Our special guest on this week’s episode of M&A Masters is Brett Hickey, the Founder & CEO of Star Mountain Capital, LLC, a specialized U.S. lower middle-market investment firm. Star Mountain employs a data-driven approach to provide value-added debt and equity capital to established small and medium-sized private companies, leveraging its scale-driven resources and longstanding relationships.
Brett graduated from McGill University with a finance and accounting degree and has over 20 years of investment and advisor experience, with over 15 years specifically focused on the U.S. private small and medium-sized business marketplace. He chairs Star Mountain’s Charitable Foundation which supports the career development of women, veterans, and athletes, as well as health & wellness initiatives, including cancer research.
We chat with Brett about the surprises that have come out of the pandemic, as well as:
Note from Star Mountain Capital: Past performance is no guarantee of future results. All investments involve risk including the loss of principal. This interview does not constitute an offer to sell or a solicitation of an offer to purchase interests in any fund, note, separately managed account or other product managed.
The investments discussed do not represent all investments made by Star Mountain Capital. It should not be assumed that any of the investments discussed were or will be profitable, or that the recommendations or decisions made in the future will be profitable or will equal the performance of the investments discussed herein.
Certain information contained in this interview constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or comparable terminology. Due to various risks and uncertainties, actual events may differ materially from those reflected or contemplated in such forward-looking statements.
Crain’s two-part survey process consisted of evaluating each nominated company’s workplace policies, practices, philosophy, systems and demographics. The second part involved an employee survey to measure the employee experience. The combined scores determined the top companies and the final ranking. Star Mountain must pay a fee to Crain’s only for survey collection purposes. Detailed eligibility criteria can be found here: https://www.bestplacestoworknyc.com/eligibility-criteria
P&I partners with a company called Best Companies Group on the survey that is behind the Best Places to Work program. P&I works with them to develop the parts of the questionnaires that are specific to money management. Beyond those questions, P&I’s survey partner develops and scores the surveys. P&I only sees anonymous responses to questions, identified only by the company name. If Best Companies determines that a firm scores above the threshold cutoff that they have set for a firm to be considered a Best Place to Work then P&I names them on their list. P&I uses the same cutoff for all firms but rank the firms against their peers by number of employees. P&I only ranks the top 5 firms per size category and then list the rest in alphabetical order. Detailed eligibility criteria can be found here: https://www.bestplacestoworkmm.com/eligibility-criteria
Patrick Stroth: Hello there, I’m Patrick Stroth, President of Rubicon M&A Insurance Services. Welcome to M&A Masters where I speak with the leading experts in mergers and acquisitions. And we’re all about one thing here. That’s a clean exit for owners, founders and their investors. Today I’m joined by Brett Hickey, Founder and CEO of Star Mountain Capital. Star Mountain is a specialized asset management firm focused exclusively on the US lower middle market. They do this by investing debt and equity directly into established operating companies, making strategic investments into fund managers and purchasing secondary fund positions. Star Mountain Capital was once again recognized by Crain’s and Pensions & Investments as a best place to work for the second consecutive year. And my guest Brett was named one of Axial’s Top 20 thought leaders for the lower middle market for 2020. Brett it’s great to have you here. Thanks for joining me.
Brett Hickey: Thanks, Patrick. My pleasure.
Patrick: Now, I guess people couldn’t blame you. But I’m just wondering if the track record you had? Were you a little sad to see 2020 end?
Brett: Good question. No, I think 2020 brought a lot of interesting learnings. And as with everything in life, it shows us the importance of agility, strategy, organization and culture, as well as insurance related matters where your expertise comes in. And thankfully, being ready for challenges and ready for opportunities. We did as a business thrive last year, and we’re excited about 2021. But of course, a lot of challenges for a lot of people which were very heartfelt around. And we did a lot of support relating to with our Charitable Foundation.
Patrick: Brett, I don’t mean to put pressure on you. But before we get into Star Mountain Capital, you have a fantastic story. And it is reflective on not only yourself, but on the caliber of Star Mountain Capital. So again, I apologize, no pressure. But before we get into your firm, let’s talk about you. How did you get to this point in your career?
Brett: Not not as a crow flies, that’s for sure. I often sit back and reflect. And I recently as we were talking about moved into a new house and, you know, made me reflect upon where my life is now and where we’re going and how I got here. And it’s it’s been a real evolution and is pretty interesting. And one of the reasons that I like to sit on different boards like Harvard’s alumni entrepreneurs, and try to be helped with our charitable foundation to inspire people that you don’t need to have grown up in the community you want to land in, you don’t need to have gone to all the best private schools and universities and so forth to get the best jobs. There are a lot of paths forward that largely relate to being strategic, having grit and tenacity, and effort really working hard. And if you do that, I’m biased to think that a lot of people can achieve a lot of things.
So with that as a little bit of preamble, very quickly, I grew up in a small town in northwestern Canada of approximately 10,000 people. A bit of middle of nowhere, sort of halfway between Vancouver and the US border. And I unfortunately lost my mother to cancer at a young age, which was pretty formative to me on a number of fronts and how I think about life. I was fortunate to have a father who was very involved in my life he was a principal of the middle school at the time and quit that and became a teacher at the high school to be more involved in my life. So as an only child, having lost my mother to cancer when I was six and she had diagnosed and fought it for two years when I was four. You’re really is made me think about community, culture health, I’m very fortunate that a lot of people again, thankful to my father’s engagement in the community, they really engaged with me a lot of my extended family helped in the life I had, I did want to ultimately get out of that life if you will and move to live somewhere A warmer as a very simple threshold test and B where there would be other careers outside of lumber and you know, forestry mining, oil and gas is is pretty, pretty prevalent for what’s there. And you see the cycles of those industries which led me to where I don’t invest in those industries today. I’ve lived and watched how cycles can be difficult and and it’s hard to time that we don’t do it.
But fast forwarding a little bit. I spent one year on the oil drilling rigs in northern Canada, which is how I ended up paying for college. I initially I was going to college in Calgary, Alberta. I was speed skating on the national speed skating training team with aspirations of going to the Olympics. I’ve been fortunate to be a Canadian record holder and a gold medalist in speed skating when I was younger in Canada, I thought it’d be a lot of fun to go to the Olympics. I feel fortunate that unlike other sports, speedskating, you know, right up front, there’s no money in it. So plan B, I didn’t know exactly what it would be, but I knew I needed a plan B. And I figured that school would really be the door that plan B, I unfortunately flipped my bicycle training on the velodrome in the summer, and got injured and decided not to continue to pursue the Olympics from that capacity. And then really switched the energy into business. And I as I learned more about business and was in a bigger city in Calgary and environment, I got very excited and very passionate about that.
And this is now in the late 90s. And so I learned to code and built a little internet company and stuff like that, which was a lot of fun. Nothing overly financially successful, just interesting, and the innovation and passion of building that was really my first taste of and I love that I also really got inspired by finance and what you can build in your career and how much impact you can have and how interesting and dynamic it seemed. And I wanted to go to either New York or London to work in investment banking, I was fortunate to get into McGill University in Canada, which is one of the best launching pads out of Canada, because it’s a reasonably well known International University and one of the top universities internationally, and particularly in Canada. And I was lucky enough to get recruited from McGill to work for a bulge bracket investment bank, at the time was the largest investment bank or largest financial institution, I should say, pardon me, and the investment banking division within it at Citigroup Salomn Barney, and thought that covering asset managers would be really interesting buying and selling asset managers looking at different strategies, evaluating strategies, and really having a future strategic thought within the investment space that way.
And so I moved to the US about 20 years ago to do that. And then I left that to try to tie together the investment banking and the finance, which I really learned to love. And I did my undergraduate degree in both finance and accounting as well. So I love math, I was one of those guys that in school, I found somebody telling me whether my story was or wasn’t good to be very subjective. And I wasn’t as much of a fan of that subjectivity. Whereas I loved math. So I loved calculus. And I like to go in and take an extra calculus classes within the engineering faculty and whatnot, because I liked the fact that you were either right or wrong. And somebody couldn’t subjectively tell you that. And maybe that’s one of the reasons I like investing were one of the ways that we get judged is our returns and our performance, and it’s black and white. And that’s, I guess, something I’ve learned to like in my life.
So getting to where we’re at today, Patrick, I left investment banking to focus specifically on than just principle, investing in the lower middle market in 2004. So at this juncture, we’re about 17 years into my career investing us lower middle market, I’ve made over 100 private equity and private credit investments, as well as over 20 secondary and fund purchases all within the US lower middle market. And the trends in the US, US lower middle market are both interesting. And I feel it’s a place that we can have an impact. From a culture community, you mentioned the awards that we’ve been fortunate to one. And, of course, thankful for my team in helping us do that. But we also do invest very aggressively in culture in team in talent, in how we build our training programs, how we invest in ongoing training, we have a Star Mountain University. And we we really put a lot of effort into that. And I’m thankful for my team for putting that effort in.
We also align interests with our entire team, where all of them own carried interest and share in the profits of our investments. We have about 75 people in total now, including our operating partners in 20 cities across the US that are focused on nothing but finding high quality private businesses, figuring out how we can add value to them. And one of the other things that I wanted to build within star mountain was a flexible capital solution approach where we could sit down with business owners, get to know them, understand their personal desires, their businesses, challenges and opportunities, and really come up with a game plan and the right type of capital for that, whether that’s debt, whether that’s equity, whether it’s a combination, whether it’s some hybrid security in between.
There are different types of capital and different needs for different businesses. And we really want it to be a Blackstone or a KKR type of a player. But within the lower middle market, where we have a full range of services and capabilities for business owners and for our investors within a marketplace where we target generating alpha from an investment perspective. And then for business owners, it feels good to be able to add value and really understand them and get to know them and that’s where it takes I guess my background is that entrepreneurial ism, the small town community where you work as a community, you trust each other, you work together. And you really have that sense of community, bringing that into the financial creativity, and being able to really drive impact. And what we do is something that I’m extremely excited about.
And sitting here today as a 42 year old, I’m extremely excited for the future, because I think we’ve really just scratched the surface and how we can add value to different businesses across the country and for our investors. And that’s, that’s really exciting for us, Patrick.
Patrick: Well, and you’ve segwayed right into, you know, my thoughts about, you know, either the commitment to a lower middle market is that, you know, I think that, as with everything, as you start doing investing, there are a number of investors quite a few that the deals just keep getting bigger, just from inertia, and then they just trend up that way. And there are organizations and their executives like you that are committed to stay. No, we like this segment of the market. I mean, I would just think, just logistically, there are a lot more of those companies out there they’re created every day, you have a bigger impact. With returns bigger opportunity you want on the smaller stuff than on the larger stuff.
But I think the other thing is important, I think you get this too is that this sector of the market, the lower middle market is underserved. There are so many of these organizations that are not as sophisticated. And a lot of times they are not accustomed to mergers and acquisitions or making that transition or taking that next step to get to the next level. And unfortunately, there are a lot of choices out there. But they’re not aware of them. And they can’t distinguish one option from another. So they default and go to an institution. And they’ll unfortunately, when they go to the institution, they don’t know any better, but the institutions don’t have the bandwidth to meet their needs, take hold their hand, get them over. And so unfortunately, the institutions are not going to treat them, you know very well, they’re going to overcharge them, and they’re not going to deliver on execution and so forth, the way that the lower middle market really needs and is essential that there are organizations like Star mountain capital and you that have the passion, the commitment, and and you want to be there to serve that.
And I like that, because what you’re doing is you’re not just trying to, you know, objectively get a return. You want and correct me if I’m wrong, but you want to come in and impact the culture. And you want to do that not just for the culture of that organization, but the culture around the community, because you grew up in that kind of community. I mean, yeah, pretty consistent?
Brett: Yeah, it is. And you you touched on a number of things, I think, are really important. And one is that things I’ve learned, I’ve been lucky enough Patrick to be invested in and have different partners and people in my life that are incredibly dynamic, experienced and successful. And that’s really allowed me to have a rich learning environment. And I couldn’t have been right enough, when I grew up in a small town to say the smartest thing I can do, knowing nothing about the finance or investment banking industries, get into that culture, get into that. And living in New York City for nearly 20 years, I’ve lived walking to my office the entire time. And the amount of effort I was able to put into that the amount of learning from people, it’s just been incredible. And some of the things that I’ve observed, and we all see this, or we all have access to this data, including the utility curve of money. We all know that once you surpass your basic needs, the incremental utility or happiness you get from money is very low.
And there’s a lot of great professors from ours at Harvard. And other than that have written about this and and lots of good people, right, that have written about that. And you see a lot of people that are very wealthy and not happy, and so on and so forth. And so I really took a step back having lost my mother at a young age and said, Who am I? What matters to me? What do I stand for? What do I want to be a guiding light for my children around? What’s the North Star? Star Mountain Capital is a name that I came up with. There is no star mountain, the star in the mountain is our North Star. What are our guiding lights? What do we stand for our ethics, our integrity, our humanity, and really staying focused on that at all times, with the strength and stability of the mountain is really the idea behind building that. And I think that the impact when you lose somebody the young age, it really makes you reflect on life and its fragility and how I built star mountain where I have a very large executive team of extremely capable people. This is not a business built centric. around me, this is a business. That’s a platform.
It’s not, you know, Brett Hickey Incorporated, this is Star Mountain capital, 100% of my employees share in the carried interest and profits of our business. We are a 100% employee owned business, despite managing approximately $1.5 billion today. And I’m extremely proud of that. And I’ll even say, you know, sharing, just personally for you, Patrick, and your audience at my wedding, to my partners at Star Mountain, were two of the four best men in my wedding. You know, we have real relationships where I said, I want to wake up every day and have fun, stand for something, trust, who I work with, enjoy who I work with make an impact for lives of businesses and people that were really impacting their lives, not just for, obviously, our investors, but for the businesses that we’re backing and we’re supporting, that’s their careers, you know, their livelihoods. And we take that very seriously. And it’s fun, it really sense of purpose in life becomes critical.
