6
Putting Your Finances in Order
Getting your finances in order is a critical step in M&A. The sooner you do it, the better.
This foundational step is vital for a smooth and efficient M&A process. Putting your finances in order will help you and your team get clarity on where you really stand as a company and acquisition target. It will be the basis for valuations. It will help you sail through and survive due diligence and know who your best target buyers are. It will also shine a light on what your alternative options may be, while best preparing bankers and advisors to do their jobs well. It can also help you create a strong, accurate, and effective pitchbook.
This is about organizing financial documents and having clarity on your own real numbers—something that will also help you optimize your finances and financial structure for potential buyers, as you'll discover in other sections of this book. Beyond presenting your company in the best light and with the best value possible, you'll be adding more value with fresh projections and financial models and preparing yourself and your team for the questions you'll be asked, from pre-LOI through to negotiations, due diligence, and closing.
This is about knowing the details, fine-tuning them, and the art of casting a vision of the value that could be.
Understanding Financials
You may or may not be a numbers geek. Many founders don't live and breathe for the finer financial details. They are visionaries, creatives, and doers. That's okay. Yet, this is one of those times when all founders, decision-makers, and those on the M&A committee really need to get in tune with the math and granular details of the numbers, financials, and metrics.
You have to know where you are, how that compares to buyer wants and expectations, and what your team can do to bridge the gap and bring your A game to the table.
Your team needs to have clarity, know the mission and messaging, and know how to answer the questions that are coming your way.
One of the first steps here is to get a detailed handle on your current finances and financial statements. You will need to provide new financial statements to potential buyers through your deal room. This information is also going to be used for your pitchbook and other marketing materials. Although you may not divulge too much up front as a private company, you have to ensure this is a good match and that expectations are aligned on both sides of the table. Otherwise, you are just wasting time.
The following financial documents will be front and center here:
- Previous years' financial statements
- Year-to-date profit-and-loss statement
- Balance sheet
- Previous years' tax returns
- Cash flow statement and analysis
- Financial projections
The Importance of Key Metrics
Different buyers put different priorities on various figures and metrics. These numbers can instantly tell potential buyers a lot about your business. They can also directly affect your valuation.
Although there are things you can do to make improvements on these metrics now, imperfect numbers can also signal opportunity and value-add potential for buyers who can come in and take it to the next level with their resources and expertise. In other cases, these metrics will rule out certain potential buyers, or make your company especially attractive to them, particularly when it comes to the difference between strategic and financial buyers.
Some of the key metrics in M&A will include burn rate, hard costs, EBITDA, gross revenues, gross profit margins, sales units, customer acquisition costs, growth rate, and debt to equity. The following sections take a closer look at these metrics.
Burn Rate
Burn rate is still very applicable and important in M&A today, especially when so many later-stage startups and public companies are still losing money—not because of any crisis, but because that's the way they designed it. So, how fast is your startup burning through money? If it isn't profitable, acquirers are going to need to carry that monthly debt obligation until they can turn it around or find another way to produce value from it.
Hard Costs
It is important to differentiate between fixed hard expenses and variable expenses that fluctuate with sales and may be easier to tweak and optimize. What overhead is there in terms of real estate loans or leases, insurance and licenses, maintenance, salaries, and so on?
EBITDA
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is one of the most important metrics potential buyers will look at when it comes to M&A. It is particularly important for financial buyers. This metric shows the cash flow after most fixed costs and variable expenses. In addition to cash flow, it also gives insight into how profitable the company is in relationship to its spending. Strong buyers may be able to take your company and restructure financing and taxes, creating far more profitability on the same earnings.
Gross Revenues
Gross revenues show the total cash coming into the business. Many buyers will be able to restructure expenses and costs under this to greatly improve profitability, though existing revenues give them a real, tangible figure they can use to evaluate the deal, justify it, and finance it. Any additional revenues they can add on top are icing on the cake. This volume also indicates what level of company it is and what buyers may be interested.
Gross Profit Margins
Gross profit margin is an easy-to-insert metric, even for early-stage startups in their forward-looking projections. It's a very telling number that instantly reveals whether the company is in the right ballpark for their industry—or that reveals big issues that wouldn't otherwise be expected. Gross profit margin in forecasts for pre-revenue startups immediately shows whether founders are on the right track or if they're out of touch with their industry.
For example, if you are forecasting 60 percent gross revenues in an industry that typically struggles to maintain a 35 percent margin, either you have created something truly amazing with a lot of value, or you are overlooking a lot of the expenses. In the reverse, if you are forecasting 35 percent gross margins in a space where investors and financiers expect at least 60 percent, then you may also be hitting your head against a wall, and you need to go back under the hood and rework your idea.
Sales Units
How many units are you selling? Have you proven product-market fit? Are you still an early-stage startup with tens of thousands of units being sold each year? Or are you a mature business with millions of units sold each year? This not only indicates the best type and level of buyer but also how accurate you have been with early predictions, and it indicates the potential of the company.
Customer Acquisition Costs
This is one of the most pivotal metrics for startups. One of the riskiest factors for businesses is customer acquisition costs. High costs here not only mean low profit margins and questionable unit economics but also signal great risk—especially if current channels falter or those costs rise further. For some acquirers, target companies with high customer acquisition costs can indicate ripe opportunities. An M&A deal could enable them to plug your product into their infrastructure and channels and dramatically boost sales units, with almost zero additional customer acquisition costs.
