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 Yudkoff:

Rick, you and I have the pleasure today of having with us as our guest Zach Duprey. Zach is one of the most experienced lenders to search acquisitions and for a number of years has worked at banks that have specialty departments that focus on lending acquisition loans to searchers. It reflects a sea change that took place several years ago in the industry, where searchers were able to move from finding a local or regional bank in the area of their acquisition and seeing if they were interested in search, to being able to form a relationship at the start of their search with a bank that will follow them anywhere nationally. So, Zach has a lot to tell us about arranging for an acquisition loan for your search.

Rick Ruback:

I'm excited about this conversation. Zach, I was thinking this morning about the first time we met, which I think is well over a decade ago. You came to visit the class Royce and I do in the spring and we had a panel on lending.

Zach Duprey:

Thanks for having me on the podcast, Rick, Royce. I appreciate it.

Rick Ruback:

Oh, it’s wonderful having you.

Zach Duprey:

So, you have a great memory. That was my first time coming to HBS. We had been introduced to search by two of your students, Mike Donovan and Tyler Hogan, who found a business in New Hampshire, and we were focused on commercial lending in that market and they approached the bank and we closed their loan. And within about a month of closing, I remember having a call with Mike and Tyler and saying, "Guys, what was that whole search-y thing you kept talking about?" And they were generous with their time and explained to me the different models of search, got us up to speed on the ecosystem, and they introduced us to another friend from HBS who was acquiring a business. From there, I was introduced to another friend, and next thing you know, I was a friend of a friend doing deals for HBS searchers, but only kind of in a local New England market.

Rick Ruback:

Right. That’s how you guys started.

Zach Duprey:

That’s how we started.

Rick Ruback:

New England only because I remember Royce and I had been working closely with a couple searchers and we called you and we said, "Hey Zach, how about this business?" And you said, "Nah, it's not in New England. Sorry, guys."

Zach Duprey:

Right. We would get calls from people saying they have a great deal in the Bay Area, and I would tell them, "Unless it's Back Bay Boston, we are not able to help you." And so what we started to recognize was the market was underserved by the banking community. We started growing from a $1 million loan to eventually a $250 million book of business.

Rick Ruback:

Wow, that's fabulous.

Zach Duprey:

This was when we went nationwide. So, we had a few New England clients, we were growing, and I went to the bank and said, "You know what? We need to go after traditional search deals. It's more predictable, there's more pattern recognition for the portfolio, and let's do that because they're nationwide." And the bank said, "Go ahead." And next thing you know, we grew very quickly. So, the first two deals we did self-funded, SBA transactions.

Rick Ruback:

Okay.

Zach Duprey:

After that it really focused on investors’ traditional model or lower middle market private equity funds doing similar deals.

Royce Yudkoff:

I’d just like to comment here – Rick, and I know you agree with this – this was actually a momentous moment in the financing of search, when you and your bank went national, because until then searchers would hunt for a company, they'd find some company in a random location, you know, and then once they had the company under agreement, they had to frantically search in that region among local and regional banks, who are the types of banks that have loan sizes that are about the size that's usually demanded by search, and find a bank that would be interested in doing that transaction, could get up to speed on search, maybe was a cash flow-oriented lender, because a lot of these businesses don't have hard assets. It was a very challenging period for all searchers because you are very time limited in establishing a new relationship, and so the product you and your colleagues innovated of going national with a focus on search kind of changed the world and made it easy to establish relationship as you started your search and port that bank anywhere.

Zach Duprey:

I appreciate that. We definitely had good luck in timing and then a lot of hard work. And so I think a big part of it was Matt Estep, who also was an HBS searcher, he and I had a conversation and it was kind of the “aha” moment when he told me that the idea of going national was the greatest thing to him because he had talked to fifty-five banks when he found his acquisition target. And to find a bank that would do a deal of that size at this end of the market, call it $1 to $5 million of EBITDA, without a personal guarantee, but you're not a private equity fund with committed capital from one large institution, the banks just didn't have a space for that. And most community banks want to lend in their local community markets. And M&A means a personal guarantee with a local business owner who's buying another local business. Larger regional banks, they might have a sponsored finance team, but they're doing deals much larger and up market. And so when you look at this end of the banking sector, there's just not a lot of appetite for deals of this nature, of this size. And then you add this concept of search, where you're going to bring in a new, unproven CEO, and I think that becomes a very, very tricky conversation at a credit committee.

Rick Ruback:

Just to echo what Royce said, I think it really revolutionized the market for search and brought it more mainstream because, just to shine a bright light on this, before you and your colleagues started lending on a national basis, the way this would work is you might search nationally, but you're going to borrow regionally. And so until you figured out which company accepted your LOI, you couldn't begin the bank process. So, you have ninety days to close from your LOI and the moment you get that signed LOI, you have to start chasing the bank process. You've never met the banker, you don't even know who the banks are. And now, when it's a national market, I think people still do a bit of the regional peaking for competition, but there is this national market that a searcher can say, "I'm going to call up Zach and talk to him about the kinds of firms I'm looking for and make sure if he has any questions about me or what I'm trying to accomplish, you know, we can have a telephone conversation”, and you get to know them. You know, they're going to learn a lot from that conversation because you've seen a lot of small businesses. But let's get back to your professional career. So, then you joined a new bank…

Zach Duprey:

Another bank, and we were always this anomaly within the banks, where we were doing something different and unique, doing a nationwide lending platform that they didn't already do. And so with Parkside, the introduction there was through Ben Geis, at Eagle Private Capital. He's a known person in the search community and we had a chat and he said, "I know the perfect bank for you. Their name's Parkside. They're here in St. Louis, and they're a fantastic business bank. They already do some nationwide M&As, so this would fit right in their wheelhouse." And very quickly we knew it was going to be a great fit for the portfolio.

Rick Ruback:

What I think is really interesting, this discussion that there's commercial banks and then there are commercial bankers. And it's really important to find the right banker and if you find the right banker, you follow that banker.

