Regulation has hampered M&A deal volumes in 2021, but acquisitions are still among the most popular ways for tech companies to scale quickly. Acquiring or investing in another company can accelerate your software development process and get you to market faster than ever. That said, it’s of utmost importance to ensure that you use the best financial modeling methods available to get an accurate understanding of potential investments.
Private equity modeling is one of the best ways for companies and venture firms to review an investment opportunity.
Financial modeling for private equity often means applying your spreadsheet or software-generated financial reports to analyze cash flow, valuation, and other key metrics to measure whether or not acquiring a company is a solid investment. A thorough and detailed financial model can uncover potential weak areas off an otherwise stellar acquisition.
For company executives, the more you know about your potential business, the better.
Depending on the type of financial analysis you choose, you may need documents like complete financial statements, balance sheets, and cash flow statements to name a few.
For private equity modeling, you will want as much information as possible.
The best analysis for private equity modeling: LBO
The most common private equity model is the Leveraged Buy-Out (LBO) model. This financial model provides buyers a look at the expected returns on acquiring a business.
To complete your LBO model, you’ll primarily need cash flow statements as well as any information you have on their debt and equity.
The complexity of this model depends on how complicated the business is that you’re planning to invest in. It is generally calculated by reviewing the purchase price, the exit value, and the cash flow generated for the period you own or invest in the business.
Once you know this information, you will be able to understand whether the investment is likely to bring noteworthy returns or at least become a liability based on its annual cash flow.
There are several formulas and metrics to keep in mind when reviewing your LBO model. Primarily:
- Net present value (NPV) - This metric is used to determine the difference in cash value today and cash flows over a period of time.
- Internal rate of return (IRR) - The IRR is not the project’s actual value but an average annual return. In this formula, your NPV should be set to zero.
- Cash on cash return - This formula is usually applied to real estate investments. So if your potential acquisition has invested in property or a lease, you’ll want to review if that is a necessary expense.
- Debt/EBITDA ratio - LIabilities and debt are also important to review. EBITDA stands for Earnings before interest, taxes, depreciation, and amortization, and it can help you understand when and for how long a company will be profitable.
- Debt/Equity Ratio - This ratio compares debt to whole-share equity and will allow you to monitor whether or not a company will be able to pay its outstanding debts in case of a crisis.
- Multiple of invested capital (MOIC) - This calculation compares an initial investment with the company’s current value. With this, you can estimate how much you are receiving on an investment.
Additional model types and when to use them
While the LBO model is essential for private equity needs, you can use several other models effectively.
Each model has its own specific use case, but each also provides essential information about the potential acquisition.
The standard 3-Statement Model provides an overview of a company’s financial health. Since this model uses historical and current data, you can understand overarching economic trends and determine whether or not the business might require additional capital down the road. Additionally, this model is excellent for reviewing long-term debt repayments and similar liabilities.
You generally need to collect years worth of income statements, balance sheets, and cash flow statements for this model.
Valuation and DCF Models
In contrast to other models, the Valuation and Discounted Cash Flow (DCF) models allow you to pin a valuation on a particular company. For a fundamental DCF analysis, you’ll need a forecast with P&L data, financial statements close to your valuation date, and a spreadsheet or modeling software.
Keep in mind that since you rely primarily on forecasts, more extended valuation periods are less likely to be accurate. Most early-stage companies may forecast only up to 5-years into the future, while more mature organizations can predict 10-years.
Budget models are typically used for a business to determine its financial planning. These review monthly or quarterly numbers and use income statements as the primary source. They are relatively straightforward and used internally.
Before acquiring any business, you’ll want to use the LBO or Merger model in addition to the Budget model to ensure that you will have sufficient funds to support the new business.
A simple forecasting model is similar to the budget model. It’s primarily used for internal modeling, and you’ll want to use this to ensure that taking on a new company won’t drain your resources.
Merger models, unlike our previous examples, require financial information for both companies. You’ll use this model to understand whether acquiring a small company provides a long-term financial benefit. For this time of analysis, you typically measure Earnings per share (EPS) or Net Income/Shares Outstanding, valuation, pricing, and stock amounts.
To complete this model, you need the income statements and cash flow statements from both parties. You’ll want to consider:
- price paid for the business
- cash, debt, new shares
- expected synergies
- additional assets, such as IP
You can use various models for private equity —both when making investments and when integrating those potential assets into your own business. From basic budgeting to LBOs, each model has its specific use and metrics. The good news is that the source materials are usually reasonably accessible.
No matter what model you use, you’ll want to invest in software that automatically keeps track and forecasts costs. Spreadsheets are great, but they can only get you so far, and they are prone to errors. Once you know what models you plan on using, it’s best to decide on a tool to help you effortlessly analyze and forecast scenarios so that your models are as accurate as possible.