“Earn the Right to the Numbers”: Why Trust Comes Before Financials in M&A

17 Apr “Earn the Right to the Numbers”: Why Trust Comes Before Financials in M&A

Shoot The Moon

“Earn the Right to the Numbers”: Why Trust Comes Before Financials in M&A

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EPISODE TRANSCRIPT

Mike Harvath  00:00 

Music. Hello and welcome to this week’s Shoot the Moon podcast, broadcasting live and direct from revenue rocket world headquarters in Bloomington, Minnesota. As you know, if you tune in regularly, revenue rocket is the world’s premier growth strategy and M&A advisor to tech services firms. With me today are my partners, Matt Lockhart and Ryan Barnett. Welcome guys, 

Matt Lockhart  00:27 

and welcome back Mike. And on to another interesting subject, right Ryan? 

Ryan Barnett  00:34 

No absolutely. And thanks for everyone listening here. If you’ve got a topic that you would like to dig into, please let us know at info@revenuerocket.com, we’d love to talk about things that you’re seeing in the marketplace today. We’re covering a subject that we can often get stuck on, and when we look at deals, we often have to find the great combination between a buyer and a seller. Has to have a strategic fit, a cultural fit and a financial fit. If you listen to enough these podcasts, you’ll hear that’s a recurring theme. And oftentimes, after you establish both that strategic fit and cultural fit, there gets to a point where finally, someone’s going to ask, Can I see your financial numbers? And today I want to see you know what happens when a seller might be hesitant to share those financials, or what happens when those financials get stuck, and I love to unpack with Mike and Matt, your expertise in dealing with these situations, on what is the seller going through and what’s in their mind. Also, what can buyers do to help make sure that trust is established to help share those financials? So Mike, why don’t you get us going? Why do sometimes, do people get stuck. And what are a few things that we should start discussing here in on this topic? 

Mike Harvath  01:45 

Yeah, well, I’ll just start with the basics of, you know, all deals. We’ve heard you say this before, if you’ve tuned in, that all deals need to line up strategically, culturally and financially, typically, in that order. And you know, oftentimes deals will line up strategically and culturally, but the financials are not in a place on what we’ll call loosely financial hygiene. Is not in a place where the sellers can actually provide the numbers to a potential buyer in a way that they can make sense of them. And so first and foremost, I would encourage you know, if you’re operating your business, and you know you’re growing it and focused on getting to the next level, that you do take time to have good corporate financial hygiene, that you do work with a good financial advisor, CPA, to get a standard chart of accounts and a clean balance sheet and move your business to an accrual set of books. Oftentimes, when firms start out, they start more running their business on a cash basis. Maybe they’re not really focused on their balance sheet in order for a suitor, a buyer, and actually, in order for you as a potential business owner to do any acquisitions of your own or to really work in a material way with your bank to fund, you know material business expansion, good corporate financial hygiene is critical. So I certainly would recommend that sellers start there. From a buyer perspective, buyers need to understand that you know when you’re beginning to a relationship with a potential seller, that you need to put as much weight and focus and energy on the strategic alignment and cultural alignment components, as well as financial and to really begin to develop a relationship with a potential seller before you just run into the numbers and figuring out a value, because it’s, it’s about all three of those things. And sometimes we see buyers that are a little too anxious and wanting to look at numbers right away. And, you know, and there’s some level of res people who are reticent to send those numbers, if they’re a seller, if maybe there’s not good alignment in those numbers, or maybe they haven’t spent the time they know they need to spend in order to get to a standard set of financial numbers from an organization perspective. 

Ryan Barnett  04:19 

Yeah, I think that’s a good start. Mike, Matt, I know that you’ve dealt with a lot of these situations in which buyers are in that stage of establishing that relationship. Matt, what advice can you give to buyers to set the stage before you even get to that financial request? 

Matt Lockhart  04:38 

Yeah, I mean, you putting yourselves in the seller’s shoes, right? I think is the is sort of the the thing that sometimes buyers don’t do, or they don’t do all the time, or they maybe go, Well, you know, we talked to, you know 50 sellers a month, right? And so the you know, they’re all the same, right? And and by putting yourselves in the seller’s shoes, understanding is that the first time they’ve been through something before, is this the first call they’ve taken? Do they understand what the process is, is all about, do they understand the the the sort of the goal and of being able to have a good, open, you know, discussion about the results of the business? Are they comfortable with that? Have they, have you spent enough time getting to know them and and allowing them to get to know you. All of those things, I think, become apparent when you do truly put yourself in in that individual seller shoes, not the collective seller shoes, but that one individual and buyers, I think, sometimes rightly so, recognize that it can Time is money and and you know that financial fit is, is gotta be, you know, critical in order to proceed on an opportunity. But maybe sometimes don’t think, as a seller does that, you know you might need a little bit more dating first right to understand and really validate those cultural and strategic fits. 

