Red Flags and What To Avoid in an Acquisition | With Steve Levely

Hey, what would you say, you know, top of the funnel when you're looking at deals? I'm sure you get approached quite a bit. What are some red flags that you look at and what are you looking to avoid in an acquisition?

I don't like seeing debt. I don't like seeing businesses that have debt on the books already. And I mean, even though we have a bit of debt in Accru that we took on for acquisition purposes, for a lot of these businesses, they haven't grown by acquisition. They've grown organically. So if their debt ratios are high, like debt-to-earnings ratios, I get nervous, right? Anything more than a 4-to-1 debt-to-earnings ratio is a flag. So if they can't pay back their debt based on 4 years of their earnings, there's a flag there. So a bit of debt's okay, but if they're breaking that 4-to-1 ratio of earnings, like their earnings, not our earnings after we normalize them, their earnings, there's like, ooh, so that means they've already taken on a bit too much debt. So that's a big flag that we see. Then it's the other obvious metrics, right? It's, are they even growing? Where are they getting attrition and why? Right? You know, where are they losing customers? Where are they winning customers?

Right?

And if they are winning, is that repeatable? Right? If they are losing, is that probably repeatable too? So it's understanding the winning and losing in the middle of that, as well as the other kind of major stakes that we kind of look at for each piece.

Super cool. So the debt itself, I mean, are you typically absorbing that? Are you buying it out? Are you—

Yeah. Like, we always want to clear it right away. I mean, most of our deals, like, it's just, I, it's only now we're looking at deals that even have debt in them. Up until now, none of them had debt, right? We did all asset purchases. So we just said, even if you've got debt, we're doing an asset purchase. So your debt's on you, you take it out of your consideration, right? So they all had different varying levels of debt. We did asset purchases. Our last deal was the first time we did a share purchase. And we have other share purchases in front of us. When you do a share purchase, that's the other caution flag. You're taking on skeletons in closets, you're taking on old debts and all that good stuff. So you got to be careful. If anything, you should be discounting your deals a little bit if you're going to do share purchases, because there is that risk.

Sellers love it, right? Because they get to pay a little bit less taxes for it.

There's the capital gains exemption that they get to wash their hands of it. Great for the seller, not the best for the buyer. Ideally, as a buyer, if you can do an asset acquisition, it's It's always the preference. And of our 10 deals, 9 were asset, only 1 was share purchase.

Right. Are you guys typically doing all cash? Or I know you mentioned a little bit, you roll up a little of equity and give them stock options, I think, which a lot of sellers maybe think about when they're selling is, you know, how much shares am I getting of the new business? And how does my long-term incentive play with the strategic acquirer?

Yeah, like early on, shares are what we have, right? And the story was, Hey, if we combined our business, your revenues were 20% of the total business. Why don't you take 20% of the equity? 20% in the crew is better than 100% of you, right?

Mm-hmm.

And that's kind of how deals got done. Um, but as time's gone on, we don't want to do that anymore. We don't want to keep, you know, diluting our shareholders with that whole model, right? Because we're past that inflection point of growth and, and profits and all that good stuff. But, but you do like a bit of equity in there, and, and we've been paying in cash. So how do you inject a bit of equity without dilution, right? And so do you do just 10% or 20% of it being equity so they have a little bit of skin in the game, but there's also upside for them. If the stock performs, it's a great win for them. Right. We have deals that one of our largest stock deals, the deal was done at 5 cents. He's still sitting on half of his shares. They're up 600%. He's pretty happy. And he's going to keep sitting on it for another few years. He's like, ah, I'm going to keep sitting on this and letting it ride. So for him, it was a great deal for him. Right. So there's a value that maybe convertible debt is something in the future. where they have a guarantee to cash or they can convert it to equity, right? So I do like the idea of some type of equity twist in there in some component. So there's a little bit of extra commitment to the business. But also if we can just clear a deal in cash, that's not a bad thing either.

Yeah, and I think one interesting point that I think a lot of sellers are always interested in is how strategics look at— if they're looking at from your shoes, if they're sitting in your perspective and how they're looking at it, if you're a publicly traded company, You guys are currently trading, I think we talked before the show, at about 5x revenue. Now, how does that affect— so if I'm looking at a business and I'm looking to pay, let's call it 2.5x the revenue, now you're absorbing that revenue that you're paying basically half the valuation of what you're worth today. How do you look at that in terms of how that affects your valuation and how should— how can you explain that to make it make sense for them?

