June 2012

A recent article in the Boston Globe reported that although more attention is on the large, primarily publicly held companies, more and more people are making their living by operating their own businesses. In fact, nationally, over 500,000 new businesses are started every year.  What this means is that over 10 percent of workers are “either starting a business or working at one that is less than 3 1/2 years old.”  And, as indicated by frequent reports, new businesses create new jobs.

Those people who start businesses generally do not have their own funds available for start-up expenses. This is due in part to the fact that bank and SBA funding is not available to them.  In addition, fewer than seven percent of new or prospective business owners will receive actual venture capital funds.  So, where does the money come from?  Second mortgages, credit cards, and family loans are the most common sources of start-up funds.  The Globe added that “over the past few years, more than 80 percent of Inc. Magazine’s Fast 1000 companies have been started with about $50,000 or less.”

The article concluded with a plea for “seed” capital and funding from both public and private sources.  Perhaps this article and similar ones will lead the way towards the recognition that those who own and operate their own businesses deserve a less arduous journey toward making the right start.

Small companies are the innovators. The need for large companies to acquire small companies is necessary in order for the former to capture new products and services.  According to Fortune magazine, “Big companies almost never innovate. This is unfortunate because innovation is one of the few ways to gain proprietary advantage and stay profitable.  It’s not that innovation itself is rare – it’s occurring everywhere.  Which means, mostly, elsewhere.  And as engineers and inventiveness continue to flourish in China and India, elsewhere moves farther and farther from here.  A healthy business must therefore not only innovate more within its walls but leverage innovation elsewhere too.

“So why is innovation so hard for big companies?  The main reason is that innovative people tend to prefer working in smaller organizations that have more focus and less bureaucracy.  Even in small companies, adopting a large-company style can frustrate the innovators.
“The problem with large companies isn’t that they fail to do large and seemingly ambitious projects; it’s that they fail to do small, quirky, controversial projects  – that  have the potential to grow.  (If everyone thinks an idea is okay, how can it be innovative?)  A large organization – its missions threatened by new ideas – is often incredibly hostile to its own innovators; the antibodies to change are strong.”

The median sales of a company going public has gone from an average $15 million in 1999 and 2000 to $164 million in 2004.  Smaller companies have decided not to go public as often as in years past, and they reap the quick – and cheap – money as a result of that decision.  The question is “why?”

A company with only $15 million in annual revenues would most likely not want to have an IPO and absorb all of the attendant costs and the on-going fees related to going public.  They also would not want to have to spend the money necessary to comply with the Sarbanes-Oxley regulations.  Smaller companies have to pay a hefty price to go public – and remain public.  In fact, a recent Business Week article reported that “Bankers expect a record number of U.S. companies to go private this year, topping last year’s 86.”

Many CEOs, in order to rapidly grow their businesses, merge or acquire other companies.  However, many of these do not work out and the acquired entities eventually get sold off.  But as long as mergers and acquisitions are in vogue, large companies will acquire smaller ones in an effort to grow as rapidly as possible.  Therefore, many smaller companies that won’t go public because of the costs and subsequent compliance issues will be absorbed by larger companies.

The trend today, at least in manufacturing, is to provide complementary services.  For example, General Electric manufactures aircraft engines and medical equipment, but they also provide financing and maintenance services for the things that they manufacture.  These ancillary, but complementary, services are big profit makers.  Small service companies that provide these services may be excellent acquisition targets for manufacturers.  If smaller companies want to grow, adding complementary services such as GE does may be the best way.

On the flip side, many large companies are divesting themselves of companies that don’t fit into their core strategy.  For example, McDonald’s purchased Boston Market and several other food franchises in an effort to continue their growth. McDonald’s discovered that they were much better off focusing on their core business than they were trying to grow new concepts.  It is believed that these other franchises will be sold or they may already have been.  Smaller companies may want to divest themselves of products or services that aren’t complementary to their core business.

Some companies have almost reinvented themselves by adding new, more profitable, and “sexier” services or products.  This can increase the value of the company.  Smaller companies, because of their size and the fact that they usually have one manager, can shift quickly.  They can get rid of products or services that don’t generate commensurate profits, or add new products or services that can add to profits, much more quickly and efficiently than their larger counterparts.

Small companies, at least for the short term, will not be likely to go public, will be able to shift gears quickly to improve profits, but may also become acquisition targets by larger companies.

In most jurisdictions, a board of directors is not required for privately held companies.  However, many of these companies have appointed what might be termed advisory boards.  Although they may not have any legal authority, owners of these privately owned companies have discovered that this team of outside advisors can assist them in many ways.

One important way they can help is just by having their name and/or company affiliation attached to the company.  This can open doors to new customers and new relationships.  Appointing advisors from both the accounting and legal fields can help insure that the company maintains strong controls on these important areas.  This board can also assist in developing company strategy and systems.  A business-savvy board can also help in management succession and can help prepare the company for sale.

In order to create a strong and helpful advisory board, “cronies” should not be included. The advisory team can consist of two to four people. They should meet several times a year, or in emergency sessions when necessary, and be available by telephone.  They should also be compensated for their time just as any consultant would be.

The deal is getting down to the wire, the price differential is close, but the parties are not yet in agreement. Following are some ideas that might get the ball rolling and help bring the parties together.

• Let the seller retain the real estate and rent it to the buyer, thus reducing the price. The same could be done for major pieces of equipment. Let the seller lease them to the buyer reducing the price. The lease should, however, like most leases, provide for a buyout at the end.
• Structure a royalty on sales rather than an earnout on gross margins or EBIT.
• Have the parties create a subsidiary for the fastest growing part of the business in which the buyer and seller share 50/50.
• Let the buyers acquire 70 percent of the business with the requirement that they purchase 10 percent more each year on the same multiple of EBIT as in the 70 percent sale.
• Arrange a consulting agreement with the seller to provide additional compensation to be paid annually.

Certainly, any agreement or deal structure should be approved by the party’s professional advisors.