Ep 486 Inside the Mind of an Acquirer: The Harvard Playbook for Buying Your Business
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Hi there, and welcome back to another edition of Built to Sell Radio, the podcast designed to help you punch above your weight in a negotiation to sell your company. I'm the executive producer, Colin Morgan, and this week, we go inside the mind of an acquirer to break down a major trend in small business exits, entrepreneurship through acquisition, or known as ETA. Now, Harvard professors Rick Ruback and Royce Rudkoff have traditionally

We'll be right back.

But negotiating with an ETA buyer comes with risks. Deals often include seller financing, longer diligence periods, and a buyer who may or may not be ready to run your company after you step away. And in this episode, you're going to learn how ETA buyers structure deals, the warning signs of a buyer who may struggle, and how to position yourself for a successful negotiation. And

If you're considering selling, this conversation will give you an inside look on how an ETA buyer thinks and how to protect your interest in the deal. Without further ado, here is Rick and Royce. Enjoy. Rick Bruback, Royce Yudkoff, welcome to Build a Sell Radio.

It's a pleasure to be here. Thanks for having us, John. It's a delight. I'm a little intimidated, guys. A couple of Harvard profs. This is going to freak me out a little bit. Not true. We know your background. We know you know your stuff. Tell you about it. And look at me. Do I look like a Harvard prof? Come on. Really?

For those of you who are listening, you will have to check out the YouTube channel and take a look. But in any event, I'm really excited. You are two of the world's most experienced and recognized experts in this field of acquisition entrepreneurship. So I'd love to dig in because I think a lot of our listeners...

have notionally heard about acquisition through acquisition. They've maybe been approached by a searcher and they're curious about it. So I'm really looking forward to digging in. Maybe we could start with maybe a basic definition for folks who don't know what entrepreneurship through acquisition is. Can we just maybe start off there? Royce, maybe kick us off.

Sure. Well, everyone has kind of heard of acquisition through startup, right? That's the famous bigger cousin to entrepreneurship through acquisition. So entrepreneurship through acquisition appeals to people who want to be entrepreneurs, people like so many of your listeners.

but who don't want to take the risk of starting from scratch, or maybe they don't have the big idea that is usually behind some startup, but they're good, practical, scrappy managers. And what they want to do is go out and buy a profitable, smaller business, usually from a retiring founder,

negotiate some kind of short-term transition agreement where that founder eases the transition. And then that buyer takes over the company as CEO after having organized the transaction. They usually have somewhere between seven and 15 years of prior management experience in other people's companies, although not usually in the particular industry they buy in.

They've lined up some debt financing from banks that commonly lend to the purchases of smaller companies. And they've commonly raised some equity from a group of recurring investors who invest in these so-called acquisition, search acquisitions or acquisitions, entrepreneurship through acquisitions. And so this happens again and again and again and again to sort of

Help people who've built a successful business and want to retire, retire and have someone succeed them in running it and organizing the sale and then creating the entrepreneurial dream for this next generation. You teed me up for the question that I wanted to ask first, which was how do they get the money? As I understand it, these are students coming out of an MBA program. They probably get student debt. They may not have had a lot of success leading into it. Where do they get the money? You mentioned there are banks.

and there are people that sort of support economically these efforts. Rick, maybe do you want to walk me through, like in basic layman's terms, how are they getting the money to buy a business? Sure. The time they go to buy the business, it's not really hard. There's local commercial banks that lend. There are SBA loans designed for these kinds of activities.

And for equity investors, there's a lot of people interested in providing private capital at attractive rates of return for these kinds of investments. You know, it's an easy investment to make because it's so transparent to the investor. They're not buying pieces of paper. They're buying to them. They're actually seeing the business they're buying.

They're buying a manufacturing business. They're buying a service business. But they can see, oh, yeah, I get it. They mow lawns. I understand what that business is. I understand what people pay. I understand where the employees come from. You know, it's easy to understand business. And so what is...

What Royce and I find fascinating, and I think true more generally than just our experience, is we've been doing this for a little over 15 years, teaching it, doing a little investing on the side, being in contact and being in the flow of this ecosystem for decades.

Pretty much all of that time. And we've never heard of an instance where somebody purchased a company, wanted to purchase a company that was a good company at a fair price that they could not finance.

Okay, let's walk through it. And imagine it's a $10 million company. That's the value that the owner wants. Let's just walk through the capital structure. Well, I mean, we should take a step back, right? Because oftentimes people who want to sell think that the value is determined by how much money they want.

because they sit down and they say, I want to buy this boat and this condominium and I want to be able to spend, you know, this much money on travel every year. And I want to buy my new wife a new gift or my new husband a new gift and my new husband a new car, my new wife a new ring, whatever it is. And the problem is, is that's of course not what determines value. What determines value is some multiple

of the ongoing cash flow of the firm. So think about that as being somewhere around four times the value, the cash flows of the firm. Maybe five if it's a bit larger, if it's a larger small firm that's less if it's a- A larger small firm. So your example, $10 million, that firm would have to have pretty high revenue quality. So lots of recurring customers or something Royce and I call enduring profitability.

