Big Deal Small Business: Live Deal Process Update (12/15)
December 15, 2021 | Issue #54
We continue the diligence process! Today’s issue is part of an ongoing ride-along into my live SMB deal. I’m doing my best to provide a window into what that process looks like, balanced by general confidentiality and process disruption dynamics.
Two prior posts related to the deal:
12/02 Update - discussed seller relationship
It’s been a busy couple weeks, leading to me missing my newsletter post last week. Most importantly, we finally got through QoE, which I assume is one of the most common reasons why deals die post-LOI.
We did have a slight hiccup on the QoE, but the Sellers agreed to a small purchase price reduction and a seller note term change, which allowed us to continue pushing forward on the deal.
In general, the Sellers have continued to be solid partners to work with through the deal process despite being super busy running the business itself. This is a key element of any SMB deal given post-closing cooperation requirements.
Vehicle inspections went off without a hitch – the technician was impressed by the quality & condition of equipment & vehicles, so we can check that box as well.
As a result, we’re heading into documentation mode, with a draft of the APA in process with my attorney.
At the same time, I’m in full swing on the creation of my investment memo. This post talks about the investment memo process, why it’s not an investment pitch, and how I like to model financial cases.
More on that below.
This Post’s Sponsor: System Six
As a former searcher, Chris understands the challenges present in the financial data and systems of small businesses. Now, as the owner of an outsourced accounting and financial operations firm, he’s here to help.
From bookkeeping to payroll processing to bill pay to invoicing to KPI reporting, System Six accurately and affordably handles all of your back office financial needs.
So, if you are under LOI or currently own a business, and are thinking about outsourcing, or even a clean-up project, please reach out to Chris to discuss how System Six can assist!
_______________________________________________________________
Investment Memo
This is a private equity process that may not be as common in self-funded search deals. Most searchers plan to create an equity pitch deck, but that's a bit different than what I'm talking about.
In any PE deal, you have to create an investment memo.
The memo, among other things, lays out:
Transaction Summary: Deal terms, sources & uses, financing, diligence completed, diligence outstanding, timeline, etc.
Investment Thesis & Key Risks: What are the key bets you're making, how did you build conviction around those, what are the key risks & potential mitigants
Company & Industry Summary
Value Creation Plan aka Business Plan: What are you planning to do with the business, why do you think you can create value that hasn't already been done by the Sellers?
Financial Model: Lay out several potential outcomes and resulting investor returns
A well-produced equity sales pitch, CIM or offering memorandum generally has most of these elements as well, but with a heavy sales pitch underlying the materials.
In PE, you do have to "sell" your investment committee on the deal, but there is an understanding that we're all on the same team, we're all investing money together, etc.
As a result, an investment memo should be a rational, balanced document that really tests the bounds of the investment. It shouldn't be a one-sided sales pitch.
Obviously, you have to convince investors to back you in your self-funded search, but ideally, you would have built a relationship with them ahead of the pitch.
That relationship should afford you the privilege of treating prospective investors like partners on an investment committee. I don't want to "sell" them. I want to cogently explain the merits & risks and come to a collective agreement that this is a good deal.
If you have a solid prospective investor base, getting serious pushback from them on a deal likely isn't due to creating bad pitch materials, it's due to the deal not being great.
Strong investors will look through any fluff and get to the core of the deal - what key drivers matter in terms of a good outcome or bad outcome.
An investment memo highlights those key drivers and provides data & facts to support a discussion about them. A sales pitch obfuscates away from those key drivers, and strong investors will see through that anyway.
Said differently, if you give strong investors a sales pitch, they'll still identify issues, but you won't have given them any facts or context as to why the issues are manageable. An investment memo tackles issues head-on.
Given that background, I built my "pitch deck" as an investment memo as if I were presenting to my PE investment committee (though a more condensed version of course).
In terms of the memo creation process, I like to start from the minute a deal starts to feel "real" - in this case, I started working on it after the IOI was deemed acceptable.
From there, it should be constantly evolving through the diligence process. It should help guide you to where you need to ask questions. As you build out pieces of the business plan section, you might realize, "hey, I'm not able to write this next paragraph because I'm not actually sure how this part of the business works..." -- that's your guide to go do more diligence in that area.
You should also kill stuff as you realize it's not important. A certain risk may worry you early on, so you build a slide discussing it and ways to manage the risk. Over time, you may realize it's just so manageable that it's not a material risk at all, and you can pull it out of the memo. If investors ask you about it, you know the answer.
The goal isn't to cover every single element of the diligence process or business in your memo - the goal is to discuss everything that matters, as concisely as possible.
In terms of formatting, either Word or PPT will work, I tend to do mine in PPT. But they are very dense slides, lots of words & info. They are not designed as marketing materials with nice formatting, images, or easy-to-digest text.
The slides are not meant to be presented live. They are meant to be read on a standalone basis, page by page, BEFORE the live discussion.
_______________________________________________________________
Financial Model Cases
Just to extend my diatribe on the investment memo being a true reckoning of the deal, not a sales pitch, I think it's crucial to model various operating outcomes with a rational approach on cause & effect.
It's tempting to model an "up & to the right" operating case on revenue, EBITDA, and cash flow.
That's not really how real life works.
First, revenue growth generally comes after expense growth. My guess is most search deals see EBITDA decline in year 1 before revenue growth starts to catch up with investments made into the business.
Second, cash flow tends to come after EBITDA growth, not at the same time. Pay attention to the capex & working capital needs of your business - you will have to spend real cash on both to support the growth in your business.
While cash flow should eventually catch up, make sure you're not modeling EBITDA growth 1:1 with cash flow growth.
Separately, you should be modeling real downside (and upside) cases.
The most important downside protection is liquidity. Model your downside cases around what it would take to run out of cash. When you hit that point, you still have options, but none of them will feel great.
Going into your deal, you should have a sense of what it would take for you to be unable to service your debt. Is it a 10% decline in volume? Is it a 15% decline in price? Is it a 15% increase in labor costs?
Answering that question will tell you what you need to manage once you're in the business.
In my deal, it's crew productivity - the owners are managing the crews directly, leading to peak productivity. Post-closing, I'll have crew managers in place who are not owners, so some level of direct labor productivity loss will occur. As a result, I'm focused on plans to manage & offset that productivity loss.
_______________________________________________________________
Conclusion
Overly rosy investment pitches & models are a mistake. There's too much personal, career, and financial risk to jump in without having a clear-eyed view of what you're getting yourself into.
I think we all know there are lots of ways to blow yourself up in SMB deals - you should just know what specific ways are likely to blow YOU up in YOUR deal.
Okay, I'll get off my soapbox now - thank you for reading.
As always, I'd love to hear your thoughts & feedback. You can 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, located in Seattle or the Bay Area).