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Green, Yellow, Red: What Signals Investors

What’s not often discussed is the soft side of a deal - the people, their behavior, and what it signals to potential investors. It’s impossible to do a good deal with bad people, which means the personalities, proclivities, and oddities play a large part in dealmaking. 

We’re fortunate to see a lot of opportunities, over 2500 just last year, and are constantly in conversation with executives. This affords us the ability to recognize patterns and develop specific criteria of behavior that provide insights into an owner’s motivations, and subsequent corporate culture. Here are some of the signals and how we interpret them. 

Green Grass, Gratitude, And Things Being Hard

Anything worth doing is going to be hard. Let me repeat: no matter how simple, easy, or straightforward something appears to be, it will be difficult. In the beginning, it’s just not always obvious why.

Why We Love to Buy Boring Businesses

We’ve had the opportunity to evaluate and invest in all types of companies, including some “sexy” businesses — ones with high growth, brag-worthy products, or screw-the-rules teams with an average age of 25. While the “sexy” factor is never why we choose to invest, it can certainly be exciting. But the other end of the spectrum also attracts us; it contains what we call “boring businesses,” the almost invisible layer of the economy that hums under the radar, quietly supplying you with what you want and need.

Important Metrics for Small and Mid-Market Companies — Part 3: Team

In an average month, my organization explores around 50 companies for possible investment. We review everything from organizational structure, culture, and financial performance, to sales systems, competitive position, and leadership style. This gives us an unusual vantage point from which to recognize patterns of success, and failure.

Getting data is never the problem. In fact for most executives, information can be overwhelming. Getting accurate data and interpreting it appropriately is an entirely different story.

In The Ceiling of Brute Force, we discussed what operational areas impede a company from continued growth. In a series of posts, we’re going to break down 19 of the most important key performance indicators (KPIs), which demonstrate how effectively the business is being run. Think of KPIs as the canaries in your coal mines. If one starts going south, you know it’s time to take a closer look.

Presented in a five-part series, here’s our take on what you should pay attention to, allowing you to focus your time, effort, and dollars. The five parts are: BasicsCustomers, Team, Operational Efficiency, and Investment. In Part 3, we’re presenting key metrics on the group of people that make your company function: leadership depth, employee tenure, and payroll ratio.

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The Little Things Impress Me Most

What impresses you? It’s a crucial question, because it says a lot about your goals, values, and purpose. Everyday we compare, evaluate, and judge. We watch others’ decisions, preferences, and outcomes in an effort to optimize our own lives. Yet what we consider to be signal, and noise, is critical to how we adjust our thinking and behavior. Brent shares his thoughts on noise and meaningful effort. 

From 2000+ to 3: Our 2015 Investment Recap

Adventur.es is entering the new year wiser, stronger and a great deal larger. In the course of making 3 late stage acquisitions and 27 early stage investments, the future of adventur.es, and who will contribute to it, became a bit more clear in 2015.

Choosing An Acquirer: Hot Date Or Life-Long Partner?

Selling your business can be a lot like dating. Are you looking for a one-night stand or for that perfect girl to take home to the family? Knowing the difference is crucial to finding the right person, or group, to buy your company.

At some point every business owner needs to exit. Some want to travel, spend more time with loved ones, or just step out of the pressure cooker. Others have health issues, are underfinanced and underequipped, or feel they could benefit from a strategic partner. But when it comes time to transition, many owners have little idea what they’re looking for. Like dating, every prospective buyer has upsides and downsides, and your job is to understand them.

