Paul Giannamore: Whenever you sell a business, you're selling a debt-free, cash-free enterprise. It doesn't necessarily mean that the business has zero cash and zero debt but the enterprise value assumes zero cash and zero debt.
Patrick Baldwin: Happy New Year, Paul.
Paul Giannamore: Happy New Year, PB.
Patrick Baldwin: I've got a few things lined up for you, maybe throw a curveball or two. By the way, it's been a few weeks since we caught up and I'll see you in a week or two down in Tampa, see you at Power.
Paul Giannamore: This is true. It's two weeks, right?
Patrick Baldwin: Yeah.
Paul Giannamore: I will be going down to Tampa.
Patrick Baldwin: Are you bringing security with you?
Paul Giannamore: I'm not. Is it a sketchy neighborhood we'll be in?
Patrick Baldwin: No, it's nice. The Ybor City, it's all the hand-rolled cigars, we've been there.
Paul Giannamore: That's right.
Patrick Baldwin: It's been two years, January 21.
Paul Giannamore: I can't believe it.
Patrick Baldwin: When you spoke with the U Group. Anyways, we'll be at the same hotel, it's nice. You're coming solo.
Paul Giannamore: It'll be Mexican-free this time.
Patrick Baldwin: That's exciting, just kidding, Mex. By the way, do you set New Year's resolutions every year?
Paul Giannamore: No. Do you?
Patrick Baldwin: No. Now that I've taken on this Fat Pat moniker, maybe I should.
Paul Giannamore: Had you done it historically?
Patrick Baldwin: Yes, I have, but this year, I couldn't quantify anything so I was like, “Should I lose weight? Sure.”
Paul Giannamore: You've got everything you want, PB?
Patrick Baldwin: No, I could still lose more weight, get better shape, drink more water, nutrition, and work out. There's the business to be had this year. If I think about setting a goal, I don't. Do you want to set some for me?
Paul Giannamore: Let's think about this here. I wasn't prepared. Goals for Fat Pat.
Patrick Baldwin: You want to crowdsource my goals now? Is that what you're trying to do?
Paul Giannamore: I could think of a couple of things that I would hear from different people, one is related to a tattoo.
Patrick Baldwin: The year is still young, there's time for that.
Paul Giannamore: Speaking about Elon Musk, what a phenomenal short Tesla has been, hasn't it?
Patrick Baldwin: Are you monetizing that?
Paul Giannamore: I shorted that Tesla bubble, it's down 12%, Patrick. It's probably been one of my best shorts ever.
Patrick Baldwin: I wish sometimes you would tell me these things.
Paul Giannamore: Look for bubbles, I'll be on the other side.
Patrick Baldwin: I just pulled up Tesla, it's ferocious.
Paul Giannamore: The question is do I close out of it soon, Patrick, or let it ride all the way down to $20 a share?
Patrick Baldwin: I don't have an answer for you.
Paul Giannamore: I'm going to let it ride. I'm standing that one.
Patrick Baldwin: Do we need to crowdsource my New Year's resolutions?
Paul Giannamore: We should, let's go ahead and do it.
Patrick Baldwin: TheBuzz@PotomacCompany.com
Paul Giannamore: You got a resolution for Fat Pat, send it on our way, and we'll read it in the next episode.
Patrick Baldwin: This is going to be delightful, I love it. None for you, though. You're not going to take requests?
Paul Giannamore: I've never been a New Year's resolution type of guy so I have zero. Unfortunately, Patrick, there are no exciting resolution tales.
Patrick Baldwin: I could see you saying, “I'm going to read 24 books this year,” or something like that, but I guess you read when you want, I don't know.
Paul Giannamore: My head is more wired to process than it is goals.
Patrick Baldwin: What does that mean for reading? Read daily.
Paul Giannamore: I don't have any reading goals or resolutions. I pick up a book when I want to. I got to be in the mood. No, I don't have that. I've never had a problem with not reading, though.
Patrick Baldwin: Do you have any travel goals? Travel as little as possible? Travel to a new place?
