Crowdfunding: Boon or

Mortgage Backed Disaster?

Financial time bomb

Equity crowdfunding is just small dollar venture capital. Its not for the uninitiated.

Much ado about something


The hand wringing by the SEC over the JOBS Act is not without justification. The real issue is about investors not understanding what they are getting into. And the level of understanding regarding intricacies of an investment isn’t determined by an investor’s net worth. Its determined by their experience and knowledge, neither of which are parameters under the JOBS Act. While part of the issue is about disclosure, the rest is about understanding the issues and pitfalls, knowing what you don’t know. As a bit of background, Title II of the JOBS Act permits the general solicitation of accredited investors. If the SEC ever agrees on a set of rule, Title III would permit the general solicitation of unaccredited investors. The wealth of an investor is a poor proxy for sophistication. Investors come by their wealth in different ways, and there is a far cry between making one’s wealth as a privately held business owner, as a professional athlete, a movie star, or as an heir.


Invest in what you understand


The very simple truth is that prudence dictates that we should only invest in that which we understand. The JOBS Act permits small business owners and startups to solicit investments over the internet and by other means. Startups are a particularly dangerous asset class, as witnessed by the professional venture capital firms that saw tremendous losses from the dotcom boom on the late 1990’s. Venture Capital never fully recovered, and is about half the size it was a decade or so ago. In the words of Prof. Jeff Sohl, Director of the Center for Venture Capital Research at the University of New Hampshire, in a phone call with me: “the Venture Capital model is broken”. It would stand to reason that if sophisticated venture capitalists have struggled, the unaware are mere cannon fodder.


I’ve been in corporate finance for 35 years, and I continue to learn more every day about what makes a company tick. That said, the longer I study it, the more everything points to the corner offices and board of directors. This is the subject of ’corporate governance’, and it’s all-important. It’s especially critical in smaller companies, where a single person can make a difference, one way or the other. It can make a difference in larger companies too, which is why presidents of Fortune 500 companies are so highly compensated.


The most dangerous investment


The most dangerous of all investments is a privately held startup with complete control by the officers of the company, that lacks a board or directors, lacks independent board members, or that has a majority of its shares without representation on the board. This is a situation that is ripe for self-dealing and myopic decision making by the management. Now, take this and have it run an inventor of the next “disruptive technology” without experience in running a company, and you have a recipe for disaster. There are a few basic things investors need to understand about the law of the survival of the fittest in Corporate America. First, new, young and small companies are the riskiest. They have limited or no management depth, little or no infrastructure, heavy or complete reliance on a single product, and high customer concentration. The loss of a single manager or customer could tank the company, as could a single product recall. These companies survive by the mere skin of their teeth, and require skill, focus and commitment by the management team. Next, the resume of the managers and board are critical to the success of a company. Take new or inexperienced management and an inexperienced, compliant or non-existent board, and you have the makings of a tax loss.


Divided and conquered


Under the JOBS Act, innumerable small investors will put relatively small amounts of money into startups and small companies. Because each investor individually has a tiny voice, the control of the company is entirely in the hands of the founding management team. There may be one or more manager/stockholders, and they will run the company to their benefit. If we think that large public companies pay their presidents too much, we are about to find out that the potential for self-dealing does not just exist in large companies. Another problem with large numbers of small investors is getting a vote on anything that management isn’t completely in support of. Having sat on a steering committee for one of the top 100 bankruptcies in the US, I can tell you that it is mission critical to be able to get a class of investors to act. Even if you know how to contact other investors, with such a small stake in the company, inaction or delay is virtually guaranteed. Now, imagine that you don’t even know who the investors are.


Mortgage backed security deja vu


To make matters worse, neither the JOBS Act or any proposed SEC rule requires an independent board with appropriate experience and skills. Instead we will have highly fragmented ownership of the company with no effective outside stockholder influence. This is almost precisely the formula that caused the chaos in the mortgage backed security debacle of the Financial Crisis. Mortgage backed securities are fractional interests in pools of mortgages held in trust. As an investor in a mortgage backed security, you would own a tiny fraction of any individual mortgage in the pool. When an individual mortgage was in default back in the old days, the lender might have renegotiated terms to prevent foreclosure. Here, where no security holder had a voice, and the servicer had no financial interest, there was no one to right the ship. This is the concept of governance at its worst. If investors are to be protected, equity crowdfunding will need to provide for independent board members that represent these small outside investors. These independent board members will need to have voting power equivalent to the stockholders economic interests. Only in this way can the interests of the “crowd” be protected. One way to approach this is that the crowd funding site maintain a list of qualified candidates for board membership, and each investor must vote for one or more of the candidates before their investment is accepted. By so doing, there will at least be some protections in place, and these protections could extend, as but one example, to the conditions under which the capital raised is released to the company.


In the Words of Adam Smith


“The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.”


— Adam Smith (1776)


1980’s hostile takeovers in reverse


The hostile takeover period of the 1980’s was based upon an absence of adequate corporate governance. Company management had become self-serving, with their corporate jets, corporate art collections, and gold plated parking lots. Boards were not accountable to the stockholders, and were stacked with inside management and their buddies. Hostile takeovers were about kicking bad management and bad boards out and making the company run better. Crowd funding can work, but without adequate corporate governance, it will become a safe haven for the self-dealing.


By Charles Smith

Charles Smith is the founder and Managing Partner of Pegasus Intellectual Capital Solutions, a Chicago based boutique investment bank engaged in mergers and acquisitions, capital raising, and restructuring and workouts. PegasusICS is the creator of the Intellectual Capital AuditTM , a methodology to identify how knowledge is used with a company and how it creates wealth, including that related to corporate governance. The firm was voted 2013 Boutique Investment Bank of the Year by Acquisition Finance Magazine. You can learn more by clicking here.


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Private Equity:
The ‘LBO Firm’ gets a PR Facelift

‘Private equity’ is an obtuse term that describes a limited partnership that invests in the equity of privately held companies. ‘Private’ refers to the privately held nature of the companies in which these funds invest. But it also intones that it is a ‘private’ – as in exclusive – club. And private it is. Only institutional investors, or accredited investors – those with a net worth greater than a million dollars, excluding their primary residence, or with an income of $200,000 or more – can invest in these limited partnerships. It has indeed been an exclusive club, and many have wanted to join it.


In the 1980’s and 1990’s, these partnerships were referred to as ‘buyout funds’ or ‘LBO funds’. Many were involved with hostile takeovers of publically traded companies. Gordon Gekko, the character played by Michael Douglas in the 1987 film “Wall Street”, was the suspendered, French collared Wall Street takeover artist with ice water running through his veins. This image led to a negative connotation to the terms ‘LBO fund’ and ‘Leveraged Buyout Fund’. In response, the industry rebranded itself as ‘Private Equity’. We now commonly just call them PEGs, for ‘Private Equity Groups’. Whether you adhere to the school of thought that the rebranding is a rose by any other name that smells as sweet, or that we are just putting lipstick on a pig, they are the same things as they were in the 1980’s.


Alternative Asset Classes

Early investors in PEGs reaped handsome rewards. The industry was a hot asset among alternative asset classes. In the early days of the 1980’s, a standard formula was to buy a company, put 10-15% of the purchase price down as equity, borrow the rest of the money, sell the target’s non-core assets, reduce or completely payoff the acquisition debt, and sell the company for a handsome profit. Hold periods might be eighteen months out to five years. During the life of a fund, which might be seven years, a fund could redeploy your capital more than once, and the compounding effect was dramatic. The only skill set required was financial engineering.


