Uncovering Capital Allocation Strategies

Every company must have a strong capital allocation strategy to maximize its potential. Without it, the company may end up missing opportunities and spending money on things that won't help it grow or become more profitable. In this episode of the M&A Science Podcast, Keith Levy, Operating Partner at Sonoma Brands, shares his experience on successful and unsuccessful capital allocation strategies.

Uncovering Capital Allocation Strategies

22 Apr
Keith Levy
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Uncovering Capital Allocation Strategies

Uncovering Capital Allocation Strategies

“Try to create as much value as you can. If you’re too focused on a successful exit, you will run into problems. Focus on what it takes to build a great business, and then suitors, investors, and acquirers will come along.” - Keith Levy

Every company must have a strong capital allocation strategy to maximize its potential. Without it, the company may end up missing opportunities and spending money on things that won't help it grow or become more profitable. In this episode of the M&A Science Podcast, Keith Levy, Operating Partner at Sonoma Brands, shares his experience on successful and unsuccessful capital allocation strategies.

special guests

Keith Levy
Operating Partner at Sonoma Brands

Hosted by

Kison Patel

Episode Transcript

Focusing on organic growth

Whether you're a public company or a private company, you look at your free cash flow as a resource to create either better earnings or stronger growth.

Through the eyes of the leaders at Anheuser Busch and the board, they looked at their free cash flow primarily to invest and improve their breweries. This investment would eliminate high-cost labor with low-cost capital and create a strong ROI over a period of time by reducing investment in SG&A.

The first priority was these capital investments, which were quite successful. We had a stringent process to evaluate what we were going to invest in and what we hoped to get out of it.

Second was share repurchase, buying back shares to amplify EPS. This is more of a tactic than actual real growth. We invested more in these to fulfill promises made at consumer conferences, like delivering 12% EPS, which can be achieved partly by buying back shares.

The third and distant priority was making acquisitions. We made some but nothing transformation to set them up as a global company.

A significant portion of our earning stream was from Anheuser Busch Incorporated in North America. This capital allocation strategy is partly why we got acquired.

Despite being a household name for over a hundred years with Budweiser and Bud Light, and being concentrated in the United States/North America, there was a lack of fiscal discipline. We had high EBITDA margins, around 47% when I left in 2011. 

This profitability allowed for some lavish expenses, as long as growth and profitability were being delivered. These included flight operations and properties in Napa Valley and the Lake of the Ozarks, which were part of the corporate perks of that era.

In summary, it's a case of acquire or be acquired.

We hired Goldman Sachs as a defense partner when InBev was coming at us. We considered actions they would likely take if they acquired us: selling jets, selling subsidiaries, reducing G&A, and undergoing rigorous SKU rationalization. 

These were all measures we actually implemented after being acquired, which we could have done independently.

The free cash flow allocation strategy, in retrospect, was flawed. If we had prioritized global M&A as the top priority, followed by investing in hurdle rate return capital projects in our breweries to replace high-cost labor with low-cost capital, and then focused on EPS or share repurchase to drive EPS, it would have been more effective.

Regarding the jets, they had seven, and they weren't inexpensive ones either. They were Falcons, costing 30 to 40 million each, with 21 full-time pilots. The Bush family, being avid aviators, flew jets and helicopters since they were young and used them as a corporate tool. 

A corporate jet, when used appropriately, can be highly effective. For example, as the head of sales and later the CMO, I could visit three or four different distributors in various states in one day and be home for dinner, which is impossible with commercial airlines.

This approach, particularly on the sales side, had a human element—being with people, breaking bread with them, meeting their sales teams, and providing inspiration by sharing corporate-level insights. 

A corporate jet can be an effective tool, but the necessity of seven jets is questionable. Additionally, their usage wasn’t always efficient; sometimes, just me and my assistant would be on an 18-person jet, which could stay in a town for a few days before returning. 

There are certainly better ways to utilize such resources. However, these practices have fallen out of fashion in recent times

Post-merger integration execution

I have to describe it in two almost very extreme opposite feelings. One was that, when we were there, only a handful of executives were asked to stay on and help bring these two companies together and drive some success. So, a lot of my friends were asked to leave.

