Buildups are the current
rage in the private equity business. Investors buy a half dozen
or so little companies and stick them together with enough adhesive
to look like a real business, then sell it to the next guy as a
consolidation play for a higher price. An army of EBITDA missionaries--young
ambitious dealmakers--is canvassing America in a house-to-house
search for cash flow. If you're a small-business owner and one comes
knocking on your door, be open to opportunity but be very careful.
If you're an investor thinking of putting money into a buildup,
do the same.
Sometimes a buildup makes great sense, an honest 1+1=3, with an opportunity to create a strong national firm out of inefficient regional ones. My firm is working now on such buildups in the fitness, eyecare and framed-art industries. But often, buildups are just games played with spreadsheets. In a proper buildup, investors buy a "platform" company as a cornerstone, then turn to a list of smaller, add-on companies. The add-ons are integrated with the platform to improve profits, combining purchasing, back office and/or customer service functions and cross-selling products. Then the new company is sold for a larger multiple to a new owner. Most business owners, when approached for a buildup, obsess over the deal they will get. This is a mistake. Your first concern is whether the buildup makes sense. Will the resulting company succeed? You will be working there. If you own the platform company, your name will still be on the building. More than likely you will still have a large part of your net worth tied up in it. Make sure the investors have the capital and other resources you need. Talk to owners and managers they have dealt with before. I once failed to do this for a consumer-service buildup. I found out later that the investors had misrepresented the profitability of the platform company and were mostly interested in their own pay and perks. I wasted three years in a boardroom with people I couldn't trust and didn't like. If you are one of the investors doing the buildup, don't treat company owners as your adversaries. Sure, you want to get a good deal, but you also must keep them as happy future partners. For your sake and theirs, make sure there is a control investor to resolve conflicts. Buildups require swift decisions. Bickering will kill a business. The platform company should be a leader in its industry with returns on capital exceeding 20% . Small companies are inherently risky; you need such returns to anchor the buildup. I once picked the wrong platform--a manufacturing company with weak management and a reputation for poor service--and provided the capital to help it buy a stronger competitor. The managers of the weak company were in over their heads and those of the stronger company were unhappy and left. The platform firm should have a senior manager experienced with integration--hire or rent one if you have to. This is a special skill, not the same as managing operations. It must also have financial and information systems capable of folding in acquisitions.
Deals in which the managers don't buy stock don't work. Owner-managers
should reinvest in the buildup at least 20% of the proceeds from
selling their companies. Above all, stick with your original acquisition
targets. At some point, hopeful sellers will come out of the woodwork.
You don't need them all.
Watch your overhead--buildups don't need new headquarters or a corporate staff. The equity investor, in fact, should bring more to the table than capital. I feel that we have helped our portfolio companies with marketing, licensing, product development, foreign sourcing and distribution, direct mail, e-commerce and recruiting.
And finally, don't be put off by all my warnings. For investors
and company owners, the rewards of a buildup can be tremendous.
A company with $40 million in revenue and $2 million in operating
income can be sold as a stand-alone business at a five-times multiple,
for $10 million. Combined with other companies in a successful buildup
with doubled profit margins--not an unusual result--this share of
the business can be sold at a seven-times multiple, or $28 million.
Pretty good pay for putting 1 and 1 together.
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