How Large of a Company Can you Buy?

09 Jul How Large of a Company Can you Buy?

Shoot The Moon

How Large of a Company Can you Buy?

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EPISODE TRANSCRIPT:

Mike Harvath  00:03

Hello and welcome to this week’s Shoot the Moon podcast, broadcasting live and direct from Revenue Rocket world headquarters in Bloomington, Minnesota. With me today are my partners, Ryan Barnett and Matt Lockhart. As you know, if you tune in regularly, Revenue Rocket is the world’s premier growth strategy, and M&A advisor for tech enabled services companies. Welcome guys.

Matt Lockhart  00:27

I’m coming to America. So it’s Fourth of July week, everybody. We’re just about, well, we’re halfway through the year. And Mike and Ryan, I don’t know about you, but I’m feeling pretty good because the activity level and is really, really high, especially for kind of the summer months. So pretty cool, Ryan. What’s going on?

Ryan Barnett  00:58

It’s been a speedy half of the year, and I can’t believe I’m saying it’s half year so, and I’m sure the second half will be just as fast. So if you want to get a deal done, there’s a great blog post on our on our website right now, kind of the our projections for Q3 2024 and the deal window is really open. I think it’s something you really have to act on now. And so really encourage you check out the resources we have available. And as always, if you have questions on your mind, please let us know. We love to talk, and we’re at info@revenuerocket.com and happy to hear specific questions that you have, as we do in this podcast, we talk about issues that we see within the week and with our customers and the issues that we’re dealing with. And one of the questions we get often is just, quite simply, how big of a company should I buy if I’m buying another firm? And so we’re going to fast forward a little bit through all the hard work of what we do and finding a great fit and and providing the marketing and outreach in order to bring a great fit. But let’s Matt and Mike assume that we’ve found a great, strategic fit, and we’ve and we understand that there’s a cultural fit, and it’s and it looks like a good deal. And with that in mind, I’m trying to frame up how big should you go as a general theme here? So, but before that, I think we need to set the stage on their what kind of acquisition types there are. So, Mike, why don’t you get us going off and just help us on this plan. If you’re going to buy a company, it has to be in the context of your, let’s say you have, perhaps you have some money from a strategic funder, or that you’re just a guy that’s bootstrapped and doing it yourself, or you’re a strategic firm that’s that’s willing to invest help us understand different types of acquisitions that are out there to frame up the discussion.

Mike Harvath  02:57

You bet so you know, certainly you may hear a lot of discussion around platforms or tuck ins or mergers, and all of these different approaches are viable and can work pretty well. They’re typically done a little differently, and it also typically portends the kind of buyer you are, if you’re a sponsor private equity fund or family office. You’re not in the industry, and you’re looking to acquire into the business, into the industry. Oftentimes, you’re looking for a platform, and so you may be a buyer, let’s say, running a IT services firm, and you’re approached by private equity firm. You know, you may look to partner with them to one, quote, unquote, take some chips off the table, but also roll equity into a new entity and have them become your funding partner to do additional acquisitions. If you do that, you’re ultimately going to be able to typically take more risk to buy bigger firms, and ultimately, you know, in many ways, build a business case to grow into the hundreds of millions of dollars. If it’s done right, then there’s, you know, tuck ins. Tuck ins typically come into a strategic firm. Let’s say you’re not sponsored, you don’t have a financial partner, you’re operating the business, and you want to acquire someone to grow that would certainly be a tuck in thesis, or, if you’ve been you, you’ve joined a financial sponsor, and you’re a platform, and now you’re going to add additional companies, also a tuck in thesis. And then there’s really the merger, right? The merger is can be a merger of equals, or it can be a merger of firms that are like minded. But in mergers, typically you’re adding a partner, and this is most relevant for strategic sort of buyers. Maybe you don’t have a financial partner, and you’re looking to grow through acquisition or merger, those are different, right? When you acquire a firm, you typically buy all of the equity and you don’t have the seller, and you don’t have someone who is going to be part of your business as an equity owner or partner. A merger, on the other hand, is much more, you’re bringing in an additional business partner who’s going to own equity, you know, just like, just like a platform or or just like a strategic buyer. And oftentimes that’s used when you know you’re, let’s say you’re a firm that wants to, we use the term merger of equals, or merger of firms of similar size. You’re it’d be difficult as someone who’s initiating that conversation to raise all the capital or get the capital needed to do that deal, particularly in the debt markets, that might be challenging. So oftentimes equity is used as currency to facilitate a murder. How do they do there? Ron,

