Transcription
[Music] Today, we are going to talk about buying a pest control business. You know, here at Potomac, we do an average of 50 to 60 transactions per year around the globe, and I get a lot of questions about the buy side of M&A. That's not a service we provide; we're largely sell-side advisors. But often our clients—you know, we've got hundreds of clients that are in various different stages of the process of ultimately selling their business—look to make acquisitions, and I get questions every single day about how to value a business, how to buy it. So that's what I wanted to talk to you a little bit about today.
You know, when I think about buying a pest control business, I guess the first thing that pops into my mind is what's your strategy with this? What's your goal? Why would you consider buying one in the first place? You know, is it an add-on acquisition? You're basically filling in density in your current market. Are you trying to enter into a new market, for example, buy a business in a separate city to give you a jump start in creating a footprint in a new city? There's a million different reasons why you might want to buy a pest control business, but I think some of the main problems that I see right out of the gate when folks start to talk about valuation is they frame the evaluation discussion in their mind with what they've heard about what a Rentokil, or Terminix, Orkin, or any of these other big acquirers are doing out in the market.
And look, if you own a pest control business, you don't have the same resources as Rollins; you don't have the same resources as Terminix. And quite frankly, the value that you can create from a deal is not nearly as much value as these guys can create from a transaction. So you have to go into this and be, I think, extremely conservative when you start to frame up this discussion. And we're going to talk about that; it's going to be a big part of our discussion today is actually talking about how to value these smaller acquisition targets.
The other question that I often pose our clients is, are you opportunistic in your acquisition, or do you want to develop a formal M&A program? And here's what I mean by that: I think there's a lot of people out there running a business, and they get the phone call: someone passed away, so-and-so is ill, so-and-so wants to retire, and there's a five- or six-hundred-thousand-dollar pest control business across town. Do you want to buy it? That's the majority of the folks that ask questions; they're opportunistic. Right? They're in the right place at the right time; they have an opportunity to do a deal. The other end of that spectrum is growing your business through acquisition, which is creating a formal acquisition program, creating the capability to go out and source transactions, so source deals, tying it to a strategy as to how you're going to grow your business and then ultimately execute. I'm going to talk a little bit about both of those today, but really what I want to focus on right now is where I think most people find themselves, which is really in that opportunistic position.
The first question people often have is, okay, so how do I even value this? And I would typically put the valuation discussion entirely aside, get an opportunity to sit down with the seller to understand, first off, does the business actually tie in to what it is that you're doing? I think there's a lot of problems that come up over time when you make an acquisition of a business that might have a very different service frequency; it might have some employees there that don't really mesh with the type of business that you run. Remember, a lot of small businesses out there remain small, don't create opportunities for their employees, and their employees ultimately self-select. If you're a young guy and you've got the opportunity to work for a fast-growing company that provides a lot of opportunities, or your alternative is to work for a $500,000 business that's not growing at all and it's been around for 30 years, I mean, there's a lot more excitement working for a large, faster-growing business. So a lot of times those employees self-select, meaning they're okay with being in the status quo in that small business. So you know, the first step is really understanding the motivations of the seller and really assessing the mix between the target business and ultimately your business, and I think some of your front-end work should really be focused on the types of services they're doing. Right? The frequency of services: is a company that's largely general pest? Is it residential? Is it commercial? Are you just buying accounts? Are you actually buying capabilities? And that'll really come into play when we talk about valuation, but I think one of the main distinctions you have to make up front is, am I buying an actual standalone income-producing business, or am I just buying a bundle of accounts?
