THIS WEEK IN BROKEN DEALS

Welcome to the Broken Deal Newsletter!

Here’s what’s in store for this week:

• Announcement: Recovering from London & Paris

• Best Link: PE-led acquisition default rates have sky rocketed and that may mean opportunities for you!

• The Graveyard: We go deep on working capital and how to know when a liability is actually a strategic “asset”

• Work With Us: We just opened up a new program for small growing M&A Advisors and Brokers to get Wall Street level analyst help with their deals on a success-fee basis. Book a call with us below to learn more.

ANNOUNCEMENT

Kristin and I are recovering from a trip to London & Paris. I’ll be back with more announcements soon! Bonjour!

BEST LINKS

Matt’s Favorites

• Someone needs to swipe this amazing real estate cold outreach script and apply it to M&A (Twitter)

• Crumbl Cookie pulls potentially genius move, acquiring Pie Restaurant to leverage it’s tech stack & scale faster (Twitter)

Finance & Capital

• PE-led acquisition default rates have sky rocketed (Twitter)

• Interesting podcast from Enduring Ventures about acquiring rights to franchise from mom & pop business owners (Twitter)

• How to get more than the SBA $5M limit to do bolt-on acquisitions (Twitter)

Salability

• Rating types of acquisitions from most successful to least successful (Twitter)

• If anyone tells you selling your business will be simple… well… consider this (Twitter)

THE GRAVEYARD

The Most Common Valuation Mistakes - Understanding the Value of Working Capital

Based on the last 20+ transactions we’ve participated in over the last 24 months, we’ve come to believe the that default state of most people within the lower middle market M&A space, at least when it comes to working capital, is utter confusion.

Many of the buyers we’ve worked with struggle to understand how much working capital terms can impact cash flow and growth rate, so over-rely on vanity metrics like EBITDA for setting valuation.

Many sellers we’ve worked with believe their large asset balances supports a higher valuation when, often, high inventory and accounts receivables balances (i.e. working capital assets) detract from their valuation.

As a result, there’s no common language that can allow a clear, reality-based conversation to take place between buyers & sellers who don’t poses this knowledge (or at least have advisors who do).

Like many things, to gain clarity, we need to go back to the fundamentals.

Defining Assets & Liabilities

Do you know why an asset is called an asset and why a liability called a liability?

Further, do these names accurately reflect how we should view these items in the sale of a company?

Here are the definitions (from Investopedia): 

• Asset - An asset is a resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide a future benefit.

• Liability - A liability is something a person or company owes, usually a sum of money.

I’ve put the key words here in italics - owns vs owes. 

Assets are owned by the company (that is, the cash has been paid for the them already), whereas liabilities are items that are owed by the company (that is, the cash has not yet been paid for them already.)

All of this sounds very simple, elementary (useless even… who doesn’t know the difference between an asset and a liability?).

The rub comes when we start asking some questions about assets and liabilities in the context of business ownership. 

You as a business owner are going to be given, for free, a choice between 2 companies. This company has the following Financial Figures:

Company A:

Revenue - $4,000,000.00

Net Income - $1,000,000.00

Assets - $2,000,000.00

Liabilities - $0.00

OR 

Company B:

Revenue - $4,000,000.00

Net Income - $1,000,000.00

Assets -$0.00

Liabilities -  $2,000,000.00

Which would you choose, and why? 

It seems like the dumbest question ever - Obviously you should choose the one with $2,000,000 in ASSETS (things that you OWN) vs the one with $2,000,000 in Liabilities (things that you OWE). And, if the previous figures were all I know about the company, then I might share that same opinion. 

But, just for the sake of argument, let’s dig a little deeper? Let’s actually take a look at the what these brief financial statements actually say about the company - 

In the first situation, things look pretty normal. Good revenue, good income, nice amount of assets, no debt. What’s the problem? 

No Problem, sounds like a good company. 

But in the second, it’s at least a little bit interesting… how is this company producing that much revenue and profit with no assets?  

