Acquisitions Anonymous - #1 for business buying, selling and operating - Is this design agency a good buy? - Acquisitions Anonymous episode 145

Episode Date: November 29, 2022

Want to receive this listing in your inbox? Signup for our weekly newsletter:https://www.getrevue.co/profile/acquanon-----Michael Girdley (@Girdley) and Mills Snell (@thegeneralmills) talk about a Productized design services agency for startups that started in January 2020 in New Jersey. We discuss how this business works and what we think about the business model. We also discussed the status of Agencies in this macro environment. The two also share their insights on strategies to buy this business without setting aside the year-to-year expected revenue.-----Thanks to our sponsor!SMBash.com - Join us in Austin, TX from April 27th - 30th, 2023, for one-on-one interaction with others who focus on buying, operating, and investing in the SMB and Micro-PE space.SMBash is a live gathering of SMB, Micro-PE, and ETA owners, operators, and investors.-----Show Notes: (00:00) - Introduction(01:01) - Our sponsor is SMBash(02:24) - Mills & Michael catch-up(03:25) - Deal & financials: Productized design services agency for startups(07:01) - How does this deal work?(08:54) - What do we think of this business model?(10:14) - How is customer relationship management in this business?(13:41) - What happens to Agency businesses in this macro environment?(16:18) - Why is this a “mullet” business? How does that work?(18:25) - Why would Mike pass on this one?(21:57) - What is the bull case for agencies?(25:19) - How would Mike negotiate this deal?-----Additional episodes you might enjoy:#143 - Is this cell tower business any good?#142 - Should we buy this Crossfit Gym?#141 - A very profitable B2B Internet Business in the Petcare Vertical#140 - Let’s SBA the heck out of this deal - with special Guest Heather Endresen-----Subscribe 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]

Welcome back, everybody, to another episode of Acquisitions Anonymous. I'm Mills Snell, one of your co-host, joined today by Michael Girdley. We talk about a really interesting agency, design, branding, landing pages, pitch decks, and this agency caters specifically to startups in the startup community. It's priced kind of uniquely. They're trying to price it based on a multiple of revenue. So we talk about that. We talk about maybe some of the inherent problems with that. Talk about their niche, especially right now, that the VC world is down cycling pretty heavily and funding is not as plentiful as it used to be or has been over the past few years. So we talk about some deal structure considerations for something like this where there's a lot of goodwill associated with the owner and their team and whether

or not a business like this is viable and is sellable. And we hope that you'll enjoy the episode. Big thanks before we go to SM Bash. Really, really great group of folks, attendees. And we We'll see you there. Today's sponsor is Essend bash. Yeah, I made it to the conference last year in beautiful sunny downtown Orlando, Florida. It didn't sun, by the way. It rained the whole time. But it was a great conference.

So, yeah, they're sponsoring again. And, you know, I think we love that show. I love speaking at it. And I think totally recommend everybody consider going, especially if you're a small business owner operator who wants to think about M&A. You know, it's a great, great conference. So I know you missed it last year. I was super bummed.

I tested positive for COVID. one hour before I was supposed to get on the flight. And I was like, maybe I could just ignore this, but it was definitely not the case. I got laid flat on my bottom. I liked it because it really opened my eyes up to kind of the future of conferences. Like, I think the days of like Web Summit or like Dreamforce are these like huge like giant conferences, like they're so lame. Like I don't think anybody wants to go to those.

But I think much more intimate type things like with Asin Bash guys did. Super curated. Yeah. Yeah. that you get more focused content around what you're trying to do. You get people that are much more like, you can have real conversations with people and they can curate who comes. I think all that's really cool.

So, thanks to April and Austin. All right. Well, we're happy to support them and we want them. So go there. And you can go to smbash.com. Is that right? Smba, sht.com sign up. So tell them we say, yeah.

