Financial Modeling for ETA Deals: Making All Four Parties Happy

Why are we here again? Alright, I think this would be more fun if it wasn't so formal. So let's make this super interactive. I'm only using a microphone because I'm losing my voice. Otherwise, just jump in. Let's have a conversation about financial modeling. If you want to grab a beer, be my guest. The bar is open.

Let's start with a question. Why do we use a financial model in our acquisition process?

[Audience: To help us through strategies, ideas. To learn the deal better. Get a feel for what we're buying.]

That's right. It's not meant to tell us answers. It's meant to help us think through the process. Why else? Better question, when do we use a financial model?

[Audience: To compare two completely different businesses.]

Right. Model one business, one deal, another business, another deal. Make some decisions about which one to take. Standardization to look through them all.

When do we go through this exercise? You get a teaser in your inbox or on one of the listing sites. What do you sign first? After you get the NDA, sign the NDA. What do you get next? The SIM, an upside-down printout of the QuickBooks file, or some bad information from the broker. At that point, you can start your work. The exercise is all about sensitizing outcomes for various parties based on the inputs you give it.

By the way, this is the worst financial model an investment banker or private equity professional has ever seen in their life. And yet it's one that I think is good for us to use because it's not so complicated that you think the answers are in the model. The answers aren't here. This will help you make decisions. It's not going to tell you the answer. For that reason, it's simple, it's useful.

We always start with the P&L. You don't start with the actual model tab. You start with the P&L. You take the inputs that the seller and the broker give you historically. They'll give you one to three years of P&L. You take the P&L and put it in our tool. Any blue cell is a hard input. You're going to change that number. Anything in orange is a number that gets used in another tab. Anything in black is a formula, so don't touch that.

You don't need to do a lot of thinking when you insert revenue, cost of goods sold, OpEx, EBITDA. Where you have to do a lot more thinking is on adjustments or add-backs. What is the purpose of adjustments or add-backs?

It is an attempt to take the seller's P&L and adjust it to represent the revenue, costs, and earnings that you'll generate from the same business. We generally are going to add back things like seller's salary, other compensation or benefits, private jets. Private jets are easy. But what do we do with a marketing program, $25K paid to a web dev agency for a marketing program that didn't work? You're not going to have that again, but the idea is there's a lot of gray here. There are a lot of adjustments that the broker or the seller want you to add back that are judgment calls.

Why is this so dangerous for us? You're paying four or five times earnings for a business. For every dollar of adjustment you give them credit for, you're paying them $5 for that adjustment. So a big red flag is always if you go to the tax return and see $0 of net income, $1 million of EBITDA, and all of the EBITDA is adjustments. That's a much harder deal to get done, much harder to get through credit, because many of the add-backs may be judgment calls and it's just riskier.

Drew, what am I missing?

[Drew]: It's really well covered. What I continue to see is that people are not as thoughtful upfront about these add-backs as you might think. It's not just questioning the add-backs, but really not just taking things like a charitable contribution and assuming that's not something you have to do. I would challenge you that the answer is maybe, because what if the charitable contribution is from the company to his or her largest customer's charitable foundation? Generally speaking, owners are not dumb the way we like to laugh about. They're doing most things for a reason. So just be careful. Also, not all add-backs are positive.

Has anybody ever bid on a business where the seller owns the real estate and the operating company? Is there generally a fair market rent payment getting paid from seller OpCo to seller real estate co? Why not? Sales tax. There's like a toll booth on that payment. In Florida, at least, you pay 7% on a rent payment, which is essentially from seller's right pocket to seller's left pocket. No reason to do it.

So then you go to the P&L and you bid on let's just call it a million dollars of EBITDA, but there was no fair market rent payment going through the P&L. All of a sudden you get into diligence after you sign LOI and you realize what's a fair rent payment? 15 grand a month. So $180,000 a year plus sales tax, $200,000 a year. So you deduct EBITDA from $1 million to $800,000, times five. All of a sudden you have a million dollar price difference overnight. You probably don't have a deal. Happens all the time.

