Outgrown the Broker, Ignored by the Banker? How to Sell in the Lower Middle Market

Bruce EckfeldtWelcome, everyone. This is From Angel to Exit. I'm Bruce Eckfeldt, I'm your host. Our guest today is Karl Sigerist. He is managing director at the Shaughnessy Group. We're going to talk to him about the M&A market and his experience working with companies in the sale process: what he's seen, the trends, the mistakes, the things people do that make it easier or harder to go through this process. Karl has a lot of experience, and I'm really excited to hear from the other side of the coin, the people who help with this process and work with founders, about what they've seen and noticed. With all that, Karl, welcome to the program.

Karl SigeristThank you, Bruce. Thanks for having me.

Bruce EckfeldtIt's a pleasure. Before we dive into everything going on in the M&A market and what you've been doing with businesses in the sale process, let's get a little background. How did you get into this work? What was your professional history? Give us a little backstory.

Karl SigeristAbsolutely. I started out as the child of entrepreneurs, which meant I learned a lot at the kitchen table at an early age. As a friend of mine said, you can't learn that at university. Mom and Dad's highs and lows as entrepreneurs, having had success and failure at numerous different businesses in different sectors. And I swore it off. I said, that's not the life for me. I'm going to get a nice corporate job, drive a vanilla car, live in a vanilla house, and have that steady experience.

I worked for the first 10 years of my career in the technology space. Back in my day, technology was predominantly hardware. Today, technology is software. Because technology was hardware, and hardware was expensive, people needed to finance that hardware. That exposed me to how you help clients finance equipment. I became very intrigued with the whole financial services space and transitioned out of hardware and distribution to financial services, putting together all sorts of finance programs for manufacturers and OEMs. Ultimately, all these programs were helping entrepreneurs finance the growth of their businesses, at a time, we're talking the '80s and '90s, when these forms of financing were just not something your typical banks did.

I grew into ever more responsible roles in these companies, ultimately leading them in chief operating officer, president, CEO, and managing director roles in Canada, and also in Europe, and then back in Canada. We exited our third business, having grown many of these from a few guys around the dining room table to real businesses with a couple hundred employees. Some of these businesses, even on the technology side, we grew through acquisition, and some we grew organically. We did a mix.

And having, as my wife says, been a failed retiree a number of times over, and being a self-confessed deal junkie, I thought, well, what am I going to do next? I thought the same entrepreneurs we helped grow their businesses with commercial and corporate finance were most likely going to have similar challenges when it came time to exit.

The thesis was that you have really large businesses, where the investment bankers will line up to win the mandate to sell them. You have really small businesses that are very well served by commercial realtors and business brokers. And you've got this group in the middle, what we coined the lower middle market in Canada: companies with more than $1 million and typically less than $5 million in EBITDA. Their businesses are too small to get the attention of the investment banks, and yet too sophisticated for a broker listing. They need a fully robust, broad auction process attracting strategic and financial buyers. That's really what the Shaughnessy Group does, leveraging myself and my colleagues. We've worked together in previous iterations of other businesses.

Initially, the thesis was to help baby boomers sell their businesses. With less than 40% of businesses today still owned by baby boomers, we're now working with next-generation entrepreneurs. So if you were born before the '80s and you have a lower middle market business to sell, we work with you. Likewise, if you're a new entrepreneur looking to acquire, whether it's through the entrepreneurship-through-acquisition model or the smaller micro private equity funds that have just done their first or second deal, we help them acquire. Given our focus on Canada, we also help foreign-based private equity and family offices that want to allocate to Canada, or strategics that are looking to enter the market, on the buy side. But about 80% of our revenue comes from the sell side, and about 20% comes from the buy side. That's where we're at.

Bruce EckfeldtI want to go back to your experience scaling your companies. You mentioned organic versus inorganic growth through acquisition. What fueled that process for you? When did you decide to focus on organic growth, and when did you decide to look at acquisitions? Were there any rubrics you used to help guide that?

Karl SigeristThe businesses we grew organically had a very, very strong competitive technological moat. We were first movers, doing things none of our rivals did, and we were able to scale because we were just so far ahead technologically. Think of it like you're selling a shovel and a guy shows up with a bulldozer. The technological difference was so severe that there was no point in buying shovel companies once the bulldozer showed up.

