TRANSCRIPT OF EPISODE

​

Richard, Royce how are you? Welcome to the show.

 

Royce: Thank you Sonali, it’s a pleasure to be joining you.

 

SM: Thank you so much for taking the time. Tell us a little about this really interesting new idea that you have.

 

Royce: Sure. Rick and I found that many people want a career that is more independent than working for someone else’s company but they have been put off from traditional entrepreneurship, startup entrepreneurship. It’s either because they don’t have some great idea that they want to build their business around or because they are daunted by the risk of a startup where everything has to be invented- product, service, business model, hiring. This option is a very different path in that you are buying an established business, its demonstrated that it can be profitable where the entire business model works or can be absorbed over a 10 or 20 year history. And so the risks are a lot lower than start up entrepreneurship and yet the prospects of financial reward for an independent, self-controlled career is much higher than working in someone else’s company.

 

These are some of the attributes that Rick and I have noticed really arrest people’s attention who weren’t aware of this option.

 

Rick: And if people have gone to business school and they imagine what their career paths can be after business school- they can take a traditional job, they can try to start something but what we found as compared to what most people do, is that this path of finding a small business to buy and then buying it with a collection of industries and then running it for maybe the next ten years of your life provides really great independent lifestyle and provides financial rewards which are pretty comparable to the traditional career paths of most business school graduates.

 

SM: This is a very interesting idea. To help crystallize this for the audience, maybe you can give us an idea of the kind of businesses we are talking about here.

 

Royce: Sure. The small businesses we teach about and we focus our students on are typically businesses that have an annual pre-tax profit of between 1 million and 2 million dollars a year, they are very stable and proven- typically they have been around for anywhere for 10 to 30 years, and they are being sold by retiring founder, the employee base is roughly on average of maybe 30 people so a good span of responsibility for a first time CEO taking over an established business and the nature of these businesses runs the full length of anything you could imagine.  What Rick and I have found is that good small businesses often operate in little niches.

 

In other words they are good businesses because they found a niche where they can be a devastating, terrific competitor, they are just small because the niche is small. So some of the businesses our former students have bought have been high-rise window washing companies, companies that pressure test hoses for fire department, companies that process insurance reimbursements for specialized healthcare providers, companies that rent musical instruments to grade school students.

 

So just all sorts of cheap businesses that you might not be aware of until you start to dive into the companies for sale.

 

SM: So you are talking about businesses that are still pretty profitable, you quoted profits of around 1 million to 2 million dollars a year and the reason they are continuing to be stable is because they are operating in such a small market that there isn’t really a scope of having a lot of competitors.

 

Rick: Yeah that’s one of the reasons. It’s also the nature of these kinds of businesses is that they tend not to be a very important part of the business that they are serving. For example, a knife sharpener for a restaurant, you know the service that sharpens the knives. There is no particular reason why the restaurant would shift to a different knife sharpening business. As long as you are providing the service, you’re there on time, you do the job well, you’re clean, you’re neat, you provide no aggravation to the restaurant, and they can start focusing on what they need to focus on. So that there is no need or reason to switch. It’s true it’s not a business with a big scope for competition. But one of the interesting things about small businesses that we think are so interesting, it’s the great service, its great execution, itself becomes a barrier to entry. People don’t have a reason to switch.

 

SM: That is a very good point. The customers probably do not care about this as much, so that they are not looking to switch so that keeps on going, the steady stream of revenue.

 

Rick: It’s not that they don’t care, it’s not a very big part of your expense items. So if you are worried about what you can do to cut expenses, you are going to look at your big expense items first. If you’re going to be wondering on being more competitive, you are not going to be as competitive on the ones that are small. I like to say that it’s important to be unimportant. But yet essential, so the knives have to be sharp, the firehoses have to be safe, the instruments have to be in the kid’s hands. But it’s not the primary thing.