Times have changed in the intervening thirty years. Back in the 1980’s, fat public companies were ripe for the picking. Their corporate governance was poor, the managers controlled the board, they sat on each other’s boards, they were self-serving, and they acquired other companies using their stock as the unit of exchange. And their stockholders suffered. They built conglomerates that were globally inefficient, all just so they could justify larger salaries and bigger bonuses. This was a case where the parts were worth more than the whole, and the conglomerates were acquired by the LBO firms and broken up into pure plays, one-by-one, and the parts sold off including their corporate art collections, private jets, and gold plated parking lots.


Many of us felt good about our work in hostile takeovers, and described it as ‘putting America back to work’. There was much truth to this. In the 1980’s many of us were concerned the U.S. had lost its edge, and Japanese management styles were in vogue. The Japanese were hard working, self-effacing, and efficient. We weren’t. We were the only intact industrial base in the post WWII era, and we had been living off the reconstruction dividend of rebuilding the rest of the world for too long. But between 1945 and 1980, ‘Made in Japan’ had become something to fear, not ridicule.


Wall Street’s ‘shot across the bow’

The hostile takeover period in the 1980’s was a shot across the bow for corporate America to get its act together. The LBOs moved down-market to smaller, less prominent, private companies, and strategies changed. As the market ran out of the low-hanging fruit comprised of fat, inefficient companies, the LBO firms started to ‘build-up’ rather than ‘break-up’. By finding a company with a talented management team in a fragmented industry, a PE firm could lever its management by buying smaller companies and ‘tacking’ them on or ‘tucking’ them in. This required the use of operating leverage and management skill rather than just financial leverage.


Management skill and ‘scalability’ became the clarion cry for the buyout business. The identification and acquisition of a strong player in a growing but fragmented industry was the key to success. This theme has been replayed countless times in the last two decades. Small, inefficient companies were either acquired or driven out of business by the larger, better managed and more efficient companies lead by the PEGs. This has had a positive effect on the competiveness of corporate America, and has put many ineffective managers and overpaid rank-and-file employees out of work, thus leveling the global labor market.


Creative destruction

This creative destruction has been universally positive for the U.S. economy, in spite of the image projected by Gordon Gekko. A review of the performance of small-to-medium sized companies by Pepperdine University shows a clear performance advantage of companies owned by PEGs in comparison to similar companies still owned by their founders or heirs.


Companies owned by PEGs have superior performance because people perform better when they know someone is paying attention. Second, the principals of PE firms have a breadth and depth of knowledge that is continually fueled by the case study-like aspect of each information memorandum they receive. A PE firm may look at a thousand – or thousands – of transactions in a year – each a case study – in many different industries. They have the luxury of being able to integrate these vast stores of knowledge and gain a perspective not easily emulated by a privately held business owner who is more than fully employed just running his company in the Knowledge Era.


But not all has been rosy for PEGs in recent years. The financial crisis left many with catastrophic losses as their portfolio companies fell short of projection. Liquidations at horrific losses to intrinsic value have decimated the ranks of PE. By some estimates, as many as 25% of PE funds that existed at the start of the financial crisis will never raise another fund. Knowing this, these PE firms – the Walking Dead – maintain their zombie companies in their portfolio so that they can continue to receive their management fees. This has alienated – and educated – many investors in PE funds, and they are redefining the terms under which the general partners earn their fees.


For now, muted returns

At present, the returns for the post financial crisis period are muted. Where a fund might return 17% or 25% in good times, a rate of return above zero in the post-2007 period was solid, and an 8-9% return put them in the upper echelons of the industry. PEGs now pay prices as low as 3x EBITDA for their acquisitions, with 5x a common figure. Granted, this is for companies that are dependent on their owner, have an ill-defined infrastructure, and may have no policy manuals, cross training, or no meaningful HR. But in the hands of a skilled platform company, that is, the one with the skilled management team, an acquisition is accretive and permits taking advantage of the infrastructure of the acquiror. The result is not just a bigger company, but one with higher EBITDA margins.


The future of PE lies in the middle and lower middle market, as far down as companies with $10 million in sales. PE firms are forcing efficiency on U.S. companies, and as they sift through the underpriced larger companies, they seek ever-smaller better performing and underpriced companies. New asset classes are developing as well, such as farmland, which has an inverse correlation with stocks, and which improves the return on the efficient frontier of a diversified portfolio.


Before investing in a PE fund, evaluating its general partners is critical. What is their current strategy? Is it well defined, and is it something you can understand? How have they performed over economic cycles? Warren Buffet is the poster child for believing you should understand what you invest in. Warren refrained from investing in the dotcoms of the 1990’s, explaining he just didn’t understand their valuations. That is a good philosophy, and frankly, a better approach than requiring a specific net worth or income. Do you understand what they are doing? If it is clear to you, then consider the investment. But like Warren, if you don’t fully understand the investment strategy, then, just don’t invest in it.


The lure of the new: Beware of Crowdfunding

Avoiding investing in things you don’t understand includes equity crowdfunding. While rules are supposedly in the works at the SEC for equity crowdfunding that would permit non-accredited investors to invest in equity, these rules have not seen the light of day, and non-accredited investors are prohibited from playing.


There is a vast difference between investing in a PE fund and investing in a crowdfunded company. When you invest in a PE fund, the general partners of the fund and their staff are acting as professional money managers. They actively sit on the board and bring tremendous knowledge to the company. By contrast, crowdfunded companies are small, young, and commonly without real corporate governance. You will be placing a bet entirely on the management of the company. Unless you are very skilled at evaluating management teams and corporate governance – in addition to evaluating the underlying product or service and technology– you are at material risk of loss. If you want to invest in equity crowdfunding, the best approach would be to invest in local companies where you can actually meet with the management and kick the tires to make sure they know what they are doing, actually exist.


Image courtesy DonkeyHotey

by Charles Smith

Mr. Smith is the founder of Pegasus Intellectual Capital Solutions, a boutique investment bank specializing in mergers and acquisitions, Capital Raising and restructuring and workouts. The firm is an innovator in the use of Intellectual Capital Audit for pre-closing due diligence and in turnarounds. Charles can be reached at



The War for Talent

The War for Talent

In the knowledge era, its all about your talent

I’ll never forget the moment as a young financial analyst when the light came on. In an epiphany, I realized that all these numbers in financial statements came from somewhere. Real things were going on someplace inside of a company where I couldn’t see, things that caused all those numbers to be what they were.

It was as if all I could see were the hands on the face of a Swiss watch, while behind them were a zillion little things working in concert to make those hands give me the time. I could see the hands move and hear the ticking, but the rest was a mystery. But in years since, it’s become abundantly clear. Those numbers for revenue and profit aren’t coming from the company’s technology, or fixed assets, or IP, or competitive advantage. They’re coming from people.

Inner workings of a watch

We are in the midst of a war for talent. If you weren’t aware of this, en garde. We are living in the knowledge era, and that means getting the best out of your knowledge workers if you are to survive and prosper. We need Navy Seals, not WW1 doughboys being sent over the top. Do a quick Google search for ‘war on talent’. McKinsey has been writing about it since at least 1998. You need to bone up.