Paul Giannamore: I will be going to some new places this year, that's for sure. I have shifted my travel over the course of the last year where I'm trying to travel more for pleasure than for business, which has never historically been the case for me. Now, I want at least the majority of my travel to be for pleasure.
Patrick Baldwin: Of course, you're doing business development while you're traveling for pleasure although it doesn't matter for your tax situation.
Paul Giannamore: No matter where I go, I’m developing some business. At the end of the day, I want the pleasure to lead the trips so I plan on doing some of that.
Patrick Baldwin: What's new? I don't know where you haven't been.
Paul Giannamore: Where will I go this year? I will be going to India and Japan. After Tampa, I'm going to be in the Philippines, that's for business, I'll be doing that at the end of the month. I've explored quite a bit of Asia but I'm starting to do a lot more business over there so I'm more interested in hitting up some areas that I haven't been to. Vietnam and Cambodia are two places on my hit list. I’d do that. I like to get back to Malaysia, I haven't been there for a while. I always find myself in Singapore so that's not on the list for this year.
Patrick Baldwin: Nice.
Paul Giannamore: I'm going to try to avoid the Middle East as much as I can, although I will end up being at Pest World East in Dubai at the end of February so I'll be there. Outside of that, I need a year where I avoid the Middle East as much as I can so that'll be this year.
Patrick Baldwin: I wonder if our friend, Michael, is going to be there at Pest World East with his falcons.
Paul Giannamore: That's true, I bet you he'll be there. Although he's not often in Dubai, he's in the Emirate of Abu Dhabi more often but that's a 45-minute ride. I bet you Michael will probably head down there. Pest World East gets a decent amount of European operators to come down and a lot of Asian ones come in. Of course, we've got the Middle Eastern ones. It's a short 2 or 3-day affair. I was in Dubai less than a year ago. In April, I was in Dubai. I'll be looking forward to getting back there.
Patrick Baldwin: ’22 is wrapped up, it's in the books. 2023, I'm wondering if you've got some prophetic things coming or if you got your crystal balls in terms of M&A if you think what 2023's going to look like keeping you busy over there.
Paul Giannamore: In our industry, not much has changed since you and I talked about this. Transactions are largely led by financial sponsors. We saw GTCR get into the lawn care/pest control space with an investment, Senske. Over the next 60 days, you'll see probably another 3 or maybe 4 private equity firms getting into the space. We're doing four financial sponsor deals with three different firms, two of them are brand new entrants. We'll start to see additional entrants get into the space.
The strategics, of course, have been relatively slow. When I say strategics, I'm talking about the usual suspects, Rentokil, Rollins, and Anticimex. The first quarter will be dominated by financial sponsors, that'll probably start to slow down as we get into Q2. We're in an environment where rates have continued to go up. We'll have another rate increase here maybe 25 basis points or maybe 50. The Fed will probably pause things in the US for a bit but rates will be higher for longer. That could potentially lead to a credit event at some point in 2023 as credit spreads continue to widen.
The leveraged loan market is pretty locked up. It's clear that a huge majority of the world is now finally moving into recession. We're going to have the US and Europe here in recession in Q1. We're going to start to see the demand destruction. We've had multiples contract. In 2023, we'll start to see the guide-downs from publicly traded companies as we get into the heart of the earnings recession. If you look at Rollins’ stock, for example, have you looked at that?
Patrick Baldwin: I have not, no.
Paul Giannamore: When I was in Doha in November 2022, that was when Goldman Sachs sold the $300 million block of Rollins’ stock. As you look at that, effectively from that date, we've continued to see Rollins trade down over the course of the last month or month and a half. Rentokil proved to be somewhat resilient. We'll start to see the guide downs. I'm not talking about guide downs in pest control, I'm talking about overarching S&P 500 in the US, it’s when we'll start to see the guide downs. We're in the third phase here, the bear market, effectively.
Patrick Baldwin: Tell me more about this credit event. What does this look like, ‘08 or ‘09?
