[00:00:04] Speaker A: Hello and welcome everyone. I'm Peter Lehrman and this is Master's in Small Business M and A. This show is an ongoing exploration into the vast and undercovered world of small business M and A, where we interview both the proven and the emerging owners, operators, investors and advisors whose strategies and methods for transaction success have been put to the test. The show aims to surface the nuanced intricacies, the key ingredients, and the important factors that can improve your decision making in your own journey in the world of small business MA this podcast is produced by Axial, an online platform that makes it easier for business owners and their M and A advisors to find, research and privately connect with a diverse mix of professional buyers of small businesses. In addition to learning more about Axial, you can find this podcast, show notes, edited transcripts, and many other related resources, all for free at Axial.
Everybody. Welcome back. My name is Peter Lehrman and this is Master's in Small Business M and A. I am extremely excited to have two guests on the podcast today, Royce Yudkoff and Rick Ruback. They are the joint authors of the Harvard Business Review's Guide to Buying a Small Business. Active Professors at hbs. Just a fantastic set of people for me to have the privilege of interviewing. Thank you both for the opportunity and it's great to be with you both.
[00:01:27] Speaker B: It's a pleasure to be here.
[00:01:29] Speaker C: Thank you for inviting us.
[00:01:30] Speaker A: I want to get into ETA and spend almost all of the time on eta, but very quickly would you all. And Royce, I'll start with you. Just take us through the coursework that you're doing right now in the Entrepreneurship through Acquisition category at hbs. And Rick, you as well. I just want to make sure that there's a little bit of context on the classes that you're teaching related to the topic.
[00:01:52] Speaker C: Rick and I really teach three classes. All of them are in HBS's second year, which is when our MBAs get a chance to elect what interests they have and what courses they want to take. In the fall, we do an overview of small business and acquiring small businesses who are kind of defining the market, the opportunity, and at a high level, how you go about buying a smaller firm and then some of the big operating challenges that managers face. During that course, students start to form an opinion about whether this career is for them and for those who are serious about it. They will sign up for our spring course, which we call ETA and which is a step by step walkthrough of each step in buying a small firm, equity raising and debt raising, and how do you source and how do you diligence? And we bring in experts from each phase of that to talk directly with the students. Think of it like teaching someone to assemble a bicycle. It is intensely practical. And then for a small subset of students that are actually committed to doing this and getting started now we do a small seminar on how to source, which is of course the first step in searching for a business to buy. And so that's a very practical focus on that first step.
[00:03:06] Speaker B: That's a great description. The only thing I would add is that the fall course is a traditional HBS case based course. 28 cases, lots of guests. I think we had guests for virtually every case last year in the fall, as is our normal practice, the spring course is what we call the field course. There we try to bring the field to the Harvard Business School, which is located on Soldiers Field. So we always say we're bringing the field to Soldiers Field. We have, I think this year planned about 140 guests. It's a crazy big number. We have a few days in which we bring real investors to hear student pitches. And we have lots of students, so we need lots of investors. So that explains a lot of the guests.
[00:03:52] Speaker C: One thing I'd just add to Rick's point about the guests is we do this for two reasons. One is Rick and I are very practical about what we want to teach the students. And so bringing in people who really do this adds to that practicality of lessons. But the other, maybe less obvious reason to have a guest is most of our students are looking at this career and saying, is this for me? Can I do this? Do I want to do this? Rick and I have found there's no substitute for putting in front of them someone, say, who has searched and bought and run a small company. You can imagine our students are looking at that person and asking those questions to themselves. Can I be that person? Do I want to be that person? So those are the joint reasons Rick and I have this heavy focus on guests in each class.
[00:04:33] Speaker A: So the 140 guests in the spring, that's over the course of the semester or that's part of some big pow wow during the semester?
[00:04:40] Speaker B: No, it's over the course of the semester. Two weeks ago, we had five guests on how to fund the search. Searchers who had purchased businesses talking about the different ways they funded this search. And we had the five different strong models represented. Like last week we had an investor pitch day and we had about, what.
[00:05:03] Speaker C: Was the exact number, 35 guests.
[00:05:05] Speaker B: It felt like a Lot of people, a lot of guests.
[00:05:08] Speaker C: Yeah.
[00:05:08] Speaker B: All smart, brilliant, a delight to be with, but just a lot to manage.
[00:05:13] Speaker A: It goes without saying that the ETA category has way more interest today. I was in Graduate School 2006-2008. There were a handful of guys from my class who went when to start a search fund, But I could count it on one hand. And today it's a much larger number, both there at HBS and lots of other schools. And then it's also a phenomenon that goes beyond the mba, which is something that all three of us are really excited to talk about today. I would like to just get your perspectives on why this is happening. Why do you think the interest is growing? Is it just a classical expression of supply meeting demand in terms of silver tsunami and opportunity? Do you guys have some point of view on why the category is growing and expanding, both in the MBA realm and in the non MBA realm in the way that it is and what is behind that? Have you spent time on that?
[00:06:09] Speaker B: One of my favorite sayings is nothing succeeds like success.