Ryan Barnett  06:02

I think it’s a great start that we’ve got all these different buyer types and and wherever you may fit in this scenario. I just frame up the rest of the podcast and in in understanding where you are and maybe where you you want to be, especially, or even if you’re getting someone coming to you, just so how you evaluate the companies that are there, if someone has that strategic funding? I think the the rules change quite a bit as they they you can buy as almost as big as the font or a percentage of the fund. And so I think there’s something to consider when I think big wallets show up at the table. It’s a little different than a strategic buying another strategic That being said, it’s all the size does matter in all of these deals. If I was to switch gears a little bit and and I’ll throw this to Matt, and if you might want to follow up. That’d be great if we think about a founder led business, and perhaps trying to start M&A are there any absolute numbers or any is there a size for maturity level you should be before considering doing an M&A buy side program?

Matt Lockhart  07:20

Well, you know, as I was listening to Mike and, you know, in our prep, this is the, I think the the the best answer is, it depends. So there’s no one exact answer, right? Because there’s all these variables in place. The funding aspect, you know, the strategic aspect, you know the opportunity to to get ahead of the market by making all of these things. It’s you know, risk and reward. So it really depends. But for our clients, who are, you know, really founder led businesses, and this is very common in the tech enabled services space, there isn’t an exact number, however you there’s, there’s sort of this maturity, scale, right? Operational maturity, financial maturity, you know, go to market, sales, maturity, leadership and organizational maturity and stability, maybe stability maturity. You could, you could change those words out. You’ve gotta be far enough along. Because, as you know, Mike is often said. You know, mergers and acquisitions is one of the most unnatural acts in business, right? And it can have a very disruptive nature to it, if, again, you’re not far enough along most sort of founder led businesses, or of the sort, you know, maybe there’s a founder led business that is backed by a financial partner, and the financial partner certainly wants to increase the the speed towards the, you know, rate of return on their investment. However, again, it’s just super important that there’s enough maturity in place with for a business to be able to develop that or realize the benefits of strategic acquisition. So it depends, I think, is a common theme that we’re going to continue to talk about throughout the podcast.

Mike Harvath  09:59

Yeah, I thought I would jump in and add that, you know, we see a sort of tipping point for financial maturity for most tech enabled services companies, when they get into the seven figures EBITDA, right? So over a million dollars in EBITDA, most firms start to get their at least financial house in order. Doesn’t mean strategically, that they’re, you know, perfectly aligned or even organically or growing well, but you might find that a surprise that you know, our advice is certainly to make sure that you’re growing on the top quartile, top revenue growth and profit realization before you would consider a merger or an acquisition or a deal, primarily because the return rates on your investments in organic growth are actually higher than M and A, and it’s something you should do first, right? You should be optimized in order to, oftentimes, we use the term up until the right on the graph before you consider doing a deal, whether that’s to, you know, combine with a private equity firm or a financial sponsor, or whether that’s to consider doing a tuck in or considering a merger, you really need to be healthy and growing. And I would encourage those of you that are thinking that you’re a founder led business, and you’re thinking that, you know, hey, I don’t, I can’t really grow, so I should buy a company to grow. That’s a failed strategy for a variety of reasons. It’s likely that you’re going to be looking to do maybe debt financing, and you’re going to have a bank looking at you saying, Look, if you can’t operate your business up and to the right. How do you think you’re going to operate an acquisition or a merger up until the right? And you’re going to have some scrutiny. So, you know, to put a little finer point on it, I think, you know, get into seven figure EBITDA, be optimized. You know, we have lots of stuff on our website about the rule of 45 and how there’s trade offs to revenue growth and profit realization, you should be operating very closely to the rule of 45 to consider, I think, an acquisition. And you know, in short, that’s really, you know, something that should be strongly considered. And if you’re not and you’re contemplating these types of activities, we’d encourage you to first work on optimizing that growth strategy and profit realization plan. The best firms in our market grow or have EBITDA in a low 20th percentile, 22 23% EBITDA is best in class. And you know, if you’re not above 15, 16, 17% EBITDA in your business, I wouldn’t count regardless of size. I wouldn’t contemplate an acquisition or a merger, or, you know, any type of M&A activity.

