In The Trenches: Interview with Chris Hutchinson
7:55PM Mar 22, 2022
Chris Hutchinson, welcome to the show.
Thanks, Steve. Great to be here and great to chatting and it's been a long time.
it has indeed, and we are appreciative of your time. And I know that you wear a number of hats within E&Y, one of which is helping buyers perform quality of earnings analyses when contemplating the acquisition of a company or companies. So I want to start there, and I want to start really, really basic, and then we'll work our way up. So to begin with, maybe you can explain to us what is quality of earnings analysis? And maybe by extension, what is it not?
Sure, that's a good question, and one that we're used to answering because it comes up a lot, I think the best way to frame it and kind of compare it to an audit in a lot of ways. So an audit is usually focused on, or not usually. it is focused on historical results and whether or not they're reported in accordance with GAAP, and their material materially accurate. Equality of earnings is really about, you know, analyzing the historical results of the business. But the focus of the quality of earnings is to help the buyer and lenders that may be lending to the deal. Understand what's the sustainable level of earnings for this business? What are some of the key risk factors and opportunities with this business?
And you're kind of using that historical look at the results, to kind of come up with slash confirm a thesis about what should this business generate going forward. And when you compare that to an audit, you know, an audit is not going to comment other than a going concern note, because they think that the company's about to, you know, may not be able to pay its debts. The audit is not going to differentiate between revenue earned from a customer that just gave notification that they're going away, and you're losing 25% of your business, from a customer that's going to keep going year after year. So it's really about what the output is, and what the kind of thesis of doing the work is about.
Now, in performing Qof E analyses on small private companies, what percentage of the time just roughly, would you estimate that you are working on the basis of audited versus on audited financial statements?
I would say that there's probably at least half the time we're working with unaudited, I'd say it's probably closer to 75%, in the kind of the call it, you know, EBITA sub five sub $10 million in that range, it's probably 75% of the time where it's not an audit. Now, probably half of that group is situations where there's reviewed financial statements, which is, you know, it's not an audit, but it's not nothing, there's some assurance given. And there's an opinion, given, but the level of work is is different than than an audit.
So for the 25% or so that are audited, how frequently do you come across buyers that skip the quality of earnings analysis, because the financial statements are audited? Because in light of what you just said, it strikes me as logical that an audit and equality of earnings will produce different pieces of output that produces different pieces of intelligence for the buyer. So do you ever come across situations where a buyer says, Hey, these are audited? We actually don't need to perform a Q of E? And if so, how do you respond to or react to those types of questions or statements?
Yeah, so I think usually, we don't see that I think, when we're doing quality earnings, what we're really doing is assessing the risk levels in different parts of the business and the risk levels with the underlying reporting. And so when you've got a quality of earnings, or sorry, when you have an audit done and you know, once you've got a chance to actually look at the Working Papers, you can confirm that things were done the way you'd expect them to be done. It just gives everybody a little more comfort, and you're less likely to find a lot of problems with the way that the company does their accounting. And that doesn't mean that you know when you need to look at the trailing 12 months to the seventh month of the year for this company. Just because they're audited at your end does not mean that those internal kind of last seven months will be accurate.
But it certainly gives you a better proxy of figuring out some of the basic problems that may or may have already been identified by an audit. We don't see many companies skip the quality of earnings process. simply because a lot of a lot of companies or or a lot of buyers are using debt, which lenders are less likely to go along with something that doesn't have a quality of earnings report. And on top of that, I think people just unless they really know the business, so maybe it's a big strategic that, you know, they've got 20 Different businesses in this space. They know what they're getting, they're really just buying it for the technology of the customers. Okay, maybe they can live without it. And there's a reason why they just want to rush through the deal. But I don't often find that we have that. That question or that debate, because most people do understand the value that comes out of it. And again, if they're trying to get financing, most of the time the lenders are going to require it.
And in terms of lenders willing to lend against transactions that either do or don't have quality of earnings, particularly in the lower middle market, let's somewhat arbitrarily define that as $3 million of EBITDA or less. Does their willingness to lend against an opportunity like that depend on whether the business in question is more cashflow oriented, as opposed to more like hard asset oriented? Said another way, if this is a business with a lot of hard assets that can represent collateral in the eyes of the lender? Would they be more willing to lend against a company like that in the absence of quality of earnings? Are we saying that, hey, these businesses are so small, most lenders in good standing essentially require one to be performed?
