What an Acquirer Will - and Will Not - Care About

Most of us haven’t sold one firm that we’ve owned, and those principals who have formerly sold their firm aren’t always...ahem...telling the truth.

Sketchnote by Emily Mills

Transcript

Blair Enns: David, word on the street is you got a little side venture you're spinning up.

David C. Baker: You said that like you're whispering to me in an alley.

Blair: [laughs]

David: It's not illegal. Word is you've got a new drug dealer, Blair. I need his name.

Blair: What is this side venture?

David: It's creativevalue.co. It's just expanding the M&A and valuation work I've done for decades and standing it up as a standalone venture with all kinds of other cool things about it. Probably launch publicly in, I don't know, two, three months, something like that. We're having a lot of fun building it.

Blair: I can remember at the beginning of the pandemic, I said to you, "Yes, you're going to be busy with M&A work." Then you weren't and now you are. Now you're creating-- Is that a marketplace for buying and selling agencies?

David: Yes.

Blair: Wow.

David: To facilitate it. We'll see. Then the second goal is to buy all of the consulting advisory services that feed this field. We're going to start in Canada and then we're going to move down to the US, so you'll probably be getting-- It took you a minute, didn't it? [chuckles]

Blair: 20 times the revenue, and it's yours.

David: Yes. [laughs] Well, I could come up with a $100. Yes, I'm good. Sold.

Blair: Our topic today, what your firm's buyer will and will not care about. Our audience just got smaller because, as you've said before, the odds of selling your firm are one in what?

David: 1 in 400.

Blair: 1 in 400, so we've just lost 399 out of 400 listeners. The four people that are left who are interested-- How many principals are interested in selling their firm do you think based on your experience, or at least revisit that idea from time to time, even if they accept that they'll probably never sell it?

David: How many? It depends on when you ask them, and they're more likely to say yes the later in life you ask them. I would think at least two-thirds of principals would entertain a serious offer to buy their firm and the rest probably wouldn't. The odds of selling your firm rise astronomically above that 1 to 400 level if you just do some really basic things, like make money.

Blair: [chuckles] Yes, there's always a catch.

David: [chuckles] Yes, or have a great positioning, certain size or certain markets that you address, IP. There's so many quick ways to raise that, so it's not as bad as it sounds.

Blair: Okay. Do you have a shorthand rudimentary model for valuing an agency?

David: No, I don't. I get that question frequently, and it annoys me as much as this one just did.

Blair: Well, I have an answer.

David: [chuckles] Oh, you do? Okay.

Blair: Even though this is not my bailiwick. I met an M&A lawyer about three years ago who'd since bought an agency and was running an agency. I was sitting next to him at dinner, I said, "How do you value an agency?" He said, "One times revenue." I think that was the shorthand like, once a year, he was valuing the firm and then dispersing some sort of-- maybe was even shares or giving people the opportunity to buy in, et cetera, at that valuation. I took it to mean that's a rudimentary shorthand for-- It's a good starting point, but obviously, all agencies are not the same. There are multiple variables that would impact that valuation in either direction.

David: Just to be clear, that's one times gross revenue, not net revenue.

Blair: Correct, yes.

David: That isn't too far off. It's probably within 30%, 40%, but there are some huge variables in there. That's a good place to start if you don't have the time to be specific, sure.

Blair: Okay. How do you want to tackle this topic?

David: Well, it came up because I am doing so much M&A work right now. There's five active searches, so I'm in conversations with potential buyers every week, multiple times. I just started noticing the patterns, the things that they don't ask about. You think, "Oh, I wonder when they're going to ask about this and be really impressed." They don't ever ask about certain things. They just don't care. Then there are other things that they really care about, and you cannot steer them off it. It's like you've got a treat in your hand and the dog knows it. There's no amount of distracting them. They know it's there. Those are the things that they absolutely need and want and will care a lot about. I just divided all of these things into what they don't care about, what they do care about.

Blair: Okay, let's start with what they don't care about. I'm looking at your list here. I'm thinking some of them don't surprise me, but the first one does. They don't care about your IP?

David: Yes. I had to put this on here, but I didn't have to put it first. I mean, here I've just popped everybody's balloon. For one thing, people that think they have IP, it's really not IP.

Blair: That's the issue, isn't it?

