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. Hey, Royce, it's Q &A Day.

Royce Yudkoff:

My favorite session of the year, Rick. How about you?

Rick Ruback:

Well, I don't know if it's my favorite. You know, usually we get to talk in our comfort zone, you know, and Q &A can pull us out of that. That's why we teach by the case method. We ask the questions, not them.

Royce Yudkoff:

That's right. It makes me feel like how a student must feel.

Rick Ruback:

Yeah, and so Katie, our producer, is here ready to cold call us and it's a little scary.

Katie Zandbergen:

Well, it's funny that you should just mention cold call, Rick, because our first question comes from an HBS alum in the Class of 2020 who mentions cold calling. They write: I have greatly enjoyed your podcast. It's all the fun of class with no risk of a cold call. My question for you is as follows. I'm curious, what motivated you to become podcasters? I anticipate part of the answer is to introduce search to a broader audience. But what was the story behind the decision? And who between you had to be convinced that this was a good idea?

Rick Ruback:

Well, Royce, would you like to start with that one?

Royce Yudkoff:

You know, I think – there's no reason our audience would know this – but the way we sort of get to places in our intellectual process is one of us proposes something and the other one takes the other side of it and then we explore that for a while and, as you know, frequently we then flip without actually making a decision to do that, but we find ourselves on opposite sides of it. So, I don't really think of things as like one favors, the other disfavors. I sort of feel like we’re operating a human lapidary, where we're just exploring all sides. That's my answer. How would you answer this question?

Rick Ruback:

I would say Royce dragged me into the podcast kicking and screaming.

Royce Yudkoff:

But you're happy now!

Rick Ruback:

I'm as happy as I ever get. No, it’s been a great opportunity to meet people and to extend our audience beyond the HBS classroom, beyond the people who read our book. My old thesis advisor, now departed, Mike Jensen, at one time published a paper in the Harvard Business Review. And his University of Chicago colleagues, in particular, were just offended that he would want to publish something in the Harvard Business Review. And I remember having dinner with Mike and he said, “You know, if I could have published in the Reader's Digest, with their 60 million readers, I would have done it. It's all about outreach and influencing people.” And that's the way I feel about the podcast. We can talk to two or three hundred students a year. We talk to eighty thousand or so in our book. Our podcast lets us talk to several thousand each time we do an episode.

Katie Zandbergen:

When we, at the end of every episode, reach out to listeners and ask them to send us questions, I'm always really excited to see what lands in the rickandroyce inbox. And we received so many questions this time around from aspiring acquisition entrepreneurs, so folks who haven't yet started the journey. This first one comes to us from a current undergraduate student who writes: I'm a junior at the University of South Carolina. I came across the world of ETA and search funds this past summer and was immediately enthralled by the idea. Since then, I've read segments of your book, listened to all the episodes of Think Big, Buy Small, and read a few studies from Stanford and Booth. I'm currently wrapping up an internship with a search fund and have enjoyed putting what I learned to work through company sourcing. However, it seems that this version of entrepreneurship is barely known or discussed among undergraduate programs. So, I have a few questions and I would love to hear your thoughts. As an undergraduate student interested in ETA, what steps should I take now to prepare myself for a successful career in ETA? For instance, how can I effectively build a network within the ETA community? And is it feasible to skip the traditional MBA-to-ETA route and go right into it after a few years working in corporate? In short, any discussion surrounding how undergraduate students can begin thinking about ETA would be incredible. What are your thoughts?

Royce Yudkoff:

I'd like to take the second of those questions first, if we could, which is, can you skip an MBA? Rick, I think this is one of the areas that doing the podcast has shaped us a bit, because if you go back five years, I would say you and I were skeptical that someone could become a small firm CEO without some years of business experience and an MBA - although we certainly recognized it was possible. In the course of this podcast, we've met lots of people who have some useful, relevant business experience and no MBA, and they do fine. So, I take away that, yes, you absolutely can get there without having an MBA. It is important to have some kind of experience which, you know, exposes you to management, exposes you to being able to do basic accounting, read a P&L. No one is fully ready to step in and be a CEO for the first time. No one ever has jobs in every possible function, but you know, if I had to put a number on it, and it varies by person and the type of experience, somewhere between, you know, five and eight years of actual useful, relevant work experience, but no MBA. And I don't see why someone couldn't do that. Rick, I don't know whether you see that the same or different. What are your thoughts?

Rick Ruback:

I agree with most everything you've said. I don't know that there's any particular length of time that somebody has to work. What I think the MBA gives you, which is really hard to replicate, is pattern recognition, particularly on programs like the Harvard Business School, where we teach by the case method. We do that because what a student is seeing three times a day are companies that are facing different problems and different challenges and different opportunities. And through just two years of three cases a day, the students see hundreds and hundreds of situations. And then, most of the time, those situations never occur in real life. But two things have happened. They’re conditioned to make decisions quickly and without complete information. And, oftentimes, you do see the same situations coming up again and again and again. So, some of these cases really resonate and they just contain some truths that can be applied outside of the case setting and they allow for this pattern recognition. So, you need to find a way of getting that pattern recognition. And my problem with the five to seven years is most people who work in a job for five to seven years walk up the corporate ladder during that five or seven years, but they're doing the same kinds of things. So, I would say, if you really want to do ETA and you don't want to get an MBA, what you should do is change roles periodically. Go from the production side, to the sales side, to the engineering side, to the accounting side so that you get to see more facets of the business because when you're a small firm entrepreneur you end up doing it all and you better see it all ahead of time.

