Royce Yudkoff:

Welcome to Think Big, Buy Small, a podcast from Harvard Business School about entrepreneurship through acquisition. We’re your hosts, Royce Yudkoff…

Rick Ruback:

…and Rick Ruback. Royce, we have an unusual episode. We're not having a guest. Instead, we've gotten some great questions from our listeners, and it'll be a show of just back and forth with Royce and I answering listener questions. Royce, let’s get to the conversation.

Katie Zandbergen:

My name is Katie Zandbergen and I am Producer of Think Big, Buy Small here at Harvard Business School. As listeners to Season One of the podcast will know, we have been asking you to please send us any questions that you may have. And very happily, we've received many questions from you, which we are thrilled to devote an entire episode to today. So, the idea for today's episode is that it will be a question and answer session with Rick and Royce. And I will essentially be hosting the hosts. Rick and Royce, shall we get into it?

Royce Yudkoff:

Yeah, this is going to be a tougher world for you and me, Rick. Usually we ask the questions, now we have to answer them.

Rick Ruback:

Yeah, this is kind of like a reverse case discussion, you know?

Royce Yudkoff:

Yeah, exactly. All right, Katie, we're in your hands.

Katie Zandbergen:

All right, question number one. Hypothetically, if each of you had to, today, stop teaching at the Harvard Business School and instead become searchers, where and how would you search? And in an ideal world, what kind of company would you hope to acquire, beyond it, of course, being enduringly profitable? Rick, do you want to go first?

Rick Ruback:

Ohhh, it’s a hard question for me. Part of it is that I'm sort of set in my ways and set in my life. And so for me, I would need to buy a company in New England because I really love New England. So, it would be a geographic search. And because it's a geographic search, it would be open with respect to industry. I'm the kind of person who likes to get my hands dirty. I like to be involved in things. I like to understand the nuts and bolts of things. So, I would probably buy a smaller business in which I needed to be involved in the management and on kind of a day-to-day basis or at least a week-to-week basis, you know, I would expect to be there and work away. And I think I would shop in the low end of the market, in kind of a million dollars of profits, because I think that's where the best buys are and the best opportunities.

Royce Yudkoff:

Rick, that's a really good answer because, you know, it's a big part of this decision of building the life you want to live in, and that's really what you addressed in your answer. And I think my answer will be additive and different. It syncs up with it, but I really like that a lot. I would say to the audience, if you look at the businesses that Rick and I have coached students to buy or that we've invested in ourselves, the first thing you'd notice is there's this unbelievable variety of services and products that they make. And someone might reasonably say, “Do you guys have no consistency, no pattern? Will you buy or recommend that someone buys anything?” And the truth is, when Rick and I look at businesses, we look through the product and service. And we look for set of characteristics that we've talked to you about. And so I agree with everything Rick just said, and I would add to that that what he and I would look for is a business that's been profitable for a long time; that has recurring customers who find it in their interest to keep buying from us year after year, so when you show up at work on January 2nd, most of your revenue is going to come from the people who bought last year and you can spend your time selling to add revenue, not replace missing revenue; that's reasonably non-cyclical; that has great cashflow characteristics, meaning your profit doesn't need to be invested in new equipment, replacement equipment, or inventory. It can be paid out to you or pay down debt or piled up to make another acquisition. Oh, and it would have low customer concentration. And so, you know, when Rick and I look at businesses, we're not Superman, but like Superman, we look at it with x-ray vision through the product, through the service. And so I would add on that list of characteristics to the “building of life” that Rick talked about.

Rick Ruback:

Royce, I agree with everything you've said and like those additions a lot. In addition to customer concentration, I would add in supplier concentration because that could make your life miserable too. I would also say, in the trade-off between multiple and growth, I would tend to lower multiple and lower growth. I really want those recurring revenues and I really want to buy in a sub 4 or 4X kind of region so that I get some price protection on due diligence and the direction of the firm.

Royce Yudkoff:

I agree with you. You and I think alike on this and, you know, you've often said in the past that, when you have growth, you're gaining customers who are customers that are by definition willing to switch and that may not be a perfect customer. So, I think that's very true. You know, you can make so much money in buying small firms at attractive multiples, that you don't need growth. I mean, growth is good but you don't need it if you buy at the right multiple.

Rick Ruback:

And structure it right.

Royce Yudkoff:

And structure it right.

Rick Ruback:

I agree with all that.

Katie Zandbergen:

All right, so we received a number of e-mails and messages from people who were asking to learn more about your thoughts on doing a self-funded search versus a more traditional funded search. And under that umbrella, I want to ask two questions just to kind of get the ball rolling on your overall thoughts on those two different approaches to searching. The first question is kind of short and sweet, which is why would you use a search fund when you can buy a company getting 90% of the financing from an SBA loan? And the second question is a little bit more specific, which is: You've mentioned that one of the key distinctions between the self-funded search and traditional search is the size of the target company, with self-funded search acquisitions typically having plus or minus $1 million EBITDA versus a traditional search having $2 million plus of EBITDA. What are your perspectives on the relationship between the size of the acquisition and future growth? For instance, do larger traditional search-backed companies tend to grow faster because they have more scale, resources, and cash flow to invest in future growth? Or are smaller, self-funded search companies better positioned for outsized growth?