 

Royce: Adding to Rick’s comments, there is a measurement that Rick and I repeatedly teach our students to look at in these types of businesses which are the recurrence of customer revenues. In other words, really great small businesses from year to year to year, 90% or more of their revenues come from the same customer. So as you start each year, you don’t have to worry about where you have to generate your revenue. You know that the overwhelming bulk of your revenues will come from the customers who bought from you last year. And then you can go around and try to add a few more customers but it gives these businesses great stability. And all of these businesses that Rick and I have been talking about have that quality in them.

 

SM: I am very surprised that this option is not heard more about because 1 to 2 million dollars in profit is pretty decent. So let’s say that right now I am contemplating taking up a job or starting my own company. And then I hear about this third option and it sounds interesting to me. How do you think a person should go about making this decision, that is this the right thing for me or not? What are the pros and cons to consider?

 

Rick: I usually start meeting students and people after they have walked down this road a little bit. But usually they think about the traditional jobs first. Because that’s the safest career path and I think there the big issue is whether the traditional job provides something the person really needs. Some association for example. You know I worked for McKinsey, I worked for Harvard Business School, I worked for GE, household brand names where you’re getting affiliation is in itself something that you’ll value or you want a social network that comes with your job.

Those are the kinds of reasons why people go with the traditional career paths. It’s also the money, its good money but as we have said the money tends to equate over ones career. So I think in the traditional thing if you really want that affiliation, you're not going to get that. But if you don't really care that much about the affiliation and you're an independent person that likes to be self-directed that moves you to a more entrepreneurship career. And as you think about entrepreneurship, you have two ways to do it. I think one is startup which has, as Royce already talks about, what I call the blank sheet of paper risk. You have to invent everything from the beginning and for some people they find that exciting and thrilling and there’s just no substitute for that. For me I would find that intimidating and daunting and also it's not really what I'm good at. What I'm really good at other than being a professor, is buying something and then moving it in the direction of higher profits. So not inventing the business model but taking the business and refining and improving it. So that’s what you think you're really good at- managing a business and not inventing then buying your own small business is the way to go as opposed to the other two paths. Royce will probably have a better cut it that.

 

Royce: No that's great you know. When we do run into people who are exploring this path, I think they were two things that seem to be pretty effective in helping them decide if this is for them. One is, very basic, you track down some people who have done this and it's a pretty hopeful community. Because young people who had gone out and bought had searched for a business to buy and bought it and now run it had reached out to others before them. And so they kind of pay it back. So I think just interviewing two or three people who marched down this path gives a lot of color as to what life is like to people. And then the books that Rick and I wrote on how to buy a small business is really something that almost every searcher or early stage searcher reads because it's a road map that march you through first to do this and then do this and even before you do it, it allows you to close your eyes and say could I envision myself reaching out to small business brokers and sourcing deals and the vision to run a small company. Just those two steps I think are very clarifying for people who think this might be of interest to them.

​

 

Rick: Can I add one more thing? One of the things we know is that people tend to make decisions sometimes thinking about how it's going to feel over the next year and we really encourage people to think how it's gonna feel over their lifetime or all over their working careers. And the reason we say that is that if you think about going out to buy your own small business is a daunting thought, you know it's something you've never done before, versus continuing the job you have or even going out to find a new job- those are things we all have a boss or possibly somebody tell you what to do. Going out to buy a business you'll have a guide like our book but a lot of this going to be a discovery for what works for you. And I think if you think about what life is like that next year, you don't have any income coming in, that's a pretty stressful year. But if you look over your lifetime, what you'll discover is that your time in running a small business is great. The time in a traditional career path has added challenges as you go through it. So Royce and I see lots of small business owners every year and we always ask them, many of the come to class, what would you do differently which, do you wish you'd taken the traditional job? And nobody ever said that now I've been an entrepreneur and I've been running my own small business, what I'd really like to do is get a traditional job. On the other hand, people who we meet who have traditional jobs, always tell us that is such a cool path, I sure which I did that. And I think the reason that you get this disparity, is that this is the kind of career- buying small businesses that as you get into it and proceed along the path, it gets better and better.

​

 

SM: I think anyone who values independence will really appreciate this and once you had a taste of it, it's probably hard to go back to a traditional job with structure and hierarchy. So it sounds like you take a class on this at HBS.

