We made it to 100 episodes! Thank you to all o ur listeners for your loyalty and feedback. Listen to our 100th episode as we dive into Working Capital and some of our favorite episodes we've put out for you.
Mike Harvath 00:02
Hello, this is Mike Harvath with the shoot the moon podcast for this week, broadcasting live and direct from revenue rocket world headquarters. Thanks for tuning in! Kind of a special podcast episode this week as it is our 100th podcast. Wow, whoo hoo. Really excited about that. With me today I have my partners Ryan Barnett and Matt Lockhart. Welcome, guys.
Matt Lockhart 00:30
Pretty awesome. It's It's amazing that it just keeps rolling. And you know, more and more when when I'm talking to people that I haven't met before. And they're like, Well, I don't you know, I don't know, I don't really care too much about how your business is going. But man, that podcast is sure awesome. So we're getting some pretty cool feedback. And, you know, I know, Ryan, you're kind of the brainchild behind the whole deal. So congrats to you.
Ryan Barnett 01:05
Thank you. And thanks for both being really gracious hosts on on this. We do this, really to share the knowledge that we've gained over 20 years here at revenue rocket and and, Mike, when you founded revenue rocket over 20 years ago, did you think you'd have 100? Podcasts?
Mike Harvath 01:20
No, I didn't even know what a podcast was 20 years ago. So I think that, you know, that's just a testament to how technology moves forward and how things change, I guess, but could never have envisioned, it certainly been a really, really fun thing to do. And I'm thankful that you guys join me here every week for this thing.
Ryan Barnett 01:45
Thank you for the opportunity. It has been good. Matt or Mike, any favorite podcasts that have come to your mind or anything that his that we hear from our customers and guests that have struck their fancy?
Mike Harvath 02:00
Well, certainly, there's a few that come to mind. One in particular, is a podcast that we did with Ashley Patel, who runs our outreach team. You know, Ashley's a fascinating guy, and certainly would encourage you guys to tune in, and there's some, you know, gems and little known facts in there about, you know, he brings a wealth of experience to our firm, and we're thankful to have him but the podcast, I found to be very, very interesting and we shared some some details on that podcast about how we do outreach and how we think that, you know, firms like ours should do that. So that was one of my favorites that came to mind. Matt, how about you?
Matt Lockhart 02:40
Well, I think, you know, one thing that we we learn is that whenever we have guests on, we get a whole bunch of great feedback, soon to be coming. And I don't think it's released yet. But we had CJ Strehl, from our finance team on just talking about sort of the conditions of the market and and what's going on there. But you know, it's as much fun as it is to be with you two guys, I think we need more guests. So I think more guests are to come in the second 100 podcasts that we do, what do you what do you guys think?
Mike Harvath 03:20
Yeah, for sure, you know, maybe we need to start looping in some of our clients on these, I think that would, you know, get some insights from them. And so you know, maybe that will, that's what we'll do in the next 100 podcasts are to loop in some personal anecdotes from our clients and how they exceed the market, how they experienced the market. And, and both strategy and m&a initiatives, I think that would be valuable.
Matt Lockhart 03:46
Well, we know they're a lot closer to the market, they got their arms and legs full on the internet, and probably quite a bit smarter than us too. So I think that'd be awesome to get our clients in there.
Ryan Barnett 04:02
Yeah, and I love to loop in the opportunity here that audience members here and you're listening today and you want to be part of the conversation and drop us a line over at info at revenue rocket.com And we're we're happy to talk about topics that you're interested in and we're happy to perhaps even you could be a guest on the show. So love to love the idea guys. My favorite actually some was in this is a little bit like picking your own children. But I think what drives us in this podcast is what we're seeing on a weekly basis. And they're very real things that our customers experiencing that we're seeing and what and how we as dealmakers are reacting. And so when we're giving it talking through these podcasts, there's a real modicum of truth and importance to what we're working through daily. So this is as much of a passion and If, if you're trying to learn about M&A, I truly think this is something that allows a novice to become an expert. And we're trying to share as much as we can and give back as much as we can, to the community out there for knowledge transfer. And we hope over the years, we've earned your trust. And if you do need to do something in the m&a space and you're in the ITC or services world, and you want to see growth, like you've never seen before, we hope that you can join us over at revenue rocket, long way to say, I'm still gonna pick my favorite, I really loved the selling in and selling out and kind of leaning in or leaning out episode we did just just a few weeks ago, I think there's so many opportunities for entrepreneurs to keep going in their business and sell in and the opportunities for growth. And I also really appreciate understanding when someone has built something, and it's time to monetize their life's work, that they have the opportunity to do so gracefully. And you can have the ad go down a few different paths to get there. So I really encourage you to listen to that. I think it's a must be, you know, in the, in the 90s, African episode, 90 ish timeframe.
