You genuinely do work for the board and for investors. And self-funded searches differ in its much higher risk for the individual. They're paying for their own search process. They're putting in more of their own capital. They're often signing a personal guarantee on the debt. But their investors are minority and non-control and can't fire them. They have to do a ton of diligence because they are along for the ride one way or another. [MUSIC PLAYING] It's great to be back. I am your host, Peter Larman. And this is the latest and greatest episode of Masters in Small Business M&A. I'm very excited to have Grant Hensel on the podcast today. Grant is the founder and general partner of Entrepreneurial Capital. And Grant, just welcome to the show. Thank you for giving us your time. Great to be here. We're going to start with the headline. You did a final close on your first fund, about $12 million fund, $12.20 million fund, in the fall of 2025. The fund is organized around being an equity capital partner to self-funded search, the ETA community broadly defined. And so congratulations on opening up this new chapter. We want to talk about that a lot. But let's talk about what led up to you deciding to raise a fund and spend all of your waking hours on Entrepreneurial Capital. It's been a fun journey. And we can take it in reverse. So prior to that, prior to raising entrepreneurial capital, I had never actually raised or borrowed any money for anything in my entire life. And so it was definitely a lead up. Prior to that, I had been investing in entrepreneurship through acquisition transactions, where a person is buying and then personally running a small business myself. And probably did about a dozen of those. And I got into that world because my wife and I did in acquisition ourselves where I searched and we found a business to buy that we then bought, that she now runs, which does digital marketing for law firms called Lexigate. And then prior to that, I was running a digital marketing agency called Nonprofit Megafone that I'd started 10 years ago now. That does digital marketing for nonprofits, has about 60 employees. And before that, I started a whole bunch of other businesses, two of which got acquired in small transactions and seven of which didn't go anywhere. So it's been a fun journey. - When did you kind of realize that, whether you knew it or not prior, like when did you realize that you were sort of swirling around in this sort of ETA and search community? Was it clear to you that that's the category that you were operating in, or did you sort of stumble into it at some point as part of a chapter in school or someone introducing you to the broader concepts? - I was introduced to the concept through a friend who was doing an MBA at Booth in Chicago and he ended up doing more of a traditional search. himself and bought a business and I just thought that was fast-standing. And then after Booth basically realized that there, I didn't love the traditional search model because I just really don't wanna have a boss. And so got exposed to the self-funded search universe and realized like, oh, this is maybe something that's more of a part of LA. - Can you say more about what you mean by, I don't wanna have a boss and why you link that traditional search that was a provocative choice? Go ahead. - It's a different world. So traditional search, just as context, you raise a search fund which is capital to fund a search process of typically two years and then you hopefully find and buy a business that you will not really, the nice thing about traditional searches, you're not putting in meaningful equity or maybe even any equity yourself, you're not taking a personal guarantee on any of the debt. But you're also effectively a CEO with equity, typically 8% that close 8% over time and 8% based on hurdles. And so in a happy scenario, you own 24% of the business, you report to a board, the board has full governance, the board to fire you. Like you are a CEO with equity, which is an awesome opportunity. Like not, not so much that at all. You just do work, you genuinely do work for the board and for investors and self-funded searches different, it's much higher risk for the individual. They're paying for their own search process, they're putting in more of their own capital, they're often signing a personal guarantee on the debt, but their investors are minority and non-control and can't fire them. They're like, they're, they have to do a ton of diligence because they are along for the ride one way or another. And I am more oriented towards the latter. Could you talk a little bit maybe about just some of your entrepreneurial chapters that maybe influenced your, you know, your predisposition towards self-funded search versus traditional search? Yeah, I've known that I wanted to be an entrepreneur since I was 12, and which was the time that I weren't what entrepreneurship was. And it made it, it's just like, I want to do that. And that hasn't wavered ever since. So it's very mysterious, but I just love it. The whole point of being an entrepreneur was to be able to build something and guide its development and sort of chart a course that is where I have a high degree of both responsibility and autonomy. And I will live or die by how well it does. And the decisions for better or for worse will be primarily my own. And that had been the impetus for starting, you know, nonprofit megaphone and growing that and being able to do that over the last many years. That was an acquired business that you then have grown or was that a-- That one was started. Yeah. You started from scratch? Correct. Yeah. Yeah. And at that point, I'd never heard of this whole entrepreneurship acquisition thing. And probably wouldn't have been, wouldn't have necessarily been ready for it at that time because I was pretty young. What was the first acquisition that you made where you were in it? Have you made an acquisition yet where you were in the operating seat post-closing? Clostis, I've gotten-- No. So I've been in the operating seat, but only for businesses I've started. The closest would be the one that my wife and I bought, but she's been the operator. And yeah, since day one, we signed the docs and then she took the baton and ran with it. And that's been-- for me, that's been an interesting evolution as I've learned. I'm a decent operator. I'm not a bad operator, but I'm a better support person to a really good operator. For nonprofit megaphone, as we promoted people into a leadership team roles and as we put a CEO in place and the less operationally involved, I was the better the business kept