I was firing a lot of my friends that I've worked with for over 20 years. And in some respects, when you go through a big M&A transaction like that, particularly as the head of marketing, you're cutting marketing budgets, cutting everything you can get your hands on, and at times you're not maybe as proud of the work that you were doing.

That's a little bit of a talk in the doing, currently versus what you were doing before, when you had sort of, quote unquote, unlimited budgets. But I understood what it was. So it was painful because again, I felt like in some respects I was tearing down a company I helped build for over 20 years.

Saying goodbye to some of my friends. And then I'm left to try and figure out how to create value with some of my colleagues who were asked to stay as well and so that was tough. Now, what was fascinating about it was, look, you're sitting there trying to bring together two 50 billion companies. Who gets an opportunity to do that? 

And I'm sitting at a table once a month with Titans of M&A like Jorge Lehman, Marcel Tala, Beto Spiro, the 3G guys, basically those are the three guys that started 3G. Just listening to them and seeing their tactics about how we create value and do it in a quick fashion was pretty remarkable to be part of. 

At times I was like, what am I doing sitting at this table with a guy who's got a 10 billion net worth, a 5 billion net worth, even the poorest guy there had a 3 billion net worth at the time, probably much greater now. That part of it was fascinating.

And I think too, like if you think about it like a playbook for perfect timing. Everybody's scared. And you know the Warren Buffett saying, when people are scared, you buy. And when people are enthusiastic, be scared.

They were just fearless and kind of went in there and the playbook was basically this, it was like, okay, you borrow 53 billion. You've got to pay that back as quickly as you possibly can. 

But while you're doing that, if you can do things to expand your margins, price, cost, and try and expand your cash flow to the extent that you can tell people, Hey, look, payment terms used to be 30 days.

Now they're 180 days. We did all those things. And if you expand your margins in a public world, pay down your debt in a timely fashion, hopefully ahead of expectations and you maintain your multiple to the stock market. We were a public company and your stock price goes up.

It just has to like, look, we were bought for 73 bucks a share in November of 2008. At that time, there was a new co-created in Belgium, and I think the shares at that time were issued at 10 euro. 

Four to five years later, those same 10 euro shares were worth 100 euro. So, if you execute that playbook, the way I described it, which we did, that's the result.

And it was remarkable to be part of. It was hard. There were a lot of emotions around that because I'm living in St. Louis and I'm a relatively public figure and it was a very unpopular acquisition because you can just almost picture the headlines, right? 

American icon bought by foreign entity and what's that going to do to the St. Louis community and this has been sort of a staple and an icon for over a hundred years. So, it was hard, interesting, a great learning experience and incredibly successful when you really look at the numbers.

The playbook was to cut expenses, increase prices, and expand EBITDA margins. By doing those things, we successfully increased the stock price. We had to say goodbye to the jets; by the time I left, I think they had one left. And probably 25 percent of the workforce was eliminated.

There are a lot of things that you take for granted that will always be there, whether it's people, processes, budgets, things, and those are all put under the microscope and called into question. Even the famous Budweiser Clydesdales at one point were questioned. 

We have 110 Clydesdales and breeding farms; maybe we should get rid of those, but they were a company asset. The Clydesdales are not just a company asset, but a brand asset. There's marketing speak, think about things like distinctive memory structure. 

I see the Clydesdales, I think of Budweiser. I see the Nike swoosh, I think of Nike. Those are things that take many years to develop and burn into the consumer's minds. The extent you can keep them, you always want to. When you borrow 53 billion, you turn over every rock, including the Clydesdales.

Then from there, I went to Mars. I operated the pet food company that I mentioned, but I worked on this deal. We were merging Mars chocolate and the Wrigley business.  The company knew I’ve been through big M&A integrations. 

They were trying to build an executive team that can bring these companies together and create even more value. They really liked to talk about creating a new business development that would create a portfolio of the future.

If you think about Mars, it has amazing brands like M&Ms, Snickers, Skittles. But if you take a closer look, they're all off-trend in today's world, loaded with sugar and fat, ingredients you can't pronounce, and artificial colors. 

