Owner Occupied Episode 5 - Peter Loses A Property Management Acquisition Deal

All right, everyone. Welcome back to Owner Occupied. I'm here with my co-host, Russell Lowry. We're excited to share the conversation that we had today. We cover a lot of great topics on today's podcast. We go into some details on buying small businesses. So I discuss a deal that we recently lost, a property management company that we were trying to buy and the deal fell through. We talk about that. We talk about Russell's two deals that he has in the pipeline and sort of some of his thoughts on where those are headed and the risks there. We go into detail on what kind of multiple should you pay for a small business and what exactly that means and how to think about different multiples for different types of businesses. We also discuss the deal that I lost. Why did I lose it? How do I feel about that? Is there a way that I could have made it happen? We get into some details there. And then finally, we wrap up discussing the risks of buying a small business. How should you think about and frame the risks as you prepare your due diligence and your LOI? So I'm really excited for the show today. Thanks for joining us and let's get right into it.

Peter, I have to tell you, I am so excited about today's episode talking about how do you actually pull off a deal. This entire space is new to me. In less than a year, I've read 15 different books on the subject. I have listened to thousands of hours of podcasts. I have followed hundreds and hundreds of small business and real estate people, read tweets, read your stuff. And so, and I'm in the middle of, I've got one contract out and one I'm terrified of losing. So, but I expect to, I expect to close on two of these in the next 45 to 60 days. So, I'm really excited about it. You mentioned that you'd been negotiating for over a year on one. And your attitude and the community's attitude toward losing a deal. Why don't you talk about that a little bit?

Yeah. So just some background. I tweeted about this about a week ago and got a lot of engagement. Basically, we had been negotiating to acquire another property management company and we lost the deal. We found out that it sold to another buyer quite recently here. And This deal was big. The company in question is about our same size. So we would've doubled essentially by acquiring their book of business. And it would've been just that. It was a bolt-on. We would've been buying the property management contracts rather than the whole business with the name and everything. All we were interested in were the contracts. So it was about 400 to 500 units. And The owner is a long-established local property management and real estate guy. They own a brokerage as a part of the property management business, and they also own a bunch of their own properties as well. So they wanted to get out of the property management side of things, the third-party management, so they were going to sell off those contracts. So yeah, we lost. And obviously, I have some thoughts on that. We can dig into it, but So that's the backstory. It had been over, well over a year, it was almost 18 months that we were sort of on and off discussing and negotiating it.

So when there's a lot of different ways that you could approach diagnosing why it, why it fell apart. Was it price? Was it, did you have a different valuation for the contracts than the, the company that wound up buying it?

So I think it was price. The seller, I tried to figure out throughout the process what was important to the seller because there's a few different levers you can pull. You can pull the price lever, but you can also pull the terms lever. And we have the ability to be somewhat creative in terms of how we structure the deal, how it's paid out, how it's valued. Whether or not there's owner financing involved and things like that. So I tried to tease out some of that information from the seller in an attempt to set up a deal that he would like, but for whatever reason, we just never got there. And I think quite frankly, in retrospect, he wanted top dollar, and that's just not something that we can do. There's a lot of things we can offer a seller of a management company, but absolute top dollar. You know, if someone wants top dollar, they can go to a national or a larger company. And that is in fact what he did.

So yeah. So if he goes for top dollar, then there's nothing you could have done, like you, you were trying to get there and tease out if there were other things or something you could have, you could have done to close that. I have a question. When I'm looking at one, I'm looking at it and I always compare— I'm, again, I mentioned two, and they're both in the same area. One is, is a bad business. It's poorly run. I can see, I know what the top three things I'm going to work on right away. And I see problems I can fix all over the place. And I'm actually more confident about that one than this other one that's much larger. It's very well run. And I see a bunch of things I can screw up. And the poorly run business, I just look at SDE and say, how much am I willing to pay for that? Do I think I can reproduce it and grow it? That's at its base, that's what I'm looking at. And I just saw more opportunity in the poorly run business. But when, as I read and people talk about multiples and industry and reading the comp and the CIM, them and people would pay 3 times, 4 times, 5 times if it's above a certain SDE. And, but when I get down to it, it's, uh, there's no, there's no hard rationale for why I would pay 3 times instead of 4 times.