The fact is, a situation like this isn’t so rare - Lots of tech companies and professional service companies effectively operate with almost no assets whatsoever, but still produce good revenue and profits. 

Still though, what’s the point of all this? Assets are obviously good, and liabilities are obviously bad, so why am I bringing up bizarre examples with obvious conclusions. 

It’s because the conclusions, on the ground, running the company, aren’t so obvious - 

Remember how the definition of an asset is something OWNED and the definition of a liability is something OWED? 

Well, what if we re-wrote those definitions a little differently - 

Asset - An item the company spent cash on that was not able to be distributed as profits. 

Liability - Cash entering the company which little to no effort was required to receive. 

Starts to sound a little different, doesn’t it? 

If I see a company listed that has both $4,000,000.00 in revenue and $3,000,000.00 in assets… what conclusion can I draw about what this company will look like if I grow to $8,000,000.00 in revenue? That’s right, it will probably take me $6,000,000.00 in assets to support that, which means $3,000,000.00 of what would otherwise be unencumbered profit will actually get “caught” in the business in the form of assets that I can’t distribute. 

Suddenly, assets don’t sound so nice. 

But what about liabilities? Surely those are always bad, right? 

I would argue… NO!

Clearly, things like Long Term Debt aren’t super great - especially if the reason I have gone into debt is because of Operating Losses that I had no other way to cover. 

But what about liabilities like Accounts Payable? Accounts payable represents goods and services that I have already received, in some cases already used, but for which I have not yet paid any cash. That’s free cash you didn’t have. 

I am not suggesting that this can go on indefinitely - at some point, you pay the bill. But, depending on how you operate your company, it’s quite possible that you have already been fronted additional cash by someone else to replace the cash it takes to pay the bills, and you stay basically ahead the whole time. Especially so if you are growing your revenue, as the new items coming in “on credit” will often be worth a larger cash sum than your bills from 3 months ago. 

This whole dynamic, where assets put something of a damper on growth and liabilities fund growth, is actually why certain industries like Manufacturing have gone out of favor since the turn of the last century. Smart operators started to realize that asset light, “good liability” heavy businesses like tech, professional services, and certain kinds of distribution services (especially ones with high velocity where you can often get paid on invoices before the bill is even due on the product) could be grown at incredible speeds, because they either funded themselves by “borrowing” from supplier and customers (in the form of deposits) or at a minimum, didn’t require re-investment of cash earnings to continue to grow the revenue. y businesses

In other words, working capital has a value unto itself that is unlike the other assets & liabilities found on the balance sheet. What’s more is that this value can be big.

So, I think, at a minimum, we should at least be able to come to the conclusion here that just because “Asset” sounds nice, and “Liability” sounds bad that clearly a company being conveyed with a lot of assets is good and a company being sold with a lot of liabilities is bad - the truth is much more nuanced. 

It’s that nuance then, that I’d like to look into when it comes to the question of Valuation - how should Assets be treated when pricing a company for sale? Should an owner get extra money for conveying assets with the deal, or extra money for conveying more assets than would typically be transferred in a similar situation? 

A True Story Why A Big Asset Broke The Deal

To answer the above questions, we have to put working capital in its proper perspective. A transaction I worked on last year was a perfect case study for this.

I had inquired about a custom kitchen-product manufacturer with $1.5M EBITDA listed for $7.5M (5x).

I ran the numbers and discovered that the company carried an astonishingly high 200+ days of inventory and 90 days of AR.

Most companies have a balance of under 30 days each.

It was immediately obvious why they wanted to sell.

For every dollar of revenue growth, the business needed about $.60 of working capital.

This working capital requirement was bleeding the company dry and the business owners were oblivious as to why their lives were so hard. They actually thought these assets made the business more valuable but, for every $1 in net income, no less than $3 in cash went out the door as they grew.  

It would have actually been better for cash flow to SHRINK the company.