doing, which was humbling, but also fantastic. And Julie is doing like a much better job of running her business than I would be, frankly. One of these days, maybe we can have a podcast you have a sort about what it's like to be a husband and wife, owner, operator, investor. You guys must have some interesting dinner table conversations. Oh, yeah. It's fun. Yeah, that's really cool. You made about a dozen investments in ETA acquisitions just on a personal basis. And then you decided you wanted to raise a fund to take some outside capital. Tell us just how you decided to make that decision. I am a mentor who I was sharing some of the deals that we were looking at with. And he invested in some of them. And he ultimately said, these are great. These are really attractive. You should raise a fund. And that had never occurred to me, prior to him saying it. And I said, I don't have an idea how to do that. I don't have a private equity background. He's not as well. He's been very successful. He's like, he figured out. It'll be fine. And it was not-- it's interesting, because I remember the days where I incorporated my first LLC. And it was a big scary process. And now you realize, this is two minutes on the Secretary of State's website. It's very easy. And it was interesting. Starting a fund is just about hiring a specialist fund formation attorney who's good and walks through the process with them. Like, the logistics aren't actually that hard. The hard part is having good thesis and then being able to raise money and deploy it effectively. And anyway, we can talk about if it's interesting to folks. But the fundraising process was surprisingly quick and surprisingly enjoyable. I don't hear that very often. Yeah. And maybe that was just us getting lucky or timing or whatever. But it was-- yeah. I figured the original target was $10 million. We ended up raising what? Over 12. And then almost 13. And then I expected it would take on the order of 18 months. And it ended up being February of 2025 through September, October of 2025. So anyway, I don't know. I don't know. I have an ant of one on that. How many-- roughly how many LPs are in the fund? 80. So pretty small average check size. It's basically all of my small business owner friends and their friends. Yeah. I mean, it would be great to just get into, I guess, maybe the way that you're beginning to develop the investment thesis and the investment-- the investment box, both in terms of the business, as well as in terms of the owner and the operator, and sort of what your talent box is looking like. And I thought it would be-- I know you began investing a few years ago on a personal basis. [BLANK_AUDIO]
So I would love to hear a little bit about what you're looking for now, but also how that's changed over the last few years. And then we can maybe get into why it's changed and some of the things that are driving those changes. But yeah, take us through sort of what you're hoping for when you look at businesses through this lens. And then, you know, also what you're thinking about when you're evaluating the operators. Our sweet spot was what we described as a trustworthy searcher buying and enduring business. And we talked about the searcher. The business part would be at least $750,000 of pre-tax earnings, ideally one to two million dollars in that range. So still small, but not microscopic. Typically, multiples in the three, three and a half to five range depending on the business and the dynamics. And then the things that we qualitatively care about the most are customer concentration, capital efficiency, economic resilience, and then and/or other forms of cyclicality, which is whatever one cares about. Like this is not a, it's not like a brilliant insight that I've had. But it does come, each of those do come from personal experiences either in businesses I've started and run or indeed personal investments I've made that have violated one or more of those rules. And I've learned painful lessons. Were you knowingly violating those rules or did you just silence things up incorrectly? I was not knowingly violating them at the time of the initial, initial experience, but yeah, they all, I can tell you stories for each of those about why I let the here economic resilience wrong. Economic resilience. So it made a personal investment in a business that does, like remodeling, home, home remodeling and that is a, that is just a cyclical economic good times. It's straight and an economic bad times like you're not really remodeling as much. There's meaningful interest rate exposure that you have there. There's meaningful tariff of exposure as it turns out that you have there and tends to be project based and the search on that is like it was working really hard and, you know, and doing putting it all on the line. But it's, it's just, I didn't appreciate at the time of that personal investment, the degree to which the industry is, those industry dynamics are just tricky. Like Warren Buffett has a line when a management team with a reputation for brilliance encounters an industry with a reputation for poor economics. It's the reputation of the industry that emerges in tact. Yeah. Yeah, that's a great, and it's not wrong. Yeah. Yeah. So at the time, what was your, what was the narrative in your mind about economic resilience for this business? I wasn't, I wasn't thinking about it. I was thinking about it, but I was deprioritizing it relative to other things that seemed attractive. Multiple extractive searchers like, just like the nicest person in the world and seemed like a great person to be in business with. And there were, the deal was well structured. I think for me, the learning was that it is better to, it's another Warren Buffett line, like better to buy a great business at a fair price than a fair business at a great price. And we probably bought a fair business at a great price. It's just tough though. That is still very tough. What are some of the other violations that you look back on and that are easy for you to remember? For non-profit megaphones, this is a business I started. We've experienced the customer concentration scenario in the past. Mostly it's highly diversified. At one point, we had a division that did Facebook challenge fundraising for very large nonprofits. Which was wonderful. For a time, over two year period, we raised $66 billion for big nonprofits that people have heard of, which was wonderful. And then dynamics in Facebook and how their ad-out rhythm worked and some other variables changed. And that strategy basically became no longer effective and that led to, for me, like the most painful