Peter J. Holton: Why the Best Deal May Look Different Than You Expected

Craig Castelli:

Welcome to The Close M&A Podcast with Caber Hill Advisors. I’m your host, Craig Castelli. Today I have a repeat guest, my partner, Peter Holton. Peter, how you doing?

Peter Holton:

I’m living the dream, Craig. How are you?

Craig Castelli:

Excellent. Fantastic. I hope it’s a dream and not a nightmare. So today we want to tackle a specific topic that we run into frequently, and I think a lot of advisors to business owners do as well. And that is that our clients come to us with an idea in mind, but oftentimes they don’t really know what they want. They might articulate a goal for a sale process and for an outcome to be a certain way, and they end up in a very different place from where they thought they’d be by the time that the deal is done and it’s by their choosing. And it’s through education and just learning about the different options that are out there because oftentimes they haven’t had that education before hiring a banker and going to market. And we tell people all the time that it’s best to let the process flesh things out and that will really help you understand what makes the most sense for you, what you think at the outset could be where you end up or it could be very different from where you end up.

And I think the two areas where we have found this to be most prevalent is when a seller articulates their opinion on a minority sale versus a control sale and specifically a desire to only sell a minority of their business. And then also when we look at the distinction between selling as a new platform to a PE firm versus an add-on to a portfolio company or even a strategic, I think there’s this vision that being the platform is the holy grail. And oftentimes the process helps an owner realize, “Actually, maybe I’m better suited to be an add-on.” And Pete, I want to start talking about the misconceptions of a minority sale and specifically get into a discussion about one of your clients who we worked with now close to a decade ago who was really adamant that’s the way he wanted to go. Why don’t you tell us a little bit of the story here?

Peter Holton:

Yeah, I appreciate it, Craig. Thanks for having me on again. Yeah, it was a business owner that I’ve known for years, a business owner that I looked up to, was my mentor and my former employer and in his early forties left the organization we were both at and started his own company from scratch and built it up very quickly and got to close to 50 million in revenue within about five years. So, extreme growth, great vision, been there, done that. And when he approached me, it was, “Hey Peter, I think I just want to bring on a minority investor.” And what we mean by that is a private equity firm that’s going to come in and own less than 50%. And so that way the business owner can still maintain equity control in the voting rights and shares and whatnot. And I asked him, “Why do you want that?” And he’s like, “Well, I still want to have control and I want to make sure that I can move the company the way I want to.” And I nodded my head and I said, “Okay.” And what I did and what we do is at Caber Hill is we do what the client asks us to do, but at the same point in time, our job is to lay out all the scenarios.

And what I mean by that, Craig, is provide them a strategic buyer. This is what it would look like. Provide them a minority investment, which is what the owner wanted, this is what it looks like, but then provide a majority, a private equity firm that’s going to own more than 50% of the firm and what that looks like. And when you do the whiteboard and you show the owner what it is, and it’s kind of like a shot in the arm. You don’t know what to expect.

But this is what we do for a living. So we get it, but not necessarily the owners. So we walk them through each scenario, give them time to digest it, let it sit for a couple of days, and then come back to the conversation. And that’s where we’re able to show the client all your options. And when you show the options, you put the onus back on the seller and go, “What do you want to do?” And so what we did, Craig, and you know this, but what we did is we showed the owner all of these options, but we still kept all the doors open. It wasn’t until we got to the point of signing a letter of intent that we picked the direction we would go. And the direction was a majority deal with a private equity firm.

Craig Castelli:

Yeah. So the punchline right there, he came in, though he wanted the minority sale, ended up selling a control stake in the business. And you know him better than me. Do you think his focus on minority was about control over the day-to-day operation of the business, about hanging on to more equity because of how bullish he was on the growth or something else entirely?

Peter Holton:

I believe it was both. And that’s where you really got to understand your client. You have to know what makes that owner tick, what keeps him up at night. And yes, I had an advantage because he was my mentor, he was my boss and my former employer, but at the end of the day, our job is to understand the client’s motives. And that’s where you go through a lot of these questions, a lot of back and forth in reading the situation, reading the room as they call it. So from our angle, it was about understanding both. Also, in fairness, there are buyers out there that have given the industry a bad name, and it’s our job to find the right ones. And so I don’t blame the owner thinking that way whatsoever. It’s just a matter of laying out the facts, letting him digest it, let him talk to the people he needs to, and then coming back to the table saying, “Okay, what’s the game plan here?”

