EP #4: Mastering Networking Capital in M&A: Insights from a $100 Million Deal with Russell Cohen

Unlock the mystery behind working capital in M&A deals with Russell Cohen and me, your co-host Jeremy Wolf, as we dissect our colossal $100 million roofing company transaction. Grasp the concept that often spells the difference between a successful sale and a deal gone awry. In our latest podcast episode, Russell, an M&A maestro, breaks down the fundamentals of working capital in a way that's accessible to all. From explaining the calculations on a business's balance sheet to emphasizing the crucial timing for assessing it, we leave no stone unturned. This is not just a recount of our biggest deal to date; it's a masterclass in ensuring your financials are robust and 'PE ready' for that major sale.

Ever wondered why some business owners walk away from a deal feeling victorious while others are left scratching their heads? The answer often lies in the nuances of working capital. Join us as we shed light on strategies for managing this key aspect and why it's imperative to have seasoned advisors, like CPAs or fractional CFOs, in your corner. With Russell's expertise, we explore how growth trends affect financial health assessments and how this knowledge can lead to a smoother journey to the closing table. Get ready to be equipped with valuable insights that could significantly influence the payout of your next big deal.

Transcript

Speaker 1: 0:02

Welcome to the South Florida M&A Advisors podcast, your trusted M&A team. Here's your host, Russell Cohen.

Jeremy: 0:13

Hello everyone and welcome back to the South Florida M&A Advisors podcast. I'm your co-host, jeremy Wolfe, joined by your host, russell Cohen. Russell, good to see you again. All right, thank you, jeremy. Yeah, man, so we were talking about the biggest sale in South Florida M&A Advisors history 100 million dollar deal with a roofing company that closed recently. Again, congratulations on that, thank you. So I know you wanted to talk a little bit more about that, because there's so many different components to a deal like that. There's so many different factors that go into it, one of which is networking capital. So why don't you start off by giving kind of an overview of what that is for people like me that don't even really necessarily know what that term means, and then we can get into how that pose challenges throughout that process of that sale.

Russell: 0:54

So the basic definition of networking capital is if you go on a business balance sheet, you got the current assets and the current liabilities. So the current assets minus the current liabilities will give you a networking capital. So what a private equity group will do is they'll go back 12 to 18 months, assuming if a business has consistent sales and EBITDA, they'll go back 12 to 18 months and get an average of networking capital. If a company is on a hockey stick growth, then they're going to take a very close look at the last three to six months and there's going to look for a nice fucking capital Now. So the networking capital is probably one of the biggest deal killers in M&A Transaction. Your advisor needs to be bringing this definition and explaining to you networking capital on the first meeting because basically what you're doing is you're getting a great multiple of your EBITDA but you're leaving money behind to run the machine. Business owner builds this monster of a company and it's a machine and it needs money to function for the private equity group or family office or the private company that buys it. So they're going to give you great, great multiple but you got to leave money money or accounts receivable behind to fuel the payroll to fuel the overhead because they're buying a pipeline but they got it. They're not going to front your expenses, they're not going to let you get a great multiple and then you take your AR and run out the door Again a contract statement and not cut a profit. So basically, so what happens here is if you are um want a larger type buyer, the quicker you grasp a networking capital then the more likelihood you can get to the closing table.

Russell: 2:50

Um. So I bring it up upfront and it's very important that we calculate the networking capital early before we find a buyer. And it's important that you calculate the networking capital while you're in the quality of earnings and it's going to get calculated at the end of the deal. So if we're doing it three times along in that process, when the private equity group or the buyer comes up with the networking capital, you're not surprised because you've been educated. So that is very, very important. And sometimes you could have your CPA do the networking capital analysis. And if your CPA is not interested in being there, by your side, we work with CF uh, fractional CFOs that will hold your hand through the entire process of from the accounting side and make sure your business is PE ready. So networking capital the quicker that the business owner takes on that, that definition and understands the process, the better chance they will get that major payout six to 12 months later.

Jeremy: 3:55

So is there kind of like a standard amount? I know you mentioned sometimes you can go back 12 months, 18 months. Sometimes if there's a hockey stick growth they'll take it for three months. It seems to me like you'll get, obviously get a better, um, the picture of the old, the, the state of the business over a longer period of time. Is there a standard that you typically apply to take those points of networking capital throughout the?

Russell: 4:17

uh yeah, yeah, most, most companies will do 12 to 18 months. Most companies are not on a hockey stick growth. They're more likely stable, or sometimes it's declining, which is not a good trend. Uh, you're trying to sell your business, um, so? So then, yeah, then.

