Some investors are providing it by combining the leverage of a buyout and the growth potential of venture capital
Once upon a time, venture capitalists were venture capitalists, buyout specialists were buyout specialists, and never the twain would meet. That made life simple, if not easy, for the capital hungry. If you were an entrepreneur with a hot new product, you knocked on venture capitalists' doors. If you were the owner of an established business, you went to the leveraged buyout experts.
Gradually, though, both kinds of investment groups began to dabble in each other's disciplines. Eventually someone was clever enough to come up with the idea of combining the best of both investment techniques. The simplified recipe for such a hybrid: add some of the leverage of a buyout to the growth orientations of a venture investment.
By itself, that's not a particularly stunning concept. But the way it's being applied is creating some unusual opportunities for entrepreneurs who are strapped for expansion cash. Instead of waiting for a good idea to walk in the door, these professional investors are spotting their own business niches and starting companies to exploit them. One of their favorite strategies is to "McDonaldize" a mom-and-pop industry. But instead of building a chain store by store, these new-style investors are constructing national companies acquisition by acquisition. Harry Hopper, a professional entrepreneur we'll meet again in a moment, calls this "shirt-sleeve investing" because the venture capitalists and buyout pros who do it are so active in shaping these companies.
The idea, of course, is to snap up as many mom-and-pop businesses as it takes to create a company with a large market share. The key is to pick an industry in which fixed production or overhead expenses don't increase significantly as the company grows. Such economies of scale (the business school jargon for this phenomenon) translate into greater profitability.
Because it's still relatively new, Carol Rabe didn't count shirt-sleeve capital among her options when she found herself at the crossroads in 1987. She had started The Seedlings Inc., a child-care business in Philadelphia's Main Line in 1981, when day care meant "a bunch of kids in a garage with no windows," Rabe recalls. Her first two centers met with immediate success, but the third struggled. AT&T had guaranteed that its employees' kids would fill 25 of 60 spots. Then, just after Rabe had signed a lease for the center, the company laid off about 2,000 workers. AT&T ended up taking only 2 of the spots.
In addition to constantly worrying over the third center, Rabe was tiring of the relentless responsibilities of being an owner. Monitoring and marketing the centers by day, she paid bills, figured out withholding taxes, and answered parents' phone calls at night. "The glow of ownership faded quickly," remembers Rabe. By the time the third center was filled, she was burned out.
As Rabe saw it, she had two options: sell out, or find more capital to expand. Maintaining the status quo with three centers wouldn't work in the burgeoning child-care industry. Rabe's affluent Main Line territory was highly coveted. If she didn't expand within it, Rocking Horse, her largest competitor, would be happy to. The choice was the same one that any entrepreneur faces in a quickly consolidating industry: eat or be eaten.
Rabe went looking for capital for expansion, and unlike many, was lucky enough to find a group of individual investors who would provide $500,000. The trouble was Rabe would have to commit to staying on for another three to five years -- with no relief along the way.
She decided to sell, though that wasn't a very palatable option either. "Once you've given a child-care business the local personality that made it successful, it is very difficult to give that up to a national personality," she explains.
It was simply good luck that Rabe found she had a third option: growing by selling out. Keeley Management Co. -- the local investment bank that Rabe had turned to in order to sell her company -- shipped off a copy of The Seedlings' selling memorandum to Michael Connelly, the gregarious president of Lepercq Capital Management, the venture capital arm of New York City investment bank Lepercq, de Neuflize & Co. Lepercq Capital had $32 million earmarked for shirt-sleeve investments and had already given Harry Hopper, an entrepreneur for hire, $2 million of it to start American Family Service Corp. (AFSC). Hopper had acquired Greentree Learning Centers Inc., a five-center child-care operation in southern New Jersey, in early 1988.
At first Rabe thought that selling to Lepercq would be no different from selling to a chain, since building a national business was Lepercq's ultimate goal. Gradually she began to see some important differences. Connelly wanted The Seedlings to capitalize on its preeminent local reputation by retaining its identity, not submerging it. The potential for introducing economies of scale was what drove all of Lepercq's shirt-sleeve investments, but that meant systemizing back-office operations, not producing cookie-cutter child care.
As attractive as AFSC's approach seemed to be, Rabe felt sure she wanted no part of the company's future. She agreed to sell 100% of The Seedlings, which had 1987 annual revenues of $604,000, for about $900,000. Still, something didn't seem right. Rabe realized that she wanted to stay involved; she just didn't want all the responsibility that was involved in running the day-care centers. Connelly and Hopper, who wanted her to stay on anyway, persuaded Rabe to take the title of director of special proj-ects.