Yeah, I would say your base your Skete banks that are doing lending like that, even if they can see that they have security and have a way out of the deal, so to speak, in a bad case, they don't want to get into deals where the cash flow isn't gonna support the loan. So even in a case where they would say, oh, yeah, we've got a lot of good underlying assets here. If they don't have a quality of earnings, then they're going to be very concerned about that ability to meet the requirements of, of doing the repayments on the loan. So for the most part, again, there's exceptions, where, if it's, we're talking like it's more of a real estate deal, or things like that, then maybe there's a nuance, but I wouldn't say that I've seen many, Skete bank, Canadian lenders who are willing to take a flyer on on the cash flow without a quality of earnings. And again, there's always exceptions to the rule. And sometimes that's just, okay, this is a big customer of the bank. And we're going to get some backstop from the parent co. or things like that, but otherwise, it's pretty much a requirement.
Okay, let's go on to what I am sure is one of your favorite topics, which is managing costs. And speaking from experience, I mean, acquirers of all shapes and sizes are understandably interested in managing their costs. They're hesitant to spend too much money on advisors too early in their due diligence processes, because of course, that's where the real money is expended. But on the other hand, the Q of E is often a critical input into that diligence process. So with that in mind, are there any ways in which Acuvue provider can kind of stage their diligence, and by extension stage, the costs that the acquire has to part with, basically to help provide some basic diligence on the company, but also keeping costs at a manageable level, before we have certainty that this deal is actually going to proceed?
Yeah, that's mean, that's a really good question and point, and for the most part, even we're not formally phasing out our work. Our goal is always to try and figure out, you know, at first blush, what's the financial reporting situation? Like? Does it seem like a mess? Or do they, you know, they have a pretty good system in place, and the numbers are pretty reliable. And then, kind of step two from that is okay, usually, they presented some sort of normalized EBITDA. And we want to spend some, you know, really good initial upfront time to get comfortable with those adjustments. Because they usually the biggest areas where a deal can fall apart, you know, in the financial diligence side of things, is either the numbers just were messy, and therefore, what was put forward as the reported EBITDA maybe has a lot of noise in it.
Or the company's done a bunch of add backs that, frankly, just don't hold up and diligence or aren't supportable. And so you, our goal is to get through that initial work and look for those biggest potential deal killers, and ultimately try and give some sort of an interim, you know, hey, here's EBITDA schedule, you know, we can get comfortable that the EBITDA here, the normalized EBITDA is 3 million. And you know, they think management thinks it's 5 million. So we've got a problem. Let's talk about the differences. For me, the last thing I want to do is have time invested into writing a report about a business that ultimately, there's the buyer and seller are so far apart because of where the financials are coming in, that this deal is never going to get done.
So that's the typical way that we try and phase it is focus on the real stuff that's going to move the needle on EBITDA cash flow. You know, you want to get at least a sense of the balance sheet and, you know, look for issues that may result in an EBITDA adjustment. But I don't need to do kind of all the procedures on the balance sheet or start writing a report until it kind of feels like we've checked the box that yeah, the earnings are what we thought they were and the deal is gonna proceed, you know, barring some sort of other problems that come up. Of which there could be many outside of the Q of E specifically.
So if we're looking at kind of the big stuff to begin with, and we need to kind of pass that test before we move on to the everything else. Like where do you start? Right? So if you're just focusing on the big stuff, the deal killers to use your words, I heard EBITDA add backs as one. But I mean, in EBITDA, there's a lot of decisions that the seller could have made that will could drastically under or overstate that number. So for example, as I'm sure you know, it's not uncommon for sellers to engage in cash accounting, as opposed to accrual accounting, maybe they're not capitalizing things that should be capitalized. So I'm just curious, when you start, and you're just you're staging your expenses, your staging your time, you're just focusing on the big stuff, like what what are the dynamics and the variables that you look at to begin with?
Yeah, so I think the first thing is, we need to build our data book that is going to be kind of the anchor, you know, here's the monthly income statements and balance sheets that we're all going to use over one year, two year three year period. And building that data book, and really just doing some, some basic analytics, looking for things that stand out as unusual. Sometimes that means fluctuations have happened. Sometimes that just means when you look at the, you know, something called other income. Okay, well, if that's a material number, is that a sustainable number? Or do we need to find out what that actually is? So it's kind of getting that basic data book.
Then when you couple that with tying those numbers into the year end financials, whether that's audited, reviewed, or even just a notice to reader, that accountant has prepared, you start to quickly see how many potential issues may be on the financial reporting side. So to your point about cash accounting, you know, we see a lot of companies in the lower market where they do cash accounting all year long. And then at year end, the accountant comes in and makes adjustments to true it up to an accrual accounting. Or maybe they do accrual accounting during the year, but they just don't do it right.
And so, if you have that initial data book, and you have a sense of where the big material stuff is, where the movements are, and then you can kind of see, okay, at year end, what kind of cleanup is needed, that's a good way to start building confidence or lack of confidence around where the numbers are coming from. I think the other big one that, you know, we always want to get our hands wrapped around as, you know, the customers and the profile of that of the revenue. Because there can be a lot of either, you know, just potential risks there or just dissecting that and figuring out what kind of concentration there is.
