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Predictive Analytics for Your Business Cash-Flow Forecasting

By Mark Taffet & Wolfgang Tsoutsouris

CEOs set a goal, develop strategies to achieve it and undertake tactical implementation.

How do you know if you can “fund the plan”?  How do you know if you have the capital to really “play to win”?

One source of capital to “fund the plan” is your company’s ability to access the private capital markets; a topic we’ve addressed in prior blogs.

A second source requires you to be a visionary and understand how much cash your company will produce that can be reinvested to “fund the plan”. Fortunately, you have a crystal ball at your disposal: Your cash flow forecast.

An effective cash flow forecast ties into your company’s operating plan and budget, telling you what your cash position will be at any point during the projected period (usually 9 – 12 months). Understanding your free cash flow and ability to raise capital will give you a realistic and reasonably precise picture of your total funding capability.

Creating a cash flow forecast requires that you and your team determine the cost of the tactical implementation of your strategic plan. It requires rigorous dialogue where your teammates make and challenge assumptions. The discussions will explore how daily execution ties to the broader strategy. They will involve measures against KPI’s – past successes and failures, improvements and shortfalls. The degree to which you and your team understand your business machine will be evident in those assumptions that survive to the final forecast model. An effective cash flow forecast helps to determine your company’s ability to:

  • make an acquisition,
  • invest in equipment or technology,
  • measure team performance,
  • guide tax strategy, and
  • fulfill hiring needs

With foreknowledge of your cash position, you can present funding requirements to lenders and investors. You can then layer in those actions and financing assumptions as a “scenario” in your cash flow model.

What if your assumptions are incorrect? After finalizing your cash flow projections, you carefully track actual performance to the forecast on a weekly, monthly and quarterly basis. If the cash flow forecast is your crystal ball, the Budget-to-Actuals Report (“Variance Report”) is both your report card and your thermometer. The Variance Report tells you:

  • the accuracy of your assumptions,
  • how your team has performed vs. KPIs, and
  • what tactics/strategies are (or are not) working.

Your Variance Report provides an early warning for where your attention is required, re-allocation of resources and/or a re-prioritization of strategies might be necessary.

The Variance Report creates an irrefutable record which measures the performance of you and your team.  If variances are recognized, acknowledged and discussed in a frank manner, you can change course rapidly, creating a culture that is nimble, evolving and dynamic; driven by data and analysis and focused on achieving your goal.

The frequency of the budgeting process varies depending on the nature and volatility of your business and industry, but the review of actual performance vs projections should be ongoing. Problems are often unexpected and you need to find them before they find you.

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Mark Taffet is CEO and Wolfgang Tsoutsouris a Director at MAST Advisors, Inc., an M&A and strategic advisory firm focused on maximizing value for middle-market companies.

Securities offered through SPP Capital Partners, LLC: 550 5th Ave., 12th Floor, New York, NY 10036. Member FINRA/SIPC

 

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Funding Your Company’s Organic Growth Plan

Step 1 in developing a strategic growth plan for your company is determining the scale and scope of its market opportunity. Expansion may come from taking market share away from competitors, participating in overall market growth, innovating superior customer solutions, geographic expansion or through other channels.

Step 2 in developing a strategic growth plan for your company is understanding how much investment you can fund. It’s great to have a fantastic plan, but if you cannot fund it, it cannot be implemented.

If you are not aware of what funding is available to your company, you may materially underutilize its resources and capabilities. If you agree that a CEO’s job is maximizing value for all stakeholders, underutilizing your company’s resources and capabilities must be avoided.

CEOs often believe that funds available for organic growth equals free cash flow and what a commercial bank will lend against tangible assets such as receivables, inventory and equipment. For successful “asset light” businesses, this is an untrue limiting belief.

