Royce Yudkoff 与 Rick Ruback：收购式创业——[Invest Like the Best，第423期]

Patrick O’Shaughnessy

My guests today are Rick Ruback and Royce Yudkoff. Rick and Royce are Harvard Business School professors who teach their students how to search for, acquire, and run small businesses directly after graduation. It’s nuts, but it’s been almost a decade since our first conversation, and unlike many past interviews that become outdated due to technology or market changes, the core principles they shared about entrepreneurship through acquisition remain remarkably relevant today.

They explore fascinating developments in the search fund ecosystem, including the bifurcation between funded searchers targeting larger companies and self-funded entrepreneurs finding success with smaller businesses. Rick and Royce share their accumulated wisdom on what makes a company worth buying, why the magic is in the multiples, and how their students consistently achieve impressive returns through patient, value-oriented business acquisition.

Please enjoy my second great conversation with Rick Ruback and Royce Yudkoff. So, Royce and Rick, it is so fun to be doing this with you both again almost 10 years later. As I was reviewing our first conversation, which was one of the most popular very early on in the Invest Like the Best story, one thing that’s quite funny is that, if you look at the interviews around it, many of them are now irrelevant in the sense that the observations of the guests have evolved so much with technology or market changes or whatever that they’re not all that useful.

Whereas yours, when I listen to it, you could argue we could just republish that one and capture a lot of the spirit of the power of entrepreneurship, entrepreneurship through acquisition, and investing that you teach and advocate for. I think that’s so cool. I’m so excited to do this with you both again. My opening question, with that observation, is: What has changed the most in the last 8 to 10 years in your class, in your students, and in the people that you back with financial capital and strategic help? What are the things that have changed since our first conversation in 2016?

Do you want me to take a crack at that, Royce?

Yeah, you go first. I’ll add some if I have anything.

1. The New Search Fund Economics

Okay. When we talked in 2016, nearly a decade ago, first of all, I had hair, so that was a big difference.

Patrick O’Shaughnessy

You look great.

Thank you. But aside from that, one of the things that has really changed is that the small-firm space, the small-firm acquisition space, has really bifurcated, with the funded searchers really moving upmarket into much larger deals. The averages keep moving around, but think $20 million of average total enterprise value.

The unfunded, or self-funded, spouse-funded, or family-funded—whatever you want to call it—searchers don’t take investor money at the time they begin their search. Those unfunded deals have actually gotten a little smaller. People have discovered that there are great opportunities buying below $1 million of EBITDA, thinking, “What if SDE is $600,000? Can I get by? Can I grow this business?”

We’re finding more and more students buying smaller businesses at lower multiples—think 3 and 4—and other students going in the opposite direction, buying much bigger companies at much higher multiples—think 6, 7, and 8. So it’s really bifurcated in a way that I wouldn’t have predicted 10 years ago. Royce, what would you add to that?

First of all, I agree that that’s the major change. I’d just like to spend a moment adding to what you said and then offer one additional change. In the United States, we have this amazing opportunity created by the SBA loan program, where every American citizen has the right to borrow up to $5 million in this government-backed loan program. That allows them to buy an established, proven, profitable business with up to 80% or 90% leverage.

That, in turn, enables these acquisition entrepreneurs to line up the equity they need, give it a very attractive return, and own 70% or 80% of the business, even though they don’t have any capital besides their sweat equity and talent. To Rick’s point, that’s proving to be an attraction to many very talented people.

The other less important change I’d add, but one that’s still notable, is that when Rick and I started teaching 15 years ago and through 10 years ago, everyone who went into our Entrepreneurship Through Acquisition program wanted to be an entrepreneur and run their own company. More recently, we’ve seen a minority stream—but a meaningful minority—of people who look at this opportunity as independent sponsors. They go into it, they don’t want to run a company, but they want to buy a series of small companies and put managers in place. Rick, I’d say that’s a change. It’s not as important as the one you mentioned, but it’s certainly notable.

I think that’s growing because people are saying, “Wow, I don’t want to pay 8 times to buy a $2 million EBITDA firm. So maybe what I’ll do is pay 3 times and buy three $600,000 EBITDA firms,” or something like that. They’re buying low, and sometimes there are synergies and roll-up potential, but oftentimes they’re just running three separate companies. They’re getting critical mass, diversification, some drive, and an opportunity to apply their talent. So it’s pretty exciting.

If I could add just one other thing, 10 years ago this career path was viewed as quirky, to pick a word. Royce may have a better word, but quirky. We used to say jokingly to students that we would get calls from their parents, and they would say, “What did you do to my kid? My kid graduated from a really good undergraduate school, had 5 years of really good work experience, and now they’re sitting in their pajamas all day, staring at a computer screen with headphones on, sort of talking to themselves. Is this a depressive episode? Is this some sign of a psychotic break? Do we need to get our child, man or woman, therapy?”

Because it was such a quirky and unusual career path. Now it’s become a much more traveled path, and our students can look back, whether they’re men or women, veterans or English majors, engineers or private equity people in their former employment, and always say, “Wow, there are literally dozens of success stories that I can look back on.” So it has now become a well-traveled and more acceptable path.

Patrick O’Shaughnessy

Can you help frame for those listening the sort of risk-and-return statistics that you’ve observed in this world in totality—in the entire history that you’ve been involved with it—but maybe even specifically tuned to, say, the last 10 years? The whole roll-up thing really has become a thing. What is success in terms of returns and duration in this world compared to other available uses of capital that are out there today?

For a searcher, there are 2 big risks. One big risk is failure to find, and the other big risk is buying a really terrible business. The first risk is that you might spend 2 years of your life bouncing around from one thing to another, and you just never get a deal done.

It could be that you’ve had 2 signed LOIs, both deals are broken, and that happens probabilistically to some fraction of deals. The due diligence doesn’t work out. The seller decides in the end they don’t want to sell. The results turn out to take a nosedive during the due diligence process, and so there needs to be a price adjustment. The deals fall apart.

I would say the failure-to-find risk is a real one. It’s really interesting because there are different views on what this failure-to-find risk is statistically. For the bigger funded searches, that number seems to be bigger than 50% suddenly, right, Royce?

Yes.

And that’s really a change. It used to hover around one-third, but now, because people are buying bigger companies, as we talked about before, they’re competing head-to-head with strategics and private equity, and they don’t always win those. They don’t have the lowest cost of capital, so they have to be bringing something else in to win those battles.

Those numbers are pretty high, the failure-to-find rate. I would just say, on the unfunded searchers, if I could, the failure-to-find risk seems to be much, much smaller. It seems to be less than 25%.

Royce and I like to think that it’s because our students are just better educated. They’re better searchers than the people from that other institution on the West Coast. Who knows? But they’re looking for very different things. They’re not looking for high growth. They’re looking for boring businesses that have steady, recurring cash flows—businesses that have sustainable profitability. Enduring profitability is the term Royce and I use.

So it’s a very different business. You’re not growing at 30%. That’s the one risk from the searcher, failure to find, and it depends on what you’re looking for. On the getting-stuck-in-a-bad-company thing, that may be the bigger risk. It actually doesn’t happen very often, in our experience.

Certainly, there have been deals where entrepreneurs have worked really hard and not made a lot of money in the deal, but generally it’s because the world has somehow changed, not because the business they bought was fundamentally bad. It’s an oil service business that’s purchased just as oil falls off a cliff.

Generally speaking, though, I don’t think people are buying bad businesses, because I think it’s hard to buy a bad business, get it through the due-diligence process, and get it financed both through the banks and through equity holders. I think investors provide a pretty good gatekeeper against getting stuck in a bad business. I can’t say it never happens, but it doesn’t happen as often as you might think.

Now, from investors, Royce.

From investors, I’ll break it into 2 groups. In funded search, Stanford has done a good job of tracking returns on funded search through an annual study report they’ve done since forever, and it’s shown that the returns to investors are in the low 30s in terms of IRRs. If you compare that to big private equity, the average returns are in the low to mid-teens, so it’s a huge premium you get from being in this market.