[Drew]: Occasionally you will see a broker who lists the deal with real estate and they say, you can choose to buy the real estate or not. But then you really need to think about whether that rent is included or not. It may be fair for them to say, if you're buying the real estate, you're not willing to have a rent adjustment. But if you choose to do the business acquisition only and you still do the model based on the cash flow that the broker is giving you and you didn't make the appropriate rent adjustment, you're going to find yourself in a bad place when your deal doesn't pencil.

[Audience question on SBA lease requirements]

The SBA requires that you have a lease for the entire length of the loan, 10 years. That's actually a misconception. It's not a hard-coded SBA rule. That could be a lender policy.

[Audience]: My landlord tried to extract value out of me in terms of the rent rate right before closing. So that wasn't factored into what the business had previously been paying. The narrative is, just because the business had a deal with the landlord previously doesn't mean it's going to carry over. The lease may end at a certain point.

Even if you see a rent expense in the P&L, it doesn't mean it's the fair market value of the rent. I also want to clarify, that assumption assumes you're paying additional purchase price for the real estate. If there's real estate involved, the best way to look at it is you value the real estate separately, independently, and you normalize them. Sometimes if you get lucky, you can arbitrage the real estate where you realize the real estate is worth more than the seller realizes.

Sources and Uses for Four Parties

The first tab of a financial model is a tool you're going to use to see if the deal you've structured satisfies all of the parties to a transaction. Who are those parties?

[Audience: Yourself, the seller, the lender, investors.]

We need to make sure all four parties to a transaction are happy. The seller is going to be happy based on what considerations? Purchase price, size of seller note, amortization of seller note, rate of seller note. What about the lender? DSCR. You need to keep DSCR above some threshold. What about your investors? Let's call it IRR and MOIC, annual rate of return and multiple of invested dollars. And then last, we've got to be happy. What do we get as the buyer? Our ownership percentage, our salary, economics for us.

The tool is all about you input your deal, then you go through and ask, if I were to share this model with all four parties, are they happy? Generally they're not. Generally it breaks somewhere.

When you review a SIM, sometimes there is an asking price. It's much easier if you've got an asking price. So if our asking price here is $5 million, the rest you're going to have some discretion on. How much is seller note? How much equity am I going to plan to put in the deal? The SBA minimum is 10%, but maybe you need more. You start with inputting the purchase price and then you start to figure out your sources and uses by your proposed structure.

Sources and uses is the source and use of cash. Sources are where the money is coming from to fund the deal. Uses are where it is going.

[Drew]: There are some that are going to be relatively stable, like deal expenses. We've got a calculator in this model. Based on your structure, if you say a 20% note on a $5 million purchase price, a million is going into that seller debt line. Then you can fill in how much equity is there going to be, and that's going to dictate what the senior debt is.

Uses are cash at closing, all the dollars that go to your seller at close via wire transfer. The balance between that number and purchase price is the seller note. The sum of those two items is purchase price. So purchase price is $5 million, four of cash, one of note. Everybody always says, done deal. Wrong. You generally need more capital to close the deal.

You have transaction costs. What's the largest cost in an SBA-backed transaction? The guarantee fee. Fortunately, you can bake it into your uses. The SBA loan will fund up to 90% of that.

[Bruce]: It's a really simple formula. You take the loan amount times 75% times 3.5%, and anything over a million dollars that they guarantee is a quarter percent.

Deal costs, let's say $150K. Then people forget this one: you want to walk into your business on day one with cash in the bank account. In your LOI and purchase agreement, it's going to say I'm buying the business cash-free, debt-free. The seller on the day of close sweeps all the cash in their bank account. So no matter if you're doing a stock deal or an asset deal, you walk into the bank account on day one with no money. So long as you've negotiated working capital correctly, that might be okay because what's going to be in your mailbox on your first day? A check from AR for an invoice sent prior to close. You should be able to fund your OpEx with those checks coming in. But what happens when you go a week without a check? You don't want to have an oh-no moment. You want to have excess cash. This is a bit of an estimate, but you always put cash in your sources and uses so you have some float.

