Two and some change years ago I made a post about my first week post acquisition. Having two more years of experience, I figured I’d share some Do’s and Don’ts of buying and running a small business. If it’s presumptuous of me to post, please pardon me. There isn’t a shred of me that thinks I have this all figured out; I really don’t. My thought is that two years in, I’m now more aware of the stuff I don’t know and my hope is that this list helps others who embark on this ETA career journey. And please note that the list parts aren’t necessarily MECE. They’re just good places to start.
1) Do make sure that the business you commit to realistically won’t run out of cash. This seems simple enough but you’re fighting against your own nature with this one- especially if you’re self-funded like I was. You do all this work to find a good target. You kick the tires and conduct due diligence. It’s easy to ignore the red flags and tell the bank or your investors the rosiest of projections. Managers tend to overpay for acquisitions because even very smart people succumb to the foolishness of their own heart and appetites. Some businesses will look good until you do the math and figure that the capex commitment is huge or that if you transition ownership, suppliers will want new deposits or the landlord will raise the rent 20% since they think you have deep pockets. Maybe the staff all didn’t get raises for the last four years and now that there’s a new owner they demand it from you. All these forces work against you and your goal to make sure you don’t run out of cash and instead substantially grow it. I don’t care where you are in your familiarity with cash flow projections; you will want to make sure that you’ve built this plan out yourself, that it’s believable, and that there is no reasonable scenario in which you run out of cash- especially as you’re trying to get up the learning curve of your particular business.
2) Do periodically set the tone of exactly what you want from each person within your company. Every quarter I take a lot of time to think and set metrics and goals for every person in my company. Then I publish them and if the team members hit the numbers, they get bigger percentages of the bonus pool which is based off the company’s quarterly profit. I can’t take credit for this; my predecessor implemented this and I just continued it but I think it’s a great practice. I’m listening to the autobiography of Sam Walton (great book to listed to for General Managers by the way) and he did something like this to make Walmart the behemoth it is today. You don’t get the behavior you ask for from people. Instead, you get what you incentivize. I want to incentivize every person in my company to show up and be fully engaged for the team and for themselves. I also want them to share in those rewards with one another and with me.
As a sidenote, I really was fortunate that I got a small business that measures everything so that we could implement this kind of feedback loop across the company. You want a raise? What do your numbers say? You think you someone else is overpaid? What do their numbers say? You can’t figure this stuff out if you have a crappy back office. So if you get a business that doesn’t have this together, then you’ll want to have a plan from day one of how you’re going to implement such a system.
3) Do give your team the space to respectfully disagree with you. In a small business, people bring their family issues and selves to the company. That includes you because you’re a person. When I grew up, my parents always gave me room to voice my opinions and thoughts. And granted I had (and still have) a very smart mouth. But, when I matured and learned to submit to what they told me even if I completely disagreed, it built a strong level of cohesion in our family and it also made them lead me as their child at least considering the concerns that I’d bring up. I do the exact same thing with my staff. If I want to take the company in a direction and you disagree, I command you to present your argument to me and I’m secure enough to respectfully disagree. I’ve always been one to have very strong beliefs about stuff but I like to hear out other perspectives. This makes the solutions that we come to as a group significantly better and I’m convinced that my staff knows their jobs better than I do. Least I could do is hear them out for things that affect them.
4) Do make your holistic goals few, explicit, measurable, and clearly understood by all. Just as with number 2 for the parts, you want to do the same thing for the whole. The worst thing that can happen is someone doesn’t understand their part in the whole. That person will become a drain on your team and if you didn’t communicate that to them, it’s really not their fault. It’s yours as CEO.
5) Do make sure that you’re incentivizing the behavior that you want. The high-level goal of a CEO is to make sure that he or she positions staff and capital to behave in the most optimal way for building the company’s wealth over time. Touched on this one earlier. That means that you have to think long and hard about whether you’re incentivizing the proper behavior. For example, if you pay sales staff’s bonuses based upon revenue alone then you’re incentivizing them not to care about profit. Then you’re rewarding bad behavior. Periodically you should look at your staff’s and capital’s behavior and ask yourself honestly what behavior you’re incentivizing. Just stopping rewarding bad behavior will usually make pretty good moves in a company.
6) Don’t overpay for your company. Not only is it embarrassing to overpay for something and then spend years of your life to pay off a note for the thing you overpaid for, but it’s also a strain only you can agree to put on yourself. Those of you going after larger targets with investors and not having to take on a personal guarantee, count your blessings. Overpaying isn’t quite as risky for you all. But for those of us who leveraged SBA funding and hold the personal guarantee, this is so crucially important.
Unless I found a business that was growing its EBITDA at 20-40% a year and that I was convinced that I could continue or increase that trajectory, there is no possible way I’d pay more than 5 times EBITDA. And really, if your earnings are stable and you have even moderate growth, you can do 5 times EBITDA on a small business and still be relatively solvent with a 10% down payment and 90% ten year note at around 6% interest. The math can work there. But it just works a heck of a lot better at 2 or 3 times EBITDA and there are other levers you can use to negotiate the EBITDA and cash flows that you want. For example, you could negotiate a cheaper rent at the time of your purchase.
