Acquisition Pro Formas for Bank Loans
Acquisition Pro Formas for Small Business Loans
This article aims to help small business owners understand acquisition pro formas from a lender's perspective. It's important to note that pro forma templates are widely available in our industry. You can obtain one from your contact at your bank or financial institution, as well as from various vendors in the M&A ecosystem. We also provide templates. There’s no need to build a pro forma spreadsheet from scratch. However, understanding these documents is crucial because, whether or not you're securing a bank loan, pro forma financial models are fundamental for evaluating an acquisition as an investment. Let’s dive in.
Historical & Projected: To qualify for an acquisition loan, banks evaluate two main factors: the past and the future, in that order. The past involves examining the last two years of combined EBITDA for both the buyer and seller compared to the debt service. The Debt Service Coverage Ratio (DSCR) needs to meet historical minimums for the future DSCR to be relevant in the loan approval process. When considering the future of the combined entity, banks rely on a pro forma. They expect the buyer to prepare and provide this document; the bank will review it but typically won’t create it for you.
The Purpose of the Pro Forma: A pro forma is a projected financial statement that forecasts a company's future performance. In simple terms, it's a financial forecast model that takes your current financial data and combines it with projections for the acquired business, offering a glimpse of the merged entity's future performance. It’s essentially a hypothetical snapshot of how your business might look financially under various scenarios.
The pro forma is structured like a combined forward-looking P&L, showing Revenues, COGS, Income, Expenses, Net Operating Income, and/or EBITDA. Most pro forma templates will calculate how many years and months the acquisition loan takes to pay for itself.
Adjusted EBITDA: Adjusted earnings provide a clearer picture of your business’s operating performance by excluding certain non-cash expenses. Add-backs are adjustments made to EBITDA to account for non-recurring or non-operating expenses. This can include items such as depreciation and amortization, which allocate the cost of assets over their useful life; one-time costs like restructuring charges, legal fees, or consulting fees; equity-based compensation; and gains or losses from the sale of assets. These items should be accounted for in the pro forma to achieve a more accurate projection. A basic pro forma might only include unadjusted EBITDA, which includes depreciation and amortization. For small business acquisitions, it’s beneficial to use a more detailed pro forma that accounts for adjusted EBITDA and add-backs.
Key Add-backs and Assumptions: A pro forma is based on assumptions about future events. Key assumptions could involve expected cost savings or revenue growth from the merger, overall financial market trends, and estimates of one-time costs associated with integrating the businesses.
Realistic Assumptions: When making your projections, aim for a balanced perspective—neither overly optimistic nor too conservative. Banks often view projections as optimistic, regardless. Identify what’s certain and probable, using the most realistic assumptions while maintaining a balanced view. Adjust the optimism and pessimism of your projections by considering the CAGR and evaluating scenarios where revenues might drop by 10% or 20%.
Don’t Be Too Optimistic, But Especially Don’t Be Too Conservative: Strive for realism while avoiding excessive optimism. For example, don’t assume a 10% CAGR if your growth has been between 5% and 6% CAGR over the past three years. However, if you’re acquiring a business that’s twice your size, a 10% CAGR may be justified. Similarly, if you’re close to a 10% growth rate but face significant attrition due to an aging customer base, yet are acquiring a business with younger demographics, then a higher CAGR could be warranted. This leads us to the next topic: providing clear explanations in the pro forma.
Explaining Variances from Historical Data: Pro formas require projecting figures that may diverge from historical data. Bankers seek to understand the reasoning behind these variances, add-backs, and assumptions. Each assumption should be succinctly articulated, with a brief paragraph generally sufficient. For add-backs, a one-sentence explanation is usually adequate. This approach provides the underwriter with essential context for each item.
Provide Context with Clear Explanations: Advisors often tend to be overly concise in their explanations. Avoid one- or two-word answers. For instance, if the profit and loss statement indicates the seller is paying $3,000 in rent, and the pro forma omits a line item for seller-side rent, don’t merely write "no rent" or "no rent per LOI" as your explanation. Aim to make the analyst’s job easier, not more time-consuming. In this scenario, a more helpful explanation could be: "Seller rent is excluded because we will not be taking over the location, which only has one assistant transitioning to our office. Please refer to the LOI for further details." This type of detailed explanation greatly assists analysts and takes only seconds to compose. Considering that analysts review numerous deals daily, thoughtful explanations significantly enhance underwriting efficiency.
Monthly Pro Forma: Banks prefer to see the pro forma broken down by month rather than presented as a yearly total. While your personal ROI forecast may extend over a longer timeframe, banks typically focus on the first one to two years.
This article is authored by Darin Manis, founder of LoanBox.