Craig Castelli:

Yep, yep. At that time especially, there was a huge premium for giving up control of the equity. We’ve seen some of that premium shrink more recently as some of the funds that historically focused on control investments have expanded their horizons a little bit and are putting one or two non-control deals in the portfolio while largely maintaining the same approach. That wasn’t the case back then. And so I think the big chasm between valuations for control and non-control deals was very eye-opening to him. But the other thing that I’ve found, and we’ve seen this in a couple other scenarios, the average owner doesn’t really understand what control means and what it doesn’t mean. And this comes into play in the day-to-day operation of the business. There’s really not a PE firm out there that I know that wants to just come in and run the business day to day, outside of the search fund realm, which we’re putting in an entirely different category for purposes of this discussion.

But true PE firms are raising funds and building out portfolios. They want to back operators. They don’t want to run the businesses themselves. So the owner who’s selling, who’s going to stay on as CEO, he’s still going to have control over the day-to-day. He’s going to report to a board, which he may not have done in the past, and he may have to seek permission for some of the big decisions, but at the end of the day, he still has control over how the business runs. On the flip side, even if you sell a minority stake in the business to a fund, they’re going to have certain rights that I always find to be a bit mind-blowing to the average entrepreneur. This is not somebody who owns a share and they just sit in the corner and hope that you give them an update.

They’re still on that board. I think the most important thing to understand is they are going to maintain the right to, at a certain point, control the outcome of their investment. So if a certain period of time lapses, they have the ability to seek liquidity for their shares, and they also have the ability to block a controlling owner or CEO from making decisions that might be harmful to the business. You can’t raise debt or make acquisitions or hire or fire C-suite executives without seeking their approval. And assuming everything is going well, you’re likely to get that approval because the goal is to grow the business, but they need those protections in order to justify making that investment. And so it’s pretty interesting that operationally, minority or majority deal, you’re controlling the day-to-day regardless. And from the standpoint of the cap table and some of these big decisions, you’re seeking your partner’s approval regardless of the volume of shares that they own.

Peter Holton:

Without a doubt, Craig. In some cases, we see business owners who think they will be a platform, who will have a majority stake and roll equity. But when you start diving into the business and to the CEO, you realize that that’s probably not the best fit for that business owner. And it goes back to what I was saying when we first talked here is you got to do your job and that is to provide the avenues of a strategic buyer with no equity roll, a minority investment, or a majority investment. And you have to let the market dictate what is going to be most advantageous for that owner. And we see this a lot with business owners that they want to be this platform and they think they have everything all figured out, but when you start digging in, they don’t. And those are hard conversations to have, but you got to have them.

But at the end of the day, it doesn’t mean it doesn’t have a good business. It’s just a matter of fine-tuning certain things, making sure that the executive team is buttoned up and making sure that the business is not solely dependent on the owner. And we, from time to time, run into that. We currently have a client that wanted to go this strategic route and not roll over equity, but he had this certain number in his head that I got to get this number. Well, the only way we can get to that number is if the owner rolls equity. And it’s the old saying of put your money where your mouth is. You want to hit that number, then you got to roll. And the buyer has to look at it from the vantage point of, okay, can we back this company? And in this case, the company can be backed.

We’ve gone through the wringer, but it’s about changing the mindset. We have one owner who thinks they want a minority investment, but they go majority. We have a business owner here who goes, “Look, I just want to transition out one to two years.” But then he sees the numbers of, wait a second, I’ll stay on. So it’s an evolution. Things change, and we have to be that sounding board. We have to provide the counsel they need so they can see the options in front of them.

