Legacy Matters: Finding the Right Home for Your Business

I have a great guest today , kazem Harfouch , who's the managing partner of Cedar Crest Capital . On our episode today we talk about how to prepare your business for sale well in advance of the actual exit , how earnouts could impact the purchase price and what makes Cedar Crest Capital different than private equity . Thank you so much for being on today .

And growing up as a kid I was exposed to that and I was like , yeah , this is pretty interesting . You know , do I want to be a doctor ? Do I want to go be a lawyer ? Uh , do I want to go into business ? And uh , I was pretty much hooked . And in high school I googled how do I become an investor ?

And Google at the time said you got to go do investment banking for a couple of years and then from there , private equity recruits you and that's the path . So great , that's what we're going to do . I left high school with two years of college done , all transferred over here locally ASU U of A . I figured you know what ?

Let's just stay close to the family , let's go to ASU . They had a banking program there called IBIS , which is an amazing program that was very fortunate enough to get into as a freshman . You know they take about 13 students out of ASU and they basically train you to become an investment banking analyst .

And at the same time , my dad started having operational issues with his business that he had no clue how to deal with , started having operational issues with his business that he had no clue how to deal with , and I realized you know what Investing in banking will definitely get me to where I want to go , but it's not going to teach me the ins and outs of

business , of what actually happens in a company . How do companies fail , how do you turn them around ? How do you fix them ? And I did a full pivot . I decided to do consulting . So I went to New York City after college .

I worked for one of the big consulting firms and my clients were private equity clients , so it was with them , with the mega funds , and my role there was to do operational due diligence .

So before they bought a business , we would come in and we would essentially look at okay , from an operational standpoint , what savings could we generate , which unfortunately is unfortunately is a fancy way of saying who can we fire , and it was very uncomfortable for me doing that , but at the end of the day , it's what we had to do , what we were hired to do

. After doing that for about three years , I was like you know what ? I want to go to the other side now .

I want to be on the investing side and I got recruited to join the Najafi companies out here in Phoenix , picked up my bags , moved back to Arizona , joined a fascinating team and was with them for about four years , and while I was there I realized the whole world is so focused on AI technology , e-commerce , digital .

I'm not smart enough to keep up with the change in technology . Every six months it's changing and we're not going to be able to compete against Facebook , amazon , Google , the world . So we decided to spin out and form Cedar Crest Capital because we realized there's a huge gap in the marketplace .

There's all these amazing businesses in this country that are too small for private equity and we define that as sub 3 million of EBITDA , don't use technology , have been around for decades 10 , 20 , 30 , 40 years and the kids don't want to take them over because they're not cool enough for the kids .

So you have all these amazing businesses where they need a permanent home . They need somebody to step in and purchase them and keep the legacies alive . So that's what we do and what we focus on . We focus on a very small subset of deals in this country and I think it's a gap that is missing and we're hoping to fill that .

So businesses of this size , half of the time the seller is fairly involved , half of the time they have a team in place . For the ones where the seller is involved , we have to replace what they do .

So we were passing on businesses left and right just because we don't have anybody in that market to run them , and it was hurting me because these are very interesting businesses .

So what we ended up doing was we started reaching out to search funds , because search funds are out there looking for deals every single day and they may have not done this before or they might not have the capital to do it . So we say you know what ?

Let's partner up , bring us the opportunity , we'll buy it with you , you'll co-invest with us , you step in to run the business . And that post went viral . We interviewed close to 250 people . So now we have almost three plus operating partners in every single state . So now we look at lower 48 states .

Alaska is a little too far , but we just looked at one Alaska is a little too far and Hawaii . We'll just have too much fun if we go to Hawaii all the time . Good excuse .

And then he went to Sacramento , opened up a bagel store there , uh , bagels I love it and then he did a souvenir store in old town Sacramento . Then he came here at T-Sol Weeji's pizza in Tempe and then , uh uh , gotten to the carwash space before it was a hot space .

