Keying Mid-Market Pricing to Buyers’ Objectives : Often, early-stage rollup or buildup targets are priced aggressively and can command large premiums for their sellers.

Among the most active buyers of privately held companies are IPO hopefuls and smaller public companies. The overall success of the U.S. stock market has encouraged IPOs, and the struggle to achieve critical mass is intense. Recently, reduced availability and higher prices of larger acquisitions have inhibited the buy-build strategies of many of these acquirers. This, in turn, has contributed greatly to the popularity of rollups and buildups involving smaller targets. Assembling enough compatible smaller companies provides the opportunity for operational savings, market prominence, and generally a higher market multiple for the parent company. The most successful rollups have been in service industries that tend to be highly fragmented and composed of target companies that lend themselves to standardization and rapid integration. There also have been successful rollups in selected segments of the distribution arena, such as industrial fasteners. Strategic buildups, on the other hand, are a better choice for manufacturers when a cookie-cutter approach won’t work. Company culture, operations, and customer relationships are unique to each entity, and proper integration often takes a long time. Interestingly, some buildups have been customer-driven. For instance, manufacturers of automobiles and heavy equipment are encouraging their larger suppliers to acquire their smaller suppliers in expectation of a higher level of service from a fewer number of providers. Pricing smaller and mid-sized companies in the m&a marketplace often is related to the acquirer’s objectives. Firms targeted for an early- to mid-stage rollup often are priced aggressively by historical standards. Many early sellers into rollups initially have realized two or three times the intrinsic value of their firms. While selling into a rollup can yield an impressive profit, timing and terms of payment are everything. Selling multiples as high as 10 to 12 times EBIT for low-asset companies that traditionally sold for 3.5 to 5 times are not uncommon in the early stages of a rollup. Later in the rollup, multiples of 4 to 6 are more likely. Requiring all cash at closing can cut selling multiples in half. Typically, sellers receive some combination of cash, subordinated notes, and stock in the acquiring company. Stock, which is often restricted, can be extremely volatile, and many sellers have been badly burned. An example of extreme volatility can be found in the stock of U.S. Office Products Co., which owns a large number of office supply stores. Having IPOed in 1995 at $10 per share, the stock bottomed-out in December 1998 at $3.85 1/2 after reaching a 52-week high in excess of $43. Many people felt that too little attention had been paid to postacquisition integration, a common problem among rollups and buildups. The IPO and new issues market has cooled off in many industries. For example, in 1997, Metal Management Inc. went public. It had accumulated a group of metal scrap recycling companies both before and after it became public. Now, however, there has been a downturn in the industry. A major factor was the economic slowdown in many offshore countries. The drop in demand resulted in a price drop in the U.S. and a dramatic fall in the values of acquisition targets. The price of Metal Management’s stock fell to a point where it was threatened with delisting by Nasdaq. The company has been retrenching and continuing its consolidation strategy. It is unlikely, however, that acquisition multiples within the industry will return to their highs soon. In contrast to most rollup targets, non-strategic manufacturers and most distributors do not command large premiums even when the buyers are public companies and their aspiring IPO counterparts. There are two major reasons for this. First, the prospects for truly rapid growth in earnings are seldom there, so there is no market hype. Second, these rather prosaic companies tend to be purchased more often by private investment groups and other privately owned companies whose objectives are different. The prices paid for them therefore tend to bear little relation to the price-earnings ratios of their larger public counterparts. The buyers of such companies tend to have a long-term view of their acquisitions over which time they typically require an internal rate of return on investment of 25% to 35%. They pay a premium for synergies only when forced to through competitive bidding. Their lenders will stretch as long as the transaction makes sense and the buyers have enough of their own money at risk. According to IMAP’s 1998 Transaction Survey, buyer equity averaged 35% to 40% of the purchase price last year. Combining these parameters with moderate growth potential tends to result in selling multiples of EBIT in the 5-to-6.5 range. Premiums beyond that are usually achieved through earn-outs, which, according to the Transaction Survey, are regaining popularity. The highest multiples are almost invariably secured through the use of skilled investment bankers who are knowledgeable about the buyers’ and sellers’ respective strengths and weaknesses. Values vary substantially from industry to industry and at different points in time. In the end it all boils down to risk and return. A consolidator doing a rollup will pay a premium for companies that, if combined into one entity, are expected to command an even higher premium in the stock market in a comparatively short time period. Prosaic companies with public counterparts commanding P/Es in the low 20s just don’t have the sex appeal to leverage upon.