The total of your uses, purchase price plus expenses plus excess cash, is project cost. That's actually the number that the SBA uses to calculate the maximum fund or the minimum equity injection. Your total sources have to match it. Like a balance sheet, it's got to balance.

The seller note is on both sides. It's both a source and a use. Generally the rest is fairly easy. It's a combination of equity from you and/or investors plus your senior SBA debt.

These are dollars that you and your investors put in. How much you each own is dictated by equity percentage. If we've heard of the phrase step-up, it's a framework a lot of people use to dictate how much of the overall pie you own versus investor one, investor two. It does not in any way have to be pro rata with the dollars you put in. In a normal business or in the public equity markets, you put in a dollar, you get pro rata ownership. Here, if we're the searcher, we're offering so much more value than just the dollar we put in. You found the deal, took the risk, signed it up, diligenced it, raised the money, closed it, signed the PG, you're running the business. You need sweat equity. That's why in our self-funded search arena, generally the economics are flipped. Most self-funded searchers own 51 to 90% of their business by putting in way less than 51 to 90% of the equity injection.

The model is a visual representation of the cash flows. It will calculate your taxable income, because in a C corp you have to pay Uncle Sam, or if it's a pass-through, you have to make tax distributions. Who takes first in the cash waterfall? Everybody always says your bank, but it's not. It's Uncle Sam or your investors. You have to give them a K-1 and a tax distribution.

The first taker of cash after Uncle Sam is your lender. We model the bank loan. How long is your bank loan typically? 10 years, straight-line am. Type in your rate of interest. When is it not 120 months? Real estate. Then it's weighted average, or it can flip if it's over 50%.

Then the seller note. Same thing: rate, am. A lot of times we do standby periods where either you're paying no interest or principal, or you're just paying interest. It's a way for you to build cash usually in the early years by not amortizing down the seller note.

The first party we're trying to satisfy is the seller. The seller is going to be selling a $1 million EBITDA business for $5 million. Do you think the seller's happy? A rule of thumb is five times EBITDA is starting to get to the high end of the range where your model will work with max leverage. If you pay more than that, you're going to find your model breaks unless you put in way more equity.

[Drew]: It can get challenging at 5x even if you put in more equity.

Is your bank happy? Blue cell, blue text means we're going to hard code what SBA lenders' minimum DSCR threshold is. SBA minimum is 1.15.

What does DSCR mean? It's how much your monthly cash flow can cover your debt payment. Except it's not monthly, it's calculated annually. Everybody, when they've never bought a small business, thinks that if they're doing $1.2 million of EBITDA a year, $100,000 of cash profit shows up in their bank account every month. It doesn't work that way. Cash flow goes like this: you fast-pay vendors and your customers slow-pay, you've got no cash. The next month all your customers pay you, you were scared so you didn't pay any vendors, you have all the cash.

DSCR is a way of representing how much cash, profit, or earnings you have above your annual P&I payment obligations. A lender doesn't want to fund you if it's too tight. They want your business's profit to be able to drop and still make the payment. If the minimum is 1.15, they will close on a loan where you have $1.15 million of cash EBITDA and P&I payments of $1 million a year. That is not a lot of breathing room. Would you buy a business with a DSCR of 1.15? Two trucks break down and your cash is gone. Two of your key leaders get frustrated they didn't know about the sale and they renegotiate comp right after close, your DSCR is vaporized.

There are many ways to make your lender or DSCR look better. One is to find a lender with a lower DSCR threshold. Another is, depending on how you structure the seller note, you may not have to include the seller note P&I payments in the denominator of your DSCR calc.