Paul Giannamore: These things tend to not repeat exactly but we've got a tremendous amount of high-yield debt out there. We're at the beginning of debt service problems. You start having bankruptcies, you get some defaults, and you get some bank problems. I don't think it'll be the same situation as 2008 or 2009 but we could see a nasty one here in ‘23.
Patrick Baldwin: From where you're sitting with the clients you're working with, have you seen an impact, maybe it's too early, in terms of residential demand? The inflationary environment and we're getting into a recession. Maybe it's poor timing to ask that being the winter season but the demand just isn't there.
Paul Giannamore: That's a great question and you're 100% right, it is hard right now, end of December 2022 and early January 2023, to make that assessment. It’ll be interesting to see what happens here in the spring, that's when it's going to start to get interesting. In theory, you'll have cancellations to tick up. Inflation has somewhat peaked. At least, right now, we'll probably end up having another inflationary spike if the Fed ultimately pivots. For now, inflation has decelerated but input costs are still going up. Because inflation on a rate-of-change basis has slowed, it doesn't mean we don't have high inflation, which we have.
It'll be interesting to see here, in the spring, what price increases people are going to be able to exert. For me, the interesting question is the best time to get price increases is Q2, April, May, and June, which is the beginning of the pest control season, and that's when to do it. It's going to be interesting to see if people are going to be able to exert as much pricing pressure this 2023. I don't have an opinion on that, as a matter of fact. Try to be like the Fed and be data-dependent. It'll be interesting to see what happens. What are your thoughts?
Patrick Baldwin: It's a good time to not be in the business. It’s someone else's decision to make right now. Yeah, it's tough. I'm feeling it personally. A dozen eggs are $6.50, I'm like, “What? This is crazy.” Gas is super cheap. Isn't that crazy?
Paul Giannamore: I paid $9.90 for a dozen eggs here in Puerto Rico over the weekend.
Patrick Baldwin: Do they let you raise chickens up there?
Paul Giannamore: We got chickens all over the place running around.
Patrick Baldwin: On your balcony? You're going to put some up there?
Paul Giannamore: My 13-year-old nephew was down here and was watching chickens cross the road so he was curious as to if that's where all those jokes came from.
Patrick Baldwin: Chickens are worth a lot of money. $9.90 for a dozen? I'm complaining. I need to stop. Gas is $2.50 so I know we've got it nice here.
Paul Giannamore: I go to the grocery store down here and I scratch my head as to how the average person down here makes ends meet. What's a large container of Greek yogurt? I don't know what size that is. Two pints maybe?
Patrick Baldwin: Sure, yeah.
Paul Giannamore: $10 at the grocery store as an example.
Patrick Baldwin: You're killing me. I didn't take you for a Greek yogurt kind of guy though, Paul.
Paul Giannamore: It was on the list that was handed to me so I purchased it.
Patrick Baldwin: I'm wondering if the places you're traveling to were also on someone else's list that was handed to you. How many of those are wife-induced?
Paul Giannamore: Zero, not many.
Patrick Baldwin: Are you going solo, though?
Paul Giannamore: Some, I’ll go solo.
Patrick Baldwin: Any other predictions for this 2023? I heard a lot about private equity and financial sponsors.
Paul Giannamore: It will be a private equity Q1.
Patrick Baldwin: Are you going to place your bet on when Rentokil is going to have a big deal or are they going to be stuck integrating Terminix for the foreseeable future?
Paul Giannamore: They're buying businesses like that right now, Patrick. They just bought RK Environmental. That was in the high teens. They're continuing to look at businesses that are $10 million, $15 million, $20 million, $25 million, and $30 million and above. I don't see them slowing down on that. Rentokil will be more selective. Historically, prior to the Terminix transaction, let's say that you have four businesses in the $15 million revenue to $25 million revenue range, they may have been interested in 3 of the 4 two years ago. Now, they might just be interested in 1 of the 4. They are being more selective as to what they go after, but they'll still do them.
