Today, I’d like to talk a little bit about a situation that is particularly perturbing to me, and how, as a problem-solving entrepreneur, I propose solving it. Namely, why small businesses contribute to over 50% of the world’s GDP yet does not share that same percentage of the world’s investment capital.
Did you know that a massive amount of the world’s money is in investment funds, family wealth funds, insurance companies, pension funds, etc.? It is in hot, sandy countries with low tax costs. And while it creates quite a bit of employment for the finance industry, it doesn’t help society in any meaningful way. The money in the world is disconnected from the value in the world. Why does a pension fund or a venture capitalist choose to invest in “bets” rather than in the value created by hardworking entrepreneurs?
Now, some money does find its way into the start-up world, but start-ups are over-glamorized. They are the roulette-wheel of entrepreneurship, and 80% or more fail. And when they do, the streets are littered with their victims; people lose their livelihoods, their homes, and their families’ and friends’ money. It gets messy. Yet, start-ups still get all the attention.
But companies that have survived start-up are a much better bet: they have a great product, great customers, and real revenues and profits. They have created a brand that people like and trust, and they generate sales and profits. These are the people we need to go and do deals with.
Unfortunately, big money doesn’t follow the value of investing in SMEs (Small- to Medium-sized Enterprises). There are three key reasons for this:
- Risk – Small companies are too risky. They lose a couple of key clients or key staff and have their worst year ever (or maybe their last).
- Scale – I call this the scale paradox: you have to be big to get big. If you are not already a big company, it is hard to win the huge global contracts, and you can’t get big unless you win the big global contracts.
- Liquidity – Small companies are illiquid. If you invest, it takes ages to get your money back. Three- to five-year plans can easily slip into ten- to fifteen-year plans, and global capital likes to be able to rotate between asset classes as the economic winds change.
However, you can address the disconnect between value and capital through “agglomeration” (virtual merger 2.0) by clustering the best SMEs and publicly listing them, thereby lowering the risk and creating scale and liquidity.
What Is an Agglomeration?
The idea behind virtual merger 2.0 or an agglomeration, as we call it, is a way to tackle those three issues—risk, scale, and liquidity—and therefore create vast amounts of shareholder value. In the private equity world, they “roll up,” which means they put several companies in the same industry together, and you then have the sum total of all of the parts. You shove them all into one box ,and off you go.
The challenge with owner-managed SMEs is that they’re below the private equity radar. These are companies that are generating profits of between $500,000 and $5 million a year. They are often lifestyle businesses that have been going for 10+ years and are generating seven-figure profits for the owners, but, basically, they’re not hitting it out of the park. They’ve pretty much plateaued in terms of their growth. They’ve reached their glass ceiling, and it’s hard for them to break through. They’re great businesses, but they can’t really go much further from where they are. Often, these people are ambitious, want to buy their competitors, or expand overseas. They want to do things, but they can’t, and they feel a bit trapped.
We look for these companies. Now, the challenge with these companies is they’re run by maverick owners who are very successful. They are key people in their particular industry, and they don’t integrate well. So, if you use a traditional roll-up method, the unique brand and culture that they’ve created with their staff and with their customers won’t really mix. You can’t shove it all into one box and expect it to be the same.
So, by doing the traditional roll-up, you end up destroying value instead of creating value. You think you’re being clever by executing all these synergies and getting rid of bookkeepers, but all you’re really doing is annoying the key talent and the key customers of the company by trying to change everything.
So, my experience with roll-ups in that SME, owner-managed space is that they don’t really work effectively and, particularly, the synergies are fool’s gold: you can never really extract the value that you want to.
In my next blog, I will share more about how agglomerations are put together and how they work in the market. Be sure to come back for that!
If you’ve been getting value from what I’ve been sharing and would like to dig a little deeper, I’d like to invite you to attend one of our Harbour Club events. Not only do I share the ins and outs of deals, but it’s also a place for you to network with other Club members and learn from them as well. Events are currently conducted virtually, so your health and safety are ensured.
This article was originally published here: https://www.jeremyharbour.com/how-small-businesses-can-compete-with-larger-ones/