Let's, let's dig into that a little bit. Um, so just for some background, SDE is seller discretionary earnings, and that's basically how much cash is thrown off by the business. That's available to the owner. And the owner can use that money for salary, they can use it for profit or take-home pay, whatever they want to do. So yeah, the multiple, I think that, you know, you got to go, you got to sort of look beyond the multiple and try to place a value on the business based on what you know about how well it's likely to perform and sort of discount that. You're trying to discount the future cash flows to a present value, and higher multiples are typically associated with more stable and more predictable cash flows and businesses that are more autonomous and don't require as much owner involvement. And lower multiples, meaning cheaper prices, are associated with businesses that are more unpredictable, less well-established, and require more owner involvement. So I think it's a very personal decision. I think a lot of it has to do with your own comfort factor with the business itself and how well you think it's going to work for you. So when I'm valuing a property management company, With a few basic pieces of information, I can know exactly how much money those doors or those property management contracts are going to make for me. So the multiple on the seller's earnings is almost irrelevant for me because I can tell you for a fact that given piece of information X, Y, and Z, I know that I can generate a revenue of X dollars per door. Once I get the door onboarded onto our systems and process. But I wasn't always that confident. When I was newer and had less experience in acquisitions and in running a business, I probably would've been less comfortable paying a higher multiple because I didn't know for sure that I could take a property being managed by another company and turn it around and have it generate profits generate a different revenue structure off the same door. Once I got it under my umbrella.

You just described my— you just described my situation exactly. I'm much more comfortable with the lower multiple, because I know I can raise it than the higher multiple. And, and saying, the owner seems very genuine and confident about its future prospects. And I'm hopeful, and we're negotiating to get to that point. But that discrepancy is interesting. So you talked about it in terms of that dollars per door, and you knew what those contracts were worth to you. Did you consider what it would mean for your business if you had 1,000 doors Could you do— could that mean a landscaping business or a— or for the windows restoration or for the bolt-on things that you would be able to do or the affiliated things that you would be able to do with 1,000 doors instead of what you've got now?

Yeah, that does play a part, you know, and there's also some efficiencies of scale that come into play when you grow from 500 to 1,000 doors. A lot of your costs are fixed, right? So I'm still paying the same rent at my office, I'm still paying the same utility bills for my office, I'm still paying the same insurance for general liability and stuff. Now of course our biggest expense is labor, and that is not fixed. You do need a certain amount of labor per door, but even that scales a little bit, uh, you know, there's some efficiencies of scale there. So yeah, you know, in terms of bolt-on businesses like landscaping and some of the other, uh, Revenue opportunities that come with higher door counts, I don't prefer to include that in my analysis of the value of a door or the value of a business, mostly because that's not a guarantee. I feel like the value of a set of contracts or the value of a business should be— it should stand alone, and the buyer's position shouldn't necessarily affect the value of the asset that's for sale. Now, the fact that I know I can take and do certain things with those doors may mean that I bid a little higher, but I'm not going to include all of that. That sounds like a good way to overpay for something in a hurry. It's one of those things like you can make almost any deal work on a spreadsheet if you get optimistic with all the little individual pieces. So But that's not to say that there's not something there. I really think there is. I just, I want to get to that scale with a very comfortable debt structure. Like, I don't want to be sort of struggling and worrying if I'm going to make, be able to make payments on, on an acquisition.

That makes the debt payments make sense. I had to get, I got into a larger deal because because Twitter talked me into debt. And that I was looking at acquisitions that I could fund with profits from my existing business. So I was looking at really small businesses that, that I could acquire with the profit and, and then conversations about leverage and appropriate leverage and debt and using the profit from the business to get the small business loan and looking at some of those numbers and at the time, 6 months worth of payments and the waiving of fees. I've learned all of this stuff and I've added the leverage component and now my spreadsheets look different because I'm looking, I'm looking at the cash-on-cash return as opposed to just a straight dollar figure of how much money am I going to make. And, and over time, I'm going to get there. And to be honest, I don't understand. I understand it intellectually that as I'm paying off the debt, I'm adding value. But emotionally, I'm really just tied to the number, the profit, the SDE number. That's what my, my focus is, my my— what resonates with my salesman heart is how much money is there at the end of the day. And I know that equity is building. And I call it deferring to expertise in that I've read enough to understand it. But it's not emotionally and intellectually solid for me. It's a deferential to other people's expertise is how I'm kind of dealing with it.