Royce Yudkoff:

On the accessing the ETA community, it's actually a very welcoming community. And steps that I would suggest are attending some of the conferences that are open to the public at various business schools, like HBS, like Booth, like Stanford, where you'll meet a cross-section of aspiring searchers, current searchers, former searchers who have bought businesses, investors, and many of these people will welcome follow-up. And then I would spend time during my breaks, or maybe even within school, interning for a variety of searchers. This is a way to pick up some of the experiences Rick has mentioned, but it's also a way to get yourself known within the community. And I think those two approaches, before long, you'll just have met a lot of people who are active in the search community.

Katie Zandbergen:

Along these lines, another listener sent a question saying, “I'm twenty-five years old. I've worked in wealth management and currently work as an account manager at a SaaS company. But I'm still feeling too young and inexperienced to pursue ETA. I'm wondering, what are common traits of successful search fund entrepreneurs? And can those be developed or do you think they're more innate?”

Rick Ruback:

Let me take a stab at this first, Royce. I mean, it all depends on the company you buy, but years in wealth management may not attune you to the challenges of running a smaller business. You're dealing generally with lots of resources. That is to say, the clients have lots of resources and the firms have lots of resources because otherwise the clients would be unhappy. It's usually a highly-resourced activity. Do you think that's right, Royce? I think that's right.

Royce Yudkoff:

Absolutely, yeah, typically very professional.

Rick Ruback:

He's also an account executive at a SaaS company. That's probably more helpful. It's giving you some knowledge of sales, but I don't know if it's giving you that belly-to-belly sales opportunity that is so often required in small firms. So, I think the real challenge is that this listener is taking jobs that work really well if you want to stay in those jobs but may not be working really well if you want to gain the experience to actually become a small firm entrepreneur. You're probably going have to give up something to switch over to the kind of jobs that give you the kind of experience – that's not to say financial service jobs are bad or aren't wonderful - but if you want to do this, this is a dirty fingernail job.

Royce Yudkoff:

I agree with that. The other part of the question, I think, Katie, was what are the traits that make for successful searchers?

Rick Ruback:

Oh boy, I sure wish we could tell ahead of time, don't you?

Katie Zandbergen:

And can they be developed or are they innate?

Royce Yudkoff:

It's hard to tell ahead of time because I think, Rick, what we found is there's no small handful of traits that all of the successful searcher CEOs have in common. They get there with different strengths.

Rick Ruback:

Wouldn't it be great if you could just go through a little checklist? We know CEOs that put a strong emphasis on this personality testing and ability testing, and maybe that would help. We've never really tried that. You know, we do that session with Tim Butler every year on the traits of a successful entrepreneur. And that session really is the traits of people who want to do that task.

Royce Yudkoff:

That’s right.

Rick Ruback:

And if you think about what those traits are, it's a lower value on affiliation. So, they care less about the brand name, they care less about the social network that they might meet at work, and they care more about this kind of fierce independence, that they get to control their own lives and that they can influence the lives of others.

Royce Yudkoff:

I agree with that list. I just don't think there's a common template for successful CEOs, perhaps other than tenacity. You know, I think these are all people who don't give up easily when faced with problems and adversities. But beyond that, you know, when you turn to how do you solve problems, each one seems to have a different portfolio of strengths.

Rick Ruback:

Right, we have not seen a lot of successful sloths.

Katie Zandbergen:

All right. So, we received this question from a listener that was an interesting take, I think, on the MBA question – like, “Should I get one? Should I not get one?” – because most of the questions that we've received around considerations of whether to pursue an MBA or not really come down to the skills that you're going to learn in the program, the hard skills. And this question takes, as I said, a slight spin on that. And it is as follows: I've been following the traditional investment-banking-to-private-equity path and even had an opportunity to get some business development experience along the way. I don't have direct operating experience, but I think I could run a business. I'm considering a self-funded search after my private equity stint, where I'll have around $250,000 to invest. My other option is attending an MBA program, but the debt from tuition and living expenses would likely make a self-funded search unfeasible, pushing me toward a funded search or back into private equity, which I really want to avoid. Without knowing every detail of my life, how would you guide me in making this decision?

Rick Ruback:

First of all, I want to know more details about this person's life.

Royce Yudkoff:

He just said, Rick, that you can't know that. That's not part of the case facts.

Rick Ruback:

But I want to know it. I mean, this idea of planning a life so far ahead is just fabulous.

