Buying Carve-outs for Future Exits

23:32Those corporate allocations coming off the P &L immediately make the business profitable, not to mention other things that we do. A business that looks unprofitable within the corporation can, in fact, be profitable on day one outside the corporation. Is that a lot of your consideration around how you model that out? I'm curious too, in addition, how accurate did you end up with this carve-out-based pro forma versus what your actual numbers ended up? We go to great lengths to put together a pro forma before we buy the business and make sure that in a worst-case scenario, it's still going to be something that we can live with and that we're somewhat happy with.

24:09But there's still risk. There's still uncertainty. And you never know until you're in it. So there is a moment, Matthew and I talk about this moment, when you're about to close and you're about to wire a large amount of money, millions of dollars, you have to be just a little bit crazy or a real believer that you are going to be successful. Joe, don't you remember walking across the street? Because our bank was across the street on 57th Street. We're like, okay, let's go down and wire the money. So Joe and I go down there. We show up at the bank. Literally, at the time, it was a retail bank. We're like, hi, we're here to wire a few million dollars to somebody.

24:41And they're like, what? Oh, come over here. Sit down. So we sit there and we do this, like, how many numbers are on this wire? And so we do the wire and Joe is looking at me and he's like, are you sure you want to do this? This isn't just vacation money. This is real money. And ultimately, we're like, we've done the numbers and this is going to be OK. Of course, we have to come home and in my case, tell my wife and watch the blood drain from her face. She realizes that here we go again. Thus far, it's worked out OK. Was there a big difference between what you model out in your best case scenario to what your actuals were?

25:16I would say that in all of the deals we've done, the modeling we did proved to be very accurate for the first year or two. So there was never a misrepresentation of what the business was. And most of what we modeled would have been very minimal revenue enhancement in the first year, but some realistic cost reduction. And all of those things proved to be true. In one of our deals, we had some representations from the selling entity, Joe, that revenue per contract, per binding contract would rise. We looked at those contracts, looked like it was going to be true, bought the company and proved to be true.

25:56For people doing R-sized deals, you have to stop at 10 contracts. We had one company that we bought that had 2 ,400 contracts. You could go on forever. You could go on down that list forever. But once you've looked at the top 25 and they're all solid, the other 2 ,175 are going to be fine. But you've got to be a little bit brave to say, I've looked at the 25 biggest. It looks good. That's what counts. On the carve-out, are there any other challenges or big things to look at when working on the buy side of a carve-out? I would... So let me answer first. As we did more, we paid more attention to cash flow and working capital and true ups.

26:38Because when somebody says to you, this is going to be an$11.5 million transaction, you have to think through all of the networking capital and changes in networking capital, because that can, depending on the business, vary radically from quarter to quarter. and we've gotten better at thinking of the number above the headline price, which is term 1.1 in the contract. When you run down through it, there's a lot of other numbers that you have to think through to do with working capital, balance sheet, and adjustments. Get into those details, make sure you know what you're ultimately committing to in regards to those adjustments.

27:18Or the headline price is one, it's the most important aspect, financial aspect of the deal, But there are many other financial aspects of the deal, including the networking capital, true ups, balance sheet items, financing, and so on. It's not just the headline purchase price. And in some cases, even closing transactional costs can be significant. We're very careful and we have help to make sure that we can do it carefully but inexpensively. But we've seen others do M &A activity where those transactional costs can be very high. I feel like if this is your first deal, you just don't know better and you're going to get taken for a ride.

27:54If you're a first-time acquirer, how do you prevent yourself from running into those problems? You have to surround yourself with people who have done it before and can help you avoid some mistakes. We chose not to hire a big law firm, even on our first transaction, because I knew that I would start yelling at them very quickly because I'd get frustrated because they'd say, on the matter of patents. We'll bring the patent team in and they'll talk to the IP team, which will talk to the labor team. And this would drive me crazy. So we happened to find an attorney who had been in a very large prestigious firm who was just like us.