And that's when I think that's where he learned the most and probably made the most of his earnings , and that's when his mindset changed about how he should be looking at businesses .

You know people think buying a business or running is very easy . It's probably the hardest thing you could ever do . Um , cause you have you have your employees lives at stake , right ? They rely on you to perform and and your family relies on you and , at the end of the day , if you don't perform , the bank will take we'll take everything .

Right , because originally I mean , I remember being younger and it's like you pull up and it's a flat fee , there's no subscription and then everyone learned that subscription-based car washes were a way to make more money off of your car wash location . So that's fascinating .

But I think you made a really good point , which is that you know , I think a lot of smaller business owners think that the pressures of operating their business as a solo or a small team has sometimes crushing pressure .

But think about when you grow exponentially and all of a sudden , like with a personal guarantee or you having a whole team of employees relying on you . You know , if your business flounders for a period of time , what does that look like for your personal life and for the life of all of your employees .

So I think that was a really good point to make and I think , something that people don't realize that as you grow , so does the stakes at play . So you touched on this earlier about how you fit this niche area where you're not , you're kind of slipping in , where there's maybe not as many potential buyers to fill this gap , and you mentioned a little bit about

how private equity doesn't really fit into that space . Can you go into it a little bit more as a potential buyer of these ? You know more traditional businesses , how you're different than private equity .

So the before deal side PE they have outside money , they have outside investors . That requires them to do crazy due diligence . They ask for maybe 1,000 items in due diligence and only 15 of those 1,000 are actually important for the deal .

The other items are just to check their box because in the event they buy this company and they're wrong and they get sued by their investors . They can prove in their lawsuit that they actually did the proper due diligence . Unfortunately , small business owners don't know what a quality of earnings is .

They don't know what these items are that big PE firms ask for and it ends up burning out the sellers because the seller is still running their business . So now , if they're answering to a thousand questions and thousand items and they're also trying to run their business , let's say the p firm decides , hey , we're going to walk away .

You know that business has tanked during that due diligence period because they've taken their head away from what's actually at stake to focus on these random requests that are not necessary . So that's on the pre-deal side . P firms tend to be a lot slower in the transaction closing process and much more tiring .

So for us , you know we we have one single LP , but it's essentially , it's essentially internal family money at this point . You know I've worked with them for a handful of years . There's a level of trust there . So we approach it from the sense of you know , we don't have outside money . We will ask you the 15 items that actually matter .

You're dealing with the decision makers directly . There's no investment committee that we have to report to . So we can , we can close a deal within 45 days , um , from start to finish , which is pretty quick in the investing world . You know PE .

I say typically , yes , there are some P firms that can be quick , but typically they're 60 to 120 days on average , which is a long period of time . I would agree with that , and that's on the pre-close . On the post-close , I would say it's even more important . You know private equity .

Their model is hey , we're going to go and we're going to buy this business and we're going to sell this in five years , because that's when we have to return capital back to our investors . We're going to , we have to grow this thing 10% per year and , unfortunately , forced growth is very risky to a business .

You're either going to fire people to boost up profitability , which hurts a business , or you're going to inefficiently spend money on marketing R&D , which is a bet that may or may not pay off . If it pays off , great .

If it doesn't , you're just burnt through all these resources and at the end of the day , they are going to sell the business , which means that brand might disappear , those employees might not be taken care of . Our model is it's not broken . Why break it ? The business has been making great cash for a long time .

All we want to do is cash out that founder or family , put somebody in place to maintain what's been how it's been historically and that allows us to keep the employees forever , keep the brand forever , keep that culture intact . And the way that we make money is from the distributions of the profit the business has been producing historically .

We're not saying we're anti-growth , we're saying we're anti-forced growth . If the business happens to grow , great . If it doesn't , we sleep well at night and that's what allows us to keep the business forever and we don't have to return capital back , you know , in five years , like a typical private equity firm .