Is there, you know, contracts that are supposed to be long term and all of a sudden, one customer is dropping off. And it's got 11 months of revenue in the trailing 12 months, but but all of a sudden, now there's no more revenue coming. And then the last piece around normalizations is that often the vendor side will put as many as they can possibly think of into the mix. And, you know, really it's about understanding If those are supportable, and if you're going to agree with those.
And those the EBITDA backs, you're referring to Yeah, yeah. Now, at what stage of the process? Do you recommend that acquires [inaudible] Q of E provider? Like what, like when would it be too early and when would be too late?
So we would typically view it that we would start the material work, once an LOI is signed, and you have exclusivity. That's not to say that, you know, there can be I've seen competitive auction situations, usually in larger deals, where people do need to ramp up and start spending dollars earlier in the process, because it's competitive. But on the typical kind of mid market deal, it's going to be, you've got exclusivity, you've come to terms on a deal. Now is the time to kind of jump in and figure out, you know, have the terms that we came to, were they based on numbers that we can all agree, were correct.
I would say a lot of times, I would have a conversation with a potential client before they sign an LOI, where we can give them some perspective on the industry or some of the key deal points to think about for the type of business that it is. But really, when we would be engaged and ramping up should be once they know they have exclusivity. And it should probably, it should either be one of the first things that gets started. Or sometimes I would say a lot of clients would say, we want to do some commercial diligence, which is kind of more focused on the customers in the market and the growth opportunities, because maybe there's a thesis that they have around that they need to validate before engaging in the Q of E.
And then the other one that I've seen can often come beforehand is if it's a software business, then people might want to dig in for something technology and make sure that there isn't a fundamental problem with the technology itself. So those are the things that I could see slowing down the Q of E. But otherwise, it's kind of like, okay, we've got an LOI, we've got a deal, let's get that going. The other reason it should start right away is because a lot of times a company that is on the smaller side of things are less sophisticated, it might take them a while to get the information that we're going to need for the Q of E. So the sooner you can kind of get an information request system in front of them and get them thinking about the information that the lead, then it doesn't become a big drag on time.
Now, in light of what you just said, this is a borderline unfair question, but I have to ask it anyways. Understanding that every situation is different. Every deal is different. For the, quote, average buyer in the lower middle market, how long roughly should they budget for Q of E to take and you know, maybe even a range, if you can't give an exact number?
I would say the way that I usually think about it is, you know, for the average or mid market company, the target may need a couple of weeks to get ready. Like once we get the request list, it's maybe a couple of weeks for them to populate. Again, sometimes they or maybe they have investment bank on the other side, maybe they've got some of that stuff prepared. So maybe that slows or shortens. But I would say it's often okay, we're engaged, here's a request list. One to two weeks later, we'll start getting kind of a lot of information. It's usually a week or two of kind of us processing, building up that data book preparing the questions that for kind of that initial detailed diligence discussion, and then having that detailed diligence discussion.
And at that point, so you're either two weeks into it, if if the company was ready right away, or maybe four weeks in, if they needed a bit of time to ramp up. And then it becomes okay, if things are relatively clean, there's going to be follow up questions, there's going to be follow up requests, but clean can be okay, another week of back and forth. And messy could be any number of weeks, back and forth. And then once you're in kind of, okay, we've got our arms around this, we kind of know what this is, then the report is called another one to two weeks. And again, you can compress those things. If there's confidence and momentum along the way, or sometimes people do want to make sure that it's staged so that you're not halfway through the report when you find out of some other issue that's come up
So, transitioning from kind of 101, so to speak, let's talk a little bit about the market as it exists today. And I'm interested to hear your thoughts on this because as of this recording, I mean, we'll see how this ages but you know, we've been a in a, as everybody knows, a prolonged bull market, particularly in lower middle market M&A. And credit is relatively cheap from a historical standpoint, it's very available, valuations are high competition is high, etc. So, I guess from your perspective, you know, what are you seeing in the market? How are you thinking about this? And maybe as kind of a secondary question? In what ways, if any, is the state of the market impacting the work that yourself and your team are doing for clients right now?
Yeah, a lot there. And very good question. I think if I first think about the state of the market, you know, you've hit the nail on the head, in terms of what we're seeing, I'd say the last 12 months has been probably going back to September of 2020, is when it really started to ramp and it has been busier than I've ever seen in my career. since then. And every time I think, Okay, this is busy, I can get it seems to go to another level. But I think it's all those things you talked about. And when you think about the lower middle market to its, it has become so much more robust than it used to be. You know, back when you and I worked on your deal, you were probably one of maybe 10 people or groups in and around Ontario, Toronto that were chasing the type of deals that you were chasing, I would say that there's probably at least 50 such groups out there.