Together with about $2 million of cash flow or $2.5 million of cash flow. Okay. So let's walk through this. So let's imagine you've got a company with $10 million of revenue. They're putting $2.5 million of EBITDA to the bottom line. The revenue is high quality. It's in a protected industry. Perfect. I want to buy it already.

Okay. So walk me through, if I'm an acquisition entrepreneur, I'm a graduate of your program, where am I getting 10 million bucks? So, Rush, do you want to do this? Yeah, let me start and you jump in, Rick. So whether it's in the US or Canada, a conventional commercial bank is going to be interested in lending to that business and the commercial bank will probably lend

about 50% of the purchase price, maybe a little bit more. Or another way of thinking about it is the bank will look at that two to two and a half million dollars and want to lend

to two and a half times the cash flow. So either way, about $5 million of that $10 million will come from a commercial bank loan that will be repaid over about seven years. And is that acquisition entrepreneur personally guaranteeing that loan? Generally not.

For very small, small businesses, they will want a personal guarantee because there's such a key man element to the business. But for a business of that size, it's likely there will be no personal guarantee. We'll talk about SBA loans for your American listeners later, but think of there as probably no personal guarantee whatsoever.

Usually in these transactions, not always, but the majority of the time, the seller will take a small seller note. And so that might be in a transaction like this, a million dollars out of the $10 million purchase price. Or maybe more, maybe two, two and a half, something like that.

And define a seller note for those who aren't familiar with that terminology. Sure. So part of getting these smaller firms sold is that the seller will step in and defer part of the purchase proceeds they get. So if the total price is $10 million, to choose Rick's example, they might get $7.5 or $8 million at closing in cash.

But two, two and a half million, they might get over the next four years in a seller note. They'd get interest on that seller note, probably better than they'd get if they deposited the cash in a bank, but they'd wait.

And then the remainder would be equity. So in our example, there's 5 million from the bank. There's say 2 million from the seller. That leaves three. 3 million would be equity that would come from the buyer's investors because usually the buyer is an early career professional. They're not going to have $3 million. And what they've done long before they've met this seller is they've gone to a group of investors, described their journey,

Many times the investors are actually supporting that searcher in this journey that is paying them the salary, paying them the expenses. There are different variations of this. Sometimes the seller will pay for that part on their own.

The buyer. The buyer will pay for that on their own. Thank you, Rick. Buyer will pay that on their own. But these are a serious group of investors who again and again and again invest in transactions like this. And as soon as the seller, the buyer engages the seller seriously in this, that's when

That person will be briefing their investors and the investors will put up that $3 million and have their own arrangement with the entrepreneur or buyer as to how much profit that person gets for success in managing this. But they will put up the $3 million. So $3 million from the investors, say two from the seller, five from the bank.

Got it. And a couple of questions. The equity holders, are they guaranteeing the debt that the bank provides? Absolutely not. Absolutely not. Okay. So they're limited liability to their investment. Yeah. Right. They're deep in the capital structure. So the senior debt gets paid. The seller debt, which is subordinated to the senior debt, will get paid before the equity holders get paid generally. Right.

So they're subordinated in that sense. They're, if you will, a cushion, a safety net, a floor. But there's no personal guarantee. So if, for example, things go very badly at the firm, the debt holders can't reach to the equity holders for additional capital.

That's helpful. And so with regards to how the acquisition entrepreneur makes money, I'm seeing how, so there's a $5 million bank loan, the seller finances in our pictures example, $2 million. So $3 million of equity goes in. How does the acquisition entrepreneur carve out some equity for them? So what happens is the acquisition entrepreneur

structures the deal with their outside equity investors so that they keep a portion of the firm. And Royce alluded to funded searchers where they have some support in their search. They're getting a salary. They're getting health insurance. They're getting other support from the entity. There, the equity ownership is fixed. It's called carry. So the money gets paid back to investors first.

And then after the money's paid off, there's some split between investors and the entrepreneurs. In the standard funded search arrangement, the entrepreneurs may get up to 30%, more likely 20%, depending on performance. In a situation where the entrepreneurs are paying themselves to search, so they're unfunded, there's no outside investors paying them to fund the search.

They're not getting a salary while they're searching. For those, oftentimes, we call it unfunded, but oftentimes, it's spouse funded, right? Sure. Or partner funded. And in those instances, the entrepreneurs own substantially more than the 20% or 30%. They might own 60%, 70% of the firm. The way they do it is investors have a sense of what kind of rate of return they would like to receive.

And the entrepreneur builds a model and solves for the amount of equity they have to give up for the investors to get the required rate of return.