Growth Rate
Growth is one of the top drivers of acquisitions and mergers. So how fast are you growing? The earlier the stage, the higher the expectations are for growth. At the earliest stages, young startups may be reporting growth on a week-over-week basis. Later on, it will be month over month. Eventually, more mature companies will be tracking and reporting quarterly and annually. How much growth is left can be a big deal, too.
Debt to Equity
The debt-to-equity ratio shows how solvent the company truly is and what real equity there is to acquire. Debt may be restructured by new acquirers and parent companies, or startups may wish to settle debts ahead of an acquisition. This is especially true if it's questionable whether new owners will have potential issues assuming any loans and credit. Current debt also shows how well the company has done at servicing any credit it's used and is a good indicator for leveraged buyouts and private equity buyers.
Why Growth and Operating Assumptions Are Critical
A significant part of valuation and driving an M&A transaction is the forecasts for growth and operating expenses.
There is a huge difference in what your company may be tangibly worth right now, with its current assets, income, liabilities, and verifiable financial track record, and what it could be worth five years from now, in the right hands.
If you only get offered what it is worth to a financial buyer simply in a conventional sense right now, not everyone in your organization may be thrilled. Yet, there is a chance to dramatically increase the perceived value of your company by forecasting where you will be as a standalone venture on your current trajectory and as a part of a new merged company.
The difference between these figures can be night and day for current shareholders, potential acquirers, and founders. For buyers, these projections can make all the difference in the perceived value and sense of urgency. They may not be able to pay you what the company could be worth five years from now. This is their chance to buy low and reap the rewards, either from what they can add or the growth your venture brings in terms of customer count, market share, revenues, cash flow, and profit and returns.
Be bold with your forecasts and vision. Be optimistic. Think big. Show the possibility.
Just make sure that your big claims and projections are anchored in logic. Be aggressive, but be able to back up those claims with facts and figures.
Your financial modeling will need to be backed by authoritative research. Although financial projections may be rough and lean for early-stage startups, they still need to be based on solid assumptions supporting your growth and operational cost claims. This is vital for the following three main reasons.
Assumptions Are the Basis for All of Your Other Financials
Detailed underlying assumptions should include figures for growth in total available market and operational expenses including salaries and cost of goods sold. If your assumptions on these foundation factors are deeply flawed, then the end calculations will be way off, too. Make sure you can link to authoritative research and statistics to back up your claims. Be sure to factor in variables such as inflation, especially on items such as raw materials, shipping, and payroll.
Credibility
You might win some points for passion, charisma, optimism, and thinking big when fundraising, but when it comes to M&A, your credibility relies on fact and your track record of what you've been able to actually achieve. If you are just picking growth numbers out of the sky, then don't expect a lot of your other claims to be taken seriously. If you clearly haven't done your homework and checked your numbers, you can expect them to want to look doubly hard at everything else in due diligence—but if they try to question and fact-check you, and you can back up your assumptions with strong data, they are going to assume you've been just as diligent in other areas of your business.
Earnouts
You may be able to add a lot of perceived value for strategic buyers with great forecasts alone. Of course, they are going to want to tie a large percentage of the price to you being able to deliver on that. You may end up staying on, in charge of delivering on those projections for the next three years—at least if you want the other half of your money. Don't promise more than you are confident you can deliver.
Modeling Out a Powerful Five-Year Projection
A core part of your financials and presentation in M&A is going to be your forward-facing five-year financial projections.
Depending on the scenario and the buyers who are courting your business, this may be a projection of your business as a stand-alone entity and its future performance and/or projections of what your company and assets could look like in the hands of this new buyer, with the latter having the potential to be many times greater than what you can achieve on your own, even with raising more capital. Be sure to consult your M&A advisors here. To effectively forecast what you could achieve together, you must be sure you understand what the buyer intends to do with your business and why it is really buying you. Otherwise, you will be totally off-base or potentially selling yourself out of hundreds of millions or billions of dollars.
With this modeling, you can identify hard synergies, which represent cost savings, and soft synergies, which are potential revenue increases. There may be other factors as well, depending on the reasoning for acquiring you. You want to show how you are meeting their goals—and, more specifically, how you are going to help them meet their goals more efficiently and with greater value than acquiring one of your competitors instead.
The basics for five-year financial projections can be found in the three-statement model:
- Income statement
- Balance sheet
- Cash-flow statement
You'll build one for you as the target company and one from the perspective of the acquiring company.
These financial statements should link to your underlying assumptions and be dynamic in nature so that adjustments and various alternative scenarios can be viewed on-the-fly to avoid losing time or deals.
If you are an Excel ninja, then you may find this relatively fast and easy to put together and then review and navigate with your team. Or you can choose a more modern startup and M&A-specific financial modeling tool.
Anticipating Questions on Numbers
The ability to present well and having a good sales game is great, but it is only going to stick if you're also prepared to answer the questions you're going to get in the follow-up.
The following are some common questions that you can expect to encounter:
- Is any existing debt assumable?
- Are there any community or charity obligations to be assumed?
- How much of the purchase price are you willing to bet on to achieve projections?
- If your numbers are so good, why would you be willing to sell?
- Are there any new regulatory fees that can be expected in the near future?
- Who prepared these financials?
- How did you arrive at your assumptions?