Martinka Consulting's Getting the Deal Done Podcast
Martinka Consulting's Getting the Deal Done Podcast
John is joined by Private Transaction Advisor David Barnett
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David is the author of eight books on business buying and selling plus a YouTube channel with hundreds of episodes.
He specializes in Main Street businesses, which he defines as those with EBITDA of under $500,000 and in this episode he discusses the positives and negatives of buying and selling companies in this size range. These are really businesses in need of an owner-operator.
David also covers:
- Buyer mistakes
- Earning definitions
- Seller misconceptions
- Provides a great success story (with it's ups and downs)
You can find out more about David at www.davidcbarnett.com or on You
Tube. #davidbarnett, #@dbarnettmoncton
John Martinka
Jessica Martinka
Contact us via either website or give us a call and be sure to check out our blog pages with new posts weekly.
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https://www.martinkaconsulting.com/
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https://www.youtube.com/c/JohnAMartinka/videos
425-515-4903
This is John Martinka with another episode of the Getting the Deal Done podcast series. It is aimed for people in the buy-sell world, MA, whatever you want to call it. And my guest today, I'm very glad to have David Barnett, who is a private transaction advisor, former business broker, and he lives on the east coast of Canada, east of Maine. He works with buyers and sellers in the US, Canada, and other countries around the world. And besides buyers and sellers, he also works with other interested parties, which he will tell us a little more about. David is the author of eight books. And welcome, David. Hey, John. Thanks for having me on today. Why don't we start with the basics? Tell us a little bit about your business, your market, maybe a little bit about your books.
SPEAKER_01Yeah, sure. Um, so you know, I as you mentioned, uh, I at one time was a business broker. Um, I used to have a business, I joined a business brokerage firm as a broker back in 2008 and then and bought the the firm in 2009. And if you remember those years, that was around the time where there was a lot of uh excitement in the financial news. And so I basically was in the business brokerage industry until the very end of 2011. And it was a tough time to be a broker. And I met a lot of people and worked on a lot of deals and I and I closed a lot of deals. In fact, in the uh time that I was a business broker, I did 36 deals here in my local area. And so I did a lot of deals, but there were long periods of drought in my business where I would go seven, eight, nine months without a deal closing. And as you can well imagine, uh, business brokers earned most of their money upon closing. And so there were some lean times and then there were some good times. It wasn't really one of those feast and famine roller coaster kind of cash flows. And by the end of 2011, I realized that it wasn't for me. And so I left the business brokerage industry and used my skills to get a job as a banker, John. And so uh I did that for a couple of years. And while I was working as a banker, my phone kept ringing. And I kept getting calls from people that I had met either in my brokerage days or had been given my name by people, and they were looking for help on deals that they were working on. And it didn't conflict with my banking role. And so I started to do a little bit of this stuff on the side, and it turned it into a little side hustle consulting business of helping people with buying and selling businesses. And then the bank wanted to reorganize and they wanted to get rid of one person here on the East Coast. And so I sort of raised my hand and I said, if packages are being offered, I'll look at one. And I decided to go full hog on this consulting model where I was basically using the skills and knowledge I had developed as a business broker, but applied it in an entirely different sort of business model, much in the same way that an accountant or an attorney does work for clients and charges them for what they do. That's the kind of work that I do today. And so when I work with buyers, I have a menu of services, different sort of analytical packages I'll help them with in looking at a business, or education programs that I offer for people that want to buy main street businesses. And then for sellers as well, it's a process with a menu. As I go through the steps with them, I do the different parts of the project, evaluation, creating a package or a CBP or a CIM for them, and then coaching them through their conversations with buyers. And I just charge them for each step along the way, just like a CPA might charge you for doing financial statements, then helping to do a tax return or whatnot.
SPEAKER_00Okay. So what is your market? And we talk about type of business or size of business or anything like that.
