Five Signs Your Portco Isn’t Ready for an Exit

A poorly managed exit process can erode value, and in the worst cases, a portfolio company that isn’t prepared to start that process can kill a deal. Tony Esposito, managing director of private equity and venture capital at Consero, and Josh Welk, founder and managing partner at Full Guard Capital, discuss the indicators that show a portfolio company isn’t ready for exit, the potential fallout from a lack of preparedness, then share their tips for what to do when you spot those signs.

This episode is brought to you by Consero Global, a leading FaaS (Finance as a Service) provider. This is the final part in a three-part series about exit preparedness. Read a transcript of the podcast below. 

Middle Market Growth: Welcome to the Middle Market Growth Conversations podcast. I’m Katie Maloney. Today I am joined by Tony Esposito, Managing Director at Consero, and Josh Welk, Founder and Managing Partner at Full Guard Capital. Tony and Josh are joining me to discuss some of the signs that a portfolio company isn’t ready for an exit and what to do when you spot those indicators. This is the final installment in a three-part series on exit readiness. Josh and Tony, welcome to the podcast.

Josh Welk: Thanks for having me, Katie. I’m excited to be here. Good to talk to you guys.

Tony Esposito: Hey, Katie. Pleasure to be here.

MMG: Let’s kick off the conversation by discussing some of those signs I just mentioned. What are a few of the biggest indicators that a portfolio company isn’t quite ready for an exit? Tony, why don’t you start us off?

TE: Absolutely. I would say one of the biggest indicators that they’re not ready for an exit is just the state of the finance function. You know, if finance isn’t fully under control, that could be a red flag for any potential buyers. What we really preach here at Consero is being audit-ready, being able to close the books quickly, and then also having a scalable system infrastructure in place so that the company is really well positioned for that exit, and then also in a position where they can instill some confidence in the mind of the buyer. Ultimately, what buyers want to see is not only a company that is performing well today, but also one that has that financial muscle, has some good infrastructure in place that ultimately can support future growth. I think another key piece is just going to be FP&A. A lot of founders out there, they’re really product- and customer service- and experience-oriented, but they can sometimes look at finance and accounting as more of a necessary evil rather than a strategic function. But, without that strong FP&A, it could be tough to answer a lot of the questions that more sophisticated buyers are going to have during a due diligence process. So, my advice to any company would be to try to elevate that finance function to be a strategic partner in the business. And if it’s not there yet, that might be a sign they’re not quite ready for that exit.

MMG: And Josh, what are some of the other signs to look out for?

JW: Tony, you hit the nail on the head on the finance function. Ultimately, looking more broadly at how we think about what drives a company value at exit, buyers are looking for quality of the cash flow stream, as well as certainty to be able to continue to deliver it. So understanding, what is your cash flow stream, add-backs, adjustments, anything that might play into that, audited financial statements? Tony made a great point that those are all very important. We also look more broadly at, well, what is the quality of the management team, the depth of the management team? Because you could have a very good business that’s generated profit in the past. The predictability of being able to deliver that going forward boils down to a lot of other factors around the business. And in our minds, first and foremost, that starts with the management team. So as you think about exiting a company, do you have one or two people, or do you have a team of four or five key leaders that are helping drive that business? As buyers look at trying to define value and interest and an opportunity, they want to know that that team is ready. And the less work they have to do to build the team, the more value you can create at exit. The other major factor, I’d say, is just being prepared for due diligence, especially if you’ve never been through the process before, it is a painful process. It’s not fun for either side. Sitting in a buyer’s shoes, we don’t like to make your life difficult, but it also can create deal fatigue on the seller side. And one of the biggest challenges in any acquisition process is speed. You don’t want to let deals carry on too long. You want to be able to react quickly. And the more that you can be prepared for that due diligence process, the better off you are. We encourage all of our teams to actively think about what goes in the data room, maintaining logs and tracking that information on a monthly basis, put new contracts, customer information, financial statements, etc., in one key place that when the time comes, it’s already all there and the work has been consistently maintained rather than it being a major process at the time of exit.