​

 

Rick: Two classes, one in the fall and one in the spring. The fall classes are the case based course where we talk about twenty eight or so difference in small business throughout the term. And your problems and challenges and opportunities and aspirations and so we do that in the fall. Then in the spring, we teach a course about how to actually go about buying a small business.

​

 

SM: I have a quick follow up question to the community of people point. Those that you can reach out to people who have already gone down this path and then talk to them about how it went. So how do I find people who've done this before?

​

 

Rick: You know the easiest way to do it if you don't know anyone who's done this and most people don't, is to just do a Google search for search fund. Because the generic term for this process is called searching and people think themselves as sort of creating a search fund to go look. And what will happen is you'll get a whole bunch of very simple little websites that have been set up by searchers, which are really aimed for business brokers or owners of businesses to check them out. And then I'd start calling the few of those people and then ask them for reference to someone else they know. I think in a handful of interviews it would really be breathing life into what is the experience like- of going out, sourcing small firms for sale and evaluating them. So I'm always a big believer in sort of talking to people who actually engaged in the experience as a first step to see and answer the question- is this for me, could I do this? That's where I would start.

​

 

SM: So you referenced search funds but I think it's into the search processes which I'm very curious about because I've no idea how to find these businesses. So let's say I've decided that, okay you know this sounds interesting, I think I want to do it. What should be my next step?

​

 

Royce:  So we will go then to the second step after you after you've done that and lovingly read through the book which will of course answer all these questions. But probably the first step that Rick and I recommend to people who are who are starting to search for a business besides this sort of bit of housekeeping like setting up a little firm meaning incorporating so you have a name which as a business conveys professionalism and purpose. Just very easy to do is to reach out to the community of small business brokers and as it turns out there are about three thousand brokers in the US who specialize in brokering small private businesses that are for sale businesses. These people want to be found, they collect listings from owners of businesses and they are looking for buyers so they can match them up and facilitate a transaction. So you start to reach by calling these people up, explaining what you're doing, conveying the credibility and sincerity of purpose and very quickly you'll start to get flow of ten-twenty businesses a week that are for sale. In the North American economy, there are thousands and thousands of small businesses of the type we're talking about. That would be the first step I think because you’ll immediately get a flow and you'll be basing choices of businesses for sale and starting to teach yourself what to look for.

​

 

Rick: Your first step really depends on a little bit of the kind of search you want to do and you may not know what the beginning. But for example if you have a particular industry that you're interested in, it may make sense to go to a trade association meeting. And before you start formally searching, see what the landscape looks like, who's in this business, where it located is and what are the revenue size is, what are the ages and general wealth of the owners. And there are trade association meetings for almost any sub industry you might imagine. Similarly, people sometimes have a strong geographic preference like I really wanna live in the New York City area. In that case then use that- frequenting chamber of commerce meetings and you begin that informal networking process that leads to get a better sense of what businesses are available and that is really a key first step in designing your search.

​

 

SM: It's good to know that there are brokers who already doing this and you mentioned that how there are 3000 brokers or so in this business. But I don't know how I would identify an industry because based on the businesses that you describe, for example someone who cleans windows of high rise buildings or knife sharpening, like these are obscure things, I don't know how I would even think about these things. So is it possible to just go to these brokers and say, you know maybe there are some interest like geography or something but just give me what you have and then I start narrowing down?

​

 

Rick: Yeah and that's the easiest search if you were open minded to anything then looking at everything. There's good and bad. One is that you've got a pretty broad net so you'll see lots of stuff.  The cost of that this is just is going to take a lot of time and then a lot of expense generally because you're going to be working nationally or maybe internationally at every imaginable industry that’s between seven hundred fifty thousand dollars in profits to a couple million dollars in profits and there are many thousands of those that you'll see in the marketplace every year.

​

 

Royce: Usually searchers set some controls on this like certain regions of the country would be a very common control or they might focus on service businesses and certainly they put a size range on it. But you're right, a big part of this is just the selection process where you're just seeing a flow of diverse businesses in a size range and then picking out ones that meet certain quality characteristics. Because you will find businesses you never even imagined existed and that will be great business.

