🧐 What I Learned Last Week 5.12.23
🧐 What I Learned Last Week 5.12.23
Curating the best M&A, SMB, and EtA-related content each week.
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📰 Articles
The Merits, Risks, and Possible Unintended Consequences of Earn-Outs
In an earn-out, the seller of a company is not paid the full purchase price upfront. Instead, they receive a portion of the purchase price upfront and the remainder is paid out over time, typically based on the company's performance.
There are several benefits to using earn-outs. First, they can help to bridge the gap between the buyer's and seller's valuation of the company. Second, they can help to motivate the seller to stay with the company and help it succeed. Third, they can help to reduce the risk for the buyer, as they only have to pay out the remainder of the purchase price if the company performs well.
However, there are also some risks associated with earn-outs. First, they can be complex and time-consuming to negotiate. Second, they can create uncertainty for the seller, as they may not know how much they will ultimately receive. Third, they can create incentives for the seller to manipulate the company's performance in order to maximize their earn-out.
Overall, earn-outs can be a valuable tool for M&A deals. However, it is important to carefully consider the benefits and risks before using them.
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2nd Deal One Year On - Lessons Learned - 1st Time Acquirors Take Note
Despite a home-run first deal, the author encountered several hurdles during their second acquisition, which was a fast-growing, smaller-scale business located on the opposite side of town.
Key Points:
Importance of an Operations Manager: The author underscores the importance of having a trained, experienced operations manager in place when acquiring a service business. Their attempts to train existing staff members as managers resulted in failure, causing customer dissatisfaction and operational issues.
Consideration of Business Location: Reflecting on the challenges of managing a business more than an hour's drive away, the author advises potential acquirers to consider the location of the business, especially if they already manage another time-consuming venture. In their case, traffic issues led to neglect and value destruction.
Understanding Growth Drivers: The author learned the hard way the need to deeply understand what is driving a business's growth before acquisition. In this case, the growth was fueled by COVID-19 related cleaning and the hands-on involvement of the owner/seller. After acquisition, the business lost about 25% of its revenue within six months, attributed partly to cutbacks in COVID-19 cleaning.
Sticking to Valuation: The author advises that if a seller demands more money at the last minute and the lender values the business lower, it's better to stick to the original lower price or walk away. The author regrets not doing so and is now burdened with additional monthly earnout payments.
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Big Deal Small Business: HoldCo Discussion
Key Points:
What is a HoldCo?: A HoldCo is an entity that owns multiple businesses in sometimes unrelated industries. It is a popular structure among wealthy families and has been gaining attention in the SMB sector. Examples include Chenmark, Decada Group, Traction Capital Partners, Enduring Ventures, and Evermore Industries. A key concept in a HoldCo is that cash flow from each business usually moves up to the Holding Company layer, where capital investment decisions are made.
Operations of HoldCos: HoldCos often have shared leadership or decision-making from a capital perspective, even though each business is standalone operationally. Some HoldCos offer centralized operations support across their companies, like a single bookkeeper managing the accounting for different companies. This can be beneficial for small businesses that can't afford a full-time bookkeeper.
Capital Allocation: A significant aspect of running a HoldCo is capital allocation, i.e., deciding what to do with the profit. Standard capital allocation choices include organic growth, inorganic growth, paying down debt, and returning capital to shareholders. The choice depends on the associated return profile.
Reinvestment Moat: The author introduces the concept of a “reinvestment moat.” It refers to businesses that reliably provide opportunities to reinvest capital at a high rate of return. This positive feedback loop can lead to greater growth over time.
Returning Capital to Shareholders and HoldCos: When a business returns capital to shareholders, the shareholders have the responsibility to redeploy that capital to continue generating returns. In a HoldCo, the returned capital can be invested across all its businesses in tandem. This allows cash flow from one business to be used for the growth of another, making the HoldCo a capital allocation machine.
Link to Search: The author concludes by connecting the HoldCo concept back to the search process. Running a HoldCo effectively requires a unique skill set, and it's a difficult job. However, running a small business is equally hard, and building a HoldCo is often seen as an aspirational goal rather than an immediate one.
The author ends on a note of caution, stating that while building a HoldCo is a potential upside, it requires discipline, experience, and a different skill set than running a small business. It's a worthy goal, but one that generally lies far down the road.
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Step-Up: The Most Important Number in Search Fund Investing
This article outlines strategies for structuring self-funded search deals to deliver a 30% Internal Rate of Return (IRR) for investors.
The typical deal structure includes 75% SBA loan, 15% seller note, and 10% equity from investors. The author proposes evaluating investment outcomes using three financial metrics: IRR, Multiple on Invested Capital (MOIC), and dollar profit, with a preference for MOIC in small-to-medium business (SMB) deals.
The returns can be broken down into Enterprise Value Creation (sale price divided by purchase price), Equity Step Up (investor common equity ownership divided by cash as a percentage of total purchase price), and Preferred Returns (liquidation preference and preferred rate of return).
Understanding these components can help tailor investment pitches to maximize the desired outcome. The author also notes caveats including over-equitized deals, which require more equity and adjustments for deals significantly above or below market value.
🧵 Best of Twitter
Key insights from Woodstock for small business buyers…
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Great discussion of NWC…
Keep this in mind if you’re buying a biz with a lease…
Focus on what matters…
🤔 Thoughts, Events, Other
AI
Here’s what ChatGPT did for me in about 30min:
Create a content calendar for a month
Create article outlines
Write the articles in an SEO-optimized way
Turn the articles into a series of Twitter threads with emojis and hashtags
Create 16 e-mail marketing sequences
Outlines for each e-mail in sequence including titles, graphics, content, CTA
Write the actual e-mails in sequence in the proper tone
Create a script for a 15min podcast on a very complex topic
Brainstorm business ideas for incorporating AI in M&A
A detailed description of each business idea and steps to launch it
It took some trial and error with prompts but the results are absolutely incredible.
The development of tools such as ChatGPT is groundbreaking and will change EVERYTHING. This is not an understatement. This is reality.
Please, please, please go play around with ChatGPT. Try different prompts. Ask it complex questions. Compare ChatGPT to Bard. I think the output will shock you.
⚒️ Tools & Resources
I want to share some tools & resources that I have found helpful. Please note that some of these may contain affiliate links. This means that I may receive compensation if you sign-up and use them.
DueDilio - #1 marketplace to hire highly vetted M&A due diligence service providers. Your source for finance, legal, tech, and other key areas of due diligence. Submit your project, review proposals, and hire.
PrivSource - PrivSource helps you source deals and connect with transaction partners without ever paying a success fee.
BizNexus - Marketplace + off-market origination in one platform. The marketplace averages about 10k active listings & pre-CIM opportunities, and the off-market origination focuses on data & multi-channel. Local Boston company and I consider the founder (Adam Ray) a friend.
X5 Deals - Proprietary deal sourcing. They do the outreach and send you relevant, actionable deals directly into your inbox.
Import Dojo - a newsletter that sends eCommerce and Amazon FBA businesses for sale to your email inbox. They send deals each Wednesday at 9:00 AM CST.
Scott Oldford - If you're interested in gaining insight into the process of building, scaling, acquiring, and selling online businesses, Scott Oldford can help.
Deal Flow Scout - Peer-to-peer deal flow exchange. Free, open, transparent.
Deal Sourcing Guide - A directory I put together of online marketplaces, brokers, DFY deal flow, and more.
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