Episode 61: Diamond Innabi of Software Equity Group on Relationships between Founders and Investment Banks

Episode Transcript  

Shiv: All right, Diamond, welcome to the show. How's it going?

Diamond: Doing well, how are you, Shiv?

Shiv: I'm doing well, excited to have you on. So why don't we start with you explaining what SEG does and the types of companies you work with and we'll take it from there.

Diamond: Yeah, absolutely. So Software Equity Group is a sell-side merger and acquisition advisory firm, exclusively focused on SaaS and technology. I think what's really special about our firm is that the way we have our model set up is we're really trying to bring kind of that bold bracket service down to the lower middle market. So extremely high touch. You know, being very selective with the deals that we're taking on because we want to be successful and we're usually successful. Our first pass success rate is somewhere in the neighborhood of 80 to 90%, which is far above the industry average. And it's because we're taking kind of this different niche approach to the lower middle market. Um, we're industry agnostic as it relates to SaaS. Uh, we like to do a lot of vertical deals, 80% of our deals are vertical. So gov tech, health tech, ed tech, you name it. But everybody across the firm is extremely experienced in anything that's SaaS or vertical SaaS related.

Shiv: Got it. And what separates you guys from other investment banks? There's a ton of investment bankers out there. Founders get pinged by investment banks all the time. So what's a way to distinguish yourselves in this crowded marketplace?

Diamond: Absolutely. So it would be the thing I just said, right, where we're extremely high touch and we take a very process driven approach to every single deal that we take on. And you know, it's, we want to be proactive when we're going to market and we want to be extremely prepared. That way we can really drive tension, competitiveness and therefore valuations. So we're usually successful with our clients either at or above our guidance every single time. And then the other portion that I think is really unique is that we're over staffing all of our deals. We just want to make sure that we're successful for our clients. So every deal is going to have, you know, an MD, a VP, an entire support team because we want to bring that extremely high level of service to our clients in every deal.

Shiv: I was talking to a friend of mine recently and we were talking about this investment banker and private equity model and just strategic or financial investors that are buying these companies. And he mentioned that there's a ton of misalignment in the industry based on how a deal might be structured. And so talk a little bit about that, like, how are you making sure because you have a vested interest in selling the company and at the same time the founder wants to exit. But at the same time, like the they're trying to maximize how much they get for their asset and you may want to get the liquidity because you're tied to the actual sale of the business. And so how do you make sure interests in that type of a situation are aligned?

Diamond: We start our relationships with companies, you know, months, years before we ever take them to market. And it's not, it's just, hey, we want to evaluate your business and make sure that when we do go to market, that you're going to be positioned in the best light for the exit that you want. So we're never going to be the investment bank that comes to you and says, Hey, we, need to sell. We want to take you to market. We're only doing that if we know that the market timing's right, your company is at the life stage of the growth of the business to be successful, and we think there's gonna be a lot of appetite for the business and the market. If we don't think that's the case, we're saying, hey, do X, Y, and Z, and then try again in a few months, a year, or hey, it's just not the right timing just based on macroeconomic trends, what's happening in your industry. So let's just keep a pulse on what's going on with the business and then we'll take you out when we do. So usually when we're going to market with our clients, we're very well aligned with each other as to what we expect and what we're gonna get. So we both end up happy in the end.

Shiv: What are some markers that you're looking for to evaluate whether or not this is the type of asset that you can sell or maximize and exit for?

Diamond: We look at it in a couple of ways. So we always want to look at financials just because the market is going to be looking at that, especially with the private equity community making up the majority of deals today. So we're looking at, you know, your rule of, rule of 40. Are you growing and are you profitable? And you don't need to be a super grower. Actually, the market's preferring not super growers, people that are really focused on fundamentals. So growing sustainably. So a little bit of EBITDA, some growth. Then we want to look at your retention. So really your rule of 40 and your retention numbers are going to be the biggest drivers of valuation, all else equal. So when we're looking at your gross retention, having that at or above 90% and then your net retention at or above, you know, a hundred, 110%. So you're keeping customers happy. You're keeping them around. You're growing profitably. Outside of financials, you know, we always like to look at companies that are working in mission-critical type product offerings. And that goes back to, you know, churn all the risk metrics that we'll see buyers really dig into. If there was a downturn in the market, if something were to happen, customers aren't going to flee. It's also not a commoditized product, right? If someone's coming in with a lower price, they're not all going to leave you and you're going to lose half of your business for that. So we like to look at financials, we like to look at the product category, and then we like to look at the industry as well. So vertical software is very attractive to a lot of folks just because you're finding a niche in the industry and you are solving a pain typically in that specific industry and you have specific product functionality to help you in that industry. So I would say those are the three things that we're typically looking for when we speak to clients or potential clients.

