Rollups: Merger Wave of the Millennium?


In the last few years, owners of closely-held businesses in many industries have been courted by a rollup team that aims to acquire businesses and amalgamate them into a national company, usually in an industry where there has never been any national presence. The rollup team, the executive staff of the acquirer, normally contains individuals with a history of prior success in "rolling up" unrelated industries plus individuals with experience in the largest industry.

Rationale

The rationale of the rollup is quite simple. The acquirer believes that, after adjusting the target's earnings to a basis comparable with those of public companies, it can pay a certain multiple of the target's earnings (say, four times earnings) for the target, while the acquirer's value in the national securities markets will be higher after the acquisition by a larger multiple of those same additional earnings (perhaps eight or ten times the acquired earnings). There is no strategy of creating a new product or service; instead, the strategy is to create value, stock market value, for owners of target companies, and, not incidentally, for members of the rollup team, by amalgamating target companies. Of course, the amalgamation may also effect cost savings and efficiencies in advertising and marketing that a national brand can achieve.

Methodology

The typical rollup first must reach the size required for an initial public offering. This can be done by simultaneously acquiring several closely held companies, doing an initial public offering, and, often, putting in place a bank line of credit. Cash plus stock in the new entity is paid to sellers of target companies. Alternatively, an existing company may form a subsidiary as the acquirer, intending to take it public. Acquisitions, for subsidiary stock and cash borrowed on the parent's credit, are made over several months, and sellers may convert or swap subsidiary stock for parent corporation stock if the expected public offering does not occur. After the public offering, an acquirer fills out its national coverage and then may acquire companies to fill expertise niches. An example of another variation is the rollup of medium-sized accounting firms into American Express Tax and Business Services, which will own the business, not take it public.

Restrictions on Sellers

An acquirer usually buys targets for stock and cash in transactions designed to qualify as tax-free reorganizations under the Internal Revenue Code. Its ability to use stock in acquisitions depends on maintaining its stock price at high levels to permit paying required multiples of earnings for targets and on maintaining the confidence of sellers that stock they receive will retain its value. To buoy the market price of its stock, the acquirer requires sellers to restrict sales of stock they receive. For example, a seller may be permitted to sell 1 /4 of the stock lie receives after one year, 1/2 after two years, etc.

Other Transaction Terms

The transactions also have usual acquisition terms: extensive sellers' representations and warranties with indemnification obligations, sellers' covenants not to shop the business before closing, restrictions on sellers' conduct of business pending closing, a due diligence investigation, and non-compete agreements. Often the acquirer seeks a letter of intent from sellers that forecloses sellers, as a practical matter, from renegotiating later. Managers may receive employment agreements, but most rollup employment agreements are highly favorable to employers. In addition to short term (one to three year) non-compete agreements in managers' employment agreements, the acquirer seeks longer term (five to seven year) non-compete covenants from sellers.

Seller Cautions

Sellers contemplating selling to a rollup should initially weigh their prospects as an independent company in the changed competitive environment that will result if the rollup team succeeds in forming a national company. Sellers must then assess the employment and financial package offered by the acquirer to the sellers and target management, analyze their succession planning and other available exit strategies, and be clear on their own motivation for selling. In all cases sellers should involve accounting and legal advisors early (before signing a letter of intent) and be prepared for downward price negotiation as a result of acquirer's due diligence investigation. It is often also important to clean up problems with these advisors before commencing due diligence.

For more information on mergers and other business issues, contact Lee Lundy at 410-/752-9705.