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Key Takeaways
- Unreliable and inconsistent data can result in a much lower purchase multiple. It creates distrust and gives buyers a reason to lower their offer.
- Another invisible barrier is having a finance function dependent on the founders. If it is founder dependent, buyers will experience high execution risk.
- When you’re ready for exit, management reports are generated in days (not weeks), your KPIs are consistent over the past three years, and your working capital is clean.
Eight months before the sale of a portfolio company, the buyer diligence group asked us to provide monthly revenue data for each customer segment. A simple request – except 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 created enough distrust of the company’s financial reporting that the buyer lowered its offer by $8 million, which amounted to about a full EBITDA multiple of what the company was worth. The business and strategic plan were good. But bad data resulted in lower purchase multiples.
This is evident from EY’s Private Equity Exit Readiness Study. 72% of companies do not have access to reliable and consistent data and KPIs needed to support exit readiness. In fact, this is not a data quality issue. The point is that valuations are influenced by unreliable and inconsistent data.
Buyers can’t risk losing confidence in a seller’s numbers. If they can’t believe the numbers, they lower the purchase price. If they have to spend additional weeks reconciling the seller’s financial reports, deal momentum will stall. If a seller’s financial reporting function is founder-dependent, buyers will experience high execution risk.
The value of clean data
In terms of how much clean data contributes to your overall value, companies that hired a third party to conduct a sell-side quality of earnings (QoE) report, according to GF Data, received an average of 7.4x TEV/EBITDAcompared to companies that did not receive an average of 7.0x TEV/EBITDA.
Independence test for financial function
The second invisible barrier is having a finance function that is dependent on the founders. I’ve seen many deals fall through when the only person who really knew the numbers was the CEO, and he was exhausted from six months of diligent questioning.
A buyer wants to be able to see that there is a finance function that operates independently and not through an outsourced accountant or a family member of the CEO. It means having someone with institutional credibility who can sit down with the buyer’s due diligence team and defend the financial statements.
And if your monthly closing requires three people to manually enter numbers into a spreadsheet, you’re in trouble. The modern one ERP system should be able to automatically retrieve the data, reconcile it, and generate the financial data without heroic efforts.
One of the best investments we made was hiring a VP of Finance 18 months before we left. We didn’t hire a CFO because we weren’t ready to spend that money, 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 Finance position was approximately $180,000 in salary. The VP of Finance added at least $3 million to our exit price because the buyers had confidence in the numbers we provided.
Which means ‘ready to go’
Companies ready for an exit have common characteristics:
Management reports are generated within days, not weeks. When a buyer requests a report of monthly sales by product line, you can provide it that day, not after weeks of compiling the information.
Your company’s KPIs have been consistent over the past three years. Buyers want to see trends. If you’ve changed the way you define customer metrics twice in the last two years, it indicates that you’re not using 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 sellers make is waiting to fix these things until they decide to go to market, and by then it’s too late. You cannot set up a financial function that operates independently in three months. You can’t create three years of clean KPI history overnight.
The appropriate amount of time to prepare for an exit is approximately 18 months before the expected sale date.
This will allow sufficient time to implement systems for collecting, tracking and reporting business data; hiring/developing the necessary internal talent to provide financial services independent of management oversight; have a third-party QoE analyze your company’s financial performance to identify areas of concern before a potential buyer does; and establish KPIs to effectively communicate your organization’s operational performance.
What it’s worth
Let’s look at some numbers. For example, take a $15 million EBITDA company. The market multiple for this type of company is typically 7.0 times. Clean data and an independent finance department could potentially increase this multiple to 7.4 times. This premium emerged as such in a study 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 incentive is: $200,000 for a VP Finance for eighteen months, $75,000 for a sell-side QoE, and $50,000 for any system improvements, for a total of $325,000 (approximately).
The return on investment for creating the premium would therefore be: 1614% ($6 million – $350,000 = $5.65 million / $350,000).
Valuation friction is like a ghost: it’s hard to see until it’s cost you money. The moment a buyer questions the accuracy of your data or the ability of your finance staff to provide answers to basic questions without having to escalate to the CEO, you have already lost the upper hand in the negotiations.
Companies that receive premium multiples are not necessarily the ones with the best story, but rather those whose stories are backed by accurate, reliable and independent data that a buyer can trust.
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