Got it. So that's super helpful. So when a funded search, the, the searcher, the, the acquisition entrepreneur, um, is getting paid by the funds. Uh, so they're, they're, they're taking less risk to that extent and therefore they get less equity than the non funded. They're doing it on their own. They're self funding the whole thing. That makes sense. And out of interest, how long does it take a searcher to find a business? Oh, for, it can take forever. Some never find, uh, it can take three months. Uh,

it can take three years. The average is a little over a year and a half. So your question suggests that how long does it take to find the business? Finding the business is often not the hard part. It's closing the business, actually structuring the transaction, getting through all the bits and pieces, the schedules. Most sellers aren't really prepared to sell

It's a lot of work. So it's not uncommon for people to sign a letter of intent. So we have the skeleton of the deal sketched out and then it will take

Somewhere between three and nine months actually to close the transaction. Wow. Really? Yeah. Three to nine months. Three to nine months. Three is the quickest. And that's assuming there's absolutely no delays.

So three months is so just think about it. There's two, three, four weeks of business due diligence that goes behind before you hire professionals. And before you get the information that you can apply for a bank loan with. Right. The bank wants to know who owns the vehicles. How are the vehicles financed?

How's this done? How's that done? Who works for the company? What is their education? You don't know that from a confidential information memorandum. Usually don't know that until you've done a couple weeks or three weeks of business due diligence. Then you start collecting proposals from banks.

That may take another week or two or three, and then you get a proposal from a bank, and then you say, great, I'd like to do that. And then the bank has a process, which takes six weeks. And then at the same time, you're continually asking the seller for information. And what percentages of your revenue is from this customer? And can I see those invoices? And where did you get your supplies? And how long have those relationships been going on?

And most sellers are busy managing their business. They don't have a, they often don't think about the business the same way the buyer does. So they've never really asked those questions. And would, it sounds like, and I just want to make sure I'm clear that they would, the acquisition entrepreneur would have the seller sign a letter of intent. Yes.

prior to having the financing lined up. Oh, absolutely. Because you need the letter of intent. So what happens is, as you know, sellers are sensibly secretive people. Sure. They want to keep information about their business private and they particularly want to keep information about the sales process private. And so they're not going to reveal the information that...

the buyer needs to apply for the bank loan until they're under this higher level of confidentiality and exclusivity. And similarly, the buyer doesn't want to bother banks until they know they have the skeletons of a deal. Makes sense. And the letter of intent

I'm assuming it would be similar to a private equity acquisition or a strategic acquisition. It would have a no-shop clause where the seller agrees not to continue to negotiate with other third parties. Exactly. That's in fact the only binding part of the agreement.

Yeah, and Rick's exactly right. And a good way to think about what each party is giving here is that the seller is taking the company off the market usually for 90 days. They'll probably extend that, but they'll have seen a lot of evidence that the transaction is moving along by the time they get to that point. But they're taking it off the market for 90 days. And the buyer, of course, is doing a lot of work on due diligence and organizing financing and spending money on accountants and later lawyers.

And so that's what each party is contributing once that letter is signed.

And the letter, of course, has, as Rick referred to, and I love this description, the skeleton of a deal, right? At a high level, it describes how much we pay, seller note, et cetera, et cetera. Makes sense. I want to switch gears and talk about the psychographics, the demographics of an acquisition entrepreneur. You've been teaching this, I think, for 16 years and seen a lot of people walk through the offices and the classrooms. How would you describe the typical student in your program?

Well, there's no one size that fits all. One of the things that intrigued Royce and I early on was what kind of backgrounds actually work really well. What we've concluded is we can't tell because we see people who are former consultants, who are former private equity people, who have military backgrounds, and we

There doesn't seem to be a particular background that leads to success. Similarly, there doesn't seem to be a demographic that leads to success. It's not the case that only men do this. We're increasingly seeing women do this. It is a for women who want to both have a career and a family. This is a nice way to have control over how they do that.

Nobody's telling them when to travel, when to work, that kind of thing. Rick, if I could just jump in on your prior point. Rick and I have always thought – we didn't always think this. Actually, we went through a few years where we were mystified as to how this could be. How can we not put our fingers on the forehead of someone and detect whether there'll be a success in entrepreneurship through acquisition because we are Harvard professors after all.

But, and I think Rick originally pointed this out, what the students are doing, what our former students are doing, these acquisition entrepreneurs, is they're selecting businesses which are good fits for their skills. And that's a big reason why you see so many skills working. It's because the people, you know, who...

Mm-hmm.

I must admit a bit of a bias. And so you can correct me and I'd love for you to do that. I listened to one of the episodes of your podcast, the most recent one with Betsy, who is an acquisition entrepreneur. People should check out your podcast as well. We'll link up to it in the show notes. But she was what I would describe as out of central casting. I mean, she was a Vanderbilt grad, right? So this is like a prestigious, very, very hard to get into university person.

She had an amazing experience there. And then she went into finance. So she ticked that box. And then she goes to not some community college or some state school, but she goes to Harvard, the highest level possible program to get the credentialing. And it all left me with the view that- Not credentialing, education. Education. Education. Education. I'll call it education. Absolutely. But at the end- We like to think we actually teach them something. Yeah.

We all have to cling to our illusions. We all,

all cling to our illusions. All right. Education. But at the end, I kind of took a step back and say, how is she going to do when the reality of running a company smashes her in the face? There is no playbook. This is going to be the first time in her life. I'm speaking for Betsy. I've never met the woman. But my assumption would be this is going to be the first time in her life where she is way outside of her depth. She's going to be dealing with things that

Most startup entrepreneurs learn by doing, right? If you start a business, you figure it out. By the time you hit 500 grand, a million dollars, you figured out the hard way by skinning your knees how to run a business.