Matt Lockhart 06:13
I think that's an awesome one, I didn't say, mine, I think was you know how to get ready. Right. I don't remember what we titled it, but it was making sure you're ready to embark upon a merger and acquisition program. And, you know, we shared some insights on the sell side, as well as on the buy side in. And I thought I got a bunch of great feedback there. And I think we're probably going to go back to that one. And I think doing it with one of our clients, as well as our chief strategist, Chelsea Nord, you know, could be an up and coming podcast here shortly.
Ryan Barnett 07:02
Love it, I agree. And thanks for the and thank you for everyone who listens and thank you to Matt, Mike, for for being here weekly. And for Maddie Schenk, who really helps us pull this all together as well. Today, we're really want to talk to kind of we have two topics, both very top of mind. One of them is in a macroeconomic environment, we're in the late part of summer here in 2022, we're seeing some pressure from capital markets, we're seeing some kind of macro economic issues that are daunting for for some, saw kind of a fall in the NASDAQ, followed by a kind of a huge jump up in stocks in the last couple of weeks. And, and Mike, it sounds like you've had a ton of discussions lately about the current state of m&a in the state of dealflow. When it comes to some advisors that you've been working with what we've seen in our deal flow and what we've kind of seen in the the overall environment. Just I'd love to hear what your thoughts are and kind of where, what do you think things are at? And tell us a little bit more?
Mike Harvath 08:13
Yeah, I think it's been fascinating, Ryan, you know, because we obviously, are in the market talking to people every day. And and, you know, I started to take a pretty hard look at, you know, what people were experiencing both our customers, and what we'll call friends of the firm, we have lots of people that have been clients that we stay in touch with, you know, we kind of have a client for life philosophy around here. So whether the meters run out or not with our work with our clients, we certainly love to stay in touch with them and keep the dialogue open. And as well as a lot of trading partners, and some of those include lawyers and, you know, private equity firms that may or may not be our clients that we're talking to. And I, you know, wanted to share an observation sort of that I had after talking to a bunch of folks over the last several weeks, which was, you know, many firms and, and PE firms and, and partners and advisors saw some pretty material slowdown in sort of their net new customer acquisition in May and June. Some saw that even in April, May in June, with a big comeback in July and August. And so, you know, I don't know if this was just sluggishness of a pipeline early in the kind of early in the summer or kind of through late kind of second quarter or if it was, you know, indicative of where the market was certainly, it was cool, whether it was coincidental or happened to be, you know, the stock market reaching a level in June and, and then roaring back in July and, you know, confidence In the market, but almost universally, we saw folks see slowdowns in May in June or April, May and June with big comebacks in July and August. Certainly in talking to a lot of these advisors and others, there's a sentiment that that was kind of what we're going to see for what we want to call sort of slowdown or sort of recessive headwinds. In that, depending sort of on what happens in the next eight weeks or so, will determine whether that was the law and things are going to continue to proceed and come back, it's my opinion that we could still see some pretty material market volatility through the end of the year. However, it I, you know, being a glass half full kind of guy, I think we're gonna see a pretty material uptick in the fall quarter. And that, you know, we're going to have a return to normal if we can consider, you know, the end of 21, and end of 22, to be normal, as we get to the end of this year. And so, pretty short, sort of quiet, or slow down, if it turns out to be that way. And, you know, in many ways, could be seen as not not much of a market correction. And in some if it comes to be which what most of my advisers and market pundits are telling me, you know, maybe the, maybe the fed and you know, the markets coalesced around a soft landing, after all, I guess it'll still take a couple months to know for sure.