Once you get a sense for what sort of business you're buying and you look at it and say, look, services make sense; I'm going to be able to—you know, a typical deal like this would increase route density. Right? You've got your service footprint; let's say you're doing two million a year, find a $500,000 operation that you could tie in. The most value-creating acquisitions for small acquirers tend to be these density plays. So you've got the target company might have gross margins of 50%, and that's basically revenue minus direct costs, and your business, let's say you've got a 60% gross margin, and once you combine the two of those businesses, you might get an incremental uptick in your own gross margin of maybe 50 or 100 basis points. So to you up front, it looks like it makes strategic sense. You know, the next question ultimately comes down to how do you value these businesses, and you know, a typical valuation metric is a market approach, right? A transaction multiple. We've all heard, you know, pest control companies tend to sell for X times revenue or X times cash flow, um, and and there's a myriad of multiples that just get sprayed around the industry. I would, if I were in your position, avoid thinking about things in terms of multiples and actually try to get a little bit more sophisticated as to how you're valuing this business. I wouldn't concern myself, first off, with competition coming in and out, paying—you know, at the end of the day, your return is set based upon your purchase price, your entry acquisition. So you need to be very conservative when you frame up the discussion with the seller, and when you think about it from a valuation perspective, you really have to look at what is it that I'm buying? I'm buying a stream of cash flow into perpetuity, and you need to value that stream of cash flow.
You know, in the business valuation arena, we talk about standards of value, and they're actually quite simple to think through. There's two that I want you to continue to have in your mind: you have fair market value, and you have investment value, or otherwise called the strategic value. Right? So there's two of them, and the fair market value of a business is what the business is worth to the current shareholders, nothing more. It's just what is that business worth on a standalone basis? And then the investment value or the strategic value—I tend to use those interchangeably—the investment value of the firm is what that business is actually worth to you, the acquirer, and typically there's a range. Usually fair market value will be substantially lower than the investment value, and there's what we call a value creation zone in between, between the fair market value and the investment value, in in any sort of M&A transaction. The seller wants to sell for as close to investment value as possible, and the buyer wants to buy as close to fair market value as possible, and so the two goalposts are where a lot of the negotiations take place. So what I'll typically tell our clients is, look, before you start thinking about what the business is worth to you, you need to start and think about what the business is actually worth to the selling shareholders. I'm having this discussion right now at the end of July 2022. We're in a market that valuations are beginning, slowly but surely, to roll over, and when you think about what goes on in the market, it has been a very, very busy market the last three or four years. Even today, there's a lot of strategic acquirers, private equity firms making acquisitions, and they're focused on larger assets. So pest control businesses that are less than a million dollars in revenue tend to have less competition from buyers, for example, Rentokil, Anticimex. The large strategics in the industry are not spending a lot of time looking at five- and six-hundred-thousand-dollar businesses, which is great for you because you're unlikely to have competition from the big players.
Secondly, the competition that you will have will likely be regionals and other small businesses. Those guys typically don't have much more experience doing deals than you do, so you're not going to really be behind the curve competing with very sophisticated acquirers looking at smaller deals. So you know, my rule of thumb is, I don't care if your business does a million in revenue or 50 million in revenue; I think a lot of the value that can be created in these deals by not only getting involved in processes that don't have a lot of competitors, a lot of other buyers, is these smaller deals. Really, the kind of the eight-hundred-thousand to three-hundred-thousand-dollar revenue range is a real nice sweet spot for a private acquire. When you think about the fair market value of the business, it's important to think about: you've got the revenue less the direct costs, then you subtract the operating costs, and you're going to come to some sort of proxy of cash flow we call it, and in very basic terms, trying to understand what the pre-tax earnings of the business is. And it's very common for owners to attempt to add their compensation back into the P&L. Now, what I say on the buy side and what I say on the sell side are two very, very different things. So when you hear me talk about sell-side M&A, I want to throw the kitchen sink back into this, but if I'm investing my own hard-earned money, I'm going to make sure that the P&L, the income statement that I'm looking at, reflects the true costs in the business. And you know, owners will often times, especially for smaller businesses, not pay themselves, or they might pay—pay themselves a very small salary in order to avoid unemployment taxes and and so on and so forth. And it's important to really understand from the get-go what sort of economic benefit is the owner actually providing to that business. So if the owner is paying himself $30,000 a year, um, but based on all your knowledge of the industry and what it is that you understand that he's doing after discussion, he should be paying himself $85,000 or $90,000 a year, you're ultimately going to have to replace that. And so once you can effectively normalize a P&L, and you know, over the course of the next couple of months, I'm going to provide a financial model for folks in the industry who want to do acquisitions; it'll be free. You can subscribe to our commentary at potomacpestcontrol.com, get yourself on the list, and we'll send it around. But once you build your model and you normalize the cash flow and you say, okay, I have attempted to make this P&L look like a market deal, you're gonna come up with some sort of metric of cash flow. At the end of the day, that's really all the seller has to sell is the cash flow that the business is currently generating. I tend to look at things on the buy side on a trailing 12-month basis. So right now we're in July, so if I were looking at a target company, I would typically want to look at at least five years of historical financials, and my extensive focus would really be on that last 12 months, which would be July 1st of 2021 to June 30th of 2022, and that will give me a real good picture on a rolling 12-month basis what the business is doing. You're also going to want to dig into seasonality. Right? I mean, depending on what area of the country you're in, depending on what area of the world you're in, depending on the type of services—is it commercial, residential—there might be some seasonality. Now, unfortunately, sometimes it's very difficult to get monthly financial statements from small pest control companies; it's it's something that I think is really worthwhile for you doing, at least for a two-year period. At bare minimum, you want to at least be able to see the revenue line on a rolling 24-month basis.
