Paul Giannamore: If you're going to take an earnout, you can't go into this with full trust and faith that the buyer is going to do what they say that they're going to do because that often doesn't happen.
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Patrick Baldwin: You look more rested than me and I know you've been doing a lot.
Paul Giannamore: Yeah, PB. I've skipped the Rocket-X thing in Dallas. There was no way I was going to get on a plane after having a bunch of people out here for a week. I'm glad to be able to not do that. Down here in PR, we've got a ton of rain and flooding. I got no AC here in the office. Everything is on generator. How was your trip down to Puerto Rico?
Patrick Baldwin: You're probably rested and relaxed because I've been babysitting the Mex for the past few days.
Paul Giannamore: It was great. It was fantastic.
Patrick Baldwin: This is extra Fat Pat, these eye bags underneath my eyes.
Paul Giannamore: I see it.
Patrick Baldwin: Rocket-X was good. I got to see a lot of our colleagues. That was definitely the best part of it, seeing everyone. Tommy Mello was one of the speakers, that was a big draw for people. Conferences makes you appreciate what's done well and what's not done well as you go to these different events. I’m glad to have other colleagues there to make the time more enjoyable, that's for sure. If you can read between the lines, yes. Rocket-X, is that a conference you would go to?
Paul Giannamore: I don't think so.
Patrick Baldwin: That's why you sent the Mex in your place. Smart man, Paul. You did a lot of filming down in PR and had a lot of people coming and going. A great time. Great to see you again, everyone down there. I don't know if that's going to be a reoccurring event, do some more filming.
Paul Giannamore: Every 2 to 3 months down here, we'll probably do that. We've had a lot of people down here over the years but that was the more formal of event we've done. I have been consistently harassed by people who did not get an invite. We're going to formalize this.
Patrick Baldwin: We've got trips to PR in the works again, every few months there. The Ask Me Anything is coming up here for FRAXN and Potomac clients. If you're a FRAXN client and a Potomac client, go ahead and make your way into our Ask Me Anything. It was a great time. The last time, lots of great questions came in ahead of time and during the show. Of course, Paul, you knocked it out of the park so lots of value there. If you have questions on that, email us at TheBuzz@PotomacCompany.com and we'll get you point in the right direction.
Paul Giannamore: On that topic, Patrick, we did have some follow-up questions on customer acquisition cost and getting more granular on that so I will be talking about that. I'll be demonstrating the calculator that we use in order to get more granular on that topic.
Patrick Baldwin: Perfect. Those are not published so Paul does speak freely. Those clips will never be heard again. How's that?
Paul Giannamore: I may have used a few naughty words.
Patrick Baldwin: I have a question, Paul, about earnouts. As I've been traveling PR in Dallas and have calls in between, earnouts come up a few times. One case in particular, I know that we've spoken about earnouts here on The Buzz in which you typically don't even include or allow earnouts in your agreements as clients are selling. Occasionally or rarely, that does happen. One bad instance where I've heard of an experience of a Potomac client was an earnout was set up and said, “For years and years and years, the seller had at least $1 million in EBITDA every year.”
They ended up in a deal in which the acquirer, a private equity in this case, takes over. They had set an EBITDA threshold. They then gain control of the business, use all that EBITDA, and put it back in the business. They're maximizing advertising growth. Even if it's not there, they don't have to pay an earnout. Whether by design or not, but it sounds like the private equity, they are sharp guys. Paul, it begs me to ask you, can you walk us through good and bad earnouts or is there a good earnout?
Paul Giannamore: Earnouts are way of bridging a gap between a seller's expectation and a buyer's assessment of value. You might say, “I'm a seller. My business is worth $20 million.” A buyer might look at it and say, “It's only $15 million.” We've got a delta of $5 million in value and we have to figure out how to bridge that gap. One of the ways to do that, and these are very common, is the acquirer will say, “I'll pay you $20 million but you've got to earn it. You've got to perform post-closing.”
Typically, in the pest control industry, historically, we've had contingent pay based upon account retention. At the end of the day, it is somewhat of an earnout. I view it differently because a hold back with a contingent pay clause, you do have to earn that but that's based upon retaining customer’s post-closing. Customers tend to be relatively sticky and so it's typically the lowest risk form of earnout. Where you have higher risk earnouts is you have to increase performance post-closing.
In that example, you might have a $20 million deal with $15 million paid up front and $5 million in earnout and it might be tied to, quite frankly, anything. Typical things earnouts are tied to might be revenue. You've got to grow revenue by X amount in order to hit that earn out. Another earnout might be tied to some sort of proxy or metric for cashflow, EBITDA might be one of those. You then might have a combination. 50% of the earnout might be based on revenue. 50% might be based on EBITDA. There's a variety of different ways to do it.
