Invest Like the Best with Patrick O'Shaughnessy - Royce Yudkoff and Rick Ruback – REALLY Private Equity - [Invest Like the Best, EP.33]

Episode Date: April 18, 2017

In this episode, I continue to pull on one of the most interesting threads that I have uncovered while producing this podcast: the world of permanent equity. My guests today are Royce Yudkoff and Rick Ruback, two Harvard Business School professors who have partnered to create a popular class that teaches students how to search for, acquire, and run a small business directly after graduation. I approach this conversation from an investors standpoint. LP investors usually partner with these searchers to form what is called a search fund. A search fund allows recent MBA grads to spend time looking for a business and ultimately acquire it. The result is a small scale but often high return proposition for investors. I loved our discussion of what to look for in a business and what to avoid. The principles we list are useful for investors of any kind, and will particularly appeal to those from the buy and hold, value investing, and quality investing camps. One point of note which wasn’t captured during the recording. One of the reasons this style of investing isn’t more well known that it is extremely costly upfront. It can take years to find a company, and once found, the transaction costs can be 20% of the total purchase price. Rick calls this category “REALLY private equity. If you enjoy this conversation, be sure to check our Royce and Rick’s book. HBR Guide to Buying a Small Business, which goes into many of the topics we cover in even greater detail.   For comprehensive show notes on this episode go to http://investorfieldguide.com/hbs For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

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The views expressed in this podcast do not necessarily represent the views of CFA Institute. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfield guide.com. Patrick O'Shaughnessy is a principal and portfolio manager at O'Shaunacy Asset Management. opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect

the opinion of Oshamacy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Oshonofy Asset Management may maintain positions in the securities discussed in this podcast. In this episode, I continue to pull on one of the most interesting threads that I have uncovered in the course of producing this podcast, the world of permanent equity. My guests today are Royce Yudkopf and Rick Rubach, two Harvard Business School professors who have partnered to create a popular class that teaches students how to search for, acquire, and run a small business directly after graduation. The course is aimed at students who want hands-on management experience as soon as possible. After purchase, there is no timetable for selling the business.

Indeed, if done well, there is never any reason to sell because the free cash flow yields to owners are higher than most alternatives. I approach this conversation from an investor standpoint. LP investors usually partner with these searchers to form what is called a search fund. A search fund allows recent MBA grads to spend time looking for a business and ultimately acquire it. The result is small in scale, but is often a high return proposition for investors. I loved our discussion on what to look for in a business and what to avoid. The principles we list are useful for investors of any kind, and will be particularly appealing to those from the buy and hold, value investing, or quality investing camps.

One point of note, which wasn't captured during the recording. One of the reasons this style of investing isn't more well known is that it's extremely expensive up front. It can take years to find a company and once found that transaction costs can be 20% of the total purchase price. As you'll see, Rick calls this category really private equity. If you enjoy this conversation, be sure to check out Royce and Rick's book, the HBR Guide to Buying a Small Business, which goes into many of the topics we cover in even greater detail. For show notes on this episode, visit investorfieldguide.com forward slash HBS. And now please enjoy this conversation with Royce Yudkof and Rick Rubek. Well, Royce and Rick, thank you very much for taking the time with me today to discuss a topic that is still relatively new to me. Probably discovered it just three,

four months ago. But I think from an investor standpoint and also from an operator standpoint is a really ripe and interesting niche in the world of investing, which is that of search funds. Maybe we could begin by you describing, pretending that I'm an LP, looking for interesting things to do with my capital. Sort of explain at a high level the idea behind a search fund and why both recent MBA grads, but also LP investors might be interested in this concept. This is Royce. I'll take a crack at it. Rick, I know you'll jump in whenever you see fit, but maybe the idea starts with the investment opportunity, which is across North America, there are hundreds of thousands of small businesses, Rick and I think of as businesses with anywhere from $750,000 to $2 million of EBITDA.

And these businesses often have founders who need to retire. The businesses are enduringly profitable, successful small firms, but there's no natural successor. And that founder needs someone who can organize a purchase and then run it as CEO. And that population is much smaller than the population of people reaching the end of their careers and these small firms. And for that and other reasons, these interesting, enduringly profitable businesses sell for around four times EBITDA. That's an amazing opportunity for an investor to buy a business that is very high quality, enduringly profitable, and trades it four times EBITDA. But they're hard to find because it's a very inefficient mechanism by which these

businesses are traded. And so what search fund LPs do is they will form a group and each pitch in a little bit of money to fund a searcher going out to look for a business to buy, vet it, negotiate it. And if they like the business, they have a right to put in a piece of the capital like a private equity investment. And that's the essential idea of search fund investing. Most of our students these days at the heart of business school, most of the students that go out and pursue this path tend to do it, tend to fund the search part themselves. So they'll have money from a prior job, a rich uncle, a working spouse, and through that run a very frugal search process, and then look to investors for capital at the time of the acquisition itself.

That may be a more intriguing investment for LPs because they can actually see what they're getting. They're getting a business usually that, as Roy says, is enduringly profitable. It's a business that's almost always easy to understand, easy to run. They can imagine it being run well by this person, that they can look at the company and get a sense of it. And usually, the equity interests are priced to earn 25% or more internal rates of return. Now, those are expected returns, but it's often a very attractive return. And what we find is so interesting is the equity for those kinds of transactions don't come from institutional capital. They come from people who have $100,000, $200,000 to invest. Because the equity need might be a million or $2 million.

They're not raising in enormous amounts of capital. One of the things about small businesses are, is that the businesses are small. That's not much of an insight, but it turns out to be the key insight. So because the businesses are small, they don't need big equity checks. They can raise it often in $200,000 or $200,000 pieces. And normally they're being raised from limited partners whose job it is not to be a limited partner, you know, they're the proverbial doctor, dentist, real estate, professional, private equity professional. They're people who have capital, but generally don't have access

to private investment. So the private equity professional probably has independent access to private investments, but, you know, most other people don't. And if they try to do it with a wealth management firm and they get a little piece of a private equity fund, they're going to pay crazy amount of fees, right? So this is a way to get access in a very personal way to the private space in the small business world. And many people find it very exciting, even at that stage, not the search fund stage. And we see, and I see investors doing just one deal, but then we also see people who are active in the space as investors accumulating 30 or 40 different participations in companies, so they can be quite active in it. Could you give me a sense for the

scale of this? So across the country, or maybe in North America if it happens in Canada as well. It does. How many searchers are there? How many schools sort of foster this idea? I know Stanford and Harvard Business have been sort of leaders. The leaders, right. But it's now, I think we looked and there are, you, I think, are the one who look.

But there's like eight or nine schools that offer courses like the ones, course not as good, but otherwise like the ones that Royce and I offer. Well, I think we can fairly say that we're the largest because the school is the largest. and Rick and I, out of our courses, which we really teach this area at HBS, we put out of that 20 to 30 searchers a year. And so, Rick, help me. My guess would be that maybe there's 50 or 60 searchers a year coming out of all the schools together, possibly. I think that's probably right.

