timeframe
compared to the same period in 2019.
But it definitely is coming
up from that period in time
where buyers and sellers
alike were just sorta shocked
and wanted to pause
and evaluate, you know,
what was going on.
- Well, let's just hope the
rest of this year is less,
you know, less eventful than
the first eight months or so.
Be helpful for us all. I think.
What do you do in the context of COVID
in terms of, you know,
how would you suggest
working with an owner
that maybe doesn't fully understand
the impact of COVID on the business?
Are there strategies to deal with
looking past COVID and
getting an understanding
of how this business might perform
in sort of this new environment?
Any thoughts there?
- Yeah, the two words that come to mind
are patience and empathy (laughing).
Honestly, (laughing)
these are not underwriting words, right?
I think these are just, you know,
in some business models that have really
taken a hit during this time,
I think it's gonna take a little time
to figure out how they're gonna recover,
if they're gonna recover, right.
And as a buyer, I think you
need to be patient about that.
And you might use...
Though this is a different
type of situation
that we're living through
than what sort of
happened in 2008 and 2009,
I always encourage people to look
at companies' financial performance
over long periods of time.
And if you can get that
data from 2008, 2009,
you know, you might find that a business
is quite resilient during
an economic downturn.
Now, this is a whole different situation
that we're dealing with right now,
but that might be a good data point
for you to understand, you know,
and being empathetic to
the business owner that,
you know, may have gone from three million
in TTM EBITDA and now is like looking
at two million in EBITDA.
They believe that their business was worth
six times that TTM number.
And you believe it's worth
four times, you know,
the new TTM EBITDA number.
That's gonna result in a bid ask spread.
And that's not to say that
you as the buyer are right
or the seller is right, right?
It's just, I think it's being empathetic
of the other person's situation,
being patient about it.
And following, you know,
following the numbers
and the performance pretty darn closely.
Again, monthly is better than quarterly
is better than annual.
So really understanding
how that business performs
during periods like this and
during this specific period,
and then trying to
understand what the KPIs are,
what the leading indicators
are for, you know,
how is this business going to perform
as we hopefully get into the,
you know, a recovery period.
Now I would say that those KPIs
should not be broad
industry specific KPIs,
but rather what are the very specific
to that particular asset
or that particular business
KPIs that are gonna give you visibility
into what the next six, 12, 18, 24 months
of financial performance are
going to be for that business.
- Got it.
A question from Christopher,
"Based on a five-year exit strategy,
"what are the industry standard
"multiple on invested capital
that you're expecting,
"or that you expect?"
Walk us through some of those,
you know, standard valuation
metrics, if you can please.
- Yeah, well, every buyer has
a different cost of capital.
So, you know, but that
said, I'll kind of zoom off,
zoom out and maybe talk
about it in, you know,
kinda more generalities.
I think that for the risk that is inherent
in this type of investing, which is,
I would put in the category of more risky
than mid market or upper middle market,
private equity leveraged
buyout type investing.
But decidedly less risky than, you know,
new venture investing.
You know, I like to describe
it as a risk adjusted approach
toward entrepreneurship
'cause you're buying an existing business
with existing assets
and existing customers
and existing employees.
And although all of those great things
represent risk mitigants.
But you know, a long winded way of saying,
I think that, you know,
over a five-year period,
if you were to be able to underwrite
to somewhere in a three
to four times multiple
on invested capital at the asset level,
I think that's a pretty interesting,
you know, risk level of
risk adjusted return.
You know, again, there's
multiple data points
in my answer here,
but a lot of them go way better than that.
And a lot of them, unfortunately,
don't go that well,
or don't even return, you know,
one times invested capital.
And that's obviously not a good situation
for anyone to be in.
But you know, that's sort of the zone
that I would think about
as an appropriate level
of risk adjusted return
or MOIC over over a
five-year holding period.
- Very helpful. Thank you.
Another question that came in,
I think I probably know
the answer to this.
"How do sellers who might be interested
"in selling their business
"approach a governing body or council
"that helps them certify
it to be attractive
"for an acquisition?"
Or, I guess, at this end of the market,
do businesses certify?
Are there ways to do that?
My thought is probably not too many
given the size of the businesses
that you're looking at,
but you know, I might be wrong.
- Yeah, what we have seen
occasionally and not often,
so very occasionally, is a business owner
that is thinking ahead,
thinking proactively
about selling their business,
whether they've engaged an
intermediary, an investment bank,
or a broker to assist in that process,
do a proactive quality of earnings,
such that, you know, when a
prospective buyer comes along
like us and says, well,
we need to take a look at the
financial of the business.
It's in order, and we sort
of say, okay, gosh, well,
this has not been done proactively.
And the numbers are cleaner
relative to, you know,
the hundred other assets
that we've sort of looked at
in this, you know, space
or related to this company
and that represents a risk mitigant
in the eyes of a potential buyer, right?