And so I’ve tried to have my North Stars and guiding lights very clear. And you know, a couple other things that you mentioned, I think are important. Also, Patrick one is being committed to something in our case, we’re committed to being the best investor in the US lower middle market, which includes Canada as well, that we can be right we’re here to wake up every day and say, How can we do a better job every day? The mantra of the young presidents organization is lifelong learning. That’s similar to star mountain, we’re focused on creating value, driving value, constant improvement as a firm and constant self improvement. I’m sure as my wife can tell you, I have lots of room for improvement. And with all seriousness, I do and we all do. And so we trademarked investing in the growth engine America, we’ve trademarked collaborative ecosystem, because we believe in that community or think of it as a small town community feeling where we all serve a purpose.
We’re all here to add value to each other, treat and respect each other the right way. And when you mentioned the M&A capabilities, one of the other things that we viewed as a clear need in the market and a clear opportunity in some of the problems that Star Mountain is solving is how do you bring that large market expertise to small businesses, right, your Goldman Sachs’s of the world aren’t working with small businesses. If somebody is working with them, you’re generally getting a very junior type of person. So at Star Mountain, my partner, Brian, who’s the chairman of our firm, was the Global Head of M&A at Credit Suisse. He was also the president of the firm running an 18,000 person business. And he also ran their $100 billion global asset management business.
And other partners of mine were divisional heads and partners running five 600 person teams at Goldman Sachs, UBS to name to few institutions, running the leveraged loan business as the heads of it at Merrill Lynch, Bank of America, Merrill Lynch. So we really have come together as a team and said, we’re all here to make money. But we care more, we care about more than just money. We care about investing our own capital, protecting our capital, we care about who we’re working with making a real impact. And so what we set out to do is to bring those large market expertise to these smaller businesses.
And again, with the right culture, the right alignment and the right partnership, and the right long term investment, I had to invest a very substantial amount of money in building technology, opening up offshore data centers in India and places like that, that we opened over a decade ago, so that we could really bring those large market resources, skills, capabilities and knowledge into these businesses, which there’s always more to do, but it really, you know, really is exciting, and I couldn’t agree more with everything you just said, Patrick.
Patrick: Okay, well, let’s put something into perspective for our audience because this is now 2021. But Star Mountain Capital, I apologize. Opened in 2009? 2008?
Brett: 2009. I guess we officially formed we sort of say 2010 is when we launched so 11 years ago.
Patrick: Okay. So 11 years ago. ESG environmental, social, government, the that culture, attention and commitment so forth. Companies Weren’t you weren’t paying lip service to it back then. Because it wasn’t on anybody’s radar. I mean, actually, from California’s perspective, it was still within California and the tech community. It was nice and it but it was still kind of remnants of a hippie type of perspective. Okay. Now we come into there and everybody’s talking ESG. And there’s this whole commitment. You were formed with this. So I mean, this is in your DNA now. And I think that’s that long view that you have I think is something that anybody in the lower middle market should really pay attention to. I also like to thank because I was going to ask, you know, what’s special about what you’re doing, as opposed to a lot of other companies.
But the other observation I have is that, and I think this is essential is that you’re having institutional grade talent that is available in a boutique delivery system. So you were, you know, a boutique. But now with the limitations of a boutique, you you have all in it comes from the talent of the your team members, but you got, you know, a less talent that’s available there at not the lowest prices. So I think that that’s striking. What other things is Star Mountain bringing to the table for the lower middle market?
Brett: Yeah, it’s a good question. It’s one or the other thing is, that’s interesting, Patrick, just to try to make this a bit more, a bit more intimate, you know, for your audience in your group. And I think the more that we’re all open and honest and authentic with each other, I think that’s a good thing. And that’s just always been who I am. If you ask any of my friends, the people that know me, well, I don’t certainly think I’m perfect by any means. But I really do care. And I really do work hard and try hard. And I’m sure if you ask my colleagues, what’s one of the things you’d say is his effort. And I guess whether it’s working on the oil rigs, or speedskating, right effort has been something that I’ve I’ve always had as part of my core DNA. And it’s important in the lower middle market, I tell people when they come work for us, it’s exciting, it’s fun.
But you’ve got to be willing to put in the effort, these businesses need help analyze them the right way to find them the right way, the information doesn’t come packaged up in a boat, you’ve got to be willing to put in the elbow grease, put in the effort and work with these companies actively to help be a strategic capital partner to them. It’s fun, it’s exciting, it’s financially rewarding. But you have to put in the effort into it back to your point around the environmental, social and governance within ESG, which people often also call impact and impact investing. I think part of it is when you have a parents, my mother used to work for IBM. And it was really tough for her with a family. Because back in those days, it was really challenging for women to have strong careers and be a mother. And so that matters a lot to me. And so I think the COVID is going to have people allow for better work life balances that I actually believe will increase productivity. I know it started out and I believe it has it’s it’s you know, there are certain things that are less efficient. But I think on balance, our productivity has increased.
We’ve invested aggressively in our team, building home offices, building the right support the right technology, the right equipment for them to have full throttle environments. And it surprises me when I talk to some people that are like no, why would I that’s people’s homes, why would I invest in and I’m like, well, you invest in an office space for them. Why Why wouldn’t you invest in your human talent, if that’s your biggest asset, which certainly for our business it is. But I think the IBM dynamic, and this is nothing negative about IBM is just all large corporations back 30 years ago. But being able to support something and help impact what I know impacted my mother is something that makes me feel good in a way that I’m trying to give back. And I think it’s something also from having a father, as a school teacher, you’re focused on educating and giving back to the community being very involved in the community, which which my dad still is to this day.
And that’s always been something I’m very proud of, I’ve really tried hard to keep that with me as part of our life and to build a different type of finance firm that is really engaged on these matters. And I try to be very forthright about it. Because it’s not for everybody, right? If you don’t care about these things, and you just say, my simple goal is to try to make the most money I possibly can with my career, then you shouldn’t come here because we want people to care about our investors, care about the companies, they invest in care about our team, and are willing to not always put themselves first, but put as our fiduciary obligation, our investors, our team, our portfolio companies to think about them. Now, now as it turns out, I think actually, this approach on ESG and culture team, I actually do believe it also will actually provide the highest likelihood of the type of financial outcome that people want.
And there’s starting to be more and more data behind that but investing in culture, investing in community invest in your team. I think, for example, the fact that I’ve chosen to give up equity will make my equity worth more and will help me therefore be worth more in the whole by giving something away and aligning interest with my team that way. So I think that’s something I know different universities study a lot around that. And there’s more and more data. But I think doing the right thing pays off long term. When you probability weighted, what we’re really focused on is a high probability of your desired outcome. And I think that if you take that approach in life, and when I think about our children, I’m trying to raise them, I don’t care what their end up being worth, but I do care that they’re good people that live a good life, that mitigate risks in life that are happy, positive, good friendships, a good career, I care way more about that. So I want to give my children and our business the highest probability of the desired outcome possible.
Patrick: There are, as we mentioned before, lots of options out there lots of firms, and there are lots of target companies, and you set the table really well on the subjective criteria that you’re looking for the subjective items that you you plan to deploy, and so forth. Let’s get a little bit objective for for our clients and our prospective audience members out there. And, you know, what is a profile criteria for an ideal target company for you? Okay, we’re, what is Star Mountain Capital looking for?
Brett: Great, great question. Thank you for asking Patrick. The, we’re looking for business owners that want to do something else with their business, whether they want to sell their business, whether they want to make an acquisition, whether they want just strategic capital, to help grow a partner to say, hey, how do I frame out the world? What do I take my business to, and then we have different types of capital available, different types of debt, different types of equity, to help grow with them. So we look for businesses that generally have at least 15 million of annual revenue. We’re not experts at startups, so we don’t invest in them. We’re not experts in real estate, we don’t invest in it. We’re not experts in oil and gas, we don’t invest in it.
And I remember that’s one thing, I think that’s key that one of my professors have told me is that if you want to be great at something, you have to know what you’re not great at, because you can’t be great at everything. So there’s certain sectors and certain types of companies that we’re not the best solution for. So carving those out. The other thing I would say is that generally, if you’re over 30 million of annual EBITDA, there are probably businesses that are better positioned to focus on you, and where you’re going at your next phase. So what we’re really experts at is taking a business from 20 million of revenue to 200 million of revenue, or from 5 million of EBITDA up to 20 million of EBITDA, things of that nature, finding strategic acquisitions, analyzing them, negotiating, structuring the investment structure with them to earn outs and all that integrating tech talent systems, financing and providing the capital, and then helping those businesses really thinking about the future strategically and how they’re structured, as well as add on acquisitions.
So for example, in a downturn, we were ready, we were geared up, we viewed a downturn was coming. And I actually think there’s a reasonable likelihood another one is coming, because a lot of things that we worried about pre pandemic, like valuation bubbles, they’re higher than they were pre pandemic. So I would caution people to think that, oh, phew, we just got out of 08, now it’s gonna be another 10 year bull market. A lot of the Black Swans that were flying around, have perhaps been better fed recently. And maybe that means they can fall harder and from further to use the Black Swan analogy, but I think that being ready to find acquisitions, so for example, we helped one of our portfolio companies acquire a business out of bankruptcy that will hopefully be extremely valuable for it, we helped another business spin off a subsidiary as a wholly owned subsidiary, because that subsidiary, really, trades is a revenue multiple versus an EBITDA multiple and perhaps it’s a telehealth business that could really be worth a tremendous amount and how to how to take that business to the next level.
Similar to if you’re a big company that can afford to hire the best talent at Goldman Sachs and a Bain or McKinsey consultant. That type of strategic advice is really what we’re bringing to the companies and you know, we’re we’re looking for high quality people that are looking for, you know, good capital partners and people to work with. And you look, we’re, we’re open for business, we invested in about 27 companies last year, this year with continue to grow, open new offices. We have six offices in 20 different places, we have at least one person in across the country. So we’re we’re delighted to talk to people that generally speaking have between 15 million of revenue and 30 million of EBITDA and our North American based businesses is kind of our market segments in the world that were built optimize value with.
Patrick: Yeah, well, one of the things they just came through on that in terms of the size and the other things you talked about it underlines and supports a philosophy I have about mergers and acquisitions. And it’s for the outsiders, people hear the news about an M&A transaction. And it’s usually the very large ones that are in in Wall Street Journal that it’s Company A buying Company B. And mergers and acquisitions for us is not that it is a group of people choosing to partner with another group of people. So it is a you can’t get the human element removed from that you have to have that.
And in an ideal situation is one plus one equals six. And it’s it’s that bridge that is key out there. And it comes really hard and fast, particularly with lower middle market where you’ve got owner founders that are selling their baby and looking for the next step. And you’ve got a willing partner there, where their attitude is, you know, with Star Mountain, we want to help we want to, you know, we’re is in our interest that your interests are also met. And it goes forward, I think that that works out really well.
Brett: And one of the other things I would just add on to that Patrick, one of the things I didn’t like doing early on in my career is having a much more limited type of capital, where I really had to sell my relationships on hey, here’s the right type of capital for you, whether that’s a senior loan or or private equity buyout. So one of the things that we built at Star Mountain is this, we have different funds in different pockets of capital with different mandates associated, which allows us to interface with businesses, with private equity fund managers, with independent sponsors with intermediaries, as really an open architecture platform to say, What are you looking for? What do you need, let’s talk about it. And let’s come up with the right customized solution together for you.
And now, I love that because I do business with so many different friends of mine, and I’m not selling them on anything, I’m not trying to stuff their desires into something else, because that’s what I have happened to have available. And so whether they’re smaller private equity funds, we also have our secondary fund capital. So we can get strategic with them, where we can buy an LP interest providing early liquidity to add value to their investors so that their investors can say, Oh, that’s great, I can be more liquid when I invest in XYZ’s fund, give them new capital for their next fund, give them new capital to help fund other deals.
Same with independent sponsors, and people launching other funds, we’re often really strategic with them. Because we understand the lower middle market, we understand the challenges we understand the needs. And so we’ve built a platform to really provide a lot of flexibility in trying to add value to as many people as possible.
Patrick: Well, one other element that comes in this is what I’m very excited about now for the lower middle market is that I mean, these deals aren’t done in a vacuum. Okay, there is there is all this wonderful stuff, we are going to come together, we’re going to combine our efforts and move forward to a brighter future. However, you can’t ignore there is risk. And what sellers come to realize as they go through the whole process is that post closing, that individual seller or group of sellers, personally, is personally liable to their buyer partners. If post closing there, the buyer suffers a financial loss due to a breach of the seller reps.
And it isn’t until they start negotiating the purchase and sale agreement, you get to the indemnification discussions, and then all of a sudden, wait a minute, I might have to pay you back for something that I don’t know about. And now you’ve got the fear of the unknown out there. And initially, they start talking about I even been in a number of these situations where we have nothing to fear, we know of nothing out there. But then they don’t have a corporate veil to fall behind. They don’t have a company fall behind. Because post closing there is no company. And so all of a sudden, you know, risk becomes very real when it’s your dollars or your house at risk. And that creates tension, particularly for people that are new to M&A. And that’s everybody in the lower middle market.
Most likely, this is their first and only sale in a lot of cases. So there’s a lot of fear there. I’m very proud of the fact that the insurance industry has come in with a product called Rep and Warranty insurance that originally was reserved for the 100 million dollar plus transaction level deals where they take that indemnity obligation away from the seller, and they move it over to an insurance carrier so that if the buyer suffers a financial loss, instead of pursuing the salad, they go right to the insurance company. The insurance company pays the loss and I mean is an elegant, elegant way. It removes a lot of tension because risk is transferred. It really helps that owner and founder of those entrepreneur exit cleanly without the worry that some, you know call in the middle of the night is going to come in and something that they never thought about came in the development the last two years it was interrupted, just because a COVID is that the insurance industry has become mature.
