We frequently work with companies in consolidating industries. When an industry goes through a period of consolidation, characterized by a few large companies actively and aggressively acquiring their smaller competitors, a unique set of dynamics take hold of the market. The number of companies being sold increases, as do the prices for which these companies sell. As a small business owner, if you notice your industry beginning to consolidate then you have a rare opportunity to make a significant amount of money. But, you can only achieve this if you are willing to say yes.
Two mistakes that small business owners frequently make are believing that the consolidation will last forever and believing that the valuations achieved during periods of consolidation are intrinsic to all companies in the industry.
Industry consolidators, whether corporations or private equity groups, approach M&A with the general objective to acquire as many companies as possible in as short a time as possible. Eventually, they reach a saturation point. When that happens, many put the brakes on their acquisition programs, becoming more selective, while others stop buying altogether. The focus can shift to greenfield expansion or simple organic growth.
Consolidation peaks when the largest number of buyers are active at the same time. Typically, these peak periods only last 3-5 years. During the peaks, valuations skyrocket as demand exceeds supply. Business owners who capitalize during these peak periods reap the biggest rewards.
There are certainly exceptions to the 3-5 year rule. Many industries that begin to consolidate between 2006 and 2008 are still being consolidated today; however, that is primarily because acquisition activity stopped from 2008-10 as a result of the recession. Absent an economic crisis or other rare and unforeseen event, you can expect the typical 3-5 year window to prevail.
Valuations increase during periods of consolidation for two reasons. First, competition drives a buyer’s decision-making. If numerous companies are committed to growth via acquisition, the market dictates pricing. As with any commodity, if demand is greater than supply, the price increases.
The second reason, which is more important for the small business owner to understand, is that consolidators utilize a unique set of criteria when valuing a business. For the most part, consolidators are less concerned with the value of any individual transaction because they understand the long-term value of completing 100 transactions. They know that if they pay 5 x EBITDA for a business that they can impose their model on it and make it worth 7 x EBITDA in a short period of time. Furthermore, they understand that once they achieve scale, the conglomerate can be worth 10 x EBITDA.
How are these businesses worth so much more after an acquisitions? Consider Company A, a national document storage company that acquires Company B, a small, local competitor and immediately shuts down Company B’s facilities, relocating all of the documents its existing facilities. Even if Company A retains all of Company B’s employees, it has eliminated rent and other expenses associated with operating separate facilities. Furthermore, by filling vacant space in its existing warehouse, Company A makes its own operation more efficient.
Beyond economies of scale, each industry carries with it unique attributes that only a consolidator can take advantage of. Consider the case of a manufacturer that sells through wholesale channels making the decision to acquire it’s customers and enter the retail market. When the buyer takes over the retail operation, it can profit twice, at both the wholesale and retail levels. This is factored into the valuation, allowing the buyer to pay a substantially higher price than a traditional retail operator.
One common misconception that small business owners have about consolidators is that they pay such high prices because they have “deep pockets.” While it’s certainly true that consolidators are typically cash-rich companies with strong margins, and having these cash reserves facilitates their acquisitions, they aren’t paying higher prices just because they can. Once competition for acquisitions dries up, they will begin to pay less for businesses they acquire regardless of the depth of their pockets.
So, how does all of this tie to the subject of this article, “Say yes to the offer”? It’s simple. When your industry starts to consolidate and corporate buyers come calling, take advantage of the situation and find a way to do the deal, even if you think you are years away from retirement. We recommend this for the following reasons:
- It’s a once in a lifetime opportunity to sell your business for significantly more than it’s intrinsic value. In one consolidating industry, we calculated that the consolidators pay, on average, a 65% premium compared to other buyers. This premium goes away when consolidation stops. Furthermore, these businesses are selling for 2-3 times what similar businesses in an adjacent industry sell for. Once consolidation ends, these business owners will literally have to double their business in order to sell for the same amount. While all small business owners are optimistic and believe they are right around the corner from doubling sales, the law of averages says that most will not.
- Selling does not mean retiring. If you are young and wish to keep working, you have plenty of time to build another business, and a lot more capital to do it with. If you don’t want to start something from scratch a second time, you may have opportunities to work for the company that buys you, at a healthy salary and with a rich benefits package. You may even be able to share in the profits as your company grows under their ownership.
- If the consolidators succeed, they may push you out of the market. If they achieve scale, they will have the pricing power to low-ball your customers, the name recognition to attract a larger quantity of new customers, and then they will use their deep pockets to outspend you on sales and marketing.
Consolidation is not a death knell for small business owners, as those that are exceptional will always survive; however, even the exceptional owners will find that they have to work much harder to compete post-consolidation. If the concept of working more for the same pay doesn’t appeal to you, perhaps that is the best reason of all to say yes.