​

 

SM: What should I be looking for when I'm assessing whether this is a good buy or not?

​

 

Rick: The first thing you should look for is whether the seller is really a seller. That seems like an odd thing but one of the things that happens in these businesses is that- take a business that has a million dollars of profits every year. That business like other businesses will sell for around four million dollars. And while that seems like a lot of money, the owner will pay some tax on it and will invest it prudently. The kind of income from the four and a half million dollars after taxes will probably be pretty small relative to the million dollars that the owner was putting in his or her pocket every year from owning the business. So what that means is that people are generally very hesitant to sell and they only sell when they really have strong reason to sell. Some of that strong reason maybe they have a health issue, they're getting divorced, they had enough of it, their fatigued- it could be any number reasons but one of the things the buyer really needs to do is to be sure that the seller is in fact committed to sell. And sometimes it's really hard to find the answer to why somebody is selling. But if the seller is young, vibrant, seems cheerful and happy and interested in selling, I think that there's some suspicion that you get down the road that this seller may not turn out to be a committed seller. He may be interested in getting pricing, may be to know what's his business is worth.  Sometimes people are willing to sell but only at an outsized price so I don't expect to sell my business for four and a half million dollars, maybe I'll find somebody able to pay me ten, even though that's more than twice than what it’s worth. So finding this committed seller is the most important thing but it's sometimes it’s very hard to do that.

​

 

SM: I've defined unhappy sellers who hate to sell because they are already in love with what they do and it's probably harder for them to part with their business.

​

 

Rick: You know most businesses are owned by people like baby boomers who started businesses and they're reaching the stage where they may want to do something else. So it's not necessarily they were unhappy, it's just that the world has changed for them and it's time for them to go do something else.

​

 

SM: You mentioned an important point that if businesses make a million dollars in profit, they’ll sell for four million dollars. How do I fund this? Because throughout this process I'm envisioning an individual going through this process?

​

 

Royce: First of all we should just paused and then understand how economically attractive is a business for four million dollars with a million dollars in annual profit. Because each year the business is generating a twenty five percent return on its purchase price. If you partially finance it with debt, return on equity goes much higher and if you grow the business, return goes much higher. So it's an extraordinary economic opportunity created for a number of reasons but exists in this small form part of the market in a way which gives higher multiple of profit than to opt for a larger business. But the way these are financed is typically part of the purchase price is financed by getting a bank loan and this can either be done through a marvelous program run by the SBA called 7(a) Program which operates through banks or just through a conventional bank loan. That will typically cover about half the price. So in our example, a four million dollar purchase, roughly two million will be provided by a bank. Typically in this market, the seller will take back a portion of the purchase price as seller debt subordinated to the bank loan and that's usually about twenty percent of the purchase price. So maybe another eight hundred thousand or a million dollars of that four million dollar purchase price. And then one to one point two million of that four million dollar purchase price is equity. Turns out that there is a population of investors that repeatedly backs searchers in providing the equity in these deals in return for a market share of the company. And this is a network that routinely five to fifteen of these investors will club together and each take up the deal and introduce searchers to each other because they want to form up in a little collection of investors who do this.

 

So once my students go out, they could have contact with a few of these investors in this network. Mostly high net worth individuals, some small institutions and they quickly work their way through the networking, assemble a group of five to fifteen investors who will look at the deal and then commit for the equity portion. And then the searcher keeps the piece as the organizer-entrepreneur-manager and if they have any money often they invest it side by side with the investor.

​

 

SM: How long can this search process last for?

​

 

Rick: So the search often takes about eighteen months, we've seen it as quick as six months, we've seen it as long as three years. A lot of luck is involved. So I think there are a few factors. When are you going to find the company, some of it is learning- you need to know that you're not going to find the perfect company but you need to learn enough about the marketplace knowing you found a company that reached the thresholds that is good enough and has a committed seller and is in a place you wanna live and has an industry that you have the ability to learn about and manage right. And so there's a number of things that have to work out for the deal to actually get concluded.

