Podcast 37: Intro to Private Equity

In this episode, Drew talks about his own personal experiences in buying and selling companies, and gives a brief intro to private equity, which he’ll discuss in the next few episodes.

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  • Insight on selling Drew’s first company, DesignPublic
  • Intro to Private Equity

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Hey, everybody. Welcome to the Nerd Marketing Podcast. This is Drew Sanocki, and I am podcasting from San Diego, where I’ve been working on AutoAnything. And for like the fifth time this winter, I am stranded in San Diego. So the New York airports are down, I can’t go home. There are no flights in and out of there. So what better thing to do than podcast, right? I can probably think of a million better things.

But seriously, what better things than to bang out a short series on buying and selling companies? We’re going to call it buying and selling companies. I call it private equity, but I think most people don’t know what the heck private equity is, so we’re going to call it buying and selling companies.

As you may or may not know, I just recently worked on a transaction to buy autoanything.com. It’s a drop ship retailer based here in La Jolla. And as part of that I’ve podcasted about maybe one or two times. Some people are curious about private equity, how it happens, why they should care about it, why is there private equity.

And it boils down to one thing, and I think it’s … these are probably the funds, or the groups of people that would buy you someday. If you are listening to this podcast, you’re probably running a small direct-to-consumer brand, or SAS company perhaps, maybe an agency. Well, a lot of those things get bought by private equity funds, or small private investment groups. And so, why do you want to know about this stuff? Well, it’s ultimately to fetch a higher valuation for your company, and to know about how to exit. That’s probably 90% of you. But 10% of you, maybe you want to get in to private equity. Maybe you want to get into buying and selling your own company.

And why would you want to do that? Well, for a number of reasons. I think it accelerates your growth. I think you can just get to where you want to go faster if you’re working with some capital, or with other people’s capital. So it’s of interest to you too for that reason.

So I want to spend three of four episodes doing a quick overview of buying and selling companies, at least my own experience with it. And I’m going to start with a story. And the story is of a young, handsome man, probably like 10% body fat. Am I painting you the picture of myself, maybe 15 years ago? Actually no, it was more like seven years ago when I sold my first company.

But I’m walking through the West Village of New York, and in my hand I’ve got a FedEx package. And in the FedEx package is a bunch of signed documents to sell my company at the time, Design Public. And this was my baby. I bootstrap designed Public in 2003, we started the business, and now at the time it was like 2011. And we found a great buyer who we worked really well with, and they gave us an offer we liked. So at the end of months of work, of diligence of them going through our books and a lot of legal back and forth, in that FedEx pack was the signed purchase agreement.

As soon as I got to the FedEx/Kinko’s, I put that thing on the counter, and that was the point of no going back. It was my company up until that document was mailed. Once it gets mailed in, it triggered all sorts of things, like the money went in … their money was already sitting in an escrow account, but I think the document triggered the release of the money into our bank account, my business partner and I.

And I had worked so hard, as you all understand, anyone who’s growing a business. You work so freaking hard on that thing, the ups, the downs, the good years, the bad years. It’s your life, and that life was summed up in 20 pages of legal documents right there. And it’s like closing a chapter, and I can’t think of any other ways where you close a chapter like that, in that sort of way. Like chapter of your life, that you poured so much into. Maybe a death or something closes a chapter, but you know … I owned Design Public five minutes ago, and now that I go to this FedEx and drop off that package, I no longer own Design Public.

And not only that, I wake up the next day with a considerable amount of money in my bank account. And when I reflect back on the major wealth-creating events in my life, they were when I sold a business. It wasn’t when I took money out of the business growing up, or when I’m paying myself a dividend, or an income out of it. It’s when I sold the business. And in that case it was the difference between being really not a millionaire and a millionaire. It really did not get any more black and white then that. You just get that influx of cash, which of course only lasts until you have to pay taxes on it.

But you get that influx, and you step up your life. Whether it’s from 10,000 dollars in the bank to 100,000, 100,000 to a million, a million to 10 million. Whatever the step function is, you’ve just grown your net worth considerably. And you start acting differently, you start looking at different opportunities, you look at the world differently. A lot of things happen, for better and for worse, when you get that influx of cash.

And talk about a pivotal event, I realized then, and it’s something that’s just been hammered home in deal after deal that I’ve been part of since then, that the money is made when you sell that company. And so I would recommend to all of you to … Maybe selling isn’t on your radar, but it’s at least something you should consider at some point. If you don’t want to sell now, that’s great, but you should at least be thinking about how to maximize the valuation of what you’re building, so you do have an asset you could sell someday.

I wish I knew a lot more about buying and selling companies then. I was much more of the tactical marketer. I’m going to put my head down, I’m going to optimize email, I’m going to optimize Facebook ads, and I’m going to optimize Google, and someday down in the future I’ll worry about what to do with this business. Man, was I wrong. I was the CEO, and part of being the CEO is, you’ve gotta think about strategically, where you’re taking that business. Optimizing deck chairs on the Titanic is not the best use of your time, if you’re on the Titanic. So the same goes with your business. Yeah, you gotta pay attention to all the best practices across merchandising, and marketing, and operations. But always spend a little bit of mental bandwidth on thinking about where you’re going to take that company, and ultimately who might buy you, or what you want to do with it five, ten years down the road.

