How Sellable Are You?
In a recent article, David discloses the questions all creative agency principals need to answer whenever they are ready to find the right buyer and successfully navigate the merger and acquisition (M&A) process to complete the sale.
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"How Sellable Is Your Firm?" by David C. Baker for Punctuation.com
Transcript
Blair Enns: Listener, David and I have been talking for half an hour, and I just said, "Do you want to do a podcast?" and he went, "Sure. Why not?" Why not. We're here anyway. Our topic today, as he shuffles his papers, why podcast at all? No. Our topic is, how sellable are you? Is this a post or is this going to be a post? The writing that I'm looking at.
David C. Baker: If you read my stuff, you'd know it was a post.
Blair: Is it a post?
David: It came out a couple of days ago.
Blair: Oh, well, it was the weekend. I don't read your stuff on the weekends. Or during the week.
[laughter]
David: You don't read my stuff at all.
Blair: All right. The topic is: how sellable are you? I really love the way this opens. You list a bunch of edge cases. Your firm, Punctuation, one of the things you do is the M&A side of the business that your son, Jonathan, runs. You help entities buy and sell agencies?
David: Yes.
Blair: We're going to talk about the common variables that make you more sellable, but you start by listing these edge cases, and you say, "For some examples across the 200 equity transactions we've led, here's some that were successful. 100% down, all cash, no earnout. Client concentration of greater than 80%. Sold to a client with buyer, even knowing all other clients would then leave." Client buys it; they're clearly not buying the revenue.
David: Done that three times.
Blair: "Internal transfer when no bank would fund it and seller refused to carry the note." I want to dig into that one. "Zero recurring revenue." Not so much a surprise, even though I think we all know that recurring revenue is valued higher. "No profit," and then, "Sudden death of the owner, a young owner with no partners." These are the edge cases, and you pointed out that "You can still sell firms that are edge cases like this, but you really want to be in the middle part of the curve on all of these variables." Before we get to the boring stuff, let's talk about some of these edge cases.
David: I was rolling my cake and eating it too. I was like, "Okay, I'm going to paint the ideal firm here, but don't not call us just because you're not the perfect firm. Give us a chance." That was my goal here.
Blair: Got you. No profit. How does a firm sell with no profit? Obviously, the acquirer is buying revenue with the expectation that they can turn that revenue into profit. Is that it?
David: Sometimes. Yes, actually, that's true if they've had a rough year and they need to fill a gap that happened. They lost a client or something. It's usually more likely that they're buying a capability, and they don't care too much about the profitability. They're just buying a capability. They want this team of people that they're bringing revenue; it's not like hiring people that don't bring revenue, they're bringing revenue with them. There's not profit, but there's revenue, and they know how to work together, and they've got a reputation, and so they're buying a capability.
Blair: How does a firm like that get valued? It's not on revenue. It's not a multiple of revenue or a profit. What is it?
David: The answer is very carefully. We have an inverse multiple, which is just a way to look at it and say, "Okay, if this firm were profitable, what would it be worth?" Sometimes you just use that, but instead of a lot of cash at closing, you just throw your risk, not into the purchase price, but you throw your risk into the terms.
I'm working with a client right now that's just about ready to close. There's this single operator that does hundreds of thousands of dollars on his own, and he's ready to quit. We can't just give him all kinds of money right up front, because we don't know if the clients are going to stay. We're accepting the purchase price, essentially, but we're throwing the risk into the terms so it gets paid over time.
Blair: What about the one where there's a client concentration of over 80%? Clearly, the acquirer really values that one client, or is it something else they value?
David: Yes, that one client, and it came with something. It came with a physical attribute that was very useful for them, and the client was a perfect fit with their established focus. In some cases, it wasn't in this one, but in many cases, somebody might buy an 80% client, because now that lessens their existing client concentration problem. It helps both firms, essentially, to combine them.
Blair: Adding that one client to the acquiring firm actually dilutes the risk that they have with their own client concentration problem?
David: Exactly. Yes. There's so many interesting things here that can happen. I just don't want to discourage people, because nobody's going to read all the rest of this stuff and say that they measure up in every one. There are lots of edge cases.
Blair: I know you know John Warrillow, who wrote Built to Sell?
David: Yes.
