Why smart people aren't starting businesses -- they're buying them* * *
No doubt about it, Stephen McDonnell would qualify for membership in any Real Entrepreneurs' club. Runs his own business; has for three years now. Plans to run a few more before he's through. What he doesn't do is start companies. "I'd be a little afraid of a start-up," he muses.
Then there's John Vinton. In his late forties, a career of high-powered corporate management under his belt, he's ready to run his own show. But please: don't send him a handbook on how to incorporate. "I don't want to start a company," declares Vinton.
Who are these guys? Going out on your own used to mean founding a company of your own. Start-up and entrepreneurship were nearly synonymous. For company builders, the 1980s were the years of living dangerously, on the edge, in brand-new enterprises struggling to get off the ground.
Ah, but that was then and this is now. And now, curiously, a new idea of entrepreneurship and a new generation of entrepreneurs are making their appearance. Instead of starting companies, they're looking to buy them. Instead of setting out for the fringes of the marketplace, they're staying firmly in the middle, often taking over mature businesses in old-line industries.
Make no mistake: these are not near-retirees buying a job and a dividend check until they're old enough for full-time golf. These are men and women in the prime of life, with experience, savvy, and access to money. Their plans are not just to buy companies but to grow them, to transform them, often to branch out from one market niche to another and then another. Entrepreneur is not a sobriquet they would take lightly.
Though statistics are hard to come by, McDonnell and Vinton belong to an apparently sizable group of buyers and would-be buyers. There's Dorothy Serdenis, 10 years at Merrill Lynch, now shopping for a company of her own. There's a man we'll call Bob Cluster, a dozen years with Federal Express, searching for a business to buy and run. Phil Harris, 20 years at Xerox and Wang, has set up a buying partnership with the giant Hambro International financial concern. "My job," says Harris, "is to find a company I'd like to run and bring it to Hambro for the equity." John Thorbeck is a couple of steps ahead of Harris. In partnership with a venture capitalist and several other investors, the former vice-president of Timberland and former president of G. H. Bass bought the Geo. E. Keith Co., an old-line Massachusetts shoe manufacturer. The deal closed just last spring.
At the moment, the business-buying marketplace as a whole is spotty. "This business is as dead as last Thanksgiving's turkey," complains an Arizona business broker, quickly asking not to be named. The retail stores and other small ventures typically handled by business brokers aren't moving, and the brokerage industry itself has come upon hard times. At the far upper reaches of the marketplace, the high-leverage megadeal typified by the RJR Nabisco buyout has also virtually vanished.
In the vast middle market, however -- sales of businesses with a purchase price between $1 million and $50 million, according to one rule of thumb -- the slowdown isn't anywhere near as pronounced. Statistics gathered by Merrill Lynch's Mergerstat Review showed transactions in that category off 1989's pace by only 3% in the first nine months of 1990, compared with a 39% drop in transactions of $100 million or more. "The middle market is likely to stay brisk and lively," confirms Martin Sikora, editor of Mergers and Acquisitions magazine. "There's plenty of buying interest out there."
Besides, what's happening is a trend that will stretch well beyond the current slowdown; indeed, as the 1990s get a little older, we will probably witness the biggest, brassiest, fastest-moving bazaar of businesses you'll ever want to see. The reasons aren't hard to fathom. The marketplace has changed dramatically in the past 10 years, and those changes will be percolating through the economy for years to come. The number of businesses for sale will be mounting. The number of buyers will be rising even faster. A whole new group of investors and intermediaries will be only too eager to bring both sides together, lubricating the meetings with plenty of cash.
It's all this buying and selling that will foster that new model of entrepreneurship -- typified, as we'll see in a moment, by such new-breed business buyers as John Vinton and Steve McDonnell.* * *
The 1980s were boom years, bringing the longest period of economic growth in recent memory. The decade also witnessed an astonishing proliferation of start-ups. Result: if you were looking for a business to buy, you'd want to be looking in the 1990s.