Royce Yudkoff:

Right, because they bring a lot of experience. They bring that ability to sort of quickly give you informal feedback on your deal and also on the likelihood of the bank's credit committee approving the deal, which is invaluable if you're on the clock to get financing and get something closed.

Rick Ruback:

Right. I would just like to say, because Zach's a humble guy, that we know many searchers who've worked with Zach, and when it comes to refinance, the first phone call is to Zach.

Royce Yudkoff:

Agreed.

Zach Duprey:

Appreciate the kind words.

Rick Ruback:

It's true. It's true.

Zach Duprey:

We've been blessed to have phenomenal clients and we really enjoy the space we operate in.

Royce Yudkoff:

Zach, maybe we could just sort of level set at this moment and, for all of the listeners who are doing their first acquisition as searchers, maybe describe at a high level the type of lending you do and that your competitors do, because there are now several banks that have these national practices. But describe with that first time searcher in mind, what is the type of loan you make and what do you look for in a borrower?

Zach Duprey:

Sure. So, our focus is on the non-SBA side of the market, so we would consider ourselves a senior secured lender to these acquisitions. So, you know, what that means is we are going to be in first position on the debt. We are going to finance the acquisition, but with senior lenders specifically, it's a relationship. We are looking to finance the deal that gets acquired. We're going to work with that CEO on the existing company, the growth initiatives they're going to make, and routine financial reporting, tracking covenants. And then we stay with that client usually until exit or until maybe things change and they might outgrow the bank or something that is completely different in the capital structure. But for the most part, we are a senior secured lender issuing, call it a $2 to $15 million check in the $1 to $5 million EBITDA range. And generally 35 to 50% of the transaction would be that senior note. Usually, part of the benefit of senior debt is you're paying a lower rate and it's less flexible, so that's sort of the trade-off of what we offer. And five to seven year loans is the norm in the market, so we specifically focus there.

Rick Ruback:

Let's take an example on an unfunded searcher who's buying a business worth a million dollars of EBITDA, so say four times, so it's a $4 million acquisition, so you'd be willing to finance $2 million.

Zach Duprey:

That's right.

Rick Ruback:

Two times. And if they said, “We'd really like to borrow three times”, no?

Zach Duprey:

That would probably be a better candidate for an SBA loan.

Rick Ruback:

So, one of the things I want to talk about is how you would advise people to think about, at this end of the market, an SBA loan versus a more traditional loan. Obviously, the personal guarantee is a very big consideration, but I think there are other considerations as well. So, you would say, “I'm going to give you 50%”, so $2 million. Maybe there'll be a million dollar seller note, and so a million dollars of equity. And then on the high side, if somebody's buying, say, a $3 million EBITDA business for, I don't know, let's just say six, so that would be…

Royce Yudkoff:

…six times.

Rick Ruback:

Six times, so that's eighteen. So, you would lend nine again or more or less?

Zach Duprey:

I think nine would be the top end. I think we would typically like to be somewhere in the two to two and a half times EBITDA, and we usually see some component of seller note or earn out. You know, deferred payment to the seller is a big part of a lot of the transactions we see. And many of the deals, we're at maybe 35% or 40% of the overall transaction, so we're seeing a lot of new equity being injected into the deals that we're working on.

Rick Ruback:

So, this is an important point, that at the higher end, where people are buying bigger businesses, they tend to have less debt because the multiples go up, but the coverage ratio, that is the number of times EBITDA you're willing to lend, so in this example it was $3 million, so two, two and a half is six, seven and a half million dollars of debt.

Zach Duprey:

I would say at this end of the market, it's not uncommon to see three times. Depends on the business, the characteristics. It also depends on the lender, right? You know, some banks can be more aggressive and more interested in deploying more debt into these transactions, but many of us want to be on the more conservative side because these are smaller businesses. They have less durable qualities, in many cases, than a larger transaction. And so I think you have to be prudent with the amount of leverage going into these deals.

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Royce Yudkoff:

I think one thing for our listeners to take away is shopping matters, as you're approaching different banks, because different banks have different types of loans that they want to make. And so the first thing you do when you approach a bank should be to select banks based on whether they lend the kind of loan you want regularly. And so the dimensions you should be asking banks about are, “What is the size range of loans you like to make?”, “Do you like to make loans that are secured by actual assets, like receivables and inventory and real estate, or do you make loans based on the historic cash flows of the business?” – because the type of business you're buying will be one or the other and you want to match with a bank that does that – and “What are the limits of your target geography?” and “What are your industry preferences?” All these kinds of questions will allow you to whittle down to a smaller number of banks that do what you're buying.

Rick Ruback:

I think that's exactly right and it’s important that you don't want to be a pioneer. If somebody says, “Oh, that's a really interesting idea, we've never done that before”, you don't really want to be the first one. Just move on. You have to find a match. And interestingly, that match might not have anything to do with you or your business. It has to do with the bank's history, the rest of the bank's portfolio, the personal experience of people on the credit committee, the relationship with bank examiners, all those things that have nothing to do with you, but it can affect you. So, you need to know where their enthusiasm is at. And if it doesn't match you move on to the next bank. It doesn't mean that just because this bank doesn't want to lend to you, you won't find another bank. Of course you will. But you want to get to “no” as quickly as you can. Royce, let’s get back to the conversation.

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Rick Ruback:

What do you think those big risks are? I think about the CEO transition. Do you think something else?

Zach Duprey:

I think the CEO transition's huge. I think a lot of times in these smaller companies, there's a lot of investment needed, and this is at the half a million of EBITDA to three, four, five million of EBITDA. They, a lot of times, are owner operated. They haven't invested a lot in technology, financial reporting. They probably need a number of new hires to be prepared to grow, so there's a lot of investment that we see necessary in the first year to two years, and…

Rick Ruback:

That's painful, right, because it all comes out of EBITDA.

Zach Duprey:

It all comes out of EBITDA, and it doesn't translate to actual growth. It's something that translates to a higher quality of business, but at a little bit a lighter EBITDA than what you got into it.