Now you've done that work; you've gotten a great sense of where the business is on a pre-tax cash flow basis for the trailing 12 months. I would recommend that you don't add back depreciation. So when you look at the P&L, often times if an accountant has prepared the financial statements for you, they might add back things like depreciation and say something to the effect that depreciation is a non-cash charge. Right? It's a financial or it's an accounting construct, and it's used to depreciate fixed assets that we've purchased historically and depreciate them over time. I think in pest control, you know, as a basic rule of thumb, depreciation tends to be a really good proxy for maintenance CAPEX, and you can never really get to cash flow if you don't run depreciate the depreciation charge through the P&L. So you take it from the revenue line, you go all the way down, you get yourself earnings before interest, taxes, but not depreciation; you make sure that charge stays in the P&L. Amortization is typically not something that you're going to really be too focused on for a small pest control company; that should be zero or pretty close to nothing.
Now that you've got that cash flow stream, what the heck do you do with it? As we talked about earlier on in this discussion, a lot of guys will will apply a multiple to it: four times cash flow, five times cash flow, and I think it's good for you to understand those multiples, but at the end of the day, the way that I really focus my attention on looking at this and the way sophisticated private equity firms focus on this is really understanding what the internal rate of return is over a five-year period on a standalone basis. Now I just said a lot, and I know this is confusing if you don't do it every day, but here's what I would do: Again, forget that you're taking this business and integrating it into yours; you're looking at it on a standalone basis, meaning you're going to run it by itself; you are going to determine what that cash flow is on a trailing 12-month basis, and then you'll project those financial statements out five years. So you're going to put together kind of a five-year model on the business on a standalone basis; you're going to have five-year historical financial statements; that's going to kind of give you a feel for the business, but I want you to do those projections because doing the projections, I think, opens your eyes to a lot of things and really causes you to think about the fundamentals of the business. Right? How is that business going to run standalone? What happens to it if the owner disappears? What happens to it if key people disappear? When you do that sort of analysis, it becomes very, very easy—you can do it on your iPhone, basically. When you look at the cash flow over a five-year period, you need to determine what your hurdle rate is; you need to determine—no one else can determine this for you, but you need to say to yourself, for me to take this risk, what sort of a return on the money that I put down do I need to make this acquisition? It could be 10%, could be 20%, could be a 30% internal rate of return, but you need to determine what your hurdle rate is. If you use market multiples, those are somebody else's hurdle rate. You know, really what the market's doing on a substitution effect really should not be your concern. If you're looking to do a deal purely from a value-creating perspective using your own hard-earned money, you project it out five years and then you discount it back. And again, similar to this, we're going to be sending around a very—a simple financial model in the next month or so that you'll be able to plug these numbers in and calculate your internal rate of return for a private pest control business. I would say you definitely want to target a minimum of a 20% internal rate of return, probably 20—20, let's call it 25% to 30%, but you definitely want to be at least in the 20s on that. The higher your internal rate of return hurdle, the lower the valuation will be.