This person I was hearing, she sounded so polished, so dynamic, so incredible. And I worried that she's never had to do the hard stuff that doesn't have a playbook. Am I getting it wrong? I'd like to jump in. Rick, I'm sure we'll have some comments. But I think that most of your listeners who started their own companies and built them up and are now getting in the middle distance thinking about retirement and sale, we're

What they did is so much harder than what is being asked of an entrepreneurship through acquisition, acquire. They had to rub two sticks together to make fire. They had to find the first customers before they could point to existing customers who are happy. They had to come up with a business plan where the revenue they got was greater than the cost they spent. They had to find employees and figure out which employees worked and which didn't. They had to do all that. And now...

20 years later, they have a business, to choose your example from earlier, with 10 million of revenues. They have customers who are happy there and are reference points for new customers. They have employees who know what to do. They have...

profits they make each year and they understand what affects profits up and down. And so this is far more understandable to a new person who is a trained manager who's had half a dozen or 10 or 15 years of experience, far more understandable than what they had to go through in starting a business. And not only that, but as part of these deals, these owners will spend three to 12 months, an average probably of four to six months

Transitioning, you know, being there for phone calls and explaining the history. So it is a much more noble task to a smart, energetic person than it would seem at first, as evidenced by the success rates of doing this. Rick, would you add anything to that? I would add so much to that. So first of all, while it's true that Betsy has this kind of shiny background, I

let me make a shameless plug for some of our other episodes. So our first season ends, uh, ends with a Q and a session, but the episode before that is one of our graduates, Gerald Pierce, who, uh, was, uh, a foster child dumpster dove for food, uh,

got to state schools by scholarship, got to Harvard by scholarship. And when we were interviewing him, he had just sold his HVAC business and his family was in a luxury resort off the coast of Spain. And so it isn't just for the people who walk in with a silver spoon or walk in with a great education.

I think what happens is that there's a scrappiness to the people who are successful at this. Another woman who was in our first season, Jackie... Copcho. Copcho, who ran a pool service in Long Island. And she described the stress to get...

120 seasonal employees trained and in vans and servicing so that everybody's pool is shiny and clean on Memorial Day. Because if it's not shiny and clean on Memorial Day, it doesn't make a difference what else you do.

And it turns out her family business, her family was in the restaurant business, right? Is that, is my memory right? They ran a pizzeria in the Bronx. They ran a pizzeria in the Bronx. And so while she had a great education and is a very smart and capable person, her background, what she grew up with around the dinner table was not, you know, let's describe, let's talk about Ulysses today. Okay.

You know, that's not the environment.

I'm not saying that was Betsy's environment, but that's not the environment of most of our entrepreneurs through acquisitions. They grew up in families that were business people and the family business was important to the family. And what they're doing is bringing that same energy and grit and drive and determination back.

together with some knowledge about how to run a business. What most founders are, we think, what we find is most founders are absolutely outstanding experts in their fields. So if it's an engineering firm, the founder is an outstanding engineer. If it's a concierge medicine practice, the

founder is an outstanding physician if it's uh an hvac business it's the person who started the business was an outstanding technician and then went on his or her own and and

And those skills are really important to get a business off the ground. But most businesses will reach the point at which you actually have to know something about management to take it to the next level. And our students, some of them have those technical backgrounds, but some of them don't. And many of them don't. But what they do have is the knowledge of business basics to get those businesses to the next level. And and.

I just think it's remarkable that nobody would think that an engineer doesn't bring value to the business, right? Of course, the engineer brings value to the engineering business, right? But the manager also brings value to the engineering business. And at a certain size, the business can employ engineers, but the manager is the person who's deploying those assets. At some point, the founder's skill set just becomes...

I don't mean to minimize it, but becomes a fungible asset in the business. And that's when you know it's ready to sell. Rick, when do you think that happens? At what size? I don't think it's size dependent. I think it depends. There's a moment in which somebody starts a business and in the beginning, the business is fundamentally a job. And at some point, the business stops being a job and starts being a business. And

You sort of know this when, I think you know this, when the founder no longer gets to do the skill that they love doing that brought them into the business. So the person who wants to make artisanal bread now finds himself running a bakery with 100 people and he's spending all his time on HR and finance and managing the real estate and

employee benefits and customer delivery schedules and hasn't baked a loaf of bread in a year. Now he's being a businessman, not a baker. And the question is, was he a better baker than a businessman? I don't know. Depends on the person, right? But why do we think, you know, you got to learn how to bake. You also learn how to be a business person. But a lot of these great entrepreneurial businesses,

They're successful because of a delicate alchemy. In part, it's the soul of the company. It's the instinctive leadership of the founder who knows how to deal with the customer in a certain way, who knows why a word on a website is bad or good. And that's very hard to teach a manager. What do you...

teach or train? First of all, would you agree with that sentiment? I think if there's, if the business is so tied to the knowledge of the owner, then it's not a business yet. Then it really is a job.

