The M&A market is hot in 2021, with strong deal volume and high valuations. Kirk Michie, founder of Candor Advisors, explains the major difference in transactions with strategic buyers and financial buyers--including private equity firms, family offices, structured equity and SPACS. Kirk also describes situations which are ideal for employee stock ownership plans.
For more than 30 years, Kirk has worked with entrepreneurs, closely held business owners, and high net worth families. He has raised and deployed more than $1 billion of capital, been involved with evaluating more than 2,000 direct investments, and participated as principal or advisor on the purchase of 21 businesses, and the sale or recapitalization of more than 30 companies. His combination of investment and business experience inform his ability to help entrepreneurs navigate complex entity, family, and legacy decisions.
Selling a business is the American dream, the pot of gold at the end of the rainbow, the reward for years of hard work. Successful entrepreneurs make countless sacrifices in hopes that they would someday reap the benefits of their labor and live a new life of vacations, recreation, and prosperity.
You only exit your business once, so you should feel confident passing this milestone. A successful business exit reflects the preparation done beforehand. Failing to plan is planning to fail.
The owner of a privately held company has several alternatives on how to exit their business. In the absence of an exit strategy, events will inexorably dictate the final exit plan. A costly involuntary exit may be caused by death, disability, divorce, disagreement, or distress.
Selling Your Business with David King will help you take control of the sale process and make it positive one.
The M&A market is hot in 2021, with strong deal volume and high valuations. Kirk Michie, founder of Candor Advisors, explains the major difference in transactions with strategic buyers and financial buyers--including private equity firms, family offices, structured equity and SPACS. Kirk also describes situations which are ideal for employee stock ownership plans.
For more than 30 years, Kirk has worked with entrepreneurs, closely held business owners, and high net worth families. He has raised and deployed more than $1 billion of capital, been involved with evaluating more than 2,000 direct investments, and participated as principal or advisor on the purchase of 21 businesses, and the sale or recapitalization of more than 30 companies. His combination of investment and business experience inform his ability to help entrepreneurs navigate complex entity, family, and legacy decisions.
Selling a business is the American dream, the pot of gold at the end of the rainbow, the reward for years of hard work. Successful entrepreneurs make countless sacrifices in hopes that they would someday reap the benefits of their labor and live a new life of vacations, recreation, and prosperity.
You only exit your business once, so you should feel confident passing this milestone. A successful business exit reflects the preparation done beforehand. Failing to plan is planning to fail.
The owner of a privately held company has several alternatives on how to exit their business. In the absence of an exit strategy, events will inexorably dictate the final exit plan. A costly involuntary exit may be caused by death, disability, divorce, disagreement, or distress.
Selling Your Business with David King will help you take control of the sale process and make it positive one.
Speaker 1:
Welcome back to selling your business with David King. I'm David King, and I'm the author of selling your business begin with the end in mind, and it's available on Amazon today. I've got the pleasure of being joined by Kirk Mitchy the founder of candor advisors. Welcome Kirk.
Speaker 2:
Thanks, David. Good to be back with you.
Speaker 1:
Kirk has been with this before and we spent a little bit of time talking about his background and the services that he offers today at candor advisors, but we'll, we'll summarize quickly here that Kirk has get an extensive career in finance over 30 years dating bank to his, uh, finance degree at USC. He's worked in private equity. He's worked as a in financial advisory services. Kirk, we, do you wanna flesh that out at all in terms of what you've done and what you bring to the table?
Speaker 2:
Sure. Um, you know, candor provides transaction advisory services to successful, uh, founder led businesses. Um, before the 30 years I've been working in finance and, um, you know, I would say kind of M and a, the last 10 or 12 have been specifically focused on either buying businesses or helping founders sell businesses. So candor, you know, supports businesses in kind of all facets of transactions. David,
Speaker 1:
Our motto is talked to Kirk first. If the owners of a business have an inkling, that there's gonna be any sort of change in ownership within the near future or even an extended plan, you're gonna have a range of alternatives. You might have some sophisticated buyers on the other side of the table. You need to be prepared for this and you need to assemble the right team of people to help you with the transaction. Kirk, let's talk about different types of buyers of businesses and what a seller can expect when they're doing business, doing a transaction with one of these types of buyers. Um, first off, why don't we define the space that the size of businesses that we're talking about here is our hypothetical business. What's the typical size business that we're serving here and, and these types of transactions.