Royce Yudkoff:

Here would be my thoughts on this. One of the reasons that most searchers who buy a business are successful is because they pick a business which is a good fit for their skills. In other words, they're not just randomly drawing from a hat. They're looking at lots of businesses. Of course, they're checking the financials and doing due diligence, but along the way, they're getting to know the owner and the business process, and they're making an assessment, “Could I run a business like this?” Rick likes to say, “If you're allergic to fur, don't buy a pet shop”, and they're doing sort of the inverse of that. My answer can't be, “You're obviously a smart person because you're doing well in private equity and sure, you can transfer over.” I think the way you get to the answer is that you start looking at companies and the companies you really like, you visit with the owner and you learn a bit about the company and you keep that question at the forefront, “Can I do what this owner does or does that seem remote to me?” That's how you answer this question. And I think it's very possible for someone at that age, with that experience to run a business. And I think there are businesses that are just inaccessible, but you can sort that out through sorting through those collection of businesses for sale. Rick, your thoughts?

Rick Ruback:

Interesting answer, Royce. What I would worry about with this listener is not that they couldn't do it. It's that they might do it and be unhappy after they did it. Because one of the things I think you should do is always try to look ahead at what that lifestyle is like. And one of the huge differences between financial services, investment banking, private equity, and the ETA path is that the ETA path tends to be under-resourced. You're making do with what you have. You're doing the accounting yourself, you’re sitting at the dealership trying to decide whether you should buy a new van or a used van. I think you need to figure out if this other life makes sense to you. It's sort of like sitting at your desk and deciding if you want to be a downhill ski racer, but you don't like going fast and you don't like the cold. You’ve got to learn to see if those characteristics, in fact, fit you. Now, you could probably find a business that aligns with your traits, characteristics, things you like. But I think that's going to be a challenge. I think you're going to have to bust out of your comfort zone and find some opportunities to learn about what might fit nicely for you.

Royce Yudkoff:

I mean, that is one of the things business school does. You know, like at our school the case method exposes you to hundreds of different businesses and brings in lots of guests, and a byproduct is you get a flavor for different types of companies.

Rick Ruback:

Yeah, the other part of his question that I find so interesting, which is why I wanted more details, is this idea that, “I have $250,000 and if I go to business school, I'll presumably exhaust that $250 and have a bundle of debt and won't be able to be a self-funded searcher.” This concept that says you need a lot of capital to be a self-funded searcher is an odd one, because you really don't. What you need to do is pay your living expenses and be able to manage the risks of broken deal costs. Other than that, search expenses are quite small and you don't have to put your own capital into the deal. You can get other investors to put in that capital. You'll give up some equity ownership, but you'll get other investors. So, you're not forced to the funded path simply because you don't have any money. Now, and this is the part I wanted to know…do we know the gender of this person, Katie?

Katie Zandbergen:

Yeah, male.

Rick Ruback:

So, if he has several children, elderly parents he's taking care of, other cash flow obligations that, you know, might not be postponable, maybe then he does get pushed to the funded search path. What do think of that, Royce? Do you agree that you don't need money to be a self-funded searcher?

Royce Yudkoff:

For sure. Investors view the time and commitment of your talent to searching and buying as sufficient sweat equity, and in a self-funded search, my goodness, you know, most of your equity will come in the form of carried interest. It's just not going to make a big difference how much cash you put in.

Rick Ruback:

Right. Most self-funded deals, the entrepreneur puts in no cash.

Royce Yudkoff:

That's right.

Katie Zandbergen:

So, the next group of questions I'm going to ask you, we received from folks who are currently searching. And the first is: I'm listening to your podcast and reading your book and I'm looking to buy a business. In my search I have started to receive e-mails about franchise opportunities. I've spoken to a few potential franchises and started listening to podcasts regarding franchises. I know that there's a wide variability regarding the quality of franchises and that starting a franchise in a new area is like a startup in a box. But if we put those two aspects aside, do you think about franchises structurally differently than buying a stand-alone business? Are they also good options that searchers should consider? Or are there reasons why existing stand-alone businesses are better investments and provide better outcomes?

Royce Yudkoff:

There's so many different kinds and qualities of franchises that it's almost like asking about businesses generally. What I would say about franchises is they bring a couple of big advantages. One is that franchisors are required to file with state regulatory authorities tons of data that gives economic information – profit and loss information, in great detail – about franchisees, so you can get a sense of whether franchisees are very profitable, all sorts of information that is really hard to get about any other industry filled with small businesses. And second, you get a lot of data. As you run a franchise, you get comparisons to other franchisees. And this is impossible in small businesses if you own a small company, to know how good a job are you doing versus other people who run the same kind of business? So, that wealth of information is a really useful thing and is a reason to maybe focus on franchises within the world of small business. The reason that you might give pause to that is when you go into a franchise, you become partners with the franchisor. Not partners in the sense of he owns half your business or she owns half your business, but in the sense that if they do a good job, it really helps you a lot. If they do a poor job or if they turn their fangs towards their franchisee population, it can be really painful. And so you're taking on a partner here who's going to have a big influence in your life, and sometimes that'll work out well and sometimes poorly. So, it's a good idea to look at franchises, but it's going to turn very much on picking out the right system, which offers you the right economics and the right partnership with the franchisor. That would be my reaction. Rick, would you modify? Would you add?