When I came in, it was really to write a thesis, build a small team, and think about what the Mars Wrigley portfolio of the future could look like. We started thinking about people's snacking habits, what they eat, when they eat them, use occasions, and products that they might choose to fit those use occasions.

One of the use occasions I thought hard about was this snacking and what I would call filled bar products to fill that snacking occasion. Filled bars, things like Twix or Snickers. 

The way I was seeing it was, maybe after a full day of work, you hop in your car, you're on your way home, you stop at a service station to put some gas in, and while you're doing it, you think, I'm kind of hungry, maybe I'll run in there. 

People are maybe still going inside for that snacking opportunity, but now they're turning over the package to read the ingredient panel. Instead of a Snickers bar, maybe they're buying a kind bar or a Cliff bar or a Larabar, something perceived as a healthier alternative.

We ended up looking at that particular sector, and Kind came up as an opportunity where we could engage in a conversation about potentially acquiring them. At the same time, Peter Rahal, the CEO of RX bar, also came up for sale. 

I started looking at both of them because we were so far behind in this agenda. We needed multiple acquisitions to begin to shape this portfolio of the future. I remember talking to one of the Mars family members. 

You have a Kind bar and RX bar; which one do you want to do? I said we should do both of them. You have to pick one. So obviously, we picked Kind. It was a much bigger, more developed business. Kellogg ended up acquiring RX for about 400 million. 

I can't give you the exact numbers of the Kind deal, but let's just say it was a multi-billion dollar deal. It was bought in stages. We bought a minority share in the first tranche, and then three years later, the agreement was to buy the remainder of the business.

Daniel Lubetzky, the founder, is an incredible entrepreneur. Kind wasn't his first venture, but that was the one that became successful for him. We wanted him to stay on as a partner in the business for at least the first few years, and I think he's still relatively involved with Mars. 

That was a great acquisition because it filled a need. It began to expand the portfolio in a direction that needed to go.

My only regret was that we felt like we needed to do a lot more deals like that during my tenure there. They've done some deals in the snacking arena, but none as big as Kind and probably nothing that I would consider transformational.

Strategy vs IRR

It was both. It was certainly first, like, you know, there are layers. First is, does Kind fit a strategic need? It does, based on what I just told you about losing snacking occasions to other types of products. We can either let those go to other competitive offerings, or we can build one or buy one ourselves. We decided to buy that one.

So that's one, but the next layer is, okay, now is it IRR? At the time, I don't really know what Mars' hurdle rates are now, but at that time, let's just say without being super specific, it was in the low teens. It had to deliver at least a threshold of that before clearing the second layer.

And then, of course, the third layer is, how are you going to create value? What are you going to do? A big company like Mars, we bought a lot of nuts. We had Snickers, peanut M&Ms, Kind bars, basically nuts and fruits and things like that. 

We thought we could use our procurement scale and leverage to bring value to buying better. So that's one thing you think about. The other thing is, Kind at the time was pretty much a North American business. It had a center of gravity in the U.S., a little bit of Canadian business, and a tiny bit of business in the U.K. 

We were like, we can bring this to Germany, China, and all over; we did business at the time in almost 200 countries. So think about the opportunity to expand that globally. 

And we thought it was a good brand because that's the other thing you think about, can that brand travel? If it's successful in the U.S., can the UK brand travel to the US? Can the US brand travel to the UK and beyond?

So, you think about all those different layers, but certainly, if it has a strategic fit, great, you cross that threshold, but if it doesn't deliver the IRR, the project's killed. It doesn't go any further. Wow, there's a lot of discipline around that, at least in the Mars environment. 

Handling projections

To your point, even when you're getting ready to do a deal like that, you're still making a lot of assumptions to create that IRR. Quite frankly, they don't always work out. If you want to do a deal, you're going to create the most optimistic case you can for the board to get behind it. 

So, often maybe we went out a little too far on a limb, saying we could expand to X amount of countries in the first three years, deliver 10 margin points through procurement, and expand distribution through our sales force, which would increase a certain amount of top line. 

These are all best case scenarios. If they don't deliver, then you destroy the economics of the IRR that you promised.

This happens a lot in the big strategic world. CEOs find something they want, a new shiny toy, and create a really optimistic case. They do the deal and then three years later, the board is questioning why none of this has been delivered, at least in the timetable that was projected. 

