New art of the deal Featured

10:03am EDT July 22, 2002

The words "small business" and "IPO" may seem not to belong in the same sentence. But Wayne Huizenga (among others) changed all that when he bought up scores of small local garbage haulers and took them public as Waste Management Inc. Now, finance professionals are scouring the country looking for similar opportunities to consolidate fragmented industries, and offering small companies the chance to become part of a larger, potentially more profitable entity-or to cash out entirely.

"Poof IPOs" and "roll-ups" are direct descendants of the leveraged buyout (LBO) and merger craze that has swept the United States since the mid-1980s. But where mergers and LBOs focused on billion-dollar companies dominating their industries and employing thousands, "Poof IPOs" identify numerous small companies in a given industry and combine them in a public company that takes advantage of unrealized economies of scale. A "roll-up" does the same thing, except that individual companies are kept private by the buyer until they reach a critical mass, and only then are taken public.

There are several parties involved in a typical "Poof IPO" or roll-up. Gabor Garai, managing partner in the Boston office of the law firm Epstein Becker & Green, represented the sellers of about 30 companies in roll-ups by buyers who later took them public. The seller must know what his or her business is actually worth in the market: "Sometimes the numbers are not as attractive as if someone walks in offers you $10 million in cash," Garai cautions. The seller should also be prepared to identify employees who should be retained by the buyer to maintain continuity. Seller's reps also advise business owners on compensation and equity issues, as well as what will be the former owner's role in the new company.

The Chicago investment banking firm Brown, Gibbons, Lang & Co., LLP, formed BGL Capital Partners as promoter for a pure roll-up of five discreet business service companies that went public earlier this year as Compass International. "They've grown substantially and they're doing well," says Michael E. Gibbons, senior managing director at Brown, Gibbons. The promoter usually starts the process by identifying, researching and contacting individual small businesses the promoter believes can be consolidated profitably. "It really is out of the business owner's hands," Gibbons says. "They're either really attractive to us when we find them, or they're not."

The promoter usually hires an underwriter's counsel, such as Ira N. Rosner, a partner with the law firm Steel Hector & Davis, LLP, in Miami, to research target companies and their industries. "Whenever a businessperson is considering getting rolled-up, it's critically important that they do very careful due diligence of the new management," Rosner advises interested entrepreneurs.

Garai agrees: "There are things at the granular level that makes these deals more difficult than people sometimes expect." He adds: "A lot of these marriages end in divorce very quickly." All parties must maintain the confidentiality of the deal, to keep competitors or other potential suitors from taking advantage of the situation before the process is complete.

Even if everything goes swimmingly, roll-ups and "Poof IPOs" are a risky proposition for most businesses. Though there's no comprehensive data tracking the performance specifically of these tools, initial public offerings generally have under-performed the stock market, according to Tim Loughran, associate professor of finance at the University of Iowa. His survey of 4,753 IPOs from 1970 to 1990 showed an average 5 percent annual return including dividends, compared with 12 percent for already-public companies for the same period. "That looks pretty pathetic to me," Loughran says, "considering it was a bull market." Yet people still invest in IPOs, "because they believe they have the ability to pick the next Microsoft," he says. "A lot of these [IPOs] don't take off right away. And some never do."