28:33He set out with his own stall to help people like us buy assets from big companies and doing these. He was like a guerrilla attorney. He would run in there amongst the opposite team and they'd all fall over dead without even realizing he'd work them over. He was fantastic because he was one of them, but they didn't realize he was one of them, but he was on our side of the table. So you've got to have a good lawyer and you've got to have a busy lawyer, a lawyer that doesn't need your hours to make his number. He's already busy. It doesn't matter whether he's billing you or he's billing clients six or seven.

29:06You don't want a guy who's like, I got a few more hours for you. And he's just filling his hours full of the nonsense he could think up to do for you. I like that tip a lot. I take that in my book here. Look, on the other side, we've for the companies that we've bought, the seller has always had outside counsel, never inside counsel. It's always outside counsel. They're all the obvious people, the most famous law firms, and there's squads of them. They come in, they're like mushrooms. You deal with five of them, there's five more of them. They're just hundreds of thousands of dollars. They're just running the clock.

29:37We don't have anything to do with that. So on a transaction cost, our cost might be$75 ,000. Their cost might be$675 ,000. Because you see it all in the 8594. At the end of the day, you see your deal transaction costs. They see yours, you see theirs. You're like, holy mackerel, you found that selling the business. It's crazy. Great tips on managing a carve-out. In terms of the businesses you acquired and your approach in creating value. I'm sure so much of this is around your leadership style, your operating model that you bring to these businesses to create value. How has that evolved over company to company in terms of what drives success for you?

30:21One of the things that we do is we put a lot of thought and effort and time and money into growing sales. In a big company, sometimes a small division will just, as I said earlier, gets swept in the corner and doesn't necessarily get the sales and marketing supported needs. And so when you focus on that and you reinvest in the sales process, you can get good results. Simultaneously, as you gather from our conversation, we're very sensitive to costs and making sure that wherever costs can be trimmed or things can be done in a more efficient way, we do it. Almost everything we'll do will have to do with raising revenue and cutting costs.

30:56I don't want to scare your listeners, But do you remember, Joe, we had the I mean, I will scare the listeners. But do you remember, Joe, we used to have these policies where it was like two point five star hotels. Right. Or is it three star hotels? I would fly and I would stay in a Motel 6 just to make the point, just to make the point to the other staff that Joe's typically the CEO. I'm typically the president just to make the point that when I travel, I stay in a Motel 6. So don't come to us and ask to stay in an Intercontinental because I'm staying in a Motel 6. So we're very frugal and we have to eat our own dog food.

31:31Do you remember the hotel we stayed at in New Orleans where there's basically there was a bit of murder? It was one of those motels with the pool and there was a murder like three doors down. It was taped up with police tape. There were roaches in the hotel. You don't have to go that far. I will say that as I've gotten older, the hotels have maybe crept up a little bit. Yeah, I don't see it. I don't stay in the hotel. The point you're making is valid that we are very sensitive to cost, travel costs. cost of operating the business and we live it. It's not like we're traveling business class and everyone else is traveling coach.

32:03No, we're careful in how we run our businesses. And I think it's paid off. It's a discipline. And I like how you said it from the beginning. I think it makes it well-earned for the long run in terms of as you grow. People respect you if you're prepared to stay in that Motel 6 and you bring donuts to the introductory staff meeting. You're setting the expectation that I'm not Nero piddling around while you employees work. I'm in there with you. We're going to make this work together. We're facilitators, financiers, planners. It's not them and us. We're there with you. We're traveling the same way you are.

32:38Now in the world after COVID, people are remote and people don't need to have an office for the same reasons they used to. But when we have bought our businesses, we've always had a very modest office because we didn't really have clients coming to that office anyway. As long as it was clean and it was safe, it didn't matter if we had a view of a brick wall or others might want a view of Central Park here in New York City. But it didn't seem like a good use of our money. So add color to that. So our first office, we had a music executive to record labels. He had all of his colleagues walk out.

33:09And so he had three offices to rent and he was in the back corner. We moved in. So there was a music executive in the back corner. and you remember the carpet was so bad, Joe, so bad that when we left that office and upgraded, we cut the piece out, we had it mounted in a frame and we put that on our wall. And when people would come in, we would say, there's the carpet from our first acquisition. Look how disgusting it is because we prefer to put money into the business than spend it on the carpet. I like it. The best thing is when people ask, is that some new avant-garde artwork? when they came to our office.

