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Optimistic or Realistic?

John Kielich, CPA - Managing Director for Kolb+Co. M&A Advisers   email | bio 
LeAnne Foster, CPA - Senior Associate for Kolb+Co. M&A Advisers   email
September 2010

Projections are nearly always optimistic. How can you determine if optimistic is REAListic?

In a previous article, EBITDA: Some Things to Consider, we introduced the concept of free cash flow as a preferred model for determining a purchase price. In this article we will discuss some key issues that need to be considered starting with revenue, the key driver of any projection. Often sellers will provide projections for two to three years to the buyer as part of the sales process and this is where you usually see the optimism.

It is not uncommon to see revenue for a company projected to increase ten percent for the next three years when historically the average increase is closer to five percent. While the initial reaction on the part of the buyer is to dismiss the projections as being totally unrealistic, there are questions that should be asked.

• Are there market drivers or internal drivers, such as a new product that would support the growth?
• Have orders been received? Are contracts in place?
• Assuming there is support for the growth, does the company have the capacity available to handle the ten percent growth?
• Is it feasible to produce enough products with existing space to increase revenue as projected?

Let's focus on that last question. If it's not feasible to produce enough products with the existing capacity, then focus must shift to the cost that would need to be incurred to achieve the desired revenue number. Costs could include more equipment, more floor space, more machines and/or more personnel (who will need office space).

• With the increased costs, how are net income and free cash flow affected? Remember to look at the capital investment to determine free cash flow.
• With revenue growth, will inventory and possibly accounts receivable need to increase?
• Does current cash flow provide the needed funds to purchase the inventory as well as to continue to meet existing obligations?
• Will there need to be an additional line of credit to support the growth?

These factors all affect working capital. It is also important to take a critical look at the expenses projected to support growth. As headcount goes up, there are other costs needed to support this personnel increase in addition to wages and benefits. Costs can be as high as $10,000 per year per person in certain companies. Consider telephone lines, office space, computers, cell phones and all the other items that are provided to an employee.

• What about the costs associated with recruiting, training, and on-boarding the additional staff that might be needed to support the growth?
• Is there a need to increase server capacity and/or other infrastructure?

As an acquirer, you may be able to use some synergies to offset the additional costs needed to support the growth, but do not be tempted to pay the seller for these. The synergies that can be produced as a result of the acquisition should be retained by the acquirer to produce the desired return.

Work with your advisers, as the buyer or seller, to determine the viability of meeting the projected numbers. Often this discussion turns out to be an educational process for the seller and they begin to understand the hesitation a potential acquirer may have in swallowing the projected revenue bait. These conversations are great because both adviser and client come away with a much better understanding of the company.