experience in my professional life, which involved laying off ultimately a department that had 20 people in it. Because the clients went away and it was a small number of big clients. We didn't have debt on the business. So it's a very survivable event. But for most people doing acquisitions, they will have meaningful debt on the business. We encourage people to underwrite, just assume you lose your biggest customer. Then maybe assume you lose your biggest two customers. And if that causes you to go under, that's not a good thing. You had customer concentration within a single point of failure, media money internet, i.e. Facebook. And subject to algorithmic change and stuff like that. Do you just broadly apply customer concentration to all end markets and all industries? Or do you think that, well, are you willing to look at customer concentration differently? Based upon those sort of circumstances that you find the business ending. In other words, if the business has three customers that represent 50% of its revenue and each one of those customers, it has iron, clad, ten-year contractual, recurrent contracts, that seems pretty different than the customer concentration that you guys had with Facebook and what you were doing with the marketing agency. Do you tolerate that nuance or do you just steer clear? No, we would view those differently. Because at that point, you're basically underwriting a counterparty risk. Are they going to go bankrupt and not be able to pay us, or are they going to not pay us for some other reason? But if they're actually committed to me, that is a very different universe. You have to think about in a scenario like that, how far into the contract are we? If we have a desire to exit this business within, let's say, a five to seven-year timeframe, will those contracts be about to be renewed? And therefore, that will probably push out any exit timeframe. I think there's just a variety of considerations. But it's not, I would say that none of these are automatic disqualification, but it's just a signal for us to pump the brakes and really deeply dive into the diligence and make sure that there's a lot of structure and thought around what is the risk and then how can it actually be mitigated? We've covered two so far that are sort of from your headline thesis, customer concentration, economic resilience. There was at least one more. Capital efficiency. So in industry that we won't participate in. And this one, I was fortunately able to learn from the experience of close friends, but or fortunately or unfortunately, but e-commerce. We don't touch because it is just remarkably oftentimes. Many forms of e-commerce are highly capital intensive. You're constantly buying new inventory, you're running ads, you have all kinds of competition, entering all over the place. And often like your EBITDA can be wonderful, but there's not actually meaningful cash to distribute transportation like asset-based transportation businesses can sometimes be the same way as can many others. Many government contractors where they have like 90 or 120-day payment terms, there's just like massive amounts of working capital that get caught into all these. And we think it's hard, especially because we're primarily investing in first-time business buyers. It's just hard to like fully wrap your mind around how painful that situation is. You want to grow. It means you're actually absorbing more working capital. Like growth is sucking cash in that circumstance. So we tend to avoid those things unless it's a really good business in other ways and there's a really good searcher and they're really what they probably feel like is over capitalizing the business at close by just putting a lot of cash on the balance sheet on day one. I mean, it sounds like the key word that you've kind of associated with the searcher is trustworthy. Like that's part of the tagline. Maybe we'll just switch to the searcher. We've covered a little bit on just sort of how you think about underwriting on the business side. For you, what does trustworthy mean? Like how do you go about assessing that? I'm sure you're meeting lots and lots of searchers. You don't have multi-year relationships with a lot of these searchers that you're evaluating. So in some cases, you might need to evaluate trustworthiness in a pretty compressed period of time. What's the approach? Yeah. There's a great book by a guy named Stephen M.R. Covey. He's the Stephen Covey, seven habits of highly-trick people's son called the speed of trust, where he has four things, integrity, intentions, capabilities, and results. These are the four things that make someone trustworthy. Are they well-intentioned? Are they a person who does what they say they'll do, even in a painful circumstance? Do they have the skills to do what they're setting out to do? And do they actually tend to get it done? Those are basically the four things that make someone trustworthy. And those are the things that we're trying to figure out and back into through lots of conversations, the meaning of the person through reference checks, through background checks and credit checks and all kinds of things. They're trying to triangulate through our personal networks and our LPs. It's nice having ADLPs because it's a pretty small world and often we can find that one of our people actually knows someone who knows them and you can kind of do some behind-the-scenes sweet thing. That's interesting. You say it's a pretty small world. I would have thought that self-funded search was like a very big world. Tell me more about what you mean by being a pretty small world. Self-funded search is a surprisingly small world because there's. platforms that aggregate people, there's an social network called search funder, which is just for people trying to buy businesses. There's all kinds of conferences. And so people just like, when I meet a searcher, I probably have like 30 LinkedIn connections in common with them. And I probably don't know if they're like pretty plugged in, if like if they're actively searching and they're trying to get plugged in with the community. And I probably don't know, you know, in a deep way, 29 of those people that I might, I might actually know one of them. And so there's often not always, but more often than I would have thought initially, some ability to try and get it based on sort of other mutual connections. The pipeline of talent that's going into self-funded search is, is it a similar pipeline of talent that's like typically more closely associated with traditional search where you kind of have a handful of graduate schools and there's