New podcast episode with Mikel Berger from Little Engine Ventures where we talk about structuring long term investments, LEV's branding and community, speeding up the closing process, and craftsman businesses. Enjoy![redacted]mikel-berger-little-engine-ventures-ep-10

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Part 1 of Transcript:

I'd describe myself not as an entrepreneur and actually that's a bit of why the types of businesses that we're trying to buy. So I'm more closer to the profile of the business seller that we're trying to offer. We say we're trying to offer a service to that they're really our customer or we're providing them a service to exit out of their business and the things that they want in doing that. Daryl is a little closer to the profile, our limited partners. I came to Purdue University in 1997, ended up getting a bachelor's and a master's degree in software development. So I haven't written code in a good long time and I don't have any business degrees, so I tell everybody I'm just making up all this business stuff as I go along. But for me, I really like that I have a couple of technical degrees. First off getting in and starting my first business right out of school with one of my professors. I had a skillset that I could come in and use and kind of provide correct value from day one, because I could write some code.

So that company that we started was called DelMar. It's still around. It's 15 years old and also about 15 person, software development contract and consulting firm. It originally started to be a software products company. So this was like pre iPhone days and I was doing some mobile apps for pocket PCs and things like that. I was pretty good at writing software, but it wasn't very good at everything else it takes to make a software business. So marketing, sales, understanding your customer segments, understanding what customer segments have money and which ones don't. Very first product was a soft basketball statistics software for high school coaches. So they do not have a lot of money, let me tell you that. I think I knew my audience pretty well. I'm kind of an Indiana stereotype, grew up playing basketball. It was pretty bad. So I kept stats. So, and this was also like pre iPhone days. So I think I charged initially like 300 bucks for the software, which now sounds crazy for what was basically an app.

But back then it wasn't that crazy. It was still kind of high, but then also nobody had a handheld device. So the coaches that used it had to go pay 500 bucks to buy a device and then pay 300 bucks for my software. So I’m 800 bucks into this thing. That took a pretty dedicated high school basketball coach to want to do that. But the idea was to bring the kind of the money ball sabermetrics type of stats that were getting popular in baseball then to basketball and particularly to high school, small colleges. There was even one semi-pro league that used it for a while, so I got a few hundred teams to use it. I joke, I got it to Mikel's hobby with a slight revenue stream. But I have bills to pay, so I took on contract work, about, 10%, 15% of DelMar's contract work was startups stuff coming out of Purdue University and things like that. And so those projects were always a ton of fun because it was blue skies and everybody was excited about whatever thing they were working on.

And it was kind of cool to come in and be the software team to build out a prototype or take a prototype to have like first commercial version kind of a level. But a lot of times it was super frustrating because a lot of those founders didn't know. They also didn't understand their market or what the real pain point of their customers was or what real value they were adding in there. And so like a lot of startups, a lot of them died something else and when we did just did his contract work and we got paid and so it was okay. Some of them though. We started to do for equity and then I realized, holy cow, when I don't get paid, I mean it's just when it was my time, it was like not good, but I just had to explain to my wife like, why things are going to be tight for a while. But then when I started paying like other people real salaries and then I was left holding equity or in some cases some invoices that I didn't know how I'd ever be able to pay. Like I got to start thinking like an investor on this because at least for me it was some pretty significant money and I didn't understand the business side of things.

Meanwhile, most of DelMar's clients have always been much more traditional businesses. Non-tech businesses that in some way had a forward enough thinking business owner that knew they needed some custom software development, that they were oftentimes at a size where their excel spreadsheets or the homegrown systems for small guys, were working at a few million dollars in revenue, but as they had grown past five, 10, $20 million in revenue, they weren't quite big enough to use the big boy software. Or they had something unique about what they did that maybe it was their secret sauce and was really why they were doing well or maybe it's just the way they wanted to run the business. They wanted software to work the way they wanted it. So that was a lot of fun. We could come in and you're kind of improve the bottom line, mostly kind of operational efficiencies. We did stuff in agriculture, education space, manufacturing handful different industries were those industries we kind of liked and got some good experiencing.