MMG: And so, building on that, what are some of the risks that organizations face when they overlook these signs that you’ve both mentioned? Tony, you want to take that one first?

TE: Yeah, I think there could be several risks. For one, the valuation can suffer. We’ve seen instances where buyers might ding the valuation if there’s a perceived weakness in the financial reporting, or internal controls or, you know, any area of the business. The second part is just favorable EBITDA adjustments. There sometimes could be EBITDA adjustments that work in the seller’s favor, and ultimately the sellers could be leaving money on the table if they’re not doing some of that work upfront. So, our suggestion at Consero to companies that are looking to go through an exit is to have a readiness assessment completed well in advance of a transaction. We usually say 12 to 24 months ahead of time is a great time to engage a third-party like Consero, just ultimately to make that process go a lot smoother, a lot more profitably for all parties involved.

And just to share one example of another risk, and that is just, you know, Josh mentioned timing and how speed can be really critical. We had one client who was operating on QuickBooks—well, they weren’t a client at the time—but they had a person in the finance function who had been with the business a long time. There was some key person risk with this in-house controller who was retiring. And ultimately, they had some private equity interest and one firm even expressed, “We’re ready to put out a letter of intent, but we really need you guys to outsource this finance and accounting function and get the monkey off your back. Implement a scalable ERP as well that can help you guys be add-on acquisition-ready. Because that was part of their thesis, a buy-and-build strategy.” And this company came to us, and we helped them implement more scalable systems. We optimized their processes, and we also brought a scalable back-office team to the table. And we did it all in less than 90 days. And in that case, it was a happy ending because the PE firm did move forward with the transaction a few months later, albeit, but just the summary there is, the more prepared you are, the better. And in this case, that seller could have exited probably four or five months earlier if they had their finance and accounting function a little bit more well-oiled from the get-go.

MMG: And Josh, I’ll put that question to you too. Are there other risks that you’d point to that organizations face if they fail to recognize some of these signs that a company isn’t ready to exit?

JW: Yes, that’s a great point. One of the challenges is just transaction execution period. As you start to think about going through the process, you bring people in the management team into the process, people get nerves around selling. It creates a lot of trepidation, noise, etc., that may exist inside the company, the people that find out about that. So, when you decide to launch a process, being able to actually execute and execute in a timely fashion is uber critical. A blown deal, a deal that drags on, it just creates unnecessary stress in the organization. And as we talked about a couple of things previously around finance, you know, professionalization specifically, those are the types of things that can give buyers real concern. “Hey, we thought we were buying cash flow of X, but as we dug in here, the accounting policies, different things, didn’t line up. It’s now 80% of X and now we have a real concern,” and maybe the valuation changes and you end up in some different discussions that don’t feel good for anybody around the table. Additionally, it also can potentially impact the types and availability of capital that you would consider. Maybe it’s not even an exit, but it’s a significant recapitalization of the balance sheet. If your numbers aren’t tight, you may be having to bring in, you know, growth equity or minority equity versus debt financing, and that impacts your ownership percentage. So, as you think about the quality of your numbers, having very tight numbers, being able to hit a due diligence timeline, and have confidence when you launch that process, only benefits everybody around the table. It isn’t just value, but it’s also creating a smooth process for your management team where everybody’s comfortable.

MMG: And Josh, are there things that private equity firms and their portfolio companies can be doing now to avoid getting caught flatfooted when exit time comes around?

