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 and I are delighted to have as our guest Will Smith, who is the creator and host of Acquiring Minds, one of the long-standing and esteemed podcasts that covers the ETA space. And we're looking forward to just a wide-ranging discussion about what you've observed in ETA over the years that you've been following the space. Welcome.

Rick Ruback:

Wonderful to see you again. We really enjoyed our time on your podcast and we hope you have as much fun on ours.

Will Smith:

Thank you, Royce. Thank you, Rick. Good to see you gentlemen again.

Royce Yudkoff:

Maybe a good place to start, before we dive into all-things ETA, is tell us a little bit about your personal and professional journey that got you to creating Acquiring Minds.

Will Smith:

Sure. I'm originally from Alexandria, Virginia. I now live in Arlington, right next door. You know, I was a bit of a “lemonade stand kid”. In my case, I ran a lottery in fourth grade, made $10, which was quite a jackpot for a nine-year-old. I always had the entrepreneurial itch and energy, have done entrepreneurial projects and businesses throughout most of my career. Went to school, got a degree in computer science, so have a technical background. Found myself in the Bay Area, working one of the few W2 stints that I had, working in tech, but with the itch, again, to do something entrepreneurial. Didn't know about ETA, never went to business school, didn't have friends that were in or around business school. At this point, I'm forty. I was mostly in tech, in publishing for my career, so didn't have people from finance or private equity in my network, didn't have the idea of buying boring businesses or anything like that. So, I'm kind of one of those people who sort of discovered this on their own, or kind of had the inkling that something like this could be possible. But that was just a germ of an idea. Just a few minutes of research and the whole ETA concept is revealed to me. And the fact that the best business schools are teaching this, the fact that this SBA loan product exists, you know, I was in “tech land”, so I kind of had a digital business orientation. Even digital businesses could be bought with an SBA loan. There was just all this energy around this. So, it was very exciting and I had the kind of “angels singing” moment that many of my guests have when they first discover it. Like, this is the path, this is the way, this is so exciting. I decided that I would do a search. As I was consuming content in this world, I actually felt like there wasn't what I call an authoritative voice. As I touched on, I have a background in media entrepreneurship. And I said, "I'm so interested in this. I'm going to be devoting all my time to learning this, to networking my way into this world anyway. What if I do some sort of media something here and maybe that media property becomes a thing?” I iterated on the idea a little bit and eventually landed on podcast, happily, and decided that I would go, you know, heads down for a year, year-and-a-half on it and see where I landed. And if nothing happened with it, I would be that much better equipped to go on the path of buying a business. But it did become a thing, and so here we are.

Rick Ruback:

Well, and it’s just because so much of life is path dependent, right?

Will Smith:

Yeah.

Rick Ruback:

I mean, it’s how those first steps get taken that end up determining a long journey sometimes.

Will Smith:

A year-and-a-half or so into Acquiring Minds, was still lightly searching, so I was asking for CIMS when I saw businesses that interested me. And when I decided to go just all in on Acquiring Minds, it was because it clearly deserved my full attention. The numbers were growing, I was getting great feedback, sponsors were having success. I understood how precious it is when you create something that people want and will pay for. And the audience was growing, et cetera. But it was like, "Wait. Am I really going to let go of buying a business and continue to be the guy who talks about it and never does it?" So, I had to get over that.

Rick Ruback:

Are you over that?

Will Smith:

OK, when I say “I got over it”, don't get me wrong. It wasn't like I'm never, ever going to do this ever. It was like for now, the podcast is the thing. And I sometimes joke that the reason why it continues to be so interesting to me is precisely because I haven't done it. Constantly being a spectator continues to whet my appetite and allows me to continue to fantasize about when it's my turn or when I’ll do it in the future. If I had actually done it, maybe I'd be less interested in continuing to talk about it. So, let's see where this path goes.

Rick Ruback:

Yeah, you're still a young guy.

Will Smith:

I fully expect that buying a business is in my future.

Rick Ruback:

Well, thank you for sharing that journey. It's such an interesting one.

Royce Yudkoff:

Will, one of the benefits of doing what you do – and what Rick and I do, of course – is we're all constantly learning about search. We're getting better at it by talking to people who have both succeeded and failed. You've interviewed scores and scores of searchers. As you look back across these people, do you have any observations about qualities that tend to make people more likely to succeed as searchers and qualities that make them less likely? Are there some things you've seen over time that are associated with successful searchers?

Will Smith:

There's so much variety, as we know. There's so many ways into this, as we know. Different types of people, different types of paths, different backgrounds. Maybe a similarity that you see across most successful people is the commitment to doing it. It's so hard to just have the self-discipline to sit down and search, and be disappointed, and dead-end after dead-end, to tell your network you're quitting and buying a business, which is so weird. Why are you doing this? There's so many opportunities to just hang it up. And people do that. You know, Stanford comes out with their data on traditional searches. So, in traditional search, fully a third just fail to find, to buy, to close.