So, I think CEOs are becoming more cautious these days, having experienced setbacks and perhaps not delivering the transformational value creation that they promised the boards based on the capital allocation of the company's money.

Integration with Mars

Yeah, I thought Mars was actually quite thoughtful about it. Remember, Mars is a private company, so they can have a lot more patience. They can do things that maybe you couldn't or wouldn't do in a public world because you're under such scrutiny every 13 weeks from analysts and everyone else. 

But Mars had the luxury of saying, 'Hey, look, we're a private company. We really don't have to answer to anybody. So we're going to do this our way.' I thought they were very thoughtful whenever they made an acquisition.

I mentioned that I ran the Royal Canin business, and that was an acquisition in 2003. For almost 10 years, the Mars family said, 'Leave these guys alone. We bought this business because it filled a very unique niche, delivering something scientifically in terms of nutrition for cats and dogs that our other large pet product portfolio isn't delivering. 

So let's not go in there and Marsify this thing and think we know the business better than they do.' They were really thoughtful about it and just wanted those teams and those businesses to continue uninterrupted and bring in the incremental value that the business didn't have.

Now, after a period of time, some of that wears off a little bit, and they say, 'Okay, we need to be more efficient. We need to maybe combine systems.' When you make acquisitions like that, and at Royal Canin, we were using Microsoft Dynamics, while the rest of Mars was using SAP, there's inefficiency there. 

There were probably different benefit schemes, different sales tactics, different marketing philosophies. We needed to bring all that together and leverage the scale of Mars Inc. to really create value.

But again, they were patient. They didn't do it on day one. Sometimes they didn't even do it until year 10, but it was important that people recognize you bought this company because you don't know everything. Maybe we don't know how to do this better than everybody else. 

So let's learn from them. Let's bring them into our ecosystem and see what kind of synergies we can create by not necessarily showing them how much we know, but learning from them and maybe just siphoning off some of the things that they know better than we do.

You know what I mean? Wrigley, I talked about going up there to merge the Mars Wrigley business together. That was an acquisition in '08, but I didn't move up there until 2017, so it was a very patient acquisition. Why was that the case? 

Well, for the first time, there was a significant amount of debt taken on to buy Wrigley, and there was still some debt remaining on the books with Berkshire Hathaway and Warren Buffett. In order to truly merge those businesses and capture the synergies, we needed to buy him out. 

We bought him out in the fall of 2016, which enabled us to bring those businesses together more carefully. Wrigley was fascinating, again, kind of a family company. Bill Wrigley Jr. was running the business when they bought out. 

What was cool about that business was Mars didn't have a significant presence in China, but Wrigley did. So when Mars bought the Wrigley business, all of a sudden, you had a billion-dollar profitable business in China that wasn't controlled by the Chinese government, which is kind of a unicorn.

Even when we were merging the Mars and Wrigley businesses together, one of the things I was looking at was how in China Wrigley had over a million points of sales for gum, and our chocolate business had about 250,000. 

If you can merge those businesses together, theoretically, you could at least double the chocolate business because of access to the Wrigley distribution system. 

Now, it's a bit of a flawed argument because in some parts of China, it can be very hot, and chocolate isn't going to sit on the shelves, it's going to melt. But theoretically, you could maybe double or even triple it.

The wait was long, and it seemed like the debt was the bottleneck. There was also just this kind of patient approach, like not going in there too quickly and changing the secret sauce. And maybe absorbing some of that secret sauce. 

When they decided to bring those companies fully together, gum was starting to stall out a little bit. People weren't chewing gum as much. That's some of the things I was working on, like maybe we can put something in gum that'll make people want to chew it, whether that be caffeine or vitamins. 

But I think that was maybe a motivation to bring those businesses together to stimulate that and create value.

Then, supposedly, I retired. In 2019, I was traveling all over the world, going to Russia, China, Dubai, UK, Switzerland, looking for high-end chocolate companies, looking for snacking opportunities. 

