Big Deal Small Business: Lessons from a a Dead Deal
September 24, 2023 | Issue #91
This is a newsletter written by Guesswork Investing about acquiring & operating small businesses. If you are a new reader / new searcher, I recommend starting with the New Searcher Reader Guide.
This is Part 2 to my Autopsy of a Dead Deal post from last week.
Last week’s post stepped methodically through the deal process and how it ultimately died. The gory details, money lost, and all.
This week’s post is more focused on the takeaways for myself & searchers going forward. Both lessons learned & silver linings now that I’m 18 months into a closed deal.
Private Markets Context
If you haven’t been in the private markets acquisition space in the past, deals dying can be jarring.
When I worked in private markets (both credit & equity), I kept a deal tracker of every deal I worked for roughly five years across multiple jobs.
In 5 years, I worked on 63 deals beyond the CIM review & initial management meeting phase. (A CIM is a Confidential Information Memorandum — basically a pitch deck made by the company trying to get acquired.)
Out of those 63 deals, we did real due diligence & financial modeling analysis on 32 deals (what I’d call “live deals”).
Out of those 32 live deals, we ultimately closed seven transactions.
For context, closing seven transactions in five years out of 63 deals is a phenomenally high success rate — I’m not bragging, I just got very lucky in terms of what deals I was staffed on. An analyst/associate (junior ranks of professional investing) has very little impact on odds of deal closing.
Even with my lucky deal staffing, ~90% of all my deals and ~80% of my live deals did NOT close. The real numbers across the industry are probably more like 95% and 90%, respectively. (By the way, this is just to get deals closed…this doesn’t account for the deals ultimately turning out to be good investments!)
Point being, there’s not always lessons to be learned — private market acquisitions are hard. Sometimes deals just fail.
That said, the dynamics of a small business deal are fundamentally different than the dynamics of an institutional private equity deal, so my comments below try to focus on SMB and search fund-related lessons learned & silver linings.
Lesson #1: Move Faster
Time kills deals at any size. Deals are just looking for ways to die — the longer you take, the higher the odds that deal beats you.
In my deal specifically, the Seller’s pace of response to due diligence requests and documentation markup slowed the bus down. And I didn’t feel confident enough to rush the Seller harder.
That said, I could have done more work in parallel, such as starting the legal documentation when early drafts of the QoE looked pretty good. I tried to avoid this to conserve deal costs, but ultimately spent all the deal costs in the end AND increased deal risk.
This is a built-in disadvantage of self-funded searchers versus traditional searchers or PE. It’s tough to spend your own money even if it’s the right move to best position yourself to win the deal.
Lesson #2: Manage the Tension Between Selling & Holding for the Seller
In institutional deals, the Sellers are usually moving on to their next transaction or gig. They don’t have an intense emotional connection to their business.
They are also getting paid 7-12x EBITDA or 10-15x+ annual cash flow, so the impact of waiting another year to sell is limited relative to selling today.
By contrast, when you buy a small business for 3-5x annual cash flow, the Seller could generate an extra 20-33% in proceeds by just holding out another year. And if they’re on a growth path, their cash flow number will be higher too, leading to a higher sale price next year.
Further, small business sellers usually don’t have a “next deal” — this is their nest egg for retirement.
That tension between the sell now vs holding for another year decision — that is heightened in small business acquisitions, and I had no practice proactively managing that tension in institutional-sized deals.
As a result, I deferred too much of this tension management to the broker in my deal that died. I should have had more frank conversations with the Seller during the LOI negotiations to make sure she understood how much cash she would ultimately receive and how her life would change post-closing.
Lesson #3: Invest in the Personal Relationship with the Seller
Throughout the deal process, I spoke with the Seller for 60-90 minutes every week or two, primarily discussing the business and our post-closing transition plan. I felt like I had a great working relationship with her.
Clearly, I did not have a great read on her or where her head was at. And look — people change their minds, that’s part of the risk.
But I should have invested more time in the personal relationship, not just the working relationship. I should have spent more time on-the-ground, in-person with her. Go out for dinner, listen to her 25+ years of war stories, meet her family, shoot the breeze.