All intellectual capital – the value of a company beyond the value of its tangible assets – can be traced back to the people that created it. As a result, the world’s largest companies are waging a war for talent. That doesn’t mean a price war where salaries are bid up. It’s about being better at acquiring talent, and then training and retaining that talent.

Internal human capital development is infinitely better than outside acquisition. That’s why talent acquisition and training are so big these days. A great culture, once built, is fairly resilient and resistant to change. It self-regulates. It prevents pathogens from getting in that would cause contamination. And if something nasty does get in, it surrounds it and attacks it and works to push it to the margin.

A great corporate culture is a huge competitive advantage once created. It is very difficult if not impossible to replicate. For PEGs and other acquirors, it is imperative to understand that when a company benchmarks well against peers, they should, as in medicine, practice the Hippocratic Oath: primum non nocere. First, do no harm.

Hypocratic Oath

Google, perhaps the most famous of all knowledge era companies, does not owe its success to superior technology. Dig deeper and you will see that its talent acquisition processes are finely honed to select for people that are creative producers. They’ve learned that GPA is irrelevant after the first few years out of college; 14% never even went. They find people that have done things that indicate that they have passion and creativity. Then they pool these people together and place them within buildings that are systematically designed to facilitate, if not cause, interaction between these bright, passionate people. The rest is just chemistry.

How Google Works

While Google’s talent acquisition methodologies work for them, research indicates that GPA is indeed an effective hiring criteria for private equity firms (and investment banks). The use of Excel, the ability to work through volumes of financial figures, the comfort with S.T.E.M., these are the stuff that new hires at PEGs are made of. Herein lies a problem.

PEGs regularly shy away from the acquisition of companies that rely on people. They say that these people-dependent companies have their capital come up the elevator every day and go back down every night. This is absolutely true. But that is the way it is at every company (especially PEGs and investment banks). The only difference is in how durable the output is that these people are producing, the half-life of the product. A long half-life of work output simply means a company that under-manages its people has a bit more time before the floor falls out from underneath them if they sit on their hands.

If you don’t have the talent to refresh these intangible assets, they become day-old bread. After all, a company’s intellectual capital – its enterprise value in excess of tangible asset value – is the result of the work of people done in the past. That is what creates class-A customer lists, positive brand image and patent portfolios. These are created over time, not overnight, and they were made by people. But without maintenance by people today, these are wasting assets. Think Palm Pilot, Blackberry, Nokia, Kodak, the list goes on.

Death of Kodak

Many PEGs eschew these icky people-management things. They don’t like them. They really don’t even care to understand them. After all, they are resistant to input into Excel. And they don’t have to use them internally. Their people are as uniform as peas in a pod and small in number. One good germ would wipe out the whole lot.

PEG employees (and investment bankers) are selected for – and trained – to use numbers as though the were disconnected from all the other numbers somehow, like if I could just change this figure or ratio, wow, look how much money we can make. What they don’t get is that sometimes the coefficients have coefficients. This isn’t guns or butter. Touch the wrong one and the entire formula changes.

An analyst or an MD at a PEG is far more inclined to ask for a price/volume report or a margin-by-product report, things that lend themselves to formulas. Their people were not selected for their ability to analyze the soft stuff, like how a company acquires, trains and retains its people, or what makes this culture tick. But these awkward human issues are where corporate value is truly created. These are the inner workings of the watch, the place where all those numbers come from.

Top 10 Differences between Average PEGs and Awesome PEGs

Ouji Board

Its important to know where your assets are on the flight deck

Defining your market segment and developing your business processes are essential to creating a unique corporate culture. These are ingredients that go into your special sauce. My firm has its special sauce, and its ingredients were derived from my personal experiences. Here are my experiences with PEGs processes and cultures that keep the average from joining the awesome.

The average:

1) Believe that high quality, high growth companies can be acquired for the same price as low quality, low/no growth companies

Some firms think that quality companies can be had for 5-6x EBITDA, and some would even say 3-5x. In the 1980’s, this was true. But today, underpriced companies are statistical outliers, a bit like a four leaf clover. Acquiring outliers is not the foundation of a long term strategy. It’s hoping that Santa will drop a bag of money down your chimney.

In today’s market, PEGs that want to buy cheap are, in effect, sorting for low quality companies. You get what you pay for, mama used to say.

My advice to these firms is that if you want quality, have a plan on maintaining and improving the company, and be willing to pay for it. There is a vast difference in the growth rate of companies, and growth is one of the biggest drivers of value. Play with the Gordon Dividend Discount model for a few minutes and you’ll understand how growth affects value.

2) Think EBITDA is the same as cash

There’s a reason it’s called the Discounted Cash Flow Model and not the Discounted EBITDA Flow Model. Companies vary wildly in their required investment in working capital and PP&E. All that matters is cash flow after reinvestment in these assets. I’ve seen companies that needed to invest 30% of incremental sales back into incremental working capital and PP&E for every dollar of sales growth. I’ve also seen companies that had negative working capital of 30% of sales. These are companies that get paid up front. This is a shocking variance.

If you benchmark value off EBITDA without looking at working capital and fixed asset reinvestment rates, you simply don’t understand value creation. EBITDA is a lazy man’s reference point. Roll up your sleeves and benchmark cash flow and growth rate for the peer group and the target. And whenever you talk to someone in-house about a multiple of EBITDA, also include a reference to multiple of cash flow so that your culture is focused on what matters.

3) Focus on beta error to the exclusion of alpha error

Beta error, aka Type II error – accepting a false premise – is looked at by all PEGs. An example of beta error is acquiring a company that performs below expectation and fails to return your hurdle rate. But alpha error, aka Type I error, rejecting a true premise, it very expensive too. That would be rejecting a company that does well.

Some PEGs fly so high they never get below 10,000 feet. “Business service company under $25 million in revenues? 6x EBITDA is my maximum price.” They never bother to look at growth rate, profitability or required incremental investment. TTM EBITDA is all they seem to need.

Detail matters, so building a better sorting system is the place to start if you are to have sufficient time to figure out why a company has performed against peers as admirably as it has. So would creating a tracking system to understand how companies did that you rejected, and then figuring out why you rejected them. But that, of course, takes effort, just like looking at actual cash flow instead of TTM EBITDA.

4) Don’t do longitudinal analysis, or don’t model

I’m shocked at the number of firms that will settle for three years of financial statements and think they know what is going on. I don’t know how they model the future if they don’t know the past. It’s like looking at a photograph and thinking you’ve seen the movie. By so doing, they miss a basic lesson from statistics: the larger the sample size, n, the greater the statistical reliability.

I can only surmise that firms that settle for three years of data aren’t modeling the future. That is in effect assuming stasis. If so, they will never accurately value companies that have a future, and are sorting for laggards.

The whole purpose of financial analysis is to identify sources of variance and determine trend. Longer is better than shorter. That’s why a good sniper can fire a 30 inch barreled rifle over 1,000 yards with accuracy, while one with a 5 inch barreled pistol does well to hit anything at 25 yards. Yes, size matters.

5) Skim CIMs

I think the analysts and associates are pretty good about doing their homework. But when the deal summary gets to an MD, it seems that they are too busy or too important to do something as menial as homework. My sense is that some believe that they are experienced and so can just feel things in their gut. Oh, to have such a crystal ball…

While a feeling in the gut is tremendously important, arming oneself with the facts first goes a heck of a long way to giving your gut something to work with. Without facts, it’s a reflex, and that’s just another name for a knee jerk reaction. Some of the greatest thrashings in military history – Bay of Pigs, the first half of the Battle of the Bulge, and the Battle of the Chosin Reservoir (Changjin Lake Campaign 장진호 전투(長津湖戰鬪; 长津湖战役 )- were due to leaders’ fatally flawed perceptions which prevented them from seriously looking at evidence already in their possession.

