Mar 29, 2022
An Interview with Craig Thompson, Co-Founder of Consolidata
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Craig Thompson Podcast
Will Fry: Excited to chat. So, just looking at your resume, you've spent a lot of time dealing with M&A, financial analysis, businesses of all different sizes, Goldman and KKR, and time in business school. Would love to hear a bit more about your background, and specifically, what led you to found Consolidata?
Craig Thompson: Yeah, of course. I have a lot of experience both advising companies as a sell-side advisor, as well as being an investor. Through that experience, I've also spent a lot of time in and around a lot of companies, I've even done some fractional CFO work for companies. Reflecting back on my path, I broke into finance through a series of lucky breaks. I went to a liberal arts college, nobody in my family had worked in the industry before. I've come to view finance as more of a foreign language than hard math. I think that was one of the biggest misconceptions I had going in. I've dedicated myself to expanding access to the language of finance because it's a big barrier for people who have a really strong business understanding, and really know their business well, but aren’t able to translate that into a quantitative articulation that a buyer might understand and want to see.
Will Fry: Interesting. So, in terms of the foreign language analogy, it's not that there's anything intrinsically so hard for a business owner, it's just them trying to learn how to speak that language.
Craig Thompson: Exactly. There's a ton of jargon involved that can really throw you off because there's very specific nomenclature for a lot of this stuff that is often not transparent and hard to learn about.
Will Fry: Interesting. What specifically stood out to you about the forecasting or modeling side of finance that led you to found the company?
Craig Thompson: What I love about modeling is it's an opportunity for a business to tell a story. I think a lot of people view it as, there's this historical information you have, you have your historical revenue, and profitability numbers, but if you're a buyer, the historical financials aren’t directly relevant to you. You're not buying the business for what it did before, you're buying it for what it's going to do in the future. I view financial modeling (if it's done right) as a really elegant way to demonstrate your vision in a defensible manner and illustrate assumptions that will help an investor be willing to pay more for your business.
Will Fry: Right. What’s the time point at which a customer typically comes to you all? Is it if they're thinking about taking on outside capital or do they want to just get better financial planning habits in place? What does that look like?
Craig Thompson: There's usually a catalyst. Sometimes that is an existing investor or a founder who says, “Hey, we're growing, and we need to reevaluate our strategic planning. There’s a lot of questions we have, that we want some answers to.” But, there's usually a catalyst where you're trying to articulate this story to outside folks who aren't familiar with you and don't know the business yet and you want to give them a great introduction.
Will Fry: Got it. In terms of the average customer, is it typically a small business that doesn't have a finance function in place, or is it more middle market, so to speak?
Craig Thompson: We work with all kinds of folks. On the small side, we've worked with companies at the idea stage. One founder, in particular, was a Philly-based woman who had a couple of successful profitable restaurants and she wanted to start a new alcohol business. So, we partnered with her at the idea stage where she was trying to set up contracts and trying to figure out how much she needs to raise for first-time seed money before she can actually launch the product and see how it'll work. We've also worked with folks as big as $500 million revenue, ice cream businesses, so it really spans the gamut. One analogy I like to use is we call ourselves TurboTax, for financial modeling. TurboTax is an amazing thing that allows someone who's not a CPA to file their own taxes. We can work with everyone from teachers who just have a single source of income to people with very complicated businesses and investments.
Will Fry: Yeah, that's a great opportunity for owners. We speak with a lot day in and day out and oftentimes, even the basic questions, they may not have a grasp on in the financial world. I’m curious to hear what trends or patterns you see in terms of financials for those small businesses?
Craig Thompson: I think it's a really interesting question. There’s a segment of buyers called strategic buyers who own a chain of stores, and are looking to buy more and put them under their brand, or they just want to own more in a particular region. That type of buyer knows these businesses really well, so you can get away, a little bit, with less detail on some of the financials and some of the numbers. But there's this whole other massive segment of buyers, financial buyers. These are search funders, people who are doing entrepreneurship through acquisition, who have the strategy to buy up a bunch of smaller businesses and combine them into a bigger business. For these types of buyers, who might be less familiar, financial modeling is absolutely critical to articulating your vision to those folks. So, I think the biggest secular trend is finding ways to help small business owners and main street businesses produce a good story that they can tell to these folks. I think that'll really accelerate transactions in the space.