Rick Ruback:

There's a lot of questions in those questions so let's just start with the question of why would anybody ever take money to fund this search? And that to me is really easy. The most obvious answer is it's the money. People are often in a position where they're giving up a job or giving up an employment opportunity to go search. And so imagine they have a job paying $100,000 that they gleefully spend on their living expenses, on how they structure their lives and their families. You know, nursery school tuitions, medical bills, food, an occasional cup of coffee out, that kind of thing. They need to think about how they're going to live without that money, and many people come to the conclusion that it's really complicated or very difficult or impossible for them to live without that money. And so they go to a funded search because it funds their time while they're searching. Now they give up a lot for that. They give up the ability to renegotiate at the time they get their deal. But what they get for it is they get funding while they're searching. And it's not only their living expenses and lost salary, but it would also be travel expenses, database expenses, that kind of thing while you're searching. So, that's why people, I think, primarily use a funded search. Royce, you…?

Royce Yudkoff:

Yeah, well, I agree with that. You've described very well the basic fundamental fork in the road of “Can I afford to search or do I need to be paid a salary when I search?” But if you do have a choice, if you have enough money or you have a spouse that's working while you search, I would say the second issue is that, of course, everyone recognizes that you get a bigger share of the company in a self-funded search, usually 65 or 70% is what you, the searcher, get in ownership because you've used an SBA loan and you've searched on your own nickel versus 25% in a funded search. And so what funded searchers tend to do is buy bigger companies. And so just as it's apparent that 65% is bigger than 25%, it's also apparent that you can fix that if the thing you buy with 25% of the ownership is much bigger than the thing you would buy with 65% ownership. And, you know, as Rick and I record this, the average funded search today is a $16 million total enterprise value and the average self-funded search probably ranges between $2 and $5 million. So, if you buy something that's three times the size with 25% ownership of the upside, you can cross over the benefit of having 65%. And so there are searchers who not only want to solve the problem that way, but actually feel more comfortable running a bigger, small company rather than a smaller, small company. So, I think those are the two reasons in order of importance.

Rick Ruback:

I would just add that this argument that says you can buy a bigger company to make up for the loss in ownership is more subtle and more complicated because, as you know, the self-funded searches tend to rely heavily on SBA debt and seller debt. And so, as Katie mentioned in the question, you can often buy the company with just 10% down of equity. In a funded search, because the funders want to put equity to work, because there are no SBA loans in funded searches, the net result is that they tend to have much more equity. And so the searchers, the entrepreneurs, have to accomplish that much more to earn their carry, right? You're just not getting the benefit of the same amount of leverage.

Royce Yudkoff:

Well, and that point, which is true, leads directly to another question in the cluster you asked us, Katie, which is about growth between the two. And the result of what Rick just described is that funded searchers have to buy companies that have the potential to grow faster because they're not using debt financial leverage to leverage up the equity return. They have to get that through growth and often they have to pay a higher multiple for these companies because other people see that they have the potential for growth. So generally what you see is funded search companies go for higher multiples and have the potential for higher growth. Self-funded companies tend to have more moderate growth and trade at lower multiples. Would you agree with that, Rick?

Rick Ruback:

I do. It's a simplification but it's the economics behind it that leads to that. It's the number of people in the marketplace and the opportunities that those kinds of businesses present. So, I agree with everything you said.

Katie Zandbergen:

Alright, next question: In your opinion, what are some mistakes that first-time searchers too often make in starting the process of searching? For instance, you mentioned in a few of the episodes that searchers may be at risk of buying a job versus buying a company. Can you expand on what that means and what to look out for to avoid this?

Royce Yudkoff:

Well, Rick, I'm going to leave to you what buying a job means because I know you speak to that very well. I would say, if you think back to my part of the answer a couple of questions ago, where I gave a list of characteristics that Rick and I look for in companies, I would say one common searcher mistake is to adhere to what I just said too closely for too long because the truth is you will not be able to buy a company that has all of those qualities, especially if you want a fair price. And so you're going to have to give up something and it's not going to be a perfect company. The challenge for searchers is when you start searching and you've never looked at small companies before, you really don't want to buy the first company you see. You want to hold to these characteristics and see a bunch of companies, and what successful searchers do is that they get some flow under their belt. They start to know what a good small company really looks like and they say to themselves, “OK, this has four of these characteristics but not these two - is this good enough for me?” And successful searchers introduce judgment and become flexible about how many of these characteristics we spoke about that they need and less successful searchers cling longer to perfect and don't close on a deal. So that is a very common searcher mistake that is usually rectified but for some searchers, they do this quickly and for some it's a Year Two learning. Rick, do you want to add to that?

Rick Ruback:

So, I agree with what you said completely but I would also add - and this may be reflective, Katie, of my personality - I think people tend to over-intellectualize this problem. They think about how they're going to search. They study industries. They think about the perfect campaign. They think about the perfect website. One of my favorite things is the number of hours people spend thinking about the name of their search fund entity. It's like, nobody cares. And I think in the end, you can study it all you want, but you just have to do it. You have to just say, “Today I'm going to source some deals. I'm going to reach out to some brokers. I'm going to look at some teasers. I'm going to sign some NDAs. I'm going to get some SIMs. I'm going to generate deal flow. I'm going to see what's available.” And it's like so many other things in life, it's so much easier to do than to think about. We all have different hobbies. One of my hobbies is building wooden boats on occasion. If you look at the plans to build a wooden boat, your head explodes. You know, there’s fourteen pages of diagrams, there’s a lot of stuff going on, this and that, screws and you can drive yourself crazy and what you need to do is just say, “Today I'm going to start” and then take it one step at a time. You’ve just got to take the first step.