[Drew]: If you're familiar with standby notes and it's on standby for two years and you have no balloon payment, which is a requirement to count a seller note as equity, then you may be able to exclude it from the DSCR analysis. In other words, have the seller note not count as debt. There are lenders that will think about it differently in terms of whether they'll count it if it's not a full 10 years. For the most part, what we tend to see is the two-year standby, eight-year term with no balloon, and then it will count as equity under SBA rules.

So long as your lender has credit rules that allow you to exclude seller note payments structured certain ways from DSCR, then to the extent you move more of your purchase price away from cash at close into the seller note and put them on some sort of standby period, you can exclude all of the payments made under that seller note from your DSCR calculation. Not just to make it look better, but it is better. That seller note becomes quasi-equity.

[Drew]: The SBA has a pretty clear rule that you will treat that as equity if it's two years of standby, eight years, no balloon. There's not a lender I'm aware of that would not count it as equity. The question is whether they then somehow account for those note payments that are going to come up in years 3, 4, 5, 6. They want to make sure there's adequate cash flow there to service the note too.

A full standby note is two years where there's no principal or interest payments or accrual. You can accrue interest if you choose. The partial standby is interest-only payments during those two years. After the two years, you start paying.

[Audience]: The working capital line of credit, is that factored into the DSCR?

Lenders will look at SBA Express lines of credit and factor that into the DSCR. They'll treat it as fully drawn.

[Audience]: Where are you seeing seller note terms as market?

It depends on your seller. If you're dealing with an 80-year-old seller, a 10-year note gets tough. In that case, a five-year term is pretty normal. But of course at that point, throw the equity concept out the window. I've seen many deals with the 10-year structure with two years of standby and eight years after. The two most common are five-year maturity and 10-year maturity.

[Sam]: So you could structure a note with two years standby and amortized on 10 years with a five-year balloon, and the lender would not count that as debt service, but that would not count as equity. There's a difference between what counts as equity for purposes of your minimum 10% project cost equity injection versus what's calculated in your debt service coverage.

Back to tactical. We have a deal that busts when you go to making your lender happy. Let's keep the same purchase price but get your lender happy. Move 50% of the consideration to seller note. It's on standby for two years, so it's allowed to be excluded from the denominator of your DSCR calc. All of a sudden your DSCR is 1.75, 1.76, 1.74, 1.95. You've got plenty of breathing room. There are deals where your seller won't move on purchase price, but you can convince them to hold a lot of paper.

[Drew]: The lenders are going to look and say, is this impossible to pay in year three? That will be a factor. But that's changed by another assumption in the model. If you put in 20% sales growth, then you won't have any issue in year three. I don't think that's a good assumption. The point is there are all these levers in the model. It's not lenders who need to make this decision for you, it's you. You've got to believe everything you're putting in this model. We can make a $10 million purchase price work, but the assumptions we've got to put in to believe that are pretty wild.

[Audience]: How might this model change asset deal versus stock sale?

When you do an asset deal, almost by definition you get the basis of the assets you buy marked up to fair market because you always have to do a purchase price allocation. Generally buyer and seller will agree to mark up the basis of the fixed assets to fair market so that you, the buyer, get to depreciate those and capitalize a goodwill asset to amortize. It brings your net income way down because you get this non-cash depreciation, non-cash amortization as tax write-offs. In a stock deal, you don't unless you negotiate for it. A lot of the talk around the increase in frequency of stock deals, they are generally accompanied by either a 338(h)(10) election or an F reorganization with an election to treat that deal for tax purposes as an asset deal.

[Audience]: Do you teach your students to model in a J-curve?

The second tab where you layer in adjustments, we will always suggest you don't have to do it early on when you're trying to see if a deal is doable. But when you're getting closer to closing and you want to see how life is going to look after close, model in adjustments for a new CRM, a new VP of Sales, a rent increase, the kind of things that tend to come up a year or two or three later. EBITDA drops because you wanted to make investments and maybe the business is growing, revenue increasing. In order to sustain that, you have to make hires. When you have to spend $150,000 on payroll for a person in an $800,000 SDE business, there's a step function to that investment that hurts. The second one is to model in ideally little if no sales growth, definitely no margin expansion, maybe some margin compression.