So if you go back, Stanford, I think, keeps the best data on this. And I don't recall the numbers in the last one, but I was a few years ago. There had been, by their count, under 200 searchers total. Cumulatively. So maybe that number is much higher now. But it's not, it's not like big. Right. Right.

So there are clearly, I'm just trying to think what in finance is at the kind of 300 mark. You know, it's not like there are more than 300 hedge funds or more than 300 private equity firms. So this is really, I mean, as an activity, this is small, and each piece of the activity is small. So think about the transaction sizes are probably between $5 and $10 million on average, right, as a range. Right. So multiply that by a couple hundred companies, and that's sort of the – and then take 25% of that because the rest – because it's usually 75% debt funded in one form or another. So there's not a lot of capital really behind it.

But it's an intriguing. So there's an interesting cycle that goes on here that hangs together, right? I mean, the first thing that arrests an investor's attention is, my gosh, I could buy a high-quality, smaller firm for four times EBITDA. I would get a 25% EBITDA yield before any leverage or before any growth. And I lever it, and the yield is just incredible. Why does that exist? And it's really, to Rick's point, because these are small, they're too small for

institutions to come in and allocate $100 million, $200 million. So it's an individual's market. It's really individual investors, you know, comprise the bulk of the investors, working with well-trained individual entrepreneurs to do this. And that lack of by-side pressure keeps the multiples where they are. I call it really private equity. Yeah. You know, because it's really private. There's no professional necessarily engaged. It's really private equity. It's best. It's belly-to-belly equity, if you want. Whenever anyone hears returns like a 25% EBITA yield, that always makes me think, okay, how is Wall Street going to muscle its way into this and compete those returns down?

So do you see any sort of collectivization of this where you see someone raising maybe a $100 million fund and funding 10 searchers or something like that in a way to kind of capture some of these returns? There are some specialized private equity funds that have entered the space. They're quite small. They're specialized on backing searchers. And there are probably three or four of them, Rick, something like that. Right.

And they all a little bit different. Some have a kind of central funding vehicle. Some have some take it a step further and have a central sourcing vehicle. But, you know, in the end, if you think about a world that's been trained in kind of the two and 20 world, right? If you're making a million dollar equity investment, right, it's kind of hard to make the economics work. If you're going to make a half dozen of these a year, it's sort of hard to make the economics work. If you just sit down with a pencil and paper, you say, wow, you know, I want to get paid more than that if I'm going to run this, right? It's going to be a lot of work.

I'll have to deal with six, you know, full quarterly board meetings, times how many firms, how many firms? times, you know, LP phone calls, this is a lot of work. I might as well put more money in. I think I'll buy mid-sized companies, not these, you know, I don't want to write million dollar equity checks if I'm running a fund. Which is, which is why the investor base is largely high net worth individuals who are just writing a check for their own benefit, but really have a different career. Maybe we could pick one of your favorite examples to kind of walk, use a story to walk through the process itself of a recent grad, an MBA grad that wants to go do this. I'll let you guys pick the company and then kind of go step by step of how it's, how it actually

works. I'll let me kick off and you jump in, have that. So I'll pick one of our grads from about two and a half years ago. And this is a company which Rick and I invested in, so we know it extremely well, which is one reason I'm picking it. But Jennifer Brous is a young woman who's an engineer from the American Midwest, came to Harvard Business School to learn general management skills. And like many young professionals, never dreamed that the outcome would be going off to buy her own company, but encountered the search fund idea and became thrilled with the idea of becoming a CEO and general manager early in her career. So in her instance, she actually partnered after graduating. She partnered with us for advice and backing.

But as Rick said, the majority of our students will just go out and do the next steps Jennifer did and counter investors when they find the business. But what Jen did is she began an outreach program to some subset of the roughly 3,000 small business brokers that populate the United States. These aren't Golden Sacks or Morgan Stanley. There are firms you probably never heard of who trade these kind of businesses in the size Rick was describing. And pretty quickly, she was starting at an inflow of deals and confidential information memoranda at the rate of 10 to 30 a week. And she would funnel these down to a small number she's interested in using some basic criteria like recurring revenue, non-cyclicality, free cash flow, enduring profitability, and then reach out and start to learn a little bit more about the businesses price test and work her way down to some businesses where she could get agreement on price and in the range we're talking about sort of three to five times that fit the qualities

that these entrepreneurs are trained for. And I just emphasize these words, enduringly profitable businesses. These aren't venture capital. They're businesses that ran for 20 or 30 years and that are profitable year and year out. Here's the business Jen bought. Jen bought a regional company that processes insurance claims for municipal ambulance departments. So when someone gets hurt and is taken to a hospital and ambulance, usually out of the local fire department, that ambulance can charge Medicare, Medicaid, or the private payer for that transport. But they don't want to deal with the 20 or 25 different payers that they're constantly engaged with. That's not their business. So they outsource this to a company

that Jen bought called Systems Design West. She acquired this established company from its retiring founder. And that company essentially does the outsourced claim processing and remits the money to the ambulance department. And that's the business Jen bought, borrowed about half the money from a local bank, borrowed about a quarter of the money from the seller and a subordinated seller note, common in this market space, and the rest of the quarter of the capital came from her investors. And that's what she's successfully operating today. So what is the typical time horizon? You know, most private equity is a fund is raised.

There's a deployment period. There's a sort of maturity period. And then you sell everything and take your gains and move on. No rules here. No rules here. And part of the reason there are no rules here is because, first of all, it's an opportunistic market. It's whatever makes sense. But second of all, if you look at businesses like the one Royce just described, Jens, it's a great business.

why would we ever want to sell it? It's really hard to find those businesses. It's really hard to find good managers running good businesses. When you find a good manager running a good business, why would you sell it? It's in fact these long holding periods, I think, that make this business, this market space, this segment, so interesting. The person, I don't think this was actually the case in Jen.

And I think the previous owner owned it for what five years or something like that. Which is rare. Which is rare. It's usually it's decades long. The person has owned this business for 15, 20, 25 years. And then they sell it. And that sales process, the acquisition process, is often painful because they're all special. And, you know, the sellers have special concerns.

The buyers have special concerns. It's always this, it's not one size fits all. It's not one contract. So it's always, you know, the transactions costs are pretty high relative to the size of the asset you're buying. And there's no desire ever to sell it. No, that doesn't mean... Everything has a price, right?

It's not just that everything has a price, is that the world continues to evolve. And, you know, if somebody ends up rolling up these services and thinks about this as an important, you know, asset for them, you know, it may make business sense to sell it. But generally speaking, it's not the private equity world, as you say, I have an investment period, flip it, and then I've got a few years to get it stabilized and run and moved and turned. And then, I mean, I've got a 10-year horizon. I've got to start selling these things off.

That's not here. Open-ended. I'd like to get into the idea of risk from the investor's standpoint in these businesses, because a lot of people hear 25% yield or 30% percent. percent yield. They start to drool, but then the smart ones will say, well, let's adjust risk. Let's adjust these returns for risk. And you're dealing with a whole slew of risks that don't exist in public market businesses,

whether it's customer concentration risk. It's a really interesting question. So first of all, it runs a huge range because some people think about buying a small firm as kind of a little venture capital endeavor. So they're buying a firm that's in an industry or segment that's growing rapidly, and they want to be part of that rapid growth. That's clearly a risky adventure. Not necessarily a bad adventure, but a risky adventure.