Ryan Barnett  06:30 

Absolutely, I think you’re right on Matt and and Mike, we’ve seen oftentimes when we represent companies on the sell side in which our package is ready. Actually, the financials are documented. We put everything together. We best explain how a company builds revenue and profit in a transparent way. Oftentimes, buyers, especially if they’re financial, will just get a request of NDA and CIM, literally one line message, just send me the NDA and CIM. Mike, why does that approach turn off sellers when the first thing they ask for is just hey send me the CIM? 

Mike Harvath  07:08 

Yeah, I think what’s important is that, you know, these businesses are not commodities. They’re in the world of technical services, IT services. These are people based businesses, and every one of them is built a little differently. And I think if all someone’s interested in is learning the history and financials, there is no attempt to build a relationship or understand alignment, at least initially, around strategy and culture, which arguably are just as important, if not more important, than you know, your financial alignment. It’s far more than financial alignment in this industry. Now, there’s other industries where that are much more commodity that where it’s less important, frankly, where typically, there are industries that have been around, you know, maybe in some cases, hundreds of years, there is a high degree of competition. There’s generally these companies operate with a pretty narrow band of operating margin, if they’re run well, and it’s much more of a financial analysis than it is maybe an analysis around you know, what does one plus one equal three? Is that really an option? Or how do you really fit a culture that is done work in this space into another culture in a way that’s meaningful and accretive, and so a much better approach by buyers is to attempt to fully understand the business, understand where the head is at of the owner, and why they’re looking for a potential deal, or maybe they weren’t looking for a potential deal, and you’re trying to convince them that a combination would be in their best interest, or at least in your mutual interest, in order to help them feel comfortable that you’re not just, you know, kicking the tires financially, trying to maybe learn something about their business that you can apply to another business or apply accordingly. I think that building a relationship should always trump just looking at financials as a way to begin a dialog around what a potential combination might look like. 

Ryan Barnett  09:25 

And I think so, yeah, go ahead, Matt, no, 

Matt Lockhart  09:29 

I was just, I think that again. And sometimes this comes from financial buyers, right? That, you know, they spend a lot of time in the finances, right? And just the the re-encouragement to to build the relationship, because the relationship is closely tied towards that, that cultural fit. And so just, I think, reemphasizing. 

Ryan Barnett  10:00 

Yeah, absolutely. I think when we work through our process and we work with financial buyers, sometimes there’s reticence of having to call well, we need to establish that relationship to make sure that cultures are aligned and strategies are aligned, especially with financial buyers. Perhaps there’s a the seller would like to not be a platform, or maybe they do want to be a platform having those discussions before running straight to a confidential information memorandum and some of the financials is a good step to take. And encourage everyone to be ready for that kind of that introduction and get to know you before launching in. Mike, you kind of talked a little bit about getting the financial books in order when you talk to a company, and sometimes when the financial request gets stalled. Can you help me understand what are some reasons that someone may stall on their financials, and why might someone have a logical way to perhaps, wait and say, Hey, maybe I’m not ready to share this yet. 