The family didn't want to move as fast as I did, and maybe in some respects, I was pushing too hard. When we were bringing those businesses together, we were looking for something like just shy of a half a billion dollars in cost synergies

I'm a high-paid guy; maybe we can work something out. I've been doing this for more than three decades, traveling all over the world. If I have an agenda that I believe in and can't get other people to move at the same pace, then maybe it's time to part ways.

I called up people I'd been doing business with to say I'm leaving, and one of the people I called was John Sebastiani, founder and managing partner at Sonoma Brands. He asked, 'What are you going to do?' I said, 'Yoga, ski, ride my bike. 

I'm not planning on working very hard. Why?' He asked if I wanted to be an operating partner at their next fund. I wasn't sure what that meant as everybody's definition is a little different. 

John's philosophy is if we build a team of people that bring in experience, expertise, and a track record of success, that helps build credibility for the fund and brings insights into making deals and doing effective deal due diligence

We're going to create a lot of value for LPs. He invited me to be an operating partner at Sonoma Brands at that time, which was fun too.

Now we have three funds, and like most growth capital or private equities or venture capitalists, everybody is looking for their next fund. That's been a great relationship. John's a fascinating dude. 

He bootstrapped himself and created Crave Jerky and had a quarter-billion-dollar exit to Hershey. That was the catalyst for him to start his fund. Like a lot of guys that start funds, it's other people's money, but John has got his own money in it too. 

He believes in what he's doing, and I like that about him. He's a successful entrepreneur. He knows what it takes to start a business and to create real value. I think that's a lot of value to our portfolio companies

There's a check and a check plus, what else can we bring? I've had three decades of experience and a track record of success in everything from beer to pet food, to snacks and treats. 

John has done jerky and wine, and we've got people on the team who are smart, young individuals with either banking or VC experience. It's a good group of folks.

We've got some really great portfolio companies. We hope someday to create a lot of value by having successful exits on all of those and delivering superior returns to the LPs.

Role of an operating partner

So basically, the way it works is we've got over 20+ portfolio companies across the three funds. I'm not involved in all of them, but there are a few that I am very involved in. 

I helped either lead due diligence or participate meaningfully in the due diligence of us making an investment. The three companies I was most involved in were Milk Bar, MixLab, and Made by Nacho.

We made a significant investment in Milk Bar, a New York-based bakery and confectionery specializing in cookies, cakes, ice cream, and other sugar products. We led their Series A back in 2019, and I took one of the two board seats we got, with John taking the other.

Another business we looked at and made a significant investment in is MixLab, a D to C animal pharma business. If you have a pet that requires medication, MixLab can provide it via mail and ensure it never runs out. 

It’s beneficial for vets too, as they're often great at practicing medicine but not so much at business. MixLab helps with that, functioning as a sort of telepharma for pets, but it’s more internet-based and tech-enabled.

The third company was Made by Nacho, which is a premium cat food offering created by world-class chef Bobby Flay. It’s interesting because most people think about pet food for dogs, but cats are highly underserved in terms of premium offerings. It’s a disruptible market.

Financially, I have a piece of the fund, so I have a carry in the fund. This means if we create value through exits, I share in that value creation. The carry is not specific to the individual company; it's across the whole fund.

When people invest in a fund, they first look at the people. You've got John, a successful entrepreneur, other team members with successful track records in VC or PE, and then me, a successful consumer packaged goods executive. 

This adds credibility. The goal is to build credibility and a strong team with the expertise that LPs believe will allow us to create value maybe above and beyond what other firms can do because of the people involved.

For me, beyond just the money, I’ve enjoyed working with entrepreneurs. They’re full of passion and belief in their idea, product, or service. There's very little time for bureaucracy or politics, which I really got tired of in bigger companies like Anheuser Busch and Mars. It’s not a criticism of those companies per se; it's just a function of bigness.

Typical compensation for an operating partner

Yeah, it varies, but the carry is usually in the one to three percent range of the overall fund. Our second fund, when I joined, was over a hundred million, and the third fund is in that same range. We hope the fourth fund will be around 250 million.

The way it works is it's a percentage of the overall carry. It's not just for the companies I do due diligence on or the ones I sit on the board of. They create a structure for a 20% carry, and then I get a percentage of that. As for salary, there isn't one. 