And we'll go from there. All right. Hey, Mills. I just want to tell you, I'm sorry for telling everyone in the last episode that you were in Florida and then inviting you to invite you to their house. I'm going to get, I'm going to get OSHA citations in the mail because somebody heard that I was in Florida doing roofing work. Practicing roofing without a license.

I'm so sorry, dude. No, we don't. The guy, the guy who texts to me, he's a local guy. He's a student at Carolina. And he was like, dude, are you in Florida? I was like, no, I'm not. And I haven't been. Please don't spread that rumor.

Yeah, I don't hang out with those people. All right. All right, okay, I got a deal today, and I'm pulling it up. So it is from our friends and tied for first with most favorite sponsor, Microacquire. So they have a listing here that I saw. And I think it's really good because we haven't done an agency before. And I think agencies have incredibly interesting market dynamics, and so I'd love to do one. So here I pulled it up, for those of you on YouTube.

and this is listed as a platinum startup, and that is a micro-acquired thing that has at least $250,000 in trailing 12-months revenue. They are asking $7 million for this business. Mills, do you have your checkbook? Yes, it's ready. I'm writing it as we speak.

Okay. So it makes me think of a story. Okay, I can't tell that one, but I'll think of it later. Okay, I'll tell the story. Okay. So I had a guy that I was friends with once, right, and still, still acquainted with him. And so he was a really rich guy. So a crazy person found out he was a rich guy and came to his house.

And the reason I found about this is the really rich friend came to my office and was visiting with me. And he said, he showed up with a dog. And I was like, why are you carrying around a dog, dude? And he's like, well, this crazy person came to my house and tried to shake me down for a bunch of money. And so this guy shows up and tries to shake him down for a bunch of money. And he's a crazy person. So my friend who's getting shaken down, he says, well, I don't have the kind of cash here that you're looking for. Do you want me to write you a check?

And so the guy goes, yeah, I'll take a check. So like he invites him in the house to sit down around the coffee table. He writes him out like a multi-million dollar check and the guy just leaves thinking he won. So he wrote the guy like a $2 million check. Like not much money for this really rich person, but a big, huge check. So the next day, next day they catch the guy, the guy, the crazy person, they catch him down at Bank of America trying to cash the check for cash at a neighborhood bank of America. So my acquaintance is telling me this story.

He's got the dog right there. And he tells me, that's why he has the dog. And he said, well, they caught the guy. And then I asked him, and I asked my friend, I was like, did they, you know, to ask the rich guy. I was like, well, did they, did they arrest you too? And everybody goes, why would they do that? And I said for writing, for writing a hot check. And he did not think that was this funny. Dude, you do not accuse, you do not accuse super rich people of only having two million dollars in their checking accounts. Anyway, so that's a little

story. Okay. Anyway, so since you have your checkbook, we'll go back to work here. All right. So the deal is listed for $7 million. And it has a 2.2 trailing 12 months revenue multiple. which I think I want to dig into. Let's put a pin in that because I want to talk about this concept of using revenue multipliers to talk about valuing businesses. So, Date founded January 2020, he or she has 17 employees working for them, located out of New Jersey. This is a productized design services agency for startup, a profitable agency with $3.2 million

in trailing 12 months revenue and $612,000 in trailing 12 months profit that has a team capable of designing everything from branding, landing pages, product design, decks, and more for startups. They do it under a simple, flat monthly fee model. So over the past year, they've had $3.2 million in revenue, $600,000 in profit, $232,000 in revenue last month, and $33,000 in profit last month. They have some competitors listed here, supersized, awesomic, craftwork studio, and I'll pause there. Any questions about what we have so far, Mills, or anything not clear? I don't know what a lot of those things are, but that's okay. What is figma?

What is? Yeah, what is, I mean, I know, I know what Slack and Asana and Notion are. But like, you know, I'm genuinely curious. So what this company does is they do a little bit of everything, like branding. I mean, do you think this is like logo design? Like, I mean, when they say like decks, Do you think they're making pitch decks for people? Like what do we think they're actually doing?