If you're contemplating an earnout, let's say that you're in a situation, you want to do the deal, there's a value disconnect, an earnout will necessarily be mandated in order to get the deal done. Revenue earnouts tend to be less risky than cashflow earnouts because the further on down the P&L you go, the less control that the seller has over the business. It’s like what you mentioned, if the revenue grows but then the new owner decides to change the cost structure of the business, then less cashflow.
Usually, how those things are determined is your first step is understanding the profile of the entity to which you are selling the business. What I mean by that is how is the buyer getting its return? Is it getting its return from dividends? If it is, they will necessarily put more emphasis on cashflow. If they want to get paid through cashflow in the current period, they're going to want higher cashflow because that's how they get their returns.
If they get their returns through capital appreciation, there'll be more incentive to reinvest in the business. Financial sponsors, private equity firms tend to focus on capital appreciation so every dollar that they can invest in the current period for future capital gains, remember, they get their returns through carry or increasing the value of the business and ultimately selling it so they get capital gains tax treatment as opposed to paying ordinary income. They are going to have an incentive to reinvest in that business. They'll have an incentive to decrease EBITDA.
This isn't a blanket generalized statement. Every acquirer is unique. First off, you have to understand the incentive structures of the company that's buying the business. Number one, publicly-traded companies are valued on cashflow. Cashflow is ultimately what increases the value of the business. Cashflow private companies is largely measured in real time on a quarter-to-quarter basis. They have a slightly different incentive profile than a private equity firm.
Where sellers typically can go wrong is having an earnout that's cross purpose to the incentive structure of the buyer. Number one, the buyer's incentivized to minimize EBITDA and maximize valuation and they're getting paid on EBITDA would be one example of that. The other problems that can happen is not properly defining what the cashflow stream is. How is EBITDA calculated and will the buyer ultimately use the same accounting conventions to determine what EBITDA is in the future period than what you have done?
They might go to the fully gap. They might be on accrual accounting. There might be a variety of different things that they've done historically that are different than what you've done. In any sort of purchase documentation, you would want to have an exhibit that defines what EBITDA is now as well as what EBITDA is in the future because accounting conventions can dramatically swing what that number is.
If you're selling the majority of your business, you will ultimately lose control in that business. I always say, if you're going to take an earn out, you can't go into this with full trust and faith that the buyer is going to do what they say that they're going to do because that often doesn't happen. If you contract to it, this is how they're going to run the business post-closing while the earn out period exists. If you appropriately contract to that, a lot of the risks can be mitigated because they're going to be required to follow that contract and if they don't, there's damages for breach of contract.
Sophisticated sellers can sit back and attempt to anticipate all the ways that a buyer might game the earnout system and document that in a private body of law, which is referred to as the definitive purchase agreement. I have had maybe 1 or 2 earnouts blow up in my life. I had Anticimex, we did a deal with Modern some years ago. We sold Modern and then after Modern was acquired, Modern bought a business.
The president of modern, at the time, shot the bed. After that took place, I had refused to do any deals with Modern Mest services. This was in 2018 and I have yet to do a deal with Modern since then and that president is now gone. That was a prime example of the president materially misstated fact. I feel like the incentive structure that Anticimex set up internally causes seller to lose money. I went out of pocket on my own money to attempt to make that seller whole for the cluster that Anticimex created.
If you recall, when we did the Atlanta sessions and we had Emily Kendrick from Arrow and a variety of different folks over, Andreas was there with his wife. If you remember, Brian Alexson came down and we sat down with him and then I spent about four hours with him in the basement. He got full blast of my extreme disappointment in how Anticimex operated with regard to that. One of the benefits of working with a firm like Potomac is that if we're doing 70%-plus of the advisor-led deals, these guys can't afford to screw with us. Not only will I not do a deal with them that will dramatically impair their ability to do transactions in that marketplace, they're going to hear from me.
That's the reason why when we did the Bain transaction, they put a better deal on the table than Rentokil initially. It was a far better home for Jeff Bain's company. We ultimately went with Rentokil because I could not trust Modern to do the right thing. How I trust whether Modern or any company is going to do the right thing is the individuals presiding over those businesses.
Patrick Baldwin: This is fascinating. I had no idea of any of this.
Paul Giannamore: Here you have it.
Patrick Baldwin: I feel like I opened up a can of worms. I thought that was the Atlanta Accord. Apparently, you were taking Brian to the woodshed downstairs.
Paul Giannamore: Brian dealt with it in an extremely professional manner. I was happy with how that ultimately was satisfied but it was not a good scenario. By the way, I'm not making a public claim that you should not do business with Modern. This was not an Anticimex system-wide issue. This was just a bullshit situation by a president who didn't live up to his commitments. When I'm doing deals and somebody looks me in the eye and promises me something and doesn't do it, I'm not doing business with you anymore. If you recall, Modern wasn't able to do deals in that market for a long time.
