How an Unbelievable Financial Forecast Can be Just That: Unbelievable
Preparing a financial forecast is a key step to selling a business. However, most projections don't pass the credibility test. Here are some of their common flaws and how to correct them in order to make your projection believable for buyers.
I'm Canadian, and I love hockey. I don't, however, love "hockey stick" financial forecasts. You know the ones I'm talking about. A hockey stick forecast is one that shows its last few years of actual results flat and then magically rockets up for future years just like the blade of a hockey stick. They are the ones that show EBITDA doubling or tripling in the next three to five years, implying never-ending blue skies ahead.
Understandably, financial projections are prepared directly by the seller or an investment banker/business broker to market the business. As a buyer, I expect financial forecasts to be aggressive, but they have to be believable. If the forecast is unbelievable, it can turn a perfectly salable business with great management into an unsalable business simply because its credibility is killed. If you hire a broker, one of the 10 things great brokers do is act as your financial advisor. They know better, so they keep your projection realistic because they know that unrealistic projections kill deals.
Here's what both financial buyers and strategic buyers look for when they are presented with a financial projection. In my experience, sellers who think that the "trust me" approach is enough end up with problems. On the other hand, take care of these common flaws in your financial projection, and you will rank in the top 10% of sellers.
Absence of a CatalystMy first question when I see a hockey stick projection is "What is the catalyst?" A catalyst is the fundamental reason why financial results go from flat to rocket-like. It can be the introduction of a new service line, the penetration of a new market, or a complimentary acquisition. You'd be amazed at how often there is no substantial answer to this question. Or, alternatively, the answer is simply "Because the market we are in is growing, so we intend to gain or retain market share."
Markets seldom grow in a straight line or double in two to three years. Even if you are in a high growth industry, new competitors will enter the market and fight hard for a piece of the pie. More often than not, companies that expect their EBITDA to double just because they are in a growing market will underperform to their projections. They simply lack a catalyst.
A Cost Structure That Never ChangesMaybe there is a catalyst and we're buying the top line growth, but margins that double as well? We know that when top line revenue goes up, fixed overhead is better absorbed so margins should improve. The more difficult question is: "How much will margins really improve?"
When a company anticipates rapid revenue growth, it is naive to think that its cost structure will stay completely static, especially for those companies that don't have a catalyst and are simply growing because the market is growing. In a growing market, all variable costs such as labor become more expensive. More importantly, if your business is doubling, you will likely incur more fixed overhead to support this growth. The overhead may not double, but projecting the same fixed overhead that the business incurred when it was doing $30 million, while forecasting revenue to be $60 million in the next three years, is not only unbelievable, it just is not believable.
Balance Sheet? Only Accountants Worry About the Balance SheetOver the last couple months, I have read at least 10 CIMs and I can't remember one that presented a balance sheet and/or a cash flow statement to go with their projected income statement. In fact, most of them didn't even take the income statement beyond the EBITDA line.
EBITDA on its own doesn't mean much. As Charlie Munger, Warren Buffett's partner, once said, "I don't even like the term EBITDA, it means earnings before all the costs: nonsense."
A projection should go all the way. It is more powerful to show the income statement all the way to the net income line, and then present a balance sheet and cash flow statement that actually tie together. Yes, I realize that the capital structure may change post-transaction so annual interest expense may be different. The buyer may have a different tax structure, so corporate taxes may be different. Leave this to the buyer to adjust. The point is that you show you understand the projection all the way through.
A buyer needs to understand what type of investment will be required to feed the big revenue line pop that is being projected. What are working capital requirements? How much growth capital spending is required? A high growth projection that doesn't consider the balance sheet impact and, more importantly, doesn't show projected free cash flow is like a one-sided coin.
There is No Plan B; It Distracts from Plan A
No plan B works in the movies, but not when you're preparing to sell a company. There should be a plan B, and maybe even plan C, D and E, if necessary. Scenario planning or sensitivity analysis is a must.
Forget about buyers for a second. As a company owner, you should know the drivers of your financial performance and the impact of tweaking each one. A great financial forecast provides all the key assumptions and makes it easy to change them so results can be recalculated. We all know that a financial forecast tries to predict the future, and the future is unpredictable. Therefore, the best financial forecasts provide various possible scenarios - best, base, worst and even beyond worst. This allows management to shine by explaining how the risk around each assumption is being managed so that one of the better scenarios results.
Making Your Forecast Reasonable
So there you have it, the key drivers that make buyers more likely to believe a hockey stick financial forecast and, more importantly, trust you as a manager.
Let's recap. Here are the must haves:
- The existence of a catalyst to support growth projections;
- A realistic cost structure that considers additional overhead to support growing revenue;
- A projection that doesn't stop at the EBITDA line and also meshes with a balance sheet and statement of cash flows; and, finally,
- Scenario planning or sensitivity analysis.