Financial Engineering and Diminishing Returns
Someone I know who was thinking about selling her business asked me if I might take a look at the numbers her accounting firm had prepared in order to help think through how aggressive (or not) she might want to be with regards to addbacks and other allocations. In looking through the spreadsheets she provided, some adjustments were completely fair and logical, while others were probably pushing it. Which is normally how it goes.
In the former category, for example, was a truly one-time legal settlement (though one can argue that every business should build in some level of annual reserve for legal expenses since we’re all going to get sued), while in the latter was compensation for recently hired employees who weren’t yet at capacity, but were expected to drive growth. The reason that’s pushing it is because the contributions of those employees should be picked up in management’s growth projections, meaning that if you add back their expense, but keep their contribution, you’re double counting.
One thing that’s important to keep in mind in situations such as this, where it’s tempting to get creative with the numbers, is that the returns on financial engineering aren’t just diminishing, but they can turn negative if you engineer too far. For example, “bespoke” metrics such as ACSOI (adjusted consolidated segment operating income, shoutout Groupon) and community-adjusted EBITDA (shoutwork WeWork) not only invite justifiable skepticism, but risk casting doubt on your entire set of financials.
To wit, we saw some numbers the other day from a business that reported earning $4M of EBITDA, but $10M of what they called “EBITDA Relevant to a Third Party Evaluation,” with the delta between EBITDA and EBITDARTPE explained by $2M in annual savings if the buyer were to just also buy the company that was licensing its IP to this business, another $2M in compliance costs (which were a “best practice,” but “not required”), $1M in employee efficiencies, and another $1M in administrative synergies.
Were some of these savings potentially legitimate? Sure. But did it seem like a good use of our time to dig in given the unseriousness of it all? No, it did not. So while someone somewhere at some point was probably high-fiving the work that grew earnings 150%, it’s precisely that someone somewhere did that that made this potential deal a quick pass for us
Or as Holly calls it, a QP!
Kewpie also happens to be the local high school mascot.
Of which our CLO Taylor Hall is an alum (you’ll need to “scroll down;” he looked good in a tux).
Everything comes full circle in Missouri.
– Tim
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