Here’s a framework to help: 

  • Sexiness: The sexy part of any deal is the valuation and, all things being equal, more is obviously better. But like most things in life, the number always comes with strings attached. What adjustments are the buyers making for deal fees, working capital, or transaction expenses? In some cases those can add up to 15 percent, or more, of the total transaction.
  • Values: What’s important to you and do you share those core values with the buyer? Do you care how your company will be run? Do you want your firm to maintain independence? Is it important to maintain the company culture? It’s crucial to find clarity and understand how the buyer’s intentions overlap.
  • History: Talk is cheap. Actions speak louder than words. A tiger can’t change his stripes. How’s that for a barrage of platitudes? But they’re true. How has the buyer treated past partners? What are the results after they take over a company? How long do they plan to own the company? Doing your homework will save considerable heartache.
  • Interests: We’re all good at some things and inexperienced at others. Does it matter who makes decisions at your company? Of course it does. The buyer’s background is crucial and there are opportunity costs to every skill set. A buyer with deep industry expertise will have better intuition, but won’t bring a fresh perspective to the table. Conversely, a marketing expert is unlikely to see the nuance of the industry-at least, in the beginning. What you need is situation-specific, and you certainly need to understand the situation.
  • Finances: The leading cause of divorce is money problems, and business partnerships are no different. If you’re a conservative operator, you probably don’t want to marry a spendthrift who’s happy to go deep into debt. You should understand what type of debt the buyer plans to put on the business, how they plan to re-invest, and they’re capacity to fund the company if potholes are hit.
  • Adversity: Relationships are messy and take work. Your ability to successfully transition the company will depend on developing trust with the buyer. A key piece to the puzzle is how the buyer handles conflict. What are mountains, and what are molehills? Is the buyer a screamer, or a stoic? Do they have patience, or tend to be trigger-happy?

Dating Pool

After you’ve thought about what you’re looking for, it’s important to understand the dating pool. What are the types of fish in the sea?

  • Private Equity Group (PEG): These come in two distinct flavors, funded and unfunded. The funded groups have raised committed capital they need to deploy, while unfunded groups are waiting until they find a deal to seek equity investors. Both plan to buy the firm using considerable leverage (2 to 7X earnings before interest, taxes, depreciation, and amortization), use free cash flow to pay down debt, and flip the company to another buyer within four to seven years who will reload it with debt.
  • Searchers: Search funds are led by one or two individuals, likely recent MBA grads, who are backed by a group of equity investors. They are looking for companies to buy and run, assuming the top management positions. Some (but not all) rely heavily on debt to finance the transaction. They typically plan to operate the company for five to ten years and then sell.
  • Family Offices: These are organizations built around the wealth of a few individuals and come in all flavors. Some act like traditional PEGs, while others function with long time horizons and commitments. It’s vital to understand the attributes of each group.
  • Strategics: These are the players in your industry and you likely know them well. Does it make sense to sell to your competitor? It all depends on your values. Strategics frequently fold the acquired company into the mothership and extract considerable “synergies” out of company structure.

Advisors

Remember all that advice you got when you started dating? There was no shortage of opinions from friends, family, and co-workers, and exiting your company is no different. You’ll hear plenty of feedback, and like dating, remember that everyone comes with various biases and interests. Here’s a quick roundup:

  • Financial Advisors: When you exit, financial advisors get a big raise based on the assets you deploy with them. They’ve seen many of their other clients exit and know some horror stories. They’ll likely advise you to “get all the money up front,” because “there are lots of ways you won’t get paid out.” Plus, they’ll get more money to manage that way.
  • Lawyers: As the adage goes, the devil is in the details. Every lawyer’s background is different, but most general practice lawyers don’t make excellent transaction advisors. They frequently miss big issues and send up red flags on inconsequential matters. And depending on your future plans, they’ll also be worried about losing your business. It’s highly advisable to find specialized counsel for the transaction.
  • Intermediaries: Warren Buffett said, “Never ask your barber if you need a haircut.” Understand that much of your intermediary’s advice will be based on how fees are structured. If fees are based on a transaction, you will be pushed to do something quickly. If it’s a retained search, you run the danger of the intermediary stringing out the process. There are many types of intermediaries out there, so be sure to interview a wide variety before settling on one.
  • Bankers: If you have loans with the bank, they’re not likely thrilled with a transaction. You’ll pay off your notes and they’ll likely lose the company’s business. This might be offset if the bank has a wealth management division, of which they’ll be quick to remind you.
  • Accountants: Like bankers and lawyers, accountants will be worried about losing business. Make sure they’re readily available to help explain the company’s financials and are capable of interacting directly with the buyer. They should be able to help field questions or concerns.
  • Your Execs: It’s not unusual to bring your senior executives into the “know.” A normal, immediate response is fear. Change is scary and few things are more nerve-wracking for employees than an ownership transition. Understand that in most cases, a majority of their advice will come from a position of insecurity and concern.
  • Regardless of who is advising you, don’t outsource your judgement. You didn’t build a successful company by blindly relying on the advice of others, and your exit isn’t an exception. Understand what you want; establish a process that will likely deliver the right buyer; and think critically about the dynamics.