SPEAKER_01Yeah. So because I'm leveraging my experience with my business brokerage career, I really was operating in what I like to term the main street space. And basically, we're talking about, you know, an imaginary line at about half a million dollars of EBITDA. Everything sort of south of there is where most of my experience lies. And that line is a bit fuzzy. It depends on what kind of industry and things you're talking about. It can move a little bit. And I do sometimes, you know, work on deals that are slightly larger than that, but for the most part, I'm in that main street space. And what that means is that the vast majority of my sellers are owner managers. And the vast majority of my buyers are people who have the intention of becoming that owner manager when they buy the business, or they are doing some sort of strategic acquisition. So they're already in a certain industry and they're looking to grow through acquisition by adding on other businesses that are in a similar business to what they're already doing. And so, um, you know, I still get, for example, people who have this idea that they want to buy a business and set it up with a systems and a manager and become more of an absentee owner. And I'll be quite honest with people, I'll say, look, you may be able to do that, but you're probably still going to have to spend several months in that business as the operator until you can learn it well enough to be able to create those systems and know what bits of information you need to keep your eye on as the owner to make sure that the day-to-day tasks are being handled properly.
SPEAKER_00Great. Good. Um what's the advantage and maybe the disadvantages of working with these companies that are under half a million dollars of earnings?
SPEAKER_01Yeah. So, you know, I meet a lot of people who are leaving the corporate world. And if they are C-level executives of very big companies, they probably have salaries in, you know, in the six-figure range, you know, a couple hundred thousand dollars. And they'll just get out there and start looking at businesses. And maybe at first they want to look at a business that might earn them 700 or 800 or million dollars a year, right? They very quickly realize that when you get into that mid-market space, there's a lot of competition amongst buyers, particularly with these private equity groups and whatnot, that are looking for financial deals. And what that does is it drives up the multiples. When you get down below half a million to Beta, you're very much in the space of owner-operatored, owner-operated businesses. Those financially driven entities that go shopping for businesses are less interested because they need to take a big chunk of that cash flow to pay a professional manager. And so those guys tend to stick with the bigger businesses. As a result, the multiples, the prices people pay for businesses tends to be markedly different, above or below that 500,000 line. And so people quickly learn that they can get a much better deal. I hesitate to use the word, maybe a better value. They pay a lower multiple below that 500,000 line. Uh, but it does involve rolling up your sleeves. As I mentioned before, these people are going to have to become more involved in the day-to-day. And there's huge advantages towards people who already have some sort of knowledge or experience, expertise in a given industry when they make a purchase like this.
SPEAKER_00Okay.
SPEAKER_01All right. Your disadvantages are basically the same things. Um, you know, the reason those private equity groups want the bigger businesses is so that they can put a professional manager in place and hire somebody of a sufficient caliber that they can take on that role and and and manage things for them. And so when you're buying a smaller business, it means that you are going to be more attached to it. Um, there's going to be less in the way of freedom. I know people who've bought businesses like that and in the below 500,000, and they put managers in place. And guess, guess who goes in to run things when the manager goes on vacation, John? The owner, right? Because there simply isn't anyone else. The the you don't have the size of staff and typically the complexity of operations to allow for a key person to leave. Same thing happens when a key manager quits. Often the owner has to step in and cover that until they can be replaced.
SPEAKER_00You know, I'll add that I've seen many, many cases of companies like this where someone will say, Well, I hired a general manager and the business started going down because they don't have that same vested in uh interest and involvement that an owner has. It's the owner's money, it's not the manager's money.
SPEAKER_01Yeah. Oh, absolutely. And um, you know, and further to that, I've seen many cases where a business owner or seller will say to buyers that he operates the business in an absentee fashion. Maybe he spends several months a year down in a sunny state, um, you know, sort of on holidays. The the difference is though, is that owner used to be the general manager and they know what it's like to run the business. And so they know what pieces of key information need to be watched in order to understand what's happening in the business. And so that owner can probably have a brief phone call with the manager once a week, get some key pieces of data and understand that things are okay or that there's a problem. A new owner who tries to do that won't have the understanding of the operations. And so things will start to slide until they get show up in the financial statements. And then, as you know, because all of this stuff is reported historically, you can often get several months of poor performance before an owner reading statements really becomes aware of what's going on.