We think those numbers are slowly trending down a bit, but they’re still way above the closest asset class, which is private equity. In self-funded search, where you have these students raising money to buy $1 million-ish EBITDA companies—$1.5 million—and buy them at 4× and finance them at 80%, the math is just extraordinary.

If you buy something for 4×, you’re generating a 25% return on assets before any growth. You lever that at 80% with, say, debt that costs 8% or 10%, and the return is astronomical. You pay your investors a portion of the common equity that gets them to a targeted return of 35%. That’s the market-clearing price in self-funded search, and the searcher is able to keep 60% or 70% of the common stock for themselves.

So deals are smaller, but the rewards are high. That’s the kind of math. The one other point I’d make is on risk, particularly on the self-funded side. You’re buying at multiples that are so low that generally, even when things don’t go right, the cash-flow yield pays down the debt very quickly and mitigates a lot of the downside. So it’s a pretty good trade. You can see why people get interested.

It’s hard to get a zero.

It is hard to get a zero.

Unlike private equity, it’s hard to find a great many instances, particularly in the unfunded market, where investors lose their capital. It just doesn’t happen very often.

I would say, in the funded market, the other thing that I find interesting—and I’m not sure about this; this might not be true, but I have the impression—is that it’s become much more of a venture-capital play than a private-equity play. I think about the way VC portfolios work. You guys are smarter and know more about this than I do, but I think the way VC portfolios work is, you have 10 firms in a fund, and you want 1 of them to win and maybe another 1 to break even. If you end up losing all your capital in the other 8, it’s not the way you wanted it, but you’re still going to have pretty good results.

Private equity is very different from that. Of those 10 firms in the portfolio, there may be 1 that has some loss of capital—usually not 100%, but some loss of capital—4 or 5 that might break even, a couple that do okay, and maybe a couple that do very well, but not astronomically well. Is that fair, Royce?

Yeah, I think that’s fair, Rick.

Unfunded search is very much like private equity, maybe even on the safer side than private equity. Funded search is really starting to feel like VC investing to me.

Interestingly, Patrick, one of the things that’s changed a lot since we talked 10 years ago is that much of funded search is occurring through institutional investors, but rather small private-equity funds that specialize in search. They’re increasingly dominating funded search, and that’s a huge change.

So they’re looking at it at a portfolio level, much like a venture-capital fund looks at it at a portfolio level, so it’s very different. If you’re an investor who’s thinking about investing in 1 or 2 of these, either invest at the portfolio level in one of these funded-search portfolios or invest in an unfunded searcher whom you know and love, somebody you know well. But not buying a portfolio of these is potentially a scary investment.

One of the things that obviously jumps off the page with those numbers that you quoted, Royce, is, if I can earn a low-30s IRR fairly consistently, how is there not—forget the institutions—an unbelievable supply of family-office capital or individual capital?

It is flowing.

Your surmise is exactly right, Patrick, and Rick’s comment is exactly right. It’s funny: We started this podcast by saying maybe there hasn’t been much change, but indeed there hasn’t, like all your other interviews, Patrick. Rick is right—it’s flowing.

When we look at the market today, there are more investors who want to get behind talented, well-prepared searchers than there are well-prepared searchers. So the choke point is the number of searchers, even though that’s grown quite a bit. There has just been a huge flow of capital.

This is an odd thing. This market is so illiquid. It’s really hard to find good companies to buy with recurring revenues—what Royce and I think about as value-investor plays—recurring revenues and enduringly profitable companies. They’re so much harder to find and transfer than you would imagine that I think that’s the bottleneck.

I think there’s a market equilibrium going on here. There are searchers, investors, and sellers. There’s a whole bunch of information costs everywhere because it’s a very fragmented market, and I think that keeps it down.

What’s interesting, fascinating to me as an economist and as an investor, is that, at least on the low end, multiples have not been driven up. If you want to buy a firm with $750,000 of EBITDA, that’s a pretty good recurring-revenue business without a lot of customer concentration, you can still do that for 4×.

You probably can’t buy a $2 million or a $1.5 million EBITDA business at 4× anymore. Maybe you could have done that 10 years ago. But you can certainly buy the sub-$1 million high-quality business at 4×.

So if the constraint is companies worth buying, it’s the right time to talk about what those criteria are that you teach your students for what makes a company potentially a good acquisition target. I would love you to riff on what those criteria are, how you arrived at them, and how they’ve evolved, in as much detail as you want, because obviously it’s an incredibly important part of the consideration.

2. The Acquisition Checklist

Not on our list is growth. Not because we’re against growth—we welcome growth—but you don’t need growth in this market because good companies sell at attractive prices. Rick came up with this expression that we’ve both embraced, which is, “The magic is in the multiples in this market.”

If I were to go through the list that Rick and I iterate, the first one is recurring revenue. We really want high-quality revenue. There are all types of recurring revenue, from contracted revenue that’s impossible to pull out to revenue that repeats actuarially, but we want very high-quality, predictable revenue so that when you show up in your office every January 2, you know that 80% or 90% of the revenues from last year are going to repeat this year.

It gives you great stability, it pairs nicely with financial leverage, and it allows you to be on the offense in marketing, meaning that all of your marketing time is basically spent growing, not replacing. So that would be one.

Low customer and vendor concentration would be number 2. That doesn’t occur so much in big private equity, where you’re dealing with big companies, but it occurs a lot with small companies where they have 1 big legacy client. You really want to try to avoid concentration with customers or vendors.

Third, avoid economic cyclicality. Again, it pairs poorly with the financial leverage you’ll need to buy this. Rick, are there others you’d want to put on this list?

Well, I think you need to buy a business that you can manage. I like to say, “If you’re allergic to fur, don’t buy a pet shop.” I mean that to be emblematic of a whole bunch of things.

There are so many businesses I could not run. I could probably run a landscaping business, but I don’t think I could run a biotech. So I think you have to have a business where you can use your talents or develop the talents to run it. You don’t have to know the business. You don’t have to be an expert in whatever the business does, but you have to be the kind of person who could learn that.

To Rick's point, often we have people express astonishment to us that a newly minted MBA who has maybe 5 or 6 years of middle-management experience can go into a business they've never operated in, and the percentages are very high for successful operation of that business. How can that be?

The reason it can be is partly that they're talented, energetic people, but it's the point Rick has just made: they're selecting for businesses that they feel they can fit with and learn how to run. They're not randomly picking businesses on this dimension. They're choosing very carefully because they're aware of that risk, too.

Right. Who ends up buying the blue-collar businesses from our students? It's usually the people who were captains and lieutenants in the Army and the Marine Corps. They're used to managing blue-collar workforces.

Right. And when we call them, they say, "It's just like running a platoon."

They say, "Well, we're running the company," but they have a different sense of what a company means. Anyway, I would add that you have to be able to run it.

The other thing that's increasingly interesting—I don't know if this is a millennial thing or not, because I certainly cared about this when I was looking for a job—is that people care deeply about where they want to live. I think Royce and I are not convinced—me, maybe less than Royce—that you can run businesses purely remotely.

I think just being there, walking through the shop floor, talking to people at the water cooler—I think all that belly-to-belly management, if you will, is really essential, especially if you're inexperienced and young and learning the business at the same time. The idea that you can buy a business in Mississippi and run it from your ski lodge in Colorado just seems incredible to me. Although I wish it were true, I don't believe it's true.

Often our students are worried about where the business is. So they're worried about the quality of the business, and they're also worried about where the business is. Then, does the business meet their criteria in terms of what they could personally manage? So it's complicated. It's fascinating.

We have this project where our students look at companies that have been for sale in the recent past or are currently for sale as part of their project in our second-year course, and that's ongoing now. We recently had this day, Royce. Tell him about that. I thought it was so interesting.