Shiv: And in that type of those types of assets, like I would classify as premium, right? Like they definitely are well desired, a ton of PE firms would have interests and even investment bankers like, would line up to kind of market those kinds of assets at a high success rate. So in those instances, what are some things that you do beyond what a standard investment bank would do? I think you mentioned the staffing and things like that, but like, how do you distinguish that asset and then what about assets that are not as premium, but where maybe they have optimization work that needs to be done or value creation or positioning work that needs to be done before an attractive buyer can be found?

Diamond: We probably spend more time in the preparation phase than any other investment bank that you'll meet. We'll spend, you know, six weeks ish before we even talk to anybody in the market because we want to do all of our diligence ahead of time. So we are analyzing all the numbers of the business, customers, financials. We are looking at all the different ways that we can position the business. We're looking for all the risk factors. So are there any skeletons in the closet that we need to be aware of? Or maybe you lost a big customer and we need to position around that or there's somebody that's at risk, right? We also want to bring in third parties to really get prepped for market. So we want to bring in a legal team to help us clean up any contracts that may have some cleanup that needs to be done. Or if there is something specific in a contract that could potentially jeopardize a deal, we want to make sure that we're addressing that before we go to market. We want to bring in, you know, potentially a tech review team where we're saying, okay, well, let's look at the product and see if, again, is there any risk factors, but also let's get a third party to come in here and validate your tech. So that way when we go to market, it's another value add that we can give to market. Sometimes we'll bring in a QAV provider to come in and look at the financials. So we're really taking this holistic view of the company to make sure that when we are in preparation and we're not talking to buyers or investors yet, we know everything about the business inside and out. Somebody on our team could go in and tell you anything you need to know and answer any question. So that way when we do go to market, we're able to position the business in the best light, also prepare for any questions before they're even asked and any risk factors. We remain proactive in the process rather than reactive. And if we do need to be reactive for some reason or another, we're really flexible and we're able to do that because we have all the information up front. I think that's the most important thing. The second thing is because we are experts in SaaS, this is all we do every day on the sales side, we typically know what the buyers want to see and what they're interested in. And so we're able to position companies in that.

Shiv: How much of the preparation phase, and I'm thinking about even founders that are listening to this, like how much of that is spent on financials and making sure all the numbers are right, you have the right P&L and balance sheet and all the right representations on revenue and everything. How much of that is also trying to almost do like pre-diligence work that you know the private equity investor will be doing?

Diamond: It depends on the company. Occasionally we'll have companies that have everything together. They have a really clean MRR sheet. They track their retention. They track their unit economics. Fantastic. It's really us going in and validating all those numbers, which because we do this so frequently, it's a pretty quick exercise if everything's clean and ready to us. Occasionally companies come to us and they have nothing. They don't even have an MRR sheet. They're just, it's just their P&L, their balance sheet and whatever they're using to build their customers. That takes a longer process and it could take the full six to eight weeks for us to really clean that up. And that's really when a third party like QAV provider and accounting firm would really be of good use for both the investment bank like SEG and the client to be able to clean things up in a way that we know that the private equity or strategic would be looking at the business as well.

Shiv: Right, that makes a lot of sense. Yeah, because in some ways like QAV is kind of done once an LOI submitted by the buyer, but doing some of that work ahead of time can also help you figure out like what is not going to work here or what are some objections we're going to need to address ahead of time.

Diamond: And the other benefit of having a QAV provider on our side is that when we do get into a diligence process or past the LOI phase, that team can work on behalf of our client to work with the buyer QAV team and speed things up, right? When we get into diligence, the legal side and the QAV side is typically the longest pulls in the pen when we get to diligence. So anyway, we can speed that up so we can get to close faster. We're trying to do that.