Royce Yudkoff:

Mm-hmm. Just do it.

Rick Ruback:

Just do it. The job thing is…you know, the phrase is so much better, you know, you want to buy a business, not a job. That is, the phrase is sort of precise, but what that means is a little more subtle. And the idea is you want to buy a business in which everybody in the business isn't just providing leverage for the owner / CEO. So, if you want to buy an electrical contracting business, you want to buy an electrical contracting business that employs several master electricians, not one in which the owner is the master electrician and if you're not a master electrician, you can't do the work, right? So that's a case of buying a job. And there are lots of examples. One of my favorite ones years ago was this specialty metals distributor. This person had this wealth of knowledge about wholesaling and delivering rare metals, you know, the metal you use for the hatch of a submarine or this piece that you need on this particular airplane. And the data was all in his head. He was a metallurgist and he had employees and he had inventory and it was a business, but it was really levering his skill. And I couldn't buy the business and run it because I'm not a metallurgist. I don't know what kind of metal you use on the hatch of a submarine. He did.

Katie Zandbergen:

So, it's about the expertise of the current owner and whether that's something you could do.

Rick Ruback:

Well, it's more than that. I think about it is whether the current owner is the nexus of all business activity. If all business activity – we’re a podcast so people can't see me but I'm showing my fingers here, weaving together - if all the business has to run through one individual, and that happens to be the owner, then it's a job. If the business is dispersed across employees, and sure the owner is the coordinator, you know, then it's a business.

Katie Zandbergen:

That makes sense. So, Rick, just now you had mentioned people researching different industries as they think about getting started in searching. And one of the questions we received is as follows: In searching in the current environment, are there any industries or sectors that you would recommend steering clear from, for instance, because they've drawn too much attention from larger private equity?

Royce Yudkoff:

I have a thought on this.

Rick Ruback:

Please, go ahead.

Royce Yudkoff:

Yeah, so one area of tremendous acquisition activity that you see in smaller firms are roll-ups, and so private equity firms, for which a small firm would just be too small to buy, sometimes compete in the small firm market by creating a platform company and that company then hoovers up all sorts of small businesses in that field. And so what I would do, unless I was planning to do a roll-up myself, is avoid those fields which are being rolled up because you are getting tough competition dropping down into a market size that you wouldn't ordinarily find them. Roll-ups occur in lots of places - HVAC businesses, veterinarian businesses, you know…

Rick Ruback:

Dentists.

Royce Yudkoff:

…dentists. And the good news is that if you look in the gigantic, highly articulated North American economy, what you find at the small end of the market, in small firms, is an unbelievable diversity of niches in which companies exist. And you'll uncover these quirky companies that Rick and I have come to adore over the years and treasure finding like, you know, companies that rent musical instruments to school children, companies that teach skills and give certifications to seafarers, it goes on and on and on. And you want to go after companies like that, where a private equity firm will say, “I'm not going to buy a $5 million company and put a million dollars of equity to work. That doesn't fit my business model.” And you want to stay away from those companies which are being hoovered up in a roll-up. So that would be my thought about where to look.

Rick Ruback:

My first question is, how is it that an English major is using the term “hoovered up”?

Royce Yudkoff:

Yeah, yeah, because it's so colloquial, right? Yeah.

Rick Ruback:

Right, it's like, and it so ages us, right?

Royce Yudkoff:

Yeah, it does age us. I was thinking about that, “I wonder if people know this is the brand of a vacuum cleaner from the 60s or whatever?”

Rick Ruback:

Right, right, with the door-to-door salesman, right?

Royce Yudkoff:

Katie, I just need to check. Did you know what I meant?

Katie Zandbergen:

I knew what you meant.

Royce Yudkoff:

Oh, OK.

Rick Ruback:

Well, OK. So, one of the downsides of what Royce has talked about is that if you are in an industry where private equity is busily rolling up and you can roll up in front of them, then you have a really good person, a really good entity, a natural buyer for your business. So, we've had students who run into businesses, said, “Oh, I think private equity is going to roll up this industry and I'm just going to buy everything that I can buy for a year and then sell the bundle to private equity.” And those former students have done really well. As I think I've mentioned on other episodes, I hate investing capital in things I don't understand. And so a lot of roll ups just don't make sense to me, but people make a lot of money at it. As to industries to avoid, as Royce says, we like to look through the industries and into the characteristics. There's certainly characteristics to avoid, but I don't know that there's a particular industry that I would avoid. I like businesses where I know why my customers are buying them and I agree with the reasons that they're buying from us, right? So, like I, you know, nothing against people who love med spas, but it's just not a me thing, right? So, I can't imagine people buying nail salons or med spas, but gyms I can understand, right? And, you know, arcane woodworking tools I can understand. So, it's just, you know, there's a lot of personal taste in this.

Katie Zandbergen:

All right, next question. We had a listener write in saying: I find every deal very competitive with so many buyers. Can you recommend some unconventional or lesser-known lead sourcing strategies?

