Expert Insights into Building an Empire through Strategic M&A (Part 2)

23:27So that's debt, or that's rollover equity, or that's seller note. And what I'm trying to design for is a two to one debt coverage ratio. So what the hell does that mean? Let's say I'm buying a company that has 500 ,000 in earnings, and that's cash earnings, low capital expenditure, we followed my model, then I want to use no more than$250 ,000 of the cash to service the debt. If the multiple the company trades for is higher than what$250 ,000 can service, I have a gap to bridge. Why do I want two to one debt coverage? First of all, that's 50 % equity in the deal. It doesn't matter if it's equity from him or her, the seller, or it's rollover, it's equity.

24:14If the company cycles down, if it loses 20 % of its revenue, 30%, I'm not scrambling to find cash to pay the loan payment. I've got two times the debt coverage that I need. So I take the total cashflow, divide it by the amount of money I need to service the debt. I'm seeking a two to one ratio. SBA will let me finance a deal at 1.2 to one with only 20 cent cushion. That's not enough. And although they'll finance it, I'm looking for two to one. What I'm really looking at is how much debt can I put on the company at a two-to-one debt coverage? As interest rates are ticking down, that's a little bit more leverage now because interest rates are lower.

24:52That money will service a higher debt. And then whatever the gap is, I want to close that gap using seller note, using seller rollover, if possible. And generally, I can. Generally, most of the kind of companies that I'm talking about buying... So again, remember I said fragmented industry because there's not enough buyers, it keeps the multiple I pay low when I'm buying the companies. And so generally between seller rollover or seller finance, seller note, and there's a thing called on standby. So a seller note on standby, it might be a 10-year note, but it's on standby for two years, the first two years.

25:26So there's no payment due during the first two years. An SBA lender will look at that and call it equity. It's not debt. And or rollover equity, their equity becomes my equity if I don't have enough money for a down payment. I've got equity because it's their equity now joining my company. And so combination of those plus the debt service coverage ratio sets me up for success in financing. And I know a lot of entrepreneurs out there think your problem is money. And that's because you don't understand money. You know plumbing or you know roofing or you know software, but you don't know money. And so there's trillions of dollars out there looking for stuff to invest in.

26:03You just have to treat money well. I have to structure it. I'm trying to solve for money. There's a lot of people I can go to if you don't have this expertise that we can work with. One buy-side advisor that I work with works with small business owners that do this. And his specialty power is he not only helps you get the company and get it under LOI and help you get through diligence, but he wants to get paid, which means he's got to help you get financed. And so he has a bunch of lenders that he works with, knows the creative ways that we can get a company financed. And he charges more of a success fee, but he earns it.

26:36Money is not your problem. Finding a good company and paying fair market value is what the problem is. But if you're trying to buy a company that trades in an industry that's 10 times... Yeah, that's what we're going to deal with in our software business here. Then you're going to need equity. I can't not create it. Or you're going to need a large rollover. So if you're a big company and they're a small software company, you may give them the 10 multiple, but they're rolling over eight turns. Yeah. You're going to get a lot less debt on it. That has to do with the free cashflow. It has to be high free cashflow conversion because I need cash to service debt.

27:08The better the cashflow, the better. The more debt you can service. Better you can do that deal. That helps a lot of how you think of those levers and how to use them. And it sounds like it varies industry by industry, depending on what your multipliers are. It does. And so that's why I was saying in the beginning is if we haven't picked an industry yet, Use my framework and you'll be fine because you'll be dealing with companies and industries that trade at low enough multiples to where you can engineer this stuff. But there are industries out there that are high multiples. Software is a good example.

27:35Multiples can be really high because a software company may have no earnings, but they have great software and it's a good potential. And that's why you see these deals and you shake your head and scratch your head and you say, why did Google pay a billion dollars for that? That made no money. And those are the software unicorns that are out there. Some industries have higher valuations than others. But the two to one debt ratios are... That's my key. That's what I'm trying to design for. So you've done a lot of deals. How have you seen the process evolve? Everything that we're talking about is buyer led at the end of the day.