As described in previous articles, approximately 40% of US institutional corporate lenders make lending decisions on the quality of a company’s cash flow rather than the liquidation value of tangible assets. The CEO of a company with $5 million in EBITDA, $5 million in receivables and $5 million in inventory may believe that their borrowing capacity is $6-$8 million, when in fact it might be $12-$20 million. This capital availability is in addition to your company’s free cash flow.

If your business has significant, realistic growth potential, a practical plan for addressing the market and a management team capable of implementing the plan, why be limited by a false belief that you cannot fund the plan? If your ROI is projected to be 2x or more than your cost of capital, why would you not put capital to work to make your company more competitive and profitable?

Based on the fact pattern above, let’s assume that a company has 1x EBITDA for a working capital revolving line of credit.   Further assume the business can invest $1.5 mil in annual free cash flow. If you only consider asset based loans from commercial banks, it will be difficult to invest more than free cash flow and perhaps $1 million from an asset based borrowing facility.

That same company can go to an institutional cash flow lender and potentially arrange a $15 mil to $20 mil credit facility, including a $5 mil revolver. Let’s assume you do not want to fully extend the company but are willing to access debt of $12 million: $5 mil for your revolver and a $7 mil term loan to fund growth. Your company will invest $1.5 mil from free cash flow in each of two years and draw $3.5 mil on its term in each of two years to fund a growth plan.

Over a two year period, the company will have $5 million available for working capital and an additional $10 million to invest in growth. For this example, let’s assume that:

  • Interest on all debt is 7%
  • Mandatory amortization for the term loan is 5% of principal plus 50% of available free cash flow
  • The company’s $5 mil baseline EBITDA has no growth
  • EBITDA generated by new investment has no return the year it is made, 15% ROI the following year and grows 15% annually thereafter

In this scenario, the company’s Debt to EBITDA ratio rises from 1-1 to 2.4-1 at the beginning of year 1: with $3 mil to $8 mil of additional borrowing capacity. It will rapidly de-lever through both debt amortization and increasing EBITDA. This can be seen in the chart below:

Funding Your Company's Organic Growth | MAST Advisors

In this scenario, your company’s Debt/EBITDA ratio falls to 2-1 by the end of year 1 and 1.4-1 by the end of year 2. Thereafter, EBITDA growth brings the company’s remaining working capital debt below the original 1-1.

Importantly, even with the reinvestment of cash flow and debt amortization, the company is still able to maintain moderate distributions to shareholders in years 1 & 2, with substantial increases in distributions in years 3-5.

Perhaps most significant, implementing the strategic growth plan will increase the profitability and competitiveness of your company. Those trends most often result in a substantial increase in the value of your business that can equal an additional 1x-3x EBITDA. In this example, the original company might be valued at 7x EBITDA, or $35 million. After growing from $5 mil to $7 mil in EBITDA, that value might be 8x EBITDA or $56 million.

If your company has the opportunity and ability to achieve significant growth and you as CEO want to maximize value for stakeholders, understanding the amount of capital that can be deployed to implement a well-structured strategic growth plan is a fundamental aspect to success.

If you have any questions, please reach out to me at mtaffet@mastadvisors.com.

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Mark Taffet is CEO of Mast Advisors, Inc., an M&A and strategic advisory firm focused on maximizing value for middle-market companies. Information regarding specific aspects of the private capital markets has been provided by SPP Capital Partners, an investment bank focused on raising funds in the private capital markets.

Securities offered through SPP Capital Partners, LLC: 550 5th Ave., 12th Floor, New York, NY 10036. Member FINRA/SIPC

 

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Cashing In Without Cashing Out: Dividend-Levered Recapitalizations

You own and run a successful company.

You feel strongly that your company will do well, grow and increase in value.

You want to continue to run your business and don’t want or need any, or any more partners.

The company is worth a lot. It may represent 60%-90% of your net worth.

Even though your company is doing well and has rosy prospects, there is always the possibility that things will go wrong and your business will falter.

Having the majority of your wealth tied to a single asset creates great risk. You wonder, “How do I mitigate that risk while continuing to own and run my company?”

