Spring 1997
by John Campbell

Billion-dollar mergers have been streaming forth over the past couple of years, at a pace not seen since the late 1960s. Below the headlines about these high-profile combinations, similar deals are transferring ownership of the small, private businesses dominated by individuals or families. No one knows the exact number of private companies sold last year, but gross estimates cluster at around three hundred thousand. J. P. Morgan & Co. estimates that acquisitions of private companies totaled nearly $80 billion in 1996, or 12 percent of the dollar volume of domestic mergers and acquisitions.

The majority of businesses turning over are tiny, mom-and-pop enterprises. But between the plankton and the whales swims a very diverse, often long-lived population of firms doing $1 million to $40 million in sales. This tier of enterprises has seen an increasingly active acquisitions market; the volume of such firms changing hands appears to be growing, and valuations are high. And in this marketplace, deals are increasingly done for the same strategic reasons motivating Wall Street mergers -- to cut costs, run more products through distribution pipelines, or increase market share.

Matching buyers and sellers of small, private firms has always been difficult, particularly when individual players are involved. The search for a match can be long and serendipitous, and the negotiations emotional since sellers typically feel deep personal attachments to their firms. Buyers, on the other hand, rarely know exactly what they're getting and must hedge that substantial risk.

As existing companies and investor- entrepreneurs have been hunting for firms lower down the food chain, however, private transactions have taken on a more objective and corporate tone. Acquisitions now tend to alter the life of the company in question, with buyers looking not for a comfortable lifestyle, but to improve the operation and perhaps fold it into an ongoing enterprise. How to add value quickly is the central concern of larger, corporate acquirers throughout this bubbling market. Many small businesses, in the process of turning over, are thus becoming more modern, sophisticated operations.

THE URGE TO SELL, THE URGE TO BUY

The expansion of the market for small, private businesses stems from an unusual conjunction of events. First, a large number of owners founded their firms during the economic boom just after World War II. Many had learned trade or operating skills in the service, or furthered their education through the federal G.I. Bill, notes Joseph Astrachan, a management professor at Kennesaw State University in Georgia. Now these owners are looking to retire or cash in, and many have no heir apparent; surveys show that only one-third of family businesses make a transition to the next generation; roughly one-third fold and one-third are sold to an outsider.

On the other side of the deal, the number of potential individual buyers has grown as middle-aged executives flee or are ejected from restructured corporations, sometimes with big severance packages. In New England, typical individual buyers of these small, private firms have earned a business or engineering degree and have worked in management consulting, investment banking, or an operating firm. They are aware that it's less risky, on the whole, to buy a business than to start one. Now they're looking for an opportunity not far from home.

But by far most acquisitions of private firms in the $1 million to $40 million sales range, according to a consensus of observers, are made by existing businesses in the same or a closely related industry. These buyers are responding to economic forces, particularly the higher level of competition, which is often sparked by new efficiencies offered by greater scale or scope. It takes size to accomplish many things -- to install elaborate computer systems, to expand offshore and keep track of foreign operations, to enforce patents and collect royalties, to supply a large customer, or to market a full line of products. Russell Robb, an investment banker with O'Conor, Wright Wyman in Boston, also notes that it's not uncommon for a firm to undertake an acquisition search, then shift gears and decide to put itself up for sale. Since efficiency often requires a horizontal combination of similar firms, it's rarely obvious which way to go.

Some of the companies on the prowl have borrowed consolidation strategies from major corporations and franchisors, rolling up dozens of little firms into one. Buyout groups have been scouring fragmented industries as varied as car dealerships, medical practices, camping gear, and Internet access. Gary Schine, based in Providence, Rhode Island, recently brokered the sale of a firm that recruits and places dental hygienists in temporary positions, to an acquiring company in the office employment industry. The acquisition tripled revenues at the acquirer, Schine says, with little increase in overhead expenses.