But honestly, if it was data and user interfaces and web and mobile, like we didn't really care as ton of fun to get in and learn at these different businesses. You get understand how their business processes worked, if you were going to write the code. And I learned, I really liked that part of it. So yeah, that was a lot of DelMar's clients was these more traditional businesses helping them improve the bottom lines. But a few of them, handful of them had enough of an even deeper vision to productize some of those software things and say if my company needs this, there's a whole lot of other companies like mine that could also use this. And so it could be commercialize those software. So we got to do that handful of times. The most successful of those was my partner now at [Little Engine 00:05:58], Daryl.

So he had a very traditional AG business that over, depending on how you look at it, six to 10 years, he transformed by using my software development firm into a total software as a service platform. So we saw this very geographically bound regional, AG firm that basically had customers in a two hour radius because that's what you could afford to pay a guy to drive a pickup truck out to visit your customers. And to the summer, we launched the [SAS 00:06:27] product. We had customers everywhere they grow corn. So he grew that up and then eventually sold that to a firm out of Illinois. So that was a lot of fun. He went and worked for him on the technical side. We helped transition things over. But after about a year and a half, the next joke is that he got tired of having a boss, because he'd never had a boss before. And Daryl started his first company was 13, something like that. And so he made it about halfway through his earn out period, which is pretty decent, left on good terms and a great team over there, but just was ready to do his own thing.

So I went back to him and was like, "Hey buddy, that was fun. Let's get the band back together. We'll do the next thing and make it even bigger." And he said, "I don't know Mikel." He's like, "I like you. We work well together. But I don't know if I have a software idea, that I need DelMar to write code for, but I'm like, I have some money now so I might buy a business or two and get something going. So I was like, oh, interesting, because I've been trying to figure out both on this startup side of things, what equity in a business should really be worth. And a lot of these startups seem like really overpriced but I don't know why I think that, but it just seems crazy. And also I said, I've been thinking about like some of my clients are actually some of the businesses that I think should be clients, but I can't convince the owner to do it. I'm like, if I own that company, here's how I would run it. Some of my clients are getting older and it doesn't seem like they have an idea of what their succession plan is.

And so anyway, we got to brainstorming and he really had already done a lot of the work for what has become Little Engine kind of laying that groundwork, but it just aligned with a lot of what I was thinking. So I had been in a process of moving myself out a day to day operations at DelMar. DelMar had grown to a point where early on I was doing a little bit of everything and I loved it. But then as it got bigger, I was the pinch point. So I was holding everything back. I was in, I call it the cage years. My partner was a big help in that, but I was still all through those times, but it still was, a lot of things depended on me. So it's really frustrating to be in a cage. It's even more frustrating when you built the cage yourself and you put yourself in it. So I took about three years and unwound myself out of that. So I'm still active or I'm still an owner in DelMar with my partner Kyle there, but I have no regular day to day responsibilities.

So that's what I tell sellers now. I'm like, "Look, if you can do it, I did. You could own, why not own your business indefinitely? You don't have to sell to us because that's what I thought, I'm prepping this business to sell it. Then I got to the point where I was done and now I'm like, "Wait, crap, this is a good business. I don't have to sell it. I got good people here and if I want to do more I can. But if I want to focus my time, other places, I can do that too." So that was kind of a journey I was on. I said, if I just got there at a weird age, like some folks figure that out when they're 55 or 60 and then they're able to kind of move into a more passive role. Some don't figure it out until they're 65 or 70 and then they're like, I would do that, but I need to be done now. And so that's kind of the profile. That's how that kind of leads into the profile of the ideal business seller for us is somebody that's ready to be done but has a good solid business. Where did the name little Little Engine Venture come from?

My partner, Daryl came up with it. So it means a few different things. The main thing is, I don't know, it's funny to name a fund after a children's book. We both have relatively little kids. But in all seriousness, the stories, I mean, you probably haven't read it in awhile, but it's a story about optimism, hard work, you're willing to do whatever needs to be done. You're not too proud to take the little toys over the hill. The Little Engine would and the other ones didn't want to waste their time with it. So we think we're willing to do whatever it takes to help these businesses stick around and grow and those kinds of things. We're also, Daryl and I are both alums of Purdue University, which is the boilermaker. So there's a train ish homage to the Alma Mater there.

Then I also say we buy these Little Engines of economic activity and they're more powerful than they seem, especially when you aggregate them together. In aggregate these small businesses, they play a huge impact on the economy, huge impact on our local communities, those kinds of things. And it's also, Daryl likes to say it's a 40 year joke in the making. So someday hopefully Little Engine will be very big and the name will be ironic.