Rick Ruback:

It's painful because you're walking around and you look at the projections, nobody ever projects that EBITDA goes down, right? And then the CEO's in the business for a few months and they say, "Oh, I need a new CRM. I need a new CFO, this and that." I mean, these are not corporate airplanes. It's not frivolous SG&A. It’s things that you would expect a $3 million business to have, a professional accounting system, a professional customer tracking system, right? All these things that the previous owner might've done it with sticky notes.

Royce Yudkoff:

And often the previous owner is an older person who has more money than time and they're not that interested in growth, you know. They're not hiring that new sales manager. And so when you come in as a young entrepreneur and you have energy and time, these are the expenses you want to make.

Rick Ruback:

Right. But I do think most sellers grow their business to the point where they filled up their SG&A…

Royce Yudkoff:

Exactly.

Rick Ruback:

…so everybody in the front office is working pretty hard and we all recognize that to take that next step forward, you're going to have to do something really sad, which is…

Royce Yudkoff:

…spend money!

Rick Ruback:

Yeah, spend money on people who don't actually sell and don't actually manufacture. I’m talking about somebody who's actually calling customers and say, "Excuse me, we sent you a bill forty-five days ago and it was due net thirty and we haven't heard from you yet and, you know, I see another purchase order from you. I just want to make sure before we send this purchase out the door, you've paid for the other purchase. Could you do that please?" That kind of basic blocking and tackling, right?

Royce Yudkoff:

It costs money.

Rick Ruback:

It costs money. And it costs money to have a computer system so that you can track every customer. The customer calls you and says, "Where is my product?" And you can say, "Oh, it was shipped out last Tuesday and UPS says you're going to get it tomorrow."

Royce Yudkoff:

Yeah, exactly.

Rick Ruback:

Customers demand that!

Zach Duprey:

We find that a lot of our young entrepreneurs, they definitely know how to assess the opportunities and what they don't recognize is the cost and the time it takes is much more difficult. So, it might be a simple thing but it isn't easy and it certainly isn't cheap.

Rick Ruback:

No, I mean, it's always the case that if there’s an IT program that you need, everybody says, "Oh, this is going to be really easy. It's going to cost fifty grand." And I always multiply by three, right? And I've never been wrong. Sometimes three has been too small. It's never been too big. So, there's the CEO transition. There's just the professionalization of the business. How about due diligence mistakes? One of the things that keeps me up at night after a transaction's closed is due diligence mistakes. And I know, for Royce and I, if we've been involved in a transaction and we get through the first six months and, you know, maybe one of us is sitting on the board and we always have this conversation, “How's the business doing?” And the question isn't, “Are they selling? Are they growing? Have they, you know, invented some new product line?” That's not the question. The question is…

Royce Yudkoff:

…has something horrible fallen out of the closet that we didn't know was in the closet?

Rick Ruback:

Are there due diligence mistakes? Because we’ve seen some and they’re horrifying. And when you own a business and you're walking down the street and a piano falls on the business – think COVID, you know, or you own a restaurant and they close it down – you feel bad, you've lost money. It's terrible, but you don't feel stupid.

Royce Yudkoff:

Right.

Rick Ruback:

Right? Whereas, if you've been promised a bunch of inventory and you never got around to checking it, and you finally buy the business and you walk into the warehouse and there's no inventory or it's expired or it's obsolete or it's all broken, you feel stupid.

Zach Duprey:

I would say that a lot of the challenges we see are not because of fraud. It's really because of just maybe misunderstanding the complexity or nuances of an industry. I think while you have a seller in there who might not be optimizing for growth or they might not be seeing the same opportunities you do for this company in that industry, they also have ten, twenty, thirty years of experience doing something that you've not done. And so I think that learning curve is steep for a lot of industries, for a lot of businesses. And so coming in and implementing Salesforce and hiring some sales folks doesn't necessarily change the fact that you’re an inexperienced operator - you've never run a business before, maybe only led a small team in the past – and now you're running a business in an industry that you have limited experience in. And I think that is where a lot of the challenges come from.

Royce Yudkoff:

Let's imagine a new prospective borrower walks in the door and describes the company they have under letter of intent. Walk Rick and I a little bit through your checklist of qualities that are important to you in the company. And I know all businesses are different, but I'm sure an experienced lender like you has sort of a mental checklist of things that are likely to make this a loan you'd want to do as opposed to politely ushering them on.

Zach Duprey:

Sure. So, I would say with every transaction we look at, there's three legs of the stool we're going to start with. Number one is the underlying business. If we don't like the industry, maybe it's just too big for us, maybe we really aren't excited about the space – you can't do the deal if we do not like the business. Then it's going to be the operator. Most of the transactions we're working on, the searcher is going to become the operator, so we have to get to know them and make sure there's good fit. You know, there's a lot of people who have great degrees and are very smart and think they can lead a business, but if it's in an industry that they really don't know enough about or it's a very technical space that they might not have the background to fill that seat, it could be very difficult. And then the third is going to be the investors. Where's the equity coming from? Do we know the people? Do they provide good corporate governance that we trust? So, those three legs of the stool are where we're going to look at every transaction, but first and foremost and most important is going to come down to that individual business.

Rick Ruback:

And do you think you look at the business differently than an equity investor would look at the business or do you think it's the same?

Zach Duprey:

Very different, but many of the same characteristics. So, we're looking at the same things on a downside risk because we don't get the equity upside, right? So, we're not participating in the big win. Our best outcome is just to be repaid that loan we're giving you at the beginning to acquire the business. So, a lot of things can happen in that business that you could still come out with a decent exit. But along the way, if you're not going to be able to meet covenants, if you're going to be struggling with your regular payments, if you're going to be a difficult borrower, it could be really hard for that bank to want to underwrite the loan. But an equity investor might see that company, that industry, even that searcher as a fantastic opportunity because of what the growth could look like.

Rick Ruback:

So, the risk-return trade-off might be very appealing. So, a lot of risk here, but there's a lot of return potential. So, I like that, as an equity investor. You, Zach, the commercial banker, say “no”?