And now with competition, there are more insurance companies coming and they are now targeting lower middle market deals with transaction values, under $20 million. Those those types of deals are not eligible for insurance in the past they weren’t. And so it’s great now that if you’re there to serve that lower middle market, here’s one more tool that removes the biggest, toughest part of that transition. And that’s getting that risk taken away from from the deal parties, because that’s the one that comes to attention and so forth. So we enjoy how this has gone. We’ve seen the credibility of it over the time. But you know, you can’t listen to me talking about it, it’s more, you know, I’m interested really, in your opinion, which, you know, good, bad or indifferent. Share with me any experience, you guys have had at Star Mountain Capital with rep and warranty insurance.
Brett: Yeah, it’s great. You mentioned something that I think a lot of people under appreciate the importance of Patrick, which is the friction and making things easier, and how to do business so rarely in life is something a one and done and the relationship never matters again. So whenever you can do things to reduce risk and reduce friction, depending on the cost of it, of course, some capacity, but I generally think is well worth it. So for different types of insurance, I think it’s very valuable to help get deals done a where you can transfer that risk, because you say to an insurance company, it takes worries off the table for both sides. It allows for a better relationship between those two parties, because the more time you spend negotiating tough things, the more you’re hurting a relationship. So if you’re buying a business from somebody, and you want them to be speaking well of you afterwards to clients, community employees, whether they do or don’t have an economic interest remaining, you want them to say you know what, these are good people, I liked doing business with them, that’s always going to be in your best interest in life.
So if you can reduce the amount of friction, you create, and getting the deal done a, b, if you can increase therefore, the probability of getting a deal done, I think that’s great. And then the sleeping well at night, from either party’s perspective, knowing that you have that taken care of with a good insurance company and having, you know, the right type of person really understands the detailed minutiae of these insurance policies is crucial, because they’re complex, and you need the right people that really get it like yourself that specialize in it, just like we specialize in what we do you specializing in what you do. I couldn’t speak highly enough for how important it is. We sometimes have people that hire their real estate lawyers to represent them and stuff on complex matters. And it’s just, it’s just so penny wise pound foolish as the Brits would say.
And you know, the right people doing the right thing is important and insurance. From my perspective, I mean, I’m a big user of insurance on a lot of fronts, whether it’s D and O policies, E and O, policies, different life insurance related things, I think there’s transactions, it’s, it’s very important. And I think, as you pointed out, the evolution of it, Patrick is ongoing, and there’s things that I still want to continue to learn more about, we’ll look forward to speaking with you and your team further about, but I think that it helps you get deals done, it helps you have better relationships, it helps you sleep better at night. And all of those things, I think, are worth something. And what I generally observed is that the cost of insurance relative to the tail risk they can solve for is often really valuable. And you have some people in life that are really skeptical that say, well, you have an insurance company, they’re making money, they’re really smart.
Yes, but they’re doing a probability weighted analysis over an insurance company, they can take a dispersion of risk and say, on average, what’s the probability this is going to happen? Whereas for you as an individual, if that tail risk is only a maybe a two and a half percent likelihood, or 5%, whatever it might be, maybe that’s reasonably small. But what if it does happen? Do you want to take that risk in life? Is that something worth you living with and taking and so I personally think that removing big impact tail risks just to live a better life as a seller is extremely valuable. And as a buyer of businesses, I think mitigating those tail risks as well. So that, as I said earlier, having the highest probability possible of your desired outcome. And maybe that means because of the cost of the insurance, you get a little bit less potential upside, but you get a higher probability of a desired outcome.
And for me in life, that creates a lot of peacefulness, a lot of happiness I think our investors appreciate I think our portfolio companies appreciate it. I just think it’s a better way to live life philosophically, personally and professionally as a business. So highly encourage people to learn more about it. understand where it’s at the evolutions as you’ve mentioned, with it Patrick, hopefully, that’s helpful.
Patrick: Brett as we’re talking today, we were just in the new year, got a new administration. COVID is, I don’t know if we are at the end of the beginning of COVID, or the beginning of the end of COVID. Time, but time will tell but, you know, as we sit here today, looking forward and you’re an Axial thought leader, you know, what trends do you see going forward? Be they macro with M&A, or just with Star Mountain Capital or lower middle market? What do you see out there?
Brett: Good question. Here are a few trends. Some of them, I will try to polish my crystal ball for and have some guesstimate into the future. I love forcing people and some people don’t like as well, what’s the what’s the probability you think of that? Or where do you graded from a one to 10? And like, well, I don’t know, you know, they give these sort of qualitative responses. And as I mentioned earlier with how I loved calculus, and less liked English literature, just due to my own, probably lack of competency in English literature relative to mathematics. I like certainty, but I like to force people to quantify their views on things. So I’ll give a little bit of views of some of my thoughts of the future. And then certain things that are also much more definitive and are going to happen.
So let’s start with the definitive trends. There have been so many things going on between COVID politics, I think people have forgotten about some major massive, definitive trends. One is the aging demographic, our population is aging, that creates a tremendous amount of both challenges and opportunities that people really think about how does that impact the future of industries of businesses, because the impacts are large, and they are systematic. So where that benefits Star Mountain is that you have more privately owned businesses and business owners that are saying, I want to transact The second thing that we know definitively is the amount of debt in the economy at a generally speaking at a sort, certainly governmental level is big, and it’s growing. Right.
So I think people need to be just mindful of understanding that I know in California, you have people that are concerned and moving to Texas is that I think the biggest probably outflow, but people are thinking about taxes. And they’re thinking about, what’s the economy going to look like? Does there come breaking points where the economy can’t invest more into x, because it has to make difficult trade off decisions. Those are questions that are important now today, with rates really low, they can finance high levels of debt. But if rates do increase, it could get very difficult. And I think that is a trend. It’s more difficult to forecast how that can impact things. But it is a definitive trend that I think people should be thinking about. I know we are thinking about it, and how that can again, impact the economy, industries, taxes, things that are systematic.
There’s a new, obviously a new party in charge, how does Biden think about things? What is he likely or less likely to do? Some of that is more difficult, so I won’t try to predict that. But it is something that is worth thinking about and how that, again, may have positives or negatives and industries and sectors and so forth. But the one thing that we always know about the government is, there’s a unknown, there’s a volatility aspect related to it, that you just can’t control what they’re going to do. And sometimes it’s hard to anticipate what they’re going to do and be able to do, right. So there’s what they may try to do and what’s the what can they actually get past and how does that impact things. But I think that’s worth really thinking about how much is government involved in an industry or business that you own and run, or that you’re looking to invest in and in whatever capacity that might be, I think is really important to think through those things. Because it’s everyone’s a little bit different and the probability weighting of it.
And we’re big fans at Star Mountain of probability weighting future outcomes, you’re never going to be exactly right. But you you do a probability weighted analysis and say, If this happens, then what and you kind of forecast a few moves out and play chess, if you will, to think about how to deal with things. As we think about some of the other things that are definitely there. But really hard to understand the impacts of valuations, public market, valuations are extremely high relative to historical measures, and people believe they’re fair or not fair, I won’t comment on but they’re high, the amount of liquidity in the market right now is very high, the additional government stimulus money that’s coming in, is really high, which is correlated to the dead, but does of course, help the economy from just more liquidity more spend.
Other things that are happening that people may less know about is that costs of goods, where manufacturing can be challenged right now, in some places a demand for certain things, high costs of certain goods are increasing. How is that going to impact the future? How does that impact potential inflation risks? People need to think about that one of the other challenges that we see out there is, from a business perspective, how do they think about their future planning? knowing some of these things? How do you think about talent replacement? One of the things that businesses I think, under evaluate is the org chart. And yes, I know that we have a president currently and a former president that are in their mid 70s.
But the probability of health issues occurring as you age increases, right? It’s just factual. And this isn’t a comment on any political person, it’s going to happen to you and I as well, it’s just a fact when you look at businesses understand the org chart, you may have like, how important is this person? And do they have succession planning really well set up or not? Because the aging demographic that we have, is more than it has ever been? So the other last thing I’ll say, Patrick, is that the pace of evolution, the pace of change, continues to increase. And I think COVID has exponentially increased that. So one of the other things that I was going to mention is that the weighting of the large tech companies and just big companies period, irrespective of the type in indexes, so a lot of people used to think of, well, the S&P 500 is a really balanced, diversified index, not so much anymore. Now, the weighting to these trillion dollar companies, which we’ve never had before in history, is huge.
So how do you think about how diversified you really are or aren’t in something that you use to be very diversified? Now, you’re very heavily concentrated in a few companies with their idiosyncratic risks that any company has, as well as sectors and so forth. And hopefully, some of that provokes some thought. I know, it doesn’t give any definitive answers. But that’s the reality of life, no definitive answers, but there are things to be focused on. And I think this is a good market to look for both challenges and opportunities, because it’s, I think the market is is riddled with them right now, maybe more than ever.
Patrick: I think you’ve outlined a whole variety of things, both challenges and opportunities. And I think that’s the successful leaders out there do that is they look for both. And, you know, they, they make decisions, straightforward. With all the information, I can’t tell you how much we appreciate having just all this, you know, perspective that you provided in what you’re doing with the lower middle market, and so forth. And I think it’s just like I said, you’ve got a compelling story. And I’m sure everybody that’s listening is probably going to want to get a little bit more. How can our audience members find you, Brett?
Brett: Yeah, thanks, Patrick. The best way from an email address perspective is email@example.com That’ll come in and then we can route you to the right people, including myself if that’s what’s needed. Second is we have our YouTube channel youtube.com forward slash c forward slash starmount capital that has a lot of good content, our LinkedIn profile, we keep a lot of good information on update in a world when physical events which I can’t wait for them to come back, do come back again, we host a lot of events, historically, close to 100 a year all across the country, try to make them fun and interesting and stuff like that, and giving people the opportunity to get together and collaborate and that builds relationships for us. And it’s part of us kind of giving back and being engaged in the community just like you do, Patrick, with this right you’re not charging people for this. It’s it’s the more we all collaborate, share information, share resources, we all benefit.
Patrick: I’m going to just buttress that with recommending people visit starmountaincapital.com. You’ve got a news tab there, you probably have one of the most, one of the more active, updated news of you’ve got a lot of great content. You’ve got a lot of great information out there. So I think that’s, that’s something that you were focused on with communications and I think that’s essential. So, Brett Hickey of Star Mountain Capital. Thank you very much for joining us today and just hope your 2021 eclipses a real productive 2020.
Brett: Here here. Thanks, Patrick. Be well everybody.
On this week’s episode of M&A Masters, we speak with Peter Lehrman. Peter serves lower middle market owners, acquirers, and advisors as CEO of Axial, the largest trusted online platform used for safely buying, selling, and financing private companies. Over the last 10 years, Axial has established a single well-known platform that business owners and deal professionals alike trust to discover and connect with new transaction partners.
Peter says, “The whole idea behind Axial was to develop a trusted platform on the internet where buyers and sellers of lower middle market businesses can find, connect with, and be found by one another at the right points in time, and on the right opportunities.”
We chat about the origins and philosophy of Axial as well as:
Patrick Stroth: Hello there, I’m Patrick Stroth, President of Rubicon M&A Insurance Services. Welcome to M&A Masters where I speak with the leading experts in mergers and acquisitions. And we’re all about one thing here, that’s a clean exit for owners, founders and their investors. Today, I’m joined by Peter Lehrman, Founder of Axial. Axial is the largest platform on the internet for buying, selling, and financing private companies. Over the last 10 years, Axial has established a single well known platform that business owners and deal professionals alike trust to discover and connect with new transaction partners. Peter it’s a pleasure to have you. Thanks for joining me today.
Peter Lehrman: Thank you, Patrick. It’s great to be here.
Patrick: Now, Peter, before we get into Axial, let’s set the table for our audience and give a little context. Tell them tell us what brought you to this point in your career?
Peter: Sure, so you can, I’ll do the sort of medium version of the answer there in terms of length, so I, I graduated from college in 2001. And I went straight back to New York, where I was born and raised and went to go and work with my brother, who had co founded a information business focused on serving investors and public companies, not private companies, I spent the first six years of my career helping to develop that business, both in America and the business was quite successful abroad as well. Over those six years, all almost all of my time was spent developing information based services and products for investors in public companies.
And then I went off to business school. And I was lucky enough to get a sort of year round and summer internship working for a private equity firm, investing in lower middle market businesses. And after spending the first six years of my career, focused on building information products and information tools to help investors in public companies make better decisions. I, I was just amazed by how little information there was on privately held companies. And you had all the same sort of cast of characters, highly sophisticated investors, and investment bankers and all these, you know, people, you know, investing in public companies, you had the same kinds of people largely investing in private companies, but just a radically different sort of information, infrastructure available for those transactions to be facilitated. And that did really strike me.
And so when I, when I graduated from, from Stanford, for grad school, I, to make a somewhat long story short, I basically jumped into the deep end, and began to build what is now Axial. So, you know, six years in the public markets, appreciating how investors use information there. And then a few months in private equity, when I was back in school, made it really clear that there was an opportunity to build a much better information infrastructure for investors and private companies. And I think at the end of the day, that’s really what Axial is all about is improving the quality of the information flow between buyers and sellers.
Patrick: Yeah, I think one of the elements of the technology, evolution throughout throughout America and the world is not data storage, data collection, it’s what to do with all that data, and how to segregate is slice it up and get it out there. And so that that’s fantastic. And I think that the more data there is, the more ways it can be utilized and leveraged and so forth. So let’s get into Axial. And I always like to ask my guests this because unlike insurance firms, or law firms that name their companies after the founders’ last names and so forth. Yeah, usually a story kind of sheds a light on, on on the person at personality of that company. So why Axial? Where’d you come up with that name?