Yeah, so at a high level, I mean, we're in the public markets, mind you. Right. So we're a public business. We're seeing a 4 to 5 multiple right now, which you see, right? You see 10 times multiples in the public markets, right? Because of growth projectiles, the industry you're in, strategically, you know, you have a good moat around your business, all that good stuff. So it's not uncommon to see even our current valuation, if not much more than what we have, right? But in the private world, one, we don't want to be buying more than we're trading for. But secondly, you want to buy what you can have recouped pretty quickly. So we've been paying pretty much 2 times revenue. 2.5 was the most we've ever paid because we can only really rip out half the costs. We don't want to take more than 5 years to pay back our investment. So obviously there's growth and you're expecting there's a growth business there too, but we don't want to be taking 5 or 10 years to get a payback, right? There's intrinsic value, but that's why you're only seeing the 2 to 2.5 times. So even if we were trading at 2 times, even if we're trading at 10 times, I don't think it's always wise to be paying more than that, 2 to 3 times anyways. Um, it's got to be super strategic for you to pay more than that because just the payback. Even if we were trading at 30 times revenue right now, it wouldn't mean that I'd be saying, yeah, we should do pay 20 times. That I just feel differently, that, that the fair value is that 2 to 3 times in the private markets because of what we have to do. We see a premium in the public markets because of scale, investor awareness, and the direction of the company, access to capital. You have way more means than the private company, way more means. So that's why you get the appreciation in the markets.

Yeah, absolutely agree. And that's kind of a similar evaluation of what we're paying at Horizon. And I think up until you get to that $5 million kind of ARR mark, I don't think you can, you know, ask for a lot more until, you know—

Well, that's the other thing too. So our sweet spot's less than $5 million annual businesses, so smaller than what we are. No one's really buying down there, and you're certainly not seeing big multiples down there, right? All the big multiples with the, you know, your $100 million plus companies, like your mid to large cap companies where you see the big, big multiples, right? For the small microcap, nanocap kind of size business, you're not seeing the big multiples there either. So there's not a lot of buyers. But there is lots of sellers, right? There's a supply and demand thing going on there. Not a lot of guys, I guess, that'll buy a business that does $100,000 of revenue, right, or $1 million of revenue, right? But we have done it and do do them.

In terms of that kind of strategy, in terms of your growth strategy, we talk about, you know, organic versus inorganic growth. You know, a lot of your focus has been on the inorganic side, which is the acquisition plays. How do you kind of make that balance in decision-making of, you know, why this is the best strategy for Accru versus, you know, You know, just focusing on one or the other?

So there's 2 things to answer that. So the first is that organically, it's been stunted because you're so much focused on inorganic. If your whole business, if at Horizon you're so focused on inorganic, it's gonna be hard to really drive your organic business, right? 'Cause you're normalizing, you're negotiating deals, you're creating awareness, like there's a lot of work there. And when you're small, you only have so many staff, you can only do one thing really well. It's hard to do 2 things really well. As you get bigger, you can kind of divide and conquer a little bit, right? And that's kind of where we're getting to. We're getting to a critical mass where you can divide and conquer a little bit. But on the organic side, what you gotta get really good at is the cross-sell upsell. If you're a business like ours that's buying complementary offerings or competitive offerings, and primarily on the complementary side, you've gotta be really good at cross-sell upsell. 'Cause yes, you buy a business at 2 or 3 times revenue and so you can maintain it, maybe grow it, but where your really big intrinsic value comes is if you can actually double that. Take that $100 a month guy to $200 or $300 a month because you can cross-sell products and services. So suddenly they're 3 times the value and the payback is so fast. So when you're acquiring the complementary, for me, I just believe it strongly and you gotta get really strong and really good at the cross-sell, upsell, and that's a path to huge returns for you and your business.

100%. Yeah, I love that strategy. And then, you know, so that's a good strategy that's worked for you. Can you share any growth strategies that maybe you've tested and ran that hasn't worked as well or maybe, you know, failed? For Accru?

Yeah, so I don't mind storytelling. So one of the acquisitions we did, we bought, um, and it ties to— it's funny, everything, all the stories tie to both, unfortunately. But we bought an automotive business called Dealer Rewards years ago, and we're excited about Dealer Rewards, um, not because we got some dealer customers and automotive that we have some specialization in, but they sold a lot of marketing services, which was a lot of like email and direct mail marketing. We're like, oh, well, this is great. Email and direct mail marketing, it's the services component, is a great complement to our product. you know, product and services, they kind of go well together. But what we learned over time was the email marketing was great for us because over time we could integrate into our technology, right? It could become a part of our product. So even if we sold less of it, it becomes a part of the product, right? And the opposite's happened. Digital marketing has grown because of the digital economy and what have you. But like fundamentally, even if it didn't, the support cost would be so low because we just have the tech do it.

Hmm.

On the direct mail side, it is still very manual intensive. and expensive. So never mind the market doing less and less direct mail because nobody wants to touch a mail piece or whatever. But like, and the cost of it is high, better to do everything digital. So never mind that, but it's very operational heavy. But I can never make direct mail be a part of our tech. So for me, as a tech-first company, services-second business, again, it depends what your business is. If your service can't become your tech, don't offer that as a service.

Hmm.

So if your service can't become your tech, I think that has to be another golden rule that you follow if you're a tech company. If you're a services company, it doesn't matter, right? But if you're a tech company first, you don't wanna take on services that can't become your tech, 'cause what you're supposed to— you're supposed to be a tech company. So don't take on services that can never become your tech, 'cause it'll always just be a service and could eventually become a drain.