Royce Yudkoff:

Welcome to Think Big, Buy Small, a podcast from Harvard Business School about entrepreneurship through acquisition. We’re your hosts, Royce Yudkoff…

Rick Ruback:

…and Rick Ruback.

Royce Yudkoff:

Today we're going to be speaking with Sam Rosati. Sam is a former searcher turned recurring investor in self-funded searches. This is going to be an interesting discussion because the self-funded market is evolving from every self-funded searcher basically needing to construct their own set of investors from scratch to a market where reoccurring investors are participating in search investments again and again and again, making it potentially easier for self-funded searchers to find a pool of equity capital to back their deal. Sam, welcome to the podcast.

Sam Rosati:

Thank you, Royce. Glad to be here.

Royce Yudkoff:

It's a delight for Rick and me. Well, maybe the place to start is at the beginning. We'd love to hear a little bit about where you're from, your family, your education, your career path that sort of led you to the point we'll be spending most of the podcast talking about.

Sam Rosati:

Well, I'll go way back to say that I'm a suffering Cubs fan. My parents moved us from Chicago to Florida twenty-five years ago. I grew up in the Tampa Bay, Florida area, and that's home. I met my wife here and we raise our three kids here. You know, I started my career here after a little bit of time, you know, in college and then in law school in Charlottesville, Virginia. And we came back to Florida after law school. I went into M&A law, where I worked for a big corporate law firm that mostly helped entrepreneurs sell their companies to strategic buyers or private equity sponsors. So, I learned the deal business from a legal perspective from that short period of my career. Maybe one of the secrets, if there is one, is I grew up in a household where my dad was a business broker and I learned the art of the deal through him. That was the kitchen table talk.

Rick Ruback:

That's great. Best education ever. Right?

Sam Rosati:

The best. The best stories ever.

Rick Ruback:

I bet. And tell us about what you're doing now because I was on your website earlier. Seems like you're both an investor and an independent sponsor. Is that right?

Sam Rosati:

Yeah, that's right. So, I got the entrepreneurial itch when I was in law and didn't really have a great answer as to what that meant and what I should do. And I would say what makes this an honor to speak to you gentlemen is it was your voices on a podcast where I learned about ETA. And I said, "Gosh, I don't know much at all, but I know how to do a deal and how hard could operating be?" Because I read your book and you made it sound easy so I figured...

Rick Ruback:

Wow. That is scary.

Sam Rosati:

Yes.

Royce Yudkoff:

A big responsibility, yeah.

Sam Rosati:

So, I left the law and I ended up buying, with my brother, two companies, a roll-off dumpster business and a building supply manufacturing business. That was my foray into self-funded search and operating small companies, and we juggled it. COVID hit. It made both of those businesses do better, not worse. We sold them, we did good, we did not do great. And I stepped back and got a chance to digest and realize, "Oh darn, that operating thing was harder than I thought. I want to go back to being a sponsor." And so that's what I do now, I sponsor deals. The primary one is a big commercial fencing business throughout the Sun Belt.

Rick Ruback:

That's great.

Royce Yudkoff:

You've become an active investor and a well-known investor with self-funded searchers, and maybe the right place to start that part of the conversation is, Sam, how do you create a flow for yourself of self-funded searchers who are looking for capital?

Sam Rosati:

Well, at the very beginning, like most things, it was organic. When we owned those two companies, I had an hour drive to one of the offices every day. To pass the time and to try and pay it forward a bit, I took a call with a searcher almost every day on the drive home. Podcast on the way in, call a searcher on the way home, who would ask for help. And the community's thoughtful that way. Generally, people will pay it forward. After about a year of doing that, I had spoken to a lot of self-funded searchers, and I had a little bit of extra change lying around so I liked the idea of putting money to work in these participations of small companies and not the stock market, which is not something I resonate with all that well. That was the beginning, and then started getting calls asking, "Okay, I like what you did. I don't understand it. Can you help me?" And long story short, I ended up inviting a few folks to come to my office and I'd put on like a little educational event. Brought in my deal team, who was just my friends – lawyers, Q of E folks, insurance agent – and created like a little, "Hey, if you want to buy a small company, here's kind of how you do it and who to call when you need help." And that has turned into this teaching business now, The SMB boot camp. Now we formally teach self-funded searchers how to do this, how to search, how to run diligence, how to close. And we've taught almost two hundred and fifty people. So now it's kind of a formal thing, not an organic thing, around generating flow.

Rick Ruback:

That is so cool.

Sam Rosati:

Yeah.

Royce Yudkoff:

So, for a self-funded searcher who's listening, what advice would you give them about when is the right time to start to meet investors? What would you tell them to do about raising money?

Sam Rosati:

What I say consistently is success in raising money when you have a deal is made a lot easier if you are not going to folks cold when you need to raise a half a million dollars of equity, trying to convince them about it. If at least they already know you and what you're looking for, you've passed that hurdle, and now it's generally just about the business and the asset you're buying. I think searchers have problems in the beginning of their search getting past the gate. These brokers and sellers, they're putting up gates and trying to keep self-funded searchers out because there's a stigma that self-funded searchers don't have money or the expertise to get a deal done. So, I'm a big fan of, “As self-funded searchers, we have people in our court” – mentors, bosses, friends, you name it. And if you can find a few of those people, put them on your website, it'll help you get past the gate early on. And hopefully those same people are willing to follow your journey – maybe informally, maybe formally – and so when you have a deal, it's not a surprise to them. So, I think that makes it easier. But of course, a lot of us have to raise more money than we think we can from people we know and so I'm kind of a big fan of self-funded searchers creating like a newsletter and sharing with anybody who's willing to read their newsletter, "Hey, this is my search and the journey I'm on and what I'm looking for and the deals I've seen recently." And it's a good way to communicate with potential investors that they may or may not really know on a personal level, so that when they have to make the ask, there is something there, even if it's not a direct relationship.