Planning A Wedding and Marriage

After dating, it’s time to settle down. But before you get married and live happily ever after, you get to go through a grueling engagement called due diligence. This process stress tests you and your company to verify the valuation. Results from these examinations may result in adjustments to the purchase price. Here are the main components:

  • Quality of Earnings: Most buyers will perform a quality of earnings assessment that tests where profits originate. The more profits that flow from higher sales or lower costs, the better. Profits from anomalies like inflation, one-time events, or changes to inventory are considered negative.
  • Capital Structure: Buyers will want proof of ownership and a list of all shareholders, options, notes, debt instruments, and any off-balance sheet transactions or liabilities.
  • Operations: Everything critical to the operations of the company will be shared and analyzed, including major customer files, strategic relationships, suppliers, competitor, and distribution information, and the research and development pipeline.
  • Personnel: You’ll share historical and projected head count by function, the current organization chart, and compensation arrangements and expectations. Personnel turnover and all employee files will be scrutinized.
  • Legal: Any lawsuits against, or initiated by the company will be reviewed. You’ll supply lists of patents, trademarks, copyrights, and licenses as well as environmental and safety records.

After this review is completed, the buyer will supply the final paperwork necessary to complete the transaction, and you’ll be on your way. But depending on the nature of the transaction, your partnership may just be starting. Many sellers “roll forward” equity and maintain a considerable stake in the new entity-making a long-term commitment to the new ownership group.

If you continue with a stake, the marriage analogy is quite apt. Each stakeholder brings a different set of baggage into the relationship, including personal reputations, routines, outside interests, and timelines. Relationships are messy and require work. Choose wisely.

This post was originally published on Forbes. 

Risk, Return, And The High Wire Act

A late night with Philippe Petit, Man on Wire

A late night with Philippe Petit, Man on Wire

“The received wisdom is that risk increases in the recessions and falls in the booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions.” – Andrew Crockett

Everyone likes to talk about returns; it’s what you can eat, boast about, and use to estimate your value added. But the flip side of the coin, risk, is of equal importance. In a world on the upswing, here’s a shot across the bow.

Risk is tricky. It’s always in the background and underneath the surface, lurking and waiting. Ignore it and you’ll probably be fine – until you’re not. And when that happens, watch out, you’re likely in a world of trouble. Embrace risk mitigation and your upside will necessarily suffer. Eliminate risk and you will get between almost nothing and literally nothing, especially in today’s low-inflation, low-rate environment. As I said, it’s a tricky topic.

Risk is not uncertainty. It is not volatility. At its core, risk is the likelihood and magnitude of permanent loss. It is the probability of a collision between a detrimental event and a lack of planning, resulting in a permanently negative outcome of some potential size. Howard Marks said, “Loss is what happens when risk meets adversity.” But as I’ll dive into later, real risk can quickly develop from unlikely sources and circumstances, converting a temporary hiccup into a death-knell.

While returns are easy to measure, risk is elusive. Economists and financial gurus constantly attempt to quantify it, but its estimation is more art than science. If you took a piece of real estate and asked 100 investors to gauge the risk of owning it, you might get many of the same risk-related topics, but few, if any, would agree on a precise score. Risk represents a rough approximation because the permutation of each actor’s circumstances are indefinite and constantly changing. Plus, each participant’s actions influence the system’s outcomes. What is high-risk to one, may be de-risked to another.

