Should I Roll Up My Industry?
My largest investor asked to me look at doing a “roll up” strategy in my space, buying out smaller players. Do these strategies make sense? Do you have any advice?
“Roll up” strategies can definitely make sense. Buying smaller, less well-run companies in your sector and squeezing out more profit at scale or with better systems can help you grow quickly. In many cases, highly engineered rollup strategies, especially in inefficient fields with lots of small, local, or unsophisticated players, can produce a money printing machine. I worked on a few rollup strategies in my career, including with someone who trained under one the all-time industry consolidation masters, Craig McCaw. McCaw famously bought hundreds of smaller cable operators across mostly rural America to form one of the then largest cable companies in the United States. Here are five points you should consider. I will give more details and examples for each point in the future classes on mergers and acquisitions:
Do you have an edge?
Do you have an edge where you can harvest greater value than the company you are buying? Rollup strategies differ from more strategic acquisitions in that you are typically looking to benefit from economies of scale, efficiencies of process, or the ability to exploit opportunities faster or better. For example, if the target company has a cost per customer of $17 per month, but you can offer the entire solution for $3 per month, you have a $14 spread advantage per month over the target. (These numbers are from a real example we will cover in the future.)
Typically, smaller companies lack efficient operations because they must replicate administration, technology, finance, legal, and support as well as because they do not achieve efficiencies of scale that larger organizations enjoy. In addition, most companies are just poorly run. Perhaps you have a sales advantage in that you have a marketing machine whereas the target has great technology without any ability to sell. The core question is: can you realize greater value with the target’s asset than the target’s current management.
Can you buy the target with its own cash?
This step is not strictly necessary, but is one that makes rollup strategies so capital efficient (and so much fun!) Rollups are best when you can pay for them out of the proceeds of your advantage. In the example above, say that the target has 5000 subscribers who pay $20 per month at $3 per month of gross profit. You have a gross profit of $17 per month because of your economy of scale and superior platform. The target owners would realize only $540,000 of gross profit over three years ($3 x 5000 x 36 months), assuming no churn, price erosion, or the like. You, however, will realize $3.06 million in gross profit over those three years. You could rationally pay $720,000 for the business (four years of the seller’s gross profit), which is less than your first year net profit alone.
But why pay it all today and use your precious cash? Pay over time! Structure the deal to be based upon cash flow and tie the seller to your success. Perhaps you need some of the seller’s talent for a few years, perhaps you need them to transfer their customers to you. You inevitably will pay something up front, but structure payments out of the profits you are generating. In effect, the target’s own customers are paying for the acquisition, using the spread your edge generates.
Can you manage operationally?
Scaling often kills companies. In addition, most mergers and acquisitions fail because the buyer fails to integrate well. Make sure you can operationally handle the scale. In a rollup, you are often buying some slightly commodified business you can add into your system where personnel may not matter as much, as opposed to cutting edge R&D or IP heavy new technology that still has years of development and market development. Whatever the facts of the target company, make sure you handle the integration well, or you are buying an expensive albatross.
Can you grow them?
This step is also not strictly necessary, but useful. Can you upsell or bundle some additional products or services to the target’s customers? Do you have a better sales machine where you can gain double the sales with existing or minimally incremental effort? Even if you maintain the original purchased business merely at stasis, rollups can still be profitable, but growing them is better.
Is the roll up a distraction from a higher use of your time?
Rollups are fun, and when the work, can be highly orchestrated, even semi-automated with the right team. However, they do take a significant toll on your management and middle level team. Sometimes your best use of time and money is grabbing some critical market share in your base market, pivoting to a new or adjacent industry, or capturing a winner-take-all opportunity. If you look at the world in five years, what is the highest and best use of your resources today to generate maximum enterprise value?
Rollup strategies are underutilized in the venture capital world, but can be magical when you are buying a customer base with cash flow, which you can then convert to a new platform or technology. We will review concrete cases of each of these points in the future.