28:08We're not waiting for a shiny deal to pop up and you jump on it. No. You've got a strategy we thought out, what we're doing, you're approaching it. Now, when we talk about actually, you mentioned one of the flaws that new acquirers do is they don't do enough diligence. How do you see this process evolve as you do more deals? What I've seen is you become more buyer led. You really start putting more effort on how you're going to integrate the company, how you're going to capture those synergies. What's your view on it? We can't just buy stuff. We have to be able to integrate it. Remember, we have to be able to demonstrate that we get more profitable as we get bigger.

28:41And so a piece of that is I acquire a company during diligence. I'm mapping out the differences between how they do something and I do something. And I literally, I could start with two income statements side by side, line by line, going through and saying, what do they spend on advertising? What do I spend on advertising? What do they spend on this? What do I spend on this? And what do I think is the art of the possible between them? And that creates the third column, which is either a positive synergy and negative synergy or no synergy. And I'm not mapping out what the differences are, which will drive my integration.

29:14But I need to get good at integration because buying a good company is only half the battle. Integrating it and making it a productive part of your ecosystem is the back half. And if you're good at buying but not good at integrating, you're going to stall out and have nothing but chaos. If you're good at integrating but not buying, you're going to have chaos because you bought the wrong companies. You have to get good on both sides of this. And if your volume is low, I tell you, if you're going to do a low volume of M &A, I can outsource this or I can hire a project manager. Someone has got integration experience and I can bring them in either part-time or full-time or contract basis to help me do a one-off integration.

29:58But if it's going to become a strategic part of your growth story, then I want to own the IP. I want to have a team of people that learn how to do M &A. I want them to learn and create muscle memory for my organization because I'll be able to leverage that over time to do more M &A and get better at it. And so I build my team over time. I may start, I told you, I hire a buy-side advisor. I start with an in-house business development person. A second resource I typically hire is a junior business development resource. Call it a spreadsheet jockey to work with my senior person. It's a two-person team.

30:34Third person's probably my first integration manager. Everybody's got a day job. I need someone whose sole job is to make sure companies I buy, it's seamlessly integrated and that things don't fall through the cracks. So there's a process. And after four or five years, I may go from no professionals in my company that do M &A to having six to eight people in my business that do nothing but M &A. And don't think you have to be big to do this. My first client, when I left being a CEO, had less than$2 million in EBITDA. Three short years later, we hired a VP of business development. We had buy-side advisors.

31:11We went out and got capital. I think they've finished six acquisitions so far, maybe one more, one less. He's now$15 million in EBITDA. We've now hired a banker. This company that was worth$14 million three years ago is worth$250 today. You can do this in a relatively short period of time. If he was growing organically, it'd take him 30 years to go from where he was to where he is. this is an acceleration of the story. Entrepreneurs, it starts with you believing in yourself and then recognizing that, hey, you know what? I don't know about you, but I have a lot of billionaire friends and I like them and they're smart people, but they're not God's gift to anything.

31:50So why were they so damn successful and were not? Millionaires know how to make money. Billionaires went all in somewhere along the way and stayed all in until they found a higher level of success. You look at Elon Musk as an example. And I love Elon. He's my hero because he's a guy, no matter what industry he starts, he finds massive success. You take a Bill Gates or somebody, also brilliant and successful. But one trick ponies are different than someone who's a serial entrepreneur, successful billionaire. Everything he starts turns into billions. So different animal. But when you talk to him, he doesn't come off as being the smartest guy on the planet.

32:30it. This is about working hard, understanding, having a vision and digging in and making it happen. You can make great things happen in your business. You just have to start by believing in yourself. Surround yourself with people who know a little bit about what you're trying to accomplish. Don't go alone and step in every pothole that's out there. Build a team of people, use a process and then go for it. Stop talking, start doing. Business fundamentals don't get away. You still got to work with the best people you can find. And then I think the other takeaway on the execution of all this is continuously get better at integrating, being able to capture value, increase margins, free cash flow.

