• 095 03/23/2020

    The objective of this article is not to present a detailed modeling exercise. The process described is intended to help develop a hypothetical framework to facilitate making difficult, but critical decisions in an uncertain time. Because it would be impossible to write an article that applies to businesses individually, this article is intended for general information purposes only. 

    Modeling a Crisis (Link to Template)
    When crisis strikes two areas require immediate analysis. The company’s ability to control its cost structure, and the company’s access to liquidity. Once you have an understanding of these two variables you can begin to explore the degree to which the business can tolerate a decline in revenue. The time available to perform this exercise is related to the company’s liquidity. 
    Regardless of the financial discipline exercised leading up to the crisis, every potential source of liquidity should be evaluated as part of this process. For most small businesses the immediate areas to explore would be as follows:
    1. Undrawn capacity under the company’s letter of credit.
    2. Relief from lenders.
    3. Relief from landlords.
    Working capital accounts and cash management practices should also be evaluated. A straightforward example would include an analysis of the company’s accounts receivable balance by account. If customers are likely to be impacted by the crisis as well, they may delay or refuse payment to maintain their own cash balances. 
    It also helps to be mindful of the fact that aggregate cash across the company’s bank accounts is not likely to accurately represent cash available. Beyond the deposits in transit, a company’s unique cash management practices should be scrutinized. I once overheard a private equity colleague use the term “drawer checks” to refer to the balance of cash represented by checks that had been signed but not sent. It has been my experience working with junior team members that the mechanical and automatic response spreadsheets have to inputs is often assumed to mirror human interaction in a business. But nothing could be further from the truth. It is entirely possible to find a drawer full of checks representing balances due with no corresponding impact to cash reflected.
    At the conclusion of this process hopefully the outcome is that available liquidity will cover several months of expenses, and that combined with current revenue the business can survive for the next twelve months. The next step is to thoroughly evaluate each expense by line item because this time horizon will shrink as revenue continues to decline. 
    Cost Structure:
    In many financial models revenues and expenses decline simultaneously in the same period, but the reality is that it is very difficult to cut expenses gradually as revenues decline. Imagine working in an environment where colleagues are let go every week. Employee confidence would evaporate, and morale would drop. The desire to measure the impact of declining revenues with an unknown time horizon before acting can further extend the lag between declining revenue and expense reduction. In discussions with managers and from my own personal experience, the desired approach when cuts are necessary is to make one difficult decision and then announce that it was the only cut required to right-size the business for the anticipated decline (and hope you are right). 
    A sad reality is that in the event of a macro crisis such as this one, an employer may have more flexibility with these decisions because employees have fewer options available to them and are less likely to leave. That said, I would argue that the effort should be focused on right-sizing the businesses in the fewest number of announced reductions possible. The process should follow a strategic plan developed by thoroughly evaluating each line item on your income statement in as much detail as possible. Anything that the business can do without should be marked, and everything within the cost structure should be identified as either fixed or variable (does it fluctuate with revenue or not?). 
    [Note: A big part of this exercise is identifying employees that can manage multiple roles. It is very likely that you will not have the luxury of specialization across roles if the business contracts significantly.]
    Beyond the income statement, the company’s capital expenditures should be evaluated. To the degree that any capital expenditures can be postponed, they most likely should be. If not, can maintenance be substituted for any upgrades that would otherwise be required? Through whatever means possible, the purchase of new equipment should most likely be delayed.
    As it relates to personnel, the senior management is often overlooked in this process. At a private equity controlled entity it is common practice to ask the management team to take a pay cut when the company’s performance is suffering. I would encourage founder-owned businesses to take a similar approach. My advice to CEOs would be to meet individually with the team members that the company could not do without and express the need for savings and the desire to temporarily reduce executive salaries for the duration of the crisis. If these individuals commit to the plan, then it can be circulated to the team at large.  
    In summary, you should now have the following items identified:
    1. The pay cut senior management is willing to accept until the business recovers.
    2. Every current expense that the company could do without.
    3. Whether or not an expense is fixed or variable.
    4. Required capital expenditures (if any).
    How Much of a Decline Can the Business Tolerate: 
    As it relates to modeling a decline in revenue there should be two objectives at a minimum: (1) estimating what the senior management team anticipates, and (2) exploring what the business can tolerate. To begin, input a year of historical revenue data (by segment if available) on a monthly basis and then straight-line revenue across the top of your model for a projected period of 12 months. The next step is to include all expenses in as much detail as possible on a monthly basis in the corresponding periods under revenue. Expenses previously marked as “variable” should be projected as a percentage of revenue, and expenses previously marked as “fixed” should be straight-lined across the projected period. (Video: Fixed, Variable & Semi-Variable Cost Structure.)
    Once you have this construct in place you can reduce revenue to determine the point at which the business runs out of cash. When you find this limit eliminate expense line items that the company can do without, and then repeat the process. After a few iterations of this process a hypothetical new lean cost structure and an approximation of the business’s breakeven revenue run rate should present themselves. 
    This information should help inform the cuts that are required and the timing of these cuts. It will also provide a floor to be aware of. If the senior management believes that actual revenue could drop to the breakeven revenue run rate in the model, it would be prudent to explore potential capital partners immediately. If the business has previously raised capital this might be a simple exercise, but if this is a new process it should be explored immediately. 
    Concluding Thoughts:
    I really want to emphasize two items. The first is that this cannot be an outsourced exercise. Identifying what is critical to the business, which employees are indispensable and which employees can juggle multiple responsibilities will be difficult (or impossible) for an outsider. The knowledge of the executive team will vastly outweigh a stranger’s spreadsheet skills set no matter how much of an Excel nerd they are (that said, working with an Excel nerd is highly encouraged).
    Second: If the management team believes that revenue might approach the breakeven revenue run rate at any point in the future, then someone should be put in charge of interfacing with potential capital partners immediately. An entity that has not previously raised capital is unlikely to find a capital partner than can transact in under 30 days and most prefer 90 days. Don’t be intimidated by the process and try to create dialogue with multiple parties. 
    This was a difficult process to summarize in one article. I reached out to approximately a dozen friends that are successful professionals and feedback varied between two groups in particular. Private equity and investment professionals responded with suggestions for more detail, and entrepreneurs largely responded suggesting that it be reduced or broken down into segments. After a few rounds of edits I thought it would be best to get it out there and initiate dialogue. I hope readers find it helpful.
    If you are reading this and have additional insights, thoughts or questions, please feel free to respond via the contact page



