At Main Street Capital Network (a group of 80+ SMB investors – individuals, funds, and family offices), we periodically send out a newsletter to searchers we've connected with. Last week's article was about investor presentation financial models. I'm sharing it with the Searchfunder community in case others find it helpful.

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Garbage In, Garbage Out

We sometimes come across a searcher or independent sponsor that found a great acquisition target, has strong relevant work experience, and models a base case 30-40% IRR in their investor deck, yet they struggle to raise capital from investors.

Why is this?

Simply put, no one believes their model.

"In computer science, garbage in, garbage out (GIGO) is the concept that flawed, biased or poor quality ("garbage") information or input produces a result or output of similar ("garbage") quality." – Wikipedia​

The base case IRR you present to investors should be derived from conservative assumptions. There are three unknowable data points that are particularly key to driving your financial model:

1. Revenue growth

2. Margins

3. Exit multiple

Revenue growth

When you buy a commercial landscaping business that has been growing its top line annually at 5%, please don't model out a 10% growth rate. Yes, we're all aware that "the current owner does no marketing or outbound sales" but your plans for SEO, cold emails, etc. should be reflected in your bull case. None of us know how effective these strategies will be.

Margins

It's rare we see models get aggressive on margins. The exception to this is when the business had unusually high margins in the past year, and the model assumes that that is the new normal. Long-term averages for margins tend to be a better starting point for modeling out future scenarios.

Exit multiple

Base case models should generally not assume multiple expansion. Unless the deal was truly proprietarily sourced, it's unlikely that investors will believe you purchased the business at a multiple well below fair market value.

Also, while it's true that larger companies trade for higher multiples, your base case should be assuming conservative growth – investors are not expecting "multiple arbitrage" from significantly higher EBITDA.

Why does this matter?

When an investor asks you: "What is driving your assumptions for higher revenue growth, top-of-cycle margins continuing, and/or multiple expansion?", what they're really saying is "Please update your model to be more conservative. I know that will lower IRR below my threshold, so I will require a higher step-up and/or preferred return to remedy that."

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