What sort of businesses do you like to acquire a Little Engine Ventures? Just looking through the list of investments on your site that you've made. There's kind of a theme of ... to your point, not software business, more hard businesses, if you will. So can you describe just a little bit about the kinds of companies you acquire and look for.

When I explained this, there are a few kind of like metrics, but actually it's more of a characteristics, a little bit of the business, but of honestly even more so the business owner that makes it a good fit. So we're looking to buy stuff with kind of 1 to 10 million in revenues. Really right now 1 to 5 million is our sweet spot. So I joke in the micro private equity space or something or in the broader private equity space, there's kind of this like pissing up the tree thing. And I think in the micro space, we pissed down the tree like ... So I don't know. Some guys are like, "Oh we buy stuff with a 1 million of EBITDA like we'll go that low." And I'm like, "1 million of EBITDA, that's like our upper range, like we'll go even lower, we'll buy smaller stuff." So we're looking, so like I said, 1 to 5 million in revenue. We like something with 30% plus gross margins because you can find growth out of that. But we're more permanent equity. And so we look to evaluate, can we buy, can we own this business? Can we see ourselves owning this business for at least 10 years, if not indefinitely? So is it going to be around for awhile?

And the auto glass that we've done, my example for that is even if in five or 10 years, we're all driving autonomous vehicles, they're probably still going to have windows in them. And those windows are probably still going to break and you're going to want to get it fixed. Even if some Purdue material science person figures out some unbreakable glass that's actually cheap enough to put in normal people's cars, like it's going to be 10 years before 80 or 90% of the cars on the road have those have those windshields in them. So we've got time to figure out our alternatives and stuff like that. So want to own them for a good long time and we can grow on over that time period. So that means we don't rule out any industry. No, I mean some industries are obviously harder, pharma medical devices, but even with that, like there's sometimes some like weird little niches even in some industries like that that have good businesses.

We tend to win and fairly, stuff that's fairly asset light, light and tangible assets. because that it's really, I mean our competition as it is, is mostly individual buyers. Individuals that are looking to some of them just buy a job. Some of them looking to buy something to really grow it. But if there are more tangible assets, more likely they can get an SBA bank loan and they can drive the purchase price up on us a little bit. I mean, we tried to direct deal source all of our deals but sometimes there's one or two people looking at it. So we tend to win a more service space oriented things with a little bit of assets. Then the geographic radius, we say we kind of publicly say 180 miles. Technically our PPM doesn't restrict us so I can buy a business in New Mexico if I wanted to. That's a good business. But we are even more now practically where we're really hunting in kind of a 90 mile radius around Lafayette, which you don't know your Midwest geography is basically Lafayette, Indianapolis, kind of almost up to Chicago, Northern Central Indiana, which when we started, we started with a much broader geography.

We were looking in and with tighter industry focus and we inverted that about a year in, so we tightened the geography but broadened our industry and basically said, look at this, I always say 80% of the problems, which is a totally made up stat, but vast majority of the problems are a function of the size of the business, not the industry. You'd have some industry expertise, some domain expertise, but most of it is managing cashflow, knowing how to hire, knowing when to fire, managing all those things. Having the systems in place. I mean we kind of take a business from this owner operator level and try to systematize it, but it's an inappropriate system for the size of business. They are 10 to 25 employees and kind of set a good base for it to go from an owner operator function into a, or those owner and operator functions are separated. That's kind of in a broad sense, has the function that we want to serve in the market for these kinds of businesses, set them up for future growth.

Like why the 90 mile focus? Is that so that you can easily travel to these business owners?

I am lazy and I don't like to drive that much. And part of that is true. The biggest reason is brand. So we're trying to establish a brand for Little Engine amongst small business owners as the best home for their small business. If they don't have a family member to pass it down to, if they don't have a key employee that can buy the business, then we want to meet, be that next option. And we'll say that somebody's already in the business should be able to run it better than us. But in a lot of these businesses, there isn't somebody that the owner has groomed. If they haven't been proactive about it, they haven't groomed them to buy the business. Banking laws are different now, so a lot of them can't finance it. And these kinds of businesses we're buying employees probably aren't putting enough away to buy the business even maybe on a longterm seller's note.