Royce Yudkoff:

So, Sam, as an active investor in self-funded search, I'm taking it you're very open to some searcher calling up, introducing themselves, telling you where they are in the journey, their background, and just staying in touch with them on some periodic basis with the expectation that, at some point, they're going to come back to you with a deal and a proposal.

Sam Rosati:

Yeah, very much so. But I enjoy it. It's both my job and a passion. I know some investors do want to see the deal under LOI before they really want to take a phone call. And I can't say I blame them. Not everybody does this for a living.

_____

Royce Yudkoff:

Rick and I often get asked by prospective searchers when they should start assembling their investors. And our best advice on this is when you start your search, you should start to reach out to people who might have an interest in backing you. Some of these may be people who know you from a prior life – former bosses or colleagues or friends – but often you're going to be reaching out to people who invest in search and, increasingly, investors in self-funded search make themselves known through websites on search and are easily accessible. Of course, investors on the funded side make themselves very well-known because they're generally full-time professionals dedicated to that. But the best practice is, early on, starting to reach out to investors, talking to them about the plans you have. And different investors will have a different appetite for hearing from you when you don't have a deal, but what you're doing is two things. One is that when you get a deal in your sights and under agreement and send them an offering memorandum, this won't be a surprise to them. They will be expecting to hear from you with this deal, and they're going to focus on the deal because they feel like they've earned it through monitoring you. And second, in some sense, you've been selling yourself to them. You've been communicating you're hardworking, you're focused on this, you're scrappy, you have a sense for what a good business looks like. So, you've made one sale already. Now you're down to one remaining sale, which is on the company. Rick, what would you add to this set of thoughts on timing?

Rick Ruback:

Well, I think that's exactly right. I would add just one thing, which is one of the things that I found is a real good asset to an unfunded searcher is a letter of support, a letter from a likely investor who says, “I know Joe. Joe's a good guy. I intend to invest in Joe's acquisition.” And the advantage of that is massive. When you approach a broker, one of the first questions a broker's going to ask – and maybe not explicitly, maybe they're going to ask it in subtle ways – is, “Do you have the money? Do you have the capital to close this transaction?” Now, brokers understand that nobody's committing capital to a deal before you've seen it, before you've analyzed it, before you've done due diligence. What the broker wants to know is you can actually raise the funds to close the deal. And nothing helps that as much as a letter which says, “I'm going to support Joe the unfunded searcher in their acquisition.” That letter answers so many questions for the broker. It just opens doors.

Royce Yudkoff:

I agree with your comments. That lead investor is really valuable in opening doors. In addition, if you've picked a lead investor who has experience in investing in private companies, they'll probably be more engaged than your other potential investors along the way, and they're a wonderful sounding board as you look seriously at companies, to talk to that investor about them and listen to their questions, you know, because their questions will form the list of your questions to the seller and prepare you to buy the company and get the deal funded. So, they form a valuable secondary function as well.

Rick Ruback:

Right, they've done this before. You perhaps haven't.

Royce Yudkoff:

And now let’s go back to our conversation.

_____

Royce Yudkoff:

What do you think searchers ought to look for in investors? Is it as narrow and stark as, "We're just looking for money to get this deal closed"?

Rick Ruback:

Show me your money.

Royce Yudkoff:

Yeah.

Sam Rosati:

Well, you guys know probably a lot better than me, not all equity is created equally. There's something to be said for some diversity on your cap table. Some folks who really want to give you their time, because if this is your first foray into small business ownership, you're probably in for some gut punches early on. And maybe those folks don't have an expertise in your industry. I mean, bonus points if they do, but maybe they just know you and they know your nature and the way you tend to make mistakes and think and manage. To the extent they can prove to be not smart money but helpful money, I think that's very valuable. I have told searchers though that I wouldn't over-index on that because actually getting investors to really engage with you for nothing other than the fact that they have alignment with you financially, that's a big ask, right?

Rick Ruback:

It's a bigger ask when you don't have alignment financially.

Sam Rosati:

True, but these participations in self-funded deals tend to be fairly small. Like, I don't know what the average traditional search check is, but I would guess these check sizes are a lot smaller.

Rick Ruback:

Yeah, can we talk about that, Sam? First of all, let's talk about the people in your boot camp. There's two hundred and fifty so far. Tell us about the typical person or the range of the typical people. What are their ages? What are their educations? What did they do before they've taken your boot camp? Just typical, high level.

Sam Rosati:

High level – early mid-thirties, on average. Post an MBA, maybe 10% or 20% of them have one or have any kind of post graduate education. Many of them don't. Many of them went from college and went into some career that they're now not all that content with. The first thing we do when everybody's meeting each other on Day One is we always ask, "Why are you doing this?" Almost always the answer is some version of independence. They are in a career that is not driving them to want to be there forever. They want independence, maybe a chance to build some wealth. We don't get many people with deal backgrounds, so not many investment banking, consulting, private equity types, because our course is mostly like how to do a deal and they're comfortable with that, even though doing a deal in this world is different than that world.

Rick Ruback:

Any military?

Sam Rosati:

Yes, definitely. A few years ago we did a military veteran-only boot camp. And now every boot camp, we bring at least one but usually it ends up being more like two or three veterans to boot camp. No charge.

Rick Ruback:

That's great. So, how many companies have you invested in with your investor hat? Not the ones you bought directly, but...

Sam Rosati:

With my investor hat, I'm probably approaching twenty.

Rick Ruback:

Twenty. Can you give us a sense of size? Are these hundreds of thousands of dollars in investment, tens of thousands, millions of dollars? Where is it sitting?

Sam Rosati:

So, the average check size for me - and I'm pretty honest about it - I take the approach that I'll write more smaller checks into more deals than to think I'm smart enough to go pick stocks, so to speak. I just don't have that conviction in my own conviction to pick the right ones. So, I like to write a lot of $25 to $50,000 checks into equity raises that are between, call it $200,000 to $700,000 or $800,000 total equity checks, so I'm a small piece.