Once you've determined what that business is worth on a standalone basis, now you've got a sense of fair market value, and the next step, of course, is to take that business on a standalone basis and really think about how you are going to integrate that business and how you're going to create value. Doing 50 to 60 transactions a year for decades, having done billions upon billions of dollars in transactions in this space, I've gotten to see a thing or two about how companies like Anticimex and Rentokil and Rollins create value by doing these deals. You know, the first step when you're doing the merger consequence model is what we talk about when you take the target and you combine it with your business. One of the first things you'll notice is they'll likely be some hard synergies, and hard synergies tend to be cost savings. They might have somebody on the payroll; a lot of smaller companies will have somebody on the payroll for 70 years; they're no longer productive, and they should effectively be terminated, so—or you might have a full-time person in the office for this small six- or seven-hundred-thousand-dollar business, and you across town have your own office and you've got five or six people working in there; you might not need that person. Doesn't mean you have to can them right away; doesn't mean you have to terminate them six months from now, but at the end of the day, you need to think about how you're going to change the cost structure of that business, and so that would be a hard synergies. Other synergies, which I think are very, very typical in pest control, is what sort of incremental uptick and gross margin you're going to get from combining business A and business B, and that's simply—you know, maybe in that area of town you don't have much density; you combine those two businesses, and instead of your technician in that area having eight stops a day, now he has 12. So you will, in effect, be much more efficient; you're not going to be doing additional revenue there, but it'll be more profitable revenue because more of that will flow to the bottom line. So that's a route density synergy. In addition to route density synergies, other typical synergies would be cross-sell opportunities. I would say when I look around at a lot of the small add-on or tuck-in acquisitions that the likes of Terminix and Rentokil have done over the years, they will typically go out and find—you know, on the very small end of the market—these one- and two-million-dollar businesses that are general pest operations, typically residential general pests; they may or may not do termite, and they likely don't do any other services. So what an Orkin or a Rentokil would do is say, hey, we're going to buy one or two million in revenue in this market; we're keeping the office; maybe we'll get rid of the office, but nonetheless, one of the main things that they do is take that million or two million dollars in residential general pest revenue, and then they cross-sell services. So if your business offers five services, let's say you're doing termite, you're doing general pest, you're also doing mosquito, you might have other ancillary services that you've added on or otherwise bundled in, you now have the ability to cross-sell those services to that customer base. It's very, very difficult to project those sorts of synergies unless you have a track record of having done it already, meaning you're not going to have any data points to go back and look at; you're not going to be able to say, over the last 15 acquisitions we've done, on average we've been able to cross-sell 10% or 15% of the customer base. So in in the kind of the first iteration of of of analyzing this, I wouldn't spend a whole lot of time focusing on the revenue enhancements you can make in the deal. There's a variety of other very kind of minor synergies. I think when you're talking about smaller deals, when big companies do acquisitions, I mean, they're doing them to either enhance capabilities; they're doing them to decrease costs, enter into new markets. There's some key things that large acquirers are trying to do, but smaller firms—you're not really—many of you won't be getting into new markets; I guess it could happen. You'll certainly be looking to lower costs through route density, and you're probably not necessarily going to be acquiring new capabilities, although you may be, and a new capability might be: you run a general pest control business; you don't do termite, and there's an acquisition target in your town that does $100,000 per year in revenue; $400,000 of that is termite, and $400,000 of that is general pest. You've got some great termite technicians over there; they're licensed; they know what they're doing; they've got the experience. Well, if you buy that business, now you could take that termite capability and cross-sell termite to your own customer base because you're not doing it now. So sometimes those capabilities are acquired, but for the most part, the extreme majority of the small deals that are done that tend to be—you know, from let's call it $50,000 in revenue up to about a million—by privately held owners tend to be route density plays, which is: we're going to buy this chunk of revenue; we're going to pull it into our routes; we're going to keep a few of the technicians; we're going to get rid of the back office; we're going to close that office down, and we will create value by doing the deal.
