Those of us working in M&A have all seen the proverbial “hockey stick” projections presented by an overly optimistic seller trying to generate interest in their business.  Usually it is accompanied by some vague explanations with a year over year growth target of “insert inflated figure here”.  Buyers typically view a seller’s financial projections with a degree of skepticism, and most will build out complex valuation models to determine a reasonable price they can afford to pay, based on their own assumptions.  In this blog article, we attempt to make the case on why you should be careful about how you present your expected growth potential and financial projections to build rapport and credibility with a potential buyer, and thereby enhance your position in the negotiation process.

The reality is that the best predictor of future performance is past performance.  Your negotiating position is enhanced if you can demonstrate that when we did “this”, the outcome was “that.”  For example, if you can demonstrate that your recruitment, onboarding/training, compensation and management of new salespeople can typically generate increased sales from “x” to “y” over a specified time period, then it follows that if you repeat this process, you could make a reasonable prediction that is credible.  Other examples abound, such as marketing and advertising spend, capital expenditures, acquisitions, new product introductions etc.  All are most credible when you can demonstrate a track record on execution.

Including projections based on a strategy that you have little experience in executing, is likely to be discounted to a large degree by a buyer.  These are more likely to be considered ideas than true projections.  While ideas are helpful in creating optimism on what may be possible for a new owner, any tie-in to the financial projections should be layered-in and presented more as speculative potential, rather than true projections.  It’s important to separate what is doable based on track record and what is possible based on new ideas, wherever possible.

One area that is often missed is the inclusion of the additional working capital, additional expenses and/or other investments that will be required to execute the plan.  Details missed on the expense side simply weakens the seller’s credibility and negotiating position.

The best approach is to have a robust business plan incorporated into your core business processes, well in advance of a potential sale or exit.  This may mean taking the management team and perhaps even a cross-section of key employees off-site to develop, review and revise your plan.  Of course, incorporating KPI’s (key performance indicators) to measure and track your progress towards your strategic goals will be helpful when negotiating with a buyer.  The most important aspect, is to be able to demonstrate to a buyer that you “plan the work and then work the plan.”
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You never get a second chance to make a first impression! The same principle applies to a potential buyer.  When sharing financial projections with a prospective buyer, it is important to get the negotiations off to a good start by having credible financial projections.  In fact, some would argue that no projections are better than those that are vague or even worse, unobtainable and/or unrealistic.

I continue to be amazed about the misconceptions some private business owners have surrounding the Private Equity (PE) industry and how they typically operate.  Perhaps it has been the negative media coverage on the greediness of Wall Street (or Bay Street) and the perception that investors promote the use of unethical tactics to line their own pockets at the expense of workers, the environment and society in general.  Perhaps it is the perception that PE firms use too much debt to finance their transactions, or that by working with them will create too much conflict around major decisions. Maybe it’s the perception that they add little value or won’t pay what a business is worth and are simply focused on buying cheap and flipping businesses for a profit.  This blog article addresses these misconceptions and provides private business owners some “food for thought” on whether they should include a “PE recap” as an exit option worth considering.

Any concern around tactics driven by greed is likely as much of a myth today as it was a reality in the past.  It is true that the typical “corporate raiders” of the 80’s bought distressed businesses to outsource operations and liquidate assets despite its impact on other stakeholders.  Most modern PE firms nowadays focus on backing entrepreneurs to help them build a better business, and to share the financial rewards with them through aligned incentives.  They also often put plans in place to reward staff and lower-level management to create alignment across the organization.

It is also true that some deals are highly leveraged and can put the business at risk if things go south, however this is much more likely to happen in the “mega-deal” space, than it is in the lower-middle market.  Lower-middle market PE firms carefully assess the cash flow risk associated with any investment and use conservative amounts of debt to leave some “wiggle room” should things not go as planned.  Also, as the debt is paid down and the comfort level around the business improve over time, they often invest additional equity to help accelerate growth.  So, while it is important to get off to a good start whenever a PE group invests in a business, the risk of debt-induced insolvency or restrictions on funding attractive opportunities is quite low.  It is also not uncommon for some PE firms to use all equity to fund deals, particularly in high growth businesses that need capital to capture attractive opportunities or to establish leadership market positions in growing industry segments.

Selling all or part of your business to a PE firm will often mean some significant changes in how major decisions are made.  Most PE firms do not want to run the business, but everyone has a different viewpoint on what that means.  To the PE firm, that means that they won’t be fielding orders from customers or making hires for the plant floor, but they expect to be involved in strategic decisions.  For example, hiring a new sales manager or CFO would likely be expected to trigger an in-depth discussion, as it would in any respectful partnership.  The key here is to have clearly defined roles and decision-making processes agreed to upfront, as the level of passive versus active involvement is highly dependent on the PE firm and the skill set of the management team.