Zach Duprey:

I would say the hardest ones to finance are obviously the ones that are not performing well and sometimes the ones that are almost performing too well, because they’re growing so fast and the needs kind of outstrip what the initial lending was.

Royce Yudkoff:

So, Zach, you laid out these three legs of the stool. Maybe we could now dive deeper into it. And you started with industry. Can you breathe some life into sort of the characteristics of industries that a banker like you likes and characteristics you don't like?

Zach Duprey:

Sure. I mean, from our perspective, the more predictable the better. And so so much of the top-performing clients we had just had fantastic revenue quality, either recurring revenue or extremely repeat revenue with sticky clients. And so I think that is one of the best starting points for us because if you have a good business with really good revenue characteristics, you have a lot more time to figure out the challenges and a lot more time to overcome those challenges than you do if you're really just struggling to keep the business afloat or struggling to bring new clients in the door. So, I think that's one of our best starting points.

Royce Yudkoff:

Quality of revenue.

Zach Duprey:

Quality of revenue, just understanding the clients, the relationship, how sticky they are. Those are some of the key things that we're really focused on. EBITDA’s important but that can change very, very quickly depending on the investments that are needed and so forth. But with a strong business, usually it starts with that top line.

Rick Ruback:

So, we tell our students to look at two criteria. We look at churn rates – how sticky are the customers? How many of the customers that purchased from you last year are buying from you this year? So, if the churn rate is quite low, it means you have a lot of recurring customers and we like that a lot. I suspect you do too.

Zach Duprey:

Right. Churn is very important for us. So, generally what we're going to be focused on there is just how long have they been a customer? Is there key man risk here? Is it one person? Are you selling to multiple divisions within an enterprise? Is there concentration? So, is that a concentrated account and, you know, they have higher churn recently? Like, that could be a big problem.

Royce Yudkoff:

Just like an equity investor would worry about having concentration to one or two customers.

Zach Duprey:

Yes, I think so.

Rick Ruback:

So, one of the businesses we featured on our first season, which I quite liked, was Jackie Kopcho's pool maintenance company in Long Island. And, you know, all those customers are repeating in the sense that you don't sign a five-year contract to have your pool serviced, I don't think.

Royce Yudkoff:

You're right. In fact, you sign a new contract each spring for the coming season.

Rick Ruback:

But she gets virtually every customer to come back. It's repeating, not recurring, but it's pretty good repeating.

Zach Duprey:

Right. And then she has a history to show that, right? And so because of that, I think a lender could easily get comfortable with it. So, obviously, a contractually recurring business on multi-year contract…

Rick Ruback:

You love that, right?

Zach Duprey:

... is super sticky. I mean, we all love that.

Rick Ruback:

High switch costs for the customer, that's best.

Zach Duprey:

Everybody loves that. Very few businesses have that characteristic. And so therefore you have to keep going down that list to say, “Well, how sticky are they? How recurring is it? How hard is it to switch?”

Rick Ruback:

1. And then the other criteria that I’m just going to say is Royce's favorite, and I’ve come to love it too, is margin. We look at margin a lot and I suspect we're probably reasonably aligned on the importance of recurring customers but maybe margin, we view differently. I don't know.

Zach Duprey:

I don't know if we view it differently. I mean, we look at margin in the sense of what's changed. Is it growing? Is it stable? Why are the margins so good for the last two years, and before that it was never a high margin business? We're really looking for the change, if there is any. I mean, some businesses are durable, profitable, and just don't have great margins. Other businesses have phenomenal margins, but sometimes it's really about what is changing in the last few years, because what we're trying to look at going into the business is how predictable is that company? So, based on what's happened in the past, is it expected to continue? And now you're layering in this transition risk, a new CEO and so forth, that is inherently going to make it a higher risk than it was today.

Royce Yudkoff:

Yeah, Rick, this is interesting and relates to an earlier point you made, you know, the distinction between equity investors and lenders, because as equity investors, you know, the reason we like a big fat margin is it suggests that there's pricing power in that business. The ability to raise price, which of course you as a lender do not really participate in but, you know, if you have a 25% margin, it means that customers either can't easily switch vendors, they can't really put price pressure on you, or it's just not important to them because there are other things in your service that are really important to them, like delivery on time, quality, et cetera. So, that's why we look at it.

Rick Ruback:

Right. We look at it as a summary statistic for a barrier to entry, to keep competitors out. Some people call that a moat, but for us it's a summary measure. Zach's looking at it differently. He's looking at it as a measure of, “Did something change and do I have to worry about some, if you would, not nefarious, but maybe artificial inflation of the quality of the business?”

Zach Duprey:

That's right. We are hopeful that what the borrower's buying is something that is expected to continue in a predictable way. And if there's growth opportunity, that's fantastic. It lowers our risk. But at the same time, we don't want to see that prior year's numbers be far off because of a major new client, a special project, or something that changed the margin profile and it's not sustainable.

Rick Ruback:

“These last two years were really good and now I'm selling because I know that great customer's never coming back. And so I'm going to sell now, I'm going to look great. I'm going to get four or five times that big number and then - ha, ha, ha, buyer - you're going to have to wake up and figure out something new.”

Zach Duprey:

Well, that's what made deals so difficult to assess in the post-COVID, you know, eighteen, twenty-four months. Everything changed. You really couldn't, you know, point to one thing to say, “This is where they should be” or “This is why there's a difference.” Everything was different.

Royce Yudkoff:

So, Zach, you identified the three legs of the stool in your assessment and you’ve breathe some life into, you know, what are the things you look at in the quality of the business, the first leg. The second one is the operator. And maybe you could expand on this a little bit because one of the challenges for you as a lender, lending into search, is that most of the time these young operators are early career managers. They typically have five to eight years of mid-level experience in someone else's company. They’ve rarely worked in the industry they buy, although it may be analogous to other jobs they've had. So, you know, it's not the same as a private equity firm, which will often hire in an executive as CEO, who's been in that industry for twenty years. Tell us how you and your colleagues get comfortable with the operator.