And I think what we've seen over the last 15 years where Royce and I have been teaching these courses is that as more and more students elect this career path, subsequent students look and say, wow, that really worked out for that person. And that person was a lot like me. That person was a Navy veteran. That person was an engineer. That person had this background. That person had three kids. I have three kids, whatever it is. But there are enough people now having done this, that people can look and find role models and say, wow, I really like the career path that this person picked, or I really like the career path that that person picked. So I think that's a lot of it. It is becoming mainstream. One of the things we do in our spring classes, we have a friends and family night where we ask the students to bring their friends and family to class. And we do that on Zoom. We usually have 250 family members or 150 family members in addition to our 100 students. And one of the things that has changed over the dozen years we've been doing this class is in the beginning, we got questions like, my child is spending the day in their pajamas, staring at their computers. How do I know when it's time for therapy? What are they really doing? Why don't they get a real job and give us grandchildren, which is what their goal should really be? And now we have questions about financing and questions about wealth and questions about how busy they'll be and those sorts of questions. So what I think has happened is that the career path has become legitimized. In the past, when you took a job at a major consulting firm, nobody asked you why you were doing that or whether you were suffering from some mental or social illness. In the past, if you said, I'm searching, people would just say, gee, I wonder what's wrong with that person? And now that's gone. That idea that you're being a pioneer, why are you doing that? I think that's gone.
[00:08:16] Speaker C: I think that's exactly what's happened.
[00:08:18] Speaker B: I would add, by the way, the fact that the job market has been a little more difficult for MBAs gives them the opportunity, the space to consider this in the past. If you go back when the job market's harder and the consulting firms hire summer interns to full time jobs in September and October, they don't really have time to think about this problem. Ours is a second year course. They may learn about this and then say, oh wow, I've already signed my offer, what do I do? And HBS has pretty strict rules that if you sign an offer, you actually have to fulfill your obligation. The job market has allowed more people, more space to think about their opportunities deeper into the fall and spring. The students don't particularly like that, but it's good.
[00:09:05] Speaker C: Better to get to the right answer.
[00:09:08] Speaker A: There's about 900 to 1,000 students per class at HBS, if I'm not mistaken. Unless that's changed and it sounds like you guys are teaching about 10% of the class, 90 to 100 students.
[00:09:20] Speaker B: More than that. In the fall, we have two sold out sections and we squeeze in about 97 or 98 souls into our classrooms. We just don't have any extra seats in our class.
[00:09:34] Speaker C: That's about 20% of school.
[00:09:36] Speaker B: Yeah, a little more and we could do more, I think, but there's only two of us. We have a similar kind of thing in the spring. All the spring course is an applications course. So we get somewhere between a third and a half of the people who took the fall class electing to take the spring class. This year it was more than half, which was unusual.
[00:09:57] Speaker A: It's great context to just hear a little bit about how the school is approaching the category and we'll spend some time talking about the MBA topics. But I also want to spend a lot of time and one of the big ideas which you guys are excited about, which is how this category has completely escaped the MBA and has its own legs outside of elite MBA classrooms as well. So we'll spend some Time there. I'd love to just get into the primary areas of change as you all are experiencing them and witnessing them in entrepreneurship through acquisition. We'll start with financing, Royce. That's what you mentioned as one of the topics before we push record. And we'll start with you. There's a lot of change in just the available financing types for ETA and for the transactions. Sounds like you feel like that's happening both on the equity side and on the debt side. It's not just happening on one side. So tell us a little bit more about that.
[00:10:49] Speaker C: Rick and I have been working this territory for 15 years and one of the things that has just been striking is how much easier and how many more choices searchers have to raise equity and debt. So if you go back even a decade, when a searcher found a deal and put it under a letter of intent, one of the things they had to do is scramble like mad to find a bank that would provide senior debt financing on that and would be comfortable with the whole idea of searching and someone who didn't know the business and was young running this. And because these loans are small, that usually meant you had landed in some territory where that business is and you'd have to go to all the local and regional banks there and see if you could get a bank commitment before your letter of intent ran out. What's happened over the last decade is there are now multiple banks that have search departments and and they follow searchers nationally. So at the start of your search, you connect yourself to them, you keep them updated on your search and wherever that company is, you'll get several banks that understand search and are willing to make loans anywhere in the country to a small firm bought by a searcher. It is a huge advantage in debt financing. And on the equity side, when Rick and I started doing this, the equity financing for funded searches, where a searcher actually raises a search fund and has their costs covered while they search. There was a small group of mostly high net worth individuals who did this part time and it was clubby and small. And what's changed about that is that there are numerous institutions which have jumped into the field, what you might think of as tiny private equity funds that focus on backing searchers. And by the way, I think Rick would agree with this, there are far more sources of equity capital for funded search than there are high quality searchers. So this is a golden moment in terms of raising equity for searchers. And then lastly in self funded search, which we'll talk about later, where you just Go out on your own nickel and look for a company and get an SBA loan. Now we're seeing the same phenomenon where what used to be everyone had to come up with their own club of investors. They're now recurring investors in self funded search that you could go to lists and work your way down. And all these people routinely invest in self funded searches. So that world of access to capital has improved massively. Rick, would you add anything or change anything there?
[00:13:08] Speaker B: I think that's all exactly right. I think it has become much easier to fund transactions in the small firm space than it ever was before. And I think that to everybody's benefit, the sellers, the buyers, certainly all those that benefit from having an active and vibrant small business community. One of the things I think is worth mentioning is that the people who are searching have changed. There was a time when almost all searchers were men. No longer true. There were a time when almost all searchers were white. No longer true. What we're finding is that searching is broadening beyond just a select group of people and is now available to a much broader set of students, which is something that I think is really terrific.