Patrick Baldwin: Are they back in good graces with Potomac now?
Paul Giannamore: They are, a different president.
Patrick Baldwin: Interesting. I had no idea. You've had a couple of earnouts that go wrong and sideways in over twenty years. A stellar record there. It's interesting to think that we prefer to learn from other people's mistakes. Even setting up this whole body of law, the contract, these are things I've never thought about in earnout terms. I don't know what other guiding principles you have as people are looking at earnouts or avoid them like the plague. You talked about being a bridge to get deals done.
Paul Giannamore: Simple things that don't happen anymore so I'm going into more detail on a lot of things because it's history. When I used to think about how Terminix would do deals, Terminix would do what was called a take and pay. A take and pay is you sell a company to Terminix, they might write you a check for 80% upfront, and they've got 20% held back for a period of time, typically, a year, sometimes 18 months, or sometimes 2 years.
Your active customers at the day of the close have to take and pay for two services, for example, sometimes it's one, sometimes it's five. It goes all over the map and it depends on the risk profile, the target, or the company being acquired. A typical plain vanilla way to look at it is they would require to take and pay. You sell a customer base worth $1 million, you get an $800,000 check today, for example, and you've got $200 million hanging back in the wind. Terminix now has to do two consecutive services to that customer base and the customer has to pay for those services hence the term take and pay.
Every customer that does not do that is considered a canceled customer and they would subtract from the holdback, which is ultimately the purchase price, every customer that didn't take and pay for a service. As I started in the industry in 2003, that was prolific. As I learned these things over time, we slowly began to build canceled baskets in there because we would say that with any specific deal, there's going to be attrition. What's a reasonable attrition?
Back in those days, Terminix and Orkin destroyed a tremendous amount of value. Everyone from Orkin, if they were on this call, would wholeheartedly agree with me. As a matter of fact, I had that conversation with them in Atlanta. Back the way they used to do deals is they'd buy a $5 million company and turn it into Orkin or Terminix the same day. It would not only scare the living shit out of technicians and employees, customers would be confused, they had a high level of attrition and they would make the seller responsible for that. That's just bad all the way around.
Over time, we were able to effectively negotiate take and pays, which are very rare now, but it used to be prolific in the industry. The slow way to chip away at that was, number one, there's a cancel basket because you guys are going to naturally lose stuff at the closing. Number two, you can't change the name of the target company for the period of the contingency. If it's one year, for one year you have to operate as the target's name. You can't change the uniforms.
We started adding things in like Terminix was constantly changing where their call centers were. Sometimes it was in Memphis, sometimes it was out in the field. You can't change the call center. It's got to be answered in the office by a local person. You can't change any terms of employment. You can't say, “This is an hourly company. We're going to make a production because now, when technicians leave, there's attrition.” You could effectively put a lot of guard rails into what they can and can't do. There were certain instances where companies came back and said, “We're going to do this.” Altair was one of those. We put guardrails on the Altair transaction.
Patrick Baldwin: It's 2015, selling to Terminix.
Paul Giannamore: 2015, November 15. We put guardrails in the Terminix transaction. Terminix had a rough 2015 and had to create a little bit of room in their P&L. It was the end of the year. They wanted to book those customers for 2015. It's a publicly-traded company. We put guardrails, one in particular was they had to continue to operate those businesses out of the 28 branches that existed. They needed to do that throughout the term of the holdback. Six months post-closing, Terminix looked at it, and there was a new CEO at the time and he looked at it and said, “Why are we paying all of this money in rent for facilities that we don't need? We're going to get rid of those facilities.”
At the end of the day, I can't keep them from getting rid of facilities. What I can do is if they've contractually obligated themselves to keep those facilities’ part and parcel with a contingency and a hold back and they get rid of those facilities and it causes increased attrition, I'm not going to be responsible for that.
Patrick Baldwin: Facilities were written in this agreement?
Paul Giannamore: Why do contingencies exist? Contingencies existed back in those days. If you go back all the way to one of the first couple of episodes of The Buzz, when we talked about this, contingencies or holdbacks were one form of behavior. If you're moving forward rapidly on a deal and you can't go heavily through the customer base and you do a preliminary audit, one way to make sure that you're getting what you're paying for is to have a contingency.
Post-closing, if it turns out that this was bullshit or these customers don't exist or the customers aren't sticky or there's a variety of things that can happen and they disappear, you haven't paid for something you're not getting. The philosophy of those acquirers is this is a simple form of diligence and it protects her downside.
On that premise, you can't do anything that unduly causes a customer to depart. Cancel baskets say, “If I've got 1,000 customers here, I'm going to assume that maybe 50 of them have used Terminix before and have left Terminix because Terminix gave shitty service but they're going to disappear once Terminix comes back into town.”