Speaker 2:
Yeah. So I would say, um, it's solidly lower middle and middle market, right? So think about anything from around, um, you know, 10 to at least 50 million and above in sales and then, um, probably 2 million or so in, um, EBITDA up to around eight to 10 million of EBITDA. And for, for the folks that aren't immersed in, in M and a every day, IBI, EBITDA, or earnings before interest taxes, depreciation, amortization is another way of just sort of thinking about the transferable economics of a business, um, or in shorthand, if you don't have debt or, you know, kind of heavy property plant and equipment, it's just your net income or roughly that number.
Speaker 1:
How often do you meet with owners of a business and they start out, you know, can you help a business that's worth X million? And they haven't really had anybody look at their business yet to give them a realistic idea and they may be worth far more than what they're thinking. It's often the other direction. But how often do you say, well, actually you've got a bigger fish here than you than you thought at the beginning. How often do they just come in with an idea of what they realistically expect without just saying these are our financial results?
Speaker 2:
Yeah, so I think most founders don't, um, don't necessarily like they might have an idea of what they'd be willing to sell for mm-hmm <affirmative> or, um, without data to back it up a viewpoint about what their business ought to be worth, but they don't in many cases, um, understand the way that the, the market, if you will, would value their business and, um, you know, for them, um, the good and bad news is that you're gonna get paid essentially a multiple of your financials, um, you know, kind of discounted by the likelihood that they're not going to continue or, um, increased by the likelihood that they are recurring and growing. Right. And, um, and the market gets to set that number. Um, and so, and, and if you're a founder that will be frustratingly disconnected from what you think is special about your business, mm-hmm <affirmative>, uh, which isn't to say that what's special about your business won't matter. It's just that it's gonna matter at the edges or in terms of differentiation or maybe, you know, in, in, in kind of modest, um, iterations, evaluation. Um, so, and, and look sometimes, um, especially lately, um, with so much M and a activity and so many buyers out there, and so many different vehicles, um, to, to buying companies, um, you know, sometimes sellers, um, are surprised on the upside, at least right now. Yeah.
Speaker 1:
These days there's often some pleasant surprises out there. Well, let's break it down here. If we got a business and it is a, a good opportunity for them to explore a sale of any form. Um, there, there may be a range of different buyers and let's just lump them together for simplicity's sake and to strategic buyers, another acquiring company that will come in and, and, and acquire them either because they're in the same market or they're in a complimentary market. Uh, and then financial buyers, uh, private equity firms, family offices. And then lastly, kind of the, the other forms of transactions, the specs, the ESOPs, the kind of non-conventional exit structures, um, let's start with probably the simplest, which would be a transaction with a strategic buyer. And if you're working with a company and they're potentially gonna be acquired by a strategic acquirer, what should they expect? How should the negotiations work? Those sorts of deals.
Speaker 2:
Yeah. So strategic buyers are gonna be companies that are in your same business. Like you said, they are companies rather than investment firms. Um, you know, they might be bigger versions of you, um, or they might be, um, you know, the, the version of your business, that's in a different geography and they wanna acquire your geography or they're adjacent to your business and they wanna acquire your customer set or, or, um, you know, kind of your product or, um, you know, service set, right. And, uh, for those kind of transactions, they're growing kind of inorganically by doing M and a activity. And you are usually gonna be contacted by, um, you know, the head of corporate development or, um, you know, a kind of a business person at the company. And, um, when that outreach comes minimally, they need to talk to, um, someone with your skill David to even if they think that's the right buyer, um, they need to protect themselves for, you know, kind of ongoing liability and make sure that the deal is structured the right way so that they get the proceeds.
Speaker 2:
They're thinking that they get, um, that any contingent proceeds they might get or well explained to them and understood by them. And, um, you know, in those cases, even though it's rare that somebody's gonna get all of their money in cash and get to just, you know, kind of point out, um, where the extra set of keys and the cleaning supplies are, um, you know, and get to write off the sunset, even though that's a rare thing in transaction, if a strategic buyer is likely to buy a hundred percent of the business, even if not all that cash comes at close, you know, that that's a simpler transaction than a financial buyer. Um, which, you know, you mentioned is, is a number of different kinds of, of buyers.
Speaker 1:
And even with a strategic buyer, you're highly unlikely to get every dollar on the closing date. Right.