Ryan Barnett 11:45
Yeah, it's been an interesting time to see, I think when you if you listen to, recent podcasts, I think it's 99, to talk about the impact of capital markets, the cost of money, and kind of the cost of capital, there's, you can understand why there's some constriction in the market. But I will go back to I think, what for me what the key finding and that podcast was very much focused on companies that have that are well run, that are in the IT services market, that are continuing to do good things on behalf of clients will continue to still be favorable acquisition targets. And if you're in this business, and you're able to continue to attract and retain customers attract, retain talent and be able to specialize in a market that you can dominate, you have an opportunity to be a very, very favorable seller, and and buyers who are able to, to work through this market have an opportunity to to still get growth together through acquisition.
Matt Lockhart 12:51
Well, I mean, look at the jobs report in July, right. I mean, it blew away all expectations. And, you know, we know that the unemployment or negative unemployment, in IT, has been in place for a while. years really? And so, I mean, if the the laws of supply and demand, are you in favor for sellers in this environment in the IT services space, and there's there's no doubt now, obviously, it's one of the the main strategic imperatives for buyers. And so, in our space, it's interesting, you know, you're talking about trading partners, again, to get a very good friend, a much better golfer than, than any of us who, who is an m&a advisor, but focuses in the manufacturing space. And, you know, it's a little tougher there than it is than it is in in our, you know, tech enabled services space. So I like your glass half full idea, Mike, and we're just going to keep plugging ahead and, and, and good times are ahead.
Mike Harvath 14:11
Sure, I think that time will tell that I think we're, you know, I think people need to remember that we've never seen, you know, a lot of people ask about well, what's the impact on valuations or rising interest rates? And, you know, what has been the impact ultimately over history? And, you know, I think sometimes we forget that, you know, it's a very narrow band of impact from pretty extreme markets. A headwind so it's if you're running a great services business, it'll always they'll always be demand for it, frankly, tech enabled services. And because of the additional, as you mentioned, that the additional impact of labor and labor shortages and talented labor shortages. I think we're going to see a very healthy m&a market move We get into the rest of 22. And certainly as we move into 23.
Ryan Barnett 15:06
That's great. You know, and just a reminder, if we had a crystal ball, we would be much more successful in life and not needing to work too much. But that that's how kind of how we're calling it today. And what we see for the, for the least near term future. To move on a little bit, guys, in staying true to our theme of dealing with topics that are near and dear to our hearts, and what we've seen the last couple of weeks, we're nearing to a point in a deal in which working capital discussions have come up. And working capital is is something that is critical for everyone and loved. Mike, just help us understand kind of what working capital is, and I'd love to hear for, let us understand kind of what it is and why it matters. And we'll start there.
Mike Harvath 15:58
Yeah, for sure, by the strictest definition, working capital is current assets minus current liabilities, you need enough current assets in the case of cash in AR to cover your liabilities or what you owe, in order to run the business. And by definition, that is working capital, certainly cashflow and the ability to actually pay those bills on time has much more to do with cash conversion, you know, timing and ratios of of the assets as to cash versus AR and a variety of other things. But by strict definition, it's just current assets minus current liabilities. And I think what's interesting is that there's really only one time as a seller, that you get to harvest excess working capital. And maybe I should, and that's when you sell, most small businesses keep excess working capital on the balance sheet in the form of cash. So that they can, they don't have to get into their line of credit. And that they're able to operate a little more efficiently, because they don't have the carrying cost of being in and out of their line of credit, which essentially, is a loan that's given to you a short term loan by your bank. And you're gonna pay interest on that money when you need it. And there may be reasons for using that, whether it has to do with sort of your cash conversion timing, or a situation where, you know, maybe there's a little dip in the business that requires you to, you know, have to get into your line of credit to kind of keep everybody and keep all your bills paid on time. And so there's, but but in short, you know, the working capital is the making sure that you have enough positive asset value to cover your liabilities and, and make sure you have enough cash to pay your bills on time. Back to the point of, you know, being able to harvest, we'll talk, you know, in a sale, why, how to optimize that and how to harvest here in a minute. But, you know, the concept of harvesting, excess working capital may not come to mind for many sellers. And there's also a sort of a vast amount of misunderstanding as to, you know, how much they can harvest and when they can harvest it. And we'll try to tackle some of those topics as well.
