Episode 11: The Boutique: Earn Your Earn Out
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Sean Magennis [00:00:16] Welcome to the Boutique with Capital 54, a podcast for owners of professional services firms. My goal with this show is to help you grow scale and sell your firm at the right time for the right price and on the right terms. I’m Sean Magennis, CEO of Capital 54 and your host. On this episode, I will make the case that many do not earn their earn out post sale. And the primary reason is a poor culture fit with the new ownership team. I’ll try to prove this theory by interviewing Greg Alexander, Capital 54’s chief investment officer. Greg will share his experience helping owners earn 100 percent of their earn out. Greg, let’s begin by establishing a working definition of culture for the purpose of this episode. How should we think about culture for the next fifteen minutes?
Greg Alexander [00:01:19] Good question. So if we limit it to 15 minutes, boy, we could talk for days about culture. But for today, let’s establish a simple definition. So and this is to say culture, I would suggest, is a common set of beliefs and behaviors. So when someone says this is the way things get done around here, they are talking about the culture.
Sean Magennis [00:01:42] Got it. I recently read an article published in the Harvard Business Review. It was written by a McKinsey consultant, and he claimed that 70 to 90 percent of acquisitions fail. And the root cause of all this failure is poor culture fit. Our listeners are owners of boutique professional services firms. They all will eventually want to sell their business. A good majority of them will have an earn out as part of their deal. Greg, if 70 to 90 percent of these deals fail, this means that most of our listeners will never see the money tied to their earn out. How can we help them avoid this very costly era?
Greg Alexander [00:02:23] Yeah, I hate it when I see this because it’s very likely that you’re going to have an earn out when you sell and you deserve those dollars you built a great farm and it makes sense for the purchaser of your firm to include an earn out as part of the deal that gives them kind of downside protection. So let’s make sure that that the listeners earn their earn out and they avoid this mistake. So the key to realizing the earn out is to make the deal successful for the acquirer. And that’s a new way of thinking. Most times when you’re selling your firm. You want to make it successful for yourself. And of course, that’s important. But you’re going to earn your earn out if you make it successful for the acquirer and the key to that is merging the culture of the acquired firm with the culture of the new ownership team. So how the heck does someone do this? So let’s begin with some context before we get to our recommendations to the audience. So boutiques have cultures, most of which are very strong. Usually the culture of the boutique originates from the founder. The founder designed a culture that he or she wanted to work in. In fact, job satisfaction is one of the primary reasons founders start their firms. There were frustrating working inside a big corporation and somebody else’s culture. So as the firm grows, the founder recruits the early employees. And guess what? They are hired because they fit the founders culture. They are people he or she wants to work with. The firm continues to grow in these early employees perpetuate the culture by recruiting the next set of employees who also get along with the founder and sync well with the culture and on and on it goes until one day the boutique has hardened around, quote unquote, its culture. This culture gets so strong that employees to not fit with it, are rejected almost like an organ transplant is rejected by its host. Clients are affected by this culture as well. Clients who view the world the way the founder does become the boutiques best clients. I share this with the audience to demonstrate how a culture of a boutique comes to be. This culture emerges over the years. The founder, early employees and the most loyal clients are heavily invested in it. They love the culture. In any attempt to change it is viewed as an attack. So you can see how emerging this type of culture is. So very hard.
Sean Magennis [00:04:55] Exactly, Greg. This context is very, very helpful. I can’t help but think that what makes a boutique successful is its culture. It’s also the thing that eventually becomes its biggest problem. Is that. Is that accurate?
Greg Alexander [00:05:10] Yes, this is correct. And the reason your statement is correct is when one firm buys another firm, these two distinct cultures collide. If the two firms see the world the same way, they become one bigger and better and happier firm. If the two firms see the world differently, the integration is a mess. And this results in the opposite outcome. Separate fiefdoms inside the firm fighting each other. Turf battles emerge over client ownership. Budget power structures, et cetera. Key employees quit and important clients take their business elsewhere. This results in numbers getting missed and missed. Revenue and profit goals result in earn outs not getting paid out. This can even in some cases, digress into nasty lawsuits and an eventual divestiture.
Sean Magennis [00:05:59] Exactly, Greg. And no one wants lawsuits or messy disputes. And our listeners want to realize the full amount of their earn out. If culture fit is what causes this mess. How can a listener determine culture fit before selling their firm?