Rick Ruback:

So, you say you have like twenty firms in the portfolio, roughly. How do you monitor them? Twenty's a lot to monitor. You can't go visit them, for example. Unless they're local, it's just too small to make that worthwhile.

Sam Rosati:

Yeah, so I think this is maybe like the business plan of being a small business investor, is that if you're going to take that approach, you really can't spend a ton of time on each one of them. I love to read their updates. I don't have rules around how often I need those updates. It's nice to get them quarterly. I love to speak with those folks quarterly, but it's not like I'm speaking to these entrepreneurs every month. That definitely doesn't happen.

Rick Ruback:

You just wouldn't have time.

Sam Rosati:

Wouldn't have time and the folks who pick up the phone and call me consistently or send me a note, I'm happy to engage with them. What is surprising is it just doesn't happen all that often.

Rick Ruback:

How about on the due diligence for the deal? Because it just seems that at that smaller level you can't really afford to do much.

Sam Rosati:

Investors will share opportunities among one another. And one of the dynamics I like a lot is when there are some other folks I trust in a deal.

Rick Ruback:

Sure, that always is great, both because it's sharing the work and there's a sense of certification of your interest, right? Somebody else who you respect and trust also thinks this is a good idea.

Sam Rosati:

Right. In this community, there's becoming more of a vendor community that's reputable, so if an entrepreneur has hired vendors, legal, Q of E, SBA lender that I'm comfortable with, you know, that speaks for something. I mean, frankly, like the communication quality and quantity pre-close with an entrepreneur, which is where we get our diligence from, speaks a lot to my interest in the opportunity itself. So, you're right, you can't invest a ton of time in diligencing each opportunity when you're writing small checks. But I think part of the bet we're all making in this community is that buying small participations in these mini LBOs should pay off over a large population of investments. And I believe in that.

Rick Ruback:

So, you're building a large enough portfolio so that you don't have to necessarily focus on individual pieces of bad news or good news in a particular company. There's just a bunch of companies to average those out across.

Sam Rosati:

I think so. And you know, some of those entrepreneurs, they won't just do it once. They're going to do this five times in their career…

Rick Ruback:

Sure.

Sam Rosati:

…and so you get a chance to ride a winning horse.

Rick Ruback:

I find it so interesting because, at least on the self-funded deals that we know well, the entrepreneurs end up owning a majority of the equity. Is that true on yours as well?

Sam Rosati:

Yeah, I mean, I'd say between the searchers’ check and their sweat equity, they're owning on average 70%, 75% of their business. That's interesting, right? It flips the economics around from the economics we're used to but, you know, if you're buying – I'll steal your story – that music company in the northeast generating a million of EBITDA for four times and you're putting 80% LTV on it, the math works. It just has to stay on the tracks.

Royce Yudkoff:

Yeah, that's a key point of what you and other self-funded investors are doing. You buy these companies at great multiples, there's a very attractive SBA leverage, and the setup of the return, even if there's not much growth, is great. So, the odds are really in the searcher's favor, in your favor, in these deals.

Rick Ruback:

But it's so interestingly distant from control because three things happen. One is the searcher owns a majority of the equity. So right there, control is kind of an odd concept. Then, you own a relatively small percentage of the outside equity, maybe 10% or so. And then the third thing is, that check itself, just in dollar size, is small, so you can't economically put a lot of resources into that investment. You look at all three factors and you're very distant from a control investment. Whereas, if you go back to the typical private equity structure, the whole private equity structure is about the general partner having operational control. And if the entrepreneur CEO isn't successful…

Royce Yudkoff:

You replace them.

Rick Ruback:

…you replace them, out they go. And here, in this structure, that's just never going to happen.

Sam Rosati:

The bank won't sign off on the operating agreement that says the minority investor group can replace the personally guaranteeing majority owner.

Royce Yudkoff:

Yeah, I don't think the SBA would allow that. What I do think is very consistent in this approach though is sort of writing small checks on a lot of different deals because you're essentially, as an investor, saying, "I love the setup of the, you know, the leverage and the price you pay for these businesses and the long history of the business, but I don't have control. I don't have time to have a lot of monitoring go on, or a lot of due diligence go on, so I'm going to spread this risk across a lot of companies because I think on average this asset class ought to do okay.”

Rick Ruback:

Right. It's a hard strategy for me personally to adhere to because...

Royce Yudkoff:

You like an element of control in your life.

Rick Ruback:

I have so little. I like to have it in some aspects, right?

Sam Rosati:

So, maybe think about it this way though, Rick. If you have one sum of money to invest over the long term of somebody's career, you can put some of it to work in things you're active in, you can really move the needle. But there's also something to be said for putting dollars to work in a way where, you know, rather than sticking it in an index fund, so to speak, in the markets and letting it sit for thirty years, imagine over thirty years how many participations you can collect and see grow and come to fruition. And so long as you're not trying to live off the yield, live off the cash flow generated by these participations, they should out earn over the long haul.

Rick Ruback:

Right, because we think the expected value in this space is better than private equity. Private equity is kind of mid-teens, would you say, Royce, on average? So, maybe it's 20%? And so the expected value in the market, the expected return of the market's probably…

Royce Yudkoff:

Eight.

Rick Ruback:

Eight, ten, something like that, depending on which academic you believe…

Royce Yudkoff:

That's a big premium.

Rick Ruback:

It's a huge premium. And we know that, just exactly what you said, Sam, that the joy of compounding is that if you can do this for a while, it will be a giant wealth creator.

Sam Rosati:

Yes. The problem is, you can't live off of it. These businesses are highly levered, so they don't have the free cash to go make distributions to the ownership group. So, anybody who does this, in my opinion, in self-funded, writing many small checks, they have to have another day job, another way to generate income to live because this isn't what does it.

Rick Ruback:

So, there's a bunch of consequences to that, right? I know you live in Florida, which has the virtue of no state income tax, I think. Is that right?