6) Don’t have investment criteria

When I go to a PEG’s website and can’t find investment criteria, I can’t help but shake my head. I can’t tell if they are just poor marketers or they are suffering from an identity crisis. If I can’t find investment criteria, I move on because I’ve already learned all I need to know.

What’s a good description of investment criteria? Here is one of the best I’ve ever seen:

It nearly made me cry with joy when I read it. Cheers to The Halifax Group. I don’t know anyone at their firm, but their attention to detail compels me to.

7) Don’t list contacts or email addresses

I am at a total loss to understand why a PEG wouldn’t list a person or their email address to write to. It tells me that they aren’t running a business. They’re engaging in a hobby. As to email addresses, isn’t a contact email, it’s a spam trap. If you aren’t getting any deal flow, consider listing a BD point person with a real email address.

8) Have overly restrictive spam filters

Some PEG’s, particularly their MDs and partners, are annoyed by the volume of email they get. Who isn’t? One lesson I’ve learned is that you haven’t arrived until you see your name in graffiti on a bathroom wall. Getting deluged with email is a sign that you’ve arrived. This is just part of playing in the big leagues.

But having spam filters set to TSA scanner levels is not the solution to “too many emails”. The solution is to have a good admin. See #2: “alpha error versus beta error”. The best BD guy I know has 3 admins that do nothing but sort through his emails. Yes, three. What you can’t imagine is how much great business he does. Never does a grain of wheat get sorted out with the chaff, and this is definitely a game of finding the grain of wheat.

Ouji Board

9) Have poor transaction tracking

I am really shocked at how people either don’t check their email regularly, or don’t respond to email on a timely basis. In my first job in finance, we had to pick up the phone in three rings. We also had to get someone to cover the phones for us if we needed to use the men’s room so that the phones weren’t left unattended. I think this is something that should be brought back: service.

A close relative to not checking email is an overly relaxed attitude of timeliness. Back in the early 90’s we used Ouija Boards – miniature aircraft carrier flight decks – to visually see where our projects where in process. With the advent of digital tools we have lost visual stimuli. Everything disappears into zeros and ones in cyberspace. Perhaps it’s time to bring back visual cues so we know when we are about to inadvertently push a $65mm F/A-18 off the starboard side of the flight deck. That said, even the Navy converted to digital Ouija Boards last year. Regardless of whether you use a physical or virtual Ouija Board, you need to immediately see where your assets are when you walk into your operations room.

Ouji Board

10) Have an NDA obsession and fish for trade secrets

When a PEG tells me that they never sign an NDA with an effectiveness over 12 months, I can’t help but laugh. The one condition where I would agree to give a PEG a short lived NDA is if I get to pry into their family affairs and am only bound to keep them secret for a year. What goes around comes around, mama used to say.

I don’t understand why there is so much chest thumping that goes on just so they can tell their buddies that their NDA’s only have a life of X years. It begs the question: if this is what negotiating an NDA is like, what would negotiating a sale agreement be like? Yee gads.

Here’s what one client of mine said to a prospective acquiror who wanted to learn about the inner workings of his company: “If you want the privilege of stepping into my world, then mind your manners.”

While I respect that a firm might have a concern with a nuisance law suit, you are about to receive highly privileged information that commonly falls into the trade secret category. If you want to fish for our client’s secret sauce, you have just blown your cover. I mark my CRM immediately with DO NOT CALL and move on.

11) Don’t monitor or mentor Millennial’s manners.

Okay, I lied. I’ve noticed 11 differences. This one seems to be mostly a Millennial generation mentoring problem.

When someone says “thank you”, the correct response is “you’re welcome”, not “no problem”. If you don’t want to train Millennials to say thank you, at least train them to use their best Arnold Schwarzenegger accent to say “no problemo” in an allusion to Exterminator II. That way I’ll know they are making a joke and give them points for wittiness.

It seems the older I get, the more manners count. As long as baby boomers are business owners and clients – the ones with the money – Millennials will have to operate in their world. There are two books to offer to your millennials. The first is “How to be a Gentleman”. I wish the title was gender neutral but the book is relevant anyway. The second is “Don’t: A Manual of Mistakes and Improprieties more or less prevalent in Conduct and Speech”, first published in 1880 and priced at one shilling. I read the second edition. Yes, it’s well seasoned, but good manners are always in style, just like please, thank

Fundless Sponsors and Search Funds:
Attractive to Funding Sources,
Not So Much for the Sponsor


Its hard to compete in an auction as a fundless sponsor

“Search Fund” is another of the numerous misnamed financial terms. “Fundless Sponsors”, a term that is a close relative, is clear by comparison. The person who is actually doing the search but doesn’t have any money is what I will call the direct sponsor. His or her funding sources are the ones with the money, which I’ll call the indirect sponsor. These funding sources could be other PE funds, their principals, or other high net worth investors.

The direct sponsor does all the leg work, doing the tedious task of sorting wheat from chaff.T Statistics I’ve seen suggest that something like 2 out of 3,000 deals that a funded sponsor looks at will be funded. I don’t have numbers on fundless sponsors, but it has to be worse. That’s a lot of chaff. And word on the street is that there is an ever increasing amount of chaff to sort through to get to that grain of wheat. After all, the lowest hanging fruit is constantly being picked, and after 35 years of buyouts, all the fruit is now at the very top of the tree, or in reality, the lower part of the lower middle market, and getting lower and smaller all the time. High quality companies are getting harder to come by.

Indirect sponsors effectively use fundless sponsors as their unpaid business development people.T I could pretty that up, but that’s it in a nutshell. The fundless sponsor wants a crack at running their own show and having their own nest egg. So, their task is to identify a company that is not being effectively marketed by an intermediary, or that is off-market. Any company that is well marketed will be acquired at a price out of the reach of a fundless sponsor. Why? It all comes down to the benefits of diversification of non-systematic risk in a portfolio.

The risk that is specific to an individual company, referred to variously as non-systematic risk, company-specific risk or secular risk – can be diversified away in a well-selected portfolio of a minimum of 10 companies.T Entrepreneurs are well known for having all their eggs in one basket. Their salary and their wealth are completely at risk and undiversified. One big slip and it’s all she wrote. This is the life of the direct sponsors. That’s why they can’t pay full price. They can’t diversify their risk. To get their risk/reward ratio in line, they have to get a higher reward to compensate for absorbing company-specific risk. This means that have to buy cheaper. That’s the math.

The indirect sponsor – the money behind the scenes – does not share this problem. They have diversified their portfolio and risk.T So have PE firms, family offices and other investors groups. Only the poor business founder and direct sponsor are completely exposed to the risks specific to that business. The direct sponsor runs the very real risk that she will work her tail off and end up impoverished. They could spend years living off their own money before they find a company, and once they do find and buy a company, if they lose a major customer, the next thing you know the company is insolvent.

As a result, the direct sponsor’s only recourse is to emulate the work of the investment banker. They must create a marketing machine that identifies companies, and a sorting machine to sort through all the chaff. Then they have to court the business owner and keep them from talking to investment bankers who are sure to tell the business owner that if they run a structured process they will get a higher price. This is a daunting task for the direct sponsor. The life of the Maytag repairman looks good by comparison.