Greg Alexander [00:06:15] It’s hard to do. It’s a little squishy, but I would suggest that prevention is the best course of action. So here’s a few things to consider when trying to determine culture fit prior to selling. So first, consider the origin stories of both firms. Do the founders have similar backgrounds? Are the founders, still the dominant cultural force inside the firm? Do the early employees resemble the founder, are the founder or founders and early employees still involved in the business? Have they become the legends? And what does this mythology tell you about the culture? Next, examine the cross functional collaboration inside the firm. If there is a lot of it, this suggests a cooperative environment. This indicates an open culture willing to partner. If there is a little of it, this would suggest fiefdoms already exists and will likely get worse. Post sale. I would also look for cultural artifacts. For example, if there are celebrations on significant dates, this would suggest a fun group. If there are contests with leaderboards, this would suggest a competitive group. If employees are acknowledged for years of service, this would suggest a loyal group. If there are a lot of legal documents and rules, this would suggest a cautious group. If there is a relaxed dress code, this might suggest a laid back group, or if people stay at budget motels when on the road. This would suggest a frugal group and on and on it goes. There are many clues, just pick your head up and look for them.
Sean Magennis [00:08:03] This is very helpful, Greg. It illustrates to me that there is no right or wrong culture. Rather, the question remains, will the cultures fit with each other?
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Sean Magennis [00:09:57] Okay, this takes us to the end of this episode. And as is customary, we will end with a 10 question yes, no checklist. We conclude each episode in this fashion to help listeners apply the learnings directly to their business. This creates for you your take home value. Let’s jump into the checklist. Ask yourself these 10 questions. If you answer yes to eight or more of these questions, you are likely to get all of your earn out. If you answer no too many times, you’re likely to leave a lot of money on the table.
Sean Magennis [00:10:32] Question number one, is the founder still involved in the business? Number two, does the founder’s origin story shed a light on the boutiques culture? Number three, are the firms legends still involved in the business? Number four, do they personify the culture? Number five, does the firm work well across functions? Number six, do the artifacts indicate the firm’s culture? Number seven, do employees who are cultural mismatches get rejected by the firm?
Greg Alexander [00:11:19] You know, I would suggest on number seven, cultural mismatches getting rejected by the firm, that’s a positive. Sometimes my people might look at that as a negative and say when we hire somebody who’s not like us, they don’t fit in. And as in the case of investing in a boutique, that’s a positive. You want the culture to be so strong that those that take to it stay with the firm for 10, 15, 20 years.
Sean Magennis [00:11:45] Excellent point. Number eight, do the firm’s best clients share a set of common beliefs with the firm? Number nine, are their deep relationships between the legends and your best clients? And number ten, is it crystal clear to potential acquirer how your boutique behaves?
Greg Alexander [00:12:08] Yeah. And lastly, on number ten, when someone’s doing diligence and they’re assessing your culture, which is a difficult thing to assess, and hopefully this episode makes that less difficult. If someone’s critical of your culture, don’t sell your firm to them.
Sean Magennis [00:12:21] Yep.
Greg Alexander [00:12:21] Right. Because you’re going to run into this mismatch.
Sean Magennis [00:12:23] Agreed.
Greg Alexander [00:12:24] And to your earlier point, there’s not a right culture or a wrong culture. It’s just a culture. And do these cultures, can they coexist well? If somebody is doing diligence on you and they’re suggesting that there’s a cultural problem, runaway. On the flip side, if you feel like even though you’ve just met these people, you feel like you’ve known them for years and years and years. That’s a good sign that you guys will, well, your cultures will merge well together post sale.
Sean Magennis [00:12:48] Totally agree Greg and taking the time is a critical characteristic as well. So in summary, remember that most acquisitions fail and this prevents owners from earning their earn out. The primary reason for this is poor culture fit. Don’t hide your culture. Lead with it. You want your sale to be successful. Therefore, you need to find a buyer who fits your culture.
Sean Magennis [00:13:14] If you enjoyed the show and want to learn more, pick up a copy of Greg Alexander’s book titled The Boutique, how to start, scale and sell a professional services firm. I’m Sean Magennis. Thank you for listening.