In this podcast, James Darnell, partner at KLH Capital talks about:

  • How to figure out who might be a good private equity partner;
  • What an owner should expect during due diligence;
  • How private equity gets to 'yes' or 'no' when reviewing potential investments;
  • How outside investment can help grow a company faster; and
  • What a typical 'second exit' looks like for an owner that partners with private equity.

About the Guest

James Darnell is a partner at KLH Capital. He is responsible for identifying, structuring and executing transactions, due diligence, financial analysis, and portfolio management. James serves on the board of directors for all KLH portfolio companies.

Listen Here



You can also get the podcast by:

Read the full transcript here:

Noah Rosenfarb: Hello and welcome, its Noah Rosenfarb, your host to the Divestopedia exit strategy podcast. Today's guest is James Darnell. He is a partner at KLH Capital, a private equity firm based Tampa. James, thanks for joining us today.

James Darnell: Thank you, Noah, for having us. It’s a pleasure to be here.

Noah Rosenfarb: James, I would like to start with getting an understanding of how people get involved in this business of helping owners with their transition. So can you share your story with our audience?

James Darnell: Sure, absolutely. My story Noah is a little bit untraditional or unorthodox in terms of getting into private equity. I'm originally from Alabama. I went to school in Tuscaloosa at the University and started my career in Birmingham actually as an investment banker, helping business owners and entrepreneurs sell their business. I did that for a lot of years and got to work with a lot of great companies there in Alabama. I was with a firm called Founders Investment Banking and really learned how to do business and do deals, but really got to see how the inner workings of the lower middle market work. In fact, a few years back, probably seven or eight years back now, I actually sold a business for a client of mine to KLH. A few months after we sold them the business, they called me and said, "Hey, this company you sold us is a piece of junk. We are hiring a new CEO and I want you to come be the CFO and help us fix the company up," which is very atypical scenario for private equity and for KLH.
So my wife and I moved to go join that company and spent a couple of years actually running that business as the CFO of that company. A few years ago, when we were ready to raise a new fund, one of the original partners at KLH was retiring and the other guys invited me to join the team full time. So that's kind of how I came to be. So I've had a little bit of time in each seat to sow, sort of speak, in terms of an advisor helping people sell companies, as an entrepreneur helping run businesses, and as a private equity guy investing in businesses, so a little bit of all angles in that regard.

Noah Rosenfarb: That's a great story. What prompted you to leave banking? Most people think about the investment banking business as such an attractive go-to-business.

James Darnell: Sure and it is. It's a great line of work. A lot of people go into it. My wife and I just had a call in to go do some other things in our lives. We’re actually thinking about going overseas and doing some international kind of aid and development work at the time and really using the skills and gifts that God had given us to kind of help other people more directly than just serving our client. So we had actually left the investment banking. We were going to do that when we got a call from KLH and it was a lot like Jonah going to Nineveh. I did not want to go at all and wife just was like, "Hey, do you really think this is what we are supposed to do?" Fortunately, I didn't get swallowed by the whale but it became very clear down the road that that's what we are supposed to do. So that's how we joined the firm. But that's the good news, right, is that God has bigger plans for a lot of us and we know about or can understand ourselves.

Noah Rosenfarb: When people think of KLH, what makes your private equity firm unique?

James Darnell: When people think of KLH, I think what we want them to think about is we are the private guys that are not the suits and spreadsheets from New York coming down to tell people how to run their business and bossing them around. We are truly partners with many of these business centers to help them achieve the goals and objectives that they see for their businesses. A lot of these guys have grown their companies and been very successful and gotten to the point where they are at today, and they have a vision where they could take their company but they need some help. They need either some money or some technology or they need more people on their team.

They need something to really help them take them to the next level and if you are able to provide these things and provide that guidance and that leadership in terms of being a value added partner, you can really take these businesses to two, three, four, five times their potential where they are at today, which is as a private equity investor, it’s a very different model for working with those entrepreneurs than the private equity model of just you're sitting on a board throwing out some financial metrics that you want to be achieved and whipping the management team in parading them and driving them to achieve those results. Sending in consultants and really just being a transactional participant at the table. So we view these things as very different and we are very much more the partners in those situations to help these entrepreneurs achieve their goals and objectives. That's what we want to be known for.

Noah Rosenfarb: How would owners figure that out? As they are represented by a banker and they've got an offer sitting from KLH at six times EBITDA and they've got an offer next to it from ABC Private Equity firm at six and a half. How should they decide? Should they go for price? Should they figure out who they are partnering with and how would they do that?

