Why private equity might want to buy you.

Private equity (PE) aligns better with the interests of bootstrapped companies than other investors, like venture capitalists. But few founders fully understand how PE works.

One of the goals of this newsletter is to get you up to speed on just how PE operates, so you can decide if and how to work with them.

A common strategy that private equity uses is called the roll-up.

A roll-up is where PE buys multiple companies and rolls them into one bigger company.

In fact, my previous company, Ampush, was acquired as a part of a roll-up and ended up being a huge success story.

That brings us to today’s email. I’ll break down:

• WHAT exactly is a roll-up?

• HOW does it work?

• And how YOU, as a Bootstrapped Giants founder, should think about participating in one

Well, to explain why roll-ups are popular, let’s go over the basics of valuations.

When you think about how stocks are priced or how companies value other companies, it goes back to what you learned in your Finance 101 class.

They’re based on discounted future cash flows.

If I were to offer you a deal that gave you $1 every year for 10 years, what would that deal be worth to you? In simple terms, it’s worth $10.

You might bring up interest rates and tell me that $1 given to you will be worth less in 10 years than $1 today. I’d then adjust the deal down, based on those interest rates. That’s what we mean by discounted future cash flows.

Now, with that in mind, what would create a higher or lower valuation?

If a company grows its revenue, it’s worth more.

A company with consistent $1M cash flow is not worth as much as a company whose cash flow grows from $1M in year 1 to $2M in year 2, $3M in year 3 and so on.

What if the company’s revenues are under competitive pressure? It might be forced to reduce prices and earn less in the coming years. That would reduce its value.

The longer a company can reasonably be expected to generate cash flow, the more it’s worth.

A common replacement for cash flow in valuations is EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). And instead of adding up all future years’ cash flows, a multiple of one year’s EBITDA is used. The 3 valuation levers above determine the multiple.

That's Jesse's Valuation 101.

Private equity wants to grow EBITDA and valuations. One way to do that is through roll-ups.

Let's use Ampush as a case study of how roll-ups work (with illustrative numbers, not actual numbers).

Tinuiti, the company that acquired Ampush, started as a business called Elite SEM.

In 2016, it had about a $4M EBITDA business. A private equity firm bought it for 8X its EBITDA for a total purchase price of $32M. That became the anchor asset in the roll-up.

Then they started doing tuck-ins, adding multiple smaller businesses at lower multiples. Let’s say they added another $8M EBITDA at 6X earnings for a total purchase price of $48M.

So their total cost for all these businesses was $80M, and the business had $12M EBITDA.

They paid a blended multiple of 6.7X ($80M total purchase ÷ $12M EBITDA).

Then they started growing the combined business’ earnings. They cut inefficiencies, started cross-selling services to clients, etc.

The EBITDA went from $12M to $20M.

At that point, they sold it for 15X EBITDA, or $300M.

Why could they sell for a 15 multiple when they bought the business for a 6.7 multiple?

Tituiti got a higher multiple for the roll-up because it improved each of the levers I mentioned above.

1. Growth

Each acquired company added to the collection of services that the rolled-up company could offer.

At Ampush, for example, we didn’t offer Amazon ad buying before our acquisition, but as part of the bigger company, we could offer many other services to our clients, which grew revenue.

The bigger company could also cut costs by sharing services.

The combination of higher revenue and lower costs increased the company’s growth rate.

2. Security

Bigger companies are considered more stable and enduring. They have more market power, a broader management team, economies of scale, etc.

As Tituiti grew, it gave potential acquirers more confidence in its ability to keep producing cash flow.

3. Longevity

Each new source of revenue added to the combined company’s ability to withstand marketplace turbulence and last longer.

Over the years, the online marketing world has seen ad formats come and go: pop-ups, banners, flash ads, interstellar pages, etc. As each format died, it took out a collection of single-format agencies that focused on those specific formats.

But bigger players with diverse offerings survived the death of any one format.

With diversity, the roll-up added to its longevity, which grew valuation.

So the private equity investors put in $80M and sold for $300M.

You can see why they were happy buyers and these deals are done often.

There are firms that specialize in deals like this.

I think there's a really interesting case for a lot of Bootstrapped Giants founders to partner with private equity to do this at almost EVERY level.

There are roll-ups that happen by people acquiring a bunch of $2-3M EBITDA businesses. There's roll-ups that happen through acquirers buying a bunch of a $100K EBITDA business at 2-3X cash flow.

$1-2M EBITDA trades at 5X cash flow. $5M EBITDA trades at maybe 8-10X cash flow… and it just KEEPS going UP.

So there's an opportunity to do this throughout the chain, and there are private equity firms who specialize in all of it.

Beyond the original sale, founders of rolled-up companies can participate in all this value creation.

Elite SEO’s founders might have kept a % of their business when they sold. Their offer from the PE could have been:

“We’ll buy your company for $32M. $20M in cash and $9.6M in the new company’s stock.”

That would have reduced the cash portion that PE invested in the roll-up to $68M. And given Elite SEO’s founders 17.6% of the new business.

So when the company was sold for $300M, Elite SEO would have had a second exit of $52.8M.

That’s why I keep repeating that PE is well-aligned with founders of Bootstrapped Giant companies.

Unlike VC, which pushes founders into risky situations that have a small chance of generating big exits, PE works with founders to create more reasonable outcomes.

But, it's not all unicorns and rainbows. Acquiring businesses is very challenging. There are culture issues, operation issues and unknown risks.

I’ll talk more about that in a future newsletter if I get enough requests for it. (Hit reply and let me know.)

I can give you the example of my acquisition of My Subscription Addiction, along with other stories I’ve heard.

—jesse