December 24, 2018
In this episode, we discuss the various operating structures we’ve dealt with during our experience running online businesses and portfolios of businesses.
Pairing operators and investors can be an interesting part of the industry and ideally it’s a profitable venture for both. However, it doesn’t always work out that way, so we’ll discuss the ways it works and the ways it doesn’t.
Listen in as we explain four operating structures and examine each of their advantages and disadvantages.
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Alright, let’s dig in…
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Justin Cook: Smaller investors may want more liquid investments, and they may not have an expectation of moving money.
Announcer: Buying and selling businesses just got a lot easier. Welcome to the Web Equity Show where thousands of successful entrepreneurs go to learn about buying and growing and selling online businesses. Your hosts Justin Cook and Ace Chapman share their real life advice, examples, and expert interviews to help you build and grow your own online portfolio. Now to your hosts Justin and Ace.
Justin Cook: Welcome to Web Equity Show, I’m your host Justin Cook and I’m here with my co-host Ace Chapman. And today we are talking operating structures. What’s going on, buddy?
Ace Chapman: What is up? Now, I know last week we got into a little bit of structuring. Now we’re talking about operating structures and we’re gonna go through various operating structures that we’ve dealt with. And when it comes to running online businesses and portfolios of businesses they can be a little bit unique. You can do some cool things thar may not work as well for offline businesses so I’m excited to talk about this stuff.
Justin Cook: Yeah, I mean pairing operators and investors is a kind of an interesting part of our market place and it’s not very well defined. So we’re going to kind of try to lay down some of the examples we’ve seen and some of the ways we’ve seen it working so that both investors and operators can take, hopefully, a piece of this away and be able to look at this a little differently. Ideally, it’s a profitable venture for both, but it’s not always. And we’re going to talk about the times where it does work, and some of the ways in which it can break down. We should mention again, as always: we’re not lawyers, we’re not accountants, you need to take to yours. We’re just kind of sharing our experiences and what we’ve seen working in the industry.
Ace Chapman: Yeah, that is important to mention.
Justin Cook: Alright, but let’s do some listener love. First up, we got a nice little mention over on Reddit, reddit.com. We had user PapaU saying, “I listen to Web Equity show right now. Super interesting if you ever want to start your own business”. So PapaU, thanks for the shout. But, let’s get into the episode.
Alright Ace, we’re talking operating structures today. We’ve got 4 kind of main operator/investor structures we want to dig into. And we’re gonna cover each, and some of the advantages and disadvantages of all of them. The first up is the Investor Operator Partnership so this pretty straight forward. This is when you have one investor, typically, and they’re partnering with one operator. Someone to actually operate and run the business, and someone whose strictly kind of an investor. So this is a cash meets skill scenario.
Ace Chapman: The thing I love about this structure is, number one: it’s very simple. Everybody knows what the other person is expected to do. And it can be a huge win-win because I come across people all the time that are operators and they don’t have a lot of cash, but they have a lot of time. And I’ve come across and equal number of people that are investors and they have some cash, but they may be a doctor, they may be a professional working corporate America and they don’t have the time to put into a deal. And so that marriage is just a really beautiful thing.
Justin Cook: What’s tough about is this is kind of matching those up. It requires some level of trust. To be fair, it’s typically the operator looking for investors. So the operator will look at kind of family, friends, peers, mentors. That’s kind of generally where they look. And it’s generally where investors are willing to get involved because they have some kind of relationship with operator. They have some understanding of some of their skill sets and their history. So they’re probably best suited to get involved in those investments. And just the kind of inherent trust this required in an agreement or operating agreement like this.
Ace Chapman: The advantages to this one are really simple. I mean obviously the operators advantages, they’re going to get the funds that they need to buy the business or maybe even some capital to grow the business so they’re not cash-strapped. I also see plenty of operators that spend their very last dollar to get them to the deal, but a lot of times we still just need some money in the account and not be at zero. So it makes it a lot less stressful when you can acquire the business, you’re not completely cashed out, you don’t need to suck everything out of the business in order to pay your bills. And then it’s a win for the investor as well. They’re gonna get equity, they’re gonna get some distributions in the deal and all they have to bring to the table is some cash. But of course there are some disadvantages.