Rick Ruback:

Yes, but I think if you look at the people who search full-time, I think most unfunded searchers find businesses to buy. And the reason is because unfunded searchers tend to be more flexible about their criteria. It is remarkable what seems like high revenue quality to an unfunded searcher.

Will Smith:

Especially two years in, right?

Rick Ruback:

Especially two years in, who finds a business that they can buy for a million-and-a-half or two million dollars, you know, has an SDE substantially higher than their previous salary, that's enough to get them over the finish line, often. Whereas in a funded search, they have these outside investors that they have to satisfy, and they've taken money and they've got this commitment to look for a particular kind of firm. So, I think if you're flexible, you can get to the finish line.

Will Smith:

I hear that, and I guess the thing about the traditional searcher is that you have to go back hat-in-hand to your investors and say, "I didn't do it." So, you're right that there are guardrails, Rick – the type of business you buy, they're not going to let you buy just whatever. Whereas, a self-funded searcher can be more flexible. Certainly, we see that. I mean, as we joked, like the longer they get into it, the more likely they are to have to loosen their standards. And I hear this constantly on the podcast, you know, everyone starts with going and looking for the perfect business. What is the definition of “the perfect business”? The one in the HBR Guide, the one as defined by Rick and Royce. So, everyone starts with the parameters that you guys have defined for the industry, really, and then discovers that you can't get it all. That's kind of the art of search, is deciding how many of these things you're going to compromise on.

Rick Ruback:

That's right.

Royce Yudkoff:

That's exactly right. And self-funded searchers do have an advantage over funded searchers, which is they can go smaller than a funded searcher typically can. The investors want to write a bigger check. So, Will, coming back to your comment, people in the audience might have expected you to say things like, "Well, sales skills or deep finance skills." But it's really kind of grit, persistence, not giving up…

Will Smith:

Obviously, all those things are important and you would hope that a searcher would have a strength in a particular area – either sales, or marketing, or leadership, or management, or the industry. I would guess that most searchers do have some particular strength, but it's not the same from searcher to searcher to searcher. So, if I'm looking for that commonality among them all, it's the ability to get it done, because this is all self-imposed. They're choosing this path, so there has to be a lot of personal commitment and self-discipline to get it done. Nobody's telling you to go do it. In fact, it's the alternative, it's the weird way, right? I mean, it's less and less weird, the more mainstream it gets, but it's still a very unusual path.

Rick Ruback:

Do you ever look at a person and a deal and say, "This just seemed absolutely crazy!" and then it turned out really great?

Will Smith:

I guess what most comes to mind are particular businesses that are unlikely search success stories. One that comes to mind, you may, in fact know Jeff Homer rolled up music schools. And his first one was a very small business, $500,000 in revenue, I believe.

Rick Ruback:

Right, and completely bootstrapped.

Will Smith:

Completely bootstrapped. I think he was as surprised as we are that the opportunity was there. So, there are stories like that where the business itself comes as quite a surprise, that there was so much there. But the pairing between searcher and business, I can't say that an example jumps to mind.

Rick Ruback:

Years ago, I had a person come see me in my office and she asked me about B2C. And I said, "Oh, that's terrible, you just never want to do that." And then she said, "Well, what about distributions in like specialty stores and gift shops, and things like that?" And I said, "Ah, that's even worse." And she said, "Well, we bought this business like five years ago that we've quadrupled and we just sold for a gain of fifteen times." And it sold like some specialty shampoo or oil or soap or something like that. And it was like, "Wow!"

Will Smith:

It's hard to know what to do with those stories, Rick, because you want to teach people the best practices here, the attention to quality of revenue, customer concentration, and so on. But at the same time, it feels like there's as many counter-examples as there are examples of these parameters working.

Royce Yudkoff:

Well, I think these rules, like quality of revenue and low cyclicality, and so on, they stack the odds in your favor, as a searcher. The more of that you can get at a reasonable price, the more the odds are in your favor. But of course, overlaying that is chance, is your personal capabilities, is the fact that often you're operating in some niche that no one's ever heard of before, and the understanding of the niche is not perfect, and it's better than you thought or worse than you thought. So, all these things make surprises happen in ETA, I think.

Rick Ruback:

I think it gives you a margin of safety around due diligence errors as well. If you have recurring revenue and you've got your cost side wrong, you can usually fix it over time. But if you're wrong about recurring revenue, it can be really hard to fix, right? So, it’s like if you buy a business that has at least the revenue quality, often times you can get enough runway to fix your problem.

Will Smith:

And it's not to say that there's some argument that you should not pay attention to these. I think the point is to understand these characteristics of businesses deeply and understand what is the spectrum of good to bad – recurring is better than episodic, and so on. And then be able to layer those over a target you're looking at and say to yourself, "Okay, this might not have recurring revenue but at least I know to understand that dynamic. And how am I convincing myself that it's still a target worth going for? I need to understand that this business that I'm about to buy has customer concentration. I'm doing it anyway and I'm justifying it because this is how I'm going to diversify the customer base, or whatever it is.” In other words, it's not necessarily a checklist that you have to check every box, it's just understanding what makes strength versus weakness. If you find weakness, you just need to talk yourself through how you're going to address it when you're the owner.