On the acquisition side, in the earlier part of my career, the businesses were somewhat geographically constrained. A lot of them were technology hardware distribution companies. They were established, they were profitable, and the owners were looking for exits. You weren't going to disrupt the industry as much, so it made more sense to grow through acquisition. For the public company I worked for, that was really the whole thesis: acquiring, consolidating, doing a roll-up of a sector. They were doing it globally, and we were responsible for doing it in Canada.

Bruce EckfeldtGot it. What did you look for in these acquisitions? What did you prioritize, and how did you filter and evaluate deals and decide which ones to go with?

Karl SigeristI think every acquirer has a different thesis. In this case, it was a real estate grab. In the industry I was in, there were two different players. One was buying the absolute best company in each industry in a consolidation. The other was buying the not-best companies in the industry and consolidating them. I had the opportunity to work for both companies. With the one, it was buy it and leave it alone: management's in place, the business is running well. With the other, it was take it over and transform it with a lot of direction from the center, because things weren't ideal at those companies. So, different strategies at different times.

With most of the clients we work with today on the buy side, it depends on whether you're looking to acquire a business to install yourself as CEO, or you're looking to invest in the growth of a business and back a new management team. Different criteria, different theses, different investment strategies. So it's really important to have that up-front strategic conversation with our clients. Who are you? What are you trying to do? What are your strengths? What are your weaknesses? Because ultimately, that changes who you approach and what you approach them with.

Bruce EckfeldtAnd how you approach it. If you're looking at a distressed asset or a distressed situation, you're going to be asking very different questions and looking for very different insights about the company. You mentioned micro private equity. I want to understand what that is. What is this category?

Karl SigeristWhat we're starting to see is entrepreneurs who started out with something similar to the entrepreneurship-through-acquisition model. They've got one under their belt, and now they're acquiring a second and a third, in some cases separate platforms. I'd also call these next-generation private equity funds. The days of getting a blank check for $100 million to go invest aren't here for new managers. What happens instead is the investors say, "Karl and Bruce, we like your idea. We want to back you. Go bring us the first deal." We do the first deal, and they say, "That was great." We do another deal, and one day we look back and say, "We've got nine different companies that we're running through nine separate special purpose vehicles." We're effectively the GPs of nine different funds, all backed by investors.

Maybe at that point you go back to your high-net-worth investors or family offices, or to institutional investors, and say, "Here's our track record." And it becomes, "Okay, you're looking to raise $500 million for your next round. You now have a track record, you have experience, you've had some exits." So I see micro private equity as firms that do their transactions one deal at a time and grow themselves into a typical asset manager.

Bruce EckfeldtIt's like adolescent private equity. Do you organize the private equity world in any way? People use the term fairly loosely, and I find there's a lot of nuance in the types of people who participate in a financial or private equity deal. How do you define a private equity deal, and how do you look at the private equity world in terms of types of players?

Karl SigeristIn our space, of course, we're not playing with the largest private equity funds at all. Our clients' buyers are typically either a smaller private equity fund that considers a $3 million EBITDA business a platform investment, or, for larger private equity, these businesses would at best be add-ons to existing platforms. In that case, you're really marketing to a strategic that you know is private equity backed. You may be coming in to talk to the CEO of a platform that wants to add on a business in Canada. But we may also have contacts at the fund, knowing that the CEO and the private equity fund have a vested mutual interest, so we talk to both parties.

Sometimes you come in through the CEO, and sometimes, depending on the fund, you come in through the private equity firm. It depends on how they operate. Some CEOs do a great job running the business and are very strong in operations, but they leave the add-on acquisitions to the private equity fund. Others, once they get to a certain size, may even have an in-house corporate development team. Each one is different, and we play on the small end of this.

Bruce EckfeldtThis category, $1 million to $5 million, how did you narrow that down? Those are very specific numbers. I understand the above and below, but how did you niche down to that?

Karl SigeristPart of the thesis was, where are you going to get your deal flow from? I was fortunate to have spent decades in Canada, and I've got an extremely large Rolodex, or, as you'd say today, LinkedIn network, for the people who don't know what a Rolodex is. So I just went out to them and said, "This is what we're thinking of doing."