Russell: 4:34

So when we were, you know if we're going to the, the roofing deal you know we were dealing with a hockey stick growth. Right, it was going from a 13 million EBITDA to a $20 million EBITDA and and and. So you know, looking back, that discussion was not was not done in the beginning, it was not done in the middle, it was done at the end, and and we had a major challenge because the private equity group did their calculations and they had a lot higher working capital versus what the seller thought. And it ended up being there was something on the balance sheet that caused the networking capital requirements to be calculated higher. So this could have been avoided if we took the, if at that time, took the approach to do it early in the middle instead of waiting to the end of the deal, and it created a lot of instability in the transaction and it almost blew up the transaction.

Russell: 5:32

There was, you know. So you're trying to avoid seller frustration. That's. That's the goal. So in this case we were able to work it out, but it was unneeded stress by by all parties, unfortunately.

Jeremy: 5:47

So was there any reason why you didn't do those calculations earlier on in the in the deal?

Russell: 5:53

You know I was not personally running the deal. I was leaning on my M&A associate and he's brilliant and for some reason he he did not. He did not do the beginning middle part of the networking capital. So, going forward, as I run my own deals or I partner with, you know, my other M&A associates I've made it. Now that I experienced it, now I try to bring in the fractional CFO very early Because typically the spouse or the CPA spouse it's over the spouse's head when we start talking that because they're not quick books pro advisors, they're not a CPA or high-end accounting person.

Russell: 6:39

They're doing the books and they're getting their way through but they're not an expert. They don't have 75,000 hours of accounting to become an expert. So I try to recommend to the sellers to bring in the fractional CFO. They will clean up, they will start working on the networking capital analysis and then as they get into the quick books so the sage books, they start seeing issues in the books and the CFO would then say you're really not private equity ready for the eyes of private equity, because sometimes in a larger deal they gotta be gap accounting and none of these small businesses are based on gap accounting.

Russell: 7:21

So we're trying to get it as very close to the gap accounting as possible. And so when the CFO gets into the books they see, they go into their general ledger and they see some funkiness and they start correcting it. And once we can get everything corrected now we can do the networking capital analysis and educate the owner on how much money they're gonna leave behind based on today, and once again we get to the quality of earnings. The accounting firm, the Q of E firm, will do the same and we'll do the same, and at the end of the deal everyone does the calculation and it becomes part of the contract. But there's always a paragraph in the letter of intent that talks about networking capital. So it's brought up early, it's in the LOI and we need to address it early to get to the finish line.

Jeremy: 8:18

Yeah, I think this speaks to the fact that every business is different. Right, there's no two that are the same. So when engaging in a deal like this, there are gonna be so many different factors to address and there's gonna be a lot of curve balls that are thrown up. There's no textbook blueprint on how to handle the perfect deal, because every business is different, so it is a learning process, like with anything else, and you go through this. Issues come up, you figure out how to fix them and then, moving forward, you apply that. That's how you become a master at your craft right Through practice, through trial and error and just continuing to grow and get it better. So it seems like you're doing that beautifully, brother.

Russell: 8:52

Yeah, and bottom line is, if a business owner who spent all the years building their business and they wanna dance in the multiples of private equity, they have to. These are professional buyers. They know they do this on a daily basis. The business owner does not. That's why they're hiring an advisor like myself. But they have to address this particular point and the quicker they believe in it, support it is when they get that great payday and it's a great payday, no doubt. And if you build a great company, multiples can be four, five, six, seven, eight, eight, x of your EBITDA. Those are generational numbers generational or signability.

Jeremy: 9:37

I was just writing that down. I love that dance in the multiples of private equity. Is that your? Is that original?

Russell: 9:45

to you. Yeah, that's awesome.

Jeremy: 9:46

Yeah.

Speaker 1: 9:47

I didn't drop you in.

Jeremy: 9:47

I love that dance in the multiples of private equity. I had to write that down. That's good stuff, man. All right, cool man. I think we'll end this segment there a lot more to talk about. Like you said, there's so many different components to this deal, so I'm sure we can pick up some other things in future segments. Anything else you wanted to share about that topic?

Russell: 10:06

I know, I think we had a good basis of that and it's something that a business owner will have to if they want to exit. They need to be embracing that concept.

Jeremy: 10:19

All right, Russell sounds good. Thanks everyone for tuning in and we will catch you all next time. Everyone take care.

Speaker 1: 10:26

Thanks for listening to the South Florida M&A Advisors Podcast. For more information, visit southfloridmacom or contact 954-646-7651.