Speaker 2:
That's right. Yeah, that's right. They look, you might get most of it, but they're gonna hold back some probably in escrow, um, for some specific performance, or to make sure that some things come through the way that been suggested, or if there were some things that couldn't get nailed down at the time of the closing of the transaction, um, that sometime in the next year or 18 months, those things need to occur or not. If they do occur, then they release the escrow and you get the balance. Um, but look, the, the buyer wants to de-risk the transaction, um, you know, one quite literally, maybe they're buying representation and warranties insurance to make sure that, um, you know, any, anything that they kind of have an unearthed in due diligence is covered so that it doesn't become a liability, but they also wanna make sure that, um, you know, they've covered eventualities, right? And, um, so they want some period of time to pass in case there's something they didn't diligence. And in case there's something that they wanted to kind of hold out for that you're still kind of tied to the business for some period of time
Speaker 1:
Now. And just taking a couple of steps back here, um, clients that are in this space that we're describing here, rarely come to me to, to explore the alternatives of range of ranges, of transactions that they might enter into the typical buyer with smaller companies. They may be existing clients of mine, and I can kind of counsel them through the different alternatives that they're gonna, that they're gonna have with deals that where you and a, you and I may both serve the client. They're gonna talk to Kirk first, right? That's what I want them to do to explore the alternatives and make sure that they get the most valuable transaction, the one that suits their company the best and the one that suits their own personal needs the best right. Talk to Kirk first. Right.
Speaker 2:
Well, and, and look, I, I appreciate that David, and I would tell you that, um, you know, the reason that it's useful for them to talk to a transactional professional before they say yes, um, are our, you know, kind of multipart one, it only gets worse after you sign the LOI. Um, you like if you're selling your company, you've lost all leverage when you sign the LOI. So if you do that before, you've gotten any council around whether the valuation is right, whether you might get more and better terms in a competitive process, or whether there are some ambiguities that you need to get ironed out and clarified, um, you know, it rarely makes sense to sell to the first company that reaches out to you. Um, now sometimes founders are afraid that they're gonna chase away a willing buyer if they retain somebody like me. Um, and what, um, I told the new client last week was if the buyer is serious, um, and they're willing to pay you full value for your company, and they're not just trying to kind of snatch it up cheaply, then my involvement isn't gonna bother 'em. They may not give me a warm hug. Um, and they may be a little prickly initially, but generally speaking, I've found that, that, um, you know, serious buyers, aren't bothered by transactional professionals getting inserted into things, to keep things honest. Um,
Speaker 1:
It should help the process, frankly,
Speaker 2:
I that's been my experience. Um, I only have my perspective, but the good news for my clients is that I've been a buyer of businesses and a seller of businesses. So, you know, my, my, you know, while we, while both sides come at it with different objectives in mind, the big picture objective about getting a transaction done is aligned, right? So if, if, um, if you got a willing buyer and a willing seller, then, you know, valuation and terms can be worked out
Speaker 1:
Mm-hmm <affirmative>, and you're kind of the reverse Darth Vader, you've been on the dark side, and now you're with the Jedi, the rebels, right? And now, you know, the secrets of the dark side, you know, how the deals are gonna work behind the scenes on the, for the buyers, the financially sophisticated transactions with strategic buyers right now that we're calling the more simplified transaction, uh, are you seeing more asset sales, mergers, stock transactions with the changes to the tax code? Everybody is making more of a push towards stock transactions, uh, but you know, tax free combinations. So you see in a different marketplace these days.
Speaker 2:
Well, I'm definitely seeing, um, so I think that, you know, the, the changes to the tax code you're talking about is the proposed increase of capital gains taxes to essentially, um, where ordinary income taxes are, which would, you know, dramatically, um, reduce proceeds to anybody who's selling their company right now. And, and while there are probably be some, uh, some horse trading, some batting back and forth, and Congress and Senate to what eventually happens. Um, it seems pretty clear that capital gains tax rates are gonna go up, um, probably next year. Right? So there is, in addition to the fact that there's somewhere in the neighborhood of a trillion and a half to $2 trillion held by private equity firms and specs and strategic buyers to do deals, which creates a lot of tailwind to the M and a markets to begin with the urgency of trying to get deals done before year end to avoid having to pay higher capital gains taxes, have caused lots and lots of people to, to try and head to market.
