This is CFO Secrets. The weekly newsletter that doesn’t trust profit until it converts to cashflow.

10 Minute Read Time

In Today’s Email:

• 👉 I bought a business last week; the inside story.

• 🦍 Elon’s King Kong Dong Joke

• ✉️ Wonderful shareholder letters

THE DEEP DIVE

How I Bought a Business with Net Operating Income of $358k for $0.

Something a bit different this week.

Back in November I posted this:

Well … last Friday… it closed.

And I promised I’d break it down in the newsletter.

So, here you go…

What’s the story?

Aside from my corporate life, I enjoying acquiring small businesses on the side. Finding good targets takes a lot of work (albeit I outsource most of that work, more on that later). But its fun.

Multiples are low, and depending on the deal structure, the cash on cash return can be exceptional.

I do this alongside a good buddy. We have complementary skills and have a lot of fun working together. He is a successful entrepreneur. With ninja level skills in making friends and building sales teams, something I don’t have.

And I can read the financials of a business, and then build a deal structure very quickly. I can also use my experience to take a pragmatic approach to the M&A process, ensuring we only focus on what matters.

We both like the challenge of adapting our approach to smaller businesses. We also share a discomfort with passive investing and like to control our own investments.

What is the business?

• Distributor of niche print equipment and supplies (combination of resale and light manufacturing)

• Long term distribution agreement for the products of a large global manufacturer.

• Customers are businesses who need printing equipment and supplies (in this particular niche). Either as wholesalers, or as part of their own supply chain

• Customer switching costs are high. Business is protected by ‘razor and blade’ model in short and medium term.

• Business is twenty years old.

Why is it for sale?

• Two owners, each own 50%. One in his late-40s the other in his mid-50s.

• Both had lost enthusiasm for the business in recent times and had been on cruise control. They were only working 2-3 days per week.

• Sales going backwards 5-10% per year voluntarily. They had sacrificed sales to increase gross margins.

• It is clear that stabilizing sales, and regaining lost ground should be fairly straight forward. It needs some basic sales practices plus a willingness to invest some margin for growth.

• They had been optimizing for $ of net income per hour of owner time invested. Had been happy to leave money on the table, for an easy life.

• They now wanted to cash out to get one last pay day, and retire from the business.

• They had considered shutting the business down. They had made a few attempts at recruiting management to support / replace them. But had made a mess of it, and gave up years ago.

What did the numbers look like?

• Revenue was $1.5m falling by an average of $100k per year.

• Adjusted net after tax income was consistently $350k +/- $50k for the last several years. This was despite falling revenues.

• This was stated by adding back owners costs, and deducting the cost of replacement management. One sales led MD, plus a part time VA.

• Net margin was increasing year after year. Net profit was flat on a shrinking revenue line. They were laser focused on doing as little work as possible to deliver their target dividend level. At almost any long term cost.

• The business had $1.4m of cash. Net working capital (excl cash) was about +$100k. And fairly flat month after month (not a seasonal business).

• The property was owned by the shareholders and leased to the business

• Book value of fixed assets was c. $50k

How did we find the business?

We look for off market opportunities. We try and find sellers before they decide they are sellers. This makes it easier to anchor expectations of the price and terms of the deal.

In other words, we get there before they ask a broker and their buddy at the golf club what their business is worth.

We have a simple sourcing machine run entirely by VAs. They contact owners of business that meet the following criteria:

• Simple ownership (ideally 1-2 shareholders, 4 max)

• At least one owner > 55 years old.

• Business is at least 10 years old.

• Business is in industry that is not exposed to being nuked by AI. Or given away by Amazon, Google or Microsoft for free.

• Net after tax profit (adjusted for fully costed management) of $300k to $1.5m. Less than $300k isn’t worth the effort. $1.5m starts to hit the radar of bigger PE.

We seek motivated sellers (who ideally are not yet active sellers). We find they are most likely to accept our deal structures (more later).

What was the deal?

We agreed the following valuation: (1.75 x Average of Last 3 Years Adjusted Net Income) + Surplus Cash - Debt

• 1.75x - We pay 1.5-3.0 x net earnings for SMBs. There are plenty of SMBs worth more than that. We don’t buy those ones. Given the persistent decline in sales, in this business, we felt a multiple at the bottom end of our range was fair.

• Last 3 Years Adjusted Net Income - This number was $358k. The books were straight forward. We had to add back the owners costs, and deduct a reasonable cost of replacement management.