Patrick Baldwin: I've got two listener questions and they're similar but equally different. Scott, not far from me here, wants to know, “I'm planning on selling in five years but I need to buy vehicles now and I'm looking at enterprise leasing. You have recent clients that had enterprise leasing in their fleet you just sold. Should I finance them? What does that mean as far as when the deal's done and maybe it's going to be before five years? What are the benefits or advantages or disadvantages of financing versus leasing with the end in mind?” How is it valued at the end, asset liability, or taking over leasing?
Paul Giannamore: It makes no difference because if you're leasing a vehicle, you would have an operating lease. You might have capital leases but let's just plain here. You've got an operating lease for your vehicles. Let's say you're paying $10,000 a month for your vehicles, that's your lease payments, so $120,000 per year. When we analyze a business, we remove the operating leases for vehicles from the P&L, that's usually an adjustment.
The reason why we do that is that we want to be able to compare that business, apples to apples, to a company that finances. It goes out, puts a down payment down, takes on bank debt or other financings, and puts that on their balance sheet. Other than interest expense, which is already removed from the P&L because we're looking at cashflow on a pre-interest basis, there are no vehicle expenses.
If you're comparing a company that has a lease versus a company that's financed, you remove the lease payments from the P&L and you assume that the assets of the business will be acquired free and clear. 99 times out of 100, leases are not assumed. Sometimes they are and it depends on the acquirer. The large strategics in the industry will virtually never assume leases. Certain things can happen on a case-by-case basis but it doesn't change.
Even if the leases are assumed, you have to look at the liabilities associated with the lease and that's a net debt item. Irrespective of whether they're assumed or paid off to the seller, the seller of the business, there's no difference. Furthermore, there's not a lot of difference at all. If we go back to 855Bugs, you guys either finance or lease. When you ultimately get to the finish line, because the leases are typically not assumed, you're going to end up having to pay those off anyway. It's almost like paying off bank debt associated with the vehicles.
Operating leases are another way of financing vehicles. If somebody asks that question saying, “I'm thinking about this with the end in mind. Am I better off buying them or selling them?” Sure. If you own those vehicles free and clear, you wouldn't have any debt, you would just deliver those vehicles free and clear with the business.
What you have to keep in mind is whenever you sell a business, you're selling a debt-free and cash-free enterprise. It doesn't necessarily mean that the business has zero cash and zero debt but the enterprise value assumes zero cash and zero debt. You get to the closing table and if you've got $1 million in vehicle financing, you've got to pay that off because you're handing over those vehicles free from any encumbrances.
The enterprise value is the value of effectively all tangible and intangible assets of the business. If somebody is like, “My aggregate purchase price is $10 million.” I, the seller, I'm handing you, Patrick, a $10 million business, debt-free, and cash-free with no liabilities, you take the whole kit and kaboodle and you're done with it. I wouldn't get hung up on vehicles. I would do whatever's best. I lean heavily toward leasing.
Patrick Baldwin: I didn't know you lean that way, I thought the other.
Paul Giannamore: It's a lot easier to deal with leasing, quite frankly.
Patrick Baldwin: Let's talk about traditional finance, drill it down for a second for me. You mentioned $1 million of liabilities, you would have to pay that out. At closing, there's $1 million, and pay off the liabilities. Call it $1 million of assets of the vehicles there, that's already been figured into the purchase price of the deal. They’re assuming, “We're going to get these $1 million worth of vehicles and you're going to pay it off. Is that right?
Paul Giannamore: That's right. The purchase price is the entire bundle of all tangible and tangible assets so they're buying all those assets with no liens or encumbrances.
Patrick Baldwin: If they're looking at 2018 and 2019, late model vehicles on a deal versus 2005, 2006, or 2008, these guys, the wheels are barely sticking on, they're going to value that business a lot differently. They don't overlook the vehicles, do they?
Paul Giannamore: It's more nuanced than that. Back in the day, there's going to be people reading this that had sold businesses to Orkin and Terminix in 2007, ‘08, ‘09, and ‘10. Back in those days, Orkin never had a sophisticated corporate development department. Matt Whiting is a super sharp guy. Everyone prior to Whiting was nice guys and don't know anything about making an acquisition.
