Tom Klein – Pre-Close M&A Value Creation Playbook Ep.220

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(00:00:00) – Intro

(00:04:37) – Deep focused search approaches vs. scattershot approaches

(00:11:18) – What numbers and measurements do you use when determining interest in an industry?

(00:20:42) – How do you think about proof of success when examining companies within an industry?

(00:28:29) – What are some of your favorite ways to research an industry?

(00:34:11) – What are the key characteristics of a business you need to see when acquiring?

(00:39:47) – What are some industries you were close to investing in but passed on?

(00:43:50) – What do you start looking for once you’ve finalized a platform acquisition?

(00:54:50) – What are some key questions you ask sellers?

(01:01:35) – What do you look for in lenders?

(01:18:30) – Advice for folks pursuing consolidation thesis’

Alex Bridgeman: Tom, thanks for coming on the podcast again after quite a while. I’m really excited to talk more about M&A and consolidation strategies and kind of pair it with the episode from a few weeks ago with Roland, which was mostly focused around after you close a business, how do you integrate and then bring teams together and go forward from there. I think we can have an awesome chat today about more of the steps prior to that, high level of looking at industries, identifying the right platforms, lenders, kind of a path towards close and whatnot. But kicking off, I know you’re a big fan of like the deep industry focused search and industry research. Can you talk a little bit about that and some of the benefits you’ve seen to that versus more of a scattershot or shotgun approach?

Tom Klein: Sure. And Alex, thanks so much for having me back on. It’s been two or three years. I did get a chance to listen to the epic Roland Lessard have a couple hour conversation with you. It was a little tough to get through. He’s tough to listen to. But there were a lot of pearls buried in there. He’s a good man and he’s just an absolute expert at integrating businesses and really integrating them extremely tightly such that, after about a year, as he alluded to, you really can’t recognize that there were ever two distinct entities. But awesome to be back and discussing the sourcing process in depth and closing. On the fragmented industry side of things, as it relates to doing a deep industry search, when you think about deep industry searches, you often think of people searching who say, oh, I’m just rushing to get up to speed. I’m just rushing to get up to speed. And implicit in that statement is often that they have found an opportunity where they are new to the industry. It’s often been brought to them, Alex, by a broker. They have not spent time in the industry. They don’t have a proactive thesis around the industry. And so in some regards, they’re always playing catch up. They’re always behind. And in tandem with that, they have no deep comparative knowledge. So one of the things I and we most like about a deep, industry driven vertical search is the fact that knowledge grows over time, not just how businesses work in the space, base, Alex, but what are the top notch metrics comparatively across functions? What should growth rates look like? What should size of customers look like? What should various KPIs look like? What should good profitability look like? What should headcount look like? You name it. And then how do the firms truly compete and differentiate? And so, that deep, deep knowledge, including that comparative knowledge, is absolutely invaluable. And as you go through the industry search, of course, and get more and more repetitions, those repetitions compound and the knowledge grows. And as the knowledge grows, you get savvier and smarter at understanding if you’ve got a good business or a great business or a lousy business. As part of that growing knowledge, you also are meeting, of course, more people. Some of this is quite common sense. You’re meeting subject matter experts, you’re meeting employees of companies, you’re meeting owners of companies, and that network grows and expands. That is another key piece of the puzzle. You’re well-known in the industry, you see more opportunities, you are able, Alex, to reference knowing people in the industry, not just for name drop or name tagging for the fun of it or for sort of bragging about it, rather of demonstrating that you know similar people and that you have spoken to other people before and that you aren’t just brand new to this and that you have done your homework. So that knowledge, the knowledge grows. The network grows. And as those two compound, your credibility sort of expands exponentially. And we can talk about that, but I mean, the combination of being armed and dangerous with knowledge, especially comparative knowledge, and then having a network of people that can vouch for you or have spoken to you prior or that you know names in the industry and it’s apparent that you do and aren’t just tossing around names for the sake of it, that has a huge impact on your ability to find good results. And I would overall summarize that in some ways, Alex, has really high return on time and effort. So, if you keep staying in this industry you’re in, assuming it pans out, you’re going to experience low friction costs, you’re going to minimize repeat work, you’re going to minimize stop-start stuff, and then you’ve got that flywheel, that virtuous cycle we were just talking about of an ever-expanding common network and an ever-expanding knowledge base. And that’s kind of the secret sauce. But I mean, of course, it also comes with really strong focus and conviction when it comes to decision-making. So there’s the return on time and effort and kind of the efficiency of what you’re doing and the knowledge you’re building. But then also, gosh, it is far easier to make a decision with real confidence and conviction when you’ve been playing around in a sandbox for nine months. I can recall in my investment banking days and private equity days, a broker would have brought you a deal and you’ve looked at a grand total of one business in that industry. Well, of course, this thing looks like a beautiful, shiny silver dollar. I mean, you’ve looked at putting a bid in on this company, reading some banker book and saying how great it is. And you’ve looked at one company, not six. So, your perspective is going to be quite limited. Anyway, does that kind of summarize it for you?

Alex Bridgeman: Yeah, absolutely. And then it kind of has a good segue into more of the industry selection discussion too. Obviously for more consolidation focused theses, having a fragmented industry with lots of players is crucial. How do you go about measuring that and putting numbers around fragmentation, addressable market, and being able to quickly check yes or no if this is an interesting industry to dive into further? What are some of the numbers and measurements you use?

