M&A Expert Value Creation Points -- #2, Building the Model

A forward-looking pro-forma financial model is central to any buy or sell-side M&A process; it's the detailed, analytical assertion over future company performance, and therefore present enterprise value on a stand-alone, financial basis. Naturally, the rational buyers want to pay the least for any given target. In order to argue for the smallest figure, they typically start by suggesting that historical revenue growth will at best sustain, or even decline. Further, they typically argue against any major EBITDA margin deviations with increased revenue, and so aren't inclined to ascribe value to the prospect of any operating leverage. This is totally irrespective of what they consider to be the true post-acquisition cost or revenue synergies; they never want to pay for the value they intend to realize once a target is under their control, nor do they wish to tip their hand to where that value may exist in their own pro-forma analysis.

The counter weapon to these buy-side arguments is a fully articulated, triple statement, forward looking, pro-forma financial model. In order to build the revenue side of such a model, it's necessary to dig deep into a client's business, to understand the full spectrum of growth opportunities that exist. The identification of these growth levers is fundamentally value creating, because they must all be valid in case the company does not trade, and instead elects to continue operating independently. These are discovered through management interviews, market research, and the application of our broad experience and knowledge surrounding the various means to increase revenue in a business. These growth levers are precisely the same ones that a non-strategic but astute and capable PE-oriented buyer considers when creating their internal buy-side model, in the context of determining their expected IRR (internal rate of return), and therefore what they are able to afford as their maximum entry price (depending on their anticipated hold period).

The various growth levers typically fall into a few categories; as an example: geographic expansion, share-of-wallet-expansion (new products, features, or service tiers), price rationalization (assuming pricing is meaningfully below the competition, and has significant room to grow on an ROI-adjusted basis), supercharging sales capacity, or the increase of inbound leads through expanded marketing campaigns. Assuming a subscription SaaS business, churn reduction could also be seen as a growth driver. Discovering the applicability of each of these potential growth levers requires significant time spent with the executive team. Most have associated costs, and some require incurring costs ahead of revenue generation (R&D in the context of product development initiatives, or marketing campaign spend ahead of leads and closed sales). And each is relatively more or less defensible, depending on the risk associated with the initiative.

Once the most defensible of these levers have been identified and built into the model, together with associated costs, the aggregate implied growth rate should be checked. For example, it's wonderful to suggest that growth might jump from 20% to 70% with the implementation of a few smart initiatives, but it needs to hold up under the scrutiny of careful analysis. In the end, you're making a series of arguments for increased enterprise value, and each will be discounted to varying extents by the buyer. Again, non of these contemplate the direct and particular synergy value in either revenue or costs that the new owner expects to be able to realize. In some cases, it is possible to provide that analysis on their behalf, but those need to stand separately and alone from the core model.

Once the projections are finalized and the model is complete, it becomes the companion piece to the CIM in the post-NDA marketing of the business. It will be scrutinized and defended, and will become a centerpiece for discussion ahead of Indications of Interest, and later, formal Letters of Intent.

The process of model building is tantamount to a full analysis of any business, and nearly always reveals new stand along growth opportunities that management can realize, whether or not the business ultimately sells to a new owner.