a certain number of folks coming from those schools that are doing traditional search, but then the remainder are doing self-funded search like is that? I'm curious what the, what is, what are the schools roles and responsibilities as a pipeline for talent in self-funded search as opposed to the more traditional form of search fund? It's much more delayed and it's much more independent in many ways of some of the schools. The average self-funded searcher is probably five to 10 years older than the average traditional searcher has more career experience is probably in a meaningfully better liquidity position personally. The average MBA, like you know, just out of MBA searcher, it potentially has student loans that they're working towards paying down and their ability to say, I'm going to search for a period of time either full-time or part-time without external sources of funding and then buy a business and pay for the transaction costs and then, you know, put equity into the deal, it tends to be minimal and so I'd say very few self-funded searchers come out of MBA programs. It tends to be like maybe they heard about it in an MBA five or 10 years ago or more likely maybe they just heard about it in general separate from an MBA program and now, you know, maybe they're a they're general manager of a small business and they've decided I would really like to actually on this thing or something like it myself. Is there a meaningful portion of the self-funded search community that doesn't realize that they are part of this like ETA category? They're just a general manager that's mid-career and then they decide to go buy a company. How many people are accidentally sort of participating in this like ETA self-funded search category but that don't know that that's actually sort of a category that they could conceivably be associated with or linked to? My guess would be that the average self-funded searcher enters the community not knowing that like traditional search exists and then and then eventually they probably hear about it and so forth but the entry points tend to be hearing about it from a friend reading a book about it like something on a conference and going to a conference about it and then and then sort of it is a pretty interconnected world. So I think people tend to then realize like okay they're all these spheres and I'm going to sort of get associated with all these spheres that tends to happen pretty quickly but the entry point is very different certainly. From a sourcing perspective for you could you talk a little bit about whether you're sourcing talent or whether you're sourcing deals? I'm sure you're probably doing a little bit of both but is there a particular order of operations that tends to to drive the way that you think about finding opportunities in this in this category? We're mostly sourcing talent we're mostly building relationships with searchers and then helping them as they go through their search process giving them feedback on businesses that they're potentially submitting LLIs on and then our deal flow really comes when they have a business under LLI and now they need external capital. We've sourced a little bit ourselves I've actually I'm working on one right now that I found just sort of through happenstance that we know of this this large community of searchers. So if we find a deal that we like we can share it with the community and and basically yeah select a searcher who wants to do the deal and and sort of probably with the whole community in a case like that or we have a newsletter and we share it with the newsletter it's called this Week in ETA and it's it's great because it lets us get just a perfect for us the most sad situations are where there's a great business being bought by a great searcher but they're not the right fit for each other and that's just a bummer so it's nice when we can do some magic making. And so like just to play that forward like you send out that opportunity to the community let's say you have like I don't know six, seven, eight people that all seem quite compelling and are all very interested in the opportunity who is controlling the deal at that point like you originated the deal but it's not your business you don't own it there's a there's a seller still involved like how do you handle the dynamics of multiple interested searchers it's not a deal that you control but it's a deal that you source like any awkwardness there or is that manageable. Surprisingly not because so if yeah if we find a deal we would go under LY and we would do initial diligence to make sure that this isn't obviously not going to go forward and then assuming it passes that we'd share it with our newsletter so for this one I think we had on the order 40 searchers express interest who had some degree of relevant background and we're looking for that search to co-invest alongside us and we'll probably do the rest of the equity but we want them to have skin in the game and then we interviewed our team did short list interviews of about 10 people and then I did finalist interviews of about four people and then there'd be a couple it's basically down to a couple people which we will then introduce to the seller and have the seller actually be part of the process because the seller has incredible instincts on what type of person will actually be most successful in the business that they've but you'll continue to drive the deal process we'll continue to drive yeah exactly I see one of the things that I see as as changing maybe more than I would have thought is policy related to the SBA and the SBA's role in this category so maybe could you paint a picture just quickly just a quick one a one on the SBA it's importance in this category that you participate in on the equity side and then I'd love to just talk about like some important changes that have been made and then we can maybe get into some ideas around how you would like to see policy potentially change river extend but but yeah let's just get into the debt side of of ETA. Whenever a self-uncertain buying a business there's almost always debt component and the debt component is typically what's called an SBA loan a small business administration loan which is not actually made by the SBA it's made by a partner bank which there are thousands of SBA partner banks the bank does the underwriting the bank funds the loan but then the bank as long as they follow the SBA rules submits it to the SBA and receives a guarantee for 75% of the principal and the SBA is doing this to basically stimulate the small business economy in the United States and the program is actually great