So you have seen, I would
say more and more sellers,
small business owners proactively engaging
the services of an accounting firm,
And it's probably not a Big Four,
the price tag associated with Big Four
usually is incongruent to the size
of these businesses, right?
But it's a mid market accounting firm
that you would proactively
engage as a business owner
to make sure that your
sort of books are in order,
and that it's in a form that
is going to be digestible
and viewed as something that a buyer
can get their arms around proactively
instead of waiting for
those tough questions
that come from all of
you as smart Booth grads
that are gonna be
digging into the numbers.
- Got it.
One more question on valuation
before we switch to sort of
structuring and thoughts there.
What are some of the
things a business can do,
or in your experience that
you've seen businesses do
both poorly in terms of valuation,
like some things that have been missed
that can significantly affect valuation
on the negative side,
versus are there some things
that businesses can do
that are high return
in terms of fairly easy things
that really helped increase the valuation?
Maybe that's too general of a question,
but just wondering your thoughts.
- Let's see where it goes.
I mean, I'm gonna reference something
we talked about earlier,
which is, you know,
we looked at that scorecard
through the eyes of a buyer, right?
That's really the perspective
that we're taking in this chat.
But through the eyes of the seller,
think about those things
that are gonna be most
attractive to the buyer,
potential buyer of your business
that is gonna make your asset irresistible
relative to the
alternatives for their time,
attention, and capital ultimately, right?
So things like, you
know, trying to mitigate
for customer concentration
and drive, you know,
repeat and ideally recurrence
and contractual recurrence
in your revenue streams, and, you know,
illustrate through the financials,
the existence of operating
leverage in your business, right.
And creating something
that's special and unique
and defensible, and
offers a compelling ROI
to the customers that ultimately use
your products or services relative
to your competitive
kind of peer set, right.
Building out a bench, right,
at a depth of the organization
behind that key man or woman
that has been responsible for founding
and the growth and
scaling of that business,
so that a buyer use that as a company
that's got some bench strength, right?
And that it's a real organization,
and it doesn't have key
man or key woman risk,
as they think about inserting themselves
into that business as
the new owner operator
of that company.
I mean, those are basically
taking the scorecard
and flipping the perspective on it
and saying, well, listen,
as a business owner,
you wanna make sure that you're...
And you're never gonna
check all the boxes, right?
No business is ever perfect,
especially in this part of the market.
But trying to do the things that you know,
that are gonna make your
business irresistible
relative to the alternatives
where, you know,
time and capital can be invested
from a buyer standpoint.
- And do you get, when you're
looking at businesses then,
just to kinda turn it around
back to the buyer and
the acquisition side,
do you sort of think about and identify,
and clearly this probably
goes into the, you know,
sort of the post-transaction
potential of these companies.
What are some of the key things
that the business owners have missed
that you could come in and
quickly and efficiently
bring online to drive value
creation very early on?
Is that part of the acquisition plan?
- Yeah, I mean, that's, you know,
that's like the couple of pages
in the investment memo around, you know,
value creation levers
that might be available
to the new owner, right.
Sometimes we're naive enough as buyers
to sort of categorize
those as low hanging fruit,
as if like a really savvy business owner
that's been operating in this industry
for 30 years as I'm like,
identify the low hanging fruit.
(both laughing)
Right, so it's a very
naive sort of exercise,
but have to listen.
The reality is, is these
businesses aren't perfect.
They're not totally efficient.
And so, yeah, critical, Joe,
to an investment thesis is,
okay, well like we've bought something
that hopefully is healthy
and has a history of profitability
and growth and stability.
And first order of business,
and we've talked about this before,
First order of business is
I'm gonna buy this thing
and not screw up what
like has been working
for years and often decades.
But then, as we settle in
to being the new owner
operator of this company,
what are those value creation levers
that we might have available to us?
And it's gonna be different from asset A
to asset B to asset C, you know.
The one might, you know,
have an opportunity
to really build out and commercialize
sales, marketing, and BD function, right.
You know, one might have an opportunity
to take a blueprint
that they've proven out
in a particular geography.
Maybe it's a footprint business
and we need to evaluate,
okay, how difficult would it be for us
as the buyer of that business
to take that blueprint,
maybe make some improvements
on the margin to it,
but very likely we're buying
from a shrewd operator
that's been in the industry for awhile.
How easy is it gonna be for
us to take that blueprint
and apply it to a
potentially new geography
or a tangential customer segment?
Yeah, those all for sure,
you're gonna wanna be
thinking about as you're
making this investment,
because that effectively
becomes your 100-day action plan,
and your first year operating plan,
and really the plan that probably guides
your activities and your priorities
and the way that you build your team
and how you invest into systems
over the holding period of that business.