Yeah, so typically people sign up for something like this. Let's say you're a startup and you don't have, you have two things going on. One is you have very lumpy kind of design needs. And two, your design needs are potentially very broad, but not enough to where you would hire a person to do each one of those things. Right. So once you get to a certain size, say you're, you know, let's say Andreessen Harowitz, It's like a big VC firm with 1,000 people.

I guarantee they have two people whose job is just to make pitch decks for them. That's what that person does. And you have a specialist around that. But say you can't afford that or it doesn't make sense for you to do that when you're a 10 or 12 person startup. You go pay a service like this to basically be your outsourced design and artistic department. And these agencies, they like this business model because it's recurring revenue, right? As opposed to just doing like project work.

It's just like, hey, you pay us every month. And then you send us work and we'll give you up to this amount of hours. And that's what they do. So it could be they could have one person who's a specialist in deck design. They have another one who's a logo design agent. They have another person who helps with like basic branding. There's another SEO person. But, you know, basically on the back end, you have 17 people in your agency and you sell 10% of them or whatever and kind of fit to what your startups need.

So this is for companies before they get big enough to have a full design and branding group inside. and you go and say, okay, I'm going to go higher with this group, and they're just going to be fractional for me. What do you think about the like all you can eat buffet model of this? Like we'll charge you a flat fee. You get unlimited design requests. As a business model, it's fantastic. Like it is so much better.

Like if you talk to everybody I know that has, that's doing agency work, like their agencies are so much easier to run and so much more profitable if they do this kind of all you can eat thing where you have recurring revenue that you can plan around. Because otherwise, you end up in the other end of the spectrum, which is kind of like any other contractor has this problem, right? Which is you're having to go eat what you kill all the time, right? And you're having to bid projects and all that kind of stuff. And unfortunately, demand ends up being really hard to predict.

So you have these swings. Like I had a buddy once who had an agency that would do custom software development. In 36 months, they went from 20, 25 employees to 125 employees back to 25 employees. Like, how is that fun? That is not fun at all. And that was because they were taking out project work. And eventually they fixed it by building a product.

And that created 95% of the enterprise value and they eventually sold. So I love this business model where you're just like having some sort of recurring stuff where you're a partner rather than a vendor. And that really helps. Now, the other side of it is you can get into a lot of trouble because, It says unlimited design requests. So I had a friend who went to this model, and he's business looked up and a third of their customers were unprofitable because her staff was, or his staff, his or her staff, was highly motivated to make the customer super happy. And that's how they got bonuses.

Well, you know what they did? They gave every customer way too much value for $10,000 a month. So you have to manage it right to make it work. But man, as a business model, I would a billion percent tread. be a recurring revenue agency, then I would be a project-based agency. And you've got to think, I mean, in any situation like this, you're going to have customers that, you know, you're making money on, right? It's to the good. And others that, you know, probably a very small portion of them that just totally wear you out. And it's like people who go

to, you know, one of those places that has unlimited toppings on the pizza, no matter what you charge. And it's like, that pizza is going to taste disgusting. Like you put like three pounds of chicken on it. But they're like, no, I'm getting my money's worth, you know. When I was a younger man, by the way, I was, I had a lot of free time on my hands and I'm an optimizer, looking, always scheming. So one time I went and took pictures of the, the buffets at Caesar's Palace. And I went and did an analysis of what was the highest, how to get the most out of my money, because you're going to pay $130 to go on an all you can eat buffet at Caesar's Palace. And I figured out two things about it. Number one, the crab lid.

are the biggest like bank for your buck. Like if you want to eat the most dollars worth of food, you go for the crab legs. The other thing is you, they will tell you basically what is the most expensive food by where they put it. Like the stuff that's way back in the back, like super hidden, that is oftentimes the lowest margin for them on a per pound basis. So that's where, those are kind of the two tricks, the two hacks that you can go to if you want to optimize your return on investment from a Caesar's Palace buffet. So it's not the breadsticks. That's not what you should go get the most bang for your buck on.

