Balancing Buyer And Seller Aims For a Viable Roll-Up: Myriad concerns come into play as both sides strive to execute a win-win deal that leverages the assets of both firms.

The roll-up rush continues. While small companies in industries as diverse as Internet service providers, corporate training, advertising, and temporary services are gobbled up by larger corporations, the consolidation trend is attracting new players to the roll-up game. In one of the newest twists, many smaller firms, spurred by the promise of a lucrative sale or a chance to bring their businesses to the next stage of development, are scrambling to position themselves to be acquired. For some, the rush is precipitated not by opportunity but by fear, as the threat of being squeezed out of an industry by huge players looms. Today, small and mid-sized companies either want to or have to get into the game. The pressure to enter the roll-up arena also weighs heavily on potential buyers. Big corporations seek to leverage their buying power through the strategic consolidation of industries. By aggregating companies, they realize the “rolled-up” potential of a particular small business marketplace. The acquisition of smaller, regional companies can be an effective growth strategy. For both sellers and buyers, a successful roll-up results in a symbiotic melding of tangible and intangible factors. When a corporate vision is shared by both parties, the chances of closing deals, retaining employees, and moving toward growth increase enormously. Both chemistry and dollars ultimately determine the success of a roll-up. The road to a successful roll-up, however, is often fraught with more than a few bumps and unexpected detours for buyers and sellers. For both parties to arrive at a desired destination intact, many factors must be taken into consideration. A game plan must be thoughtfully prepared and executed to ensure that a win-win scenario is achieved. Preserving Human Resources For sellers, a number of considerations come into play while preparing for the complex transactions that accompany an acquisition. Seasoned sellers – especially those in a service industry – know that their human resource assets are valuable commodities. Unlike hard assets such as machinery, tools, and other tangible goods that sit in plants and factories and are easily accessed for inspection and assessment, human resource assets walk out the front door every night. To assure a potential buyer that the intellectual property dimension of a company will be retained during and after a roll-up, sellers must implement thoughtful contractual arrangements with employees. The small “warm and fuzzy” firm must introduce legal agreements with employees to assure buyers that the key employees will remain with the company before, during, and well after the sale. An employment contract with a one-year non-compete agreement will provide additional value to acquirers by protecting them against an employee who becomes disillusioned with the newly combined company and leaves to start his or her own business, or join a competing operation. At the same time, a contract assures employees that remaining on board will provide them with some job security after the sale. Comprehensive non-compete agreements are valuable in negotiating with a potential buyer. Along with non-compete agreements, sellers also must introduce a series of success-based bonuses and incentives to motivate employees to present the best face to the buyer. Typically, the employee should receive a sales bonus, cash payment, or equity in the seller, which he or she can realize when the sale is executed. These types of arrangements create enthusiasm for the sale in the work force. Often, these agreements award bonuses to key executives that are tied to the ability to convince the remaining members of management to accept employment with the buyer. For example, the top marketing person may get a bonus for staying and an extra incentive for convincing top sales staff to stay as well. These agreements can become very detailed. Employees may get a stay bonus from the seller at the closing of the deal and another bonus a year later if the employee remains with the new company. Employees also can be given direct interests in an acquirer’s purchase price by being awarded advance equity, phantom stock, bonuses, and other financial incentives and by accelerating their ownership in direct relationship to purchase price increases. A challenge that many sellers face also may result from the nature of the work force itself. Very often, small firms are populated by employees who have left a large corporation for the excitement and entrepreneurial environment of a small entity. It may be that these entrepreneurial types will find themselves being acquired and working for the very company they left. For these employees, incentives become key motivators. Performance-based incentives, for example, for meeting earn-out targets after the closing may be put into place. Retaining a company car or country club membership may be all it takes to convince a key executive to stay. There are all kinds of fairly subtle employee-focused incentives that sellers should consider, both on the “carrot” and on the “stick” side. Assuming a Roll-Up Posture Along with human resource assets, sellers also address “classic” issues to position themselves as an attractive roll-up candidate. There are many games sellers can play in hyping up the company that may have built-in, long-term consequences that buyers find hard to decipher. To present a lean, streamlined, efficient operation, many small companies jettison seemingly expendable overhead expenses. These cost-cutting measures may not impact the business in the short term but they can present detrimental, long-term implications. For example, a small firm may drastically cut travel and entertainment expenses, get rid of nonessential staff, and defer capital expenditures and maintenance in order to show more earnings and generate a higher profitability for the business. On the surface, these measures may be difficult for the buyer to recognize. If, for example, a potential buyer notices that travel and entertainment expenses had recently been cut by 50%, an owner can justify the measure by explaining that only his or her country club membership was cut because it was not necessary. In reality, however, this membership may have been a key component of a successful marketing strategy. Sellers also may rush products out the door in an effort to make the business look more attractive. This productivity demonstrates to a buyer that the business is creating products, new demand, new customer relationships, and new sales. What the buyer won’t necessarily know, however, is that the new products may not have gone through the appropriate test cycles and reliability procedures that earlier products of the company were tested against. Although sales remain steady because of the company’s reputation for reliability, and the products may operate perfectly well for a year or two, they may ultimately fail or require more maintenance down the line. As