Compromising to Close
August 17, 2021 | Issue #36
Big Deal Small Business: Compromising to Close
August 17, 2021 | Issue #36
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Guest Writer Today!
I’m very excited to introduce a guest writer for today’s newsletter: Bradley Roofner.
Bradley has gone through the full process of searching, buying, transitioning, growing, systematizing, and then finally selling a business to a publicly listed acquirer — he’s the ideal person to learn from for aspiring searchers like me.
Bradley and his business partners purchased a commercial landscaping company in 2017 located in Austin, TX. They grew WLE for three and a half years before being acquired by BrightView, the largest and only publicly traded landscaping company.
What is most significant about their story is the rate at which they grew the commercial maintenance business (the recurring revenue part!). When it was all said and done, they grew the revenue of that business line at over a 100% CAGR from $1MM to $14MM while they owned the business.
When Bradley and his business partners purchased the business, it had several suboptimal features:
Recurring revenue (commercial maintenance) was only 15% of the total revenue, due to a large new-construction department
Almost none of the revenue was on an official contract
No professional management team in place
While far from ideal, these were all issues that Bradley and his partners were able to fix over time as they scaled, resulting in EBITDA growth and multiple expansion on exit.
Compromising
Bradley had to compromise on several business characteristics when he & his business partners acquired WLE, but they then worked on improving each of them ahead of an exit.
Today’s post explores evaluating risks in potential deals and debating when to stomach the risk and when to move on.
The idea is to encourage thinking critically about the materiality of situations that do not perfectly meet your search criteria in an effort to give you a better understanding of your personal risk tolerance and ability to compromise.
The goal is to help a searcher get to a close, given that every deal has blemishes.
Short Note on Price
We will intentionally ignore transaction price and deal structure as ways to mitigate risk, focusing solely on thinking through what risks can a searcher uniquely embrace.
The reason we are ignoring price is because a searcher needs to have completely worked through their ability to take on the risk, before looking to price to offset risk.
A cheap business with a risk that shouldn’t be assumed in the first place could lead to a permanently impaired investment.
Search Criteria vs Reality
The sad reality is a searcher will probably not close on a deal that perfectly meets all of his or her search criteria.
Creating detailed search criteria is an excellent exercise in clarification and focus. However, if you are looking to meet all your search criteria, you will probably need to be 1) agnostic to geography, 2) able to search for a very long time, and 3) willing to pay a top tier transaction multiple.
Assuming that most people will not have all three of those luxuries (or a special heaping of luck!), a searcher will likely need to make concessions on at least a search criterion or two to get a deal done.
The question then changes from “does this business hit all my criteria” to “on what criteria can I uniquely relax, knowing that once I own the business, I can apply effort to cure the issue?”
This is a very personal thought exercise because each searcher could arrive at very different conclusions based on his or her prior experiences, aptitudes, network, and risk tolerances. Put another way, how can a searcher view a deal entrepreneurially vs. purely viewing the business as frozen in time?
Risks are (sometimes) Fixable Problems
Risks are present in any deal. You have to figure what risks you personally feel more ready to take on vs. the average buyer. Acknowledging the risks and assessing my ability to fix them helps solve the proverbial “why am I so lucky to be the highest bidder” dilemma.
To frame these problems, we are assuming the deal is 1) not a turnaround, 2) within your circle of competence, and 3) marketed at roughly the EBITDA multiple that you would want to pay for the “ideal version” of the target business (again, we’re trying to take price out of the equation for this exercise).
Given those assumptions, you’re now looking at a “lesser version” of your ideal target business due to a few known risks. Before deciding which risks to accept, we want to discuss how to think through the risks.
Below are three examples of risks, the problems those risks can create, and the potential fixes for those problems.
Quality of Revenue
Risk: The company’s revenue quality is a degree or two less attractive than you’d like or a step down compared to industry peers.
Example Problem #1: A landscaping maintenance that has monthly recurring revenue, but with no real contracts in place.
Potential Fix: Can you introduce a standard form contract into the business without experiencing massive customer churn? Does the deal still work at a 15% loss of revenue in year one if you assume your growth targets from year two onward?
Example Problem #2: The business has repeat purchasers, but not regularly re-ocurring or recurring revenue.