Typically, when they would make these acquisitions, they would value the customer contracts, they would value the vehicles, they would value the receivables, and so on and so forth, and put it all in a letter. By the time you got to the closing table, if your vehicle, in the blue book value, was $100,000 and they thought it was $150,000, now your purchase price goes down by $50,000. It's not the way the world works.
As the acquirers have gotten more sophisticated, they're valuing the business based on that stream of cashflow. How does the age of the fleet impact that? Why I said it's nuanced is because they'll look at the fleet and they'll say, “From a maintenance CapEx perspective, what do I need to do on a go-forward basis in order to keep this fleet relatively modern?” It's the adjustments they'll make to their financial model on a go-forward basis that will determine what they're going to have to spend on maintenance CapEx.
Remember, cashflow is EBITA less maintenance CapEx. You're taking EBITA and then you're subtracting whatever would be maintenance CapEx. It's the acquirers’ projection of maintenance CapEx. If you got a super new fleet, less concerns in the immediate years as to replace those. If you've got an old fleet, they're going to have to increase their maintenance CapEx numbers, which will impair the forward cashflow projections, which will slightly decrease the value of the business. I say it's nuanced because it is.
Patrick Baldwin: On the flip side of the coin, leasing. What does that look like? Especially if I'm signing up for a five-year lease and I decided to sell in three years, how does all that get washed out?
Paul Giannamore: A lot of these guys are on programs where every year they might be turning a third of their fleet. Every three years, effectively, that fleet is turned over. The lessors’ enterprise is always a pain in my ass every time I do a deal, they're a nightmare to work with but there are a lot of folks that use it, and you're able to turn over your fleet quickly. It's easier, in a lot of ways, to do that. Personally, this has nothing to do with M&A.
When I look at it, I say a leasing program seems to be efficient. I look at it as potentially the way to go for a lot of people and a lot more people are doing it now. Look at all the big companies, those guys are all leasing stuff, they're not buying and financing vehicles. The last I looked, AX was using enterprise. I don't know if they're using enterprise anymore. There are a lot of companies that use that. Enterprise is not the only game in town, they’re a massive fleet leasing company but there are a lot of other ones out there as well.
Patrick Baldwin: You're saying that 99% of the time, the buyer will not assume or you can't assign the lease to them. Do the vehicles just vanquish? What happens?
Paul Giannamore: You pay off the lease.
Patrick Baldwin: Then what?
Paul Giannamore: They go to the acquirer.
Patrick Baldwin: For the remainder of the lease?
Paul Giannamore: There are buyout values in leases.
Patrick Baldwin: I got you. You're buying out the remainder of the lease. The vehicle then stays in the business. Got it.
Paul Giannamore: Correct. You're delivering it free and clear. People always worry and say, “If I'm under a lease, I'll get shafted at the end because it's going to end up costing me more money.” That doesn't appear to be the case in most instances. The devil is in the detail on lease contracts. There are equity leases, open-ended, and closed-ended, and there are a variety of different types of leases and I'm not a lease expert.
Patrick Baldwin: Why do you prefer them? If the enterprise is a big pain in the butt, why?
Paul Giannamore: I'll give you an example, the enterprise won't accept wire transfers. We're doing a closing and we want to pay a bunch of stuff off, “Let's send $1 million to the leasing company.” The enterprise is like, “Don't send us a wire, send us a check.” Now we've got escrow agents and attorneys drafting checks out of closing escrows. That's why it's a pain in the ass, but that's not a big enough pain in the ass to not do it is what I'm saying.
Patrick Baldwin: At the end of the day, it's the Mexican that has to suffer through it.
Paul Giannamore: Exactly.
Patrick Baldwin: Your clients aren't experiencing that pain as much as your team.
Paul Giannamore: No, they're not. Correct.
Patrick Baldwin: That's interesting to take a check over a wire, to each his own.