Rick Ruback:

I would just add a little bit, which is one of the things that is really challenging about startups is there's no established business model. We don't know what the enduringly profitable business model is of most ideas. In franchising, the franchisor has built a business model and that's sort of what you're buying. You're buying the branding, you're buying the advertising – although you pay for that – but you're also buying the business model. And you know if you put these two golden arches up and you make hamburgers a particular way, it's all going work out okay. So, for an established franchise, that works out really, really well. Many people though are going to go into franchises that are off the beaten path. They're not the household names. They're not the golden arches. And with that you then have to do all the things Royce talked about. You have to really evaluate the model. But if it's a franchise where you see lots of people successfully pursuing the model and the franchisor seems to be aligned with the franchisees, in terms of growing the business, then it can be an excellent path because you're getting an established business model, and that's what I really like.

Katie Zandbergen:

This next question comes from a Harvard Business School alum from the class of 2021. They write: I thoroughly enjoy listening to your Think Big, Buy Small episodes. It's almost like being back in class, especially since my EC fall was virtual due to COVID. My question for you is what diverse set of qualities / perspectives do you recommend searchers assemble in an advisory board, in addition to legal and accounting? I continue to hear searchers reference their “team of advisors” who act as a sounding board during the process. I've kicked off my self-funded search and would love to hear what you've seen work well or not so well and how to best utilize this team during the search process.

Royce Yudkoff:

I think it's extremely valuable to build a relationship with a small number of other searchers who are where you are in the process because a load of your questions are going to be where talking to someone else who's following a slightly different path will help you sort out, “Is this a reasonable term in the non-disclosure agreement I received from a broker? I'm trying to model this business and I'm confused on this.” So, part of your team of advisors should be one to three people who are searching like you, who you like and respect, because you'll find you'll trade ideas with them all the time. That would be one element. Rick?

Rick Ruback:

There's almost always more investors than you have room to have advisors. And so the question is which investors you pick as advisors early on. So, first of all, I think you want an advisor / investor who is willing to give you the time it takes to be successful. So, if you have a question, “Is this a stupid company to buy? Is this a crazy term? In a transaction, how much seller debt should I ask for? How do I deal with this key employee?”, that kind of thing, high-level questions, I think you want somebody who will make the time and take the phone call. You want somebody who's responsive. That's number one. Number two is you really need somebody who you feel like you can be honest with. People get in trouble, I think big trouble, when they have facts that they should tell their board and they don't want to tell their board because they don't like their board or they don't feel comfortable with their board. So, if there's bad news, you want to have a relationship with somebody on the board that you can say, “Hey, this bad thing happened. What do I do?” One hopes there's never bad news in the business, but that's not the universe. There's good news but there's occasional pieces of bad news that you want to get out to your board members quickly so they can help you respond. One of the questions that I always have is whether you need industry expertise on your board of advisors. Now, obviously if you're starting your search, you can't do that because you don't know what industry you'll be in. I don’t know. I have a mixed view of whether industry expertise is helpful. Certainly in some industries it is, but what I think is really important is an open mind, a relationship, some creativity, and some willingness to put your shoulder to the wheel and push away as need be.

Royce Yudkoff:

Rick, I particularly liked your observation that wanting to find people who'll take your call. You know, my experience on this is that you want talented advisors. Unfortunately, talented people are usually busy people.

Rick Ruback:

That's right.

Royce Yudkoff:

So, one of the criteria for having effective advisors is that they have a reason to spend time with you. It could be that they aspire to be a prospective investor, and so they view this as in their long-term financial interest. They could be a friend and care about you. They could be another searcher and they're trading questions and ideas with you and so this is a reciprocal relationship. But don't imagine that if you just ask people to be an advisor that you're going to get a talented slew of people. You're going to get people who are not that busy, which is a bad signal.

Rick Ruback:

Right, right.

Katie Zandbergen:

All right, next question: I enjoyed your Season One Q &A episode, particularly the discussion on valuation methods and the cost of capital, and specifically DCF valuation modeling – and just so listeners know, DCF is discounted cash flow. You mentioned that in small firms, the market cost of capital is often imperfect and capital is scarce and difficult to access. Because of this, DCF may not be the most suitable valuation approach, as one of its fundamental assumptions, that you can borrow and lend at the same rate, does not hold. With DCF being less applicable, the multiple-based valuation approach has become the prevailing method. However, you both emphasized that searchers should still build detailed DCF models to understand key drivers, such as the relative importance of early versus later cash flows. I found this insight valuable and had a couple of follow-up questions. One, what type of financial modeling is most common for searchers to perform? DCF, LBO, or another approach? And do you offer any modeling templates for beginners to help them get started? What do you guys think?

Rick Ruback:

Well, let me take a stab at that because I think…

Royce Yudkoff:

I'm wondering if you sent in this question under another name, Rick.