And that's just in kind of the Toronto market. And 50 might be an understatement. But the point is, it's the robustness of that pool of capital is significantly enhanced. And then I think if you a couple that what what I've started to think about a lot in recent months, even is, I think there's a lot more businesses in the market now that have been built to sell. And when I say built to sell, I don't mean, you know that they were perfectly built with the perfect stories so that they're saleable. But what I mean is, instead of what used to be probably a high percentage of private companies that were owned by, you know, families, and maybe had been founded by previous generations. And so sometimes they were going to keep the business forever and keep passing on. And then some of them said, Okay, well, maybe we should sell.
I think now, those those businesses still exist, don't get me wrong. But the proportion of businesses that have been founded over the last 10, 15 years, that were founded by people who said, Hmm, I think I've got an idea for a business here, I want to grow this, I want to try this. And then I think if I, you know, if I get it, right, I'm going to be able to sell it for 10 million, 50 million, whatever number of million dollars. And so you have this population of business owners now that always keeps M&A In the back of their mind. And, you know, now they're getting phone calls once a week from some new private equity or hedge fund or private capital provider who is planting the idea in their mind that, that there might be an opportunity to sell.
And so I think there's just a lot more permanent volume and activity in the market that sure it's right now the valuations are strong because of the cost of capital, because of the fact that most companies earnings have been strong. But even once bumps are in the road, which we've already seen bumps in the road, if you look at supply chain costs and some of the human capital costs that are impacting earnings. Those are bumps, but it's still chugs along. And it doesn't mean that deals are easier, and it doesn't mean that people can take shortcuts, so I don't think our work is really removed. If anything, our work is a little more challenging, because you have to factor in these things like, how did COVID impact this business into the analysis?
But when you look at valuations being so high, people are paying more money, taking on more debt to do these deals. If anything, the level of work has gone up on a deal because there's less room for error. If you're buying a business at four times. And you get you know, you get a bit wrong. Well that might be fine, but if you're buying it at seven times, and you get it a bit wrong, it could be catastrophe.
You mentioned COVID. And that's something that I specifically want to get to. But before we do, I want to dig one level deeper into why the market is as robust as it is like from the supply side, it sounds like there's a greater supply of businesses for sale, which makes sense in light of the demographic tailwinds. With the baby boomer generation looking to retire, as well as kind of the bump unexpected, at least from my standpoint that COVID provided in terms of some of these sellers looking for liquidity. But then on the demand side, that's that's where you discussed, you know, there's just a lot of people looking for deals, in the lower middle market. I guess my question is like, what, what's driving that demand? Is it private equity going further and further down market? Is it family offices that are looking to do direct deals, instead of more passive fund investing? Is it more search funds? Like what what's the source of this increased interest in the lower middle market?
I think it's all the above in the sense that, yeah, for sure, there's just more like, I think M&A as a general, you know, topic is more prevalent. So people that are in different industries, you know, consulting, private equity, investing, equities, all those kinds of things, they're all aware of it. And it's viewed now is something that people can go do. And so you see a lot of people coming into this market, because, hey, they maybe they've done well, they've built up some capital, but they have this kind of hunger to own a business to try and really take something for themselves. And run with it. And so I think, maybe before, they might have, either not to have that appetite, not been aware of it, or not really thought of it as a viable option.
Versus now again, I just find there's, again, there are a ton more search funds all the time, there are a ton more family offices, and I use that word loosely. It's not necessarily, but the family office market in Canada is not nearly as robust and developed as the US. But there are a ton of families or individuals or groups of individuals who do have capital and maybe say, hey, this is an asset class that makes sense for me to be a part of, because maybe I don't trust what, I want my valuation to be impacted on whether Putin decides to do something and, you know, that disrupts the public markets. Or I can't really get any earnings from any return from investing in, you know, risk free assets.
And maybe I've bought as much real estate as I can, and that market is insane. So, yeah, it's a good market to look at. And then I think when you talked about private equity coming down the stream, I don't really there's a little bit of that. I think the bigger part of that is private equity professionals coming down stream, right. And the number of people who have worked at, whether it's investment banks or larger private equity, built up enough capital and said, Okay, well, I'm gonna go duplicate this at a smaller scale. It's my fund. It's my, you know, my venture. That is a huge part of what the growth is too.