SPEAKER_00Yeah, one of my favorite examples is a business where the owner was truly uh he truly worked halftime and he did some of the bookkeeping. And that's when he wasn't at his place in the Caribbean. And with 45 or more years of experience in the industry, he could see things going off track immediately. Whereas the eventual buyer, or you or me, or a lot of other people, wouldn't see it till they were they were really off track, not just starting. So it's a great point. So let's talk about mistakes. Let's start with what mistakes do buyers, or now as they are known, searchers, make?
SPEAKER_01Uh, it's a great question. And um, I actually sat down one day and and this became this very question became a one of my books. Uh, it's called 21 Stupid Things People Do When Trying to Buy a Business. Uh, because I kept seeing the same mistakes happen with people over and over again. So I sat down one day to make a list. It turned out I found 21 things. And so some of the big common ones that come up is that when you're looking at these smaller businesses, they tend to be valued not on multiples of EBITDA, but rather on multiples of seller's discretionary earnings or seller's discretionary cash flow. There's there's several acronyms that mean the same thing. Right. It is the total amount of money available to an owner operator that works full-time, which means that that number, whatever it is, let's say it's $150,000, that number includes the salary for showing up every day. And so what will happen is people will look at that number as though it's a profit and they will fail to account for the value of their time. And they won't take into account that, hey, you know, I need to show up here every day. And what is my time worth or what is the fair market value of a manager in this role? What do I need to deduct from that SDE number in order to get the true earnings of the business outside of my own salary? And then further to that, they will forget about how that SDE number was arrived at. So a typical business broker will take the net income of the business, they'll add back the owner's salary, any, you know, sort of uh expenses of that that aren't true business expenses. You know, if you have a teenage daughter with a company cell phone, that kind of thing, all those things get added back. But one of the things that's added back is depreciation and amortization. And in these small businesses, depreciation and amortization doesn't really get a whole lot of attention, but because it's a non-cash expense. But what a lot of searchers fail to realize is that the depreciation and the amortization is a way that accountants represent the value of the machinery and equipment wearing out. And so we need to be thinking about what kinds of investments does this business require moving forward in order to keep all the equipment and machinery working. There are always going to be investments in buying new machines, new vehicles, replacing things, et cetera. And that's something completely ignored by that seller's discretionary earnings figure. And so, really, when you sit down and you start looking at this, that seller's discretionary earnings has to include your salary, it's got to cover your debt service, it's got to cover the reinvestment required in the firm. And then another one that people always forget is it's got to provide some sort of return on the capital you've contributed. So, in a lot of cases, John, as you know, when you're buying a business, the buyer will put in some of their own money, they'll borrow some from the bank if they're able to, and maybe they'll ask the seller to finance part of the deal. Well, the bank payment and the seller note, that's part of the debt service. People often forget about that chunk of money they put in. They need to earn an adequate rate of return on that cash as well, which a lot of people forget. And so those are some of the big ones that I see all the time is just people getting excited about that number, imagining, hey, if I if I do this deal, I'm gonna get to enjoy this income of 150 grand. That's not the case at all. And then, of course, if they're paying too much for the business, they often end up overcommitting their cash flow to debt service, which can just put them in a tight position if they have any kind of downturn. And when I work with searchers and we work on these deals, um, I'm I always caution people if I see a small business, one of these main street businesses that has sales figures that bounce around 10% every year, in my books, that's flat. That's pretty normal to have things go up and down by you know a margin of 10%, yeah, or maybe even a little bit more. And so if you've overcommitted your cash flow to debt service, sometimes a 10% decline in sales could be a 25, 30, 40% decline in profit. It all depends on what kind of business you're in, what percentage of your revenue is cost of goods sold, and what percentage are fixed overheads that can't be moved, you know, uh if things decline.