Blair: It's probably time for me to reread that book. In that book, there's a story of, I think, a design firm owner who gets fed up with his business. Goes to a business consultant or a broker and says, "I want to sell." The broker or advisor says, "You have nothing to sell." The guy can't believe it. "I've been doing this for years," et cetera, et cetera.
Then this sage, the business broker, sends the hero, the agency owner, on a journey to make his business more saleable. I'm curious: the opportunities that come to you, the agency owners who come to you and say, "I want to sell," roughly what percentage of these firms would you look at and go, just like the sage in the book, "You have nothing to sell." Versus the other end of the spectrum, which is, "Oh, you've got something really valuable here," and then obviously probably the messy middle. What does it typically look like?
David: It depends on what their mental state is when they come. If they come to us and they want to sell, and they have already flipped that switch that you and I have talked about in other episodes, then, listen, we're just going to have to make the most of it. It's not in the cards for them to go back for three years, or two years, and fix the things that need to be fixed in order to maximize the sale price. We just need to work with it.
In other cases, that happens, and nobody's in a big hurry. They're just curious, and so they do a valuation, and they'll say, "Oh, that's actually better than I thought it was, but I'm going to stick with it for a while." Or sometimes they'll say, "Oh, that's not quite as good as I thought it was." We try to plug that gap.
We have a program we call Prepare for Sale that does three things for them. It does a benchmarking first. We're looking at how their firm is performing regardless of whether there's a sale in the future or not. Just, "How's your firm performing? What are the gaps that you could fill? What are the levers you pull in what order?" and so on. Then, we do a valuation to look ahead to how a buyer will look at the firm.
Then, the third and final module for that is to put a plan together. We identify who is the most likely buyer of your firm, not specifically, but categorically, who's the most likely buyer, and let's move in that direction. It should happen by this time. These are the things that need to happen, and so on.
I would say that the clients that come to us and talk about this are more sophisticated than they ever have been. I think it's simply because growth and acquisition, either on the buy or the sell side, is a part of our business language these days. Chances are good that in their neighborhood, they know one or two people that have gone through this. It just seems more likely. It doesn't seem like something that only happens on Wall Street and so on.
I don't know exactly how this plays into it, but people are clearly open to the idea that they may have three or four different careers in them that might have very little to do with each other. Owning an agency doesn't feel like a sentence as much as it used to. Part of that is because they're not tied to any long-term lease. There were times in the past when if you were in New York City, you were signing a lease for 15 years, at least 10 years.
Those days are well, they're still here in some cases, but not to the same degree. When we get conversations with people, they're usually pretty smart about this, and there aren't nearly as many surprises as there used to be.
Blair: How often do you encounter somebody who comes to you and says, "I want to sell," and you look at it, and you go, "You have nothing here. There's nothing to sell"?
David: Probably 1 in 10 conversations, I would guess. We say that, but not quite like that. We're just honest with them. There's always an option, but the option is not a lot of money sometimes. The option is to be acqui-hired by somebody else or just merge without any money changing hands.
Blair: Can you point to the number one reason why something wouldn't be saleable at all? It's probably on this list, is it?
David: It's almost always no profit. Somebody just thinks, "Why in the world would I buy this? There's no profit." That's the usual reason why there's not much of a market for a firm is because there's not much profit. You, as the principal of the firm, you've always got your reasons for it. You've been growing really quickly, or, "We tried this great experiment. It was worth doing, but we lost a lot of money doing it. We've corrected it now, but that's why there was no profit," or, "We lost this one client. That's in the past." You always have reasons for no profit. Those reasons, you've got to be able to articulate those, and the buyer wants to hear them, but there's still no profit at the end of that story.
Blair: That's why in that preparation for sale, one of the things you have to do is start to show profit and say, "Well, you've got to take profit to show that this is a profitable business." Is that correct?
David: Yes. Oddly enough, there's an optimum amount of profit. Too little is bad, obviously. Too much is bad, too. People look at you for different reasons there, too. There's this optimum range of about maybe 15% to 20% at the lower end would be pretty ideal. You really wouldn't want to go below that very often. Then, up to 40%, 45% after that, people are going to start looking. It's like, "Wait a second, how is it this profitable? What's going to fall apart at some point?"
Blair: The idea is that you're taking all your profits now instead of reinvesting in the business.