No, it's the French fries. Yeah. Anyway. But yeah, I mean, and the way that that's just, I think this business model can totally work. It's just the idea like when you do this, you just have to be super duper mindful about it, right? You just got to make sure that you're managing your clients really well. and dealing with it that way. You're dealing with churn, too.

You know, okay, like at the end of the day, if you're not delivering value for somebody and they're like, oh, my gosh, we're paying this, you know, agency $6,000 to $8,000 a month. We haven't used them in two months. Let's get rid of this thing, which is why they're giving discounts for three, six, or 12-month contracts because they're like, hey, you know, use us and don't think twice about it. 100%. Well, and then so there's two things that are worth thinking about with this. business. Number one is, this is the, their customers, it says, we our customers are startups.

This is the worst VC funding environment in the history of like my, my, you know, it hasn't been this bad since like 2001. Like things are really, really, really, really bad right now. The tide has come out. VCs have no more money. Startups are scrambling to try to try to figure out how to go to survival mode. And guess what, guess what happens? Guess what? Guess what? gets happening to this business, the second the VC funding spigot ends, right? You're going to, instead of spending $10,000 a month, like, you're going to fiber, right? That's the way this is going on. So to me, this is a big, big problem for this business and why it scares the hell out of me at this point is, yeah, I think this person started their business in January 2020 at peak VC euphoria and

rode the wave up to what it is. And there's nothing but headwinds in front of this for the foreseeable future. Now, could you hope that some startups trade down and fire their designers and come do this? They're not doing that. They're going to five or two. Like, they're all scramble to stay alive. So that's a huge headwind for this business. So I'll pause there, but I have one more insight about agency businesses general. Yeah, one thing to piggyback on that is, you know, I wonder about the role of specialization in an agency like this where, you know, if you can do everything, right, You can do, you know, branding, landing pages, product design, decks. Like, if you're the one-stop shop, you may lose some of your, you know, I guess selling power, right?

In pitching folks, especially in a down market because they may go, hey, look, we don't need an all we can eat buffet. We really just need, you know, a refresh on our deck. And we might be able to pay somebody, you know, two grand to do that. But they're really good. They are the expert, you know, or. These are the logo people. This is who everybody uses for logo design or whatever. I would be a little bit worried about just being the generalist in, you know,

in a downward trending market. Yeah. I mean, I think that's a challenge. I mean, there is a benefit to them being a generalist, I think, to give the, the bull case for this. There is, you know, VC and startups to some extent are a, are a place in which signaling is like more important than anything else. Like, there's, than any other industry, it's all about signaling.

And for example, like, having been on the other side doing VC investments, if somebody showed up with a deck that looked like it was from 2005, like, that's a signal. And that's a really bad signal because VCs and investors and folks dealing with startups are extrapolating on very limited information, like very limited information. And so a situation like this where somebody's an all you can eat sweet, potentially is very good because I would want somebody building my deck. So it looks like the zeitgeist of the trends that are going on right now. So I'm a big fan, you know, actually of this.

And I can see it like you're saying, there's two sides to it. Like it's a double-edged sword. What do you think about it's based in New Jersey and they have 17 people? I mean, are these businesses, in my impression, are just almost 100% remote. Do you think that's the case here? If done well, if done well and done in a way that's sustainably, this is what I call a mullet business have you heard me talk about that before business in the front our new podcast our new to the podcast a mullet business is a business with u.s leadership or u.s. kind of sales reps

and then all the real work gets done offshore right so all the stuff that you need an american to do to develop relationships and stuff like that and do business in a very native american style that person is in the u.s and then there's people overseas doing this so it looks like they're maybe not doing that. It wouldn't surprise me if this is all native people in, you know, Red Bank or some random town, you know, in Northern New Jersey, Summit, New Jersey or something. If I was to get into this business, I would not, you need to leverage overseas talent or you're not going to be price competitive. There's just no way. And I've looked at my friends who do agencies' mullet style and the ones that do them with all U.S. talent, guess who's happier?