Ryan Barnett 18:42
Mike, thanks, thanks for that the general definition here, I just, I want to understand that. So when companies acquire a seller, there, there has to be enough cash in the business to run it as a growing concern. So for example, this is this would be something like having enough cash to operate the next payroll. Is that am I understanding that correctly?
Mike Harvath 19:08
Yeah, I mean, the definition in most of the legal documents in an m&a transaction defines that when you buy a business, that you're buying it as a going concern, right, it is a, it has enough capital to operate independent of the transaction. And I think as a seller, you have to keep that in mind. It'd be, you know, for example, if you if you the shoes on the other foot, and you're selling your business, and let's say you're a buyer, you wouldn't want to, as a buyer have to put in a bunch of cash in addition to what you spent on the business in order to operate it. So you really have to be mindful about how you transition the business. Now with that said, buyers sometimes take advantage of sellers. I don't want to say all the time, but sometimes, because this whole concept of what is working capital and how much of it is enough, is somewhat misunderstood. And so we'll try to add some clarity to that here and, you know, things that you should look out for as well. But it is a fact that if you're going to sell your business, you need to be thinking about selling it as a going concern, concern. And so it should be adequately capitalized to operate without the buyer having to, you know, put cash in to operate it.
Ryan Barnett 20:36
And just a follow up clarification there. How long is that for Mike? Is that like enough to run it for 30 days, 60 days indefinitely?
Mike Harvath 20:47
Yeah, it should be to cover a collection cycle. So assuming that, you know, you have adequate working capital, they have what's called positive working capital, that you know, current assets at a minimum equal current liabilities, you need to be able to convert all those, all those receivables into cash. So, you know, typically for a well run business that's collecting most if not all, their error on time, you know, that could be 30 to 40 days, probably.
Ryan Barnett 21:20
Okay, thank you. I think that that helps us get a bit of insight on this. When you're thinking, a, as a seller, and you're thinking perhaps, a year from now, we've seen scenarios in which companies have carried a lot of cash on their balance sheet. And we've seen some buyers that have taken different approaches to evaluating working capital, for example, taking a year's average cash on the balance sheet. Can you Mike can you give us Mike or Matt, either one, can you give us some help in some methods for determining the adequate amount of working capital?
Mike Harvath 22:05
Well, I'll speak to, you know, just this point, because I think it's important. Oftentimes, you know, as I mentioned before, most, most companies most small IT services companies, tech enabled services companies are over capitalized by the strictest definition, meaning they have more positive net working capital, then that's probably required. So, you know, if you look at the working capital net working capital of zero, which would mean that current assets minus current liabilities, you know, equals zero, the delta between those two things, that anything, in addition to that is considered positive networking capital. And, you know, oftentimes, people keep more positive networking capital around for all the reasons we talked about earlier, they just wanted to be more convenient, they don't want to have to get into their line of credit, or whatever it might be. Now, it's, it's the tactic of some buyers to look at the average positive net working capital as to what's required to run the business, when in fact, that may not be the case. And they may request that you leave that amount of positive net working capital in the business on the sale. And, and we think that's probably an overreach, we do think it's appropriate to leave 30 days of operating expenses in the business, but 30 to 40 days, but not not, you know, not a, you know, twice what you might need to operate the business or three times, you know, and these are coverage ratios, you can look at what a coverage ratio is, you can look that up online, but, you know, wildly over capitalized businesses are ones that have a lot of positive net working capital. You don't want to leave that in the business because technically, as an owner, that is your money. And you've just choose chosen to leave it in the business for ease of operations, essentially. And so being able to determine what is the actual adequate amount of working capital that passes the test of a buyer not having the money in post calls, is the adequate amount, any amount in addition to that you should be able to harvest and typically that gets paid out after a collection cycle or at about 90 days, sometimes you'll hear the term true up. That's typically when that gets paid out. But hopefully that adds some clarity and answers the question, right.