Now, let's talk about COVID. Because I think no discussion about current market dynamics would be complete without a discussion of COVID. And certainly, as we all know, 2020 and I suppose 2021, as well was a well, it's interesting year, to say the least. And I think substantially, all buyers and sellers of businesses would agree that it was a non representative year, or I certainly hope it was a non representative here. My goodness, I'm not sure I can handle that again. But the reality is that for folks like you like there's a lot of what I will call non ordinary course dynamics flowing through a company's financial statements, right.
There's government support, there's wage subsidies, there's either a, you know, headwinds or tailwinds on revenue. So much so, that when I'm evaluating businesses, as an investor now, I'm seeing a lot more of this phrase COVID Adjusted Earnings. So from your standpoint, like how should the average buyer think about their target company's financial performance in 2020? Like is COVID adjusted a real thing? Should we take this seriously? And, you know, what have you seen in terms of like legitimate add backs in this regard? And maybe what have you seen in terms of totally bogus add backs in that regard?
Yeah, so it is the most kind of topical thing that comes up in every deal now, or say almost every deal, I'd say. There's some industries where it doesn't seem to, you we're in the software space, like a lot of software, businesses who have recurring revenue, nothing really changed. But for most industries, there is an impact. And I think, when we approach it, and when most buyers approach it, it's trying to figure out what is the, you know, in a lot of ways, what is the new normal look like? And the most common thing you might see is companies that have a human capital element where there was disruption to the ability to work, and that, you know, a lot of construction businesses a lot of.
And I say, construction, probably, that's not the right exact word, because some of that stuff, they were still able to work, but the way that they worked changed. And when you factor that in, it is hard to tell what revenue impacts and margin impacts were from that, versus just changes in the business or bad jobs? And then, then, especially I find there's a ton of, you know, government subsidies in those businesses. And it comes back to that question of, okay, in some cases, you look at a business and wow, they, you know, maybe it's a janitorial business, and they had record earnings in 2020. Plus, they were able to get government subsidies. And so you're like, well, those government subsidies do not belong in our sustainable earnings.
And by the way, you know, maybe they ramped up to a level of work with their clients that is not going to be sustainable, going forward. And then you think about other businesses like anything in consumer products, they've almost had a whiplash effect, where, at the start of COVID, everything in consumer products was through the roof. And so you then try and figure out and parse out was that a, you know, just growth in the business, and we're going to new demand level for this business, or we've been able to grow our online business to a new level. Or was that a blip where people ordered a million masks, and they're not going to order a million masks going forward. But then what happened in 2021, is that the demand seemed to continue.
But the costs just went through the roof, you know, container costs going from $3,000, in China to $20,000 at China has a dramatic impact on cost. And then labor. Labor costs are going through the roof. So now you see a lot of those consumer products, businesses where okay, somebodies questioned whether or not the growth trajectory or the revenue levels from 2020 were going to reoccur. But now on the other hand, the vendor is saying, Well, yeah, my margin isn't compressed this year. But that's not going to be the fact the case forever, you know, we couldn't react quickly enough to the changes in costs. But in long term, we'll get back to a normalized level of margin.
So it sounds like the the job of the buyers, based on what you're saying, is to try to figure out to what extent is what I'm looking at right now, sustainable and representative of what the business is going to achieve on a go forward basis? Because, like you mentioned the janitorial business, right? And let's say that in 2020 2021, they had to do a lot of one time deep cleans and retrospect, or retrofitting of offices. As a buyer, if you're paying a multiple EBITDA, but you're potentially paying a multiple of an artificially inflated number, unless you believe that this is the new normal. And then similarly, with supply costs, right? The seller might say, well, you know, the cost of a container from China has tripled. But I don't expect that to be the norm going forward. Therefore, I'm going to adjust that out. The question, I guess, for you and for all buyers is really asking the question, to what extent is this indeed a one time non recurring thing or to what extent is this is this what the business is going to look like moving forward?
Well, I think that's not unfortunate, but that is the reason why these kind of issues require a lot of first understanding and asking of questions, and then forming of opinions. And I would say that for the most part, the answers are gray. There isn't usually a black or white answer to all of those questions. And it really does require that next layer of step, thinking about the true impacts and making sure that they're understand, and then stepping back and looking at the big picture. Because on the one hand, you might say, well, that particular company, again, go back to the consumer goods, maybe they had 20% growth in their online sales. And that drove a huge revenue growth. Some companies that means well, yeah, but as soon as things change, they got that one time, because it was about selling a product that was hot at the moment and is going to be gone tomorrow.
Another company, it might be, yeah, but that was kind of the new normal of what people want to buy. And when they want to buy it, and how they want to buy it is allowed this company to grow their sales, because they were there and they were ready to serve the online market. And they they did it well. And going forward, people are just gonna keep buying from them. And it's gonna go up from there. So there is no, there's no one answer. And there's no one answer, even by industry. janitorial, for example, you might have some people that had clients where their business was shut down. So maybe they literally did not lose revenue. And then you have other ones where the businesses had to stay open with enhanced cleaning. So unfortunately, there's no easy answer to any of these things.