[00:13:56] Speaker A: Totally agree with that. And I think that's also part of the self funded search category as much as it is within the MBA realm. On financing. Do you all have any point of view on how the SBA could make changes over the next few years? There seems to be some interest in having the SBA sort of index the sizes of the loans and have that change in the way that stuff gets indexed to inflation and in other government policies. But are there other areas related to the SBA and just the SBA's relevance to search and to self funded search in particular, that you guys think is either interesting or is potentially going to change the way that the market works or has changed the breadth of the category?
[00:14:41] Speaker C: First of all, I think one of the issues right now is that there's still a lot of people who are interested in buying their own small company that don't understand the SBA opportunity. One of Rick's and my students memorably said that every American has the God given right to borrow $5 million from the federal government to buy their own business, which was sort of an interesting turn of phrase. It's actually not really God given, it's government given, but it's an amazing opportunity to borrow up to 90% of the purchase price of the business. Often a chunk of the remaining 10% is taken back in a seller note. So you, you don't have to be rich to do this. And so I'd say the first thing that should change is there should be a more widespread understanding of commitments you make and the opportunity you have in these loans. But I would just touch on two things that the SBA could address. One is Congress caps the limit of the loan size, and this loan size has stayed unchanged for like 20 years. So there's clearly an opportunity to go up, inflation adjusted. And I've never calculated there's no reason the cap shouldn't be at 10 million, for example. That's a Congressional issue. And then the SBA takes a bit longer than a conventional loan. And I think searchers just have to be good upfront communicators with sellers. It's not a huge amount of time. A conventional loan takes 60 days. This might take 90 or 100 days if well processed. You just have to communicate that to the seller. So they're following the milestones, too. But it's a challenge.
[00:16:12] Speaker B: Of course, a higher limit and a smoother process would be terrific. But I would just point out that there's been institutional adaptation. There are entities that help people find the SBA loans and help get them through the process much more quickly. And they'll also help find you secondary financing. So if you had a $7.5 million hole, most of these banks or many of these intermediaries will find you that line of credit or that subordinated note a couple of the other things that's really interesting about the sba. One speaks to Royce's first point, that people often don't understand it. The personal guarantee intimidates lots of people. It shouldn't. Most businesses would have to have a cataclysmic decline before the personal guarantee ever comes up, because there's no covenants. The only covenant is that you actually pay your cash obligations. And so it's not like a typical traditional loan, where there's quarter to quarter covenants that are set so that if you fall 20 or 30%, you're going to go ding on the covenant and transfer the power of that loan loan back to the bank and have to renegotiate something. What we call the menu of misery, because none of those things are pretty joyful. But in the sba, there is no menu of misery. You just have to pay. And so people worry about that. We've had decorated combat veterans who were shot at with real bullets in places like Afghanistan or in airplanes, and they get intimidated by the risk of the small business loan and the risk of the personal guarantee. I've never seen combat, 70 years old. I think I'm going to get out of here without having seen that. But I must say I do not understand how you could be more intimidated by the SBA's personal guarantee than somebody shooting at you with real bullets. It seems to me that there's a lot of misunderstanding there. People I think are coming around to that, but it is a slow process and it's very difficult because these are really family decisions. ETA is really a family decision. And so even if the searcher understands it, it may be that other family members, particularly their spouse, may find it very scary.
[00:18:37] Speaker A: Can you say more about it as a family decision, Rick? I just want to make sure that gets developed. What are you getting at there?
[00:18:44] Speaker B: I think the decision, particularly for mid career searchers, but even for a lot of our searchers right out of hbs, HBS has generally an older class. Our typical entering students a little over 27 years old. Many of them are married, some have children. And so the decision to forego a more traditional job and pursue the ETA path is very much a family decision. So we tell our students to talk to their families and we spend a lot of time on that issue. ETA sometimes requires relocation, often requires relocation. A spouses maybe have to change jobs, kids are going to have to change schools. You may be moving further away from family. It's a complicated family decision. Searchers who don't involve their family in those decisions run a great risk that even if they have a great company, they could have a miserable life because the rest of their family is unhappy. We know not a lot of searchers. I don't think you have to take off, you have your second mitten to count them. But people who buy businesses and think their spouse will just get used to living there and it doesn't work. And we know other searchers, interestingly, who say, well, I'm not going to relocate my family. My business has seven offices and I'm going to be mainly traveling between those seven offices. I want to locate near my family or my in laws so that my spouse will have a support network while I'm traveling. And if a kid's sick and we need emergency daycare, we have a grandparent nearby. Those kinds of things I think are very, very sensible considerations.
[00:20:26] Speaker A: A traditional career is also a family decision to the extent that you have a spouse. But I guess it just doesn't have the open switches associated with the search process. If you take a job from HBS or you take a job in the corporate world, you know where it is. You know what the salary is, you, you're going to be located. Whereas to set off and execute a search, you don't know a lot. You don't know where you're going to ultimately live. You don't know whether you're going to be successful. You don't know exactly what you're going to be capable of paying yourself once you acquire the business. It just has a lot more deferred answers.