James Darnell: Yeah absolutely. I mean, a little bit self-serving here, but yeah, I would absolutely say it's not about price. You got to be in the neighborhood of the right value because people aren't going to sacrifice a ton of money for some of these intangible things but as long as you are in the ballpark of where the value for the company should be, and most advisors, most private equity guys can quickly tell you where that is by the way. It really does come down to fit because you are going to be working with somebody for years and years when you enter into a partnership with them. Just like you wouldn't get married to somebody just based on what their picture look like online - or at least I hope you wouldn't. You want to get to know them. You want to go have coffee with them. You want to dinner with them. You want to meet their family.

Private equity in bringing on a business partner is the same way. We want to spend time with entrepreneurs in social settings. We want to do something recreationally fun in terms of going fishing or shooting sporting clays and going hunting. We also want to have some good brainstorming business meetings about where we take the business and how we can all chip in and really help grow the business. So I think that time together is probably the most important thing that entrepreneur would be wise to do as he's considering private equity but then the other thing is checking out a private equity group’s references. Private equity groups most of the good ones are very quick and very happy to provide references for the entrepreneur to talk to.

What I would encourage the business owners to do is to ask for references of managers and business owners that are currently partners with the private equity groups, but also the name and number of a partner that they have historically worked with that is no longer in the portfolio both for a company that went well as well as a company that went poorly. Again, I think most private equity groups while they would, you know, that would be a tough question for them would be willing to share that information, and those are the guys that the business owner is really going to be able to understand how that private equity group behaves with. When things are going well, how did they react? When things were not going well, how did they react? I think that can also provide a great window of insight.

Noah Rosenfarb: How should owners make their way to private equity firms? Should they go direct or should they use your former colleagues that are bankers, intermediaries to make introductions?

James Darnell: That's a good question Noah. I think a lot of it depends on the scenario and circumstances that the business owner or steward of the business finds themselves in when they are evaluating a deal as well as the competitive nature of the business and how sensitive that company is to disruptions. I'll use some examples. If you have a company that was run by a strong-willed CEO who kind of really run the business, was the driving force behind it and tragically, that CEO died. The estate found themselves owning that business and not really knowing much of how to do it and what to do with the company, weren't capable of running it. I would absolutely encourage that estate or that trustee to engage a wise counsel in the form of an investment banker or a business broker, to help them navigate the waters of selling that business as quickly as they could. That's very much a situation where you want to hire an advisor and help figure out what to do there because it's just not selling the business, it's also what is the business worth and what do you do in the interim and how do you run it, and how do you make sure it doesn't go upside down while you are trying to figure that out. So that's one scenario.

The other is a business owner who's contemplating retirement maybe not this year but a year, two, three years down the road. What does that business owner need to be doing? In that scenario, there is a type of adviser called the Exit Planning Advisor who is somebody that essentially serves as a consultant to help that business owner map out over the next 12, 18, 24, 36 months, what does he need to do as he begins to prepare his business for a sale, for his ultimate retirement? What are all the things that he needs to do? Very much like a really estate agent would help you as you were thinking about selling your house, saying, "Hey, you need to paint these walls here. Let’s put some new hardware on these doors over here. Let's have a landscapers come in and put some new flowers." An Exit Planning Advisor can help you figure out what you need to do the best to set your business up for the long run in terms of retirement.

But then there is also lastly a scenario where a business owner has got a company and he wants to retire, and he doesn't want to go through a big long arduous process that have taken 6-12 months to sell his business because the company really needs capital quickly or there are some circumstance in his life where it needs capital quickly, or maybe he's nervous about competitors finding out that the business is for sale and taking advantage of that in the market place. He just wants to talk to two or three groups who would be interested in investing in his company or buying in his company, and again just cut a fair deal with something that can be done quickly. In that circumstance I would encourage you to just reach out directly to private equity groups and talk to folks directly. There is a number of online resources.

Noah Rosenfarb: Yeah. Let's talk a little bit closer to the owner and if they are going to go direct or if they are going to go through a banker, I know you mentioned socialize with the firm that you are talking to, get those references especially a deal that went well and a deal that didn't go well. Is there anything else they should be looking at?

James Darnell: Sure, absolutely. They really want to make sure that they understand the expectations from the private equity group. As the business owners doing their reverse diligence, they need to be asking as many questions of the private equity group as the private equity group is asking to them. Things like, what is your investment thesis in this business, like why are you investing in this company? What are your expectations for our communication? How often are you going to want to hear from me? What form? Is that a phone call or is that an email? Do you want me to do slide decks and prepare these things as models? How often I'm I going to see you in my business?