Royce Yudkoff:

Well, Rick, you and I have been watching this market for 14 years and, you know, if we just take the typical business services company with a million dollars in EBITDA, that probably traded between three and a half and four times 14 years ago. And today it probably trades, I don't know, between four and four and a half times, which is not much movement over 14 years. Now we can find sectors which have gotten hot, small vertical software companies, companies in spaces that are being rolled up actively. But I don't perceive this market as very competitive because if it was the multiple is the canary in the coal mine. Well, first of all, do you know what a canary in the coal mine is, Katie? Because that's also an arcane, long-ago profession.

Katie Zandbergen:

I do know what a canary in a coal mine is. And I think you mentioned it in an earlier episode, but maybe if people are tuning in for the first time, why is the multiple the canary in the coal mine?

Royce Yudkoff:

Well, because when the competition starts, the way you resolve five buyers wanting one company is it gets bid up. And so you see the multiple of EBITDA moving up. And so that’s your evidence that a market has gotten more competitive. And I'm not seeing that, outside of certain sectors. But Rick, you know, maybe you're seeing something different or have a different take on this, so your thoughts.

Rick Ruback:

Well, I have two comments that are unrelated. So, the first comment is, as you find more activity by funded searchers, as funded searchers move up and start buying companies in the three, four, five million dollars of EBITDA, you're going to find competition because there the smaller private equity firms are also participating. So, if you start dancing with the larger animals, you know, you're going to find more carnivorous activity. So, that was point one. So, size is a big role here. If you buy a business that has $500,000 of pre-tax profits, I'm pretty sure you're not going to have ten bidders.

Royce Yudkoff:

Right. You're probably not going to have any bidders. You're probably up against the owner's reserve price and bidders are coming along serially, you know, “Will you take a million?” “No, I won't take a million.” “Will you take a million one for this?” And that's the way it's being conducted.

Rick Ruback:

Right, right. People often analogize this to selling or buying a house and I don't think it's like that at all. I think there's much more activity and much more transparency in real estate than there is in small businesses. Anyway, that's point number one. Point number two is that Royce and I often recommend using brokers because it shows a commitment to sell, which we think is very important. But one of the downsides of brokers is, of course, brokers are the agents of the sellers. And we have had in class brokers all the time to talk to our students about the process and how it works. And one of the lines sticks in my head - Royce, I don't know if it's stuck in yours - is one of the brokers said, you know, “Oh yeah, this was a very competitive process. We got competitive bids from the same buyer. You know, I know when I do my job well when I get a buyer to bid against him or herself.” So, you call up and you say, “I want to buy this business.” And the guy’s had it in his catalog for two years and nobody has called. And you call and the guy says, “Well, if you don't buy it today, I don't think it's going to be available tomorrow. There are so many, I can't tell you. You’re the seventh phone call I had today”, right? And I don't know that they lie, but they certainly…exaggerate? Is that fair, Royce?

Royce Yudkoff:

Exaggerate is fair.

Rick Ruback:

They exaggerate the amount of competition and that's sort of their job and you, as the buyer, have to have confidence about what the marketplace is like and form your own sense of value and try to negotiate in good faith, but have a reservation price, something you won't go above.

Katie Zandbergen:

Speaking of the valuation of small businesses, that leads us actually to our next question, which is: In my MBA finance course at the University of Michigan, Ross School of Business, I recently learned about the impact of the cost of capital, i.e. the discount rate, on asset valuation. Can you comment on how the discount rate applies to the valuation of small businesses? As a searcher, assuming I'm looking at companies with EBITDA between $750,000 and $2 million, should I aim for three to five times EBITDA regardless of prevailing interest rates or should I adjust my valuation range according to the cost of capital?

Rick Ruback:

All right, I think I should get this one, Royce.

Royce Yudkoff:

I think you should answer this. I think the audience should know I travel with my own economist and when we get questions like this it goes right to Rick.

Rick Ruback:

One of my areas of research for many, many years was around cost of capital. And one of the things which I find it really intriguing that schools don’t do a great job teaching is what's the foundational requirements to use cost of capital in valuation. And one of those foundational requirements is a nearly perfect capital market and an efficient capital market, and that is a great assumption for public firms. It's a great assumption for any large firm that has easy access to capital markets, has analysts following, has fair amount of information about the firm. In those places, the kind of discounted cash flow calculations that you use the cost of capital in, those calculations make sense when you have a near perfect capital market. When you have a small firm, the capital market couldn't be less perfect. It's one of the reasons why Royce and I were so intrigued by the small firm space, because we're going from a world in corporate finance where much of the analysis and thinking is in a world in which any good idea, any positive net present value project, can get capital to a world where capital is quite scarce and hard to get. And since capital is quite scarce and hard to get, the cost of capital isn't the right valuation approach because you can't borrow and lend at the same rate, which is one of the real requirements of using a discounted cash flow analysis. So, with DCF out, the multiple has become the prevailing approach. Now that said, I often recommend people develop detailed models, not to do the discounted cash flows but sometimes to compute discounted cash flows, to figure out what's important in their model. So, how important are later cash flows? How important are early cash flows? Those kinds of things. So that doesn't mean you don't do the modeling exercises. It just means you don’t really trust the valuation you get from your discounted cash flows. With respect to interest rates, obviously in an inflationary environment, like we have now or had last year and might have again next year, depending on how things evolve, of course, you need to take account of the interest rates, but that’s coming in through your cash flow modeling because the interest rates are being reflected in higher interest payments, and so you can kind of look through. And to the extent you don't get an SBA loan but get a conventional loan, you'll find those higher interest rates impact the amount you can borrow because of the covenants. Higher interest rates mean higher covenants. What is troubling about that question is that people are learning a tool without learning when the tool applies.