I'm not just going to pick on Terminix here, that could be Orkin, Rentokil, or anyone, Bugs, you name it. You have all those provisions. At the end of the day, if that's a form of your due diligence and you are going to make sizable or significant material changes post-closing that cause either the loss of employees or the loss of customers, I, the seller, should not be responsible for that.
I'm not going to tie your hands, like, “If you want to do these things, and that was the same thing on Alterra, Terminix, you said that you wouldn't do this. I don't care if you do it but if you lose, customers don't come looking for me. I want my money. Put it in that brown paper bag and slide my cash across the desk. I don't give two shits what you do.” They looked at it and said, “It'll save us a lot of money if we get rid of these facilities because we have facilities and we're going to take those employees and we're going to jam them into our other facilities. Nothing we could do about it.”
Down in Puerto Rico, I was talking to Ben Morgan, who was an employee of Alterra. He owns Anthem. He was an employee at Alterra, he went to Aptive, and then now he runs Anthem. We were talking about those days because he was a manager at Alterra when we did that deal. I was strolling down memory lane with him talking to him about some of those decisions that Terminix made post-closing.
Terminix needed to come up with money and they integrated those offices rapidly, contrary to what they said to us. When they came back to me, that's why I stood firm and said, “This is going to be expensive because you guys did lose customers and it was because you tried to save money so you lost a lot of customers. You got to pay Uncle Paul. It's time to write some checks.”
Patrick Baldwin: Was that breach of contract?
Paul Giannamore: Should that have turned into some sort of a legal action, what we would've argued is that they breached their contract that they were not going to do that. Those guys are people too and they look at it and said, “We know we said that. We weren't going to do that but now it makes more sense for us to do that.”
In all due respect to Terminix, they didn't fight us on this either. They didn't tell us to go pound sand and we're going to go and do this. They were very respectful and came to us and said, “We have to do this and we've made this decision from a management perspective. We collectively need to put our heads together and understand what sort of damage we will sustain and thereby you will sustain. We're going to do everything in our power to make sure you are made whole.” They did do the right thing.
Patrick Baldwin: Hindsight 2020, the decision that they made, was it financially sound or if they could do it over again? I don't know if you have any color there to say, “If they had to do over, they would do it differently.”
Paul Giannamore: The problem is if you run a privately-held business where you're not reporting stuff on a quarterly basis, you tend to make different decisions that are longer term in nature. I believe that Terminix probably would not have done that if ServiceMaster were not public because they would have a longer-term horizon. Those guys would have probably said, “It's better that we do everything in our power to retain these customers and let's figure out how we can do this in a different manner.”
When you got a report for the quarter, you look at it and say, “Let's dump all of these leases. Now, we can make an adjustment on a go-forward basis. Our projected 2016 results will be $3 million higher on the cashflow number.” When the business is trading at 12X EBITDA, that's $36 million in enterprise value right out of the gate. That's the problem with publicly-traded companies. Sometimes, by definition, they have to make short-sighted decisions and that's just what happened.
Patrick Baldwin: Have you seen earnouts outside of Potomac where people are out doing on their own, making their own deals happen, or earnouts have gone sideways?
Paul Giannamore: I see it all the time. We get calls over here from people that have done deals and they want my help ex-post the transaction. It's too late to do that. You get giddy and you think, “I'm going to get millions of dollars and I've got this earnout,” and then you don't spend any time really, number one, thinking about the incentive structure of the actual buyer.
How do you remain in control particularly if you're leaving? That's a big issue too, whether you're staying or leaving. If you're departing, that becomes all the more important because you're not even in the boardroom anymore. You have nothing to say. It's easy for people to take acquirers at their word. Some acquirers that I've seen in the pest control industry go above and beyond.
I'll give props to Rentokil here. There have been some times, even Rollins, for example, where I have seen situations where there were some misunderstandings. They said, “We're going to do X, Y, and Z.” They didn't have all the information at that point in time and they've stepped up even in light of the fact that they probably shouldn't have. They would have been legally, morally, and ethically justified to say, “No, we're not going to pay this.” I've seen them step up and pay it.
They do that because they are prolific acquirers in the industry. They want to try to keep good relationships with sellers. Sellers can sometimes get confused as to what's being promised and what's not being promised. It's just not all bad. I've seen these guys step up and make some difficult decisions that cost them money in order to keep people happy, even though they didn't really have to do it.
Patrick Baldwin: How high up the food chain are you going to make these? These are very consequential decisions. In the case of Modern, it sounds like if we just put Modern and Rollins up next to each other, Modern, a platform of Anticimex so you were dealing with a platform president at the time who decided to, let's say, do the wrong thing for lack of a better term. Rollins, in a similar situation for what it sounds like, end up doing the right thing. Now, it would be Jerry Gahlhoff. Who gets involved?