Now, let's move on from kind of the current market to what you've seen, kind of persist over your many years of doing this. So talking about common themes and observations and your experience. I'm curious, you know, in your experience performing, God knows how many Q of E analyses. You know, when working to smaller, medium sized businesses are there, you know, a handful of, let's say, common adjustments, or restatements that you just find yourself having to make over and over and over again?
Yeah, yeah, I would say the usual ones, from a cross industry perspective is, you know, are they doing proper cut off on a monthly basis. And so many of the smaller companies, maybe they're not closing the books off on a monthly basis, maybe they're doing it quarterly, maybe they're literally waiting for the accountants to come in and do it at the end of the year, because the owner just wants to make sure they can see what's in the bank account, and they're close enough to the business to have a pulse on it. So that is a very common, not problem, but yeah, issue that we need to deal with.
What is an example of either a proper cut off, or for lack of a better phrase, and improper cut off?
Sure. So I think it's really, you know, if you get to a month and you essentially, just keep booking your invoices when you get them and you just book them as you get them and you issue invoices to your customers, and that's when the revenue is recorded. You know, you maybe have a cost coming in, you know, three months from now that if you were following GAAP, you'd say, Okay, well, we know that we've been incurring this for three months, but the bill isn't coming until till next quarter. But we need to accrue for it. You know, a smaller company just may do nothing. Right. It's like, they don't care whether revenue or costs hit March 31 or April 1.
Right. Right. So not making kind of proper month end accruals basically, yeah, that's right.
So that's the general one. And then I think it comes into the common things for each industry. So when it comes to software businesses, the classic one is deferred revenue. And when they have, you know, multi year or even a 12 month contract, have they recognized the entire revenue when they issued the invoice? Are they different, some of that to be recognized over the period of the contract? If you think about a business that has inventory, the classic ones that we see are whether they're valuing their inventory correctly. And when I'm when I say that it's, you know, I mean, are they actually counting in regular basis? Do they have a perpetual inventory system?
Are they looking at their inventory reserves and treating those on a consistent basis month over month, year over year? When it comes to, again, any kind of construction type business and software sometimes to if they're doing project work. It's that whole revenue, you know, revenue accounting methodology. So, percentage of completion accounting is a very good way to understand the month to month, and kind of particular trailing 12 month period earnings of a business that's in the construction space. But you see a lot of businesses in that space, you don't necessarily follow the right accounting in the Lower Mid market. So those I would say, are the three most common kind of industry specific issues we see.
So one critical component of substantially every transaction of which I'm aware is the working capital adjustment. And that's where I want to go next. It's interesting, I wrote a blog on the working capital adjustment a month or two ago. And when I published it, I remember telling my wife saying, oh, man, this is the lamest blog I've ever written, like, nobody's gonna read this thing. It's so boring. It's so technical. To my utter shock, it is the most read blog post I've ever published. So clearly, people have questions about those. So that's why I want to dedicate some time to it. So I found that in a lot of cases, sellers, tend to have a very hard time understanding what a working capital adjustment is, and specifically why it's necessary. And often the question, they pose that question to the buyers? And of course, you know, a lot of buyers can explain it, but they need to explain it in a way that is digestible. I mean, how do you recommend that buyers respond to this seemingly basic, but very frequent question?
Yeah. And, Steve, it's like, the question that I get most often from my clients, sometimes as the buyers, my clients, as vendors, sometimes the vendors themselves are asking me that question. And there is, unfortunately, there's no easy answer, but the way I would best describe it is, you know, as a buyer, I'm valuing the business on the sustainable cash flow or EBITDA, that I'm expecting to generate going forward. And as such, you know, you as the seller need to deliver to me all the assets, I need to run that business to generate that cash flow. So that includes the fixed assets, which everybody usually gets, that includes, you know, things like customers and brand and the employees, and generally people nod along and yeah, they get it.
And then it's, but that also includes, you know, the inventory, the receivables, net of the payables, because those things are still required to run the business as well. And I think the simple example I would give is, if you keep the receivables, which is probably what you've commonly heard from some vendors who don't understand the concept is they say, well, those are my receivables. And the answer is, well, if you keep those receivables, then when I buy the business on day one, for the first 30, 60, 90 days after closing, I'm not going to have any cash coming in. And so essentially, I have to buy the business for $20 million, then you need to deliver all of the assets, which includes the fixed assets includes the brands, the customers, the employees.