Katie Zandbergen:

Yeah, the circumstance.

Rick Ruback:

Right, so it's like giving people a hammer and now they're trying to…

Royce Yudkoff:

Do surgery with it.

Rick Ruback:

…put a screw into a piece of wood, banging it with a hammer because that's the only tool they have.

Royce Yudkoff:

Yeah.

Katie Zandbergen:

All right, next question: My wife and I have successfully searched for, located, acquired, operated, and sold two small businesses in North Texas. In one of your earlier episodes - and I'll just add here that it's the Geoff Duckworth episode - you expressed puzzlement at why a small business owner would want to tie up capital in owning real estate. Although both my businesses operated out of leased facilities, I learned in my prolonged search processes that it's a lot easier to get bankers' attention, support, and favorable terms, if real estate is involved. Owning your facility also offers the security of knowing that your rent is never going to go up and the landlord is never going to give you any trouble or end your lease. Finally, real estate is generally a good long-term investment. But the main reason I'd advise a small business buyer not to categorically reject an opportunity that includes real estate is the potential financial benefits. What are your thoughts?

Royce Yudkoff:

Well, I have a couple of thoughts, if I could jump in first.

Rick Ruback:

Go ahead, Royce.

Royce Yudkoff:

I think it would be useful to take one step back on getting loans so we could take two steps forward. When you're buying a business and you look for a bank to borrow from, there are two types of banks. One group are banks that essentially want to lend against assets, so they will lend money to help you acquire a business and their plan to get repaid is, number one, the cashflow of the business will repay them. But if that fails, they want a set of assets that they can put liens on and grab those assets and sell them to pay back the loan, assets like real estate or equipment or inventory or receivables. And those are called asset-based lenders. And it's just, not that they have a sign outside the door, but there are a lot of banks that have that philosophy of lending. And the other group are cashflow-based lenders, and these are also banks and they are willing to lend to buy a business against the cash flows of the business, even though it's a service business that has no equipment, no real estate, no inventory, very little receivables, but they feel very secure with the cash flows of the business. And when you are buying a company and looking for a lender, one of the first questions you want to ask is, “Do you require assets to secure your loan or do you lend against cash flow businesses where there are no assets?”, and lenders will divide on these issues. My suspicion is that the person who asked this question is dealing with banks that are asset-based lenders and experience excitement when they're presented with a piece of real estate because they want to lend against assets like that. But I think the larger advice to searchers is you should determine very early what type of lender a particular bank is and bring your deal to lenders who fit with that. I don't think that real estate enhances your ability to borrow because when you show up with a business, say worth $4 million and you're trying to raise a couple of million dollars in a senior loan, if you also add the seller's real estate to that, sure, the lender will lend you more, but he's not going to lend you more than a hundred percent of the value of that real estate. He'll lend 50, 60, 70, 80% of that. It's not at all clear to me how that helps finance the business you're buying. So, I think it's all about the lender you work with, not about forcing real estate into the transaction. Rick, your thoughts?

Rick Ruback:

I do have some thoughts, but I agree with everything you said and I think that's exactly right. It's a rare situation where you solve one problem by adding another problem to it, which is what borrowing for both the building and the business does. I would also add though that I distinguish between two kinds of businesses, businesses where the real estate is really integral to the business and businesses where the real estate is not. So, let's talk about the latter. If you're a medical billing company, you probably don't have any specific real estate at all. You need an office park, a condominium floor with a bunch of desks and some computers which are often portable, and you can move to the office building across the street or in another block of the same city, probably in a weekend, with probably very little professional moving help. And those businesses, I think, should never own their real estate, for reasons I'll explain in a minute. The former kind of businesses though, where the real estate is really integral to the business, and the way to tell is that you couldn't do the business without the real estate. So, one of my favorite examples, I think I've mentioned it before, was a candy factory and they had these pipes of hot goop going through the building and, you know, you could never move this business because the machinery would cost you millions of dollars to move and reorient. And so that real estate was an integral part of the business. You couldn't do the business without the real estate. If you're buying a business where the real estate isn't essential, isn't part of the business, then what I would say is you should focus your attention on what you do best. So, if what you do best is real estate speculation, then you should do real estate speculation. There's certainly a host of people who've made a lot of money in real estate. If that's your expertise, do it. If your expertise is buying and running a small business, do that. Next question.

Katie Zandbergen:

Next question. How can you find and evaluate potential mergers and acquisitions attorneys for small business transactions? And how should a searcher think about closing costs for a deal, and specifically the legal closing costs?

Royce Yudkoff:

Well, I'll take the first half of that question. The best way to find a merger and acquisition attorney is to talk to several searchers, preferably ones that you have some relationship with, and ask them if they'd strongly recommend the merger and acquisition attorney that they used, because this is a profession, like other skilled professions, where most people can't directly evaluate that person's skill, but it can be seen through work they've done previously. So, I would go on a reference from someone you trust who's done the same thing that you're trying to do. And then when you meet with that attorney, I think the most important thing to ask them is, “How many small firm purchases and sales have you done in the last two years?” And the answer should be like ten or more because experience in that sector tunes them in to market terms and conditions, common issues in negotiating small company purchase agreements, and you want someone who has done this a lot. So those are the two steps I'd take on finding. Rick, do you want to either add to that or turn to the issue of how should the searcher think about closing costs?

