Publications: Analysis and Structure of Roll-Up Transactions

Roll-up transactions have become a very effective way to consolidate fragmented high-growth industries in which there are a number of small competitors and few market leaders. Roll-ups are performed for a variety of business reasons: (i) increased diversification through cross-selling of products, (ii) increased liquidity of investment as well as potential for growth on an investor's return, (iii) reduced administrative and operating costs by centralizing certain company operations that are currently duplicated, (iv) changing economic or business conditions in a certain industry, and (v) better managed entities.

The classic roll-up consists of two or more companies called "Founding Companies" operating as subsidiaries of a newly formed private or public entity (the "Holding Company"). The structure of the deal and the players involved determine the combined entity's success. Characteristics of successful roll-ups require: (i) the proper capital structure, meaning the right combination of cash, stock and debt, (ii) strong management at all levels, including the promoters, agents and underwriters, (iii) a defined acquisition strategy, (iv) tangible synergies, including the value added and effects on operating expenses, and certainly (v) strong Founding Companies.

Identifying the Right Industry

The first step of any roll-up transaction is identifying the right industry in which to consolidate. As stated earlier, the most effective roll-ups are those in high-growth markets that are fragmented, which contain many competitors and few market leaders. Certain successful rolled-up industries in the past have been oil field services, funeral homes, office supply stores, medical services, floral products, environmental testing, boating centers, and recreational vehicles.

Our firm has experience in identifying factors and opportunities for successful roll-ups. We have participated in a number of roll-ups in some of the industries already mentioned and in other industries, including airport shuttle services, auto body shops, collection agencies, specialty consumer finance companies, dry cleaners, and temporary staffing companies.

Identifying the Founding Companies

Once the industry is selected, the right platform of Founding Companies must be selected with which to start. This requires a tremendous understanding of how the particular industry operates and what value may be added by combining the Founding Companies. Often the most successful roll-ups are among Founding Companies that each service a particular niche in the market with little or no overlap in products/services. Often the roll-ups include companies that operate in different stages of the same market.

Creating Interest

This stage may be the most important to completing the roll-up. Selling the specific benefits of the industry roll-up may be the toughest challenge. Timing is also an issue. Often the promoters of the deal approach the principals of the Founding Companies and potential investors/underwriters simultaneously. The current climate for the roll-up market is promising and investment banking firms have been enthusiastic.

The Deal

There are a variety of ways to structure roll-up transactions. Roll-up transactions traditionally were private ventures, either through the use of venture capital groups or by offering limited partnership units in the newly formed entity. Today more roll-up transactions are completed with an initial public offering, with the option of private capital to fund the cost of "going public."

Funding the Early Stages

Promoters may decide to either pay the costs incurred to negotiate and prepare the initial public offering themselves or raise capital through a private offering. The investors of the private offering will have the opportunity to acquire additional shares in the Holding Company upon completion of the IPO. The subscription payments may be either paid in full at the time of the private offering or on call or in agreed installments as the needs of the Holding Company require. In the event the IPO or acquisition program is not completed, the individual investors may be entitled to claim some or all of the loss as ordinary loss under Section 1244 of the Internal Revenue Code.

The Acquisition Program

Once the Founding Companies agree in principal to the negotiated terms, a letter of intent is entered into to acquire each Founding Company, which outlines: (i) the basic economic terms of the acquisition, (ii) the employment and incentive compensation arrangements for the principals of the Founding Companies and (iii) the conditions to proceeding through the various stages, including due diligence and execution of definitive agreements.

Definitive Acquisition Agreements

After letters of intent have been entered into with all Founding Companies, the Holding Company will negotiate and enter into definitive acquisition agreements, which will include (i) customary representations and warranties on the part of the controlling shareholders or members regarding the business and financial condition of the Founding Companies; (ii) list various conditions precedent to closing on the part of the Holding Company, including (A) the absence of material adverse changes in the business or financial condition of the Founding Companies; and (B) the successful completion of the IPO; and (iii) list various conditions precedent to closing on the part of the Founding Companies, including among other things, the successful completion of the IPO at a per-share price not less than a specified amount.