I did much more of that in my deal that ultimately closed, and I could feel how much easier that made working together post-closing.
You’re building a “trust bank” with your Seller (not my term, but I can’t remember who I got it from, apologies). Each positive, human, enjoyable experience you share with them is a deposit in a shared trust bank. Each tense moment, each sticky negotiating point, each disagreement — that’s a withdrawal from the trust bank.
If you run out of trust before the deal closes, the deal dies.
If you run out of trust partway through your transition period, you could be in trouble as an operator.
Investing in the personal relationship is crucial in the small business context. It not only makes the whole process more fun & enjoyable, but it materially de-risks the deal both pre-closing and pots-closing.
Silver Linings
Losing a small business deal feels different than losing a large private equity deal, even at the 11th hour. I used to have an army of lawyers, consultants, bankers and accountants holding my hand every step of the way. Losing this deal felt more visceral, more personal, more real.
That said, there were real silver linings, especially related to how the experience drove significant personal & professional growth. This ultimately helped me get a deal done.
Negotiation: I took ownership of every workstream in the deal, including negotiations with the sellers, lenders and investors. That’s a role that my bosses at work usually handled. After this deal, I felt more confident in taking that role, as well as more attuned to how small business owners approach a sale of their business.
Equity Financing: I built out a fantastic & supportive network of investors who understand the risks inherent in SMB leveraged buyouts. I found the people who fit the deal profile I was undertaking and who I wanted on my team going forward. A core segment of the investors from this first dead deal ended up being investors in the deal that eventually closed.
Debt Financing: I got all the way from the banks laughing off a COVID-impacted tourism business to a bank commitment letter in hand. I had a deeper understanding of how to navigate the mind-numbing bureaucracy of SBA 7(a) loans. I was far more efficient and slightly less confused the next time around. Also, I had a commitment letter in hand that, with some light redaction, I could show to brokers instead of a “proof of funds” to show that I am a serious buyer who can get financing lined up.
Legal Docs: I was used to having high-priced attorneys who would handle the minutiae of legal docs, and just flagg the important items to me. In this deal, I was in the weeds, reading every single word of every single document. This made me a better dealmaker all around. And while the burnt legal dollars were painful, I did end up with a finished set of operating agreement documents with investors that I was able to largely recycle the second time around.
Clean Transition from Work: Had this deal closed, I would have had to leave my existing job a bit more abruptly than I wanted — I had a game plan on how to handle the transition cleanly, but it wasn’t perfect either. With this deal dying, I was able to give TONS of notice to my firm, and we worked out a really amiable transition out of work and into search. I had & continue to have a ton of respect for the people at my last firm, and am really thankful I was able to leave on great terms.
Location, Location, Location: This deal would have led to a VERY odd lifestyle of splitting time in Alaska and someplace else. The deal I ended up closing is in my hometown, where I have a real support base of friends & family, and actually understand the local dynamics. It just fits my life far better.
Conclusion
When you’re in the aftermath of a dead deal, it is beyond frustrating. It’s hard to describe just how frustrating that moment feels. You go from super busy, hair-on-fire busy, to suddenly having NOTHING to do. Your deal pipeline has likely dried up at this point, so you have nothing new to work on. You are torched emotionally. You burned a ton of personal cash in the process and have seemingly nothing to show for it.
If you’re a searcher who hasn’t ended up in this situation, it’s important to know that this is a very real possibility. Budget for it both financially & emotionally.
If you’re a searcher who has had this happen, hopefully you can focus on the lessons learned & silver linings in order to maintain the push to a closed deal.
Rooting for you all, and hope this was a helpful set of posts!! For thoughts or feedback, just hit reply to this email or post/DM me on Twitter.
Thanks,
Guesswork Investing
P.S. I run a local building maintenance contractor in Seattle, WA that focuses on single family residential & commercial properties. To the extent you know folks in the RE industry in Seattle (both homeowners & property managers), I’d always appreciate intros.