Rick Ruback:

I agree with every word you said. I just want to emphasize one, which is that, you know, if you needed wrist surgery, you wouldn't look to a knee surgeon, right? You would hopefully find a wrist surgeon. Now I suppose if you're in a deserted island, you go to whoever happens to be running around with a knife. But generally speaking, if you got a broken wrist, you want a wrist surgeon. If you got a torn ACL, you want to get somebody who's fixed a torn ACL. The same is true in business and hiring an attorney. If you want to buy a firm that has a market value of around $4 million, you don't want to hire an attorney who is used to dealing with 40 or 50 or a hundred million dollar transactions because they're going to be crazy expensive and they're not going to understand the market that you're working in. Similarly, you don't want to hire your real estate attorney. You don't want to hire a trust and estate attorney. You really want somebody who knows this marketplace. In terms of costs, Royce, boy, I don't know. I mean, I would say that I don't think that's a place to economize, on the attorney's fees, and it's because contract law is complicated. Most people are not very good at reading contracts. And so you really want somebody you know and trust. And, I don't know, if you're buying a $4 million business, Royce, what do you think?

Royce Yudkoff:

75 to 100 grand, something like that for the lawyer.

Rick Ruback:

I was going to say 50 to 75, something in that neighborhood.

Royce Yudkoff:

I think it should give searchers some comfort on this issue, because that is a lot of money, is one, you only really start using your lawyer intensively late in the letter of intent to definitive agreement process. You have completed most of your business in accounting due diligence. You've worked a lot with the seller, so the odds of closing are higher when you sort of click on the lawyer. And then second, all lawyers and just about all accountants will accrue their bill and not send you monthly bills until the closing. So, when you pay those is when the bank and the investors wire their money in, you wire the money to the seller, the lawyers and the accountants present their bill to you, and you pay them out of the equity or debt cash that you've received. The problem, of course, is if a deal doesn't close, you have to have some reserve for broken deal costs. Sometimes lawyers will carry you on those, but you're not paying these as the deal is going forward.

Rick Ruback:

And I would say the structure of the deal has a big impact on your legal costs. If you decide to create a really complicated earn out or really complicated seller note or a really complicated inter creditor agreement, all those things will substantially add to the cost of the legal work. Similarly, if you're in a business, or you're buying a business where the structure is complex, there’s three or four interrelated companies, in this assets or that assets, or it's a carve out of another company, all those things create more complexity and more complexity means higher legal costs.

Katie Zandbergen:

The next question comes from a listener who sent us an e-mail asking: I'm exploring the idea of an ETA brokerage and consultancy for searchers and business owners in Africa. I think there's a significant opportunity for value creation in the region through the growth of ETA activity, and I don't think many searchers are aware of the potential for personal fulfillment and financial gain in the region. Along these lines, I'd love to hear your thoughts on what you think about the potential for entrepreneurship through acquisition in emerging markets.

Royce Yudkoff:

I think there's great potential for ETA in emerging markets, and Rick and I have seen boatloads of it in Latin America, Eastern Europe, in particular. Less to-date in Asia and Africa, but we see it there, and there's tremendous opportunities to bring developed market business ideas into those markets. What I don't love is the idea of starting a consultancy or brokerage to serve that market. The way to take advantage of that market opportunity is to do ETA. I find that small companies don't make good consulting customers or brokerage customers because the dollars they have to work with are small and therefore the dollars they're willing to pay to an advisor are small. So, I don't like brokerage and consultancy for small companies anywhere on the planet. Rick, what do you think?

Rick Ruback:

I agree with that. I think you just don't get the potential for fee income in the smaller space. With respect to emerging markets, we have former students who've been very successful in buying businesses in Africa. What I would say is that, from my discussions with them, ETA in developing markets is very much a personal journey. That is to say, you have to go meet potential buyers. You can't use the kind of e-mail systems and brokerage systems. You're selling the idea of searching, you're selling yourself to potential capital providers. It's something that, I think at this stage, requires an entrepreneur to be very entrepreneurial. You actually have to go out and do most of it yourself. So, I agree with everything Royce said about brokerage and consultancy generally to small business, but I think in developing markets, it's even a more challenging situation.

Royce Yudkoff:

I agree with that, Rick, and there are two more comments I'd add about emerging markets, which is, first of all, I think you have to be from that country to be effective in an emerging market. You know, the United States and Canada are a little bit unique in being very accepting of immigrants who want to launch entrepreneurial ventures. There are many countries around the world where it's just harder to do business if you don't have a network of relationships and understand the language and the country. The second thing I would say is, there are many opportunities, like growth, that you don't get in developed markets, and there are many challenges you have that you don't have in developed markets, like a shakier rule of law. One of the best ideas I've ever heard about investing in a developing market is to acquire a business that has all of its costs in that local currency and all of its revenues in a developed market currency because it's an exporter. And in most of these developing markets, while each one is different, they commonly share a characteristic of a steadily depreciating currency. And so, you put yourself in the way of this change, where your costs are depreciating and your revenues are not. And so that's one thing I would look for.

Katie Zandbergen:

This next question is related to the last and it is: While the US market is well structured for search funds, have you seen any good examples abroad? That is, which countries outside of the United States are, in your opinion, most friendly to searchers and why?

Rick Ruback:

There's a lot of activity in South America, a lot of activity in Canada, activity in Mexico, activity in Western...can we still call it Western Europe, Royce?