Relieved of the burden of ownership, she began to get excited by Lepercq's plans for growth and its determination to maintain a high standard for quality. Revitalized by such prospects, Rabe became vice-president of operations three months later. By the time Hopper was ready to move on to his next entrepreneurial project, less than a year later, Rabe was sold on Lepercq's strategy and confident of its support. She agreed to take Hopper's place as president and chief operating officer.
Rabe's deal represents one end of the spectrum available to business owners in such shirt-sleeve deals: all cash and no stock. Had she known from the beginning that she wanted to stay with the company, that she simply wanted capital to expand, she could have sold The Seedlings for all stock and no cash, ending up with as much as 50% of the holding company. "We can do it the first way, or the second way, or something in between," says Connelly.
As it turns out, Rabe's approximately 3% stake, negotiated when she became president, may turn out to be worth more than her 100% stake in The Seedlings. If the company grows to about $35 million in revenues, as Lepercq plans, it should be worth some $56 million. That makes Rabe's slice of equity worth $1.7 million. Of course, her ownership position will probably be diluted somewhat before AFSC reaches that size, but it's still likely that she could net at least as much from partial ownership in AFSC as she did from complete control of The Seedlings. Had Rabe gone instead for an all-stock deal, a 50% share of AFSC could amount to some $28 million under the same Lepercq forecast.
But will the forecast come true? AFSC has opened up three new Greentree centers, one new Seedlings center, and instituted four more after-school programs. Connelly expects 1989 revenues will exceed $3 million, ahead of projections. Already AFSC is one of the 25 largest companies in the $15-billion child-care industry.
Growth through the shirt-sleeve strategy has a price, though. While you give up the problems of sole ownership, you gain other headaches. Higher debt expenses, for example, will be one reason economies of scale, which are supposed to reduce expenses, may not materialize for a year or two. In AFSC's case, overhead costs have actually risen, because AFSC has installed management information and administrative systems designed to support a much larger organization.
If AFSC's next acquisition could be arranged quickly, The Seedlings and Greentree wouldn't have to strain so hard under the higher leverage and bigger operating systems. But that isn't as easy as it sounds. Last year, Rabe, Hopper, and Connelly spent almost six months arranging an acquisition that would have nearly doubled its size before abandoning the transaction because the candidate didn't live up to its earnings projections.
The biggest risk for business owners, though, probably isn't in how shirt-sleeve deals are executed -- it's in relinquishing control. Carry the acquisition strategy to its logical end, and it's easy to imagine a company that's chock-full of warring egos of former owners.
Also, some entrepreneurs may not enjoy having an investment group as a majority owner. While Lepercq, like most such groups, leaves day-to-day control of the company to the president, disagreements are inevitable. "We talk them through until we reach a consensus," says Connelly. Hopper suggests that the owners of acquired companies define success in measurable terms at the outset. That way, he says, "when subjective relationships have their inevitable peaks and valleys, you have an objective standard that you can look to."
For Rabe, shirt-sleeve capital was the answer, in large part, because she didn't want complete control. "Owning The Seedlings as a single owner was the most intense thing I've ever done. The responsibility never went away. With AFSC I find I feel the same kind of responsibility, but we have national presence and I have the kind of support I need. I know I'm not the only one responsible for making these companies work."* * *
THE RIGHT STUFF
What investors are looking for
Expansion capital may be just what you're looking for, but is it looking for you? Consider the criteria that Chicago's Golder, Thoma & Cressey, the granddaddy of grow-your-own investing, uses.
* No hair-raising growth rates, thanks. Investors prefer healthy but manageable growth -- between 8% and 20% per year.
* The more the merrier. Lots of companies mean there's lots of acquisitions candidates and, possibly, little serious competition for a major player.
* The right numbers. Do economies of scale -- the magic formula that lowers costs as a company's size increases -- exist? How big are they?
* Fair prices. Asbestos removal, for example, is a terrific business for a consolidation strategy, says Carl Thoma. But not terrific enough to justify what the owners are asking. Golder, Thoma & Cressey likes to pay five to eight times cash flow.
* Talent. The best strategy in the world is useless if investors can't find the managers to implement it. Job requirements: experienced in industry, understands integration process, shares investors' vision.
Golder, Thoma has spent $170 million on consolidation investments, creating regional or national companies in the funeral-home, bottled-water, paging, printing, propane distribution, and food-service industries. While the firm devotes itself exclusively to shirt-sleeve deals, most investment groups do them on an ad hoc basis. Finding such investors takes patience and lots of networking with venture capital and leveraged buyout groups.