• Surplus Cash - The business had $1.42m of total cash. But we agreed that $60k was a reasonable working capital ‘float’ for the business and should be left behind in the business. So we quantified surplus cash at $1.36m

• Debt - the business had no bank debt, but we agreed that any accrued but unpaid taxes up to completion date would be treated as debt in the completion math.

The Terms of Payment were as follows:

• The Surplus Cash minus Debt ($1.36m minus tax liabilities) would be paid upon completion. Being able to extract this cash tax efficiently, was a win for the sellers.

• Goodwill; $625k = 1.75x $358k would be paid as deferred consideration. Payments commencing 90 days after completion in 32 instalments. So the seller note was cleared by the 3rd anniversary of the transaction.

• We agreed no interest on the seller note, and no security. This was a good result : )

• 3 months handover period plus a further 0.5 day per week for the next 12 months.

What does this deal structure mean?

Working on the basis the business earns $30k per month fairly consistently

By the time the deferred payments start we will have c. $140k of cash in the bank. $50k float + 3 x $30k.

After that we have just under 3 years of paying off the seller note at a rate of $20k per month from our expected profits of $30k per month. I.e. generating a net $10k cashflow per month

Once the seller note has been paid off, even if profit remains flat, we will have generated a total of $410k cashflow. $410k being the cumulative net profit over 3 years, minus seller note. And on current performance, at that time we will then be generating $30k per month of cashflow.

Clearly our expectation is that we will be able to grow profits and cashflow. We will install a strong sales leader from the industry in the business as CEO. We have several candidates, my buddy is brilliant at that bit.

The key thing with this deal, is that we were able to structure it without putting $1 of our own capital at risk. We are quite prepared to put capital at risk, but it wasn’t appropriate in this deal, where sales are in decline.

We do not like using bank debt for a transaction like this. 3 reasons;

• We don’t sign PGs. We share an anaphylactic reaction to anything that exposes our personal assets . It’s a red line.

• We like the incentive alignment that comes with a seller note. Everyone is incentivized to make sure the business succeeds post completion.

• We can run light on DD, because our risk is very low, and the seller is carrying post completion exposure.

This deal structure allows us to complete very quickly and with a simple legal and DD process. This lack of friction allows us to move smart and fast when we spot something we like.

This deal structure might sound too good to be true, but they are out there if you focus on finding off market deals.

My buddy is great at making friends with business owners and tests our deal structure with them early on. We only advance discussions with owners that are motivated to sell within the tram lines of our deal structures. That means saying ‘no’ quickly to a lot of deals that might appeal to others who take a different attitude to debt.

What did the process look like?

We first contacted the owners of this business in May 2021. After a short dating period we put an offer to them (based on 2.25x earnings!). They rejected our offer, and we went our separate ways.

They contacted us again in Summer 22, explaining they were ready to deal on the terms we offered before.

We then had a few months of discussions:

• We explained that with another 18 months of sales malaise, our offer on the multiple had reduced from 2.25x to 1.75x.

• We had a lengthy back and forth on the treatment of working capital. Eventually they accepted that the working capital of +$100k, and cash float of $60k, were essential to run the business. And so were not additive to our offer. All other cash in the business would be additive to the goodwill payment.

At the end of November 22 we agreed a letter of intent, subject to legal contract, and due diligence.

There was then a four month wait to get a long term renewal of the distribution agreement with the global manufacturer. This was a condition precedent for us. The potential of the business is tied up in this unique distribution arrangement. The sellers were well motivated to sort this out, as they wanted to get their business sold.

We did not start due diligence until this supply agreement was in place. Even then we conducted focused, limited due diligence. I did enough to satisfy myself that the books were clean, and a desktop review of key contracts. This was probably 8-10 hours work over a couple of weeks.

I could use my experience to be extremely focused on the two or three things that could be deal breakers. Remembering that the risk in this transaction was very limited for us.

If we had capital at risk, I would have commissioned a fuller QoE analysis and legal DD review. But it wasn’t necessary here. And in fact, by keeping the transaction simple for the sellers, this was vital in getting the deal done. The terms were favorable. Our goal was to get this done before the sellers changed their mind!

As a result financial DD (which I did myself), focused on key areas:

• Ensure that the adjusted net profit assumed in the transaction was representative of true run rate (and tied to tax returns).