​

 

SM: I mean eighteen months to three years is a fairly long time. So I guess if I have to embark on this process, either I have to be able to support myself for that period of time because I won't have any income or do any of these funds actually fund my search?

​

 

Royce: So there is 2 or 3 ways to do it. One way to do it is to do it all on your own money and when people do it all on their own money and it’s not really necessarily their savings. So what they do for example, is to have a working spouse and they're searching for a business living in the apartment the spouse is paying for. So some ways just family funding. Some people go back and they you know they move in with their parents again and take a room in the basement and search from that. So that's one way to do it- call that the highly frugal path if you will. And the advantage of that is that once you buy the business, because you've not taken any money from anything, you get separate terms of the financing at that point. So you'll usually get a much better deal for yourself if you do it that way than if you do it the second way. The second way is to actually raise money for the search phase. And people usually raise enough money to pay themselves a salary. Usually the salary is half of what they would make in the marketplace. And the idea is half funded by investors and that’s the half they get and the other is in equities into the eventual business. So they'll raise enough money for that and expenses. Usually when they raise money, there are often two people searching together so that quickly can add up to well over five hundred thousand dollars of search capital. And so they'll usually do that by finding fifteen or twenty investors who are willing to put in the amount of money they need to get to that. And then they're going to make some promises to the investors. Promise isn't that I will for sure find a business to buy. Promise is if I find a business to buy, you'll get to buy it under these terms we negotiated that time which you gave me money to search.

​

 

You know for the investors, at the time of the deal, are going to get a better deal than they would have if the first commitment they made was at the deal stage. And then the third way, people find is a family office or a wealthy individual and they say wouldn't you really like to own a small business? Well I'll go out and buy you one and you give me a salary. So it's kind of a nontraditional funded search. You're not raising money from twenty investors, you're raising money from one and using those resources and the backing of that wealthy individual or family office. And those are three and there are endless variations of that third choice because it just depends on the people who were involved, to what makes sense. So there are those three paths. You do it on your own self-funding, you get funded in a kind of traditional fund way with fifteen or twenty investors or you go to some other mechanism to get funded.

​

 

SM: And I think this also sheds light on the kind of mindset that the person needs to be in because you need to rough it out for eighteen months to three years. And I think this is a little different from starting your own company because then you're starting it you’re building something. So you can see how it's getting built and maybe you're starting to get some feedback from customers. Whereas this can maybe be a little bit more taxing because you don't have anything to show till you actually have a business that you bought.

​

 

Rick: To say every day is a bad day and until you have a good one.

​

SM: Exactly yes. So you have to be willing to for next three years to not have anything and you have to be comfortable with that.

​

 

Royce: And usually searchers have an informal network about the searchers. I mean part of that is to exchange ideas and figure things out but part of that surely is to keep up the morale and spirit. You kind of work alone through the search process. Most people who go down this path don't do it because they like to search. If they really like to search they go into a business like private equity or investment banking. They do it because they want to run a business so it requires some tenacity and sense of purpose.

​

 

SM: So I just have a few more questions more around making a successful transition to the business. So let's say you know I identify business, I go and have my initial conversation, it looks like a good business and I buy it. Now how can I make sure? Because you are describing them as fairly traditional businesses, people who are in these businesses may not necessarily be like you from similar backgrounds. How do you make that transition?

​

 

Royce: Well one thing that I would just put out there is in virtually every acquisition of the small firm, part of the deal is a transition agreement with the selling owner-founder where they'll stay around for anywhere from three to twelve months transitioning their knowledge and experience in relationships to you-the buyer. And of course because that seller has typically taken back a note for anywhere from twenty to twenty five percent of the purchase price they have a real powerful motivation, economic motivation in addition to the fact they probably care a great deal about the business. They have a powerful motivation to make that transition goes smoothly. So one of the things that a buyer is getting is on the job training with the experienced seller and how to operate the business. That's one key element in making sure the step off to a good start. Rick would you add anything to that?