Rick Ruback:

I didn't. I didn't. But I did answer the question last season in the Q &A part, so I feel a little guilty that I did this. Maybe I'm a little bit like the dentist who gives candy out. I'm just building latent demand. So, let me answer the question around modeling. It's an interesting question because I don't think about the different types of models as being all that different. The difference between a discounted cash flow model and an LBO model is just which kinds of cash flows you look at. Either you’re looking at equity cash flows or free cash flows but the start of the model always begins with revenues, costs, overhead, that kind of thing, right? So, we're building down to some measure of EBITDA. And then the question is, “What are we going to do with that?” Are we going to analyze it at the EBITDA level? Are we going to bring it down to the equity cash flow level? And if we bring it down on the equity cash flow level, we’d mostly call that an LBO model, but I think it's about the same. I think you want to do a model so that you can answer questions like, “Am I going to have enough cash in the business? How much cash should I fund at the time of closing to deal with unexpected surprises – I guess all surprises are unexpected – unexpected events? That kind of thing. Do I need a hundred thousand? Do I need two hundred thousand? Do I need fifty thousand?” And I'm going to get that by looking at how tight my cash flows are month to month. And so I'm going to do a cash flow modeling exercise, which is a little bit different than a DCF exercise because DCF usually do year-to-year. If I'm worried about my cash flows or my covenants, I'm probably going to model month-to-month. So, I would certainly do that kind of modeling to ask that question. Then the other reason you do this is you really want to know what the drivers of value are. Where does the cash flow come from? And sometimes you learn really interesting things like, “If I could just improve my SG&A function, if I could not necessarily hire different salespeople, but if I could make my back office more efficient, I might save a few percent, which is going to have a huge impact in my business.” I might learn that, because of the structure of my business, I'm going to have enormous operating leverage. And so sales are particularly important because if I can get that $500,000 of additional sales, $400,000 of those are going to drop to the bottom line because I have so much operating leverage. Those are the kinds of questions you want to have and those are the kinds of questions you want to answer, and every entrepreneur has those questions. What they don't know is how to analyze them. And so you build the model and you free yourself from your to-do list for an hour or two – I know Royce is going to snarl at that thought – but you free yourself from your to-do list a little bit and you just sit in front of your computer and you play “what if?” games and you see what's important.

Katie Zandbergen:

So this is our last question from a current searcher, which is: In the Zach Duprey episode, you talked about due diligence mistakes and said that you've seen some that were, and I quote, “horrifying”. You provided an example of not checking on the promised inventory and then, after buying the business, walking into the warehouse and realizing that there's no inventory or that it's expired or obsolete or broken. Can you provide a few other specific examples of mistakes that should definitely be avoided during the due diligence process?

Rick Ruback:

Oh, what a fun day this would be, Royce. I feel like if we answer these questions, we should have dolls that we can stick needles into.

Royce Yudkoff:

Well, let me start on this – and Rick, I know you'll have some comments on this. First of all, don't be paralyzed by the prospect of a due diligence error. The truth is when you step back and look at all of the searches that Rick and I follow, overwhelmingly, the due diligence was gotten right enough that it works out fine, that most of the first six months after searching works okay, that the surprises are offset by good news or by just hard work and good management. So, this isn't something where, you know, you're facing a grave probability of danger. One of the reasons is that the most important piece of due diligence you'll get some professional help on, and that's determining that the past financial results are accurate and representative of current financial results, the so-called quality of earnings that's done by an accountant or a mergers and acquisitions advisor. Having said that, I would say that one of the most common due diligence mistakes is that thrifty, smart sellers who really know their business max out their SG&A before they sell the company – that is, every single department cannot take any more volume without adding more people or more expenses. And that's very difficult to tell from the outside, that that's going on. But what it means is you, as the searcher, have bought this business and you have a plan to grow sales 10% a year. But what you're not doing is you're not budgeting in the first necessary expenses to add a sales manager in this region, add another accountant, add another production foreman that'll proceed any growth in sales and mean your profits go down. So, I think that's the most common.

Rick Ruback:

It's the opposite of operating leverage, right?

Royce Yudkoff:

Yeah, exactly.

Rick Ruback:

It's the opposite of operating leverage. You think you can grow and get all these great returns to being bigger, and what you learn is you're at that nasty point at the step function. And you take that first step and you just fall through.

Royce Yudkoff:

Exactly. And it's just really hard to detect that. There's no analysis you can do, even when you walk through the facility or ask people. It's just very tricky. So, we see that a bunch, don't you think?

Rick Ruback:

Yeah, we do, although I think we've come to recognize that when we see it. But it's interesting that if you see a business that's the last year was a fabulous year, you say, “Oh, I'm not sure I want to buy that business. They're obviously selling at the peak.” And then if the previous year was the best year and this year's down a little bit, you say, “Oh, maybe the business isn't sustainable. Maybe they're trying to get out of the sinking ship.” You know, maybe there's just no perfect time to buy a business and you just have to evaluate the situation that you're seeing. Anyway, back to due diligence mistakes. The one that I find most troubling, and I wish I could say I've never made it, is mischaracterizing the revenue as recurring when in fact it's more episodic than it looks. And this can happen so many different ways. You find businesses that have massive backlogs and you say, “Well, of all the things I have to worry about, I guess I don't have to worry about revenue.” Well, if the economy takes a little bit of a downturn, you could see that entire backlog disappear, and one of the things you learn is that people had put orders in not because they necessarily wanted the stuff but they wanted the spot in the production line. And once they decide they don't need the spot in the production line, they're moving away. Your customers, perhaps they're all part of a cyclical industry. So, mischaracterizing revenue as recurring when it's in fact episodic is, I think, the most painful due diligence mistake. You know, it's really hard. Royce and I, in our classes, talk about the difference between repeating revenue and recurring revenue. And sometimes it's really, really hard to tell. It has to do with, “Does the customer have switching costs? Do they have other alternatives?” And, you know, you can't tell from the outside. Often it's the kind of thing that you learn when you're in the business. And then you start pulling hair out – if you had any – and then you say, “Ah, geesh, I can't believe I made that mistake. Darn!”