I think that's fair. Yeah.

And so, when you look at it, you had some conservative estimate of the debt. If you had paid what was top dollar, if ultimately paid, would you have made money on it and just not made the, the as much or the multiple or the risk? If you had paid what they paid, your business wouldn't have failed, you would have made it work? How does that?

Yeah. Ian Formigle: Great question. I think if we would've paid— So at one point we were fairly close on the numbers. Let me see. I'm going to just run a quick calculation here that will give you a sense of how close we were. We were about 13% off in terms of pricing. There was a 13% delta between what they wanted and what we were willing to pay. I think if we would've come all the way and paid 13% more for the business and closed on it, we certainly wouldn't have failed. We would've made it work. I think the deal would've carried more risk than I was comfortable with, and the margins would definitely have been tighter. A lot of it would depend on how things went for that first year. Depending on how many clients left and how easy or difficult the individual properties were to manage, how smooth the transition and transaction process went, and how easy the seller was going to make it for us. There's just so many variables when you're buying a business like that. It's easy for me to see it going both ways. I think I think chances are it probably would've been fine and I probably just would've been grumpy about— Because when you're buying a bolt-on business, it's tempting to just look at the revenue that that business is generating and then say, "Okay, well, the bolt-on business I'm looking at buying, let's say they're generating $100,000 a year in revenue," just to keep the numbers really simple. And the seller is asking $50,000 for it. Uh, oh, well, that's great because I'll have paid it off in the first 6 months. No, that's false, because what you're looking at right there is just the gross revenue. Um, what you really need to be looking at is the profit, because there's, you know, that revenue doesn't come for free. Now, there is a certain amount of, like I was talking about before, there's some fixed costs that you already have. And so in a sense, some of that revenue that you're buying does drop to the bottom line, but a lot of it won't. And what ends up happening in a service business like ours is your expenses are flat, flat, flat, flat until you have to hire someone, and then there's a huge stair-step jump in your expenses. And if you haven't accounted for that properly, that's when you're going to start feeling the pain of, Hey, suddenly there's not really that much money left at the end of the month by the time you make payroll. So yeah, it's, it was close. And I think we probably could have made it work. But I'm not really, you know, losing any sleep over missing out on the deal because there were risks as well.

Right. And do you, the way I look at it, I, and the way I look at it, I'm looking at it and saying I pretty much 13% seems to me ballpark. You've dialed in your business so much that you understand that in a, in a way that allows you to proceed at pace. And it would probably be a great comfort to your investors and your— is your business partner similarly situated? Is he in your ear saying, we're close, let's do it?

Or— No, that was me. He was the other one. He's more conservative. Conservative in terms of the price. We're very closely aligned, but I'm probably more the one who's like, "Eh, let's just pay a little more. We'll figure out how to make it work." Because it's really easy to get caught up in the psychology of doing a deal, the excitement of it. It feels good. You know you're going to get all kinds of congratulations and the team's going to be excited and your friends and family and your Twitter community are all going to be cheering and congratulating you. But You can't let that get in the way of the facts and the numbers. I mean, you could make a deal every month if you wanted. Making the deal's easy. All you have to do is pull out a checkbook. If you want to build a business that's profitable and sustainable, there's a lot more to it. So just to make it concrete, this Property management company, I know for a fact that one of their clients has over 100 doors, just one client. And so that one client represents over 20% of the business. And if that one client were to leave, say within the first year of the transition, or maybe on like day 366 of the transition, suddenly 20% of the value of that deal just went out the door. And if you didn't sort of price appropriately for that risk, now all of a sudden you're way in the hole on the overall deal. So that was one of the concerns of a few that held us back from bridging that gap.