Paul Giannamore: I'll give you a prime example. I did a transaction with Rentokil several years ago and there was a $2 million error in our favor, in the favor of the sellers, in the letter of intent. We screw up. We signed the letter of intent. We relied on it. It's one of the things that happens when you've got kind of a standard template that you use for a lot of different deals, a couple of terms get stuck. We've signed a letter of intent, we've gotten into diligence, and a $2 million additional value was allocated to us, the sellers, in this transaction.
This wasn't like a $2 million deal and we got double the price. It was a decent sized transaction but $2 million is $2 million and it was still material. We got through DD and we got to the purchase agreement stage. The purchase agreement came over and it did not have that particular term. I made a phone call. Alex looked at it and said, “Shit. That's my bad. Can we change that?” I'm like, “No, we relied on this.” He said, “Okay.” That ultimately went all the way up to Andy Ransom, which was like, “We, Rentokil, made an error and it's going to cost us $2 million bucks. We're at the asset purchase stage. What do we do?” Rentokil said, “Our bad. We screwed up. We're going to take the hit for $2 million.”
In retrospect, it's hard to determine whether it'll blow up or not. I don't remember the competitive landscape right now for that particular transaction. That is an example of a company saying, “We're going to own our errors and that's costing us $2 million but we are going to do the right thing by the seller.” I never forgot that gesture from them. I'm talking about it publicly.
Patrick Baldwin: It goes a long way, doing the right thing. In the case of others not doing the right thing, it definitely has an impact years later. Going way back, Paul, I've heard the term take and pay in terms of door-to-door a lot, paying their back end and taking pay there. I never heard it in the case of doing a deal like this, at least at a level where you're at. Do you see that a lot? Because that term is shared, is that more so on the door-to-door side of deals because there's higher attrition, there's more risk, for lack of a better term, in acquiring a door-to-door business that take and pay exist more often in those type of deals?
Paul Giannamore: Several years ago, 95% of pest control deals had take and pays in them. I don't care how big they were. Maybe the Ehrlich transaction didn't have it take and pay but you would find a business with $10 million, $20 million, or $30 million in revenue and those had take and pays. That was just the way it was done. Over time, as more acquirers got into the market, acquirers were forced to do more diligence, transactions became more competitive, and that disappeared.
Patrick Baldwin: You gave an example early that’s a $1 million deal, $800,000 paid at the time of closing, and $200,000 in earnout. The performance of a take and pay, if it's never achieved, do they go and claw back from that $800,000 or is the $200,000 at risk? Does it depend on the deal?
Paul Giannamore: You're saying if they blow through that $200,000?
Patrick Baldwin: Yeah.
Paul Giannamore: It depends on what the contract says. Back in those days, the boilerplate contract, for example, for a lot of acquirers was like, “Once we blow through that $200,000, we can send you a bill.” Now, even when I first got in the industry, I scratched my head and said, “That sounds absurd.” We need to tie the indemnification provisions of the purchase agreement to that which is held back by the acquirer.
For example, an environmental indemnification, you take a $20 million deal and let's say that there's a $2 million holdback, for example, 10%. Back in those days when there was take and pays, there's also indemnifications for fraud and a variety of different provisions. One big one that everyone always fought about was environmental.
If you were dumping chlordane in one of the great lakes and you did a $20 million deal and the total damages from an EPA claim was $50 million bucks, acquirers wanted that open-ended. They wanted to be able to go back and look to you, PB, for $50 million and you're like, “I'm worse off than if I held my business myself because I only got $20 million, hell, I only got $18 million and now I got to pay a $50 million tab. I don't want to do that.”
One of the big issues that I had with pest control when I first got into the industry is, back in 2003, Orkin and Terminix were the biggest buyers. In the corporate development guys, the guys doing M&A were just dudes that kind of grew up at Orkin. One guy started as a technician and wasn't particularly good at it but could somewhat use Excel and knew how to use email and they're like, “You're a fine fella and you're nice. Why don't you be an M&A guy?” Somebody that had zero experience of formal training whatsoever, anything related to doing transactions. It was a cluster.
When I got into this space, you've got these moronic business brokers running around that don't know anything about deals whatsoever because their experience is, “I've sold my pest control company, therefore I'm an expert.” I'm looking at this and I'm saying, “Why aren't indemnification clauses tied specifically to the hold back so that if you blow through an indemnification for anything other than outright fraud, fraud is one of those situations where a buyer should be able to go back to somebody.”
If you sold a business doing $6 million a year in revenue but you filed fake tax returns and you made up all sorts of faulty records and you were able to fool auditors and they just bought nothing, you should be able to go back and just nail these guys. For environmental and employment related claims and all this other stuff, it's like, “Acquirer, you're holding back money for a year or two years. You blow through accounts, taking pays, and you got an environmental claim. That's all you get.” You don't get to go back to the seller. If you don't like that, then spend more time and money on DD.
