Financial models in different scenarios

How the scenario that a financial model is built around and the proposed transaction or event that it is built for plays into the ongoing running, growth and development of the business is the lynch pin of any financial model. It is arguably almost as important (if not more important) as the exit or the completion scenario, as the business needs to continue in order for the vendor to receive their earn out or their vendor loan repaid, or for investors to get their required returns.

Below, we discuss some of the key things to consider including in a financial model depending on the business scenario and the particular transaction that it is built for.

Product vs. service business model drivers

All business models today can still be categorised into one of three groups: product businesses, service businesses, and that group in the middle that incorporate both. While in the UK our service industries account for 72% of turnover, all three of these groups represent a substantial part of the economy with distinct differences and needs. How we model each is also significantly different.

Product businesses

For product businesses, the key is in understanding what the drivers of that business are and modelling from there. That starts with the management team knowing and understanding their unit economics (i.e., the profit and loss related to each customer or ‘unit’ of production). And perhaps more importantly what underpins them, such as their customers, their market influences, and their competitors. Producing a model on this basis can not only help simplify the model, but from a strategic perspective it can be beneficial as it enables both management and other model users to see whether a certain decision increases or decreases profitability on a per customer and aggregate basis. However, for some product businesses, a unit economics basis can be an oversimplification and, instead, the product calculations need to be broken down further in order to walk the user through each step of the product journey, particularly if production capacity is likely to directly inform investment decisions surrounding scale.

Both approaches are fine, and the right answer is different for different scenarios, but the latter is likely to require involvement from more stakeholders (such as marketing and operations teams) and not just take input from the finance team. This shouldn’t be an issue but knowing this ahead of the build and ensuring stakeholders understand what information is needed from them in good time can save both time and headache, particular in businesses where ongoing reporting is perhaps not as sophisticated.

Service businesses

In the case of service businesses, the input measures are typically quite different. For example, for companies with turnover driven by an individual’s hourly rate, the important things to understand are most likely:

  • What charge out rates are,
  • What average hours worked are (and the percentage that is ‘chargeable’ versus none),
  • What recovery rates are, and
  • How work in progress (WIP) is valued.

WIP becomes of vital importance in service businesses and most companies will have different ways of how they value WIP which needs to be interrogated before building the model. This is because if the functionality of WIP calculations is not understood then in 99/100 occasions, it will be modelled incorrectly. If the key income driver of the model is not calculated correctly, unfortunately that is not something that is easy to ‘tweak’ at the end; it is a complete rebuild.

In service business scenarios, documenting assumptions becomes much more important because they will need to be evidenced. In a product business scenario, they are much easier to evidence because there should be product schedules and granular data more readily at hand. It is not as straightforward for service businesses as if charge out rates, recovery rates, team structure or other ‘production’ costs have changed then the assumptions become a lot more dynamic, and without evidence, that is where things can get really complicated.

 

Black swan events

The bit that becomes difficult (or, arguably, impossible) to model is black swan events. A good current example of this is the recent rises in gas prices. Eighteen months ago, a generic assumption on an annual basis would have been alright, but now there is almost a weekly variance in those prices. Therefore, a consideration needs to be made for how that fluctuation is factored in. This can be done by making the inputs and timings of changes dynamic, however, what really needs to be considered and included is the reasons behind including these dynamic options and what any significant changes mean for the bigger picture.

 

Different organisational structures

There are several considerations that need to be paid to the organisational structure that is being modelled. This is particularly the case if the model scenario involves the creation of a NewCo., which is often the case seen in certain M&A deals, MBOs and in the creation of Employee Ownership Trusts (EOTs).

  • The main consideration here is whether to build the model with NewCo. built into the group from the outset, or whether it needs to be built in as a separate entity at the point of transaction. Depending on how that is handled, there are then further considerations such as vendor loans that either sit in NewCo, but that are funded by TradeCo and how the repayments between the two are going to work. This is particularly relevant in MBO and EOT deals. Our suggestion is always to model as closely to what will happen in real life as possible, as it reduces the margin for confusion and error – not to mention avoid overcomplicated formula and model structures

 

However, sometimes the deal that gets agreed is more complex than the scenario that has been originally modelled, and to change it would not have significant commercial benefit. In these instances, a sensible conversation has to be had to ensure that ‘real-life’ accuracy is balanced against commerciality.

A recent example:

A large retail company undertook a sale via Management Buy-Out. The MBO was backed by Private Equity (PE) and existing management also had a small minority stake. The PE offer that was made allowed for the management team to also realise some of their investment with a cash out.

The initial model built was geared towards a traditional MBO with a single NewCo. However, as the cash out to management was a separate deal, there was a need for a second NewCo to be created over the first. The additional functionality required to demonstrate this additional aspect was complex and could have significantly delayed the deal, not to mention increase the fee to the client.

Instead, we discussed with the client the ultimate end goal of this particular deal and, therefore, what that meant for the model. In addition, by considering the net position that would be created by the implementation of this structure, we were able to include the key features required of both NewCo’s within the initial model structure. A solution that all parties were happy with.