Peter: So I labored pretty hard over this name, there were a few things that I was trying to accomplish. And there’s a lot there’s a funny story that I can tell as part of this, too. So there were a couple things that I wanted to accomplish. The first was, I wanted to spend very little money on a domain name. And it’s hard to do that actually, like a lot of good domains are like already taken, and they’re really expensive, or you can’t get them. So that was one thing that I wanted to do. I wanted to not, you know, start the company and spend 10s or hundreds of 1000s of dollars just buying our domain name. So I was hunting around on GoDaddy and looking to buy a domain name for you know, 19 bucks a year that was you know, that was sort of goal number one.
Patrick: And maybe that was common, by the way. Sorry.
Peter: Yeah. But you know, I, you know, there’s a lot of value in a good domain name, but I just couldn’t get comfortable spending a lot of money on it. So that was one thing, the second thing that I had thought about, and then I guess I had read about, you know, in some startup article or something from grad school was, you know, sometimes these were the, you know, the name of a company can just be sort of unfairly advantage just because it comes really early in the alphabet, right. So, as I was coming up with my list of names for, you know, for the business, I did have a little bit of a predisposition to try and find something that I thought would start with an A or a B, or something like that. And it really does turn out if you look at like, you know, the way that an index or a category or a list of sponsors at ACG conference, or something like that, very often, it kind of is like alphabetized, right.
And so if you have a, if you have a, an A or a B, or something early in the alphabet, you kind of get a little bit of unfair visibility. So that was rattling around in my head, as I was thinking about it. Obviously, the specifics of Axial ultimately really resonated with me. So the word Axial has a couple of different meanings. There’s a medical meaning for Axial, but the one that was actually much more interesting to me, and the one that like, kind of persuaded me to try and pursue a domain name, and a company built around it is there was a, there was a philosophical and religious age called the Axial age. And that age refers to the period in, in the history of the world when some of the most profound and some of the most significant religions began to sort of take hold.
So Confucianism, Christianity, lots of different religions, became developed during this period called the Axial age. And so the Axial age is often sort of thought about as this period when, you know, men and women and civilization began to sort of learn about right and wrong, and reason and virtue and and, you know, good and bad. And it was like this period where men sort of like, you know, came out of the caves and became, you know, sort of more enlightened right and, and filled with more information and more knowledge. And I have to say, having spent, you know, that, that summer, in that year in private equity in 2007, and 2008, I really did kind of feel like the way private equity and deals were getting done. Really, it did feel in many ways, like the Stone Age, there was no use of technology, there was really, really limited use of the internet as a means of Information Discovery, building relationships, it just sort of felt like, you know, private equity for all of its sophistication was just completely behind in terms of embracing technology, information, and, you know, just the dawn of the internet as a way to transform their work.
So it all kind of, you know, came together in my mind that, you know, there was an Axial age for private equity and for business owners, and that axial age for business owners and private equity would be an age that was based upon, you know, free or very, very affordable access to information and we could be one of the driving forces in that, you know, in that opportunity set. So I landed on it, unfortunately, axial.com was not available. So I bought axial.net for $19.99 on godaddy.com. And, and axial.com, alluded the company until actually just last year, we finally locked up the axial.com domain after a multi year negotiation. And there’s a funny story behind that, too, so.
Patrick: Well, and, you’re tackling an area when you talk about, you know, private equity, particularly in the lower middle market. When it comes to information five, six years ago, yeah, they were in the Stone Age, because it was almost as if they were an exclusive club. And if you ever wanted to identify a private equity firm, let alone team members on the on the firm or contact details, they kept that so restricted. It was as if, hey, you can’t reach us unless we know who you are, which becomes a challenge if you’re out there in the marketplace. I mean, you don’t want to be the best kept secret in the market if you want to if you want to grow. So I mean, that was pretty daunting. When you started doing that back then it would have been easier to go and look at the higher flying publicly traded or the larger area. Why? Because you have a focus with the lower middle market, both in terms of companies that are target companies looking for a buyer, as well as private equity, or financers in the lower middle market. Why that focus?
Peter: So I think that the reason that we chose the lower middle market was not in any way, accidental, I think the lower middle market has a level of dynamism to it, that makes it a market where solving the information problems that plague buyers, and sellers make it harder for buyers and sellers to find one another, to be found by one another, to assess one another as counterparties and partners, there’s a lot of problems and challenges that are, I think, much more unique to the lower middle market than to really any other sort of, you know, quote unquote, category of, of private capital markets. So, by contrast, the venture capital community still remains highly concentrated in Silicon Valley, New York, Boston, and now increasingly, you know, Austin, Texas, and maybe one or two other areas.
You can get your hands around a great amount of that community quite quickly, it’s geographically concentrated. The super large cap private equity community, right, it’s, you know, they all have headquarters between 40th and 60th Street in Manhattan, right, and they have offices around the world. But, you know, there’s not that many multibillion dollar private equity firms out there, when you go into the lower middle market, everything changes, there are literally 10s of 1000s of, of active buyers, between the private equity community, the portfolio companies that are owned by the lower middle market, private equity community, I think, I think that there’s about 10,000 private equity backed portfolio companies in the lower middle market now. So in addition to all of the funds, then there’s then there’s a whole whole nother just huge range of acquisitive, privately held companies that are owned by those funds. And then you have, you know, folks like J2 you know, or you interviewed the folks from J2 the other week, you know, and they’re, you know, a Fortune 500, and a strategic buyer, all of that sort of fragmentation, all of the dynamism of people entering and exiting the market. That’s what makes it very, very hard, I think, for buyers to find sellers at the right points in time on the right side, on the right opportunities.
And for sellers to find buyers, the right points in time on the right opportunities. In addition, people tend to age out or succeed out of the lower middle market. So you know, as you get bigger and bigger as a corporate buyer, or as a private equity buyer, you kind of have to put more and more money to work. And the easiest way to do that is to do bigger deals. So even like, you know, most most operators in the private equity market in the lower middle market, if they’re really successful, they actually almost like grow out of it. And so as a result, you don’t have a lot of people who sort of stay in the lower middle market forever, there’s a natural exit and attrition out of the market. Because success means bigger font sizes, bigger font sizes mean bigger check sizes, and then all of a sudden they’ve left and they’ve gone up market, and then a new crop of people come back in right so so all of that sort of dynamism and all of that movement creates a really important information challenge for the market.
And, and, you know, we try to solve that through the axial platform. There are other companies like pitchbook, that have built great products to try and solve, you know, aspects of those problems as well. But you just don’t have those problems if you’re a multibillion dollar firm like Goldman Sachs, Blackstone, you know, there’s just not that many buyers and not that many sellers at that part of the market. And it’s just a, it’s a different ballgame than the lower middle market entirely.
Patrick: There’s an interesting dynamic you reminded me of is as we’re doing research, and so forth, and again, five, six years ago, there are literally 1000s more private equity firms now than there were not too long ago. And a lot of them were outcrops where you had investors who really enjoyed being in that lower middle market space. And by you know, the very nature they just grew bigger and bigger and the deals got bigger and bigger and they lost touch it was almost like my daughter’s where they would start crying when they as they started growing. They outgrew their favorite shoes, and they still try to cram their feet in and they just couldn’t and you know, it’s just a natural law of evolution for them.
There are others though with with private equity. You love that small lower middle market. You just build that portfolio. You, sell it to there. There’s always a bigger buyer out there and they’re actually more bigger buyers out there now than before. But you know, as I see it not only in the private equity side, but just for owner, owner and founder businesses out there that a lot of them are aging out, or they’re finding some way to take that next step, if there’s not enough resources out there information wise for those owner founder individuals out there, they’re gonna default to large institutions, because they just they’re familiar with the name, they’re not familiar with being out there, who are these other buyers and sellers, they don’t even know about family offices, this is another class of buyer out there. And so if they default to brand names or institutions, they run the risk of trying to transition their business with an organization that for no fault of their own, you know, these institutions overlook them, they’re not as responsive, they won’t value them as much.
But they will overcharge that. And, you know, there are resources that can be brought to bear that are, you know, fit to that lower middle market. And it’s a vast, vast market. That’s one thing that’s very nice for, you know, supply siders like me, I want to be in markets that are growing, not markets that are very limited, they may grow a bit. But you know, there are a lot of these out there that all need help. And so the more that we can bring information to bear on that, on that group, that is a part. That’s why I have a passion for the lower middle market.
Peter: Yeah, I mean, you know, I hear all the time and about, you know, all the lower middle market, you know, it’s so underserved. And, you know, and that’s like, you know, to me, that’s kind of old news, and sort of a cliched theme, there are a lot of outstanding investment professionals, investment bankers, lawyers, CPAs, providers of financial products, insurance products, like what Rubicon is doing in the lower middle market, I don’t actually think that the lower middle market is underserved. In the way that I hear people always talking about well, you know, buying businesses in the lower middle market, because it’s really underserved. I think the real issue in the lower middle market, at least now, is not that it’s underserved. It’s that there’s a huge, you know, diversity and array of different providers and partners that you can, you know, theoretically choose from, right, you can sell your business to a private equity firm, you can sell it to a permanent capital organization like J2, you can sell it to a strategic buyer.
There are family offices in the market, there are lots of different intermediaries. Some of them are two, three person, four person organizations that do high quality work, others that do low quality work. Others that are 100 person organizations. Yeah, so I think I don’t think it’s underserved. I think it’s, I think it’s well served, I just think it’s very, very hard to, as a business owner, to know, to know, all of these people to know how to sort of assess all of these potential partners to work with. And so I think that’s actually the bigger challenge, right? It’s not whether it’s not that there’s not enough people serving the lower middle market, it’s helping the owners and entrepreneurs navigate those, that huge list of choices, right, there’s 100, private equity firms, I mean, what am I going to do, like, you know, go to every single one of their websites, they all sound the same and say the same thing, right? So how am I really going to figure this out?
So that’s what I think is actually the bigger challenge. It’s not that they’re underserved. It’s that it’s that there’s too much choice, and, and they need help slicing through those choices by getting their hands on, you know, good information, and, and good resources. So that’s a little bit of my sort of, like devil’s advocate argument to what you know, is sort of the cliched chatter on how the lower middle market is underserved. I think it’s really well served. I just think it’s a lot a lot of different operators down here. I mean, one of the things I was going to say just prior to your prior question. In the lower middle market, it’s the only part of the sort of private equity sort of quote unquote market where you truly have these, like individual business buyers who are buying, owning and operating businesses for their own account. We on the Axial platform serve a set of clients who are buying businesses, they’re not raising outside capital. They are not a family office, they are a person, they are an entrepreneur. And they own and operate a small portfolio of SMBs small and medium sized businesses, they buy their own capital they buy it with a combination of bank financing and their own capital. No such creature exists up market right yeah, there’s no there’s nobody who’s you know, buying businesses for their own account in the multi 100 million dollar category except t for Jeff Bezos, right, you know, who’s behind the Washington Post or whatever. But there is none of that.
And so I think that’s one of the really interesting things in the lower middle market is you can, you don’t have to sell your business to a private equity firm, you don’t have to sell it to a strategic buyer. There are actual entrepreneurs in the lower middle market who have made a career buying businesses for their own account. They’re not a fund, they’re not anything, they’re there, they’re a person just like you are. And that kind of buyer just doesn’t exist in any other sort of part of the the private market. So lower middle market is just so unique, because it’s just got all of this sort of dynamism and diversity and different ways to skin the cat.
Patrick: Well I didn’t, I didn’t realize because I’ve been chanting that same thing underserved market and so forth. I think it’s almost like they’re getting an overabundance of choice. And, and they’re, they’re almost just blip stuck, and with with too many choices, and it can feed into, okay, well, where do we go, you know, information overload and choice overload, and so forth. But yeah, you’ve got a, you’ve got an Axial brings a solution to that. So let’s talk about this a great segue into because Axial isn’t just Axial, there’s the Axial, that’s the online platform, but then you’ve also got the Axial network.
Peter: Sure. Yeah. So I mean, you know, the whole idea behind Axial was, can you develop a trusted platform on the internet, where buyers and sellers of lower middle market businesses can find and connect and be found by one another, at the right points in time and on the right opportunities. And that’s a straightforward concept, right? It’s like, you know, we’ve been written up in various publications, as you know, the match.com for m&a or the, you know, the Tinder for m&a is the way Bloomberg wrote the story on us. So it’s just it’s a straightforward concept. It’s obviously a hard problem to actually solve perfectly.
And we definitely have a long long road to go that we’re excited to go down to make it better and better. But the core functionality of the Axial platform allows for a owner of a business who’s looking to raise capital or sell to either on his or her own behalf, or through a trusted intermediary, who they have hired on their behalf to go on to the Axial platform to confidentially upload a bunch of information on the business and the transaction that they’re looking to execute. And to do that, in total secrecy, as if you’re sort of like you have like a one way mirror on the market of buyers, as you upload the data onto the platform, Axial returns back to you a set of recommended potential buyers or lenders based upon the data that you’ve uploaded.
So if you’re looking to raise $30 million of debt, we’re not going to recommend growth, equity investors, if you’re looking to sell your business, and you operate a manufacturing company, we’re not going to be recommending buyers of software businesses. So the more data you add into the sort of fields that we’ve built, the richer a set of recommended buyers we can provide to you, or lenders or equity investors in the business. And it’s at that point that the business owner who is deciding, okay, who do I want to engage as part of this process gets to sort of have that one way mirror, it’s kind of like, you know, the, you know, the, the lineups when you’re in prison where like the person goes and looks and you know, sort of points, you know, but you don’t get to see who they are, they’re behind a one way mirror, that’s basically, that’s basically the tool set that we give to, to the investment banker and to his or her client.