So I realize that now, and it’s where I like spend a lot more of my time. At the time, I didn’t, and that FedEx package was … I don’t want to say a rude awakening, but it was an awakening of sorts.

So that was my own little story. But the big takeaway for me in selling a business was that for me personally, it was something like 80% of the total value was I the sale, not in my personal income along the way. For you listening, why would care about buying and selling? Well, if you take money either to sell your business, you get a major wealth event. But you could take money to grow faster. There’s all these reasons why you’d want to care about private equity.

So today in this episode, I just wanted to introduce you guys to the concept, and then maybe talk a little bit about what buying and selling entails. Who are thee people that buy and sell companies? Who would you want to sell to someday? And when I think about buying and selling a company, and when I think about private equity funds, I think about … They really do two things at the end of the day. Private equity is about investing in private companies, and/or taking public companies private. So this is not the stock market. None of us, unless we’re really fortunate, are going to have any dealing with the public markets. Someone listening to this podcast may IPO someday. If you do, more power to you. I think those of us on the podcast, what we aspire to do someday is have a private exit. So private equity just means you’re buying private companies.

Why do they do this? Why does a private equity fund do this? Just go Google Robert Smith. They do this to make money. Robert Smith is one of the guys I really respect and look up to. He came out of Goldman Sachs, and started his private equity fund. And I don’t know, it was five years later, it’s managing 30 billion in assets. He’s worth 4 billion. He’s probably the second wealthiest African American in the U.S., behind Oprah. The guy has all sorts of stories about how eccentric he is. He got married on some mountain in Italy, where they had to fly everybody up off helicopter, and John Legend performed there. He’s the man, you know? And there are a few women in private equity too. Not as many as we all would like to see, but at the end of the day I think they do this to create value, and that value translates to the return that their funds get.

What else are the advantages of private equity, other than making money? Well, they provide companies with fund to break through their limits. If you are running a small direct-to-consumer brand, you know as well as I do, unless you get up to like 10 million in revenue a year, you don’t have enough money to typically hire out middle management. And that was a struggle I dealt with at Design Public. It’s the founder, the solo founder, who runs the business. And if you’re lucky, you can get a couple other talented members of your team, but there’s a real limitation in hiring. So imagine what you could do with some capital to go higher.

For those of you on Amazon, Amazon’s a great way to get some quick growth, but it’s a capital-intensive business. You gotta take inventory. Imagine what you could do with a lot of funds at your disposal to put into inventory. Or those of you who have found the mythical Facebook channel that throws off a ten to one return on ad spend. What if I gave you a million dollars to throw into that? Could you really step on the gas?

So private equity helps companies break through limits. And the vignette I gave at the beginning was about an exit, it was about selling your business. But there are a lot of advantages of just taking money from funds like this, or people who have cash, angel investments. And that all falls under private equity. It’s not just exiting a company. So, helps companies break through limits.

Number two, I think private equity can really help you gain expertise. And here I think of, again, all direct-to-consumer brands listening to this. There are the big guys in your space who do this for a living. I’m thinking of Unilever, consumer packaged goods companies, P&G, the big apparel brands. And yeah, a lot of them are slow, and methodical, and they don’t understand eCommerce well. But you take money from a party like that, or a PE fund that specializes in those things, and you get a lot of expertise. Expertise, because these people are on your board.

If you’re an apparel brand, you might get someone on your board who ran apparel at J. Crew or something, and can really help you dial in your supply chain. Or if you’re selling a beauty product, imagine having someone from Unilever on your board, who can help you with packaging, and just a lot of the things you struggle with. Whereas you bring some expertise in online marketing, and maybe merchandising. These people, you take money for them, it’s not only the dollars, it’s the fact that a lot of times, if you just take money, if you raise money, they might want a board seat, and you get some advisors who can help you with things. So those are just a couple of the side benefits of working with a private equity fund, or a private investment group.

Now, you guys might be wondering, “How does a guy like Robert Smith create a $30 billion fund?” He goes and raises money … And typically they raise money from institutional investors, I’m thinking CalPERS, family offices. The biggest holder of wealth in our country are these family offices. They’re people like the Bass family, who just have billions and billions of dollars, and they’ve got a certain percentage allocated to private equity, just like they have a certain percentage allocated to public equities. And that private equity allocation goes to many private equity funds, and the funds then distribute that to their investments. So schools, endowments. Harvard has I don’t know how many billion dollars in their endowment, but a portion of that goes to private equity.

And even some of these private equity funds are on the public market too. So I think of Buffett. Berkshire Hathaway at the end of the day does a lot of private equity work. And they are a public company, so they raise money from the stock market. Blackstone’s another big one you might have heard of. So, that’s where they get the money.