Sam Rosati:

That is right.

Rick Ruback:

But the businesses are not all in Florida.

Sam Rosati:

No, not at all.

Rick Ruback:

Are you getting twenty K-1s and twenty state tax returns to file and all that joy?

Sam Rosati:

Yes, I get a bunch of K-1s. I haven't filed an on-time tax return in a decade.

Rick Ruback:

Well, on time is October 15th, right?

Sam Rosati:

Right, good point. And in Florida, with hurricanes, it seems like they're kicking it to the new year every year. But I've thought long and hard about putting a C Corp blocker under my holdco so that I still have to get K-1s and I still have to file that corporate return, but at least I can file the ultimate K-1 on my personal return without waiting.

Rick Ruback:

I would just say that there are a whole bunch of local CPAs celebrating this podcast right now.

Royce Yudkoff:

Yeah, and wanting to meet Sam.

Rick Ruback:

Well, no, and just hoping that every person who has, you know, a million, two million bucks of liquid assets, are saying, "Hey, I hope they copy Sam because I'll be filing state tax returns forever."

Royce Yudkoff:

I'm totally sold on the idea that this is an attractive asset class for the same reasons as searchers are attracted to it. You can buy established, enduringly profitable companies at low multiples. You get great leverage from the SBA. It sets up a very nice return. That said, like any investor, you need to select which businesses you want to be in and there are two parts to that. Part is the business selection and part is the selection of the entrepreneur. Let's start with the entrepreneur first. Here's my question, which is, your challenge is a little bit different from other investors in private companies. You know, in PE firms, because they're buying big businesses, they usually recruit in a manager who's had fifteen or twenty years experience in that business and has some kind of track record that's on point to look at. And in funded search, they don't have that. You know, they're usually dealing with someone who's at an early point in their career, but they really are very focused on following that searcher over the year to two years it takes to find a company, and they really know, get to know him or her over that period. As an investor in self-funded search, you don't have either of those. Your courtship, if I could use that word, is sort of brief. So, tell Rick and me…

Rick Ruback:

Well, he's got the boot camp.

Royce Yudkoff:

Well, that's how you meet him. Yeah, I guess there's that. Well, tell Rick and me how you make an assessment and how many interactions you have before you say, "Yes, this is someone backable." How do you do that, Sam?

Sam Rosati:

This is the hardest question by far in this adventure, which is, if we're talking about investing in self-funded acquisitions, this is by far the hardest thing to do. And yeah, they come to boot camp, in most cases, and I get to spend three days with them, and I get to have seen their background, their application, all those things. That's great. But maybe the answer I should lead with, they're like, "What are the proxies that I'm looking for?" I think I've probably learned through the tougher outcomes, through the businesses or the entrepreneurs that have had a harder time, what I look for now - and I would say, in most cases, because the entrepreneur who buys a business doesn't have experience in that industry, the thing that I look for is a natural inclination for sales, because when you're buying a business that's levered you can survive a lot of things, right? Truck going bad, a couple people quitting, you know, there's a lot of things you can live through. What you can't live through is a meaningful revenue decline. You cannot survive that because revenue drops 20%, earnings drop 40%, and you can't make your payment. So, an inclination, an aggressiveness towards sales, and a business-entrepreneur fit where the sales function doesn't rely upon, say for example, a technical education or skill that the departing seller has. I believe strongly in that because if revenue can stay level or grow, all of the other problems, generally speaking, can be solved.

Rick Ruback:

So, Sam, I agree with you, but - I'm going to put a “but” in here - which is that one of the most terrifying things I think a CEO can ever do is hire a salesperson. And the success at hiring salespeople is, I would say, just dismal, right?

Royce Yudkoff:

Mm-hmm.

Rick Ruback:

And there's good reason for that because great salespeople are highly valued in the organizations that they're in. So, if you find one who's on the market, often it's because…

Royce Yudkoff:

…they're not highly valued.

Rick Ruback:

They're not highly valued. And it could be it just wasn't the right fit but it could also be something more basic. But I've been involved in the interview process for some sales directors and I've interviewed people and I walk away with saying, "Oh, that person will be really good." And then three months later, I hear from the CEO, "That person's a real loser. We got to get rid of them." And if that happened once, I'd say, "Okay, you know, it's really hard to pick an athlete." But it happens all the time.

Sam Rosati:

Can I add a “but” to your story, though?

Rick Ruback:

Yeah, go ahead.

Royce Yudkoff:

A “but” to the “but” – yeah, go ahead.

Sam Rosati:

On average, these small companies we're buying or we're investing in, the ones that I sponsor, tend to be a little different - I don't want to give that impression off that I'm acquiring these small businesses - is that you said “Director of Sales”. I don't know of any million dollar EBITDA businesses that have like a sales management function. The sales function is done by the front desk or the owner…

Rick Ruback:

But my point is it's really hard to assess whether somebody's a good salesperson, and I only want to back self-funded searchers that have that potential to be good salespeople…

Royce Yudkoff:

How do you see that potential in that human?

Sam Rosati:

Because I'm being sold in the sale of a participation in these small businesses.

Royce Yudkoff:

I get it. So it’s, if he's an effective seller to me, he can take his product and sell it to their customer too.

Rick Ruback:

Ooh! But that is such a reach.

Sam Rosati:

But in most cases, these folks are not comfortable raising equity. It is just as new to them to go sell equity to investors, that it’s for them to go into a niche-y small business and sell a product or service to a customer.

Rick Ruback:

Well, this is really interesting because, Royce, you've made this point to me lots of times, and this is a different context for this point, which is, when people are pitching an investment or people are doing their quarterly board call, this is the time when they're trying to put their best foot forward. And if that best foot isn't very good…

Royce Yudkoff:

…what are they going to be like on some random Tuesday, as they’re calling on a…?

Rick Ruback:

To a customer who cold calls them that they don't really care about, right?

