The Search Fund CEO & Value Creation

Again, this is an old post that I deleted but apparently shows up as a reference with dead links throughout the search ecosystem, so I am reposting it. Please replace any dead links with this one. I think the old post might have been titled just "Value Creation," but I can't be sure. Thx. Big Love.

In every search fund business (or business in general), there are only two things the CEO needs to focus on: people and numbers. You may have a particular technology product, competitive threats, sales and marketing strategies, and existing customer relationships. But your ability to navigate those issues, and many more, will be determined by how well you utilize the people in your organization and the mathematical analysis you develop to measure everything you do.

I’ve written elsewhere about people, so this column is about numbers. It’s a topic that has been close to my heart for a long time as a CFO by original birthright. But in working with search fund CEOs recently, I noticed that it keeps coming up as the critical path to success again and again. So I decided I had to try to write some of the common themes down in the hopes that future Search Fund CEOs will be prepared for what awaits them when they get handed the keys to the castle.

Figure Out What is True

You had a quality-of-earnings analysis done by a reputable firm, talked to customers, poured over seller-provided financials, built investment models, including a bases case, as well as worst and best cases, interviewed existing financial employees, and thought you knew what you, and your investors, were buying.

You were wrong. You will figure out how wrong you are in the first month on the job.

It’s not your fault. In any acquisition, there is a significant difference between looking in from the outside at a potential target and sitting in the CEO’s seat when it comes to financial reality. In the case of search fund targets, the generally poor financial management in place magnifies this difference. You are getting a deal for an excellent, profitable company because it has been undermanaged. There might be a bookkeeper, maybe even a controller. But there are unlikely to be any good. And there will be surprises. It’s just a matter of the magnitude.

It’s a good idea to do a systematic internal audit of everything financial when you hit the ground and keep a very open line of communication with the seller while you are doing it. Maybe have a weekly meeting where you update him or her on what you have figured out. If the surprise is big enough, you must have a frank conversation with the seller about how to adjust the deal.

Your goal in the first 90 days is to establish the financial baseline. By the end of that period, you want to have complete confidence that there are no more unexpected financial surprises than what you represented to investors. And you have figured out how to mitigate the surprises you did uncover one way or another, with complete transparency to your board throughout.

Develop Solid Books and Records

Once you have a financial baseline, you need to focus on the financial record-keeping process on a go-forward basis so that management and the board get the correct financial information in an accurate and timely manner. It’s doubtful that this process will be in place when you walk in the door. It may be that you will need to hire a controller and/or CFO to help build this process.

A key here is financial reporting. At a minimum, you will want to get into a very predictable cadence around closing the books monthly, quarterly, and annually to provide meaningful financial statements to you and your management team, the board, and investors. Depending on the situation, you may need to develop weekly or daily information flows to get your arms around what is happening (see key drivers below).

Variance Analysis

The most crucial concept in financial analysis is variance analysis. How did what happened compare to what you expected in a forecast or budget? How does it compare to what happened in the prior period or the same period last year? Where are the significant variances? Once you are sure that the financial data you are getting is reliable, you need to spend all your time drilling down on what caused those variances until you understand what is happening.

A business is not a static organism. A financial statement is a two-dimensional snapshot. Only when we look at variances, do we understand how the company is progressing through time and whether we are on the right track.

Key Drivers (again and again)

In all businesses, there is a pyramid of what some would call “key drivers.” I’ll start at the top, where they are all the same, and work my way down.

We all strive to increase shareholder value—the business’s equity value. Search fund acquisitions will generally be valued based on EBITDA size and historical growth (some would argue that SaaS businesses are also valued based on ACV or recurring revenue).

Below that in the pyramid, every business will be a little different. It’s up to you to determine the key things you can measure that are going to determine, in the end, your ability to grow EBITDA over time, even if that growth isn’t necessarily in a straight line (requires an investment period to reorganize or rebuild a product or hire new management or invest in sales and marketing).

But ideally, you can break your business down into 5-7 measurable factors that determine whether or not you are on the path towards EBITDA growth and, therefore, shareholder value growth. I like to keep those critical drivers on a scorecard on a single piece of paper and refer to them frequently. To the extent possible, have the management team members responsible for one or more of those factors do the same with the component drivers that will determine their success or failure.

The key drivers (or KPIs) themselves may be different over time. It may be that certain factors are crucial in one stage of your development, but once you have achieved a specific scale, other metrics emerge essential for the next leg of the journey. Keep asking yourself if the metrics you track collectively determine your success in creating shareholder value.

Your First Budget

“You never get a second chance to make a first impression” is a wise adage when constructing your first budget. You have your investment model. Then, you have everything you have learned on the ground between the time you took over as CEO and created your first budget (generally the stub period between the acquisition and the start of the following calendar year).

You certainly don’t want to disappoint your board or your investors. And hopefully, you found some mixture of positive and negative surprises on the ground. But in the vast majority of cases, the negatives outweigh the positives, so you have a lot more to fix than perhaps you thought you would.

The most important thing you can do is set your board’s and investor’s expectations in your first annual budget in such a way that you have a very high degree of confidence that you will meet or exceed that set of numbers on the most critical metrics (like Revenue and EBITDA).

Any budget is a delicate balancing act between conservatism and showing progress toward the long-term goal of shareholder value creation. In many cases, the right approach to the first budget in your Search Fund Acquired Company is to recommit to the market opportunity and the future perfect of where you want to get but take a measured approach to how far you expect to get in your first full year on the ground. If it turns out you go faster and crush the budget, great. But you want to avoid overpromising and dramatically underperforming out of the box, thus damaging your credibility as a leader. This is the set of numbers by which you will be measured month-by-month, quarter-by-quarter, and for that year. You can start with what you know you can achieve and go from there.

The Strategic Plan (Multi-Year Forecasting)

The best CEOs are constantly walking around with a multi-year strategy in their heads, so they know how each decision they make impacts when and how they will get to the Promised Land.

For Search Fund CEOs, who have generally never been in the role before and are dealing with companies that have been historically undermanaged, the first months and even years on the job feel typically like drinking out of a fire hose. So, going through a financial articulation of a multi-year strategic plan is something they have not been capable of for quite some time.

But once you have figured out what is true about your business, you have put in place solid financial reporting, you have gotten the hang of driving down into the details of variance analysis, you know what the key drivers in your business are, and have a process for continually driving them forward. You have established a solid budgeting process where you meet or exceed annual targets … you know a lot about the company you are running. And you probably have a view on the right longer-term strategy. And you even might be ready to work with your CFO and your board on a multi-year strategic plan to codify just how you intend to take your company to the size and valuation that was your goal when you bought the company, to begin with.

I think of the multi-year strategic plan as re-writing the PPM, only with a hundred times more realism and information than you had as a searcher who only knew your company from the outside and had never been in the CEO seat. Don’t do it before you are ready, but do enter the process when you are ready.

Summary

I hope these tidbits are helpful to you if you are preparing to take over the CEO chair, have recently bought a company, or have even been at it for a while. Your people are the engine that will create value in your business, but the numbers are the information flow, allowing you to lead them in the right direction.