[00:21:02] Speaker B: This is something I don't know, but I think searchers that we've talked to, one of the things they report is, is that the business really becomes part of their family in a way that a career in consulting does not or a career in private equity does not. I don't imagine as an assistant professor, my wife and children were deeply interested in my research or the latest programming challenge I had or data collection challenge I had. I don't think they really cared about how I modeled things. They didn't offer any opinions about statistical variations or how to appropriately compute standard errors. They weren't really interested. I don't know why they weren't as very interesting stuff, but they weren't interested in that stuff. And I suspect if you're running a business and we've heard it over and over from people, the business becomes part of their family.
[00:22:02] Speaker A: I was actually curious to talk a little bit about private equity and the relationship that you guys see between private equity and ETA Royce, obviously great to have you as part of this. Having run a private equity firm and started a private equity firm and now you're doing this, how do you see ETA and private equity? Are they going to just sort of run in parallel as these separate categories that are adjacent to one another? Is there going to be some sort of osmosis between the two that begins to sort of emerge? If you could see a world where the SBA is granting 10 million in debt as opposed to 5 million in debt, the purchase price of the businesses that the search category could go after would become full fledged lower middle market businesses. I'm just curious how these two distant cousins are going to potentially become much closer to one another over the next five years or ten years than over the last ten years.
[00:22:58] Speaker C: I'll start then. I want to turn it over to Rick, who has taught corporate finance forever and will have his own views on this as well. I think they are going to remain in parallel, slowly slightly growing a little bit closer. There are several things going on. One is searchers will buy a small business. Sometimes they'll own it forever, but often they'll professionalize it, they'll grow it and it becomes of interest to a private equity firm because of its size and greater professionalism. As a searcher, in some ways you could think of yourself as you're in the build to suit business for a lower middle market private equity firm. Reason private equity firms don't want to do that themselves is twofold. One is these firms are small by private equity standards. You're investing equity of 1, 2, 5 at the high end, maybe 8 or $10 million. And that is just really, really small. For a private equity fund that's trying to invest a $500 million fund, you're tying up expensive people. You're trying to get a fund to work. It just doesn't work in their economics. And then on top of that, it's actually more work because most often with these search targeted companies, not only do you have a big professionalization and growth job, but the founder CEO is retiring. So you, the private equity firm have to find someone who you can recruit in, who will be good and who will run that firm. The searcher is displacing that because they're organizing the transaction and then they're running the firm. So private equity firms generally don't want to do this. They want to be the buyer of the firm five years later at the next level. And when I said they're growing a little closer together, it's only because some lower middle market private equity funds will themselves back a roll up and that roll up will buy these kind of firms. But the searchers only find themselves in competition there if they're choosing to go into a sector that's being actively rolled up by private equity firms today. If they're not there, then they won't see that. So that would be my reaction as to the parallelism of private equity and searchers.
[00:25:00] Speaker B: First of all, it really is different between funded and unfunded search. The funded search community has really gone up market. So the typical transaction size last time we looked at the Data is about 16 or $17 million with equity checks at 8 or $9 million. But I think if you were to look at more recent data, you might see them even higher. When you look at a transaction that's $30 million being done by a searcher that feels like a small private equity transaction. It's not a small search transaction. It is interesting. The multiples that they pay are also rivaling the private equity multiples because they of course have to compete for those targets, those opportunities with the private equity firm. Private equity firms have Been stigmatized on occasion, completely unfairly. Royce, of course, unjustly. Unjustly.
[00:26:01] Speaker C: All a calumny. Yeah.
[00:26:03] Speaker B: And so there might be an occasional seller who will say, well, I really don't like private equity because my Aunt Sadie was in a hospital owned by private equity and she broke her toe and whatever they'll say. So there's some kind of stigma associated with private equity, but I think that's fading. And particularly if somebody wants to sell their business, I think they can swallow hard and sell it to the people who have the highest price and the highest likelihood of close. And one thing we know about private equity firms is that once they go through their commitment process, the question about whether they can get the capital is not really a relevant question. They might have a question about whether they can get it through their valuation committee, where they get it through their approval process, but once they get it through that process, there's no question about the committed capital. So I think the funded search has really gone up market. They're paying higher multiples and they're engaged in higher transactions, which I think come very close to private equity. The smaller end of the private equity firms, they're not competing with kkr, they're not competing with a multibillion dollar fund. As Royce pointed out, you just can't fill up a multi billion dollar fund with two, three, even four or $5 million transactions. And if it's an $8 million transaction, you probably never going to be more than 25% of the total equity. So the net result, I think, is that it's just impossible for a big private equity firm to do what searchers do. But on the up end of the market, they are competing on the lower end of the market. I think everything that Roy said is true. Somebody asked me, I don't know, five years or so ago, after we've been teaching this for a long time, somebody said to me, well, you were trained as a researcher. So now that you've been doing small business for a decade, what have you learned? And I said, I have learned that small business is small because everything special about small business investing comes out a result that they're small, they're coming in small check sizes, and so you have to find a way to minimize your fixed costs.
[00:28:09] Speaker A: On the scaling up of the purchase price. Among the funded search community, there seems to be a bit of a narrative just around the very best returns of search are in the rearview mirror maybe now. Not that they're bad going forward or that they will become bad, but I would be Interested to just get your perspectives on returns. Royce, you mentioned it's a bit of a golden era to raise equity. If you are a really promising searcher yourself, there's just more capital in the form of maybe both equity and debt. I think you were referring to the equity than there are great searchers to back despite a big expansion in the supply of searchers coming out of business schools and mid career. But yeah, I remember reading like a Yale paper on returns and some speculations on returns that maybe clouded the picture a little bit on the future being as impressive I guess as the past when you look at the Stanford reports on returns.