For one thing, sales of traditional small and midsize companies -- manufacturing or distribution businesses, for example, started 20 or 30 years ago -- are likely to pick up quickly in the next few years. "Maybe the owners looked at selling in the 1980s," explains Richard Baum of the Mid-Atlantic Cos., a network of business-planning consultants based in Mountain Laurel, N.J. "But business was great, and they could go out and play golf. Now the expansion is over, they're saying, 'Jeez, I'm 65 or 70, I don't know if I want to go through all the hurdles again.' " Globalization and other long-term forces restructuring the marketplace will push the process along. How many aging owners really want to take on new German or Japanese competition? How many even want to take on some hotshot U.S. entrepreneur who's using the latest technology to grab market share?
The key legacy of the last decade, however, isn't just a backlog of traditional business sellers, it's a wholly new supply of businesses for sale. "You had a new breed of business starter in the '80s," points out Lisa Berger, author of the book Cashing In. "They started companies not because they wanted to run the business the rest of their lives and pass it on to their kids. It was, 'I'm gonna bust my butt to make this business successful, then I'm getting out.' "
Examples? Take Clay Teramo, founder of Computer Media Technology Inc. (CMT), a Mountain View, Calif., reseller of magnetic recording media for computers that made the Inc. 500 for the last two years. For Teramo, starting CMT back in 1984 was both terrifying and exhilarating, particularly since his initial assets consisted mainly of a Rolodex. But once the company was successful, boredom set in -- and Teramo began looking for a buyer. "The business was just perking along wonderfully, and if I were 50 years old, that's where I'd want to be. But I'm only 31 -- I want the juice, I want to build again. The fun part for me is to start something new." Teramo sold CMT last November.
Many of the starter-uppers went so far as to structure their businesses for easy sale from the beginning. "I began this company with selling in mind, and I've designed it to keep it groomed for sale," says the M.B.A.'d owner of a year-old diaper-delivery service, requesting anonymity. Rather than invest in her own laundry facilities, for example, she contracts out the washing of the diapers. The decision hurts her in the marketplace a little, since competitors can tout the quality assurance provided by in-house laundering. But it keeps her fixed assets low and thereby expands the number of potential buyers. Francis Farwell, founder of WinterSilks Inc., a Middleton, Wis., mail-order apparel company, also planned to sell from the start and also built the business accordingly. The key decision: instead of plowing all his earnings into growth, he made sure the company maintained a sizable free cash flow, making it more attractive to potential buyers. A year ago Farwell sold out, pocketing several million dollars.
Then too, the 1980s gave birth to a host of new industries, from asbestos abatement to video rentals. These businesses are undergoing a constant -- sometimes brutal -- process of churning and consolidation, leaving a lot of company founders eager for exit. Marshall Smith, a Boston-area entrepreneur, started a chain of paperback bookstores in the 1960s; the chain grew rapidly, only to founder on a couple of rocks named Waldenbooks and B. Dalton. When Smith started his Videosmith chain of movie-rental shops, he "anticipated the same thing as happened in bookselling" -- and sold out on the upswing rather than the downswing.
The treated-lumber industry, to take another example, is populated by an estimated 300 small companies, many of them started in the past decade. "It's a perfect example of a fragmented industry -- one that's already undergoing consolidation," says Elizabeth Squeri, editor of "Buyouts," a newsletter.* * *
The buying side of the company marketplace underwent even more of a transformation during the 1980s; indeed, a seller of 10 or 15 years ago would be amazed at today's array of potential purchasers.
Big corporations, both U.S. and overseas, still work the acquisition trail, seeking smaller companies that can provide them with new products and new markets. They've even stepped up their efforts in the current downturn. ("More Big Companies Set Sights on Small Acquisitions," read a recent headline in The Wall Street Journal.) But traditional corporate acquirers have been joined by a coterie of other business buyers, including small companies, investment partnerships, and well-connected, market-savvy individuals. Each group works by its own logic, seeking out certain kinds of businesses and avoiding others. Taken together, though, they represent an accumulation of buying power that simply wasn't available to business sellers in the past.