it breaks even so it doesn't cost taxpayers money because the SBA charge is guaranteed fee and it basically enables small business lending in a way that wouldn't really be possible without it and so it's a crucial component to the ecosystem the biggest changes that have been happening recently are one there's been some narrowing of the folks that are eligible you're basically only eligible now if you're a US citizen there used to be other ways that you could be eligible but now you have to be US citizen and then the underwriting standards have tightened and tightened basically to to say that they have reverted to a previous level of tightness during the COVID era some standards were relaxed that led to higher default rates which is not what the SBA wants to see and so they've reverted to historically more normal but certainly tighter than recent underwriting standards which we view as a big positive because small business is going bankrupt is bad for everyone and yeah using less leverage using more equity being more conservative in your underwriting is probably a good thing forever on if you have like a wish list of policy recommendations for the SBA or for the president what would those be and to what extent are those a wish list that is advantageous for you at entrepreneurial capital and to what extent would you know the wish list be different if you were sort of thinking about you know kind of what's best for entrepreneurial small business as an ecosystem in America maybe they're one and the same but if they're different I think it'd be interesting to just explore both certainly the biggest news of the month in SBA policy arenas is that there are some changes to the e-trans system which is what banks use to submit the beneficial owner information that it basically led to if you own less than 20% and and do not have control of a business that has an SBA loan you don't have to sign the personal guarantee and historically when people are getting SBA loans applying for SBA loans they would be checked against the database to see have you defaulted on a previous SBA loan that you personally guarantee.
because if yes, we're not making you another one, which absolutely makes sense. Do some technical changes now that 100% of the beneficial owners of SBA businesses are being entered into E-Tran because they all have to be US citizens. People, even that are minority owners in a new business that were awesome minority owners in another business that maybe experienced distress are being flagged by the system and then those deals can't go forward, which is something that we've actually engaged direct to with the folks, the policy folks at the SBA about and they have shared that this is not the intention and that they're working on a fix for that, which is really wonderful to hear. This is a couple weeks ago that we had this conversation, so hopefully that gets resolved quickly because if that were to stand, it puts a significant, it basically makes so you couldn't be a repeat investor in American small businesses. You couldn't be a repeat investor to the extent that any investment you made had experienced financial distress that had made its way back to the lender, right? Right. So if you have a fully clean investment record, you've backed nothing but a bunch of successful ETA businesses, it wouldn't get in your way, but if any one of them had some form of documentation related to distress, it creates a problem. Correct. Yes, so it's good. It's fine as long as you're perfect and right. That's not the rule of an. What is, how do you underwrite a portfolio in this category? Are you assuming, broadly speaking, Inventure Capital, right? There will be one business that returns the fund, right? And ideally, then there's a couple that are profitable and IRR generating maybe one that more than returns the fund, and then there's going to be many that are shut downs in total losses. That's like the portfolio theory of most forms of American venture capital, certainly in the early stages, private equity, probably quite different from that, even in the lower middle market, certainly in the middle market and upper middle market, like they're definitely not underwriting to tolerate any zeros in the portfolio. What do you, how do you think about that? I mean, I know you're only a couple years into both personally investing and now investing on behalf of yourself and others, but do you anticipate just total failures in the portfolio as the cost of doing business, or is that avoidable? And are you taking enough risk if you're avoiding this? Those losses? We badly hope to avoid it, of course. We would be very different from venture capital, or we're not assuming 70% of these fail in one of them returns the fund and the others are fine. This would be much more of maybe a normalish distribution, but still with a tail on the positive side. So your power laws and the prido principles seem to apply in all arrows of human endeavor. And this wouldn't be as extreme as venture capital, but there's still certainly some outsized upside possibility. For us, when we built our math, we assumed on the order of like a 10 to 15% impairment/default/zero capital return scenario. Our hope is that we do better than that, but we wanted to be conservative in our projections. Every investment we make, we very much, we never would deliberately make an investment thinking, well, this could be a zero, but the upside is just so good. That tends to be rare in the types of businesses we're dealing with. That's probably just not that good of a business, or it is a good business, but it's not in the category. It's actually more of a startup, and that's really outside our mandate. Have you visualized like how you might handle a situation where you've backed an ETA searcher or the businesses in distress? You obviously are a minority partner that owns less than 20% so you're not subject to the personal guarantee, but the owner or operator is, but you're maybe the largest outside equity capital partner. And it's like if you don't put more capital in, like, have you thought about those scenarios and how you think you'll handle them? You probably haven't stared one of those down yet, but that seems like an important thing to visualize and to be prepared for in advance. Totally. Yeah. Yeah. I mean, for us, and yeah, I hadn't had to encounter that yet, but the question that would be in our minds is, is this a capable person running a business that should be able to do well, and maybe has been hit with a one-time disruption that is, that black swan type of event? I think that our instinct would be that that is very worth