Investors’ default position is to find reasons not to buy your boutique. They are looking for the risks and approach due diligence as a way to de-risk their investment. On this episode, Harry Dugan, Managing Director at STS Capital Partners shares how to build your firm to minimize those risk for a potential acquirer.
Greg Alexander [00:00:15] Welcome to the Boutique with Collective 54, a podcast for founders and leaders of boutique professional services firms. For those not familiar with us, Collective 54 is the first mastermind community dedicated exclusively to helping you grow, scale and exit your approach to the firm. My name is Greg Alexander. I’m the founder and I’ll be your host today. And today we’re going to talk about how to de-risk your firm through the eyes of a potential acquirer. And my goal today in covering this topic is to make sure that you, as the founders, last leader of your boutique that might want to sell your firm someday. You know how investors or strategic acquirers are looking at your firm? Most of them come into this process. And their default position is to find reasons not to do the deal. U.S.. Are an eternal optimist and you find reasons to do the deal. And sometimes there’s a disconnect there. So I want to make sure that we’re looking at this thing in its entirety, and we’re lucky to have a great role model and expert in this area with us. His name is Harry Dugan, and Harry is a member of Collective 54. This is what he does for a living. He’s been through dozens, if not hundreds of these deals. And he’s going to share his wisdom with us today. So, Harry, welcome to the show.
Harry Dugan [00:01:41] Hi, Greg. Thank you very much for having me. It’s a pleasure to join you today.
Greg Alexander [00:01:46] Would you provide a proper introduction of yourself and what your firm does?
Harry Dugan [00:01:50] Sure. So I’m a managing director with STS Capital Partners. STS is a boutique I bank. We operate around the world. We are exclusively a sell side advisory firm. So we have been working for over 20 years in helping founders and family owned businesses maximize their exits and and achieve success to significance.
Greg Alexander [00:02:18] Okay. Very good. So let’s talk about the topic today, which is de-risking your deal. So maybe maybe I’ll start with a softball question, which is through the eyes of a potential acquirer. What are maybe the top 3 to 5 things that cause a deal not to happen?
Harry Dugan [00:02:38] Well, it’s great that you talk about risk and you make some really great points in the book and. And just to start there for a second, you know, buyers, financial buyers and strategic buyers, they’re investors and they don’t want to lose money. You know, they these are folks who, you know, if they’re investing, Warren Buffett famously said the number one and number two rules are, you know, number one is don’t lose money. And number two is never forget. Number one.
Greg Alexander [00:03:04] You know.
Harry Dugan [00:03:05] So they you know, they come at this with a very skeptical perspective, you know, especially if they’re very acquisitive, if they’re a financial investor or their private equity firm, you know, their job is to make investments in place money. And they want to make sure that they’re going to get a return and that they know what they’re buying. So they’re going to be very thorough and scrutinize, you know, you as a company through their due diligence process. You know, the I think the biggest thing that kills deals in this case is surprises you. You want to avoid surprises at all costs. And, you know, there’s some ways that you can do that. You know, you need to be honest with yourself. You need to be honest with your banker and your advisors, and you need to choose your moments. But be honest with the buyers as well, because if you have the right advisors, there’s a lot you can do to strategize and put yourself in the best light and avoid those surprises that kill deals through the process.
Greg Alexander [00:04:11] So, Harry, give me an example of a surprise that would that would cause a problem or maybe something that you see more often than you would like.
Harry Dugan [00:04:21] Yeah. A lot of times it’s, you know, issues with the history, with the finances of the company, the accounting issues. A lot of points you raise in the book, you know, about the quality of your contracts, the quality of your receivables, the customer concentration. I think that, you know, you need to be be honest and position your business in the best light possible, which is going to make it the most attractive to the buyers. But at the same time, you can’t sweep things under the rug or hide things, whether they’re accounting issues or their lawsuits or their prior employment issues, you know, things like that that come out. If a buyer feels like they’ve gotten to a certain point of their diligence and they feel like they were misled, that that will easily kill a deal. Whereas if you acknowledge these things and you put them out at the right time early in the process, and you give the buyer a reason to say yes and how these aren’t a challenge or they aren’t an issue, or how you either learned from them or dealt with them, then they’re a lot easier to work through.