33:47And we say, no, that is carpet. That's a piece of the carpet from our first office. Yeah, I would have went with the artwork. No, these are great examples in terms of your operating approach, the focus on revenue. Think of it as an entrepreneur, like you've done it, you've bought this business. You're the boss, you're the boss. You give orders, people take those orders. It's incredible. Let's go out and buy myself a beautiful recliner and sit at an enormous desk. It's like, no, no, no, no, no, no, no. Go buy a plastic table from Staples, sit down and get to work. Don't do any of that nonsense.

34:21Yeah, no, I agree. I think it's a good discipline to have at the beginning because then you'll inherit a lot more value in the long run. And like you mentioned, you can ease up over time, get upgraded. A little bit. A little bit. When you see the returns coming back, what about the time to exit? How do you determine the right time to exit? The best time to exit is when someone comes and approaches you and says, we want to buy your business. However, I have an internal time clock. Matthew will tell you about it. Basically, when we buy the business and the day we close, Joe puts the date five years into the future.

34:51And it's like, we will have sold by this day, the fifth anniversary. We go in there and from day two and day three, can we sell the business? Can we sell the business? We're not really going to sell the business, but Joe is always interested in selling and I'm never interested in selling. And so we fight it out. We do always know that the five-year clock is coming and we need to exit on or by the fifth year. Because by that time, as entrepreneurs, you've done whatever you can do. Again, is that you can grow a business from two to$10 million and maybe you can convince yourself you're the right team to go from 10 to 20, but there's probably a better team who can take it to the next level.

35:28If you haven't done it in five years, let's reset and do what we do again for another five years in a different organization. But it's important that when the time comes to sell the business as healthy, that it's growing. that it's profitable, and the machine is well-oiled. Yeah. You mentioned earlier, Joe, that when somebody approaches you, can you contrast that between working with an investment bank? Have you looked at creating that competitive process? We have hired investment bankers to do a running process and effective and well-run. In a perfect world, someone comes and approaches you, but more likely and more often for us, we have engaged the banker.

36:06We've made a list of the potential acquirers. We put together a sim and prepare the management team. And it's, as you know, a disciplined process that works. Why is one better than the other? To have a buyer approach you and have more of a proprietary process as opposed to running a competitive process through an investment bank? Carrying a competent outside bank will guarantee that you expose the opportunity to all relevant, appropriate buyers. You may not like what you get. You may not like the response you get, but you will have covered the market. If you choose to do something in a private way, somebody approaches you, you never quite know how the market would speak.

36:46Whereas if you go out wide using a bank that has contacts in the particular sector, sector prices the deal for you. So you prefer the bank process, it sounds like, Matthew. I prefer the bank process as a seller, yes. Unless I'm very sure that the list of the buyers is very small and I know them all. Joe, on the other hand, prefers the source by the buyer process. Well, yeah. I mean, when a buyer comes and approaches you and you know by comparison, by looking at comps and other deals that have happened, that you're being offered very healthy price can be quick and simple. Because the process with an investment banker has not been quick for us.

37:23When we hire a banker, it sometimes can be a prolonged process. Never goes as quickly as you think. Never. Yeah. You have this marketing phase and prep before the marketing phase. and I could see it overall being a lengthier process. Do you feel it's easier on a proprietary deal or the buyer source that it's just easier and we can mutually agree on our timelines and be more amicable in how we work together versus the bank process or the other things that are different? It's hard to say which is easier, which is quicker, I already spoke about, but which is easier, I think it varies. I hate bank run processes, I really do, because they're going to start talking about PowerPoints And as soon as somebody mentions the word PowerPoint, I get hives all over my skin.

38:04I gave up PowerPoints in the 1980s. I'm not doing any PowerPoint slide, but they do this deck and it's got 100 slides and it drives me crazy. Ideally, you would sell to a knowledgeable, informed person that's already in your business because they could quickly deliver you the value because they're knowledgeable. But some businesses, the pool of potential buyers is extremely wide. strategic buyers, investment buyers, left of center buyers, and you do have to engage a bank. But I'm allergic to large companies. So I do get the highs very easily. But luckily, Joe... I don't mind a slide deck. I agree.

