• 112 12/31/2020

    In this post we are including a personal budget template and a "watch-me-build-it" tutorial video that explains how the template works. Please see the video below for more detail.

    This is an exercise I have worked through every year since I was 25 years old. At the time my father told me that as it relates to financial performance, he believed data tracked generally tended to improve over time. He was a lifetime investor (and absolute nerd :) that focused most of his career on private equity. In his opinion, the scrutiny applied to personal finances should mirror the scrutiny applied to a new investment. 

    So early in my career he encouraged me to create a balance sheet to track personal assets on a quarterly basis. It felt like a silly exercise because I only had a checking account and a savings account at the time, and building a spreadsheet with just two entries felt dumb. Fortunately, I recognized that he was much smarter than I was, so I went along with it.

    What I started to notice, however, was that the quarterly practice started to change my behavior. I wanted to show an increase in each quarter, which required a thorough understanding of my expenses. So I developed the personal budget template associated with this post to better understand where my cash was going. Awareness encouraged a more frugal mindset, and my savings as a % of my earnings started to increase.

    The change was simple. Instead of looking at cash as a resource to support my lifestyle, I started thinking about keeping the value of that cash on my balance sheet. If I received a large bonus, for example, I would weigh an increase in rent against the decision to purchase a condominium. The condominium, purchased at an attractive price, would cause my balance sheet to grow over time whereas an increase in rent would cause my balance sheet to shrink in each subsequent period (all other variables held constant). 

    This practice also gave me the confidence I required to leave my full-time position in private equity to pursue building ASimpleModel.com in 2020. And it is in that vein that I wanted to share this post. If you are contemplating a change in 2021, make it an informed decision. This template can be used to evaluate what is possible, or to simply identify potential savings should you want to improve your financial cushion.

    All the best in 2021!


    Post Script: Should you want to develop the Excel skill set demonstrated during the "formatting blitz" portion of the video, please visit the Excel for Models course.   

     

 



  • 111 12/23/2020

    Seasonality can have a drastic impact on the amount of working capital required to run a business, which is why it is frequently cited as one of the primary revenue-related challenges in negotiating the working capital adjustment in a private equity transaction (aka “the working capital peg”). To help give this concept some teeth, in this post we will use visuals to explore how seasonality impacts the liquidity required to maintain a business. 

    To emphasize this point, imagine that you have an opportunity to buy one of two businesses. In this hypothetical scenario, both companies generate $10 million of profit selling 1 million pool floats per year at a price of $30 dollars each. Financially, everything about these two businesses is identical apart from monthly sales volumes and the liquidity required to support these volumes. In other words, the primary discrepancy relates to seasonality.

    High Seasonality Example

    In the first example we will assume that the busines is located in Texas, and that all of the company’s customers are also located in Texas. Texas is notoriously hot during the summer months, so it would be practical to assume that the company’s sales ramp in anticipation of the heat and that sales peak sometime in summer (please see chart). 

    Working Capital High Seasonality

    The management team of this company, being fully aware of the company’s revenue cycle, significantly increases inventory purchases early in the year. By June of each year this company has all the inventory it will require for the summer season. During these summer months, sales increase, inventory is sold off and the company generates cash. 

    The challenge is that such a ramp in working capital requires cash to accommodate both inventory purchases in advance of sales and the delay of cash receipts from accounts receivable. In the image that follows the chart has been updated to include cash.

    Working Capital High Seasonality

    From the chart above it is obvious that the company made a profit selling pool floats because it has substantially more cash after the selling season, but what you will also notice is that the company nearly ran out of cash attempting to fund the growth of inventory and accounts receivable. Had sales spiked more abruptly, the $15 million cash balance that the company started the season with would have been insufficient. It is a little counterintuitive, but strong growth can bankrupt a company with positive net working capital.

    Low Seasonality Example 

    If you were to take the exact same annual sales but reduce the seasonality, the outcome is wildly different. It is in fact quite obvious from the chart that the amount of cash on the balance sheet is no longer necessary. In this new scenario, with the exact same number of units sold at precisely the same profit as before, cash does not drop below $11 million (please see chart). 

    Working Capital Low Seasonality

    To reiterate, in both scenarios the company makes $10 million of profit selling 1 million pool floats at an average price of $30 dollars each. But this “low seasonality” business, which clearly operates in a fantastic geography where people buy pool floats year-round, requires substantially less liquidity to achieve the same economic result. In fact, the highly seasonal business requires more than 3 times the amount of liquidity to make the same amount of profit!

    The best way I have found to communicate the value of this discrepancy to an entrepreneur or CEO is to ask them to imagine that they own the business in its entirety (some of them already do); and then explain that if they can find a way to reduce seasonality the difference in liquidity can be transferred from the company’s balance sheet to the owner’s bank account. 

    For more information on the working capital peg in a private equity transaction please see the course titled "Working Capital Adjustment Process" (Subscriber Content).

    Related Video: Introduction to the Working Capital Adjustment 

     

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  • 110 12/08/2020

    Private equity due diligence has been traditionally taught with a focus on commercial, financial and legal due diligence. But you will not find a single investor that will downplay the role of management in an operating business, and while information technology (IT) may have been viewed largely as a support function historically, it is increasingly viewed as a driver of growth and value within an organization. For these reasons in this post we will address management due diligence and IT due diligence as well.