33:13And then your company builds muscle memory. And so M &A is a process. That's why I kept pointing out in the last five, my last five-year run as a CEO, one company in the first year, seven companies in the next two years, 15 in the next two years after that. It's like a pump on a farm in a well. And this is Texas. So wells are 800 feet down and you're pumping that arm and you're pumping until your arm falls off and then the water starts coming. It's a process. It takes a while to build up deal flow. But once deal flow starts coming, once you learn how to do M &A and learn how to do diligence and integration, you get better.

33:51And as you're getting better at it, now all of a sudden you can do more of it. It's like a snowball rolling downhill. You'll be prepared for a slow start. That's like in any business as well. Yeah. I want to talk to you about exits. Yeah. In my mind of this conversation we're having, I'm thinking of the cartoon where the little fish, then the big fish bites, eats the little fish, and the bigger fish eats the little fish. And when we do these deals, using rollover equity is a part of it. But that, hey, after the five-year term, we're going to sell this business. to the bigger fish. And then we get a good payout at a higher multiplier and get a good success story there.

34:28And then they run that same story again. Talk me through anything I can learn from you on that because I feel like that's an area where I still have some reservations. Yeah. Using the deal room story. You built the business and get a lot of private equity firms about every month, I get about five to seven that are inquiring. But I'm getting to 20 million AR, valuation is going to be a lot higher. Maybe we just wait till then. That's going to be a two to three year path. I want to challenge myself to change the thinking on this a little bit, Adam, of, hey, maybe there's a different story. You don't have to sell your whole business where you just are left with a minority.

34:57Maybe you sell a minority piece, and then later on you sell a majority. Talk me through how you think of exits. A couple of things to unpack. Number one, you already said, if I get to a certain level, I get additional value. Where we exit, the size we are when we exit matters. And it's not just this continuum where I pick a spot and say it could be any number and it's going to be an upward trend. What I'm trying to say is there are natural exit points where you'll find a great deal of PE buyers. And if you understand the world of PE, you'll know that not all funds are the same size and people focus on lower middle market, upper middle market, et cetera.

35:35And so based on fund size, all funds last for 10 years. All funds must deploy their capital within the first six years. They must average hold periods five years. But they all invest six to 8 % of their capital in one company, no more than 12, which means big funds don't buy small companies. Big funds buy big companies, little funds buy little companies. And it's created with these dynamics, natural exit points. So I'm going to lay out a few for you. Typical exit window really starts to open at$4 million of EBITDA. And it runs up to about$7. That's where your lower level middle market PE firms start to buy and look for platform companies.

36:16Below that, people may call themselves a PE firm and they may be registered as a PE firm, but they don't have traditional funds. It's two guys who made a lot of money at KKR and then the friends and family and they got$50 million they're playing with and they call themselves a PE fund. If your company is below$4 million in earnings, you're selling to either a strategic as an add-on, or you're going to sell as a platform to a sub-PE firm that is below the threshold of where the first real firms that have funds with limited partners and raise traditional capital in a traditional manner. So four to seven is the first exit.

36:52Next exit used to be 15, but it's come down. There's not enough good stuff to buy. And so every level has been flexing down a bit. People used to buy at 15, exit at 50. People used to buy at four, exit at 15. The people who buy at 15, not enough good companies to buy, they're now looking down at 10. And so I've got a pack of buyers between 4 million and 7 million of EBITDA. Another pack of buyers at about 10 million to 17 million of EBITDA. And then it jumps up. It jumps up to about$40 million in EBITDA. People that buy at$4 million go to$15 million, exit. That's about how much they can grow a company in their typical five-year hold period when they start at$4 million of EBITDA.