Changes in technology and market demand have also intensified the urge to grow through acquisition. Boston Scientific Corporation, based in Natick, Massachusetts, has made a dozen acquisitions of catheter-based medical device makers over the past three years. Hospitals and other medical providers, under pressure to reduce costs, have found it advantageous to consolidate purchases and buy turnkey packages from fewer suppliers. These customers also want the latest proven technology. Boston Scientific's acquisitions, says CEO Pete Nicholas, are designed, in response, to build "strategic mass" -- a broader platform of products and processes that strengthens the firm's marketing presence. Acquisitions shorten time-to-market; developing the products internally would simply take too long.

SEARCHING FOR A MATCH

The market for private firms has very different characteristics from that for publicly held companies. For one thing, the buyer possesses far less information, making the process riskier and costlier. Out of a desire to keep the transaction confidential, the private seller often will limit access to customers until the late stages of negotiation. In addition, pride of ownership may tinge the seller's choice of a buyer.

Private transactions thus tend to take a long time, with buyers spending a year or two searching for the right match and perhaps another half a year closing the deal. Many private firms that change hands were not originally for sale, as buyers generally have to approach an array of potential candidates with purchase offers.

Thomas Tremblay's experience illustrates how arduous the search can be. Tremblay had an impeccable background for an individual buyer: an engineering and business school education, and eight years' experience in the venture capital industry. Sensing an opportunity and a challenge, at age 40 he decided he wanted to purchase his own company. So in 1992, Tremblay set about his search, in a far more organized and focused fashion than do most individuals. From his contacts in venture circles, Tremblay assembled a group of a dozen investors. They funded his base salary plus expenses during the search, with a second round of funding to be used for the acquisition.

One Typical Structure for a Manufacturing Company

Tremblay rented an office in downtown Boston in order to be in the thick of information and to distinguish himself from the "wannabes," since "a good seller quickly qualifies the real buyers." To further establish credibility, he did a series of mailings to six hundred intermediaries such as lawyers, bankers, and accountants. Tremblay learned of more than two hundred acquisition candidates, got serious about thirty, and made offers on six.

Among the six was a pneumatic tool firm called Guardair Corporation, in South Hadley, Massachusetts. Tremblay spoke with the 89-year-old owner, who said it was not for sale. But they had a pleasant conversation, and stayed in touch. Six months later, when the owner's eldest son died unexpectedly, the owner invited Tremblay to make an offer. They grew close to a verbal agreement, but family issues stood in the way, nixing the deal. Negotiations started up again months later and terms were agreed on, but the founder had a stroke and the bookkeeper left, so Tremblay had to renegotiate the deal with a second son. Tremblay finally bought Guardair in 1994, a full two years after launching his search.

WHAT'S IT WORTH TO YOU?

Once the search has led to a likely prospect, the heart of negotiations involves placing a value on the business. There are three main ways to proceed, says Jan Squires, a finance professor at Southwest Missouri State University. The asset-based approach looks at the replacement cost of the assets, setting a floor price as if the business were being liquidated. The market-based approach asks what similar businesses sold for, a method similar to pricing real estate based on comparable sales. Either method can work well for stable, old-line businesses, and useful rules of thumb have evolved to facilitate the process. Thus a plumbing or electrical distributor might be sold on book value (assets minus liabilities) plus a premium depending on its size, location, lease, and reputation. This works because such firms have 80 percent of their assets in readily valued inventory and accounts receivable -- there's no brand, patent, or other form of intangible goodwill to appraise -- so what one sees is largely what one gets.

Squires and other financial experts, however, argue that the "correct" way to value a business is the earnings-based approach, which tries to place a value on the cash flow. But this approach requires more sophistication. Even in traditional industries, the buyer must uncover the pertinent financial flows. Many sellers, particularly in family firms, have limited familiarity with financial concepts such as discounted cash flow, and don't have the figures at hand. So the buyer must construct an accurate estimate of the cash flow that the business can be expected to generate.