[00:29:06] Speaker B: So now this is the finance professor side of me. I'm so sorry.
[00:29:10] Speaker A: It's elusive to measure.
[00:29:12] Speaker B: Yeah, I mean Bob Merton, who's sort of the smartest person I know, in thinking about expected returns he would say that expected returns are about the most difficult thing you can measure and estimate. He once told me at a dinner I was at MIT and we overlapped at MIT and then we overlapped at Harvard. So I got to know Bob well. He once said that he would trade all the empirical research in finance for just one expected return handed down from Sinai or whatever your religious affiliation is so that you can find out what is the God given expected return. You can't really tell it. I think you can't look at 10 years of data and say oh I can tell this is the golden era has passed. There's just not the statistical precision to do that. And we're talking about at most a few hundred transactions. If we can't do it on the stock market, how could we ever do it on the search market? So number one, we just don't have the statistical precision to tell anything. Number two is again, I think this is really going to be different from funded and unfunded. And the reason is something every student knows that we've had that I say over and over again the magic is in the multiples. If you buy a business for three and a half times or four times, you're going to have a great return because you have an ebitda yield of 25%. If you don't goof up the business, you're going to have a fabulous return. Put a little leverage, add a little growth, it's not hard to get mid-30s. If you buy a business for eight times because you're a funded searcher competing with private equity and going up market, it's a different story. So I think in the unfunded market the potential for high expected returns is just as good as it ever was. I think in the funded market we need to worry about the multiples that are being paid.
[00:31:02] Speaker A: How do we worry about those constructively, Rick, how do we worry effectively about a searcher paying eight times EBIT and out competing a private equity firm for whatever the reason?
[00:31:13] Speaker B: If that's something an investor's uncomfortable with, they shouldn't invest in funded search. That's a simple solution. I just think they have a different model of the way the transactions work. Just like there's this division in investing between growth investing and value investing. Royce and I have a very strong value tilt and we think growth is great. But you buy a business for three and a half, four, four and a half, even five times and you're locking in a pretty good return even if you're not able to grow the business.
And so there are multiple ways to win. In funded search, it's different. You're going up market, you're really betting on the growth hypothesis and you're trying to roll up, you're trying to do multiple arbitrage. You're doing a whole bunch of different things which have worked really great in recent past. But who knows? I'm old enough to remember having to study in graduate school when everybody thought conglomerates were just fabulous in the 1960s. And then we woke up and said, wow, we don't really need conglomerates anymore. And people went from the conglomerate premium almost instantly to a conglomerate discount. That led some of the acquisition waves which occurred.
[00:32:28] Speaker A: It sounds like it could potentially be two stories. There's the self funded search story which stays at the lower end of the markets, typically sub 10, certainly sub $15 million purchase price or even sub 5 and then funded search. It's a little bit more, not anybody's guess, but it's a little bit more of an unclear picture. If they're doing bigger deals and paying larger multiples for those deals, they just have to respect the expected return associated with paying eight times versus four to five times. And they're really in the private equity game either rolling things up, driving growth, catching a cycle, having something great happen with like a strategic acquirer, et cetera. It's just a little bit more of an open set of outcomes with funded search than it is with self funded search.
[00:33:15] Speaker B: I agree with that and I think it's also point out that the typical contract between the funded searcher and their investors encourage them to do all the kinds of things you talked about. It's not a steady eddy. You need to do something that's Going to expand the risk to allow you to earn your return, your reward as the searcher. So I think it all makes sense that you're paying a higher multiple. It's a riskier transaction, both because of the risk of multiple compression and because the way you've incentivized your CEOs encourages them to take that extra step to try to increase returns. And when the returns happen, it's great. It's just when they don't that it's sad.
[00:34:00] Speaker A: The MBA search has typically been a traditional search, a funded search. As Royce was saying earlier, it was a search that was funded typically by a cabal of investors, HBS grads, guys like Herb Grossbeck out west, big investor. There was kind of that whole category of investor. And so MBA investing was largely like a funded search, not an SBA oriented search. Do you guys think that that could change?
[00:34:30] Speaker B: So for us at hbs, I would say if you asked our ETA class, because we did this recently, we said, what are your intentions with respect to funding? I believe it was about 75 to 80%, raised their hand and said they would do a self funded search, an unfunded search.
[00:34:51] Speaker A: Wow, that's a big shift.
[00:34:54] Speaker B: It's actually not a big shift. At hbs, it's been about that way for about a decade.
[00:34:59] Speaker A: I'm surprised.
[00:35:01] Speaker B: But you're corrected about most business schools. It's right. Royce and I spend a lot of time teaching about unfunded searches as well as funded searches. We take a pretty balanced approach, and in our investment lives, we invest in both. And we think this career path should appeal to people who are interested in both. And they're different, and the transactions are different, as we've already discussed. So we think we might give them a little more balanced treatment. But when our students see that you can own 60, 70, 80% of your business, they get excited. And so they're willing to go down market in size, pay the lower multiple, but get the benefit of finding a terrific target. When they find the terrific target, there's many investors who will take the 35 or 40% IRRs, even if it results in only 20% ownership of the company.