The consolidators. Most of the small companies pursuing acquisitions are looking to expand their markets -- and market shares -- in growing industries. Consider Terry MacRae, co-owner of San Francisco-based Hornblower Dining Yachts, who has built a $23-million company in only 10 years. MacRae's strategy: judicious purchase of mom-and-pop cruise-boat operations in San Diego and other California coastal cities. Most cruise operators, he observes, know boats; what they don't know is stuff like accounting and budgeting and marketing. So they're happy to sell when business looks bleak or the competition heats up. Over a series of deals, MacRae has learned some sophisticated tricks of the acquisition trade. Money for his purchases, for example, has come not only from straight debt but from limited partnerships and subordinated mezzanine financing.
The same phenomenon can be seen in software, environmental services, and a host of other new industries. Symantec Corp. has snapped up several smaller software companies; with its recent acquisition of Peter Norton Computing Inc., it is now one of the larger companies in its industry. Mindis International Recycling, a four-year-old metal-recycling company headquartered in Atlanta, has grown to $100 million in sales, mostly by buying local scrap yards. "The small guys are on the acquisition trail," says Jeff Mick, a principal with Bridge Group Investment Banking, in San Francisco. "Particularly the ones that have relatively sophisticated managers."
The investors. Giant leveraged-buyout deals may have peaked and vanished with the 1980s, particularly now that Mike Milken is out of business and Drexel Burnham Lambert in collapse. But the buyout concept has percolated down into the world of small and midsize companies. Partnerships that might once have been scouting out venture capital investments are looking instead for small-scale buyouts and recapitalizations of existing companies, and are often planning to stay with their new acquisitions for several years at a minimum. In many cases, private investors and money-fund managers are bankrolling the partnerships.
At the upper end of this scale, investment managers such as Chemical Venture Partners, in New York City, and Abbott Capital Management, in Needham, Mass., have hundreds of millions of dollars at their disposal, much of it destined for management-led buyouts in the $15-million-to-$200-million range. "Managers of businesses will become what entrepreneurs were in the '80s," says Abbott's Stanley E. Pratt, a general partner. "We've learned that the really big returns come from the growth and revitalization of existing businesses." Maybe not surprisingly, some of the industry consolidators are getting their financing from these sources. Chemical Venture Partners, for example, has bankrolled PTN Publishing Corp., headed by Stanley S. Sills, brother of opera star Beverly Sills. PTN has acquired some 15 small specialty trade magazines.
The partnership/buyout concept is being applied at the lower end of the marketplace as well. Mike Stevens, for example, put together a limited-investment partnership only a little over a year ago. His targets: small, family-owned companies, with $3 million to $30 million in annual sales. Stevens's financial partners include one money-fund manager and several individuals, mostly company builders themselves; they can come up with $1 million to $2 million in equity on any given deal. Typically, Stevens says, he'll plan on retaining the current general manager or finding a new one, making sure he or she has an equity stake in the business as well. "At any given time we're talking with 15 or 20 managers looking to buy businesses. People with experience, ready to put some money into it. They're usually good at running the business, but they wouldn't know how to structure the deal or where to find the money to buy it."
The buyout entrepreneurs. Almost by definition, buying a company requires more experience than a start-up -- no one's likely to finance purchasers who haven't yet cut their managerial teeth, and bootstrapping is rarely an option. And the ranks of experienced and footloose managers have swelled in recent years as America's largest corporations have slashed their white-collar payrolls. "You'll see the impact of all that downsizing for another 25 years, through the end of those people's careers," says Bridge Group's Mick. "It'll make them more receptive to doing entrepreneurial things." Many of the corporate refugees, adds Mick, neither want nor feel well suited to a start-up situation. "Doing entrepreneurial things" means looking for a business to buy.