Royce Yudkoff:

Right, exactly.

Rick Ruback:

Where they might have a long-term relationship with us and they're underperforming to us, for somebody they don't have that long-term relationship, that's pretty scary. So, Sam, I accept that. That's a really good point, that if they're not good enough for you to have confidence in how they'll behave as a CEO, then maybe you shouldn't make that investment.

Sam Rosati:

It's still a gut instinct you have after a couple conversations, but if you read their deck of information on the opportunity, and then you have a frank call about, you know, the business, the industry, the cap structure, them, the fit, the people, and you have pointed questions at diligence gaps, seeing how they respond and then seeing how they come back and how aggressive they are in trying to take the bull by the horns and gets you over the finish line or not, tells me a lot. And I think that's my second thing, which is that sort of aggressive mentality where, if there is an issue, they are going to get in the weeds and get their hands dirty and fix it, versus an inclination to try and delegate it out or scale it out or...this is hard. This is hard to manage small businesses and people and P&Ls and vendors when you're new. And so like that aggressiveness is not as common as I thought it would be, and it's a proxy that I use.

Rick Ruback:

Right. I agree that if you ask the person, "So, there's a stuffed-up toilet in the factory, what do you do?" And one person says, "Call a plumber." And the other says, "Find a plunger." You want the guy who wants to find the plunger.

Sam Rosati:

I like that. I'm going to steal that story.

Rick Ruback:

Well, we're borrowing it from somebody else who we know and love as well.

Royce Yudkoff:

Let's talk about the other side of the assessment, which is the business. The searcher is, at some point, coming to you and saying, "Sam, here's the business I'm buying." What are the characteristics you screen for in the business?

Sam Rosati:

Sure. Also, guys, I want to say, your book and your teachings helped me sort of live my own version of a dream here, so I want to say thank you before this is over. When I read your book, it said “enduringly profitable”, right? And I got it, like I read it, it went through my brain. It's not until I got into some small companies and I saw revenue be shaky for a while that I understood on a personal level what it was like for there to be issues around enduring profitability, or inconsistent revenue. That is like my north star when it comes to diligencing a business, is the enduring nature of the revenue. And I know you kind of go one step further and to say the enduring nature of the earnings, and there's a lot of diligence to be done between cost of goods sold, gross margin, and the bottom line, but for me, it's the ability to say, “This business is going to have consistent revenue, growing revenue over the long haul”, and I'm okay with a little bit of project-based revenue, so long as I can get comfortable with it. That's a big one. I guess everybody wants to buy recurring revenue businesses but would you rather a recurring revenue, 25% net margin business and you have to pay nine times for it? Or would you rather a bit of a projecty-based, 18% net margin business that you pay three times for? And that's the one you get a lot of in this self-funded space, is that second one. The profitability thing is easier to manage when revenue is growing, if you buy right. So, that's what I look for. Poke holes in my argument though. Like, I want to hear why that's wrong.

Rick Ruback:

No, I think that's just right. The question that I always have when I look at a business that doesn't have contractually recurring revenues is how reoccurring are these revenues? I always have this analogy or these bookends in my mind. One is where it's almost impossible for the customer to switch, and the other is the coffee shop on the corner where you go by every day and so you stop in and get a cup of coffee. And so the buyer would say, "Aha! Rick is a recurring customer." Well, Rick isn't actually a recurring customer because if a coffee shop opens up two doors closer, I'm going to that coffee shop. You know, if he goes out of business, I'm not going to have a problem getting coffee, right? I have no switching costs. So, I struggle sometimes understanding where on the spectrum those are.

Sam Rosati:

OK, so I have a partner in my fencing business that does a good job of analyzing this and I've used this on the self-funded investments, things like customer churn or things like what percentage of your customer base repeats every year, right? So, this isn't recurring revenue. Maybe three companies that have contractually recurring revenue. Everything else is some version of repeating customers. That's what you are to your coffee shop…

Rick Ruback:

Yeah.

Sam Rosati:

…and so trying to quantify the repeating nature of your customer base and revenue year after year, and some version of that plus an analysis of margins, kind of gives you a sense for like how valuable of a service or product are you offering to those customers to come back year over year? And if bought at the right price with a decent entrepreneur, that summarizes the bets I'm trying to make.

Rick Ruback:

Rough numbers, of the people who call you up asking you for money, how many do you invest in?

Sam Rosati:

Excluding my kids, right?

Rick Ruback:

Well, kids, I mean, I don't know the age of your kids but, you know, if they're like teenagers they want money every day, right?

Sam Rosati:

They are not. They are nevertheless relentless.

Rick Ruback:

Yeah, okay. All right.

Sam Rosati:

I haven't tracked it, but I would say maybe 40%. And I'd say over the last year or two, I've had a little bit harder of a time. Maybe it's because this community is getting more popular or I'm getting more looks, but it's hard to find those diamonds in the rough – from a deal perspective, not a person perspective – in the last couple years, where the numbers are requiring a bit more aggressive assumptions for the math to pencil.

Royce Yudkoff:

Sam, I'd like to talk a little bit about the process of searchers assembling a syndicate of investors. If a searcher calls you and you like his or her pitch personally and also on the business, do you help introduce them to other investors so they can rapidly form a syndicate? Because that's, of course, in their interest, but it's also in your interest because if you like them you want them to raise that capital and get the deal done.

Rick Ruback:

And from investors you want to work with.

Royce Yudkoff:

And, yeah, that's right, Rick. Thank you. And you'd rather have investors who you know and have worked with elsewhere. So, tell us how that works in this space.