Potential fix: Can you introduce streamlined re-ordering processes, a subscription system, or a contract to formalize existing purchasing behavior or create new ones?
Owner Dependence
Risk: The current owner is heavily involved in critical areas of the business.
Example Problem #1: The owner performs all business development activities.
Potential Fix: Can you personally sell this product or service successfully at first and then systematize it later? Can you creatively diligence by looking through Indeed resumes of active applicants to see how easily you could hire an in-market, qualified salesperson to replace the owner?
Example Problem #2: The owner is the key relationship manager for the majority of customers.
Potential Fix: Would a 6-12 month transition period be enough to convince the customer on you as the new face of the company? Can you structure the right incentive package for the previous owner to transition the relationships to qualified Account Managers?
Declining Earnings Trends
Risk: The business might be shrinking on revenue or EBITDA lines, or may have flat-lined recently.
Example Problem #1: Revenue is declining, but the owner says “I have been stepping back and focusing on other things / retiring…”
Potential Fix: Can you reverse revenue trajectory by building a sales team, improving the brand & marketing, giving special deals on pricing, or selling into a new customer set or channel? Are there obvious areas of neglect in the business deriving from a distracted current owner?
Example Problem #2: EBITDA margins are declining
Potential Fix: Do you both understand & believe the story as to why this has happened? If so, are you comfortable implementing price increases, negotiating with vendors, etc. in order to fix it? Can you capitalize the business well enough to buy yourself time to run experiments on ways to improve profitability?
A Compromise Framework
Now that we’ve examined how to think through risks, the million dollar question is which of these risks to compromise on.
Let’s examine a framework to evaluate personal readiness to tackle risks & create fixes.
We’ve created a simple 2x2 grid (visual below), with the following axes:
How much does this risk impact the business earnings and / or value?
How likely am I to be able to handle / solve this risk?
For example, take the Owner Dependence risk, specifically where they are the only sales engine. We would score that as High on the “impact earnings” axis. The day after closing, the company’s key (or only) salesperson walks out the door.
But for Bradley, he would score this as very fixable as he has been through the process of building a sales team to replace an owner already in his career.
Take another variation of the Owner Dependence risk, one where the owner performs many key functions, including owning key customer relationships — the day after closing, this represents significant business continuity risk. The business may fail to perform services at the same quality levels or key customers may churn. As a result, we would score it high on the “impact earnings” axis.
This newsletter’s host doesn’t have much experience in operations management, so he is much more wary of businesses with high levels of owner dependence, particularly with crucial day-to-day tasks. He would score this risk as Low on the vector of “how likely am I to handle / solve this risk” and instead look for a business with a healthy amount of overhead in place.
But let’s look at the Quality of Revenue risk. While seemingly Low on business earnings axis, it is High on the business valuation impact (so we may score it on the middle of that axis). Effort applied here many not change monthly revenue but should generate multiple expansion given the business will be less risky to operate.
The newsletter’s host does have confidence he can improve quality of revenue by analyzing existing customers’ purchasing behavior, strategically adjusting pricing, and introducing new revenue models. He would rank this as High on the “how likely am I to handle / solve this risk” axis.
Conclusion
Timing, geographic preference, lifestyle preference, and other factors are going to force compromises on the quality of business. Trade-offs will be a reality if a searcher wants to actually transact on a business.
Consider using the 2x2 grid above to document risks you personally want to avoid because they are high on business impact and low on your confidence to solve for them.
Conversely, after reminding yourself that every deal has drawbacks, contemplate being more flexible on deals that have either 1) low impact risks that you can stomach, or 2) high impact risks that you feel ready to tackle.
Use prudence in assessing what you are getting into and make the right compromises in areas that are fixable.
Once you have mentally decided you can assume the risk and improve upon it post-close, then you can look to negotiate price and deal structure as additional ways to mitigate risk pre-close. The other way around can lead to precarious situations.
That’s a wrap! A longer post than normal thanks to Bradley’s excellent contributions — a big thank you to him.
As always, I’m all ears to hear your thoughts & feedback. Hit reply to this email or find me on Twitter.
Thanks,
Guesswork Investing
P.S. I’d always appreciate introductions to potential acquisition targets or brokers (primarily targeting $750K-$1.5M+ of SDE or EBITDA, ideally located in the Northeast, West Coast, or Colorado).