The search phase: knowing where you stand at every moment

Whether funded or self-funded, the search has the same constraints and objectives when working on search-fund compatible targets: lower mid-cap companies with a clear path to growth tend to expect mid-cap valuations###-###-#### x EBITDA) while still exhibiting lower mid-cap risk profiles (significant liquidity risk, high cost of capital, unability to attract top-talent).

This post is to share several experiences the practices and processes that help maximize sourcing outcomes (in terms of good companies that are for sale), although based on a European experience, it will hopefully resonate with current searchers and save some time to future ones.

I set out to source deals for myself in June 2015, and for the 6 months before that, I had discussions with everyone who searched and bought a company that I could contact, including the ones who failed to some extent (spanning from being fired by their sponsors while still realizing capital gains, all the way to chapter 7 liquidation).

I will certainly re-iterate what Stanford and IESE entrepreneurship departments have said in their articles:

- That looking for targets by sector increases productivity (i.e. number of good targets that would consider your offer)

- That having a partner has a positive impact on the search performance (in terms of closing on a deal)

- That people with a background in Investment Banking or Private Equity seem to become a significant demographic in the broader searcher community

This is also true outside of the search fund community of entrepreneurs, and I do believe it increases your efficiency in many aspects.

When considering the “sector based approach” vs an opportunistic approach, there is clearly the advantage that you’ve already answered the “fit” question in the first one for all the targets you will come across. It is also more productive to target suitable companies that aren’t necessarily for sale in a sector approach, as you build credibility in the sector as you go on. Most importantly, if your search doesn’t solely rely on brokers (and it shouldn’t, in my humble view) that search effort will continue even if you move to the next sector.

The tools are very similar across geographies (company registrars in many countries mandate some amount of disclosure) then you can also use services/data bases such as ORBIS and the likes. The key is to have your own metrics for screening, as your objective is to weed off all the companies that aren’t suitable with your plans (free cash flow too small or highly cyclical, industry is too capital intensive etc.)

So with the premise that you should look into every opportunity (brokered, hidden-market, “cold contact”) but with a sector approach, allow me to share my hindsight on my last 2 years of search and the many years of other buy-out entrepreneurs who accepted to share their –sometimes painful- experiences.

Know yourself and surround yourself accordingly

One clear conclusion I reached looking into defaults is that a number of them could and should have been avoided by not doing the deal altogether.

This happened to capable, competent individuals, who lost situational awareness and rationalized issues that shall always be walk-away reasons: hyper-concentration of the “order book”, acute dependency on one individual in the company, important and inherent technical risks, strong cyclicality of cash flows are some of them, unless someone else than the buyer (read: the seller) bares them, such is often the case in carve outs.

Most people will start being over committed in deals towards the end of the search phase, particularly if the deal has taken them away from further origination work. This sunk-cost situation is more to do with the context than with character strengths, particularly if the sell-side advisory is good at his job.

The only robust thing I built into my search from the start was to have “bright line” investment criterions, and identified walk-away clauses for every sector I was searching for target; that and a mentor.

My a mentor was an entrepreneur that failed and succeeded several times in what I was trying to accomplish and to whom I could go to as a “sparring partner” on every deal: to justify my valuation, my view of the risks and how I intended to mitigate them etc.

Having a search partner can play the same role if you stay cautious and avoid “group think” situations.

Another important person around you is your deal lawyer and your accountant/financial auditor: there’s a world between a deal lawyer who truly understands the nature and the specificity of your project and a deal lawyer who treats all deals the same. If they’re simply doing what you ask them to, they’re not applying their expertise but rather their technical skill, and that won’t help uncover “hidden squeletons”.

I had an M&A lawyer who’d always refer me to specialists anytime he suspected issues about tax, labour law or environment regulation despite over 20 years of deals in industrial companies (i.e.: with environmental, labour and tax issues). He was still saying there was a better person than him in his immediate surrounding for those specialist subjects.

Get to know the seller early

Beyond structuring the way you deal with Info Memos, Due Diligence and exclusive negotiations, there are many things you can do to “de-risk” the human factors aspects of buying an SME from its founder, all revolving around asking for more access, more discussion and more disclosure earlier as you establish rapport and let him know more about yourself and your intentions. I have close to a handful of deals which fell through a few hours before the closing only because of that.

The emotional attachment that a founder has to his company cannot be down-played and can be a big advantage for your offer if acted upon. It is important, if the seller is the founder, that you make him speak about the early years and the difficult times: this goes beyond showing consideration, as it will allow you to understand the values and the priorities of the seller (the job security of this staff, the valuation, the future of the company). Another important discussion is to ask about the “story” behind the last 2-3 years numbers: what happened with the customers, the suppliers. Gauging the understanding of the founder will help you pitch your project and substantiate your offer, but most importantly it will give you the opportunity to demonstrate your aptitude in taking a company you don’t know, in a sector you might be an outsider in, to the next level.

Do your “First ninety-day” plan early

In companies, onboarding fails most because the new comer doesn’t understand and adapts to the culture and the issues behind it fast enough. I used “The first ninety days” by Michael D. Watkins, every time I went beyond my preliminary Due Diligence as things move too fast after that to get time to plan.

After the Due Diligence, you should be able to spell out the first priorities you need to cater to for the closing and as a consequence right, after the closing. I believe it is important that you get the plan for the first months down to “who to ask”, “whom to work with” etc.

Discussing some of your forward views with the seller is sensitive but doing it with parsimony can help establish trust on your understanding of the company’s situation and your aptitude to move things forward. Notwithstanding the fact that your LPs will require such a plan at some point in the transaction, this structure and time invested will make things clearer and more straight forward for the next deal in this sector, should the current one fall through.

Get a support system…outside of your searcher circles

I never quite understood why my fellow entrepreneurs kept emphasizing the “loneliness” of the role; that is until I was there. As the searcher, your risk appetite, your constraints and your ambitions do not always align with your LPs, and might at times not align with your search partner. While major differences will be dealt with both by the search fund shareholder agreement and your incentive structure that will be in place when you close the deal, there are many instances where you will need an external, involvement-free look at your actions, your image and the impressions you give. You need to be able to speak to someone who is close enough to notice a change in your behavior, opinions and mental strength while being remote enough not to be affected by it.

Sometimes simply stating the obvious to someone completely foreign to this business helped me move on quicker: I did a preliminary check and the company potential doesn’t sustain the founder’s price expectation, I let him know in the most friendly way possible and told him that I’d always be here in 3 months from now, but within a range that was commensurate with the performance of the company …what’s left to wait for? Nothing.

Keep you network activated on one single agenda item, until the very end

Whether it is investors who didn’t take option in the search fund structure, broader connections who we just happy to introduce you to family owned businesses, or peer entrepreneurs you’ve met in Expos, your Network must be constantly under the impression that you’re sourcing for a target. There is no point in making them ride the roller coaster of getting into negotiations for a deal, then having the deal fall through and update them that you’re back on the road meeting companies. You’re essentially meeting companies until you are not anymore: either because you have closed a deal or because you are closing the search fund altogether. As much as it is tempting to prime the job searching machine a bit ahead of time, you should only notify your Network that you are on the market for a job only when it is definitive: you are not hedging, you are simply taking your losses.