So it allows us to really focus truly on the long term . And the hardest part of our job is finding a good business or good people hands down . So why do you want to sell it in five years once you find something you like ? We don't want to . We want to keep it forever . So that's what makes us a little bit different .

that . And you're right , there's a lot going on right now where kids aren't interested in buying the boring business from mom or dad .

know , private equity groups that perhaps don't have their best interests at heart , and so you know , I think , at the heart and soul of every business owner wanting to sell that has that , you know , blood , sweat and tears invested from , you know , long , long time ago , cashing out is a part , big part , of that equation , but also maintaining the legacy that you

built and seeing your business continue on and supporting those employees that have seen you through thick and thin that can sometimes get lost in translation .

I liked that you also talked about the due diligence process for private equity , because I don't think people really know , for starters , right , they don't always know that that's part of the process , but they also don't realize just how cumbersome and , quite honestly , a little ridiculous the number of questions .

I'm going through a transaction right now that has private equity on the other side and they have asked the same question about three or four different ways and my client has kind of looked at me and said why I've answered this question and I'm like that's just how this goes right , just just regurgitate your answer . They're regurgitating their questions .

It'll go in a big circle , but I like that you gave context in the background of of why that is the case . Right , it's a checking off of the uh , the boxes right as part of their process .

Back when we approached him and I'm his quasi-banker , you know I help him out when I can and they asked for 1,000 items and one of those being , you know , quality of earnings from EY , which is , you know , one of the big four and my dad's business he's a small business , it's not a big business .

He comes over to me he's like hey , what is this , what's this QOV thing from EY ? I was like we're done talking to him , we stopped talking to him , we cut it off . They were just going to kick the can down the road and just waste his time .

And a strategic actually stepped up to the table and understood the industry and was able to ask , you know , 15 , 20 items and got the deal closed . You know there are very friendly strategics and there are , you know , not friendly strategics which we can hit on , you know , later on in this conversation .

If there is an earn out right , there's something tied to post closing performance . If , say , private equity were to come in and make the purchase and there's an earn out tied to it , what is their forced growth plan ultimately going to do ? Granted , at first glance you're probably like , oh , the forced growth plan ultimately going to do ?

Granted , at first glance you're probably like , oh , the forced growth is going to just cause my earn out to be amazing . But to your point , what are they going to cut in the process ? What are they going to change in the process that ultimately might negatively impact the EBITDA in the following years ?

And I mean , you see , you know things firsthand in the field .

But also you hear of stories in passing about , you know , companies beginning even not private equity , right outside of that , people coming in and blowing up existing processes that are in the business that are doing well , just because they don't like how it's done and all of a sudden the earn out is completely gone or wiped out .

We can maintain how it's been performing and we'll be okay and that's what allows us to be comfortable with okay . You know we don't have to go in here and blow things up to stay competitive . We can maintain the culture , the employees , the brand , everything as is . But back to your question of you know forced growth . You know change p coming in .

They have to grow this . It question of you know forced growth . You know change PE coming in . They have to grow this . It's a bet . You know some cases they might do very well and they might grow this thing and everyone might be happy . In other ways they're taking a risk right .

Anytime you make a change to something that's already been working , there's a risk you could break it and it happens a lot . So that earn out definitely is not going to be hit and if they rolled equity over , the equity is probably also going to take a hit . But that's what happens . And we tell everybody look , you know , they sit across the table from us .

We talk to sellers all the time . They're like what would you do , what's your strategy with this business ? And I tell them I'd be an idiot if I sit here and tell you because I don't know , I have to go into your business , give me six months to learn it , and then from there I'll tell you what I think , where we can go with this .

Um , and you have a strategics and PE firms come all the time say , oh , we're gonna do this , we're gonna do that , we're gonna fix this yeah , how do they know ? I don't know I mean they're they're gonna know more

than the owner , who's been doing this for 40 years . So we just tell them straight we don don't know . I have no clue . What I do know is I want to keep everything you have in place and then , if we find some sort of opportunity , then it'll come up . But it won't be . And day one , day 60 , you know , six months to a year type of thing .