David: It is, but even if there is IP, which is rare, but it does happen, the buyer's going to say, "Wait, if this IP is as valuable as you say it is, then shouldn't it show up in the numbers? Why would I pay extra for IP extra beyond the value that it's already delivered to your performance?" The only acceptable answer to that is, "Well, we developed it more recently, and we haven't been able to take advantage of it."

If that's the case, you almost always want to just peel it off from the sale and keep it. If they don't want to pay you what you want for it, then just give them some free non-resellable license to the IP and so on. You can tie all this up legally and just keep it yourself, but this is just an important point. If the IP that you have is not showing up in the numbers, then the buyer is not going to want to pay any extra for it.

Blair: Got you. That makes sense. This idea of like, whether your IP is real or not, I guess we should explain for the few people who don't understand. We're talking about intellectual property. If it's not protected in some way, copyright, trademark published in a book, turned into some sort of software or somehow licensed to people, then it's probably not intellectual property. It's more like a point of view or something.

David: Right. A process.

Blair: Yes, but it's interesting point if the buyer doesn't value it and you value it, hold onto it. License it to somebody else, sell it to somebody else, et cetera. Wait, till they come back to you and go, "It turns out that IP is valuable." What else is on this list of things that buyers won't care about?

David: Anything that happened three-- you could almost say two years. I'm trying to highlight the things that are a little bit different in the M&A world now. In the past, for instance, almost every valuation would look back over your earnings for the previous five years. I don't know anybody that does that in this industry anymore. What happened five years ago is completely irrelevant to the value of your firm now and the trajectory. The last two to three years, they certainly do matter, but it just doesn't matter what happened before that.

Even what happened in the last say three years ago, how does that matter? Well, it establishes a trend. In some cases, that's a good trend that will supplement the story. In other cases, it's not so great and you'll have to explain it. In other cases, maybe there was a legal issue that caused you to incur all kinds of fees, and you could explain that and braise your net because it got lowered artificially and all that. Whatever happened longer than that just doesn't matter.

It's also not equal weighting. What happened last year is more important than what happened three years ago. You have relative weighting that changes the impact. If it's more recent, then it has more impact, but anything had happened more than three years ago just doesn't matter.

Blair: If they're looking at net revenue, and the last two years were great and the three years ago was pretty poor. They're not weighting those years equally?

David: Correct. It probably would be a good story because things have improved significantly. If it's a bad story, then you'll have to explain it.

Blair: Next on your list is your culture. You're saying buyers don't care about culture?

David: Yes, but I'm not saying culture doesn't matter. I'm just saying that buyers don't care about it. I've never had a buyer ever ask a question about it. They just assume that the culture is good enough for you have to produced this financial result, and they assume that it will continue. I'm not saying it doesn't matter; I'm just saying it doesn't matter to them. If the culture is bad, they assume it's going to show up in the numbers.

These people look at things in a very cold disheartening way. We keep wanting them to look at things the way we do, and they just don't, and no amount of convincing them will actually work. We just need to accept that, still believe in the value of culture, but because it's the right thing to do because it makes our lives and our employee's lives better, our client's lives better, but it's not something that's sellable in a sense. That's all I mean by that.

Blair: Okay. Prospective buyers don't care about your culture that much. The next on your list, the middle management team. This one surprised me a little bit, but maybe you can clarify. You're making the distinction between the senior management and middle management?

David: Sort of like the principle equity layer, the people who own significant stock in a company, and that's usually calculated as 20% or above. They do care about anybody who owns something in the company, but they don't care about the next level down. When they do care about it, it's always very late in the process, and it's almost always just the account people, the ones who are responsible for client relationships. I can't remember, done 150 some deals, I cannot remember a single time where people even asked about it. They'll get the name and they'll look at the compensation and they'll maybe look at how tied up they are from a non-competitive standpoint, but they're just not going to sit down and interview them. It's just a non-issue to them.

Blair: They are interested in the senior leadership and you say people who have some equity stake, but that next row down, they don't care?

David: They just don't. They just figure that the earnout, whatever that is, is going to align our interests sufficiently that you, as in the seller, are going to keep caring about this enough and protect us because if you don't, then you're not going to get the full amount of the sale through the earnout. I shouldn't say they don't care, they just figure that you care enough because of how our interests are aligned that they don't need to care about it.

Blair: Okay. Next, number five on your list of things buyers won't care about, your hourly rate.

David: [laughs] Yes.

Blair: I guess there are other financial metrics that are more meaningful than your hourly rate.