Also, while we’re on the topic of overpaying for acquisitions: I believe that asset sales are quite possibly the most wasteful purchase methods imaginable. Don’t get me wrong; there are pros to them but in my opinion, they do not outweigh the cons. Gain on an asset and capital gains are usually unequal but, in the cases, where they’re the same, so much more of the purchase price under an asset sale goes to taxes, it’s ridiculous. I learned this from Moran Pober and I generally don’t think asset sales are a good idea for an acquisition. And more than that, do you really want to tell all your customers and vendors that you’re the new owner and have them renegotiate or attrite somewhere else? Just going after a stock sale can give you a lot of room to avoid overpaying.
And when you think about it as an investment, you can’t get anything in the publicly traded stock market for anywhere close to the multiples that you can get for small businesses. The S & P 500 PE Ratio is around 25 then the ebitda multiple is conservatively in the double digits. If you put $100k into this and invest it for ten years you stand a good chance of coming out ahead as long as the earnings of the business that you buy is stable. This is especially true with leverage. Essentially, I’m saying that everyone is overpaying in the public markets but they’re cool with doing so because there’s less risk and the stocks there are more liquid. But if your goal is a long term investment, then the right small businesses seem to be much more attractive to me.
7) Don’t forget to forecast changes in working capital and capex as you’re looking for a target company. This point will be basic for those coming from finance roles but for those who don’t come from it, it behooves them to understand the nuances of capex and working capital changes. Capex is capital expenditure and when you get the tax returns of a target, you’ll want to not only look at the income statement and its addbacks but you’re gonna want to look at capex over the last four or five years. The formula for capex is = Net PPE end of the year – Net PPE start of the year + Depreciation. This tells you how large the cash capital expenditures were in a given year. For example, a target may be selling for 3 times EBITDA and it’s growing at 20% a year. That looks attractive. But as you’re doing digging you find that the expected life of its equipment is so short that each year 25% of its plant and equipment has to be replaced. That CAPEX eats up a large portion of EBITDA. So the thing may not look as attractive as an asset light business.
Likewise, working capital is current assets minus current liabilities. If you find a way to accelerate your receivables faster than the seller did when they ran the business, then you should assume that you’ll free up some cash flow and the target should be a little more attractive to you because it puts off more cash under this new management.
8) Don’t underestimate the importance of the culture that you set. I hate to break it to you but you need to go to therapy if you want to be a CEO. All of your issues and blind spots and values will affect the health of your business. If there is something toxic in you, it’ll show up in how you manage. Steve Jobs was a brilliant CEO. The way he started Apple and these other companies and later turned Apple around is simply legendary. But when he was a young CEO in some ways he sucked because his own personal disfunction tore his team apart between warring product lines. When he matured he worked through a lot of that and by the time he was turning Apple around he had enough talent, confidence, experience, and humility to hear out his detractors and make the whole company perform in some amazing and special ways. If that genius had to work on himself, you will have to do the same. If you elevate toxicity in leaders, it’ll spread throughout the culture of the company you get. Whether you like to think about the human side of all this or not, you will affect the culture. So make sure to work on yourself, your issues, your traumas, your dreams, your drivers, etc.
9) Don’t let success go to your head or failure make you lose heart. Let me tell you what doesn’t care about your feelings and ego: the market. It is important not to let the market dictate how you feel about yourself. I have seen two companies tangential to mine just go belly up (by the grace of God mine is growing). In Richmond a signage company that had been in business for several decades couldn’t collect from a key customer went completely belly up. In the snap of a finger fifty people were out of a job and a couple was out of a large portion of their retirement and maybe all of it.
I purchased my second business from a gentleman named Bill. Bill used to be a door-to-door salesman (for cleaning supplies I think). One day he knocked on the door of an Atlanta facility that made drapes for AMC theaters. Back in the 80s AMC and Regal were in a race to build the most theaters. Bill went to work for the east coast end of this company and asked to buy it from the guy in Oakland, CA who handled the west coast. They agreed and Bill immediately said, “We have got to diversify our customer base.” And he started Georgia Stage (not affiliated with my company but a good company nonetheless). Within three years of his purchase the other company on the west coast had went out of business because AMC and Regal stopped building theaters.
Why am I saying all this? Because when you’re successful, you’re never far from market conditions or management missteps that can destroy a lot of wealth in a short amount of time and you need to remember that. So you’re successful? Keep living and it’s only a matter of time before you fail at something. The question is really only how big the failures will be. And likewise if you’re failing, don’t lose heart because you’re likely a slight repositioning of yourself or of the market itself (which changes all the time) from a homerun success. We want to think that there are people who have it and those who don’t but that’s stupid. No one really knows what they’re doing and there are no big shots in real life. I believe this to my core. At 34 I was unemployed, fired three times, and I had to move back into with my parents (renting my old room from them as I entered the final stages of my first acquisition). A few months later, I bought my company and a few months after that I was solidly a millionaire. Now if my math is correct I’m a multimillionaire. Who knows whether I’ll become a billionaire or take huge losses? But in all this, the most beautiful part of this principle is that if you’re humble enough to listen, even in great failure, the market will tell you exactly what it wants so that you know how to better negotiate and win.
10) Don’t fail without making the most of it. I want to be clear. Failure is part of the process to success. If you aren’t regularly failing at something, then you’re staying safe in the comfort zone and not really trying. But you should never accept failure that comes without demonstrating and demanding that you and the folks who work for you plan for how to turn things around, mitigate the risks next time you try to reach your goals, and learn from each attempt. “If at first you don’t succeed, dust yourself off and try again.” Aaliyah was onto something powerful. Calvin Coolidge said, “Nothing in the world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent.”