Paul Giannamore: It's interesting because a lot of the vehicle financing companies will still require checks. It's the only time we're ever cutting checks. Sometimes there'll be a shareholder who’s 90 years old and doesn't want to get a wire transfer, “Fine, we'll send you a check.” Vehicle financing companies and leasing companies tend to want checks for whatever reason, although that will certainly change.
Patrick Baldwin: In the terms of the deal structure, they're virtually washed.
Paul Giannamore: Correct.
Patrick Baldwin: I got another one. I was talking to another listener, Merle is what he wanted to be called for The Boardroom Buzz. He posed a question to me and I said, “I know a guy that could probably answer this a thousand times better than me.” He posed this question and said, “I'm thinking about selling equity and maintaining 60%. I want to sell 40% of my business for roughly $250,000. What does that look like in terms of taking the cash and then lining out assets, liabilities, and equity? How do I divvy all this up and move forward with the business?” I said, “Let me ask Paul.”
Paul Giannamore: There's a variety of different ways you could do it. He could personally sell equity. You could have the company issue new equity securities and effectively dilute him down through treasury. There are a lot of different ways to do it. This is not legal advice whatsoever. He needs to talk to a competent attorney and tax advisor that could suggest how he does that.
A very plain-vanilla way to do it is to sell a portion of his shares. He owns 100% of the business, he's selling 40%, and then that money would never end up in the company, to begin with. Unless he wants it to be in the company, then the company would have to issue and dilute. There are a variety of different ways to do it. Plain-vanilla would be signing over 40% of the shares.
Patrick Baldwin: Does it matter how much cash is in the bank account or how much he has out on a line of credit or vehicle loans? Does that all come into the equation or does he need to figure the value of all that out before he makes his offer?
Paul Giannamore: When you're selling 40% of the business, when you value a minority stake in a business, you first start with the enterprise value. Enterprise value is the value of all tangibles and tangibles. Let's use round numbers and say the business is worth $1 million and you're selling 40% so now you've got to build what's called an equity bridge. Let's use a home. Somebody buys a $1 million home and they put 20% down and then they have an $800,000 loan. The enterprise value is $1 million, what's the equity value?
Patrick Baldwin: $200,000.
Paul Giannamore: Correct. What you would ultimately have to do is go enterprise value, build equity, and build a bridge to determine which net debt items in there should adjust to equity. Usually, when you're talking about minority stakes in businesses, there are often discounts and two prominent discounts would be a discount for lack of marketability because a 40% shareholder can't go out and freely exchange shares on a market. There's a minority interest discount because you would lack control.
Let's assume for a second you were able to value the business. Let's say that 40% of that $1 million business is $300,000. Let's forget the valuation calculus for a second. Now, he takes on the shareholder, he's going to have to have a shareholder agreement because he's going to need to understand the rights amongst the shareholders. Does somebody have drag-along rights? Could the minority shareholder drag him along into a deal?
There's a variety of different consent rights. Who controls the composition of the board? What does corporate governance look like? There are all those sorts of things. When you ultimately go to sell a business, let's say shareholder A owns 60% of it and shareholder B owns 40%. Shareholder B, the minority shareholder, when they ultimately sell that business, will need to sign a non-compete.
A lot of times, people forget about the fact that in order to be able to sell it, the 40%-er is going to be considered a material shareholder. Let's say five years from now, the business grows and you want to turn around and sell it to Rollins, Rollins is going to say, “Shareholder A and shareholder B, you guys have to sign non-competes.” Shareholder B that owns the 40% might say, “I'll sign that non-compete but you got to give me $100,000.” Are you allowing him to have blocking rights or at what point do you determine what the consent rights are? You need to do all that stuff from a corporate governance perspective upfront.
In my experience, the extreme majority of general-purpose attorneys know enough to be it dangerous and they think about the broad-based stuff. If you're going to do that, you need to get somebody that understands shareholder agreements and can draft something like that so that you as the majority shareholder, on the one hand, are in control of the business. If you're the minority shareholder, you have a certain amount of rights and so those rights have to be determined upfront because they can create a lot of problems.