38:41If it's 100 slides, it's painful. And who pays attention? But if it's 10 slides, I can get through 10 slides and there's real value there. Yeah. Again, if anybody ever says the word Merry Mecco to me, you probably have to put me in a asylum because I did so much of that stuff in my 20s when we were doing strategic stuff for Bain or a growth share matrix. I'm probably going to have some kind of fit. Overall, it sounds like you're open to the direct inquiries, but as timelines get near, you're more likely to engage with an investment bank to sell a business. That's well said. Can we talk through lessons learned during the exits you've gone through?

39:19What were the key lessons? Well, one of the biggest lessons is don't miss your numbers. When you go through that exercise with an investment bank and you put together your sim and you put together your projections, you better make sure that those projections are realistic and that you're going to hit them. Yeah, absolutely. If you miss those numbers, there's a direct impact to the purchase price. Isn't that what the bankers do? Pull out lipstick on the pig? Isn't that... Yeah, they want you to show the hockey stick and it's going to be a quick sale. So the broken hockey stick, that's somebody else's problem.

39:49But we know that the sale process can take a year. And so whatever you forecast for next year, you're going to live it and you're going to have to justify it. We tend to resist hockey stickitis, right, Joe? Realistic. We want a realistic set of numbers that we can hit. Be real on the numbers. Yeah. Be realistic about your expectations is that when you start a process, by the time you sign with a bank, you should be done 365 days later. Nobody will give you that number. They will all talk about four to six months, but you may well still be working on that project 365 days later. Can't get ahead of yourself, get frustrated or annoyed.

40:29The process does take time. Sometimes you get lucky. Anything around timing? I'm always curious about it. I've heard from a family member, if you get a good offer, you should put a consideration on it. That might have been your cue to sell. I actually had an uncle that had that lucrative strategic offer, didn't do it, raised, raised, raised, ended up selling a number of years later, less than what the original preemptive offer he had from a strategic. I think there's a famous quote along those lines from Jimmy Goldsmith, who is a very successful UK-based business person who said, someone asked him, how did you get so rich?

41:03And he said, I always sold too soon. And so if you sell too late, it can be very problematic. Joe will always sell, always. And I will always want to hold. And so it's only a matter of time before Joe overwhelms me and we sell. And one of the craziest things that we saw in our experience together is an asset, a small asset that at one time had an offer north of$20 million, I think. We saw the LOI. Yep, 20 million bucks. And then the world changed and we ended up buying that for... $10 ,000. Yeah. Wow. If you don't sell when you can at the right price. You can close that deal when that money's on the table and the world changes.

41:45The tide goes out, you're left naked. Wow. That was a little bit extreme. That was real and it was true. But that is a crazy example. Anything around communications when exiting? Part of this lends to how do you choose, because a lot of times you're running a competitive process, between the different buyers. But any specifics around the approach to communications and even getting into how that can lend to knowing which buyer you should work with? Or is it just about the numbers? What's about confidence that you will close? As the buyer, we always give exceptional confidence that we will do what we say.

42:21We may not offer the price they want, but if you want to sell and you want to be certain of closure, we will close. And you look for the same thing when you exit. 100%. No point in somebody dangling something in front of our eyes with an extra zero on it. If they don't have the financing, Many people don't. If they're not actually going to close, many people aren't. If they're shopping many other deals at the same time, they'll pick another one. Confidence to close is really important. What are your clues to identify that? I think that's a radiation. That's a sense, a trust, a business sense about somebody.

42:55Also their track record. We got to a point where we bought five where people like, how can I trust you? There's an announcement, five, four, three, two, and one over the last eight years. you'll be number six. It's all very straightforward. There's also personal judgment when you look somebody in the eye and you assess whether you can trust them or not. How much of it goes to alignment on how the business is going to be operated after close and really, I guess, aligning on the strategy or vision of the deal you get into versus you hold that close and just try to negotiate terms to get the deal done?