JW: Absolutely. So internally for us, we are not believers in a one-size-fits-all box. Every company’s unique. They’re dealing with different challenges and dynamics, but we are big on trying to create certain buckets of measuring, items around professionalization, around value creation, that we see a path of, you started here, you move to a next step, you move to a next step, and finally you maybe hit the goal, or you outpace the goal. And so creating some sort of internal scorecard that’s specific to the company that you invest in, trying to identify: what are the key attributes of your investment thesis that are going to help you capitalize on value? And then trying to measure on a regular basis how the business is performing against that scorecard. Again, we have, you know, call it five or six key buckets that we try to track against, but the initiatives within each of those buckets could be a little bit different by company, but we try to create goals of how do we continue to improve every step of the way. And as we progress through those goals, especially if you see the financial performance scale and growth in the company and profitability, that’s when we start to see, okay, maybe it’s time to think about an exit versus if we’re behind on that scorecard, probably not the right time to be thinking about that exit process. Additionally, I’d say as you think about a sale of a company, we’re big believers in doing a sell-side quality of earnings analysis. So, sometimes they can be expensive, especially for founder-owned businesses that are maybe looking to sell to private equity for the first time, might not be an interest in spending the money. “Hey, that’s the buyer’s due diligence.” The more you can get out in front of that, for all the reasons Tony mentioned around financial professionalization and making sure there’s no hiccups in due diligence, if you have an independent accounting firm validating your numbers, you know, verifying that what you’re representing to the market makes sense, do that upfront. It smooths out the process and helps you kind of keep things moving along. And then the last thing I would say is, and I mentioned it previously, maintaining that internal data room. Call your accountant, call your attorney and ask for a standard due diligence list. Call your private equity partner and ask for their standard due diligence list. And then create that internal data room that maps against a lot of those items, you know, you’re going to have to provide when that exit process comes. The more you do that on a consistent daily basis, it takes all the effort off at the end of the day. And additionally, there’s times where a buyer might have an inbound phone call and say, “Hey, we are very interested in your business for a specific strategic reason.” You might not have been thinking about selling, but now the opportunity is there. The work you’ve done over time allows you to be able to capitalize on that process quickly, if it makes sense.

MMG: And Josh, I was hoping you could also talk about what leadership teams at portfolio companies should be prioritizing throughout the process.

JW: So, it’s a great question. We lead first with the importance of our management teams. Our companies could have a great product, great service, great system, but if we don’t have quality management teams, you know, things can be a challenge. So, we’re very much focused on the strength of our teams, very much focused on building the teams as we grow, and getting the right people in the right seats. First and foremost, regardless of the process, you have a responsibility to run the company. The number one thing that can derail a transaction is: you’re distracted from running the business. Things are getting in the way. You’re focused on the deal; you’re focused on due diligence. You’re focused on answering all these questions and you miss something. And all of a sudden, the numbers start to trend down. The numbers kind of fall off of plan or under the projections that you thought you were going to deliver. That’s going to create a lot of questions from the buyer. So, when we think about educating our teams for exits, what to prepare for in exits, we’re a very big believer in leveraging third-party resources as much as possible to augment what the management team’s doing. So Tony is a great example of Consero, leveraging a third-party FP&A function, you know, doing the modeling, doing the projections, doing cash flow planning, you know, helping with due diligence, administration, whatever it may be. Same thing with your accounting firm and your law firm. The more you can push the day-to-day due diligence execution of the deal process onto third-party advisors, the more you can stay focused really on driving the business. Because that is the most critical part to ensure a smooth transaction. And quite honestly, it gives you leverage if you’re outperforming those projections, you have leverage as a seller to say, “Hey, you offer me X, but I’m beating this. And now you’re dragging your feet on the deal.” You can kind of, you know, keep them honest in the transaction process. So that is a big piece is to keep the leadership team mission focused on driving the value of the business.

MMG: And Tony, I want to bring you back in here as well. Anything that you would add about what leadership teams should be prioritizing?

TE: Yeah, I couldn’t agree more with everything Josh just said there. And, you know, I’ve seen an example of this with a company that we brought on to Consero. They had signed a letter of intent with a private equity sponsor at right about a $5 million in EBITDA run rate, but they were doing really well. And the adjusted EBITDA, looking forward to end of the year, it’s looking like it’ll be more of a $8 million, $9 million year. So that just goes to show it’s important to keep a focus on just the day-to-day operations. The exit process can really be time consuming, distracting, and if you let your financials dip, that’s going to have the opposite impact on the valuation in the deal terms. So that’s number one. You know, to expound on just third-party advisors a little bit, super important to bring them in. You don’t want your management team to have to give up their nights and weekends for a period of 30, 60, 90 days, whatever the LOI period is and that exclusivity period is. Bring in specialized experts, whether it’s in finance, legal, any other areas that could just take on some of the minutia that comes with a due diligence process. And then I would just say,      be careful with the third parties that you’re choosing. The good news is that if you’re working with someone like Josh and Full Guard Capital, they have a lot of experience helping companies exit so they could help to guide and advise on what third parties to use. But for those companies that are more founder-owned, I would suggest doing reference checks, finding advisors who have a proven track record working with companies in that same industry, and that understand the nuances of not only the industry, but the business model, and then bringing them in early. So, the earlier you can bring in a third-party, the better. It’s all about being proactive to make sure that exit is successful.