Sam Rosati:

Five years ago, it worked by you pull out your phone and you text a couple friends. Text my brother, my dad, or a few folks that I knew from this community. But this community has changed and grown a lot. So, today what that means is there are five, maybe six, that I know of, committed capital funds whose mandate is to write checks into self-funded SMB acquisitions. In some case, their mandate also is independent sponsor and traditional search acquisitions, but they are tasked to do this. So, that's easy, right? I can call my friends up who run those funds and offer up the opportunities. Boot camp has been interesting in that maybe one person per boot camp will come back and say, "You know, I had this idea that I wanted to be the entrepreneur but, you know, I'm 45 and I have a career. I'm kind of learning about SMB acquisitions. I actually would rather just passively invest in opportunities." I get a fair number of those. Yeah, I'd say that's how it works now. There's still no formal place to go to. A couple friends and I are trying to build a website where people can go when they're a searcher and they can post their opportunity and it would aggregate the investor community to be able to write checks into vetted deals.

Royce Yudkoff:

Well, that makes sense. That certainly is hugely helpful to searchers because instead of having to create a, you know, brand new group of investors from people they know, they can use experienced investors to introduce them to other experienced investors.

Rick Ruback:

Would you charge a fee?

Sam Rosati:

I think to start, we're not, because I think there's some regulatory requirement, licensure required. You can't take a fee unless you're licensed on equity raising. So, we'd have to find other ways to make the math work, sponsorships or things like that.

Rick Ruback:

Have you thought about simplifying all that and just creating a GP/LP structure, take some limited partner money and invest that directly?

Sam Rosati:

I have but it's hard to make the economics work on small funds. If an equity raise on one deal is $400K and you can't be more than half of it, otherwise you trip the SBA's 20% rule for who signs the guarantee, it's just hard to put meaningful dollars to work. So, running a fund has never gotten to that level of interesting for me, personally.

Rick Ruback:

Yeah, it's really hard. I think that's why the investor space continues to be fragmented. So, suppose somebody listening is somebody with say, you know, a million dollars invested in Vanguard and has a career as a software engineer, as a biologist, as a lawyer, whatever. They don't have access to this community. And they said, "You know, this is a really interesting idea. I could take my 10% return, make a 20% return. Why don't I do that? And why don't I invest $250,000? I'll put $25,000 in ten deals and see what happens. I can afford to lose $250,000", so says this person. Would you think they're crazy? And they're just going to do it. They're going to meet the people and say, "I like you. I'll give you my twenty-five grand." And that's it. Because they're not professional investors and they're not business people. They don't really know what to look for. They foolishly haven't read our book or listened to our podcast. So, what do you think?

Sam Rosati:

This has happened forever, right? The local dentist invests in opportunities. The problem is if you don't know what you're looking for, you're going to get the call from your college roommate for his startup idea and, you know, your cousin's dog looking to do a crypto...I think the point is so long as you’re putting a ring around the folks who have learned about buying established, enduringly profitable - your phrase - small companies, this community can help train the right prospects to pursue. I worry about that biologist because he or she doesn't really know what to look for and so he or she may be better off going to one of these funds, writing a single check or investing in a few funds and getting the diversification and filtering of those general partners. That's what I would say.

Rick Ruback:

Yeah, the fee's probably worth it, right?

Sam Rosati:

I think so.

Royce Yudkoff:

One of the great opportunities for searchers in self-funded search, as you've said already, Sam, is they're the majority owner of the shares and they control the company. We see that temptation all the time. Last year in Rick's and my courses, we had about thirty of our MBAs graduate to go search and I think about half did self-funded search and half did funded search. So, it's a lot of attraction in that control that you talked about earlier, Sam. From an investor protection point of view, what governance do the investors get? We know they don't get control. You and I, Rick, have seen a put-call after five or seven years, so the investors have a contractual right to say, "You may want to keep this company and that's fine, but you need to take me out at market value." Or a prohibition against related transactions. Sam?

Sam Rosati:

Look, I think the answer is the same for governance as it is for economics. It's still the Wild West. You still see crazy proposals, and for entrepreneurs who can get those deals done, good on them. What is happening is because enough of us have gotten to be serial investors and we're in a lot of opportunities, we kind of have a bar, which is to say some minimum threshold around things like how the searcher can compensate him or herself and family members, what consent rights it takes to take on additional debt, do additional M&A. Typically, sale of the business is a decision that's left to the entrepreneur, but it's kind of the normal governance terms that you'd see in an operating agreement. I get the question about the put-call right all the time. I think it's intellectually interesting. What makes it hard is how to negotiate the valuation mechanism up front, and I find that really hard to do as both the entrepreneur and the investor. I have seen that a lot less than I expected when I got into this community, six, seven years ago.

Rick Ruback:

I think the reason that the put-call provision is so valuable is because it creates the opportunity for a conversation. It forces the entrepreneurs and the investors to sit down and say, "What do we want to have happen here? How would we like the future to unfold? Am I happy running this business? Am I getting frustrated running this business? Do I like having you as an investor? Do I not?" Oftentimes that conversation just clarifies things in a way that just would not happen if you didn't have that provision.

Sam Rosati:

That's a good point, Rick.

Rick Ruback:

I think it's more about the conversation than necessarily the exercise of the right.

_____

Royce Yudkoff:

Rick, one thing that would be very helpful to a lot of self-funded searchers is to discuss what market terms are, generally, for self-funded search equity. Do you want to touch on how that equity is priced? And then I can follow up with talking about governance.

Rick Ruback:

Sure. The pricing on self-funded deals or unfunded deals is reflective of the fact that the searcher is only seeking capital at the time they have a deal in-hand. The searcher approaches investors and says, “Would you like to fund this?” And typically what unfunded searchers do, what we teach our students to do, is to do a model that has conservative growth in it. By conservative, we mean 5% a year in EBITDA growth and constant margins and no multiple expansion. And then we ask them to just solve for the equity that gives outside investors a mid 30s, say 35%, internal rate of return.

Royce Yudkoff:

When we see that being done, generally it leaves the searcher with something like 60% to 80% of the gains owned by them. In other words, they have to return the investor's money and then they usually end up with 60 to 80% of what's left after that.