A most efficient way to mitigate your risk of wealth concentration is to do a dividend levered recapitalization.

This uses the same financial engineering that private equity firms employ. The difference is that you can:

  • Maintain your existing ownership position
  • Take almost as much capital out of your company as you would in a PE deal
  • Maintain management control and continuity
  • Avoid the fees PE firms charge and disruption they can create

An example of how a levered recap mitigates your risk of wealth concentration in your business might go as follows:

  • Your company has EBITDA of $5 million
  • The Company borrows $20 million – 4x EBITDA – on a NON-RECOURSE basis
  • $5 million remains with the business for working capital
  • $14 million is paid out to you as a dividend, with ~$1 mil paid in fees & expenses to the various parties to the transaction
  • Your cost of capital in today’s market will be 6%-7% above LIBOR
  • The multiple of EBITDA and interest rates available improve as EBITDA grows

The $14 million you take as a dividend will generally have significant tax advantages vs. receiving annual profit-sharing at ordinary income rates.

You and your family have greater financial security if anything should happen to your business.

What happens to your company? Isn’t the risk to the business increased?

The answer is, not really.

Management hasn’t changed and the company has adequate working capital to continue to grow and thrive. After taking the dividend out of your company, debt is quickly amortized: not so fast as to eliminate growth investments, but fast enough to “de-lever” your company rapidly.

In the example below, the assumption is that your company’s EBITDA will grow at 10% annually and that you will want to balance debt amortization with growth investments and continued cash distributions to shareholders.

Year 1

Year 2

 Year 3
Company EBITDA $5.0 million $5.5 million $6.0 million
Existing Debt $20.0 million $19.0 million $16 million
Amortization – Scheduled $1.0 million (5%) $1.0 million (5%) $1.0 million (5%)
Remaining EBITDA $4.0 million $4.6 million $5.2 million
Amortization – ECF Sweep

(see note below)

 NA $2.0 million (~50% After Tax Cash Flow) $2.2 million (~50% After Tax Cash Flow)
Ending Debt $19.0 million $16.0 million $12.8 million
Ending Total Leverage 3.80x 2.90x 2.13x

 

This example demonstrates that by year 2 after the dividend, shareholders can again begin to take distributions from the company, and that the ratio of debt to EBITDA reduces from 4x EBITDA to begin to 2.9x at the end of year two, and 2.13x at the end of year three. Please remember that 1x EBITDA is your working capital line.

2.9x EBITDA – 2.13x EBITDA do not represent a high leverage ratios that should create risk to your business.

In years 2 & 3 after required debt amortization, you have the option to apply the second 50% of after tax cash flow to distributions to shareholders, further balancing your wealth portfolio. You may also apply those funds to growth initiatives.

An alternate path is to apply those funds to faster debt amortization. If this tact is taken, ending debt at the end of year two will be $14 mil – 2.55x EBITDA. At the end of year 3, ending debt will be $10.6 mil – 1.77x EBITDA; a conservative level.

It is important to re-iterate that a dividend recap is a RISK MITIGATION STRATEGY for balancing your wealth between your company and personal holdings.

The borrowings described above are NON-RECOURSE to you. Should something go wrong in your business, you and your family have – in this example – $14 million more held outside your business to mitigate risk to your personal wealth.

This article covers a lot of ground quickly and may leave you with more questions than answers. If you do have questions, please contact Mark Taffet at mtaffet@mastadvisors.com

 

 

Mark Taffet is CEO of MAST Advisors, Inc., an M&A and strategic advisory firm focused on maximizing value for middle-market companies. Information regarding specific aspects of the private capital markets has been provided by SPP Capital Partners, an investment bank focused on raising funds in the private capital markets, and an affiliate of MAST

NOTE: Cash payment of Excess Cash Flow (“ECF”) sweep amortization occurs after the yearly audit is completed. ECF is generally defined as EBITDA less the following: (i) capital expenditures for the period; (ii) cash taxes; (iii) principal payments; (iv) cash interest expense; (v) cash management fees; (vi) restricted distributions for each year. ECF is a highly negotiated term of any credit agreement.