• Get clear on what the cash balance at completion was expected to be. And what assumptions underpinned this. We used a ‘locked box’ mechanism. I’ll tackle different completion mechanics in a future newsletter. In this case, it meant we carried the risk if there was any funny business to manage cash at completion.

We then had ten days of getting the documents prepared. We left this as late as possible, as this is when we would start to incur abortive costs, should the deal not complete.

• We used a specialist SMB M&A attorney, the seller did not (they used a family attorney, who was unfamiliar with M&A).

• As a result, I led discussions with sellers, to ensue nothing drafted by our attorney spooked the seller or their attorney. We made sure the drafts were well balanced and fair. And we were very accommodating to the specific request of the sellers.

• We used the rapport and trust we had built to help them get comfortable with the documents.

• At no time did we let the lawyers discuss and negotiate directly with each other. This was critical to keeping speed up, and abort costs down.

What now?

Clearly our plans are to invest in and grow the business.

And the temptation is to get going straight away. But our priority for now is safe transition from the current owners.

We call this phase ‘Do No Harm’.

Smart folk with big ideas can f*ck up an operation that’s running well, through hubris and over-enthusiasm.

Our priority for the next 6 months will be to ensure the business can operate independently of the sellers. Once we have seen that, we will start to execute our growth plans, which will include complementary M&A.

We are one week into the transaction, and have been really pleased at the quality of the team and the management.

It looks like we got a good one, at a bargain price. And at an IRR of (#DIV/0), regardless of whether it goes well or not!

What can you learn about SMB acquisition?

I do not consider myself an expert in the art of SMB acquisition. Unlike corporate M&A with heavy advisor budgets, where I have much more experience. This is quite different.

So there are better people to listen to on the art of SMB acquisition than me. Xavier Helgesen, Michael Girdley, and Reg Zeller to name a few.

Nonetheless I enjoy the challenge (and the returns).

Here are the things, I’ve learnt so far about SMB acquisition over the last couple of years;

1. The best deals are off market, especially with sellers who don’t know how to value their business. Think of it like a selling process.

2. Building rapport & trust with the sellers is extremely valuable. You can become their source of expertise for getting the transaction done. It’s important this trust is used honestly, and not abused.

3. Being simple to deal with is important. Don’t be corporate. Understand what the real risks are, and address them properly, but don’t walk through the motions for the sake of it.

4. Don’t obsess over the price. Maybe even give them the price they want. But you MUST control the terms and structure of the deal. This deal only worked because of the seller note. We would have paid another turn of net profit if needs be. Providing it could have been paid through an extension of the seller note period.

5. Seller notes are powerful. They aren’t just a source of funding. They rebalance the risk profile of a deal, because the seller wants to ensure they get paid out. This transforms how you think about risk. And also incentivizes the sellers to fess up to the skeletons in the closet.

6. We are prepared to wait for deals that work. The terms of this deal were very favorable. That’s not luck. It’s because we are able to quickly say ‘no’ to 99 others that wouldn’t be so asymmetric. We spent c. $35k on sunk marketing costs (mostly VAs) to find this deal (+ a pipeline of other potentials).

I will share the progress of this business, as well as future SMB acquisitions through the newsletter from time to time.

MEME OF THE WEEK

The World’s most influential human has the sense of humor of a 13 year old boy. I’m here for it.

BOOK CLUB

This week I will recommend a book I’ve just finished. Dear Shareholder by Lawrence A Cunningham assembles some of the finest letters to shareholders ever written.

Cunningham has sourced examples from Jeff Bezos, Robert Goizueta (Coca Cola), and of course, Warren Buffett, amongst many others. It’s fascinating to hear the reflections of the greats in their own words year by year.

There are many lessons that can be taken from the book, but the three that stuck with me were:

1. The high regard in which they held their duties to their shareholders

2. The clarity and simplicity of their communication

3. The brutal honesty and public accountability these letters forced must have helped focus the mind on what matters, contributing to the outstanding performance these managers delivered.

FEEDBACK CORNER

A review form last week…

This is not a course of action I recommend.

FRIDAY JARED

Jared has seen things…

Some would say today’s Silicon Valley could have done with a few more folk capable of experiencing shame spirals in recent times. The antidote to hubris.

As always, you can find me here on CFO Secrets, and here on twitter.

Anyway, until next week…

Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend. But I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need to make the right decisions.