Tom Klein: So that’s an awesome question because I didn’t used to use numbers around this, and I’ve made, as we’ve talked about before, Alex, a number of mistakes around this that wasted time and created frustration. So, I do think being disciplined around some numbers on this is important. If you think about fragmentation, just stepping way back, if you’re pursuing an acquisition in a fragmented industry, assuming with the hopes of doing further M&A, which I think we’ll discuss today as the core part of kind of a consolidation play or a consolidation thesis, you’ve just got a far better shot at landing that first platform and then operating the business in an industry that doesn’t have titans in it, that doesn’t have really large scale incumbents with scale and pricing power advantages. It doesn’t mean there aren’t some large scale players, but the way we like to think about it is we really like the rule of 15 to 20. The rule of 15 to 20 is that the top 15 to 20 players in the market combined do not have more than 50% of the market share of the revenue, say. Other people say the rule of eight, but I don’t know, that more looks like the cell phone industry and really, really consolidated industries. Maybe cell phones rule at 3 or 4. But rule of 8, wow, 8 players with 50% of the market, each have on average 7%. Maybe a couple have 15, 20. That’s just top heavy. So, we really like to focus on rule of 15 or 20, making sure there’s a nice long tail of medium to small size businesses, Alex, that can both allow for room to run in the initial finding of a platform and then hopefully there’s a bolt on M&A element. That’s what has been our bread and butter and has been something we’ve always been attracted to from an industry thesis standpoint. That’s one key kind of metric. I would just also add that when you think about fragmentation, one of the other advantages of smaller players is you’re going to get to compete against fairly small fry, unsophisticated competition. I always used to like to joke, being a big fish in a small pond is a lot of fun. And it is, and that doesn’t mean the players aren’t talented in that space. It doesn’t mean they’re not passionate and committed. But often they fell into business by accident. They may be hobbyists. They may be skilled in one of the attributes of the business, but not good businessmen or women. So, go back to one of my old lives, Alex, language services. They might have been a great Japanese-English language pairing translator for highly technical biopharma content. They had the passion, they had the skill, they developed a language services business that grew up to be something substantial. It doesn’t necessarily mean that they have the skill set of a good business person or a good manager. And so those can be very different things. So, those fragmented industries often attract hobbyists, enthusiasts, and there are, as someone that is a businessperson or a real manager, there’s a real opportunity to compete in kind of these unsexy, underbelly, off-the-grid type of industries that have that fragmentation. One of the other metrics I would use that maybe we could talk about, kind of total addressable market, is that somewhere where we can go now? Yeah, so one of the big mistakes I’ve made in the past alongside Roland is that you’ve thought through why an industry has attributes that you like, it’s checked certain boxes for you, and it’s clearly fragmented based on some of the market share characteristics we just discussed. But what people can fail to do is they can fail to think about the total addressable market, the TAM of that industry and its relationship to the number of potential targets they can find. And that’s probably the most important concept that I see missed that separates success and failure in a search, especially in a kind of consolidation play search. And what I mean by that is I’ve historically gone by the view that you should have 50 minimum targets that you can reach out to in the size of revenue and EBITDA you’re interested in, ideally, actually, maybe 75 to 100. And you could say, well, why that number? I’ve experienced typically about a 20% positive hit rate, success rate, ability to talk to an owner from a very well-researched, strong outreach process that’s customized and thoughtful. So if you’re at a minimum of 50, Alex, gosh, you’re looking at eight to ten at bats, so to speak, out of an initial 50 outreaches. And that’s just not a lot. I mean, imagine meeting your future spouse that way, with eight or ten dates across everyone you’ve ever met in your life. Or say you had to decide to pick a home that you knew you had to live in for 10 years. It was like not an option to leave. Would you only look to talk to the owner or do good research on eight to ten homes? I don’t know. I would think to avoid adverse selection and to find the best possible home or spouse, you’d want more. So, you think about these industry deep dives, I mean, they can be three month, 12 month, seven year, ten year long adventures that absolutely consume you. And so, you want there to be enough attendees at the concert to talk to or enough companions on the bus, whatever analogy you want to use, like road race participants at the race. Because the last thing you want is to run out, you run out of targets. That’s the worst frustration of all. So you really want to size that TAM right to deliver on the number of targets. And of course, it depends what revenue and cashflow you’re chasing and how narrow or broad your search is. Are you micro-regional, are you regional, are you national, and then are you looking for five million of EBITDA, one million of EBITDA? You can do some- I mean, I can give you some examples, but you can do some quick math and comparative work to ensure you have enough targets with a certain industry size. So, based on my EBITDA requirements and my geographic reach, is a 5 billion total adjustable market, Alex, big enough for me to get that 50 targets or to get 75 targets, or do I need 10 or 15 billion? It sounds very simple, but people get enamored by industries and start talking about how lovely the growth rates are, and, oh, these products and services are so good and sticky, and, oh, there are so many, this industry is so fragmented and has great retention and all these buzzwords. Then you find out there’s like 10 targets nationally in that EBITDA range, despite it being a fragmented industry, because it’s a very small industry. Anyway, does that make sense? I could give an example if you like, or I don’t know.

Alex Bridgeman: I mean, examples are always good. One kind of question I’m thinking about that or within that group of topics is having- like the rule of eight or rule of 15 to 20, it’s probably good to have at least like a couple large players in the industry who can like be a proof of concept that you could build a large company in this industry. Like it is possible. Like if you have a $60 billion industry but the largest competitor is only 100 million in revenue, maybe that’s not ideal versus a 30 billion dollar industry that has several billion dollar competitors. I don’t know. How do you think about like proof of success when you look across the landscape of companies in an industry? Is it a positive signal to see a couple large players or several large? How do you think about that?