Royce Yudkoff:

When you think about qualities you want to see in a business that a searcher buys or that you might invest in, as an investor in searchers, what matters most to you? How do you sift through businesses that are candidates to be purchased?

Will Smith:

I do think quality of revenue is number one. Maybe my definition of quality of revenue has changed, because you do hear recurring revenue versus not, as if it's a binary thing, and I've come to think of it as just the likelihood that a dollar earned last year is going to reappear for whatever reason this year. And so if that dollar is contracted, it's very, very, very likely to come back this year. If it's not, but it still is very likely for some other market dynamic reason, I can get comfortable with it. And so I've let go a little bit of holding on too tightly to the fact that it's recurring. That is, sure, the highest quality, but there are other ways to achieve high quality revenue. I take a more nuanced view on quality of revenue, but of course that is still paramount.

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Rick Ruback:

Royce, it was interesting to hear that Will is in agreement with us that if you could only look for one thing in a business, you'd look for revenue quality – and I've adopted this practice of looking at margin because if there's a good healthy margin, that's almost always indicative of good revenue quality.

Royce Yudkoff:

Recurrence, right? Customers don't want to leave.

Rick Ruback:

Right, customers don't want to leave. You have a little bit of pricing power so lots of things work out well. But I was reflecting that there are lots of businesses that just don't have great revenue quality. And let's limit ourselves, to self-funded searchers, so let's limit ourselves to businesses sub a million dollars…

Royce Yudkoff:

…of EBITDA.

Rick Ruback:

…of EBITDA, yeah. I would suspect that 70, 80% of those might have statistically recurring revenue, but they don't have contractual or even recurring revenue at the lower level, that we like to see, where maybe there's not a long-term contract but there's this high switching cost that makes us comfortable that the customer isn't going to leave them.

Royce Yudkoff:

Right. I agree with your percentage guess. That would be my guess too, that most of those businesses in that size range don't meet our traditional quality standard of recurring revenue.

Rick Ruback:

So, what does that mean? Does that mean that 70% of the businesses with EBITDA less than a million dollars will not sell?

Royce Yudkoff:

Well, that's a good question.

Rick Ruback:

Because that would be terrifying, right?

Royce Yudkoff:

That would be terrifying, and I think not having what we all agree is good revenue quality doesn't doom them. I think they probably can sell but it's much more limited. It's either at a lower price, or very forgiving seller terms, or their market are sort of other professionals in that space who really understand that business well. I think the reason that Will and Rick and Royce are so focused on revenue quality has a lot to do with what's going on in an ETA transaction that might not occur in everyday commercial life. And what I mean by that is when you buy a company as a searcher, you're going to put on financial leverage for a significant part of that purchase price, and you have to meet regular payments. If it's not an SBA loan, you'll also have covenants to worry about. And leverage pairs poorly with a bouncy, unpredictable revenue stream. What you really want is a very predictable, steady revenue stream that generates steady cash flow that allows you to service your loan with a high confidence. And in ETA, you're putting yourself in that position, but if you're an owner of a, you know, mediocre revenue quality business that bounces up and down and you have no debt on that business because you founded it thirty years ago, that's less of a demerit for that business. So, some of these considerations on recurring revenue are very ETA-specific.

Rick Ruback:

What I think is truly intriguing is that often recurring revenue is in the eye of the beholder. So, we have seen recently a number of contractor deals, where a general contractor is being acquired or landscaping businesses are being purchased. And what we're told is, “Well, they don't have high switching costs, but the customers tend to buy from the same business year after year.” And so they often think, “Well, the people who mow the lawn are recurring revenue businesses.” I don't think that's really right. I don't think those are high revenue quality businesses, but what you see is an increasing number of search deals, particularly in the unfunded space, where people are just sort of substituting repeating revenue for recurring revenue.

Royce Yudkoff:

Yeah, I agree with that. And a difference between those two categories is really about switching costs, that it costs you nothing to change your landscaping service and you keep the same service because they do good service and a sense of inertia keeps you from bidding it out every spring. But that low switching cost means that that landscape operator doesn't have a lot of pricing power, which is one of the things you get with high switching costs.

Rick Ruback:

And that’s why the margins can be emblematic. You can look at the low margin and say, “You know, they're not losing customers, but they're not able to raise prices.”

Royce Yudkoff:

Right.

Rick Ruback:

The other thing that we sometimes talk about is, “Is it a business or a job?” And some of those 70% are jobs. But you know what? There's nothing wrong with buying a great job. You just have to understand that it's a job that you're going to go from making $100,000 a year in your current job and maybe you're going to make $250,000 or $300,000 a year when you buy this business, pay off the debt that you acquired, and maybe it'll be low risk and you'll get all the advantages of independence. But you won't get to grow the business, you won't get to have that scale, you won't get to use that gearing that comes with employees who are making money while you're doing other things.