43:33Well, we did buy one business for a founder, an elderly person who didn't have anyone who wanted to take over the business in his family. And he said that he had a higher offer from someone else, but he sold to us because he thought that we were going to do right by his business. And he knew what we intended to do. And he thought that was more important than taking more money from someone else, which I thought was interesting and kind of nice, reassuring. Is that part of the approach? You build that in this narrative of being good operators and doing what's best for the company and the people?

44:02Is that a big part of it? I think so. We have a track record of doing right by our employees and making sure that they have some ownership and that they are treated well and find working with us rewarding. Many people, when they sell a business, that's a top priority. It's how they feel about the team. Also, when you come out of a deal, everybody's got to feel good about the deal because we're not going to do one deal. So if you do one deal or you only do one deal in your life, you can create a lot of destruction and bad will amongst people. But we do many deals. So we always need everybody, the buyer, the seller, the buying bank, the selling bank.

44:37Everybody needs to talk well of us and everybody needs to speak well of us because there'll always be some connection from the next entity somehow to the old entity. So you can't have a reputation that follows you that you're a poor person morally. People know that we're straight and they know that we are value buyers. We do close quickly. That serves us well. We sleep better at night and we get more deals. That's an important part. Reputation matters. Earlier, you gave me advice first time carving out a company. As a first-time founder exiting, what's your best advice to make sure I don't screw up some things that lose a lot of value for me?

45:14As a first-time founder exiting. Yep. What are these key things I really want to negotiate? And it seems like some of it might be relevant from the buy side when you talked about these adjustments to make at closing and paying attention to those. Joe, I think that sometimes we underestimate the importance of our attorney as the third person around the deal team. He's not with us as we run the business, but the same guy that buys the business with us is there at the end and selling the business. And that person can save you from disaster when you're buying and selling a deal. And you have to listen carefully to what they say because unfortunately, they don't always agree with you.

45:53But as a first-time buyer and a first-time seller, ignoring your attorney's best advice is not a wise thing to do. If you've got the right attorney. So we go back to the same theme of luring up, make sure you got a really good lawyer you're working with. You've got to have a fantastic lawyer. You've got to interview a bunch of lawyers and you've got to find somebody that sees the world your way and not somebody who's 70 % booked and wants to use you to get towards being 100 % occupied. You want to find a lawyer who's already 100 % working flat out because that's a guy who's got a lot of clients that want to buy a lot of his hours.

46:29You want to steal some hours from that guy, not fill in an attorney's schedule who hasn't got enough clients. And again, when you negotiate, a lot of the terms are principle to principle. I'm going to buy this for$10 million. No, you're going to buy it for$11 million. Your attorney doesn't negotiate that. You negotiate that. But then you leave the room, and then they get into all of the holdbacks and indemnifications, the escrow amounts. that attorney is going to run point on several of those deals and see he has to be completely aligned with you. And you need to pick that person very carefully.

47:04Joe and I will do all principal terms, a lot of other terms that get put into that 40 page APA. Another piece of advice for someone if they're entrepreneurs who want to do what we do and find these businesses and acquire them is start small. Because the first one invariably will have some surprises and it may not go as you hoped. And you want to make sure that you don't bet the farm on the very first deal. You're wiped out. These are good examples. Are there any things that you would consider negotiating around to preventing a buyer from screwing up the business? One element I think of is retention packages for some of the key people and maybe working with them and helping them identify and negotiate those things.

47:46Is that something that's really relevant in terms of trying to preserve the business or hand it off in a good way that doesn't get screwed up by the buyer? Or do you just not put as much consideration on that? It's solely the buyer's responsibility? It's very difficult to have control over the situation once you've sold the business. If you have a strong team and they take on your team, you can be a little bit more confident. But still, there's often the us versus them when an M &A transaction occurs and some things happen that are not the way you would do them and want them to unfold. So it's difficult.