Tom Klein: Yeah, I mean, that’s dead on. I mean, certainly you’d be puzzled about a company’s ability to scale if you had a ridiculously long tail of tiny companies, and it was the landscaping industry for every industry you were looking at. I mean, I guess there’s some large landscapers, but that one comes to mind of just being super, super, super long tail. But I mean, those large players can be absolutely critical. You may be able to get public financials on them. You may be able to talk to employees there, which are my favorite type of employees to talk to. They may have formerly worked there or work there now, but you’re not seeking to buy the 500 million revenue player that exists as one or two or three of the larger behemoths in a fragmented industry. Those are lovely comps to study, understand how they grew organically, inorganically, set some baseline scale margins and ratios. I mean, those can be critical in sizing your targets. I mean, a lot of the work we’re doing here, when you’re sizing them, sizing potential outreach is guesstimating. You’re setting up often employee to revenue ratios, revenue to employee employee ratios and using public information to try to estimate how big a company is and then maybe across a range of profitability coming off the top line. So some of those, they don’t have to be public because sometimes the private’s publish enough stuff, but some of those large guys, it is very important to see that they exist and study their history and study how they’ve gotten to where they’ve gotten to and then use a bunch of their benchmarks to craft your outreach. I can think of- we were looking at home healthcare for a few months 10 years ago, got all jazzed about it, wrote a bunch of research memos on it. We were looking at one section within home healthcare around private duty, which insurance doesn’t cover as much and is less related to the government medical programs. We must have spent a month on this and got all excited and got to the end of the line. This is like a $3 billion industry for North America, and we had like 12 targets. We were chasing two and a half to five million of EBITDA at the time. But what we started learning was for two and a half to five billion EBITDA, if you’re running a US national search, which is a fairly common size, especially for a tag team of searchers or entrepreneurship through acquisition folks, we started really honing in on $10, 15, 20 billion industries. By the way, when I say industries, I mean I’m sort of saying the addressable industry size before you cut down into all the verticals and subsegments. So, companies in that industry that provide reasonably similar core products and services with fairly similar business models, but they may have very different end markets and customer types. Like you can keep sub-segmenting to the end of days and get to nothing, but so it’s sort of fairly similar core products, fairly similar business model type, total addressable market. But that became our sweet spot was $10, 15, 20 billion industries. I’m currently working on something that’s much smaller and that’s far more regional. And so, I’m getting the benefit of potentially only looking for maybe a third or fourth of that EBITDA, but I’m only covering a tenth of the country. So, I’m actually focused right now to get those 50 targets we talked about, maybe even more, sweet spot is 75 or 100, I’m focused on 40 or 50 billion dollar industries actually instead of 10, 15, or 20. Now that would be a lot- it would be lower, Alex, if I was running a national search, but I’m sort of running a fairly localized regional search as part of what I do with Roland. Again, it helps to be looking at a million of EBITDA or a million and a half, but I’ve lost 90% of the US. Again, it depends on what you’re looking for and how wide the breadth is. But I just think it’s so important to make that that strong correlation, Alex, between the TAM and the number of targets. I’m making an assumption that most of these fragmented industries have sort of a regular distribution across them of this size EBITDA has this X percent of the market, etc. It’s fairly similar across these industries that are fragmented by what we previously discussed. Sometimes people say that advice saved them and it’s not something they started thinking about, and I was trying to emphasize that we learned the hard way a long time ago. And you can make the same mistake twice in that area too, because again, you can get enamored by industries and not create enough at-bats or reps for yourself to let an industry search flow the way it should. People will email me or call me and say I’m giving up on the industry search. I’m giving up. I appreciate that this is what people say it does, this is how it’s worked out for them, and blah, blah, blah, but it’s just not panning out. And what I find, excuse me, is that usually it’s a result of one or two reasons. One is they haven’t let it bear out and they’re getting some FOMO from watching people they know or are associated with get all sorts of, quote, results, meaning their peers are talking to a lot of companies and they forget that their process is slower, slower at the start, but then exponentially grows on that credibility curve we were talking about midway through. Or they’ve started and they chose the first or second industry where they didn’t have enough targets. So it’s usually a patience thing, or they chose an industry with this target problem, and they ran out of targets in a month. And when I say ran out, there weren’t enough sellers or a lot of the companies had family in them and were not at a stage that they were interested in a transaction or the businesses they contacted that were willing to talk to them were of low quality. And so, people say, well, I put in all this time on the up front, and I couldn’t see it through. So usually that’s a TAM target issue, and then other times, it’s an envy, an envy piece of watching and listening to what their peers are doing in the shotgun approach.

Alex Bridgeman: What are some of your favorite ways to research an industry in those first couple days or weeks exploring a new space? Personally, I’ve found industry podcasts to be pretty useful, you can hear some of the- pick up more of the lingo, and they often interview experts from around the industry. So, you’re almost introduced to them by default. It’s amazing how many industries have an industry-specific podcast. Even the smallest of industries, someone has content that they’re creating. But I’m curious what you found to be most useful or interesting.

Tom Klein: I really agree. Podcasts have been an amazing advent, especially with the micro-specialization in the last five years, like you just referenced, and the ability to go to some of the most arcane or specialized industries, and somehow some guy is talking about that on a weekly basis. I guess that’s us talking about entrepreneurship through acquisition and independent sponsors, search funds, whatever you want to call it. But yeah, I think podcasts are great. I think I’m a big fan of the old school trade associations. I think you get a really good lay of the land there. I think you get to see a lot of players really quickly. I think LinkedIn’s underrated on this stuff. I think there’s a role for Wall Street research, back to the public side and larger entity side that you’ve mentioned, Alex, although that has gotten worse in years as Wall Street research coverage is kind of… Quality research has moved higher and higher and higher up to large cap companies rather than mid and small cap, but there’s a role for that. I think there are ways to talk to subject matter experts in the middle of your research. I love to, midway through my process, as I’m beginning my outbound contacts, I really like to use a variety of different networks, including personal networks, six degrees of separation, cold outreach, and LinkedIn to reach people who are in the industry, Alex, but are not at the target companies you are seeking to acquire. And so generally it’s larger companies, or they might have been, some of the greatest ones are folks that used to work at the companies you’re interested in. And you’d be amazed the number of people that will talk to you if you demonstrate a willingness to talk to them and make it clear you are not potentially acquiring a company in that industry, but you are acquiring a company in that industry. Very different. And especially if they’re still in that industry or had a fondness for it and want to come back to the industry, you’re a future employer. We hired our COO of our business in the last industry I was in based on one of these subject matter expert LinkedIn calls and became a dear friend and colleague and is absolute all-star. So that’s sort of a heroic outcome of a subject matter expert call. I’m not suggesting that it works out that way always. But you can get 30, 50% yeses to speaking to you, again, if you can come off credibly in how you convey yourself and what you’ve been up to and that you are about to be in this industry and be an employer in the industry. And there’s all sorts of ways to talk to salespeople. I find salespeople are great to talk to because they know the players in the industry and they can speak to customer interactions. But product people and operations folks are good, too, maybe a little bit more internal focus, which I prefer to talk to salespeople and account managers who tend to have a little bit more of an outside pulse and a better view of the landscape, so to speak, because they’re less internally focused, if that makes sense. But that’s one of my favorite little gems, and I try to do that before I talk to owners in the process of doing outreach to owners and some of those conversations will unmask rather faults in your thesis or cracks in your thesis or they will fill in major knowledge gaps, and that’s just priceless information because that’s real-world stuff, not theoretical stuff, not generalizations, not sometimes way too high level research information that you have. It’s very deep dive. It’s very specific. You get to the nuts and bolts of how these companies work. And you take pages of notes, you take pages of notes from these conversations. You can’t get enough of it. Sometimes you type up eight or ten pages of notes in these conversations and you barely say a word. You are just listening because it’s all just gravy and juice, and you’re sponging all this information and trying to absorb it. And if you sponge well on your first owner calls, you might as well sound like that industry sales guy you’ve just talked to.