No matter its size. I guess we could look at a company like Dell. Under Kevin Rollins, Dell struggled. Dell was an incredible success story up until the time that Dell tried to move away from the business. It's a multi, obviously multi-billion dollar business. He's come back in the company and it's become an incredible success story again.

He's an instinctive leader that's brought Dell back from a manager who kind of knew the basics of how to run a company. He knew more than that. I'm not giving him credit. But he didn't have the instinct. I would argue there are, you know, Steve Jobs would be another example. There are lots of, you know, very celebrated examples of this where the entrepreneur has to come back into the business, even at a very big size, because they're the only ones who understand the soul of the company. Yeah, I agree.

Well, I would say two things about that, John. First of all, the stories you just related are true stories. But I think for every one of those stories, we could look at many more stories of the business that outgrew the founding entrepreneur where he or she just didn't know how to manage the business and got lost.

And frankly, the most common story is the entrepreneur builds a great business. They're now more of a manager than they were, you know, the creator of the services. And also as they've gotten older, their priorities change. You know, suddenly they find they have more money than time and they want to act that way. They don't want to work 70 hours a week. They want to work 35 hours a week.

And so maybe they're not paying as much attention to the business as would be great for the business. It's great for them as the owner of the business. And so there are forces in life which start to...

Start to create the opportunity for someone who is young and hungry and trained and doesn't have much money but wants to have success. Really be a suitable successor for people like this. So I think the truth is there are founders who are impossible to replace. There are founders who ought to be replaced. Yeah.

And then most of them go in the category of can be replaced. But they can be replaced. Yeah. Particularly with their health. Yeah. So yeah, the zero to one, you know, the Peter Thiel, there's most, I think entrepreneurs, I think many of our listeners would fall into that. They're great in the startup, right? They're, they're great for the first couple of million in revenue, first 10 employees, and then feel a little out of their depth when we're starting to get into 30, 40, 50, a hundred employees. Right. Yeah. And so I think they would concur. I've just,

pushing the envelope to say, you know, and when they say they're working 70 hours a week and maybe they don't want to work 70 hours a week, I think it's not so much they don't want to work the 70 hours a week. It's they don't want to work the 70 hours a week doing the stuff they have to do then. Right. Because they're no longer baking bread. They're no longer doing the engineering drawings. They are managing H.R. They are dealing with grumpy customers.

difficult employees they're not they're not you know they're not sharpening their pencils or are mixing the wheat and gluten and whatever you do to make bread uh you're hungry aren't you rick no i'm not i'm not i'm actually not but i uh

You know, it's remarkable how things like we say baking bread and it's like I should know that, right? I feel like I'm at a George Bush moment, if you know what I mean. Like milk? What's a gallon of milk? Is it $50? Is it $2? Right. I don't actually, you know, I mean, I've thrown ingredients in a bread maker and press the button, but that's really it.

Uh, so, okay. So let's go back to where we started this portion of the conversation, which is, I was trying to put my finger on like what, you know, how would you describe psychographically, you know, demographically. And, and so what I've heard, uh,

You know, I think it'd be fair to say if you took a survey of Harvard Business School graduates, you'd have a portion that would go into consulting, a portion would go into investment banking, all of whom would have very, very, thanks to you, all incredible skills, education about business. It sounds like your graduates from your program combined those same skills.

business chops expertise with a degree of scrappiness and willingness to get their you know feet hands dirty and sleeves rolled up that perhaps the grads that go into investment banking or go into consulting may not have this it's the scrappiness plus the education that makes the the ideal and the drive there's a lot of and the drive there's a lot of drive and you know i'm i'm a big fan of saying success is a delicate mix between confidence and humility and

And what I think is true about the people who are successful in this place is that they really do have an interesting balance there.

They have confidence in themselves, but they're willing to walk into the entrepreneur and say, I don't actually, you know, I've done all the studying I can to learn about your business. I've worked really hard to understand it, but I need to learn from you. I'm not going to come in and say, let me tell you how to run your business. They don't do that, but they absorb like a sponge, right?

So what's the pitch for an acquisition entrepreneur? Because if we go back to our hypothetical $10 million business doing $2.5 million of EBITDA, let's imagine it's an HVAC company, 50 employees. There are a lot of people that want to buy that business today.

There are private equity groups rolling up HVAC businesses. There are probably strategic regional players that want to add another HVAC company in a new city. And then along comes your grad. How do they compete against a potential private equity buyer willing to pay a premium, a strategic acquirer, again, willing to pay a premium? Dave, Royce, you can take that if you want, but I was going to say they probably can't.