It's purely based on the carry. But, if I'm doing a deal, I may work a few hours every single day. If we're not doing a deal that I'm very involved in, I might not talk to people for weeks.

I attend board meetings and am available to CEOs or management teams if they want to ask questions. There are also specific update calls that I'm part of. There is separate compensation for board participation. When I take a board seat, there's either cash and equity or sometimes just equity as compensation, depending on the situation.

Big company vs Small company in M&A

Well, I'm more favorable towards smaller entities because of the people involved and the processes. Big companies are layered with processes and stakeholder management; they're just slow and lumbering. 

My philosophy is that opportunities in business are like windows; they open for a specified period of time, and if you're nimble, fast, and decisive, you can move through that window before it closes. 

Big companies are often so slow, checking every box, and very risk-averse. They don't want to make a mistake, which I understand because there's a lot more at stake when you're a huge company. 

They want to do what they feel is right to protect the entity. However, if you're too protective, too risk-averse, and too slow, you're going to miss deals and get a bad reputation in the private equity, venture capital, and entrepreneurial community. 

That's just not a company I want to do business with because they don’t move fast enough. There's too much bureaucracy. They'll be looking under the hood constantly, and people don’t want to deal with those kinds of folks.

But people do want to deal with those who are decisive, nimble, quick, and willing to assume some risk. I find smaller companies to have these qualities, whereas bigger companies tend to lack what I'm interested in spending my time on these days.

Smaller entities are more efficient in the sense of making a deal, creating a term sheet, doing those types of things quickly. Big companies are actually very efficient in their manufacturing environments and in some cases, they're getting smarter by combining a lot of back office stuff, trying to streamline systems. 

So they're actually quite efficient in those areas, but they're just not very efficient in M&A and deal-making. They struggle to come to the table with a legitimate term sheet quickly that can get people excited and want to move forward.

Venture capital vs recapitalization strategy

Venture capital strategy is willing to assume a lot more risk either at pre-revenue or very early stages where the business is barely off the ground. There's a massive belief that the particular investment is going to have a significant return. 

In a venture mindset, you might invest in 10 portfolio companies, where five of those may go to zero, two may return capital, and maybe one or two moon shots will return the whole fund. That's the mentality as a venture capitalist.

When talking about a recapitalization, that could mean a business needs capital. Maybe there are existing shareholders who are tapped out or have lost their enthusiasm for the business. You can get some folks to bring in secondary capital and take out those investors. 

Both VC and recap situations share the common element that capital is fuel. Whether you're in an early stage or late stage business, this capital can help you grow, build infrastructure, hire the right people, and make your products more available and visible to consumers. 

All that requires money and there has to be a belief that the investment will generate a return in a timeframe that is considered reasonable.

Most people in the early stage investment world used to say three to five years, and now it's more like five to seven, maybe five to eight. So, your holding periods as an LP in a fund are going to be longer, and as a venture capitalist, a growth capital company, or private equity firm, you have to have enough patience to not disturb the growth process. 

You have to allow that business or idea to have enough time to actually germinate, establish roots, and eventually grow.

VC and recapitalizations are different in the sense that VC is coming in at a very early stage, while recaps are probably coming in later in the game.

I mean, when people put money into private equities or venture funds, they're going to want a much stronger return than they can get in the S&P. Typically, people are going to want to capture 3x their money within five years. That's sort of what your typical expectation is.

I'm not sure about the math, but let's just say, if you think about the rule of 72, your money's going to double every 72 months. A VC or private equity growth capital is going to drastically accelerate that if they do it well. However, you're going to have to assume a lot more risk for that, because some of these companies may or may not make it.

In short, in a venture capital strategy, the company tends to allocate cash into a startup as equity. Whereas with recapitalization strategy, there's cash to purchase shares from the current ownership, and also a cash infusion to support a growth plan.

Cashing out from an owner’s perspective

There's a specific company in our portfolio right now where we're going through this with the founder. He wants to take some chips off the table because he left a big corporate job, started a business, and has been drawing a meager salary to put as much money as possible back into the business. 

But now, with a family and expenses, he needs some cash. So often, it's the entrepreneur coming to us saying they need to realize some value, knowing full well they're probably giving up future value if they just let those shares ride.