Shiv: What are some of the main reasons why during this phase before you're even taking a company to market, what are some of the main reasons why a deal is falling apart or you're like, hey, we're not ready to go to market, we need to fix these specific issues first?

Diamond: Yeah, that's a good question. I, it doesn't happen as often because we're usually having that conversation before we sign the client or in that, you know, months or years ahead of sale. We're talking to you, making sure that it's the right time during the preparation phase. It has to be something that's pretty big that changes the outlook of the business overall. So we're in the preparation period and you lose 50% of your revenue for some reason. We can usually position around things like that, but if it's so large scale that we're saying, it doesn't make sense for you to go to market right now, you have a great product, great team, let's try to fix this issue or these two issues that happened during our prep phase and then go to market, you're gonna be in a better position than trying to go to market now, potentially failing and then going out to market again.

Shiv: Yeah, because you're gonna then that's your second at bat with the same potential buyers Yeah, how much work are you doing during the prep phase on the overall story of the acquisition? Because I think about this a lot because we see a ton of CIMs and SIPs and management presentations and all the time because when PE firms are buying companies else they'll sign us to an NDA and we'll look at look at the that information as they're entering diligence and they all look the same to me. Like, it's, you can swap one company's revenue in and put in another company's revenue. It's pretty much slide by slide, regardless of which investment bank is kind of doing it. It looks and sounds the same. And I think it's a huge missed opportunity because every acquisition can have a story. And depending on the buyer, that story needs to look different. I almost think that there should be 20 different CIMs based on the type of buyer that's gonna go actually acquire this asset. So how do you guys think about that and telling the right story to the right buyer?

Diamond: That's an excellent question. We are very specified with how we position businesses. And what I mean by that is we're not building CIMs for every buyer. So it just wouldn't make sense in the context of a broad process. But when we're looking at businesses, there's usually, let's say there's 10 things that you want to position and tell the story around. Five of them are going to be the same for every company that we're bringing to market. Good financials, good product. But the other five are really unique to this business. Are you playing in a field that there's three competitors and it's a scarce asset? We want to highlight that. Are you playing in a market that's seeing 100% growth year over year? We want to highlight that. So that's part of the prep phase where we're trying to figure out what are the five things that are really unique about this business that make this a need to have for an investor or a strategic. So we do a lot of that work and the storytelling is, it's a huge part of how we bring value to our clients because we're bringing this really compelling story and these growth opportunities, but we're supporting everything by data. So we like to do both sides. We're never just going to be saying something and not having any support for it. But we also don't want it just to be a data book. So the storytelling is really big. Where our unique insight into buyers comes into play is we are having calls with these buyers almost immediately after we send them our teaser, because we want to be able to pitch these businesses in the light of that buyer. So it doesn't make sense from a materials perspective, but we have rationale for every single buyer that's on our list. We want to cast a wide enough net that we're getting to the market, but we want to make sure that every buyer that we're talking to, there's a reason why we're talking to you. Investor, you told me that you're interested in this specific vertical like GovTech. This is a gov tech company that I think fits perfectly, right? You're a strategic. I know that you're looking for this specific product category. Let me send this to you. You're a strategic. You just did a deal in this space that this is going to complicate, compliment it. I'm going to send this to you and I'm going to talk to you about it. So we have our pulse on pretty much every single buyer in these vertical markets. So we know how to talk to them about the opportunities that we're bringing them.

Shiv: Yeah, I think you made some great points there. think just a huge opportunity that I see is there's M&A, which is like purely financial based and you can come up with great reasons to buy a company that has high net revenue retention or is growing a rule of 40 and things like that. And then there's other other reasons to buy companies because it fits in with the strategic roadmap of an acquiring business. And especially when we're talking about strategic investors. And there are a ton of those, a ton of deals are done by strategics that are also backed by private equity. In those instances, it's about cross-sell and up-sell and how these companies can be integrated together and what the efficiencies are. And none of that story is ever captured in whatever is being pitched to the investor. So it's very hard to evaluate or even understand what the opportunity is.

Diamond: Yeah, and we really try to make the investor or the strategic’s job easy. So how can we connect those dots for you to make this a compelling opportunity? Yes, we could just send you something and we could just assume that you know why this is interesting to you or that it's going to fit in the hole that you're trying to fill. But why? I mean, we know, we'll tell you, we'll connect those dots and make it really easy. And that's also why we do put together our materials in the way that we do. We know what the investors are gonna bring to their IC and what they need, what the strategics are gonna bring to their board. Let's help them out and make this just a quick check for them where they're saying we're interested, we wanna learn more, let's move forward in the process.