So you understand fair market value; you understand investment value—that the business will be worth more to you than it is to the selling shareholders. There are ways to model this out, and what the big acquirers do is look: they've done the same thing you did to determine fair market value; they'll take the acquisition target; they put together forward projections; some acquirers do it five years, some do it 10 years, but they put together these projections going out over time, and then they say, okay, now we've got to draft an investment committee memo, and we've got to explain to the investment committee of Rentokil or Anticimex why we want to use corporate's money to do this deal. And so when we do that, we're going to say, okay, what are the hard synergies? We get—remove those from the P&L; what are the revenue enhancements we're getting and the additional cost savings? So route density, what's that going to do to our P&L over time? The capabilities that we've bought, how we're going to be able to sell more services and get different revenue enhancements, and they will actually model this stuff out for you. I don't know that I would really get too hung up on that, at least on my first acquisition. I think as you get more sophisticated and you build a team, really the core for you is understanding what fair market value is and then taking control of the process. Usually when you have small pest control operators, and when I say small pest control operators, I'm talking about—you know, again, the million-dollar-less player—they call you up; you sit down with them; you've modeled it out. When I talk about taking control of the process, my suggestion is you shouldn't sit down with an acquisition target and ask them how much they want for their business. I think it's very, very important from a psychological perspective for you to be in control and for you to anchor a number low. So let's take an example: Let's say there's an eight-hundred-thousand-dollar business, and it's running roughly a 20% pre-tax cash flow margin, so roughly $200,000 on the bottom line, and let's say you've modeled it out and you want an internal return of 25%, and that implies a four times cash flow deal. So very simple: $200K on the bottom line, uh, 25% internal rate of return becomes an $800,000 enterprise value; that's about where fair market value would fall out for that business, and when you make the acquisition offer, you know, I think…
It's important to, let's say, that the fair market value is $800,000. You want to pay less than that, and you're willing—you've done your modeling—and you're willing to pay up to $900,000 for that business. Well, you want to come in and anchor low. So I'm not going to be able to tell you right now, you know, every situation is unique. Some sellers are more difficult to deal with. I mean, there's a lot of different unique situations. But again, you want to be the one that writes that offer—a one-page term sheet, non-binding—and basically anchors that number on the very low end of what you think you can hand to them with a straight face.
Furthermore, you know, in 2022, the extreme majority of pest control deals are done at between 80 percent cash at the closing to 100 percent cash at the closing, and that's probably 95 percent of deals—somewhere between 80 percent down and 100 percent down. On smaller deals, it's much more realistic to see down payments of anywhere between 10 and 50 percent. So let's say that you strike a deal at $800,000; you know, it would be reasonable for you to maybe make a two- to three-hundred-thousand-dollar down payment and then pay the seller out over a five-year period with a seller note.
Um, you know, I certainly am not giving you legal advice on this discussion. You're going to want to talk to a lawyer. I would steer clear of any sort of personal guarantees from you. You just put together a promissory note; it's over five years. Although I don't really do many transactions anymore that have any contingencies or holdbacks that are contingent upon performance, that's very, very rare for us as sell-side advisors in the industry. If I were out buying a target, there's no way I would do a deal without making sure that there's some sort of a contingency in there based on future performance.
So let's pretend the $800,000 business has been doing—growing at one percent per year—right, dramatically less than the rate of inflation, and you're going to pay $300,000 up front and $500,000 over time. You do want, at least for a period of 12 months, some sort of a contingency in there that if revenue rolls over or somebody like that—the owner or any of the employees—go out and solicit customers and begin to impair the value of the business that you've just acquired, you want some contingencies in there. And contingencies can be very simple, I mean, and I've seen them done a million different ways. You know, the big companies like to do what we call "taken pays," so a customer post-closing would have to take and pay for one service or two services or three services before they're actually deemed a non-canceling customer. If they don't do that, then that customer's clawed back from the actual promissory note. And you know, I think in a subsequent discussion I can go in further depth on that topic, but you definitely want to make sure that you have some sort of a clawback provision.