    Private Equity Due Diligence

    (click on the image to expand view)

    Author’s Note: When I first started working in M&A, IT due diligence was frequently grouped under financial due diligence because IT infrastructure supported financial reporting. From the time I transitioned to private equity in 2009, I rarely saw a due diligence process that did not require a separate third party to perform IT due diligence.  

    At a more macro level, private equity due diligence should also be divided between confirmatory due diligence and exploratory due diligence. Most exploratory due diligence is focused on commercial and management due diligence, which per the image is where the private equity firm will be most directly involved. At this stage, the investment team is exploring the opportunity as though the information provided is accurate. The objective is to develop the confidence to move forward before engaging third parties to confirm the assumptions supporting the team’s investment thesis. 
     
    Confirmatory due diligence is expensive. It involves validating the assumptions supporting the investment thesis, and generally requires engaging third-party specialists. While three of the categories above are exclusively labeled “confirmatory due diligence,” it is possible that all five categories will involve some amount of confirmatory due diligence. With respect to commercial due diligence, and by way of example, a private equity firm can hire a third party to perform industry analysis (see video below) or to perform a customer survey. Some private equity firms, especially those with a strong industry focus may not find this necessary because they have this expertise in house. As it relates to management due diligence, however, in any process it would be irresponsible not to engage a third party to run background checks on the management team. 
     

     
    Due diligence can be highly unpredictable. It is impossible to know everything that will be uncovered in advance, and the time allotted is generally insufficient. Close enough transactions and you are likely to be surprised by findings post close. As such you can only hope to be as thorough as possible in the time available. In the text that follows we will address each of the five topics in summary format. Don’t be intimidated by vocabulary, what follows is simply a description of a highly detailed checklist.
     
    Commercial Due Diligence
    Commercial due diligence is the process of evaluating a target company’s commercial activity and estimating its potential in the future. This requires both a thorough understanding of how the company operates and the industry in which it does. The list that follows provides a high-level summary of areas to focus on as part of this process. 
    1. Market Position
    2. Industry Growth & Landscape 
    3. Customer and Supplier Base 
    4. Financial Performance 
    5. Capital Intensity 
    Management Due Diligence
    In due diligence you should take every opportunity to engage with the management team and get to know them. On this front it is impossible to be sufficiently thorough. In addition to personal interaction and Q&A sessions, the sponsor should also hire a third party to perform background checks.

    Pro Tip: I worked with a CEO that in addition to running background checks had a handful of additional data points that he liked to collect for any important hire. A simple but effective data point he developed was to compare the salary the hire claimed to be earning and the salary being offered to the value of the home listed on Zillow for the address on the CV. He would not hire anyone for a role with P&L responsibility if the salary did not comfortably support the value of the home. 

    Financial Due Diligence
    Financial due diligence is focused on confirming the financial performance of the business as it has been presented. This may be confusing because financial performance is included under commercial due diligence as well, but the focus here is on the detail supporting the financial information evaluated in commercial due diligence. By way of example, and in addition to the financial statements listed above, this requires looking at supporting schedules, trial balances, bank statements and audits.
     
    You may have heard that valuation is as much art as it is science. In that context another way to explain the difference is that financial due diligence is the science-heavy component of financial due diligence. Before you can begin to confirm assumptions about how the company operates and develop confidence in projections, you need to know that the data used to create this projection is solid. 
     
    Legal Due Diligence 
    Legal due diligence is largely comprised of “confirmatory” due diligence, which is to say that at this stage the buyer should be highly confident of their decision to move forward absent any new material findings. To confirm assumptions made by the buyer to arrive at valuation, and to confirm that the company is not exposed to large unknown liabilities, the company’s structure and compliance with all laws and regulatory frameworks must be thoroughly evaluated. In the Legal Due Diligence lesson we will explore this process in detail by covering each of the topics that follow:
    1. General Corporate Information
    2. Governmental and Regulatory Documents
    3. Financial Documents
    4. Litigation Documents
    5. Business Contracts
    6. Real Estate and Tangible Assets
    7. Environmental
    8. Employee Compensation and Benefit Documents
    9. Intellectual Property
    10. Tax Matters
    11. Insurance
    Technology and IT Due Diligence
    On the subject of IT due diligence and IT infrastructure more specifically, variations in technology and levels of sophistication between businesses makes it difficult to apply a standardized process (as with much of private equity). That said, for any business dependent on technology the systems supported by IT infrastructure should be evaluated for the following three items: (1) Current Capability, (2) Capacity to Scale, and (3) Risk (Security). To develop an opinion on these three topics, the following items should be thoroughly evaluated:
    1. Enterprise Applications (e.g. Enterprise Resource Planning (ERP), Supply Chain Management (SCM), Customer Relationship Management (CRM))
    2. Network Infrastructure (A diagram should be included.)
    3. IT Staff and Org Chart
    4. List all Hardware and Software
    5. Cyber and Network Security
    6. Backup and Recovery
    7. Training (This applies to IT staff, but also to end users. Increasingly firms have in-house cybersecurity training programs.)
    While not a comprehensive list, this should provide an idea of some important areas of focus. Increasingly all firms will have a strong technology component to them, and as more software solutions are built for businesses, it will become an ever more important area of due diligence.
     
    This content is a highly summarized version of a more comprehensive lesson available as part of the Private Equity Training curriculum. Please click on the image below to learn more. (Note: related content available as part of the Preliminary Due Diligence and Closing the Transaction courses.

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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.