What Royce and I recommend is entirely different. We recommend you buy these dull firms that are enduringly profitable, that have been profitable for many years before you bought it, and that you can reasonably transfer to a new owner. hopefully minimize the risk in that transfer process, but then run it in an enduringly profitable way afterwards. So the businesses themselves are inherently less risky, and because the businesses, at least the ones we recommend our students buy, are less exciting for sure, less upside for sure, but not much go to zero risk, right? So if the inherent business doesn't have much go to zero

risk. It's not so clear. You know, it's true. You might not get the 25. It may turn out to be 10, but it's, if there's no go to zero risk, if you know what I mean by that, it doesn't, it doesn't feel that risky to buy a business that, you know, 90% of its customers come back and buy every year. Does that feel risky to you? If I could just, I agree with Rick. I'd just like to add a few things. As you know, Patrick, before coming back to HBS, I spent many years in the private equity business. And, you know, I'd highlight three differences in this space that make it less risky than the private equity I spent my career in. The first is, the first two, center around the fact that you're buying these businesses at around four times EBITDA. So in the private equity business,

one of the big risks you face is, you know, you buy a great business for seven, eight, 10 times EBITDA, and then there's multiple compression, the whole space re-rates, and suddenly these businesses trade for seven times, not nine times. It's really hard for a re-rating to take place when a business is bought at four times EBITDA. It's just, there's an almost irreducible minimum here. The second is, in regular way, private equity, there's the risk that you never get to the end of your game plan because you default on your loan along the way. And if you buy a business at eight times and you lever it at four to five,

times, you know, you have to watch your covenants very carefully. In this space, when you buy a business at four times, your senior debt is usually two times ebidah. It is just hard to default when you are levered on day one at two times ebidda and then bringing that leverage down. It is, it's just a very forgiving structure and the seller debt underneath that has no covenants. So that risk is much lower. And then the third risk, which is a real risk, is that you are replacing a very experienced retiring CEO with a first-time CEO. Now that first-time CEO is energetic and smart and very well trained, but that's usually addressed through a management transition agreement of six to 12 months, where that retiring CEO, who after all has a big chunk of seller paper still in the business

and is being paid to affect a gradual transition. So those three risks that you'd ordinarily face in private equity, at least the first two are highly mitigated, and the third one is managed, which is part of the reason why Rick describes, even though the returns are, the underwritten returns are very high, the go-to-zero risk seems very low. And I think as we look at least at our former students, I can't think of any who've had a go-to-zero experience. We haven't had early days, right? Right.

But we haven't seen those yet. And the other thing is that, and I don't know if this is true. I don't know. This is speculative. on my part, that the small firm world is just different. It's like a different sector of the economy than the big firm public world, and even the big firms that private equity invests in, and that a reasonably well-diversified portfolio has bits of all the various sectors in it. Now, as a private investor, you might not be able to get those bits of that, right? But just like it makes sense to have, you know,

tips in your portfolio and not just long-term bonds. It probably makes sense to have some of this smaller private equity, really private equity, as I like to call it, in your portfolio, because I think it moves with the economy in kind of a different way. There's a, yeah, I always like to separate things into beta and alpha, right? And there's, there's some equity beta wrapped up in all this, right? They're exposed to the U.S. economy, and I realize maybe the risks are, mitigated, but let's say upward re-ratings of valuations would be obviously a good outcome, but one that has beta components to it.

And then there's obviously the choice of company, which I always think of as the potential for alpha. And you use the term enduringly profitable a lot in the book. And probably my favorite chapter in the book was chapter 10, where you really get into the characteristics that people should screen for in these businesses, which I'd like to get into in some detail because I think that the chapter itself, while it's meant to be about small businesses, could very easily be applied as a sort of moat, definitions of a moat or something that public investors might look for, value investors might look for. The whole idea sounds very

Warren Buffety, value, moat, margin of safety. Those concepts kept coming up in my mind. So maybe we could walk through kind of a punch list of the desirable characteristics and maybe some examples to demonstrate them. Well, I'll start with the one that's always on top of your in my list, Rick, which is we encourage our students to buy businesses that have recurring customer bases. And that means customers where they are automatically going to repurchase the service or the product from year to year because it's in their financial interest to do so. And that to not do that almost requires a whole new round of work in reevaluating and selecting. So just to pick up on the example we talked about earlier in our discussion, Jen

Brous's Systems Design West, you know, when a local ambulance service contracts with system design West, they link together their electronic information systems, and they get into a regular rhythm where they're getting a check every month and they're getting some standardized reports on their collections. And the whole thing stops being something on the radar screen of that local fire chief, by the way, whose business and career it never was to chase down insurers. He or she got into that business to put out fires and rescue people. And so something would have to go terribly wrong in order to want to reevaluate and disconnect and do all that setup work again, not to mention the fact that the real leverage is not in

the charge that Jen levies for each collection. It's on the collection rate that her firm administers for the local department. In other words, they're looking at the fact that they get 96% of all billings collected, not at the fact that they're paying $19 or $20 per toll. Another business we know well that one of our former students bought is a high-rise window washing business. And at first, you might think, if I've ever heard of an uninteresting commodity business, it's got to be the guy up there wiping the outside of the window with a sponge. But in fact, if you're the manager of a 40-story building, that cost is infinitesimal to. you, and in fact it's passed through as a common area maintenance charge. You don't even pay it. But you are concerned that on your Class A building, your window washers are on and off the

building quick and not disturbing the tenants, and more than anything else that a bucket is not dropped on a convention of trial lawyer stopping below. In other words, safety is paramount. And if you're the firm that has been around for years and years and you have a safe record, you don't want to be the building manager who recommends a change and then something happens. These are just two of many examples. Right, and just to continue. So suppose you do recommend the change, then the guys come, and you've got to explain, and you've got to spend a half a day with them telling where they can put their supplies,

where they should dump the water, where on the roof they should tie off their ropes. It's a bunch of work, right? Switching costs. It's switching costs, right? And why incur them? And I think all these businesses, so it's interesting. your preamble on these questions were whether people with big firms would be interested in this. I'm not a professor of strategy, but one of the things I am intrigued by in the small

business space is that strategy seems to be different for small businesses than big businesses, right? In big businesses, you're pretty almost always looking for what is a pretty insurmountable barrier. And the barrier tends to be something real like a patent and idea, low cost position, low cost position, brand something, you know, license, whatever. In small firms, the barrier is often excellent execution. So people don't switch because you as a small business person do what you do really well. You never give them a reason to get mad at you. And that is itself a barrier in the same way a license might be for a larger company. And so it's, it, the corporate strategy is a little bit different and the way they're runs a little bit different, but the net effect

is the same. You're getting really good returns because you're providing a really good service. And if you provide a lousy service, your customers will leave you. They're not bound to you. And it helps that they're a switching cause. when a customer needs to make that. Because the customer might call up and say, you know, I'm really unhappy that, you know, that you guys dump the dirty water in the wrong place. I'm not going to fire you for it, but don't let that happen again. And you'll say, of course, I'll never let that happen again.

