Mergers and Acquisitions For Dummies (48 page)

Financial projections

Ideally, an offering document should have five years of projections. I know that's a lot of work, especially when projections are taken with a grain of salt, but Buyer should be able to get a good sense of where you think the company is headed.

Your projections should include a narrative explaining the assumptions you used to create them. For example, explain your rationale for revenue increases and how expenses are related to those revenues. Achieving the projected numbers is imperative, so you're much better off to project low growth and beat that projection than to project rapid growth and fall short. You're sure to create problems for yourself if you pad your projections to an unobtainable level. Not achieving those higher projections often leads to a lower sale price. Plus, Buyers are on the lookout for overly rosy projections and may discount projections that the historical financials don't support. (See the preceding section for more on historical financials.)

Another important figure in the projections is CAPEX. CAPEX (short for
capital expenditures
) occur when a company makes some sort of investment in itself. Instead of immediately expensing the expenditure, thus reducing profits by the full amount of the investment, a company may be able to
capitalize
the expenditure and write off the expense over a period of time. Examples of CAPEX include anything that will be used for a long period of time: computers, software, furniture, improvements to the facilities, manufacturing equipment, and so on.

For example, say a company pays $1 million for a piece of equipment with an expected useful life of ten years. Writing off the full cost of the equipment in year one doesn't make sense because the equipment will be used for nine more years. Instead, the company writes off the amount of the equipment used each year, or $100,000 per year. This write-off is called
depreciation.

Because annual capital expenditures are not captured in the venerable EBITDA calculation, Buyers should take a close look at a company's CAPEX needs to fully understand the true cash flow of the business.

Balance sheet basics

One of the most important figures from Seller's balance sheet is the company's working capital. For the purposes of M&A,
working capital
commonly means current assets minus current liabilities. Typically,

Current assets = accounts receivable + inventory + prepaid expenses

Current liabilities = accounts payable + short-term debt + current portion of long-term debt + accrued (
unpaid
) expenses

For the purposes of M&A, you don't include cash and equivalents in this calculation. However, for accounting purposes, you do include them.

Working capital is important because it represents the liquidity of the company. All current assets should be convertible into cash within 30 days, and all current liabilities should be able to be paid within 30 days.

Buyers, eye the balance sheet carefully to see whether the company you're looking to acquire is sufficiently undercapitalized, has a reasonable reserve against bad (uncollectable) accounts, and has its current liabilities all within terms. If any of these items are remiss, you may be taking over financial trouble.

Depending on the nature of the business, working capital may have some seasonality. For example, retailers typically have very strong fourth quarters as their sales are driven by the gift-giving season. Other companies experience peaks in late summer with the back-to-school season. As Seller, you want to spell out how this seasonality affects working capital so that Buyer gets a more accurate view of your company's situation.

Income statement basics

The selling company's income statement contains lots of important information for the offering document; check out the following sections for some notable income metrics.

Be sure to distinguish in the book which party gets any cash on the books. In most cases, cash belongs to Seller. If a company has $500,000 in cash and is selling for $5 million, Seller receives $5.5 million (before taxes, expenses, and advisor's fees, of course).

Recurring revenue and customer concentration

Recurring revenue is always a plus for a company, and Sellers are wise to mention the amount of recurring revenue in the offering document because it may increase Buyer interest and therefore the offer price.

Another metric,
customer concentration,
is the opposite of recurring revenue. If a company has highly concentrated sales (large amounts of sales with one customer or a small number of customers), Buyers may be less inclined to pursue a deal or offer a high price. Customer concentration is a bit of a slippery eel to grasp and define, but generally speaking, if a single customer accounts for more than 20 percent of revenue, or if a small number of customers (three to five) accounts for more than 50 percent of revenue, the company may have a customer concentration issue.

If Seller doesn't have a concentration issue, that's a key selling point definitely worth mentioning, if not touting, in the offering document. If Buyer cannot ascertain any customer concentration issues (after reading the offering document), Buyer should make a point to ask Seller about customer concentration during a follow-up phone call or e-mail.

If you do have a customer-concentration issue, try to mitigate that issue. For example, if a single customer accounts for 40 percent of revenues but is a large, multinational conglomerate with multiple decision-makers in multiple offices, point out this distinction to Buyer. In this example, you can argue that 40 percent of revenue is not under the control of a single decision-maker, thus mitigating some of the risk of the concentration.

Gross profit, gross margin, and SG&A

Gross profit
is the amount of revenue that remains after the cost of producing sales is subtracted. For example, if sales are $100 million and the cost of goods sold is $40 million, the gross profit is $60 million.
Gross margin
is the percentage calculation of gross profit. In this example, the gross margin is 60 percent.

Contrary to popular usage, gross profit and gross margin aren't interchangeable. Any time you see the word
margin,
that means percentage. Far too many businesspeople refer to gross profit as gross margin, saying, “The company has $10 million in gross margin.” Actually, the company has $10 million in gross profit. If revenues were $100 million, the company would have a 10 percent gross margin.

Gross profit is important because it's variable — it fluctuates based on revenue levels and pricing. Gross profit needs to be high enough to cover the other costs of the business, called SG&A. SG&A is comprised of salaries, rent, insurance, utilities, supplies, and so on. Although SG&A includes both fixed and variable costs, most companies have a good idea of their SG&A, and therefore know exactly how much it needs to generate in sales to create sufficient gross profit to cover SG&A.

When companies fail to generate enough gross profit to cover SG&A, that's a bad sign! If a company lowers its prices in order to generate higher sales, those lower prices may result in lower gross profit, and if gross profit dips below SG&A, the company is in trouble.

Other income and other expense

A good offering document should detail the nebulous “other income” and “other expense” categories. Essentially, these categories are revenues or expenses that aren't related to the underlying nature of the company. If a t-shirt manufacturer sells a piece of equipment for $50,000, it reports that income on the income statement as “other income.” If that company also terminates an employee and pays that employee a $20,000 severance, it should report that expense in the “other expense” section. (Hopefully, firing employees and paying severance isn't a regular event.)