Who do we want to see if they're happy next? Investors. The question is what IRR and MOIC do investors need in order to invest? With Tony and Sam's panel, 30% IRR and 7.5x MOIC. 7.5 is a bit aggressive, more like 3.5x.

With negative cash flow when you pay that much and your debt service on that much at purchase price, you don't have enough cash. Your equity is losing money. The big decisions for equity investors are how much equity are you going to put in. The minimum is 10%. What actually creates better returns for your investors? Putting in less. The more equity you put in, the better the deal looks for the bank because DSCR improves. Your numerator EBITDA doesn't change, your denominator principal plus interest goes down because you have less bank loan. So putting more equity in is one way to make DSCR look better. Besides lowering the purchase price, the second no-brainer way to make your deal look better is put more equity in. The problem is, the more equity you put in, the lower the IRR, the lower the MOIC, and most importantly, the lower the percentage of the business you own.

Step-up. It's not a great framework, but it's a mechanism for allocating percentage between you and an investor. If we collectively put in $500,000 of equity, and the investor puts in all 500 and I put in zero, how much should the investor own normally? All of it. But there are lots of deals where investors put in all the equity, the searcher puts in none, and the searcher owns more than 50%.

The step-up concept says, instead of comparing relative equity check dollars on a percentage basis, how much of the total purchase price was injected in the form of equity? In this instance, 10%. With a 2.5x step-up, it tells us 2.5 times the 10%, or 25%, is how much total equity the investors will own.

A higher step-up benefits investors. One and a half is the low end of the step-up we see, three is the high end. In a world where $500,000 of equity is put in by investors with a 2.5x step-up, the investor group is going to own about 25% of the business. You own the rest. That's really what we're working for. The investors generally don't ask how much do I get to own. The question is what is the IRR and MOIC on the piece I own.

Are you going to be happy in a scenario where you own a $1 million EBITDA business and you own 76% of it for putting no dollars in?

[Audience question on how investors are paid back]

The pref is accruing. If they have a 10% pref on a million dollars, that's $100,000 for that year that you generally pay out in pref. But it's not a mandatory payment. It just keeps accruing if you aren't paying it.

[Sam]: The pref is confusing because most of us describe pref as interest on investor money, but there can never be required payments on equity, otherwise it's just debt. Think about a preferred return or preferred dividend as money you owe the investors when you decide to make a payment. Generally the way we see it, you're the searcher and you're going to own 76% of this business. You're getting that for your sweat, your risk, your effort. But your investors' money comes in as preferred equity. It's a senior equity security. You have to pay your investors back both their invested dollars, in this case half a million dollars, plus all accrued pref interest on that money for as long as it's outstanding. You can't pay yourself a distribution on your ownership interest until you have returned all of your dollars and their pref back.

For the first dollar you want to distribute, your SBA lender doesn't bar you from doing that. There are no covenants related to investor distributions. So you decide I want to pay $200,000 out. Avoid making the mistake of assuming you're going to get 76% of that distribution, because you're getting zero until you have paid 500 back plus the interest component. There's no compelled payment to investors. The distributions are discretionary.

If your pref rate was 10% and you waited exactly one year to pay everybody out, you'd owe 550. If you waited two years, it's compounded interest. So you're incentivized to at least make the payment, but it's expensive capital, so you're incentivized to pay off the investors as soon as you can without risking the business.

If you have three really good years and pay all your investors out, and then in year four you have 200,000 to distribute and your investors have gotten their 500 plus their pref, the money gets sent out 76% to you, 24% to investors. Once that flips, then you're in the money.

Carried interest is generally not a concept in self-funded search deals. It's more of an independent sponsor concept.

They're owners. After the pref is paid back, they just own that percentage. It's a participating preferred stock instrument.