David: They don't even think in terms of hourly rates.

[laughter]

We are so obsessed with this, aren't we? You and I've talked about hourly rates so much, and I don't know that we've ever really explored why it is that our industry is so obsessed with timekeeping and hourly rates, but it just won't come up. You think of it in a couple of ways. One is, this is how I make money. It's selling inventory, but then you also think about it as a positioning tool. Like we charge $200 an hour and some of our senior people are $240. There's this firm in town, they only charge $160. Can you believe that? I wonder how good their work is. I'm being facetious here, but it just isn't going to come up. Again, I'm not saying you shouldn't care about these things. It's just not going to come up in a buyer discussion.

Blair: What about effective hourly rate?

David: I've never seen anybody measure that.

Blair: Really?

David: Yes. They don't care about the metrics that I often care about, although I am trying to change that. Whenever I publish the specifics of the deal, I am publishing the benchmarks and telling them which benchmarks are higher and which are average and which are lower. Just so they get a very quick bird's-eye view of the firm, but that's all coming from me. It's not coming from them.

Blair: Got you. Sixth on your list of things buyers won't care about, your process or process depending on it.

David: Yes, right. The stuff we slather all over our website.

Blair: Yes. Is that related to IP at all?

David: In the principal's mind, it is. [laughs] In my mind, it isn't. Process is very useful for you. It helps you bring along people who don't know the way you like to do it. It helps distinguish your firm's work from other firms. It is important for the client to see it and so on, but if I set you down and I set a buyer down and I see the conversation and I say to you, the principal who are selling your firm, "All right, I want you to tell the buyer here the most important things about your firm." They're going to spout off about these kinds of things, and the buyer is just not going to care at all. Like, "Why are you even telling me about your process? I don't get that at all."

This is something else that I'm not sure where we, you don't have law firms talking about this. You do have doctors. You don't have engineers. Why do we talk about process so much? We need to talk about that, Blair, sometime. I don't know where it's coming from.

Blair: Well, quickly, we talk about process-- Sorry, you've got me saying it wrong. We talk about process in new business because it's a closing tool. It's reassuring. It says little variability and process equals little variability of outcome. It communicates we've done this before, we do it all the time. We have a bulletproof way of doing it. Don't worry, everything's going to be okay. Probably we would communicate that to the buyer because we think the equivalent for the buyer is stickiness of revenue. I would assume that's on the list that we'll get to of things that they will scrutinize.

David: Yes, for sure.

Blair: I think maybe in our minds, we're talking about that, because we think that somehow equates to, "Look how easy it is for us to sell, and we're going to keep clients." Well, the truth of whether or not you keep clients is going to be in the numbers. I get your point here. The last one, the seventh thing on your list of what buyers won't care about, you just threw this on there to be provocative, awards.

David: I just looked out on the field and-

Blair: [laughs]

David: -I saw somebody that had one last ox that wasn't gored, and I just needed to finish off the whole herd.

Blair: [laughs] It's an interesting metaphor. They don't care about your awards, whatever?

David: If it's another agency buying you, it probably wouldn't impact the price, but it might impact the desirability, whether they want to actually do the transaction and then they'll certainly find themselves into the press release that's written, but after that, nobody's going to think about it.

Blair: We've covered the list of what buyers won't care about: your IP, anything that happened more than three years ago, your culture, your middle management team, your hourly rate, any process you have, proprietary or otherwise, and the awards you've won. Now let's get to the good stuff. What will they scrutinize? I guess, therefore, what are the things that you need to really pay attention to if you're working towards a sale?

David: Wouldn't it be awful if this episode just ended right here? We would sound like, we think people are such idiots to sell their firms. Why would anybody? It's like, "Okay, folks, we're going to give you CPR."

Blair: We're going to save this.

David: Positioning. That's not a surprise as it is on here. You and I talked about it so much. This was not true, starting 25 years ago, and then ending 15.

Blair: Yes, you are either an ad agency or a design firm, right?

David: Or PR.

Blair: Yes, or PR. Now you're like some sort of really interesting hybrid firm that solves a very specific type of problem for a specific type of client.

David: Yes, before I didn't have a firm in Seattle, I needed one. There are seven, which one should I buy? It's like that's not happening anymore. Geographic moats are just largely disappearing. Often, the positioning they're looking for, it's not just I want a really well-positioned firm; they're looking for a firm that is specifically positioned in something. It could be vertical, it could be horizontal, but they're either looking to supplement previous purchases that they've made, or they're looking to make you the anchor purchase.