injecting additional capital into, and that's going to have to be structured, thoughtfully, and so forth. But we do think that we can potentially act in a way that's respectful of our LPs interests as well. Fundamentally good businesses run by capable people from from strange one-time shocks. They're probably not going to love the economic terms that we have to provide the emergency capital on, but it's better than death. So options are good. I think the trickier scenario would be if you invest in a business, like I haven't encountered this yet, but I have friends who have where you invest in a business where there's just dramatic cell or fraud. It turns out that's the number one reason. It's the most common reason for SBA back to acquisitions to default is it turns out really meaningful fraud or really meaningful violations of the non-compete. That's just tricky because you may have bought a business that is fundamentally non-operative, non-viable. At that point, we probably have an obligation to, as painful as this, not throw good money after bad at predictor LPs interests. Well, it sounds like the technical issues with the SBA are not like, it's not like a long-term policy change that they're making. What about like the 20% threshold? Do you have a point of view on things like that and whether those things should go up or down? What are some perspectives that you have leading aside E-Tran or whatever the sort of technical issue is that's kind of like blocking good deals from getting through what are some of the other interesting ways that the SBA could change to advance ETA or to represent a more and more compelling alternative to private equity backed exits. Just what are your thoughts on just general policy ideas to be on the table in any given presidential administration? To me, the goal of the SBA program, as it's originally intentioned and to this day, is to enable small business ownership in the US and have that be a viable, have selling a small business to another individual owner be a viable path because if you don't have that, you eventually, businesses just cease to exist or they get absorbed by increasingly large companies and this vast majority of small businesses and probably almost all the small businesses we invest in only work to the extent that they have a very talented committed owner with an enormous amount of skin in the game who eats breeds and sleeps them. It can't be run by control, it can't be run by just by putting in a general manager and collecting checks on the beach much to the contrary of various social media portrayals. Why is it true that they must be so all in? What do you think drives that? I think that there is a, obviously industry specific, but there is a degree to which small businesses tend to exist in industries where there are not meaningful economies of scale. Maybe there are even dis-economies of scale and there are not meaningful ways to, like, home services is interesting and there's all kinds of aggregation happening in home services. And that can be great, but there's a dynamic within highly people-oriented businesses where they have a relatively small group of people led by a person who's leading from the front and actually earns the respect of their team just tends to win on average against a highly corporate machine because there's not crazy economies of scale. At the end of the day, it's really about a group of people working together and caring about the job and getting it done well. And that, on average, is done better by a team of 10 to 100 people than a team of 10,000. And that's just, therefore, we have a small business economy. And that's wonderful. And as a result, small businesses are hard. There's all kinds of non-economies of scale that you have to deal with. And as the owner, you probably don't have a whole HR team and a finance team and all kinds of support functions that people take for granted. That makes small business ownership. I'm a difficult job where you have to wear a lot of hats. What would happen if the Small Business Administration 7A program, which today grants a $5 million loan? What if they granted a $10 million loan? How would a change in policy like that reverberate through the ecosystem? It's interesting because the $5 million limit was put in
place over a decade to go quite a long time ago and has not been inflation adjusted. So in effect has been decreasing. The interesting thing and I see the SP is also like I applaud their efforts to raise underwriting standards and make sure that people who have the liquidity and have the skills are the ones actually buying these businesses because there is a dynamic where if SPA capital is too easy to access, view us to business for sale and we already see this to a certain degree that's SBA eligible, you'll get like 50 buyers who each say I'd like to buy your business and I'm going to use SBA money for most of it and then I'm going to use investor equity for the rest of it. And that person is probably not the right buyer for that business. Like they should be more personal liquidity and this is to me from our conversations it sounds like one of the things the SP is thinking about is there's a required equity injection but should a certain percentage of that be coming from the guarantor. And I think that's a wise policy because equity is good but but also individual like the operator or the owner operator equity is important. And so I do think the risk with there's pluses and minuses. The risk with increasing the cap is that then you have you have that dynamic which tends to increase multiples up to the cap of whatever is acceptable from a debt service coverage ratio for banks. For businesses of a certain size and that's mediated by the SBA loan ceiling. And so it would raising the raising the maximum significantly increase the number of SBA deals and the total dollar volume transactions. Absolutely. Would it significantly increase the dollar value of existing small businesses that are currently right above the SBA limit? Yes. Because those businesses are the hardest to sell in some ways because they're too big for the SBA but they're too small for anyone else. And so there's an interesting gap there. The equity injection that they would be considering that would have to be made by the like person who's making the personal guarantee effectively. That's how they would set that up. Yeah. Yeah. What are your thoughts on personal guarantees? Like what do you think about that element of the you know of the framework? I think it's interesting. I think from a government policy standpoint it absolutely makes sense. I think there's no way