Zach Duprey:

Sure. So, I think it comes down to how they're managing the process, right? They're going to sign an LOI, they'll get introduced to us. And now we get to experience how they're managing the different stakeholders involved. They're working on structuring the deal with their attorney. They're navigating the first time the seller has ever sold their business. They're working with their investors, who all need to learn about the transaction and get on board. And they're working with us as a lender, as well as sometimes other service providers, quality of earnings, sometimes there's other diligence that's being done. And so we're assessing how they're interacting, what they're learning, how they're communicating. Many of the skills may be outside of managing people that the incoming CEO is going to need to exemplify very well before that transaction, so we're watching how they handle that.

Royce Yudkoff:

Because this is something else they're doing for the first time. And so in that way, it's sort of a proxy for when they become CEO and are doing a bunch of other things for the first time.

Zach Duprey:

Absolutely.

Rick Ruback:

So, for example, if they're slow to answer an email, like you ask them for something and it takes them three days and you have to remind them twice. I mean, you're going to look at that and say, “Wow, what's that going to be like when we're into the next stage of our relationship? Am I going to enjoy this for the next five years?”

Royce Yudkoff:

Yeah. When I'm not prospectively handing them $3 million to buy the business, but I'm just trying to get my darn question answered!

Rick Ruback:

When they're not on their best behavior.

Zach Duprey:

We're looking for transparency. That's one of our biggest things. If we just feel like we're not being told the full story or that they're telling certain people certain things and not everybody the same things, those things can be difficult because we are looking for a long-term relationship. They're going to have to be reporting to us and providing, you know, regular covenant reporting, financial reporting. We are going to work with them and probably grow the relationship over time. And so we don't want to get started, where we're unsure if we can trust how they operate.

Rick Ruback:

Would you expect that a potential acquirer who's communicating with potential equity holders and potential lenders simultaneously, would send the same set of projections to their equity holders as the bank?

Zach Duprey:

So, I've heard people do it both ways. I'd like to see exactly what they're thinking of doing, so if they're sending to their equity investors what the real plan is and then sending us something different, that's not productive, because what we're trying to figure out is not just the loan today – do we want to do this acquisition with this person and these investors – but what is their growth path? What are they trying to do with this business? Because we might not be as excited about the future, and I'd like to tell them that today so they can find the right partner. Maybe that's us, and I hope it is, but if we're not, we want to know that going in, not six months or two years down the road, when they're now executing on the plan that they had all along, and we might not necessarily have been on board with it.

Rick Ruback:

And that's kind of infuriating, right?

Zach Duprey:

Right.

Royce Yudkoff:

I think one big takeaway for searchers / listeners in this conversation is that lenders like Zach are really, in most ways, just like equity investors, in that they really want to understand the same issues about the business, revenue quality, customer concentration, expenses needed to grow, with the important difference being that the equity investors are moved by growth in profit and the lender is really not impacted very much by that, and so is going to be much more downside-focused. But otherwise the questions and the conversations are quite similar. Don't you think, Rick?

Rick Ruback:

So, I think both want to see the same quality of earnings analysis and customer analysis and business due diligence, that kind of thing. I think the questions that they're going to be interested in are different. I think the lenders are going to be much more concerned about the downside and, from what Zach says, the variations in the business. It's like if you look at a five-year projection, the lender is likely to look at the year where you had the lowest margin and say, “What's the risk of this happening again?” Whereas the equity holder is going to look at the year of the highest margin and say…

Royce Yudkoff:

“How do we make that happen again?”

Rick Ruback:

“How we make that happen again?”

Zach Duprey:

I think we're all looking for alignment, right? We want to have a mutual, beneficial relationship, that we're on the same page, and I think that's where the transparency really comes into play. A lot of times we can get there, but we want to make sure everybody understands it. We don't want to show up at a credit committee with this material change later on because that was the plan and we just weren't aware of it.

Rick Ruback:

Now, obviously, when you buy a business, the plan only lasts so long, right? There's going to be opportunities that arise, challenges that arise, and you're not asking people to necessarily only execute along the path that they conceived of at the moment they bought the business. But what you want is, “Tell us what you’re hoping for, what you're concerned about. We'd rather know about the risks than be kept in the dark.”

Zach Duprey:

I think that's said well. We definitely like to talk to them ahead of time, know what's going on, and be a part of that solution as well.

Rick Ruback:

Yeah, so one of the things I take away from this is that the stupidest thing a potential acquirer can do is to sugarcoat the business to the lender. You haven't said this but I get the feeling like one significant misrepresentation and you're out.

Zach Duprey:

I would say that's right.

Royce Yudkoff:

I agree with that, Rick, and I would add that, you know, to the searcher walking into the lender, they may feel like they know that business much better than the lender does because they've spent weeks or even a few months studying that business. But what the lender has is a whole bunch of pattern recognition from seeing that same business presented over the years by other would-be borrowers, so it's easy to fool yourself into thinking that you're the expert and they're not.

Rick Ruback:

They might not know this particular business but they know lots of businesses like this. You know, part of the things that people complain about lenders, they say, "Our equity holders are looking through the windshield and our lender is looking in the rearview mirror." That's their complaint. “Why don’t the lenders look through the windshield at what's in front of the business?” But I get it, because when you look in the mirror, you're not saying, “Oh, history's going to repeat itself.” You're saying, “What's the inherent variability of this business? And I got to look at history.”

Zach Duprey:

Right. Predictability matters to us and, again, the future enterprise value might repay the loan to get us out of a deal, but that's not the key focus. It's being able to repay that debt and being comfortable in that credit and making sure it's predictable to be able to do that.

_____

Royce Yudkoff:

Rick, one of the fascinating comments Zach makes is that he is interested in seeing from the borrower a growth projection as well as a base case or downside protection. And at first, that's a little counterintuitive because you'd think the banker would solely want to see what's going to happen in your plan, and what happens if you fall short of plan, and “Will my loan be safe?” But there are some reasons why he wants to look at that growth case too. Do you want to discuss a couple of those?