I'm going to talk to my, you know, it was a new crew chief. I'm going to make sure that's resolved. I'll do, you know, some people work to resolve. It's not that nothing ever goes wrong, right? It's the world. Things go wrong. but people have an incentive to work through it. So the number one criteria we recommend is high recurring customers.

And, you know, Rick and I ask our former students to measure that. We want them to buy businesses ideally where 90% or more of the customers come back from year to year, and certainly over 80%, so that you start your year knowing where your revenues are coming from. That is number one. Then there's a list of others, and I'm not sure the list necessarily has an order, but I'll tick off a few. And Rick, you jump in. Certainly low cyclicality is important.

Often our ex-students are buying a business from someone who ran it debt-free for years and years. The entrepreneur through acquisition is going to have debt on this and doesn't want to encounter cyclicality. So leaning towards non-cyclical businesses. Or seasonality. Or seasonality. Seasonality is also really common in small business

and can be really difficult. Now, of course, cyclical. has a longer tail. It can ruin years, not just a season. But if you're in a business that has, you know, take a landscaping business or something like that, where you have this huge working capital run up in March, April, May, and maybe even June before, you know, because you're ramping up, buying materials, employing people, you know, the business could be hugely profitable, but you may not be able to fund your growth. or even the delivery of your current customers if you've financed too closely on the acquisition.

And so now you have unhappy customers. The business shrinks. It's this cycle of doom and gloom, right? But so anything which keeps the business from being steady makes it much harder to manage and much harder to be successful at. Which leads me to my third nomination after cyclicality, seasonality, and recurring revenue, which would be low customer concentration. This is also a big issue in small businesses, which often get started by being built around one big customer,

and the entrepreneur gets very good at serving that customer's needs and tries to bolt on other clients, but has a business with very big customer concentration, and so we strongly recommend entrepreneurs through acquisition and investors look for businesses with very diverse customer bases. And supplier concentration can be almost as troubling. Right. Slightly different, but almost in troubling.

I always approach it by asking a different question. I think the question is you want to ask, why is this business small? That's a good question. And some businesses are small because they're lousy businesses. Probably most. Well, I don't know about that. But some businesses are small because they're a lousy businesses, and those are not the ones you want to buy.

But some businesses are small because it's serving a local market in kind of a special way. And that's the one you want to buy. or this just meaning they're a devastating competitor it's just their market is small yeah their market is small they're they're they're they're the best and everybody wants to use them but you know you can only ship bread 50 miles and so you can be the best bakery and have huge profits but unless you want to build another bakery you're going to be small you can only wash windows as far as you can send your trained crews and drugs and so and so you need to ask that question and And you need to be able to answer that question in a way that that's convincing, right?

This business is small because, you know, its market is well defined. It's small. It doesn't have very many competitors. But, and you need to work through those answers. And then I'd toss on two more criteria. One is a criteria that equally well applies to big businesses, and that's good free cash flow characteristics, that almost all of EBITDA is available for debt service, acquisitions or distributions to equity. That's a universal investment rule, but it applies to small

businesses. And then finally, I'd say that the business has to be one which can be transferred away from the selling owner. You know, after some reasonable period of training, the business isn't connected to Mr. Smith, who founded it, but anybody could, any qualified person can run it. And there you have an opportunity often for a big step-up in performance because you're bringing in someone who's frequently better trained at the things the business needs now than the founder was trained in because he or she usually started the business around a native skill set related to the product. And that's less important for a business that's 20 or 30 years old. So let's take that list. Can I just say just one thing before we go into that list, which is, whenever we articulate that list,

and sometimes our students articulate that, you know, go through this list. And sometimes searchers will call us up on the telephone and former students and say, you know, it was really helpful in class. We have this list. And I can't find any companies that are like this list. And it's...

That was going to be my next question. Yeah, it's sort of like, you know, you know, you know, who's the perfect husband, right? who's the perfect spouse. You know, well, you know, you know, Tom Brady, he seems pretty good at what he does and he makes a lot of money. You know, maybe he works a little too hard and gets beat up all the time on Sunday. Yeah, right.

And, and, you know, in the real world, you have to sort of compromise. Right. You don't get everything. You just don't get everything. And you as a searcher or an investor, you have to decide what is good enough for you. Because the package doesn't exist with all these perfect pieces in it. It's pretty rare. But it's useful to start with that.

It's useful to start with that. But you got to understand you're probably for sure not going to end up with that. and even on something as basic as recurring revenues. This is something Royce and I have been talking about recently in the last few months, that there's sort of something different between recurring revenues and repeating revenues. And think about the difference between something where the computer systems between the two companies are tied together. That's kind of the classic recurring revenue. example, but then think about your local restaurant or pub.

You may stop by the local pub frequently, and you know, when somebody buys that pub, they'll see Patrick down there and follow it down and say, oh, yeah, he's a reoccurring customer. But you know, you know, if they offend you just once, you know, if they put, the pitcher beer over your head just once, or if they decide to show opera instead of football on Saturday afternoons, you know, it's pretty costly for you to go to the pub across the street, right? So you're kind of a repeat customer, not a recurring customer, right? So even on the things that seem so well defined, like, did you have a recurring customer base? Did 80 or 90% of the customers that bought this year, did they buy last year?

seems like an easy question to answer. Even that has some subtleties to it, right? So I'll rephrase the way I was going to ask the question, and I'll use your phrase, which is good enough. Good enough. There you go. So what percent, let's say there's hundreds of thousands of businesses that fall in the revenue or EBITDA range, what percent of those do you think would qualify via these five and whatever other criteria is good enough? Oh, that's a hard question. Well, can I, let me answer it this way. And while I'm answering it this way, maybe you can see if you can climb that mountain. But when we send searchers, when searches go out to buy a business, it takes between six months and two years to find a business that is good

enough or better than good enough and probably with an average of 12 to 15 months. So they are pawing through hundreds of businesses to find one that is good enough and can be purchased at the fair market price. So I think the answer is it's not easy to find these. It's easy to find lots of choices, but it's hard work. Yeah, it's hard work. It's hard work. I don't have the answer.

I don't have the answer. What I think is really interesting is that different people will see the same business very, very differently. And some of it has to do with our natural inclination. nation. So if you really want to live in, you know, Vermont and you find a business in Vermont, you'll say, oh, that's a great, deep down inside, yeah, right, a biased assimilation, whatever you want to call it, right? It's this sense that, yeah, I want to love this business, so I'm going to love this business. And the reverse goes for businesses and, you know, places you don't want to live.

I won't give you my list of those. But and so it is interesting that because we've had this opportunity to go and notice how a half dozen people can look at the same business. And five of them will say, oh, this is just a dog. And one of them will see something that the others didn't see and get all excited by it. and, you know, it might end up being a transaction. It is rare. What I think is really rare is, what did you say, Royce? You thought there might be 50 searchers?

I don't know what that number is. But suppose it's 50. What you'd think is that they'd be stepping on each other's toes all the time. Right. And, you know, in five years we might have heard of one example with multiple searchers were engaged in the same transaction. It just doesn't happen. And the only explanation I have is,

that people just see different things in deals. And that it's a big universe. And it's a big universe. One of the things that you just see everywhere is the inverse relationship between how exciting something is and the size of the opportunity. That, you know, your point about boring, simple, long-established businesses can be a lot better than maybe the exact opposite, which I would think of as the venture capital model, where the hope is all in the future.