I explained the math to the broker who I’m not sure really understood what he’d gotten himself into and let him know I pass.

Even at 5x EBITDA, this business was overpriced. It actually DESTROYED value as it grew.

And if I’d relied on EBITDA alone, I might have done the deal. Thank god I didn’t.

What does this story teach us?

Working capital can be one of the most important “signals” about the intrinsic value of the business and should influence the multiple you are willing to pay. The presence of large amounts of assets is a signal of at least one and possibly all of the following problems:

1. Weak industry structure

2. Weak management

Notice that these are often considered qualitative due diligence that often stem from, in the case of #1, a review of the business’s industry position (typically Porter’s 5 Forces and Porter’s Value Chain) and #2, a review of the business’s Operational Maturity. Only now we can put quantitative metrics to these factors.

This is why its important to clarify our thinking about working capital. It tells us, often in very unambiguous terms, just how good of a business we’re dealing with.

So, to gain further clarity, we need to separate out what I’ll call Business Model liabilities & assets from all other assets & liabilities.

Think of Business Model assets & liabilities as typically Customer-Related Items like advance deposits, unearned revenue, insurance premiums whereas all other assets & liabilities can fall into the category of “Non-customer” or Non-business model assets & liabilities.

By way of example, you’ll recall how Amazon financed much of its early growth through vendor float by taking credit card payments from customers immediately and paying book vendors up to 90 days later with that cash. Amazon’s growth in revenue actually produced excess cash flow the business would have had to raise from outside investors if this negative cash cycle had not been in place. This would have been costly to equity holders, which means there’s an intrinsic value that can be calculated from this Business Model related items.

Essentially, Amazon’s long AP cycle and short AR cycle was a positive to valuation, as it increases sustainable growth rate and intrinsic value.

Therefore, when there are positive attributes to working capital, increase valuation.

When there are negative attributes, decrease valuation.

How much to adjust valuation based on working capital is a different question. I rationalize all valuation from the perspective of impact to future cash flow, so this is always a separate, though potentially related, exercise to balance sheet valuations that many business owners like to use. Said differently, positive Business Model Assets & Liabilities should impact the “multiple” you are willing to pay for the business, simply because their presence will produce more future cash flows, all other things being equal (and this amount of cash flow can actually be calculated). A deep dive on this is a topic for another article, however.

Remember, our major concern in valuation is always “How many dollars will I get back for every $1 dollar I invest?”

Analysis Tools & Techniques to Assess Business Model Assets & Liabilities

We’ve covered a lot. Let me leave you with a few high-impact tools to implement this new way of thinking yourself.

• TECHNIQUE #1 — DAYS INVENTORY & A/R TREND — You should think in terms of “what’s the basic amount of inventory to run this business?” Above that is wasteful. Calculate this by reviewing the monthly balance sheet going back multiple years on a Days Inventory basis. The formula for this calculation is generally:

  • ((Inventory / Cost of Goods) * 30)).

  • In Excel, calculate high, low and average for the data set using the MAX(), MIN(), and AVERAGE() functions

  • Also review monthly metrics for seasonality trends

• TECHNIQUE #2 — NET WORKING CAPITAL AS % OF REVENUE — Sometimes when revenue goes up, working capital increases much faster than profits. If this is the case, we want to know about it. The formula for this calculation is generally:

  • (Change in Total Net Working Capital / Change in Revenue) = Net Working Capital % of Revenue

  • If Net Working Capital % of Revenue is greater than Net Income Margin, the business likely destroys value as it grows and should be avoided.

• TECHNIQUE #3 — RETURN ON ASSETS — ROA of under 15%-20% over history of business is a major red flag that the business is either mismanaged, in a bad industry, or both. Unless you are an excellent operator with experience in the industry, avoid businesses with chronically low ROA. The formula for this calculation is generally:

  • (Net Income / (Total Assets - Cash))

  • Compare going back no less than 3 years

All for now. See you next week!

THAT’S A WRAP

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