“Strategic planning is the continuous process of making present entrepreneurial (risk-taking) decisions systematically and with the greatest knowledge of their futurity…”
In the mergers and acquisitions world in which we live, there is a longstanding syllogism among some that the best predictor of future behavior is past behavior. This philosophy is not limited to those in m&a. In “The Tempest” Shakespeare has a character remark that “what’s past is prologue”, and we know many people who subscribe to that theory when evaluating business opportunities. We, however, prefer to rely on Peter Drucker – who once said “strategic planning is the continuous process of making present entrepreneurial (risk-taking) decisions systematically and with the greatest knowledge of their futurity…” In other words, it is about taking the available information – and using that information to make intelligent decisions now, in light of future expectations.
It’s all about the future – not the past.
But how does all this theory relate to information technology investment banking?
Take the recently announced Verizon/Yahoo deal as an example. In July, Verizon announced that it had agreed to acquire the operating business of Yahoo for ~$4.8 billion. A few months later, after reports surfaced that some 500 million Yahoo accounts had been breached in 2014, Verizon reportedly asked for a $1 billion purchase price reduction. Why? Probably because they saw that any prediction of future financial results would now have to take into account the possibility that this breach could result in customer defections and create challenges attracting new customers – it’s all about the future.
If past were always prologue, than valuing firms would be easy – and everyone would agree on the math. But it’s not that easy. Buyers (and sellers) are smarter than that. They buy (and sell) based on their respective expectations for future results. Buyers trade the certainty of cash or equity or debt capacity now for the uncertainty of the future. Sellers trade the possibility of future results for certainty today.
While past performance is one important aspect in informing a potential buyer about future prospects, it is not the only one. In fact, a better predictor of future performance relates to the ability of the management team to take the facts at hand and use them to systematically predict the future. That’s why we stress to sellers the importance of getting their near–term forecasts right.
The best forecasts are built from both the top down – looking at what future is likely – based on experience; and the bottom up; i.e. client by client or segment by segment forecasts, using historical growth rates (or averages) and taking into account business specific factors such as seasonality. But most importantly, we tell clients that they need to be sure that they can hit the near-term marks.
It’s about trust.
For many of our clients, a typical sell-side process can range from 4 – 10 months, so there is usually at least handful of months for buyers to compare actual results to management forecasts. An underappreciated aspect of a process is the psychological impact of “hitting” or “missing” the numbers. Missing the numbers has a more significant (negative) effect on a process, than the positive impact of growing a few more percentage points. Buyers’ trust in management’s veracity about the salient facts on the ground and their ability to manage in the future is a key element in many transactions, and that trust begins to erode when management forecasts are not attained during a process; confidence decreases around not only around future financial assumptions, but also around other “facts” that the management team has asserted to be true.
We experienced this scenario recently, while advising on the sale of a company that had forecast revenue growth of about 30%. In a situation reminiscent of the Verizon/Yahoo one, after a winning purchaser had been notified and a purchase price agreed – but before a definitive purchase agreement was signed, it became clear that the company would actually grow revenue by ‘only’ 28%. This led the purchaser to become nervous. Could they “trust management” on other statements. It also led the buyer to conduct a closer examination (in extraordinary detail) of financial estimate inputs and pipeline prospects. The time to provide this additional level of analysis and create a revised forecast led to lost deal momentum, and started a conversation about the buyer possibly reducing purchase price. Had the client been a bit more conservative in revenue forecasting all this could have been avoided. (Fortunately, in this case, profit did not suffer and we were able to show that future revenue growth was likely to be as forecast.)
It’s all about the future.
Our advice to our clients is straightforward: disclose everything; and create a financial forecast that is as solidly grounded in past actual performance as well as in reasonable future expectations. Base it on a combination of current run rates and pipeline prospects; anticipate that the pipeline timing may be hard to predict, but be methodical in how those opportunities may contribute to near term results.
And ultimately, be sure. Don’t miss the near–term projections.