Closing

The closing of the acquisition of the Founding Companies would occur contemporaneously with the closing of the IPO. All Founding Companies would have to be acquired for any to be acquired. However, the IPO raises enough funds and registers enough shares for future acquisitions as well.

Acquisition Structure

A roll-up transaction may employ the following structure:

The Deal

The Holding Company is organized by the Promoters, which consists of a group of individuals/companies using their own funds, not a private offering. The Promoters are issued shares of stock upon incorporation of the Holding Company. Subject to the consummation of the public offering, the Holding Company agrees to acquire all of the outstanding stock of the identified Founding Companies in a combination stock and cash offer and assume the outstanding debt of the Founding Companies, including personal guarantees/debts of certain executives of the Founding Companies. The purchase price of the acquisitions will vary based on the earnings.

The consideration for each Founding Company may be determined through arm's length negotiations between the Holding Company and each Founding Company based on a uniform formula reflecting primarily each Founding Company's respective operating income, as adjusted to reflect long-term debt assumed and other contractual adjustments. Independent valuations based on prescribed standards could also be used.

Simultaneously with the offering, the shares of the Promoters of the Holding Company split to give the Promoters control of a percentage of the outstanding voting stock (generally 10% to 15%). Upon closing and completion of the offering, the Founding Companies are issued shares of Holding Company as part of the consideration for the acquisitions. The Holding Company and the Founding Companies control a significant portion of the outstanding voting stock (generally 40% to 60%). The public, therefore, controls 25% to 50% of the outstanding voting stock. The proceeds from the shares sold as part of the offering will be used to pay the cash portion of the consideration for the acquisitions and other expenses. These shares are fully tradable but the shares owned by the Promoters, the executives of the Founding Companies, the Founding Companies, and the Holding Company are not registered and restricted from trading for a certain period of time.

Management

The Board of Directors is comprised of the Promoters and executives of the Founding Companies. The management of the Founding Companies will remain intact but management of the Holding Company generally includes the Promoters. The Holding Company focuses on strategic acquisition planning, financial management, and human resources. Certain operating activities are also placed in the hands of the Holding Company to achieve certain economies of scale.

Employment/Compensation

The Holding Company enters into employment agreements with the Founders. The executives of the Founding Companies also enter into employment agreements. To induce the executives of the Founding Companies to complete the roll-up, a lucrative compensation package is essential. As part of the Executives' compensation packages, they may receive bonuses and participate in a variety of stock purchase or stock incentive plans.

Tax Issues

Generally, the acquisition structure will involve some type of tax-free reorganization depending on how the Founding Companies are organized. Most likely, the Founding Companies merged into new subsidiaries of the Holding Company (so-called “reverse triangular mergers”), and the Founding Companies were the surviving corporations. The stock portion of the consideration would be tax-free while the cash portion of the deal would be taxable gain to the Founding Companies. The assumption of debt may or may not have been a taxable gain depending on whether the debt was corporate debt or personal debt.

Other Acquisition Strategies

If limited liability companies are involved, the Internal Revenue Code does not make any provision for tax free mergers of limited liability companies. Thus, members of a Founding Company that is a limited liability company who receive Holding Company securities as merger consideration would realize taxable gain to the extent the value of such securities exceeds their basis in their limited liability company interests.

An alternative to a merger might be for the members of a Founding Company that is a limited liability company to contribute their membership interests to the Holding Company in return for Holding Company shares (or, alternatively, for the limited liability company to contribute its assets to the Holding Company in return for Holding Company shares, which would then be distributed to the members in liquidation of the limited liability company). It might also be possible to convert the limited liability company to a corporation and then effect a merger.

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