37:36They get up to about$15 million, they sell. People who buy at$15 million go to$50 million. People who go to$50 million then sell to someone who goes to$100 million. And then someone at$100 million goes to$200 million, and then they go public. So there's these natural exit windows that exist. And you as an entrepreneur should have your eyes set at, I'm going to four. I'm at one, I'm going to four. I'm at two and a half, three, I'm going to go to 10. I'm at 10, I'm going to 40 is a long journey. You're going to find pools of capital looking for stuff to buy at these natural exit points. That's where I really see the multiple arbitrage happen.

38:13I get rewarded with larger multiples being paid by people. So knowing where I'm building to is important. But then there's, who am I going to sell to? I have to learn how to pick a good partner from a bad partner. And no short way to say it, you're going to have to do diligence. You're going to have to talk to people who've been CEOs, who've sold companies. I want to talk to people they've fired. I want to talk to people that are still there. And I want to learn what it's like to work with this PE firm, because they're all going to tell you how great they're going to be as a partner. And like any industry with 8 ,000 players in it, there's some good, some bad, Some got awful and some that are great.

38:47So I'm going to have to do diligence. But you mentioned something I want to touch on. Minority versus majority. The majority of private equity capital is in what's known as a buyout fund. And a buyout fund by its very charter must buy a 51 % controlling stake. They've told their limited partners, their investors, I'm going to control every company I invest in. And if you say, I want to sell a minority stake, you have just eliminated the largest pile of private equity capital on the planet. There's fewer minority investors. And therefore, there's also less money being paid. There's less competition.

39:27There's not as many of them. And they're not giving you the same multiple to buy a minority stake. But there's a trade-off. I would tell you, get comfortable thinking about life as a minority shareholder. This is capital. They're not bringing a management team. You're engaged. If you're working hard, if you pick the right partner, you're not going to notice a lot of negative aspects of working with private equity. They'll be a good partner. You'll actually enjoy having this capital and these people who can think through sophisticated financing. You'll never worry about capital again because they'll bring the capital and the debt relationships that you need to grow.

40:04Your focus will be solely on growth. When I think of minority investing, It can be done, and I know some minority firms that are out there, but you're going to get typically lower valuations. It's somewhat limiting. So for those of you out there who are concerned about being a minority shareholder, I say Elon Musk and Jeff Bezos before the divorce. Two richest people on the planet both own less than 13 % of their companies. It's okay to be a minority shareholder. If you have the right partner, your focus is still on growing and running your business. They won't be as intrusive as you think. When we pick bad partners or we pick the wrong partner, that's where it can go sideways.

40:42Or when we check out. I'm an entrepreneur, just sold my company. I got a ton of money and I'm not working very hard anymore. They want to win the championship this year. You just won a championship, but you didn't do anything for them. They need you to work harder than you've ever worked before using their capital, partnering with them, and you'll get a second bite of the apple. So if you want to do a minority sale, you can. Those people are out there. You'll give up some equity. And it'll almost be like a mezzanine lender will give you debt, lets you do a kind of a little dividend recap, take some money out, some chips off, and they'll get a percentage of ownership and your company will service the debt.

41:19If you can't service the debt, then it has to be more equity. But there are people who will do minority. Don't get me wrong. I just think if I'm a seller, be a seller. The control freak inside of me is still a kind of counter argument for you. But I'll continue that over some drinks with you sometime. I think that could be a good long conversation and be a fun, challenging one. I like how you explained that spectrum. I think you're absolutely right that the majority of the market are buyout funds, and that's who's going to pay the highest multiplier. The minority, you got to really find the right one wisely and go from there.

41:50And they'll have a minority rights agreement. You're not getting off scot-free. You're not making every decision, and they're going to have some control. So you've got the same thing. You just switched who the majority shareholder was. But the dynamic is pretty similar. The options are options. You got to weigh them. I think the big thing I've been putting a lot of consideration in is the partners. I've heard of a marriage, right? You get a bad marriage. Things could be awful. You get a great marriage. Things are great. And that private equity partnership seems to be pretty symbolic of that. Your experience, I'm sure they all haven't been pretty.