You don't see anybody from the VC world having anything to do with our world, it just doesn't happen. There is a lot of activity from the PE side, private equity, some from investment banking, some from consulting, and then you have some oddball buyers, like clients every once in a while, or large privately held or mid-tier publicly held firms, and they're all really driven by positioning nowadays. I mean, real positioning, not just the stuff that you announced that you feel good about, but really good stuff that's true.

Blair: Got you. Positioning is important. As we've talked about it before, it's very related to fundamental business strategy in some ways. It really just is the business strategy. Next on the list is size. You need to be big enough. You can have all these other things in place. If you're not at a certain size--

David: It's just hard to pull off. It doesn't mean it's impossible, it just means that, okay, we're in a different playground here, so a few rules apply. Starting about 15 years ago, the sometimes spoken but always understood minimum was if you really want a serious purchase here, you need to be 10 million in AGI or 3 million in net profit. There were many, many exceptions to that, but that was just where the big money was drawn to.

Nowadays, you hear different things on the AGI side, but I'm also hearing more frequently that one and a half million net is worth paying attention to. The argument from the buyer side is, listen, the due diligence takes about as much effort, the legal fees and all that, we just can't spread that across a smaller purchase. Now, most of the firms that I sell are 3 million net and below, even lower than 1 million in some cases, and I still have a very active practice. It does mean that you're kind of below the radar if you're below one and a half million, and it takes an unusual effort to sell your firm. That's what I mean by big enough.

Blair: I would assume that everything on this list or almost everything on this list of what buyers will scrutinize will affect the multiple the price that they will pay, but this one, maybe not maybe this is more binary, you're worth buying or you're not. Does size impact the multiple that a buyer would pay?

David: I hear that trope a lot, and I don't actually see it in the marketplace. There are advisors out there that keep repeating that, and I just had not seen it. I am seeing some similar thing during the earnouts where they'll say you'll earn this if the growth rate is double, you'll earn triple. It's algorithmic instead of just linear, but I don't see that, no, it is more binary.

Blair: Net profit, number three on your list. This is got to be a big one.

David: It's a percentage. If your net profit is less than 20%, you've got to have a really darn good explanation. Anywhere between 20% and 45%, actually, if it's higher than that, people scratch their heads and think, "What am I missing? What's going on here? Is this real?"

Blair: This is EBITDA you're talking about?

David: Right, EBITDA. 20 to 45.

Blair: Why would people scratch their heads above 40, 45?

David: Like, "What am I missing here?" It just seems too good to be true.

Blair: Is this legal?

David: Yes, right. Then they start thinking otherwise they say, "Oh, okay, so how big is this firm? If I lose five people, how much of the staff am I losing?" They start to get nervous about it. It's not a good reason to not aim for as high a profit as you can ethically make but 20% to 45% is what people are looking for.

Blair: Okay, that's pretty straightforward. Then next on the list, trend lines for their gross and net revenue.

David: Yes. The net is very obvious. EBITDA calculations are standard across all industries. That's earnings before interest, taxes, depreciation, amortization, but they don't understand how we do gross profit. If you have changed how you-- Let's say that you normalized how you report financials and now it just looks weird. Like there was a big drop in something and a big rise in another, and they're wondering what happened here. You have to explain all of that stuff.

What they really care about is trend line. In 2020, which turned out better than any of us were expecting, they can still help explain why something happened like it did. They really are going to look at, okay, what happened here? Not just why did it drop that? Why did it rise? They do care a lot about those trend lines and how to explain them.

Blair: Okay, that makes sense. Number five in your list of what they will scrutinize, client concentration. There's got to be a high and a low threshold for this, I imagine?

David: There is, and here's where my advisory practice differs from the M&A world, in that I think you're fine up to 25%. A single related client source that represents 25% or less, I think you're fine. They are not that forgiving, usually. They want something smaller, like 10 to 15% would be their comfort level. If it doesn't fall within that range, then it may impact the price, but it certainly will impact the terms. You'll have a larger percentage of the purchase price tied to actual result after the transaction closes just to protect themselves, but they're really going to shy away from any client concentration problem. The single thing that could kill a deal is that.

