Acquisitions Anonymous - #1 for business buying, selling and operating - Can we make an SBA loan pencil on a 5% margin business? - Acquisitions Anonymous 195

Episode Date: May 23, 2023

Bill D’Alessandro (@BillDA)  and Heather Endresen (@EndresenHeather) kick off Heather's first show as a co-host. They review a managed IT services provider and a convo about SBA programs.-----Thanks to our sponsor!This episode is sponsored by Acquisition Lab. Acquisition Lab, created by Walker Deibel author of Buy Then Build: How to Outsmart the Startup Game, is an accelerator with a highly vetted cohort-based educational and support community for people serious about buying a business. After going through the Lab's month-long intensive, you have ongoing access to almost daily Q&A sessions with advisors, regular live deal review forums with Walker, hand-picked vendors for your deal team, and a very active Slack group with other searchers on this path. Our team personally understands how to buy a business and will help navigate all the complexities of the process, as well as provide a trusted framework, tools, and resources to support you from search to close. The Acquisition Lab recently celebrated its 70th business being acquired and well over $100m in aggregate transaction value. The Lab is there to stand by your side, so you can take the right action (at the right time) and avoid wasting countless hours trying to "go it alone".For more information, check out acquisitionlab.com or email the Lab's director Chelsea Wood, [e-mail] to weekly our Newsletter and get curated deals in your inboxAdvertise with us by clicking here Do you love Acquanon and want to see our smiling faces? Subscribe to our Youtube channel. Do you enjoy our content? Rate our show! Follow us on Twitter @acquanon Learnings about small business acquisitions and operations. For inquiries or suggestions, email us at [e-mail]

Everyone, welcome back to another episode of Acquisitions Anonymous, the internet's number one podcast on buying, selling, and operating small businesses. I am one of your hosts, Bill Dallisandro, and I had a blast doing today's episode with our newest co-host, Heather Anderson. So Heather is joining us in the rotation, and she comes to us after a 12-year career in small business lending. So I was psyched to introduce to the pod. This week, we covered a managed services provider.

This has been a sector that's been all the rage in searchers. lately we kind of picked it apart, found some things that were a little questionable. But the real thing to stick around for is about halfway through, I took Heather totally off track and dug into the SBA program, why it works, kind of where it comes from, and how it differs from some programs in some other countries also. So I thought it was really educational to hear from a lender someone who's worked so deeply in the SBA program. So first half about the manager service writer, second half about the SBA program.

I hope you enjoyed this episode with myself and Heather. This episode is sponsored by Acquisition. Acquisition Lab, created by Walker Debel, author of Buy Then Build, How to Outsmart the Startup Game, is an accelerator with a highly vetted cohort-based educational and support community for people serious about buying a business. After going through the lab's month-long intensive, you have ongoing access to almost daily Q&A sessions with advisors, regular live deal review forums with Walker, handpick vendors for your deal team, and a very active Slack group with other searchers on this path. Our team personally understands how to buy a business

and will help navigate all the complexities of the process, as well as provide a trusted framework tools and resources to support you from search to close. The Acquisition Lab recently celebrated 70th business being acquired and well over $100 million in aggregate transaction value. The Lab is here to stand by your side so you can take the right action at the right time and avoid wasting countless hours trying to go it alone.

For more information, check out AcquisitionLab.com, link is in our show notes, or email the Labs director, Chelsea Wood, at Chelsea at buy then build.com. All right. I am very excited for this episode because this, I think I have the honor

of doing the first episode with Heather as one of our new co-host. Heather, how are you? I am great. I'm super excited to be here. Thank you, Bill. I am pumped. So for you, for those of you that don't know, Heather,

Heather is probably one of the smartest people in small business lending I have ever met. I'm going to toot her horn here for just a second while she blushes and looks at me. She has done this for so long. And whenever I have a SBA loan or a small business financing question, Heather is my first email or phone call. And she always knows the answer 100% of time. I don't want to put words you in now with Heather, but I imagine you have probably looked at more deals than any of us on the podcast, but from the lender side, I would think.