Back in those days, they didn't have anyone to do that because they had a guy who was like, “I was just spraying for bugs a couple of weeks ago and now I'm doing deals.” He doesn't know what the hell to do. Now, companies are hiring transaction services guys to do QOV studies and they've got all sorts of outside consultants and people that know what they're doing so they can do higher levels of DD, which is pushed, it's tightened indemnification language. It's tightened up holdbacks.
The big one was Steritech. I don't remember how big that claim was but it was a big indemnification claim because Rentokil bought Steritech and Steritech had a bunch of software that Rentokil thought they were buying that they actually didn't buy. That was an indemnification claim. Do better DD is what you need to do. Do better due diligence. Make sure you really understand what you're buying.
In order to be competitive in the market, you have to tighten up indemnification language and hold back language. You have to reduce risk for sellers because there's a lot of other buyers out there. If you're not willing to spend the time and have the right people on your team doing the DD, somebody else is going to do it. That's ultimately what happened. I was in bulge bracket investment banking and then I went into private equity. When me and my original partner started Potomac, we're doing these deals and we just scratched our head when we're looking at how they're doing it in pest control, I was like, “Holy shit, it’s good doing this stuff on napkins.” It's changed quite a bit.
Patrick Baldwin: I've never heard of the Steritech-Rentokil software misunderstanding.
Paul Giannamore: It's like, you don't even know me. You're learning all sorts of new stuff on this episode. I guess I'm being particularly open because there's a lot of learning lessons here for readers as far as how this sort of stuff goes. Everyone talks about transaction multiples and this, that, or the other, but there's a lot that goes on into the deal and structuring the transaction so that you don't say, “I got $20 million. I'm set for the rest of my life.” A year later you find out you actually only have $5 million and not $20 million because the courts caused you to write a check to the company that bought your business. It's unfortunate.
We had a guy who called us and he was dealing with a private equity firm and I started to hear some of the terms that were on the letter of intent and I'm like, “You need to hire a lawyer.” He's like, “I got a lawyer and he's a smart guy. I've used him for a long time.” I'm like, “He's clearly not an M&A attorney.” He's like, “He is. He's done 4 or 5 deals in the last 20 years.” I'm like, “4 or 5 deals over the last 20 years does not an M&A attorney make. There's a lot of things on here that are going to be extremely expensive to you. Don't get caught up in all starry-eyed when you're looking at the purchase price because I can tell you right here and right now there are some massive claim exposure.”
When you're repping and warranting stuff in a purchase agreement, it’s hard, especially when you start to talk about financial reps. PB, I guess this might be an Ask Me Anything that we’ll go through. I can go through my body of knowledge. Here's my legal and FDD notebooks right here. I've got hundreds of case studies of all the things that I've seen. I put together these internal checklists here for the firm to make sure that everyone here understands every single little knit that these acquirers throw at them.
Patrick Baldwin: That's insane. What do you do if someone calls you up?
Paul Giannamore: PB, my secretary knows more about indemnification claims and reps and warranties than most attorneys in the United States do at this point.
Patrick Baldwin: I know you have a Mex secretary. Do you have a real secretary?
Paul Giannamore: I do.
Patrick Baldwin: Can you tell us the end of the story for this owner that called you up? He's got an LOI from private equity and it's nuts.
Paul Giannamore: That disappeared, it's gone. He immediately felt like they were taking advantage of him and ripped it up in the trash and said, “I'm out of here.” They were not necessarily trying to take advantage of him. I look at it and say to myself, if you and I were out buying a business and a seller was willing to take on all of the risk of the deal based purely on his own ignorance, is that taking advantage of the seller? In some ways you could argue that that's the case but in other ways, that's how things go. You can't walk into a Turkish bazaar and start buying fine Turkish carpet and rugs from Antolia and expect to get a good deal from those guys if you have zero idea what you're doing and have no idea how to value those things.
Are they taking advantage of you? No, you're an idiot. You should not be playing there. Whose fault is it? Is it their fault or is it your fault? It's the same thing in business. Are they taking advantage? No, they look for people that don't have a proper set of advisors that know what they're doing so that they, in fact, can get a better deal because if they get a better deal, they get better returns at lower risk. They advance their career.
There is something to be said about. You have a duty to your own family and your own company to go out and get the best deal that you possibly can. You don't need to pay above market for stuff. You, in fact, need to go out and find people who, in their own mind, are smarter than you and are making a lot of strategic missteps and mistakes. It's just like the game of poker, how you win is when the guy sitting across the table from you makes a mistake.
I don't think that's taking advantage. I think that that's the way that it is. You have no one to blame than yourself. You end up with a significant potentially terminal illness, you could go to the urgent care clinic or you could go to the best-in-the-world or the best-that-you-can-afford. The decision is yours. If you go to the urgent care doctor and you expect to be treated for sarcoidosis, it's your fault when you kick off.