[Speaker:ROBERT_LEONARD] You could bridge the gap. I know in one of the ones I'm negotiating now, I looked and the owner sits on 5 different nonprofit boards that do a lot of printing with the business. And she's, she's been there in the community for 30 years. And a lot of their businesses associated with that. And so I— part of my offer tied— she could identify, we would identify the accounts together. But those, for certain, certain that those accounts, if anything happens to those accounts, then, then the seller carry is impacted as opposed to the initial price that I'm bifurcating that.

And I think that's really smart.

Yeah, I felt comfortable if, if, if I identify the accounts, and she's resistant or hesitant to that, then it gives us at least some starting ground to narrow the gap on the valuation. If If you're not certain of the money, then why should I be? Exactly.

Yeah. And that was actually, you know, that, that, that was, it's a very similar situation that we had where we identified that and some other risks. And we said, hey, you know, we're more than willing to pay for these if they bear out, but we would like you to share in the risk. And if these accounts walk in the first year or the first 2 years, you know, that's going to come out of your second payment. And the seller in this case was not having it, really didn't like that arrangement and felt like, well, once you're managing the property, it's on you. And yeah, there is a certain amount of truth to that, but you're also asking me to pay top dollar for a client with 100 units who may decide to sell through no fault of my own. And I can't— So I think one of my big takeaways was like, The seller has to be motivated, right? And they have to— There's people all over who are just, "Oh yeah, give me a number. What are you offering?" And it's like, "Well, hold on. What's your motivation for selling? I'm not just going to spend 2 weeks doing a deep dive on your business and preparing an LOI and an offer if you're not even motivated or serious." So It was frustrating to kind of be dragged along for over a year. And we didn't know there was other bidders. They kind of made it seem like we were their one and only. And they sort of, I don't know, it didn't leave me with the best taste in my mouth when it was all said and done. I mean, I guess business is business and you want to try and get top dollar for your business when you're selling. But I probably would have done it a little differently if it was me.

[Speaker:ROBERT_LEONARD] Okay. You mentioned that for over a year. Was, was that negotiating or due diligence? What was the, what was the breakout? What was the breakout in that?

Well, so there was a, there was a few month period of sort of a combination of negotiation and due diligence. It was like, back and forth, they were giving us information, we were sort of refining our number, our offer on the LOI, and then All of a sudden, they were like, "Well, we're going to continue to own the business for a little while here." And for whatever reason, they just didn't decide to sell. And then, so 9 months went by, and then all of a sudden, they reached out again all in a hurry. And they were like, "Okay, this is back on. Can you resubmit an updated LOI?" And so then, we had to do all this work again with the latest numbers from them. And So it was, there was a long period of like no activity in the middle, but there was like a lot of activity on either end of that.

Got it. So they, it sounds like they thought about selling, there was a break, then they really decided to sell. Yeah. They brought you back in and then they went with another buyer who paid top dollar.

Yeah. And ironically, the buyer, uh, the buyer who's a large, you know, the, the co— it's a large company owned by a pretty well-known guy in the property management business. And this is like, they buy property management companies left, right, and center. I mean, I think they've done over 20, maybe close to 30 transactions like this. And so over a year ago, when I was initially negotiating with this seller, I actually called this guy, the eventual buyer, and I asked him for advice about the deal. Now, I didn't mention the name. I think he just sort of coincidentally found it on his own, but I sort of explained the situation and gave him the background and said, "Hey, we're kind of at a standstill. Do you have any tips?" bought a lot of businesses. And he gave me some really good advice. Just wasn't enough to actually get it done. And then sort of coincidentally, he ended up buying it later on. But yeah, it's kind of funny.