And of course, it's gonna change.
You're not gonna get it
all right, pre-acquisition.
You're gonna learn a tremendous
amount post-acquisition.
Hopefully you underestimated
how great the business is
as opposed to bought something (laughing)
that is far less attractive
than you thought it was.
But that plan is gonna change.
But you absolutely have to
have the initial framework
and your assumptions around
what those things are
that are gonna be available to you
to grow that business after you acquire.
- We actually do have one
more evaluation question
from sum-mash.
"How do you value intangibles
"that have yet to
provide material results,
"impact profitability, cashflow,
"for example, technical
innovation, patents,
"those sorts of things?"
Does that come up a lot?
- Not as much as you think.
And you know, it's very difficult work.
We're now getting into a zone
that is frankly way above my pay grade.
It becomes sort of
venture capital investing
so that how do you put
value on a technology,
or an idea or a system
that is yet to be fully
commercialized or monetized?
And that's a topic for another session
that I have no business leading, right?
So really I...
It's tough in ETA-style investing
to ascribe a meaningful
amount of value back.
It's just a model that's not well set up
to really pay for frankly,
pay a lot for those types
of intellectual properties
or systems or technologies
that have yet to be commercialized.
Listen, if you're gonna acquire 'em
and you believe there's value in them,
and that it compels you
to pay incrementally more
for that business, because
you have a unique skillset
or an ability to vet whether or not
that is a very unique and valuable piece
of intellectual property, then great.
I mean, all the power to you.
Again, I think about things
through the lens of risk,
and if that is something
that you're going to pay
a meaningful amount of purchase price
or sale consideration for,
and it's yet to bear fruit
or produce economic
results associated with it,
that to me jumps out as like a a big risk
in the purchase price and structure.
- Got it.
That's helpful.
We've got about 10 minutes left,
so let's get to the final portion
of what we wanna discuss tonight.
Sort of structuring the transaction.
Can you take, you know, I'm
sure every deal is unique,
but, you know, are there
some typical things
that you see on the structure side?
What are some of the, you know,
common structures that you see?
How does it get negotiated?
Let's kinda start general
and then we can dive down
into a couple of the other.
- Yeah, sure.
I would say, I guess at the highest level,
do what you can to keep
it simple (laughs),
because the more complexity you add
into a capital structure,
I think the more opportunity that you have
for future disagreements
between buyer and seller.
And we can talk about
sort of what I mean there.
But I think, you know, you often see
relatively straightforward
and simple structures
as it relates to the
purchase of these businesses.
So there will typically
be a component of debt,
you know, probably third-party debt,
maybe seller financing,
which I would put in the category,
seller note, I'd put that
in the category of debt,
though it's not really third-party debt.
You know, that's, again,
I'm using kind of rough numbers here,
just like the valuation
ranges that I shared with you.
Of course, there's examples
above and below this.
But, you know, that constitute
50% of the capital structure.
So think about, you know,
two million dollar EBITDA business,
bought at five times, 10 million
in total enterprise value.
You know, you might have
two, two and a half turns
of debt, you know, third-party debt
of self-financing or
some combination thereof.
So five million dollars of the total
10 million dollar sale consideration
might be in the form of debt.
The equity typically will
come from you potentially
as the investor that's going
to lead the operational charge.
It's probably gonna come
from a group of investors
that you've raised money from.
You might have some equity
in that part of the table
that is rolled equity from the seller.
Really creative and nice way
to align interests with a seller,
if that's important to
the thesis going forward,
and minimize the amount
of cash that you need
to bring to the closing table,
though, you're giving up
some of the upside, right,
in allowing the seller to roll,
typically pursue with you as the buyer
in the newly formed capital structure.
You know, and then you get into things
like earn-out and contingent payment.
You know, those I mention last
because they tend to be tricky.
They tend to be hotly negotiated,
pre-acquisition, for sure.
And then when they don't
play out according to plan,
meaning they're not paid
out from buyer to seller,
they often result in disputes
and sometimes litigious disputes.
And that's no fun for anyone.
So again, I go back to
like keeping it simple.
I think that some of those earn-out,
and some of that creative structuring,
contingent payment and that sort of stuff
becomes an effective tool
when you're trying to creatively
get to yes with a seller.
You know, if they just believed
that their businesses were,
you know, you arrive at
the same TTM EBITDA number.
You figured out, you
know, kind of what that is
and buyer and seller agree on that,
but they believe their
business is worth six times
and you believe it's worth five, right.
You know, we've seen,
earn-outs be effective
in those types of situations
that sort of say, okay, listen,
if the business continues to perform,
or it hits hurdle X,
Y, or Z in the future,
we'd be happy to pay you that
additional turn of EBITDA.
But, you know, in the
event that it doesn't,
we have to have some downside protection
on our purchase price.