​

 

Rick: No I think that you've captured the essence. There is the transition agreement. One of the things both Royce and I recommend is that when you buy a business, if you identify a business that you really like and that you think is a good sustainable business, once you take it over, you shouldn't make any big changes right away.

​

 

SM: Have you seen people make any common mistakes as they go through this process things which you have seen happen over and over again?

​

 

Royce: The search process or of the running the business process? The transition process?

​

 

SM: Well, more about the search process but also the transition process.

​

 

Royce: Yes I can start off on that, Rick but I'm sure you have your own list. I think that two of the common mistakes that Rick and I see in searchers, one is that they'll start searching and they'll be looking at typically twenty or more deals a week and then they'll find a deal that is very interesting to them and while they pursue that deal (and remember from the time you find a deal to the time you close on it, could be three to five months) they drop their sourcing for other deals. Sometimes a deal you work on doesn't actually end up closing, you start to do due diligence, you discover that in fact it's not what you thought and you pass on it. Then after you restart all of your sourcing again and you slow up your process. Rick and I always recommend to people to keep on sourcing as long as you can, even up to the closing up the deal. So that is one mistake that we see searchers make.

 

And the second is that they don't screen rigorously enough. Part of this business is to be spending all your time generating new opportunities, filling the top of your funnel and then spending the other big part of your time on those few deals that are likely to be attractive to you and what you're likely to be able to close on. So you have to have that sort of ruthless efficient funnel and sometimes we will see searchers sort of asking more questions and having this big inventory at the middle of the funnel which sucks up time and takes it away from those two ends of the funnel where the value is in created search. Those would be common mistakes that come to my mind.

​

 

Rick: Those are certainly the biggest and most common mistakes that you've identified there. I would just say little bit later on in the process, one of the things we find is that people have a too broad due diligence list. Instead of looking at the one or two things that are really important, they'll want to ask every question about the business imaginable and as a result it's hard to ever get the business to close. It’s that sort of magical focus on what do I need to do today to get the deal done. What question has to be answered not because it's an interesting question but because if the answer to this question is no, I'm not going to want to do the deal. And if a question doesn't arise that you know the answer is no, I won't do the deal, then you shouldn't be asking that question. You should focus entirely on deal execution.

​

 

SM: But do you recommend to people to try and get a co-founder almost like a partner who will go into the business with them.

​

 

Royce: I recommend they get a dog. Because the good thing about dogs is that they give you unconditional love. And they're really happy with biscuits. They do not want half of your or the value of the business you're about to buy. And the problem with a partner is you're taking over a business that was run by one person and now it’s going to be two. You are going to have to split the pie in some ways. Dogs don't require you to.

​

 

SM: I have one small question. You mentioned how there are these smaller brokers who do this. So do I just go to like Google.com and search for buy a small business and see what comes up or do you recommend any search?

​

 

Rick: These people, as you can imagine, want to be found. You know they're not like Mossad agents to try and not be found. Their business is all about collecting people on both sides of the transaction. So you start by just googling small business brokers and there are a couple of industry associations of small business brokers and they will be able to provide membership list to you. And so very quickly, you'll find your way to more small business brokers and then you can possibly reach out to. So that is a very straight forward part of the process and it moves very quickly.

​

 

SM: Okay well thank you so much Richard and Royce. This was wonderful and I think this is a very good option for people to consider. It is certainly a new option that I don't think many people think about. Is there any other advice you'd like to share? Also where can people find you online? You mentioned that you blog about this a lot and people to definitely buy your book.

​

 

Royce: You know, just Google our names right though and they come up with lots of podcasts and videos.

​

Rick: Exactly. You'll see the full set of literature we've written and then of course the book is available on Amazon and elsewhere. So those are two ways to get to our work very easily.

 

​

 

SM: Okay all right. Well thank you so much and enjoy your travel. It seems that you're traveling for the book or something else right now?

​

 

Royce: We're just away from campus during the summertime when we write and do other work so that's where you found us on this. Lovely day before that for the holidays come up but thank you this is been they spent a lot of fun talking to you when you pass some great questions.

​

 

Rick: Thank you so much.

​