As I worked my way through law school, I had worked for 5 different law firms so by my third year had concluded I wanted to go into business rather than practice law. I chose consulting both because the major consulting firms were willing to hire lawyers and consulting seemed like a great way to get “fire hose” overview of the business world.
While on a flight from London to Amsterdam to look at a potential acquisition for a Bain & Co. client, I saw an article on the Apple IPO and the role of Arthur Rock as an investor and Board member. His partner at the time was Harvard Law School graduate Thomas Davis, who also founded Mayfield Fund. I had found my inspiration. I thought venture capital represented a field where the deal skills of a lawyer and the market intelligence of a consultant might be a good fit. I began to interview in earnest and landed a job at Centennial Ventures in Colorado.
Over the next 32 years I became a voracious student of all things technology and healthcare. I chose those two fields because in the first case it is the agent of change and in the second case because of the size of the markets and how it affects all of us personally. Over time I began to focus on later stage deals. This was due to the fact that I am not an engineer or a doctor or a PhD, but a business trained lawyer. The fit was therefore best in companies where a particular formula could be applied, along with my cumulative experience.
Eventually in 2010 I focused exclusively on deals with the following characteristics: (1) profitable (2) small companies ($5.0-$10 million in revenue typically) below the radar screen of the private equity firms (3) software/SaaS/cloud or healthcare services where I had been investing all this time, (4) majority ownership, the so-called control transactions (5) a heavy value element where EBITDA multiples would be no higher than 7.5 in technology and no higher than 6.0 in healthcare services (6) a minimum of $1.5 million in EBITDA.
A key characterization of these companies is that they are typically run by Baby Boomer-aged management who are looking to retire. Usually there had been no outside money or just friends and family. The entrepreneur wanted to get liquidity, diversify his holdings, and retire or semi-retire. This meant that we as a sponsor group had to have the new management already selected and groomed by the original entrepreneur or bring our own new top management.
Management transition is a key issue in these deals. Roughly 10,000 Baby Boomers will turn 65 today, and about 10,000 more will cross that threshold every day for the next 19 years. Most haven’t founded businesses, but this generation is the richest ever, forecast to have assets of about $54 trillion by 2030.
Our management is often younger, but more importantly either trained by a top MBA school or having extensive management experience or both. The classic 21st century analytical management with familiarity with dashboards, key operating metrics or ratios, and internal operating software has a different perspective than the seat of the pants entrepreneur. This is positive in terms of risk reduction and visibility to key levers of growth. What are often missing are the industry contacts and the natural selling skills of the original CEO.
Think of these small buyouts, what we call micro-buyouts, as the bargain basement of technology deals, healthcare deals and many other industries. These are not the type of technology deals appealing to venture capitalist. In fact, if these companies have ever received VC then we know they are “ruined” either because they became very successful or are of the size and valuation that we cannot afford, or they have burned through a lot of equity and don’t have much to show for it. Either way, it makes the companies ill suited for a value-oriented majority control investor.
Still we have proven we can produce venture style investment returns without taking venture risk. No, we are not going to hit a 100 to 1 return. But we have produced 5X-realized returns since 2010 across 8 exits from 26 investments. These returns come from 4 basic sources: (1) leverage (2) efficiencies (3) revenue growth (4) multiple expansion. The large buyouts depend primarily on the first two. They have the stability of operations to take on relatively high leverage and they can produce efficiencies by application of analytics, metrics, and internal software.
In our small buyouts the opposite is true. The gains come primarily from growth. We do leverage our companies, but the leverage is typically not more than 3X EBITDA or 50:50 equity/debt and often smaller. We do not look for efficiencies in the classic sense of making EBITDA margin growth the primary goal. We instead try to preserve as much as possible the typically high margins enjoyed by the original entrepreneur.
We instead often add expenses initially to drive growth. The higher growth brings with the hope of eventually higher EBITDA margins from economies of scale. Most important, by creating higher critical mass, we bring the company into the scale necessary to attract a much broader buying audience. A $10 million company with $2.0 million of EBITDA might attract a 6X EBITDA multiple while a $20 million company with $4.0 million of EBITDA might attract an 8X EBITDA margin. This EBITA multiple expansion is critical to our returns.
Some who are lawyers might wonder whether they can be successful in technology businesses competing with engineers, or in general competing with MBA’s. But the investment field is full of lawyers who first observe the business world, and then enter it successfully. Deal skills are highly attractive to investment firms. Analytical skills necessary to decide upon the attractive markets and the attractive business models are held by many lawyers. The opportunities are there and the most important ingredient is a curious mind and an attraction to the field.