Alex Bridgeman: Yeah, I like that. Then in identifying an acquisition that’s fit for being that platform acquisition in a new industry, what are some key characteristics you need for that business to have, whether it’s size or team construction or margin or some other characteristic you’re looking for? What makes a good platform versus a bad one?

Tom Klein: Yeah, so, at least for me personally, when you’re kind of doing that research that you alluded to, it can be overwhelming the amount of information that’s out there that can lead you down very long rabbit holes and can also lead to very significant amounts of reading on very tangential topics that can often consume days or weeks. So I think it’s important, as you do your reading and listening to industry veterans, to kind of know what boxes you’re trying to check to the point of your question. So, we like to operate with kind of a Pew matrix rating system that covered five or six key areas that had certain percentages attached to them of importance, some factors being more important than others. But as one example, and this isn’t everyone, but we were big fans of unsexy services. So, services that were not front of mind, that were not top of mind, that were maybe viewed as a little bit underbelly, a little bit that can’t be profitable, or that’s got to be unautomated. Often, these unsexy, underbelly services are a small piece of a big puzzle, but that doesn’t mean they’re a small market. So you just look at like translation. I don’t know. It’s like a $30, 40, 50 billion market now in the US; it was 15 at the time for us. But translation is in the underbelly of everything – manuals, product specifications, safety sheets, legal, legal jargon, websites, code, meta tags for subtitles and Netflix content. I mean, it’s everywhere, but you’re not really aware of it per se. So sometimes you can get a nice size TAM, but that piece is a small percentage of a customer’s budget, which is always nice because there’s less pressure on you from the customer. So sort of you’re a small piece of a much larger decision and a small piece of the budget. But I would add a second characteristic to that. You’ve got to be a must-have service. You don’t want to be a nice-to-have service. A must-have service tends to be predictable. It tends to have recurring revenue. It tends to weather good times and bad. And it tends to be something that is not dispensed with lightly. So unsexy services, must-have services. I think of course growth comes into play. I think a lot of people chase really high growth. We used to chase more mid to high single digit growth, which keeps it off the whiteboards of everyone else because often people are chasing double digit or 20s growth. We used to like two or three times GDP growth, which would attract people, but wouldn’t attract the masses. But growth is obviously, alongside recurring revenue, as important as it gets. The fragmentation rule we talked about is important, Alex, really, really important, both for the original and for a bolt-on consolidation play. Those would be some of the critical characteristics. We talked about the number of targets out there. Another one that we used to focus on as well was product life cycle. This relates to growth, but not always. If you think about a growth phase, emerging phase, a high growth phase, kind of a mature phase, and a declining phase. And we typically like to stay out of declining industries where there’s really no room for differentiation, where you kind of have almost true commoditization, but also stay out of the front side of that curve that’s more startup-y, very unclear where the industry’s going, very unproven business models. So, there’s a nice sweet spot from a product lifecycle development standpoint that sits kind of between the growth and mature phase. And that usually is kind of where you get these five, six, eight percent growth rates, where there’s still room to develop new products and services and take larger wallet share of customers but that is not so new that it has a venture element to it and it’s not so old that all the tricks of the industry have been played and differentiation across quality, service, speed, other attributes have become meaningless. So that was another element of what we look at.

Alex Bridgeman: What are some industries you’ve looked at that you felt you were fairly close on but for one reason or another you decided to move on?

Tom Klein: Well, one example I would give was, again, and this happened numerous times, again, is you do all your homework, you map out the criteria we just talked about, you prepare a lot of outreach to owners, you do a lot of outreach, and you just don’t have enough targets. So, I mentioned that example of home healthcare as an example. Another example would be, this is 10 years ago, so it’s a little bit dating me, but I spent maybe six or nine months, Alex, in the healthcare revenue collection, revenue cycle collection businesses. So, there’s a ton of inefficient processes that exist, as most of us consumers know, from receiving a medical service all the way to payment of that service and all the intermediaries in between and paperwork and processing and coding that goes on. And so, we looked at a bunch of businesses in that, the revenue cycle management, all the way to the end in collections and including debt collection around representing hospitals and doctors’ offices to make sure their bills were paid. I would say in that industry, the reason we folded up shop was not for lack of targets. In some ways, we folded up shop because the business had become way too commoditized, back to the discussion we were just having around kind of where are you in the life cycle. The businesses, we were hard pressed to find ways to differentiate in those businesses. And additionally, what had appeared to be a fragmented industry at the get-go was becoming increasingly consolidated. And I should say, it wasn’t just the consolidation happening amongst the debt collection competitors. There was massive consolidation happening on the provider side, meaning who your customers would be. And we haven’t really talked about that yet. But one of the elements here is that you can have consolidation at your customers and still be believing in your fragmented industry. And then you realize that the customers you’re going to go find are massive behemoths. And you are now no longer able to target thousands of hospitals and hospital systems. Maybe you’re down to hundreds because they’ve all bought each other and done big M&A deals. And now you’re going to be scrapping and you’re going to be running up against the bigger players that you were hoping to not compete against, the existing incumbents in the industry. And you just have a lot fewer opportunities to win deals and it probably takes a lot longer to win new growth deals with larger customers. So that would be an example of one where the industry looked quite different when we got in there from a commoditization standpoint and also from a concentration standpoint, not so much of the providers providing debt collection services, but of the customers that you would be servicing. So that’s a little bit of a twist on the fragmentation piece that it’s important to look downstream, not just the competitors in the industry itself, but who the customers are.