Royce Yudkoff:

I think that's a good point you're making, Rick, because when you misestimate the quality of revenue, that's something that's really hard to fix. Transforming the revenue quality is super difficult, unlike fixing a cost structure or changing out people if they're not what you thought they were. You can't do that with revenue.

Rick Ruback:

Right. And it's a little bit like customer concentration or supplier concentration, but those you know, you find those.

Katie Zandbergen:

This next question comes from a listener who recently closed on their deal.

Rick Ruback:

Congratulations.

Katie Zandbergen:

Yeah – writing: What resources can you recommend for the post-acquisition experience that would help in managing the change in CEO and ownership, as well as in operating and growing the acquired business?

Rick Ruback:

A case of scotch.

Royce Yudkoff:

I actually think that the best resource is right in front of you and it's the business itself. If you pay attention to how the business works, six and twelve months later, you will be transformed, in terms of your ability as a CEO of that business. And so one of the things that Rick and I always say to searchers who buy businesses is, “You're going to have lots of decisions to make every day but on big decisions, which we define as decisions that are hard to reverse and expensive, try your mightiest to defer those decisions for at least the first six months because you will be a much higher quality manager.” So, the resource is right in front of you, it's the business you just bought. If it's the kind of business we suggest you buy – that is, an enduringly profitable business – it will be fine as you learn it. Just pay attention and don't make any major decisions for six or twelve months.

Rick Ruback:

Let me just add to that, beyond my case of scotch, I would just say what you need to do is not overburden the company by acquiring additional resources. So, you don't want to hire a strategy consultant if you're a $500,000 EBITDA business. You don't want to hire an IT consultant. You don't want to hire a CRM consultant. You don't want to add to the overhead costs of the business. I think it's really important to pay attention to what Royce just said. The business has been doing really, really well. That's why you bought it. Just continue it for a bit. But be very resistant to adding costs, particularly fixed costs. What do you think, Royce? You think you should hire a career coach?

Royce Yudkoff:

I wouldn't hire a career coach.

Rick Ruback:

Hahahaha!

Royce Yudkoff:

I would save the money because you're likely to find something more valuable to spend it on in your small firm, like a salesperson or something like that.

Rick Ruback:

Yeah, I agree.

Katie Zandbergen:

What about searchers working with recruiters? Like, once they've acquired their company, I've heard of folks who want to form a good relationship with a recruiter because hiring is such a challenge.

Rick Ruback:

I mean hiring is a challenge, but you don't know who or what you want to hire until you've been in the business for a while and you can really make an assessment of who's doing their job well, who's doing their job poorly, what the opportunities are, where you should shrink, where you should grow. Do you want to offshore some of your management functions? All those things you need to ask questions about, but you don't know the answers until you bathe in the business for a while.

Katie Zandbergen:

Right. Next question: I'm an HBS grad from the 20th century. I first learned about ETA during a talk that Rick led during a reunion event, and it's been in the back of my mind ever since. Having recently retired from corporate life, I'd like to focus my next chapter on supporting young entrepreneurs pursuing ETA. In your book and podcast, you mentioned that deals below $2 million pre-tax earnings are typically priced at a three to five times multiple. Investing in ETA deals looks really attractive when priced in this range. I've also seen studies from other business schools weighted towards typical funded search, that suggests that deals are typically done at or above six times pre-tax earnings. As an investor, I'm hunting for 30% IRR deals. This drives towards smaller deals with self-funded searchers or larger sponsored search deals with higher growth rates. You talk on the podcast about the trade-offs for searchers between sponsored and self-funded. How about for investors?

Royce Yudkoff:

I think the questioner has a good understanding of the search market and there's basically a classic growth value divide among investors. I think investors who believe that growth is a great path to make money lean into traditional search because the average traditional search acquisition is a $16 million enterprise value that was bought at about seven times, and embedded in there is the prospect of growth because when you buy a business at seven times EBITDA you will not get to a 35% return without growth. You know, after you compute the effect of financial leverage you will fall far short of 35% unless you get some reasonable rate of growth.

Rick Ruback:

Can I just add to that? And in those deals, there tends to be less leverage.

Royce Yudkoff:

Yeah, exactly.

Rick Ruback:

And I was just going to say the other thing that's really key about those deals is they assume that they can sell at the same multiple they bought at. When you buy at four, it's hard to imagine it's going to go down to two – maybe it could, but it would be an unusual time. But if you buy at eight, it could easily go down to six, and the distance between six and eight can destroy decades of good work.

Royce Yudkoff:

Yes, because the business has financial leverage on it so those two multiple clicks come off your equity, not off the total enterprise value.

Rick Ruback:

Yes, it is so sad.