Royce Yudkoff:

I agree. I'd add another category that explains why you and I and Will all focus on revenue quality, and that is, you know, almost every searcher buys a business that they've never been in before and so that first year is a huge year of learning. And the searchers with the best outcomes, they're making lots of decisions every day but they're trying not to make big decisions that commit a lot of capital to them, that are hard to reverse. They're trying not to do that for six months or twelve months because they're such a better, more informed manager at the end of that. And high quality revenue businesses tend to be very forgiving of that pause. And businesses where every job is a project, those are less forgiving of that learning period. And so that's another reason why revenue quality matters so much more in ETA than it does in everyday commercial life.

Rick Ruback:

Yeah. Now, let’s get back to the conversation.

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Will Smith:

I would say, I also really like fragmentation. I mean, that's hardly a big insight, but I was just listening to your podcast with the gentleman rolling up the auto body shops. It is so powerful to get into a business, you really understand what makes it work, and then you can buy other businesses, and so easily identify which ones have potential, which ones you can fix rather quickly. And you can really get a lot of scale there. And then when you combine that with the fact that so many of these very fragmented, very mom-and-pop businesses, those owners don't have another option to exit, you get this double-dip where you have all of this industry expertise, where you can move the needle like crazy if you can just get your hands on that business. And secondly, you can buy the business very, very cheaply because there aren't other buyers for it. You can get great seller financing deals and lower multiples, even than we're used to seeing broadly in ETA. And it's very, very powerful. I love that dynamic. It was interesting to hear you say, Rick, that you don't like roll-ups.

Rick Ruback:

Yeah, well, I've come a long way. I love some roll-ups – roll ups where there are obvious scale economies, obvious knowledge, different ways of doing the business because you've rolled up and because you've learned. I love those. I don't love so much when you're just sticking fragmented firms together and not changing anything and then trying to resell them as a bundle. You know, there's been no integration. And so I always ask people, “Where are the gains? Just show me what the gain is going to be from combining these firms.” Is it cross-selling? Okay, I understand cross-selling. That's a real clear gain. Is it going to be economies of scale in SG&A? I understand that. But it has to be something.

Will Smith:

I agree with you that roll up can have that connotation of “you're just jamming all these businesses together that happen to be in the same industry, and then hoping for multiple arbitrage.” That's doesn't feel like good roll up. Good roll up though, if we can say that part of the opportunity in ETA broadly is that we, searcher-buyers, are going to go in and improve these businesses – there's a little bit of hubris here – that we're going to go into these dusty-not-rusty businesses and be able to improve them. OK? That's kind of premise number one. And premise number two, your thing, Rick, that the magic is in the multiples. Well, both of those, in a Jeff Homer-style consolidation, are amplified because he's become an expert in music schools, so looking at all these subsequent music schools, he can be that much more certain than all the rest of us searchers are that he can improve the business he's going to buy. And he can command an even better multiple than we typically see in ETA because he's the strategic. These two things that we like so much about ETA, it actually amplifies them yet further.

Royce Yudkoff:

I agree with you, Will. And I think there's a couple of characteristics about the small firm market that structurally helps searchers like Jeff do this. One is more than in “big company land”, more than in “PE land”, you're buying from a retiring owner, and usually, that owner, for the last set of years, has been not pouring too much time in their business. They're quite reasonably saying, "I have more money than time and I want to behave accordingly." And you substitute in a young, hungry searcher, and they're going to pour their hours into this, and so structurally, there's a reason to believe the business will get better if more CEO energy is put into it. And the other is that you often find, as in Jeff's example, the owners are really artisans. They understand the craft of the business, but they're not often business managers. That's just not their background. And someone who comes to their business with a few years of experience in a business setting just often looks at it differently than the seller did. You know, I'd like to come back to the question we opened with, about recurring qualities you see, and maybe tackle another piece of the equation, which is when you've seen things go wrong for searchers, when they don't end up with the outcome they dreamed of, are there some things that you see again and again?

Will Smith:

Yeah, but unfortunately there's also no answer for it, which is seller dishonesty. And it's frustrating because that's also the thing that, from the moment a searcher sits down with the seller, their Spidey sense is on and it's the most obvious thing to look for. And yet, for probably half, if not more, of my so-called bad stories, it came down to that, the seller obfuscating something or being fraudulent. And there's a spectrum of misbehavior here. And you ask the searcher the obvious question: "Did you detect this?" And the answer is almost always “no”. Building trust is so key in this world, between buyer and seller, so it's never something that's overlooked, which is why it's so frustrating. It's like, "Of course I was trying to sense if I could trust this person. And they seemed really trustworthy. I had dinner with them, I whatever.”