Greg Alexander [00:05:28] You know, I’ll give you an example of something that just happened here recently from a member. He is in the middle of building. Someone’s trying to buy his firm and he goes, Hey, Greg, I need your opinion on something. So what’s that? So seven years ago, I got a DUI. Yeah. Should I disclose that? And I said, yes, you should. It goes, well, you know, I don’t want this to derail a deal. I’m like, listen, if this company does your homework, they’re going to find it anyways. And why do you want to lie to me? It was seven years ago. I mean, you’re not an alcoholic. You’re not you’re not in recovery. It was a non-issue. I mean, there’s a lot of people look at you as if I was thinking about buy and you told me that I would not want to buy you even more because I know I’m dealing with somebody who’s who’s honest and is not trying to hide anything. But, you know, sometimes founders, they’re they’re so, I don’t know, private or scared. I know what the word is like. Like, for example, why would somebody working with you as their advisor misrepresent their financials? I don’t I don’t get that.
Harry Dugan [00:06:27] Yeah, I that’s a great example and it’s spot on. I live through a deal in a very similar circumstance where a seller had a, you know, felony conviction for something stupid he did when he was in his early twenties. And it was 20 years later, but because it was never disclosed and the buyer discovered it on their own, it felt like a betrayal of trust.
Greg Alexander [00:06:53] Yeah.
Harry Dugan [00:06:55] Whereas if it would have just been put out there upfront and dealt with, you know, the buyer could have gotten over it, got through it. I think, you know, being honest with with your advisor, you know, not misrepresenting your financials, you know, the sooner you lay all your cards on the table, the more your advisor, your banker, your your team that’s working on the deal can strategize and, you know, work through that stuff. You know, we don’t want to hide anything. We don’t want to mislead anyone. We don’t want to feel like they were misled, you know, even through admitting something, because this is a thorough process. If somebody is going to write you a check for 30 or 50 or $200 million, they are gonna do their homework. And if there’s any skeletons in the closet, they’re going to find them. So you’re better off to just get them together yourself. Be honest with yourself, be honest with your advisors, and then strategize how you’re going to tackle it.
Greg Alexander [00:07:48] Yeah. You know, another story just to bring this topic to life. Another one of our members was who had a successful exit about a year ago, was bragging to the potential acquirer, which in this case was a strategic about how great their culture was. And the strategic started calling former employees and some of the former employees did not have positive things to say.
Harry Dugan [00:08:10] Yeah, so.
Greg Alexander [00:08:11] The culture got exposed. I mean, that’s the kind of diligence that people are going to do. They’re going to call your former employees are going to call your ex clients and just try to sweep those things under the rug. It’s just not a good idea.
Harry Dugan [00:08:23] But there’s really, really easy stuff. I mean, they teach kids today who are applying for their first job to clean up their social media profiles. They don’t have weird things that you posted late at night after a night out with some friends, you know, come back to bite you and make you be perceived as something you’re not. You know, a lot of times, even when I’m speaking with a new client and I want to make I just want to do some homework on my end to see if there’s somebody, because I’m going to make a big investment in this process, in this relationship. And Greg, as you pointed out several times, you know, bankers get paid when the seller gets paid. Yeah. So I, you know, want to be careful about who I’m partnering with for for this process. And, you know, I’ll just do a Google search on their name, on their company’s name or, you know, look up the company name in lawsuits, see what pops up in the public record, you know, things like that. And when you get into a process, you get into the to the ninth inning with a buyer, you know, they’re going to run a background check on you. I see it all the time. They’re going to ask you to sign a release and they’re gonna run a credit check and a background check. And if you are planning to exit the company and the value is in your leadership team there, they might do background checks on your senior leaders. So if that’s not part of your hiring process, you might want to proactively do that in advance. So you know what you’re getting into.
Greg Alexander [00:09:48] Yeah, exactly. Let me ask you some tactical questions. So, remember, 85% of our membership are people who have never been through an exit before. They’re the original wealth creators, the founders. They haven’t been through an exit, and they’re doing this for the first time. Is it worth it to get audited? Financials? Is it worth the expense of the effort?