Alex Bridgeman: Yeah, I agree. Switching gears a little bit to sourcing, once you’ve had a platform acquisition done, what do you start looking for in those follow-on acquisitions? What are some of the approaches you take once you have a platform acquired and set up?

Tom Klein: Yeah, so, I think maybe I could just start with, in some regards, the common approach here and that’s to typically rely on brokers, Alex. And my view is if you’re really good at what you do in this, brokers come to you. Because they talk to other owners and they learn that you’re out hunting in the market, meaning you’ve basically talked to enough owners that it gets out that you’re out in the market. And then owners are telling brokers and brokers are calling you. So I think people rely on brokers immensely. And said another way, they’re relying on properties that are for sale. And for sale properties have a whole host of characteristics. They’ve often been dressed up for sale. They have a competitive auction. They don’t allow you often to get to know the owner or they shield information or limit information. So that’s just a very different process. You may not be able to get to know the team or the owner personally. You are competing with other people, which of course drives up the price. And the business has been set up for sale, which can both create some optical illusions or delusions but can also, in some ways, create a dynamic that’s unnatural in the financials or maybe put the business in a light that is shinier and nicer than it should be. So, I mean, that’s what you’re paying a broker to do if you’re selling a business or selling your home. So, I think that is a just classic pitfall, even more so when you buy a platform company and now you’re the CEO of the platform company, Alex, is to, even if you’ve been thoughtful about doing cold outreach to businesses that aren’t for sale, you suddenly like return to Brokerville; I call it Brokerville. And I’m just not a fan. I also think you can become a CEO, you sort of have 10 hats you’re wearing and lots of newfound responsibilities. And I see a lot of CEOs, young and old, sort of outsource this to corp dev teams or to a CFO or a trusted lieutenant, whatever, what have you. And I think one of the best ways to do this is to still personally do the outreach as the CEO. I find that owners are, when you’re reaching out owner to owner and it’s clear you’re doing the outreach, I think owners are wildly impressed. They are shocked in some ways. You’re usually the larger dog on the street. You might be two, five, 10, 20 times their size and they can’t believe you have the time or interest in talking to them. And they can’t believe you’re calling or emailing or sending them a letter. They especially can’t believe that you sent them a letter. And they appreciate the personal touch, just like when you were doing the search, that owner appreciates a lot of customized and thoughtful communication. I can’t tell you how much bad written communication I see in this space that is error-filled, not customized, or sort of generic, and calls someone by the wrong name or gets someone in the wrong industry or uses the wrong company name or says nothing authentic. So, I think keeping that direct ownership of the M&A outreach. Once you get to a certain scale, this gets hard to do. But you can go a long way doing it as the CEO yourself and staying really authentic in your outreach. I like to think of this as, I think I’ve said this to you before, but I mean, I’m a big fan of the written letter. What we’re doing here is very audacious, especially the original search, but even any bolt-on M&A is audacious. But if you just take a step back to the audacity of the search fund model, I mean, for young first-timers doing this, let’s think about what we’re saying here. It’s like, hey, we’ve never met, like stranger here, hi. Like your company’s not for sale, but I’m calling you or emailing you or writing to you. I’ve never run a company. I may never have even bought a company. I’ve never worked in your industry. I like your industry. Even though I’ve never worked in it, I like it a lot. And I’m interested in buying your company somehow. And I’m going to take your CEO founder seat. You’re out. Have fun. And will you talk to me? Will you consider talking to me? Will you stay on the phone with me? Will you, if it’s email or letter, will you talk to me? I mean, that is an absurd, audacious, like absurdly audacious stream of things to get out. There’s a lot to get out there that sounds crazy and laughable. And if you’re talking to someone who’s 60 or 70, who grew up on typewriters and the written word was paramount, and there were no computers or email, and people still took pride in penning letters and having pen pals, there’s a certain respect implicit in the form of a letter. If it’s well-written, there’s just an implicit extra respect for having received a stamped letter. So, I just think there’s a lot to get out there and it never comes off well in an email. There’s just too much action, and people aren’t looking to email like that. They’ll read a letter though. They’ll read a letter. They will. They’ll read a letter around their kitchen table or their office. But you want to get all that out in an email. And by the way, Alex, if you’re not getting all that out in an email, you’re likely confusing them. You’re going to confuse them actually no matter what; I should take that back. But if you try to cut corners and don’t get all that out, they’re like, wait, are you trying to get a job here? Wait, you’re doing what? You’re doing research? Or wait, you own a competitor? Or you’re investing in me? Or you’re a lender? Or you’re doing a survey? It’s just very confusing what you’re trying to do. So yeah, big fan of the written outreach and letters, even once you’ve got a platform company. And just being authentic and unsalesy too. I mean, you take a step back to when you knew nothing about the industry. You know almost nil; you almost know nil next to the level of knowledge of the owner. You’ve got to comport yourself appropriately and be humble and admit what you don’t know. And then you buy a platform company, you’re still new to the industry. You might have been in there six months, a year, two years, three years. You don’t want to come across as someone that thinks they know everything in the industry, and you certainly don’t want to tell an owner that his company’s a great fit for you. How would you know? You only competed against them in two different sales processes and know one of their employees. How do you know that they’re the perfect acquisition? So you can’t make blanket statements that jump through six hurdles. I think you need to acknowledge way up front that this is maybe unlikely to work out or that this may not be the right time or that this is something that may not be a fit for that owner. And that’s just true. Like very few of these deals work out and very few of these people will actually talk to you, if we’re talking about a 20% yes rate on really well-written communications to really well-researched companies. And you still, of those 20 conversations, sorry, of those 20% of conversations, so say 10 out of 50, maybe you keep going with three or four of them. So the odds are long to begin with. That’s why you want the right targets. So why would you phrase your language in sort of a conclusive way or a this is great and awesome and going to work out, or we know this will be a perfect deal, or we know we’re the right fit. I mean, it’s actually the opposite. And being willing to emphasize that ignorance in some respects, being willing to emphasize what you don’t know, being willing to emphasize some of the long odds, being willing to emphasize that you don’t, you aren’t aware of the personal situation of that owner and what they’re currently going through and how they’re set up and what their dreams, hopes, and aspirations are is important. Like it’s authentic and it’s just the way this stuff works. I mean, you’re eventually going to hop on the phone with someone you don’t know, and yeah, it’s going to be pretty awkward to start with. And trying to basically take your seat, or if it’s an add-on to a platform business, parts of their company might be submerged or absorbed, and they’re going to sail off in the sunset. So anyway, it’s never a super easy conversation to have. And so why not acknowledge some of that in the upfront? So those would be some of the things that I would emphasize. Some are for the platform, but also some for once you’re in the CEO seat.