And where do they get their returns, once they are investing in you? I can think of three ways. So a typical private equity fund might buy an asset, and number one, take dividends out of it. So I recently was partnered up with Kingswood Capital, a small PE group out of Los Angeles, and we bought AutoAnything. And say we are able to bring efficiencies to AutoAnything, like we dial in their paid spend, maybe their supply chain, we get some margin expansion. Maybe the company’s doing a lot of things that had hurt margin in the past. Well, hopefully the company starts generating cash, and the PE fund could then decide to take the money out of the company as a dividend payment, just like you would if you bought a dividend-paying stock.

So that’s an interesting play, especially when it comes to eCommerce, where you don’t see a lot of eCommerce IPO’s. Maybe the strategy for the typical PE fund that focuses on direct-to-consumer is, we’re going to buy this thing and run it for cashflow. eCommerce multiples tend to be lower relative to SAS and other tech companies, so let’s buy up a bunch of these consumer products companies and just generate a great dividend check.

I don’t know if any of you know Bill D’Alessandro. He’s a great guy who’s spoken a lot at the eCommerceFuel events. But that’s what he does. He buys direct-to-consumer brands and runs them for cashflow. I think if you have an exit someday, you’re lucky. But in the meantime, you can make money. So dividends is one way to generate returns.

Multiple expansion is another. So when you go to sell your business, most people who are looking at the business will slap a multiple on it. What that means is, they will look at things like the cash you take out of the business every year, and/or the revenue it generates, and say, “Hey, at that level of cashflow, I’m going to value that business at three times.” Meaning you took $100,000 out of your business last year, I’m going to value that business at $300,000.

And the things about multiples is, they get bigger as the company gets bigger. So you think at the low end, maybe an eCommerce company would be valued at two or three times owner’s discretionary cash flow. Well on the other end of the spectrum, as they get bigger and bigger and bigger, maybe that multiple becomes 10 times. And ultimately, think of a public company. What’s the multiple of a public company? Question? Show of hands? It’s the PE ratio.

So on one end of the spectrum, on the public markets you’ve got PE’s of 25. That means for every dollar of income that company generates, I’m going to pay $25. And at the low end, at the end of probably everybody listening to the podcast, it’s more like three or four times. For every dollar the owner takes out, I’m going to pay you three or four dollars.

So one things that private equity funds do, is they may buy these smaller companies. And maybe they’ll buy several of them in the same category, and they’ll go on this acquisition spree in an effort to get profits up, and revenue up. And as those profits and revenue increase, then you’ve got some multiple expansion going on. So I buy a bunch of assets at three times cash flow, and maybe I get them up to the point where I can sell them at five times cash flow. Or if I’m lucky, 10 times cash flow. So, that’s called multiple expansion. It’s very common private equity tactic.

Incidentally, do you know why multiples go up as the companies get bigger? Again, show of hands? And the answer is … I’m looking at you, Andy McKesson, because he’s got his hand up in the front row. It’s because there’s less risk in the business. So there’s a lot of risk if I own the mom-and-pop shop on the corner, and there’s a lot less risk if I buy 100 mom-and-pop shops. It’s just less vulnerable to any one thing happening. I think my income, the traffic to the sites, is all a little bit more stable the bigger it gets. And so, it should fetch a higher multiple.

So number one, we got dividends. Number two, multiple expansion. And then number three, the third thing that a private equity fund might do with a company is exit it. So I buy an asset, and maybe it’s busted up. I fix it up, I slap some lipstick on that pig, and it looks great, and then I turn around and sell if for a much higher, higher price than I bought it.

Here I think of Dominic Ang, who runs Turn/River Capital. I worked with Turn/River for almost a year a couple years ago, and worked on several deals. And I look at Dom as a merchandiser of companies. So Dom buys low and sells high. He’ll buy SAS companies. He will add a lot of value to them, and then increase the revenue, increase the profitability, and increase the user base. And then, he sells them for a lot more than he bought them. So, his play is exits.

So those are the three ways that a private equity fund generates returns. And how good are those returns, by the way? I’ll put a link to a chart in the show notes, but private equity blows away everything else. And what do I mean by everything else? Well obviously it blows away cash. The return on cash is what, a percent now, if you get a Capital One account? Blows away bond returns, and blows away stock returns over the long run. And looking back over 10, 20, 30 years of private equity returns, I would say it’s like 30% better than the stock market.

So if you think of just from an asset management perspective, private equity is a good investment. It’s a good use of your time. If you want to ultimately get in the game, the private equity game yourself, you should do so expecting, or looking for better returns than the stock market.

Okay, so that’s just a little intro to private equity, and buying/selling companies, why you should care about it, how it might impact you, what it is, what they do. And in the next couple episodes, I’m going to get into a little more details of how a deal goes down. If you want to sell your company, how that deal might do down. Or if you ultimately take an investment in your company, how that deal might go down.

I also want to talk a little bit about how to maximize your valuation. Something we should all be thinking about. There are just little things you could do right now that add a lot of value to your business tomorrow. So I want to get into that.

And then I also want to give you a little bit of a who’s who. I want you to know the handful of people who I deal with. They are the people who play in direct-to-consumer, who may invest in you, who may buy you someday. And I want to show you how you could get started doing some private equity yourself for as little as $10,000, $20,000, and show you some people who are doing that also, because I think that’s interesting.

So that’s it. Intro to private equity today, and I’ll talk to you next time.