Our basic investment criteria has not changed since we launched: get paid for the risks we take. We are not seeking guarantees. We provide guarantees and accept risk. Our guarantees often come in the form of cash and simple agreements. The risks we are willing to accept are diverse but of like kind, and of a form we are capable of underwriting.
My goal in this post is to walk through the criteria in more detail than a bullet pointed list and clarify specific changes for 2020 and the near future. Scroll to the bottom for the bullet point and come back to read the context if you’d like.
I want to start by clarifying our counter intuitive approach –we think of business owners as our customers. We provide them a unique value, both in terms of cash, simplicity and spirit. In the exchange, we expect to retrieve more value than we paid… but are willing to accumulate this profit over a very long holding period. We expect to make some mistakes. Our preference is that our victories are of a far greater magnitude than our errors. We’re in it for the long term and won’t sacrifice survivability for an extra point of return. We love piling up consistent, successive actions, aimed in a common direction.
Viewing business sellers as our customer is fundamental to our spirit of partnership. We know what it means to be owners and can deliver a unique experience to other owners who like the way we do business and want to see their adolescent company join us in like spirit.
As a result of the above principle, it is important for us to write our criteria in a way that our customer is identified and connected to us with the least amount of friction possible. We “sell” directly. That is, we work directly with business owners. Intermediaries often create friction or prioritize alternate goals. We’re not opposed to the existence of brokers and investment banks, we simply don’t win many auctions (zero as of this writing.) Besides, removing friction costs is the only way to profitably access the smallest section of the marketplace. I like having options and this market is terribly inefficient. So, we’ve made this a priority. Low friction cost = low tolerance for “helper fees.” I’ve written about this numerous times and this aspect is not going to change. Call or refer us directly or be prepared for us to move on.
Early on in our partnership we emphasized how we invested. Then, we began talking about employee count, and being asset-light. We then narrowed our geography. All of these are still true. At our 2020 annual meeting, I told partners our next company would likely be larger than our recent past. Why do we emphasize these other aspects instead of EBITDA as most other investors do? (I promise not to gripe about the D&A portions)
Why not EBITDA? First off, few outsiders know the earnings of a private company off the top of their head. The advisors might, but we don’t want to be contacted by the advisor. We want the owner to contact us directly, and the use of EBITDA in the description smacks of a financial buyer, which most sellers don’t love (they think it’s an economic-only minded buyer). They prefer creativity. Plus, the description is not readily avialable for the friend of the business owner. Secondly, most really good investment ideas are more complicated than a simple multiple of EBITDA. There are far more factors at work and sometimes this one is not the blocking issue to a sale. We have to see beyond the recent past and make an estimation about the business under new ownership. As a result this means we are sometimes open to buying businesses with negative EBITDA or other weird quirks. Ultimately, leading with an EBITDA range does not strike at the heart of our customer’s desire –which is a smooth transition, at a fair price.
What’s our alternative to accomplish similar thing? Employee count.
Sharing the employee count is helpful for referrals and does not offend the seller. If anything, we want to work with people who are proud of their team. And, we want a description that our mother’s can use (non-finance people.) While our mothers have not been great referral sources the concept of simplifying the description criteria has helped make other people stronger referral sources within our region. Many times, the business owner’s friends know they don’t have an ideal succession plan. And the employee count is a helpful proxy that may lead to an introduction, a conversation, and at least some helpful commentary from us.
Specifically, we have been using “teams of 10-25 people” when describing our target companies. We moved forward on teams closer to 10 (several less than 10); and took more time on the larger companies. There were to be more at risk. We did this in part because we wanted some six or so companies for diversification, and partially to establish our reputation as serious buyers. Plus, our underwriting was strongest in this smaller team size. And finally, we had less patience as a result of just getting started. Today, we own several companies and can be more patient. We can first look to reinvest in our current enterprises. And we have a clearer line of site on the next 5-10 years than we did when we started. Things are promising. Today we are more excited about teams greater than 25 than sub 10 person teams. We also have a little more experience with a larger aggregate team today than we did then. Updated criteria? “teams of 15-50.” (you can proxy revenue and earnings from this if you want.)
We do not centralize operations. We keep accountants, insurance agents and other vendors involved post closing as best we can. Vendors are great referral sources. They know enough about the company and can sometimes get a conversation started more easily without throwing up red flags or accidentally alerting key employees. Vendors often call me or Mikel and say things like, “I don’t know if this would be something you would have interest in, but I know this company that has about $X in sales in Y industry.” That’s a good, natural start to a conversation. They don’t say the company name and we can keep things very surface level without risk of either knowing too much, too early. Some of these vague introductions have led to email introductions, which have led to meetings that ultimately resulted in transactions. These “vendor-advisors” get to know us, and we can avoid wasting the owner’s time if we are not a good fit. I also get calls like this for companies much larger than we can afford. I am able to tell them we are not a likely fit. Depending on the situation, I often try to steer them toward public companies where we are shareholders. We don’t take referral fees. We try to build goodwill across our partnerships. We used to talk about revenue of $1-$10M. Today, I’m looking for companies with $5-$50M revenue. But again, this is a proxy for team size and overall business complexity. Simple is better. Partnerships are best. Vendors and customers of target companies are likened to partners in the investment.