SPEAKER_00Yeah, I you know, I agree that uh, you know, I have I've been known to say uh sellers discretionary earnings is a quasi-fraudulent term, and it uh it encompasses a lot. Um I guess one of the good news pieces is if you go to a bank, at least the banks I know, they will plug in a fair market salary for the owner or the manager, and they're not gonna fall for that. Um, and also on the depreciation, I I don't know what it's like in Canada, but in the United States, as you may know, there's are so many ways to accelerate depreciation. And we have what's called a section 179 deduction, which means most small businesses they write it off the year they buy it. You know, maybe lower taxes now. And I have good CPA friends who say they try to tell their clients, don't do that. You're gonna be making more money in the future, get the deduction later. But you buy that $50,000, $100,000 vehicle and you want to write it off right away, and it truly is an expense that has to be adjusted for over time. Uh that's what depreciation is.
SPEAKER_01I I only start to put any degree of confidence in that depreciation expense when you're talking about a mid-market business that has a sufficiently large fleet of plant and equipment that things are being replaced every year, you know, because then that depreciation figure may actually relate to the true decline in market value of that stuff. Um, but with small businesses, um, yeah, I you you have to do the work on your own. One of the my favorite crutches uh that searchers might want to employ is that if you look at the business and you see a couple of key pieces of equipment, uh, many small businesses might have just a couple pieces of really expensive things. What you can do is figure out what it would cost you to buy one of those or to, or better, to lease one uh and then use an online lease calculator and then take that monthly lease payment and use that as a deduction against your SDE, because that's a pretty good proxy for what the effect will be on your cash flow when you have to replace one of those things and you decide that leasing might be the right way to do it.
SPEAKER_00Okay. Well, let's flip it around. You work with uh owners and sellers also. What are some of the mistakes they make uh or the assumptions they make?
SPEAKER_01Yeah, so you know, one of the biggest hurdles that most of these sellers have, you know, that book, uh eMyth by Michael Gerber?
SPEAKER_00Yep.
SPEAKER_01Uh a lot of these sellers are your technicians. They're experts in the industry. They're not necessarily trained in being business people. And so the very first problem that I always run into is this misalignment between what they think the business is worth and what the cash flow might dictate the business is worth. And often it's tied up in this idea of what they've put into it. You know, I always use the example of the uh, you know, the double wide trailer home with the golden faucets. I mean, you can put many nice fixtures into, you know, uh a mobile home. It's not going to increase the value of the mobile home, you know, by the amount of money you put into the plumbing fixtures because there's a certain limit there on where it will go. And so I'll see a lot of people who will say, I put years of work into this business before I drew a salary. They expect a buyer is going to pay them for that. Or they'll say, you know, I just replaced all of this equipment, so my business is worth more. And I'll draw the analogy to a house with a roof. You know, everyone expects a house to have a roof. When the roof leaks, people will pay less for the house. But if it has a brand new roof, it doesn't mean that people are going to pay you more for the house by the uh the amount that you just invested in putting the new roof on. And so I end up having this conversation a lot with people where I'll say, you know, the the buyer's paying a multiple of that cash flow because the risks of the industry dictate that this is what the cash flow is worth. In order to generate that cash flow, we need certain things in the business, including that machinery. If it was all old and decrepit and worn out, the buyer would be looking for a discount because they would know that they need to replace stuff. The fact that you just replaced it, all it's going to do is prevent an argument about the equipment because people are going to be satisfied that it's in good condition. And so, so that's one of the areas that often comes up uh with sellers. And, you know, financial statements, you know, I mentioned earlier about uh, you know, adding back and the owner who's got the teenage daughter with the company cell phone. If someone's running a business and they've got all kinds of these personal tax management things that they've thrown in there to try to lower that profit, um it, you know, it's not the best way to start a meeting with a buyer or the buyer's banker, right? If if you are going to be selling a business, you want those financial statements to be an accurate reflection of what's going on. And you want the tax returns to be matching them as closely as possible so that you don't raise a lot of questions. Um, you know, when I'm working with searchers, John, in this main street space, they will often come across businesses where all manner of things have been done as far as adding personal expenses into the business and maybe not declaring some of the revenue and all kinds of other foolishness to reduce that profitability. And I actually celebrate this. I say to these searchers, that's great because now you've found someone who's made their business unbankable. This seller is now going to be forced to accept your offer, which has a low down payment and a large amount of seller financing because no one's going to be able to bring this deal to the bank. And I've seen this play out time and again. And this is my warning to sellers is if you keep running down that profit with these tricks that people like to do, what it's going to mean is that the cost you will ultimately bear is that you will have to be the banker in your deal.