Speaker 2:
Um, there's definitely, um, some preferences that, um, sellers can have for whether they want to try and, um, you know, do a stock transaction, have somebody buy the company outright, including all of its liabilities and, you know, everything that, that comes along with it. Um, usually if it's a private equity firm, they're gonna wanna do an asset purchase and pick and choose, um, their liabilities and have the entity get wound down after they do the deal, they'll create a new company to hold it. And some of that becomes, um, like if you're a first time seller and you have no idea whether, um, you know, somebody putting a stock purchase or an asset purchase on the table might have an implication for you from a tax and a liability standpoint, you know, that there's, you know, one big glaring reason to have a transactional professional involved because something like that can, can have a huge Delta on your proceeds, especially on an after tax basis. And maybe even the way you're sort of looking over your shoulder after you've sold the business about whether you've got any retail liabilities or something like that. So it can matter greatly
Speaker 1:
In my experience of working with private equity firms and other financial buyers, uh, you know, taking a, a client that may have a relatively simple entity structure with owners. And then we're, we're gonna usually see the private equity firm or the financial buyer draw up something that's completely different with multiple entities and squares moving in every different direction. Triangles, if there's gonna be a financial buyer, if there's gonna be a private equity firm, and they're gonna want to create new entities and, and flow through entities and that sort of thing. And in that case, do you often see more asset transactions? I do assets. Yeah,
Speaker 2:
Absolutely. I do. And look, if you're, if you're an S Corp or a sole proprietorship, um, you know, it might not be that big a deal, but, um, it's, let's say you're a C Corp. Um, you know, not that I think, um, a lot of the things you and I work on are C Corp, but let's say you're a C Corp. Um, you know, if an asset purchase is done because the buyer wants to be able to amortize the Goodwill of the business over 15 years and write off part of the transaction, um, so that they get some economic benefit through tax savings, then your entity, um, you know, pays taxes on the deal. Mm-hmm <affirmative> right. So your C Corp pays, you know, let's call it around 30% taxes in California. And then what happens is you as an owner and or the other shareholders of the C Corp, then on those net proceeds.
Speaker 2:
So the remaining 70% pay your full share of capital gain and state income taxes. So while it's not completely double taxation, um, it's a big hit, right? You might give up as much as 55, 60% of the proceeds to taxes. If you're a C Corp, you got an asset purchase. Yeah. Whereas if you could talk the buyer into making that a stock purchase, then all of a sudden that second layer of taxes goes away. Right. Mm-hmm <affirmative>. Yeah. And if they're worried about your liabilities, they can buy rep and warranty insurance, or you can split the rep and warranty insurance, you get more money after tax. They want you to get more money after tax, right. They're they have to pay you the same gross amount either way. Right. So part of the conversation in a deal like that, David is around, well, what, why would the buyer want to structure it like an asset deal? Um, and is it because of, um, the liabilities or is it because of the tax piece? So there might be some liability there, you know, if you're not gonna get the same economic benefit,
Speaker 1:
Mm-hmm, <affirmative> my philosophy to be blunt is that you can paper a transaction. You can structure the deal, you can allocate the risks, you can do whatever holdbacks are necessary, so that you get basically the same sort of allocation of risk as, as if it were an asset sale. And don't worry that, you know, you're gonna be able to take it out on the seller. If there's unknowns out there, it's usually the taxes that are the immovable object here. But moving along here into the, the heart of this discussion, the financial buyers, we've got different forms of entities out there, or different types of financial buyers. Could you describe, uh, for the listeners, the different types of financial buyers, the traditional private equity firms, the family offices, growth, equity, structured equity, what are these different types of buyers and are they looking to do different types of transactions?
Speaker 2:
Yeah. So great question. A lot of complexity there. So, um, putting them into kind of, um, buckets, um, traditional private equity firms that have funds where they go out and raise a bunch of money from investors and then make, you know, half dozen to two dozen investments for each fund that they raise. And they're out in the market every three to five years to raise more money. Um, you know, those kinds of private equity investors are looking to generate, um, you know, returns by buying into your company, adding capital, strategic guidance, operating expertise, building it up, selling it in somewhere between three and seven years. And then, um, you know, not only generating a return on the invested capital, but then they get what's called carried interest or a performance fee on that. So those fires very definitely want chances are they want you to hang around, um, and, or have your successors hang around to run the business because they're not operating people.
Speaker 2:
They don't necessarily want to absorb your business into their larger structure. Um, you know, so those buyers are trying to generate an outcome or return for their investors, and they're probably gonna pay you some cash. They're gonna have you retain some equity. They might have you take back a seller note and they might add in something like what's called an earn out where you get paid more money if certain results happen in the future, but those are contingent. Um, you know, and, um, and then you've got two other kinds of private equity buyers that kind of, um, you know, use similar structure, but come at it slightly differently, the kind of family office or long tail private equity investor, um, isn't looking to necessarily resell your business in three to seven years to try and generate their return. They actually want to get the cash flows over time.
