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Key Takeaways
- Unreliable and inconsistent data can result in a much lower purchase multiple. It creates mistrust and gives buyers a reason to decrease their offer.
- Another unseen barrier is having a founder-dependent finance function. If it’s dependent upon the founder, buyers will perceive a high degree of execution risk.
- Being exit-ready means management reports are generated within days (not weeks), your KPIs have been consistent over the past three years and your working capital is clean.
At eight months before selling a portfolio company, the buyer’s diligence group asked us to provide monthly revenue data for each customer segment. A straightforward request — except that this information existed in three different systems — Salesforce, QuickBooks and Excel spreadsheets.
It took us six weeks to gather the information, and after we provided it to the buyer, the differences in the various systems had generated enough mistrust of the company’s financial reporting that the buyer lowered its offer by $8 million, which equated to about one full EBITDA multiple of what the business was worth. The business and the strategic plan were good. But poor data resulted in a lower purchase multiple.
According to EY’s Private Equity Exit Readiness Study, 72% of businesses do not have access to reliable and consistent data and KPIs needed to support exit readiness. In fact, this is not a matter of data quality. It is a matter of valuations being affected by unreliable and inconsistent data.
Buyers cannot risk losing their confidence in a seller’s numbers. If they cannot believe the numbers, they will decrease the purchase price. If they need to spend extra weeks reconciling the seller’s financial reporting, the deal momentum will cease. If a seller’s financial reporting function is dependent upon the founder, buyers will perceive a high degree of execution risk.
The value of having clean data
In terms of how much clean data adds to your overall value, according to GF Data, businesses that hired a third party to conduct a sell-side quality of earnings (QoE) report prior to exiting received an average of 7.4x TEV/EBITDA, compared to those that did not receive an average of 7.0x TEV/EBITDA.
Finance function independence test
The second unseen barrier is having a founder-dependent finance function. I have seen many deals stall when the only person who really knew the numbers was the CEO, and he was exhausted from six months of diligence questions.
A buyer wants to be able to see that there is a finance function that will operate independently and not by an outsourced bookkeeper or the CEO’s family member. It means there is someone with institutional credibility who can sit down with the buyer’s due diligence team and defend the financial statements.
Also, if your monthly closing takes three people to manually enter numbers into a spreadsheet, you have a problem. The modern ERP system should be able to pull the data automatically, reconcile it and generate the financials without needing heroic efforts.
One of the best investments we made was hiring a VP of Finance 18 months before our exit. We did not hire a CFO since we were not ready to spend that money yet, but we wanted to get to a point where the closing process would be more formalized, have a good ERP system and be able to provide consistent KPI dashboards. The cost of the VP of Finance position was approximately $180k in salary. The VP of Finance added at least $3 million to our exit price as a result of the buyers being confident in the numbers we provided.
What “exit-ready” means
Companies that are exit-ready have common traits:
Management reports are generated within days, not weeks. When a buyer requests a report of monthly revenue by product line, you can provide it that day and not after taking weeks to compile the information.
Your company’s KPIs have been consistent over the past three years. Buyers want to see trends. If you have changed the way you define customer metrics two times in the last two years, you are indicating that you do not use data to run your business.
Your working capital is clean. Having clean working capital, correct accounts payable and accounts receivable, and correct inventory levels removes friction from the deal.
The 18-month window
The biggest mistake that sellers make is waiting to fix these things until they decide to go to market, by which time it is too late. You cannot establish a finance function that operates independently in three months. You cannot create three years of clean KPI history overnight.
The appropriate amount of time to prepare for an exit is approximately 18 months prior to the anticipated date of sale.
This will allow for sufficient time to implement systems to collect, track and report company data; hire/develop the required internal talent to provide financial services independent of management oversight; have a third party sell-side QoE analyze your company’s financial performance to identify areas of concern before a potential buyer does; and establish KPIs to effectively communicate the operational performance of your organization.
What it’s worth
Let’s look at some numbers. For example, take a $15 million EBITDA business. The market multiple for this type of business is typically 7.0 times. Clean data and an independent finance department may be able to increase the multiple to 7.4 times. This premium was noted as such in a study conducted by GF Data. Therefore, the additional enterprise value for this premium would be $6 million ($15 million x 7.4 / 7.0).
The total cost to create the premium would be: $200k for a VP of Finance for eighteen months, $75k for a sell-side QoE and $50k for any system improvements, for a total of $325k (approximately).
Therefore, the return on investment for creating the premium would be: 1614% ($6 million – $350k = $5.65 million / $350k).
Valuation friction is like a ghost — it is difficult to see until it has cost you money. At the point a buyer is questioning the accuracy of your data or the ability of your finance staff to provide answers to basic questions without needing to escalate to the CEO, you have already lost the upper hand in negotiations.
Companies that receive premium multiples are not necessarily those with the best story — but rather those whose stories are supported by accurate, reliable and independent data that a buyer can trust.
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Key Takeaways
- Unreliable and inconsistent data can result in a much lower purchase multiple. It creates mistrust and gives buyers a reason to decrease their offer.
- Another unseen barrier is having a founder-dependent finance function. If it’s dependent upon the founder, buyers will perceive a high degree of execution risk.
- Being exit-ready means management reports are generated within days (not weeks), your KPIs have been consistent over the past three years and your working capital is clean.
At eight months before selling a portfolio company, the buyer’s diligence group asked us to provide monthly revenue data for each customer segment. A straightforward request — except that this information existed in three different systems — Salesforce, QuickBooks and Excel spreadsheets.
It took us six weeks to gather the information, and after we provided it to the buyer, the differences in the various systems had generated enough mistrust of the company’s financial reporting that the buyer lowered its offer by $8 million, which equated to about one full EBITDA multiple of what the business was worth. The business and the strategic plan were good. But poor data resulted in a lower purchase multiple.