What Rick's referring to is that we assemble a library of recent small-company purchases from a network of cooperative brokers. The students filter through those and then come up with a company they really like. Then they break into groups of 6 or 7 of our students who have done the same thing, and they collectively come up with which is the best company to buy. So you have 14 or 15 groups now in our class.

And about 100 companies. About 100 sims that they've paged through and looked through.

The result is that they come up with about 12 different companies. There's no consensus on this. They're different.

Right. You'd think that there would be 1 great company, and everybody would say, "Oh, that's the company I want to buy." No, that's not what happens. Beauty is in the eye of the beholder.

Yeah. I think on this point, we arm our students with this list that we've just gone through. It's a filtering criterion. But the truth is, you're never going to find a company that has all of those boxes checked, particularly if an attractive price is on the list, too, which it surely is. You're just not going to find companies that have all of those qualities.

The piece that we really try to tune our students into is that they have to develop judgment about how good is good enough. They do that by, as Rick and I like to say, bathing in deal flow. Eventually, you start to see what different qualities of companies are, and you see that next company and say, "Okay, it has 5 of my 7 criteria, but it's in the upper quartile, so I ought to keep working on this because this is a good one."

That's the other piece that's really hard to teach, but you can teach people to keep their eyes open to judgment.

How concentrated is the supplier base of capital—the investor supplier base of capital—for these searchers in the major ecosystems, with Stanford and HBS being the big 2? I have heard, if you ask around, that a very small group of people has almost like an unofficial ROFR on investing in the great searchers coming out of these institutions.

That would seem to make sense to me. If I kept earning 35% returns for decades, I would sure want to plow capital back into the next batch of searchers. Is this accessible? If I want to do this, could I go do it?

I mean, first of all, you need to have capital to begin with—the academic problem. But I think it's a pretty open market, and the reason I think that is that our school—our institution, Harvard—sensibly has very strict rules about relationships between faculty and students, particularly while they're students.

So we can't even implicitly acknowledge that we're interested in investing in a student, no matter how much we like them or how much we like their business plans or how sure we are of their success. We always tell them the same thing, which is, "We're not allowed to even have a conversation with you, but if you're interested, reach out in May after graduation."

What we find is that every year there are a few students who like us enough to wait until May to see if we're interested, but a lot of students get funded. If they're looking for search funding, they're doing it before that, and if they're funded, they don't need funding. When it comes time to fund, they usually give us a call.

What we discover is that often they don't need much equity capital, and they're able to get it either from section mates, family friends, or former employers. There's an advantage to having smart money, but there's an advantage to having less-smart money. These investment opportunities are not just dribbling off the trees.

The way most searchers like to structure their cap table is that they like to have 10 or 12 different investors. Some investors push really hard to get a big chunk of the cap table of these funds for the reasons you asked about. But for the most part, searchers want a diversified base of investors for a variety of reasons.

They want a variety of advisers and voices. They want to diversify who owns their business. So that naturally invites a dispersion among investors. I'm with Rick: I don't see the Harvard and Stanford searchers as dominated by 2, 3, or 4 big institutional investors.

3. Search Funds Go Mainstream

I was going to ask about spillover. Originally, this concept was very localized at Stanford and Harvard. It's gone to lots of other schools, as you said. Has it also spilled out of the academic community entirely?

Yes.

Maybe talk about that a little bit.

Rick and I, since we launched our podcast a couple of years ago, which is really directed beyond the business-school campuses, have become more tuned in to what's going on away from the MBA ecosystem.

That's a world which, unlike the business schools, is overwhelmingly self-funded, using SBA loans and tuning into smaller businesses—those kinds of $750,000-to-$1 million EBITDA businesses that Rick was describing. That world today dwarfs what we talk about in the MBA world.

It's actually got its own population of individual recurring investors writing quite small checks for the reasons of the math we discussed earlier. It's got many times the number of participants, all of whom are able to get this favorable government-backed financing, line up investors, buy these attractive businesses at low multiples, and often don't have MBAs but have a lot of useful professional experience or are just outside those top MBA schools. It is a big, big place out there. Rick, would you add anything to that?

Yeah, I would say I agree with every word you've just said. I run into unfunded searchers everywhere. I coach little kids' ski racing up at Mad River Glen, a really small mountain relative to corporate skiing these days. The other day, I was having lunch and realized that there were 3 people I could throw French fries at who were searching for businesses at some stage of conducting self-funded searches.

It was a little place in Vermont. What are all these people doing there? It's just everywhere. So it's become mainstream, and I think the reason it's become mainstream as a career path is that you can build the life you want to live, earn a great living, and have independence in a way that you just don't get from a boss.

There maybe was a time when working for a big corporation had this safety to it, but I think that's pretty much gone. I think people recognize that you can work for your big company for 25 years, and they can eliminate your division or send it to South America or Asia or whatever, and you're going to be out of a job.

We like to distinguish between the risks you can see and the risks you can't. When you're running your own business, you can see those risks. When you're working for a big company, you can't see those risks. They just happen to you.

4. The Coming Seller Wave

Maybe say a word about what drives the trends and what drives the availability of these businesses for sale—the sellers, who they are, and where they come from. My suspicion is that a lot of this is baby boomers who built their businesses and are now ready to sell them without some other option that they prefer, and we know the stats about how big that generation was and how many of these companies exist.

If you compare the next 10 years to the prior 10, do you think the supply side of the story is better? Will there be more of them that are more fit to be bought?

What trends do you see, if at all, in the base of companies and in the motivations of the sellers?

I think your description is exactly right, Patrick. The seller who is at the center of the bullseye for searchers is someone who is an expert in a product or service, started their business, spent 25 years building it, and now is 65 years old and has run the business for 20 years.

Several things have changed. One is that the business has gotten larger, and at the top, it no longer needs an expert artisan. It really needs a trained manager, and this person isn't that in most cases. If it's a blue-collar business, maybe it was an HVAC guy who got fired, bought a truck, and built up a business. It makes $1.5 million a year, but it really needs a manager at this point because it employs 60 people and has lots of customers.

Second, the business is at a size where he really doesn't have an understudy CEO. It's not like a larger company, which has a thick bench of talented middle managers. He or she needs someone who can not only organize the capital for the transaction but can then step in and run it because there is no internal successor. If there were, they could retire and just keep owning the business. Some businesses are suited to that, but most businesses aren't.

And the third thing is that they've reached an age where, as Rick and I like to say, they now have more money than time, and they're behaving accordingly. They don't want to work Fridays anymore to launch a new territory, but a searcher who's not wealthy, energetic, and hungry does.

And levered.

And levered. So this is the catalyst moment. This is why these sellers sell to searchers, and this is why the searchers see opportunity there. But Rick, I don't know if we have a view that somehow we're at a peak of supply.

That's a really interesting question. I think if you go back to the world before COVID—you've heard of COVID—the world before COVID proceeded in an orderly fashion, as much as the world ever proceeds in an orderly fashion. I think lots of baby boomers who owned businesses got to the position where they said, “Wow, COVID's been really bad for my business. COVID's been really great for my business. COVID's really disrupted my business. I need to wait and see what's going to happen.”

For the businesses that did really poorly, some of them bounced back. For the businesses that did really well, some of them have bounced down. So they're still juggling. They're still looking for a steady state.

When you go to buy a business, you want to look at 4 or 5 years of prior cash flows. That's going to include COVID still. There has been enough movement in results—just COVID-induced movement in results—that I feel like there have been a lot of sellers who are just treading water. “I'm going to wait till next year. I'm going to wait till next year. I'm going to wait till next year.”

One of the sad things about waiting for next year is that things don't stop happening. You've got tariffs, you've got inflation, you've got all kinds of crazy things that happen in the marketplace. While small firms are probably less impacted than the big public firms, it does boil down.