Justin Cook: You see this kind of investor operator agreement a lot with FBA businesses right now. Typically, FBA businesses require quite a bit of cash invested in inventory and so if you have a growing FBA business they’re constantly needing more and more cash. So you’ll have an investor that comes along and starts putting money in the business to help it grow. Add fuel to the fire. And they’ll take on, you know, kind of a larger and larger piece of that FBA business as it needs cash and they purchase more and more inventory. Again, as I said, it typically happens with kind of friends, family, peers, mentors. Someone that knows the operator and can help them provide value and definitely the cash they need to grow the business out.
Ace Chapman: That’s something that I usually see in these deals. Most of these investors are not gonna be completely passive. They want to have some involvement, like you said, in a lot of cases the best structures for this are when you’ve got somebody that you know, they’re a friend, but it’s somebody that’s gonna want to talk to you. They’re not just gonna wait and get a check every quarter, or every month, and you never give updates. Planning on the investor being involved when you’re doing this kind of deal structure is something you want to expect.
Justin Cook: That’s right man. Because it’s one to one and they’re gonna be wanting updates and will hopefully be able help out the operator, even if they’re not involved in the day to day.
Alright, the second one we want to talk about would include multiple investors working with typically one operator. And so an explanation for this might include: a group of investors that are looking to invest into a deal and they’re looking to have a single person ultimately running the business. What are the advantages of this is that it minimizes the risk to some degree by having multiple investors. And so there’s just less exposure per deal.You know it might be a $800,000 deal and ten people are in it $80,000 versus one or two people for the full boat. It’s also a good way to diversify income for investors and investments for investors so they can have multiple deals like this where they’re involved with multiple different parties.
It also allows operators to level up and get the benefits of growing or expanding a larger biz. Where in the first example, maybe they could afford a $300,000 deal and they get another investor that could bring another $500,000 so they’re at an $800,000 deal. It could be, they can afford $300,000 as an operator, but they’re able to get a 2 or 3 million dollar business with bringing in multiple investors. And each investor has less exposure.
So that’s some of the advantages with the multiple investors to operator partnership or structure. Let’s talk about some of the disadvantages, it might include something where you have conflict because they’re might be multiple investors–five, ten, fifteen, twenty– and those investors just generally have a different view of how the business should be run. And who should be responsible for what and how involved they should be overall.
Ace Chapman: When it comes to those kind of issues and you’re dealing with multiple investors, it’s a little bit tougher to get those personality types. Try to figure out, who does want to be involved? Who does just want to check every quarter? And who feels like they should be able make decisions in your business? When you’re doing these types of deals, having that expectation set early on is a lot more important than just the one on one relationship because you’re dealing with people that are investors. And you might have one investor that wants the go one route and another investor that wants to go another route and you may not agree with either one so as you get these different personalities involved, and different opinions, you need an agreement on how you’re going to make those final decisions and make sure that everybody is happy.
The other thing is that, the operator may not run the business efficiently. Sometimes that could just be that the operator isn’t the right person, other times it could be that you’ve got these extra distractions and you’re trying to make these decisions. And you’ve got these investors that are involved and giving their opinion as well.
And then the final is that smaller investors may want more liquid investments and they may not have an expectation of losing money. One of the toughest things with small investors, especially inexperienced investors, is that they don’t have a lot of experience investing. You know, I love working with really experienced investors because they expect, okay sometimes things aren’t going to go right. Sometimes I’m gonna have to change strategies or go left when we talked about going right. And it makes it a lot easier manage those. So when you’re dealing with those smaller investors, they may have a bill that comes up expect liquidity so that they’re getting their money back all of the sudden and then things go wrong they still expect to get their money back. So have a plan for all of that.
Justin Cook: That’s really interesting, Ace. I had an experienced investor, of course, explain the experienced versus inexperienced investor problem to me when I was looking at potentially having tons of investors get in. Like crowd source investment for these online businesses and he brought up the point, “look, if you have someone putting in 10, 15 thousand dollars versus 100, 150 thousand dollars. The person putting in 10 thousand dollars is gonna expect to be able to take that 10 thousand dollar out whenever they want. They’re expect liquidity, and if they don’t get it, they’re typically much less understanding of the fact that they can’t be liquid on that. They’re also the ones that are gonna wanna check in every week. And get an update on how their 10 thousand investment is going, where if you have someone put in 300 thousand dollars they’re likely to let it sit, and marinate, and as long as you give them quarterly reports they’re good with it.