Our contacts at the Big Four accounting firms, PricewaterhouseCoopers, KPMG, Ernst & Young, said, "That's a great idea, because we have clients we do audit work for, tax work for, all sorts of work for, but when we send them over to our deal teams, the deal's too small." Likewise in Canada, banking, wealth management, and investment banking are highly consolidated. There are really five major players. You may have your wealth management with Toronto-Dominion Bank, and you may have your company's corporate credit with the same bank or another one. You're talking to your wealth manager, saying it's time to transition the family business, they refer you to the investment bank, and the investment bank says, "We don't play south of a $50 million enterprise value."

So all of these contacts said, "We need someone we can refer to who isn't also going to try to take over the wealth management after the transaction, or steal the accounting work, or what have you." So we stick to our lane and help the family realize the value and protect their legacy and the business, and our referral network continues to manage their wealth, the accounting firms continue their work, and so on. We just stick to that.

You see this often. Shops like us start out this way, then have ambitions and start doing bigger deals. That's great, depending on what you're trying to do. But as soon as you start doing that, you're getting into territory that's well served by your referral network. My whole career, it's been: I say what I do, and I do what I say. That's how you build a reputation.

Bruce EckfeldtFocus on your niche. So say you get an introduction, a referral, and you're talking with a founder-CEO. Where do you start? What's the initial part of the conversation you need to understand, and where do you go from there in terms of figuring out where someone is, how ready they are, and their time frame?

Karl SigeristTypically one of the first things we do is talk about confidentiality. We need to put an NDA in place, recognizing that everything needs to be confidential. It needs to be confidential because of the stakeholders in your business. You may be exploring this and not actually executing on it, so the fewer people who initially know about it, your employees, your suppliers, your customers, your rivals, the better. Confidentiality is an absolute must.

Once we've put a confidentiality agreement in place, we start with something real simple: the last couple of years of financial statements. At that point, we can assess what the statements are. In Canada, you have different degrees of assurance. If your business has never borrowed any money and has no outside investors, you can get away with what we refer to in Canada as a compilation engagement, which is really statements for the owners of the business. And of course they've got tax returns. But if you're borrowing money from a bank in Canada, you're going to be at a review engagement, so the level of assurance moves up. It also means the statements have been vetted to a level of assurance and they're GAAP compliant. And if you get larger, you most likely have audited statements.

So the first thing we look at is how strong management's ability is to report the results of the business historically, and what level of assurance we've got. If you think about all the reasons deals fail, often after the LOI is executed, nothing is worse than a lack of preparation. So we look at this as investors ourselves: would we invest in this business? What would we need to know? Can the organization that wants to be sold bring this information to us completely, thoroughly, and professionally, and how quickly can they do that? If they don't have everything you ask for...

Bruce EckfeldtIt takes them six weeks to turn around.

Karl SigeristRight. Then you already know there's preparation work to be done. 80% of lower middle market transactions fail.

Bruce EckfeldtWhy? How do you break those numbers down?

Karl SigeristAt the highest level, it's simply preparation. Lack of preparation of management for the process, and lack of coaching and mentoring about what will likely be expected of those people through the process. You hire an intermediary to help you through the process because you should be focused on running your business. You cannot do this part time. You cannot do this off the side of your desk. You have to realize that the people buying your business buy businesses for a living, and you're trying to do this part time. You're showing up to the party ill prepared.

So always bring in professional advisors to help you through this process while you continue to operate your business. Your business will be under more scrutiny than it's ever been as parties start to look at it, and you need to be comfortable with and ready for that scrutiny ahead of time.

So, to your question, reasons why deals fail: overvaluation, and lack of preparation, which I touched on. The business isn't transferable. That's the Genghis Khan model. Genghis Khan was a great ruler who ruled a vast empire, but the moment he passed away, the whole empire collapsed.

Bruce EckfeldtI may use this one.

Karl SigeristThat's the way I think about it. And then there's no succession plan. Genghis Khan did not have a succession plan. He was still fierce and successful, and history remembers him, but you don't want to fail. You've built your little empire, your business. It needs to be transferable. Business transition is an ownership change, but leadership succession needs to happen once you get to a certain size and place in your business.

You hear it from time to time, a business associate suddenly passes away over the weekend, and that business is left with no leadership succession. The family is left in the lurch, the employees are left in the lurch, the customers. Whether you're selling or not, you need to have a succession plan, particularly as your business starts to scale. Those are the five main reasons they fail.