[00:36:00] Speaker C: I think in addition to the compelling economics, one consideration students think through is do I want to be the CEO of a bigger small firm or a smaller small firm? What are my training and skills and inclinations fit better with? It's not just a economic decision, but as Rick said quite correctly, economics are a huge part of the decision. Not all of it, but huge.
[00:36:22] Speaker A: Why don't we branch into talent and the way that talent is evolving, particularly based upon some of what we've been talking about and just the movement of more and more talent potentially into the unfunded search category. I didn't realize it was as prevailing at Harvard. It certainly was not like that at Stanford. Maybe I'm just not following the data as carefully as you all are.
[00:36:44] Speaker B: Peter, I think you're exactly right. Harvard I think is pretty unusual in this way that so many of our searchers end up going unfunded. It may be because our students are a little older, I don't know. We've had funded searchers, they always call Royce because he's the nicer one. But we've had investors in funded search take him to lunch and say what's Ruback saying? Why aren't we getting these great funded searchers? Why aren't we getting the talent? Why is it going in a different direction? I think we are different for that reason.
[00:37:15] Speaker A: Going back to a comment from a handful of minutes ago, as you said, it used to be this male only field coming out of MBAs. It seems like you have the benefit of more and more self funded oriented searchers at Harvard that you've been able to teach. You guys are also very excited about the way that this career path could unfold for the multiple of people who will never go to a business school, never go to Harvard business school, never go to any graduate school. Do you field calls from people like that? Do you have conversations with mid career searchers?
[00:37:48] Speaker B: We do. It's really hard in the fall because we have 200 students. You know, when I used to teach private equity finance or advanced corporate finance, we had some office hours, but it would be like a little bit because nobody's changing their life because of your course. And when we teach about small business, a lot of students never really thought about it until they take our class. It's a transformative experience for some of them. Not all 200, but some of them. And it opens their eyes to choices that they hadn't imagined before and they want to talk to somebody who knows something about it. And thus they want to knock on one of our doors. And so we do a lot of office hours in the fall. In addition, we have a group of visiting executives also who are former searchers, all of them, and successfully acquired and sold businesses. And so we have them also meet with students so our students get a lot of time to talk to people. But alumni do reach out to us as well and we host alumni events periodically and get follow on Questions.
[00:38:56] Speaker C: One of the things we're most excited about in our podcast is reaching out. In addition to people who have no connection to business school, they've held some sort of executive job for a number of years. They're interested in being an entrepreneur. Startups scare them. Startups feel frightfully risky or they don't have a big idea. It's presenting this opportunity because there are a lot of people who have no business school degree who have done this successfully. And as Rick said at the start of the interview, nothing succeeds like success. And so when you can point, as we do in our podcast, to the journeys of people who maybe got a BA or 8 or 10 or 15 years into their career and make a wonderful segue into owning their own business, we've seen before that it's very inspiring for people to consider it for themselves. So that's an audience we really are trying to reach.
[00:39:47] Speaker B: Suppose I graduated from engineering school and I've been working in various roles in an industrial company. No P and L experience. What is it that I need to know about business to do a small business acquisition? What do you think that is, Roy?
[00:40:04] Speaker C: I think you have got to have learned how to be effective with people in a business setting. So EQ stuff, EQ stuff. I think you have to have some basic knowledge of P and L and you know how to read a financial statement. You don't have to be a financial analyst, but you have to be able to be literate. I think you just have to have some commercial savvy that it's okay to negotiate. You want to make your costs less and you want to make your revenue more. But I think that's about it. Because these firms that are being bought as searcher acquisitions generally aren't these really, really complex things. They're performing a basic service, as evidenced by the fact that the founder almost never had an mba. The founder was really good at that service or product, but they were never trained as a manager. Almost always. So it can be done. I don't know. Rick, would you agree with that? You asked the question.
[00:40:57] Speaker B: I would agree. So it's basic accounting, a commercial sense. I would say a little bit of risk tolerance. And I would also say, and maybe this is covered in your first thing, but I would add the importance of sales, that they have to be willing to go belly to belly with a potential customer and talk about the virtues of buying from their business instead of another business. There may be another trade or two we're missing, but I think that's it. And I don't know, you can ask whether an MBA actually helps in any of that. It certainly helps with the financial accounting and our students get to see hundreds of cases so they learn about business. But that's not the only way to do it. I would certainly say if you were that engineer that I was talking about and you were thinking about doing this, a night school course, an accounting or an online course of some sort on accounting wouldn't be a bad idea. I think that'd be a really good idea.
[00:41:57] Speaker A: What do you think is the right sourcing and searching model for a mid career professional versus the traditional search? In the traditional search world, you raise capital, you put your head down and you go full time building a pipeline of targets and opportunities through all the various channels, direct to owner through the intermediated channel. You're running an all out campaign and that's your day job. You wake up and you do that. Maybe you pull together a set of interns. If you're 10 years in at Danaher, 10 years in at Transdigm, one of these fabulous industrial businesses, or not, or something that's less well known. But how do you start the search process? As you said earlier, it's a huge family decision. So you're not just going to pause your job and resign probably and start searching full time. Unless you are. That's why I'm asking you guys how is this happening? If you're a mid career guy, what is the process by which you create the room to go at this?