So it is, for instance, with John Vinton. A Columbia M.B.A., Vinton pursued a classic big-company marketing career: stints with Procter & Gamble, Frito/Lay, and Gillette, then eight years as president of yogurt maker Colombo, a subsidiary of a French multinational. In the past Vinton might have continued to climb the corporate ladder, keeping his eye out for an upward move into another giant company. In today's climate, he'd rather run his own business.
The trouble is, Vinton isn't a start-up kind of guy. "My experience lies in building companies, not in starting them. I'm not a classic entrepreneur, a guy with an idea that's waiting to be cultivated." Then too, he wants an organization big enough for the management skills he spent a career learning. "I've got business-school experience. I know how companies can be managed. I want to be in an environment where I can use the techniques and where there are resources available to do that."
For several months now, Vinton has been looking for a consumer-goods company to buy. It's not what you'd call an idle pursuit: thanks to his background and contacts, he can bring plenty of money to the table, both his own money and the funds of well-heeled private investors who know him and his capabilities. It's the same with other big-company refugees. "There's a sizable group of people -- I guess I'm one -- who maybe have a little money put away, and because of their exposure to people in their previous careers know where more money can be found," says Dorothy Serdenis, the Merrill Lynch veteran. "Because I know some people that would be willing to invest with me, I could buy something bigger -- maybe up to $10 million -- than I could ever do on my own."
Traditionally, executives who bought small or midsize companies were simply opting out of the rat race, trading the perks and potential of fast-track corporate life for six-hour days and month-long vacations. New-breed buyers like Vinton have other things in mind entirely -- innovation, modernization, and growth. As with any entrepreneur, their objective is to build a company, not just a bank account.
Case in point: Steve McDonnell, who in 1987 became the proud owner of Jugtown Mountain Smokehouse, a tiny specialty-meats producer in Flemington, N.J. McDonnell didn't know much about meat when he bought Jugtown. But he had plenty of experience in business, and he figured that even a sleepy family-owned company could provide opportunities for a growth-oriented owner. So McDonnell invested in new meat-processing equipment and a new computer system. He introduced hitherto-unknown fundamentals such as cost accounting and budgeting. He changed his product mix to keep up with market trends, emphasizing low-fat products such as smoked turkey. Hitting the road, he sounded much like a start-up entrepreneur. Give me a chance, he'd tell prospective customers. It's my first company, and I'm just trying to get it off the ground. Off the ground it got: sales rose from roughly $300,000 in 1987 to an estimated $1.4 million in 1990.
Recently, McDonnell has begun merger-and-acquisition discussions with his major competitor, a move that would both triple his company's size and eliminate a good deal of price competition. ("It would give me, uh, a little more flexibility on pricing," he delicately puts it.) He's also pursuing a larger company that specializes in European-style meats, and is investigating joint-marketing arrangements with specialty-food producers in other parts of the country. In short, he's aggressively going after growth, while avoiding the rigors and agonies of a start-up. It's a model of entrepreneurship with a growing appeal.* * *
What's interesting about buyers such as McDonnell, of course, isn't just their objectives -- it's their effect on the marketplace. With so many buyers and sellers out looking for deals, a host of new constraints and opportunities present themselves to business owners.
Point one: companies -- all companies -- will be regarded more and more as liquid assets, capable of being bought, sold, or combined in any number of ways. You want to sell out? There'll be plenty of buyers, even if you run a service business. (See "Are Service Companies Different?," page 5) You want your business to grow? Think of your company not as an immutable institution but as a collection of skills and assets, then perform the appropriate strategic calculations. Maybe a segment of the business can be spun off, and the proceeds used to acquire a competitor in your company's primary industry.
Or maybe you can engineer the kind of merger that makes the whole more than the sum of its parts. Tim Herman, owner of a $1-million manufacturing company called Airprotek Inc., saw his business stagnating; it wasn't big enough to compete effectively, and Herman didn't have the money to help it grow. But one of his competitors, he knew, was in the same boat. And that company had products complementary to Airprotek's.