I often see that folks that don't do a lot of acquisitions can really get mired in the details when it comes to doing an upfront assessment of the business. Right, you want to see tax returns and internal financial statements and all sorts of stuff. For me, I kind of think it makes a lot more sense to try to get some internal financial statements up front, maybe a tax return or two if the seller will give it to you, and maybe some exports from festivals, PestPac, ServSuite, whatever sort of software the small company is using. You know, on the front-end assessment, I think you should be willing and able to maneuver relatively quickly, meaning you don't want to spend much time up front assessing the opportunity. You want to be very decisive, get the materials within a few short days, make your assessment, come back, put a term sheet on the table; don't get mired in the details, because there's a lot of opportunities out there. And unless you really want to build that capability again, get the least amount of information from the seller up front that you need in order to make that assessment. You have plenty of time in the due diligence period to actually really dig deep into the business.
Let's say that you put your offer on the table; you know, the seller is likely to negotiate with you. I think one of the things that I would keep in mind if I were you is there are a plethora of opportunities for most people. Sometimes you live in a really rural area; there's only one or two other companies. But I think for me personally, where we are today in the summer of 2022, it is an absolute horrible time to be a buyer of assets. I am selling everything across the board. I am selling everything from stocks and equities to real estate—everything that I have, I am selling—just given the fact that the Federal Reserve is hiking into a downturn. This, in my opinion, is going to be a train wreck in slow motion in the coming years, and I, of course, want to have the resources available to pounce on opportunities. So now is really not the time to be buying. I think six months from now, 12 months from now, that'll be a great time to start to really be aggressive on the buy side. And you know, we'll get through this period over the next kind of six to 12 months where I think the market's going to dramatically change. I think that as much as pest control is recession-proof or recession-resilient—yeah, it is recession-resilient—but at the end of the day, when the recession does come, it really is going to put the strain on a lot of these smaller businesses. Plus, when you add in the stagflationary environment that we have—something we haven't seen since the 70s—I think it might make for a very, very interesting opportunity for folks out there in the industry to go out and pick up these businesses on the cheap. Because I do know—I mean, look, I've been doing this in pest control since 2003, and in 2008, 2009, 2010, you know, I wasn't even focused on the U.S. domestic market during the Great Financial Crisis. I mean, there was tumbleweed blowing through the M&A halls of pest control; the large companies weren't buying, and the guys who went out there opportunistically, like you, were able to make an absolute killing. I saw people buy businesses doing two million dollars in revenue for four and five hundred thousand dollars. I kid you not; I saw it with my own eyes. So I think those opportunities will be out there if you're patient, and you should be very patient as a buyer, because your return is set based on the amount of money you pay for the deal. I mean, it's set when you enter the deal; it's your entry multiple. Be patient.
Um, now might be a good time, if you really want to take, you know, advantage of potential great opportunities in the future, is really to kind of spend some time thinking about how you're going to model this out, spend some time thinking about how you're going to integrate this into your business. You know, what, now in the summer of 2022 into the fall of 2022, get out there if you actually wanted to develop a formal acquisition program, get out there and spend time meeting with everyone else in the industry in your area and let them know, "I've got this family-owned business, or this is my business here; here's how many people I have; here's how much we've grown; here's what I plan on doing in the industry." If you're a privately held pest control business, you can really play up the "I'm the local guy; don't be a sellout," because what many, many sellers—even some of the bigger sophisticated sellers—don't understand is there's a huge difference between what a large acquirer can pay—not only from a capacity to pay perspective but also the resources that they have in their pocket—versus what a local player can pay. And sellers often think that price is objective—like there's one price for my business, so it doesn't matter, you know, it doesn't matter if I sell to Oregon or a small player; I'd rather sell to a small player because price is objective. It's ludicrous, but there's a tremendous opportunity to take advantage. I mean, look, a lot of these big companies out there—the private equity firms—take advantage of sellers whether they have $500,000 businesses or $50 million dollar businesses when they do not get sophisticated advisors on their side. So if you can find an opportunity with a business broker or some, you know, a seller that doesn't have any really good advice, and you might find yourself in a position to get a phenomenal deal. And I know sometimes people feel bad about that, right? It's like you feel bad when you know somebody could have sold something for three million dollars and turned around and sold it for a million dollars, but you should not, because you're not taking advantage of them; you're taking advantage of the opportunity. Everyone in life has an opportunity to hire advisors who are sophisticated and who could protect them, right? You get in trouble with the law; it's your decision whether or not if you've got the resources to go out and find a fantastic attorney or if you're going to represent yourself in trial.