But here is the play. Most Fundless Sponsors and Search Funds are generalists. To compete, they need a real strategy. Paying 5x EBITDA is not a strategy.

Generalists don’t see expertise like experts do. Generalist PE firms simply do not have sufficient time to research a narrow niche and see value where it exists. They simply miss the value proposition. An expert in the niche sees it quickly and can see how to monetize it.

My advice to direct sponsors is to become an expert in a very narrow field and get funding sources that are experts in that field. By becoming an expert, the direct sponsor knows real competitive advantages when they see them. A Chem E, EE, etc. with an MBA and some hands-on-experience at both a large well-run company (3M, DuPont, Monsanto, etc.) and an investment bank is a great start.

Becoming an expert in a very narrow niche vastly reduces the amount of chaff that a direct sponsor will need to sort through. By narrow I’m talking 3 or more digit NAICS code. Getting funding sources equally as expert in that narrow niche gives the direct sponsor a mentor that can coach them and also understand what they are really looking at when the direct sponsor finds a gem. Lastly, being an expert in a narrow field gives a direct sponsor a chance to really run the company better, and in so doing help move the risk/reward equation a little bit back their way.

While this solves the big problem of finding value at a reasonable cost, it still leaves the problem of the undiversified portfolio. So, if you want to partially own and solely run a company just for the money, don’t. Do it because you are compelled to, like a moth to flame. Being crazy helps, like someone that starts their own lower middle market investment bank.

Recurring Revenue Models:
Financial Nirvana, or
a re-run of “Can this Marriage be Saved?”

Old post card

Less than bliss

There are countless entrepreneurs trying to start – and private equity firms seeking to acquire – companies that have recurring revenue models. I am perplexed by this. Part of the problem is that the phrase is ill-defined. After all, if a company doesn’t have recurring revenue, they go out of business right away, right?

I mean, I understand the cost of customer acquisition, and that constantly trying to find new customers would be an exhausting undertaking. But I am hard pressed to think of a business that doesn’t eventually sell to its past customers again, except perhaps for certain lower middle market investment banks, present company excepted, and home renovation general contractors. Even car manufacturers sell more cars to their old customers if their cars made them happy. Customer loyalty programs are all about this. Lower middle market investment banks and home renovation general contractors should take note.

Some investors attempt to clarify by saying that they want “sticky” revenues. But revenues are only sticky if customers are happy, your product offering continues to be competitive, or there are significant switching costs. So it starts to sound like customer satisfaction and switching costs are really the metrics to follow, but these aren’t new.

Investors will then add that they want contracts in place with customers, that contracts equate to recurring revenues. If that is so, go get a contract as a subcontractor for Comcast as service technicians and see how far that gets you. And look where mobile phone contracts have gone. Market competition has caused them to evaporate. So much for contracts. It was nice while they lasted, but competition has a way of making them disappear.

Looking back at my tender youth, I don’t recall a single reference to recurring revenues in any of my finance or marketing texts or in any of the financial models. Nothing in CAPM, DCF, efficient frontier, Sharpe’s Ratio, The Five Factor Model, nothing, not a word on how recurring revenue creates a competitive advantage, allows you to beat the market, or how it improves risk/return in a portfolio.

Beta, from the weighted average cost of capital model, is as close as I have come to this elusive, if not mythical recurring revenue. Companies whose stock performance correlates with the market have higher betas, and thus, higher cost of capital. If that is the gig, then isn’t this really about the correlation with the market, or a lack thereof? Remember, anything that can be diversified away in a portfolio isn’t a value driver.

We note that many of these recurring revenue companies are software and tech related. These are growing markets, and stocks performing well in growing markets in nothing new.

Some PEGs argue that part of the secret sauce of their recurring revenue models for their SAAS companies is that they offer a free version to get us to try them, and then we’re hooked. Wa ha ha ha ha, they cackle. This reminds me of the ladies at the grocery store giving out free samples of cheese and sausage on little toothpicks. Again, nothing new here. Test drives have been around for quite awhile. Ben Hur probably took one.

Proponents argue that recurring revenue increases predictability. But my own understanding of finance is that predictability in the short run is a not a variable incorporated into any valuation model. DCF is a perpetual value model with its last step reaching out to infinity. Performance in the long run is what matters, at least according to Warren Buffett, whatever that’s worth.

I’ve seen numerous articles about how you will never miss a quarterly earnings announcement if you have recurring revenues. Again, I have yet to see any research that says that this increases shareholder returns in the long run. And while never missing an earnings release sounds tempting, the flip side is that you will never exceed an earnings release either. That’s like robbing Peter to pay Paul, mama used to say.

While there is indeed a mania about recurring revenues and how companies that have them trade for significantly higher multiples than those that don’t, my sense is that I am seeing the dot-com days reincarnated. After all, AOL had recurring revenues. They flew high until they were disrupted. And that, my friends, is where I think we are headed with recurring revenues.

Remember Bally’s, the gym? They were one of the original recurring revenue models, started in 1983. They had all the bells and whistles, like contract receivables and recurring monthly income, and where did that get them? Liquidation. Why? Others built better mousetraps while Bally’s was counting its money like Richie Rich . What goes around, comes around mama used to say.

In chasing short run predictability, myopia is bound to set in. That will make the brick wall all that more unpleasant when a disruption causes recurring revenue models to hit it. Investors will be dazed and heard muttering wtf? in hushed tones.

I don’t believe that any of the fundamentals have changed. Meeting a market need in a large market, having high customer satisfaction, capturing market share in a market where switching costs are material, running efficiently and producing high operating margins, these are the value drivers that matter. Adding contracts only makes one feel falsely safe, like taking refuge in a basement fallout shelter in Manhattan during the Cuban Missile Crisis, or practicing Duck and Cover once you see a mushroom cloud.

A recurring revenue model with contracts is like marriage. After all, marriage is a contract and switching costs are high. But without solid customer satisfaction and constant renewal, it is destined for the scrap heap in the long term.

Recurring revenue models aren’t going to go away, but their premium to market will. When sufficient longitudinal data permits analysts to compare long term rates of return, investors will find they overpaid for what they got back.

M & A:
To Add Value, Pay Cash, Go Hostile

Man with boxing gloves

To create value in Mergers and Acquisitions, take the gloves off

In the first solid research we’ve seen regarding the value created from Mergers and Acquisitions, the conclusion is that the winners are big winners and offset the losers.. The data that is commonly quoted is that 70% of acquisitions provide negative returns to stockholders. But that data goes back to the 1980’s, and does not account for the huge winners. It is equivalent to the private equity fund strategy: the big winners offset the losses of the losers which can make up the majority of acquisitions. That is also very much the way Venture Capital works.  The perception that up to 70% of mergers and acquisitions destroy value is out of date, according to a U.K. study which was commissioned over the furor of Cadberry by Kraft Foods, which was, by the way, a bad idea, as evidenced by the subsequent split of the two companies in October 2012. To learn more, contact us


by Charles Smith

Mr. Smith is the founder of Pegasus Intellectual Capital Solutions, a boutique investment bank specializing in mergers and acquisitions, Capital Raising and restructuring and workouts. The firm is an innovator in the use of Intellectual Capital Audit for pre-closing due diligence and in turnarounds. Charles can be reached at

M & A:
Family Offices Bypass PE Firms

Door with key

Family offices are now investing directly in privately held companies and bypassing private equity funds.