So they get to confidentially upload the data on the business and the deal they’re looking to execute, they get to see all the potential buyers on the axial platform that might be a fit. And those buyers have all essentially articulated their investment criteria, their transaction histories, the reasons for their interest in particular types of businesses. And then the seller gets to decide who they want to invite into a private dialogue to begin discussing the transaction. So that’s basically what you know what the business. That’s what the business does, again, and again, and again and again, for different sellers and for different buyers is enable those kinds of introductions and those kinds of customized conversations to happen at a scale that we think didn’t happen and couldn’t happen before.
Something like Axial. We automate in addition to that, we automate you know, the execution of NDA s and the distribution of CIMs the confidential information memorandum. So we we’ve used software to automate I think a lot of the more busy drudgery oriented admin work of an analyst or associate investment banker, and let the the bankers and the deal team sort of focus on more valuable sort of more value added interactions and and more interesting work. From the buyers perspective, that obviously, you know, creates a a, I mean, ideally, we’re augmenting your your pre existing deal flow, right. So you know, every buyer buying businesses have some of their own deal flow, it’s a function of their first party sourcing networks and their personal networks, we don’t aim to replace that, we just aim to augment that and sit on top of that, and grow the reach and distribution that you have on the buy side.
So that’s the, you know, that’s the core nuts and bolts of Axial without creating too much of an advertisement for it. I mean, well, but we just, you know, found is that, you know, as a result of building this network of buyers and sellers on the platform, there was an opportunity for us to build real community around that and not just have it be this sort of cold machine like software organization. And so we began to hold events for our members that use our software platform. And for the last six or seven years, those events have all been in person, we started holding digital events in March of 2020. Coincidental with the arrival of COVID.
But what we’ve really found is that by creating an environment where both digital and in person events can happen among and between our members, it’s just kind of like the Yin and Yang, for the business, the software platform enables a lot of scale, a lot of productivity, a lot of automation solves a lot of problems for you know, for the members on the buy side and the sell side. But the events, enrich the network, enrich the platform, create the opportunity for more meaningful relationships to be formed. And while that’s not important at the beginning of a deal that is critical at the end of the deal, so you just can’t very few deals get done. And go all the way, you know, go the whole distance, when there isn’t a pretty strong sense of trust and chemistry between the buyer and the seller.
And so anything that we can be doing to improve the quality of the relationships and strengthen the trust within the community of members that use Axial, that’s good for us, because it makes it easier for them to find and be comfortable doing deals with one another. So that’s kind of how we thought about the network that sits on top of Axial as opposed to just sort of raw lines of code that you know, that power of the application itself.
Patrick: Now well, I think that you know, my belief about M&A is this is a people business, this is not a Company A buying Company B, it is a group of people choosing to partner with another group of people. So ideally, one plus one equals six and and that’s the objective get out there. And you cannot get the human element out as much as there’s a lot more efficiencies with technology and the gathering of information, that you’re still the person to person network, it is essential, I think that you’ve honed down the membership, because it is the lower middle market area. And these are the deal players that are there.
And these are long term players, they’ve been around for a while, and you’ve built up the network over 10 years. So this is a fairly well established credible venable group group of participants in there that, you know, they don’t do it once I mean that, particularly the buyers, they they, you know, we’ll be doing this again and again, and some some sellers may want to go out and adventure down down the road as well. That’s the big element out there that you just referenced was, you know, with business development, in M&A, a lot of it because it was all in person was fragmented. And then when you could collect people together would be at an ACG conference and other industry conference.
And that’s where, you know, for me, it was a real challenge, just trying to track down private equity, managing directors that are either at conferences or at shows or out on the road, and so forth. COVID comes in, boom, all that stops. And, you know, the whole traditional model for business development now has changed. Actually one of the members put out a real thought provoking article, I interviewed him not too long ago, Mark Gartner, where he talked, business development has changed forever. And there are organizations like yours that at least, you know, you may not close something from beginning to end virtually. But you’re getting, you know, around second base by using the Axial network that does that. Why don’t we talk about you know, how COVID has changed Axial and M&A in your realm?
Peter: Yeah, for sure. I mean, I think, you know, I do think that COVID has definitely had a permanent and material impact on on on, on financial transactions deal making in private markets. I mean, the public markets were already so automated, you know, the exchanges and trading and all of that. So I think they were really far less impacted by COVID than the private markets. And, and so, here, I guess a couple of thoughts that I have with respect to to COVID, and business development, and just generally private markets, I think the first thing is now that everybody can meet face to face, without meeting face to face.
That is going to redefine the, the value of the need for and the appropriateness for an actual physical in person meeting, right. So, fast forward two years, vaccinations are done, you know, COVID is effectively gone. Everybody can now meet with one another very cost effectively without leaving, you know, their their basement. Right. So what does that mean, for the in person meeting, I think the in person meeting is not going away, I think in a world where everybody can easily meet on zoom, and there’s essentially no marginal cost to meet, you know, over zoom. The people who make the effort to continue to meet with people in person to continue to have that be part of their business development mix, whether it’s in private equity, or whether it’s in any other sort of high touch, you know, sort of big stakes transactional category are going to, I think they’re gonna have like an advantage if they use those types of meetings, right? It’s like, if you think about what happened to the written letter, once email arrived, yeah, right.
So, you know, if someone sends me a bottle of champagne at Christmas, or whatever, and I send them an email, like, Hey, thank you so much for the champagne. You know, from their perspective, that’s nice that I sent, you know, sent them a thank you note, right. But there’s something totally different when I take out a fountain pen and a nice piece of stationery, and I write them a note and put it in the mail and put a stamp on it and go out of my way to do those things. And, you know, and and they get a nice piece of, of, you know, handwritten mail in, in the mailbox a couple days later, I think there’s the same, I think the same kind of shift can can can now translate to this kind of Zoom in person meeting, it’s going to be a way more efficient space because of Zoom and the speed with which you can meet in person, you know, or not in person, but you know, meet face to face over the internet.
But there’s going to be something very significant about the person who makes the effort and the investment, to get on an airplane to get in their car to get in a train, and come in and see a business owner face to face. Right. And so I don’t think that that advantage is going to go away. One of the things that I think so that that’s one big change, I think another really interesting changes. You as a buyer of businesses, or as an investment banker, courting business owners to to earn their business and be their advisor of choice, if you have been developing the relationships in advance of any transaction, and part of the development of that relationship has been in person and part of it has been over Zoom. I think that subsequent transaction can occur extremely quickly now, right?
So if you if I’m buying businesses, and I’ve already met an entrepreneur, and I’ve been following his business for two or three years, and he picks up the phone, and he calls me, and we have a Zoom call, and he says, Hey, I’m ready to go, Well, I’ve already met him in person, I know who he is, I’ve been following his business, I can basically do the rest of that deal over Zoom. Right. So I think that like the back half of a lot of transactions can happen way more quickly, in a post COVID world, provided that the relationships between the buyer and the seller have already been sort of created, you know, up the funnel. So I think that’s, you know, that’s really interesting. I also would say that private equity is probably a few years away from actually moving to a fully virtual diligence process, the venture capital community has already gotten there. And they tend to move more quickly for a number of good reasons than private equity, largely because they’re not really ever doing controlled transactions.
But it is totally common now in the venture capital world, to meet an entrepreneur over Zoom, and, you know, right them a $10 million Series A or Series B check, you know, six weeks later or two, three months later, without having ever met them in person that’s happening all the time now, in the venture capital category. I know that private equity still feels like they more or less can’t quite fully do all of the m&a due diligence that they need to that way. But again, I would take the devil’s advocate point of view here and say, the efficiency of of being able to do things like this, the quality of bandwidth, the quality of the technology, all this stuff. Just think that within five years people are going to be capable of and comfortable doing full control buyouts with very, very limited in person contact. I just, you know, you heard it here first.
Patrick: And you’re gonna just see competitive pressures forced that, where
Peter: I think that’s right. You know, as soon as one private equity firm says, hey, we’re willing to do it all virtual? Well, I mean, you know, it’s just a prisoner’s dilemma at that point, right, then everybody else has to sort of try and figure out how to do it too, right. So it only takes a few brave souls in private equity to say, hey, let’s try and figure out how to really do basically all of this virtually. And in the course of figuring out how to do that, they have created a really interesting competitive advantage that allows them to move faster and close deals with shorter closing windows. And that’s really compelling to bankers and to, you know, to business owners, and then the whole rest of the market has to follow suit. So I really do think it will happen, I don’t think it’ll happen in 2021. But I do think it will happen before 2025, for sure.
Patrick: Well, there’s a perfect segue when you talk about diligence, and you know, dealing with risk, and so forth, I mean, you have to get over the first hurdle of just making sure that you know, by yourself that there’s a fit there, and then and then you move forward, then you go through the whole diligence process. And, you know, there’s risk with a lot of stuff. And you know, both parties want to go ahead, and if they can’t, if they can’t mitigate or limit the risk they want to transfer now. And so that brings me right over to probably one of the other big developments in M&A.
And that’s insuring deals through a product called rep and warranty insurance where the seller reps, rather than being the personal liability of the sellers, to the buyers financially for any breach of the seller reps. Well, now we can just transfer that risk over to a third party insurance company with deeper pockets in both parties in most cases, and all of a sudden, seller gets clean exit, they don’t have to worry buyer if something does blow up, their their risk is hedged. And it is something that’s beneficial. They’ve gotten cheaper, because the claims they’re there, but they’re not huge monster monster claims that are driving up rates as in other things.
And so it’s become just a real, efficient, elegant tool. I’m curious, because this product wasn’t really available for the lower middle market until about 18-24 months ago, it was reserved for the 100 million dollar plus deals. Right? Tell me with, you know, whether ever experience that you’ve seen, and you’ve drawn from your members, what have you heard about rep and warranty?
Peter: Well, so, you know, I have never been an M&A buyer of businesses in the lower middle market in the way that our clients are, but I have raised outside capital for Axial. And, you know, I remember very well, the, you know, the, the endless back and forth over reps and warranties, as part of, you know, raising rounds of financing for Axial. So it’s a huge deal. There’s lots of deal breaking moments that can emerge in the reps and warranties part of the negotiation. And yeah, from, from my perspective, for that piece of risk in a transaction, to become the focus of professional underwriters with very, very deep pockets, to transfer that risk away from the seller, that I mean, you know, I’m sure the buyer still have to get comfortable with just the inherent risks of buying the business.
But I, that is an incredibly good development, in my opinion for the lower middle market and for capital markets for private companies. Because it is, it’s hard to believe that that doesn’t increase the velocity with which capital can form around small and medium sized businesses, if you can take a piece of risk. And, you know, and transfer it both away from the seller, and also have the buyer have peace of mind, you’ve just taken a huge a huge aspect of deal making that makes the deal longer, makes it slower increases breakage risk, and you’ve taken all of that and you know, you haven’t, like farmed it out in some careless way.
But you now just have a place where you can you know, where you can lay off that risk, and that allows the deals to proceed probably more quickly. I don’t know how the insurance underwriters of reps and warranties go about their work. Are they doing that work fairly expeditiously? Like how fast can they diligence, the reps and warranties that they’re preparing to underwrite?
Patrick: Yeah, the misconception out there is that underwriters will perform a whole set of their own diligence when they’re looking at a transaction. In reality, what they do is they’re relying exclusively almost exclusively on the buyers diligence. They Want to see what the buyer looked at? They look at the reps than they just are going to be pulling the buyer and say, show us your legal report, show us your HR report, show us financial reports. And if they’re not audited now they flex they’re flexible will show us a quality of earnings report, show us that you went check the boxes as much as possible. And if we felt that you you’ve done a thorough enough job, then we’re gonna we’ll backstop you. It’s completed in a matter of days. So the only thing that’s been constraining on the insurance industry is more deals are getting quoted. And so more diligence reports have to be analyzed. And, you know, five years ago, there were only three rep and warranty insurance companies. Now there’s over twenty.
Peter: I mean, I think that’s an incredible development for the lower middle market, I think for for underwriting to happen in a handful of days in, you know, in many cases, that takes the reps and warranties risk takes the tension that that creates between the seller and the buyer and creates a third party, I think, the way we tend to look at the you know, for us at Axial, we’re always trying to sort of figure out where’s the friction in deal making in the lower middle market, right, what is the source of friction, because, you know, that’s what’s slowing down the pace and the velocity of transaction execution, that’s what increases the likelihood of deals falling apart.
So whenever an innovation arrives in the lower middle market, that’s decreasing the speed with you know, improving the speed with which deals can get done, figuring out ways to take risk, and move it off the table or distribute it more efficiently. Those from our perspective, usually, those are almost always very good things for the lower middle market, they’re good for entrepreneurs, they’re good for business owners, they’re good for the economy. So it’s great to hear that the reps and warranties market is growing in the lower middle market and not just, you know, sort of for the big dogs north of $100 million. I mean, that’s, that’s really exciting.
Patrick: Well why don’t we because everybody’s all had their appetites whetted for Axial. Give us the profile of an Axial member.
Peter: So, you know, I guess, it’s been so great to just serve the diversity of member types that we’ve served, you know, you know, the, you know, sort of at the top of the food chain, so to speak, I mean, they’re, you know, the portfolio companies at a place like, you know, KKR that are looking to acquire small, lower middle market businesses, those are customers of Axial, right, we have a, you know, corporate corporation that’s buying home health businesses and behavioral health businesses, it’s owned by KKR. And, you know, their clients of Axial and they’re out looking to buy small, you know, just small, you know, single location, retail, behavioral health clinics, and they use Axial as a channel to source deals for that, right.