48:18And I do keep tabs on the businesses we've sold and some of the people. And sometimes it went great. Sometimes it didn't go quite as well. Even though I find that a little frustrating personally, when it doesn't go well, it was sold. So it was out of our control. You are walking on very thin ice if you are trying to tell a buyer what to do in any way once you have closed that door and sold. It's like trying to put your hand through the hinge. You know, good luck. They want to be able to call on you for advice, but they don't want to be attached to you or forced to do anything at all. And even though you might want to lean forward and protect a key resource, the way you do that is that you make sure before you close that there's some agreement that gives them protection after close, but you're effectively, we're going to have nothing to do after close.

49:05And we're going to always, we're going to reduce significantly the amount of money we're going to have to pay after close that is in any way contingent or either as a buyer or a seller, You want to reduce the amount of contingency. You just don't want the arguments after close. We sell, we move on. It's great to work with you. You're great. We move on. Then just what you're obligated to for any transition period, if you have those in the terms. Sometimes there's a three-month TSA or something like that. We also don't want to, if you've got things like earnouts, unless it's a very simple earn out, a percentage of revenue, for example, but that might work.

49:44But if you're looking at any percentage of net profits two years down the road, forget it. It's never going to work. This is going to be fuzzy math. They're not going to spend money marketing your business. They're going to merge streams of revenue together. You got to try and keep it simple. It's really good points. Joe, Matthew, what's the craziest thing you've seen in M &A? I think that transaction that I mentioned earlier where a business could have sold for $20 million and ended up going for$10 ,000. That was... You actually acquired. It is. I've seen, yeah. It really was instructive in many ways because we got to know the sellers.

50:18And to be honest, we felt sorry for them. You remember the analysis they gave about the Rolls Royce. We'll give you a hundred bucks for the Rolls Royce because the wheels have fallen off. And they took it because at the time, I think we got a call saying, we have to take an offer, so give us an offer. That was a very sobering moment because their footpath for the grace of God go we is that we buy these things. The tide can go out on us too. It was crazy to think of the difference in valuation between three years prior and when we acquired that asset. There is a humanity to this, especially when you're buying from people, not a corporation.

50:54At the end of the day, when you're buying from a multi-billion dollar corporation, if your deal closes or it doesn't close, none of the deal team care. They don't care about you. All they care about is executing the transaction and getting their next bonus, a big corporation. but these were entrepreneurs and didn't work out. And we looked at each other and if we're going to be in that situation on a deal, we're going to be in a deal where we lose money. It's a sobering thought. We've been up to bat, what, six times together, Joe, and we've lost money on a deal. You can't get annoyed. You can't punch a hole in the wall.

51:31You've just got to think, what's my RBI? is that nobody has an RBI of 0.9. It doesn't exist. You just got to go again. You got to go out and swing again. Yeah, keep the batting average up best you can. Best you can. Any other crazy stories? Did you ever want to top that, Matthew? I do not. That was pretty crazy. Along the way, Joe, we've met some very crazy people. Yes. You will recall that we almost bought a radio station? Yes, we've met people who are unethical. We couldn't close because they're in jail. Right. They're in jail. By the time we, yes. And then, yes. Actually, we met a couple of people.

52:10A couple of people selling businesses that actually went to jail a couple of months or years later. You have to kiss a lot of frogs to find a prince. We spent our time together talking about deals that we did. My goodness me, there were lots and lots and lots of deals we didn't do. All kinds of odd things. I think that we let the fish get away that we should have let swim away. You look at those as wins or just part of the process? Not buying those two businesses, the owners did end up serving in federal penitentiary. Those were good decisions. Not wins of their own. I don't think we have any regrets about deals that we didn't do that we should have done.

52:51And particularly not those when the people were unethical or of that caliber. Well, but Keith, I'm asking us to tell a story, a really crazy story. Those guys, those different businesses, we got back on the train that day. You were like, I don't know about this. This feels really weird. And yeah, it was weird. Also, you have all your gut on that. It was great. Great. Joe, Matthew, I enjoyed the conversation. I really appreciate taking the time, helping me become a better M &A scientist. Thank you for having us. We've enjoyed rustling through our memories together very much. Those of you still tuned in, thank you.

53:27Till next time, here's to the deal.

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