MMG: I’m interested to hear from both of you, maybe starting with you, Tony, about how portfolio companies should discuss diligence issues as they’re working through them with a potential acquirer. What tips can you share there, Tony?

TE: The most important thing is to be just transparent and upfront with issues, because that could come back to rear its ugly head down the road if a company isn’t. So, a lot of the time these issues will come out in that sell-side quality of earnings analysis, and that’s why it’s so important to get that done as a company that’s going to market. I’ll give you one example. A company that we had some conversations with, a private equity sponsor introduced them and they were interested in making the investment, but the company had some sales tax liabilities, and this was relatively unknown to the company itself. And after going through the due diligence process, the PE firm did uncover this sales tax liability, which was pretty significant, and it ended up being a broken deal because of that. So, had they been upfront with that, had they done their due diligence themselves and realized there was a sales tax liability, that probably could have been navigated, but because it came just as a blindside to really all parties, it destroyed trust and ultimately led to the deal not getting done. So, it just goes to show how important it is to be proactive, be upfront about where you’re weak, understand those weaknesses, and present that all as transparently as possible so that you can navigate the exit process and the due diligence process.

MMG: It’s definitely a powerful cautionary tale. Josh, what would you recommend for how portfolio companies can address diligence issues with an acquirer?

JW: Yes, I would echo Tony a lot just about being upfront, honesty, truthfulness from the start. And that probably starts with third-party advisors, even before you really launch the process, before you even get to talking to, you know, actual buyers in that exit process. You know, we tell everybody we’re talking to that we’re going to kill a lot of trees in the process and have a lot of documents, and sign a lot of things, and say a lot of things in those documents, but if we get to closing and feel like we are going to have to open them after closing, we’re probably not in the right partnership because we should have a good enough relationship by that point in time and a good enough level of trust. Look, things happen. Business happens. I’m not saying you don’t open those documents after the fact. Sure, certainly people do. However, we really want to feel comfortable that we’re doing business with the right people and that there’s a trust factor, that if something happens day one after closing that we’re going to address it as a business issue. We are here to be your partner. And if there’s trends in the due diligence process of feeling like we were surprised or something popped up, or, you know, maybe this was hidden, even if it wasn’t, it certainly when we’re committing millions and millions of dollars to buy a company representing our investor capital, you become skeptical and you really start to think, “What else is out there? What else is being hidden?” So being forthright and upfront I think is key. And sometimes you might not hear the news that you want to hear but starting out with your third-party advisors and saying, “Hey, we think there’s this potential issue hanging out there.” They may advise you, “Hey, delay the exit process. You talk about exit readiness. Delay the exit process for six to 12 months. Let’s go try to resolve that issue and put it behind us so when the time comes, it doesn’t become a problem.” They may also say, “We can launch a process, but we need to be forthright that this is out there and has to be dealt with.” So, the more you seek advice from those advisors that sell companies for a living, I think Tony also mentioned industry expertise, we are big believers in focusing on areas that you understand well rather than being a tourist in all kinds of different industries. So that also goes to the sell side advisors, especially in investment banking, if they understand healthcare, or they understand a specific piece of manufacturing or aerospace and defense, leveraging their expertise in that market to understand what type of due diligence issues could create a problem. Being out in front of that from day one will just make those conversations, and the process go much more smoothly. So really, again, the scorecard, being honest with your advisors as they go through the process, encouraging honesty and truthfulness with the sellers, and also, the sellers demanding that from the buyers, that the buyers be forthright with them too. There should be an equal feeling on both sides to feel comfortable about that partnership.