Blair: It seems to me there's a difference in perspective on this because you have a slightly contrarian perspective that you've sold me on years ago. I repeat, often, and that's the idea of your client base should be smaller than you probably think it should be. You could tell me the numbers, but like 10 to 15 clients roughly. You could have quite a lucrative firm that has 10 clients. One of those clients might represent 25% of your revenue, and it's still a good business. To mitigate against the risk that's represented by an oversized client, you would see how a buyer would find appeal in a larger client base, but that flies in the face of your thinking and mine on what your client base should look like.

David: It almost highlights how we think so differently. An M&A buyer is assuming that we have largely standardized packages that we're delivering to clients. The industry is almost always customizing everything. From their standpoint, the idea of all these little bitty clients that they have to customize services for drives them crazy, and that's what drives me to push those numbers up in terms of percentage and down in terms of total count. The outside buyer doesn't realize how much we customize things and doesn't understand why 52% clients wouldn't be a good idea.

Blair: Got you. Next on the list, new business systems.

David: Yes. How are you going to keep up the great results you've had? They really care about this. This has shown up a lot in the last three years. Tell us about your new business system, specifically? What are you doing? Where are these clients come from? What are you doing consistently? What's your lead flow? What's your turnover? How do you replace them? What happens if we switch your role a little bit as the principal or one of the principals. This is a really big thing for them more so than ever before. What is your new business system?

Blair: They're going to want to see into your CRM system. When you pull out that Excel spreadsheet, you say we get business from referrals, word of mouth, here's an Excel spreadsheet of opportunities we're working on. Yes, sorry.

David: Yes, right.

Blair: Okay. Yes, that's proof of your ability to codify new revenue coming in. After a new business system, you got two more here. I'm going a little bit quickly. I'm itching to get to the last one. The next to last is revenue visibility. Monthly recurring revenue, et cetera. It's tied to the last one of scalability.

David: Yes, this is their phrase. We don't say revenue visibility, that's what they say. They want to know, okay, in a typical year, how far in advance can you anticipate what percentage of your revenue.

Blair: Are you signing multi-year contracts with your clients or just one year and you go, "It's project to project."

David: They say, "Is this thing still working? Sorry, what did you just say?"

[laughter]

Then, the scalability. They're only buying it to scale it. Nobody's interested in what you're making, financially. They're interested in what they can do with that. They want to know what they need to do to grow this thing. If it's not scalable, it's not going to fit. Now, I'm talking about the typical buyer. If you're talking about another buyer that just wants to add capacity or they just want a different service offering or whatever--

Blair: Plugging a hole.

David: Yes, but an outside buyer, they care about scalability. What can we do with this business? They're interested not just in maintaining the growth path you've had, but maybe even increasing that rate.

Blair: It's really about the upside. What's the upside?

David: How are we going to reach it? That's the new business system.

Blair: Yes. We've talked about what buyers won't care about, and we've just talked about the things that they will scrutinize like crazy. There are eight of them. You're positioning, your size - you need to be big enough, your net profit, the trend lines for gross and net revenue, client concentration, whether you have a new business system or not, and what they call revenue visibility, what we would call recurring revenue or a contract length, then the idea of scalability or the upside. We've talked about it before. We'll probably talk about it again. There can be a tendency to productize and pursuit of scale. It's not necessarily the same thing. It's not even the right way to think about the issue of scalability in a customized services firm, but we'll reopen that can of worms again in the future.

You want to finish just by making a point about most people listening haven't actually sold a firm before. We all know somebody-- You and I who know hundreds of agency owners, we know multiple people who have sold agencies. I think you implied offline or in your notes somewhere that don't believe everything you hear from the principal who sold their firm. Do you want to just speak to that for 30 seconds?

David: The amount they sold it for grows over time. It's just very mysterious.

Blair: Like the fish you caught.

David: Right. What they did to make that happen just becomes glorified like a statue in the town square. There are many ways to do this. Talking to somebody who did it once, who fell into it in many cases, it's not necessary. You got to pay attention to more of the buyers and not the few sellers who don't necessarily remember all the details correctly.

Blair: Thanks for this, David. I think this has been really helpful, and I think you might be hearing from some people. I'll certainly be visiting, what is it, creativevalue.co?

David: .co, yes.

Blair: Is that site live?

David: It's not live yet. Just a holding page, but we'll have more up there soon.

Blair: Cool. I suspect we will come back to this topic of buying and selling firms at some point in the future. Again, thanks.

David: Thanks, Blair.