Conversations: Gavin Lew, Who Founded User Centric and Sold It to GfK in 2012

Conversations Our next conversation is with Gavin Lew, who started User Centric, a user experience consultancy, in 1999. In 13 years, he grew the company to over 60 people. He sold the company in 2012 to GfK, a German consumer research company with over 10,000 employees in over 200 offices around the world. He remained at GfK for close to 6 years before leaving to found Bold Insight.

Gavin, what was the context of your acquisition?

In 1999, I started a company called User Centric. We focused on UX research and design, before UX was a known acronym and name. User Centric offered research methodologies that were different from market research. We were behavioral scientists. About four years into it, I met Tara Bosenick, founder of the German company SirValUse. Tara said, “I think global UX will be big and you guys are just like my team in Germany, kind of a small, niche company.”

Tara’s company was bought by GfK which was the fourth largest market research firm in the world. As part of that deal, she said, “I need to buy User Centric.” So GfK was the acquisition vehicle for a little German company to merge with a little US company and form a global product group.

Why were you exploring an acquisition?

Being a small consultancy can be tough. There were a couple moments, like in 2001 or 2008 when the world essentially shut down, where our survival was in question. Coming out of other dry spells between 2008 to 2012, there were periods of fallow years. Owning a business comes at great personal risk because at the end of the day, owners are personally responsible for real estate leases. Leases are a pretty big part of operating costs. Beyond leases, there are salaries; salaries are a consultancy’s greatest cost. As all businesses, cash flow can be challenging, even for profitable businesses, because it is based on timing. If we don’t get timely payments, we could not make payroll. If we don’t make payroll, something bad happens. The team morale, the culture… it changes your world.

In times of crisis, you are reminded of risk. During the financial crisis of 2008, we had to reduce staff. When we had an opportunity to form a global UX practice within a large company, we said, “Okay, why don’t we just take all the risk off the table, get a good salary and maybe blow the doors off and make an incredible global team? Take the acquirer’s MSAs, their sales staff, and let’s build something amazing.”

Tell me a little about the financial structure of the deal.

The valuation is pretty classic. It’s a multiple to top line and a multiple to EBITDA. Our multiple was above one. In other countries, they can go for multiples well above one and sometimes closer to two. It just depends on the markets and in some ways the mood of the market.

Did you have an earnout?

I did. The earnout was partial upfront, and then partial on the backend of three years. It was based on a few things: the global revenue, the internal revenue that you actually generated, and profit. Elements were weighted. This was a win because risk was mitigated, the team was intact, and growth expectations were reasonable.

If I could offer advice, it would be that the elements that you previously took for granted must be controlled, if your earnout has an EBITDA component. You need to hold as many factors that contribute to EBITDA constant on your earnout, and understand the variables that go into EBITDA. As business owners, we just do really good work and we leave the accounting to others and that’s the area where the buyer can take advantage. I knew the costs of things that I paid for when I owned my company. But being part of a larger organization, control over costs can be pooled and weighted in ways that I did not consider. For example, as a business owner, pre-sale, you know how much your monthly lease payment is. You know your total IT expenditures across a year. You know your legal costs. But as part of a large organization, these costs could be aggregated across the organization and allocated by headcount. So your monthly lease costs are part of an aggregate and you are not responsible for just your monthly, but the aggregate across the organization divided by headcount.

Imagine you’re a lean and efficient organization prior to acquisition—now your IT, legal, real estate, HR costs go from actual to a per-head cost that may be different and these differences impact your EBITDA.

But if it’s an acqui-hire, it’s the value of your people. Can you retain the critical people? Do you want to cash some money out and give it to them on the side? If you do side deals with your top people, will that come out of your pot? Or will the company plan for retention bonuses during the first or second year of acquisition?

You want to negotiate that upfront and say, “Look, here’s what I’m going to do. In order to hit my numbers, to make you happy and make me happy, I need these people and I need this kind of money to keep them.” How much of it can you get from the sale price versus what you’re going to pull out of your own sale price?

Another bit of advice is to have your earnout based on what you can control. My example—and I should have seen it—I didn’t make all my earnout. It didn’t hit 100% and that was because one of our weighted variables was global revenue, which I didn’t have full control over. My counterparts in other countries flatlined and I’m like, “Had you just gone up a little bit, I would’ve hit my earnout.” Control what you can control. That’s easy to say in hindsight.

It seems like a lot rides on committing to key metrics, before really knowing the dynamics of how you’ll achieve those metrics.

Most businesses are cash-based. We went from cash-based to accrual, and a different form of accrual, which is German, called the International Financial Reporting Standards, or IFRS. I was naïve to IFRS. I did not understand the difference. A lot of businesses count cash when it gets in the door. IFRS will count cash on an accrual basis.

Design agencies tend to bill by the month, versus 50 upfront and 50 at the end. We would bill 50/50, and that could be a significant number that’s not counted. We would get money and hit a certain number, but with the IFRS standards, it takes a while to accrue. We’re like, “Whoa, that’s revenue.” And they’re like, “No, it’s not revenue until it accrues in the standard accounting principles.” We would respond, “That’s not how we counted.” But even if we got paid upfront, we only get credit for what we accrued. It’s great for cash flow, but it’s not been accrued.

What are some of the things you encountered after the acquisition that you weren’t expecting, and that weren’t so great?