So if risk is undefinable, subjective, and obscure, how can it be understood and controlled? As John Maynard Keynes said, “It is better to be roughly right than precisely wrong.” The path to managing risk is to understand yourself, your situation, and the controlling factors that might lead to negative outcomes. The goal is to operate responsibly, allowing for enough risk to gain rewards, while not playing financial Russian Roulette. Think Goldilocks. Not too hot, yet not too cold either. But only you know the appropriate temperature.

For operating companies, there are numerous sources of risk and the purpose of this article is not to cover them all. In fact, volumes of books have been written on the subject. What I’d like to do is raise the warning flag in what feels like a “heated” environment. While most middle-class American families may not feel excited about their personal finances, the current state of business is looking uncomfortably optimistic. Everyone can see public company valuations, which are somewhere between elevated and nearly euphoric, depending on the measurement technique. In the private markets, we’ve recently seen small, mediocre, and cyclical businesses go at auction for 8X current year projected pre-tax earnings. That’s stout and while that individual situation may turn out just fine, the odds don’t work out favorably. It’s kind of like a craps player having a good night. Good for her, but play enough craps and it probably won’t work out profitably in the end.

My digression into valuation is to demonstrate risk. The less risk investors feel, the more they’re willing to bid up assets and as long as everything is up-and-up, the game continues. Risk taking in good times leads to outsized returns. But assumption of risk alone won’t drive long-term gains. It results in an opacity between being lucky and being good, or what Nassim Taleb would call “lucky idiot” syndrome. Every bull market produces a class of lucky idiots who won (temporarily) for all the wrong reasons.

So what? I’ll let Warren Buffett explain: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” Elevated valuations, aggressive transactions, and a general feeling of financial FOMO (fear of missing out) should give you pause, lead you to take inventory, and provoke a plan for the future. Cycles happen and the good times don’t always roll. So when the music stops, or gets inaudibly quiet, how quickly and easily can you find your seat?

The most glaring source of risk I see time-and-again for businesses of all shapes and sizes is financial. How do you monitor and maintain cash flow? How have you structured equity and debt? What are the likely outcomes from growth or shrinkage? Two recent first-hand experiences stand out to me.

A well-known and well-respected entrepreneur recently approached us about investing in an “emergency round” of capital, the other Series E. They had been “killing it,” growing like crazy, and had raised a moderate seed round from a variety of angel investors. They were actively talking with VCs about doing a Series A round of financing. The problem was that they had started their raise too late, while simultaneously experiencing margin compression, lower lead conversions, and a few large, late-paying customers. The result was a “successful” company about two weeks away from death.

We had another recent opportunity to provide emergency financing for a company on the opposite side of the spectrum, an established firm of over 20 years. The founder/CEO was a prominent member of YPO and a big charitable donor. He had experienced decades of success and his company was an undisputed leader in their niche industry. A few years back he took on growth capital to expand, which included a preferred return and a big payment that was quickly approaching. His customers had stopped pre-paying and he struggled to finance the up-front investments needed to start receiving the long-term contractual payments. He continually took on very expensive short-term financing, the business equivalent to payday lending. Despite being highly profitable and growing, he recently found himself insolvent and with no way out.

Risk doesn’t only manifest in bad times. Loading a company with debt, maintaining small cash reserves, and not closely monitoring the results from the business’s trajectory can all prove disastrous. But risk comes in many more forms:

  • Culture Debt: Internal company politics can be brutal. Rivalries form. Factions get created. Turf wars rage. In good times, money can cover up a lot. In challenging times, watch out. While this debt may not be reflected on the balance sheet, it’s real and spring loaded.
  • Code Debt: For software-based companies, there’s always tension between shipping product and quality. The result is risk embedded in the code base. Band-aids and patches can be effective short-term solutions, but eventually problems arise and long-term solutions are expensive in every way.
  • Systems Debt: Robust systems are major drags on resources in the short term. A company doesn’t become more profitable by hiring in HR, accounting, or legal. Resources dedicated to building out internal systems are costly, regardless of efficacy. As companies defer these costs, risks build and eventually things explode.
  • Expectations Debt: When it comes to bringing on outside investors, or high-level employees, expectations matter. If you raise money with high expectations, very bad things happen when you don’t perform. The higher the expectations, the less your margin of error. The same goes for employee promises. Stock options can be extremely attractive, or utterly worthless. It just depends on expectations.
  • Leadership Debt: People sometimes succeed despite themselves, but as Charlie Munger has said, “If you live long enough – most people get what they deserve.” In the short term, it’s almost impossible to differentiate luck from performance. But if the company has out-grown its leadership, watch out.
  • Aggregation Debt: Most risks are correlative and additive, meaning they are mutually connected and the addition changes both profiles. This makes most risk non-linear, where the addition of small risks over time can create explosive situations. While individual risks can be looked at in a vacuum and reasonably estimated, Yogi Berra seems particularly apt: “In theory there is no difference between theory and practice. In practice there is.”
  • Concentration Debt: The special sauce that allows most companies to prosper is a form of human equity. It’s specialized knowledge about how a system works, or some hard-to-gain expertise, or a handful of high-value relationships. People leave, die, or get addicted to something unfortunate and go off the rails. The more concentrated this human equity, the higher the risk.

People go through ups and downs. Every company experiences favorable results and hits potholes. Economies cycle. The trick is to plan for it. I equate running a company to wire-walking. Regardless of the participant’s skill, the nature of the wire matters. How much does it flex? How wide is it? How slippery is it? How long is the wire? The risks of a business are similar. More debt, of any type, makes the nature of the wire more challenging. The height of the wire is irrelevant until you fall off, but when that happens, what is the result? Is it complete destruction, or merely a suboptimal outcome?

As an investor, the higher the valuation, the higher the wire. The more cyclical, debt-laden, and inexperienced, the more likely the fall. As a general rule, we like our companies walking on two-by-fours about six inches off the ground. We certainly won’t produce the highest returns this year, or next, but we’ll be around in twenty years.

This post originally appeared in Forbes.

Winning at the Wrong Game

“Grand strategy is the art of looking beyond the present battle and calculating ahead. Focus on your ultimate goal and plot to reach it.
- Robert Greene

While most are terrified of losing, I fear winning -- winning at the wrong game. Losing carries a sting that encourages learning and subsequent change, but winning reinforces perspective, builds confidence, and emboldens further pursuit. But what if you continue to win at the wrong game? It can take a lifetime (or longer) to realize and correct course.

Winning and losing always comes down to preference. One man’s win is another man’s loss. To that extent, the score of life is extremely personal. The challenge is our comparative nature. Whether we like it or not, we’re constantly being judged, with money, fame, and power as the dominant metrics for most. It often proves challenging not to adopt a similar viewpoint, or at least occasionally take a peek at the world’s scorecard.

But as the old adage says, “Where there’s smoke, there’s fire.” Those metrics often do tell us something. The wealthy, powerful, and famous are, on average, more remarkable than the general population. The problem lies with the individual. Those attributes are merely the byproducts of some combination of luck and value creation. In the short term, true performance is always obscured and metrics are easily faked, making meaningful progress difficult to measure. How much of last year’s returns were the result of good fortune? Who knows. How much credit is your neighbor consuming with the new Beemer and designer clothes? Only time will tell.

Truly winning starts with establishing the right goals (for you) and adopting a long time horizon. It takes both, each of which is incredibly challenging, to produce a positive outcome.

Is “getting healthy” about losing the most weight? Is “being wealthy” about having assets or cash flow, or something else? Over what timeframe do you measure returns? In the short term, couldn’t the winning company have the most financial, cultural, or code debt?

Be cautious in admiration and courageous in self-reflection. In 2008 the three most admired athletes were Tiger Woods, Lance Armstrong and Oscar Pistorius.