Rick Ruback:

I think it's so interesting that you say that because one of the things we see on almost every CIM that we look at or every business we talk to, that there's always some add-backs. And the owner is often living in the business. And the owner gleefully says, "Well, you know, my business earned $300,000 but my SDE is really $900,000 because I spent $200,000 on my boat that I charged to the business, and all the dinners I had, all the vacations I took, I charged them all to the business." There's that level of dishonesty. I always wondered, why doesn't the IRS look at these add-backs and say, "Wait a minute, wait a minute, wait a minute! If this wasn't a legitimate business expense, how come you added it back?" That never seems to happen. And if you were to say, "Well, I'm not going to look at any sellers' business that has substantial add-backs," you'd be a pretty lonely searcher. And then the question is, “Okay, now I know you're willing to maybe not be as truthful as the IRS would like on your taxes, are there other things you're not truthful about?” Where do I draw that line?

Will Smith:

It's such a good point because one other way that we'll talk about this is like if you detect some dishonest thing in your interactions with the seller – putting aside add-backs for the moment, because that's a special case – you should extrapolate. That's data. And while you might have only uncovered the one thing, you should assume that it exists in ten other places. And so the kind of conventional wisdom is one thing is not one. It's kind of like the infestation in your house. If you see the one bug, there's probably more.

Rick Ruback:

There's no one rat.

Will Smith:

Yeah. So, to your point, Rick, it’s like if you take that advice to the extreme, then any add-back that looks at all in gray area, “I'm going to disqualify the business”, as you say, you'd be a lonely searcher. I guess on the add-backs thing, you would look at the list of add-backs. I mean, actually, that can be a pretty good tool because if we allow that there's some social acceptability, it's almost encouraged by accountants even, that you run some of your personal expenses through your business, it's like, “Okay, as a society we've accepted some of this is okay, but has the seller breached even what we all consider acceptable?” Maybe that's the line? But it's a hard one.

Rick Ruback:

It's a hard one. I mean, we have seen so many of these and when you try to engage the broker or the seller in this conversation, it often feels like you're talking to a rock. Because to their minds, it doesn't seem at all dishonest. It's just standard procedure because they've been doing it for decades. One that I thought was a really interesting red flag for me was an instance where a company negotiated with an employee and said, "You can charge $10,000 a year of personal expenses on the corporate card. And that way, you don't have to pay taxes on it and I don't have to pay employment taxes on it, and you get all these benefits and I get to deduct it anyway off the corporate card. Isn't that great?" And I thought, "Wow! That sort of crosses a line." And that created a lot of discomfort and, on further investigation, what the searcher learned was this person was actually charging $50,000 a year because they discovered that, when you give somebody the right to cheat, they don't just cheat the amount they've agreed on.

Royce Yudkoff:

Because they're cheaters.

Rick Ruback:

Because they're cheaters. So, it is a slippery slope.

Royce Yudkoff:

On this point, like both of you, I don't have a formula for unveiling the liars and the cheats. It's hard. What I do take comfort in though is that the overwhelming majority of business owners are basically truthful and honest. So, even though it's hard to solve this problem, you're not undertaking an activity when you search that is just fraught with risk, where, you know, one out of every three business deals, there's a material lie that was perpetrated.

Will Smith:

I agree, Royce, and I don't mean to suggest that it's everywhere, but in the population of “searches gone wrong”, it is over-represented. That's anecdotal, but that's my sense.

Royce Yudkoff:

Yeah, that's valuable information because I think people are casting about for, you know, "What should I put more focus on?" And your answer is, "Well, this – but it's really hard to uncover."

Will Smith:

Yeah.

Rick Ruback:

Don't you think a lot of this happens because the buyer just doesn't know what questions to ask the seller? You know, one comes to mind is a transaction that Royce and I knew well years ago, where the seller said, "Oh, we have digital records of all of our transactions." And after close, the buyer said, "Well, where are these digital records? I can't find them." And they said, "Oh, here it is," and handed them a floppy disk. What the person did was they took all their paper invoices and they brought them down to the copying center and had them scanned onto a disk. That's not what any of us would think about as digital records or an information system, but I don't think the owner was lying. The owner just didn't understand the question, “Do you have a digital record?” "Yeah, I have a digital record, it's right here on this floppy disk."

Royce Yudkoff:

I think it's surely true that – and Will, this goes back to your wonderful example of why roll-ups are powerful – when you know a business, your due diligence is going to be a lot better and you'll make a much better assessment of the business. But I think in the end, there's going to be an information asymmetry, and if an owner is determined to lie or defraud, it's going to be hard to catch them, right? So, you know, imagine the owner who sets up another company and purportedly sells services to that company, and bills it, and collects cash, and that company is him too, and he's recycling cash to himself. How would you ever catch that? Your accountants won't catch that.

Will Smith:

It should be no surprise that it's hard to catch a bad actor because they are going to be playing defense and trying to project trust.