David: Exactly.
Blair: Interesting. The rest of this piece is about the questions that you would ask a potential seller if they came to you and said, "Hey, I'm thinking of selling. What's this thing worth?" You go through a list of questions. We're not going to go through them all. I think the listener can imagine what some of the more common questions are, but the second one on your list is where are they working from? It's a question of, "Are your employees onsite or remote? Why is this so high on the list?" You make the point here that it always comes up among the acquirer.
David: It does. Partly, it's just curiosity. If the buyer's going to buy the firm, they want to know, but there's also an HR component, too. We'll work with buyers who would never buy a firm with a single employee in California, for instance.
Blair: Really?
David: Yes, because the HR rules are so different there. If you have 1 or if you have 10, it's all the same. The first employee you have in California, everything changes. Now, people that have firms out there, they're used to it, and what they just heard shocks them. If you're working for another state with very different employment laws, you know what I'm talking about.
They want to know how complicated is this going to be? How expensive will it be when we have employee retreats? Are these people nearshored or offshore? There are very legitimate reasons for that, because they're going to be finding new clients for the firm they acquire. How will that employee spread contribute to the story that they're trying to tell? You wouldn't make any changes in your workforce because of this question. It is what it is, but buyers are going to ask about it.
Blair: They're going to say, "You get rid of the California-based employee first before we buy you." Or anywhere in Europe.
David: We're exaggerating here.
Blair: One of the questions is what's your profit percentage? You also make the point, we talked about that more is not necessarily better. There's a window that's expected. You also make the point that beyond the percentage, you want to know what the actual number is because when the EBITDA crosses certain boundaries, the valuation changes.
I think we talked about this before, but can you just tell us, generally speaking, what are the boundaries and what are the multiples of EBITDA at the various boundaries?
David: That would be a question that's probably more specifically answerable by Jonathan. This is what drives some roll-ups because, let's say you buy two firms where the EBITDA, regardless of the percentage, that wouldn't matter in this story. You buy two firms and the EBITDA is 800,000 each. Together, the EBITDA is 1.6 million. That story together means that the EBITDA has crossed that magic million-dollar EBITDA line. I'm just pulling numbers out of the air here, but let's say the multiple was 3X before; maybe it's 4X after that. Then there'd be other boundaries at 2 million or 3 million and so on.
The larger the number, regardless of the percentage, the more that impacts the EBITDA. Now, there's lots of other things that impact an EBITDA multiple, but this is one of them. Even if you have a firm that's, say, 25% profitable, but that yields 500,000, that's not going to be as good a story as an EBITDA that's above a million.
Blair: I've never understood why the multiple would be higher at a higher number of profit.
David: The way the buyer thinks about it is that there's a certain amount of administrative overhead and it doesn't scale. That's what they're thinking of primarily. Then, you have one new business program for a firm, whether it's a big firm or a smaller firm. It just scales better. That's the reasoning.
Blair: Rather than going through the whole list, what else on your list do you think might surprise people about the list of questions that you ask them when they come to you wanting to discuss selling their firm?
David: Some of them don't realize that to maximize a sale, two things that might surprise them. One is how much cash at closing are you going to require? If you're open to an earn out, which means you hit certain targets. They could be very simple targets that you get that money later over time. That just aligns your incentives with the buyer's incentive. Then the other surprising question that sometimes comes up is the impact of an earn-out so your willingness to stay on.
Now, in the past, earn-outs were always five years. When I would get an offer, an LOI across my desk on behalf of a client, they were so formulaic. It's almost as if they just copied a template, and the earn-out was always five years. You never see an earn-out that's five years. It's three years is the max anymore.
You might want to stay there longer, and there might be incentives for you to stay there longer, but you're not going to only get the full purchase price if you stay longer than three years. Some earn-outs are significantly shorter. We do a lot of SBA 7A work where an internal employee or an external buyer is going to purchase a firm funded by the Small Business Administration loan called the SBA 7A loan, and in that case, there can't be an earn-out.
The seller is going to leave right away. They can still help with the transition, but they're gone really soon. The SBA wants this new employee to have the full entrepreneurship experience on their own, and that's how they fund it. In those cases, there's very little earn-out at all. For a traditional purchase that isn't funded that way, there's almost always going to be an earn-out, and if there isn't, then you're probably not maximizing the sale. That's one reason why we encourage people to think ahead.