It's not in some established history. And this whole idea made me think of, I'm obsessed with, forests and trees in ecology. And there's this technique called coppicing where you take an old, dead tree stump and you plant a new tree on top of it. And it grows about twice as fast because it uses the established root system from the prior tree. And so you can grow.

There's a small list of trees you can grow like this, but you can get wood much quicker than if you were to plant a brand new tree. And that analogy kind of sticks with me with these businesses of long-established traditions in the community or the geography. And there's another example that I would love for you to explain a little bit because, and the example is castronics. And one of the things that I found most interesting in your checklist, not, I don't want to call it a checklist, but criteria for companies that might be attractive is that the business,

it's an enterprise business, it's providing some good or service to another enterprise where that thing is a very small percentage of the overall pie spent by that company. So you don't want to be selling an airplane Boeing. You don't want to be selling Boeing engines. You want to be selling them carpet or something like that because they pay less attention. So if you could give the Castronix example, I think that's a fantastic case study. It was a fantastic case study. It was a fantastic success for the two entrepreneurs.

We use it to close our course in the spring because we like to end with something very happy. Aspirational. Aspirational. So Castronix performs a very humble function, which is they carve into the end. end of pipe. What is the words for? Thread. The thread so that you can bolt together, you can wind together two lengths of pipe and put it down an oil or gas well and do it again and again and again. And that threading needs to be, have two characteristics. It needs to be highly accurate. So when you're at this remote site with a lot of expensive labor around and you're on the clock,

those fit together beautifully. And second, it has to be timely because you can't stop a well because the pipe was six hours late in arriving. Those are absolutely critical because they make a huge difference in cost and safety at the wellhead. But the actual cost of the pipe, of the threading, is a tiny fraction of the cost of buying the pipe and transporting it. I mean, it's like... It's like $45 a pipe against a $2,000 pipe with $1,000 of transportation cost. I mean, it is just nothing. And so what the buyer cares about is, are you on top?

time and does that threading flange together. And price is really tertiary. And so it makes for a very high margin business with very little switching because the idea of switching to a new provider is really very scary and just cutting price does not make that sale. Right. And remember, these are remote locations. Right. So Castronics was in Kimball, Nebraska. And I don't remember the case in detail, but I think there was not another pipe threader for 200 miles. 500 miles. It was hundreds of miles. And so, what are you going to do? I mean, you're going to somehow put the pipe on a truck, drive it 1,000 miles to save $15 on your threading. And again, because these markets are relatively small markets, the idea of building a new pipe threading

facility to split that market in half is just not that appealing as a proposition. It could happen if you're totally undisciplined in raising price, but if you're reasonably thoughtful about it, you're not going to invite in competition. Right, and the competition they did face is you remember had more to do with transportation costs. It had to do with railroad sidings and size of the storage yard and other things and not so much with the pipe threading. And there's certification is on pipe threading. And there's oddly, for an economist, oddly different kinds of pipe threading. You would think like it would be like one pipe threading, right? No. You know, different engineers specify some are internal threads, some are external threads,

some are this, some or that, some have coarse threads, some have fine threads, lots of. I mean, it's like a hardware store, but with, you know, really long pipes. You know, Patrick, we've been talking about this a lot from the perspective of sort of how does this look as an investment, and then you touched a moment ago, contrasting it VC versus this, for the entrepreneurs who get excited about this, they often have a few characteristics in common. First, they're in love with the idea of being a general manager and an entrepreneur. They're really agnostic about the product or service that they're making.

They're kind of excited by the idea of putting together labor and capital and a strategy and customers. Business and business to business, exactly. And so that's one characteristic. And then second, they want to be an entrepreneur, but they don't have the kind of new idea that a sort of silicon, Valley high-tech person might have. And thirdly, you know, they're careful about risk. And the idea of starting a business and blowing up is distinctly unappealing. And this is a path to entrepreneurship with less risk. And I think those are at least three traits you and I see a lot. That's right.

Some really care about their product. I'm thinking of Ari and his home nursing company is, you know, his... Right. He wouldn't just swap to any kind of business. He wouldn't swap to any kind of business. It's important to him to be able to provide care. But it's interesting how many of the entrepreneurs we meet when we ask them, what's your biggest source of satisfaction? Most of them talk, firstly, not about their income, not about that, not about necessarily even their independence,

but their ability to impact their employees' lives, which is sort of really interesting, right? to have 45 people whose names they know, whose families they care about, and they get that if they goof up their business, they're going to goof up the lives of these 45 people. And that weighs heavily on them. And it's a source of focus. And it is interesting. CEO after CEO, some very young, early 30s, you know, this is what they're thinking about every day. And it's sort of, inspiring to see that in our students. A popular idea now is that you want to focus on things that don't scale well.

And this is sort of the classic definition of something. Yeah, I guess so. I hadn't heard that, but that's an interesting idea. It's difficult to scale that lack of scalability creates some sort of moat around. That's kind of interesting because a couple weeks ago it was everything you know you only want to do things. Everybody wants to write the killer app because it scales so well. Yeah, the idea has become popular because some of the big Airbnb

is the example that everyone uses. These big tech companies that seem like pure scale engines began and gained traction because of the things that they were doing that didn't scale at all. So the founders going to take pictures of, you know, helping the early listers actually do the listing themselves, things like that. So it's kind of an interesting idea. It brings me to the inverse sort of the negative screening list. So you've given us characteristics that you like to see in a business.

Maybe we could touch on some things that are big red flags, apart from the ones like cyclicality, seasonality, that you've mentioned, things, or maybe it's entire, it could be entire industries. Yeah. Or, or style. I'm happy. I'm happy to take a pass at that because I'm, I just have this long list of things that I, you know, you know, I try to be more upbeat.

But anyway, I don't like technology companies, right? Anything that has this, you know, I'm looking for companies that have logo to zero. risk. And if you have a technology company, somebody, you know, alternative technology can simply drive you out of the marketplace. Similarly, and, you know, it's all very personal different investors, different investors, different people who analyze companies that have different views. That's what makes the economy so great. But I'm not a big fan of anything that has stroke of pen risk. So, for example, there was a time when autism clinics were like the best investment ever.

And, you know, I guess it was a time before that MRIs were the best investment ever. And the problem with all those is that they have all this reimbursement risk. Somebody can just change the reimbursement rates. And, you know, what are you going to do then? and if reimbursement rates drop by 20% it doesn't change your cost of providing the service at 20%. Those dollars come out. They don't decrease profitability by 20%.

They probably decrease profitability by, you know, 90 or 100%. It's just terrible, right? Because those dollars come out of the bottom line, not the percent. What else? I also really, you know, it's funny, we have this discussion with our book editor every once in a while, reoccurring discussion. I like things that you come back to because it means that they're still sort of unsettled, right?

