There has been renewed activity in the petroleum marketplace lately by investment firm types promising fabulous exit strategies to petroleum company owners. These clever Wall Street guys promise to bring several petroleum companies together and then take the whole package public, making you a wealthy retiree. The idea seems reasonable until you dig a little deeper into the facts.
The lure – The idea sounds practical. Combine several smaller businesses into one big business so economies of scale can be achieved in back office operations, plus get buying clout from volume. It seems logical and reasonable.
Next, add the ingredient that your company becomes much more valuable as part of this new large entity than in its current stand alone status. For instance, the investment guy might show you that your business is worth $10 million as is, but could grow to $20 or $24 million worth as part of the new company. To come into the roll-up, you might get offered a cash signing bonus such as a 10% down payment of your company’s individual value, and then offered the rest of your company’s value in stock of the new corporation. So you think, just come into the group and make a quick extra $10 million! Very enticing!
Now, picture this really smart investment guy with a great resume including a former well-known accounting or investment company, with the added bonus of being well connected to financing sources and coming to the table with ready cash! Wow!
And just for good measure, he promises you the added benefit of sharing education and benchmarking with your fellow CEO’s you respect and admire. Certainly ten heads are better than one! Well, before you get too excited about the whole package, ask yourself is it likely and real!
The theory – What truly drives owners to jump on the roll-up bandwagon is increased value promised to occur from cash flow due to economies of scale and buying clout. If the investment guru can take ten small businesses producing $2 million each in cash flow, combine them, and suddenly the cash flow for the combined ten-business firm is $40 million instead of $20 million (assuming public buyers want shares in a petroleum company), the idea should work. And in fact, that’s why lots of business owners in all types of industries jump into roll-ups. It all seems so logical.
The reality check – First, cash flow usually doesn’t double. In fact, cash flow often goes down significantly in the first year due to the bureaucracy of the big company. You must remember the management fees those savvy investment guys are charging. (They need to make a buck too, right? After all, they brought those ten companies together!)
Then we have control issues. With ten companies and ten Presidents now brought into one big company, who actually makes decisions? During the courting phase, the investment guys tell owners they will still maintain control. The reality is far different. The most vital capital expenditure and growth decisions now become Board of Director decisions. How would you like it if your board rejected a decision or project you think should be a slam-dunk? Unfortunately, most boards have a short-term, sell-the-shares-as-soon-as-possible mentality resulting in decisions that sacrifice long-term stability for short-term gain.
Next, envision ten entrepreneurs with ten egos all in one big happy company. Let’s see…ten company Presidents trying to agree on strategic direction and decisions. Sure, that will work! The reality is that autonomous business owners become less than happy when forced into group democratic decisions.
Now let’s talk capital. Remember those great capital sources in the beginning? Well, when the cash flow doesn’t double as promised, previously available capital sources can dry up very quickly. So now the owner is left with an under-performing company and a shortage of financing – not a pretty picture.
So here are the facts. In a recent study of 81 roll-up companies highlighted in FSB Magazine, the most recent 45 roll-ups completed from October 1995 through December 2000 lost an average of 19.6% per year in shareholder value! Paul Kocourek, a senior partner in the well-known consulting firm of Booz Allen Hamilton who did this extensive study, described managing a roll-up like “herding cats.” He said that is why these deals don’t do what you expect them to do as investments.
For an owner that accepts the bait of a roll-up, the most difficult part of the lure versus the reality is that by the time they become cognizant of the negative impact on the company, they are already so tightly locked into the deal through binding contracts that they can’t get out. Once in, it is next to impossible to get out and salvage what may be left of a formerly strong family company.
The moral to the story is when the investment guy comes knocking at your door, if the strategy he suggests sounds like a roll-up, don’t allow yourself to become seduced by the lure of big money. It’s highly likely you will be sorely disappointed.