Patrick Baldwin: I picture myself going through a Turkish bazaar and they’d be like, “We got this guy.”
Paul Giannamore: That's how things happen. The deal world is the Wild West. This particular individual basically lit the LOI on fire and screamed bloody murder that he was being taken advantage of by the private equity firm. They were not purposely trying to bilk him, there's just a disparity in experience across the table, and they just took advantage of the opportunity. I would do the same thing and I advise others to do that.
You don't want to find yourself in that sort of situation. A lot of times, when I get on with you, PB, and I'll say this for the benefit of our friends out there, I have no idea what we're going to talk about. I didn't know you were going to bring up earnouts and here we have it. One thing that I got a kick out of, you guys were at that Rocket-X thing. The crew that you were hanging out with are a bunch of animals but they were getting these emails from PCT. A bunch of people forwarded it to me because I got a kick out of it. Everyone gets calls from buy-side brokers now. Everyone is getting emails.
Now, of course, the buy-side brokers are going to the pest control magazines. Anyone can go to PCT. By the way, this is how PCT makes money and I expect them to do this. You can go to PCT or any one of these magazines and say, “I want to advertise and I want to send out an email directly to your customer base.” They're like, “Sure, it's going to cost you X thousand bucks but we'll send out an email. It's part of the advertisement.” They sent out an email and the subject is, “Considering selling your pest control business? We can help at no cost.”
When somebody is giving you something for free, you got to ask yourself, of course, “What's in it for them?” This is typical of buy side brokers that contact owners of businesses. By the way, PB, this isn't an advertisement for my own services. I'm specifically pointing this out as a public service. A buy-side broker is literally a boiler shop where you've got a bunch of people sitting around and sending out emails to folks like you and I operating in the industry.
I get a lot of emails from buy-side brokers wanting to entice me to sell Potomac because they think Potomac is a pest control business, which is not. I show up on a lot of pest control lists so I get all these sorts of things as well. What the buy-side broker does is the buy side broker gets paid a fee by a financial sponsor, a private equity firm, typically. Sometimes strategics will hire these guys, but mainly it's the private equity firms.
What the private equity firms try to do is they don't want to be in auctioned situations. They don't want to focus on shopped deals because it gets very expensive. They try to get “proprietary deals.” What they'll do is they'll send out emails and you'll look at it and say, “Let me read this. This company has helped 50-plus business owners sell their business at no cost.”
PB, they must be running a charity, I'm assuming. This is what they do. They go out and help wealthy business owners sell their business at no cost. “This month we have twenty complimentary consultations remaining for the first PCOs who reach out.” Good thing they're keeping a good schedule and they're not like, “We're not going to do a lot of work. We had twenty slots and not a slot more so twenty of them are open.”
“During your consultation, ye'll help you understand the following, one, how to maximize the value of your business.” They're working for a buyer. They're not being paid by you. They're representing a buyer and the buyer is paying them but they are going to help you maximize the value of your business. They're going to provide you strategies for enhancing financial reporting capabilities. They're going to discuss with you the characteristics of reputable buyers. They'll discuss with you what selling to private equity really means and everything you need to know to confidently speak with any potential buyer.
“Remember, our advisory services are always free and there's no obligation attached to your confidential consultation.” I've got the second AzPPO keynote where I talk about this. The buy-side brokers go out, send out these emails, and you respond. At first, it's like, “It’s just a confidential conversation, just the tip.” You start talking and the next thing you know, a couple of weeks, you're pregnant. You've signed an LOI and you're in DD and then you realize you've done the zero-price discovery and these guys have jammed atrocious terms down your throat because you haven't gone out and done a proper process, which is a moronic way to sell a business.
For buyers out there, if you're growing your pest control business and you want to do acquisitions, this is the stuff that you need to do. Let's go back to the bullet points. If you can go out and tell them how to maximize the value of their business and strategies for enhancing financial capabilities and all this sort of jazz, if you can find some morons out there that will listen to you, you're going to be able to buy their business on the relative cheap.
This is what you should do. You should always watch what the private equity firms do. When they sell their businesses, they were in formal controlled processes. They've got investment bankers that go out and do exactly what it is that we do, always. I've worked for a lot of them and I only do it on the sell-side. I never do it on the buy-side. I represent private equity firms, sell their businesses in competitive processes, and make them a shit ton of money.
When they buy companies, they try to avoid competitive processes, and they send out emails full of shit and hoping they send out enough of them. There's going to be some morons out there they're going to take the bait. You, my friends, should do exactly what the private equity firms do, sell your business, run a formal control process, be agnostic to who the buyer is, and say, “Show me the money.” When you go out and buy, this is what you do. I wanted to provide that as a great example.
Patrick Baldwin: I love the public service announcement.