Okay. Yeah. Well, I'd say two things. Actually, yesterday, Rick and I had in class a HVAC company founder who sold his business to a searcher, but we'll talk about that in a moment. Go ahead. I want to follow up on Rick's comment because he's right. There are businesses where there is a lot of private equity interest. So in HVAC, your perfect example, John, there are lots of private equity buyers. You can line them up. You can get a bidding contest going and sell them

But for most smaller businesses, there aren't a lot of private equity buyers for at least two reasons. Even though these are very high quality companies that any sensible person will want to own, the first is they're small. And the economics of a private equity firm don't favor buying smaller businesses because

They live off a management fee and a share of the profits they make for their investors. And if they can do larger investments, it is much more lucrative for the firm than if they do lots of smaller investments, which are very labor intensive. So small sort of turns off a lot of private equity firms. And the second is that the owner, founder, CEO...

is often selling as a step towards retirement. And now that private equity firm not only has to do the work of buying a small firm, deploying a small part of their capital, but they have to do the extra work and take the risk of bringing in a successor, making sure that person works, doing all the work of hiring them and vetting them and supervising them. And that is not an attractive combination for most private equity firms. And it's really hard to do and not always successful.

Exactly. And so what many of your listeners are going to find is those buyers aren't that keen. The kind of buyer who's keen is someone who is capable of pulling together a transaction, the equity, the debt, and structuring it, and then wants to run it as CEO.

And in addition, you know, what they want to do is they actually, they want to be the founder. They want to run that business for five or seven or nine years. And some founders actually place value on that separate from just getting a sale done. That's the first most important reason. But they just say, I don't want my company just subsumed into some larger holding company. I don't want the employees laid off by some heartless PE firm. I want someone who sees this as a business to...

curate for seven years. Rick, would you add something to that? I would add just a few things, Royce. One is that your example is one that tilts against the searcher because HVAC is, of course, a business that has attracted lots of private equity interest. And most of the buyers of HVAC companies eliminate the management and just roll the clients into the larger company. So

and in your example of $2.5 million of profitability, it's at the borderline where it's a standalone entity for a small private equity firm. Make that a $1 million or $750,000 EBITDA business. Private equity isn't gonna touch that ever because it's just way too small. Now, it may get rolled into another portfolio company,

But then you need to think about that many small businesses are in these niches that you might never even have heard of, except you're looking for the small business. And it's remarkable. You find these little manufacturers of custom batteries, of this, of that, services that you didn't even know existed. People have, you know,

very successful careers in running. And so these businesses aren't subject to roll up because they're kind of idiosyncratic. They're not easy to roll up. They're too small.

For a private equity firm to buy and you need to replace the manager because if you're making $750,000 in owner's compensation, you know, if that's your EBITDA and the owner's taking $500,000 or $600,000 a year and doing whatever with it, which is fabulous, they probably don't want to spend $200,000 for number two.

you know, of equal to their quality. And so some owners say, well, gee, why should I sell my business four times? I'm going to just keep owning it and I'll hire somebody. And then it turns out that they might say they're going to hire somebody who has the same skill set they do, but they don't. They hire, they take the general manager that they have who,

was good at getting things out the door or managing the shop floor. And they give that person a new title and maybe a 25%

bump in salary and they say okay now you're running the firm execute your strategy well that person doesn't generally think about strategy that's not what they've been doing their whole career that's not what they've been trained to do so they just execute on the owner's strategy and that works until the world changes and guess what the world changes all the time and so uh

That strategy just doesn't work for a small company because you really need somebody who has that skill set who can actually run the business. So, yeah, two and a half million dollar HVAC, we can have a long conversation about it. But, you know, $750,000 specialty manufacturer, short conversation.

Now we've really peaked, I think, a lot of the ears of our listeners because for a lot of our listeners, they are in those unique industries. There isn't some roll-up going on. And they may be a little south of the numbers we were talking earlier, $600,000, $700,000, $800,000 of profitability. They're like, if I could just get to $2 million of EBITDA, I'd attract the big strategic, but I can't get there or I don't want to. And so this is a really interesting...

potential for them, in particular, if they don't want to see their employees gone, they want someone to come on. Carry on their legacy. Yeah. Yeah. Yeah. You know, I wonder, do you get the chance to vet the candidates for your program? Are you involved in admissions at all or do you just get what you get from the admissions office? Well, we get what we get, but our admissions are pretty good. And, yeah,

Harvard Business School, there's about 925 students in each class. We have room for 200 in our two sessions that we offer, two classes that we offer. It's pretty competitive to get in. So the people who want to get in are the people who are really interested in that career path. They don't, they don't come just because we're pretty faces, you know, uh, we think, um, uh,

And so there's a bit of self-selection. We tend to get more married students. We tend to get more military students. We tend to get more people of color, people for whom this career path seems particularly attractive going in unconditionally before they really see it. Who do you screen out? We don't screen out anybody. But-

There are a lot of people for whom this just doesn't fit. Well, I like to say the most difficult thing a CEO does every day is write down their to-do list because it's the definition of the to-do list that determines the success of the business. And a lot of people really like to have the to-do list given to them.

And for a lot of careers, very high level careers, you get a to-do list. If you're working, if you're a partner in a private equity firm, you're effectively getting a to-do list. Find a firm that we can buy and then execute and make profits at that, right? And there's a to-do list. I mean, it's maybe a high level to-do list, but it's a to-do list. It's not presented that way, but that's exactly what it is.