How often are you going to be in here, wanting to meet with me and take time out to do things? What are my reporting requirements? What do I owe you? What do I owe the banks? How do you feel about add on acquisitions? If we want to buy somebody, how do we handle that? How do we handle value and the equity of our business as we go to offer stock and do some of those things? I think just being really well prepared and educated in terms of what the reverse diligence to look like would be an important consideration for that business owner.

Noah Rosenfarb: I was meeting with an owner this week and he says, "I want a private equity firm to come in and pay me a whole lot of money and then tell me what to do." I said, "Well, typically it doesn't work that way. They want you to tell them what you want to do so they could fund it." What are your thoughts on that?

James Darnell: Yeah, that's exactly right. I think that business owner is guilty of what a lot of folks do and they think private equity is going to come in and be their new boss. We are not bosses, we are partners. Most of the time, we've never been in your industry. We've never been in your business and so while I've done dozens of industrial service deals, I've never been in and ran a company like that myself. So I can't tell you what you need to do for your company. I can tell you the best practices and how to grow and increase value in your business but I can't help you, tell you what to do and micromanage you. What I would say to that business owner, "If you are looking for a boss then you should consider selling your business outright to a strategic and private equity isn't probably the right fit for you."

Noah Rosenfarb: Let's talk a little bit about the reverse conversation. When you are doing due diligence on a potential business, what are some of the things you are looking for? What often might get in the way of getting a deal closed?

James Darnell: The first thing that I want to understand that business is why does the company exist? What are the services they are providing and how is the company making money? That is the number one thing I want to look at so I can understand. So I can ask myself the question, is this company going to be around in 10 years? That's kind of first line of thinking that we, private equity guys, or at least in our shop, we go through is understanding how the business makes money and will they be around in 10 years. Then the next thing that we want to know and understand is where is the revenue for this business coming from? Who are the customers? What's going on in that market? What's going on in those dynamics? Are those customers consolidating? We've got a risk of customer concentration being created over time. Are those customers outsourcing this? Is it easy for them to internalize it?

There is a whole host of questions you want to understand, but where is the revenue coming from is the second. Those are really the primary kind of things we look at right out of the gate in a business, and then from there, you go in all the other kind of classic evaluations of suppliers, competitors, financial trends, all those types of things.

Noah Rosenfarb: When you are doing those evaluations, how often do you kind of put them in the "do more" research pile versus "I'm going to pass right away"? How quickly can you tell?

James Darnell: It's funny, that's a good question. Usually you can tell pretty quickly. Everything usually falls into one of three buckets, it's either a clear no that, "Hey, this isn't going to work for us" or, "Yes, this will work for us. We just need to validate that this is what it is," or very rarely would fall into a pile of, "This could work, but we have more questions and need to understand it better." Usually that's the function of not having a complete picture of what's going on, as opposed to actually having a confusing business model that does not have complete information.

Noah Rosenfarb: Let's kind of start with picking apart the "no’s". What should an owner do if they are in the 'no' category? Is there a way out for them and can some of the advanced planning help them get to a 'yes'?

James Darnell: Sure, absolutely. The first thing that they should understand is that it's not personal, which is very hard for most of these small business owners because they've spent years and years of their life - blood, sweat, and tears - building this thing up. So it's very hard for them to not take it personally. The first step is to just remember that it is business.

The second is to understand that the 'no' is all really relative to value for the business because there is an old saying in the businesses that "all risk and all reasons for saying 'no' can be priced into a deal", but the problem is these business owners don't, you know, their expectations for price aren't calibrated, aren't correlated with the risk. That's usually where the disconnect comes in is the perceiver is from the buyer and the value that they would need to be associated to compensate for that risk versus what the business owner, honestly frankly, needs to retire because most of the time the way they think about value for their business.

The second thing I would say is, understand that it's just not a "no" that a deal can't ever get done. It's a matter of value. Business owner, if you were able to force the transaction today, it would be at a value you weren't comfortable with. So what I would encourage you to do is find some help, find a good advisor, find some resources online. Talk to a private equity guys that will help you and put a plan together of how you are going to mitigate that risk that caused the private equity guy to say no. If you are able to be successful in mitigating some of that risk, then six, 12, 24 months down the road, you can either reengage with that suitor or you can find somebody else and that risk won't be present and you kind of get the value that you are looking for.

Noah Rosenfarb: James, if you say 'no' to an owner, what are some of the things that they should go back to the drawing board and consider doing?