 

 

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Maximizing Value in a Corporate Sale: Business Infrastructure

Is your company’s infrastructure adequate to support its current operations? Is it adequate to support your projected growth?

Your company’s infrastructure includes many things. Office, manufacturing and/or warehouse space; IT systems; purchasing and supply chain logistics; administrative functions; and more.

Potential buyers will view your company’s infrastructure as either mitigating or creating risk to your quality of earnings and growth potential.

If your company’s infrastructure is where it needs to be, the business will be more robust and able to take on challenges and growth opportunities. If it is fragile, and barely able to keep up with current operations, then the possibility that something will go wrong (whether or not you sell) skyrockets.

Inadequate infrastructure signals to prospective buyers that there is high risk to quality of earnings and potential for growth. Any prospective buyer will understand that they will have to develop and implement an investment plan to improve the basic assets of your company. This represents additional time and cost, and slows down a buyer’s post-acquisition plans.

Alternatively, having your company’s infrastructure primed, and ready to take on growth opportunities and industry challenges provides assurance to prospective buyers and mitigates their perception of risk.

Company infrastructure is an aspect of your business that you may take for granted; potential buyers won’t. Due diligence will unveil the adequacy of your company’s infrastructure and will be a factor in whether or not you are able to maximize value in a sale.

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Maximizing Value in a Corporate Sale: Obsolescence

If obsolescence issues are present in your business, potential buyers will naturally understand there is increased risk for your quality of earnings and growth potential. One question any good buyer will ask is “are your products/services going to be obsolete in the next 3-5 years?” Smart buyers will not stop there.

With evolution in business accelerating, potential buyers will ask if your products/services will simply be less competitive in the near to mid-term. If they are, risk to quality of earnings and growth potential increases.

Most company’s products/services will not be obsolete in the next five years. Smart CEOs and owners make sure their company is always improving what they deliver to clients and customers.

The area many companies ignore in regard to obsolescence issues involve their business processes:

Are your revenue generation processes becoming obsolete? Sales, marketing, advertising?

Are your financial control and reporting functions keeping up with your company’s growth?

Are you employing financial and operational analytics and business intelligence tools that are becoming standard operational tools for strong businesses?

Is the management team that got your company to where it is the right one to get it to the next level?

Are the production methodologies used for your products/services at a current state of excellence?

The list goes on.

As you examine all aspects of your business, do so with an eye towards competitive analysis. That is what good potential buyers will do in due diligence. The more competitive your products, services and business processes, the greater the likelihood that your company will have high quality of earning and growth potential. Potential buyers will factor that into their valuation.

You can sell your company if there are weaknesses in regard to obsolescence. You will simply not maximize value.

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Maximizing Value In A Corporate Sale: Business Concentration Issues

Having too great a percentage of your company’s revenue from one or two customers creates business concentration risk, a risk to quality of earnings that will be recognized by any potential buyer. Those important clients/customers may simply take their business elsewhere, rapidly eroding the economics of your business. Even the most airtight supply agreement leaves you with some risk.

Similarly, if your business is reliant on one or two key suppliers, the risk of being cut off will be a red flag to any potential acquirer.

Mitigating these risks seems simple, and sometimes is not. If you can obtain additional customers and or suppliers, do so whether or not you are selling your company. If it is simply not possible, maximizing the value of your business may be best realized by consistently distributing out as much cash as possible, rather than seeking a sale. If you do decide to sell, a transaction containing contingent payments – an “earn-out” – may be needed as a risk-sharing mechanism between current shareholders and a buyer.

Customer and supplier concentration are not the only areas where business concentration risk may exist

If one or two salespeople control most of your revenue, risk flags will fly, as they could opt to leave at any time including after a transaction. If one person controls the flow of financial information or your IT infrastructure, risks arise. If decision-making, even on relatively minor matters, is controlled by one person (perhaps you), risks to both quality of earnings and growth potential exist.