I think there are lots of sellers who are waiting and waiting for times to settle down. And, of course, I don't know—do things ever settle down? I don't know. I think there are a bunch of sellers who are now reaching the end of their patience and health and are going to become more interested in selling as time goes on.

So I think what you're going to see is—luckily, we'll never know if these predictions are true—I don't think the Patriots are going to win the Super Bowl next year. I do think the Celtics will win the NBA championship. And I do believe that there will be some surge over the next 3 or 4 years of pent-up selling, and then it will go back to some steady-state level. But there are a lot of businesses out there that need to transition.

5. Durable Sectors And Outliers

I have lots of questions under the umbrella category of technology. The first is related to the types of businesses that you do and don't see people buy, and we have such a big sample now. I'm sure there are some central tendencies. You always hear roofing or HVAC, or stuff related to the home or basic things where in 10 years there will still be roofs, and probably an AI won't install them. If it does, all bets are off.

Do you ever see people buying more traditional software- or technology-driven businesses as searchers at all? And maybe just say a word about the central pockets or tendencies of the kinds of businesses that meet the 3 or 4 criteria that you laid out earlier, and what doesn't, despite being important businesses.

There are certainly people who buy software businesses. What we find, though, is that they tend to buy niche software businesses. They're software for podiatrists. They're software for small municipalities. They're things where you're unlikely to get big disruption and unlikely to have these cataclysmic shifts. So it's software where the underlying market is fairly steady.

What we don't find—or, at least, if we find it, we throw it away really quickly—is people investing in very fatty software, the latest computer app or social media, whatever it is. So there's less of that. But there is, if you will, the business of established software: improving it, growing it, maybe migrating it to the web, while the market is niche. That seems to be a pretty sustainable investment thesis.

I agree with that. And dealing with the other part of your question, Patrick, when you list off the businesses that you did—and Rick and I could list more, but just for our listeners—roofing, HVAC, veterinary services, there are a whole series of these that have attracted the interest of searchers.

When Rick and I look at them, the services are all different at a superficial level. You're fixing your roof or you're taking care of your dog. But when you look beneath that, the reason searchers are attracted to them is that they all look alike when you're looking at the economic characteristics. They have recurring or reoccurring revenues and a very diverse customer base and vendor base. They're not economically cyclical because you have to purchase that service when something prompts it. That's why searchers are drifting into these areas.

It turns out that, amazingly, despite all these smart people looking for these opportunities, every year or two there seems to be a moment of epiphany: “Oh my goodness, there's another area. There's overhead garage doors,” or, “There's automotive repair.” A new area becomes hotly pursued, like HVAC began to be 5 or 7 years ago. I think it's these businesses with these characteristics that are being unearthed.

Sometimes what they're doing is bringing management talent and skill to a segment that didn't have that management talent and skill. We just did a podcast with one of our former students, Logan Leslie, and he's doing a roll-up of auto repair facilities.

What was fascinating is that it used to be what would happen is—you can imagine, think about an 8- to 10-bay automotive repair facility—the way this gets started is somebody starts repairing vehicles, and the person is probably a pretty good mechanic and pretty good at repairing things. As the place gets bigger, suddenly you're hiring and ordering and doing accounting and doing a whole bunch of back-office stuff.

Then, as you get to a certain size, the founder is no longer pulling wrenches and changing water pumps. All they're doing is management activity. They might be fabulous mechanics, but it's unlikely they're both a fabulous mechanic and a great manager.

What Logan has done is said, “Let's let the fabulous mechanics be mechanics, and we're just going to take the management piece and do that centrally.” It has been a fabulous success and really clever. And as Royce says, it is an application of the same idea, whether it's veterinary services, concierge medicine or apparently automotive repair or HVAC. What you're doing is allowing enough specialization for management talent to bloom.

One of the things that we've been studying recently is Asurion, thanks to a project with Will Thorndike covering that company. It makes me wonder how often you've seen what I'll call an extreme outlier, venture-type multiple-of-capital outcome from this space, versus the lower-variance, whatever the 33% a year for 10 years math is for MOIC.

How often are you seeing true outliers emerge from this style of investing, in that bizarre category of Asurion, which you could put up against any venture investment of all time?

I would say that's extremely rare. What's not rare is that if you persistently invest in this space, you will get money multiples of 3×, 3×, 3×, 3×, 8×, 3×, 3×, 3×, 10×, 3×, 3×, 3×, 7×. You can make a living doing that. That's really okay.

You might have some 1×s mixed in there, too.

Rick's right. You'd have a few 1×s mixed in there, too, but I think that is much more representative of the space. I think any private equity firm in the world would love to hang its hat on those kinds of multiples of invested capital.

One of my favorite lines of yours, Royce—I think you said this to me—is that the lower middle market is the only industry in the world where your best competition leaves every year.

Yes, that's right. I did say that.

Can you talk a little bit about that observation and dynamic?

It's the nature of the professional investment management industry that you're basically paid very much by the amount of money you manage. And so you enter at the bottom end because usually you can raise a small amount of money, because that's a very fruitful part of the market. Those people who go in there and do a great job have more money offered to them, and they raise a larger fund.

And to make sense of that portfolio, they buy bigger companies, and so it goes. The most talented teams just move up in assets under management, move up in investment size, and leave the space that they were so good at, making it available to new entrants in the market. It happens in no other industry, right? Coca-Cola executives don't wake up and say, "Oh, we've done a fantastic job here. Let's make garden furniture and give this up." But private equity does that all the time.

Yeah, it's a fascinating dynamic at play, which I guess makes it an evergreen opportunity set. Back to thinking about the companies, I'm curious what the most common subtle red flags are that, through pattern recognition and just seeing a million of these, through your students and directly yourselves, you've built up over time.

I'm not talking about the obvious ones, like terrible customer concentration or completely nonrecurring revenue—the opposite of the things that you've said—but more just the little ones, like, "Ah, watch out for this thing or this thing." Maybe we'll call them yellow flags, not red flags. What are some of the most interesting things in that category?

I'd say it's a job, not a company. You misjudge something about the owner-CEO, where it's a set of personal relationships or personal expertise that's really driving the company, and it's not really a business. It's too much her or him. That would be a red flag that you don't pick up in the numbers.

I always focus on the ability to get the deal done, because no company is very good if you can't actually get a transaction completed. For me, the biggest red flag is multiple owners. If you have an owner in their 70s and another one in their 50s, and the owner in their 70s has been working on the sale, there's just an unbearable probability that when the person in their 50s finds out or understands what the transaction really means, they're not going to sign.

And you can go months and spend money on QoE and attorneys, write asset purchase agreements, and feel like everything's going great, because you're only communicating with the partner who wants to sell. Everything's going really well until it just never closes.

That's a great one.

I hate that. Committed sellers are at least as hard to find as good companies. You really need to pay attention to why people are selling and whether they really are selling. And if you have more owners, you have more places where you can fall off.

Here's another one. This is really unique to small firms. In small firms, the owners, to some extent, live inside the company. It's routine that, in a $1.5 million EBITDA business, the owner is spending $100,000 on personal expenses and running them through the business.

As a buyer, that's his decision. You're going to add that back to EBITDA because it's really EBITDA spent in another form. That's just common. I'm not making a moral judgment on it; it's just common.

But what you have to watch out for is that sometimes you see these companies where the owner has just gone wild, and there's a gigantic amount of living within the company. It's not 5% or 6% of EBITDA; it's 50% that's getting added back.

And the issue you have to start thinking about is not even documenting that to make sure it's true. It's that if this person is so willing to take those kinds of risks and color outside the lines, how is he going to treat you as the buyer? No matter how much due diligence you do, the information advantage is asymmetric and in the seller's favor.

And so, at some point, you have to say, "There's an ethical question here that could stab me in the chest." That's a small-firm thing. You don't encounter that when you're buying shares of Microsoft or dealing with companies that go into big private equity firms.