James Darnell: I think they should understand why the suitor was saying no and if it was something that was addressable in the form that they can go out and fix about their business which would help get them to evaluation that everybody could agree on. Or if it was a more fundamental no in terms of the suitor he was starting to just don’t invest in that industry. Like at KLH, we don't invest in retail companies and that's just part of our charter we've never have and that's just something we don't do. So you could have the best retailer in the world come to us and want an investment at the best valuation in the world and we still wouldn't do it because that's just outside of our charter.

So some people will say no. They don't like healthcare. They don't like industrial services or they don't like whatever the industry or sector that is that the company is in. But then there is other reasons we say no, which are really, "Hey, we’re going to say no on this opportunity because we don't think we are going to be able to get their own value. We would offer you something for this business but we don't suspect that the value that we would pay would be something that you would be interested in." In that circumstance, the business owner has got to understand and I think be humble enough to ask the question of, what would you pay that would get you excited about working with me and in terms of a price? That way the business owner can at least know where he is starting from and then presumably he's got a number in his head where he's trying to get to, and he can understand what he's got to do to bridge that gap.

I think just be straight up for the private equity groups and ask for their help in figuring what they should do. In fact we had a company like that that we've been talking to for probably four years now. We met them four years ago as a nice little business. It was small at the time about $1.5 million in EBITDA. They came to us and we said, "Hey, we like your company but you are just a little small. You've got a couple of issues going on." We've stayed in touch with that business owner for probably once every six months, I keep in touch with them, and the company is growing and doing well. They are going to kind of grow into the right size where the business owner is also building out his team and his circumstances was just a situation where he didn't have any people around him that could help run the business. It was just him and so he's been bringing on new people and hiring folks and doing all those kinds of things. It has taken him a while to get there because the business is growing. You've got to run the business day-to-day, but we are very excited about staying in touch with him and one day it is going to be the right time to do a deal with that guy. We are going to have the benefit of having watched him for four years and got to know the company for four years so there will be a lot less risk on our part in getting that deal done and getting comfortable with moving forward on that company.

Noah Rosenfarb: Once you do get comfortable with moving forward with the company and you sign a letter of intent, what recommendations would you have for owners that are going to go through a due diligence process for the first time?

James Darnell: That's a good question. It's hard to help somebody understand what it's like. What I would say is, the first is make sure that they pay attention to their business first. That their deals can come and go, but the most important thing is that the business continues to do well through a closing process and through the post is still a lot of process. What that means is communicating with your buyers saying, "Hey, there is only X amount of hours in the week, my waking hours. I need to allocate 40 or 50 or 60 or however many there are to the business." Then for the closing process, I'm going to work on the closing after the fact. So I think people just need to go into that as wide open.

The other thing I would counsel him into doing, is a lot of these business owners particularly if it's their first time is they are afraid of telling anybody. They don't want to tell anybody until with the wires are moving and the cash is in the bank. That's a very risky kind of way to handle it because if you do that, you have to shoulder the burden all by yourself. There is an old line that says "Many hands make light work." The more you can bring your team in to what's going on, particularly your CFO, controller, and your account staff - if you have those luxuries - as well as your lawyers, that can really help do a lot of the heavy lifting. Again, business owners are always resistant to spend their money but I think that that is a circumstance where they've got to do that, where if they can just spend a little bit of money and make those investments, it will make their life a whole lot easier and the closing process a whole lot easier.

Noah Rosenfarb: We didn't quite start the interview with the premises of partnering with the private equity firm which in my mind is, the owner has an interest in continuing to own some portion of their business and they want to leave the charge to growing their company because they still see a brighter future than the past. So they are not ready to get out entirely but they either need capital for business, they need capital personally, they want to secure their financial independence. Assuming that's the premise of why people are partnering with a firm like yours, tell me what happens after the closing and what's the success rate of being able to achieve those owner goals and what's the typical second exit look like for that owner?

James Darnell: Sure, absolutely. So the big idea behind partnering with private equity is the idea that you get to harvest some of the value you've built in the company at a reasonable or fair valuation so that you can reduce your risk and your family's risk in the form of having all of your personal net worth or most of your personal net worth tied up in the business. So you are able to affect the liquidity event which allows you to take a big chunk of money out of the business and put it somewhere else that's more safe or relatively more safe than the business because it's not wise to have all your money tied up in one small company or one company.

So you are able to have that liquidity event but you are also able to retain control of the company and run the business day-to-day. You are able to keep your job, what you are doing day-to-day, and in most circumstances, keep a big chunk of ownership in the business to continue running the company and growing it, and achieving on the goals and objectives that you had laid out and the reason you want to bring on a partner to begin with.