So I bring this up because a lot of times, you know, I'll get calls from clients of ours that might be, you know, a $50 million dollar firm, and they say, "Hey, Paul, I've got this $3 million opportunity, and like, I think I can get a great price on it. I kind of feel bad what this guy's willing to let it go for because he doesn't even, number one, understand what's going on in the market from a financial perspective; he doesn't realize that valuation is subjective, and how much should I really push down on this? I mean, really, should I knuckle in and really try to drag him down as far as price goes?" And I say, "Absolutely; this is business. You want to anchor low; you want to pay as low as you possibly can, because guess what? At the end of the day, if you live in a market society, and if you're creating more value for your customers and your more value for your people and more value for yourself, you're actually creating value for society as a whole, and I almost view it as your duty to take those idle assets out of the hands of non-productive organizations and put them into the hands of your more productive organizations." You'll never feel bad about that.
From a diligence perspective, I mean, this is when it gets complicated, and you know, Patrick and I on the Boardroom Buzz have had, I think, a few discussions historically on due diligence. I think we've done some buy-side sessions, so you can pull them up. But let's say that you've made an offer, you've negotiated, now you're signing a non-binding letter of intent or term sheet. You should give yourself at least 60 days for diligence. You know, on the buy side, if you get an attorney in there who knows what he's doing, he's going to try to limit you to 15 or 30 days of exclusivity, but really what that means is you sign a term sheet with a seller, and you tell the seller, "Hey, this is non-binding; here's what I think I'm going to pay you; I'm going to pay you $800,000; I'm going to give you $300,000 upfront; $500,000 over the time—over time; here's the interest rate—and I need to do diligence." So you are agreeing for a period of at least 60 days to not have any discussions with any other buyers, right? So you're—you're signing your name next to this; you're not going to have any other discussions with any other potential buyers. I have exclusive right to look at this business because I'm making investments in the diligence process; I might be hiring financial guys; I'm hiring legal guys; I might hire an environmental guy—who knows—I'm hiring a lot of advisors; I'm spending time, money, and effort to look at this; I want to know that the seller can't go around and shop it. Fine. In addition to the exclusivity clause, you need to specifically outline the types of assets that you're actually buying. Again, this isn't legal advice; you need to talk to a very competent attorney that has experience in buy-side M&A when you do this. And a guy that I've known for a long time named Mike Stanza—he's in his 40s; there's a lot of guys in this industry that are running around in their 70s and 80s—some of these attorneys that tend to do a lot of these deals, you know, these guys, in my opinion, stopped being decent 35 years ago. So you don't have to hire Mike, but there are guys like Mike who are relatively young who know how to actually use email and word processing programs as opposed to putting notes on stuff handwritten. Find yourself a good attorney, and when you structure your letter of intent, you're—you're—you're choosing typically to do an asset deal or a purchase of assets, and again, I'm not going to go too into the legal aspects. There are certain times where you would want to do a share deal or a stock deal, but for the most part, your letter of intent would effectively say, "I am buying substantially all the assets of XYZ Pest Control Company, including but not limited to," and then you need to highlight the things that you want, right? You're buying the customer list; you're buying the goodwill; you're buying the intellectual property, so on and so forth. And there's a lot in a letter of intent. I'm going to actually go through a letter of intent a few weeks from now to kind of give you guys a better idea or a clearer look on the inside of a letter of intent. But once you get that LOI locked up, now you got yourself 60 days. At the 60-day point, that's when you really want to get down into the internal financial statements. You want at least five years of tax returns. On the Buzz, I can't remember the episode—Patrick here, he would certainly know it—but we talked about getting tax transcripts. So if you are a U.S. acquirer, or rather, if the target's U.S.