We have these situations from time to time, and we want to be thoughtful and good partners about working with them when they have a need or want. We don’t get hurt by that, and there's just a way to make that work for everyone. 

When there's new money coming in through investments, some of that can be put in the business, and some can allow the founder to take some chips off the table.

I think it's always important to recognize that founders can start to get weary after a certain point. They work hard and aren't making much money because everything is going back into the business. They need to generate something to stimulate income. 

Sometimes it's not just about the income, but also about easing the stress. Money doesn't buy happiness or solve all your problems, but it does make things easier. Strained relationships, whether between husbands and wives or business partners, often have money at the root of their issues. 

So when money can make things a little easier for someone, like a founder in a particular situation, we want to be thoughtful partners around that.

Minority vs majority recapitalization

During a majority recapitalization, the balance of power will shift to the people that own the shares. As an entrepreneur, be smart about it, and do not borrow more money than you need. 

If you do, you’ll just spend it and then find yourself beholden to the people who own the paper. Borrow what you need.

It’s okay to give up a significant amount of equity if you think the pie you're going to create is significantly bigger than what you have right now. That’s what you’re betting on. There’s nothing wrong with that, but be smart, thoughtful, and frugal about it.

The money you borrow should be thought of in terms of sources and uses. Here’s my source of money and this is what I need. Here’s how I’m going to use it. This is what it’s going to deliver. If all that comes to fruition the way you’ve planned, then you’ve hit it out of the park. 

The problem arises when you borrow a lot of money, it doesn’t deliver, and then you need to borrow more, continually giving up more of your share of ownership.

Smart private equities and VCs are going to put preferences on these things. If the company ends up getting sold for a certain number and the private equity has a two or three times preference, they’re going to get their money first, and everyone else gets whatever is left over. Sometimes there's nothing left. 

Unfortunately, I’ve seen founders really get into trouble by borrowing too much money and overleveraging. The money they’ve borrowed is burned through and hasn’t delivered the results. This creates problems, animosity, and a lot of issues that you want to avoid.

The biggest problem often with some of these deals that don't turn out to deliver at or above expectations is execution. People don't execute. You ask for money, you say you're going to do this and that it's going to generate X, Y, and Z, and then it doesn't happen. 

Suddenly, you need more money. Can you execute better? Because if you can, maybe you won't have to do another series C or D or E. You have what you need, you're creating your own oxygen, and you're delivering on your promises. 

I used to always tell my teams when I was running businesses that a plan is a promise, and you should always be in the habit of keeping your promises. When that happens, you build confidence, build momentum, and perhaps reduce the need for additional capital and give up ownership.

Impact of valuations and interest rates on investment decisions

It's been a really interesting last couple of years, and we might be easing our way out of it, but we're still in the throes of it. If you're a business and an entrepreneur, whether you're an early stage startup or one that's been going for a while and needs capital, it's a very difficult time to raise capital. 

One reason is high interest rates. While there's capital available, it’s being held tightly, with a cautious approach to allocating it. If you need money and someone is willing to deploy that capital, you're going to have to give up more ownership than you would have three or four years ago. The balance of power has always been to some degree in the hands of those with the capital, but even more so now. 

Access to capital is difficult, whether you're going to take on debt, which means a lot of debt to service due to high interest rates, or go the route of a growth capital company or PE, then they're going to ask for more ownership.

It's tough times for founders and owners. The good ride of 2021 is over. It might be getting better, but based on what we're hearing and seeing, you'll see some relaxation from the fed, maybe some rate cuts down the road. 

This will flow through to those who need to borrow money, and maybe create some enthusiasm for overall financial markets, which could loosen the purse strings of those who have been stingy about allocating their capital.

People have learned some lessons over the last few years and have made some mistakes. They're learning from those things, both on the sides of investors who are making investments and the entrepreneurs that are taking those investments.

If you were a fund investing in a sector that was trading at a 10X multiplier and now it's 5X, what are you doing? It's about execution, putting your nose to the grindstone, being frugal about spending money, and trying to be efficient on the SG&A side of the equation. You're trying to create the value that you think you can create.