Rick Ruback:

Yeah, that's very much the range. And it, of course, depends on the quality of the deal. Also, the amount of debt. These deals tend to have more leverage, often SBA – Small Business Administration, 7A loans. But in addition to those small business 7A loans is also seller debt. So, it's not unusual in a $4 million acquisition to need, I don't know, what would you say, Royce? Half a million dollars of outside equity?

Royce Yudkoff:

That's exactly what I was going to say, Rick.

Rick Ruback:

Typically, an unfunded searcher has no problem finding investors. Obviously, not all deals are created equal. Some deals have no recurring revenue. Some businesses just don't have a bright and shiny future. So, maybe those deals are un-fundable, but we've never seen a deal, you know, that was any kind of good-to-okay deal and above that didn't have an easy time of raising outside equity.

Royce Yudkoff:

Rick, I'd like to tack on to your comments by talking a little bit about how the company is controlled as between investors and searcher. You and I see some guardrails on this. Not all deals are the same but one path we see a lot is that the searcher just completely controls the company. They do have the majority of the common stock, 60% to 80%, but they've contractually committed a couple of things to their investors. One is that after a certain number of years – five years, seven years – the investors can put their shares back to the company at the fair market value. In other words, the investors have a contractual right to sell their shares, even though they're in the minority, even though the searcher otherwise controls the business. And the second provision we usually see paired with that is that investor consent is needed if the company is going to do any kind of deal with the searcher or the searcher's family, what are called affiliated transactions. That's a common governance pattern.

Rick Ruback:

I think searchers have to think about that. Royce, let’s get back to the conversation.

_____

Rick Ruback:

Sam, we like to end our podcast by asking the people who've been kind enough to participate if they have any questions for us. So, what do you think, Sam? Any questions?

Sam Rosati:

I do. In theory, the brightest minds in our country, in the world, are going to Harvard and they're learning about ETA. What is the inside baseball around the vibe of ETA? Is it becoming more and more popular? Are people leaning self-funded or traditional? You know, is it becoming less popular because we've seen it play out and it's harder than it looks? What are your students saying about ETA at HBS now?

Rick Ruback:

I think it is increasingly popular. I think there is enormous interest in this topic, both because traditional jobs have become less appealing, and this opportunity has become normalized.

Royce Yudkoff:

Meaning they've seen cohorts of students before them go and it works out well on average for them.

Rick Ruback:

Yeah, I mean, we run this session in our spring class where we invite people to bring their family members. We usually do it in the evening on Zoom, and we'll have hundreds and hundreds of people from all around the world. And we used to get questions like, "Why did you do this to my child? My child was going to go get the job at McKinsey. They're happily married. They're going to go have grandchildren, live in the suburbs. And now they're going to sit in the basement in their pajamas looking for a business to buy. Why did you do that? Why did you wreck our kid?" We’ve had this conversation. We hear that less and less these days and it has now become a reasonably well accepted career path.

Royce Yudkoff:

At HBS, like at many other business schools, as ETA developed, it was almost all a funded search approach to searching. That is, everyone who did this would raise money from an established group of investors in funded search. They'd get a salary. It'd cover the expenses of the search, and in return, they'd pre-negotiate the split up front, and the split is a lot less favorable to the entrepreneur than in self-funded search, although often they get more capital, so hard to say if the dollars in the end are better or worse. But over time, at HBS, that has moved from almost no one doing self-funded to last year it was 50/50. Some years it's been 70% self-funded. So, it's really an established, popular choice. Interestingly, it's not quite there at most other business schools. Most other business schools, for reasons we don't fully understand, still lean majority to funded.

Rick Ruback:

And I will say that the terms for funded search have improved in response to people electing the unfunded route, so the salaries, the benefits, the support have all improved.

Royce Yudkoff:

The size too, right?

Rick Ruback:

And the size.

Royce Yudkoff:

Because the funded search investors have recognized that, “Okay, you might get a smaller entrepreneurial percentage share, but we can focus you on buying bigger companies and thus deliver more dollars to you.”

Rick Ruback:

Right. It is something that is getting lots and lots of attention by our students, and including our graduates who are coming back.

Royce Yudkoff:

Yes, we see a lot of that, people who are five, eight, ten years out…

Rick Ruback:

They've taken traditional jobs, they've worked for private equity, they've worked for consulting, and now they're coming back and saying, "Wow…”

Royce Yudkoff:

"You were right, professors."

Rick Ruback:

“You know, hanging out in O'Hare Airport really isn't as much fun as I thought it would be.”

Royce Yudkoff:

Exactly.

Sam Rosati:

Very interesting.

Royce Yudkoff:

Well, Sam, thank you for making the time and it's been a privilege speaking to you and…

Rick Ruback:

…and a lot of fun.

Sam Rosati:

Likewise. Thanks for leading the charge. I don't know how many people are able to tell you this, but when they read your book, they hear you guys, sometimes it changes their life for the better. It's entrepreneurship still. It's hard, harder than I think we all imagine when we get into it. It really seems easy when we read your book or listen to podcasts, but for a lot of us who didn't know what the heck to do when we were stuck in our careers, it's been great. So, thank you guys.

Royce Yudkoff:

Thank you, Sam.

Rick Ruback:

Thank you for that.

Royce Yudkoff:

We appreciate that.

_____

Rick Ruback:

Royce, one of the things I thought was so intriguing about this conversation with Sam was his comment that reminded me of so many conversations you and I have had about what keeps institutional investors from this great asset class.

Royce Yudkoff:

And it's size, of course, the small size of these investments. There's a virtuous cycle to it, right, which is what makes either being an entrepreneur or an investor here so attractive is that the multiples you buy these good businesses at are really low. And then you ask reasons why these multiples are low and part of the answer is what is absent are these big institutions coming in with tsunami waves of cash, bidding up multiples, because they're small. They can't put $100 million to work in this space and so they stay out, and it keeps the multiples at a very temperate level.