Addressing these types of operational concentration issues are within your control as CEO. If you decide against addressing such issues proactively, you may mitigate risk in a number of ways. Providing bonus payments to key people contingent on staying with the company through the transaction process, and alerting the potential buyer that employment agreements should be arranged with key people are two actions that may mitigate these risks.

Your company can be sold if you don’t address concentration issues relating to customers, suppliers and operational functions. The value will simply reflect the risks to quality of earnings and growth. Those risks will be evident to any competent buyer during the due diligence process.

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Maximizing Value in a Corporate Sale: Quality of Strategic Plan

How potential buyers think your company will perform once they own it will determine their valuation.

Your strategic plan is the single best tool for explaining to potential buyers that your company has achieved its current performance due to thoughtful, calculated, well planned and implemented strategies. Your current strategic plan will show potential buyers that the same quality of analysis and thought provides them with a blueprint they can implement that maximizes the likelihood of continued success for your business.

If you don’t provide potential buyers a strategic plan that is clear and coherent, there will be an assumption that luck or you personally are wholly or largely responsible for what your company has achieved and what it might do in the future. Luck and your executive capabilities will be perceived as risk to your company’s future quality of earnings or growth potential under the ownership of a potential buyer.

Many companies small and large, do not have prior or current strategic plans that are clear, coherent and actionable.

All the thinking and information might be in your head, but if it is not written clearly and coherently, other people will not be able to understand it. If this describes your company, putting a plan together will pay off when you move to sell.

If your company does not have a quality strategic plan, it is important to hire an investment banker who will generate one for you. Having your “story” told in a way that potential buyers can understand, and which will stand up to the extreme scrutiny of due diligence, is critical to the process of allowing potential buyers an opportunity to understand why maximum value should be paid for your company.

If you don’t have a quality strategic plan, or an investment banker who can explain your business’s historical and going forward business strategy you can still sell your company. You simply will not get maximum value.

 

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Maximizing Value in a Corporate Sale: Introduction

You are a CEO. You lead a successful business you share numerous qualities with your peers. Among them, being somewhere between bright and “whip-smart”. You turn ideas into reality. Your leadership has a direct impact on your company.

Selling your company will be one of the most important financial events in your life. Maximizing value in that sale is critical to all stakeholders.

You approach me as an investment banker who sells companies and ask “What’s my multiple of – EBITDA or Revenue or Book Value?” How do I get maximum value when I sell? What are you going to do?

Some M&A professionals, your lawyer or accountant would gladly answer those questions.

BUT …. you are taking the wrong approach to maximizing the value of your company in a sale.

The same characteristics that make you a successful CEO will allow you to maximize value in the sale of your company.

As your investment banker, my job is to present your company’s value proposition to appropriate potential buyers in a clear, compelling, accurate manner. This will allow them to perceive its value. From that perception, we can negotiate price and terms. Accuracy is critical: You must assume EVERYTHING will come out in due diligence. If any representations are proven false in due diligence, or material omissions arise, you will undermine credibility on every aspect of negotiations.

This series of articles will demystify the process of maximizing value in the sale of your business and explain how you, as owner and/or CEO, control that outcome.

 

The premise of these articles is that two things determine the value of a business:

  • Quality of Earnings – Is profitability from your core business sustainable?
  • Growth Potential – Whether your market or industry are growing, static, or shrinking, does your company have the ability to grow at an above-average rate; are you better than mediocre.

The next six installments of this series will discuss the most import factors in maximizing the value of your company by creating upside or risk to your company’s quality of earnings and growth potential:

  • Quality of Management
  • Quality of Strategic Planning
  • Business Concentration Issues
  • Obsolescence
  • Business Infrastructure
  • Financial capacity, controls & reporting

All of these factors are controlled by you as owner and CEO.

Tune in in two weeks for our next segment.

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