“To get the valuation you want,” Chris Bouck told the owner of a home services company, “you need more size and scale.”
Bouck, a principal of SDR Ventures, a lower-middle market advisory firm in Greenwood Village, Colorado, knew that growth would be hard for that business because its territory was limited by a franchise agreement with a national chain.
“What if I brought other franchisees into the deal?” the owner asked. Buyers will pay a higher multiple for larger businesses with more growth potential, Bouck replied, but he cautioned that orchestrating a deal with multiple parties can be very difficult.
Undaunted, the owner spent 18 months convincing the six other franchisees and the franchisor to sell as a single entity. SDR arranged a sale to a private investor group at a significantly higher valuation than it estimated than any of the companies would likely have received on its own.
Few advisory firms attempt to sell multiple firms at once, despite the value created by this approach.
“When we did the first one, people looked at us askance,” says Scott Mitchell, a managing director at SDR. “There are too many variables, they said, and something is going to fall apart.”
Nonetheless, after that deal, SDR saw an opportunity.
“Creating value through consolidation is a private equity strategy as old as time,” Mitchell says. “We decided to steal a couple of plays from their playbook and create more value on the front end for our sellers.”
In the last year and a half, SDR has completed two more transactions where it marketed two or more companies as a single investment, a structure that it calls Pre-investment Roll Up (PIRU):
- Three traffic light and intelligent transportation system providers in Colorado and Georgia combined under the name Lumin8 Transportation Technologies via an investment by Crest Rock Partners, a Denver fund, in July 2020.
- Two firms involved in different aspects of supply chain consulting, dubbed Spinnaker SCA, were bought by Black Lake Capital of Denver earlier this year.
Across its first three PIRU deals, SDR estimates the valuation for sellers was 65% higher than they would have received on their own. Meanwhile, it’s finding that more investors are starting to see the benefits of the structure outweigh the additional complexity.
“As the world becomes more competitive, we’ve been forced to consider smaller deals that may have issues with concentration or economies of scale,” says Chadd Scripps, the managing partner of Black Lake Capital. “The nice thing about this kind of situation is that the questions about size, concentration, and even the management team being reliant on one person, go away.”
SDR has identified five elements that make PIRU deals work.
1. Casting a wide net to find sellers
The advisor will need to reach out to many potential participants to find a group of complementary companies that can be sold together.
“A lot comes down to timing,” Mitchell explains. As is often the case in the lower middle market, some owners are ready to sell, and others want to keep running their own business no matter what deal is on the table.
Mitchell looks for a set of companies that bring complementary products or geographies. Combining direct competitors in the same market, he says, “causes too much tension.”
2. Creating a unified vision for the combined company
Once the sellers come together, they need to agree on what Mitchell calls a “straw man” organization chart for the combined company.
“You can’t just go to a buyer and say we’ll have a three-headed CEO,” he says. “You’ve got to show a united front and explain how the businesses will be integrated.”
There’s also some hard-core spreadsheet work for the advisors to create a projected financial statement for the combined companies. “You can imagine with small companies that each of them is going to do their books differently,” Mitchell says.
3. Agreeing on how to share proceeds
While the operating plan doesn’t need a formal agreement, SDR believes that the sellers need to commit in writing to how they will divide any sale proceeds.
“You can’t have a deal blow up because some guy wants 5% more of the purchase price at the last minute,” he explains.
The terms of each of the SDR’s three PIRU deals have been different, but they all are designed to reflect each selling company’s size, profitability, and growth potential.
“You’ve got to put your investor hat on and be honest about what’s worth a higher multiple,” Mitchell says. Ultimately, he adds, sellers can come to an agreement so long as everyone sees they will do better selling in a group than on their own.
4. Imposing penalties on sellers that back out
There’s no way to force a prospective seller to go through with a deal if the owners change their minds. SDR, however, has come up with a structure meant to discourage cold feet: Participants agree that if a buyer offers a price above a set amount, any seller that backs out would have to pay the legal, advisory, and other expenses of all the other members of the group.
5. Simplifying the transaction for buyers
SDR insists the sellers appoint one law firm as lead counsel for the group, for example. And since sellers have agreed in advance on how to split the proceeds, buyers only need to offer a single purchase price.
“The buyer doesn’t need to negotiate with five companies and five sets of lawyers,” Mitchell says.
To be sure, many potential buyers still shy away from PIRU deals, but Mitchell says that the success of SDR’s first three deals will help some skeptics see the opportunity in them.
“Sure, you can say there is risk in trying to close two deals at once,” he says. “But compare that to the reward from cross-pollinating two companies and getting a deeper management team, more customers, and greater growth potential.”