Rick Ruback:

Well, yes, but first let's talk about the basic question, which is you think that the bank really cares about protecting its downside. The bank has no upside. Its upside is you fulfill the obligations you've promised the bank. You do really well, they don't get extra interest or extra principal.

Royce Yudkoff:

Exactly. If you want to put some numbers on this, which is always clarifying for you and me, the equity investors and searcher are hoping to make 25% or 30% or 35% on their investment every year. The bank is making the spread between the interest they charge you and their cost of funds, which is like 2% or 3% a year. And so someone who makes 2% or 3% a year is very focused on never losing principal. Someone who is making 25% or 30% or 35% a year is willing to take more risks - and this is the eternal tension between equity investors and lenders.

Rick Ruback:

Yeah. And the way I thought about it is when an equity investor puts money in a search investment, they anticipate getting, I don't know, what would you say, three times their invested capital back?

Royce Yudkoff:

Yes.

Rick Ruback:

And a good one five and a great one more?

Royce Yudkoff:

Yes.

Rick Ruback:

Whereas a banker puts the money in and what multiple of invested capital do they want to get?

Royce Yudkoff:

They want to get back their capital, you know, plus.

Rick Ruback:

They want to get like 1.1 or 1.2, right?

Royce Yudkoff:

Yes, exactly.

Rick Ruback:

It's just such a stark difference, right? The equity players are playing for a number that's three to five or more times their money and the debt investors want their money back with just the interest. So, it's just so different.

Royce Yudkoff:

By the way, if I could just mention, when searchers send out an investment memo to their prospective investors and an investment memo to their lenders, of course the facts need to be the same because you're telling the truth, but the investors are going to be far more interested in the narrative around growth and opportunity, and the lenders are going to be far more interested in why the business offers great safety of principal. So, there’s sort of a “what matters most” focus that's slightly different in those two communications, as a result of what we're talking about.

Rick Ruback:

Right. But what Zach says is he wants to see both communications, which I thought was really intriguing because my inclination would be to send him the downside scenario, say, “When things go badly, you're still going to get your interest and principal back. My equity holders might get nothing, but you're going to be paid off in full and I'm going to be able to meet all the covenants.” And what he says is, “No, no, no, no, no. If you're going to try to grow at 10% or you're going to spend a million bucks to open up a new service center in a new state or a new region”, he wants to know that because that's a million bucks that's not available to repay his loan. So, I hadn't really thought about that but growth eats cash, and he cares about cash. And so the more you grow, the more cash you need. And that's great but unless your business is a money tree, you're going to have a cash flow problem if you're trying to grow.

Royce Yudkoff:

That's right, and Zach wants to get out in front of that.

Rick Ruback:

And the covenants have to be built to accommodate that, so my learning is I had always known that you should be honest with everybody, and certainly honest with your lender, but I hadn't realized how much the lender depends on the searcher to share the equity information. You know, next time a searcher asks me what to send the bank, I'm going to say “everything”.

Royce Yudkoff:

Yeah, I think in the end, an experienced banker is very much like an investor because they will get to the truths about the strengths of the business and its needs for cash and all of the issues that your investors will. It's just that they weight things differently than the investors weight them.

Rick Ruback:

That's right. They look at different questions.

Royce Yudkoff:

Let’s return to our conversation.

-----

Royce Yudkoff:

Zach, you had mentioned there were three legs. Do you want to add anything on the third leg?

Zach Duprey:

So, on the investor side, I think for us it's very important that people who have regularly invested in businesses, who have worked with young CEOs before, who have their pattern recognition for this space, this ecosystem, it's hugely valuable, I think, to the outcomes. Just everything from coaching the CEO on, “It's about time you talk to the lender now because of this challenge or because of this acquisition you want to make.” It's also just hugely valuable, not tripping over things that they could have avoided. You know, when you've seen a lot of acquisitions and young CEOs running companies, I think there's a lot that you can learn. I think that learning is something that these CEOs could greatly benefit from. And so for us, we just want to make sure we have professional investors who have experience in pattern recognition. Also, that there's deep pockets. I think when we first got into this space, a lot of it was friends and family money. And ultimately, I don't know where your uncle's money came from, and I don't know if he knows anything about running a business, or if he'll ever invest in you again. I just know that you had enough money to close the deal. That's not the type of investor that gets us excited about a transaction.

Royce Yudkoff:

You want someone who, if there's a bump in the road, has the resources and willingness to potentially put more money in it.

Zach Duprey:

Right. They understand what they're getting into and know how to support their CEOs.

Royce Yudkoff:

You know, I'd just like to turn the topic, if I could, to something very practical for people who are making an acquisition for the first time and perhaps borrowing for the first time, which is when in the deal process does it make sense for the searcher to knock on your door? Is it when they're starting their search? Is it when they've got a deal under LOI? Is it five days before they're going to close and it suddenly occurs to them that they're missing $4 million? That's a joke. But give some advice to searchers who are embarking on their search when they should be communicating with someone like yourself.

Zach Duprey:

It's a great question, Royce. We get it a lot, and I think we usually tell people during your search, you probably should reach out, like begin to build a relationship, get a sense of what different lenders like and don't like, size of transactions they like and don't like, because that could be meaningful when you finally find your deal, what lender you should be talking to. But I would say at LOI, you should be talking to your lender early. And the reason why is, at that stage, you want to find out which people have no interest in that industry, transaction, deal size, for whatever reason, because you don't want to find that out when you're six-to-eight weeks away from closing and you're not sure where you're going to be able to find your debt provider. So, we like to look at a deal early on and say, “You know what? We just really don't like this space.” Or, “We don't do transactions that are a hundred million dollars. It's too big for us.” Or sometimes it's very simple and you say, “We love this space. We've had good success here. We know what we're doing. You should keep us in the loop as you're going through the transaction because we'd like to participate on this one.” And I think that can be very valuable.