Shiv: Do founders understand that? Like, do they understand the selling process of a company or are you having to educate them on, hey, here's actually what it's going to take to exit this thing. We need to actually craft this whole story together along with the financials and everything else that goes with it.

Diamond: I see both sides. You know, there's some clients that come to us that are really green who say, listen, I know why this is important to hire an expert, but I don't know all the intricacies. So we go in and we do kind of that selling education process. The ones that come to us and say, I don't know what I don't know are great because we're able to really show our value and say, Hey, this is the process from start to finish. And then sometimes we'll have. clients come in that say, been through this process before, or, you know, I've been on the other side and I know how difficult this is and I need your help. Those are both great scenarios to have, but we do have clients that come in that have been growing their company for 30 years. This is all they know. They don't know anything about A raise, selling. Um, so it's a pretty educational time for us to go through that.

Shiv: What about on the buyer side? and that's great on the founders. Like one of the things I think about as a founder building this business, I often think about it, hey, if we're going to build this business, what type of investors might meet me at some point? Will we exit it at another point? I always am contemplating these questions, but in my head, I always think if we were to exit, here's the type of company that would buy us. And so how much of the work that you're doing or the work with founders is about actually making a short list or dream list of potential acquirers, not just, let's say, institutional investors.

Diamond: Yeah, that's a part of the prep process. So we usually have our list because we've done so many deals in these spaces where we're saying, this makes sense for this group. But we have a lot of founders that come to us and say, I have been carrying on a relationship with XYZ company. I know they're interested in us. Let's talk about how we get them even more interested in the sale process. Or they'll say what you just said, these are the ideal acquirers. And this is kind of my dream for the business. So we'll talk about it and say, does it really make sense to go through a process where we're trying to engage with this company when, you know, maybe they've never done a deal, they've never done any kind of acquisition, they don't have the cash on hand, they, you know, they're too big, whatever it may be, we just want to make sure that we're not talking to everybody and everything if it doesn't make sense. So we do, it's a very collaborative effort trying to get that list together, but there's occasionally cases where we're saying, it just doesn't make sense to go through the effort of getting in touch with them, going through the NDA process, all of that.

Shiv: Yeah, I think I think I think that at least as a starting point helps the positioning of the assets, so that makes a ton of sense. The other one I wanted to ask you is on on the on the growth growth avenues or hey once you acquire us, here are some things that we haven't done yet or that are in our pipeline that if we have the right investor we can grow this thing faster to unlock more EBITDA or whatever so, how much time are you spending on those kinds of conversations?

Diamond: Those are my favorite conversations, but it's not everything. Where we sit in the market is, the analogy we use is, hey, what's in the rear view mirror and what's in the windshield? A lot of the investment, a lot of the strategic rationale as to why to acquire a business is gonna be a rearview mirror. What have you done? How have you alleviated risk and where is the value in this business? it in the product that you've built? Is it in the customers that you have? Is it in the growth that you've seen over the last few years? That's really going to be the solid case for where evaluation is coming from. The cherry on top is going to be all those growth opportunities. The really important ones are going to be near term, right? What are you executing on today that it's, maybe you have a couple customers in a new market and it's a huge market and there's a lot of opportunity there. You already showed me that you have customers there. So you check that box and that's an opportunity for us. So the near term opportunities are really important. Then you think about long term opportunities. What is pie in the sky? What could we do with this business to get people thinking, right? It's not so much going to be driving value, but maybe you're increasing interest with a specific investor who's, for example, really interested in payments and there's a payments opportunity, but you've done nothing in payments. We want to talk about that. Where can you monetize the solution on the payment side and get an investor strategic thinking about that, right? But I would really say most of the valuation and all of the stuff that we're talking about in this market, at least we're not VCs. We're not talking to VCs. It's going to be in the rear view mirror. And then what's going to be the opportunity is going to get, you know, mind's thinking and maybe a little bit of cherry on top in terms of valuation.