Alex Bridgeman: And what are the kind of key questions for once you get them on the phone or chatting with them in person? What are some of the key questions you need to get answered pretty quickly before moving on or not?

Tom Klein: So I think we talked about the discipline, Alex, in industry selection of all that reading you’re doing and listening and absorbing like a sponge. You also need to keep in mind those business characteristics that you’re seeking to vet and check the box or feel good about before embarking further time and effort. So that grounds your research and kind of creates some goals. If you don’t have goals on research, it can just go on forever. So I try to be very specific in these calls. It’s not necessarily in the upfront, but I want to get a sense for how many employees they have and what their revenue is. Employees can be a good proxy, but you’d like to hear about revenue. You’d like to hear about recent growth. I don’t necessarily talk about EBITDA or profits, especially if you’re doing a bolt-on acquisition. Because on the bolt-on acquisition, you’re going to have lots of synergies, and you’re going to be figuring that out later. You care a lot less about a business having some level of initial profit. You know what a typical business can get to profitability-wise on a standalone basis, and then you’re going to be somewhat cognizant of levels of synergies you can layer on that to achieve an incremental EBIDTA margin at an acquisition. Especially for a consolidation play with a bolt-on acquisition, the EBITDA is just a lot less important. It also can be a fairly invasive question to start off a first call. Really, revenue, size, how they’re growing, which doesn’t have to be an exact specific number, like what did you grow in 2023, like a robot. It’s kind of like, hey, what were you doing five years ago? That’s just a different way to phrase it. How did things look five years ago? How have things been recently? And you get a sense for it. And customer concentration is massively important. So, people go down these three, four sets of discussions where  they haven’t asked, and then suddenly, they find out its two customers are 50% of the business. Now, when you own a platform business, you can absorb a bunch more customer concentration. We use the same rule of 15 or 20, maybe the rule of eight on the customers of a business. I like the 15 or 20, but you can sort of tolerate a rule of eight. When you already own a platform business, it’s different. I mean, if you had really entrenched customers with deep teeth into them with some way that it’s made stickier with a contractor, customized processes are very long tenure and a lot of tentacles into different decision makers. You could buy a business where one customer was 20% of the business. You could, and maybe you break the rule of eight and the top eight are 65%. Because these customers become part of your larger business. So all of a sudden, in a consolidated fashion, Alex, that largest customer might only be your 12th largest customer now. And so that matters. And then you just have that dilutive impact of putting something smaller into something larger. There’s a lot less risk there. And of course, you have synergies in an acquisition. So those are a nice hedge or downside protection against some sort of unexpected customer loss. But you can tolerate higher customer concentration. And then the other thing I would say is I do like a massive hair check or red flag issue. So there’s hair on everything, but like massive hair or a red flag, that can be anything from owner character issues that pop up, if someone says something that verges on an unethical business practice, I mean, probably not going to have a second conversation with them. Is one segment of the business, some division of the business, is it in decline? I mean, that might not be a deal breaker, but is some large segment of the business in significant decline and being hidden by a higher growth rate other division and sort of one of the segments of your business is going to go to nothing over time? Is the owner not in control of the business? Is the guy you’re talking to or gal you’re talking to not the decision maker? Where you have fractured ownership and kind of five other people have a say in the thing. I mean, that can get very complicated. Maybe the price talk he or she is giving is way outside in Looney Tunes land, Alex. Maybe there’s relatives everywhere in the business and it’s just how am I going to get this done and in a way that is not sort of just a family business. So those can be some things that pop up early just as examples of red flags or massive hair where it’s like, okay, in addition to maybe the customer concentration’s outrageous or maybe the whole business is declining. But you try to get those things out early and part ways as friends, not waste time flying somewhere or bothering three of your employees to come get on a Zoom and then you learn one of these things. I mean, you try to learn this stuff early and before you start requesting a lot of extra information or go under NDA, right, Alex? I mean, it’s just not worth it. Sometimes you miss stuff, but you hopefully try to check those boxes up front.

Alex Bridgeman: Yeah, that makes a lot of sense. I think there’s an interesting kind of set of discussions- There’s an interesting discussion here too to have about lenders and lining up a lender who can support you as you do follow on, add on acquisitions and hopefully bigger ones eventually over time too. Can you talk about picking a lender and some of the things you’d like to have happen with that relationship over time?