I think maybe that's true. Yes. I've been looking at small business acquisition deals for over 12 years now. So I'm afraid to even say how many deals that might be to age. myself. But it's getting better and better all the time just because I'm doing so many deals. Which is awesome because I think one of the things that makes this podcast really good is there is always somebody on the recording that has a specific experience with the deal that we're doing and can draw. And you can say I've seen a couple of these, et cetera. And that's actually what we have

today. So you pick this deal, Heather. And it's a space that I know a little bit too. So you want to kick it off and read us the deal? I will. Yes. This is a managed IT services business. It has 13 million in sales and cash flow of $683,000. And the asking price is $2.2 million, which is about 3.75X. You know, so let's look at what they're telling us about this one. They're saying up on the headline, $450 clients, $200,000 a month in recurring revenue. So that's $2.4 million of the 13 is recurring revenue. revenue. Their service area is 75% local. They're based in the Twin Cities, 10% regional and

15% national. They've got 39 employees. 10, let's see, well, we don't need to break down where they all are, but a total of 39 employees. So it's a good size operation. Strong recurring client base, word of mouth referrals, and well-established. So we've already said how many customers they have. They've been in business for 30 years. Let's see. Technology life cycle management, IT staffing, cloud solutions, data storage,

data security on and on there. Let's see, they're talking about the employees again. 18,000 square foot building, 9,000. I'm sorry, yeah, 18,000 square foot building, 9,000 of it is used for warehouse, production space, which is kind of intriguing for this sort of business. And the remainder is occupied by tenants.

So it doesn't sound like they're selling the building in that purchase price, though, just giving you a sense of the kind of square footage that they occupy. So Heather, what is this business do? Help me understand. What does it do? Yeah. So they are like outsourced IT serving small businesses. And what they're saying here in their teaser is that they're serving education,

finance, health care insurance. So it would be interesting to know are these small agencies, small hospitals, or are they doctors offices? Most of the smaller deals like this that I've seen, they serve small businesses. So it's usually some form of outsourced

IT and they usually have some area of specialty or the better ones tend to have like a vertical expertise. This one doesn't seem to describe a vertical expertise. And, you know, it's got pretty low recurring revenue as a percentage of sales. It's got about 18% recurring revenue. And I think you tend to want to see

higher than that, like 50 to 60% contractually recurring revenue. So one thing I think that's pretty interesting. So they've titled this listing, managed IT services, which if you are in the search fund world, this is a pretty sexy industry. A lot of people have really liked this industry. It's been rolled up a fair bit. And what that basically is, and the reason searchers like is it's really sticky, right? There's like recurring revenue. You go. you're answering tickets, you're on a monthly retainer for all your clients. You know, you know how all their systems work. It's kind of hard to fire you because you got to retrain all the employees on how to go

to you, et cetera, et cetera. So they can be really good businesses. But Heather, as you pointed out, I think they might be fibbing in the title a little bit because you said there's only 18% recurring revenue, but they said, of course, managed IT services. And then in little small font, they said that they sell equipment also. Right. And you have to watch out for that in this industry because if a big chunk of revenue is coming from selling equipment, that's just one-time revenue, usually with really skinny margins.

I was also kind of intrigued about the whole paragraph they're talking about the facility. 18,000 square foot building is pretty big with a big warehouse. That sort of speaks to maybe selling equipment rather than really doing the managed services that folks are usually interested in. I would also say that I've seen these MSP companies, a lot of them go fully remote since COVID. If they're truly doing the MSP work, it's kind of, you know, computer desk work. And those employees have tended to stay in a work from home environment, you know, since COVID. So it kind of seems like a huge facility for a company like this to have. Yeah, I agree.

So we use an MSP here at National Dog, and whenever I zoom with them, they're all in their homes. Exactly, as you said, right? Because they're doing remote IT support and configuration and all that stuff. And, you know, this business has an 18,000 square foot building and all these employees. The other thing that tips me off that I think they're selling a lot of equipment is their margins suck. Right? It's 13 million sales and 683,000 in cash flows of 5% net margin. I would think, Heather, do you know what's typical for this?