So that’s like some, you know, big name and KKR. And then, you know, just, you know, just a month and a half ago, a ex investment banker, professionally trained, I think at B of A for many years spent, you know, did his tour of duty in New York City, he went back to move back down south, and he’s, he’s one of these guys who buys and owns businesses for his own account. He doesn’t have outside capital. And he bought a wholesale distributor of dairy products and dairy supplies business, and he bought the business, he sourced it through axial, bought the business for about 5 million bucks. And, you know, so what we’re really trying to do on Axial is not create a platform where only the really well heeled and really well capitalized sort of institutional and corporate buyers can, can succeed, we’re trying to create a platform and a business model and an offering where all different kinds of buyers from all different sort of walks of life, can pursue acquisition opportunities through, you know, through the platform.
So that’s a little bit about like, sort of, you know, the spectrum of buyers on Axial, I mean, you know, the, the, you know, the bullseye target, are, you know, lower middle market, buyers of businesses focused on companies that have typically somewhere between a half a million and 10 million of EBITDA. So that’s really like, that’s the sort of core sweet spot for Axial is sort of half a million, maybe 1 million of EBITDA up to about 10 million. There’s transaction activity that occurs above that range. But the overwhelming sweet spot is sort of within those two goalposts on the sell side. Again, you know, some of the more well known names on the sell side in the investment banking world using Axial, there’s firms like Stephens, which is a pretty well known investment bank based out of Little Rock, Arkansas.
They do really big deals, they’ve got a really respected presence, you know, up here in New York City. But, you know, we were working with, you know, Business Brokers that operate a single shingle, you know, and, you know, they have their own LLC, they sell one or two businesses a year. That’s how they pay for, you know, their mortgage, and put their kids through college. And they’re able to use Axial, the same as, you know, a fancy investment bank, with a lot of, you know, a lot of pedigree. So we really are trying to basically, what we care about is whether or not you are a good faith, high quality participant in the lower middle market, right. And we don’t care.
You know, if you’re at a fancy brand name, whether you’re at a big organization or a small organization, what we care about is whether or not you’re genuinely focused on doing high quality deal making, and transacting in lower middle market businesses, as an owner and operator, an advisor or a capital partner. And if you can clear that criteria, then we really feel like we have built something that could be you know, could be helpful for you. So that’s the spectrum of profiles. There’s very little business owner activity on Axial directly. So most of the business owners hire an intermediary and the intermediary is using axial on their behalf. I’d say 15% of all activity on Axial is from a business owner directly. And the remaining 85% is intermediaries who use Axial’s tools on behalf of their their sell side clients.
Patrick: What trends do you see this coming year 2021 for either Axial in particular or M&A in general?
Peter: Well, I think what’s going to be really interesting is to is to watch how dealmaking occurs in the world, in and around sort of retail 2.0, right. So, you know, when COVID hit, like, retail 1.0 just got destroyed, right? I mean, unless you were a grocery store, or you had the scale of Walmart or Target. You know, I mean, it just was it’s very, very brutal out there. But I think now, there’s been almost a year of time. And so I think, retail businesses of all different kinds are have have had eight or nine months to try and survive, and to try and sort of reinvent their business models, right. And so I think there’s going to be some really interesting, innovative models that take advantage of local retail distribution and storefront capabilities.
And I think while the big mega wave trend is obviously ecommerce, and that’s only accelerated because of COVID, I think there’s going to be this sort of resurgence of a new model and a new form of retail. And I think there’s going to be some really interesting growth capital and maybe interesting m&a transactions that sort of occur on the, you know, on the upswing of retail, which right now is so massively distressed. So I think that’s like an interesting area to watch for some interesting green shoots, as new business models get get created there. I think on axial in particular. Look, I think, you know, one of the interesting trends, and it’s not a new trend, but I just think that there’s more and more. There’s more and more entrepreneurship through acquisition happening in, in the lower middle market. So there’s a lot of people who are leaving Apollo or leaving KKR, and saying, you know, what, I’m just, I know how to do deals.
Now, I’ve been really well trained, I’m a professional principal investor, I can go out and using a platform like axial or even not using a platform like this using my own relationships, I can go out and find deals, you know, for my own account, I really think that that form of entrepreneurship, where people can go and buy small and mid sized businesses either for their own account, or the little bit of backing from family offices, not just the independent private equity sponsor model, I think there could be like a really huge wave of growth in that category. In 2021, and and beyond.
And I think that that that’s another interesting, interesting one to watch where, you know, people say, I’m not going to make the climb to managing director over the next 10 years, I’ve decided, I’m just going to go out on my own, I’m going to set up my own little principal investing vehicle, and I’m going to go buy five to $10 million businesses. And so I think that that’s going to change the face of private equity in the lower middle market pretty significantly. I think the trends already underway, but I think if you like by 2025, I think it’s going to have like, been quite transformational to the complexion and the demographic realities of lower middle market buyers.
Patrick: Peter Lehrman, thank you so much. This has just been very entertaining. Very informative.
Peter: Well good. It’s been great to be on the show. Thank you very much.
Patrick: This is great. How can our audience members find you?
Peter: Well, I’m available to anybody anytime via my email address, Peter@axial.net. The website is www.axial.net and it’s also now axial.com which is great. So either one of those will take you to our website. And it’s free to get started on Axial. So we have subscription based offerings, but we also have offerings that are free to get started. So anybody can get underway for free on Axial on the buy side or the sell side. And there’s lots of resources there as well to just sort of learn about what we do and how we’ve been helping people. So feel free to reach out to me or feel free to head to the website.
Patrick: I agree. I will say that I have stolen from you and Axial content wise, just ideas because you guys have some great content out there. Great cutting edge trend things and because you’re in, of and for the lower middle market, who better is a resource to rely on for cutting edge insights.
Peter: Appreciate the thumbs up there.
Patrick: Very good. Thank you.
Peter: All right, Patrick. Thank you.
On this week’s episode of M&A Masters, we’re joined by return guest, Codie Sanchez. Codie is the Managing Director of Entourage Effect Capital Partners and one of the most sought out speakers in the cannabis business. She also co-leads Unconventional Acquisitions, an educational resource making the buying of businesses accessible to anyone willing to put in the work.
Codie says, “If you have the mindset to be an entrepreneur and to get to go and grind and build your own thing, you have the ability to be a deal maker, and to buy businesses, period.”
We chat with Codie about the abundance of opportunities to buy small businesses right now, as well as…
Patrick Stroth: Hello there. I’m Patrick Stroth, President of Rubicon M&A Insurance Services. Welcome to M&A Masters where I speak with the leading experts in mergers and acquisitions. And we’re all about one thing here. That’s a clean exit for owners, founders and their investors. Today I’m rejoined by Codie Sanchez, Managing Director of Entourage Effect Capital Partners, the first private equity firm to focus their investments exclusively in the cannabis industry. Long before legalization had taken hold they were there. You can find our original interview on Apple iTunes, or in the link to our show notes.
I’ve asked Codie back to share with us her newest adventure, Unconventional Acquisitions. Unconventional Acquisitions is an online platform that teaches individuals how to acquire a business in a simple nine-step process. Here’s a question for those out there who either are or know an aspiring entrepreneur, why build a business from scratch, when there are literally millions of small, profitable underlying network profitable businesses out there just waiting to be acquired? This conversation is especially timely because even in the throes of a pandemic, there’s never been a better time to be in the acquisition game. Codie, great to have you back. Welcome to the show. Thanks for joining me today.
Codie Sanchez: Thank you for having me. Thrilled to be here.
Patrick: Codie, before we get before we get into talking about mergers and acquisitions, and acquiring companies, because that’s something that you’re going to be leading the way in on the micro and lower middle market space where there’s a ton of opportunity. Tell us what got you to this point in your career following the great success you’ve been already having in the private private equity space?
Codie: Oh, thanks. Well, um, you know, I think we have a little bit similar stories. And that, you know, from my background, I did very traditional Wall Street everything from asset management to alternatives and PE and hedge funds to investment banking, to product distribution. And, and what’s interesting is, you know, I started out as a journalist before any of that, and we did talk about this a little bit on the last one.
And the interesting trait that a journalist has is we just asked a ton of questions, and we never associate asking questions with being unknowledgeable, or having an ego around not knowing something. And what I found in finance is in finance, people do you know, we like to pretend like we know everything all the time in finance. Oh, yeah, I already knew that. Like, this is, you know, I got this, I don’t need to ask you these questions. And yet the smartest dealmakers I’ve ever found are the ones that asked really smart questions. And so I was kind of amazed how much journalism played right into dealmaking investment banking, PNP.
And, and venture capital, it’s really just can you ask a lot of really dumb, low level questions and get somebody to explain it to you at a very foundational level. And so I used that to get into finance climbed through a bunch of finance companies like Goldman and Vanguard and State Street and built up a pretty big asset management business in Latin America, and then sold out of it. And right about the time, I guess, about two years before I sold out of that business, I started realizing that, you know, may be similar to you, Patrick, like, why am I making all of this money for companies in my LPs, or investors? And why am I not taking this same idea and applying it to my own portfolio, I’m highly overweight, public stock markets in which I don’t have an unfair advantage. And I don’t have the ability to create some sort of arbitrage. And I’m underweight hugely on private sector. And the only private sector exposure I have is through private equity funds that you know, I have part of the gpn. And so that sort of led me to start thinking, Wait, I need to start questioning these tools that I use for big buyouts. And instead, why wouldn’t I apply them to creating my own portfolio? And that’s when I started investing.
First, I did what most people do, which is angel investing super sexy, you know, you think you can go and get 100 x trade very binary, and then realize quickly that that’s a great way to lose a lot of money, and have fun and learn and support an ecosystem. And that’s fine. But that I didn’t like the, you know, you invest in 10 startups and eight fail or sort of flatline. And so I said, Why wouldn’t I instead do what we do in PE and buy small businesses? And so I started doing that and like, let’s call it 2000. And I guess it was it was like 2014 was the first year that I started buying these businesses myself, instead of doing mega deals for big Wall Street firms. And, and then I, you know, my strategy is very simple. It’s like buy hold forever. And so I invest in these companies that are very boring and continue to invest in them, put operators in them and run. And then that’s got us to where we are today, which is talking more about, you know, I’ve realized how simple this actually has to do with how pro programmatic it’s not easy. Like you have to do work. There’s no free lunch. But it is simple. There’s a process that goes to it.
Patrick: Well, in from this experience that you had you developed a couple of channels here, you had one, which is called Contrarian Thinking that’s out there, that is a regular newsletter, where you’ve got all these, I guess, business hacks and other ways around where, you know, you’re not trying to find. I don’t want to say shortcuts or the easy way, but you’re finding clever ways where you buck the conventional wisdom. And you go ahead and do that. There’s another venture that you came came in develop with called Unconventional Acquisitions.
Now, when we hear your background and that you were Goldman, your State Street, and you had this great reputation, you train high end universities and so forth, that can be a little daunting for other people to say, Well, you know, of course, Codie, you can go buy a bunch of little businesses, and it sounds like they run themselves, you just plug and play. But I don’t have any experience. I don’t have the capital, I don’t have that. And so what do you say to those people about this? And how hard or easy is this to get started them walk into the process?
Codie: Yeah, well, first of all, I mean, I think there’s this, you know, we in traditional private equity, and, you know, hedge funds or alternatives. We’re, we like to overcomplicate things and make them sound scary, because then we get our two and 20. Right, which is how we make money. Yeah, exactly. So the more complex we can, I mean, I have this one graph I like to show which shows, you know, a pricing arbitrage theory, and it’s the algorithm that you use in order to get to this theorem, and it’s very daunting to look at. And then I explained that the graphic what it actually looks at, which is like, buy low, sell high, sell, sell high, buy low, you know, and basically, that’s all the theory is, and we don’t have to overcomplicate it. So, for buying a small business, you know, the couple things that you have to think of is this, if you’re destitute today, and you have no money to your name, you probably shouldn’t go out and try to buy a small business with debt, because you’re going to have to have some sort of assets or personal guarantee.
But if you are a W-2 employee, you know, have some savings built up in some way, shape or form, it is exactly like buying a house or a car, except we get very comfortable buying a car or a house because it’s normalized in society. But if you think about it, the return that you get on buying an auto or a car is always it’s a depreciating asset by and large. And yet, you’re willing to take that kind of risk on that sort of investment, even though it’s a depreciating asset immediately. And the same thing with a mortgage, you go out and have a sum of money 15 to 20%, down, let’s say 10%, maybe in this environment, and you lever up to buy a house that you think you will not only get to live in and be able to afford, but potentially will have upside potential and sell. The problem is neither of those assets actually pay you. And so if you apply that same model of you can get a loan to buy a business, just like you can get a loan to buy a car or get a loan to buy a house, you can become sort of comfortable at a base level, it’s the same thing, then we have to get into operating the business that’s different.
And so we do talk about, you know what that might mean. And there are some businesses that are very passive, and there are some that are very active. And so this is why more people don’t do this, because real estate is like, you buy the business at a set price. And you flip it or you buy the business at a set price. And all you have to do is get a renter in and the process is so normalized, that there’s no, there’s no variance, there’s no change really in one multifamily unit to another multifamily, or one single family unit to another single family unit and business. There’s various things are different between a landscaping company and the HVAC company. But the crazy part is they’re not that different.
So my belief is, is that just like, today, we have sort of commoditized investing in real estate, we’ve commoditized investing in stocks, we’ve commoditized investing in funds and ETFs I think in the future, we will commoditize investing in small private businesses. And it’s the next evolution, it just hasn’t happened yet. Because the returns are double or triple what you get from investing in real estate with the amount of capital that you have to put down.
Patrick: It’s interesting that you come up with this give us a little bit of an example when you’re talking about this where you can go ahead and buy a business and it pays you I mean yeah, I would just for somebody that says Oh, I see this corner bakery and they want to get out of business or the owner wants to take off. Do I have to become a baker? I mean, yeah. paint a picture for us on on just working something like that.