  • 094 03/03/2020

    Purchase price, in the context of an acquisition, is not as simple as it might otherwise sound. To arrive at the purchase price for a target company the parties involved must first agree on the value of the company. This value will then be defined in the definitions of a stock purchase agreement as something similar to Base Purchase Price or Initial Purchase Price. 

    Using Base Purchase Price for the purposes of this example, a series of adjustments must then typically be made to arrive at Purchase Price. This is largely because most transactions are contemplated on a cash-free, debt-free basis, and because it is impossible to accurately measure net working capital in advance of or on the date of the transaction. 
    Consequently, to arrive at Purchase Price the Base Purchase Price needs to be adjusted for the following:
    1. the amount of cash on the balance sheet;
    2. indebtedness (to be defined later in this post);
    3. working capital;
    4. and transaction expenses.
    Items (1) and (2) above, adjust the Base Purchase price for a cash-free, debt-free transaction. This means that the Seller is entitled to the cash on the balance sheet on the date of the transaction, and that the Seller is responsible for debts owed by the company (defined as Indebtedness). Item (3) is addressed in a post titled The Working Capital Adjustment in a Purchase Agreement. And item (4) is included to make sure that the Buyer is responsible for the fees and expenses associated with the transaction.
    In summary, to arrive at Purchase Price the following adjustment are made:
    1. the Base Purchase Price;
    2. plus Cash;
    3. minus Indebtedness;
    4. plus the amount by which Net Working Capital is greater than the Net Working Capital Target;
    5. minus the amount by which Net Working Capital is less than the Net Working Capital Target;
    6. minus the Transaction Expenses.
    In a purchase agreement all of the capitalized words in the bullets above require definitions. The definition for Indebtedness frequently covers half a page or more (we have included an abbreviated definition). To visualize how the definitions and the calculation of purchase price come together we have included a summarized example on the pages that follow. 
    Stock Purchase Agreement Language:
    The download associated with this post contains hypothetical language detailing the above sequence as it might appear in a stock purchase agreement. Download PDF File.

  • 093 02/19/2020

    The working capital adjustment in a stock purchase agreement can have a direct impact on the price paid for the business. Given that price is arguably the most important variable in a transaction, and that the working capital adjustment can impact price, it follows that the working capital adjustment deserves special attention. (PDF Document) 

    This adjustment is required because it is impossible to know what a company’s working capital will be on a future date (specifically the date of the sale). It can take a business anywhere between a couple of weeks to a couple of months to close its books, making this an adjustment that can only take place after the transaction has closed.
    Sequence for the Working Capital Adjustment: 
    On the date of the transaction, the Buyer will pay to Sellers an initial purchase price, which is subject to an adjustment for working capital (note: additional adjustments can be included, but this post will focus solely on the working capital adjustment). The initial purchase price will include an estimate for working capital for the transaction date (Target Working Capital). 
    Between 60 and 120 days after the closing date, the Buyer will then deliver a statement to Sellers with their calculation of working capital (Final Working Capital). If all parties agree that the calculation is accurate then an adjustment will be made as follows.
    1. If the Final Working Capital is greater than the Target Working Capital (Excess Amount), then Buyer shall pay directly to Sellers an amount equal to the Excess Amount, and Buyer and Sellers shall promptly deliver a joint written instruction letter to the Escrow Agent to release all funds in the Working Capital Escrow Account to Sellers.
    2. If the Final Working Capital is less than the Target Working Capital (Shortfall Amount), then Buyer and Sellers shall deliver a joint written instruction letter to the Escrow Agent to release an amount equal to the Shortfall Amount from the Working Capital Escrow Account.
    Example to Provide Context:
    When a healthy business is acquired, the purchase price is generally based on a multiple of earnings (commonly EBITDA). What the purchase price assumes, among other things, is that the business will have adequate working capital on the date it is acquired to maintain this level of earnings.
    For a simple example, let's eliminate all working capital accounts with the exception of inventory. Assume that you acquire a business that uses raw materials (a component of inventory) to sell a finished good. Post acquisition you learn that the business does not have any inventory. This is an extreme example that would hopefully never occur because you followed a proper due diligence plan, but it helps communicate the need to adequately measure working capital accounts. Without raw materials production would halt and you would have to use cash to purchase the amount of inventory required to continue operating. The working capital adjustment in a stock purchase agreement secures this cash from the sellers so that the buyer is made whole. 
    In other words, the working capital adjustment makes sure that the buyer receives a historically normalized level of working capital at closing so that the business can be operated as it was prior to the transaction.
    Stock Purchase Agreement Language:
    The linked document contains hypothetical language detailing the above sequence as it might appear in a stock purchase agreement.  


Models are:
A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above



*Answers a, b, c, d, e, f and g are all correct.