If this were like 100% services, I would think better than that, right? Yeah, it would be much better than that. That's exactly right. The selling of hardware and maybe software even is going to be really low margin, and that would put you closer to this 5%. It sure does look like that's what they're mostly doing. Yeah. They say they've got $161,000 of equipment, and then they say PCs, notebooks, servers, storage area networks, network gear, warehouse equipment, and office, FF&E. So, yeah, I think there is definitely a kind of parts and PC distribution model that's pushing a lot of this revenue. So the first thing I would ask

I know, Heather, you saw you pulled out, it's about 18% recurring. But is anything else actual services or is the other 82% entirely selling computers? And that would really scare me. That exactly right. That would really scare you because that's not going to be repeatable on a consistent basis. And, you know, you might be looking at revenue and earnings on this teaser. That's the best year they've ever had. Or if we look back, you know, three or four years, it's pretty inconsistent.

year-over-year if it's just hardware sales. We'd for sure see that. And I think what lines up with that, too, is they say when they talk about service areas, so this is based in the Twin Cities. And they say that 75% of their revenue or their clients are local, 10% are regional and 15% are national. And that would suggest to me that some part of their business is, I need a new hard drive right now, like drive it across town and install it, which in and of itself is not bad.

because if it's like that mission critical stuff, you can charge an absurd premium for it, right? I have a funny story about this. My wife used to work at a large filtration company. They made filters like air filters and car oil filters and stuff. And they ran at SAP, on-premise, SAP, ERP implementation. It was like a bazillion years old and running on all this custom hardware. And one day, one of the drives broke.

like one of the hard drives broke, and they did not have a backup. And it took this multi-billion dollar company to a standstill for lack of like a drive that was not made anymore. The whole company stopped because they couldn't, their ERP was toast, couldn't move. So they paid a guy $100,000 for a $100,000 hard drive that he had, like, this guy must have bought it on eBay or like had it in a closet or something. But they were down for like three or four days. And this guy like flew in from some other state with the hard drive and sold to them for $100,000.

Wow. I have never heard of that other than for like boat repairs, like yacht repairs. I've heard of that kind of thing. But yeah, this could be that kind of thing, kind of emergency, you know, repair. I also notice that they've got 10 people in sales out of 39. And that kind of speaks to, you know, a lot of selling. a lot of one-time selling, not recurring repeat customers. Yeah.

And you see a lot of that with the hardware, too, because it's like, oh, you're open a new office. Do you need a whole bunch of computers or chairs or phones? You used to see this a ton with phones. I think we've done a couple episodes on telephony, hardware resellers. And it's just a tough business. Yeah. A lot of outbound sales, a lot of cost. Yep.

Yep. Now, what I do like about this business is it's been around since 1992. So that's some serious longevity. I would imagine you're pretty integrated with some of your customers. And that's why I'd want to understand, like, are they really churning 82% of their customer base every year? You know, if it's not recurring revenue, do you have to go out there and get 82% in hardware sales back? Or maybe is there some, you know, kind of long-term client relationships where it's billed hourly, but it's not retainer or something like that? I'd really want to dig into that, quote unquote, non-recurring and see if maybe some of it was a little bit reoccurring, at least.

Yeah, they probably have some sticky relationships that don't have standing orders, but that they repeatedly sell to, I would think so, yeah, or something this old. Yeah, and I mean, like, going down the listing, you know, they say that they've grown SDE every year. This is a hilarious graph. This is from Mills, who's not with us today, Mills' favorite broker, the firm. who he cannot help or rant about. There is a graph on here that shows their cash flow went from $416,000 to $565,000 to $683,000 over the last three years. So it's growing really nicely, but the Y axis on the graph is just $0,000,000, and then $1,1 million. There's like not enough degrees of precision behind the decimal to even tell what's going on.

So really bang up work by this. Well, not only that, but it's 2018, 19, and 20. and that's a little old. Yes, a little old. And that's what's interesting through, so 2020 is the COVID year. So their gross sales are flat. It was really interesting. So sales-wise, they went from $9 million in 2018 to 13-6 in 2019 to 13-0 in 2020.

But the SDE went up substantially from 416 to 683 kind of over that period. Yeah. So better margin. A little, from 4.1 to 5.2, a little bit better. Which actually shows you the power of margin points, right? Like one margin point, you know, puts $130,000 in the sky's pocket. Yeah, and I'm just curious, you know, that's 2020, probably their best year. What's happened since then?

