Cash Confirms the Valuation Economics
Learn how to rely on the old saying, ‘Cash is king,’ in this third of a six-part article series on evaluating an acquisition target.
The market values and trades on the recurring monthly revenue (RMR) of a customer base, but there are a number of definitions and business systems used to classify and document that RMR. Within your due diligence efforts you should review the customer dynamics of
- accounts receivable aging,
- billing cycles,
- aging criteria by bill type,
- service billing types,
- set out of one-time services,
- exclusion of sales tax or one-time fees, and
- payment averages and days outstanding
to confirm the performing nature of that base. However, in a large transaction it is often difficult to dive into each customer, even after exporting the base into an Excel format that can make it easier to work with.
One of the most important due diligence steps you can take is to confirm the cash generated from a customer base over a 12-month cycle using the company’s external bank statements. With the advent of ACH and credit card payment methods through clearing houses, the activity can be voluminous with a larger base, but this is a critical “valuation proof.”
By separating all other cash activity for a 12-month period such as wire-ins from loan borrowings, equity infusions, payroll transfers and other business activities that flow through the company’s operating or customer receipts bank account, you can determine if the customer base pays for the billed services regardless of billing cycles. After segregating installation and time-and-material revenues collected and dividing the RMR collections by the 12 months, you should begin to approximate the average monthly RMR collected. Compare this figure with the total and average RMR billed figure for the same period and assess what may be causing any differences.
To further refine this important analytical “proof,” you should adjust for the differences between beginning and ending accounts-receivable balances to adjust for the collections or aging of older balances that arose from prior periods. Based upon a company’s accounting policies and procedures, you also may need to explore how deferred revenue accounting may enter into your “cash adjustment” to arrive at RMR cash collected related to billings. While you can require that this analysis tie to the penny, we have found it to be more of a “proof” of what we have examined within the other customer and business system information.
This due diligence step also helps to provide excellent insight to the running of the business. You gain a perspective on how tight or profitable the business is performing on a cash basis. While this cash analysis is a very important due diligence step, it can prove complicated when the target company is experiencing distressed conditions. Our due diligence work has uncovered some very creative companies and entrepreneurs who work hard to “manage incoming funds” to approximate receipts. It takes a careful analysis of the underlying deposit and its posting to the accounts receivable records to verify the aging that is most often relied upon to determine the performing nature of a customer. You can extend this cash analysis to substantiate the actual receipt of customer funds as posted to reflect payment history and thus proper accounts receivable aging, which can be very telling as you analyze the payment history of a customer base.
If the underlying customer information looks good and this cash analysis helps to prove the RMR stream, you can rely on the performing nature of the target RMR and not have to adjust your letter of intent terms as you head to a purchase agreement. This analysis also can offer a level of confirmation that the originally negotiated holdback terms are sufficient to protect the buyer as anticipated at the outset of the negotiations. n
Editor’s Note: Part 4 in “The Art of the Deal” series will focus on how the installed equipment and monitoring communications platforms can affect the valuation of a company in today’s market. As our industries push to adapt to the sunset of land lines and head into the very rapid evolution of Wi-Fi, IP, radio, cellular, the cloud and other equipment/signal protocols, buyers are becoming far more aware of the economics that they will incur to transition or upgrade a customer base after acquisition. This new dynamic is clearly altering the valuation of companies — either decreasing or, in some cases, increasing market values and affecting the design of a deal. Look for it in the April 2014 issue of SDM.
About the Author: John Brady is principal of TRG Associates Inc., Old Saybrook, Conn. (www.trgassociates.com). Since its inception in 1991, TRG has been successfully assisting in due diligence and acquisition planning.
The Art of the Deal
With the security and fire industries still very fragmented and continuing to grow, the acquisition opportunities within the United States and Canadian markets continue to be very active. As importantly, the capital markets continue to be very supportive of both industries when they identify capable management teams to back.
The predictable cash flows associated with the recurring monthly revenue (RMR) in these industries are the “crown jewel” that drives impressive operating margins. Author John Brady, principal of TRG Associates Inc., Old Saybrook, Conn., has been privileged to perform a vast number of valuations and due diligence efforts on behalf of buyers and sellers over the past 20 years and identifies what he has found to be the important aspects in the “art of the deal” in this six-part article series.
While maintaining a disciplined approach to evaluating a seller’s business is critical, there is an art to buying a selected group of RMR customers. This article series explores the important aspects of that art:
- What should go into any acquisition valuation of RMR and the company as a whole? What revenue has value?
- How does the attrition history of the seller impact the level of due diligence and ultimate valuation?
- In performing due diligence, cash is your key indicator as to the health of the target company and the associated RMR. How do you analyze that important asset?
- How does the buyer assess the installed technologies and signal platforms of the seller’s customers and what effect do those have on valuation?
- How does the buyer assess the service expectations (obligations) and economics of a customer base? You won’t change those expectations overnight so assess carefully.
- The letter of intent: how to fashion the art of the deal in a “hot market” versus practicing prudent investment principals.