Royce Yudkoff:

And self-funded search is the other alternative. That is the place for value investors because you're typically buying smaller businesses that are lower growth rate businesses, but you're getting them for four to five times and often with higher leverage because these searchers use SBA financing to get a higher loan-to-value ratio. My partner has revealed him and I as value investors, I think, Rick.

Rick Ruback:

I think I've said that before.

Royce Yudkoff:

You’ve said that before.

Rick Ruback:

Do you disagree with that?

Royce Yudkoff:

No, I do agree with that. I guess what I wanted to say is, it's not a closed case on this. It's a question of who are you and what is your investing style? What investing style do you prefer? And that should dominate which of these two approaches to search investing you take.

Rick Ruback:

The other thing I think it's important to say to this investor, because this investor has revealed something about himself, which is he's retired from his corporate job. So maybe he retired at fifty-five, but let's suppose he retired at sixty-five. One of the questions you have to pay attention to is liquidity. These are among the most illiquid investments on the face of the earth. It is hard to imagine a secondary market in which you could sell and create a liquidity event in search fund investing. Probably a better chance in a funded search than a self-funded search, but either way, really an uphill battle, I think. So, it's worthwhile to recognize that the hold period of these investments can easily be a decade or more. It's not unusual to see them out at fifteen years. You know, if you're sixty-five, you got to ask the question, do you really want to be in this investment at eighty? Because you might well find yourself in that investment at eighty. The public markets have a great liquidity and that is part of the reason why the private markets have higher rates of return, because you're giving up that liquidity.

Katie Zandbergen:

All right. We received a number of questions about artificial intelligence. So, the first question: My question pertains to AI and entrepreneurship through acquisition. With recent advancements in AI technology enabling smaller teams to accomplish tasks that previously required larger teams, how do you think these developments will impact those pursuing the ETA path? Do you foresee greater success and efficiency, or do you see potential risks due to the rapid pace of technological change. And just following up: How do you think about the use of AI tools for due diligence? Do you think that they potentially add value or is it best to rely on more traditional methods? What are your thoughts on artificial intelligence and ETA?

Royce Yudkoff:

What I think about most is, when I'm looking at a business and artificial intelligence makes less expensive, whatever they're producing, are they the kind of business that will have to pass that savings along to their customers because they're in the kind of competitive business where their competitors are also applying those technologies and bringing their costs down, and competition causes all prices to go down, and customers are unsticky enough that they can beat together the heads of different vendors? What I want, knowing that there is this kind of cost reducing technology coming along, is a business which is more likely to benefit from those cost savings because they don't have to pass them on, the kind of business where the customer doesn't want to switch because it's not in their interest and you can keep that excess margin. The direction of the technology itself is beyond my capabilities and training, but possibly being able to assess how sticky customers are as the production costs of their vendors are going down, that I think we have a shot at getting right.

Rick Ruback:

Interesting answer, Royce. The other thing I would think about is the application of AI to search itself. I think you would imagine – I certainly did – that AI would be a great benefit to searchers. And what we've seen so far is it's been less of a benefit than we imagined. And I think I am beginning to understand why. I am not an AI expert by any means but I think AI is really good at processing information. What that requires is information. And small firms are wonderfully secretive. They often don't know what their financial results are, never mind sharing them with anybody and providing them in any public space. So, AI, I think so far, would have to sort of invent the financials and then interpret the financials. And I don't think they're there yet. So far we've not seen enormous advantages in AI in the sourcing world. We've seen some efficiencies. People can write better e-mails by using AI. But our students report back to us that AI really is replacing interns, not replacing searchers. That is, what they used to have interns help them, you know, collect the information to write a personal letter to a CEO, now that they can use AI, the problem is – same problem with the interns – is if the information's wrong, you know, there's no way to recover from that, right? With that particular seller. So, so far AI, I don't think, has been a great advantage on searching. Maybe that's going to change, but it hasn't yet. What do you think, Royce?

Royce Yudkoff:

I do think that's right. And I was reflecting, you know, that, say, maybe a decade ago, you and I would see occasional breakout students of ours who would use e-mail in creative ways to get to owners. You know, they would have fifteen staged e-mails and drip them into the owners of companies, at scale. You know, they'd be doing this with thousands of owners and, for a while, they got a leg up on other searchers and produced some interesting deals. But that knowledge proliferated and soon almost every searcher was using mass e-mails in a very sophisticated way. And I think that owners of businesses kind of became thick skinned to that and that's forced searchers to find other ways to get to those owners. I'm fearful that AI will also become like that. As it becomes more widely understood, the competitive baseline will just move up and it'll be hard to get an advantage from it.

Katie Zandbergen:

All right, gentlemen, final question – and this is a good one: You agree on so much that is discussed in these episodes of Think Big, Buy Small. Are there any topics related to entrepreneurship through acquisition on which you don't agree?

Royce Yudkoff:

That's a fun question.

Rick Ruback:

That is a fun question. I saw that question just before I took my dog for a walk and I thought, as I'm walking through the icy woods, “Well, Royce would be meditating and thinking about this in a museum.” You know, there are so many differences in our personal styles, but I'm not sure we have any strong disagreement about ETA itself. I think we have some preferences. I am more intrigued by smaller businesses, I think, than you are, Royce. And you’re more open to larger businesses than I am.