Matt Lockhart  12:58

You know, as you were talking, Mike, I was thinking about, sort of, as we’ve talked about in in past podcasts, the very best firms have an ongoing inorganic growth strategy, right? And we’re talking about, how big of a firm should you buy? Well, I think that part of that maturity is also the maturity related to your corporate business development capabilities. Now for many of our customers, we act as the Corporate Development Department, and obviously, after 25 years, we wouldn’t be around if we hadn’t gained a sense of way, if we, if we didn’t, didn’t build the best in class capabilities around, you know, corporate development and business development both, but in the context of thinking about how big of a firm should I buy again? It it that maturity, it needs to be in place in terms of your corporate development activities, your post merger integration capabilities, your ability to attract the right strategic fit, your ability to think about what is the very best strategic fit. And so I was just that you were talking about financial maturity and and your growth maturity, but that corporate development maturity is also key. So you know, if it’s your first time, maybe you’re thinking about doing something that is on the smaller side, so that you’re you’re sort of exercising those muscles around your corporate development and your integration capability as well. So there’s just all these, these sort of maturities that need to be in place and but I think your guidance that you know if, if you haven’t developed the skills of growing organically and then realizing that profit, you know, whatever that is, whatever those numbers are, then you need to stay focused on that

Ryan Barnett  15:13

Great discussion, Matt and Mike. It’s something that buyers should think long and hard about. This. Do I have the maturity there? Do I have the capability to make that decision then understanding relative to my size, what are other buyers going to be? So if I’m a relatively small firm, are the firms that I’m going to deal with even smaller, and will they have a more complex challenge in their own maturity sales? And am I buying someone who just hasn’t figured things out yet? And and so there is, I think there is a point in which you really got to consider, is this the right move? So I think Mike, Matt, large organic growth, large capability, large integration, or great integration capabilities, will make a big play. Great stuff, great stuff. If I was to look at during this a little bit, and I’m starting to look at targets. And Mike, well, let’s start over here. But what metrics should you consider in the valuation of a firm? What’s important to start to frame up the discussion of how big a firm that you should take a bite at.

Mike Harvath  16:25

Well, to echo Matt’s comments, certainly there’s it depends again, but you know, for a long time we’ve talked about, you know, a firm about half your size is pretty easy to relatively easy, if everything else is aligned, to find, acquire fund and ultimately integrate I’m glossing over a little bit because to Matt’s point about having a great corporate development function, I just want to emphasize that point because there was an interesting study done recently that talked about your likelihood to get an M&A transaction done if you do it on your own, and the percentages are very, very low. They’re in the single digit percentages. We’ve seen some studies that said you only have about 1% chance of actually doing that, where, if you use an advisor, you know most advisors are about 50, 50-50, if they’re not focused vertically. And our our success percentages are much higher than that, because we are focused in the space. And I think some of our many years, we’ve been over 90% success rates on our M&A transactions mandates and and I bring that up because you don’t want to go down this journey thinking that you know you want to roll your own regardless of the size, and then fail. It’s just a huge distraction. And there is a big business case for making sure you use a competent advisor. But back to the question at hand, as you look at probably in the half your size to maybe twice your size, revenue rises the range, and it’ll depend on the structure you start to gain up to your size and revenue or larger, it oftentimes will portend the merger, one in which equity will be used as consideration, and just because the economics of structuring a deal get to be much more challenging. Now there is some acceptance, you know, if you’re in a sort of a turnaround situation, let’s say you’re acquiring a firm that’s in trouble financially, then you know, maybe that business is a lot larger. I would argue, however, that those fixed or upper situations and turnaround situations are very, very challenging, unless you’re the absolute, very best operator already, and if you have confidence that you have the resources internally to deploy against a firm that might have some financial distress or could be optimized financially. Turnarounds are very, very difficult and fraught with issues, and I often say there’s many skeletons in the closet that you won’t learn about even after doing comprehensive diligence until you get past close on deals that are in financial trouble or are underperforming. And so I would just caution you that it’s fine if you have those skills and you’re operating well and you feel your operating model is that you know one of the very best versus your peers to contemplate those types of turnaround efforts. And you know, in those cases, you can oftentimes acquire those businesses that are much larger than yourself, and then just, you know, tune them up. But typically the guidance would be about half your size to maybe twice your size, depending on the structure and platform and financing, and all that.

