By Rob Hong, Co-Founder & CEO, Sapling Financial Consultants
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If a home is the average person’s biggest purchase, then buying a company is a daunting task that few ever have the privilege – or burden – of doing. And unlike a home, which is tangible and relatively simple, a business has thousands, maybe millions of moving parts. Evaluating this complexity is tough. Buyers reasonably tend to focus on items like the company’s product, the founder’s vision and competence, competitive reviews, etc. But few things represent a 360-degree view of the business like its financials. Unlike the other items, they are tangible, straightforward, exhaustive and quantitative. So, they reflect the business’s health in a particular way. As a result, they should be high on the diligence list for searchers.
While a quality of earnings service (“QofE”) provider – like my firm, Sapling Financial Consultants Inc. – will tend to address many of the pitfalls and green flags in a company’s financials during an engagement, to save both financial resources and arguably the searcher’s most valuable resource – their own time – it’s helpful to personally do some preliminary due diligence before engaging third-party providers, and possibly even before signing a letter of intent (“LOI”) with the seller. In this article, I will discuss six pitfalls that we have seen, and three “green flags” that tend to indicate a high-performing organization.
Pitfall #1: Directional Disagreement on Normalized EBITDA
The first pitfall that can indicate a problem investment is a significant disagreement on what normalized EBITDA really is. Occasionally, this is pretty simplistic – the buyer tells you in passing that the company’s EBITDA is $4M, and then you check the financials or confidential information memorandum (“CIM”) and come up with $1M. This could just be a reflection of the fact that many owner-operators are their company’s chief salesperson! In such cases, pointing to the actual printed figure will usually quickly bring the discussion back on track. More often, though, that $4M may be reasonably documented, but upon some basic investigation you realize that $1M of addbacks comes from double-counting, $500k comes from assuming that the sales team will all of a sudden (effectively) take a 40% pay cut, etc.
These types of disagreements can quickly indicate trouble, because the owner may not only have to capitalize EBITDA that is 75% less but also deal with a lower EBITDA multiple. In other words, the seller may believe they have a Ferrari but actually has a beat-up Corolla. Often, this level of disagreement is alone sufficient to rupture the deal. As a result, a quick analysis of normalized EBITDA, and how it has been derived, is always worthwhile, long before QofE and other diligence providers have been engaged.
In circumstances where the owner is willing to accept the change, questions still remain. First, what kind of accounting function has resulted in such a poor understanding of numbers? Second, why is the owner willing to still move ahead?
Pitfall #2: Large Divergences between EBITDA and Cash Flow
A second pitfall is when there is a large divergence between EBITDA and Operating Cash Flow. Recall that EBITDA is a simple proxy for Operating Cash Flow that eliminates fluctuations in working capital to hypothetically present the business’s true economics. In many circumstances, it does (more or less) live up to this standard, but not always.
The above image shows the cumulative EBITDA vs cumulative Operating Cash Flow, anonymized from a recent client engagement. Generally, we expect these numbers to fluctuate around each other, and with faster-growing companies, EBITDA should pull ahead of Operating Cash Flow as the business fulfills a growing order book faster than it can bill and receive cash. But absent significant growth, EBITDA and Operating Cash Flow should eventually converge, as they do in the image. If they don’t, it could mask collection and collectability issues, shortcomings in the quality of service/product provided, excessive purchases of now-obsolete inventory, and more.
Pitfall #3: Constantly Changing Numbers
A third pitfall that we have found is constantly changing numbers. I’m not referring to fluctuations in financials (whether revenues or margins) – depending on the company and industry, this could be normal. Instead, I’m referring to something a bit more mundane: constantly changing financials for the same period. It’s still surprising for us, but we regularly come across companies – on both the sell-side and the buy-side – where they provide us a trial balance, then ask us to use an updated one two days later, then two more days later will provide still a further updated trial balance. We even had one client tell us they sent us the “wrong GL” without mention of any updates! Fortunately, in that case, we were representing the buyer, who summarily backed out.