Matt Lockhart 24:48
You know, I'll just add a little bit right. And I think that to your point that you know, when thinking a year ahead of time, is you know, to Mike's point You know, thinking about the cash on hand to the business, but also thinking about, you know, if there are any long term debts, debt in the business and thinking about that, and managing that, I mean, shoot, you know, way back in the day when we were running our own business, and we kept way more cash in the business than we needed, we almost felt like, Well, geez, we're, we're doing the right thing, because we're protecting ourselves. And it's almost like a, kind of an immature, for us, it was sort of a immature mentality that it made us feel protected. Whereas the reality is, is the business just continues to go along, in managing the business and you're, you're, you're managing your AR, and and that's, you know, that demonstrates a level of maturity. So, you know, when you're thinking about that, in the context of m&a readiness, you know, you're thinking about the fundamentals, which then makes it a whole bunch easier to just go to the formula for, you know, sort of what is truly cash free debt free, with an appropriate buffer.
Ryan Barnett 26:20
That's exact kind of leading into just cash free debt free. I just want to make sure I totally understand this I could probably Mike or Matt could probably use another just a definition update on what cash free debt free means. What what we've seen in deals is that sellers essentially need to not have debt and that debt will not transfer into the deal. So is that a correct assumption?
Mike Harvath 26:47
Yes, particularly for long term debt, right. So it's very rare that a buyer will assume long term debt, I don't want to say never, but it's very rare that they will, usually they want to retire that debt and the primary reason they want that is because they have to be able to buy the business without any encumbrances. And typically, when you have long term debt, you've made a pledge to the bank, or to someone else, whoever's loaned you the money, that they're going to secure that debt, with the assets of the business, including your AR. And so you have to be able to sell the business without those liens, if you want to think of it that way, on your business associated with, say, a loan or security that someone might require for that debt. So that's why, you know, debt free is an important concept that almost in every case, is a consideration because to transfer that security, or to transfer personal guarantees, which are often also, you know, many times required in small business on debt is challenging. So it's, it's best at most buyers, I'd say 99% of the buyers wanted to be debt free, particularly as it relates to long term debt. Now, trade payables, which are technically also debt are generally assumed in a transaction. And trade payable would be, hey, you're gonna pay your lease payment for your office, or you've got to pay, you know, for utilities, or you got to pay for, you know, a variety of things that are in the normal course of business. And those are, those are assumed, so they don't go into the debt free category. Cash free is an interesting concept, because cash free is actually in the strictest definition in a fast growing business might not be the right way to think about it. And why I say that is if you have an inordinate amount of your assets on the ledger of your balance sheet tied up in AR, in a cash free debt free transaction, you relinquish the AR to the buyer. And you know, how that's handled is pretty important as it relates to coverage ratio associated with the liability side of the balance sheet. And, you know, we're we've got a great team here at revenue rocket that specializes in this and helps our clients negotiate these every day. I know these topics sometimes can be a little bit confusing, but it's important to understand sort of, you know, whether a cash free debt free transaction will work for you as a seller, or whether a different approach on calculating working capital would be more fair or to allow the business to be transitioned as a going concern, and yet allow you to harvest the most of that working the maximum amount of excess working capital? And so a little bit more of a question, a little bit more of an answer to the question that you asked, but hopefully added some clarity.
Ryan Barnett 30:27
Absolutely. That kind of went into there's definitely a view that buyers typically want a cash free debt free and sellers want a bit more of a coverage ratio approach? And depending on what side of the table you're on, there's a there's it's certainly a point in the negotiation. And which leads me to the to general question. And math, I know that you've been dealing with this a lot. Lately, and in the last few deals, working capital always seems to be contentious. And I've been in certainly a number of conversations that have been almost argumentative. And I'd love to if you have any advice to sellers and buyers of how to how do you approach this from an emotional standpoint, and in a negotiation standpoint, you've been really great at getting through some of these impasses and love to hear hear your thoughts.