I'm guaranteeing loans that someone could just default on and then walk away. And so I think that'll always be a component to the program and I think it makes sense. I think from an ecosystem standpoint it filters out in some ways in a positive way and some ways in a positive way. It filters out people that are viewing, buying a small business in a flippant way. Like it's just, it's a very serious undertaking. And so that tends to attract a more serious person who is really willing to bet on themselves and that's a really positive attribute. The interesting thing which I think is not out of line with the SBA's desires and so maybe they may be viewed as positive as well as people with more meaningful personal assets are therefore less likely to want to do an SBA loan. Like they would rather potentially pay more for a conventional loan if it's an option that doesn't have a personal guarantee because the PG stands more when you have a $4 million net worth versus a $200,000 net worth. And so, but I think that's an intentional policy outcome. I think that they're, they want the loan to be more available to the latter than the former. What occurs in a situation where the buyer has $100,000 or $200,000 of net worth and the business goes out and they're subject to the personal guarantee, but they have no ability to pay it off with their personal liquidity either. Just personal bankruptcy. Personal bankruptcy, basically. Yeah. Yeah. Yeah. What about leverage levels? You definitely hear a lot about, you know, buying small businesses with no money down and just use government debt and a seller note. For conventional loans, there are no conventional loans that will that will approximate the loan to value ratios that you tend to see in this category. Why don't you think that that seems to suggest that market-based lenders are not comfortable with 80% and 90% lever transactions. Why do you think that the government is comfortable with that is it just a, is it just a function of the personal guarantee or do you think that that's a place where policy changes could lead to potentially healthier long-term outcomes by just having these businesses be less levered to begin with? I do think that would be a positive. I do think that that is in a prior world where equity was very scarce, it would be very hard for transactions to happen without the levels of leverage that the SBA currently allows for. The equity lens cap is developing. We exist. There are other people like us that exist. I do think that deals could still get done with more conservative leverage. We frankly push for that because our view is that it's asymmetrically. If you buy and run a good small business, you buy it for four times earnings, you pay off the loan and you grow it a little bit. It is just an excellent economic out-trump, even if you use slightly less leverage. The risk of death decreases dramatically as you dial down the leverage. Those we invest in, we just push people naturally towards use less leverage. I think that that would be. Those are the types of changes that it made. As recently as a couple of years ago, you could count a cell or note under certain circumstances towards part of the 10% equity injection that was required, potentially up to half. Those rules have been tightened and we think that that is appropriate. You won't buy a house with 95% leverage because technically the SBA will lend you. Everything technically can lend you everything up to the 10% required equity injection and under some of the old rules, maybe even up to 95%, which is just crazy. That would be, yeah. Do you have any visibility on that changing or is that just doesn't seem to be part of it? So that part has already changed. The cell or note counting. Now the cell or note can only partially count if it's on standby for the entire 10-year life of the loan. It's like, okay, fine. You're at least sequencing your debt payoff. I think that's very prudent. I don't know. I think that would be interesting to see. I didn't see any, from our conversations, we didn't hear any rumblings of increasing the equity injection amount or reducing the max leverage. It'll just be interesting to see as we get more years of post-COVID with the new rules do the default rates come back down to where the SPA wants them. And if not, I wouldn't be surprised if they make some of those tweaks. That's really interesting to hear your thoughts on the policy. What would be a really adverse policy change for entrepreneurial capital? Well, any continuation of what we're calling the one strike year out rule is obviously in either the short or the long term game over for anyone who's a repeat investor. American small businesses. So that would be probably the biggest one. But that seems to be just this technical issue, right? Is it really more than that? Or is it just like they have really old outdated systems and they're accidentally triggering something that is completely unintentional? I do think it happened unintentionally. It's slightly more, because we asked the same question, is this just a technical issue? And they said there's technical components, but there's also a, there was a loss to the government that happened here. So we just need to think through the degree to which that is sort of understood within our systems. Yeah. Sounds like it's slightly more than technical. That's an interesting one then. What else would be bad? I understand the limitations. I mean, the program as a whole has fewer people are borrowing because you have to be US and formally green card holders. Green card holders tend to be quite entrepreneurial. And so that's, but that's something that's already happened. Other things that would be really bad. I mean, lowering in a limit would probably be bad. I don't know if the limit needs to be raised, but lowering it would be, would be a bummer. Reducing the amortization. Right now it's 10 year straight line amortization, which actually really helps. It's a, it's a really good structure in many ways because it lets you have better debt service coverage. I think actually lowering, like lowering the minimum required debt service coverage ratio would be bad because it leads to more aggressive. What you don't want, the reason why we're in favor of strong underwriting standards is if you don't have them, the most aggressive buyer coupled with the most aggressive bank will buy the business. And then that person is most likely to default and that's just bad for everyone. When you think about the equity landscape and how that's evolving, do you, I mean, there's a lot of, a lot of private equity activity up market from these businesses. And there's been a lot of growth in just a number of lower middle market private equity firms buying, you know, $25 to $100 million businesses.