Existing financial statements may be of little use, notes David Milton, a finance professor at Bentley College in Waltham, Massachusetts. The firm's income statement probably was created for the taxing authorities and, to avoid double taxation (corporate and individual), private firms often pay out all the profits as salaries. The owner's boat, the gardener, the trip to Vegas, and overcompensated family members may also appear as business expenses.

Buyers trying to value a business must also anticipate the possibility of risks and unpleasant surprises such as polluted land, customers spooked by the sale, or skimming by an employee. It's often advantageous to hedge such risks not by paying a lower price but by clever structuring. Thus the buyer often requires the seller to take back a note for a significant portion of the price, or insists on an "earnout" -- a payment contingent on the seller staying on for a year or more and the firm meeting certain earnings milestones. This not only protects the buyer against adverse surprises, it also enlists the cooperation of the seller in the success of the transfer.

Such was the case when Metapoint Partners, a limited partnership based in Peabody, Massachusetts, acquired NPC Incorporated of Milford, New Hampshire, last year. NPC, which makes rubber-molded products and concrete coring machines for sewer systems, was being run by William Gundy, a creative engineer who was not interested in administration or marketing. Metapoint's president and general partner, Keith Shaughnessy, saw several risks as he assessed the deal. A single customer in Japan constituted 20 percent of sales, a share that was growing, and Gundy, who'd been burned when negotiations with another buyer fell through, was reluctant to allow the Metapoint partners to meet the customer. Gundy also carried lots of ideas for new products or improvements in his head, but had never written them down, and he wanted to retire. Shaughnessy reduced these risks by convincing Gundy on Metapoint's need to meet the large customer. The purchase agreement also stipulated that Gundy would stay on as a consultant for a year to help with product development, and that Gundy would take back a note for more than one-fifth the price.

ADDING VALUE

For individual buyers, acquiring a company has sometimes served as a means to a comfortable lifestyle. But more and more buyers, individuals as well as corporations, hope to ramp up marketing, bring in professional management, exercise greater control over costs, and otherwise bring change -- and presumably add value -- to the enterprise.

Thomas Tremblay recalls that he acquired, in Guardair, a company housed in an old mill building where employees were still using rotary telephones and manual typewriters. The product catalog featured outdated photographs and copy. Sales leads were filed in a shoebox, and every few weeks someone would mail out sales literature. On the other hand, Tremblay saw value in a solid product line with a defensible brand name, a national distribution network, and a diversified list of end users.

Tremblay started to change long-standing practices. He logged the sales leads onto the firm's new computer system, shortened the follow-up time, and referred leads to distributors and sales representatives. He upgraded the telecommunications system and the catalog. He fired a few underperforming employees, and hired a new controller and a sales and marketing manager, both with substantial industrial experience. Guardair's sales have doubled to a projected $3 million this year, and Tremblay says his investors are happy with their investment so far. Now he's looking for an add-on acquisition.

THE CORPORATE ADVANTAGE

Increasingly, individuals from outside a particular industry, such as Tremblay, find it difficult to compete in the market for existing businesses. "When I looked at deals, it was usually a corporation that beat me to it," Tremblay says. "Corporations know their competitors and see the warning signs [of a potential acquisition] quickly-- who's not bidding on a job, who's losing good people." Aggressive firms in the industry not only have an edge during the search, they also have a leg up in the process of adding value, applying more sophisticated managerial and financial techniques to the particular line of business. Consequently, they can afford to pay more for an acquisition.

In addition to firms inside the industry, companies like Metapoint now specialize in acquiring private businesses and improving their operations. Metapoint, the limited partnership started in 1988, has assembled thirty wealthy individuals, mostly current and former CEOs of major industrial corporations, as limited partners. So far, it has made fifteen acquisitions of mid-technology manufacturers, each doing $10 million to $40 million in sales. The target firms manufacture proprietary products sold to industrial customers, preferably have large market shares, and are in some way "undermanaged."

Metapoint can provide a few economies of scale to each portfolio firm, notably by obtaining better terms on bank loans than an individual firm could get. Jim Connolly, executive vice president at Fleet Bank in Boston, says that he's comfortable extending a higher level of credit to a proven partnership such as Metapoint: "They have a track record we can judge, and they're putting real money into the deal. That's important if the firm runs into trouble later."

