A couple weeks ago there was an obscure story on the page B6 of The Wall Street Journal, titled "Hospitals to Make, Sell Generic Drugs." I took notice, and if you do business with larger companies, so should you. In fact, your bedsheets should be drenched in sweat.

This marks a tipping point in the transformation of the American economy. On the heels of the announced CVS acquisition of Aetna, the entire healthcare sector is thrust into more chaos. Not to be outdone, the same dynamic shift is happening in media and communications, with the AT&T merger of Time Warner

It is a time when entrepreneurs need to be uber-aware. These fundamental shifts in market dynamics are either a tremendous opportunity, or a sea change that could put you out of business.

When the pharmacies buy insurance companies and the hospitals buy drug manufacturers, it is a clear sign that the world has changed. As there are slim pickings for companies trying to consolidate or roll up industries horizontally (buying like competitors), they are seeking out vertical integrations. Downstream companies- especially the smaller ones- are going to feel the pain. 

Larger companies are trying to consolidate their suppliers. As companies get bigger, their behavior as customers change, and their professional procurement practices become more pronounced.

Their goal is to have fewer vendors who can satisfy their onerous requirements for everything from cybersecurity to HIPAA. Some even audit their suppliers on business practices (an auditor recently asked one of my clients to see their performance reviews). Perhaps most frightening of all, they are asking for revenue and client information to ensure their suppliers do not have too much concentration risk tied up in a few customers (notably, them). 

All of this puts tremendous pressure on small and medium sized business. To alleviate the threat of concentration risk, companies need to grow with other customers just to keep the ones they already have. So how does a small or medium sized company compete in this world of vertical integration?

1. Vertically integrate yourself

For years this was the playbook for larger companies, selling hard goods and acquiring suppliers so they could participate in profit upstream and downstream. They controlled things like raw material costs and cycle time. But there is a trend toward integration for smaller service companies.

One of our clients, who started with about 30 employees, did this beautifully and tripled its employee count in about eight years by adding services that typically would have been offered by other providers. They even created an online portal for their service, which they sold to competitors to provide technical guidance while leveraging the competition's sales teams (as they were too small to have a big team themselves). Ironically, they were acquired at a high multiple and combined with other companies offering other adjacent services (more vertical integration). 

Look for ways to be more "capable", thereby eliminating the need for suppliers in services that are directly adjacent to yours in the value chain.

2. Enter into alliances

One way to expand capabilities is to enter into more substantive alliances. For example, one of our small clients outsourced almost all their manufacturing (they still do assembly), so they can focus on what they do best. Since they aligned with a larger manufacturing operation that was better-equipped, it enabled production of more items with more features.

3. Fund so you can buy

Capital is dirt cheap. With $963 billion of dry powder on the sidelines, private equity firms are clamoring to lend. If there were ever a time to bring in investment, or borrow in order to complete an acquisition, this is the time to get favorable terms.

Through a recapitalization or similar financial engineering, companies can borrow to buy smaller competitors at low multiples, driving up value as they scale, get larger and absorb overhead over more volume.

4. Let technology be your friend

Technology is the great equalizer. As larger companies partner with smaller ones, they will be looking for those who have solid integration of systems and can offer seamless transactions.

An accounting firm we work with bought a technology firm so they could ensure their clients had both strong systems and the ability to provide business intelligence and analytics. 

5. Utilize free agents

One of the reasons the gig economy has boomed so fast is that contractors provide lower-cost alternatives to employing a full staff of people. By leveraging people with highly specialized skills (part of the time), you can put together a team of experts that make your team look larger than it is and provide more value to your client.

Published on: Feb 7, 2018