Harry Dugan [00:10:12] There’s not always audited financials depending on the size of the company and what their financing situation is. I mean, processor companies tend not to have as much working capital requirements as somebody in manufacturing or distribution. So, you know, they might not have a really complicated line of credit that they need for their financials, for their bank. And what’s more important than that is an engagement that you’d hire an accounting firm for, call it quality of earnings. And most buyers will do a quality of earnings engagement, which is not an audit, you know, an audit. I started my career in accounting. So an audit is a technical analysis of is the balance sheet correct? Do the financial statements fairly reflect the position of the company? Equality of earnings is a more thorough analysis where they’re looking at your sales history and trends, your margin trends, your customer concentration, you know, all these things, your cost positions are your are your payroll costs exploding so that a an investor can predict it with the best information they have as to what their return on investment is going to be. And I highly, highly encourage closely held, founder led or family owned businesses, especially if you don’t have audited financial statements to hire a firm to do a sell side. Quality of earnings engagement. And just like with any other skeletons. So that way you are going to know exactly what they’re going to discover in due diligence. You can choose to share that with them in advance, and it can oftentimes speed up the diligence process because everybody has confidence in the numbers. And and, you know, you’ve taken them halfway through the diligence process.
Greg Alexander [00:11:59] You know, regarding quality of earnings acuity, as it’s referred to, oftentimes, you know, you can hire a brand name accounting firm and spend a lot of money on it, or you can hire a small accounting firm and do it on the cheap. The brand name accounting firm will tell you that if their name is next to it, it’s going to increase the firm’s valuation because it’s more credible. The small accounting firm will say, that’s B.S.. Q Is Acuity the brand name of the accounting firm that does it doesn’t mean anything in terms of its impact on valuation. What say you on that?
Harry Dugan [00:12:36] I think the firm that you engage for that should be appropriate for the size of your business. You know, if you’re if you’re $20 million pro serve company, you don’t need to hire, you know, KPMG to do your Cuvee. But a, you know, you definitely you don’t want to have a Joe Bob CPA who’s a single operator with a shingle outside of his garage. Do it either. You know, you want to get a reputable regional firm that has a good reputation, that has a practice, that has an M&A practice, that does these a lot. And they’ll know exactly what a buyer is going to be looking for. And they can help take you through it before you feel like there’s somebody, you know, crawling around in your closet.
Greg Alexander [00:13:24] You know. Now, regarding this, you know, so let’s say I’m the owner of a $20 million processor firm. I hire a reputable accounting firm to do a quote. And I get to the point where I sign an ally and I’m in actual diligence, the acquiring firm, the person I’m selling myself to, are they going to do another query and somebody they hire?
Harry Dugan [00:13:44] Sometimes it depends on their their risk appetite. Right. You know, you’ve you’ve hired a good firm. You’ve got it. They’ll probably get an their own independent firm to review the query that you did. But it will not be nearly as thorough or exhaustive of a process.
Greg Alexander [00:14:03] Yeah. Okay. Got it. All right, Harry, my last question regarding, you know, derisking, which is the topic today. Sometimes founders get crazy with add backs and they try to goose their EBIDTA by adding back everything in the kitchen sink. Any rules of thumb here you can share with us?
Harry Dugan [00:14:23] A. Know, my my personal philosophy is to put everything on the table and the buyer will decide, you know, what’s a what’s valid or not. I think going through a Q of process with with a firm that that has experience with this that that does them for buyers and sellers, they’re going to help with that. And that brings up another great point, Greg, which I forgot to mention is that, you know, the cubes aren’t cheap. You know, depending on the size and complexity your firm, it could be, you know, $50,000. It could be $150,000. But if if the firm that’s doing it finds an ad back, a legitimate add back that you forgot about and you’re selling your company for, you know, call it ten times EBITDA. You know, all they need to find is, is $20,000 and that’s easily paid for themselves.
Greg Alexander [00:15:12] Yeah, at my experience. 20 K Yeah, yeah. Yeah. So it’s worth it. All right, I will. Listen, we try to keep these episodes short, so we’re at a time window. But on behalf of the members, it’s great to have somebody like yourself in the membership who knows how to get deals done, who’s on the sell side, who deals exclusively with founders and family businesses. So thanks for being on the show today. I really appreciate it.
Harry Dugan [00:15:36] Thanks for having me, Greg.
Greg Alexander [00:15:38] Okay. So for those that are in pro serve who want to belong to a community and learn from people like Harry, consider applying to Collective 54 and you can do so at Collective54.com. If you want to read about this subject and others like it, consider picking up a copy of my book which is titled The Boutique On a Start Scale and sell a professional services firm. Thanks for listening and I look forward to talking to you again in our next episode.