It brings to mind the question of the same accumulated pattern recognition of what people do well that helps them close transactions, whether it's negotiating tactics or just communication style, or methods or processes that they follow. Have you learned anything about just increasing the probability that, once you have a deal, the transaction itself closes, something that you've observed in your students?

Well, weekly communication helps a lot. You need to have a meeting. I like to have them on Wednesdays. The reason I like to have them on Wednesdays is that you get Monday and Tuesday to cram, to get the stuff that you promised last Wednesday done.

And so does the seller. And so does the seller.

And so does the seller. You get Thursday and Friday to actually do it in an orderly fashion. So I love Wednesday meetings, but you need to have a Wednesday meeting where you say, "What's going on? Where are we at? You were going to do this. I needed that last week. The banker needs this. The lawyer needs that," whatever that is. So that's really helpful.

The other thing that's really important—and this is so hard, what I'm about to say—is that you want to pay a price that allows you some margin of safety for due diligence surprises. In a lot of small firms, Royce's example was the owner perhaps being a little bit nefarious. But sometimes the owners are not nefarious; they just don't really know.

They think they have contracts, and they don't really have contracts. They think they have what we would call contractually recurring revenue, and they don't. They think they have all the documents. They think they have all the licenses. They think they've been paying all their sales tax.

And as you dig in, a lot of those things—the broker talks to the owner, or the broker writes down what the owner says, puts it in fancy language with some pictures, and produces a CIM. You bid on that CIM.

If you bid a full price based on that CIM and then discover maybe revenue quality isn't as high, or they've been underinsured and you have to have higher insurance, or employees haven't had raises in 5 years, or there's a bunch of accrued bonuses that need to be paid, if you've paid a full price, then your only choice is to go back and say, "We need to readjust this price."

Sellers, when they sign their LOI, think about how they're going to spend every penny of that price. They've purchased their vacation homes. They've designed their boats. They've planned their trip around the world, and they've spent every penny of that $2 million or $5 million that you want to spend, that you plan to buy the company for.

And when you say, "Well, it isn't going to be $5 million anymore. It has to be $4 million," they're going to go kooky. It becomes irrational at that moment. Those deals tend to bust.

So I would say you want to give yourself enough room so that you can absorb some due diligence disappointments. But having said that, the LOI process is competitive, and brokers want every penny they can get.

Sure, they care about whether you have funds and what's the likelihood of closing, but since most buyers are one-time buyers, they don't have a track record of saying, "Well, we're not the highest price, but you should take our bid because we always close."

6. Value Creation After Closing

One of the amazing things about this process is that, as you said before, you don't really need growth or margin expansion to get your return. The magic is in the multiple, as you said.

But when you have observed margin expansion or top-line growth, which of course is beautiful gravy given the purchase prices, what has been the most common reason that becomes possible? Is it something common that the new CEOs and owners are doing? Is it the installation of better technology and processes? Are there common trends to when you do see margin expansion or growth go in a different direction?

As part of the transition into ownership of the business, they go talk to their customers, and they discover that there are services and extensions that their customers are so eager to get. The seller might have said, "Well, that's a lot of work. I don't want to do that." These young whippersnappers have a lot of energy. They say, "Oh, yeah, we can do that. We can do that." And they're able to grow because their customers actually want what they provide.

I think the small-firm space is capitalism done well. You find entrepreneurs working on their businesses so that their businesses delight the customers. The customers are thrilled to pay for the services or goods they're getting.

Nothing succeeds like success. If you have a vendor that's doing really good stuff and never disappoints, delivers on time at high quality, and when something goes wrong, makes it right instantly, and the owner gives you their cell phone number, boy, those businesses are going to grow.

I agree with that. That's the pattern we see again and again.

I have an unrelated-to-the-business question, but a question about improvement and growth. I think you should both be proud that you've built this class that has now influenced—when I was asking around ahead of our conversation today, it's pretty unbelievable the number of people whose trajectory and career you've now influenced.

That must be a special feeling. It's on the back of this thing that you've built. So you've had all these reps teaching students these ideas, and I know that the class is now, I think, the top-rated class at one of the most competitive, one of the best places in the world where you could teach a class like this, arguably the best.

So that's a pretty cool achievement. Talk me through how you've done that. If you were to, on the side, teach a class to other would-be professors who wanted to follow in your footsteps, what have been the keys to making the class so popular, improving it over time, and making it consistent? Reflect on the class itself a little bit, because it's had a huge impact.

That's a new question for us, Royce.

Yeah. Rick, I entered academics 15 years ago to partner up with you. You've been in this longer, so I'm going to be really interested in what you say.

I would offer 2 things that we've done consistently. One is, the class is extremely practical. There's very little theory taught because we think that the students come to this class because they want to evaluate whether they want to do this as a profession, and then, if the answer is yes, they want to stack the odds in their favor of doing it. Every time we write a case, every time we develop a teaching plan, we're always thinking about what practical lesson we're teaching these students.

The second thing we do is bring in the case protagonist for almost every class. Part of this lets the students ask questions and breathe some additional life into the case. But really, the reason we have them there is that there are 2 questions that Rick and I know are on the students' minds. They can look at this person and listen to this person, and they can answer: “Do I want to be this person, and can I do what this person does?” That's hard to teach but easy to show.

Those are 2 of the things that I think Rick and I have found are very powerful, and students routinely comment on them in their end-of-year evaluations. So that's what I would offer as things that we've done well. Rick, thoughts?

I'm going to do the rare thing of disagreeing with you. We teach a lot of theory, but we teach it in the context of practice. So we're teaching a lot about how to think about business, how to think about management, and how to think about corporate finance, but we're always doing it in the context of a concrete, meaningful example.

It's not that we're not teaching theory; we're teaching theory in a more digestible form, perhaps, than equations on the blackboard. There's one case we teach that just always amazes me. Every time we teach it, I look at the teaching plan and say, “This just can't work.” And we go ahead and teach it, and it's like, wow. Students come back and say, “Wow, I learned so much today.” It's an amazing case.

What is it?

I'll leave the protagonist out because it's an unfortunate situation. Former students buy a business, and things go badly. Demand falls. It just so happens to be the moment of the Great Recession. They're aware of the Great Recession, but they hadn't thought it through in their particular business.

Demand falls, they have a sticky product, and they decide to cut the price 10%. We ask students, “What is the implication of cutting the price 10% to profitability?” What is remarkable is that, after a year and a few months of business school, our students are mesmerized by this question. It never occurs to them to say, “Well, let me see. If my cost of goods sold is unchanged and my SG&A is unchanged, but I cut the price 10%, wow, all that money is just coming out of profits. My profit margin was whatever it is, and so, boy, I've just taken out my entire profit margin.”

Then Royce will go on to say, “And if you're 70% debt, what does that do to the equity holders?” And they say, “Wow, I've just destroyed all the equity value with this 1 decision.” Now, there's a lot of theory in that discussion, but it's an interesting example.

Some other things that I think have really been helpful: first, Royce and I have a fabulous partnership. We really enjoy working together. Interestingly, our students think about us as perfect substitutes for each other. I'm the pointy-headed academic who got his PhD at 25 and hasn't really left academia, and Royce is the super-successful consultant and private equity founder.

We have very different backgrounds, we have a lot of mutual respect, and I think when our teaching works really well, we're bringing the best of both of our backgrounds to it. So that's really important.

The other thing that's really important—I don't know how this will sound; I truly believe it—is that we really like our students. We have fabulous students. They're accomplished, clever, thoughtful, hardworking, and serious. They're great. We can go years before we cold-call a student and find them unprepared. It just doesn't happen. So we really respect and like our students. That is really helpful.

We also think—at least, I'm pretty sure I speak for Royce in this—we're really die-hard capitalists. We really do believe that if you go out and run a small business better, you're making the world a better place. We really believe that. For us, we feel like it's not evangelism by any means, but we feel we're really helping the world and we're really helping our students.