Is whether our book is really helpful if you want to buy, I don't know, what do people call it a lifestyle business? Like a solo entrepreneur, very small scale type thing? No, it's like, you know, you've always wanted to own an antique shop. Got it. And so you want to buy an antique shop. And you want to live in rural Vermont and run an antique shop on a deserted road in which three cars go by every four months. And the question is like should you should you use any of the things we talk about to sort through those, I call them hobby businesses.

Because that's not really the audience we have in mind. That's not really the audience. We channel people who want to make money and have a success. Right. And, you know, imagine that the level of activity, be it through employees' lives or whatever, are really important. But so, you know, in the abstract, all the things we advise, all the things we suggest you look at for companies probably apply to these hobby businesses. But I would never invest in somebody who was buying a business because they just love the business. You know, I always wanted to be, you know, I love wooden boats, so I'm going to buy a wooden boat shop, right? That is a way, it seems to me, to lose.

It's commendable, but it's a different. Right, I like wooden boats a lot, but I, and I seem to pay a lot of money for the people who work on them for me. So, so maybe that's a great business if there are enough crazy people like me. But I, you know. It's clearly not a hobby. These are small businesses, but not a hobby. Let's talk about growth a little bit. So obviously these tend to be mature businesses, or at least they've been around for a while,

tend to be lower growth businesses. People tend to think of growth as a good thing, all things equal, but it creates problems. So I would love to hear your perspective on just growth as an idea, and then I'll ask some more specific questions around. Well, maybe I could start with a little math on why when you asked Rick and I what was important in a small business to buy, not on our list was growth. It was notably not on our list. I'd like to share a little math, and maybe you can talk about some of the challenges with growth that we see with growth.

Here's the math. When you buy an enduringly profitable, mature, small business at four times ebita, you are pulling off a 25% yield on your total purchase price. If you financed about two-thirds of it with debt, senior and seller debt, and that debt is typically at some single-digit interest rate, your return on equity before any growth is somewhere like 60% or 65%. If you actually grow the business, even at a moderate rate, 5, 6% a year, that's even higher. Now, of course, part of that gross return of equity has to go to the entrepreneur, but there's just plenty of return here without trying to find or manage a business to high levels of

growth. And the business is one that's been around for 20 or 30 years. So that's why we focus on a lot of characteristics other than growth, because even without growth, it's pretty good. So what are the challenges with growth? Growth just creates risk. So if you think about looking for businesses that has high reoccurring revenues, the faster growth, the lower your reoccurring revenues, almost by definition, right? Right. New customers, new problems. New customers, new problems. and it's not just new customers, new problems, it's new customers probably different problems, right? And it may be that with growth, you're adding more high-value-ad customers,

but that's not the way it usually works. You usually end up, you know, it's usually end up like mining. You know, you get your most valued customers first. That's like the coal that's nearest to the top of the ground on it. And with each increase in volume, you're digging deeper into that mine and your costs are going up and you're less valuable. So it's just a lot of risk in growth. And the other thing about growth is, of course, you pay for growth.

When you're buying the business, if the business is priced at four times, you know, there's one business not growing priced at four times, and there's a similar business that's growing at 25% a year, you're not going to buy that business at four times. That might be six times. So you're paying for it up front as if, you've been able to realize it, and then you have to go realize it. You know, that said, I think every business does better if it can grow a little,

but I really like growing a little as opposed to growing a lot. One of the other compounding problems is for the business growing at 25% if it's capital-intensive, and I know you said – Yeah, you run out of money really quickly. You don't want businesses where you have to dump working capital investment in constantly as you grow. So I'm curious about the financing kind of part of this. And financing for a little small businesses is obviously very different than for big businesses with more diversified client bases, et cetera, et cetera. So how do you think about financing?

One of the things that I always loved about Warren Buffett's career is the switch to an emphasis on float financed business models. You know, you mentioned recurring revenue, which makes me think of subscriptions, which is sort of front-loaded recurring revenue. so you can sort of finance your growth via float. Do you see that kind of thing at all? Yeah, we see those as businesses which are sort of engineered to not require working capital. Right. And clearly there are great business models that are like that. There are businesses for, I mean, Dell Computer may be the famous lodge business like that.

But there's also in the smaller business space, one of the businesses, that I continually be intrigued about, these businesses that are trash brokers. So you own a shopping center, you've got a dumpster in the back, and, you know, you get that dumped with your local dumpster company, and you don't even think about it. And these guys knock on your door, and they say, how would you like to pay 15% less? And you say, that sounds pretty good. You know, that sounds really good. And they have a network of trash haulers, and they know what the prices are, and they do it every day. You've never done it before.

And they say, do you want to do it for 30% less? And that's great if they can do it for 30 or 50% less, which is pretty typical for them. You get 15% savings. They get 20% savings, and everybody's really happy. and because they have the task of monitoring it, you pay, you the shopping center owner will pay in advance. So they're like a negative working capital business. They're like a little bank in addition to managing your truck. Great business.

Not all businesses can be like that, sadly. And your more general question, I think, is how small businesses get financing not just for the acquisitions. The acquisitions are pretty straightforward. they use SBA financing if they can. SBA is the small business administration. There's a program called 7A, which is really terrific for buying a relatively small business. And if you can take advantage of that, if you qualify and the business qualifies, it's a great idea to pursue it. It takes much longer to get the business acquired, but it's, you know, it's 10-year covenant-free debt.

It's about as good as you can get, right? all you have to do is pay your bills, and that is your bills to them, and that's it. You pay your current with interest in principle. They don't have any complaints. Don't you wish all lenders were like that? And then there's usually some seller debt and some equity. But more difficult for smaller businesses is simply getting out of the normal working capital or corresponding banking relationships, line of credits, kinds of things.

That money is really hard to find for small companies. And so that, I think, really provides limitations to growth. Back to one of my opening questions, which was, you know, imagine I'm an LP, and there's a lot of people listening who are LP-type investors. If someone is really interested in this concept, what's the path forward? How do you actually get involved if you have a check you want an equity check you want to write and effectively either fund the search or fund the acquisition at the end of a search. What's the process for people that aren't sort of tied into the networks of these schools,

which tend to lead the charge? Well, I'd offer a couple of thoughts. And Rick, you may have a few thoughts. So the largest body of entrepreneurs through acquisition come out of the sort of 10ish or so business schools that teach around this course. And these schools often have events. You know, here at Harvard Business School, once a year, there's actually a big symposium of searchers and speakers come and searchers. People are

planning to search both within the school and outside the school come. And someone who's interested in this space should actually come for a day and they'll meet lots of people who are in various stages of their search. And not only will they meet a set of people, but those people will introduce them to other people. And so if you're willing to invest just a little bit of time in networking, you can pretty quickly start to get introduced to the car. population of searchers who will need money. Yeah, and if I could just interject. Please.

And, for example, we have a spring course, which is a field-based course. So we bring lots of professionals in. Not this week, but next week. We have 30. 30 potential equity investors coming in to meet our students, and our students will pitch them on hypothetical deals, deals that were real deals maybe a year or two ago, some of them current. And they'll make that pitch and they'll build those relationships.