MMG: We’ve been talking so far about signs that a portfolio company isn’t ready for an exit, but on the flip side, what are some positive signs that a private equity firm and their portfolio company have a positive relationship and are ready to work towards an exit together? Josh, do you want to weigh in on that one first?

JW: Sure. I’ll circle back to the whole leadership team. That’s really priority number one for us. And I’ve seen a number of situations in my career at a prior firm, where I’m at now, where sometimes there’s misalignment with the management team and it creates consternation or concern that, you know, well, what happens to my job? Or, you know, I don’t like this value, or I’m going to try to hold the deal hostage at the last minute, and I thought I got this deal and now I’m not getting this deal. Being able to be upfront and addressing that alignment with the management team, it really starts day one     as you build your team. Maybe it’s when you buy the company. It’s certainly when you bring executives and recruit executives into the business, the alignment of incentive equity, retention bonuses, other types of tools that really get folks not just aligned on the vision, but financially aligned with the outcome of that sale process.

And then when the time comes to actually launch it, be in sync with that management team. Understand what they want. The worst thing you could do is present to a buyer, “I got a five person C-level team that’s going to drive this business, you know, 200% growth in the next three years for you, and here’s how we’re going to do it.” And then the buyer gets a chance to talk to them and they’re like, “Yeah, I really only want to do this for two more years and then I’m going to transition out.” That’s going to create a major problem, and you want to be out in advance of that. So that alignment is a very key piece. It’s also a very important piece again that that team show well, in terms of one, the buyer has to believe the cash flows, but two, they have to understand the risk again, that those cash flows continue. The management team being able to speak confidently to that vision is a really important piece. So, again, I feel like I’m saying a lot about the alignment and, and a kind of harping on the importance of the management team, but it is the biggest thing, one, we try to build in our companies, and two, we look for when we’re trying to find a target acquisition to add to our portfolio.

MMG: And Tony, is there anything you would add to that in terms of positive signs that that exit readiness has been achieved?

TE: Yeah, I think Josh hit on most of it, but I would say it’s just overall things are going in the right direction. The business has that steady month over month, year over year growth, and they’re in a position where they’re ready to go to market and the narrative is positive. Also just going back to the initial goals of the investment, right? Has the company hit those growth goals and doubled or tripled in size and, if so, okay, now it’s time to really start going down that path of the exit and making sure there’s open communication with the PE sponsor, the management team, all the third-party advisors is super important. And then the other piece I would just add is the alignment around the post-transaction plan. So, this includes decisions about who’s going to stay on after the sale, how long are they going to stay on and transition potentially to a new CEO or new management team. But, I think Josh really summed it up well and those are just a couple of other indicators I would include that signal it’s time to pursue an exit together.

JW: And Katie, I would also add, we were talking a lot about third-party advisors and in situations where it’s maybe a family-owned business, a founder-owned business, it’s their first time looking at potentially selling their business or getting institutional capital. Those third-party advisors are extremely important in educating you upfront and preparing you for the process. On the other hand, if you’re now a first or second time PE-sponsored business, but maybe you’re a new management team member into that experience, or you’ve joined the team and you haven’t gone through the PE sale process, make sure you’re adding your PE sponsor into that equation. They are also a quote unquote advisor to the transaction. They’re going to be the biggest driver in supporting you. They should be supporting you in due diligence, modeling, FP&A, other things that are preparing you for that exit. And I think pushing that PE team to your deal team, the partner, to really get aligned up front and saying, “We want to meet and talk about this. We want to understand your vision for the exit, the value creation plan.” We want to understand when you talk to the bankers, what are you selling as the value prop to make sure that the vision is aligned so that the PE sponsor and the company are directionally focused on where they want to see the company going forward, what they want to accomplish in a transaction, but also how the PE sponsor can really help them manage the third-party advisors, as well as be a key part of helping them shepherd through that process.

MMG: Oh, that’s a great point and I think a good place to wrap us up. Josh and Tony, thank you so much for joining me on the podcast.

JW: Thanks for having us. It was great. Appreciate your time.

TE: Thanks so much, everybody.

This transcript was prepared by a transcription service. This version may not be in its final form and may be updated.

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