At best, this indicates a poorly functioning finance function, perhaps marked by low-calibre talent, turnover, or even problematic relationships with customers and vendors. At worst, this could be a sign of the finance function being directed to portray the financials in an over exuberant light, or even fraud or money laundering.
If this happens to you, compare the EBITDA between different versions. I am willing to bet you it went up!
Pitfall #4: Excessive EBITDA Adjustments
Fourth in our set of pitfalls is excessive EBITDA adjustments. Granted, there will almost always be some level of this, and even large EBITDA adjustments can be reasonable (e.g., if the management team are all partners in the business are and paying themselves excess salaries to move taxable income out of the business itself, a very large, positive EBITDA adjustment would reflect QofE best practices). However, the sheer number of adjustments could indicate poor financial controls in the business. Too many personal expense adjustments could indicate an unfortunate lack of separation between personal and business. Too many “one-time” adjustments could signal a company with poor planning, or worse, a management team that takes responsibility for “wins” but not “losses”. Finally, too many accounting adjustments could mean that financials have been prepared sloppily for years, and adjusting entries are used to band-aid these problems.
Pitfall #5: High Customer Concentration
A fifth pitfall is having high customer concentration. One company we worked with was a professional services company with $10M of revenues, of which $6M was tied to a single publicly traded company. A 60% concentration of revenues is always a risk, but it was particularly risky here because professional services are more easily in-sourced for a large company than, say, manufacturing services, as there is no physical “plant”, and the company in question had tens of thousands of (mostly professional-level) employees. If our client had lost that customer, the business would be facing significant layoffs, and a loss to almost all of the EBITDA – and all it would take is one ill-timed decision from a client VP.
It’s important to be careful around this issue. My company, for instance, works with many private equity firms and their portfolio companies. As a result, a single “client” – representing a single decision-making group – could have even a couple dozen different names in our financials, between different fund vintages and portfolio companies. Yes, do check customer concentration in a straightforward way (customer dollars divided by total revenue dollars) the moment you have access to your seller’s books, but also ask lots of questions, and do your digging online to see if the top customers may have subsidiaries, portfolio companies, or related entities under different names which will have the impact of understating customer concentration without adjustments to aggregate revenues into a single customer name.
Pitfall #6: Poor Tie between Bank Accounts and Income Statement
Finally, a sixth pitfall appears when you’re unable to reasonably straightforwardly reconcile between what is in the bank account and what is in the income statement. Given even the most cash-based income statement tends to have a number of accruals, this involves bridging the gap between the income statement and the cash flow statement by adding and subtracting various accounts and then checking the starting and ending cash balances over a specified period. For us, this does take a bit of careful work, but things usually decisively fall into place, and any aggregate discrepancies tend to be small (< 2-3%, at which point further investigation is not always merited relative to the cost of that additional investigation).
Arguably, in a fast-pass analysis of this type before the QofE, you probably don’t need to winnow the discrepancy down much below 10%, as further diligence should help narrow it further. But if, after a significant amount of analysis and discussions with management, you are still unable to resolve a larger discrepancy, it may be time to pack it in – or at the least, trim EBITDA back by the difference, and apply a lighter multiple.
Green Flag #1: Consistent Accountant-Prepared Financials
Now that we’ve discussed pitfalls, let’s turn our attention to three “green flags”, or positive indicators. The first relates to consistency in accountant-prepared financials. Here, we like to see the company has been engaging a third party, and ideally that same third party, over several years. Moreover, if an opinion is issued, we like to see that opinion to be consistently unqualified, or “clean”. Don’t worry too much about the size of the accounting firm – as long as the firm is in good standing, the financials and associated opinions carry weight. Often, the owner’s business has grown, and they have stayed loyal to a local firm – that tends to say (mostly) good things about the owner’s personality. Overall, just engaging an accounting firm for reviewed or audited financials is the mark of a well-run firm, especially when you consider that many business owners have only themselves to report to. Spending money on this expensive service indicates a desire to “do things right”, as well as strong planning for a potential future transaction.