And again, the profile of our typical business owner, when they're done, they're ready to be done and even a five years seller's note is just like, "I don't have to repo this thing from this employee that I love." If it doesn't go well and so they at least have the mental weight and we're a cash buyer at closing and small short transition period. And they move on and they feel proud about what they've done with their work life and we wanted to retirement or whatever their next adventure is, time with their grandkids or camping or ...

So how do you structure Little Engine Ventures to have that long time horizon while also having investors who invest in Little Engine Ventures? How do you structure those two sides?

Yeah, so a lot of it is what people think, but what we don't do is we don't raise capital on a deal by deal basis. Large part of that is because I can get better deals. I give a better experience to the seller because when I put an LOI out, it's not contingent on bank financing. It's rarely contingent on bank financing. It's never contingent on me taking this back to my investor pool and network and having them say yes or no. Me and Daryl make the investment decisions. The limited partners are truly limited, they don't make those decisions. So if they invest in the fund, because they believe in this space and they trust us to find those. So we have 35 limited partners. We don't want a lot of limited partners. If you look at any kind of investing book, you should spend the least amount of time on LP management. But I think more so than the number is the type. So almost all of our limited partners are small business owners themselves, so they get what we're doing. I would say I can explain carry to a small business owner that's never invested in a fund before.

I will never be able to explain small business to a "professional money manager" that doesn't understand how small businesses operate and the ups and down and the fluctuations. And philosophically that helps because they know they're in this for the long haul. We also manage that in a partnership. So I probably have 35 of[redacted],000 is our minimum. We also have a maximum, we won't take more than 1 million from anybody at the initial onset. So we need to get to know them and they need to get to know us. And I can't let any one partner get too big because then even if for very valid and good reasons, they're like I'm 80% of your fund and I need my money now. Sell stuff cheap and everyone else is like, what just happened? Like why are you selling stuff? I'm like, "Well, I got to pay back the big dude and sorry, that will happen to you but ..." So we're a little bit pseudo market makers. We can get into more details of it if you want, but basically they have an annual in and out that they can request after a lock up period and stuff so people can do ... We don't do dividends.

When cash comes back up from the ... If the companies are cash flowing and they're returning money to the fund, Daryl and I are charged with reallocating that into either existing businesses that need it and the most cases to do, that's how we do the next round of acquisitions without taking on additional capital and diluting the partners, the existing partners as we do at the cash flow. So we don't dividend out. We do our annual reval and then people can kind of come in and out with whatever portion they want. Again, after that lockup period and can adjust based on their family's needs. So actually we provide more liquidity than the traditional fund that's got you locked up for five, seven years until they flip the company. We're trying to be an alternative to their existing private business that which any business owner knows. Sometimes it takes a lot of capital and sometimes it has work. If it's run well, sometimes it goes into modes where it has more cash and it knows what to do with. And you can take money out and reward yourself for the hard work.

So Jason Fried talks about that with Basecamp in that part of the pricing and having the tiers or no tier, sorry, only the $99 per month for every customer. The whole point is to not have that customer that can pull out and ruin your business. It seems like you've kind of taken a little bit of that.

Yeah. Exactly. We look at LP concentration just like any business looks at customer concentration. So for me the parallel to DelMar is I've always managed clients. I had a rule at DelMar, I tried to never let one client get over 20% of my business. Sometimes with guys like Daryl when he was growing fast and it's like crap. He was 40% of my business last quarter. Like so I can shut him down and say, "Hey, I'll stop doing this work for you." Or I lost it and we found more clients so he got back into a happier proportion for me without having to ... But that was tough. That was, I mean, was a good problems to have, but there's still problems. We've never had to lay anybody off because a client dropped us or had something bad happen in their business. You've got to have these protections and stuff, which is ... Also, we tried to do on the company side, every company's its own legal entity.

I mean we've done 12 acquisitions and that roughly correlates to seven companies. So we're like, we've done to auto glass, we've done to roll off dumpsters and those are combined up into the same entity. If they're truly different businesses, we've got them in a separate entity and so they've got to live and die on their own mistakes hopefully don't propagate. We are trying to propagate the good stuff, but we're actually really careful about having things be too homogenous across all the operating companies because as Daryl likes to say, the knife cuts both ways.