But it also includes the inventory and the AR and, you know, net of the AP because if I cut a check for $20 million to buy your business today, and you've taken all the receivables, then for the first 3060 to 90 days, I have no cash flow coming in the door. And so then I really am saying, I'm going to pay $20 million, and then I'm going to go to the bank and get another million dollars that I'm going to have to put into the business to fund that initial investment in working capital. So it's never just because I say that and you know, you and I understand what it means. It's not doesn't mean it's easy, but I find that that's a good way to just try and put some perspective around it of the actual cash investment.
Yep. And I find that look, you know this better than anybody, basically nothing is as simple as it first appears as it relates to the working capital adjustment. The definition of working capital is heavily debated. And the peg is debated and of course, the PEG is relevant because the business needs to be delivered with a target level of working capital which is otherwise known as the PEG and selecting it is not as easy as it may sound on the SIR on the surface. Are there any specific questions or considerations that buyers should ask of themselves when selecting a PEG? And by that I mean, you know, probably for seasonal businesses, there are unique considerations for growing businesses for declining businesses, anything like that trying to think through when you know, what is a normal level of working capital? Is it the average over the past six months, 12 months, 24 months? Like, there's a lot of questions. So how should buyers think about actually selecting the PEG?
Yeah, I think the biggest point that it comes down to is what is really expected going forward. And so, in a case, the most common principle we see is the trailing 12 months, that tends to be the most common PEG, however, some businesses, yeah, they've fundamentally changed in the last six months, and something is different, that needs to be factored in. Or the other big thing, or the big question that I come back to is, what is the buyer paying for? So if we've agreed on a deal, where I'm going to buy your business for five times, you know, the trailing 12 months, EBITDA, then it probably, you know, barring some sort of wild change, it probably doesn't make sense to look at an average of the last 12 months.
And, you know, on a normalized basis, accounting for any unusual items. If, on the other hand, you were did a good job negotiating with me. And you said, you know what? \My forecast EBITDA for next year, is $5 million, you should pay me five times five. Well, now, as a buyer, I'd say, okay, that's fine. But if working capital is percentage of sales is 20%, then I would say that we should be paying, setting a PEG at 20% of next year's revenue, not this year's revenue. So it's those kind of nuances that need to be factored in, when it comes to a seasonal business. My personal opinion is that the whole point of the working capital PEG is to account for seasonality or unusual fluctuations. And I think, as a buyer, if there's really unusual fluctuations, because of seasonality, that are going to dictate a different capital structure, you kind of need to factor that into the valuation itself. So if you know you're going to need to have an operating line of $2 million, that's just for a couple months of the year, but without it, you can't fund the business. Well, then you have to kind of factor that into how you think about the capital structure.
Yep, makes sense. Now, after closing, some inexperienced buyers are dismayed to learn that the negotiations actually don't stop with the seller post closing. And of course, at least in my experience, the most notable negotiation that still remains outstanding is the actual working capital adjustment and the payment either from buyer to seller, or vice versa. And these can range from very peaceful to highly contentious in some cases. So I'm curious, in your experience, when you do see more contentious negotiation, after closing, are there any kind of common themes or reasons that you've seen or uncovered over the years, maybe things that buyers should look out for?
I think the most common one is when people are setting pegs, and they're setting it on numbers that are different from GAAP, that's where the biggest challenges come up, because maybe we've got some schedule, we've all agreed on, you know, working capital target a 2 million bucks. And then an auditor comes in, the buyer's auditor comes in and does a closing balance sheet to kind of get ready for the opening of their audit going forward. And lo and behold, you know, they didn't do this accrual. And they have to adjust this provision. And there's a whole bunch of adjustments that come through. And all of a sudden, the actual working capital comes in at zero. And it may not be because there's a $2 million delta between where the PEG was and where the business is today.
It may just be because the definition for the agreement was GAAP, and the historical numbers were not based on GAAP. So you end up with these kind of definitional changes. That's where people really fight because it's kind of like well, what's the legal words, and then what's fair and then there's a whole bunch of, you know, pointing fingers and all kinds of stuff. So, for me, that's really the the art of getting the working capital, right is making sure that there's transparency on everybody's part of what is intended to be the way that we're going to measure this at closing, and let's put it put a sample right in the purchase and sale agreement. Maybe we want to put specific, show a whole trial balance that identifies what accounts are part of working capital, what accounts are not part of working capital.
Maybe some accounts, you know, fixed assets, or goodwill maybe has nothing to do with any economics of closing the deal. So you, if you kind of lay all that out, it leaves a lot less room for people to to be confused or to be unsure of the outcome. And then I think most importantly, it's everybody has a clear picture of, hey, whatever we're doing to come up with this PEG, is going to be kind of the same thing we're going to do when we close the deal. And when we look at the closing balance sheet, sometimes that means it's not in accordance with GAAP. And that might be the appropriate answer. But you just have to actually walk through those steps and think through the logic of it. And both sides having transparency is where you avoid fights.