So Herman and his erstwhile competitor merged, with each getting equity in a new -- and considerably more valuable -- business. "We double the size of the company and double the size of the product line," says Herman. "My share of the new company is worth more than my 100% ownership of the old one."
Point two: the owner who decides to buy, sell, or merge will find plenty of knowledgeable experts to turn to for advice. Until the 1980s the smallest companies were sold by local business brokers or by word of mouth, and the largest were handled by Wall Street. Everyone else had to depend on a catch-as-catch-can marketplace. Maybe a buyer could be found through industry contacts. Maybe a local accountant or lawyer knew enough to engineer the transaction.
Today any number of advisers and middle-market investment bankers are doing a thriving business helping entrepreneurs design and consummate deals. "Five or 10 years ago there was no one like us to handle a [middle-market] transaction here in Houston," says John W. Adams, executive vice-president of Windham Capital, investment bankers. "Firms like ours add another level of experience and sophistication to buying and selling." These experts have effectively expanded the marketplace as well. Networks such as the Chicago-based Intermac (the International Association of Merger and Acquisition Consultants) maintain international databases of prospective buyers and sellers. So do some of the giants that have recently carved out a foothold in the industry, such as Merrill Lynch's Business Brokerage and Valuation unit.
Finally, even if you yourself never expect to buy or sell, consider the effect of everyone else's buying and selling on the competitive landscape. Not to put too fine a point on it, there aren't any safe niches anymore.
During the 1980s the most aggressive and shrewd businesspeople often set out to start their own companies. They typically went into high tech or into other brand-new industries in which they could develop a market of their own. And today? Well, Steve McDonnell has charged into the smoked-meats business -- an industry that until recently still dealt largely in cash. John Vinton wants to buy an established consumer-goods company. John Thorbeck, of Timberland and Bass, bought an old-line shoe manufacturer. Company owners who find themselves up against such high-powered entrepreneurs will also find the competition has been cranked up a few notches.
So it might be wise to look around -- at your company, your industry, the marketplace you do business in -- and ask yourself where, among all those seemingly sleepy companies, the entrepreneurial opportunities lie. Because it's a safe bet that, sometime soon, the new breed of business buyers are going to come looking. When they do, you may wish you had gotten there first.
Phillip H. Harris, 47
Career Highlights : Xerox, 14 Years; Wang, 5 Years
Ideal Acquisition: An industrial products distributor or light manufacturer that needs sales and marketing expertise, with at least $10 million in sales
Would Look At: Any industrial products company ("I don't know anything about consumer goods")
Willing To Pay: Up to five times earnings before interest and taxes
Primary Source of Equity: Hambro International Venture Fund
Opportunity Spotted: "A lot of low-tech companies aren't well managed and don't understand marketing. They don't employ multiple distribution channels or costing methods that allow them to look at profits by channel. Most of the owners don't even have a computer on their desks. Good management, marketing, systems -- that's the value I can bring."
Dorothy Serdenis, 45
Career Highlights: Municipal government, 10 years; Merrill Lynch, 10 years
Ideal Acquisition: "Anything really -- provided the challenges were interesting and the personal chemistry was right."
Would Look At: Retail businesses; manufacturers of retail products with $50 million in sales
Willing To Pay: Up to $10 million
Primary Source of Equity: Savings; other private investors
Opportunity Spotted: "I want a business where I can see real value. For instance, as the population ages there will be a greater need for products and services that help older people. That's going to create a demand for businesses in health care, for instance. As a buyer, you can see the trend and you can see real value."
H. Michael Stevens, 39
Career Highlights: IBM, 2 years; Summa Four Inc., a start-up telecommunications company, 7 years
Ideal Acquisition: Family-owned light manufacturing company, $3 million to $20 million in sales
Would Look At: Corporate subsidiaries
Willing To Pay: Three to six times pretax earnings, up to $20 million
Primary Source of Equity: Investment partnership
Opportunity Spotted: "Family-owned companies frequently haven't reached their potential. The owners have been taking a lot of money out; now they're getting on, and they don't want to risk their capital base to take the company to the next stage. They usually have good management. But they just don't have the horsepower to tackle that next step."