Speaker 2:
And they're more of kind of the Warren buffet approach to private equity, the favorite holding period being forever just by great businesses and hang onto 'em and get the cash flows from 'em. And sure you're trying to improve 'em and make more valuable, but you're not necessarily trying to generate, um, you know, a liquidity event with each set of funds that you raise from investors, right? So that's more patient capital. And then you mentioned structured equity. Um, you know, that the way to think about structured equity or growth equity is they're like the first group of private equity buyers, but they're generally buying a minority stake. So they might still control the business, but they're not buying more than 51% of the business. And chances are, they're giving you the ability, the founder, the ability to take some chips off the table, get some cash, but they're also injecting some cash into the business to grow, to do other acquisitions.
Speaker 2:
And then the two of you will participate down the road in a second bite of the apple. And I I'd throw in another, um, group, and maybe you were heading in this direction anyway, and that is, um, specs or special purpose acquisition companies. Um, so these are essentially a way to kind of become a public company through the side door. Um, you've got a spec promoter that goes out, raises a bunch of capital from mostly wealthy investors, um, you know, professional investors institutions, and then goes on the hunt to try and find, uh, a really successful small business that they think, um, if they can buy it at a private market, multiple, um, and then take it public at a public market, multiple, get that multiple expansion that everybody's better off. And then they take, um, a pretty large percentage of the equity in that ultimately the public, uh, entity.
Speaker 2:
And they take some pretty healthy fees along the way. So the promoter of the spec, um, very definitely makes out well, you as a seller, um, depending on what you wanna do, definitely have a monetization event. You get valuation increase. Um, if all goes well, you may or may not have a liquidity event. And what I mean by that is essentially you get, you become, um, probably the largest shareholder in a thinly traded public company. Um, so you can't exactly sell all of your stock three days after the public offering and have restricted stock. And you're now gonna be running or a significant shareholder in a public company, but there's around 300 specs out there right now, David, that are looking for, um, successful private businesses to buy mm-hmm <affirmative>. And so they're becoming a pretty important part of this, um, kind of private market capital structure.
Speaker 1:
You mentioned one common term in private equity that I, you know, private equity, uh it's, it's just, it's used every day, but to the ordinary business owner, they may not know exactly what carried interest means and, and what that term means to the, the seller. What, what does that matter to me if you're gonna earn your money in some sort of financially ed way that I don't, you know, doesn't matter to me what's carried interest and, and how should the seller be looking at carried interest?
Speaker 2:
Yeah, so, um, the seller, in some sense, doesn't really care that the buyer, um, might have a structure that allows them for carried interest mm-hmm <affirmative>, but it does get to the buyer's motivation, right? So if I'm a private equity firm and I buy your company and, um, and my goal, if I buy your company for 10 million, and my goal is to sell it for, you know, 25 to 50 million, right then the way I've structured things is that my fund charges management fees, mm-hmm, <affirmative>, that's how I keep the lights on at my private equity firm. And if I pay you my limited partner, my investor and my fund, mm-hmm, <affirmative> a certain amount of what's called a prep or preferred return. So let's say that for the fund or for each investment in the fund, if I generate say eight to 12% per year, that I pay out to you, mm-hmm, <affirmative> after payment of the prep, whether it comes in three years, five years, seven years.
Speaker 2:
So after I've charged management fees to you, and after I've paid you the prep, whatever the difference is between what we're selling the company for, and that, you know, kind of further sale down the road. Um, and what I paid for the company in the first place, plus the management fees and the preferred returns, whatever that differential is, I get to keep a piece of that. Usually 20%, that 20% is called carried interest. And the reason that private equity firms and the owners of private equity firms are so wealthy in many cases, is that carried interest is not taxed as ordinary income, even though it's their day to day business. Mm-hmm, <affirmative> because they've held it for more than a year. In most cases, they're tax the capital gain, and that's got a real multiplier kind of effect on their capital mm-hmm <affirmative>. So, you know, private equity generally makes a lot of money through carried interest. They have to make their, their limited partners, their funds, a lot of money to get a lot of carried interest. But, you know, it's important to know if you're a seller that that's their motivation to buy your company cheaply, to sell it for a lot of money and get a big chunk of the differential.
Speaker 1:
Now with most financial buyers, if a seller's going to be acquired by financial buyer, shouldn't they expect a multistep transaction. That's gonna be some subsequent event. That's gonna be another liquidity event.
Speaker 2:
Yeah, absolutely. Um, it'd be really, really rare for, uh, a financial buyer of any sort, not to wanna retain the founder or kind of the, uh, founder and key management people. Mm-hmm <affirmative> um, cause generally speaking, they're buying a majority of the business mm-hmm, <affirmative>, they're taking control of the business, um, by structure and they're probably incentivizing, um, you know, the founder or seller and maybe even part of their management team with, um, carried or rolled equity in the transaction. Right? So, um, if the, if the seller rolls some of their equity or retains some of their equity, um, you know, then the financial buyer, um, you know, is looking to keep them involved. One to de-risk the transaction, right? As long as the founder stays involved, you know, key relationships stay intact and things keep going until the private equity firm can understand the business well enough to run it without the founder.