That's a, that's a, the people who have closed transactions, the person that you were negotiating with probably knew this person in the community too. So they had, they had a, they had, they had some of that insight. But again, if it meant more, if it was worth more to them, it doesn't mean necessarily that they overpaid. They may have been able to extract value out of it that you totally agree, you know, the, that guy that owns 100, they know him really well, or, or they've mitigated that risk, risk in a contract way that you, you weren't comfortable, or that because the price they were paying, the person was willing to assume more risk on, on that side. So on the We see a lot. And I think some of these, maybe the deals we're talking about may be a little smaller. A lot of the literature on this, it's almost, it's, it's, it's funny to me because I apply it to much smaller businesses. But they're talking about businesses in the, you know, a small mid-market business with $50 million. Those kinds of things, they're much smaller. But the, the weeks of accounting and lawyer fees and that sort of thing, what I've done is I found a way that businesses— that banks deal with distressed businesses, they they do a 13-week cash flow analysis. They, they look at a year's worth of transaction data. They estimate all their costs, the variability of everything, the lag for between sales and collections and AR. And then they project it for 13 weeks and, and then they use some actuals to true up and dial in the model. And And for me, not being a spreadsheet guy, and having a higher margin consulting business, I've never had to do that level of detail. Yeah, sort of to make the books work. But I found that to process these businesses, when I say that's what I look at, how much is coming in, how much is going out, putting it on that spreadsheet, and then looking at that 13-week. And now that I've done a few of these, I can compare the cost of goods sold across this industry and stuff jumps out. So, so my due diligence now, I feel like I may be missing some things or some elements. But as far as the actual, the detail, the numbers on the business itself, I can get my mind around those things really quick. What are some other things you're looking for in your due diligence? That beyond the numbers on the dollars per door?

Yep, there's a lot. So we look at the geography of the properties. We need to know where are all the properties located within Central Ohio and what kind of properties are they. Are they single family? Are they multi-family? How big are the unit counts? And also the, the constant— the client concentration, like I was talking about earlier. So How do you value a business that has 100 doors, each owned by 100 clients, versus, you know, 100 doors owned by 2 clients, right? Those would be valued differently. Um, so those are all a factor. We also look at, um, what's the reputation of that seller, you know. Are they— do they have a reputation for being a straight shooter and, you know, an honest, upright guy, or is this someone who's Has a reputation for just making a buck by any way, and what are we going to be inheriting if that's the case? We look at the actual contracts themselves. So how closely aligned are the property management agreements with our property management agreement? Obviously, the closer the better, because that's the easier it's going to be for the clients. There's always going to be a transition period and you're going to lose, you're going to churn out a few of the clients no matter what you do. I would say 10% would probably be the absolute minimum you could expect and probably closer to 20%, just because no matter how smooth you try and make it, certain people are going to sell, certain people are just going to take the opportunity to shop around or self-manage. So Those are all things that we look at and sort of try to account for in our offer. Let's see, churn, client concentration, geography, property management agreements themselves. And I think also we look at the philosophy of the property manager. How closely is that aligned with our own philosophy in terms of cultures and values and the way they do things. There's a lot of different ways you can do property management and every individual company does things a little differently and has a different way of thinking about sort of high-impact or high-leverage activities and events that happen throughout the course of business. And the more aligned those are with our own Again, the easier that transition is going to be. And then of course, the financing piece plays a role as well. If the owner is willing to, you know, carry a note at a reasonable interest, you know, that makes me more willing to pay on the higher end. If they're willing to prorate the payments based on how many clients leave, that's going to affect it. How long are they willing to space out the payments and things like that? So yeah, there's, like I said, a lot of different levers.

You didn't mention, and maybe in a different acquisition or experience, in this one you were just looking at contracts, right? The people risk and the personnel risk is very real. I am in one of the— I mentioned a poorly, what I think is a poorly run business that I'm buying. The actual staff that works there is really good. It's just had a disconnected out-of-state distanced owner. And so, and so there's not been that energy on site. But the manager knows his field and his industry really, really well. And, and I want to be associated with him. I'm excited to learn from him, learn the business from him. But honestly, as I look at the list of employees that do all the work, I haven't even met most of them. As I'm making the offer. And, and some of the extremes that people go through— rehiring everybody, background checks, drug tests, that sort of— those sort of things. Do you have any experience acquiring people in the course of a transaction, or have you given thought to that?

