For almost every M&A transaction the Confidential Information Memorandum (CIM) contains both actual financial results and projections. (The rare exception is a company whose entire value is a patent portfolio.)
In companies with external investors, management teams are familiar with projecting financials. This is a necessary part of projecting future financing requirements.
For internally financed companies that are ready to exit, the entire idea of projecting future financial performance is often unfamiliar. Many CEOs have asked me what the benefit is of a projection when so many variables are impossible to predict.
That’s a good question.
Why Buyers Want Financial Projections
There are several reasons financial projections are included in almost every CIM:
1. The current management are the world’s experts on this particular business. What the buyers really want to know isn’t the financial history, they want to know the financial future. The best people to ask about the future prospects are the current management team.
2. Financial projections are the most important input to the valuation conversation – especially for high-growth companies. If a company has five years of historic financials with steadily growing profitability, then historic financial performance may be adequate for valuation. But with many modern companies, especially technology companies, the growth rates are so high that the historic performance becomes less and less valuable as an input to valuation – especially for the sellers.
3. For many buyers, the starting point when looking at any new company is the financials. When they receive a CIM, they’ll page ahead to the graphs showing the combined historical and projected financial performance. That’s what they want to see first to provide an orientation. That’s just how their brains work. Every buyer is different and a good CIM needs to answer every question.
You Can’t Predict the Future and You Shouldn’t be Liable
Buyers know the company management can’t predict the future. Nevertheless, they absolutely want to see, and discuss, management’s opinion about the future opportunities for the business.
CEOs and boards are often concerned about liability associated with projecting financial performance. They’re often familiar with the prohibition on projecting financials in public companies. The private M&A market is quite different. With M&A transactions, the definitive agreement should always make it clear that the buyers have not relied on the financial projections to leave no possibility for a potential liability. With a good M&A lawyer on your exit team, there shouldn’t be any liability in honestly projecting future financial performance.
For companies that have been operating for more than two or three years, the standard financial model includes:
- Annual financials from start-up or the most recent 5 years
- At least 12 months of detailed projections (‘the monthly budget’ for at least 1 full year plus the remaining months in the current year)
- Three years of projections (after three years buyers know the projections are usually a copy and paste)
The entire financial model should be in one Excel sheet (so if a buyer had a large enough monitor they could see the entire company history and projected performance on one screen.)
In private-company M&A transactions the financial model is usually ‘normalized’ to produce a ‘normalized EBITDA’. This process adds back items that are either non-recurring or wouldn’t be incurred if the buyers owned the business. This process usually requires some discussion for each company’s accounting policies – and I won’t try to describe all the variables here. The normalized EBITDA should be the amount of ‘free cash flow’ the company has generated (under the normalization assumptions) and will generate going forward.
Unlike standard financial statements, the financial model should include revenue detail by product. If a company has four primary products, or product lines, then each should have a row above the total revenue subtotal. When the gross margins are significantly different for different products lines, the model should also include a cost of goods line for each product.
Some companies use very detailed expense categories in their accounting systems, which may be more than the optimum level of detail for a private company M&A financial model. The expense detail in a CIM is usually less than the detail companies have in their accounting systems but more than you’d find in a public company annual report. Most companies use between 10 and 20 expense categories. This is another area where there are no absolute rules and each case has to be considered based on the characteristics of the company.
Presentation and Graphs
Most CIMs include a bar graph showing historic and projected annual revenue similar to the examples below. Generally a separate graph is used to show the normalized EBITDA over the same years. These graphs are very similar to what you’d see in a public company annual report. The financial model bar graphs are usually included in the executive summary as well.
Input from the External Accounting Firm
Depending on the team’s level of accounting expertise, it often makes sense to involve the company’s external accounting firm when preparing the normalizations and projections. Accounting firms are familiar with typical practices for normalization. For many companies today, revenue recognition has become a very important element in financial statements and projections. Most management teams just aren’t familiar enough with the complex revenue recognition policies under US GAAP or IFRS accounting standards. When you’re showing projections in the same spreadsheet as your historic financials, it’s essential that the same accounting treatment be applied for the historic and future periods. For these, and other reasons, it’s usually advisable to have the external accounting firm review the complete financial model, check the normalization, projection methodologies, assumptions and formulas. In some cases, the prospective buyers will also require the external accounting firm to do a “quality of earnings report.”