Speaker 2:
Um, but then also maybe, um, to keep driving forward, maybe the seller, um, you know, if, if, if you're a founder seller and say you're, you know, forties or early fifties, or even mid fifties who says, look, if I could get some more capital, um, I could acquire two of my competitors and then hire more sales people and go after, you know, some non-US business and some other channels. And I could grow this thing three to five times where we are now. Um, well that's music to a private equity firm's ears. You know, they're gonna wanna do a transaction with a motivated seller like that all day long and then participate in what is the seller second by to the apple. And of course their first liquidity that by owning the business. So that's, that's really common in private equity.
Speaker 1:
When I worked with a lot of VC banked companies, you know, a tech entrepreneur that would go out and really just know their tech or know some way to monetize internet techniques and that they would raise money and immediately be looking for the moment where the VCs would say, okay, now we need a real CEO and it wasn't an insult to anyone. They wanted that. Yeah. Now somebody who knows how to run a business, come in and make this thing valuable. And I'll ride your coattails when a private equity firm comes in, they're not looking to make an immediate change of management. There may at some point be a change, you know, but aren't, they just more looking to make in a, a more of a buy and hold investment like you're describing.
Speaker 2:
Yeah. So that's an important distinction. So first of all, for, for, um, for folks who aren't as familiar with the difference, venture capital is much earlier stage, uh, you know, it's private money. It comes from limited partners, they have funds. So there's some commonalities between that and private equity. I, the way I think of the difference is that, you know, private equity is not only later stage, but where venture capital is focused on what I would call concept risk, you know, does it, is it wor does it work? Is it a business? Can it flourish private? Equity's focused more on execution risk, can it be done better? Can it be done more profitably? Can it be scaled? Right? And so if you think about it to be an early stage founder and take venture capital, your impulses and your ideas and your enthusiasm and your passion matter a lot, those things don't really scale though.
Speaker 2:
So unless you're the rare entrepreneur who has management talent and the ability to become good when you've hired that 50th employee and start to really make the company much, much bigger, chances are, you're not the right person to keep running your company. Mm-hmm, <affirmative>, um, you know, whereas private equity, they want real executives. They want people that know how to run businesses. And, um, they're usually if they think that a founder isn't the right person, um, you know, kind of to run the business long term, they'll usually have that conversation in the due diligence period. And maybe even before they're in due diligence to have a hard conversation with a founder and say, look, you don't really want to run this business long term. Do you, we have an operating executive that we think we could plug in here mm-hmm <affirmative> and do really, really well.
Speaker 2:
And that operating executive is, is gonna be kind of connected to the private equity firm. And so they're gonna be reporting back to the private equity firm, um, and kind of do their bidding if you will. Whereas a founder who's used to running their own company, especially if they've been running it for 15, 20 years, you know, at some point is gonna be pretty annoyed with the financial buyer who wants certain reports and wants certain reporting and wants to have conversations about things that the founder's been doing for a long, long time. And he doesn't wanna be <inaudible>. And, um, so almost always there is a, a point where the seller, even if they're, you know, planning to work with the private equity firm until the, the second sale, there's almost always a point in there where they consider leaving or the private equity firm considers replacing them. Um, it's common, right? So, um, as a seller, you should just sort of, kind of anticipate that you might run up against that at some point,
Speaker 1:
Kinda like with the prenuptial agreement, you don't need it to say when it kicks in <laugh> it's there and <laugh>, you never know when you're gonna need it, but, uh, that relationship is defined. Um, when you work with people who may just have some anecdotal, uh, you know, advice on selling their business, that they may have got at the country club, or, you know, friends playing tennis, and they've heard, you know, you will get more money for your business, from a strategic buyer. They see that, you know, a financial buyer is gonna cease ways to squeeze more value out of the company after they've been there and had a, a share of the ownership. Uh, do you have to kind of disabuse them of these ideas and, and maintain some flexibility and know that it's kind of a case by case. There may be ways where you come out a lot better, if you can stay on with a financial buyer and, and, and realize a portion of the value that they can bring to the table.