Let's close the loop. In that deal, the seller was happy at $5 million. The bank got happy by increasing the seller note, putting it on standby so you can pull the seller note payment out of the denominator of DSCR. You're happy because you own 76% of the business without putting any dollars in. But there's still one party not happy: investors. So how do you get the investors happy while keeping seller, lender, and you happy?

This is the crux of the tool. There are many ways. Lower your purchase price. That's obviously a hard one. Use less debt, increase the equity injected. Rather than putting in 500,000, let's put in 1,500,000. All of a sudden IRR went from negative to positive and MOIC went from 0.7 (they lost money) to 1.5x. But fundamentally something flipped. Look how much ownership you now own versus your investors. 29%. With a 2.5x step-up, that's why it flips. The point is, you can say I'm going to increase the equity a bunch, which means I can take less debt, my DSCR looks good, my seller's happy, but I own 29% on a deal where I'm the sole person running it, I found it, I'm the personal guarantor. Am I willing to do that deal?

[Audience]: What percentage of deals are you seeing where the searcher puts in zero equity?

Far less than the majority. Usually searchers are putting in some dollars. Some lenders require it, some don't. A lot of investors like to see the searcher put in some dollars that are at least meaningful to the searcher.

[Audience]: Closing in a couple of weeks on a $10 million acquisition, the searcher equity is $40K and they take 70% of the business.

There are situations not solvable by a model. This is one of them because the model doesn't work when you pay five times EBITDA. Exit at 10 times, 35% annual growth every year. Even if you brought the interest rate down to 10%, it's not going to make that much difference at 5x. Even in a world where you put in 28% equity to project cost, this deal is not going to work because it's not good for you and not good for the investors. You need a purchase price decrease.

If you bring this down to $4 million, you don't need 1.5 million of equity to make DSCR work. You can go back to your original 500,000. The lender is completely fine. You're back to owning 71%, and your investors are going to get a 25.7% IRR and a 6x MOIC. They're happy. The only problem is you had to cut your purchase price by a million bucks. That's the game.

We model everything for the full 10 years because of the SBA loan. A big part of IRR and MOIC is an assumption on sale price, which hugely moves the needle. So one of the assumptions you have to make is how does your exit multiple look versus your entry multiple.

[Audience]: On the investor panel, Sawmill said as long as the searcher-now-operator is enjoying operating the business, they'll stay on board. Tony said they need to see five to seven years.

It depends on how they structure their fund and where they raise capital from. Some have an evergreen-type structure. Some are wealthy individuals who might just ride it for 30 years. There are options. Just because the investor wants a liquidity event doesn't mean you have to sell the business. There are mechanisms like put options where the business is then required to buy that out.

This is a great question to ask investors when you're having a call with them. What are your intentions? How long are you okay being in this for? What happens if I decide I want to run for 20 years? As an investor, it's important to be honest about that up front. There are plenty of investors that are happy with either type of deal, but the worst case is if you think investors want to hear one thing, so you say that, do a deal with them, and it's something different. Figure out what you want, what your vision is for your involvement in the business, when you want to exit if you want to exit, and then go find investors that share your vision. Like a prenup, have all these conversations up front to make sure you're marrying the right people.

[Audience]: How do you assess salary?

Like most of the economics in the deal, generally you propose the economics to your investors. There will become a point when you go to raise, they're going to ask you what kind of salary do you want to take. Are you going to have a bonus? Is it mechanistic or discretionary? If discretionary, do the investors get to consent to it? Can you raise your salary without the investors' consent? All these things go into the negotiation, but generally don't wait for them to tell you. It's your job to propose to them. It will also impact the debt service coverage ratio. It will reduce the cash flow pro forma the business has.

We've barely scratched the surface of what we cover in bootcamp. Things like how much excess cash you put in that little bucket could be a much longer topic on working capital. We've seen a lot of people come through, over 300 alumni now, and we craft our entire curriculum around all of the pain that you go through trying to source, diligence, close, and get a deal all the way done.