Codie: Yeah, so I like to use Oh, even pull up one of the models that we have here, I’m one of the deals we did. But like, I like to use really simplistic models to start. So one of the first businesses that I bought was a laundromat. And now I’m not saying that you should go out and buy a laundromat because a lot of people doing that it’s a little bit more commoditized over the business. But if I look up the model right here, about how we bought that first laundromat, essentially a laundromat very simplistic right, you have the storefront, you lease out the storefront, you have the cost of utilities, water and electricity are the two biggest costs in tandem with rent, you have, you know, some sort of automated sensor for the door to open and close, you have a security camera, you have the machines in the system, and then you have a cleaning person wanted once a day a couple times a week, whatever the case may be, that is literally the business.
And then you would be the one doing, you know, taking in the money theoretically on every other day basis a couple times a week basis. And you know, you need a bank account, and you would need to file your taxes each year. Let’s say this is a very simplistic business. And this business is one where you can be basically an owner investor in it, even if you don’t have an operator. So there’s two ways to buy business owner or investor meaning you own the business, you just invest in it, somebody else operates it, you have an operator, or you can be an owner operator, where you run the business and like you said, you buy the bakery, and you bake the cakes, right?
Most people when they’re doing deals like you and I have done them a million times, we don’t want to be the baker. You know, we want to invest in a business. And we want to at least rev out of the business, something that’s meaningful for us. For me, I don’t want to do a deal unless I make 100K a year in profit. Ideally, I like a little bit more than that, because I want to have like 250-300K in profits. So I can pay an operator 150K to run the business itself. I step out, I take the 100K additional profit as a cash distribution each year and the rest goes back into the business. But for a laundromat, like what’s fascinating is, here’s an example of how it works. So like, and we can link to this. I wrote up a piece on this one that was public because it’s a deal I did it was a few years ago.
There’s nothing proprietary about it anymore. But small businesses all trade at like two to three x their profits for the most part businesses below $5 million in revenue. These businesses by and large doesn’t matter the section two to three x profits. And you know, these businesses like a laundromat, the one that I was looking at was making like $67,000 in profit a year. Not a ton, right? But where are you going to get a real estate property today that pays you $67,000 a year profit? It’s going to be very hard to do. Right?
Patrick: Plus the headache too.
Codie: Yeah, well, and you’d have to put a lot of money down so you’d be putting you know your your cash on cash return or your ROI, your IRR would be really low. Because in order to get $67,000 in profit, you’d have to spend a lot now that so if this plate if this laundromats making 67K, that means it’s worth something like, you know, let’s call it 100. In this case, what it actually came out to was the valuation was $125,000 is what they valued the business at. So the purchase multiple amount of what something like 1.9 to two x something like that. And and the interesting part about this business is that, you know, like you mentioned, Pat, there’s 80 million Boomers retiring this year, or in the next couple of years. There’s 10,000 a day.
Patrick: Yeah, over the next 10 years, we got about 80 million Baby Boomers retiring, a large chunk of that, I wouldn’t say majority, but a large chunk are business owners.
Codie: Mm hmm.
Patrick: And so yeah a possibility where are they they’re they are incentivized to exit. They may not be exit exiting big so they’re not looking for that and they have no other place, you know, to send the business because their their children, or current employees aren’t interested in taking over. Now what do you take the car, just park it on a on a corner, leave the keys in it?
Codie: Yeah, well, or, I mean, it happened to my uncle and he had a business that was doing $5 million in revenue plumbing business. And it was doing about $1.72 million in profit. And he just wound down the business. It was old. You know, he was 67 years old. He had no idea he could sell it. He didn’t realize that was a thing. He didn’t go to college. He grew up a sharecropper. And so nobody told him so we wound down a business that would have netted him if it was 2 million bucks in revenue, let’s say could have been four to $6 million dollars, right? So anyway, but if you take the laundrymat, philosophy $67,000 in profits, let’s say it’s worth $125,000.
The beautiful thing is you can go and get an SBA loan from the government for that $125,000, usually they’ll cover about 90% of the price in tax returns that have been shown to be in the profits over the last three to five years. And you can acquire an asset for very little money down, you do have to put a personal guarantee on it. But for very little money down, you can acquire $67,000 in revenue. And the case of this one, which I bought, we got a loan for like, I think we were able to get a loan for 100K, from the SBA. And then we did a an equipment loan for the other 25K. So and then we got the seller to finance two thirds of the deal. So I had $125,000, in my hand.
Patrick: And the seller was fronting the money for you, too.
Codie: And the sellers fronting the money. Yeah. And so you know, the breakeven is immediate with with the debt, or the breakeven is essentially, you know, two years without it. And those trades happen all day long. Every day, we have, you know, we just had five students close their first deals inside of 60 days at Unconventional Acquisitions, because this stuff isn’t rocket science. It’s It’s simple, but it’s not easy.
Patrick: Well we talked about this earlier reference with real estate, and I want to make sure that we are not falling into this trap, because it has the air of you can you can make profits with no money down and do the traditional house flip, just come to this hotel ballroom, give us give us 100 bucks, and we’re going to show you how to do it and everything. That’s not the case here. This is a real legit issue. That’s very dynamic. Okay. And I mean, if you can talk to that, how is different from that real estate flipping mentality first? And then secondly, you know, I just was thinking about why is this happening now, what’s different between pre 2014 other than maybe the, the financial collapse and recession in 2010. But what’s happening that’s making this easier?
Codie: Well, a couple things one, the SBA do does have a new loan program, it’s continually continuously gotten easier. We just had a call with the guy who implemented the most recent version of how the SBA does loans. But the thing that I really think has changed as it’s just the internet, it’s that for the first time, I mean, you’ve already mentioned the Baby Boomer generation. So there is a massive supply and demand change over happening here, where, you know, in real estate, you have a massive amount of demand across the entire industry, there’s basically no market that’s not at all time highs for real estate right now, except New York and San Francisco, some of the urban city centers, but in and then, you know, supply limited houses in San Diego where I am right now, we’re going like this, we’re trying to buy a place in Wilmington, Delaware, like we can’t get to there to see them fast enough, happening all over the country.
But in small businesses, the average small business stays on on a listing for for more than a year, one in 11 businesses will not sell inside of one year. And so it’s because, you know, we weren’t taught this. I mean, I’ve been in PE for a decade plus, and I never thought to apply what we do at the mega scale to the micro. And I don’t know why. But now with the internet, with the baby boomer generation changing with interest rates at all time lows, with, you know, the ability for people to get debt from things like the SBA, and with more knowledge out there about the micro PE space. I think it’s starting to open up and change. So anytime there’s a supply and demand imbalance, I think the market wants to write itself. You know, and that’s, that’s what’s happening here.
There’s, I mean, we talk about cannabis a lot because I invest in a lot of cannabis deals, but cannabis is hugely devalued. The only other industry that is devalued as cannabis is energy, but they have some systemic issues. And then you put small businesses down there is businesses, I mean, we’ve bought businesses for one x multiples, or we bought businesses for a percentage of their revenue for us coming in and helping them grow the business and optimize it, and no money at all. So there’s lots of ways to do this. And if you don’t believe it, then go chat with an entrepreneur of a small business like an old you know, 65-75 year old entrepreneur, go talk to your dry cleaners or your laundromat or your landscaper and and see how they feel. And you’ll very quickly ascertain that most of them are ready to pass the reins, but to your point, they don’t know how to and that’s where these buyers come in.
Patrick: I’d like to get into a little bit more information about the the Unconventional Acquisitions program that you have set up if you want to be an entrepreneur. or acquire businesses. There’s a particular mindset for that. And there are a lot of people that are probably withering away in jobs or in fear of insecurity where they are now. And they want to be free and go out and do this and going to be their own be their own boss, and so forth. But like you said, it’s easy, but it’s simple. It’s just not easy. What kind of mindset would you know, from your experiences is needed for this?
Codie: Well, it’s such a good point, because I think most of the reason why people don’t get deals done is because they’re, they’re scared. Well, it’s really two reasons why one, most people don’t take the first step to the people who take the first step, give up halfway through three, the people who don’t give up halfway through, don’t continue on the path long enough. And then for the winners are just the people who are left. And so you know that the game is largely persistence. Because like I said, I mean, you know, none of these businesses are rocket science, we’re not, we’re not telling people how to go and cure cancer, or invest in biotech or do these really complicated things.
So I think you’re right, the mindset is basically, if you have the mindset to be an entrepreneur, and to get to go and grind and build your own thing, then you have the ability to be a deal maker, and to buy businesses, period. If you have the mindset to be an employee and execute on the things that you’re going to execute on and to be flexible. When things go sideways, you can be a dealmaker. And in fact, I think people are crazy these days, for, you know, continuing to work at jobs with one income stream only, I think it’s super dangerous. And I think you don’t have to leave your job to do all of this. But you should diversify your assets, you should have some real estate.
And I think you should own some businesses that cash flow as a distinct asset class, even if you don’t want to leave your W two and go run it. So those are the two types of people, we have people who want to leave their W-2 or they want to get paid more. They want to own their own business, and they want to go in and own or operate. Or people like me who are like I run a fund. I like what I do. But I want more asset classes, and I want more cash flowing income. And so I’m an owner investor, but you’re right mindsets, so critical.
Patrick: And the way you have a setup, it’s, again, it’s not rocket science. And it’s just a matter of if you know what numbers to look at. You don’t get yourself in too big of a hole to go in, you can execute and again, you don’t have to be there on on the ground. And I can tell you just in the mergers and acquisition stage, some of these businesses that are being acquired are like you said, landscape it, where you just have somebody that bought one, you know, mow and blow outfit, and then just added another one added another one, add another one, you know, and again, this isn’t for everybody. But you know, within three, four years, that’s a $25 million venture that gets sold to a private equity firm and private equity firms you think are going after the next cutting edge fascinating, shiny new toy. There are a lot of lawns that need to get mowed.
Codie: Yeah. You’re exactly right. I mean, we have one student who works with us. So it’s hard. It’s funny calling him a student because he, you know, we I’ve known him for a while. So we have talked deals before. And when he came into the course and started working on some of it, his name’s Robert, he built up a landscaping company, exactly like he talked about was commercial, not residential. And the landscaping company built it up to $20 million dollars in revenue. And then you know, sold it to a private equity fund for six x their EBITDA. So you know, essentially their profits. And, and that business, he he didn’t, he did it himself, he built up the whole business. And now he’s come back and he was on garden leave, he had to take a year off. And now he’s like, I don’t want to buy I don’t want to build a business.
Again, that was like brutal, excruciating work. Now what I want to do is I want to buy a couple landscaping businesses and roll them up and combine them. And I want to do it with a pest keeping business too. And I want to bundle this home services in my area. And so we’re working through that with him on how to do it. And he has like three LOIs out right now. The guy’s an incredible operator. He’s never done deals before. You know, he’s an immigrant from Ireland, he had no no financial background. And so that is I think, the differentiator if I could go back to my 15 year old Codie, and change my mindset of I’ve always built little businesses and then I’ve sold some and you know, whatever.
But I wish that I would have bought more. Because the income that you can get with the not assurance because you got to be careful of that but buying a business that’s already doing 100,000 a million dollars in profits, you have a lot more wiggle room to mess up. You know, when you’re doing a startup, you’re funding it yourself for maybe years. But with this, you can use the funds in the business to really grow. So, yeah, I think there’s like nine steps to do this. You figure out those nine steps and and I think anybody who has that persistent grit that you talked about, has the capability to get after buying a small business.
Patrick: Well, let’s talk about those nine steps and Unconventional Acquisitions. This is a platform, we’ll we’ll link it to our show notes. But it is in your online guide, as a whole series of steps on how to do where you hold people’s hand all the way through. Let’s talk about that.
Codie: Yeah, so the reason we created this is because not dissimilar to you, I’m sure you get asked all the time. You know, when you’re a provider in the PE and M&A space, you just get asked to look at deals constantly, and you have a lot of the same phone calls. And so anytime that happens to me in any segment of my business, I try to create some guide that people can use to answer those questions, but so that I can leverage my time, so I don’t have to be on the phone all the time. So we created this originally, just to scratch an itch of mine, which was love you humans don’t have time to be on a phone call explaining all these deals to you. Here’s a guide you can do it will give all the proceeds to charity. And and then what happened is that the the guy did 50K pre launch.
And so you know, there are a lot of people that wanted to learn this. And so then I was like, wow, there’s a business here. And maybe we can get this group of humans together. And then they can be a great deal flow source for me. So I can get more deals, they can get more deals, we can syndicate stuff together. But it’d be fun. You know, and I don’t like to sleep, apparently. But how the course works is the first is sort of the intro to the why that we’ve been talking about, you know, the opportunity in small businesses, what does it mean to be a small business that the size, scope sector? What’s a bad sector to be in? What’s a good one? What’s a bad business to buy? What’s a good one? So that’s sort of the intro, then it’s the what type of business and that means what type of business for you. So this is where you kind of gain some clarity around, you know, do you want to? Do you want to operate the business, you just want to invest in it? Do you want to make a million dollars a year? Or do you want to start out making 50?
What what are the goals for you, then we give sort of like some guidelines and templates on how to do that. And then it’s, it’s deal origination is what we call it, but that just means finding in the business. So you know, going out and figuring out, okay, I have my parameters, I want a business that does 100K, I want it located in San Diego, because that’s where I am, I want the business to be, you know, low capital expenditures, and I want to have to have a lot of, you know, inventory and machines and whatever, wanted to be a pretty streamlined business. So we kind of narrow that down, and then you go find them, there are a bunch of different ways to find these businesses.
The Internet helps a ton now, then it gets into how do you sell yourself to the owners? Because you know, if you’re like me, and they see me, I might look a little young and the 65 or 70 year olds are going to be like, what are you going to do my business? So it’s how do you sell yourself? Then you get into valuation? How do you value a business bunch of templates, you know, models that you can use that are very programmatic. Nothing like that creative that we have. This is pretty industry standard. If you’re in PE, and then you get to negotiating the deal. So how do you put together the term sheet? How do you talk to them about buying a business. And then finally, you get to find it. That’s the part that I always love, because you can get super creative. A loan from equipment. A loan from the SBA seller financing, you know, maybe you have an investor come in, there’s tons of ways to do it. And you can play it’s all a game in financing, and we tell you how to a bunch of different ways to do it.