Mike Harvath  11:04 

Well, I think when people look at their financials, they probably know, as a business owner, that, you know, maybe they don’t have the quote, unquote cleanest set of financials. It doesn’t mean you’re not making money and you’ve been successful, you know, and you’re, you know, growing your business, right? Those are different things, and you know, having good financial hygiene helps you run the business more effectively, likely with a higher growth rate and more profitably, because you really have to have a clear dashboard of the business. And if you don’t have a standard chart of accounts, for example, or if your balance sheet is not up to date and clean. You can’t effectively have a clear dashboard on how to run the business, or even how to make preemptive changes in the business to offset cash flow issue or crisis, or to be able to navigate any potential you know, market to malt that may be pushed your way, or even how to navigate maybe, you know, noticed by a big client or whatever. And so oftentimes those delays are because the owner is finally coming up to say, Hey, I’m fully recognizing that my financials are not as clean as they should be, and in order for someone else to make sense of these numbers, I’ve got to do some work on them, and typically that means they have to work with their CPA or a financial advisor to either move to a more standard set of P and L or to clean up their balance sheet, and that is never a quick process. And so, you know, you would think logically as a business owner, well, I’ll just call up my CPA and, you know, have them help me kind of get this aligned, and it should be a short effort. I can tell you from experience, having done this, you know, every time I’ve owned a business, as the businesses matured into a place where the numbers had to be kind of moving from cash based accounting to accrual based accounting and really fortifying your balance sheet that it takes a long time, not only a lot of meetings with that financial advisor to get that advice and counsel, but also decisions have to be made by you and how you’re going to organize and categorize the business. And as you continue to scale and grow the business, there’s additional decisions that have to be made about, you know, accruals and how you manage certain expenses in the business, and how you, you know, need to forecast the business. And so if you realize that only, or you understand that and you’re trying to address it, by the time a potential buyer is looking at your business, it’s really too late. And so a lot of times we see a stall in providing financial numbers come at the same time the realization of that seller is like, hey, my numbers aren’t really as clean as they could be, and don’t tell the whole story. So I’m going to go try to get that fixed with my CPA kind of quickly. And it’s never quick for all kinds of reasons. It takes a long amount of time and diligent effort to get that done. There’s also reticence to provide numbers. Sometimes, if you know the seller doesn’t feel the buyer serious or that they’re just on a fishing expedition. So they may only provide some of their numbers. They may provide just their P and L, and maybe not their balance sheet or, you know, or if they’re embarrassed about something in their numbers, which certainly you know that exists too and they don’t necessarily want to share. The reality of the matter is, numbers are numbers. There’s nothing controversial necessarily about numbers, provided a buyer can make sense of them. I think being in a position to share them under NDA at any time is important. So. Um, because you may need to share them with your bank. You may need to share them with a potential partner that maybe you’re considering bringing in. You may need to share them with your employees. If you have sort of an open book philosophy, you want to be able to allow people to review those numbers and make sense of them. You you will want to share them, likely with any potential suitor, or if you’re doing a recapitalization effort, and so making sure that those are put together and you can stand behind them, and I have confidence in the way you know your accounting practices are being managed will certainly make it easier to share them. But even if that is the case, there’s certainly plenty of reasons why a seller may be a little bit reticent to share them, and in my experience, that’s been primarily due to there’s just not been enough time put into the relationship, building the relationship with a potential partner or or acquirer yet, and they just don’t trust you. And you know, at the end of the day, you need to build the relationship on trust, 

Ryan Barnett  16:03 

right? Absolutely, and with that, trust is established dollars, I think, are much more resident happy to share their their numbers. And I’d like to to back up a little bit when we talk about financial requests, the documents that are typically requested in in this process are financial or P&L statement, a property law statement, typically for the last three, ideally five years, to show like complete P&L, so your profit, where does your revenue Generation come from, ideally, that has some breakdown in how that revenue is generated, and that aligned with the cost of goods sold and the rest of the cost of the business. Ideally, you’d also have the last 12 months of your business. So month by month, how does that p and l look on the other side, you’ll look for, typically, for a balance sheet, we want to a yearly balance sheet as well as a current balance sheet, and then the other documents are a forecast. Oftentimes, when we ask for a forecast, we see a little bit of delay on that question, as many IT services. Companies haven’t either established a growth rate or their their business is perhaps lumpy, and they they’re not really confident in putting a forecast. So sometimes we see delay in a forecast if that opinion for the future hasn’t been formed, and then the last thing we typically look for is owner ad packs. And we’ve had a few podcasts on owner ad packs. But when you run your business and you have the opportunity to run some of the expenses to the business, or you have one time expenses that may not be contributed to profit. You want to have a good con, good list of those. Add backs, to be clear. So can P&L, balance sheet forecast and add backs. And those should be things you have on hand, relatively on hand. 

Matt Lockhart  17:58 

yes and no. Right, right? I mean, to your point, some smaller IT services firms haven’t gotten, haven’t really exercised the muscles around forecasting in a consistent way and and they may not have thought about add backs, right? So one of the things that you know we can do is, is we can limit the request. You know, three years, current year, you know P&L, you know, past three years of balance sheet that gives a good picture. And then we can work with sellers who maybe haven’t exercised some of those muscles or haven’t really thought through or understood, you know what add backs are, and we can help with those, right? So that’s another as a means of facilitating and enabling. You can, you can sort of advise and bring sellers who aren’t used to this along in in the process. 

Ryan Barnett  19:01 

Yeah, a shameless plug for an M&A advisor at this point working. And oftentimes when we’re working with buyers on the buy side of a campaign, we take that approach, or even that Dutch Mike you call it the Dutch uncle approach, of really leading through someone through the process, and there becomes a collaboration with the seller to build trust and to to walk them through this document. And at the end of the deal, at the end of the day, deals get done between a willing buyer and a willing seller. And in order to get to that, there has to be a bit of transparency in the process to make sure that everyone’s aligned. And as that request will start out relatively light, the more you get into the process. And you get under a letter of intent, and you get into due diligence, those requests are going to become more and more substantial. And so to your point, Matt, just starting out, there’s got to be buyers have to have some semblance of what they’re at. And I will say that a P&L is there’s not a lot of differentiation or trade secrets that sit in a P&L, and so if you’re thinking about, hey, I’m giving my business away. A, you’re under a non disclosure agreement, but B, your P&L just tells the financial story, and buyers need that baseline in order to provide an offer to acquire your company. Mike, just one more question here. You talked about a number of companies that have their financials, perhaps not in order. And feel free to jump on this one too. But sellers sometimes, if they have not had a great year, or perhaps the forecast is a little bit lighter than they’ve expected. Should companies engage in M&A discussions if they have had a marginal year, and what can you do to help show kind of the truth of where you’re at and maybe what the future could look like whoever comes up you first can answer this. 