a part of a buyer’s due diligence, an examination of maintenance history and warranty records is routinely conducted. The buyer will simply extrapolate those records going forward and use it as a basis for valuing the company. But those more recent products may experience a worse warranty record that will not be discovered until later. Behind the Veneer Every company for sale takes steps to make itself more attractive, and to gloss over potential problems. Buyers must be aware of the various strategies that sellers use to enhance the value and the attraction of their businesses, both in terms of present and future revenues. Buyers will want to do due diligence on these companies to scratch beneath the veneer of a stable and happy work force and glowing balance sheet. People-intensive firms are, ironically, most reticent in allowing intensive due diligence. At a company where buyers should spend enormous amounts of time kicking the tires, they find that they are not allowed to speak with key employees in depth. It’s much more difficult to uncover the core of a company when human resources comprise the bulk of the assets. Certainly, due diligence can be tedious at times, involving the study of hundreds and even thousands of individual documents in order to locate concealed risks. Due diligence also can reveal hidden assets that can add surprising value to an acquisition. For the buyer, it is imperative to motivate the seller to do the deal. Buyers should generate excitement for shareholders and employees alike by demonstrating the tremendous upside of entering into a roll-up. Although employees may be reluctant to leave the relative autonomy and comfortable family culture of a small firm, being part of a more substantial enterprise will provide them with access to greater economic resources. Buyers should emphasize the possibilities a large company can offer in fulfilling business dreams. Perhaps the owners of the small firm didn’t have the resources to expand into Europe or Asia. Maybe they would like a more substantial research and development budget, a chance to extend the product range, or promote the business with the strength of a big-budget advertising campaign. With the support of a larger entity, employees are more likely to realize their potential, see substantial financial gain, and reach a higher level of personal satisfaction. The opportunities that a large company offers can be very compelling to employees in a small firm. Excitement, however, should not prevent sellers from investigating the true motives behind a potential buyer’s interest in the smaller company. Some big players sniff out the competition, dangle an attractive offer, and shut down the operation. If this happens, employees will find themselves out of work and tied to the obligations of any non-compete agreements they may have signed. There will be hidden agendas on both sides of the sale, and it is wise for both buyers and sellers to look long and hard at motivating factors. Earn-Outs: Boon or Bust? An area of great promise as well as great conflict is found in earn-outs. Post-deal payments reduce investor risk while providing incentives for people who remain with the new firm. In a classic earn-out, a portion of the purchase price is deferred or not set specifically, but is based on the performance of the acquired business. Performance may be measured in revenues, earnings, or numbers of units sold. Earn-outs also can be a fixed portion of the purchase price, typically one-third to one-half, represented by a promissory note and payable over time. For example, for a small company purchased for $10 million, $5 million could be paid by the seller up front and another $5 million over the course of the next two to three years. When the fit of buyer and seller is right, the earn-out potential is tremendous. The synergies of rolled-up companies create potent, valuable entities. Future earnings are maximized and earn-outs are met when the interest of buyer and seller are joined. When synergies are not realized, however, earn-out payments may be delayed, reduced, or never paid, and there is no upside for the seller. An earn-out payment stream is tied to the company’s performance and is not guaranteed. When a fixed earn-out is based on a performance formula, the fixed payment is typically a note that is subordinated to bank indebtedness. The minute the company is not performing well, bank covenants are triggered. In this scenario, earn-out payments – even under promissory notes – cannot be paid until bank covenants are met. While those notes look like they are fixed obligations, in effect they depend on the performance of the company. When the time comes for the buyer to make good on seller earn-outs, there may be all kinds of reasons not to pay – some genuine, some not. Even if a buyer meets performance criteria, there is no guarantee that payment will be made. The acquiring company has every incentive to stonewall unless it decides to go public. Settling Earn-Out Disputes When financial obligations are not met, sellers can choose to mediate or litigate for compensation. The most effective approach for sellers is to bring a case to court. Litigation ensures that evidence is brought to light and that interest can be added to a judgment. For buyers, the best option is to mediate or arbitrate a dispute. Buyers harbor great hostility toward litigation, as all records become public and damaging evidence can surface to adversely effect future acquisitions. For too many buyers and sellers, however, a non-public process such as arbitration and mediation are usually entered into. In the end, the time and money expended during the course of this process usually equals or exceeds that of litigation. To enforce any judgment an arbitrator may hand down, however, a seller still may have to go to court. To ensure an earn-out will be paid, a seller must analyze the terms of sale and the overall business plan in granular detail. The seller makes an investment in the decision of the buyer and must adhere to sophisticated formulas and a mutual interest in the vision of the company. As the potential for industries to be rolled up continues, both sellers and buyers should seek to leverage each other’s capital, talent, distribution channels, and manufacturing capabilities to maintain market leadership. GETTING BY THE HYPE Everybody wants to catch the roll-up wave. No wonder – it can be a very lucrative investment technique for both buyers and sellers. Spurred by the promise of a profitable sale or outstanding growth potential, many firms are scrambling to position themselves to be acquired. At the same time, buyers, feeling the need to do roll-ups in order to achieve desired growth levels, are scouring their industries for viable roll-up candidates. In this competitive environment, buyers and sellers will do everything they can to increase their value and appeal, so it will take thorough due diligence and careful negotiations to cut through the hype and work out a successful deal that will leverage both parties’ assets and position the rolled-up firm for market leadership.