We're showing them a new career path, and they're going on and doing wonderful things for their workers and communities. It's super fulfilling for us. I've been at Harvard Business School for a long time, nearly 38 years now. Before I did this course, I taught everything in corporate finance, and I could go decades without somebody saying, “You really changed my life. Thank you so much.”

Teaching discounted cash flow just doesn't evoke that kind of emotion in people. I don't know why. It does in me. But I don't know that we hear that every day; we hear it quite often. We see it in our students, and we see students coming back over and over again saying, “Your class was pivotal in my life.” We hear it in our podcast, so it's really great.

How much do you teach capital allocation? That strikes me as something where, on average, the seller is going to basically have never thought about or been taught the basics of smart and thoughtful capital allocation, whereas the average student in your class probably has thought about it a lot and been taught it, maybe by you. That could be a hugely powerful lever in some of these businesses at some stage. Is that true, or am I missing the mark?

I would say we direct our students to businesses that are capital-light. Once they buy a business—and we probably should have put this on our list of qualities—we're nudging them toward business-services companies where EBITDA almost exactly equals free cash flow.

So capital-allocation decisions are very episodic. They usually center around a tuck-under acquisition. Sometimes they're expenses that are really investments, like launching a new sales force. Of course, they're taught how to do projections and see what kind of return there is on an expense. But I don't think there's a lot of allocation that goes on in these businesses because of the nature of the businesses we suggest they buy.

I mean, the nature of small business is that they're generally undercapitalized and have to ration capital. By the time they go to make capital investments, usually those decisions are pretty apparent: “I have demand for another technician. That technician needs a new van. I'm going to buy a new van.” There's a lot of that.

One of the things we do talk a lot about, Royce, is IT investment, and we're generally negative on it.

Oh, interesting.

We generally say our students are of a generation that can't get home without checking their phone to find out how to drive there. It hadn't occurred to them that they could just go the same way they went yesterday. They can't just go to a restaurant; they need to do whatever they do on their phone before they go. Anyway, this is a generational thing.

What we think is that many of our students want to go into a business, particularly if it's being sold by somebody who's in their 60s or 70s, and it's probably technologically light. Our students always have this great desire to spend a couple hundred thousand dollars on a CRM. We have 2 answers to that.

One is that a couple hundred thousand dollars is a lot of your free cash flow. You've got to be thoughtful about that. Certainly, in your early years, if you're SBA-financed, you don't have debt covenants, but a lot of them are conventionally financed, and they do have covenants. They need to be mindful of those.

So one is that it's pretty expensive, and two, you don't really know what the business should be like in your first year. You've got to really wait. If the old owner managed it with sticky notes, buy some sticky notes. Go to Staples. They're not very expensive. You could buy a lot of sticky notes for the cost of a new Salesforce application. Try that for a year and see what you really need.

Because you'll be a better manager at the end of year 1, and you'll know exactly what you need then. That's a part of this.

That is 1 form of capital investment. And, by the way, our students routinely ignore our advice on this, but we feel good giving it.

7. How To Find A Business

What advice would you give to those listening who haven't gone to school for this or studied it in an academic setting but want to do it? They want to conduct a search to buy a business. We haven't talked much about the literal process of a successful search. Where do people begin? Are there databases of companies? Is it best to first identify a vertical that interests them and then go pound the pavement? What does the process of a successful search look like?

It's not pole vaulting. I always wonder how people actually do the first pole vault. How do they do that? Or a ski jump. Put somebody on this thing that's taller than the Empire State Building and say, “Just don't turn. Go straight.” “It'll be okay.” I don't know how that actually...

“Here’s a stick. Stick it in the ground when you get close.” “When you land, it’ll be fi—” I don’t know how that happens. This is a mystery to me, but searching is not. You just commit to it. There’s this thing called Google. You can find brokers. You talk to brokers. You get on their lists. You do some searching. You look at some databases. You try to find what companies are out there.

It’s like so many things in life: just do it. Just decide you’re going to do it, and then just do it. Royce and I describe it step by step in our book. I think those steps can still be followed. But it is the case that most people discover that it’s a highly personal activity. They’re going to do a geographic search in a small geography. They’re going to move to that geography, and they’re going to go to every chamber of commerce event they can find. They’re never going to have breakfast or lunch by themselves. They’re going to meet people, meet people, meet people, and find the business. They’re going to go door to door if they need to, but they’re going to meet every business owner in the locale.

If people are doing a national search, it’s a very different process. But again, it’s heavily brokered, or maybe it’s direct outreach in an industry. What I think doesn’t work is theorizing about what industry might be exciting in the future and spending 6 months theorizing about an industry before you actually call. So when we work with new searchers, we say, “Your goal for this week is to have an owner’s meeting. Just have a telephone conversation with an owner. Just do that.” That leads to something.

I agree with everything Rick just said, and I’d add a couple of numbers that add to this sense of possibility. In the United States alone—and searching has become global—there are approximately 3,000 small-business brokers, professionals who do nothing but intermediate small businesses. And there are something like 300,000 small businesses that change hands every year when the seller sells.

So it is not that hard to get into the flow of this. It’s harder to filter and find a good business at the right price with a committed owner. But getting started and bathing in a flow of companies—which is how you learn and how you find—is really not that hard.

8. The Searcher Long Game

A lot of what you said makes me wonder about value creation and the duration of the opportunity. Three things come to mind. One is the magic is in the multiple; the difficulty of finding a company and getting a transaction done; and the fact that lots of the margin and growth comes from the initial conversations with customers. These are all things very early in the story of one of these transactions, which makes me wonder: Is the vast majority of the value created pretty much up front? How long do you see the typical person running one of these companies? What does that distribution look like?

I want to think a little bit more about your example, because everything you said made perfect sense, but that’s not the way the empirics look. What it looks like is that people buy their businesses, and then they all project 5% or 10% growth in their conservative case in their first year, and they all have 5% or 10% losses in their first year. It’s 5% worse than their base-case year.

Some of that is because sellers sell in good years, and so there’s this averaging, central-limit kind of thing. But it’s also learning the business, meeting customers, distraction, the seller’s distraction, and the business having some degradation during the sale process. All those things happen.

But I think the idea is that what you said is right. The first 2 are about getting to the transaction—that is, getting the transaction done. The talking to the customers happens often during that first year, but you’re not able to capitalize on or make good on those ideas, usually for a year or 2. So what we see is that year 3 is the really good year. Do you agree with that, Royce?

Yeah, totally. That’s when these entrepreneurs have really learned what the customer wants and start to come up with programs and service lines that address that.

What is the normal life cycle, and who do they tend to sell it to when they’re done?

Before we go to that, I want to say one more thing. Will Thorndike, who you know well and we know well, and has been a longtime and thoughtful investor in this space, has actually looked at a lot of the data and concluded that everyone sells too early: that the successful companies really compound their success in years 7, 8, 10, and 12, and that there really should be much longer holds.

I think we agree with that idea because the successful searchers we know really well keep getting better and better, and the companies keep growing. What takes searchers out more than anything else early—meaning in year 5 or 6 of operating the company—is that they have 95% of their net worth in this one company. It’s a good company, but their capital allocation is just not sensible anymore.

They’re an entirely different manager than they were when they were a newly minted MBA. They are now an accomplished CEO entrepreneur with 7 years of experience, and maybe there’s a different economic deal that they could get on next. In many cases, this propels a sale, which I think, Rick, I know you’ll speak to this too, but I think we have questions about that.

It’s a little bit like if you bought a business, went through the J-curve of the initial investment, and sold right after that. Here, you’ve finally become a really expert CEO in this business. You’ve got the business pointed in the direction you want. It’s really doing well. Why would you deny yourself the next half-decade of that? I think it’s a capital-allocation issue.

Yeah, I think it’s diversification.

Diversification issue. Thank you.