Rick Ruback:

Right. And so the multiples are lower but on the flip side that adds kind of a price protection so that it becomes a safer investment because you're just paying less for it to begin with.

Royce Yudkoff:

That's right.

Rick Ruback:

So, it’s kind of odd. Why don't you see an institution saying, "Look, if it's good for Sam it ought to be good for me. I will just raise a bunch of capital and then invest in $50,000 chunks." And the answer is, if you're getting a 2% management fee and 20% of the capital gain…

Royce Yudkoff:

…you can't make those economics work.

Rick Ruback:

You just can't make those economics work. Because he says he has twenty deals, average size, you know, somewhere between $25,000 and $50,000. So, the portfolio must be somewhere between a million and $2 million, right?

Royce Yudkoff:

Yeah, you did that right.

Rick Ruback:

So, 2%...

Royce Yudkoff:

…is $20,000 a year in management fees for a private equity firm to create a very significant portfolio, in terms of number of phone calls and number of deals you've supervised.

Rick Ruback:

And managing a group of limited partners. And when the limited partner says, "Hey, this firm, it went to zero. Why did you invest in it? How come you never told us it was in trouble?" And you said…

Royce Yudkoff:

“I don't actually call these investments I make after I make them.”

Rick Ruback:

“I don't actually do a quarterly report. We actually haven't received financials. And none of them are audited and we don't really check on them because we're too busy.” I think that's going to result in a mess, right?

Royce Yudkoff:

Yeah. I think it's why this is a space that is dominated by individual investors, individual human beings whose money it is.

Rick Ruback:

Which is a great opportunity.

Royce Yudkoff:

It's a great opportunity. And, you know, one of the things which Sam touched on, which I think you and I both agree with, is, yes, you can't do all the due diligence you'd ideally like to do. Yes, you have a limited time to know the entrepreneur. But the set-up of these investments is so appealing because you're buying into these companies at very low multiples, because that's the market price; the entrepreneur is using SBA financing, so typically they'll be 70%, 80% financed with SBA debt; and the return on equity at the purchase, if revenue just stays the same and EBITDA just stays the same, the return on equity is great for everybody. And yes, things go wrong. But when you lay out a portfolio of twenty or twenty-five of these, the odds are it'll do okay.

Rick Ruback:

You say that with such conviction and I know it's because I'm a successful salesperson, because I've been trying to sell you that idea for years. But I also know that you are more likely to slam dunk a basketball than actually have an investment that's going sideways and not pick up the phone and call the entrepreneur and say, "What can we do to help? How come things aren't going well? What levers can we pull? How do we get this ship back on course?" Because you're an active investor, deep down inside.

Royce Yudkoff:

Yes, that's all true. I don't think I could do this myself because I grew up in private equity, where control is part of it. Maybe I've become an academic, where I can actually identify the…

Rick Ruback:

Well, you are an academic now.

Royce Yudkoff:

Yeah, I am an academic now. So, I can see the truth and point it out even if I can't do it myself.

Rick Ruback:

Yeah. It is an intriguing thought that this asset class exists and it's available, it doesn't have to be particularly high net worth individuals.

Royce Yudkoff:

That's right.

Rick Ruback:

If you have $500,000 saved for your retirement, this isn't how to invest it. But I think if you don't have a situation where you have a particular horizon in mind…and I also think you don't want to have one, two, three of these. I think Sam having twenty is great. He's approaching the range where he's getting diversification. One more thing about this, Royce, is there are so many people interested in making investments in these unfunded searches. It's really remarkable. I think just listening to Sam's enthusiasm for unfunded searches and his discussion of the breadth of the investments that he's made, as well as other investors he works with, I think it's just really exciting and opens up opportunities for unfunded searches that probably rival funded searches. And it's just really nice to see this network of investors evolving and I think is a great asset to unfunded searchers.

Royce Yudkoff:

I agree, Rick. And, in particular, the market has changed from one where someone who's an unfunded searcher has to create their investor base out of pure networking. Now, you can actually call on a recurring investor in self-funded search, like Sam, and if he likes the deal, he's going to introduce you to other people in his prior syndicates and help you build out that group of investors, even if you're starting with no contacts of your own.

Rick Ruback:

Yeah, maybe it's like a funded search was a couple decades ago.

Royce Yudkoff:

It's very exciting. It's really wonderful for entrepreneurs.

Rick Ruback:

It's opening up the next chapter.

Royce Yudkoff:

That was a great conversation with Sam, Rick. We learned a lot about investing in self-funded search. In our next episode, we'll be hosting Will Young, a former student of Rick's and mine who bought AeroWave Technologies, a fascinating company based in Dallas that sells and services two-way radios to schools and other companies and institutions. We'll hear how Will bought the business and how he's grown it successfully, together with his team.

Rick Ruback:

Royce, do you remember last season?

Royce Yudkoff:

I loved last season and I loved best our final episode.

Rick Ruback:

That’s right, and we’re going to do it again. We’re going to take questions from our listeners once again…

Royce Yudkoff:

…and then you and I are going to answer the questions they’re sending in.

Rick Ruback:

We’re going to try anyway. The best way for them to get the questions to us…

Royce Yudkoff:

…rickandroyce, as if it’s one word, at hbs dot edu.

Rick Ruback:

Because we’re really one team.

Royce Yudkoff:

Almost one person.

Rick Ruback:

Hardly of one mind on most things but that’s what makes it fun.

Royce Yudkoff:

You’ve been listening to Think Big, Buy Small. We’re your hosts, Royce Yudkoff…

Rick Ruback:

…and Rick Ruback.

Royce Yudkoff:

Katie Zandbergen produced today’s episode. 

Rick Ruback:

Craig McDonald is our audio engineer. If you have any questions, comments, thoughts, feel free to just e-mail us, rickandroyce, all one word, at hbs dot edu.

Royce Yudkoff:

We’ll be back next week with another episode of Think Big, Buy Small.