Royce Yudkoff:

I think so. It might be dating us again in some horrible way, but...

Rick Ruback:

Well, I guess we should say, and in the European Union. When you go beyond those countries, it all gets a little bit more complicated and part of the reason it gets complicated is because the financial institutions are less developed. And so when you go to banks or investors, you have to sell them on the idea that you're going to buy a small business, and what that entails, and convince them that it's actually a reasonable thing to do. So that's number one. And then number two, you have to do the same thing with the potential sellers. So, I think it gets harder but we've seen our students do it. What we have found is that when students want to return home and earn MBA salaries but not work for multinational companies, ETA is the best path for that.

Katie Zandbergen:

All right, next question: I am a Navy helicopter pilot, and I'm getting out of the military next summer. I'm now working on my application to Harvard Business School in order to get the best education and network possible for this pursuit. I'm fairly certain I need an MBA to pursue this, given my lack of experience on the business side of management and because it seems that MBAs are practically a prerequisite for starting a search fund. Is the assumption that an MBA is essentially required true?

Rick Ruback:

No!

Katie Zandbergen:

Okay, next question.

Rick Ruback:

Hahaha.

Rick Ruback:

No, I don't think an MBA is required but I would say this. I've been in a helicopter a few times, but I've never been a helicopter pilot. They look really complicated. My guess is when you study to be a helicopter pilot, you don't pick up a lot of basic economics, basic finance, and basic accounting. And I think you need all those things. What I think you do acquire in the military, which is really special, is you acquire some leadership skills, enormous leadership skills that are mentored, which is a rarity and a really special skill. And you develop an approach to people problems that is also very special and I think dominant of what we teach in business school. If you combine military background with what you'll learn in a business school, I think you'll be in great shape. But I think if you don't know the basic accounting, don't know the basic finance, don't know the basic economics, it's really hard to do. I would say though that, for example, if you have an undergraduate degree in engineering and you've been working in a large corporation for ten years and you know something about product development, you know something about sales, you know something about manufacturing, whatever it is you know, you've led a small team, I don't think at that point you need an MBA. I think you've gotten the MBA through experience.

Royce Yudkoff:

I think you can also control this by maybe the size and complexity of the company you buy. I think if you're going to do a funded search and buy a business for, you know, $10 or $15 million of total consideration, an MBA is a really good idea and your investors are likely to expect that as part of your CV.

Rick Ruback:

Yeah, do we know - there must be, but I don't know any - examples of funded searches that don't have MBAs?

Royce Yudkoff:

Yeah, I come out where you come out, which is, you know, we've worked this terrain for 14 years and there must be, but we don't know any. They’re pretty scarce, right?

Rick Ruback:

Yeah. But non-funded, you know, self-funded, spouse-funded, lots of them.

Royce Yudkoff:

Yeah. If you look at the self-funded, spouse-funded, you know, searches of buying a smaller, small firm with an SBA loan and a few investors, lots of them. Happens all the time. And I think someone who's had, you know, an officer's responsibility in the military can take over a smaller business and do very well with it. That's a choice too, to think about as you weigh ETA, MBA, non-MBA, size of firm, that's part of the mix.

Rick Ruback:

But don't you think you need to know the basics of finance, accounting, economics, or no?

Royce Yudkoff:

I do, Rick, well I…basics would be the operative word. I think you can learn those or get help with those to the extent needed in a small buyout from a lot of places. You don't need to invest in a two-year MBA to learn how to do an Excel model and to understand “How does bank debt work?” There are boot camps that'll help you. There are friends you can reach out to that'll help you. You may disagree, I mean…

Rick Ruback:

Yeah, I mean, I sort of disagree with that one only because it's one of these things that you don't know what you don't know. And so what you want to do is have enough background so you can do some pattern recognition. And I don't think like a two week or a two weekend bootcamp on Excel modeling is going to give you intuition on what makes for a good business. So, I think you need to know those basics and I think you can learn them. The other thing is, of course, you and I are both finance professors and so we find this stuff pretty easy. Whereas flying a helicopter seems really daunting to me.

Royce Yudkoff:

Yeah, me too. Although I've read, by the way, that 50% of all American males actually believe that if they were asked to fly a jet plane, they could step in and land that jet plane, which concerns me about my fellow men.

Rick Ruback:

I actually think – so, now we're far afield - but I think flying a helicopter is more complicated than flying a plane. I don't really know. I've not flown either, but…

Katie Zandbergen:

We’ll delve into this in Season Two.

Rick Ruback:

We'll delve into it in Season Two.

Royce Yudkoff:

Thank you, Katie. Thank you for saving us.

Rick Ruback:

Yeah, thank you.

Katie Zandbergen:

What are your predictions for how entrepreneurship through acquisition will evolve in the next five to ten years?

Rick Ruback:

I can go first if you want, Royce.

Royce Yudkoff:

You go first, Rick. Yeah, no, you'll have the... I think you'll have a more interesting answer.

Rick Ruback:

I think it’s becoming more common. I think there is pent up demand to sell by baby boomer owners who haven't figured out what the right transition is, and they need to find somebody who can both manage the business and come up with the money to pay them. And that is really hard. A private equity firm is unlikely the answer. Big companies, not the answer. Selling it to an employee through an ESOP or something like that is almost never the answer. And so they need people who are like the searchers to find the business, buy the business, and be able to run the business. So, I think we'll see more of this as, you know, people from the tail end of the baby boomers are moving into their 70s and, you know, many are blessed with good health and are still busy working, but you got to think at some point they'll want to retire.