Yeah. I would think there was a lot of buying of equipment when the work from home took place in 2020. and you'd think that that would have cooled substantially in the last couple of years. Yes. So what's interesting is I'm sure there are actually a lot of businesses like this that have really crushed it because of COVID, right? You had maybe you had a whole bunch of employees on site, right? And you justified your on-site IT guy and all that stuff. And then everybody goes work from home and all of a sudden you're managing this kind of distributed cloud infrastructure, right?

And people are, your desktop users are having problems, but they're not in one place. and it's remote support anyway, you know, I'd imagine there are some of these MSPs that have just crushed it and all these, all these companies, you know, the demand for MSPs, I would think, has gone way up. Yeah, absolutely. I would think so. And it's interesting that they haven't sold into more recurring revenue contracts in all that time. It's, you know, it's a mature business from, in terms of, you know, how long it's been around.

But it's not mature in terms of, you know, converting customers into, you know, recurring revenue contracts. That would be an interesting thing to kind of understand why. Yeah. If I had a guess, as we've already postulated, I think this is much more of a repair business. So of their 39 full-time employees, 19 of them are in the service department, which I don't know if that's like actually fixing and reconditioning computers in that warehouse. I don't get the sense they mean like service in that they're on Zoom all day doing remote customer support. I think you're right about that. it's a pretty heavy staff for what they're doing.

Yeah, I just get the sense they've got a lot of computers in a warehouse. But, you know, and some of these are really interesting. Have you received, like looked at the liquidations business? Have you ever financed any? I have not. No. Like, there's these whole businesses that await and that these have had a COVID wild ride, right? Like, if you close your office and you're like, I've got all these computers and phones and

servers and I don't know what they're worth and I just want them to be gone, you can call these liquidators. and they're just like, we'll buy everything. Like, here's $100,000. And you're like, oh, great. And you just get to hand the keys to the landlord and they sweep it. So then they take all of your desks, all your computers, all your phones, all your chairs, all your everything. And they like value it all.

And then they recondition it and then go out and probably the sales team from this company goes out and tries to sell it to other companies who are opening offices. And so you can, I've seen guys make just oodles of money doing this. I mean, I'm in YPO and there are like, I feel like I meet another YPO or like every week who is a liquidations guy. It's crazy. And it happens in every industry, you know, clothes and overstock in the Amazon warehouse and everything. But there can be huge dollars in it. Oh, yeah. I can imagine.

Well, I'm looking at the structure, of course, being as a lender here, I'm always thinking about the structure. And I'm looking at what they're suggesting here. They're suggesting a bank. loan of a million $650. Obviously, a business of this size, that's going to be an SBA loan with a 10-year term. Of course, they're using the old rate of 6%. That's no longer the case. You're going to be paying over 10% now.

And that's, you know, 1.65, 75% of the deal at a 3.75 multiple. That would work from the year that they gave us, the $683,000. What I think would be really interesting is, you know, some sensitivity testing on that. you know, what would happen. Let's look back, or let's look at the years since COVID, and I kind of bet that the cash flow hasn't been as high, and the debt coverage might not be there. So I might go with a little lower leverage on a deal like this if I were to buy it at all. I would be really worried about buying, you know, this company just based on the fact that it does seem to be equipment sales, and that is really going to be probably inconsistent revenue

year over year. You know, you make a good point about the sensitivity testing. This is why I'm so glad you're on the podcast. You come at it from the lender point of view also, which is that you've got, everybody buys a business and they're like, oh, it's going to go up and to the right, right? Or at least it'll keep doing what it's already doing. But that does not always, like there's a third option here, which is that it shits the

bed. And you've got to think about that on the front end and go, how much can this decline before I can't pay my debt? Absolutely. That is the way lenders have to look at the deals is not what could go right because we're not investing and sharing in that upside. We're always looking at what could go wrong to decrease this cash flow and make it so they can't pay. So yeah, I think when you're thinking of debt and how much, you have to think of shitting the bed, as you say. Yeah.