That’s another way of putting words in Royce’s mouth. Some investors are willing to recapitalize and re-incentivize the CEOs. It’s a cumbersome thing because you don’t really know what the value of the business is. It’s really hard, and a lot of it depends on the business.

CEOs, because they’re so focused on their business and have such a concentrated position in their portfolio, may have a key 3-year contract. They won each of the last 3 years, but they get convinced that the next one won’t be won. I don’t think it’s because the facts on the ground have really changed that much. I think they look and say, “Oh, my word. If I don’t get that contract, it’s going to have huge consequences for my personal wealth, and I don’t want to bear that risk.”

So I think as you have more to lose because you’ve accumulated wealth and have an illiquid, undiversified position, that tends to drive people to sell. Whether they sell too early or not, I don’t know, because I think from an investor standpoint, they might be selling too early. From an entrepreneur’s standpoint, they might be selling at just the right time because they’re living with this really high cost of capital, because they’re bearing all this total risk, not just the diversifiable risk.

Thinking about the topic of transitions, Royce, I’m curious if you’d be willing to talk a little bit about your decision to leave private equity and go do this instead. You talked me through this when we were together a month ago or so, and I thought it was so interesting, your thought process for making a big decision, frankly, kind of at the peak of your private-equity powers.

I think anyone who looked at it—if you built an HBS case study and ended it exactly when you made your decision—it would be very easy to say, “Yeah, this thing goes on to be one of the dominant private-equity firms.” And I think you built the firm a little differently than many others did. Can you say a few words about your choices in building that business, and then especially why you made the decision you did at the end?

Sure. I co-founded it with someone named Andrew Banks, who had been my partner previously at Bain & Company. When we started it, it had a strong sector focus, which was different and new in the late ’80s and early ’90s. Today, it’s table stakes in the private-equity business, but it was a powerful driver of Apry Partners’ success.

Andrew and I ran the firm for a quarter century. We did it for 25 years. It was a wonderful experience. Metaphorically, I ran to work every day because I enjoyed myself. What I’m about to say is true about Andrew as well. We started to envision how we would reflect on our lives at the age of, say, 75 or 80, looking back. If we spent the incremental 15 years—not a quarter century, but 40 years—running a private-equity firm, would we think that was a really sensible allocation of our professional lives?

The answer was no, it really wouldn’t be, because 25 years was a great experience, but there are other things in life that are different and interesting. So that really motivated us to want to do something different. By the way, it helped that the firm was doing well. We had a talented group of partners in the next generation who could step up, and this would be good for the investors and for them. That was important, but that was really what was driving our thinking.

I will add 2 things. One is that there was a catalytic event for me. I was working late one evening in my office, and my dear friend and longtime partner, Andrew Banks, came in. I always think of this a little bit like Charles Dickens’s A Christmas Carol, when Jacob Marley comes in and wakes up Scrooge and tells him what the future will be like if he doesn’t listen to his partner, Jacob Marley.

Andrew said, “Royce, when we started this thing, we had more time than money, and now we have more money than time, and we ought to act accordingly.” I thought to myself, “That is really good advice.”

I'm not gonna admit it to Andrew. It'll just ruin him. I guess I just admitted it. Hopefully, he doesn't listen. But those were the reasons for leaving. And when I left, it was very disorienting because I was leaving something I was very good at. What could I do to replace that? I had the immense good fortune of partnering with Rick Ruback and building this in a partnership with him, and boy, I'm so glad I did it.

9. The Future Of Business Education

Rick, I have a related question for you. You said 38 years now at HBS—an incredible run, with every kind of experience as a teacher of young people. What would you say about the state of higher education platforms and classes like the ones that you teach—how effective they are and how they need to evolve in an AI world where you can learn whatever you want at your fingertips if you're curious and enterprising? What needs to stay the same based on all your experience, and what needs to change?

Well, that's a hard question, and I think I'm not the best person to answer that because I'm really limited by my experience because I'm not a very techy guy. I can log into my computer, and I got a new phone. I don't even know how to shut it off. So I don't know. I'm not a person who really thinks deeply about how AI is going to change our educational experience.

But what I can say is I taught at MIT before I came to Harvard, and at MIT, we taught things. At Harvard, we really teach situations, and what I find is that our students are extraordinarily good at pattern recognition. It's hard to see how this learning happens. It's hard to measure it day by day. It's hard to quiz them on it. But what is absolutely true is that after 2 years of a case-based education, you've seen hundreds and hundreds of situations, and life is going to give you those situations.

So I can't tell you the number of times I'll meet with an alum and they'll say—we'll be talking about something and they'll say, “Oh, that's just Butler Lumber.” Now, it's not about lumber distribution in the 1950s, whenever that case was first written. That's not it. But it is the case of a company that, in the case of Butler Lumber, makes financial profits but no cash profits because all the cash goes into working capital. So there's that pattern recognition that just sticks with people, and I think it's really hard to Google your way to pattern recognition.

It's like so many other things. There's no gizmo to teach you how to be a really good alpine skier. There's no piece of AI or science that's gonna make you stronger in the weight room or faster on the track. I think you just have to do the work. As I like to say, success only comes before work in the dictionary. I think that is true in learning. I don't think there's an easy way to learn. I think there are fun ways to learn, but I think you actually have to put in effort to learn.

Anything you'd add to that, Royce, about your 15 years now of experience at the school—how things should stay the same and/or change?

I so agree with what Rick said on this. I think at great institutions, there's a tension between research and practical teaching. Schools have to find a balance because different constituencies want different things out of those institutions. Faculty, alumni, and the general public want the benefits of the research and new ideas that come out of them. Often, the students want a very practical education, and you're operating one enterprise that's trying to produce both of these. Finding the right balance between those two is an eternal challenge for a fine school.

I've been very struck, being inside Harvard as a faculty member, by how challenging it can often be to deliver both of those. As a student, you experience the faculty just in their capacity as teachers, and you don't see that there's this huge other component to their careers.

One of the things that's special about the Harvard Business School is that we understand we're a business school. We're not an economics department. We're not a behavioral science department. We are very much a business school. So while as faculty members we spend more than half our time doing research, that research has to have a business focus for it to be valued by the institution.

Now, what that business focus is can be almost anything. It can be some behavioral way, or it can be a new way of managing a workforce, it can be a new way of managing a portfolio, it could be all kinds of things. But I used to like to apply the rule—and I don't know if the institution would still agree with this rule, but I do—which is, if you're working on a research project at the Harvard Business School, you need to imagine that somebody would actually pay for the results of your work. Maybe not the cost of the research, but they should be willing to pay something for the results of your research. And if nobody cares enough to pay for your research, then maybe you should be doing it in the economics department or, God forbid, the Kennedy School. But not here.

One of the coolest things about what you do is that you get to have these ongoing relationships with students beyond just the couple of years that you're with them in the classroom. I've talked to a couple of your former students before this, and they all say the same thing: They still call you for advice, for commiseration, or just to catch up, and you have relationships with them for a long period of time.

What do people most commonly call you with, looking to you for sage advice or someone to talk to? What are the most common reasons that you continue to get those calls beyond just having a great relationship with a person? And maybe that's the right answer.

We certainly get questions about specifics in the small-firm space. “I'm considering this deal. The seller wanted to do this. Does that make sense? Does this equity rollover make sense? Does this structure make sense? I'm having a problem with somebody on my board. How would you approach that?” So we certainly get those practical business questions.

I think we get questions when people are struggling with something. Something just isn't clear to them, and they want to go back and have somebody to talk to that they think is smart or clever or nonjudgmental or something. So we get a lot of those phone calls, I think. Do you agree, Royce?

I do agree with you, Rick. I would add to the list that these are very smart people, and often when they're dealing with a problem, it's because you could go either way on that problem. They call for a second set of ears that they trust to listen to this. More often than not, if you force them to make a decision, they would make the same decision you're making, but they just need to hear someone else who understands business and whom they trust saying, “Yes, that's sensible.” So I think there's a bit of that. Before they jump, they want to get a confirmation from us.