 

  • The creation of new entities as part of a deal can create complications relating to the integration of historical information which will be based on the business in its current/ historical running. The process of reconciliation between old and new organisational structures needs to be handled with care; your financial advisors will be able to appropriately advise on the treatments of any income and cost entries that are impacted by the change.
  • Other organisational structure considerations occur in the event of a sale in a group scenario. Imagine a Holding Co. and 2-3 trading subsidiaries with intercompany sales and services. In this example, there are broadly two options for how to model the business:
    • Consolidated – this involves producing a model that treats the group as a whole. This is a completely valid method of modelling, however, consolidated reporting needs to acknowledge that it ignores the complexities within the group, such as intercompany movements. This is acceptable for scenarios where the whole group is being sold (although some sellers may still want to understand the detailed picture that sits behind the group level).
    • Individual – if part of the business is looking for funding or to be sold in isolation then a consolidated model is unlikely to be appropriate. In this scenario, it will prove beneficial for each subsidiary to be modelled individually and the group structure, consolidation and the funding structure will then be overlaid on top. For instance, suppose that Subsidiary B required debt funding but had very few assets or trade of its own, it is not cash generative and it does not have sufficient profitability to suit a cash flow lend; Subsidiary A in this example is well-developed, has a strong balance sheet and financial performance. In this scenario, Subsidiary A could take on the debt, and then loan it (with suitable covenants and protections) to Subsidiary B. If that situation had been modelled on a consolidated group basis, that nuance and understanding of how the funding could be serviced would be lost, reducing the chance of Subsidiary B being successful in getting the support it needs.

 

A note on LLPs

Limited partnerships (LLPs) are an interesting challenge when it comes to modelling, particularly for growth or sale. LLPs have a very different structure to private limited companies, of note is the differences in how tax planning is approached and the structure of the balance sheet. Understanding both of those aspects at the start can save a lot of headaches further down the line.

 

 

Transaction specific considerations

Growth capital/ equity funding

Growth capital models are always fun to build as it is an opportunity to demonstrate how an injection of equity can accelerate a business’ performance and create value for all stakeholders. However, in the process of securing that funding, a potential investor will need to understand how their investment turns into value and returns for them. To achieve this, we recommend building in a forecast capitalisation table (or ‘cap table’). This illustrates the impact of the proposed raise on existing shareholders, option holders, and on the founder shareholders. We build cap tables on a fully diluted basis i.e., with all share options and preferences exercised, and with different exit scenarios built in. By building them this way, it is a great tool to talk everyone through to a soft-landing on the reality of what the funding and any future funding has on what they will receive on an exit, particularly the management team. One example of where this is useful is in understanding the impact of share options on the next deal. This is something we have seen recently, and by having everything built in from the start, it avoids any shocks and difficult conversations with shareholders regarding their dilution later down the line.

Debt funding

We would argue that any model has some debt funding functionality built into it. It can be modelled very simply, e.g., amortising loans, or with additional complexity added in, e.g., those pegged to performance metrics. However, at the very least we would advise building in a simple set up early on, as it is usually quite easy to force most loans to fit that in order to test the impact of different funding scenarios without having to build a whole new section of the model. Then, once the model and its outputs become clearer a more sophisticated debt set up can develop.

The nature of funding also impacts the key inputs and outputs on the dashboard regarding what is pulled out of the three financial statements. When a business starts looking toward a transaction or funding event, they need to think about what their funding and investor options might be – it can be useful to consider two or three of the most common scenarios. Yes, there will always be the curveball or the investor that is difficult and want the model to be flexed in a way that isn’t ‘normal’ for the business. However, no model will ever please everyone, it only emphasises the importance of having a solid ‘normal’ scenario as a baseline, with the functionality to overlay on top of that with particular ‘potential’ scenarios.

 

As a general rule when building a model, if in doubt, include what might be needed as it saves getting deeper into the model build and finding a key piece of functionality has not been incorporated.

 

 

M&A

Ultimately, there is a transaction and there are a lot of similarities across all the types whether it is a trade or PE deal, an MBO or an EOT. The major concern here is regarding organisational structures, as discussed above, and how the creation of NewCo. fits in.

One aspect that is often overlooked but certainly needs to be considered, is the fee perspective on the transaction. If the business is taking on Private Equity funding or bank debt in the process of the M&A transaction, often there are post-transaction obligations such as ongoing fees (e.g., monitoring fees and management fees) from the funder. These fees can often get forgotten about once the deal is complete, but it is vital to understand what they are at the point of transaction and post, as you need to understand how the business is going to perform and whether it can adequately service the fees. These fees can often be substantial and are ordinarily charged on a quarterly basis. This can create cash shortages during already cash burdened times of year – by factoring them into the model build the business will be able to identify whether it can service the fees on that basis or whether during negotiations they need to try and agree to pay non-standard financial quarters to improve cash management. From a NewCo perspective, often the fees charge will be payable by NewCo, but to service these money needs to transfer from Trade Co. as NewCo does not yet, or will not, generate sufficient cash. Once again, the model should be built to reflect this movement. 

This article was written by Nathan Young, Strategic Corporate Finance Manager at Price Bailey. If you are looking for support in building a financial model for your business or transaction, then please get in touch with one of the team using the form below. 

 

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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