Family offices are making the break from investing in PE funds.  Instead of investing in private equity funds, they are investing directly in privately held companies.   This trend is clear to us, and we work regularly with family offices that are in search of portfolio companies and add-on acquisitions.


Family offices don’t have to restrict themselves to a limited investment mandate like PE does, and they can be more flexible in their thinking.  They don’t have a time horizon they have to live by, and they don’t have to use leverage. And some don’t, or do so modestly.


The financial engineering skill set possessed in the private equity world used to be confined to PE firms.  Now they are fairly widely distributed.   And with the economic downturn, talent is available for hire.


Still, it takes something special to be able to pick and grow winning investments in private companies.   Some of the family offices have it.  Many family offices came into being because the patriarch or matriarch had a company that they built themselves.  This skill set is still intact if the head of the office is the founder.  This is less true once the second, and certainly the third generation of trust fund babies take hold of the reins (or don’t).


The move to independence from Private Equity is just part of why PE is in a transition.  Among the PE firms, there are have’s and have not’s, with the have not’s suffering from insolvencies and poor performing companies in their portfolios that preclude them from raising another fund.  Their talented people exit when they see a lack of a future.  The fund manager hangs on for dear life trying to maintain a heartbeat in his zombie companies which by now are the only things that make up his zombie fund.  He keeps them alive so that he can earn his management fees.


Privately held middle market and lower middle market companies considering a mergers and acquisitions transaction, or a capital raising transaction, may find that a family office suits them well.  They are patient money, understand private company ownership, and bring skills to the table that can make everyone wealthier.  And they will consider a minority stake where many PE firms require control or outright 100% ownership. To learn more, contact us

by Charles Smith

Charles Smith is the founder of Pegasus Intellectual Capital Solutions, a boutique investment bank specializing in mergers and acquisitions, Capital Raising and restructuring and workouts. The firm is an innovator in the use of Intellectual Capital Audit for pre-closing due diligence and in turnarounds. Charles can be reached at



Capital Raising in the Middle Market:
Basel III Will Hurt

dinosaur skeleton with monacle

Community banks as we know them may become extinct if they don’t evolve.


An article in the American Banker which stated, “Community Banks: Basel III Will Put Us Out of Business”, is not news, at least not for those that follow our thinking.  The community banks are being treated just like any other bank, and that’s not just because of Basel III.


The truth as we know it is that the Fed wants fewer banks.  We still have something like 6-7,000 banks nationwide.  Canada has six or seven, and even adjusting for the difference in the size of the economies, we need about 100 at most.  We have a long way to go.


Banks with assets of about $10 billion are as efficient as they can get, at least according to the statistics we have seen.   Moreover, they are still small enough that they don’t present systematic risk.  And importantly, they have sufficient scale to have in place the tools that the Fed really wants them to have.


Since the the end of 2009, the number of banks in the U.S. has decreased by 15% compared to 20% in the 1980-1989, 36% in the 1990-1999, and 22% between 2000-2009. Data on average assets per employee tells a similar story of disparate scales. Since January 2010, the bigger banks have nearly twice (87%) the assets per employee than the 4,090 community banks with assets between $100 million and $1 billion. The gap between bigger banks and the 2,056 banks with under $100 million in assets is more than double (119%). The trends suggest that these disparities will keep getting bigger.


The Fed wants to sit and look at its dashboard and understand the health of the economy.  They also want to be able to see in near real-time the effects that any particular event or decision will have on it.  It doesn’t want any surprises, and that means no exceptions.  They want the same loan being credit scored the same way with the same amount of capital reserved against it regardless of what bank it is housed in.    That is not the least bit unreasonable.


Importantly, the Fed can’t have a real-time dashboard if community banks are still using Excel.  The Fed wants the enterprise risk systems of all banks to download into theirs.  That means survivors need sophisticated systems, and sophisticated systems require scale.


The consequence is that capital raising for middle market and lower middle market companies being funded by community banks could be in for a nasty surprise.  Credit availability could evaporate for some banks, and their borrowers.  Companies that are at risk of financial distress will find themselves looking for a new (likely non-bank) financing source.  If they don’t, they may find themselves an involuntary sell side M&A candidate.  That happened a lot during the financial crisis.


The way bank assets are rated will put term loans into a very expensive category.  The longer the term, the greater the capital that must be reserved.  Short term loans will the only thing that many capital-short banks will be able to offer, such as one year, or 364 day revolving lines of credit. With all their debt due within on year, that leaves companies vulnerable to liquidity risk.


Our advice to lower middle market and middle market companies is to understand the credit strength of their bank.  If you aren’t sure how strong is strong, please don’t hesitate to contact us. To learn more, contact us

by Charles Smith

Mr. Smith is the founder of Pegasus Intellectual Capital Solutions, a boutique investment bank specializing in mergers and acquisitions, Capital Raising and restructuring and workouts. The firm is an innovator in the use of Intellectual Capital Audit for pre-closing due diligence and in turnarounds. Charles can be reached at

To College Grads Who Want to be Investment Bankers

College Grads

It’s not as easy as it looks.

For those new graduates thinking about a career in investment banking, there are different parts of this industry you can focus on: investment banking with a bulge bracket, regional or boutique firm.  Or there is the investment banking side of commercial banking.  Being on the other side, the buy side, is just as cool, and maybe even more prosperous.  Private equity, family offices with PE divisions, companies with a PE group and university endowments all have their appeal.


Each has its own culture.  And culture is tremendously important to your success.  Culture is hard to describe and, in my view, can only be experienced.  I would suggest that you take interest and aptitude tests as a starting point.  Then, if you look like a fit, try to interview with all of them.  Your personality, drive, and goals must match those of your employer or you’ll both be unhappy.


A boutique firm like this one is very very different than a bulge bracket firm or a regional investment bank.  There are vast differences between the commercial banks as well. Within a large firm you can focus on a specialty within corporate finance:  debt capital markets, equity, mergers and acquisitions, or restructuring and reorganization.  At a smaller firm like PegasusICS, you would do it all, as they are, in our view, closely related.


Be aware that it is not an easy path to walk.  It takes innate, upper single-digit percentile ranking in numerical reasoning, people skills, emotional intelligence (if you want to be a rainmaker), immense drive, tenacity, and a belief in yourself.


But there are universal truths.  You have to be smart.  You have to work hard and love what you do.   There must be a part of you that loves the thrill of the chase, and solving problems.  You must be able to pick yourself up after suffering a set back and dust yourself off and go right back at it.


You must also have sufficient self confidence that you can admit when you don’t know something.  I tell analysts that they should only bring me right answers.  I can get wrong answers for free and save paying their salary.  If you know the answer, wonderful.  If you don’t, say you will get back to me.  Know what you don’t know.


I would also add that you must be very, very honest.  To me, honesty is our secret sauce.  Too many people aren’t.  It differentiates us.  Money – as it was put to me by a senior banker when I was an analyst – is a very serious matter.  Whether someone is borrowing it or lending it, you want to rely on the word of the other party across the table from you when you are dealing with money.  A corollary here is that you should never work for people that aren’t honest.  That means an employer, boss or client.


Integrity is only part of it. Being forthright is the other part.  To be forthright is to offer information that the other party needs to make a decision.  You can be honest and still not be forthright.  Strive to be both honest and forthright, work hard, and think more about your client than you do for yourself.  Be willing to throw yourself on a hand grenade for them.  Make them a lot of money.  They will like you for it.  It’s hard not to like people that make you a lot of money.  And that will earn you a clientele.