[00:42:54] Speaker C: You're asking a great question and it won't surprise you because it's a great question. We get asked this question a lot by people who are considering this. I'll offer a couple of thoughts. I know my partner has a couple of thoughts on this too. If you're a mid career searcher and you're going to do a self funded search and therefore you're buying a smaller small company, imagine sort of a million dollars in EBITDA as somewhere in the midpoint of what you might be buying a little smaller, a little bigger. What I think we would do is we would start contacting small business brokers of whom there are something like 3,000 in the United States and seeing their listings because you're then dealing with sellers who have made some kind of commitment to sell their data has been somewhat organized by the broker. There's a process and you're at an end of the market where there isn't that much competition. It's not zero competition, but the competition isn't fierce. You are letting the broker be of real assistance to you in presenting qualified opportunities. You can later branch off and add a direct sourcing wing of cold calling owners. That's very labor intensive, but maybe you'll find a segment or two that fascinates you through that search and you'll add that on. But for this kind of searching, I would A, use brokers and B, sadly, tragically. I hate to say these words, but I would make it a full time activity because you need to look at a lot of deals to find that very good company to buy and that means you need a lot of at bats and it's hard to do that when you're working nine to five on weekdays.
[00:44:26] Speaker B: Well, I think some people get lucky and some people search part time and they find the deal of their dreams and they're able to move it forward.
[00:44:33] Speaker C: And they become famous in the search.
[00:44:35] Speaker B: World for that and they become famous in the search world. We've done a podcast or two with people who have done that and that's just wonderful when it happens. But I don't think you should depend on that. I think for most people you really, really have to work very hard to find an acquisition target that you are interested in that's available that you can buy. And so I think it has to be a full time job. And I think more importantly, in the scenario you described, Peter, what you need to do is in addition to do it full time, you have to shut off a little bit of the family noise. Because just like that typical parent who warned about whether their child was actually working when they were hanging out in their pajamas all day long staring at their computer, so too will this person's spouse. You need to turn off some of the noise. Just because you're searching full time doesn't mean you can take the cars in for service because you don't have anything else to do all day long. That's actually not the case. As for sourcing, the one thing I would add to Royce's comment, I love brokerage sourcing, but the other thing that's really important is that more and more people are doing geographic searches. And if you are doing a geographic search, brokers are an inefficient or difficult way to do that because most brokers take mandates in a pretty broad region or even nationally. And so if you want to buy a business in Boston, you just can't look in Boston based brokers. You won't find it that way. So we really strongly recommend that if you're doing a geographic search, you embed yourself in the Business community in the place you want to buy. So that means you want to go to the Chamber of Commerce breakfast, you want to go to the Rotary Club, you want to meet with attorneys, you want to meet with estate attorneys. I think it would be great if you could meet with cardiologists, but they don't really like that idea. But find out who the potential sellers are going to be Somehow be active in whatever religious organization you can be true to be active in it because you need to embed yourself in the business community however you do it, religious organizations, softball leagues, whatever it is.
[00:46:57] Speaker A: If you were to sketch out a version of the future five to ten years from now and the self funded ETA category, how would you like to see it in its more sort of fully mature state? What is the picture in your mind of what you're hoping to see? Where ETA is gone completely beyond the circles of the top MBA programs. It's now this very significant separate category of mid career professionals. Could you paint a picture of sort of what that looks like in a maybe more stable state?
[00:47:31] Speaker C: I think one characteristic of ETA in the future that is very realistic is that it will be extremely common that people five to 15 years in their career, as they think about alternatives to the job they have that they may not be completely satisfied with, are thinking about buying their own small business in exactly the same way today as they think about switching jobs that other advertising agency or distribution company or whatever would be the obvious company to company transitions in their industry. They're also thinking on that list. Is this the moment for me to buy my own company which is not where we are today, but I think is a reasonable expectation of just a widespread consideration of that as an alternative.
[00:48:12] Speaker B: I love that. What I would add to that though is it would be great if somehow the transaction process, particularly on the low end of the market, got a little streamlined. It would be really terrific if there became the kind of standardization in data rooms. You know, when you buy a house, you get kind of a reasonable amount of uniform information. You know the age of the house, you know how many bathrooms it has. If you ask, they'll tell you when the last roof was put on. They'll tell you what kind of heat it has. Right? You're going to get some well defined data about a house just through an MLS listing. And while I don't think we're going to get MLS list people are trying, but I don't think we're going to get MLS listings because owners tend to be very secretive for good economic reasons. But it would be really nice if some of the things which have happened in slightly larger transactions, for example, there's a Q of E by a reputable firm done by the seller. Maybe we don't go to that stage, but we go to something where we streamlined and made the data analysis much, much easier. You know, you don't have to be an architect or an engineer or a builder to buy a house and feel confident about the house that you're buying. I would love it to be the same for a small business.
[00:49:35] Speaker A: The growth and the prevalence of equity capital as well as like the national lenders. Could there be a set of fit for purpose changes in terms of equity and debt facilities for the mid career self funded searcher? It feels like a lot of the institutional debt and equity providers, not all of them, but it seems like a lot of them are backing a lot of traditional searchers, at least on the equity side. Do you think that evolutions to the equity and the debt facilities that could get built to specifically back the self funded searcher? I know there's a 20% limit, otherwise you have to sign up to the personal guarantee. You can't own more than 20% as an equity owner, otherwise you have to be a cosigner on the personal guarantee. But I'm just curious whether there's structural changes to the equity and debt capital markets that could help bring this about in addition to the streamlining ideas that you've both mentioned.