unknownOkay.
SPEAKER_00Um, give us a couple quick examples of people you've worked with that have done it right.
SPEAKER_01Yeah, sure. Um, so one of the things that I that I do in my business is I have a coaching program. Uh, it's a group program for people that are searching for a business. And one particular job Gentleman in that business, he bought his parents' business and ran it for a couple of years and he wanted to grow through acquisition. And so he joined my group and then he started to look for other businesses that were available to buy. And he found a really good one. And by understanding clearly what that business was worth, he was able to draw a line in the sand of what he was willing to pay and what kind of deal he was willing to do. And he started to negotiate and talk with that seller. And the seller really had an inflated view of what the business was worth. And because of his clear understanding of what this business was worth, he wasn't willing to cross that line. And his negotiation broke down. They stopped talking with each other. And then a little while later, they started talking to each other. And then they stopped talking to each other. And then they started again. They went back and forth over the course of a year with three or four different periods of talking or not talking to each other until finally a deal was struck that made sense for the buyer. And so what made this such a great instance is that the true power that any buyer has is in not having to do a deal. And I've said many times before, I would rather see a buyer leave their money in the bank and go get a job at McDonald's than put a bunch of money into what turns out to be a bad deal. Capital is just too precious. You don't want to roll the dice. And so the deal has to make sense. And I encourage buyers to really understand what they're willing to do and what they're not willing to do, and then work on those deals. What happens a lot of the times out there in the marketplace is that if you get a competitive situation with many buyers, the smart buyer will sometimes get outbid by a buyer who doesn't really know what they're doing, who has a lot of money available. You can't let that upset you because that person probably just did a dumb deal. You have to keep working at it to find a deal that makes sense for you. And often it means trying to find deals where you avoid those competitive situations.
SPEAKER_00Yeah. Or what happens in that situation, David, is the naive buyer offers too much, can't get a deal put together, but the numbers in the seller's head, well, this is the offer I got. Well, you didn't get the deal done, but it's the offer I got, they keep saying.
SPEAKER_01You know what? That's what happened with this gentleman. Another buyer did come along and made an offer, but by the time that offer got to the competing buyer's banker, it got squished because it didn't make sense. And this is some of the things that sellers sometimes don't realize is if you off if you ask for too much, you actually are going to chase away what I call the reasonable buyer. The reasonable buyer has good credit, they've got money, they've got equity, they have expertise in the industry, and they've done some research to know what businesses sell for. And so if they see you asking double what your business is worth, they're going to think that person isn't going to be worth my time. They're going to, they're going to waste my time. The person you're not going to scare off as a seller asking too much is the naive person who doesn't know what they're doing. They're going to come along, they're going to spend lots of time talking to you. They'll maybe even make you an offer for what you want. But by the time it gets to those other parties, the attorney, the accountant, the banker, right? It's not going to pass muster with those people and it will never end up coming to fruition. Um, when it comes to sellers, um, I just alluded to a couple of these things. I had a deal uh last year in Wisconsin. I was helping a gentleman sell his family bakery, and um, and I did a YouTube video about it actually, where I interviewed him. We talked about this deal. Um, and so he had a really good understanding of what the market would probably pay for his business. So his expectations were properly set. I showed him what the deal terms were likely going to look like, uh, whether the buyer could get SBA financing or whether not, sort of two different scenarios of what the deal would look like. And then he'd probably have to hold some degree of financing in both cases, as well as what it might look like as far as the real estate, because they owned the building. And I warned him that the good there was a good chance the buyer wouldn't be buying the building. And what would that mean for their relationship? And so when he finally met the right buyer, he was able to recognize the strengths of that buyer and he knew this person's going to be able to run the business. They're going to be both a good person for me to invest some seller financing in and a good tenant. I don't have to worry about my mortgage. I know that they'll be able to run this business and pay rent. And the seller then actually went with the buyer to the bank meeting to demonstrate that the two of them were working together in a collaborative way to help solve the problem of getting the deal done. And they were able to get through everything with the bank and every other issue that they ran into. Um, I think it was just a few weeks, and then they had to wait a little bit for funding to come out, and the closing happened, and now they get along really well, and the the seller is still talking with the buyer all the time as a sort of a coach and mentoring kind of role.