So we have not done that before. We were actually looking at interviewing and potentially hiring a few of this company's employees just because we were going to need the, you know, the, the higher employee count to service all the additional units. It wouldn't have been a part of the deal, but yeah, certainly something to consider. I mean, when you have a really good employee like that manager you were describing, on the one hand, that's a great asset because that's someone who can really show you the ropes and, and help help the trains run on time and all that, but it's also a risk, right? Because that guy could leave and then what do you do? So it's kind of scary. It's like two sides to that. I think that gets back to how well documented is the business in terms of the processes and the procedures of the day in and day out operations of the company, and then how well structured and organized is the management layer. So If someone were to leave, is there a job description you could pull right off of a, you know, a binder and a job listing you could just copy and paste and pop it up there? And then once the new guy starts, is there a training manual that they can use? Is there someone else that's been cross-trained for that role? So all of those things, you know, is where my mind goes when I think about people. You know, the gold standard here is like a McDonald's or something, right? Where They can take anyone off the street and have them become a functioning cashier within half a day or something because they've got training videos and they've got— everything's just crystal clear. They've got their systems and processes lined out. And you contrast that with some of these small businesses where it's like not even the 20-year veteran even really knows how everything works there because the owner keeps so much of it to themself. Or, you know, there's just no documentation whatsoever. It's always like, well, Johnny knows how to do that. I always just get him. And, you know, so it's, there's a lot there.

And that is, that is the case. And maybe it's a definition of well-run, but the really well-run business, it was immaculate, organized. When I, when I toured, it was comparing it to the other one. It was night and day. But that's where I saw, I saw the opportunity, one, to mess things up. But they'd been doing it for so long, the building was optimized for the work that they were doing. But I don't think any of that, the process was documented. They had signage and direction and checkoffs. But I doubt there's a manual that says, in case, you know, in case of disaster, do this. But that layer of management was there. And so you had, you had, you had the people in place and there was a decent amount of cross-training. It doesn't shut down when one person on one process gets sick. Yeah. But the, the risk associated with that one person leaving was less. But I thought in my process of getting up to speed and learning new industry to me, that documenting some of this stuff and, and I don't have any intention to sell immediately or anything like that. But I thought adding, adding and creating documented processes over time would help me both learn, but then I think about it in terms of improving. So that if I have to change the written process that I've got, because how they explained it is a little different than what I'm seeing. Even if I have to do that myself as they're working through it. At some point, I may have some value add to it to an industry where I'm, I'm more inexperienced. Sure. Which might be scary to you because you're talking about buying in something where you, you're intimately familiar with what they're doing in that bolt-on and I'm talking about buying something in a related business. Vendor. Yeah, different risk tolerance, I suspect, and, and deeper wisdom on your part on the processes and that engineering background on, on how to run a business. And so I'm confident I can sell enough to make up for whatever deficiencies I might have in the running the business, then I'll go generate more, more sales because they deliver a high-quality product. So yeah, if I If I put it in front of people, I can get them to buy it.

Yeah. And in a lot of ways, it's a simpler business, right? I mean, it's a product business, you're delivering a product. As long as you can make a high-quality product and market it well, you're going to be fine. You know, I've talked at length about the complications of property management and how difficult it can be with, you know, the challenges of having two customers, your your client and your tenant both. And they're— so yeah, I think, I think you'll be fine. It's exciting. I'll probably be right there with you in a little while. We are in contract on a different business. It's a small engineering company. And that's actually set to close here in April. I'll be able to talk more about that as we get a little bit closer. That business, my business, my current business partner is going to go off and run that. He and I will be 50/50 owners, but he's going to go off and run that business as CEO. I'll stay here in the management company and run it without his involvement in the day-to-day, which is fine. And so he'll have a similar experience to you in that he's going to be jumping into a business that he's not been intimately involved with before. He has an engineering background like I do, so to a certain extent he's familiar, but The business that he was in before as an engineer is different substantially than this one. So yeah, I'm excited to talk more about that as we get closer and probably parallel with your own journey.

Well, it'll be interesting to see what the reaction is. I feel like I've learned a lot, but I also have the details of the transactions that I'm working on top of mind. So this may have been something that was just interesting for you and I, but I look forward to seeing what, uh, what everybody else—

general interest. I know there's a lot of folks that are either looking to get involved or are involved in, uh, small business acquisition. So yeah.