As I have told my analysts over the years, by the time you are in your forties and fifties, you will have a reputation  whether you like it or not.  Make sure its a good one.  If you do, your life’s work will make your later years easier, and business will flow to you.


Lastly, I strongly recommend that you get a mentor.  This should be someone that knows the industry and that you trust. While there are constant innovations being made, much of the skill set has to be acquired by learning from someone that themselves was taught them.  This is apprenticeship.  Your mentor can also tell you who’s who.  This is hard earned knowledge, and is very valuable in a knowledge industry like this one.  Be loyal to the people that take care of you.  And good luck.

by Charles Smith

Mr. Smith is the founder of Pegasus Intellectual Capital Solutions, a boutique investment bank specializing in mergers and acquisitions, Capital Raising and restructuring and workouts. The firm is an innovator in the use of Intellectual Capital Audit for pre-closing due diligence and in turnarounds. Charles can be reached at



Capital Raising Without Venture Capital

Venture Capitalist

VC to my rescue? No, I’m fine, thank you though.

Entrepreneurs – those beginning their journey following their passion – commonly don’t come from the world of finance.  They are inventors, engineers, salesmen, and creative types.  So when they go to look for financing, the thing they’ve heard about is Venture Capital”.  It is all so seductive, this… Venture Capital.  It’s capital to finance ventures, right?   It all seems so logical.


The problem is that the world of Venture Capital is broken.  And those aren’t my words.  They are the words of Jeff Sohl, Executive Director of the National Center for Venture Capital at the University of New Hampshire, uttered while we discussed the best way to help a manufacturer have access to more innovations than through its own R&D.  There’s not much to misunderstand about ‘broken’.


Rumors abound of someone with a great idea getting oodles of dough from a Venture Capitalist.  It’s a bit like hearing about Bigfoot.  We’ve all heard the stories, but do we know anyone personally that’s actually seen this thing?


For those of you out there that want something that’s real and obtainable, look into the SBIR.   Did I mention its free?


So what is this SBIR?  The Small Business Innovation Research program is a US program, coordinated by the SBA in which 2.5% of the total extramural research budgets of large (over $100 million) federal agencies are reserved for contracts or grants to small businesses.  In 2010, that represented over $2 Billion in research funds, of which $1 Billion was from the DOD alone. Over half the awards were to firms with fewer than 25 people and a third to firms of fewer than 10. A fifth were to minority or women-owned businesses. A quarter of the companies in FY10 were first-time winners.


The program has three objectives:


  • to spur technological innovation in the small business sector
  • to meet the research and development needs of the federal government
  • to commercialize federally funded investments.

The purpose of the program, in the words of its founder, is to “to provide funding for some of the best early-stage innovation ideas — ideas that, however promising, are still too high risk for private investors, including venture capital firms.”   That is good news for many entrepreneurs.


So, with this as backdrop, here is my point in a nutshell.   If Uncle Sam isn’t going to finance you, think about your chances obtaining Venture Capital.


And for you not-so-small companies, the SBIR defines “small business” as a business with fewer than 500 employees.


The SBIR program agencies award monetary grants in phases I and II of a three-phase program:


  • Phase I, the startup phase, makes awards of up to $150,000 for approximately 6 months support for exploration of the technical merit or feasibility of an idea or technology.
  • Phase II awards grants of up to $1 million, for as many as 2 years, in order to facilitate expansion of Phase I results.  Research and development work is performed and the developer evaluates the potential for commercialization.  Phase II grants are awarded exclusively to Phase I award winners.
  • Phase III is intended to be the time when innovation moves from the laboratory into the marketplace. No additional SBIR funds are awarded for Phase III.  At that point the business must find funding in the private sector or other non-SBIR federal agency funding.

Commercializing your product is the challenge.  After being burned a decade ago, Ven Cap tends wait on the sidelines before it invests in a company, well after its revenues come rolling in.  To get from Phase II to commercialization, you need to bootstrap your company.  Professor Sohl was one of the authors of a very good article on this subject, Mitigating the limited scalability of bootstrapping through strategic alliances to enhance new venture growth.  


Once you have revenues and approach break even, we can help you raise capital for growth.


The nice thing about the SBIR is that your company owns the intellectual property and all commercialization rights. Companies such as Symantec, Qualcomm, DaVinci and iRobot were started with R&D funding from this program.


A similar program, the Small Business Technology Transfer Program (STTR), uses a similar approach to the SBIR program to expand public/private sector partnerships between small businesses and nonprofit U.S. research institutions, and is funded at present at .3% of the relevant agencies’ extramural research budgets.  In FY10, that amounted to over $100 million, but that is a pittance compared to the SBIR’s $2 Billion (unless you are the lucky soul to get the $100 million).


To get started, look into the FAST program (“Federal and State”).  It is a program of State-based business mentoring and assistance to aid small businesses in the preparation of SBIR proposals and management of the contracts.  It is more active in some states than others.


We don’t arrange finance for startups.  We finance late stage startups, those with customers and revenues.  Look to the SBIR to get you started.  To learn more, contact us

by Charles Smith

Mr. Smith is the founder of Pegasus Intellectual Capital Solutions, a boutique investment bank specializing in mergers and acquisitions, Capital Raising and restructuring and workouts. The firm is an innovator in the use of Intellectual Capital Audit for pre-closing due diligence and in turnarounds. Charles can be reached at


Marketing’s Importance to M & A
and Capital Raising

Inventor with machine

It has to be cool to other people too.


Late state start-up companies can only get to be late stage if their marketing is as good as their product. If you are the only one that thinks your product has a value that is greater than the price you need to charge to earn a respectable profit, you need to reconsider either the needs of the market, your manufacturing costs, or dropping or changing your product.


Private equity firms and strategic buyers want to see that you have nailed the demand of market. While many entrepreneurs believe that venture capital will come running to your door, that is rarely the situation. The Venture Capital world is a fraction of the size it was a decade ago. Both the world of M&A and capital raising are impressed by profit and unimpressed with ideas. Lots of people have ideas. But precious few can execute on them. And that requires marketing.


So if you want to sell your company, or ultimately raise capital, you will need to bootstrap it, show you know how to run a lean company, and prove that your product does indeed meet the demands of a substantial market segment. You will also need to establish that your market segment is large enough to support an impressive revenue and earnings trajectory. And the only way to prove that is with actual results exemplified by growing sales and profitability. Getting a workable model of your product developed, creating your Marketing Mix (Product, Price, Place and Promotion) and getting your product in the hands of paying customers is the only proof that acquirers care about.


These are some questions you need to ask yourself. What do I know, really know, about my customer? What distinguishes them from everyone else? What do they do, how do they think, act, and behave? What need of my customer am I satisfying and how are they satisfying that need now? How do I intend to keep on satisfying it once my competition verifies with its own product offering that they too think I am on to something?


How do I intend to reach my customer from a distribution standpoint? What are the economics from the point of view of my distributors? Can I make the product at a low enough price so that everyone in the supply chain earns their cost of capital or better?


Shelf space, whether in a grocery store or elsewhere, is tough to get. If you have to work through intermediaries, you have to understand their needs in terms of margin and turnover. Think in terms of profit per square foot per annum.