[00:50:26] Speaker C: Well, I think on the self funded side we're seeing a rapid streamlining of equity to self funded searchers and that is that today there are now professional funders of self funded searchers in the equity piece. And if you go to one or two of them and they like your deal, they'll introduce you to eight or ten other recurring investors in self funded search equity and you will rapidly get your equity table filled out even if you personally have no network of investors. And that is a gigantic change and a gigantic easing on the debt side. Peter, you make a great point. I mean I think it's hard for conventional loans to compete with SBA loans, but when you get above the $5 million loan size there for the self funded searcher, it becomes more challenging getting term debt. And so somehow either getting more institutions that are interested in lending to self funded searchers and maybe the 5 to 8 million dollars loan range would help somewhat.
[00:51:25] Speaker A: I want to make sure we cover the talent changes that you mentioned earlier a little bit. We've only touched a little bit on it just in terms of both the skills that people have, as well as going from being like a male dominated MBA field to something much bigger and broader than that. How do you see it getting more diverse in terms of the talent that's in it? What do you think could be a stable state of female search entrepreneurship versus male entrepreneurship? Do you see it diversifying more across degrees like engineering and liberal arts as opposed to other vectors? What are the ways that it gets more diverse over the next five to ten years?
[00:52:01] Speaker B: Nothing succeeds like success. When we have searchers in our classroom who talk about what it was like to have babies while searching, what it was like to be raising a family while they're running a company, I think that opens the eyes for a lot of women. A lot of women say, wow, if I want to succeed in my typical private equity job, and of course there's wide ranges of differences across, across firms, but I have to be willing to commit to lots of hours, particularly when I'm in the middle of a deal, I really have to put that deal front and center. Whereas if I run my own small firm, I can set my own schedule, I can set my own agenda. If I need extra help, I can get another assistant in the office. I have control. I can't control my customers, of course. I can't control financial markets, I can't control the national economy. I'm not saying there are no risks in the world, but I can control what happens in my own firm. I can control the team I work with. I think what we're seeing is that many women are looking at the ETA career path and saying, wow, that really is compatible with having a family. That is compatible with having dinner with my partner and my children every night. I could do that. I might end up working on midnight every night after I put the kids to bed. But such is life. There are no jobs that pay a lot of money that you only have to work 30 hours a week on. You're just not a whole lot of those. I don't know anybody who's successful that doesn't work 80 hours a week. So I think people are seeing those role models and those role models are being successful. And so that will further expand. And I think that's true just across the spectrum. Nobody chooses to do business with a firm because of the race, the gender, the age of the owner, the religion of the owner. I mean, maybe some do, but most say what I really care about is I'm getting a great service, I'm getting a great product, and I'm getting it at a good price. And it's helping me do whatever I do better.
[00:54:15] Speaker A: It's been great to zoom out with you both and just dream about sort of where this market can go over the next five to 10 years with the benefit of all the exposure that you guys have. Is there an update to your book or are there any forthcoming publications that the audience can look forward to from either of you or.
[00:54:33] Speaker B: We have a terrific podcast that collects a lot of our ideas. We've talked about whether we would update the book or not. The listeners won't know this, but Royce is smiling with a big Cheshire cat kind of smile because we've been for two years discussing whether we should revise the book or do the podcast. We've done the podcast. We love it. The new season's coming out this winter and there'll be another season.
[00:54:59] Speaker C: Think big, buy small. You should say the name, Rick.
[00:55:01] Speaker B: Think big, Buy small. The same name as our book is coming out and it's been pretty successful. But it as, you know, probably, Peter, while it might be an effort of love, it does take some time. So that has pushed the book project off a little bit.
[00:55:18] Speaker A: Well, it's great meeting you guys. It's great to be with you. I really enjoyed the conversation. I'm excited to be a listener to the podcast. Thank you for all that you've done to put your work out into the world through the book especially, which obviously goes so much further than the HBS classroom. That's obviously an incredible way for the world to learn about what you guys have been teaching up in Cambridge. So thanks for coming onto the podcast and spending this time with me. I've really enjoyed getting to meet you all and talk about these topics that we all care about so much.
[00:55:48] Speaker C: Thanks for having us. It's been a pleasure speaking with you.
[00:55:50] Speaker B: Yeah, it's been a real delight, Peter. Thank you.
[00:55:53] Speaker A: If you enjoyed this episode, check out axial.com there you'll find every episode of this podcast, as well as our recorded Axial member roundtables, some downloadable tools, tools for dealmakers, Axial's quarterly league table rankings of top small business acquirers and investment banks, and lots of other useful content that we've created over the course of time. If you're interested in joining Axial as either an acquirer, an owner considering an exit, or as a sell side M and A advisor, you can get started for
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[00:56:40] Speaker C: Peter Lerman is the CEO of Axial.
[00:56:43] Speaker B: All opinions expressed by Peter and podcast.
[00:56:46] Speaker C: Guests do not reflect the views or opinions of Axial.
[00:56:49] Speaker A: This podcast is for informational purposes only.
[00:56:51] Speaker B: And should not be relied upon as.
[00:56:53] Speaker C: A basis for investment decisions. Podcast guests may have ongoing client relationships with Axial.