So it’s really interesting that if you take smaller investments they tend to be more all over you and kind of more wary of locking up those investments long term.
Ace Chapman: An interesting example of this comes from a world that is not ours at all, which is Silicon Valley. Where people raise outrageous amounts of money and, you may have heard of Theranos which went for 15 years, never made any money, and also the woman that ran it was scamming people. But, the interesting this is that nobody feels sorry for the investors because it was people like Rupert Murdoch, it was the Walton Family.
If she had raised those funds from individuals that were just trying to pay feels, that would be a whole different thing. So a lot of people are attacking her are coming from a totally different perspective of just the commercial product that she put out was terrible. As opposed to, oh you stole this money from Rupert Murdoch. And then you also got interesting things when you’re dealing with investors that big– Rupert Murdoch, just like, hey I don’t want to sue you just buy the stock back from me at a dollar. He invested 25 million and it was worth it for him to get the tax right off. So it’s a different world when you’re dealing with larger investors opposed to smaller investors.
Justin Cook: Yeah, that’s a problem man. Third operating structure we want to talk about is the investor loan. This is just effectively when investors give out a loan to an entrepreneur that may need that extra cash to be apart of the deal. One of the advantages of the investor loan is the investor is gonna get fees and interest back on the deal. So they may charge some fee on terms of loan origination, just do the deal the originally and they’re likely going to charge some amount of interest over time [inaudible 00:12:09] when it’s paid back.
Ace Chapman: These are really simple deals, but of course there are some disadvantages on both sides. For the entrepreneur, the business could fail and they’d still end up owing money to the investor that made that loan. The other thing, for the investor, is if the business does fail and the borrower can’t pay that money back then he’s out of luck. And one of the toughest things when you’re an investor and you do these deals is, it doesn’t come with much recourse or much steering ability when it comes to the strategy of the business. You’re just a lender, and so you only have a right to get those payments every month or quarterly or how the agreement is structure, You don’t have any right to tell that person, even if you see them about to drive the company over a cliff, hey you need to change this strategy or give input.
Justin Cook: The other thing is, you don’t have much upside to it either. Even if you saw some amazing opportunities that the operator is kinda missing out on– I mean the fact it may just protect your investment and your return on that investment– there’s some reason to do that, but you get no upside for giving them any kind of additional contact, or benefits, or connections that they don’t have they may actually help them grow. Not as ideal.
There’s actually kind of a crowd funded way to do this that’s through a company called “UpFund.io”. So they basically will do loans on inventory for FBA businesses so the people that need the loans can go to them, kind of lay out their case, UpFund reviews it and they will offer it to their group of investors. Just full disclosure, I’ve done some investment there personally, but I can set up this auto-invest feature so it deals, they vet, once it goes through vetting and gets approved then it will take some amount of money out of my account and automatically invests it with them. And then you get your money back over time.
It’s kind of an interesting approach, just kind of a crowd funded way to do the loans there and it’s totally hands off which for me is kind of nice, but if there were any opportunities for me to actually help those businesses grow, I wouldn’t be able to do it. I’m not even connected to the operators at all. In fact, a side note, Joe and I were talking about things like UpFund and other things and in terms of what kind of conflicts guys like me would have and should we really be investing in these types of deals. And it’s something I had to stop. Not because I don’t like what they’re doing, I think what they’re doing is pretty cool, but I had to back out of that investment because Joe and I were like uh not so good.
You run into, in our industry, you run into potential conflicts all the time. It’s interesting to think about how to navigate those issues.
Ace Chapman: It is! I love what they’re doing and I think–in this space– it’s a neat thing to be able to diversify and have some things where you’re invested in equity, some deals where you are invested in the notes. So I’m looking forward to checking that out.
This last one, of course, is one that is near and dear to my heart it’s private equity funds.
Justin Cook: Yeah, man. Private equity funds are invest directly in these companies usually by purchasing these private companies. They often use leverage buy outs to acquire financially distressed companies and they’re typically a larger group with a larger pool of money looking to make interesting acquisitions and investments.