42:22Maybe on record, we all say they will be. But I know they haven't off record. What do you look for in really getting a good sense of what's going to be the good partner? Well, there's hands-on, hands-off. A hands-on meter says, so let's say you're a transitioning Fortune 500 executive that's been recruited to go run a PE-backed company. In the Fortune 500 world, you lived in a hands-on environment. You had bosses who were crawling up your shorts every day. And so you're used to being micromanaged. And for you, you might actually be more comfortable in a hands-on environment. If you've been an entrepreneur calling your own shots, you're a cowboy and you can't put a saddle on and no one's putting a saddle on you.

43:00You don't want a hands-on partner, micromanager, and this is going to go south quickly. You're looking for a firm that's more hands-off. I've worked with some firms that are hands-on and frustrated the living hell out of me. And there were times where we were cussing at each other and you're wondering, this divorce is imminent. And then we turn around and sell the company for a record payday and they give me a gold watch and we're the best buddies ever because we won. So there's the battle, and then there's the war stories that come later. And you know what? It's intense, no matter how you slice and dice it.

43:31And then I've had other PE firms where I'm looking over my shoulder. Hello, is anybody home? Do I have an owner? Is somebody back there for me to talk to? Because they're so hands-off and disconnected. So there's this spectrum, and this is called governance. How do they provide governance on their investments? What's the process? Is it going to be weekly calls? Am I going to have a framework that says every time I want to spend 50 bucks, I'm going to need some snot-nosed punk associate to sign off on it? Or am I going to be able to run my company as I have been within parameters? And I understand if I'm going to sell off major assets or buy something big, I'm going to need...

44:10There's ordinary course and there's unusual and extraordinary course. And so I'm going to have different kinds of rules. And so governance is something that an entrepreneur should spend time talking to the firm about. And again, this is like dating. and everybody's on their best behavior. And so I also tell people, if you're an entrepreneur, be on the lookout because while you're negotiating a deal, this is a four to six month process to get through diligence and get all the paperwork done. And there's going to be some stress on the way. Somewhere during that time period, the real owner is going to peek out from behind the mask in the fake arranged marriage mask, and you're going to see the ass.

44:49You're going to see the real person inside. And if the real person inside looks just like the one in the mask, you're fine. But if you see a personality that's, well, that was a red flag, you probably just got a glimpse of what life in a stressful situation with your new partner might look like. Be on the lookout. Likewise, they're looking at you. How are you going to act when the negotiation gets tough or they're trying to reprice you? How do I do my diligence? Should I be talking to other CEOs in their portfolio, what's the best way to do? I would ask them for references. I would ask them for references of portfolio companies that they've sold.

45:26So I'll talk to someone who went a full five-year flip with them and had an outcome. Full five-year flip. And then I'll say, I want to talk to some current founders who've sold to you. And I might even say, I want to talk to a founder that sold to you and you fired. And they'll be like, well, why would you want to do that? Because when there's a divorce, I want to understand how the divorce went. Yeah. Right? Divorces happen. I don't care the why. But I want to understand when we negotiate contracts and employment agreements and shareholder agreements, these are really prenups. These govern the divorce.

45:59And I want to know how people were treated when there was a divorce. And you know what? I could tell you some people could call me and say, hey, Adam, you know what? I've been a long time in this game and I've made a lot of money for a lot of people. But I've also been let go because we had a difference of opinion and I moved from one company onto another. I made the first two buyers a crap load of money. And then the third one was frustrated. They paid too much. Not my problem. That's their problem. But you know what? I can tell that there are firms out there who, if there's a divorce, they treat people fairly.