Paul Giannamore: Definitely watch what these guys do and emulate what they do because it's a great way. This company are working for a particular buyer. It's funny because the company that they're working for, I sold them to a private equity firm in a controlled auction process. The sellers made a shit ton of money. The private equity firm hires the buy-side firm. They don't want to buy auction deals anymore. They want to be able to go out and buy them on the cheap. I will not mention the company's name. It's great that they're doing this and they should continue to do it. I hope they get some guys on the cheap.
Patrick Baldwin: Pull them into the Turkish bazaar, if you will.
Paul Giannamore: Pull them into the Turkish bazaar. The Mexican and I were talking about it and he was like, “Why do you always support this sort of stuff?” Every acquire deserves some wins. At the end of the day, how do you have an edge in the market? Your edge is if you're smarter and more educated than everyone else in all aspects of business, particularly management, M&A, and so on and so forth. If you are experienced, if you are educated, you will protect yourself from doing stupid things. You need others to do stupid things.
If this particular company can go out and buy some stuff on the cheap, they're going to have more money to pay a higher price for yours. I like to see this. I like to see acquirers get wins on the cheap because using my M&A sales discussion when I'm trying to sell a platform business is, “Buy this business for $100 million. It's expensive. It's north of twenty times EBITDA and this sucks and I get it. Buy this.” It's not a fixer upper. It's growing at a rapid clip. It's got all the fundamentals, everything you want. The founders are great.
Partner with these guys. You will be able to go out and there are a lot of ignorant sellers out there and you're going to be able to go out and get some deals and blend down your entry multiple. I show, historically, how this has happened over time. You can go through all of AX's platform businesses, buying Modern, McHale, Killingsworth, and all those companies. Everything they've done, they paid a shit ton for those platforms. They were able to go out and buy a lot of these small companies that had no idea what they're doing on the relative cheap. It's not just Anticimex. Rentokil does this work and all of them do this.
Private equity guys, there's a lot of runway in the industry to be able to do this. We may have a broad listener base in pest control but I have a feeling the folks that are reading this right now are the smarter and more sophisticated industry players. There are thousands out there that have zero idea what's going on. I'll say it for the last time, friends and colleagues in the industry, watch what these guys are doing and emulate them and go out and buy yourself something on the absolute cheap.
Patrick Baldwin: I love it. That's great advice.
Paul Giannamore: If you're using FRAXN, we're doing everything we can to help you guys grow that business because I love the financial reports. For me, on FRAXN, the reports are almost a commodity. It's a P&L. At the end of the day, that's a commodity. What sets FRAXN apart is the level of service and sophistication that your team is bringing. When I talk to folks, we had some FRAXN clients down here in Puerto Rico that were in the mix. I heard a lot of great things about how responsive you guys are and how you are focused on making sure that they are getting educated. Get on FRAXN, you do that, and Potomac will help you get the best price you can.
Patrick Baldwin: I love it. Appreciate it.
Paul Giannamore: As always, it was great seeing you down here in Puerto Rico. I look forward to the next one. We will probably be doing one in June 2024. It will be more formal. It will be more organized.
Patrick Baldwin: Formal as in dressed up?
Paul Giannamore: There will be more formal dress. I know that there was a lot of bathing suits and beaches and so on and so forth. I'm trying to plan the next one. I don't know if it'll be June 2024 or not. We'll have to think. It will be at some point this summer 2024. It will be limited to twenty participants. There's already been a lot of folks that reached out. Right now, we’re not equipped to do a bigger one. For those who want to come down, you can also express your interest as to why you want to come down at TheBuzz@PotomacCompany.com.
Patrick Baldwin: I love it. Maybe I'll email you my interest in coming back.
Paul Giannamore: If you could, send it to TheMexican@PotomacCompany.com. Go ahead and do that. Let him decide.
Patrick Baldwin: I love it. I appreciate it, Paul. I learned a lot. Have a great week.
Paul Giannamore: You too, brother.
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Dylan Seals: Thank you so much as always for supporting us at The Boardroom Buzz. We know your time is valuable and the fact that you spend 45 minutes or an hour with us means the world. All the media that we put out from Potomac is meant to honor and celebrate you, the service industry owner. As Paul would say, “Yee who toil in the pest control vineyards.”
As part of giving back, we have this podcast, but more than that, Paul and I have been working our tails off over at POTOMAC TV. We've spent a tremendous amount of time, energy, and resources to build out that platform to bring you market updates, to bring you visual breakdowns of the merger acquisition process, and to tell stories and present information in ways that, frankly, it's not possible for us to do on The Boardroom Buzz.
Adding the visual element takes it to the next level. I want to invite you to go to YouTube and find us, it's POTOMAC TV. Potomac.tv will get you there. Go there and subscribe. Check out some videos and leave some comments. Let us know what you like and let us know what you don't like. Let us know what you want to see more of and we'll see you over there.