And the investors come, you know, they give us a day. That's really very generous of them. We throw. But by the end of the day, they will have met 60 or 70 students that will be at some point, maybe not next year, but sometime in the next five years be interested in buying a business. So there are lots of events at lots of schools, you know, not just. the Harvard Business School, where an investor can be helpful to the students as well as get to

meet the students. And this community is a pretty network community. In other words, the searchers tend to build networks among themselves. And so when you as an investor get known to a few of them and ask them to introduce you to others, it's easy to build up a network of contacts. Rick and I know a number of high net worth individual investors who have other full-time careers, but have built up portfolios of 20, 30, 40 different investments in companies. The other path to do this is, as we mentioned earlier in the discussion,

there are about four or five small specialized private equity firms that invest solely in this area. And one low work way to do this is to become an LP and hire them and start to learn about the space derivatively. Another thing, which happens a lot, is that, that, People who are buying companies simply look for, I call it retail placement, that they're looking to friends and family and kinds of friends and family of their friends and family to find. These aren't big checks.

They're looking for $100,000 or $200,000. And what I think is true, certainly before I learned about this space is I would hear about these things and say, You know, you hear about these things that your local religious organization, your country club, your whatever you do socially, you know, your ski lodge, whatever you do. And many people just say, that's crazy. I'm never going to do that. That's stupid. Why would I put 100,000 into liquid? It's easy to just chop that tree down before it's grown at all, right?

And I think what I've learned since I've been in this space is that it really makes sense. to listen to that, right? That may be a great opportunity, and you just have to be open to it. And I just think they occur. What do the economics look like in this? So we're used to, in the alternatives world, two and 20, sort of the standard fee schedule. How do the economics break down for the searcher, which I guess I'll call the GP in this equation, what does their incentive structure typically look like for someone that's running one of these firms? There are two different – you might apply? No, go ahead.

There are two paths that searchers take. The one that's most common for our graduates is to be a self-funded searcher, meaning on their own nickel, they go look for a business. It might take them a year, year and a half. They find a business and get it into agreement, and then they raise the equity for that transaction. In that deal, the typical arrangement with the investors is as money comes out of the company, whether it's distributed as dividends or at sale, first retirement. all of the investors' capital. Then it returns some sort of preferred return, usually between seven and ten percent annually for the money that was tied up. And then the investors get a chunk

of the remainder. How much is that? Well, when they embarked on the deal, they all worked off some sort of plan. They all agreed on. And the investor's share of the remainder of the profit pool was carved up so that they had a targeted 25% net return. That's about the market clearing price. The investor is underwriting to getting their money back first plus a preferred return, and enough of the remainder that when they embarked on this, the target return was a mid-20s net return for the investor. That usually means they own about half the common, roughly.

And the entrepreneur, their incentive is after they've paid back the capital, paid back the preferred return, they're getting about half the common. common too, and that will usually be a few million bucks for a five, six, seven year journey. That's the independent sponsor. The independent searcher. The other alternative is the searcher wants to line up the funds to execute the search because they don't have the money to do that, and also because they want the advice of an in-place group of backers from day one, and there the investor is underwriting the search, a much smaller

ticket, a few hundred thousand dollars across a group of investors to the shot for the shot at underwriting the equity. And there the investors typically get 80% of the common, not roughly 50%. But they're taking more risk. Yeah, it makes a lot of sense. I love to learn via contrast. And you spend a lot of time, Royce, in the traditional private equity world. So I'm curious looking back and obviously you're still involved in that world as well, although I think less so then in your heyday. What was right and wrong about how things worked there? You already mentioned the multiples being higher. But what concerned you about that private equity world from an investor standpoint? What should I be concerned about, maybe in general with the private equity model

or specifically in today's environment? Well, the biggest challenge of being an investor in the private equity world is that a enormous amount of capital has flowed into private equity, driven by the low interest rates, which have just sent this tsunami wave of cash into private equity. And private equity, like any inefficient space, there's just a huge dispersion between the results good managers get from what bad managers get. It's sort of the opposite of the bond universe where there might be a half-point difference between best and worst. There's a 15-point point difference of 15 points of IRR between the best managers and the worst managers and the best managers and the best managers are oversubscribed. So it is extremely hard to get your money into a good

manager. And that's the biggest challenge of being an LP in the private equity space. That's not a problem here because there is no institutional competition in this space, because the check sizes are too small to interest institutions. If you both had to pick one company that you've encountered in this whole journey, and I just got to hand you the keys to it, not in terms of managing it, you just own the whole thing. What business do you love best? What business would you want to own in perpetuity that you're aware of? I can't answer that question.

You know, at least the ones we're invested in. I think about them as like my kids, I can't say. I can't possibly say, oh, yeah, I really like this kid. I wish I didn't have the others. Yes, particularly because the CEOs with whom we're partnered, very well listened to this. Right. And they'll say,

oh, you don't like me. I always knew they were, I always knew Jen was your favorite. But let's, I think, I think responsive to your concern, we should pick a business

that we have no financial association. Take a business that we have no financial interest in. So I'd nominate one. Okay, go. So, so some former HBS students who are not our students and with whom we have no financial association bought a business that works for counties and cities

handling their insect conditions. control. And so they go in and they spray pesticide around the community and make sure, and it's particularly predominant in the south where there's a lot of mosquitoes in the summertime. And so this is a highly recurring revenue business because if you think about what that city is doing, they're hiring someone to spray poison among the populace. By the way, in the industry, they call it product. Spread product among the populace. Too much product. You know, Fido is paws up in the backyard to little product and their mosquitoes. Do you want to be the city employee who switches vendors to get a 5% lower price? And so this company just has, I mean, they do very, very good

work, but they have, for larger reasons, they have a very recurring customer base. It's relatively price insensitive and it's completely non-cyclical. And the business has a number of other characteristics. But it's a business that I think passes Patrick's test of, you know, if you owned it, would you keep this in the family forever? And I think I'd raise my hand and say yes. Yeah, and it's interesting. That particular business, that particular business extended beyond the mosquito control business

to pawn debatement, weed abatement in ponds. So it has a very similar characteristic. And so there are these other pieces to it. So that was a good pick. Now I have to pick one. That's why I went first. Because Rick and I share. the same data so yeah yeah so i so i there are businesses uh you know let me let me pick a couple

instead of picking one so uh i think uh there's one business we teach about it in our class we're um uh with a woman who runs it uh was very entrepreneurial and got a big contract for being if you will, the fringe supplier of particular chemicals that come in from overseas. So not that big supplier that presides 90% of the market, but just the 10% market. And that business is, it's an importing business, but it has a kind of brokerage field to it, right? There's not a lot, a ton of working capital. So there's a lot of working capital, but there's not a lot of capital. And that business has the potential to be one of the most profitable businesses I've ever seen. You know, when we teach that, you know, I ask my students, you know, when you come across a money tree in the forest, what do you do?

And the answer is, you shake it. You shake it and take all the money you can. And then look for other money trees just like it. You know, that is a really good business. It's counterintuitive, too, because our students always ask, boy, you're the 10% percent, provider of this chemical, isn't that a scary position? Don't you have to discount against the big supplier? And they explain, no, actually, we charge a premium because the reason people want us is because they're scared to have a sole supplier. They want a small second supplier, and they're willing

to pay a premium to us. And they may have the potential to make millions and millions and millions of dollars a year. And it's, and I think an example of this great service creates its own barrier. because the CEO, I think I have this right. The CEO was sort of parenting and working in the business came across this opportunity and had been running a small business, you know, small importing business, and then came across this big opportunity that was transformational, how it at least has the potential to be transformational in all their lives. I love that.