Shiv: Totally, yeah. It's funny you mentioned payments when we sold our last business Wild Apricot, which is a software business, payments was one of the main things we highlighted during the acquisition process, and it was one of the first projects we worked on to implement. So, that's great. What about a broader vision for the platform and also M&A as part of that? So hey, once you buy us here, our additional targets, we can kind of add on or bolt onto this platform to increase the enterprise value. How much effort and thought process is going into that?

Diamond: We do a lot in terms of product expansion. So if you have a really nice platform where we're saying, this is great as it is, but there's a lot of opportunity around it to build ancillary products or go into tangential markets, we're doing work on that. We want to make sure that we have that story really clear. And there's two ways you go about it, right? You can either buy it or you can build it. And we usually present both of those when we're presenting materials or talking to buyers and investors. And then we have specific targets that we know about, the client knows about, we're offering those up occasionally. It's more rare that we're actually talking about specific targets because we're talking to a private equity that has a thesis in the space. They're typically aware of who's in the market that's actionable, but it's really more of the storytelling of where you can go outside of your current product, both on the buy and build side.

Shiv: Got it. And more of a like market question for you. With how things have been going macroeconomically over the last couple of years, interest rates rising and everything, how have you seen deal flow and pipeline and just ability to exit plus also founders that are looking to sell or our expectations, right? Like are founders still looking for those multiples that were available three, four years ago or have expectations changed?

Diamond: Yeah, the last five years have been interesting, to say the least. I view it as kind of a pendulum where we had pre-COVID period that was great. Deals were getting done pretty steady. COVID happens 2020, 2021. We see these huge uptick in valuation and deal activity. And then it kind of tapers off, right? The pendulum is kind of swinging back and people are scared and there's a lot of risk aversion and sellers are nervous to go to market because of rising inflation and interest rates. And then buyers, cash is more expensive and they're struggling to do deals unless it's super safe and there's not a lot of risk attached to it. What I'm seeing now is this slow pendulum shift back to the middle where we're seeing deals kind of back at those pre-COVID levels, both in terms of valuations and in terms of fuel activity, where the market's kind of stabilizing. So sellers are more eager and interested to go to market. Actually, I'm kind of seeing this backlog of companies that wanted to go in the last 18 months and were nervous. And so they're ready to go now. And then, strategics and private equity saying, we need to do deals, we want to do deals. Interest rates and inflation are cooling. So people are more excited and optimistic for the year to come. And I think now we're kind far enough from those COVID levels of 15X on EV, where the market's stabilizing and people are getting back to where they were pre-COVID, both in terms of the numbers and just expectations for deals.

Shiv: Got it, yeah, that makes a lot of sense. Are you seeing a lot of bolt-on or add-on deals more than platform deals?

Diamond: We're seeing pretty even split. So when we're looking at the market, it's a third, a third, a third between strategics, pure play private equity and private equity back to strategic where those bolt-ons would happen.

Shiv: Interesting. Okay, that's good to know. And good to know kind of the pulse on the market, especially as you guys are marketing these firms. So last thing as we close off the episode, any advice for founders that are looking to get started with a process like this? And how did they get in touch with you?

Diamond: Absolutely. I would say the first thing to do is talk to somebody an expert and just get a pulse on your business. Because folks like SEG have a really close eye and ear to the market. We know what's going on. We know it's attractive and we can also provide advice and tips to where you can improve your ability to get a successful outcome, whether that's, you know, fixing some things in the business or refocusing attention on areas that either need attention or would be more interesting when you go to market. A lot of, you know, investment banks like SEG, we just like having those conversations and we like building those relationships over time, even outside of a sale or a sale process. So have those conversations often and early and just get an understanding of where your business stands today. And then when the opportunity comes where, you know, you're ready to go through a process, you're well prepared and you've already been having those conversations with experts in the market. So, SEG, we love having those conversations, like I said, just to build relationships, you know, not charging any sort of retainer. We just like to have those conversations because we're so informed on the market and we're ready to chat. So, you can contact me directly via LinkedIn or my email. I'll give Shiv all my information. Or there's a contact us form on our website, softwareequity.com.

Shiv: That's awesome. And Diamond will be sure to include all of that in the show notes and make sure that folks have your email and the website links there as well. And with that said, thanks for coming on and sharing your wisdom. I think a lot of founders and even investors listening in would have learned a ton from it. So appreciate you doing this.

Diamond: Thank you, thanks for having me.