I was gonna say that often they call me when they have this sense that they might be wrong.

Because you always say, Rick, “Feedback is a gift,” and so—

I say feedback is a gift, and I'm willing to say to somebody, “That's really stupid. Have you thought about that? Why would you do such a stupid thing?”

This is a really interesting thought because I never considered this. When they suspect they're wrong, they call you, and when they suspect they're right, they call me.

I think that's correct because you're always more cheerful after those phone calls than I am. I'm like, “What happened to these students? Why do they wanna buy such a crappy business?” And you're like, “Oh, I talked to so-and-so. They have such a great deal. It's 80% recurring revenue.” And I say, “I don't get those.” They call me with a pizza joint.

I guess that's why you have such a great long-term partnership.

Yeah, that's right.

Since I've interviewed you both before, I've already got to ask you my traditional closing question, so I have to come up with a new one this time. The one I thought would be fun is to ask each of you what your favorite case has been to teach your students, and maybe tell us a little bit about that case and why you like it.

The first or second case we teach each year is a case called Nashton Partners, and it's about 2 HBS students who actually graduated a few years before we started the program. Before there was any entrepreneurship through acquisition teaching, before it was a thing, they cottoned on to it and they did a laborious search. They bought a small municipal extermination company that had great revenue qualities, and it took a few years to figure out how to crack the code.

Once they cracked the code, it led them to 7 years of fantastic growth, both organically and through acquisitions, and they sold it for a huge price. It's a template journey of how people who were never in the multifamily extermination business figure out a business, how they find a company that has the qualities you wanna find in these businesses, and why they can do a job that the owner before couldn't do.

It's a way of shining a light on this and saying, “There are many forms this can take, but this is a good picture to remember when you think about ETA.” And I just love that case because it explains the journey we're gonna take them on. It has a great place in my heart. We've been teaching it since, I think, 2000.

That is a great case, and it's nice to start off with one that we know is gonna work out pretty well. We usually do that as our very first case of the year. I was gonna pick one that will probably make your teeth hurt. Can I pick 2? Because they're actually very similar.

No rules here.

One is a company called Capital Digital. What I really, really like about Capital Digital is that it was purchased by a student of ours, Nick Anderson.

And as all good cases came, I was at another student's wedding and happened to be sitting beside Nick, and I said, “How are things going?” He said, “I can't tell.” He described his 1st year of owning the business, which had its challenges, but what was hard for Nick was that it was almost impossible to figure out what was really going on.

It highlighted how special small business is. Small businesses are small, their information systems are small, and the evolution of information is small. In this instance, there was nothing wrong with the business, but it sure looked like there were things that were wrong with the business. It was just that the firm needed to worry about its product mix a little more carefully than it was doing, but it was very subtle, and it took them a few years to figure it out. Once they figured it out, they've been tremendously successful in the years since. It's this evolution of information that I find fascinating.

My other favorite is a really odd choice, Royce. It is Brian Bonk and the Pelfries case. We close our course with this case. Every time I'm getting ready to teach this case the night before, I say to myself—and sometimes I even call Royce—and I say, “Royce, whose stupid idea was it to have this case as the last case?” This is just a terrible, terrible case.

It's a story about a young man who gets his PhD in biology at MIT. While he's in the process of getting his PhD in biology at MIT, he comes and takes our classes and decides there's a lot of smart biologists in the world, but there aren't a lot of smart biologists who own small businesses. So he's going to go buy a small business. Royce and I work with him, and we really enjoy working with Brian. He finds this business. Can I say what it does, Royce? Is that okay?

Yeah, absolutely.

He finds this business that is in the most unusual marriage of businesses you can imagine. It is the largest rabbit slaughterhouse in the United States. Who doesn't want to own that and just be able to say to their grandchildren, “I killed 5,000 bunnies this week”? I have to be careful. My grandkids sometimes listen to this.

And a biotech version that takes the byproducts of the rabbit meat and turns them into biological products that turn out to be essential in the development of so many things, like Prevnar and a whole bunch of vaccines. So it is a really interesting business. Half of it really appeals to Brian, as you might imagine.

Anyway, the last case is about Brian's attempt to close the business. I think it takes—we have the number of days in there—but it's like 280 days or something crazy like that. Moses got to the Promised Land more quickly than Brian gets to the closing.

It's a video case, and the way we did the case was we had Brian record his impressions whenever he wanted to on his iPhone. Then the magic of editors pulled that all together into this video case, which is about an hour long. You see this journey, and it's like, “Well, I thought this issue was resolved.” Brian says, “Well, this issue's back. I thought it was resolved. This is the 4th time it's not been resolved. I don't know what to do. I'm just so frustrated. I guess I just have to get back to work.”

It just shows the frustration of search, the challenge of search, and why it's hard, because information isn't always available at one time. Anyway, that's kind of a favorite of mine. It's a weird favorite, right, Royce?

Yeah, I love it.

It makes me wonder if there's anything that, when people like me ask you questions about this whole domain, you're surprised they don't ask about. What's something, if anything, that comes to mind that I haven't asked about at all today that's essential or interesting to you, having spent more time in this space than just about anybody else?

The question I always have is why more people don't do it.

Hmm.

We have 920 students graduate every year. There ought to be 100 people searching. We get somewhere around 20–25 a year.

And then probably another 20 out of that class over the next 3 or 4 years.

Right.

Not 100, for sure.

But not 100, and that doesn't mean there aren't great jobs in private equity and in corporations and in consulting. But for my taste, this is such a better career path than working for somebody else.

Is it perceived as low status?

Not anymore.

Yeah, I don't think it's a low-status thing. If I were to think about the people who choose to go into large enterprises, the things they would say are important to them, I used to believe they weren't rational and that they only needed to listen to the preachers, Rick and Royce, for long enough. But what I've come to realize is they have a bunch of values that are sensible—

And different.

—and different. Thank you, Rick. That's exactly right.

Those would be, in no particular order, that they want to work in an enterprise that has lots of resources so they can do the polished work that they've been trained to do and get satisfied by. They want to be surrounded by coworkers and colleagues who are like them—highly educated, who show up at work wanting to be the best they can be—because work is a social activity.

They want to be part of something larger than themselves, not limited to but including a great brand name. They want to be part of the team that brings Coca-Cola to China. These are things that are really important. If you say, “Well, wouldn't you rather be more independent and not have a boss?” they'd say, “Sure, of course, but I want these other things more.” I think that's why people look at this path and say, “It just doesn't fit with me.”

I agree with every word you said. I would also add 1 minor thing. Maybe this is my thought, and this may not be true, but I think if you somehow dug and peeled their hair away and dug inside their brains for a little bit, you would find that not everybody is comfortable with doing the most difficult thing that a CEO does, which is write down the to-do list.

It is so much easier to work for somebody and have them tell you what the to-do list is. “I work for a private equity firm. They've told me to work on this deal,” or, “They told me to source in this industry.” They're not telling me to pick any industry and source it and have my entire wealth tied to that industry. And even if I do do that, they're not telling me to run the firm after I've bought it.

There's a sense where you say, “When you're managing a small business or finding a small business, you're saying, ‘This is important to me, this is important to our firm, and this is the direction we're going to take.’” Not everybody's comfortable with that.

I have learned so much from you both. That's my question too: from multiple perspectives, from the investor perspective and from the searcher perspective, I think you learn so much running a business that you can't learn any other way. Obviously, your work has done this. Hopefully, conversations like this one get more people curious.

I encourage people to read your book, listen to your podcast, and immerse themselves in the ideas that you've accumulated over 15 years together. Thanks so much for doing this with me again, and for your time, and for everything that you've done. It's so much fun to do it 10 years later, and I guess I'll see you in another 10.

I'm looking forward to that.

Thank you, Patrick. This was really great. It was as fun this time as it was 10 years ago.