Finally, the spread between the value paid by industry buyers (strategics) and PE for quality firms is often very narrow or even nonexistent.  In some instances, strategics pay more for rare assets that are a perfect fit for their business by sharing with the seller a portion of the expected synergies.  However, on the flip side, PE firms only make money when they successful invest the capital entrusted to them by their investors, and many have large amounts of uninvested capital to deploy.  This has driven up competition between PE buyers and between PE buyers and strategics in recent years.

The primary objective of most Private Equity firms is to put their investment capital to work by 1) buying/investing in good businesses at a reasonable value, 2) working closely with the management team by supporting and helping them to build a much larger, more profitable business within a few years, and 3) monetizing their investment by selling it once it is worth a lot more, and finally, 4) returning the capital to their investors at an attractive rate of return.  For sellers, the opportunity to roll equity in a professional partnership with a PE firm can be very attractive even if they sell their initial stake at a slightly lower value than what the highest bidding strategic will pay.
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In the end, it is quality businesses run by entrepreneurial owners, with aligned incentives and clearly defined roles and responsibilities that produces a successful outcome for all parties.  Considering a sale to a PE firm, with an equity roll, can be an excellent way to implement a two-step exit plan for entrepreneurs looking to maximize value, but only for those that are patient and open to changing how they operate and how they make key decisions.

You never get a second chance to make a first impression! It has been said that it takes the average person about seven seconds to form an opinion of you that never changes.  The same principle applies to a potential buyer of your business (although it is likely to take a little longer than seven seconds!).  In this blog article, we outline some key considerations when sharing financials with a prospective buyer and how EBITDA addbacks impact a buyer’s viewpoint on value.  Addbacks are positive or negative adjustments to earnings that aim to reflect the business’s “maintainable earnings” for a new owner.

From our buy-side advisory engagements, we often see two scenarios. 1) where no addbacks have been included, and the internal or audited financial statements, or sometimes even the tax returns are the first numbers a buyer sees, or 2) where the addbacks are so broad and all-encompassing, that they negatively impact the buyer’s first impression of the business.  The risk for scenario 1, is that you may miss out on a non-recurring expense that is not reflected in a preliminary offer. It most often happens when the seller is not actively selling the business and is simply responding to an interesting inquiry.  The risk for scenario 2, is perhaps more serious.  It is natural that the seller wants to present the business in its most favourable light to get the best offers. The issue, however, lies more in the pending consequences during the negotiation stages that can lead to a disappointing outcome.

With unrealistic addbacks, your best buyers may now view everything you share throughout the negotiations with a more sceptical lens based on their perceived first impression of your credibility.  The negotiation process can be thought of as a balance of power, that changes as the process progresses.  It is critical during the first impression stage, that you present yourself, your business, and your financials with credibility.  That means EBITDA addbacks with clear justification and documentation that can be verified and articulated with well-thought logic around your assumptions backed by real facts.

Owner benefits are the most obvious, and often the easiest addbacks to identify and justify.  While some private companies have very “clean” financials, others have the country club expenses, cottage maintenance, kid’s salaries and the owner’s home renovations embedded throughout the statements that need to be adjusted.

Including addbacks such as the full salaries for key owner/management may seem logical, if there are no plans to stay post-transaction.  However, from the buyer’s point of view, there will still be expenses associated with the business’s management.  Adjustments should be based on the business’s needs and valid assumptions on market salaries, by using outside sources, such as salary surveys for the industry and/or region.  If the company is owned by an affiliated company that provides administrative, accounting, IT, or banking support, those also need to be included in an adjustment.

There are often other non-recurring expenses that should be added back but need to be clearly justifiable.  These are particularly important in rapidly growing companies and include additional or unusual expenditures on new hires, R&D, patent applications or advertising for example, where the benefits will accrue to the new owner.  It is tricky to convince buyers that these will not necessarily recur unless they can be clearly defined.

In order to get a deal to the finish line, addbacks will be thoroughly assessed by the potential buyer or buyers, and if a deal is to close, it will be based the buyer’s due diligence.  Addbacks are often reviewed by an outside firm, through a “Quality of Earnings” (QofE) review and a buyer may adjust any preliminary offers based on any material items that are discovered.  Given the increasing frequency in which a QofE is undertaken before closing, it is best to make an accurate estimate of the correct adjustments well before the QofE review, and ideally before any potential buyer sees any numbers.

In summary, the best approach to gain credibility and a good first impression with potential buyers, is to carefully and thoughtfully adjust EBITDA where the reasoning can be easily explained and justified.  Opening the dialogue with unadjusted financials leads to a potential missed opportunity to capture some value and throwing unrealistic adjustments at a buyer, just raises questions that are better left out of the negotiation process.  Adjusting EBITDA is just one of many steps business owners need to take to properly prepare for a sale of the business.