Ace Chapman: For me it is was one of those things where, you know, for probably 15 of so years people would mention, “oh you should do a fund”. The biggest thing that you have to overcome is there is a lot of legal work and so I pushed it off for a long time until a couple of years ago and put together my very first fund. The history of private equity funds is a very interesting one, if you’re ever interested in kind of going back, but it became really popular in the 80’s with leverage buy outs.
Nowadays, people use it as a strategy just to get a stronger return than you can get when you’re investing in the stock market because, as we know, when we buy the business we can get that cash flow. We’re not just waiting for good news or the stock to go up, we control the company. We make the money. We can reinvest that cash flow in other things. So the advantages here is you’ve got a group of experts that afford to manage or to hire to manage the acquired companies. The other thing is, that usually you have some requirements that you have to work with investors that meet certain SCC requirements that are basically accredited investors. Those people bring expertise because in a lot of cases they built, a couple of my investors, have built hundred million dollar businesses and so if they they’ve done that they bring some of their network as well as their expertise to the businesses you’re buying. So you can go to these folks and kind of compel them to help you with the strategies in your business.
So we talked in the first operator investor structure the benefit of having that cash, and each of these cases you don’t want to get into deals cash-strapped. And that’s part of the thing that private equity funds have the biggest benefit of is that they are able weather the storms, and you want to be able to do that in your deal structure. Not just think, oh everything is gonna go really well, and so you have a plan that’s based on making money forever. Not a plan for, okay where do I get cash if I have to go a few months and things aren’t working correctly.
Justin Cook: Yeah, structuring through a private equity fund typically is– we’re talking more money here. We’re talking a very carefully laid out structure as opposes the typical operator investor partnership or structure, right? So there are a lot more legal requirements. There’s typically less control or direct input by the investors because they’re part of a fund. So sometimes they can be leaned on for expertise, but that’s typically not part of the deal, even when it could be. So when those funds are put together, thinking that through is helpful.
It’s funny you mention Albeiz from the 80’s, I don’t know if you know or not. Have you ever heard of that Dan Payne guy?
Ace Chapman: Absolutely, of course.
Justin Cook: Have you met him? Have you every worked with him?
Ace Chapman: No, no, I’ve never met him. I’ve had some clients that have gone to his–I was about to say mansion–a castle in Scotland for trading.
Justin Cook: Yeah, that’s a crazy, crazy dude, man. I did a Podcast interview with him on [inaudible 00:18:40] quite a while back and he’s just a really fascinating guy. Really harsh, he really bites, but you know he kind of beats people up. I think a lot of the kind of younger generation he’s talking to kinda needs that, and maybe it helps them kind of whip them into shape. I sound like an old guy now, “you need to whip these young whipper snappers into shape”, but that’s kind of the approach that Dan takes. Older guy kind of like beats them up a bit. That’s how he made a bunch of his money back in the day was through leverage buy outs and putting teams together so it sounds somewhat eerily familiar to what you’re kind of talking about here, you know, with kind of these smaller companies. He was doing them with much larger businesses, but it can be done with these six or seven figure deals as well.
Ace Chapman: Really the idea here is the same thing that we’ve been talking about with the other three structures. It’s being able to get into a larger deal with more capital. You’re leveraging your time, your expertise into something where if it does have a 20% uptick instead of it being on the 100 thousand dollar business, and now it’s worth 120 it can be on a million dollar business and now it’s worth 1.2 million. And so those numbers do make a big difference the larger you get and [inaudible 00:19:52]. If you have that one amazing deal and you bought that 20 million and it two, three exes then you’re done.
Justin Cook: Yep. Alright man, let’s do a kinda wrap up on this episode. The first operating structure we talked about was the single investor operator. These are typically the most common. You’re going to see more of these, and you’re going to see more opportunities in this space, And usually, the operators are searching for investors, but there are also some savvy investors that are out there looking for deals as well. You might find them on Angel, investors out looking for those deals. I have friends that are doing it in this space so they’re out there as well.
The second one are the multiple investors where they’re sharing the risk and allow for the kind of smaller individual investments instead of the 500 thousand dollar investment, you’re talking about a 50 to 100 thousand dollar investment. And we’re talking about larger purchases. One of the problems with multiple investors is that you have more moving parts, right? There’s more investors, there’s more investors interest and worries that you need to be taking into account.