Speaker 2:
Yeah. Great question. So look, all of the things constant, the strategic buyer ought to be able to pay more for the business because they don't have to generate a return for their limited partners and account for management fees. Um, and they've, you know, got some, some scale economy's already built in, right? Mm-hmm <affirmative> so the strategic buyer ought to be able to pay more, but I'm not so sure that that's, that they are paying more right now. Um, I was in a process that just closed two weeks ago that has been going on for nine months. We retained a great investment bank. There was a great management team in place. It was a fantastic business. Um, and of the 11 indications of interest we had, um, you know, when we went out and started talking to potential buyers, both sending 'em out, you know, kind of a, a teaser email, um, with kind of a one pager on the company and also making phone calls to potential buyers.
Speaker 2:
Um, two of the three lowest bids we got out of that first 11 indication of interest were from strategics financial buyers, um, are really, really heavily capitalized right now. So they are in some cases out bidding strategics. So if the guy at your country club, um, who may or may not have gotten a great transaction, you don't know because he's the one there telling the story, right. Um, maybe five years ago in the area of business that he's in strategics were the better buyer, but maybe not right now. Right. So, you know, it's, it's, it's tricky to take that, um, you know, anecdotal information and infer that there's always a hard and fast rule. Generally speaking, if, if you're, if you think that competitive tension can get, um, you know, a higher price for the business and that an advisor who can get out there in the marketplace and control a process and create some competitive tension between potential buyers, then you wouldn't wanna limit the number of potential buyers because that would limit the competitive tension. Right? So if you say to your investment banker or your financial, um, you know, kind of counselor advisor in this case, I only want to sell to a strategic, well that eliminates all the financial buyers and there's that source of competitive attention that might actually be the more well healed part of things. So really you need to be close enough to the markets for your specific kind of area sector domain, and the current sentiment in the market to be able to decide that
Speaker 1:
We're seeing a hot market right now, we're seeing a very active market, and we're seeing some fr valuations, uh, without telling your secret sauce or your specific market insight, why would you summarize in a nutshell, why is it a good market right now? What are the good trends that we're seeing out there? Uh, do you, would you, if you're a seller, would you think there's a degree of urgency to get out there and, and seize this opportunity to sell in this good market? It,
Speaker 2:
Yeah, so, um, there are a couple of things. Um, so one and the overarching thing is that, um, cost of capital is really low right now, you know, um, if you are, um, whether you're strategic or financial and you're borrowing money, or you have access to, you know, bank money, um, you know, capital's cheap, right? And so it is in some ways cheaper to buy growth, um, especially with a little bit of leverage than it is to, to, um, create it organically by hiring more sales people and, um, you know, rolling out new divisions and investing a lot in CapEx, right? So for all, uh, businesses capital's cheap that makes M and a activity easier because private equity firms always borrow a percentage of the, the, um, the deal. But the other factors are things like you mentioned one earlier that, um, if capital gains taxes are going higher next year, then, um, that creates more frenzy right now to try and get deals done before year end.
Speaker 2:
Um, but there are a few other factors too. The pandemic actually kind of put a, a, a pause on a lot of the deal activity. So you had a good economy leading up to the pandemic, a lot of money raised to go do deals. And then the private equity firms that are now in a hurry to get deals done, had to focus on their own portfolio and make sure they got through the pandemic. So they weren't as active out there in the marketplace trying to buy. And so they did that portfolio triage, and it took 'em 12 to 15 months to get back out in the market and start buying stuff. Right. So that brings another thing into play, which is when private equity firms go out and raise capital, they usually have about a three year window to put it to work. And if they don't put it to work in that three years, they gotta give it back to their limited partners.
Speaker 2:
Right. So what it did was take, you know, a third to a half of their investment period away. So they're in a hurry to put that money to work in many cases, not all firms, but some are in a real hurry to put money to work, right. So all that is creating on a tailwind or positive sentiment to get more deals done, right. And, um, you know, add in the specs, that's 300 news sources of capital that are out there, you know, competing with private equity firms and strategic buyers, and then add in how people feel about the stock market. Do people feel like the stock market can continue to generate double digit returns? I mean, we'd suggest that, you know, all this money going into cryptocurrency or all the money that's going into, um, direct investments, like private equity would suggest that people are looking for alternative sources of return. So if you're a seller of a successful small business, all of those things, you know, kind of in your, to your benefit, all of those things create tailwind. So it makes perfect sense that it's frothy right now. Mm-hmm,
Speaker 1:
<affirmative> it sure does. And it's a good thing so quickly, if we will, we've gone through a variety of different potential buyers, when is a good opportunity to use an ESOP, when is a company, you know, suited for that and, you know, would they try all the other alternatives first or is some, or some companies better suited for going straight to the ESOP transaction?