Matt Lockhart 31:28
Thanks, Ryan, you probably, because working capital is sort of one of the last things right and appropriately so because, you know, it's on the heels of all of the due diligence, that is validating the deal structure that was set forth in the letter of intent, and so it has to come towards the, towards the end of the process, well, the end of the process is, is also going to be the most emotional part of the process, oftentimes for sellers, because it's sort of that point in which they are, you know, getting ready to, to let go. And, and it's oftentimes the case, especially with, you know, founder led businesses, which we oftentimes see in this space. And so the reason I say that is, is it's just it is a naturally emotional time. And, and so then you are entering into the equation money. And we know that that's only going to raise emotions. So what are some of the ways in which we like to attack an a, an early definition of what working capital or the structure the expected structure of a deal. So right in the letter of intent, putting the expectation forward, that it is a cash free debt free situation so early in the stage, and then if there's advisors on both sides of the equation, then those advisors should be able to get together and, and define what you know, agree upon what cash free debt free means, right? First off, and and then lay the path for how to determine the working capital Peg, Right, the you know, what is necessary for operating the business as a going concern. And, and so, you know, and if there isn't advisors in on both sides of the equation, then just opening up the discussion and putting it out on the table, that here's the right, and here's the fair and logical path, that, you know, nobody's trying to make a cash grab towards the end of a process, that there is a very logical path to defining both what cash free debt free means as well as what a working capital peg allotment will be, to, you know, to that everybody can agree upon. And so if you can agree upon the logic and you can agree upon the process, well, then hopefully, you're doing what it takes to reduce the, the emotion, if you will, and doing so early is always better than later and, and, you know, sometimes it's easier to do than others.
Ryan Barnett 34:42
I'll add here, If there's a plug for advisor, I think this is where it's at. If you are trying to try to negotiate working capital loan it's very difficult. You still have to work with the people across the table. And this is something Where I think you've literally feel cash being pulled out of your pocket as a seller. And you have to have a, you need help from someone to do the pushing and shopping around that.
Mike Harvath 35:15
I would also add that, you know, the working capital in negotiation directly impacts purchase price, right. So at this point, you know, usually, to Matt's point you through due diligence, we're down to the final strokes, and you're looking at a schema for working capital, that needs to be applied at an after the transaction. Because for example, there may be expenses that come in to the working capital calculation that you didn't even know about until after the transaction, things like utility bills that may cover a period of time where you own the business part of the time, as a seller and a buyer owns at for another part of the time and those things, you know, in short, follow the ownership. But then, you know, there's always the question, well, how do you get that figured out? Right? Well, that gets done in the trough up in this, you know, trough of the typically happens about 90 days out and gets reconciled. And that true up, likewise, there may be a payment that comes in. And this is, again, where cash free debt free can be a little tricky. You know, let's say you the day of close, you get a material payment from a from a vendor. Well, that technically, is in a cash free debt free would be the sellers payment, but it does impact how you calculate working capital. And so coverage is important in how coverage is actually calculated as important. So, you know, we think that debt free with a with a reasonable coverage ratio, and a true up can take a little bit of the drama out of the negotiation. And to your point, Ryan, I think being able to have an outside advisors opinion on this and being able to, you know, go to bat on your behalf to make sure that it's fair, because no unfair working capital negotiation will actually work out it, it's got to be, you know, your buyers buying a going concern with fair working capital, and they understand how either a working capital deficit or a positive net working capital above what's required, is going to get resolved. Sometimes buyers will agree to have a negative net working capital position and have that adjust purchase price or in some cases, you know, there's other components of the negotiation that that would drive, you know, parties to agree to something in the working capital negotiation. But takeaway is that there's always a negotiation, typically, and your best position to have someone who negotiates this every day working on your behalf to optimize.
Ryan Barnett 38:05
Yeah, thanks, Mike. I have just one quick last question. And I'll turn it over to Matt for any thoughts as well, but it is working capital typically considered part of an enterprise value. Okay. When you say hey, the enterprise value of a deal was x is the harvest of working capital part of that?
Matt Lockhart 38:26
Well, certainly the harvest, yes. So the the overall harvest to the seller of being able to harvest that excess working capital and based upon upon again, no fair definition is certainly part of the overall enterprise value of what is achieved by the seller in the transaction. Right. And so, you know, we also consider excess compensation the you know, part of the overall enterprise value that can be realized by a seller if they're selling in and speak into your one of your favorite podcasts there, Ryan. So, yeah, I certainly think so.
Mike Harvath 39:10
Thanks, guys.
Ryan Barnett 39:11
Thank you.