As to surviving past the first generation of your product, how do you intend to continue to obsolete your existing product? While patents are nice, if you don’t have any cash to finance the inevitable infringement by larger competitors, you will eventually be pushed out of the market. The only way to ensure surviveability is to come to market with your product’s replacement before the competition does.


And how do I estimate demand? How exactly does one estimate demand and price a product that has never existed? There are methodologies, such as the use of Choice Theory, to estimate the demand curve. But that works best with products that are fairly easily comprehended by your consumer. What it really takes is a keen understanding of the human mind, and that is far more than just having an understanding of psychology. Factor in 6 million years of evolution, and we start to get a clearer picture.


Remember that there are always early adopters, the mass market and laggards. Your marketing mix and marketing campaign should reflect an understanding of these personality types. Focus on your first iteration of your product getting in the hands of the early adopters. Hopefully, they are opinion leaders, and other customers will decide they need your product too.


So, if you really want to have a company that other people want to buy, focus first on marketing and the psychology of your customer. And if you really want to be rich, focus on business-to-business services and products. There are far fewer new products and services being developed for b-2-b than for the consumer market, much to the sadness of venture capital and private equity firms. To learn more, contact us

by Charles Smith

Mr. Smith is the founder of Pegasus Intellectual Capital Solutions, a boutique investment bank specializing in mergers and acquisitions, Capital Raising and restructuring and workouts. The firm is an innovator in the use of Intellectual Capital Audit for pre-closing due diligence and in turnarounds. Charles can be reached at

Our Interview with The Suit Magazine

Interview of Charles Smith The suit magazine

Interview of Charles Smith, Managing Partner, Pegasus Intellectual Capital Solutions LLC, by Robert Jordan, Managing Editor of The Suit Magazine, September 27, 2012



 1. Charles Smith, you are the owner of Pegasus Intellectual Capital Solutions, LLC. Can you  explain the gradual evolution of the business? What were you doing before then?


I’ve worked in corporate finance for 33 years, starting out in secured lending in the middle market.  One of my colleagues back then was Andy Code, who went on to found the private equity firm of Code, Hennessey Simmons, now CHS.  I watched Andy’s success, and by the mid-1990’s, I made the transition from commercial lending to investment banking.  I realized that someone had to provide the transactions for the growing appetite of PE firms.


As the market has become more efficient in large corporate and upper middle market, I’ve transitioned to middle-market and lower middle market where there are a vastly higher number of companies, the value equation is far more favorable to a buyer, and operating skills are a far greater part of the success formula due to the lack of depth on the bench at this privately held companies.  I’ve been evaluating the skills of management all my career, and we now refer to this as the Human Capital component of Intellectual Capital. this way of looking at value creation is really only about 10 or 15 years old.


The other major change has been the movement of enterprise value from tangible assets to intangible assets.  In 1975, only about 18% of the value of the S&P 500 was due to intangible assets, so called Intellectual Capital.  Now that is 80%.  Unless an M&A professional can understand the drivers behind the creation of Intellectual Capital, they are a couple decades behind the reality of the market.  That’s why our firm emphasizes the importance of value creation through intangible assets, which is what Intellectual Capital really is.  As for me, I’ve joined the Intellectual Property owners Association and am a member of the Licensing Executives Society.  We spend a lot of time working on the Human Capital aspect of value creation.  Relational Capital would be second in importance, and Structural Capital would be third, since we see that as a derivative of Human Capital.


2. How do you determine what projects to take on? What specifically do you look for?


We focus on engagements within our zone of experience, and deal size.  Corporate Finance work has a high fixed cost component, and it is as much work to do a small transaction as a large transaction.  Our favorite industries are Ag business, food, manufacturing, distribution, and business to business services.  We’ve also done a lot of transportation, such as rail and air, and now pipelines.


Most of our clients are mature companies, and many have aspects of financial distress, or alternatively, have a high growth trajectory that puts their demand on cash beyond their ability to finance it in with internally generated funds and traditional debt.


As far as start-ups, we only work with companies that are post-revenue with a strong sales and earnings trajectory.



3. What have been some challenges you have experienced on the buy-side of the business with respect to working closely with clients and understanding their aims and objectives to develop an approach to the transaction?


Many PE firms get so many information memorandums that they are fully employed just trying to sort them into piles.  I think that is a mistake.  An organized search yields diamonds in the rough that they would never run across in an information memorandum or offering memorandum.  The very best deals never see the light of day of competitive bid situation.  We have created a buy-side search engine that we have refined over the decades, and we find things others just don’t, or can’t.


While most any PE firm will outline what their strike zone is, it is far more fluid than they really let on.  That makes it a bit hard for them to delineate what they are looking for.  Think of it this way:  describe what you were looking for in finding your spouse?  Would you ever have been able to describe them?  Would you have known you had found them when you first met?    Looks are deceiving, and we can’t tell a book by its cover


4. What is the general state of the mergers and acquisitions industry today?


M&A volume has been fairly quiet at the upper end of the market, but we are seeing a lot of activity in lower middle market.  That’s where we are putting our resources right now.  Business to business services, anything food or Ag, are popular.


5. How do you manage to foster that innovation and creativity within your team while maintaining confidentiality and ensuring that the existence of a transaction only becomes public knowledge when appropriate?


Innovation and creativity are the result of hiring the right people and nurturing them in the right environment.  Lateral thinking is something we encourage.  Lateral thinking is far more than thinking out of the box.  It’s integrating information and ideas from disparate functions and fields and creating unique solutions to unique problems.

You only have to look down your reading glasses once at someone who has thrown out a novel idea to chill the air and prevent innovation.  We just don’t do that.  Genius and eccentricity are close cousins.  There is a reason they use the term “mad scientist”.

Maintaining confidentiality is also the result of selecting and hiring the right people.  You must also create and maintain an environment where the leadership walks the walk, where integrity comes first before all else.


6. Can you share with our readers the day to day life of your work? A motivational experience or an anecdote?


Our work is balanced between creative work, client contact, business development, and continuing education.  We believe in and practice the Japanese concept of Kaizen, or constant improvement.  The moment you stand still, you will be passed by the rapidly changing nature of the Knowledge Economy that we live in today.

One of our transactions right now is 30 year old company that found itself in financial distress for reasons outside of its control.  We have a cash crisis coming up  in six months.  We’ve been able to find a PE firm to partner with them, and I believe that the combined attributes of the two parties will create a real dynamo, able to capture share in its fragmented industry.  Five or ten years from now, it will be a dominant force in its space.


7. Explain how the economic downturn effected business? What were some negatives and positives?


The downturn has been great for our business.  The tightening of credit, the smaller credit box of commercial banks, the imposition of Basel III, and Dodd-Frank, have led to greater demand by companies for help with their financing.  Restructuring and workouts are slowing, but many companies are weary and fatiguing. They survived the shock of 2008-2009, but were sufficiently damaged to be limping along, a kind of corporate walking wounded. Many business owners are just worn out.


8. What are some goals for 2012?


We’ve built a business development model that has its roots going back to the mid 1990’s, and we have refined it to the place that it has become a smooth running  business development engine.  We will always have more work to do on it, but it is working very well.  We have to turn it off from time to time to catch up, and that is a great problem to have.


We also have some engagements in the later stages of a long development time we hope to have up on the shelf in a new tombstone.  We are quite proud of the work that is being done.


We have also made great progress on learning to use innovative collaborative techniques to create better solutions and greater efficiency.  We think this will give us a competitive advantage in the market. To learn more, contact us