Speaker 2:
Yeah. So this is, um, you know, I see ESOPs considered a lot more often than they get used. Um, so there are a couple of things. Um, first of all, an employee stock ownership plan, um, can be financed by the bank. It can be financed by the seller, or it can be financed, you know, by both of those folks. And it can be for a minority or a majority of the business or for all of the business. Right. Um, ESOP's work really, really well for project based businesses for smaller businesses that won't, um, generate, you know, kind of that much in the way of proceeds for the seller. And what I mean by not that much is, you know, let's say you run a business that does, um, you know, 4 million of, uh, sales and, um, you know, uh, uh, a million of net income and you, the, the, um, owner of that business take half of that net income, um, as, you know, kind of salary and distributions.
Speaker 2:
So you're taking a half million dollars a year out of a business, generates 4 million at the top line. Well, if you sell that business, um, it's only gonna sell we're probably four or five times, right? So you get four or 5 million. And when you're done paying what amounts to around 40% in taxes, you know, you've got like 3 million left, 3 million is not gonna generate $500,000 a year, spendable return the way your business does, but let's say you can sell that business for, you know, $4 million to an ESOP. Um, you might avoid capital gain entirely on that. Um, so you might get to put some of that money to work for kind of your investment benefit or to go buy a, you know, kind of your bucket list, um, boat or car. Um, and you might be able to continue to take distributions from the business, cuz maybe you don't sell all of the business, right.
Speaker 2:
There are some tax advantages to an ESOP. Um, you know, so, and, and maybe you as the, you know, kind of builder of that business have some key long-term employees that while you've compensated 'em well, they certainly don't have the kind of money necessary to be able to buy you out of the business, but you'd like to make sure that they continue on with the business, with an ESOP. You can do that, right? Because you all continue to be shareholders in the business, you go out and find a bank to help them buy you out. Partially you avoid the capital gain, um, you know, on, on the portion you get and you continue to be involved in the business and they continue to have their jobs. So, you know, usually an ESOP is gonna happen at a lower valuation than, um, a sale in the marketplace, but for the kind of business it works well for, there's probably some tax advantages and some legacy advantages to the people that sell to an ESOP.
Speaker 2:
And, um, and we have some great resources in town. We have some great ESOPs consultants in town. Um, university of San Diego has, um, the Byer Institute that, um, does great consulting work on evaluating whether businesses really good work over there, you know, should, yeah. Yeah. So I mean, cuz Bob Byer, the founder of AIC was, um, you know, a big fan of employee ownership and that was a huge company. It was ESOP owned. Um, so it's a, it's a great way to maintain your legacy and keep your people intact. Um, and, and definitely should be at least part of the consideration for any small mid-size business.
Speaker 1:
Uh, Kirk there's as always, there's no shortage of information that you just shared and, uh, we've saved some for the next time as the listeners can hear, there's a lot of complexity to selling your trans, selling your business to the different types of transactions, the different types of buyers that are out there, that it can be a bit overwhelming, but there is someone who is on your side who can help you navigate the process and understand your options. And that is Kirk. And that is why you talked to Kirk first. So it's, it's a always a pleasure to have you on and to hear, uh, this, this wealth of information that you're sharing, as long as you know, we we'll ramp up here. Is there anything among these different topics that you think that we, we should get out there now on, on these different types of buyers and transactions?
Speaker 2:
Yeah, absolutely. The takeaway I would have is that look, um, chances are your network, doesn't have the right resource to answer some of these questions. Um, and, um, and I can tell you that, um, the buyer of your business, um, whether it's a strategic or financial buyer is a full-time predator and you are part-time prey and, um, you owe it to yourself, whether you retain an investment banker or transactional professional like me, you know, get a, a talented M and a lawyer like yourself, David, you owe it to yourself to at least match up with your potential buyer, by having some advisors who know what the market looks like. And I can tell you that, um, our business is, um, is, is, is, is so busy and so active right now that we are certainly not trying to talk anybody into anything. So, you know, give us a call, shoot us an email. Um, if we can help, we definitely will. Chances are there's somebody in our network that can help. And, um, you know, there's no reason to try and do this alone and there's a whole bunch of reasons why that's a bad idea. So always appreciate, um, spending time with you, David. I, I, uh, I thank you for being on and uh, love the podcast. Yep. Thanks.
Speaker 1:
Love having you on you. Keep those wheels turning and think of the subjects to cover on our next podcast, cuz you'll be on again. I appreciate, uh, your time and with that, this was selling your business with David King. Thank you so much. Listeners, go check out the book, selling your business, begin with the end in mind. We'll see you next time.