ARE SERVICE COMPANIES DIFFERENT?
Three years ago a $2-million telemarketing company might have been a long, tough sell for broker Bob Gurrola. After all, it was a service company, light on assets -- at least the kind that cast a shadow or comfort a banker -- but freighted with intangibles such as loyal customers, management strength, goodwill. The sort of company that, though profitable, doesn't store its value or find its financing in the usual places.
Nevertheless, this telemarketing firm kept Gurrola's phone ringing with calls from vice-presidents of IBM and Hewlett Packard. "I've got top-notch people earning $150,000 a year looking for the opportunity to run their own shows."
Until recently, some of those same buyers might have thumbed their noses at service businesses. Why the interest now? The low price of admission, for one. Service companies, because they are unencumbered by hard assets, might seem riskier but also come cheaper, typically selling for less than manufacturers with similar earnings. "Buyers are finding they can get the same amount on the bottom line as, say, a manufacturing company, but without tying their equity up in expensive capital equipment," explains Richard Green, president of National Business Search Inc., in Dallas.
The exodus of midlevel managers from big corporations has enlarged the pool of buyers and fueled demand. But changes in valuation practices and capital markets have made service businesses more salable.
"Valuation has become more sophisticated," notes Robert Reilly, a partner with Deloitte & Touche in Chicago. "We are learning to break out the value of a supplier relationship, a customer list, a favorable lease, the assets that are off the balance sheet."
Owners and appraisers insist that conventional book value isn't the measure of a service company's worth. So what is? "Strong historical cash flow," says Bill McClure, managing partner of Amerimark Capital Group, a merchant banking firm in Dallas. What buyers inevitably purchase is the company's future earnings. But profits promised don't sway many bankers.
How, then, are the deals financed? A more sophisticated capital market has emerged for small, closely held businesses that did not exist five years ago, say industry watchers. Regional merchant bankers and cash-flow lenders are more tolerant of softer assets. Money-center banks such as Citicorp or venture groups such as GE Capital have taken to financing some intangible assets. And now that merger mania is dead, even Merrill Lynch confesses to being "more willing to talk to companies doing under $10 million in sales," says Richard Hanson, a director of Merrill's financing and credit services, part of the business financial services group.
Despite the array of alternative lenders, loans for buying service companies are not easy to come by. Bob Scarlata, principal and owner of The March Group Inc., in Nashville, says that "demands a more realistic approach by the buyer and the seller. The owners know they'll have to carry most of the debt." Besides, owner financing is often the best way to win your asking price.
"The discount for an all-cash sale can be so steep -- as much as 50% -- that many sellers are unwilling to accept the price," says Jeff Jones, president of Certified Business Brokers, in Houston. A typical transaction will leave the seller carrying a note for two-thirds of the sale price. But some choose to carry the entire balance at a premium rate. "They see financing the business as a good return on investment," says C. J. Harris, whose firm, based in Greenville, N.C., specializes in brokering businesses.
While service sellers might realize a nice return on a business that never demanded much capital, they rarely walk away scot-free. The owner, often the company's most valuable asset, can expect to sign a noncompete covenant and probably an earn-out or employment agreement as part of the sale. In many transactions, a significant portion of the purchase price can be deferred and paid incrementally over the life of the seller's consulting or noncompete agreement. That not only minimizes the buyer's up-front costs but clearly defines and protects one of the business's major assets. And the cost of the seller's employment contract is tax deductible.
Given the time it takes to sell and transfer the business, smart sellers plan their exit one to three years in advance. "You don't have a lot of tangible assets,"' says David W. Brandenburg, who sold his computer dealership in the summer of 1989. "So you're selling the viability of the business and its growth. How can you guarantee that? By doing better each quarter." -- Anne Murphy