A CFO’s Life in Private Equity – Part II – Getting Your Financial House in Order
The private equity journey Kevin started in Part I continues in this second of his 5 part series. Now that you know the ground rules of private equity learn from Kevin how to get you financial house in order for private equity. Here is Kevin and Part II of a CFO’s Life in Private Equity.
A lot of mid-market companies have “okay” financial processes to meet the requirements of their annual review-level financial statements for the bank. Unfortunately, annual financial statements, produced several months after year end, almost never meet the requirements of your new investors whose job is to make a return with other people’s money. You will find that they take this role very seriously and will never be satisfied with the current set of reports and analysis. There will always be more needs for analysis, insight, and reporting as the business changes and they become more familiar with your company. Further, they will ask for scenario analysis and one-off reports as they look at potential bolt-on opportunities. It can be tough for some finance professionals to live in a world of constant change and requests, especially when your current management team may be quite satisfied with what you and your team provide to them today.
During the sale process, there will be significant information requests about all aspects of your business. The majority of this information will come from your financial reporting and forecasting processes and systems. However, unless you are running a tight close process today with robust systems and analytics, the need to upgrade the finance processes will become apparent as the private equity firm, both during the sale and after, will want to dig deeper and analyze your business more than you have in the past. With millions of dollars now invested in your company, you will also find the timeline to produce this information and analysis is much shorter as well. A process or system that is slow to produce average information will not last over the long term and become a friction point.
Here are some points for you to consider as I have seen it in many mid-market companies:
1. Are you truly doing accrual accounting?
If you are not publicly traded, risks due to errors in your financial statements are reduced. Therefore the requirements of an audit are lighter. If your company only produces review level financials, the requirements are even less stringent than those required for a publicly traded company. Eventually, even financially savvy business leaders will allow certain non-GAAP accounting transactions to be recorded in your numbers as it doesn’t truly affect their view of the business, the bank’s opinion of the company, or how much cash can be paid to investors. A lot of CFOs of successful smaller companies have not had the reason to change what they are doing. So, they continue with a lot of processes that can resemble cash accounting.
These non-GAAP processes do impact the valuation of the company and can slow down the sale process. Here are some common areas where accrual accounting can impact the value of your company:
(a) Progress billing
Many private companies that have progress billing recognize revenue when the invoice is sent out, irrespective of when the work is done. By not recognizing true percentage completion method of revenue, you are likely leaving unrecognized revenue and ultimately, EBITDA “on the table” during negotiations. Percentage completion accounting, assuming allowed within your business, will recognize revenue earlier in the process, but only if you have a reliable process to have good estimates and a way to accrue costs as jobs progress.
Coupled with not being aggressive enough on progress billing, a lot of business owners believe they are really good at invoicing the maximum amount to their customers. However, when you switch to accrual accounting on costs and revenues, you may be surprised to see that a significant number of customers are actually materially *underbilled* each month (see cost accruals below!). As a result, the company has less cash flow than it could have and some inefficiencies in working capital. Both of these maladies impact the value of the company and the ROIC that it generates. This, in turn, has an effect on current cash flows and ultimately reduces the value the company gets from a private equity investor.
For companies that have simpler revenue recognition processes, such as when an item ships, may find that there are a couple days lost in getting an invoice out to a customer. This may not seem like such a big deal, but this revenue is lost EBITDA and with a high multiple, can materially impact the cash paid to the current owners of the business. Further, the sale will also include a payment for working capital. If this accrued revenue is not included in working capital, or the process around accruing revenue is not robust, your current owners are likely to receive a reduced value for their working capital.
(b) Cost accruals
The impact of cost accruals ties directly in to progress billing. If you are not accruing costs based on a robust purchase order and receiving process, taking several weeks to close the books, and are waiting more often than not for invoices to come in to support your costs, your company can be anywhere from 30 to 90 (or more) days behind in recognizing costs – which if you are using to generate the invoice for your customer, means that you are unknowingly financing the customer!
Changing to a cost accrual process can be tough as you are asking people across your company to understand and be able to accrue and forecast costs. But better visibility on accruals and when expected payments will allow you to better manage cash before the transaction. After the transaction, you will be expected to prepare a 13 week cash flow forecast regardless of what you were doing before!
As someone in private equity, I am okay with you doing cash accounting…it means that if we invest as a private equity firm there is a ton of upside in optimizing your working capital!
2. How long is it taking to close your books?
A lot of mid-market companies take two to three weeks to close their books. Many only close their books quarterly and only “get it right” once a year. Often the finance leader isn’t pushing for this process to be efficient and the company ownership isn’t asking for numbers to be delivered earlier either as they do not see the value in doing so. The cost of an inefficient process and delays in getting information to make decisions with isn’t often seen by the finance or company leader, but very real. If the month end takes three weeks to get finalized, it means that usually the numbers are not reviewed with the business leader or are reviewed weeks after when a change in business direction could have been made.