And then you can choose, then the last one’s legal and contracts. This is where we talk broadly about what they are, we give you some examples, but you really got to go get one done by an attorney in your area and the business. And then lastly, it’s the first 90 days, so you’ve bought a business. Now what and really, those are the steps. And if you follow them, you know, we’ve had students close deals in 30, 60 and 90 days. But they’re driven you know, they don’t just like, you know, they got you got to do some work to make this happen, just like anything else. But the returns, in my opinion are amplified.
Patrick: Well, there’s also the magic of you got to make sure that the target company that you want to work with or acquire, they got to be willing to play the game too. And you know, and there are a lot of cases I think if you’re well prepared, and you have a good game plan, you’re going to go a lot farther on the trust scale than somebody that just calls him out of the blue which private equity that happens all the time there haven’t been his death is a sexy way of saying you know, cold calling. But you’re right. The one thing I would ask about and this is just my insurance background kicking in your your unit on legal and contracts and so forth where you’re doing you are making a real recommendation, hey, find a good attorney. And, you know, here’s the game plan, but make sure they get to the point quickly.
Codie: Oh, yeah, no, no, I mean, what we basically tell you there’s, there’s like kind of seven key documents you need. But those key documents gotta have drafted by somebody, you know. And so we kind of break down like, in there, you can basically see, there’s like, you know, you need your, you need a standard NDA that they, you know, to protect them, and you and you need an LOI, that’s non binding, and, you know, then you might need a term sheet. And then you might need some, you know, liability paperwork, and then you might, you know, so we kind of walk everybody through what those are.
And the goal is to say, these things, when I first started learning them in PE, they overwhelmed me, you know, it seemed like a lot, but then you realize, it’s just after you do a few deals, it’s all the same process. And as long as you have that good bend show of insurance, and accounting, and legal, then and your your banking institution, whoever your SBA loan originator is or equipment loan originator is, then then all these deals start looking very, very similar.
Patrick: It’s, I think this is akin honestly, to cooking a huge meal, the first time you do it, it’s so difficult, because you got to chop this much, you got to do this and add these ingredients. And you don’t know exactly how long to heat something up and you know, saute things and add them when you add them. How much oh, I forgot my measuring spoon, how much spice do I put in, and all these things you worry about, because you don’t know how it’s gonna come out. You know, and it’s even more stressful when you try cooking for a big family that are for an event for the first time. But if you prepare a particular dish a couple times three, four times, you don’t even have to refer to the recipe. And you can make little changes because you can kind of know the tweaks and so forth. I think that’s what you do is you outline all that, and then you give them the basics.
And then if they want to leave something out, which I do with mushrooms and olives all the time, or put something extra in, you know, a little more spice. Those are things that you can do. And I think you lay that out really, really well. Codie, as we’re getting through this down, we’re on the on the backside. Hopefully we’re at the end of the beginning of the Covid 19 pandemic, as we’re speaking now we’re looking at 2021. What trends do you see, you know, in M&A in acquisitions of small businesses, just give us give us the Codie Sanchez contrarian view on what she sees out there for the world ahead
Codie: Well, you know, the biggest thing that we’ve been sort of obsessing about lately is, you know, something like 67% of all businesses on Yelp, that closed temporarily have now closed permanently. So there has been a massive blow to small businesses in the US. And it’s a tragedy, it’s a real tragedy, and the economy is going to struggle to get back from that. But wherever there’s a tragedy, there’s an opportunity. And so the opportunity in that is that business owners are more incentivized now than ever to sell. Especially if you think about the demographic of who is who is most impacted by COVID-19. It’s later generations predominantly, who are the same people who run these in person, brick and mortar businesses. And so, you know, we are seeing valuations at the lowest levels I’ve ever seen.
And we’re seeing deals get done in ways that I haven’t seen in a long time to, namely, just because people are incentivized to move on. And anytime you have these sort of shocks to the economy, business owners get tired, they’re beat up, you know, they’ve been doing this game so long, even if it’s profitable, they just, it’s, you know, it’s been a 10, 15, 20, 25 year endeavor for them. And so there’s a real opportunity for new blood to come in and invigorate these businesses. And then the interesting part two, I think, is the closed businesses. We had one of the students in UA call me her name is Brittany, and she’s in our mastermind, and I love masterminds in general, because it’s just an excuse to only talk to people about the things that I’m interested in.
And nobody wants to small talk with me. And there’s, you know, nobody’s talking about the weather or the kids, which just get to talk deals and nerdy finance stuff. And so, you know, Brittany, one of our students, she owns a gym in Dallas, and she was talking about how sad it is that all of these other gyms in Dallas, she knows the owners of closed. I was like, Brittany, you need to buy them. What are you doing? She’s like, I’m like you just call them and you tell them that you’re sad and you feel bad for like, No, no, no. She’s like, well, I don’t have the money to buy them. And they’re like closed. There’s nothing to buy. I’m like, oh, timeout, and that’s when I realized that these.
Once you get the dealmaker glasses on you can’t take them off. It’s a beautiful thing. But you don’t realize that that happens. And then once you get the dealmaker latches on, you can’t walk into a place and not see an opportunity. It’s real weird. It’ll happen to you if you start learning this stuff. But with Brittany, I was like, Wait a second, I’m like, what you got to do is let’s call him immediately set up a phone call with some, like one of these people, I’ll just listen in, and I’ll sort of help steer you before the call. But you got to call them up and say, Hey, Sarah, I am so sad that your business closed, you know, it’s breaking my heart, I thought about you, because you know, your business is going under. And that means you won’t have an annuitized income stream. But but there’s value to your business, you have customers that were continuing to come in, you have instructors that have people that you know, love them and your gym to do personal training classes. So what we should do is, let’s do this, why don’t we annuitize over your customers and your instructors to my business, I’ll pay you a percentage of every customer that you bring over for a year.
So you will still get to make some income, even after you’ve had to shut your doors and your clients, they have a new home. And so you know, I’m going to do with this with a few other providers. But I thought of you first because you’re a friend of mine. And I wanted to talk to you about it. And what is she done, she’s brought in four new gym owners, to her business. And she’s essentially bought out their revenue stream with a rev share agreement without putting any money down. And so these creative deals I think, are fascinating for business owners. And if you aren’t looking at them right now, you should be.
Patrick: Saying you provide that kind of platform, that forum with Unconventional Acquisitions, in addition to the modules for learning, you got that whole community you had, as people say, a tribe out there and it’s a deal tribe.
Codie: Yeah, that’s exactly right. Yeah. So that’s just out here looking at spreadsheets, getting excited about deals. But yeah, that’s exactly right. And, you know, the goal is, I have a goal I want to make 100,000 business owners in the next 10 years is the goal with UA. And we want to try to employ through those 100,000 people, a million people in the US. And so, you know, it feels like at some point, as you’re building wealth and doing things in your businesses, you know, you have to have more for that that comes from it than money. And so that part’s really fun for us is thinking about how to get America back to work, and how to get small businesses back in the game.
Patrick: I’ll tell you, one of the things that’s out there is there’s the concept of a finite game where you’re going out and businesses out there to win win win, and everybody’s a competitor. And then there’s the infinite game. It’s a book that I’ve recently read, where you’re not, there’s no edge, there’s just you know, we’re going to look for other opportunities here, look other objects, and you’re just opening up these new windows for a lot of people. And you can see there’s a natural multiplier effect.
And you and I talked about this with mergers and acquisitions. It’s not just one company buying another company. And so some one company disappears, you got one left. It’s a group of people choosing to work with another group of people, short and long term. And together one plus one equals six. And I think I mean, what a great platform and this is your real true gift on giving back. And Codie I can’t. I’d like to say I’m very, very proud of you. We’ve known each other for a while, but this is just great. This is just literally blossomed. And I’m very excited for people to learn more about this is the unconventional acquisitions. Codie, how can our listeners find UA and and reach out to you?
Codie: Yeah, so you can go to unconventionalacquisitions.com or because apparently we love vowels, you can also go to howtobuyasmallbusiness.com, it doesn’t have so many vowels in it, either one of those and take you to the site, you can sign up for the newsletter there. I also talk about a lot of this on contrarianthinking.substack.com which is my newsletter, and then I’m just Codie Sanchez on all the social medias, and I’m pretty active on Twitter, Instagram and LinkedIn. So any of those spaces and pretty much all over there is like my email address. I respond to all the DMS. I don’t respond right away usually, but I definitely do respond. So any questions, let me know happy to show behind the scenes.
Patrick: Codie, thank you very much. Great racing with you.
Codie: Right back at you. Thank you for having me. This is fun.
For lower middle market companies looking to be acquired, these owner/founders, often of businesses they have built from the ground up, are looking for a once-in-a-lifetime liquidity event.
They are ready to sail off into the sunset, perhaps into retirement or perhaps another business venture that will require as much capital as possible. They want to truly cash in from the sale and walk away without further obligation or liability.
At the same time, while they are experts in whatever their business does and passionate about their company, they are not well-versed in the world of M&A. You might consider them “unsophisticated” Sellers.
This creates an atmosphere of fear in these Sellers that can make them reluctant to move forward, especially when they realize they are personally liable to the Buyer if any losses are incurred post-closing from a breach of the Seller reps. But, as you’ll see in a moment, Buyers who take the right approach can remove that fear in one fell swoop.
What are these Sellers afraid of?
There could be issues with ESG (environmental, social, and governance) that could come back to bite them years down the line if a lawsuit is looming. Unfortunately, often these companies have not taken out Directors and Officers Liability insurance, which would protect them and pay legal costs and any claims due.
Any number of issues not uncovered in due diligence, such as IP infringement, tax problems, or others, that are no fault of their own, could crop up. In these cases, the money from the sale held-back in escrow could be at risk. This chips away at the major cash payout they were expecting. Money beyond escrow could even be clawed-back in some cases.
Not to mention, there is a lot of uncertainty in the new U.S. government administration.
They feel their future wealth is in danger – in more danger than ever before.
What a Buyer Can Do
Buyers can take away that fear by hedging the Seller’s risk with Representations and Warranty (R&W) insurance. This specialized type of coverage transfers virtually all the risk away from the Seller over to an insurer.
This insurance removes the need for indemnification provisions in the Purchase and Sale Agreement and for a major part (typically 8% to 10%, sometimes more in cases where the Buyer believes there is more risk) of the sale price to be held back in escrow, which makes the Seller happy. If there is a breach in any of the Seller Representations and Warranties, the Buyer simply makes a claim with the insurer. And there is no chance of claw-back.
And claims do get paid consistently, Buyers should understand.
This process also eliminates the need for such extensive negotiation in the lead up to the sale because there isn’t so much back and forth between lawyers for the Buyer and Seller. (Which can have the added benefit of saving both parties on legal fees.) In many cases, a Seller will be okay with a more Buyer-friendly agreement because R&W coverage has so effectively limited their risk.
As you know, Buyers want broad indemnification provisions to cover any potential loss, while a Seller’s goal is to narrow what breaches are covered and the survival period. With R&W in place, and a third party (the insurance company) paying for losses, no need to argue. In fact, some industry watchers maintain that deals with R&W in place are eight times more likely to close.
Previously, R&W coverage was the province of major deals – hundreds of millions or billions in deal size. But in recent years, Underwriters at many major insurance companies are taking on transactions as low as $15M.
And it’s very affordable. Right now, you’re looking at a rate that is 2% – 2.5% of limit, including underwriting fees and taxes, which is a significant drop in what it cost just a couple of years ago. The rising popularity of R&W insurance among savvy PE firms, as well as some Strategic Buyers, means more policies being written. And there are more insurance companies than ever offering this coverage. That has brought the cost down.
Better yet for Buyers, because of the removal of risk and peace of mind, Sellers are more than happy to pay for R&W coverage. Given the choice between accepting risk and the escrow that goes with it, Sellers will eagerly cover the costs, making R&W essentially “free” for Buyers!
It’s clear that for Buyers in the lower middle market space, the advantages of R&W insurance far outweigh any minimal additional cost and additional due diligence required by the Underwriters (which probably should have been done anyway and doesn’t necessarily add significant time to the process).
One important thing to note is that large Strategic Buyers – we’re talking the Apples and Googles of the world – have more than enough leverage that even if a Seller wants it, they are not likely to agree to R&W coverage. For them, any losses from something going wrong when acquiring a lower middle market company are just a drop in the bucket.
Lower middle market deals are right in the sweet spot for R&W. For smaller Buyers who understand that the fastest way to grow inorganically is with key acquisitions, it’s the perfect vehicle to bring Sellers to the table. As more Buyers focus on this space, it’s essential for them to have R&W to be competitive.
Buyers should bring up the concept of using R&W insurance early on, with a provision made at the Letter of Intent stage. It’s a gesture of goodwill of sorts that soothes concerns the Seller may have. Of course, knowing that any losses post-sale will be covered gives the Buyer peace of mind as well.
As mentioned, with this coverage in place at the beginning, negotiations are much smoother and go more quickly.
In the current climate, lower middle market Sellers are running scared. Buyers bringing R&W insurance into the equation will go a long way to gaining trust, making them feel secure and ready to go forward with the transaction.
It’s important to deal with an insurance broker well-versed with Representations and Warranty insurance and its role in M&A. While some of the bigger providers do offer this coverage, they focus the majority of their time and energy on bigger deals.
I specialize in securing this coverage for lower middle market deals, and I welcome your questions. If you’re a Buyer or Seller interested in finding out more, please contact me, Patrick Stroth, at firstname.lastname@example.org.