You know we want consistent earnings that have been around for a while . There's a proven history there . We want the business to have been around for at least 10 plus years and for us , the most important questions we ask us can this business run without the owner ? Meaning , is the owner a key person in the business ?

Are they ahead of sales , ahead engineer for a certain product , or is it more ? They're taking care of their employees , taking care of the customers ? You know , dealing with the typical business things that we can replace , um , you know that's certain type of things we look for .

There's a framework we like to use and we're going to give you some little confidential stuff here on on the podcast . Uh , one , uh , can amazon replace this business ? Two , has this business been around for 10 plus years ? Three , is this a simple business to understand , meaning low to no technology ? Four uh , can you predict the cash flow ?

It must have a repeat customer base . Here in this state we have a lot of uh contract contractors , construction which are great businesses , but the problem with those you're always chasing the next project . So for us it's difficult . You're always chasing the next customer .

We don't want to be in that type of business , but there are other folks that make a lot of money doing that and that's their specialty , just not ours .

There's a lot of businesses out there that people don't necessarily need , that produce good cash flow but at some point in time it might get cut off . I'll give you some businesses that we've looked at historically that we really liked . You know there was a police car manufacturer we worked on that one .

And , uh , so that's one of the things , right , technology can't really change that . Uh , these are highly customized , so you can't put them on the assembly line , right . These are highly customized , so you can't put them on the assembly line , right . Every municipality has their own requirements for what they want . So that was . That was a very interesting one .

Metal plating is one that we're involved with , right now that all they do is they coat parts that go into commercial planes . You're always going to need that especially what's happening ? in the world . So things like that , things that people may not necessarily think about . There's a business that we're looking at now in California .

They actually create the ICU for you at home . So let's say , you know you were born with a complication and you're in ICU . They will actually set up the whole ICU system in your house so that you don't have to be in the hospital and the family can be with the child at home . Nice , and that's a business that you'll always need .

issues . Now you're , in a lot of times , coming in and and adding an operator to the business . Is that a way for you to sidestep the key man syndrome or do you feel like , no matter what , if someone is experiencing that sort of key operator issue , it's almost impossible to overcome ?

Where we don't touch is if the owner is the head sales responsible for all the relationships . Then we don't know are those clients loyal to the business or loyal to you ? And we don't know . We can maybe find out due diligence , but it's a bet . So those are the ones where , quite frankly , we just walk away , unfortunately .

And if you're strategic and you're in the space , maybe they can get comfortable because they're already in the industry . Right , they can bring in one of their team members who's an expert in this space , who has relationships .

Um , that's different , but from our standpoint it's very hard for us to replace what that owner is doing yeah unfortunately we have to pass on a lot of stuff for that reason and we tell folks all the time you know , bring us in early enough , we can tell you what to do and what to improve and what flags that other people might look out for , and then they

have time to kind of work on that and bring in the right people , transfer that knowledge over .

No , I appreciate that because I don't think it's black and white and I think in a lot of instances , if you do get to somebody in advance you know I talk a lot of instances if you do get to somebody in advance , you know I talk a lot with clients who are planning four , five , six , seven years out , right From exiting , and you know the conversation always

revolves around what can I do ?

So I think , as a business owner , a follow-up question that I would want to ask is if you're putting in these operators post-closing and let's say I don't have a key operator issue . Maybe I have some stuff that I need to hand down , but I can do that with certainty what does it look like for me post-closing working with you guys ?

Am I on a consulting basis with you ? Am I transitioning for 30 days ? Is it more long-term or is it really depending on the type of business and , obviously , the operator's involvement ?

And then from there we'll have a consulting arrangement where , if something comes up , you know , we'll pay you for your expertise , but we don't require them to stay on board for a year , two years , which you hear in a lot of private equity transactions . You know , uh , we truly want to be an out for you , we want to be succession plan for you .

Um , and that's what we , what we stand by . So give us two months and then go off into Hawaii and do whatever you want . Um , you know , we're not going to keep you for two , three years . At that point , just keep the business .

