Rollups Are Harder Than You Think
Written By Adam Yohanan
Many people are talking about an M&A strategy known as “rollups.”
What is a rollup? It means buying many small businesses in a particular industry and combining them into a larger company.
I have a few concerns, but first, let’s discuss the upside.
Rollups provide two key economic advantages:
Save on Expenses. The company receives lower prices by buying larger quantities of goods and services. If one laundromat needs to repair 5 machines in a year, it gets a higher price from the repair company than the laundromat rollup that needs to repair 50 machines in a year.
Sell for a Higher Multiple. All companies sell for a price equal to a certain multiple of their annual net profits. For example, if the net profits are $1 million and the multiple is 3x, the company sells for $3 million. However, larger companies sell for a higher multiple than smaller companies in the same industry.
Example:
Imagine you buy 10 laundromats for $3 million each at a 3x multiple. The total purchase price calculation would be $1 million net profits x 3 = $3 million purchase price.
When the companies were separated, you invested $30 million in 10 businesses with a combined annual profit of $10 million.
If that was the total profit when the businesses were separated, what would be the total profit when combined? The profit would be higher when the businesses are combined because the expenses would be lower. If the combined company’s total profits are 20% higher than the total profits of the separate businesses, profits will be $12 million per year instead of $10 million per year.
What about the profit multiple? Instead of a 3x multiple, you might have a 5x multiple. So when you multiply your $12 million per year profits by 5, you get a valuation of $60 million, which is double the $30 million you spent to acquire the 10 laundromats.
Why doesn’t everyone do rollups?
None of this information about rollup economics is secret. All sophisticated investors know this. So why don't they all stop what they are doing and start rolling up immediately?
Why don't you stop what you're doing and start rolling up immediately?
The reason is that this investment strategy of buying, combining, and selling many businesses within the same industry is really hard, even for experienced private equity professionals.
The reason why it is hard is not the difficulty executing multiple M&A deals — anyone can find a lawyer and an SBA lender — but rather the difficulty integrating the businesses post-closing.
Why integration is so hard:
Combining small businesses — with all their people, history, and baggage — is not something that happens in an Excel sheet. It’s something that happens in real life.
It might be easy to crunch the numbers and say that if we lower our expenses and increase our multiple, we will make a killing. But it's not easy to do the following:
Pick a dominant culture
Replace existing statuesque
Combine adverse personalities
Demand compromises
Combine systems
Fire vendors
Change branding
The challenges go on and on, and most of them cannot be flagged in legal due diligence or in an accounting or quality of earnings report.
Why debt adds gas to the fire
With all these integration challenges, amateurs should consider giving themselves room for failure. But unfortunately, SMB guru influencers often advise the opposite: they advocate borrowing 80-90% of the purchase price—like a mortgage, but it’s a small business, not a house.
This financial approach allows for massive gains on your 10% cash investment but gives the buyer almost no room for error. If profits dip, the strain of the debt payments could bankrupt the company. Moreover, if a personal guaranty backs the loan, personal bankruptcy often follows.
Adam Yohanan is a transactional business lawyer with extensive experience representing companies, investors, and entrepreneurs in a wide range of high stakes business transactions.
Adam handles the small and large transactions in the life of a businesses, including mergers & acquisitions, entity formations, partnerships and joint ventures, investing and fundraising, commercial contracts, and dissolutions. His office can be reached at 212-859-5041.
Haley Kopp is a corporate lawyer focused on representing start-ups and small companies in formations, venture capital, angel investor financings, mergers and acquisitions, and general corporate matters.
Haley's diverse experience gives her a practical approach to solving complex business issues, whether guiding companies through financing rounds or corporate transactions. Her office can be reached at (619) 512-3652.
This guide is meant for educational and informational purposes only and should not be considered legal advice. It is essential to consult with an attorney or other advisors regarding all legal and other important matters.