And so creatively coming
up with an arrangement
to bridge the bid ask spread
between buyer and seller,
you can use tools like that,
and they are used in
this part of the market.
- That's really interesting.
Are there any specific structural aspects
that you would just say avoid full stop?
Like we would never do this.
We've never seen it work out.
Anything like that?
- Yeah, I guess I don't
have a good example there.
I mean, it's, probably my
guidance on that would be,
be really honest with yourself
about the facts and circumstances
around those contingent
future payments and earn-outs,
because they can get
really contentious, right?
Like if you've taken operational control
of a business and you've got an earn-out
that's tied to a future 12 months,
24 months down the road EBITDA target,
you can see how there might be a dispute
between buyer and seller around well,
if you had operational
control of the business,
you did X, Y, and Z.
And I would've never done
that with my business,
or I've would never have
invested into that system
and drove down sort of EBITA
in the short term, right.
It gets really tricky.
So I think that the biggest mistake
I see people making in
this part of the market
is thinking too naively
about the use of earn-outs
and how they can solve all
gaps between buyer and seller
without thinking through the
potential future implications
around, okay, what if things don't go
exactly according to plan
because they very rarely,
never go exactly according to plan.
Either it goes better or worse than plan.
- Sure.
One quick question here.
"What is the maximum
leverage EBITDA multiple
"that you believe is prudent?
Do you have sort of a, this is,
I wouldn't go any higher than this
or does it just really deal dependent?
- Yeah, I don't have a
hard and fast rule on that.
I think that typically
given the risk profile
associated with these businesses,
vis-a-vis their, you know, 10, 20,
50 million dollar EBITDA counterparts
that are just larger organizations
inherently less risky,
I would say favor a capital structure
in this part of the market
that is more conservative
than some of the, what I would categorize
as aggressive use of
leverage capital structures
that you see upmarket.
So be conservative.
You're gonna probably benefit.
You might, in an upside scenario,
trade a little bit of your return
or your IRR by not pushing
it on the leverage.
But in the scenario where
it's tight (laughing),
you're gonna want that breathing room,
and the room in the covenants,
and the room in the free cashflow
to make the investments and
the operational flexibility
that you really need in
these small businesses.
- Great.
So just a couple of final minutes here.
If you wouldn't mind, take
us through a structure
that you've done or you've seen
that you've just thought
was really interesting
or that really worked out well.
Give us an example of
something you've done
where you've been really
pleased with how it turned out.
- Yeah, so absolutely.
So a four million dollar EBITDA business
bought at just above five times.
Let's, for simplicity's sake,
let's call it five times.
About 50% or, you know, 10 million dollars
of the 20 million enterprise value
came in the form of a third-party note,
senior secured financing on top of that.
Again, included in that 10 million dollars
of debt financing was a
piece of seller financing.
Typically that's a very
attractively priced
covenant-free piece of
paper that, you know,
sits subordinated in the capital structure
to your sorta senior secured.
That's a nice little component of debt,
And it tends to have
some of the added benefit
of aligning interests with
seller post-acquisition.
And then on the equity side of the ledger,
all of the capital went in
as a participating preferred
equity security alongside pari passu
some rolled seller
equity rollover as well.
And the cool thing about
that seller equity rollover
was that we were able to,
by painting a picture,
and not an unreasonable
picture of what future existed
ahead of this business
under the partnership,
and it's a continued partnership
with the selling principal shareholder
operationally going forward,
that rolled equity component
that is a minority equity
position in the capital structure
was going to be worth a
meaningful amount, right?
So you'd sometimes characterize this
as a second bite at the apple, right,
for a selling shareholder.
And he got a really nice
alignment of interests
around growth and that seller,
former principal
shareholder, former operator,
I'm supporting you as the operator
and your investor group
in the continued growth
'cause they're participating
in it economically.
And that was and continues
to be a situation
that represents a lot of alignment.
You know, it's relatively simple
in the sense that there
aren't a whole bunch
of different contingent
payments or earn-outs
with tiers and hurdles
and confusion around,
did we hit 'em and did we
not, and that sort of thing.
So I guess that would be an example
that I would reference
this one that, you know,
we've had some success in.
- Very interesting.
Thank you for taking us through that.
We've reached time.
It's been a fast hour.
Thank you as always for agreeing
to chat with us here tonight.
I really appreciate your input.
Once again, I wanna thank everybody
that's joined us this evening.
And remember we will have
at least one additional
webinar in this series.
The next one we'll invite one of the
entrepreneurs-in-residence
from Brian's firm
to share some of their experience
with us and go from there.
So again, Brian, thank you so much.
Really appreciate the time this evening.
It's been wonderful as always.
And look forward to chatting
with you again soon.
And thanks everyone for joining.
- I enjoyed it. Thank you.
- Take care.