Katie Zandbergen:

Royce, what do you think?

Royce Yudkoff:

I totally agree and I think that as more people learn about ETA, there'll be more liquidity opportunities for these companies. You know, that five years ago that these companies could only find a buyer when the owner went around to connections he or she knew or found a local broker who went to other people in that business. And now I think they're going to have more choices of a way to get their entrepreneurial reward. So, I see it the way Rick does. I think this is going to be increasingly common as an exit opportunity and an entry opportunity.

Katie Zandbergen:

Do you think technology and AI will play any role in helping folks to search or in helping sellers to sell?

Royce Yudkoff:

Not materially, because here, to go back to an analogy which Rick made, this is not like selling a house, where the homeowner wants everybody to know that that house is for sale because it's in their interest to know that. The small business owner desperately does not want his or her customers or employees to know that he or she is contemplating a sale. And that need for secrecy means that these sales get handled in a very careful, special way that doesn't lend itself to some machine processing of opportunities.

Rick Ruback:

Right. Owners of small businesses are for good many reasons secretive. And, you know, AI and scraping and all those other things are only going to work if that information is out there. If that information isn't out there, you can't scrape to find it. And so I don't see a big change. You know, Royce has mentioned, we've been doing this for 14, 15 years, and every once in a while there comes across some new idea for database or a brokerage service or this or that, that, you know, the online brokerages and all that. And I think they're helpful and they've made the market a little more efficient, but it is a long way to go to be nearly as efficient as selling a house in a major city.

Royce Yudkoff:

Katie, I think we're done with our questions.

Katie Zandbergen:

I have one more. It's a question from your producer. If listeners could take away only three things from Season One of Think Big, Buy Small, what would you want those three takeaways to be?

Rick Ruback:

Only three things, huh? Well, let's do this, as we'll do. I'll offer one and Royce, you can offer the next one?

Royce Yudkoff:

Okay.

Rick Ruback:

Thing one for me would have to be that this career path can be transformative. It can take somebody's life that's on a particular path and dramatically improve the quality of that life. And I think we've seen episode after episode when we've heard the stories - Geoff Duckworth, Robin Kovitz, Jerod Pierce. Those are all episodes that are just enormously transformative. You hear how this journey has just opened up opportunities for them and their family that they likely couldn’t have imagined before. So that's my number one, that this path can really improve your life.

Royce Yudkoff:

That’s a really good number one, I have to say. I would offer as number two that most people, when they hear about entrepreneurship through acquisition, think of it as risky and something suitable for people who are comfortable taking big risks but hopefully what they took away from Season One is that it's actually the opposite because you are buying a business that's been profitable for ten, fifteen, twenty years, providing a service to customers who come back year after year after year, because it's in the customer's interest to do that. And, in fact, that is not a risky business. And if you contrast that to the job you have, which might be working for a very large institution, you have to reflect that in that job, you have a customer concentration of one. And that institution might be around forever but that doesn't mean you're going to be around forever inside that institution. And so if you actually reflect on it calmly and don't confuse entrepreneurship through acquisition with its much more famous cousin, entrepreneurship through startup, which is indeed very risky, if you reflect on it carefully, it's just change. It's not greater riskiness. So, that would be my number two on our list, but sadly, tragically, Katie offered an odd number, which I think means it's back to you, Rick.

Rick Ruback:

Yes, that means it has to go back to me. Right, right, right, right. I would say for number three, that searching is hard. That the market is in fact very fragmented, that it is very hard to find good companies, and it is harder to find committed sellers in places you want to live, in businesses that are selling for a fair market price, which is often in the three to five times pre-tax profit, and in a business that you can actually run, that you have the expertise to run. And there's a reason why people talk about the highs are really high and the lows are really low. I think there's a reason why the psychological challenges are there. It's hard work, and it's hard work without a lot of positive feedback until you purchase the company and two to three years later you say, “Wow, I'm so happy with what I've done.” That's what I would say number three is.

Royce Ruback:

On that note, Rick, as you know, this is our 12th and final episode of Season One and so this has been a lot of fun and I think done good work and listeners should know that we're starting to produce Season Two and we'll be back in the wintertime airing episodes from the next season.

Rick Ruback:

Right. And in Season Two we're going to dig a little more deeply into self-funded searching and spend some time discussing where you come up with the capital to actually make the acquisitions. In the meantime, feel free to e-mail us. I hope our listeners continue to reach out to us with questions and ideas and things that they think we should think about or things we might be able to help them with as they go through their journeys. And we'll be back, we'll be back with Season Two when the snow flies and we might be dropping in a mini episode here and there in the fall.

Royce Yudkoff:

See you soon.

Rick Ruback:

Well, talk to you soon.

Royce Yudkoff:

You’ve been listening to Think Big, Buy Small. We’re your hosts, Royce Yudkoff…

Rick Ruback:

…and Rick Ruback.

Royce Yudkoff:

Katie Zandbergen produced today’s episode. 

Rick Ruback:

Our audio engineers are Mari Shear and Craig McDonald. If you have any questions, comments, thoughts, feel free to just e-mail us – rickandroyce at hbs.edu.

Royce Yudkoff:

We’ll be back next week with another episode of Think Big, Buy Small.