And what's your view on how the equity landscape might change in terms of competitive intensity? Is it more resistant to competitive intensity? Could it become substantially better capitalized in the next 10 years? Or how do you think about just the way that equity capital landscape might evolve, given how small these businesses are? And some of the nuances around capital structure and the SBA's importance and the whole thing, etc. It's interesting in our realm of the market, which I would call the lower, lower, lower middle market or the micro market, because there are, so there's us and then there are other folks like us that are now professional investors in this ETA, self-hunting search world. The interesting thing is all of the people who have funds like us, including myself, have other sources of income. This is not how we actually pay the bills. And we just tend to be small business owners. We tend to really enjoy this. I actually think the returns will be great, but it's a very long journey. Like the value proposition of start a fund to invest in ETA searchers is extremely unattractive if you don't have other sources of income. And so I do think that there will be for that reason, I think that this, it will be hard unless something foundational changes for this area of the market to be oversaturated, because in some ways all the people providing capital do it are doing it out of a personal desire and enjoyment of this type of business that doesn't, is not economically rational. And so that's interesting. Yeah, it's economically rational, but just in small quantities of dollars, right? Isn't that? It's extremely economically rational to invest. Like the deals, I think, and we'll save, you know, no promises, but I think the deals are very attractive. The transaction costs are high. Like I travel a lot to place, you know, I'm going to visit a business in California next week where we will invest $600,000. And we've done all kinds of diligence and there's all kinds of stuff. And so that, we have a team like, that's just not, it's a great business. It's awesome. Like it's a wonderful business being bought for three and a half times earnings. Like it's wonderful. It's awesome to be an LP in that thing. Doing the transaction costs is expensive. Yeah. Yeah. Yeah, that seems more competition resistant than the upmarket parts of private equity. Yeah. And I'm curious, I'm like, there's, you know, there's buses and minuses to that. But maybe in closing, like, is it correct to say that like the model that you have today, where you're raising a fund, deploying capital in this micro part of the American Small Business Market while also continuing to be a board member or business owner yourself? Is that, like, is that the grand handsel of the future? Do you think like five to 10 years from now? Like that probably is what you'll be doing and how you'll think about your career and how it evolves? I think so. You know, reserve the right to be wrong. Of course. Yeah. I do really enjoy it. Yeah. Yeah. And so like, if you were to be successful with this first fund, to what extent would you raise $12.8 million again versus 24.8 versus a lesser number? Like, what are your thoughts on how, you know, how you would continue to run it back? If you found it, continue to be financially and personally, you know, sort of rewarding and gratifying. Yeah. The constraint for us is deal flow as with everyone. And so you don't want to raise more money than we can responsibly deploy. Yeah. I'm the biggest LP in the fund. It's deal flow and it's check size per deal too, right? Exactly. Exactly. Yeah. Yeah. Exactly. And because we want to be helpful to the people and available as needed, we're minority so we're not control or we're not, you know, we're not running the business. We want to be helpful. And so and that takes time. Yeah. My, I like the committed capital vehicle structure for this. And so I do expect that, you know, Lord, we raise future funds. And I would expect them to grow moderately over time. If we have the deal flow to support it, I think that the thing that will be most interesting for us is, and we're starting to see this from my personal investments because they're a little more tenured is those people get to be a year, you're going to have two years in there. They've got their feet under them. Things are going well. And then they start looking at add on acquisitions. And that is very exciting to us because we already know the person. We know the business. And now you have an opportunity to deploy in conventional capital. We're actually the transaction costs are meaningfully lower potentially from a diligence standpoint. And so that will be interesting to see. Like to me, that's the way that this maybe scales without deluding the focus or deluding the quality of the diligence. Grant, where's the right place for people to find you? This has been fantastic. I want to make sure that if anybody wants to get a hold of you, they know how to do it in a way that you want them to. Fantastic to be here. LinkedIn is probably the best. Just Grant Ansel on LinkedIn, HNSEL. And then we have a newsletter called This Week in ETA. That's free. I think it's thisweekinutia.com. That goes out once a week, which is a lot of fun. It's great to have you on. I've learned a ton and it's been great to dive deeper into this part of the market. Look forward to having you back in a couple of years to report on how things have gone. Thanks, Peter. Hi, Varsha. If you enjoyed this episode, check out Axial.com. There, you'll find every episode of this podcast as well as our recorded Axial member roundtables. From downloadable tools for dealmakers, Axial's quarterly league table rankings of top small business acquires and investment banks and lots of other useful content that we've created over the course of time. If you're interested in joining Axial as either an acquirer, an owner, considering an exit, or as a sell-side M&A advisor, you can get started for free at Axial.com as well. Lastly, if you have ideas for podcast show guests, feel free to reach out to me directly at
[email protected]. I promise I will respond. Thanks for listening. [MUSIC] Peter Laramann is the CEO of Axial. All opinions expressed by Peter and podcast guests do not reflect the views or opinions of Axial. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Podcast guests may have ongoing client relationships with Axial.
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