Rick Ruback:

And it's a business decision too, because the more you pay for your accounting due diligence, the more likely you are to find these problems. But do you want to spend $50,000 on accounting due diligence for a $2 million acquisition? Or do you want to go with the $10,000 provider and hope there's nothing under the rug? And most people go with the $10,000 provider and say, "Well, I looked under the rug, it's okay." But then, of course, it's many times a first-time buyer and don't have that sophistication.

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Royce Yudkoff:

Rick, it was so interesting that when we asked Will what he thought the major source of failure was in ETA acquisitions that he nominated seller fraud. And, of course, when that happens, it can be a disaster, but I think that there are other more common causes of failure that you and I would nominate. Do you agree with that?

Rick Ruback:

Well, let me take a step back and talk about Will's idea that there are sellers that are fraudulent. No doubt there are. We've not run into very many. What we see instead is that sellers often do things the way they've been doing it for twenty years. They don't understand the perspective perhaps of the young buyer who thinks about things differently. The story I told about digital files, that's not fraud. That's just a generational difference of a basic understanding. And similarly, we've seen many cases, for example, where the seller is underinsured, where the seller has made mistakes. They have employees that should have been W-2 employees that are 1099 employees. Most of those are not fraud in the sense that there's a willful desire to be deceitful. Most of those just evolved into this way of doing business and they've never had reason to doubt it.

Royce Yudkoff:

That's right. If you ask the seller about that, they would often say, “Hey, I'm scrappy and thrifty and that's part of operating a small business.” They wouldn't see it as fraud at all.

Rick Ruback:

Now, obviously there are due diligence mistakes on the part of the buyer. If you buy a business and the seller has represented there's a certain amount of inventory, you didn't check it and then you get in and find out the inventory is old or obsolete or non-existent, I think that's on you, don't you?

Royce Yudkoff:

Absolutely.

Rick Ruback:

The real question is people who have long-term struggles with the businesses they run. And when you and I reflect on it, we see things like a lack of executive control. People don't feel like they're in charge. It's not that you need to change everything on your first couple days of owning a business. That's not the idea. But the idea is that everybody knows who the boss is. And if you don't like the way somebody's doing something and you say, “Hey, I'd really like you to wear a company shirt when you go and provide service.” And they say, “No, we don't like the company shirts. We're not going to do that.”

Royce Yudkoff:

Yeah. What do you do then? Do you sort of enforce a sensible company policy? Do you back off?

Rick Ruback:

Yeah, particularly when there are cultural differences between the workforce and the now-owner-slash-CEO. You know, if you have a largely Hispanic workforce and you don't speak Spanish, that is a disadvantage. If you've never managed a blue-collar workforce and you have a blue-collar workforce, that is a disadvantage. I don't think those things are things you can't overcome. I think it’s this executive control. One of the things that I find always interesting is when buyers have models that assume significant growth when the business is hardly grown at all. And when asked why the business is hardly grown at all, they say, “Well, the seller just never invested in sales. I'm just going to hire a sales force and then I'll quadruple my sales.” Well, it might be, but there might be another reason why the seller never hired a sales force.

Royce Yudkoff:

Right, and sometimes you and I see this paired with a very high recurring revenue, very sticky customer business. And so, you know, that's a moment where the searcher should say, “Well, wait a second. If the glory of this business is that 98% of our customers come back each year, do you think that my competitors' customers also have this characteristic and therefore it's really tough to sell them on prying them loose?” And my model should reflect that.

Rick Ruback:

Right. So, anyway, I think due diligence mistakes are there. I think this over-optimism with respect to growth can be there. And on much rarer occasions you find that there's just a mismatch between the role that the searcher will have to take in the business and the searcher. So, the searcher imagines they're spending all their time on strategic issues but, in fact, the CEO is the scheduler and working in the business, and if they don't work in the business, the business doesn't work.

Royce Yudkoff:

Right, and it turns out they either hate that or they're not good at that. And that's a problem because they've bought a business of a size where you can't easily insert someone else in to do that job.

Rick Ruback:

Right. We often hear about these expansive plans and all of it assumes that you're going to have enough growth and scale to absorb this additional SG&A, but that's not always true.

Royce Yudkoff:

Right. Now, let’s get back to the conversation.

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Rick Ruback:

Do you ever find people who you say, "This person just shouldn't search?" What do you think?

Will Smith:

Well, people like that are unlikely to be on the podcast because to come on and be a guest, you have to have already bought a business. I don't really talk to searchers. I talk to now-owners. There are occasionally moments where a guest on the podcast has bought something or made a move that I think was not wise. And it's awkward because they've already bought the business. And who am I? Maybe I'm totally wrong. So, it's awkward for me because I want to be educational and transparent with the audience, but I also don't want to discourage this person, let alone publicly.

Rick Ruback:

Suppose somebody's looking at a business – let's say it's an electrical contracting business – everybody who owns these businesses has been a master electrician. And now, some young MBA who's not a master electrician wants to go buy this business. Do you think if there's a business that has some inherent skill where the CEO has historically been an expert, do you think that's okay?