This first green flag establishes a pattern – good practice tends to be boring.
Green Flag #2: Regular Budgeting & Variance Analysis
A second green flag relates to having a regular budgeting and variance analysis process. Budgeting is a project that requires taking feedback from all of the business’s leaders, as well as reference to recent historical performance, to formulate reasonable expectations for the coming year or years. The very process of setting a budget – forget about the numbers themselves for a moment – is helpful, as it forces leaders to revisit past plans and their outcomes, and to adjust their current expectations in light of both past results and current economic and industry conditions. Given the significant time investment involved, a decent budget is just having a budget at all; but a great budget exemplifies collaboration across disciplines, with thoughtful reflection on both recent successes and failures.
A business can improve from great to excellent by regularly performing “variance analysis,” an exercise whereby management compares performance against budget and explains where it over – and under-performed across various categories. This is also time-intensive, something many business owners forego, but it can be invaluable in providing leaders with near-real-time feedback that they can use to adjust their approach to managing employees and their specific areas of responsibility.
As with the budgeting process, we don’t recommend excessively worrying about the accuracy of budgets as shown through the variance process. Yes, if the company missed budgeted EBITDA by a 200% margin, that may (or may not) be a problem. But many business owners rightly set high expectations. If they targeted growing at 50% and hit 35%, it’s worth checking against their industry – I’d say there’s a fair chance they still wildly outperformed. More important is that the company shows they take time to understand where their misses come from and take steps to improve.
As with the first green flag, this is a fairly mundane process – but not to be overlooked. It’s helpful at this juncture to provide a reminder – as a searcher, you are trying to buy a company with a large amount of debt, grow it, and then sell it several years later. Your investors want to make money, but they also don’t want to lose it. With the elevated debt burden that comes from a leveraged buy-out, a boring company is the type that has the best chance of staying on time with loan payments, especially with the ebbs and flows of the business cycle. Yes, the headlines show flashy companies with charismatic CEOs and revenue growth rates in the hundreds and thousands of percent. But they also show, often for the same companies, horrendous losses, accounting anomalies, and dark triad personalities in leadership. If you want to gamble, with all the risk and upside that entails, then find a job in venture capital. Boring is the name of the game here.
Green Flag #3: Steady-Eddy Revenues and Margins
The last green flag has boring written right into it. And that’s boringly consistent revenues and margins. Ideally, the business will show steady growth in revenues – exuberant is great, but not necessary – as well as stable margins. If revenues and margins fluctuate a lot month to month, ask some questions to understand why. For many companies, this is simply a reality of the industry’s business cycle. For others, it could indicate accounting is done periodically (e.g., invoices are sent out once a quarter to conserve company resources). As long as you are satisfied with the explanation, focus your analysis on a year-to-year basis. Consistent revenues and revenue growth speak to happy customers, and a solid handle on sales and marketing is required to bring in new ones. Consistent margins imply that as the business has changed and grown, the company has been able to scale its internal processes successfully while maintaining quality. Together, these two things likely mean few mass layoffs over time, and correspondingly, good morale and hopefully strong retention. Boring may not mean a lot of headlines, but for employees focused on taking home a paycheque while covering a mortgage and supporting a family, this kind of stability is critical, and will carry over once you take the reins.
I know we’ve only covered three green flags and six pitfalls, but as Leo Tolstoy said, “All happy families are alike; each unhappy family is unhappy in its own way.” If you think you’ve found a particularly unhappy family, turn around and head the other way. If you’ve found a happy family, figure out a fair price, offer just a little bit more, and prepare for a fruitful relationship. And if it’s something in between, make sure that you adjust your price accordingly. That way, at least you’ll be indirectly compensated for the extra work ahead of you for the next several years of your life!