What about dividend policies? What are you going to dividend out? How are you going to determine that? Is it monthly? Is it quarterly? Is it 50% of operating profits or 75%? What will be reinvested? You take on a shareholder, people often don't think about that thing. Six months later, one shareholder wants to reinvest everything and the other shareholder is waiting by the mailbox for the monthly check. Those are important things to document who determines those policies and that's part of board governance type thing.
In my experience, the myriad of people that call over here and talk about buying, like, “Paul, I want to take on a partner.” They mainly focus on the valuation part, which is important, that's step one. We’re playing in the same ballpark. In my mind, a lot of things that are far more important than headline valuation are all those other things. I don't even remember the question.
Patrick Baldwin: You answered my question by giving me a thousand more questions. going back to number one, the headline, what things should be considered in terms of making an offer, like, “If you want 40%, this is what it's going to be.” I'm thinking like Shark Tank here, like, “We did this much in sales in the last twelve months and this is what I'm asking for.” What is it? Assets, liabilities, annual recurring revenue, and annual revenue? What does that incoming shareholder have access to or their shared responsibility in? All these vehicles have liabilities, you're part of paying these. Does he need to pay these off? I don't know.
Paul Giannamore: A lot of indenture agreements will have anyone that owns greater than 10% of the equity capital of the business has to be a guarantor on things and so on and so forth. My first question is why take on an equity partner, to begin with? People take on partners for a variety of reasons, sometimes it's to take capital, and they need money.
Other times, they want some expertise that they don't have. If it's to get capital, I would say equity is the most expensive form of capital out there. If you could borrow debt capital as opposed to selling equity, you'd be in a better position in a lot of ways. You should explore all opportunities to take on cheaper capital, which is debt.
Secondly, if you're doing it to get some expertise that you don't have, my question is always, could you go out and buy that on the open market? Do you have to give up a portion of your company for it? There's the other class of people that will say, “This guy is going to run the business for me. He wants to invest and he's going to run the business.” In that particular case, it could make sense.
To answer your question, what will the new shareholder be on the hook for? It comes down to a case-by-case basis depending upon what's outstanding in that business. You can't be responsible for something unless you sign as a guarantor. Unless they have to sign up with the bank and then if there is bank debt, there might be covenants that say, “If somebody buys more than 10% of the business, they have to now become a guarantor.” As a minority shareholder looking to get into the game, those are things that you would want to investigate.
Patrick Baldwin: This brings back memories, back to 2011 and getting an appraisal with you and Jeff the “Shady Attorney.”
Paul Giannamore: That wasn't shady, it was the opposite of shady. Yes, I do remember that.
Patrick Baldwin: One of the kindest people ever. Your recommendation is don't take the capital.
Patrick Baldwin: When Merle called me and asked me this question, I’m like, “Why?” I’m figuring out what the end game is. What’s his motivation or incentive to do that?
Paul Giannamore: Publicly traded companies have to think about this stuff too. When they think about the breakdown, what is the profile of their investors? What are the institutions that are in their stock? What is their MO? Are they growth investors? Are they conservative? Do they want the company to reinvest in growth? Do they want high dividends and low growth? What is the profile? In your particular case, the guy that was going to come in wanted dividends out of the business.
Patrick Baldwin: You called them coupons.
Paul Giannamore: Coupons, that's exactly what I did call them, that's correct. He wanted to collect coupons. Whereas you and Bobby wanted to reinvest back in the business, that's a mismatch, which was going to result in problems. Plus, there is a massive delta between investment value and fair market value.
Fair market value is that hypothetical construct of a buyer and seller where there are no synergies in the transaction. That's me coming in saying, “I, Paul, want to buy 40% of some business.” I'm not creating synergies. I'm not a strategic acquirer. Whereas investment value or strategic value, as it were, tends to be a lot higher, specifically in the last 7 to 8 years as valuations have gone up.