Now, as you were describing that, my mind went to the reality that I think a lot of buyers in this market counter, which is the seller is using either an unsophisticated or an inexperienced financial advisor. Now, when you encounter a seller, that is using an advisor that fits that description, I imagine that makes your life considerably harder, as opposed to considerably easier. So how do you handle a situation like that? Are there any best practices, anything that you do differently in situations like that?
I think it's, it's really up to the buyer. On the one hand, as I said, the more you get specific and lay things out and show people what it means. You do have less surprises on the other hands. You know, you could just say, hey, as long as we anchor, you know, as long as we feel like we know what's really going into the target. And we know we can anchor to GAAP, for the most part GAAP will result in, call it more liabilities or a lowering of working capital compared to what somebody might do on their internal numbers not in accordance with GAAP. So it's really just about sometimes we're just assessing the risk areas and saying, okay, well, we think that we're protected here, if we get into a fight, and we think that we're protected in our, we don't know the answer for sure.
But we know that if it's wrong, it's probably wrong this way. And so with all the other deal dynamics, the vendors pushing the close, maybe the unsophisticated visors, pushing them saying you guys got to close this deal, or we're gonna blow up the deal. Well, in that case, maybe you just have to, you know, close the deal and deal with the deal with it later. And so it's not really up to me to decide, my role is to help educate the client about where I see the issues, and what some of the options are on how to handle them. It's ultimately up to them as to whether they again want to open up a new can of worms and potentially drag things out. Or if they want to just make sure they feel protected in their position and deal with the consequences later of the other side, not having the same education level.
You're more diplomatic than I am, I still have PTSD from dealing with unsophisticated advisors and in my transaction, but that is a topic for another day.
The big difference, Steve, is that when you were dealing with them, you are often going to have to partner with them after closing, when I was working with them, I'm kind of more just providing a service to my client.
That's right. And that's why I was always happy to make you the bad guy. That's right, which you were very willing to do, which I appreciate. Last question for you. Before we part today, Chris. You talked to a bit about what's included in what's excluded from working capital. And it's almost never as simple as the terms academic definition, which is current assets minus current liabilities. And I suspect that many people listening to this who are in the midst of a deal are probably fighting with their sellers about what's included and what isn't included in working capital. So I guess at a general level, how should buyers think about that question?
Yeah, so I think for me, it comes down to think again, I go back to the tunnel. Balance has a whole bunch of different accounts on the balance sheet. And they really do have to fall into one of three buckets, right? It's either this is part of cash or debt, and therefore, we're going to settle this in closing, where, hey, you've got cash balance there, you're walking away with that, or if you've got debt, I'm gonna deduct that from the purchase price. So that's category one. Category Two is, as I said before, like, maybe it's goodwill, nobody's gonna, you, as the buyer, are not going to say, oh, my gosh, you know, at closing, the goodwill was a million, and now we've amortized it down to half a million, you owe me half million dollars. That doesn't make any sense, right?
So when it's not those two, then that means it's most likely working capital. And so really anything that I as a buyer, care what that balance is, at closing, it's really part of working capital. And then it's about getting it right in terms of how it's going to be accounted for, and what the right target is. So that's probably the oversimplification. But I think it's a good principle to use, which is, if I care what that balances, and it's not being captured by the definitions of cash or indebtedness, or income taxes, which are being settled outside of the working capital, then it's probably part of the working capital calculation.
So, what are those three buckets? You have cash or debt, which I get. And then is it intangibles? And then if it's not in either of those two, it's working capital? Or did I get that wrong?
No, you got that right, other than the example of goodwill or intangibles is not kind of the the name of the bucket, it's more the name of the bucket is, this doesn't really have an economic impact on the valuation of this deal, because I see an accounting item. So you know, another one sometimes is deferred taxes, where there's current portion of deferred taxes. And sure, you have to think about the kind of consequences of future amortization on a tax basis versus accounting basis. But for the most part, usually I would never see deferred taxes as part of the working capital definition. And so it's stuff like that, where anything where you look at that account, and you're like, well, this is just an accounting policy, and it doesn't really matter from an economic perspective, then it can go into that. You don't need to worry about this bucket.
Got it. That's really helpful. Chris, for any listeners who might want to get in touch with you, what's the best or the easiest way for them to do that?
Easiest way is probably on LinkedIn or to call or to email. I don't know if you want me to give those details out. But yeah, anyway is fine.
Awesome. Well, we really appreciate your time. Thanks for sharing your insights with both myself and our listeners, we really appreciate it.
Thanks a lot Steve, was great to chat.