the mullet ones like they make more money it's let's hassle like it's just it's just labor arbitrage in terms of making it all work there so yeah to answer your question like there does seem to be an opportunity in this one to like not do it all with us talent which i think would be smart and i mean i think that reflects their margin right i mean agencies can be more profitable than this kind of roughly 20% margin that they're running if you are very lean from an overhead standpoint, and everything is basically just like a cost of goods sold. It's cogs. Hey, look, we did this work.

We outsource this. You know, we're charging, you know, maybe a hundred times or 50 times more than the cost of, you know, our overseas workforce. 100%. So brings me to my second point with this, which is why I would not buy this business. Like here's the reason not to buy this business. they are asking $7 million for this business. Now, okay, it is what it is.

So let's do the math there. $7 million for the business, and they've done $600,000 in trailing 12 months' profit. If the business stays the same size, it will take you close to 11 years to get all of your money back. Pre-tax. Pre-tax money. 11 years.

Like, it's really interesting when you talk to a seller, by the way, and you do that math for them. And they're like, okay, I want four times revenue. I was like, okay, if your business stays the same size, I will be 67 by the time I get all my money back. Do you understand what you're asking me to do? Like, that does not work. And this business is very subject to the whims of change, right?

Like, this business is not going to look in, if it's still around in 10 years, in 11 years, it's not going to look anything like this. Okay. And you could say, all right, well, two times revenue. Great. Like, or 10 times EBIT. really how they should be talking about this.

And this is, I want to get on a soapbox and talk about using revenue multipliers as a shorthand where it just does not make sense to use it. And this is one of those cases. This is an EBITA business being sold as a revenue multiplier. Like you should be back of the envelope valuing this business. I've got like my Mussolini hand, by the way. I'm like, look, like, like, Khrushchev.

You ever did you, there was a speaking book, by the way, that was called Khrushchev's shoe. And it was back in the 90s where it was supposed to teach you how to be an authoritative speaker. And it was famous because Khrushchev, who is the premier of the USSR at one point, like during a speech, took his shoe off and started hitting the dice, like started hitting the podium. So anyway, the book was called Khrushchev's shoe. And yeah, it is not, it is not continued on into the pantheon of great business books. It's not read anymore. For some odd reason. For some odd reason. But yeah, so this is a perfect example where like revenue

multiplier, like, it's useful sometimes. High growth, high margin software startups with recurring revenue. By all means, don't use EBDA, don't do EBTA multiples to value these businesses or think about what's fair. But, like, this is not one of those cases. This is an EBDA business. This is a cash flowing agency services business with high churn, and it requires you most likely to work in the business to keep it going. Like, it is just the wrong lens to use to think about this business. But when you look at it from an EBITA multiple, like, come on. Like, it's just, no, it's not, it's in fantasy land. Yeah.

And I think, you know, the only case, right, where somebody in this position could command, you know, a 10x or an 11x EBITDA multiple is if they have some, you know, hugely differentiated recurring revenue model. Like, if these customers were so sticky, like if it was highly regulated or there were crazy barriers to entry, like, you know what? we do super specific work for the pharma industry and like basically we have no competition. Okay, there may be a scenario where you could imagine paying this much, but it has to be a function of, you know, de-risking the revenue and also it's a function of growth.

My guess is the argument they're going to make around this price, you know, this valuation is, well, look how fast we've been growing and they're going to project it out into the future if they're smart and say, look, we've been growing over the past, you know, two and a half, almost three years. You know, look how fast we've been growing. We'll cut our growth rate in half. And, you know, this is, this is, it perform us. It works.