As others have said, your and your business owner should not be happy with investing more than a four or five days on the full close process as there is significant other areas where finance can be adding value to the business beyond just closing the books. A lot of companies have a long month end close process ingrained with a lot of reasons why it needs be like that. But a private equity company won’t care for these reasons nor will it want to invest any more in time and resources on something that happened in the past. I know that I don’t!
You, as the leader of finance, need to believe that having a short close is good for the business and be the vocal advocate to make it more efficient. There a lot of tools here on CFO.University and I strongly recommend that you look at them for potential places to make your close more efficiently. For me, over the past three years I have worked on improving the close across 14 platform companies and have seen improvements in all of them. The biggest change has been with one platform company that, prior to our investment, used to close its books on a quarterly basis and it took three weeks to do so. With buy in from the President, the hiring of a strong Controller, and a continuous plan to improve the process, the financial close is now done, along with the associated analysis, is consistently completed in three days!
3. How good is your finance staff?
I have walked in to new investment companies and be greeted by the president who says “thank you for coming – you can tell me what to do with my Controller!” My list looks like the table below and I ask the Controller and President to rate how they are doing with a red/yellow/green. This then gives us a roadmap steer us to where things can be improved and the order in which they should be worked on.
But if you don’t have the right people on your team to deliver against these objectives, then as their leader you either need to improve the skills of your team or find new team members who will be able to deliver against those objectives.
4. You are using your ERP, right?
The use of ERPs by finance departments has, in my opinion, definitely improved over the last decade but a lot of people still like to have that final Excel reconciliation or resist automating processes. Why? Because they perceive the cost of change to be more than the value add to the business. If they stepped back and took a long term view, they would see how much more value they would add if they weren’t buried in Excel spreadsheets and journal entries. I always take a hard look at the finance team and their use of the ERP as part of due diligence. There are more apps being developed that work with your ERP and automate manual processes such as timecards, expense reports, and approving invoices.
Again, even if you don’t sell to private equity but your team is doing a bunch of work outside the ERP you are just inviting errors to creep in to the process. Your team may be able to handle those manual processes now but once the additional requirements of the private equity firm start piling on, the likelihood of missed data, deadlines, and requested reporting goes up. Unfortunately, finance leaders can lose their jobs if they continuously miss deadlines, quality, or both.
5. How good is your reporting?
Significantly improved reporting will be expected from the private equity investor. The new insight derived from better reporting can result in significant improvements in the performance of the company.
This is the subject of the next article as there is a lot to deal with here - but to give you something to think about, can you answer all of these questions:
- What is your allocation of overhead? What happens if we change the drivers?
- What is your ROIC by each project / product you delivered last year?
- Where is the biggest change in ROIC and what can we do to improve it, and by how much?
- What inventory that you carry is overstocked (ie. you have too much) vs. how much is dead (hasn’t sold in last two years)? How has that changed?
- What is the trend of your customers for sales? Payment terms? Churn?
- What is your Days Sales Outstanding (DSO) this quarter? Last quarter? What caused the change?
- What is your current cash cycle? How does it fluctuate? What truly causes it to fluctuate?
- How does the ROIC compare across each of your lines of business?
- What is in the probability of certain business events happening and what is the impact upon the company over the next three years?
6. You have a budget, right? And a forecast?
This is the topic of a later article, but many mid-market companies either do not prepare a budget or regular forecasts. Both of these outputs, while debated by finance professionals, are valuable financial tools to help management assess what is happening and the impact of their decisions on the financial performance of the company. I have seen a lot of companies get complacent and just roll forward the budget as the forecast when they know that a lot of the assumptions in that budget are no longer valid. This is fine until something happens to the company or the marketplace and the financial performance is no longer the same!
Your job as the finance leader is not to complain about the time and effort it takes to prepare the budget or forecast, but rather spend the time to dig in to the details and create meaningful models, along with summary reports, that help your non-financial partners better understand what is happening, why, and what levers they have to change the financial performance of the company in the future.
7. Policies and Controls
A good business has good controls….and good controls are the result of good business. Many mid-market companies have controls in place that rely upon the good nature of most people but do not have adequate protection to prevent something material happening. Some of the major gaps I have seen in financial controls companies usually fall in to these categories:
- Issuance and managing of credit with customers
- Personal expenses
- Purchasing authorities and process
- Information technology access
The first place these essential controls start is by having a well defined, written policy in place. The internet is a great place to look for these policies. Part of your job as the finance leader is to not only create the policy and ensure there is compliance, but also to educate everyone in your company about why good financial controls and processes protect the financial health of the company.
If you aren’t testing your organization’s compliance against policies, there is a high probability that there are activities going on that are not in compliance with your controls…or that your controls are not effective! Private equity investment or not, one of your jobs as the senior finance leader is to safeguard the assets of the company. Regular testing of compliance against controls and policies allows you to see how effective they are and where improvements need to be made. And just like your business that is always evolving, your financial controls and processes need to evolve as well.
A poor accounting process can take a turn of EBITDA off a company in valuation – to say nothing about the cost of poor working capital upon cash flow and ROIC!
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