—the company you're buying is a U.S. target—you can request tax returns directly from the seller, but then on top of that, you can order a tax transcript from the Internal Revenue Service. And I gotta be honest with you, there's a lot of times—there's material differences—not a lot of times, I shouldn't say that; it's actually rare nowadays—but there are times when somebody would report to the IRS a million dollars in revenue and actually be doing only $800,000 a year. Why would they do that? They're paying more taxes; I get it. But with where transaction multiples have been in recent years, it makes sense to pay the government more in tax money because the multiple of cash flow and revenue you're going to get is substantially higher than the tax liability. So if you could forge that stuff, you know, you align your pocket, so you have to be careful with that. So you want to do your tax and accounting due diligence; you want to, to the extent possible, spend time with the people that you'll ultimately be employing. In fact, if I'm a buyer, I want to talk to everyone; I want to talk to the guy or the gal working in the office; I want to sit down and talk to every technician; I effectively want to be able to interview these people. And those are the types of things that you should be doing as well. Clearly, you want to do a lien search. In certain jurisdictions, sometimes liens that exist on the books are actually transferred to buyers, so we call that successor liability issues, so you're going to want to do a financing statement search. Again, if you've got a good attorney, he or she'll be able to execute that for you and do the lien search. I'm not going to go full deep into diligence because I could spend days talking about the crazy stuff that I've seen and the things for you to look out for. What I ultimately wanted to get at here in this whole discussion is, number one, you're not Orkin; you're not Terminix; you really need to be extremely conservative. Number two, most of the discussions that I hear from the layman in the industry as to transaction multiples tend to be so—don't talk to your buddy who, "Oh, I've done a lot of deals; I can tell you this"—that's not really the way to do it. If you really want to do it right, you're going to have to educate yourself, right? If you're going to do deals—if you're not going to just do a one-off—if you're going to get do deals, you have to understand in very basic terms how to properly value these businesses and assess your risk. You do it; you owe it to yourself; it's your money. When you negotiate with these people, and again, Patrick and I have discussed this on the Buzz, don't ask a small seller what they want, because they're going to give you a number that's dramatically higher than anything you're willing to pay. You want to anchor low; you want them to negotiate from your low number and up as opposed to, "Hey, I've got an $800,000 business; I want $3 million." Now you're negotiating from a $3 million starting point; that's not where you want to be. You want to be negotiating from a $400,000 starting point and going up versus the other way around. And for some people, it seems counterintuitive; some people were like, "Hey, you know, maybe the seller won't want that much, and if I put an offer on the table, maybe it'll be more than he actually wanted for the business." I think the chances of that happening are so infinitesimally small that it probably will never happen to you. And if it does, congratulations, um, because if you valued it right, you're not overpaying for it anyway. But I wouldn't worry about offending people; you know, this is a financial transaction, and a lot of times people say, "You know, I was insulted by the offer." Who gives two shits? At the end of the day, you're not dealing with your family or your friends; you are entering into a financial transaction, and you need to make sure that you've measured the risk, measured the return, and that you're paying the low amount—the absolute lowest you possibly can—for this business.
You know, I appreciate you tuning in today. I will be doing a lot more on the buy side of M&A going forward; it's something that I spent a lot of time doing, you know, back in my investment banking years and back when I worked for the largest publicly traded private equity firm in the United States, doing buy-side stuff. It's not what I do right now because, quite frankly, it's not as lucrative as doing sell side, um, but it's something that I do enjoy, and I think I can provide a lot of value to you in the industry talking about this stuff. So thanks for joining me today. Subscribe to our Potomac TV YouTube channel, as we're going to be putting a lot of videos on this. Go ahead and subscribe to the Boardroom Buzz as well. I will be sending out the financial model; I don't know what I'm going to get around to it; I think once the M&A environment slows down a little bit this summer, I will put together a quick and dirty financial model, and I will send it out to our subscribers. Go to potomacpestcontrol.com, subscribe to the commentary, and you'll get it. Again, thanks for joining me. [Music] [Music] You