The other example, I really, like, it's just about the opposite spectrum. It's a red-hent baking company in Vermont, Middlesex, Vermont. And it's a guy, Randy George and his wife, Liza, that, Liza Kane, that own this bakery and has really, not only provides a product that Randy finds, and Liza find very fulfilling to provide, right? They make this artisanal, organic, that's just really wonderful. And if you're ever in, if you're ever heading to Sugarbush,

you can stop right there in Route 2. Or better yet, if you're heading to Mad River, you can stop there. And just get, you know, fabulous bread or fabulous scones. And it's just like one of these great businesses that sells a great product. And it's like, how do you describe it? I mean, it's their lives, right?

It's the lives of Randy and Liza making this product that they're just really excited to make. It's like a different thing. Well, and I also like the business. Rick happens to have a ski house near there, and so samples the product regularly. I actually like the economics. There's a moment in our class when we teach about this business. When we ask. When we ask.

How much does it? How much does a loaf of artisanal? organic bread cost. And we ask our students. And there's usually a range of like a $3 range around the price estimates, which tells you how unimportant price is to the buyers, right? We didn't, we never talked about margins at all. Is there? Hires better. Hires can be better, right? Or induce competition. No, so here's the thing. It only induces competition if people know what your margin is. And in these little companies, nobody actually knows. So this is one of the fascinating things.

Is that sort of obvious? As Rick and I have researched this subject and taught this course, we've been astonished by how we pull into these small towns, and there are these absolutely nondescript unknown businesses where the owners are pulling out, one, two, three, four million dollars a year, and no one has a sense of that. But the margins in the businesses that we've been describing to typically run 20 to 30% of sales would be kind of at the normal range we expect to see. some higher, rarely lower.

Yeah, it's an interesting, another dimension to consider, you know, for those interested in the space. One of my favorite questions, because it's not usually the way people would ask about experience, is to hone in on, for each of you, the most memorable individual day of your time. You can I let you pick. It can be your life or it can be your career outside of HPS, or it can be specific to the search idea and your involvement with it. Most memorable day. But then you have to say, I mean, you have to say, oh, it's the day I fell in love with my wife, the birth of my children, or the day I found the dog.

You can't, because, you know, you're just going to lose. However I answer that, I'm going to lose. Okay, so for you all narrow it down to just your involvement in the idea of search funds. I'd like to offer for me. Okay, go. So, you know, I came back to Harvard Business School about six years ago, and Rick and I partnered up together. and we started teaching this course to students. And one thing I'll say about Harvard Business School

is virtually no student comes here thinking, I'm going to buy a small business and be the CEO owner. They have many different kinds of dreams, but they're other dreams. And some subset of our population take our course and say, this is me, this is me. And both Rick and I have this experience as we've been teaching this course, hundreds of MBAs, of students who make that decision coming up to us, and saying, Professor, thank you, you've changed my life.

You know, I've had a long career as Rick has, and it's not common that people say that to you, but we've gotten engaged in a business where we have multiple people come up to us and say that, and it's a deeply moving experience. I'll agree with that. I'll agree with that. That's a really good example. I also find that it's really interesting and exciting, uh, to see people as they're on this journey. It's interesting to help them think about things. So, you know, we'll have students in class who were, you know,

genuine war heroes and special forces people and, you know, professional football players and people who've done things which are, you know, great accomplishments in their lives, but also to me as a little, short guy in the 60s kind of scary, you know. And they'll say, and they'll say,

oh, I could never buy a small company. It's really scary. And I say, well, you know, nobody shoots at you when you buy a small company, right?

There are no bullets flying. And, and, and, and, there's usually kind of a comical few moments, but then,

then the soul soldiers particularly go on and explain, you know, when we're in combat, we're in combat for just a little bit of time, and we'll spend years training for those few minutes of combat. And when we do this, the kind of stress is permanent, right? We're responsible for their employees all the time. And we don't really train for it, right, except in the courses that Royce and I teach. So it's sort of this really interesting juxtaposition of world. that I find. I find really fascinating. My closing question, which is the same for everyone,

is for each of you to tell me the kindest thing that anyone's ever done for you. See, that's again, one of these things where I'm just going to get in trouble. I'm not going to do this. I'm just not going to do this, you know, because I'm immediately going to say, you know, when the dog sits beside you,

and just cuddles up after a long walk or a long hike, and I know, if I say that, my wife will be furious at me, so I'm not going to say that. Okay, I'll rephrase for you. again, a very kind thing that someone's done for you. I don't know, Royce. Could you pick one for me? Royce working with me. That's a very kind thing.

Well, we do have a lovely relationship. I'll say that. We've crafted a wonderful partnership over five years. Gee whiz, that's a tough one, frankly. I think, you know, I think people go into teaching in part because you change people's lives, reflective on my earlier comment, and whether students choose to go down this path or just learn about this path and it shapes their life in a different way,

I think the appreciation they show to us is something that makes what we do feel very worthwhile. And I think that's a kindness that they dispense to us, which we really feel and is important to both of us. I think that's right. And I guess I will say in a more personal life, I will say that, you know, I feel really lucky, to teach you at the Harvard Business School. I've been here for since 1987, so I guess that's

30 years. And, you know, there's just been a number of times where this school has been wonderfully kind. I don't think about that at the Harvard Business School, but I'll just reflect one example that I think was amazing. I had a kid who was seriously sick, and, you know, the family had gathered in my house, and it was the year of the huge snowstorm. storms. Remember that year other huge snowstorms? Maybe. Yeah, maybe. And, you know, I live in back, bad, and there was no place to put the snow. And I get the call from somebody in the dean's office that says, Rick, I know you're going through a hard time.

Is there anything we can do to be helpful, just anything we can do to be helpful? You know, anything at all? And I say, yeah, you know, I just can't park in my back. You know, my parking lot is filled. And in like 32 seconds, it seemed like. You know, I'm back off to the hospital. My oldest son calls me. He's babysitting his kids.

And he says, you just won't believe what's happening in your backyard in the alley. Right? There's like 10 dump trucks and a bulldozer picking up the snow and moving it along so we can have a place to park. You know, that was one of a dozen nice things. Harvard Business School does. So I really appreciate that. That's a fantastic place to end. I will be sure to provide ample links and resources for people in the show notes that are interested in this entire world and idea. Thanks for your leadership on the area for at the Harvard Business School. And thanks for your time today. Thanks, Patrick. It was a pleasure.

Hey, everyone. Patrick here again. To find more episodes of Invest like the Best, go to investorfield guide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfield guide.com forward slash book club. After you sign up, you'll receive a full investor curriculum right away and then three to four suggestions of new books every month. You can also follow me on Twitter at Patrick underscore Oshag, OSHAG. If you enjoy the show, please leave a quick review for us on iTunes, which will help

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