That's one of the things you told me once that always the kind of rattles around in my head is that lenders don't get any of the upside. Right. Exactly. So, like, no matter how great it goes, the lender gets 10% or whatever a year, but not really because there's a spread on cost of capital, right? So it's even less than 10%. It's even less than that. And in fact, in today's environment, it's less than before because margins have been squeezed due to deposit costs. So, yeah, the lender's got a very limited amount that they're going to make on a good loan. And they can't afford very many bad loans, bottom line. And And if you have a great deal and you just knock it out of the park, we're always going to be happy for you as a lender or your bank is going to be happy for you. But they're not sharing in that.

They're just getting paid off. And they're probably getting paid off sooner than they want to be. Right. From a lender's perspective and don't share anything proprietary from your past life, but how does a lender look at cost of capital for a loan like this? You know, if they're just make it easy, right? If they're lending money out at 10% on an SBA loan, you know, they've got a cost of capital and it's deposit cost or its treasury's cost, you know, or whatever, or it's their whack or however they do it. How do they think about it and where those numbers come in? So like what's, what kind of spread does a bank take on a SBA loan?

Yeah. So with an SBA loan, there's kind of a little bit nice, nicer math for a bank because of that SBA guarantee. But from a, you know, strictly from a margin perspective, they're looking at that bank's net interest margin, which you're going to see all the bank's earnings. you can look at any bank and see what their net interest margin is. That's effectively what they're making gross on the loan. With an SBA loan, they're not taking any risk or having to hold any deposits for 75% of the loan.

So the actual cost of capital is a lot cheaper. And then they also have the advantage of being able to potentially sell 75% of the loan in the secondary market and kind of accelerate their earnings on that and take all their earnings kind of in one year instead of over time. So they have a number of more interesting levers to pull with an SBA loan to make money and reduce risk, which is why SBA loans tend to stay flowing, you know, or banks keep lending even in a difficult environment, much like we have today where, you know, conventional debt has really dried up quite a bit. And SBA really hasn't changed all that much. But that's kind of the point, right? That's the SBA program working, right? Like, that's what it's designed to do. Exactly. That's right. it provides that government guarantee so the banks essentially i want to say don't care but care a lot less about you know the macro environment or even the creditworthiness of the borrower than they would

otherwise without that backstop that's right i mean the simple way of saying it is the bank can afford to take a lot more losses 75% if you will more losses in their sba program than they could afford to take in their conventional program um so that's really that's the that's the key difference and that is why the sba is there it's it's actually really really critical to our economy. Yeah, it's, it's a really awesome program. It's, I talk to my friends that are not American and it blows their mind, the SBA program, because they don't have anything, no country, to my knowledge, has anything like the SBA program. There's one. There's one. When I worked at a bank that was Japanese-owned, we had folks come over from the, the Japanese parent bank in Tokyo and spend

a couple of months and we get to know them. And they, I explained to them what I did. And I said, I'm sure you don't have this in Japan. They said, oh, no, they pulled it up on their iPhone, translated it in English, and showed it to me. And said, we have it. And we use it for everything. All small business loans are in the government program in Japan, which I thought was.

That is cool. I didn't know that. Yeah. Which is also weird because it's not like Japan has a super vibrant entrepreneurial economy, though, does it? Yeah. No, they don't. But at least for capital, it's probably a situation where if they're going to get a loan at all,

it has to be backstopped by the government in Japan. So they do that. Well, so that's the other kind of interesting market distortion that happens in the states, right? Like, so we have this great program, the SBA program, which is very attractive. But it becomes so attractive, it is functionally impossible to get a small business loan that is not an SBA loan in this country, right? Yeah, we're almost to the same place Japan is in a sense that way. Correct. You've really below a certain EBITDA, and I would say that's probably.

probably 3 million right now, it's almost impossible to get a non-SBA loan. And that's good news and bad news because the good news is if you're a buyer and you're trying to negotiate a deal that will be SBA eligible, your seller's going to find out that they kind of have to do that. They don't really have other options. So it makes it a little bit easier. But it is the only game in town for a smaller company. At least it's a good game, right? Like it's a 10-year and more, I guess it can be five, right? But it's usually 10. And it's reasonable. I mean, it's what, spreads of like 500 basis points over treasuries roughly or LIBOR?