Will Smith:

Yeah, I'd say that's a big theme, Rick, of the podcast, is bridging that divide between your skill set as a searcher and the owner's skill set or what's going to be required. I think you were touching on it, but the classic one is maybe not a technical skill set but just the culture from white-collar to blue-collar. It's a theme that I always hammer on, and I keep top of mind, and I bring up that if you are a white-collar professional and you think you're going to go buy a blue-collar trades business, there is so much difference there culturally – let alone the fact that you're not a, you know, an HVAC technician – that I really just try to broadcast how rocky that can be. Now, people do it, so I don't want to say, “Don't do it.” But I also loudly say, "Don't underestimate the dramatic change in your life, working from your home office or going into an office, to showing up at a shop every day with a crew of blue-collar people who know how to do the thing and you don't, and you're just an Excel guy, and what that's like.” That's one of the big adventures, one of the big patterns in search. It's not to be underestimated, so we talk about it a lot.

Rick Ruback:

What I often struggle with is that if you don’t know the business side and you don't know the technical side, that seems scary to me. I think a lot of sellers are so expert on the technical side, their lack of business acumen is maybe hurtful for the bottom line, but not hurtful for their relationship with customers.

Will Smith:

It's more common than not that the searcher-buyer does not have the technical skills. But almost all of my guests have some sort of business background, even if they were just in a W2 in a corporation. If somebody has no business background, then I would say, “Go get some business experience before you become a business person.”

Rick Ruback:

That was certainly well said.

Royce Yudkoff:

Will, Rick and I will commonly tell our students, "When you buy a business, you'll have lots, and lots, and lots of decisions to make. Try not to make any really big decisions in the first few months because you will be such a better manager of this business after six months or twelve months.” Do you have advice you'd give to someone who was in their first few months of what they should or shouldn't be doing?

Will Smith:

Certainly, what you already touched on, “To change or not to change?”, or “How much to change?” is always a hot topic. I think, as with so much of this, it's all case-by-case but, all else being equal, I agree strongly with you and Rick that you don't know what you don't know when you first get in there, so don't start pushing buttons and pulling levers. A couple more things, in the spirit of waiting before you make any big changes, just come in with the attitude, the posture of a student. You kind of have to – you're going to be learning, you’re drinking through a fire hose, as the cliché goes. But if you also just position yourself that way to the employees, you're learning and you're humble, you're elevating the people. And this dynamic that you're going to have with these employees that you've inherited is delicate at first, and yet so important. So much of the success of this project hinges on that. This is an opportunity to really elevate them, and show them deference and respect for their knowledge. Look to them as the experts. Treat them as the professors of this business that you've bought. I think there's a lot of goodwill that can be built with such a posture. The other thing – and this sounds kind of throw away-ish, but there's some real power in this – good faith gestures, small gestures. The example that comes to mind – actually, an HBS guy – he bought a very small business, $300,000 in SDE, and on his way to his Day One speech, he picked up a dozen donuts to bring to the very small team of less than a dozen people. And a couple years later, he hears from one of the key employees, in fact, "You know, I was going to quit. But you brought the donuts, and so I gave you a chance." The point is not necessarily that donuts bought allegiance. The reason this person said that is because they had been through transitions before that had been so negative, so they just had a prejudice, about what a transition’s like. So, they were like, "I'm not going to go through one of these again, I'm going to quit." But in walks our searcher with a donut, and it was just enough of a positive vibe set that this person stayed, heard them out, stayed another day, stayed another day, and continued to be with the organization. I thought that was such a cute but powerful story.

Royce Yudkoff:

Great story.

Rick Ruback:

Small things matter a lot. And I think it's a mindset. Patrick Dickinson – very successful searcher, really good guy – describes how, when he bought his very first business, he cleaned out the toilets. And he said, "Nothing is as appreciated by a factory worker as somebody who's willing to un-plunge a toilet." Because not having that toilet working really wrecks their day. And a small gesture, and maybe not for everybody, but…

Will Smith:

I love that.

Rick Ruback:

…a really clever idea.

Will Smith:

That, in particular, could be a way where, if you're a white-collar person, maybe a freshly-minted MBA, buying a blue-collar, a trades business, where, you know, everybody here are technical experts and you've got no credibility on that front, but you can show your willingness to get dirty, that goes a long way in those types of businesses.

Rick Ruback:

You'll even hold the flashlight at midnight, if need be.

Will Smith:

Yeah.

Rick Ruback:

So, Will, we always end our podcast by asking our guests if they have any questions for us. Now, you ask people questions all the time and you've had us on your podcast, so you've had some chances to ask us questions, but one more chance.

Will Smith:

Okay. My question would be about the flavors of search. So, so often we hear about self-funded search versus traditional search funds. Independent sponsorship is another version. I don't know if it's ETA exactly, it's kind of down-market private equity or up-market ETA. I'm starting to see searchers be interested in this path. Is that something that you're seeing in your students? Is it something you're considering teaching more directly? What would you say about independent sponsors, and is it another flavor of search that's destined to grow?