Ryan Barnett  20:00

And then, Matt, I’ll, um, yeah, that. I think that’s great guidance. And it’s half this, about half your size is a good place. You can and you can go as high as a two time your size, or even higher. And if you’re looking at a firm, you’re going to consider that revenue is going to be a baseline. Obviously, the you may acquire a company that is 10 times your size, if they are, let’s say, a hardware reseller, and their margins are much lower. So revenue in its absolute is just one metric. You have to consider the the profit generation. Typically, we are seeing deals traded on a multiple of EBITDA, not revenue. So you may have a lot more leverage in a company that doesn’t have profit, but may have a different revenue model. So it’s something to consider. It’s not necessarily just straight up two times revenue. It could be much higher if, if that firm is a different type. And of course, you gotta look at the growth rates, and I think you gotta look at the the kind of your your general return on investment and such as well. But I think the general guidance that that helps someone frame that up, is there when you think about buying someone you’re typically or oftentimes, either your financing this, or maybe your own cash reserves, or you’re working with a perhaps a traditional bank. Matt, are there some kind of debt ratios someone should start to think about, or any way that they should leverage or work with a, you know, doing their own financials to help finance a deal.

Matt Lockhart  21:47

Well, yeah, I mean, again, we’re going to fall back on it depends, depends upon the nature of the deal, depends upon the nature of the potential acquisition targets, financials themselves to to Mike’s point, the the healthier the business is, the the easier it it’s going to be to finance and and create your your return rate modeling and etc, etc. So Mike, Mike, Mike is better than me at sort of creating a target of a debt ratio, right? But I think that the most important piece to think about is, what is the new co right? And when we say, use the term NewCo, what is that combined company’s financials going to look like, and the ability to service that debt very, very comfortably through good times and bad via the the cash flow of the of the business, right, and also being able to continue to invest in the business, to increase performance related to the Go To market, to increasing the growth rate and etc, etc. So, you know, obviously, in servicing that debt, understanding that, you know, three or three years ago, two years ago, interest rates were at a point in which it was a lot easier free money in as as some of our clients considered, but, but again, you know, back to this, this sort of foundational point of having enough maturity, the more mature you know, then maybe the the more of increasing your risk appetite related to sort of your financing plan and and servicing down that debt. Mike, what did I miss?