Craig Castelli:

Right. And we can’t necessarily tell them on day one, you’re going to land here, not here. I think most of the time we go into these processes and we pretty quickly see these companies for what they are. We can see whether a company has what it takes to be a platform. The reality is there are very few jobs out there that are harder than being the CEO of a private equity backed company. And the owner who thinks they’re selling because it’s step one in this glide path into retirement probably shouldn’t sign on to be a CEO leading up to and into the next turn, if not through the next turn. They have to really be committed to building the business, and there certainly can be some steps along the way to retirement, taking some chips off the table, diversifying your risk with a plan of when you eventually want to get out, but you’re not slowing down in these scenarios.

Whereas if you sell as an add-on, you really are just controlling your own business day-to-day at most, if not exiting the business pretty quickly. And I think that’s something that until they really get into the weeds and figure this out, they don’t know. I think there’s also this just allure to being backed by private equity. When you don’t have a management team and you don’t have the proper systems and controls in place, it’s going to be really, really hard for a PE firm to get on board that way.

Peter Holton:

I couldn’t agree more with you, Craig. Owners out there who think their business can be a platform need to talk to their advisors. They need to figure out, okay, well, what does the platform look like? What does an ideal CEO candidate look like? What metrics do I need? Revenue, EBITDA, management team, all these other things, so they can start formulating that in their minds. Because you and I both know the number one reason that businesses don’t sell is because of unrealistic expectations.

You can put that on price, you can put that on team, you can apply that to anything. Having that business owner walk through the options and talk to their advisors and figure that out beforehand, it doesn’t force them or channel them in one direction, but what it does is it opens up the avenue of, oh, there’s other alternatives because people think they can only go one direction, but that’s not the case.

Craig Castelli:

Yeah. So it’s funny, my friend Scott Bushkie from Cornerstone Business Services conducted this survey earlier this year of 750 business owners, and a couple things I jotted down that I just thought were relevant here. About 43% have minimal to no knowledge of their exit options. More than 60% have never had a formal valuation, yet more than 80% plan to exit their businesses in the next decade. Wow. So you have this huge pool that plan to exit, but have no idea what their company’s worth, have no idea what the options are. By the time they get on the phone with an investment banker, they’re probably going to say, “This is what I think I want to do, or this is what I don’t think I want to do.” So whether it’s posturing or just a lack of understanding, it’s probably a mix of both. It’s eye-opening to see that lack of preparedness and where it can lead.

Peter Holton:

I couldn’t agree more. It’s eye-opening what business owners think they want to do, but they do a great job of running their company. When it comes to that exit, they don’t use the resources that are in front of them. I think that’s just mind-blowing to me.

Craig Castelli:

Yeah. So thinking back to the deal we initially started out, we gave it away. He ended up taking a control deal. It was structured in a way that allowed him to retain meaningful ownership while still receiving substantial cash at close. The cash he received represented a significant percentage of the overall enterprise value relative to the equity he gave up. So he still owned a meaningful percentage of his business after receiving life-changing cash at close and stayed as CEO to lead the business for several years through a lot of growth and diversification into other areas and truly a success story. And if you had just said, “Yes, sir, thank you, sir. I’ll do whatever you want, sir,” and only pursued a minority deal, we might not even have hit his minimum valuation threshold, but certainly wouldn’t have put him in the position that he’s in today.

But the fact that you stepped out and said, “Hey, I hear you, but let’s also just listen to these other people and let’s just see how these compare,” really set him on a life-changing course.

Peter Holton:

Yeah, we sure did. I mean, the whole team did, but again, it goes back to understanding what the owner wants at that point in time and then understanding, okay, what are the alternatives that I can bring to the table? Because if X doesn’t work, we got to go to Y. And if Y doesn’t work, we got to go to Z and figure out what those alternatives look like. So the whole point is to be open, honest with our clients and do what they ask us to do, but then really roll up our sleeves and go above and beyond that to show the value that we bring to the marketplace.

Craig Castelli:

Yep, exactly. Respect their desires, but also understand that you know the market better and it’s your job to make sure that they have experienced the full breadth and depth of what we can offer and what the market can offer to their business.

Peter Holton:

Agreed.

Craig Castelli:

So Pete, this has been a lot of fun. Thanks a lot for joining me here, and thanks everybody for watching us on The Close.

Peter Holton:

Thanks, Craig.