This was not that big of a deal back in your day, although it still existed but not to this extent as it does today, the delta between investment value and fair market value. What's an example of that? The $1 million business might be worth $1 million on a fair market value basis. We refer to these as standards of value. The standard of fair market value might be worth $1 million. From an investment value perspective, it might be worth from $2 million to $3 million. Valuation is typically a range concept.
What's he buying in for? Is he buying in an investment value or is he buying in fair market value? He should be buying in at fair market value. Now, if you own a business, you're turning around and saying, “On a fair market value basis, my business is worth $1 million bucks but I could probably sell it for $2 million. I'm going to sell 40% of this business for $400,000.”
Theoretically, the minority shareholder could say, “Sure, fair market value is $1 million but I should get a discount for lack of control and I should get a discount for lack of marketability. Instead of $400,000, I'm going to give you $200,000 or $250,000 for that 40%.” A few know that but a lot of folks out there have gotten themselves into bad deals because they don't understand that there are these specific discounts that take place when you're dealing with minority shares in liquid privately held businesses.
Patrick Baldwin: in Merle's case, what he's looking at is bringing an operator so that he can relocate and leave the operator behind to run the business in terms of private equity, and in terms of leaving some chips on the table because I have to say that. Are there alternatives to selling equity with capital, like, “Here's capital and here's equity.” Are there other ways that this could be accomplished? Profit share? Bonus structure?
Paul Giannamore: I would say all of the above.
Patrick Baldwin: Jumping all the way to equity partners is a big leap.
Paul Giannamore: You could work together for a period of time with some sort of agreement. The minority shareholder could pay a small amount of money for an option to execute at a specific price at some point in the future. although that's unilateral, that would allow the minority shareholder to do it. There are some things that you could do. I'm probably particularly biased because I tend to see more problems from this stuff. It's often people come to me and say, “I wish I didn't do that.” As opposed to, “That was a great idea. I wish I would have done it all day long and more.”
Patrick Baldwin: In regards to partners?
Paul Giannamore: Yes. I rarely ever get calls where people are saying, “I want to sell equity in my business.” There's not a day that goes by that there's not some inbound into Potomac, which is, “I've got a problem with my partner, he's lazy, he's on the couch all day, and he's not doing anything.” The list goes on. That happens.
Patrick Baldwin: I'm picturing this big pie chart and I'm wondering which wedge of it is partnership problems as far as where you're having to get in and problem solve and get creative and be the counselor.
Paul Giannamore: It's different. On the sell-side deals, we often have a lot of partners that are multiple shareholders owning a business. There is a lot of therapy that goes on. As a matter of fact, somebody called right before Christmas, a super nice guy having issues with his partner, and I referred them to Corey's partner, Fran, who's an ASA, and who does all of our 59 to 60 evaluations for tax purposes. We don't do divorce value. We don't do any of that stuff anymore. Whenever there's partnership-type stuff, I will get involved from a high-level perspective but we don't even do that work in-house anymore. It's not where I like to spend my time.
Patrick Baldwin: As you've been saying this, I'm thinking about someone that could help them out that does these all the time. This is unsolicited but Phil Rinehart is an attorney that also owns a pest control business out in Vegas. Phil would be an excellent connection for Merle in particular. Phil's been great and I know he deals with partnerships and both putting them together and taking them apart and all sorts of things, getting all paperwork together. He's helped me out with a new business. Phil Rinehart is an amazing person in the industry. We'll see. He'll be at Power here in a couple of weeks too.
Paul Giannamore: That's right, I remember that now. That's would be nice. I’m looking forward to seeing you, Phil.
Patrick Baldwin: We're in 2023. We're up and running. Can't stop time now. Please, I would love to hear your goals and resolutions for Fat Pat. Email those to TheBuzz@PotomacCompany.com. I don't know what the end of 2023 is going to look like for me but I think I'll have a tattoo.
Paul Giannamore: Sounds good, Fat Pat. I look forward to seeing you in a few weeks up in Tampa.
Patrick Baldwin: Paul, have a great week. We'll see you.
Paul Giannamore: Take care, brother.
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