Mike Harvath  24:15

I think you covered it well. I mean, a lot of it depends on your capitalization structure. So you know, it’s not uncommon for a founder led business to start to do smaller acquisitions and fund them with debt. You need to have a good banking partner. You need to be able to forecast the cash flows accurately of NewCo as you outline, and you need to be able to be comfortable with the debt position that the company is in. It will, depending on how leveraged you get, it can consume a big portion of your profitability, and at some point the business gets large enough where it’s challenging to keep doing that like you can. You need to be able to put sustainable. Profit on the board with retained earnings, one to keep your bank happy, but also to be able to sleep at night, I think. And you know, you want to make sure you can manage the business through good times and bad times. And every situation is a little bit different. I mean, banks are concerned with, you know, collateral, right? They want a business that’s solid, that can collateralize a loan they want to understand the cash flow of the combined entities and how they’ll be able to get paid back, frankly, and have confidence in you as an operator, that you’ll be able to do what you say you’re going to do, and all those things mean that you’ve got to have a track record of success, but also a good banking partner, and maybe in another podcast, we can just talk about what constitutes a good banking partner. I think as you get larger though, there’s a strong business case to become to recapitalize the business with an investor with private equity. We’ve seen this. We’re operating in the middle of this environment right now where we’ve helped a client do some acquisitions, ultimately through leverage, growing the business to, you know, a nice size, and they’re now going to recapitalize the business. We do this regularly so they can continue to acquire, but not take all the risk or lever up the balance sheet with debt. They’re able to do it by working with a financial partner. And in the current environment, there’s, you know, you can argue how many there are, but there’s hundreds of private equity firms investing in our space, and we certainly see lots more almost every week coming in. You know, I talked to one yesterday is pivoting from real estate to IT services. I talked to one two weeks ago that was more in what we’ll call home services and their traditions are pivoting to tech enabled services. Companies, you know, they’re moving away from guys that mow your lawn and fix your sprinkler system to moving into, you know, technology and IT services, and ultimately, they are focused on, they’re focused on this pivot. And because of this pivot away from or into our space, there’s, it gives you choices for recapitalization, and I think you’re going to find that, you know, there’s a great opportunity, once you get to scale to partner with a financial partner, to move the business into the you know, in many cases, hundreds of millions of dollars of revenue, in some cases billions. There’s great case studies out there firms that have done that with financial partners successfully. And I think you have to be cognizant of where you are on the journey. You know, if you’re early on early days, then it’s likely that you’re going to be leveraging up and using your own sort of balance sheet and success and track record of success to grow through acquisitions early days, but it’s likely you’re going to outgrow that, and, you know, unless you’re playing the very long game of, you know, operating for the next 30 or 40 years, and you’re early in that journey, it would make lots of sense for you to partner with a capital partner and continue the journey of acquisition, where you can take more risk and, frankly, take some quote, unquote chips off the table by selling some of your equity to that financial partner to be able to further fund and grow without all assuming all of the risk. Essentially, what you’re doing here is a shared risk model so that you can take more risk collectively and be in a position to go bigger. And in the end, I think that thesis over the years has proven out pretty to be pretty successful in high cash flow businesses like, you know, tech enabled services. And I would encourage everyone who’s listening to be thinking about that, and when that tipping point occurs for you personally,

Matt Lockhart  29:03

Wow. I mean, we’re pretty fired up today, guys. I think it shows just back to that. It depends thing, but also just how much we love this. We love to help people grow through acquisitions. Mike, I mean, shoot, when you founded the firm and you named it revenue rocket, and then quickly behind that growth champions for IT services companies. It’s because, you know, you really did a lot more buy side work than sell side work because you you so believed in the benefits of of doing acquisitions and and developing an inorganic growth strategy. So we’re fired up about it, but we also to make sure that people are successful in their inorganic growth efforts and and, well, there’s a lot of it depends right in terms of creating that strategy and that and that successful sort of acquisition growth path.

Ryan Barnett  30:19

I definitely hear the passion and both Mike and Maddie Halvorson a long time. And these are hard lessons learned, because I just would love to ask one question, and we can wrap it up here, but acquisitions are hard, and no matter what the size of a deal there’s going to be getting through the deal, the funding, the integration, the working together, making sure there’s cultural alignment, strategic fit, and even if everything is pieced together, it’s still a lot of work. Whether you’re buying a firm that’s a 10th of your size or 10 times your size. And I guess maybe it’s a debate or a question, and I’m sure it’s an independent answer, but should should a company be buying as big as they can, Is it a general rule of thumb of of kind of buying as much as they can, or is it something a little bit different?