On overvaluation, after we get your financial statements, the first thing we do is a valuation of your business. We typically do that work complimentary, because we want to be able to dig deep and come back to you and say, "Bruce, your business is worth $34 million." And Bruce is going to say, "Well, I think it's worth $80 million." Here's the information, here's the data, here are the comps, here's the cash flow, here's what another investor is going to come up with. And if you can't align with us on this work and this valuation, you're going to have a hard time with whatever happens next in the process. Your intermediary M&A advisor can run an amazing process and bring multiple parties to the table, but the gap is still there.

In our case, we work almost entirely on a success-fee basis. That means we'll invest something like 2,000 hours from our team to help sell a company. The last thing we want is to get to the end of that process and have a massive gap between what the different methodologies tell you your business is worth and what the market is saying it's worth. So we can't afford to engage with clients where there's this massive overvaluation. And a lot of folks have never done a professional valuation. It's typically an expensive and time-consuming ordeal, so we typically do that work. We're former entrepreneurs. We want to have skin in the game when we come to sell your business.

We also need to be culturally aligned with our clients, because this is an emotive process. You're going to be working together for three months, or two years. COVID happens, and you're together for three years. Your business gets hit by some geopolitical event, the deals pause, the timelines extend. So we're often together for a long time. One seller called me "the brother from another mother," because we'd been working together so long. He had a fantastic exit. That's probably why he called me that.

Bruce EckfeldtThat probably helped. I want to talk about two things. I want to get back to the cultural piece, but first the valuation. When you first look at a business and come up with these initial valuations, what models do you use? Given the type of business and the type of exit they're considering, what strategies, tools, or processes do you use to come up with valuations?

Karl SigeristThere are two ways. Are you selling assets, or are you selling shares? That's the first question. Let's assume we're selling shares, selling the company. Assets are a whole different thing, typically. Then we need to look at the industry and the sector. If you think about what's historically been happening in the technology space, companies are being valued on a multiple of revenue, and the Rule of 40: you had to have a certain growth rate and a certain margin. So different industries are valued differently.

For most traditional businesses, if you founded your business 10, 20, or 30 years ago, and you've got nice, reasonable growth, but not a rocket-ship growth rate, you're going to have gross margins, and you're going to have an EBITDA or a profit. The future cash flow of your business is the only thing the buyer has to get a return on the present value they're giving you today. So the future, the growth and the cash flow that comes off of it, has a lot to do with value. A discounted cash flow model helps you with that. Are there other assets or intellectual property the business has that might be worth more outside the business? You have to do some analysis on that.

And then there are comparable transactions. If my buggy whip company with $1 million of EBITDA sold for $4 million, four times EBITDA, a similar company will likely sell for slightly more or slightly less. What causes it to go slightly more or slightly less is quality. Is your growth slightly better than your peers'? Are your gross margins better or worse? Is your SG&A better or worse? And is your ultimate EBITDA margin better or worse than your peers'? If you're beating your peers on all these things, you're a much higher-quality company, and you'll probably get the higher end of the comparable multiple range for your business.

If you're below, our process points that out, and that's also a benefit. Now we can say, "Well, Karl, your business has a good growth rate, but slightly lower margins." Karl can start to work on that, so that when they finally do go to market, the company has already started making moves to improve itself.

Bruce EckfeldtHow do you navigate that? That's an interesting one. You get an introduction, you start looking at a company, and say they're at $3 million, but there's some hair on it. They could be doing some things better. And also, at a smaller size they might be at a three times multiple, but if they could get bigger, they could be at something much higher. Right now they might be at a standard four or five times just because of size. How do you advise owners: "If we were going to sell in the next six to 12 months, you're probably looking at this, but if you focus on these things and hit these numbers or grow a bit over the next two or three years, we could be talking about a really different game"? What's the process for helping them sort through that?

Karl SigeristA lot of what we do is education. And you just touched on something. A company with less than $1 million in EBITDA is going to have a much lower multiple. As soon as you get north of $1 million, then $2 million, $3 million, $4 million, not only does the sheer amount of EBITDA dollars increase, but the multiple also increases. That's one of the plays. Typically, companies under $1 million of EBITDA are going to have a three or three-and-a-half multiple. When you start getting to $2 million or $3 million of EBITDA, you're getting into seven, seven and a half, eight times.