Tom Klein: Yeah, so I think a lot of people will focus on, and with a lender, on items that don’t matter at the end of the day, that are super marginal. As an example, they’re too focused on the interest rate or the amortization of the required pay down of the principal, the required amortization, or the nitty-gritty of, say, various covenant terms. What we’ve had success with is really being focused on acquisition capability, meaning sizing up with you. So being able to have a larger balance sheet and keep lending to you. And then flexibility as it relates to those acquisitions, specifically like how is EBITDA, acquired EBITDA looked at, to be very specific. What is the language and treatment of acquired EBITDA? As an example, we didn’t do a deal at Morningside, a language services company I ran for 5 years with Roland, we didn’t do a deal for 18 or 20 months. And that was because our business itself needed to be prepared in a much better way to do a deal. So we had unclear org charts and roles and responsibilities. We had no HR department. We were missing like three other departments that you would typically find. We had no unified reliable metrics. So, what are you going to show up with? You’re going to show up with your own dumpster fire at an M&A target and create another dumpster fire basically and not impress anyone who you have one shot at a first impression amongst all these new employees to want to be a part of the business and achieve great things and combine these companies. So we had to clean up our own house, get the strong A players in the right seats, going in the right direction, build strong repeatable processes, whether that was our own organic growth, automation, product development, tech enablement, things of that nature, clean up and build new processes, and then set about iterating our goals and metrics, Alex, so that we could have our own metrics and validate why they were important and track them visually and produce them and set them and have a why behind why we were setting our goals around those metrics. Otherwise, you show up at a target company in a consolidation and it’s like, well, how are you comparing these two companies? Because you certainly have to use Apple’s to Apple’s metrics, and you certainly better have the metrics that count and are worthy of counting and following and tracking and improving on. So, you also want to identify folks who can take part of their time and their work to be in M&A and teach them about M&A before you go do it. So there’s teaching, there’s building, there’s getting the right people in the right seats on the right bus going in the right direction and getting your own house in order and your own processes, repeatable processes set up. You’re not going to really impress a lender if you don’t have that stuff, because that lender’s going to do diligence on you, of course. And you start talking about M&A, and their ears may perk up, they may not. Some lenders don’t do M&A. Some lenders don’t like to provide a lot of incremental leverage on acquisitions. Some lenders don’t have capacity after they initially lend to you. But certainly, if you start talking M&A, the lender’s going to look at you differently, they’re going to diligence you harder, like on the platform business, because all of a sudden, you’re talking about throwing some wrenches that they may not be used to here and there, talking about bringing additional risk for what they’ve lent you. And so, they’re going to have higher expectations around how you run your business and the visibility into its performance and key metrics. So that’s what I would say about lenders. The structuring that you want to do with lenders, if you do find one that’s excited about doing a consolidation play and believes in your ability to execute on that with the platform that you have, Alex, I would throw out two areas that are really key. One is trying to get a permitted acquisition program put in your credit agreement. Said another way, that’s basically having an on-demand callable amount of incremental leverage for future bolt-on acquisitions in your debt facility. So long as the deals are in the target industry that is your focus and so long as once you’ve completed the deals, you’re in compliance with your covenants on a pro forma basis after the acquisition. In our case, in one company that Roland and I ran, we had $20 million of callable leverage. We ended up doing far more of that in debt, but we had $20 million of so-called callable leverage for a few deals that made us feel secure that we had a lender who was ready to provide that debt. And by the way, for a lot of the deals under 10 million in revenue, we had certain kind of easy ways for them to approve the loan. Like in certain deals, we didn’t have to do a full quality of earnings report. And so that can save a lot of time and effort and the way the documents were fashioned with this lender. It was actually a major Wall Street lender, their specialty lending group, who again had a lot of flexibility. But so that was that permitted acquisition program that kind of had an accordion-like facility that was larger than the original funded debt on the platform. The other key thing is how you write the definition of pro forma EBITDA. So, sort of consolidated EBITDA, meaning EBITDA from the platform plus the synergized, hopefully synergized EBITDA from the target that you acquire, the smaller target you acquire. So maybe it’s easiest to give an example here. So, say you had like a 10 million revenue company, Alex, like owner operated, say it had 500,000 of EBITDA, of kind of reported EBITDA. And you’re buying that business for say $7.5 million. I’ll just make up the purchase price. So maybe a lender out there is offering you three times the EBITDA. So they’ll offer you $1.5 million of leverage for the deal out of the gates. So, okay, $7.5 million purchase price, I need $6 million of equity. So, I either need the cash or I need to go back to my investors to get 6 million of equity. The question is, do you really need to go back to your investors to do that or use your own cash? Can you be a lot more thoughtful in how you set up the incremental leverage on this acquisition to fund that $7.5 million purchase price? So I’ll give you a couple examples of how I think about this. You want a lender who’s willing to give you credit for EBITDA that is larger than exists today based on identifiable and planned expense savings or cost cuts that will come in the future. And so, what you’d like them to do is say, hey, Alex, I’m going to give you credit for this now, so long as you go perform the actions you promised to take. So, let’s start just with like a standard one. In that same example, let’s say the owner and his wife are taking $500,000 out of the business with benefits and perks, and they’re going to no longer be with the business 90 days later, let’s just say. Well so, now all of a sudden, you tell the lender that and the lender agrees, okay, you can roll back the $500,000 over the last year into your EBITDA on an as-if basis, as if the owner of the target acquisition has departed the company already, even though they’re going to not be gone for 90 days. And I’m going to let you count that back one year, all the way back. And so now, your EBITDA is not $500,000, your EBITDA is a million dollars. Ah, so okay, now I’m providing you let’s just say 3x leverage. Now I’m providing you $3 million to do this acquisition. Okay, so now we’re getting somewhere. That would be a very basic adjustment. Now, you might say, why isn’t that adjustment always there? Well, some people don’t let the old owner- they let the old owner stay in place, which 19 out of 20 times is an absolutely horrible idea as a horizontal acquirer, which we can talk about. But anyway, that would be a standard adjustment. Then you get into things, Alex, like advanced adjustments where let’s say you have some planned senior executives who, at your company or the acquired company, where after the deal is done, you aren’t going to need two COOs or two CFOs. And maybe that means your CFO is no longer with you because this CFO at this other company is amazing, or maybe the COO at the target company is going to need to go or wants to move on or wants to retire. And maybe there’s some facilities that are going to be redundant or maybe there’s some accounting teams or technology teams where everyone’s not going to stick around and some people want to leave, or you have a much higher performer in one company, and you don’t need both. So if you plan to take actions where you’re going to have a smaller number of people, whether via retirement or voluntary quits or terminations, say 60 days post-closing, what if you commit to your lender, hey, I’m going to take these actions within 60 days. So, there’s $500,000 of cost savings there. Can I get some more debt for those cost savings? So say yes, Tom, they will provide that. Now, if you don’t do those after 60 days with a 30-day grace period, you’ll no longer be able to count that in your EBITDA, and you could be out of compliance. You could be- well, not necessarily out of compliance, but you could be, but we won’t count that in how we look at your cash flow for purposes of what you’ve agreed to do from a covenant basis, how much coverage you have in your coverage ratios and your covenants from a debt to EBITDA standpoint or EBITDA to interest standpoint. So now all of a sudden, you have a million and a half of EBITDA times three, Alex, so you got four and a half million of debt. So now the last bucket is let’s move to the black belt adjustments where now the lender’s looking a little googly eyed, and they’re tired of your requests. They’re beaten down. Maybe they’re sad they took the original meeting with you, but they’re two months into diligencing your company, and they told you you were a great operator and you got a great business. But now you make a final request. You explain to them that you’ve got $2 million of COGS, cost of goods sold synergies. Maybe these are data synergies or vendor synergies that are going to take a long time to extract, but my company has a super awesome, low cost fulfillment engine that’s larger and better, and I’m going to take all the volumes, the transactions of the acquired company, the smaller company and funnel them through my better faster cheaper gadget. And that’s going to reduce cost by two million dollars. So, I say to them, hey, I’m going to go achieve about a million of these. I’m going to achieve two million over the first year, but about a million in the first six months. And they say, oh gosh, I don’t know if I can give you those. That looks really complicated. There’s so many things, so many ifs there. There’s so many things that have to happen for you to achieve those synergies. I can’t give you credit. And then you say, well, wait, wait, wait, wait, wait. Let me show you exactly how it’s going to work. Maybe you can show them the last deal you did and how much of what you said actually happened and how you achieved it and over what time fences and how it all sequenced and that your core business wasn’t just overly distracted from it, blah, blah, blah. So then they come back to you and they say, okay, we’ll give you the cost of goods sold synergies that you can achieve in the first six months up to a million dollars. Okay. Well, now I’ve got three million more debt from that million dollars. So now I’m at like seven, seven and a half million of debt. I’ve now all of a sudden gotten to a place where I’m funding the entire bolt-on acquisition with debt. And it might look like I’m getting a multiple on it of say, what, 15 times, so seven and a half on that 500K of original EBITDA, or you could say seven and a half times on a million of EBITDA, so you include the owner, the basic adjustment. But really you have a lot of confidence, Alex, that it’s really three times leveraged because you’re extremely confident in the cost savings. You’ve measured twice, cut once. You’ve ticked and tied and looked at this six ways to Sunday. You may have also done this one, two, or 16 times before. And you’re confident you’re actually only putting three terns of leverage on it because you’re confident you’re going to have two and a half million of EBITDA or even more. In the case I just gave you, if you got all those COGS synergies, you’ve got three and a half of EBITDA. So it’s this asymmetric situation where the lender is saying, oh, you have 500,000 of EBITDA, and I’m saying, no, we’re going to get to three and a half or four. And okay, we settle on, with various conditions and time fences, I’m going to give you credit up front for two and a half million of EBITDA. And that’s just, that stuff is enormously powerful in creating another whole flywheel around basically being able to use de minimis or small amounts of equity to finance these acquisitions in a setup where you have a really good synergy machine working and you know the timelines, you know how to measure the cost savings and where you have real buy-in from your core platform team. So I just wanted to give that example. That’s like a real-life example actually. That’s not a hocus-pocus thing. But most people would get like one and a half to three million dollars of debt on that deal, and I’m saying there’s a path with the right team and the right analysis and the right thinking and track record a little bit too to go get seven, seven and a half million of debt. So I don’t know if that made sense as I was talking through it, but that’s so important and I see so many people come, including for deals I’m in, come back for more equity all the time. And if you’re running a profitable business and you know how to integrate companies well, you often can use debt. And you’re using debt responsibly, like some of those headline multiples sound really high. But if you’ve done this a lot of times, you’re very confident that your overall leverage may well decline actually. Your core business may be four times leveraged and you’ve ended up synergizing this thing down to two and a half times leveraged and your overall combined leverage ratio drops. It’s a huge capital allocation value driver that requires significant negotiation and understanding of how lenders operate and the types of things they want you to commit to and time fences. And look, it helps to have a track record for sure.