Well , and I think too a lot of people who are at that stage where they want to cash out of their business , they're ready to be retired , right , and so this idea that , you know , private equity or not being kept on board for a year or more in some instances is not optimal , or maybe their health is not in the best place and they can't physically be on

board for a year or two , and so I think that it's something that every business owner doesn't really consider until the LOI hits their desk and , all of a sudden , there's a two-year potential contract for them .

You know they built this company from the ground up and that's what they've done for 30 , 40 years . So for you to tell them to stay on board to be your CEO or something , it's just it just sounds very messy .

This is the most important thing to them , this is their identity .

It's extremely important to who they are and where we have most challenges , and the stuff we face is they have a hard time letting go , and it breaks our heart when we hear about sellers unfortunately getting ill or something happening to them and they just shut the doors down Happens all the time .

And now their family left millions of dollars on the table that they could have exited , but sellers wanted to keep working until , unfortunately , something happened to them and we are trying to prevent that . So we're out here trying to speak to as many people as possible because we want them to know that , hey , you have this option .

People don't realize they can sell their business for millions of dollars . They're just like we're just going to shut our doors , we're going to retire . So it's that psychological angle which is actually probably the hardest part of what we do .

It's not finding the deals , it's not finding them , it's none of it's , it's the psychological piece that's by far the hardest part of what we do it's so true it's so tough so , so true and so tough , because I feel like there's this window for a lot of business owners where they're still very capable .

of handing off of potential generational wealth . Right and we always kind of just talk in passing about this between myself and my clients is that you know this is not something we're doing . You know , it's almost like estate planning in a way . It's really hard to get people to understand the value of putting together a will when there's nothing wrong .

Yeah , but it's the same version of what you do for your business , because one day something could be wrong and if you haven't spent the time which it takes considerable time to put in all of that sort of standard operating procedures , all of the sort of the Bible of your business , right , or whatever you want to call it , your operating manual that you can

then go to as someone outside of the company and be able to page turn through and figure out how to operate it even in your absence . So I really like that idea of being able to have these conversations earlier .

I know there are certain pockets of the United States that are seeing more of their businesses just disappear because of this , because they don't know , which is wild to me .

Yeah , um , yeah , so something , something we've been testing the waters with is , let's say , you are maybe five years out from retirement . You know , instead of getting the phone call at year five when like , hey , I'm what , if you want to take some chips off the table , bring us in , you know , we'll buy maybe 51% of the business .

Therefore , they have some chips off the table . They've de-risked themselves a little bit . Now they can really . You know , they have some money in the bank and they want to run it another five years with a partner that we can maybe help them . Have you thought about this ? What about this ? Have you thought about this ?

bring a different perspective and then in five years , when they're like , okay , I'm now , I'm ready , we're already there , we'll just , we'll purchase the remaining piece of the business I like that um so that's something we've been testing a lot with recently , because we're seeing a lot of folks that are , you know , maybe to the outside world it's retirement age ,

but they still have so much energy and there's so much fire in them and they just want somebody to come and go through the trenches with them and we and we can do that . Um , and it gives us an end , essentially because in five years when they went out , we're already there , we already have a relationship . It makes it easier .

For us that was either a win or something that was a hurdle that just couldn't be overcome , just from the perspective of a potential business owner , to know what are the potential pitfalls or things that could create ripples in the transaction process um , good question .

You know that's going to happen and so we will , you know , pay a price based on that future growth . You know that's the total price , but the cash that will give you our closing is a little bit less than that and if we hit , and if we hit these hurdles , you know , next two years you will get paid out that the non , the total purchase price .

So sellers like it because you know they feel like they have another , another bite at the apple . Essentially , if things go well , they make some more money and buyers not us , but other buyers do like to use that tool because it's a way to bridge a gap in negotiation For us . We try to be extremely transparent .

We are never going to dangle a carrot that we don't think is achievable . And there was a deal we were working on where the business had a spike post COVID , as most businesses did , and we did not know what was normal , you know , is that ? Is that going to reoccur ? I keep hitting my mic . Is that going to reoccur the next two years ?

