Second quarter lessons
Q2 Update on White Cedar
Many readers in the early days of their search found it helpful when I shared my First quarter lessons, so I will be sharing my quarterly learnings for the search phase going forward. While I hope to provide as few of these as possible (meaning I successfully acquired a business), I aim to benefit those in the first year who look to gain some traction early on. Let’s dive in.
Focus, focus, focus on the type of business you want to buy
This lesson was so important to me that I wrote a post about it back in September called Refining your focus. While I will not bore you with the same details, drilling in on software businesses for the duration of my search brought me much-needed clarity on how to spend my time and present myself to business owners. As long as you focus on acquiring a business with strong economic characteristics where you may have some domain expertise, it does not matter what industries you choose, whether they are in blue-collar services, tech-enabled services, healthcare services, or software-as-a-service. With more focus, we can better understand what makes a good business in that space, the competitive landscape, and valuation expectations, all while mastering your story to pitch to prospective sellers. These will help you more than the common spray-and-pray approach across various business models and sectors. Yes, refining your focus significantly reduces the number of feasible acquisition targets, but the cost of coming across as a jack of all trades and a master of none can threaten your credibility with a more general search thesis.
Understand the core business model before getting bogged down in the details of an opportunity
I can’t lie; it’s easy to get caught up in wanting to analyze every detail of a business’s financials after a round of email outreach campaigns and failed owner calls. Once we get our hands on some decent data for an opportunity that appears to be a close match, my MBA-wired brain feels deprived of some classic financial statement analysis and wants to dive right in. In the second quarter, I spent approximately three weeks on an opportunity that I was excited about, creating a deal teaser to send to investors, a cohort analysis, and a financial model, thinking that I fully understood the business and how it made money.
With my analysis and a product demo complete, I did not focus my attention on the core of the business. It turns out that I had failed to recognize that it made money through services that another company was providing, sending a royalty to that supplier, and passing out its software platform for free to its customers. The issue was that I focused too much on the numbers and not enough on the basics of the business. I wasn’t looking at a software company but instead, a services company enabled by technology.
To combat this challenge that many searchers face, start with the company's product or service and distill it down to an elementary level. Throughout my ETA training (both formal and informal), I underappreciated the feedback on being able to describe what a business does in a few short sentences. If you can answer the following questions and explain them in simple language so that someone without any industry knowledge can understand, you will be ahead of most people:
What products and/or services does the company provide?
How does the company provide such products and services? Or put differently, what are the costs (direct and indirect) that enable the company to make money?
Who pays the company for its products and/or services, and for what exactly are they paying?
Under what terms (if any) does the customer pay for the company’s products and/or services?
Using the above example, I missed key questions #2 and #3, as I did not initially catch that the business was packaging other companies’ services and paying its supplier a royalty for distributing their services. Fortunately, I caught on before submitting an offer or LOI and moved on unscathed. But no matter what questions you use to qualify a business, don’t breeze through the business model because of the initial excitement of an actionable opportunity. After that deal, I slowed down to spend more time framing these questions in a way my young nephew might understand.
Thoroughly evaluate opportunities to gain the conviction needed in moving an opportunity forward – from qualifying a lead to submitting an LOI
On a similar note, once you’ve gotten to the core of what a business does and how it makes money, there is no time to get complacent. I found that I was unstructured in progressing opportunities forward and did not have consistent tools to evaluate them. My sight was locked in on executing an LOI without the logic and processes on how to get there. So, in the second quarter, I built much of the infrastructure (i.e., analysis templates and processes) to evaluate deals more objectively than before. The underlying logic was to construct a systematic gating process that could save time, reduce cognitive biases, and guide the qualifying process during the early stages of an acquisition opportunity. Here’s the breakdown of what the result looked like:
Early qualifying activities
1 to 2 owner conversations to determine high-level fit
Product demo
Quantitative analysis for the previous three years
Historical financial performance (P&L, cash flow statement, B/S)
Cohort analysis of customer sales data
Preliminary LBO model
Company and industry scorecard
ARR/EBITDA multiple analysis
Acquisition alignment
Preliminary terms regarding equity rollover, seller note, earnout, etc.
Board or advisory role involvement and transitionary period
Deal teaser for investors
Company description
Financial overview
Investment thesis
Key bets
Revenue quality
Competition and industry
Operations
Deal structure
After the early qualifying work, sections two, three, and four are being built concurrently using templates I created using Microsoft Excel and Google Docs. This list may sound like a good amount of work for a solo searcher, and it is. That’s why these templates can help you speed up the process of gaining conviction (or not) around a potential deal. While some searchers may prefer to save this work for post-LOI due diligence, I recommend doing the heavy lifting upfront. With finite resources and time, searchers cannot afford to execute LOIs with owners to just back out when diligence findings turn unfavorable.
Further, you don’t want to get caught up in a situation where you have to back out because you didn’t do your work upfront. There’s obviously a reputational risk at stake for future opportunities, but more importantly, we should respect a business owner’s time and efforts. It doesn’t matter if other buyers shoot from the hip with unthoughtful LOIs; protect your reputation as a serious buyer and show them the respect they deserve. Sometimes there may not be enough information to answer all of the questions on the list above, which is also okay. Transparency with the seller on where you will focus your diligence efforts moving forward is crucial in finding answers to those questions.
Progress over activity
In the first quarter, I provided OKRs (objectives and key results) for the next quarter, focusing on increasing lead generation and owner conversations. As I recommend establishing goals to share with your investors and to hold yourself accountable, be mindful about how you choose them. The north star of any search fund is to buy a great business, not to be active, and some goals will distract from that desired outcome. I found that some of my OKRs drove counterproductive behavior by taking calls or in-person meetings with owners who could have been qualified without a conversation. Given how valuable our time is in the search phase, we must be ruthless in prioritization and avoid this trap. It is only natural to fall victim to these types of perverse incentives with quarterly goal setting, so make sure that you are aware of how your objectives may cause you to drift off track as you look to meet your targets. Keep your eye on the prize, not how others may perceive you.