If you're running out of personal engagement or energy towards your firm, you don't just have to anticipate how long it'll take for you to find the buyer; you also have to back up how long you're willing to work in an earn-out.
If you're starting to see your engagement level drop and you imagine that, "Oh, I could do this for another three years." If you want to maximize the sale price, you want to start looking for a buyer now. That way, you can maximize it because you can stay for the whole earn-out. Those are the two that come up pretty frequently as surprises.
Blair: The last question on your list has to do with new business. How do you land new clients? I'm curious, as somebody, this is the focus of my business, how deep do you dig? What's the information you're looking for? What are the answers that, when you hear them, you think, "Oh, this will make it easier," versus, "This is going to be hard?"
David: Yes. That's when we ask this question, and we're on, say, a Zoom call, and the person on the other end says, "Oh, can I share my screen?" They pull up something, and they show where prospects are in the funnel. They can tell us the average tenure of a client, what the drop-off rate is, and so on. Then they say, "Now, we usually have this many conversations a year with interested parties, and X numbers, this percentage turns into clients, and so on."
That gives me tremendous confidence that they have a system. Somebody that's relying on referrals doesn't have a system. They can't pull up a chart like that. As flattering as it may seem for you as the seller to say, "Oh, marketing is for little people. We don't need to do that."
Blair: Word of mouth, they say with pride.
David: Word of mouth, yes.
Blair: Which means we don't really know.
David: Or they also say, "Oh, thankfully, that hasn't been a problem because we have clients working with us that have been there since the entire length of the firm's existence, 13 years." I'm dying inside because that's not a good thing. They're thinking this longevity of clients means we don't have to worry about new business.
That is not what a buyer wants to hear. A buyer wants to know that you have a system that drops opportunity in regularly. They don't usually think you have a sales problem. If they think you have a problem, they think it's a lead problem, a lead generation problem.
Blair: That system, friends, is called Win Without Pitching. [laughs]
David: I knew that was coming. I just knew it. [laughs]
Blair: Let's pick one more question from your list of questions that you would put to a potential seller of an agency, David. What kind of buyer are you looking for? This is interesting. It didn't really occur to me that the seller would be particularly interested in a certain type of buyer or would reject some buyers.
Although one of the sub-questions that you would pose is "Are you open to a PE buyer?" Then you say, "Note, you always should be." I want you to unpack that one. What is it about a PE buyer that would cause some people not to entertain them as an acquirer, and why should they entertain it?
David: This, I think, comes from firms that have been around quite a while, and they have an older view of PE, informed by some movie something. Where they think that the PE buyers are soulless, only care about growth, and the earn-out is going to be more of a sentence than anything. Obviously, there are PE buyers like that out there, but we would never let one of our clients be bought by one of those. We found that PE buyers are, across the board, very good buyers.
They're sophisticated. They can provide funding for growth. They're great to be on boards to help you with that. They have reasonable expectations. They have an exit path. They may ask you about rollover equity, which another buyer might not. You have the opportunity, and it's actually a good sign for you to do this. You have the opportunity to say, "Hey. Listen, let's turn 20% of my equity into a second bite at the apple down the road," which isn't going to happen outside of a PE buyer. We just find that PE buyers are consistently a pretty good choice, and you at least ought to be open to it.
The reason we're going to ask this question now is just to find out what the truth is in their mind if they say, "Well, I never would want to be bought by such and such," or what if they say, "I think our best buyer is going to be one of the holding companies," we're going to say, "Oh, click. Hang up the phone." That's just not the case anymore. Jonathan wants to know how sophisticated are you because it's easier to find certain kinds of buyers. We just want to know what's in your mind so that we know how much we're going to have to talk you into something else if it's not an accurate portrayal.
Blair: You're more likely to buy a holding company these days than to be bought by one.
[laughter]
David: You got an extra $10 lying around now.
Blair: My friends at the holding companies, I'm sorry, I just had to get that kick in. All right. This is interesting.
If somebody wants to take a first step with you on this, let's just complete the commercial for Punctuation.
David: Now that you've done your own commercial.
[laughter]
David: Just contact jonathan@punctuation.com.
Blair: All right. Thanks for this, David.
David: Thanks, Blair.