More significant than scale economies, though, are the management controls Metapoint offers each enterprise. Shaughnessy, the general partner, says most firms Metapoint has acquired had been dominated by an owner-operator who had surrounded himself with weaker managers. The owner had been near retirement, or was simply tired of the business. After clinching the deal, Metapoint installs professional managers, often as co-investors who can raise their equity stake if they meet performance benchmarks. It also places one or two limited partners on the board of directors, mainly to offer ideas and personal contacts. The new leadership then revamps the management structure; this typically involves a new information system that can track costs and profitability by product and help run the enterprise more effectively. Such managerial and financial controls have allowed Metapoint's partners to earn more than their desired pretax return of 30 percent.

The corporate acquirers of the world, moreover, are now pervasive. Smart, industrious individuals may still be able to strike it rich by acquiring an ongoing business, but the odds increasingly favor corporate buyers. Their pockets are deeper, their contacts broader, and their size often provides an edge in marketing, distribution, and management. When small, private firms change hands these days, more of them are apt to grow not just larger, but also more formal, objective, and wedded to technology. The world of small business, in short, is growing more corporate.

Rise of the Limited Partnership

Private equity funds, usually organized as a limited partnership, have swelled from an estimated $4 billion in 1978 to almost $150 billion today. Less than one-third of those funds provide venture capital for startups; two-thirds go to established firms for expansion, often through acquisitions, according to economists George Fenn and Nellie Liang of the Federal Reserve Board of Governors in Washington, D.C., and Stephen Prowse of the Dallas Fed.

The rise of the limited partnership responds to the two problems that face private equity investors, write Fenn, Liang, and Prowse. The first problem is finding good acquisitions, since sellers know so much more about the condition of the business and tend to accentuate the positive. The second is aligning the manager's interests with the investor's. The limited partnership mitigates these problems, as the limited partners contribute capital, while the general partners search for acquisitions and monitor the managers of their portfolio firms. And since the general partners share in the profits, and their success in attracting investors for the next fund depends on their reputation, they have an incentive to earn a high return for the current fund.

The Value of Liquidity

Firms looking to acquire small businesses within a particular industry often chant a mantra of "adding value." United Asset Management Corporation, based in Boston offers one value in particular: to "monetize" the seller's wealth. Founded in 1980 by Norton Reamer, UAM pioneered the idea of rolling up institutional money management firms and has since acquired almost fifty, with $175 billion of assets now under management.

Franklin Kettle, executive vice president, explains that a typical firm acquired by UAM manages $2 billion in assets, generates $10 million in annual revenues, has twenty employees, and has overhead costs of $2 million. The four partners in a typical firm thus divide $8 million a year, but their entire estate is tied up in the business, and profits can be volatile.

UAM cashes out the partners by buying a substantial share of their equity, then signs them to a long-term employment agreement and leaves them in charge of the operation. The acquired partners share in the upside growth, but are more secure on the downside, and use the proceeds to diversify their personal wealth.

Firms looking to acquire small businesses within a particular industry often chant a mantra of "adding value." United Asset Management Corporation, based in Boston offers one value in particular: to "monetize" the seller's wealth. Founded in 1980 by Norton Reamer, UAM pioneered the idea of rolling up institutional money management firms and has since acquired almost fifty, with $175 billion of assets now under management.

Franklin Kettle, executive vice president, explains that a typical firm acquired by UAM manages $2 billion in assets, generates $10 million in annual revenues, has twenty employees, and has overhead costs of $2 million. The four partners in a typical firm thus divide $8 million a year, but their entire estate is tied up in the business, and profits can be volatile.

UAM cashes out the partners by buying a substantial share of their equity, then signs them to a long-term employment agreement and leaves them in charge of the operation. The acquired partners share in the upside growth, but are more secure on the downside, and use the proceeds to diversify their personal wealth.