Well, it's a spread over Wall Street Prime. SBA has always been based on that. And maximum is 2.75 and averages two, two and a half for acquisition deals that don't have real estate. Which is damn good if you've ever borrowed. If you ever done any non-SBA debt, that is pretty thin spread over private. It's pretty thin. And also you don't have any covenant. You know, for a lender like me who has lent in conventional space,

covenants make it really difficult to grow your company because you can't spend too much. You can't shrink your EBITDA too much. With an SBA loan, you kind of get free rein to do what you want to do after you buy it. I heard this from other SBA lenders, not you, of course. But I have heard that once you basically originate an SBA loan, as long as you keep making those payments,

no one is ever checking up on you. even though you sign all those papers and there's all kinds of, you know, things you can't do and things you shouldn't do and, you know, things you're prohibited from doing. I have heard that as long as you just keep making the payments, you will never hear from anybody. They can't really do anything other than call you. That's all. If your financials don't look that great, but you're still making the payments, they can't do anything. So, correct, basically. Yeah, there is nothing.

I think I even talked to somebody once who, his business went out of business. And rather than default, he just kept paying the loan because it was really cheap and long term. And he was like, geez, if I default, I'll have to declare personal bankruptcy or pay it all right now in a bullet. So he just kind of like didn't say anything and just kept making payments from his personal account and then just paid off the loan. I believe it. If you have the cash flow to keep paying where it doesn't really matter where it comes from,

the bank's going to accept the payment every month. Right. Right. Yeah. Yeah, it's a good program. So back to this deal. The risk, though, when you lever up like this, this deal has a 5% EBITDA margin on 13 million of sales. So the problem, though, is great, if this margin point goes from 5 to 6, you just made a significant percentage more money, right?

Your profit just went up 12.5%. Or sorry, you just went up 20% from 5 to 6, right? Like, that's a big jump in your profit. But you go the other way. You go from 5 points to 4 points to 3 points. you go from five to three, you're not servicing your debt. Right. You know, like it happens real fast.

So you can have a 2% swing in net margins and not service your debt, which is super scary. Yeah, absolutely. And this has been a business that, like you said, it's been around a long time, but it probably didn't have debt all that time. So this person that's been running this business was able to go with skinny margins. That's what it took to keep people employed and keep the lights on during those times and get better margins when they could. But when you've got debt, you don't have that option. You won't be able to make your payment. So, yeah, I think a skinny margin business is kind of scary to put debt on for sure.

Yeah, overall. I mean, skinny margin businesses are very, very scary for a lot of reasons. I mean, even if you're not levered, right, pretty soon in a skinny margin business, you can have a job and be working for free as the owner, right? I mean, pretty quick, that cash flow can compress to almost nothing and you're working for free. and you're really in trouble if you got debt. So thin margin businesses scare me. I don't like them.

Yeah, I agree. So, Heather, is this business saleable? I mean, it's got almost $700,000 of cash flow, supposedly. It's got 450 clients. Is this a saleable business? I don't like it. I wouldn't buy it. And I think it would be tough for someone who did want to buy it to get debt for it.

I think it would be a tough one. Do you think there's a small one? structure or a price that does make it transactable? You know, the price would have to be maybe three or below, depending on how inconsistent that 683 is. And the seller note would have to be a lot bigger. They're offering 12.5% here. You'd want a seller note that's big enough that in your downside scenario, if you turned off

the payments to the seller, you'd still be able to make the SBA loan payment. So that could be 20%. It depends on what your downside scenario looks like, but maybe a lesser multiple and a bigger seller note, maybe. Yeah, any version of bank debt scares me on this one, especially personally guaranteed bank debt. You know, the deal I would take this seller is, you know, how about one and a half million dollars? You know, I'll pay, you know, it's their price of 2.2 right now. I might say, I'm going to pay you 20% of EBITDA until you have received $1.5 million. Yeah.

Something like that. And that's really clean because his payments scale down. As EBDA scales down, his payment scales down. As EBDA scales up, you pay him faster, which is fine. But he shares a lot of, in a lot of your risk in that structure. I think that would be a smart way to go with this one. Cool. Anything else to add in this deal?

Not for me. All right. Well, cool. We'll wrap it up there. Thanks for being on, Heather. It's awesome to have you. You guys will be hearing a lot more from Heather on her wisdom from the lender side. She is a regular part of our pod now. I will rotate through with Michael Mills and I co-hosting.

So hope you all enjoyed it and we will see you next week.