Yeah, I mean, it's not right. And if you're working for investment banking or consulting, they're going to tell you go. You know, if you're a consultant, they're going to tell you go visit this big company and they have this problem that they've hired us and do a power. You know, you have a month and put together a PowerPoint slide that they're going to sell really great ideas. That's your to do list that you have a deliverable. It's well defined. And for a great many people on Earth,

I would say most people on earth. Having that well-defined to-do list, the objective, I know exactly what I need to get done in the relatively short form, relatively short term. And there's somebody smart telling me what that is. That makes people happy.

So they don't fit this, right? You have to have – this is this confidence and humility thing. You can be really confident in your ability to execute a to-do list, right? But it's – It's interesting because it does get back to our earlier conversation around the difference between a startup entrepreneur and an acquisition entrepreneur because the startup entrepreneur is the ultimate to-do list person, right? Like they're literally starting from a blank sheet of paper. They got no to-do list, right? Right.

It sounds like the folks that you're educating are somewhere in the middle. They don't want to sit in the 64th floor of the Bank of America tower and just doing out the PowerPoint presentation. And at the same time, if they were truly total blank slate thinkers, they would probably start something rather than buy something. Maybe. So there's somewhere in the middle. Maybe. I don't know that...

that sort of being, this is my personal bias. I don't think being a blank plate, you know, blank piece of paper is a higher calling or even more creativity or more drive. I just think it's a different skillset to create something out of nothing than to take something and make it spectacular. That's a different skillset. Okay.

You know, it's pretty typical for our students when they take over a company. You know, things don't really move a lot in the first year. But if you look five years out, most of those businesses are double or triple the size they were when they bought them. It's amazing. And it's not because of luck. It's because they go visit their customers and they visit their customers and listen with an open mind.

They look at their marketing materials and they don't say, this is the way we've always done it, so we should keep on doing it. They're saying, gee, maybe we should go to Google words and get higher in the search engine. And maybe that's how we should market. Or maybe we should market at trade shows. Or maybe we should do belly-to-belly sales. But they're open-minded to a bunch of alternatives. I think that's special and different than founders.

When does it not work? You've been a tremendous advocates, both of you for this working. And I think in large measure, it does. You've got a tremendous case studies and all your podcasts of real success stories. I'm sure there are some examples where it breaks.

Can you share some examples or commonalities where it doesn't work? I mean, you said this is going to air relatively soon. So, I mean, I can't tell you the number of communications I received in the last week from firms I know well and former students who have international trading partners with Mexico or Canada who suddenly find themselves in like, what do I do now?

And that's kind of wait till tomorrow. It could be different. So, look, bad luck happens. The world changes in various ways. And so there are these external forces sometimes that happen that you can't see. And that certainly happens to people. Some people buy businesses, you know, that are broken and they think they can fix them.

You know, you know, they're going to buy a business. They're trying to buy a business in a cyclical industry at the bottom and be ready for the rocket ship recovery. But if they get that bottom wrong and it goes down, down, down another few years, they find themselves quite sad or miserable. Sometimes people make due diligence mistakes. They just don't understand the businesses they're buying. They think they understand them.

But they don't really. And then you have problems. Sometimes, you know, Royce and I encourage our students to buy dull businesses with loss of recurring revenue that are enduringly profitable. They're not they're generally not sexy. They're not growth oriented. They're let's grow a little bit. Let's never lose a customer. Let's pay off our debt.

Let's do things well and improve and get marginal efficiencies and do it better and grow by being just better at executing what we have. I agree with everything Rick just said. And I would just add that one of the pieces of advice we give our students again and again is after you buy a business like the kind Rick described,

You know, in that first year, you will have plenty of decisions to make. Every day you'll be making decisions. But try not to make decisions which are big and hard to reverse in the first year. Big meaning a lot of money is associated with it. Hard to reverse meaning if you discover that you decided wrong, it's tough to pull out cheaply.

Try to avoid that because if you've bought the kind of business Rick is describing, you have some time to wait before you make those decisions. The business will be fine and you will be so much more knowledgeable a manager about that business at the end of six to 12 months than you are in that first month.

And that is a safety belt when you get into any established, successful, high quality business. But not all, but not all surgical acquisitions are like that. Some people really look for high growth. They say, I'm not going to buy businesses that are 4X multiple that's dull. I'm going to buy a business that has lots of growth potential.

where I have to develop new software to succeed, where I have to develop new markets to succeed. And those businesses are like any startup business. You're basically bolting a startup onto an existing business. But in that instance, the thing you're bolting on is pretty big because you have to get this growth to succeed. And in that instance,

It's just like a startup. They don't all succeed or what fail because the markets don't appear. There's a competitor. So all those things happen. But if, if, if you're in a business that's been enduringly profitable for 15 years, you really have to do something wrong to goof it up. Like really not just wrong. Like you make a judgment arrow, like, like really stupid. You know,

you know, as you're describing this business, I kind of the Hippocratic oath came to mind. He was like, do no wrong. I kind of get that. The other train of thought that happened for me was if I were an employee in one of these businesses that has been there for 17 years or whatever, and this young hotshot 20 years, my junior Harvard educated new owner shows up and