But the reality is that you can't maintain this type of growth trajectory, you know, even macro characteristics aside. Yeah. I mean, that comes back to the other part of this. It's like, okay, to justify this has got to be grown quickly. But it misses the inherent dynamic of small business agency work, which is it's a great way to, without a bunch of investment, to create yourself and live a very, I would say, bordering on pretty rich life. You can make a lot of money running an agency,

and it can grow very quickly. The problem is it tops out. It tops out, by the way, right about where this person is. Tops out, you're making $600 to a million a year, and you've busted your for the last five years and been in there, making it all happen, you're never going to get above that. And it's because so much that business is based on relationships, and you can only scale your relationship so much when you're doing that. So your options to get bigger in an agency world are go upmarket,

which congratulations, that's a lot more competitive. And we've already talked about in this situation, how your bigger customers, naturally, once you get to a certain size, you don't need the service anymore. You hire a designer. Like, that's just the way it works. So you can go up market. Unfortunately, that's a totally different type of stuff.

Or like you just kind of grind it out, right? And live the vagaries of agency life. But every time I see somebody try to get above this level, they bounce back down. They do that 25 to 100 back to 25 person that I talked about before. So you can't grow this. Like it just doesn't work. Well, on top of that, what makes it even more difficult is this is all, you know, just non-transferable goodwill, right?

It is, it's, it's the owner's personality. It's the owner's relationship. They're probably not self-performing all of the design work, but the brand is almost always synonymous with the individual, even if the, even if the company isn't named after them, which most of them are, like, how can you get away from this person, right, having been the rainmaker for a long time? And people go, oh, yeah, I hired so and so. And most of the time, they're saying the founder's name, not necessarily the agency's name.

like within a year of that person being gone, all of a sudden the agency looks totally different. And those customer relationships, you know, probably don't migrate super well. Yeah. Yeah. I mean, this is another one of those businesses that maybe they find somebody to buy it. But I just don't see this transacting. I mean, where would you price this business if you were to buy it? I don't, I mean, I honestly don't know because like part of me thinks,

well, okay, maybe maybe their best alternative is to go to a key employee and say, hey, look, I'll sell or finance this, a portion of this. You can buy me, you know, buy me out over time or buy in over time. And the problem with that is that, you know, that person's going to do the math and go, why would I pay you all this? Because there's literally no barrier to entry. I could just turn around and do the same thing myself. And I probably have, if you're going to that person, they probably have enough of those

customer relationships anyways. So I think it's a total catch-22. I think this business usually ends up functioning like a bond, and you just clip the coupon for as long as you can. And there's not a lot of like exit value. There's not a lot of like residual value at the end of it. I see businesses trade like this for half to one and a half times earnings with an earn out on top of it. So maybe, I mean, maybe that comes back to your point, which is, you know, you tell me the price, I'll tell you the structure. Like, could you justify a $7 million thing here?

Yeah, you probably could. Like, okay, I'm going to give you half of your earnings up front. You know, so 300 grand up front. And then I'm going to give you 50% of all my distributions until you get to $7 million, assuming that I make $600,000, all my, 50% of all my distributions above $500,000 for the next decade. And then, you know, so if it grows, I'll get you to $7 million.

Otherwise, I pay you typical agency multiples for something like this. You know, the problem is, unless somebody's forced to, sell in that situation, they realize, oh, well, you know what would just be easier? Like, why don't I just hire somebody to run this for me? And I can make 400 grand a year and not do any work and, like, take a few customer calls every once in a while. Like, yeah, and if it, and if it ends up winding down, so be it. Like, I still, I still, you know, collected cash flow while I could. And I probably did better than trying to sell it and, you know, getting my, getting, taking a massive haircut. Yeah. Maybe they'll get it.

That's the great thing about selling a business. You only got to make a market of one. Got to find one sucker. Unfortunately, we'll not be anybody on this podcast. All right. Anything more on this one? I don't think so. Good luck.

Good luck. Enjoy this one. Oh, fun to do an agency one. All right, man. Good talking to you. We'll catch you next week.