Royce Yudkoff:

And following on this topic, give us a sense of the timing from when the searcher gets the company under LOI, puts together a meaningful briefing document for a lender like you, and gives it to you. What is the rough expectation of when you would be ready to fund on that deal?

Zach Duprey:

Most deals, forty-five to sixty days. In this end of the market, this $1 to $5 million EBITDA, I would say most deals have a 90-day exclusivity in their LOI. Most of them take about 120 days to close because of the sell-side component here. And we're probably brought in thirty to forty-five days into the process because they now have an investment memo, they now have a quality of earnings. And then it's going to take us two to three weeks to really understand the deal, that person, the investors, and make that decision to proceed. And then I would say four to six weeks to close. And usually we're waiting for two weeks to a month before it's finally ready to get there with the sellers.

Rick Ruback:

I want to ask, if somebody is buying that million dollar EBITDA business and thinking about should they go SBA route or should they go conventional? So, there’s so many things about the SBA they love. They love the ten year amortization period. They love the no covenants. That's a special thing. And they love that they can borrow such high amounts of the acquisition, easily 75% but sometimes much more than that.

Zach Duprey:

So, I would say on the SBA loans, you are taking a lot of leverage for a very small business but you do have a different ownership upside. In the transactions that we do, there's far more equity being invested, so the CEO is not going to own as much of the business. But I would say the SBA loan is a ten-year loan with no covenants, but it's really not growth-oriented. If you want to grow, usually having a commercial lender, a senior lender like ourselves, we are there to support that growth over your hold. Whereas an SBA loan, you often then have to refinance and find another partner to be able to do another acquisition. It also has a cap of $5 million, so you don't have the same transaction size. In this case, it's a smaller deal.

Rick Ruback:

I think the point you raise is very important for our listeners to think about, which is you really have two problems when you're buying a business. The first problem is, “How do I actually close the transaction?” And the SBA might be an easier route to that. I know it's a longer process, but if you're willing to do a personal guarantee, there's fewer problems in getting the loan, fewer due diligence questions, I feel like.

Zach Duprey:

I agree.

Rick Ruback:

And so it's easier to close. But then if your expectation is you want to grow the business, you want to make tuck-in acquisitions, what you’re saying is you're going to quickly outgrow that lender.

Royce Yudkoff:

And it's a cumbersome refinancing process with the SBA.

Rick Ruback:

Well, right but it's also, by the time you're at $3 million of EBITDA, chances are you should have something closer to $9 or $10 million of debt because you're making capital expenditures, you have to pay your taxes, all kinds of other things are going on. You need that cash to grow. What is our famous finance learning? Growth eats cash, right? So, you need to get that cash from somewhere. EBITDA will provide some of it, but not all of it. And you're going to spend more time worrying about your lender and the debt constraints than growing. Whereas, if I have Zach as my banker, I can call up Zach and say, "Hey, Zach, I want to do this. I want to do that. I want to make this CapEx." It doesn't mean you'll say “yes”, but you'll at least be interested in having the conversation.

Zach Duprey:

Well, right. I think one of the big challenges we'll have with an SBA borrower looking to refi is they put such little amount of equity in initially that there really isn't much capital at risk when we're looking to refi to a much bigger loan.

Rick Ruback:

Oh, I hadn't really thought about that. So, when that person who has borrowed $3 million, now wants to go to $5 million because they want to do $2 million of CapEx, you say, "Well, okay, great. You're going to be now a $6 million company, which means I'll lend you two and a half or $3 million. I can't lend you that additional $2 million because you didn't have enough equity to begin with."

Zach Duprey:

They didn't have enough equity to begin with, oftentimes because they don't have the covenants, they don't have the same quality of financial reporting down the line because they don't need it. So, I think it's a great program with a lot of opportunity and it can be very formulaic, which is very easy to close the loan, to your point. I think though there are limitations to it, and I think it can be difficult for a growth-oriented company, in many cases.

Rick Ruback:

That's really helpful. I learned a lot from that.

Royce Yudkoff:

Me too.

Rick Ruback:

We are out of time, but we always end by asking our guests if they have any questions for us.

Zach Duprey:

How many students from your class are searching now compared to ten years ago?

Royce Yudkoff:

Well, this has been a sea change. When Rick and I started this program fourteen years ago at HBS, zero to three was the number who would typically go out.

Rick Ruback:

I like to say you could count it if you were wearing mittens.

Royce Yudkoff:

Yeah, there you go. Two mittens. Last year we had thirty students leave our class and go search.

Rick Ruback:

So, that's more than fingers and toes together, right? So, this is a challenge.

Royce Yudkoff:

Yeah, and what we've also found over the probably last half decade, Rick, is that a large population of people will pause, take a traditional post-HBS job in someone else's company, and then shift over into search. And that if you look five years after a class has graduated, roughly another equal number to those that searched at graduation, leave those jobs and search, so the thirty becomes roughly sixty in each cohort. So, it's a big change and probably reflects maybe what you're seeing across many business schools and among mid-career searchers.

Rick Ruback:

And I think helped by you, helped by the ecosystem that allows this lending. We used to have students who were terrified that they would find this great gem of a business and they couldn't close on it. This was their nightmare. I think in the years Royce and I have been studying this, we've never seen that example. I don't know if you've ever seen that example, but I don't think that happens, right?

Zach Duprey:

No, I don't think so. Not too often.

Rick Ruback:

Yeah, but students were really worried about that. And, you know, when we started this, there were probably forty or fifty high net worth individuals that were investing on the equity side, and the lending was all regional. And now there are probably hundreds and hundreds of investors on the equity side, if you include all the limited partners of the various funds that are now invested in search, plus all these family offices that had never participated before, so the amount of equity investment is hugely expanded. And the amount of debt financing thanks to, I think, the trailblazing that you did, is enormously expanded because there's now, what would you say, three or four banks now, beyond what you do?

Zach Duprey:

There's a handful for sure.