Alex Bridgeman: Yeah, certainly. Any last pieces of advice for folks pursuing consolidation theses?

Tom Klein: I’m trying to think. I think we covered a lot of the financing stuff. We covered a lot of the authenticity and outreach stuff. The only other thing I’d add is that when you’re doing these deals, maybe I’d add two things. One is just I really do believe in the exponential credibility curve that we covered in the beginning. I like to say that in the course of doing an industry search, you develop cocktail party level knowledge after maybe two owner conversations. You develop like full dinner party level knowledge after four conversations and maybe numerous NDAs. And then you develop like one week vacation knowledge where you could sit on the beach with someone for a week after six or eight conversations and lots of comparative detailed information. So you’d love to get to a place when you sit down, this has happened to me numerous times, where you sit down with an owner and the owner’s, his or her key deputy, and you’re asked early on in the meeting, like how many years have you worked in this industry? That’s a pretty good sign that you’ve done your homework in a way that is thorough and substantial and that you’ve made the rounds of the industry and built the network and knowledge base that we discussed early on. So, I’m a big believer in that, and it always is very clear to these owners when you’re using industry-specific jargon or metrics or you’re mentioning other owners or industry players that they know personally or respect that you’re someone that’s been around enough to be worthy for them to talk to and not be a waste of time for them. That’s the thing they don’t want is just a big waste of time. So big fan of that kind of knowledge network snowball compounding that results in a really exponential credibility curve, so to speak, upward as you move through this process. And you have to give this process enough time to experience that curve, which we kind of alluded to with some of the pitfalls. So that would be one piece. And then, the other piece that I would sort of beseech people to be careful on is that all these horizontal acquisitions are not created equal. If they’re in the same relative geography and same product and are really close lookalikes, that’s one thing. But you’ve got to be thoughtful about doing deals that are horizontal with a different geography, Alex. Now I’m not just talking about other countries. I’m especially talking anywhere there’s other languages and I’m talking about where you have like three different time zones like say east coast, west coast. It’s something where you can experience far lower synergies looking at something with a different geography, and that matters significantly.

Alex Bridgeman: Tom, thank you so much for coming on the podcast. I always enjoy chatting with you and Roland and glad you guys are being more active as search investors too. That’s going to be a lot of fun. So thanks for sharing a little bit more.

Tom Klein: No problem, Alex, thanks for having me on and really enjoyed it and always happy to do this. So thank you so much.