SPEAKER_00Great. Um any other final thoughts you have?
SPEAKER_01Um, yeah, just that um, you know, if anyone out there is thinking about getting into business, um, I I know John, you probably run into this in your career too, but I've just met so many people that have gotten into business by trying to start something new and have run into all of the troubles and difficulties that people do when they're when they're trying to start something new. Really buying a business is the way to go because you already have a track record there and you've got customers and employees that know how to do the deal or know how to do the work in the business. But you can still make the same mistake that some of those business starters make. If you get into a deal under the wrong conditions, under the wrong terms with too much money down, et cetera. You know what this pandemic has shown us is that if you were in an industry that was affected by the government orders to close down and restrict work, you were then stuck in a place where you had to figure out how you were going to manage your cash flow, how you were going to pay your bills with your revenue throttled by closures, for example. Well, when you buy a business, that seller financing is a very powerful tool because we can build in certain clauses and conditions into that seller financing note that can give a buyer different avenues to escape hazards, and all of this stuff can be negotiated in advance. For example, this is a this is a clause where I live, there's a lot of seasonal businesses. And so one clause that I've been putting into some of these seller notes for years is that during certain months of the year, the buyer has the option of interest-only payments. So if you're talking about a seasonal business in the winter time, you know, the buyer gets to hang on to their cash by making interest-only payments. I've seen people successfully get that clause accepted in seller financing notes where if sales fall below a certain benchmark in a given month, that the the buyer would have an option of an interest only payment. The seller's still going to get all their money. The effect is simply to elongate the total length of the note, and that the seller actually ends up with more money because they collect that extra month of interest. But being able to save that cash when things aren't going quite well in a given period of time can really make a huge difference for a buyer, especially if something completely unforeseen like this pandemic were to come along.
SPEAKER_00Yeah, I've had that type of note happen in the past, although here with the SBA loans, it's rare is because they will they want, you know, bankers get paid more when they lend more, so they want to lend more, and it takes away that flexibility in in those kind of situations of a seasonal business. So, David, uh tell the uh listeners about where where do they reach you? What's your website?
SPEAKER_01Yeah, the easiest place to find me is at davidcbarnett.com. And um, you'll find there that uh I've got a lot of videos. I've been making videos now since 2014, one every week, and almost all of them are generated by people submitting questions about buying, selling, financing, or managing small and medium-sized businesses. And so I'd be more than happy to have people come and subscribe to the YouTube channel. I've also got an email list where I send out emails regularly. And as John mentioned, I've got a bunch of books. All of the books are available on Amazon, and they're all surrounding the topic of buying, selling small and medium sized businesses or making investments in them.
SPEAKER_00Well, thank you, David. It was a pleasure to have you here today. And uh I know people will get a lot of value out of this podcast.
SPEAKER_01Awesome. Thanks, John. Great to see you again.