Katie Zandbergen:

Defined how, Rick? Like, what's smaller?

Rick Ruback:

If somebody tells me they're going to buy a business with $500,000 of EBITDA, I think that's fabulous. And if somebody tells me they're going to buy a business with $6 million of EBITDA, I say to myself, “Wow, that is a daunting task.” And I'm not sure Royce sees the world in that same way. Is that fair, Royce?

Royce Yudkoff:

Yeah, that is very fair. You and I have been working together and friends for a long time.

Rick Ruback:

Fifteen years.

Royce Yudkoff:

Fifteen years, exactly. And more than any other topic, we've talked about ETA over that period – by no means exclusively, but a lot. And so when you see us today, you know, recognize that there have been thousands of hours of discussion of different issues, and so it's not a surprise that we would come to a consensus on a whole bunch of these points. They may not have started that way. If you had sat at lunch with us a dozen years ago, I think there would have been more things where, you know, we didn't exactly agree, but we’ve kind of, I guess, each of us has improved our understanding through this partnership.

Rick Ruback:

Yeah, I think that's right. I will just reflect, Katie, that yesterday we were having a meeting with an entrepreneur and this particular business, it's not cyclical, but it's episodic in the sense that there are up years and down years. And what we discover is that bond covenants can be a real annoyance in a business like this. We've known that. And I heard out of Royce's mouth – I woke up in the middle of the night saying, “Hmmm, I wonder if that was really Royce” – and Royce said, “Maybe this business just shouldn't have any debt.” And I don't think I would have ever heard that…

Royce Yudkoff:

This might be your influence, years and years of saying that adding debt to businesses doesn't create any value in and of itself. Maybe it's finally influenced me, Rick. How about that?

Rick Ruback:

Yeah, I don't know. And then you said, “Well, you know, this business has a lot of operating risk. Why should it have financial risk?” And it's like, “Wow, I think I've said that once or twice myself.” And there are certainly lots of examples that go the other way. One of the ones that sticks in my mind is that there are lots of things which I've never felt the need to write contracts on, never just felt the need to write them down. And Royce is a stickler for writing down our understandings so ten years from now, we don't have to reflect back on what we think we thought then. We can actually see what we thought then. And, you know, over these fifteen years, I've just seen how valuable that is, that this kind of orderly approach to business actually allows you to do much more, that the casual stuff and the easygoing stuff seems easy and casual, but it in fact adds costs, lots of costs and frustration. And, you know, that's something that I leaned heavily against early on but I've come around to Royce's view on that and hundreds of other things. I still don't answer e-mails every day, Royce.

Royce Yudkoff:

Thank you, Rick, for that and back at you on many things I've adopted from you. But for years I was puzzled because our students view us as being so different. I think that you and I view ourselves in the important ways as being quite similar, in terms of interests and values and codes of ethics. For years, I was sort of puzzled at this reaction from students until it finally dawned on me that it's sort of a superficial and stylistic comparison, but not anything that's deep.

Rick Ruback:

Yeah, I think that's such an interesting question. I did struggle with thinking about things that we disagree on. I mean, I think, for example, you like roll-ups better than I do.

Royce Yudkoff:

Yeah. Okay. That's right. But you're finding things to like about them. See the Logan Leslie interview for more information.

Rick Ruback:

Yeah. Katie, one of the things that Royce has convinced me of over the last year or so is that there really are gains from roll-ups. I've struggled with that. But, as we talked about in the Logan Leslie episode, you can find these gains from roll-ups that can be quite substantial in places you never would have seen – in his case, better management. That's something that I never would have thought of. I think it came naturally to Royce. Royce just assumed that I understood that. I didn't. But I sure learned that in that episode.

Katie Zandbergen:

Well, it's a great partnership that you two have.

Royce Yudkoff:

Agree.

Rick Ruback:

Agree.

Katie Zandbergen:

And on that note, it's been great for me to host the hosts today. Thank you for having me.

Rick Ruback:

Thank you, Katie, for all that you do to make this podcast. We wouldn't be here without you, so thank you.

Royce Yudkoff:

Exactly right.

Katie Zandbergen:

And to Craig McDonald too, behind the scenes.

Royce Yudkoff:

Our formidable audio engineer. Thank you, Craig.

Rick Ruback:

Our formidable audio engineer. Well, Royce, this brings us to the end of another season. I can't help but think of the muppets at the end of every episode, you know, those two grumpy guys up in the corner there.

Royce Yudkoff:

That's us.

Rick Ruback:

That's us. It's been a lot of fun and I've really enjoyed it. I'm looking forward to Season Three. We have a lot of interesting guests coming up, as we kind of broaden the scope of people we talk with. It's going to be a lot of fun. And once again, in Season Three, just as we did in Season One and Two, we'll answer listeners' questions at the end of the season. So, please send those questions along. I enjoy recording all the episodes, but this is really a lot of fun. Thank you listeners for sending in such great questions and keep on doing it.

Royce Yudkoff:

Thanks everyone. We'll look forward to joining you next season. 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.