Is that going to reoccur ? Maybe in one year ? And it was adding too much risk to us and we could not come to an agreement with the seller on that component . We came to an agreement on the total price . We came to an agreement on the working capital . We came to an agreement on almost everything and we had a lot of respect for that seller .

But on the specific earn out , given the way that the industry was going , if it hit in that first year and then in year two everything stabilized back to what it used to do , we would have significantly overpaid for that business and that was a risk to us and we were not willing to take that risk .

Now , if it was a two-year earn out , we were ready to close the deal and the only reason we put that earn out in place ? Because the business didn't have the , the earnings history that we like .

And I continue to repeat myself to the seller you know , if you had history , you know three , four years of earnings at this level , we would pay you all cash at close and we'd walk and it'd be a done deal . So earn out only comes into play for us when you don't have that historical history . Otherwise , you know we want to pay you full cash at close .

We want to buy as much of it as possible because for us , you know , we're fairly selective in the things that we do . Um , when we find something we like , we want as much of as possible . And I think earn out can get messy with a lot of people because then you're gonna decide revenue , earn out , gross profit , earn out , ebitda , earn out .

You know some people say you can manipulate ebitda earn out . Right , you can put more costs in there , which reduces it . So as a game you can play revenue . It's harder to play with revenue but then your cogs can go up right Out of your control . Inflation can happen . Now your gross profits a lot less . You know revenue is hit , so they're messy .

We just try to avoid them . But you probably have a lot of earn out stories from your deals .

If something were to happen post-closing and all of these what-ifs come into play right , they're no longer at the helm . The buyer could come in and start making changes and in a lot of cases the buyer isn't like you guys representing that they could . They're going to not change anything to make these drastic changes .

So the biggest concern right is that they come in and they wipe everybody out ,

and so I think that from an earn out standpoint , I've seen the chips fall to the benefit of more of the buyer side than anything , because you do have so much variability and especially and I know this isn't necessarily an area that you guys specialize in , but I work a lot with professional service businesses and even if those services can be performed by , say ,

another accountant , people love their accountant . They're tied to that person . It's the same with a physician practice they love their physician .

So , like you know , I just I feel like it's difficult when I'm , you know , working with a client that's in a professional service business , for them to have an earn out and to to sit there and tell them this isn't going to impact you because inherently you have attrition , because you are tied to the business in some personal capacity and replacing you , I think

, is an art form that's . A broader conversation that I talk about with my clients is when they're selling and it is based on their , you know , personal relationships with their clients . How can we make that transition a lot less scary ?

Because inevitably you're introducing someone new to take care of an important part of their life , and I think a stepped approach that you know relies , to your point , on psychological aspects where you're introducing people . As this is someone who's going to come in , we're going to make this gradual .

You're going to get to know them things to lessen the burden , but to your point , you always have to play a psychological role in this process .

And I think that one important thing to note is that there are ways to have an adjustment to the EBITDA during the earn out phase to essentially add back in , like you were talking about , management fees and all these things that could be pulled out , which I know that's outside the scope of what you guys like to do , but especially for them , they tend to have

issues with rebates and discounts and all these other things , retention stuff that's pulled out , that needs to be added back in so that your EBITDA and the earn out ultimately is correct .

So tough and it could be in anything . It doesn't have to be acquisition based or exit planning .

It's an interview of , I think , like seven really famous investors A lot of them we've never heard of , and it talks about how there's so many different ways to make money and they just found their niche and they were laser focused on it and they stuck to it . And it may not be the cool , sexy things that everyone's doing with technology .

You know , it kind of hit on the head like we are just going to stay in our lane and we're going to continue to do what we're doing and people might talk negatively about it and that's okay . You know , this is where our passion is and it kind of uh solidified that .

It was written in a very fun way and they talk about now just you know , in the business sense but also in their personal lives how they , how they maintain both and they would stay happy , et cetera . It was very , very interesting read .