Royce Yudkoff:

Yes, we're seeing what you're seeing, Will, in some form. If Rick and I go back a decade, everyone in our classes wanted to buy a company so they could be a CEO-owner, and that the buying part was like eating their vegetables to get to the dessert, right? They didn't really want to be in that process. And now we see a measurable minority of our class learning about small market acquisitions because they want to be a PE-like financial player in that and someone else will operate the company. So, we're definitely seeing the mix changing. It's so far a distinct minority of people in our class, but it's also distinctly different from what it was previously. Rick, what comments would you have on our experience with this?

Rick Ruback:

I would the ones that I most admire begin as operators and, you know, they buy a business that happens to have a general manager who's quite good. They keep the general manager. They provide some strategic work, and then they go out and find another business, and another business, and another business. And they're independent sponsors in the sense that they're getting independent funding for each deal, but they're all under one common umbrella. Almost always, they morph into a private equity fund, because the problem with independent sponsorships is that you need enough investors who are willing to do the hard work of evaluating each deal. In a private equity firm, you just really need to evaluate the general partners. And I think it's a really interesting model. We think that one of the things that’s special about search is the searcher is bringing both the ability to manage and the capital. In the independent sponsor model, often times they're not bringing the ability to manage, but they're just bringing the capital, but it's at a smaller level.

Will Smith:

Great. Thank you.

Royce Yudkoff:

Will, thank you so much for joining Rick and me.

Rick Ruback:

Yeah, thank you. So much fun!

Will Smith:

Thank you, guys. Really great to reconnect and be on the other side of the mic from you.

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Rick Ruback:

So, Royce, do you think there's really more interest in ETA these days?

Royce Yudkoff:

I do think there's more interest in ETA. I mean, we have only to look at the size of our classes from when we started this fifteen years ago with fourteen humble students. And now, you know, we've gone through the cycle where we sell out three sections of ninety or one hundred people, and ETA is spread to so many other business schools, and self-funded ETA outside of the business school system is buoyant. There's clearly a lot more people focused on it. I think the question is, “Is this a problem for the opportunity or is it not a problem?”

Rick Ruback:

Yeah, I don't think it's a problem for the opportunity. And the reason is because I think there are lots of sellers out there. I think there are lots of people who were postponing sales through COVID and other market disruptions and are ready to sell. The baby boomers, many of them started businesses, are ready to move on. What do they call it? The gray tsunami or something like that?

Royce Yudkoff:

Yeah, the silver tsunami.

Rick Ruback:

Silver tsunami. I think the market's pretty deep. I love being involved in a segment of the market which is growing and vibrant and attracting energy and becoming mainstream. It makes people more willing to sell to searchers and I think it makes people more willing to pursue this career path, and getting great managers into smaller businesses is something which has to be good for the world.

Royce Yudkoff:

I also think that prospective searchers quite reasonably will look at the larger number of people searching today and ask if that's a problem. What's less obvious to them is something that you and I have seen that has made the world of search so much better for searchers, say over the last five or ten years. And my list on that front would be loans are much easier to get. There are lots of banks, both SBA issuers and conventional loan issuers, that now have search fund departments or at a minimum have made many, many loans to searchers and so are very familiar and like that transaction. The world of investors in search has grown many-fold, both on the funded side and the self-funded side, and gotten more organized – particularly equity investors. Brokers are now trained and have learned what search is, and it's gone from something that seems really peculiar and even dodgy to something that is an accepted channel for selling businesses. And, of course, in learning how to search, there's much more information available, like Will's excellent podcast, like books. So, when you look at what makes searching more effective, the searcher today is far better off than the searcher five or ten years ago.

Rick Ruback:

It’s so interesting.

Royce Yudkoff:

Rick, I think we agree that was such an interesting conversation with Will Smith, who has an opportunity to talk to so many searchers and has a real bird's eye view on ETA. Next week, you and I are hosting Tom Allsworth. Tom doesn't have an MBA, and I raise that because a number of our listeners always ask us, “Do you need an MBA to do this?”, and the answer is clearly “No”. He did accumulate some useful business experience prior to buying two companies, which he continues to own and operate, and we're going to hear his story in next week's episode.

Rick Ruback:

I’m looking forward to it.

Royce Yudkoff:

Rick, we end each season with a very special episode where we ask our listeners to e-mail us and offer questions they have after listening to our episodes or after their experiences in search. We pull out the questions and you and I discuss them.

Rick Ruback:

You know how much fun that can be.

Royce Yudkoff:

It’s a favorite of ours and a favorite of a lot of our listeners. So, listeners, shoot us an e-mail at rickandroyce at hbs dot edu and we’ll put them in the bunch we go through and answer them in our final episode of Season Three. We’re looking forward to it. 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, all one word, at hbs dot edu.

Royce Yudkoff:

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