And then we talked about loans. Which loans can help operators avoid giving up any equity. UpFund.io is a good example of that, but a lot of times from the investors perspective it’s just a note. They’re just getting their percentage. They’re not getting any equity in the longer term deal so in terms of really devoting resources to it, it’s probably not as worth it.
And then the last one we talked about were private equity funds. We talked about how this can diversify the portfolio overall. They are typically large enough and have enough money and enough spread to bring in a real professional, and that includes both the operators, but also the tangential kind of like professionals that are involved: lawyers, accountants, Facebook Ads has experts that kind of thing.
Ace Chapman: Yeah, I am a very big fan of just getting access to the people that you need to make a deal, not just work, but just exponentially grow.
Justin Cook: Alright man, so we talked about these 4. These aren’t all happening at the same rate in our industry right now. I said the investor operator is definitely the one that is more common. I think because it is the simplest. Where do you see over the next 2, 3, 5, 10 years our industry going? Are we going to see kind of more of this, and what are the impacts on the industry?
Ace Chapman: Yeah, I’m excited about the third and fourth just because that’s gonna have the biggest impacts on the industry. I think we’ve seen together, especially in these last ten years just the uptick every single year and the number of deals that come available for sale. I think a lot of it will depend on that. So I think you’ll have companies like, you mentioned UpFund, but you’ll have companies that may be a service based companies that help out people that are just running an FBA business and just want to get access to capital. But then, as a side effect they are also a great tool for somebody whose in this world of doing acquisitions and buying or selling those businesses as an alternative way to fund that. And so that’s what I’m really interested in, is to having, right now in the last few years SBA is willing to lend on these deals. Having these services like UpFund. Those kind of things, making this a more normalized asset where you can get the services that you need, and the capital you need, I think that’s going to be exciting. And as we get more of these deals that are out there, the demand is there to make it legit for those companies to exist.
I think we’re a little bit aways from seeing large private equity funds enter the space just because there aren’t enough options in deals. So I’m excited to see guys like you increasing the number of deals that are available for us to come by.
Justin Cook: [inaudible 00:23:39] Some of our main priorities at our company right now is: how can we get better deals, more deals, more deals on the platform so something to focus on. And the more that we get, the more opportunities become available for investors, and for investor operator and multiple operator structures to be set up and realize. I think number three, in terms of investor loans, I think the crowd funding platforms to do deals is really interesting. That’s why I mentioned UpFund, but even the more traditional hard money investors. What’s interesting about that is the SBA’s it can be a real challenge and there are areas where they don’t operate. For example, anyone that is not an American citizen on the sales side so just being an non American citizen disqualifies for SBA so deals that would otherwise be SBA approved that aren’t because of a specific issue, I think there is a lot opportunities to invest in those types of deals.
I also think that I agree with you, the private equity fund on like a smaller scale, the kind of private equity fund like that you’re setting up and other’s are setting up, I think is doable. I kind of agree with you that the large private equity groups, for them to move down– some of them are and some of them are moving down to the 7 figure deals from like 8 and 9 figures and they’re moving in the 7 figures– but I don’t know if they’re going to keep creeping down because I don’t know if it moves the needle for them. Generally, as they grow they have a larger and larger portfolio so going down market just doesn’t make a big enough difference to the big picture for them. Do you know what I mean?
Ace Chapman: Yep, that’s the key there is not deal with it in my fund all the time where we look at a deal, and it’s an amazing deal it’s just not right because just the size we’re looking at we need a certain return on the whole portfolio. So if I need to put even a little bit time into this small thing, it just isn’t worth taking the funds resources and putting it in. So I can only imagine what those guys, you know I have a tougher time doing some of the smaller deals and lower center figure so with a larger fund it just becomes a tough thing outside of just experimenting and dabbling.
Justin Cook: Yeah, with a 10 or 20 million dollar portfolio, like with a 500 thousand dollar deal it still might make sense, but with a 500 million dollar portfolio, you know a 500 thousand dollar deal just–even if it quadruples– is like, oh it doesn’t really matter.
Ace Chapman: Yeah
Justin Cook: Alright man, well that’s it for this episode. If you dig it, please head over to webequityshow.com and leave us a comment and let us know what you think. You can also drop us a review on iTunes ane we’ll really appreciate it. We’ll be back with another episode where we dig in on how to grow and expand your portfolio. See you next week.
Ace Chapman: See you guys next week.
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