We are open to cyclical businesses, or companies that have a few blemishes. We’re open to niche industries or things we are not in yet. The more important criteria is proximity. We want a lot of companies in a dense geography. Why? It creates a tipping effect in the marketplace. Is that worth it? Should you do the same? I don’t know, and frankly, I don’t care. We believe our business model is a bit of switchboard with us at the middle. To get the market, we need to be active enough in a tight enough zone to get the referrals first… and last. It also works for us because we’re relatively young, early in our journey and long term owners. Since launch, our focus has been within 90 miles. Tight? Yes. Sufficient? Yes. Changes? None.
We might look at something a bit farther if it’s in an industry we are already in. In some cases we want to expand by acquisition in new geographies. But, that is a strategy within existing companies and not exactly a Little Engine Ventures criteria. (Did I say, we look to invest in our current operations first?) We are going to spend little effort developing new markets. We’ll expand along our fringe after the interior is as dense as we can make it.
I’d love to buy great companies at fair prices, that need zero work, but when we started we couldn’t afford these companies… and I was super price sensitive. Plus, we had excess time and experience available. There are moments when its way easier to buy minority interests in wonderful businesses in the public market than pay a premium for control and then need to extract the seller. This doesn’t mean we won’t be buying anymore control, it just means our alternatives change as the terrain changes. Our criteria for the public markets are not terribly different but serve little value here. They do come with pre-selected management.
In time, I’d like to buy control of companies with sound management in place. We have done a few deals where staff or people close to the company were promoted. These have worked very well. We’ve tried to bring in generalists ahead. This has been much more challenging. In those cases we ultimately interviewed for the position once we knew the company a bit better and this is working must more smoothly. I normally serve as Chairman, and the CEO runs day-to-day. Any big strategic items are discussed at a level that helps them execute. Mikel and I occasionally “help” but it’s really irregular. Any prospective seller is encouraged to talk to our managers to understand our respect for the company post closing.
Since our launch, almost every single seller has wanted a hard break from the owner responsibility and day to day management. Basically they’ve wanted out and haven’t known how to achieve it. We helped. Several retired. Each of these transitions are difficult. If you expect to be able to extract yourself from your company without any difficulty, you have unrealistic expectations. It’s really hard. Period.
In cases where the seller did not fully understand what selling meant on an emotional level, it has been more difficult. They’re just not ready to let go, and they don’t really get it until after the cash hits their bank account. Or, they look at some small changes we and the new manager make as huge and we ultimately drive them nuts. It can happen. So, I’ve always tried to sniff out how ready they are to leave or have a Chairman “over” them. It’s an emotional intelligence thing I’ve honed. Some are more prepared for this than others and it often comes by way of personality testing and just asking hard questions. It’s also a criteria we talk about really early. I ask “what are your goals?” and depending on what they say, I can get a read on their motives and how ready they are to leave their adolescent business in someone else’s charge. Most conversations are no where close to ready to transact smoothly. Early on with Little Engine Ventures I have tended to acquire companies where the seller thinks the business may not survive without them –but I see a path to make it durable –which they do not. These types of situations were ideal early on because the price was so good. Their alternatives were bad… including liquidation or selling to an incompetent, or disinterested employee.
I’m getting long winded –but the topic is huge.
I’m changing our criteria to “Management Candidate Identified.” I want sellers to bring an opinion to the table about who would run the company. Ideally, they bring an employee to one of our first in person meetings. If they call, I’d like them to have two types of problems. The best call starts this way: “I like what you’re doing and think you’d like our company. I have a manager but she doesn’t have the cash necessary. How does this work? Could she run it?” This is a great start, made better only if they can also say, “She actually brought the idea of selling to you before me a few years ago.”
The second best call starts with, “I’ve been following your work and want to know how this works. I don’t have a manager identified and understand that is important. A couple of my employees might be able to, but you need to visit with them to determine if you are comfortable.”
In both cases above we must evaluate the leadership options and if we don’t like either we can go to work finding someone after the sale. If we hold the company for 30+ years we probably have to do this more than once. We understand that is always a risk. We are not trying to eliminate the risk. I’m very open to finding a new CEO, but I don’t desire it. What I do desire is feedback and help from the current Chairman/CEO on what the business needs. These needs –and our opinions–may differ. I want to be able to work through it with the previous owner. It’s super helpful to have help! If we cannot locate someone ahead of closing, I’d like to have the seller running the business until we find someone together. This allows me to follow along and figure out what the best options are. Ultimately, the owner (us, post-closing) must select the manager. But, I’d like to have some options on the table provided by the seller prior to closing. This resolves a lot of confusion. If you are an employee and prospective manager of a 15-50 person team, please contact the owner, get him or her onboard, and then contact me. We might be able to buy the company together.
In summary, if you know of someone with the following situation, please call me, or share my contact information. I promise to keep it private.
- A business owner who is emotionally ready to sell. We work directly with owners.
- 15-50 employees (often $5-$50M in revenue)
- Within 90 miles of Lafayette, Indiana
- Day-to-day Management Candidate Identified. Seller has one or two employees who could handle day-to-day management that we can interview prior to closing. (we’ll take responsibility for expansion, capital expenditures, or business model changes.)