Why is that? Because with a company making $2 million or $3 million of EBITDA, a bunch of things have happened in the history of that company. It's likely larger, its systems are more robust, its management team is in place. The 50 people who make $1 million of EBITDA are not the same 50 people when they start making $3 million of EBITDA. Maybe it's 65 or 75 people. They're more efficient, they're more effective, and the way they run the business is just better on every qualitative measure. That's how your multiple grows. Yes, it's raw dollars, but the raw dollars are ultimately the result of the quality of the team that produces them.

Bruce EckfeldtI always joke that it's the same reason insurance premiums for 40-year-old men are much lower than for 21-year-old men. All the risks, all the things that can happen, have probably happened already, so we're dealing with a different profile.

Karl SigeristIt's not likely that a 40-year-old gets two speeding tickets on a weekend, unlike a 16-year-old I know who did.

Bruce EckfeldtLet's talk about making the market. I think that's a really interesting part, and the core of what you end up doing for these companies. You've got a really interesting company with some opportunity. There are future cash flows. There are underlying assets and capabilities that could be really valuable to people. How do you decide, "Okay, this is probably the path. We're probably looking at a financial buyer," or "We think there are some strategic opportunities"? What's the process for figuring out the market, and how do you start to make that market for an actual transaction?

Karl SigeristThere's always the question: who's the strategic audience for your business? There are strategic acquirers. Then there are financial buyers who already own strategics in your space, which is kind of doubling up on the same strategic, coming at them through both the CEO of the strategic and the private equity firm that owns it. There are public strategics known to acquire businesses in this space. And then there's the whole private equity or financial buyer world, which is both private equity and family offices.

Having been doing this for coming up on eight years in November, we've built a very large proprietary database of strategic acquirers and financial acquirers, both family offices and private equity, whom we're regularly in communication with about their investment theses, what they've acquired, and what they're looking for. Typically we will develop a strategic list with our client that we will reach out to on our client's behalf. But we also have this massive network of financial buyers, family offices, private equity, their law firms, their accounting firms, and all the other advisors in the community who have their eyes open for their clients in turn. So typically it's very broad. Obviously, we're looking for companies with broad appeal in that way.

It's a very big undertaking. There's the preparation of the company, the preparation of the marketing materials, and the quality of earnings report we typically have our clients do. Doing sell-side quality of earnings work also coaches and mentors the sellers for deep due diligence. We produce the CIM, we produce the teaser, we produce the target list, and we start our outreach. By this time, our clients have been heavily coached and mentored by our team on all the questions they could get. There aren't too many questions that come up once we're in market that they haven't already been asked by our team, or by the quality of earnings folks, or the M&A lawyers who are part of the process. So it's a massive undertaking.

Bruce EckfeldtAnd time frames. What do you generally tell folks?

Karl SigeristWe say it could take up to two years. Again, it depends on how prepared you are. I had a business we were selling where we set up the data room and had the audited statements and everything already set up before we even engaged the investment banker. Most people are not that proactive, and they don't really need to be. Part of your role as the investment bank or M&A advisor is to help coordinate this whole project.

But most of it is preparation. If you engage six months after your year-end, or you take too long to get your quality of earnings firm the information, all of that adds time. The preparation phase can go real quick. If you give us everything we need, we can have your CIM ready in less than five weeks. But it all depends on how quickly we get access to the information about your company: your financial systems, HR systems, sales and marketing, CRM, marketing information, operational information, ERP information. If that's all quickly forthcoming, we can be in market real fast. Unfortunately, it typically isn't.

Bruce EckfeldtDefinitely, typically not.

Karl SigeristBecause, again, these people aren't dedicated wholly to our preparation process. They need to continue running their business. So we plan for it, and I think it's probably under two years. And then even with the best-laid plans, you get a war in Ukraine, you get a regime change in the United States or other countries. Life happens. COVID. It seems to be something every couple of years.