46:30It's like, hey, we were good people heading into it and we're good people coming out of it. And so talking to people who went the full trip, talking to people who sold nor let go, talking to people who are there now, you'd be surprised. These people don't just sell a company line. An entrepreneur will tell an entrepreneur what they think. What point in time do you do that level of diligence? After LOI, before the close. Okay, between LOI and close. Yeah, if you're the seller. You're the seller. Now, if you've built a company and you've hired an investment bank and you have 30 probable buyers in a process, you can't do that level of diligence on 30 buyers, but you can start looking at the kinds of companies they own or start trying to figure out if you can gather some intelligence just about what kind of buyers are out there.

47:16But very quickly, you'll see as bids are coming in or refresh bids are coming in, as 30 becomes five, I can start doing a little bit more homework on five. I might look at companies that they bought. I might know somebody who ran one or built one. But at any rate, it's somewhere before the close, I need to figure out that this is a partner that I can work with. because you'll never have more control than you have in the first sale. The first sale, you can say yes or no, and it's not just about money. We want market clearing price, but you can also be choosy on buyer. But once you're sold in that ecosystem, the PE firm is likely going with the high buyer next time.

47:56And you can guide that as the CEO somewhat and still have the ability to pick a partner because you can decide not to stay or to stay. There's always some ability to control, but there's multiple parties at the table. We need to do diligence. We can keep going. And I've just looked down and realized we have not been using our outline. Well, that's why we keep getting back together. So I have to do another one of these because I unfortunately am 25 minutes late for my next meeting. Hey, before we wrap up, all I got to ask you, what's the craziest thing you've seen in M &A? The craziest thing I've seen in M &A, there's been times where I have seen just crazy valuation.

48:31And I'm talking, you know, like I say, you're in the software world. My son's in the software world. He's a CTO of a software company owned by a large PE firm. And I look at the multiples that get paid and it's crazy. It's crazy. The math sometimes gets crazy. And you think, how can this even possibly be? It's funny though, because Mitt Romney is quoted as saying, I don't know if it's true or just a wives' tale, but he's quoted as saying in the 1980s, there's a bubble coming in the world of private equity and someday it's going a burst. But yet, 40 years, 50 years later, instead of hundreds of billions in assets under management...

49:08I just read something yesterday. McKinsey put something out yesterday that said that there's over$7 trillion in assets under management right now in private equity. $7 trillion. When I wrote the first PE playbook, it was 2.83. When I wrote the second PE playbook, it was six. And now it's seven, less than a year from the time it hits six. The money just keeps on pouring in. The money has to be put to work. I don't know what to tell you. Craziest thing I've ever seen. Some people pay crazy multiples for company and you wonder how could they ever make this pencil? How do they ever grow it? And sometimes they do and sometimes they don't.

49:48I have to agree with you. I think from my career and the days I did M &A until now, Wow. It was EBITDA was the standard, not top line revenue. Yeah. And the multiples being paid seem to keep creeping up. They poked down a little bit here with the high interest rate environment, but now the interest rates are ticking down and multiples are starting to creep back up. So I don't know. It's a great time to be an entrepreneur with a company to sell. That's all I have to say. Valuations are crazy. They are. Adam, thank you so much for taking the time to have this conversation. You've helped me become a better M &A scientist.

50:17Those of you still listening, hello, M &A scientists. I commend you. Yes. Adam and I will both personally congratulate you. Reach out to both of us on LinkedIn. I know you're a pretty active networker as well. Yep. I always welcome ideas, criticism, so I can continue getting better at doing this and create more value for you. Till next time, here's to the deal.

50:53Thank you for taking the time to explore the world of M &A with our podcast. We love hearing feedback. Tag us on a LinkedIn post, add a review on Apple Podcasts. We'd love to hear from you. If you need help standing up an M &A function or optimizing one that you already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email, Kisan, K-I-S-O-N, at mascience.com. Or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit mascience.com for a lot more content and resources. That's where you can also subscribe to our newsletter.

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