An example of that is a company that we worked with called Federal Resources. We partnered with the CEO of that company, Robbie McWilliams, to help buy out some of his family members who were in the business that owned the business with him 50-50. They had a very different risk tolerance that Robbie did and they didn't like growing. They didn't like personal guarantees and debt. They just wanted to kind of have a nice small little lifestyle business that could be great for their family whereas Robbie had a vision to really grow his business and take it to the next level. By grow, I mean three, four, five times the size of that was when we invested in it.

By investing in that company, rationalizing the share holder base, buying the conservative shareholders out and giving Robbie the resources in terms of the people and the money that he needed to continue growing his business, he's been able to grow his company in such a way that his second bite at the apple will be three times as large as his first bite. Let me say that again. His second bite at the apple will be three times as large as his first bite and that's not because we bought it on the cheape by paying some kind of ridiculous valuation. We paid a fair value. It's just that he's been able to grow his business so aggressively during a very short time frame as we made all these investments on it.

Noah Rosenfarb: Do you think most owners invest the capital of outside ownership differently than they can invest their own capital? Whether they are going to hire that next sales person or buy that next piece of equipment or go after that acquisition, my assumption and my experience is owners are more likely to invest in their company when it's not their own money at stake. They are still careful and they still care about the capital, but they are more willing to invest in their business when they've achieved that level of taking some of those chips off the table.

James Darnell: Yeah a very much is now, I mean, because here is the reality is a lot of these business owners are running these companies as lifestyle businesses where they are naturally inclined or naturally incented to maximize the after tax, net cash flow for themselves and their families on an annual basis, which is very different than growing a business to maximize the equity value of the company over the long run because to maximize the equity value of a company, you've got to make investments. You've got to hire. A perfect example is in the accounting department. You usually have to hire a CFO and you have to invest in a proper accounting system, a large scale ERP or MIS system, both of which cost $200,000.

For the business owner who owns that business he's like, "Man, that’s actually $200,000 out of my pocket every year. Why would I spend that? What's the point in that?" Whereas we understand that by making those investments, sure, it's costing you $200,000 a year but it's growing your equity value or the multiple of your business by a half a turn or a turn. What is that worth in terms of the growth in the equity in your business? It just comes down to a fundamental paradigm shift and how the people are thinking about their business, both in their willingness to make those investments as well as their willingness to take risk and to hire the new sales people and to move into the new market, and do all the things that they know that they should do but just know that they are not betting their retirement and their kid’s college fund on it every time.

Noah Rosenfarb: Yeah. So what advice do you have for the owners that are listening that are thinking about transitioning out of their company in the next two years as it relates to starting a discussion with a private equity firm? When should they get started and how should they get to people like you?

James Darnell: I think you should get started, there is no hard and fast rule, but the earlier you get started, the better outcome you are likely to have based on your goals and objectives because it gives you more time to make the moves that you need to make, to set your business up for success as an investment platform or as an investment for a private equity group. So it gives you time to round out your management team. It gives you time to grow the business to the level it needs to be to get you to the number that you want to get. It allows you to take care of any outstanding litigation and to move into that new building you've always wanted to do. It gives you time. So the sooner that you can reach out to either a private equity group, an exit planning advisor, a business broker, or somebody in the industry to help begin to understand what you need to do, the better. You never want to be jammed up with your back to the wall and have to do something, then you are never going to get the best outcome.

Noah Rosenfarb: Any other final thoughts for listeners and anything else you'd like to share with them also with your years of experience.

James Darnell: I think we touched on a lot of things here, Noah. I would just say that private equity can be a great avenue for business owners who are looking to ultimately retire or exit their business. Don't just wait until you go on a long vacation with your wife and your kids, you start to have grand kids and then just realize, "Wait, I want to spend more time with my family or I want to retire" because then you are not going be positioned for retirement. So start sooner rather than later and be intentional about the process, and then you can usually have a good outcome.

Noah Rosenfarb: Great. James, if our listeners want to get in touch with you, what's the best way?

James Darnell: The best way is to go to our website at www.KLHCapital.com and you can learn all about our firm there and you can find my contact information there. You can either call me, email me, text me, send me a message on LinkedIn, any of the above.

Noah Rosenfarb: Great, well I want to thank you for joining us today. Thanks to all our listeners for tuning in. Please don’t forget to join us every time we release a new podcast, rate us on iTunes, and tell your colleagues and your friends about the conversations we’re having here. Thanks to everybody and we’ll see you again soon.