Rick Ruback:

And certainly the SBICs are more involved than they were in the past, small bank investment companies that just do debt. So, the path now seems just much more reasonable.

Zach Duprey:

I agree. I think there's more opportunity, and it kind of sticks with the thesis of the amount of businesses that need to transact, and now the interest is there, and so it's an exciting time to be in this ecosystem.

Rick Ruback:

It's great. I think about it as like venture capital thirty years ago. You know, it's just starting to get institutionalized, there are lots of opportunities, both for searchers but also for lenders and investors.

Zach Duprey:

Absolutely.

Royce Yudkoff:

Zach Duprey, thank you so much for spending this time with Rick and me. We've enjoyed talking to you and it's been a learning experience for all of us.

Rick Ruback:

Yeah, thank you so much. This was so much fun.

Zach Duprey:

This has been great. I really enjoyed our talk.

_____

Rick Ruback:

Royce, one of the things about Zach's business model that I find so intriguing is that it is very much tailored to funded search, not unfunded search. And the reason I say that is that in a funded search model quite often there's less recurring revenue than there is in an unfunded search acquisition, and more growth. You know, in the unfunded search, we look for more recurring revenue and we understand if we go to a sector that has more recurring revenue it's going to be harder to get new customers because we'd have to pry those customers from their relationships. But in funded search, it's a little bit different. They usually look for growth because growth is really important to get the financial payoffs that the searchers need. So, while a typical unfunded searcher will have 70% or 80% of the equity, a funded searcher might have, in hopes 30%, if they meet the performance target, but if there's two of them, that means they have at best 15%, so it's a very different model. And the way they get paid off is they have to grow to get some multiple expansion. So, I thought it was really interesting that his product, just like the SBA product fits like a glove for most unfunded searchers, the commercial loan, in the way he described it, works really well in the funded model.

Royce Yudkoff:

I think that's a really interesting point you bring up and I'd offer a few reasons why there's such a fit with conventional loans and funded search. One, of course, is – as you pointed out – conventional searches generally lead to larger acquisitions. The SBA loan is capped at $5 million, so if you're buying a $16 million purchase price company, which is the average for a funded search today, you probably need an $8 million senior loan, and that's well above what the SBA would do. So, conventional loans become much more competitive to get those type of acquisition loans. The second is that conventional searches, acquisitions tend to trade at higher multiples because they're higher, faster growing companies, so it's routine that you and I see those trade at six or seven times EBITDA, sometimes eight times EBITDA. Zach mentions that he only wants to be no more than 50% of the loan, but he's also capped by two and a half times EBITDA. That's typically as high as he will go. So, he will bump into that limit first on a traditional search, and it puts that loan in a delicious place for the lender, which is on a seven times acquisition, you're two and a half times, so you're like 30% of the company's capital structure, the top 30%, which makes you very, very secure. And so that’s a really happy place to be. And then finally, I think in a funded search, you generally have recurring professional investors in search behind that. And if the company gets into trouble, there's some deep pockets who are used to investing, who can step in if the company needs to be de-levered a bit. You know, in a self-funded search, the population of investors can range from some professional investors to friends of the family and people who don't know quite what to do if the business hits a bump and needs a little extra equity capital. So, I think there's some tasty things for a bank in being in that part of the market. What do you think, Rick?

Rick Ruback:

Just to add to it, in many unfunded searches, there's just a scent of equity.

Royce Yudkoff:

A scent of equity. Exactly.

Rick Ruback:

A scent of equity, right? They take the seller note and they make the seller note as big as the seller will bear. They take the maximum SBA note and they may be buying the business with 10% of the purchase price as equity. We've seen even less. There’s no nice cushion below them, but the SBA doesn't care because…

Royce Yudkoff:

That's not their mission.

Rick Ruback:

Yeah, it’s not their mission. I think there’s reasons why the two markets have evolved so differently. You know, it's interesting how all these things fit together to me. So, since Zach will only do two or two and a half times EBITDA, and the businesses are selling for seven, eight, nine, that the funded searchers sometimes buy when they buy bigger businesses, that means that they have to put more equity into the deal. More equity in the deal means it's much harder for the searcher to accomplish their carry objectives. The only way they can accomplish their carry objectives…

Royce Yudkoff:

…is through high growth.

Rick Ruback:

…is through high growth. So, you have this flywheel that all kind of works together.

Royce Yudkoff:

Yes, exactly.

Rick Ruback:

And when you look at the behavior, you can see why they work the way they do. Whereas the unfunded searcher doesn't need that growth to repay the loan or to get a great financial payoff.

Royce Yudkoff:

Right, because they've bought that at a low multiple and the cash flow that's thrown off each year in itself is a nice return on equity.

Rick Ruback:

Right, it's its own reward.

Royce Yudkoff:

This probably explains why Zach focuses on a growth scenario as well, that he knows that searcher and that group of investors are going to pursue growth because the capital structure impels them to do that.

Rick Ruback:

Yeah, that's exactly right. Everybody's incentives are directed towards more growth. That was such an informative conversation with Zach. He's had such a wonderful influence on the small business community. It was just great being able to catch up with him. Next week, we return to our journeys. We'll be speaking with Brian Seeling, who has an interesting journey, from software engineer to small business owner. Royce, do you remember last season?

Royce Yudkoff:

I loved last season and I loved best our final episode.

Rick Ruback:

That’s right, and we’re going to do it again. We’re going to take questions from our listeners once again…

Royce Yudkoff:

…and then you and I are going to answer the questions they’re sending in.

Rick Ruback:

We’re going to try anyway. The best way for them to get the questions to us…

Royce Yudkoff:

…rickandroyce, as if it’s one word, at hbs dot edu.

Rick Ruback:

Because we’re really one team.

Royce Yudkoff:

Almost one person.

Rick Ruback:

Hardly of one mind on most things but that’s what makes it fun.

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:

Craig McDonald is our audio engineer. If you have any questions, comments, thoughts, feel free to just e-mail us, rickandroyce@hbs.edu.

Royce Yudkoff:

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