IT, real estate, finance, salaries… you’ll never get another chance to rightsize all those things. I should have considered that HR would now involve a corporate process, and I no longer controlled it. You are told that you have control over your business, but when you add corporate processes, you will find that things that are easy become challenging. Before closing the deal, I should have executed more changes.

Hypothetically, what if the HR data says your people are overpaid, but you aren’t privy to or in control of this data? As an organization, you hire employees who come in with expectations and see departures due to salary. If you feel that your team is leaving because they can get higher salaries elsewhere, then there is a disconnect.

As a business owner, when you are not able to adequately compensate those who are knowledgeable, trained and loyal, the business loses the talent. The outcome is that good people quit for money somewhere else and then you have to hire someone off the street that needs to be trained. This is the flawed logic that hurts the time and effort spent developing organic talent. If you lose that power, then you will spend a lot of resources as attrition occurs.

This describes the challenge of running a business and being placed inside a large business where processes are put in place to manage units of varying degrees of success.

Here is another hypothetical—one to be considered during acquisition negotiation. Consider your Information Technology costs. You know the annual cost, because you pay it. But when you are acquired, actual costs do not apply. Finance might give a per head allocation, similar to real estate. I will be the first to say that this “per-head allocation” might be higher than you could imagine as a small business owner.

Say you had 100 employees. If your IT allocation was $10,000 per employee then that is $1 million. As a business owner, IT tends to be laptops and communication devices/services. If laptops are cycled every 3–4 years, you know the costs. But across a major corporation, there are other costs and when they are aggregated with IT salaries, the “allocation” that is placed on your P&L can be much, much higher than what you expect. The impact of this is that your EBITDA is saddled with much higher costs, which lowers your profit. But nothing in your business substantially changed. Your profit went down, and if your earnout is based on a profit target, then you made a miscalculation.

If your earnout is based on profit, there are lots of variables that go into it. IT, and real estate, and other financial things where you can get into the aggregate, of which I had no idea of the impact that these charges would have to profit. You need to lock those things down in your P&Ls. If you’re being purchased based on your profits and you’re giving projections based on those models, you have to hold as many things constant as you can (or at least variable within reason), or you’re going to not make profit because you’re getting pulled into the aggregate.

What are some of the things you had to give up after the acquisition?

When you run a business, you have discretionary income—whether it be a car, or the use of a red carpet club in a lounge in an airport. There are lots of things that, from an expense side, you can take personally and benefit from. That’s discretionary income. All of that goes away.

Things that you had absolute control over could now be in the hands of other organizations. Let’s say you had an initiative where you worked with a university to recruit strong candidates; it was successful and you wanted to do it again, so you presented a plan to leadership to do it again. And they applauded it because, comparing how much it costs to acquire a handful of people, and I can do it for hundreds of dollars? Everyone said, “no-brainer.” And what if it took not a month, but over a year to get that initiative funded because action sat in another organization? There are politics, power and influence levers that you didn’t have to navigate when you ran your business.

You’ve described some issues that seem to have had a pretty significant impact on your ability to manage your team. In hindsight, were there places in the sale process that you feel you could have headed these off?

I took people at their word for things. I asked them, “What if there is a major change in corporate structure? My earnout should pay out at 100%.” They said, “We’ve had hundreds of acquisitions. It’s never happened.”

Be strong. Or have your legal counsel be stronger. Consider responding, “I hear exactly what you’re saying, and if that’s true, then there should be no problem for you to put it in writing. If there is no risk of it happening, then you should be fine signing it.” During negotiations, it is all about position, not acquiescence. Negotiation is the one time to lock in what you want to control.

There’s a whole page and a half of definitions in the contract. Know how they define revenue and profit, and how those can be manipulated. These definitions are key. Your assumptions need to be written down. I could easily see the scenarios where it could have been devastating.

There’s just a lot of strategies that I did not consider prior to the final contract. In some ways, lawyers could have helped, but they have to know the behind the scenes financials of your particular business to identify where to place hard caps or ratios that should be applied. When you are in negotiation, you go in thinking that everyone’s going to be great. You want educated counsel to be that “cutthroat lawyer” who tells you where you have risk to have a lower EBITDA or clauses which could have disastrous impact if control is lost. These are business elements that you know, but may not have articulated aloud. The contract is where everything needs to be clear.

I thought, “I taught at a university, so is that considered another job? Am I still allowed to do that, or am I violating my employment agreement? What are the terms?” And your employment agreement doesn’t always sync very well with your purchase agreement, so you’ve got to align those.

When you reflect on your experiences, what sort of advice would you give a design owner who is contemplating a sale?

Consider what the end game is for your personal finances. Selling can take risk off the table. But the first step that anyone should think of is, after taxes and after shareholder partitions, is it worth it? If you sell your company for a million, after taxes, it’s going to be $500,000. Is $500,000 worth it? Where is that threshold?

Is this a situation where you still need to work, or where you are going to retire? If the number is less than your target, then why not just keep going? That’s the one thing I think people have to really think about. At what point does it become worth it? Because if you think about the acquisition, they’re going to pay you some money upfront. That’s their biggest risk. But in an earnout, depending upon the terms, depending upon how you hit your targets, you’ll get more money, but it will come from the profit of your business unit.

During the five or six years that I was at GfK, I knew that my team made more money in profit to the acquiring company, than I did with my earnout. This is an example of what could happen if you are successful. Ask yourself: is the earnout large enough to make it worth the effort and change? Are you okay that the acquiring company will be paying you through your own profit?

For me, the advantages—reducing risk, and global growth—outweighed the concerns and it was a win-win.