Matt Lockhart  31:17

Well, you know, I think it is a, it depends deal. But I think, to your point, Ryan, that a couple of things to think about is, the larger a firm is likely, right, the the more mature the firm is, the more stable the firm is. And then back to that, that idea that, you know, the more put together that target is, the easier it is to integrate, again, assuming a great strategic fit, and the easier it is to finance, because that firm is going to have, you know, Real strong cash flows to help support the deal. You know, the smaller the firm you know, sort of in principle, maybe the less mature it is, and and so, you know, there’s some, there’s some risk in that. Now again it goes, it goes back to, what is the strategic principle for making an acquisition? You know, sort of the the flip side to what I was saying is, is, if the number one sort of strategic reason is, is you are buying a capability, right? Well, then maybe a smaller firm that has the capability is is the easier path to take, right? But you know, to your to kind of to your point, Ryan, sometimes the smaller firms may be more work and more challenging and bring more risk in.

Mike Harvath  33:02

Yeah. I would add that the motions that you go through to do an acquisition are very similar, regardless of size. The challenge becomes oftentimes the larger deals become a little more complex, and it requires more art, if you will, to get them done. And, you know, that’s where a good advisor comes in. The smaller deals typically will have some issues with how they maybe have had their standard operating procedures, whether it’s financial maturity or operational maturity or, you know, just their discipline, right? And both of those things can be challenging, right? But in general, the motions to go through in evaluating the efficacy of a deal, you know, a larger firm with all things of being equal, which oftentimes are not, but let’s assume they are, is probably preferred if you can structure the capital side of the deal, because it has the potential for a much bigger return when push comes to shove. And I think in some ways that that is important. Small strategic acquisitions can also do that. If the you know, old adage of one plus one equals three or four, you can get to a place together you can’t get apart. Those that thesis hold up whether it’s small or large. So you know, back to your point, Matt, it certainly does depend. But I think I wouldn’t shy away from larger deals if it can get funded, particularly if operational and financial maturity and that acquired business, or the one you’re merging with is is definitely more mature than maybe other choices.

Ryan Barnett  35:02

yeah, thanks. Mike, Matt, this is the last question, if I asked to repeat back or summarize what I heard. I heard that you need to have your own house in order before buying another firm. So make sure that you got your own organic growth going, and make sure and then you have your creation plans and that you’re you have the operational maturity to run a process and find the right firm for your consideration. I heard that a general thumb in acquiring is a is between about half of your revenue all the two times your revenue is the general thumb. Of course, you can go larger or smaller based on the strategic fit or the operating model of the firm that you’re going after. I heard that it’s critical to understand the key metrics of your target, so understanding their growth rates, their profit contribution, and ultimately the cash flow of the deal to help finance that in a way that’s going to be cash flow positive for everyone, including the interest that you may be acquiring from using a lender. I also heard that you’ll need a great banking partner, or even a capital partner along your side to help share that risk and be in a position to go a bit bigger. And then we wrapped it up with a I think it’s a great discussion. Acquisitions are hard, and sometimes you want to go as big as you can and get the most out of that. But if you’ve got a strategic company that helps fit something in your portfolio, that smaller deal might be actually the smarter one. So great topic on both the got a topic for the future on, on, how do we evaluate great banking partners? So I’m excited to do that in an upcoming episode, Matt and Mike. I’ll leave it over to you for any closing thoughts.

Matt Lockhart  36:47

Well, as a primer to that great banking partner, we have a great banking partner that has helped us, you know, fund a couple of deals here recently and and so if you’re looking for that that relationship, give us a call. And if you’re thinking about starting your inorganic growth path, give us a call. If you’ve done a few and you want to do more, well, give us a call. We’d love to talk. As you can tell, we’re super passionate about it and and with that, Happy Fourth of July, guys, Mike?

Mike Harvath  37:33

There you go Matt, with that, we’ll tie a ribbon on it for this week’s Shoot the Moon podcast. Make it a great week and have a great holiday.