Our team has gone through a number of these different newsworthy events. In the '80s the market crashed, and in the '90s... Today there's a whole lot of talk about tariffs and free trade, or the lack of free trade. Some of us are old enough to remember pre-1994, when tariffs were just the normal course of doing business. Post-COVID, there was supply chain risk. You may have had diversified suppliers, but you didn't do the analysis to see that, yes, they were different suppliers, but they were all from the same country. Today with tariffs, it's similar with customer concentration. "Yes, I don't have any one customer that's more than 10% of my revenue, but they're all in the same country." So that's another layer of analysis that wasn't there previously.

Bruce EckfeldtI want to finish with two or three things you'd advise early-stage founder-CEOs to do, whether when they first start their company or in its early stages. How they organize themselves and their business in ways that will serve them well later, when they start to get into this process. Things that are harder to do later, where if you get them right sooner, it's going to make your life a lot easier. What would you advise?

Karl SigeristFor about 20 years, I was a seed or angel investor, and I worked with a lot of startup CEOs. A lot of what I shared was what people in my day shared with me. One of the first things someone asked me was, "When you get on an airplane, what's the first thing you check?" And of course I said all kinds of things. He said, "You check where the exits are." I said, "Okay, how does that relate to business?" Well, ultimately every business will have an exit.

So when I worked with startup CEOs, a lot of my initial work with them was around valuation. What is your business worth, and why is it worth that? What are the metrics that drive valuation in your business, and what activities are you doing that have nothing to do with the future value of your business? Let's stop doing those and focus on the things that create value. As a startup founder, you and your board or your advisors or your investors need to be aligned on valuation, even at the early stage.

If you're dealing with product-market fit, product, market, and fit are three distinct things. Many founders think there are two things, but there are three. If you can't get clarity around that... Engineering founder, amazing product. There are people out there who aren't buying my product yet, so there's a market. But have you got fit? Do you have traction? Traction isn't just eyeballs. Traction is healthy tension in the market, where people are trading their money for what you're selling. That has to happen. Then you're starting to create value.

That's what I look at with all businesses. You can get very busy doing things and fill your day with busy work. Where is this tied to strategically creating value in my business? It's common in the angel and investor world to ask: is this a business being built for great growth, or is this what we call a lifestyle business? A lifestyle business is going to give you and your family an amazing lifestyle, but it's very difficult to find investors to support you. It will also be extremely difficult when it comes time to sell, because most financial buyers aren't looking for lifestyle businesses. They're looking for businesses they can acquire and scale, with a management team in place that can take them forward.

For smaller businesses, there is the whole entrepreneurship-through-acquisition community. They're trying to solve exactly that problem. For businesses that were lifestyle businesses but could become more scalable and more transferable, the entrepreneur through acquisition comes in, takes the risk, takes on the business, probably clears out all the cousins and family members and memberships and stuff that aren't really part of the business, and is then able to scale it.

Bruce EckfeldtGood advice. I think a lot of this is ultimately thinking like a buyer. If you're just thinking like an owner the whole time, you'll never really get out of that box. You've got to think about what a buyer is going to do.

Karl SigeristI say this to entrepreneurs: "Listen, you figured out a niche. You figured out what customers needed. You were able to completely put yourself in the shoes of the customer and figure out something they wanted that no one else had figured out, and you're selling it to them. When it comes to selling your business, you need to behave the same way. The buyer is your customer, and you need to understand it from the buyer's perspective, and you'll get there much faster."

You sometimes get sellers who take every question about their business personally. It's no different from whatever product or service you're providing. People are going to ask critical questions to better understand the value that comes from your product or service. It's no different when you're selling your business. When people ask you critical questions, they're telling you they're interested. They're not objecting. It's a good sign from a sales perspective.

Bruce EckfeldtKarl, this has been a pleasure. If people want to find out more about you and get more information, what's the best way?

Karl SigeristI would say look me up on LinkedIn and connect there. You can also follow our company on LinkedIn, and our website is shaughnessy.group. We publish a tremendous amount of content like what we talked about, and we've learned that education is the start. And talk to us early. I'm talking 10 years ahead of time, seven years ahead of time, five years ahead of time, because a lot of these things take time to implement. Some of this is aspirational for businesses, and the more informed you become, even if you never engage with us, your business will just do better because of it. So thanks again, Bruce.

Bruce EckfeldtI always joke that the best time to start thinking about an exit is when you found the business. The second-best time is now. Karl, thank you so much. I appreciate the time today.

Karl SigeristExcellent. Take care. Thank you.