Mike Harvath  21:06 

Well, I think, you know, I’ll just jump in. I mean, I think the reality of us full transparency is important. Uh, regardless, right? If you’ve decided that you’re going to engage in a conversation, maybe you go back and look at your numbers and you go, maybe they’re not as good as I thought they were. Or we’ve, we’ve taken some lumps this year. You know, that’s all business goes, right? There’s ups and downs in business. I think the long term trend is far more important. And I think most smart buyers understand that as well. And you know, whether it is you got notice from a client or something’s rolled off, or whatever, doesn’t mean that a good deal can’t be made. And I think conventional wisdom would say, Well, you certainly want to sell on a big high and or recap on a big high when you’ve had a great year, your best year ever, and all that. And as much as that helps. It’s not the only time when you could transact a deal, and it’s not only the time that you can transact a deal that’s fair. Because certainly, I think buyers understand the market dynamics that are at play out there, and they understand that everyone can have, you know, some up years and some down years, and they’re going to look at the long term trends of the business, I think, and, you know, want to understand the specifics, of course, like, Hey, what happened here, what happened there? But, you know, if they can understand that in a meaningful way and see that it was, you know, maybe more of a one off situation, then I think their their interest won’t wane, and the impact your value is what it is. I mean, I think what’s important to note is that when you think about the value of your business, it’s not just a one year point in time valuation that’s at at play here, it’s what, what’s happened over the last several years in the business. What is the forecast really look like? You know, where are you at achieving, you know, net new bookings in the forecast and and so I think, you know, the full picture, the fulsome picture, and transparent picture is far more important, I think, to the whole discussion. And you know, making a decision to go to market is a personal one, and for regardless if you’re selling in or selling out, and the timing of that has a lot more to do in my personal experience than just with your near term financial performance, right? Maybe it’s you’re approaching retirement, maybe you’ve had a bad health diagnosis, maybe someone in your family has maybe there’s just a whole host of options or issues that are at play here, and so trying to time the market when to sell your firm is kind of hard. I think, you know, having consistent performance over time is what builds value, and that’s what you should be focused on. 

Ryan Barnett  24:10 

Yeah, great advice there. Mike, that’s a really the questions I had here, I what I heard was buyers, you really need to establish trust, and you need to establish a relationship to kind of earn the right to the financial documents, and so spend some time building that relationship to to to get there and to make sure that you understand the business so and you’re aligned on on future goals. So that’s going to be things like, what do you want to be? What do you want to do in the business? Do you want to stay in? Do you want to sell in? Are you open to working with this company for a long time? Or do you want to get out? So having some of those questions in your mind are helpful from a seller just getting I heard that you a get your financial books in order. I think that’s a general. Business practice. But in the case where you’re looking to share those financials, the there’s a bit more of a spotlight there. I also heard that financial documents are should be just a course of your business, and being transparent in their in their use, is critical, but sharing those with a buyer can help them quickly moving along the process. And it’s something it’s not something you should get stalled at. Also heard it’s great to keep your business and work towards moving it up into the right and help maximizing the business. But the there might be an opportunity at hand that can either pay for future success or that can help get you out of the situation that you’re in today. Matt, anything you want like to add to this? 

Matt Lockhart  25:49 

I think the last thing is, is, that’s what advisors are here for. Is we help, we help both buyers and sellers, make the process go easier. In the case of sellers, we help organize the financials. Have them ready, have it so that it is an easier process. And for buyers are part of our job is to read the room and understand how to curate the early stages of a potential relationship with a with a seller who may not be on the market or may not have ever been through the process before. So that’s why we help get things done, right? Mike, 

Mike Harvath  26:35 

absolutely, absolutely. Any final thoughts from either view before we wrap up? 

Ryan Barnett  26:44 

Just let us know info@revenuerocket com. You can always see our current deals at revenue rocket com, slash current dash deals. And feel free to to contact us if you just want to to talk about M and A and the IT services world. We’re happy to trade notes on where we see in valuations and what the market is doing today. That’s it for me. Thanks, Mike. 

Mike Harvath  27:07 

Thanks guys. With that, we’ll tie a ribbon on it for this week’s Shoot the Moon podcast. Encourage you to tune in next week. We’ll unpack further topics of interest around it, services, M&A and strategy. Make it a great week.