And I'd be kind of look at them and saying, okay, like, like, what are you going to, are you going to decide to do anything? Or are you just going to sit there and smile at me and say, do no wrong. And so I wonder what coaching do you give these entrepreneurs, these acquisition entrepreneurs in it to do ingratiate themselves with the employees who are in these companies that are doing the work? Like,

Is that something you talk about or educate them on? How to ingratiate themselves with the employees of the company? You know, we have a class guest who talks about how in his light manufacturing business out in the oil fields, he talks about how

He discovered his biggest value add was un-plunging the company toilets. Because if people couldn't use the toilet, they actually couldn't do their job. And so as soon as the toilet got plugged, he dropped what he was doing and went and plunged the toilet and cleaned out the bathroom stall. And I don't think he's... I mean, that may be a more graphic and colorful story than most. But I think...

fundamentally, that's it. If the floor needs to be swept, you sweep it. You don't, particularly our guys with military backgrounds, our men and women with military backgrounds, but it's true throughout our, I've never met anybody who's an entrepreneurship person

who's buying a business and wants to run it as a CEO who doesn't expect to work really hard and get really dirty, not just intellectually dirty, but like really dirty. The floor needs to be swept and there's no end. You know, you're not going to take the technician off some money making activity to sweep the floor. You're sweeping the floor.

Yeah, I guess our military, ex-military students would refer to this as leading from the front. They're not asking you to do anything that they're not showing you they do. Or another civilian word for it would just be humility. And that goes a long way, right? Because- I think if you're not willing to do that stuff, you don't. I mean, look, the nature of small business, especially in the size range that I described earlier, is that these businesses are under-resourced.

There is no HR person. There is no maybe no full-time accountant. There is no this or there's no that, right? There's no janitor. There's no building maintenance person. And so, you know, you're going to spend your weekend fixing that door that doesn't work. People just do that.

That's a great place for us to end. I am so grateful for you spending the time educating me on this important sector of our economy. I think you're obviously very passionate about this, and I think your students are very lucky to have you both as professors. So thank you for giving me a few minutes of your time. I think I'm enormously grateful for

Well, that's really kind of you to say we enjoyed our time here. It was great. Thank you for hosting us, John. Oh, my pleasure. Your book, by the way, is one that I have read personally and found it really helpful in educating myself. It's the Harvard Business Review Guide to Buying a Small Business.

I think I would recommend everyone who's even remotely interested in this to pick up a copy. It's a great book. Is there anywhere else that people could learn more about you, follow you? What else can people do? Well, the school has encouraged us starting a couple of years ago to have a podcast similar to the book, teaching people how a small firm gets bought and

And it's called Think Big, Buy Small. You can get it wherever you get your podcasts. But the school really is interested in us reaching beyond campus to the many entrepreneurs and would-be entrepreneurs who are interested in the subject but don't know how. So that's what our Think Big, Buy Small podcast product is seeking to do. And that's really been fun because we've gone beyond the normal HBS searchers. We certainly have had some HBS searchers like Betsy, as you described earlier, who

in general, as I described earlier. But many of our searchers, many of the people who appear are not people who you would imagine or who have graduated from the Harvard Business School. And we have a lot of, what should I say, a lot of Main Street businesses and a lot of businesses that you just wouldn't have imagined. So

It is a great way. I think our podcast is a great way to learn a little bit about business in a way that you don't from even reading the Wall Street Journal. So it's a lot of fun. We're having a lot of fun doing this.

The podcast is called Think Big by Small. I've listened to it. I think it was a great introduction to your work. So I encourage everybody to download it and follow. If people want to reach out to you on social media, do you accept social media or is the podcast the best place for folks to go? There's an email address associated with the podcast. And so the easiest way to reach us is through that podcast email, which is rickandroyce at hbs.edu.

Awesome. And we'll put that email address along with links to the book and the podcast in the show notes at BuiltToSell.com. Professor Ruback, Professor Utkoff, thank you for doing this. Thank you so much. Thank you so much. Be well.

And there you have it for today's episode between John, Rick, and Royce. If you enjoyed today's episode, be sure to hit that subscribe button wherever you're listening to today's show. And if you want to watch this full video interview, you can head over to our YouTube channel at Built to Sell. If you know of someone who'd be a great fit to be a guest right here on the podcast, you can nominate them. You can head over to builttosell.com slash nominate or email me at colin at builttosell.com.

with your nominations. For show notes, including links to everything referenced in today's episode, including definitions for some of the more technical terms that you may or may not be as familiar with, you can head over to Rick and Royce's episode page, which you're going to be able to find over at builttosell.com. Special thanks to Dennis Labataglia for handling today's audio engineering. And thank you to our community of certified value builders who help us bring our message to you.

Our advisors are experts in helping you build the value of your company. To get in touch with an advisor or learn how to become one yourself, head over to valuebuilder.com. I'm Colin Morgan, and I look forward to talking to you again next week.