Roll-ups: Swimming Against the Tide
Some of us don't feel comfortable unless we're bucking the conventional wisdom, and right now the conventional wisdom is running strongly against roll-ups. I'm referring to the companies formed in the 1980s and '90s by merging a bunch of small, privately owned entrepreneurial businesses into one large, publicly traded entity that would supposedly rise to the top of whatever industry it was in. As it turned out, the vast majority of roll-ups were flops that cost investors millions of dollars. These days you can't even mention the term roll-up in financial circles without drawing hostile stares. Meanwhile, articles keep popping up in the business press comparing the roll-up bust with the dot-com collapse.
All of which makes me think it's time to give roll-ups a second look.
I believe there are industries today that are ripe for a new breed of roll-up. They are highly fragmented, with dozens of small, privately owned mom-and-pop companies accounting for the lion's share of industry sales. Most of those companies are available at a reasonable price for the first time in many years. Consequently, an opportunity exists for an enterprising group of people to bring a number of such businesses together into a single entity and thereby create a new industry leader -- provided the investors take care to avoid the mistakes of their predecessors who gave roll-ups a bad name.
Those people used a particular model to turn out roll-ups in cookie-cutter fashion during the boom years. The model was based on the illusion that you could take a group of hard-driving entrepreneurs who had fast-growing businesses and bring them together in a new company where they would work together as colleagues and employees, continuing to grow their joint enterprise as fast as they'd previously grown their separate businesses. Not only that, but the new entity would supposedly achieve all kinds of cost savings by merging various back-office functions into a central administration to which each of the former entrepreneurs would happily report.
I think you could consolidate gift-and-souvenir companies without running into the problems that doomed the previous generation of roll-ups.
Now, anyone who had spent much time around hard-driving entrepreneurs would have realized that such a scheme was bound to fail. Their egos alone would make it impossible for them to work together, to say nothing of reporting to a boss. What's more, most of the roll-ups were in highly competitive industries with low barriers to entry. If the hard-driving entrepreneurs became disillusioned, or were fired, it wouldn't matter that they'd signed noncompete agreements. One way or another, they'd find a way to go back into business and compete against the roll-up, taking with them a significant percentage of the customers they'd brought in.
And the participation of hard-driving entrepreneurs was just part of the problem. What about the insane idea of trying to merge so many companies simultaneously? It's difficult enough to pull off the successful merger of 2 companies, let alone 10, 20, or more. As for the supposed economies involved, anyone who looked closely could see that they were largely figments of the deal makers' imagination. Nevertheless, the roll-up specialists were able to sell their vision to the investing public, which rewarded them with astronomically high valuations of the stock in their new entities, at least initially. The deal makers could thus afford to offer vastly inflated prices for the companies that were being acquired.
In the pre-roll-up delivery business, for example, you could buy companies for about 22 cents per dollar of sales. I bought several companies at that price in the mid 1980s with the understanding that the owners would be paid over five years. Then along came the roll-ups offering $1 to $1.50 per dollar of sales with the entire amount being paid in a lump sum after the initial public offering. Granted, most people received part of their payment in stock, but the cash portion alone was usually more than the company's entire value a short time before.
That was typical. In industry after industry, owners suddenly had a once-in-a-lifetime opportunity to sell their companies for more money than they'd ever dreamed of having. I know of one guy who sold his business to a roll-up for $36 million in cash, which was three times its actual worth (based on the present value of future cash flows). How could anyone turn down such an offer?
The result was a general increase in equity values. Every roll-up produced a ripple effect throughout the industry in question and beyond. Owners saw the prices that other companies were going for and began to value their own companies accordingly. With expectations so high, it became almost impossible to do such acquisitions on terms that made financial sense.
Now valuations have finally come back to earth. Thanks in part to the roll-up collapse, expectations are once again in line with reality. Owners who want to sell their companies are looking for a reasonable price and, in many cases, something else: an assurance that their business will be in good hands and will continue after they leave. That change opens up the possibility of doing a different kind of roll-up.
Take the gift-and-souvenir business I wrote about in the February issue (" Opportunity Knocks"). You may recall that the business was started by an artist named Pat, who came to me for advice about two years ago. (See " Help! I Need Somebody," November 2000.) I teamed her up with Don, an experienced salesperson and executive, and together they acquired the license to use the FDNY logo of the New York City fire department on a wide variety of products. I now serve as Pat and Don's adviser and financial backer.
A few months ago, we began looking closely at the gift-and-souvenir industry in which they operate. It turns out that almost all the major players in our geographic area are small companies doing a few million dollars a year in sales. Typically, the owners are people nearing retirement who've spent two or three decades building their businesses with tender loving care. They regard their companies almost like their children, but they're ready to get out.
I think you could consolidate gift-and-souvenir companies without running into the problems that doomed the previous generation of roll-ups. To be sure, you'd have to do it differently. Instead of focusing on high-growth companies, you'd target mature, stable businesses. Instead of seeking hard-driving entrepreneurs, you'd look for owners who want to retire. Instead of encouraging the owners to stay in the business, you'd make it easy for them to leave. Instead of taking the new entity public, you'd keep it private, raising any funds you need from banks and private investors.
Of course, a skeptic will ask, "Where's the value in such a consolidation? You say you want to acquire mature, stable businesses. How are you going to generate the incremental cash flow you'll need to pay off your investors and still have enough money left over to justify the time and effort you'll have to put in?"
That's a fair question, but it overlooks the opportunities that often exist in mature, stable businesses. Sometimes they're mature and stable not because they lack the capacity to grow but because their owners are no longer interested in driving sales. The gift-and-souvenir companies I've been looking at are a case in point. They have great reputations, excellent credit, and superb distribution channels that no one has tried to use for other gift-and-souvenir products in at least 10 years. In this case, moreover, there really are ways to cut costs by combining operations. So a consolidation would allow you to increase sales and reduce general and administrative expenses, thereby creating the additional cash flow you need.
The opportunities are so tempting that we're already in negotiations to bring some of these companies together in a single entity, but we still have one hurdle to overcome. Whenever we explain what we're doing to potential financial backers, their eyes narrow, their nostrils flare, their fists clench, and they say, "That sounds an awful lot like a roll-up."
I guess that's the price you pay for swimming against the tide. Maybe we'll have to call our new entity something else -- like, say, a roll-in.
Norm Brodsky is a veteran entrepreneur whose six businesses include an Inc 100 company and a three-time Inc 500 company. This column was coauthored by Bo Burlingham. Previous Street Smarts columns are available on-line at www.inc.com/keyword/streetsmarts.
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