As for the distinction between platform and add-on investments, it's important to reserve capital for follow-on rounds. If you don’t do that, you either didn’t believe in the business strongly enough to make the first investment, or you'll just dilute yourself. 

You always need to make sure you have some dry powder for great ideas and founders that come along. It's always a balancing act, not a perfect formula. If you have a $100 million fund and have allocated $50 million, you should be thinking of reserving $30 to $50 million for follow-on rounds. 

It’s about not just looking for the new shiny toy but focusing on a portfolio where you go all in on what you believe in. Most good funds should be building and adhering to this discipline.

Timing on investments 

Yeah, really good question. This is like the two-headed llama, the push-me-pull-you. You want to make sure that a business you invest in has enough time to reach terminal velocity and unlock value. However, oftentimes funds want to ensure they have enough exits to raise the next fund, which doesn’t always allow enough time for the business to unlock its potential.

That's definitely an issue. But then, you're right, sometimes you wait too long. I’ve been involved in situations where we probably waited a bit too long or maybe had a more inflated price tag than what the business was worth and didn’t take the offer that was on the table. 

A couple of years later, you regret not taking it. Timing is crucial, and right now, particularly, the holding period is a bit longer. The time to actually allow businesses to develop is taking longer, maybe due to not having enough money to accelerate growth or business development.

Some people just get lucky. John Sebastian's example with Crave is great. He wasn't really ready to sell the business, but someone put a very tempting offer on the table, and he took it. In his case, timing was perfect. In other cases, you've seen it go the other way.

Evaluating exit strategy

It's a difficult question because, as you've seen, there have been a lot of down rounds recently. People raised money on big valuations in 2021, and now in 2024, the dynamics are completely different. They still need money and are willing to issue equity at a much lower valuation. 

This creates problems for both the entrepreneur and the existing investors. For example, if I invested at a hundred million dollar valuation and now we're doing a new round at a fifty million dollar valuation, that's not good for me, so that’s tough.

On the boards that I’m on today, and even those I've been on in the past, what I’ve always advised people is yes, you want a successful exit at some point and you're trying to create as much value as you can. But if you're so focused on that and not on creating a great business, you're going to run into problems. 

Focus on what it takes to build a great business, and then suitors, investors, and potential strategics that may want to acquire you will come along, often when you're not even thinking about it. That focus sometimes gets lost.

When I was running a company last year, people kept wanting to talk about our exit strategy. I didn’t want to talk about that. I wanted t hem to think about what it takes to build a better business. Your job every day is to drive positive change and create more value. 

Anything else is a distraction. We’re guilty of it sometimes as growth capital companies and investors, pushing people into those directions because we want that for our shareholders and LPs. 

But there’s a fine line between allowing the business to stay focused on what really matters and just focusing on how much you can sell the business for one day.

It's tough to keep everyone happy - your customers, your team, shareholders, and staying true to the mission or staying focused on IRR. But again, if you put all the noise aside and everyone just focuses on building the best possible business they can, then value will come. It will come.

Advice for practitioners

One thing to remember is that the check isn't always just a check. If you're an entrepreneur, you have to think about what comes along with that. Number one, consider the culture and the ways of working of the people you will now be beholden to because they own a piece of your business. That's something I've learned a lot about.

In general business or investing, it’s better to under-promise and over-deliver. I see a lot of over-promising, even in some of our deal flow, where people promise hundred million dollar run rates in three years and positive EBITDA in the same time period. That's over-promising. Finding the right balance of enthusiasm with realism, and the ability to execute on that, is crucial.

I've made some personal investments outside of the funds, where my instinct told me it wasn't going to actually come to fruition, yet I still put the money in, and I've had some misses on those. Really, the key is under-promising and over-delivering, and execution is a big piece of that.

For people who want a career in M&A, whether on the fund side or corporate development side, a fair amount of financial acumen is essential. You need to understand the numbers, the IRR, and how to read a P&L to look for potential issues before doing a deal. 

But just as important is real-world experience in the sector you may be interested in, whether that’s tech, consumer products, or services. It’s about combining academic knowledge, like having an MBA, with a deep understanding of the dynamics of the segments and categories you’re working in.

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