Introduction
In all M&A work, and regardless of whether you are on the buy side or the sell side, Financial Modeling is the first significant step in making a GO / NO-GO decision. This article goes beyond the basics to explain key output criteria for making that decision.
Why Financial Modeling for Business Owners Matters
Financial modeling for business owners provides critical information that drives both early-stage decisions and later due diligence:
Early: identify potential deal structures
Early: identify and analyze line-of-business profitability
Early: compare Asset purchases against Stock deals
Early: estimate lending / SBA costs, and compare and contrast these against seller financing
Both: develop a high-quality Proforma necessary for financing
Both: calculate Net Present Value and IRR under a variety of scenarios
Key Strategies and Best Practices
Strategy 1: Create a flexible deal parameters page
A solid model supports multiple options for financing and deal structure, including seller financing options and earnout options.
Strategy 2: Decide how to model income and expenses
For back-of-the-napkin analysis, or if you are dealing with less information (like that generally provided in a CIM or online), we like to model income and expenses using broader brush strokes, like total revenue, total CGS, total operating expenses, etc.. In this case, it is easiest to use Percentage-of-Sales modeling, where we estimate COGS and operating expenses as a historic percentage of sales. But if we have detailed financial statements, we can get much more specific with our modeling. I suggest generating basic statistics for every account, then deciding how to model each account for the Proforma. If your model is for an acquisition, you can and should adjust your model based on expected synergies.
These are crucial decisions, as mistakes made during modeling can have an outsized impact on profitability after the close. Your modeling decisions should be "reasonable" and "defensible." Reasonable decisions come from experience; defensible ones are evidence-based and come from analysis.
Strategy 3: Understand how deal structure affects your Net Present Value (NPV) and Internal Rate of Return (IRR)
Many Sellers have set up C corporations with the expectation that they will qualify for the Small Business Stock Exemption. This is riskier for the Buyer because you're purchasing liabilities along with assets, and it also means you get no tax benefits from amortization or depreciation, whose value can be significant. The net present loss for a buyer in this scenario will not equal the net present value that accrues to the seller, so a fair negotiation process might recognize this and split the difference. Buyers represented by brokers with little or no understanding of finance will need to be educated in this regard.
Financing, too, affects your NPV and IRR. From a strictly finance perspective, maximizing debt (up to but not past the point where the debt load cannot be serviced) will maximize your NPV, but this is an uncomfortable knife edge to ride. Acquisitions rarely turn out as expected, so leave some wiggle room to compensate for the unexpected.
Strategy 4: Model the cost of capital
When you use bank or seller financing, make sure that you understand all of the cash flows. Amortization tables alone are often insufficient, especially with bank loans that probably include up front (amortizable) lending fees, SBA guarantee fees that change every time the government wants to encourage behavior one way or another, and prepayment penalties that can vary year by year. Speaking again from a finance perspective, you need to understand your Weighted Average Cost of Capital (WACC), as you must generate returns greater than your WACC to achieve profitability.
Advanced Techniques
George Box famously stated that "All models are wrong, but some are useful," so the goal of early modeling is to create a model that is good enough to make the right decision. To close the gap between good enough and as good as possible requires more advanced techniques, commonly referred to as Stochastic Modeling. Instead of using simple statistics to model revenues and expenses over time, e.g., increase revenues by 3%/year and expenses by 2%, we use statistical distributions to model changes over time and then perform Monte Carlo analysis to understand the range of possible outcomes and their probabilities.
Measuring Success
The Proforma developed during modeling can and should be used to assess the success of an acquisition. Yes, it will be wrong! Nonetheless, determining where the errors are and understanding why the results don't match expectations is critical, both for pivoting when necessary and also for doing a better job with your next acquisition. Academic studies show that most acquisitions fail to meet expectations, but that firms that routinely acquire other companies get much better at it. See the bibliography below.
Conclusion
Financial Modeling is an essential component of modern business sales and acquisitions. By following these guidelines and best practices, you'll be well-positioned to achieve your goals and drive meaningful results.
Bibliography
Barkema, H. G., & Schijven, M. (2008). How do firms learn to make acquisitions? A review of past research and an agenda for the future. Journal of Management, 34(3), 594–634.
Conn, C. L., Cosh, A., Guest, P. M., & Hughes, A. (2005). The impact on shareholder wealth of top-tier vs. lower-tier acquisitions: Evidence from public and private targets. Journal of Business Finance & Accounting, 32(5‐6), 817–845.