Will Fry: Totally agree. One thing that we struggle with is we'll see owners that may not even have QuickBooks or some type of accounting software set up, or they do and things aren't properly categorized. But at the same time, they're busy operating their business and they're working 60-70 hours a week. What's your recommendation in terms of the 80-20 for where they should invest?
Craig Thompson: Yeah, it's really tough because 80-20 is almost a misnomer. It's more of a 20-80 which is if you can talk qualitatively about the number of employees and if you have historical tax returns, that's the bare minimum or the 20. But, if you're setting up QuickBooks, and you're running revenue, but not your costs through it, and it's hard to understand, a lot of buyers will look at that information and say, “I don't know what to do with this, so I'm just going to impose some really drastic haircuts.” So, it's a decision that you as a business owner have to make, which is if you're looking at a $500,000, or a million-dollar exit, then it's worth taking some small percentage of that expected proceeds and investing a little bit of time in building some of that up.
Will Fry: Buying a business and selling a business nowadays, there's a lot of friction involved. It's not quite normalized behavior, like buying a house or buying a car. What do you view as the biggest barrier to liquidity? What, if the market changed, would unlock a lot more buying and selling activity?
Craig Thompson: I think the stuff that Beacon is doing is great, just expanding access to information. So, I'm just excited for the future of technology to reduce a lot of these friction costs. But the process is increasingly getting commoditized and I think there’s a tremendous opportunity for technology to reduce a lot of those friction costs.
Will Fry: Amazing. A lot of the time that we spend over here at Beacon is trying to put ourselves in the buyer's shoes and, to your point, understand what information they want to see and how we can handhold them through that process. When you're buying a business, a lot of unsophisticated buyers don't even know what questions to ask. They know they need to ask some questions, but they don't know where to start. In terms of putting ourselves in the buyer's shoes. Would you recommend that they dig more into historic financials or spend more time on future forecasts? What is important to you or what would you recommend?
Craig Thompson: Yeah, I'll bucket it into three categories. I'll call it operational due diligence, legal due diligence, and financial due diligence. So on the legal due diligence side, you can get indemnities from buyers, you can ask them to rep that they have no legal issues, outstanding or pending, or anything that they expect to be pending. If you write those into closing documents, that at least gives you some protection. On the operational due diligence side, do site visits. Even if they just have a factory or a warehouse, go to the warehouse, make sure stuff is there. And then, if you understand the business really well and you know this is something that has a positive value, you can bid a price that's low enough that you can guarantee yourself some favorable financial return. So I would call, operational and legal due diligence, the “go/no go” on should I try to buy this business. Then, all of the art of how much to pay is in the financial due diligence.
Will Fry: During that initial financial due diligence, what does that entail? Is it making sure that the numbers are trending in the right way? Is it verifying that the numbers reported are true? The reason I asked that is that we deal with small businesses all across the US and they have varying degrees of accuracy or reconciliation between their tax returns and their QuickBooks. The more sophisticated buyers will come in with a CPA to do a quality of earnings exercise, but every buyer doesn't even know that exists, much less has a budget to pay for it. I'm curious to get your take on that.
Craig Thompson: Yeah. The quality of earnings is a pretty important exercise. One way I would think about it is that not doing that exercise exposes you to more risk to the downside than the cost of the exercise. If you're paying, three, four, or $500,000 for a business, and you're considering a $500,000 bid, I would probably rather bid at $480,000, do the quality of earnings, and risk the sale not closing. Rather than, bid the 500, get the sale on that incremental, and then have all of this risk exposure of maybe they don't produce nearly what I thought they did.
Will Fry: Sure. For first-time buyers listening, do you mind just walking through what exactly is the quality of earnings, what does it entail, and then to your comment, what are some of the risks it can help rule out?
Craig Thompson: Yeah, the quality of earnings is an important part of the due diligence process. In this world of private companies where there's not some single way that people report what their earnings are, or how they report expenses, the quality of earnings is when you go to a third party who knows this stuff, and ask them to go in, and really look at all of the line items in this business and verify that what they're saying about their financials is true. The quality of earnings can also help you translate numbers that might not include the outputs that you care about into outputs that you care about.
Will Fry: The outputs of a quality of earnings, do they speak at all to forecasts?
Craig Thompson: They speak to baselines, they don't really speak to forecasts. All a CPA will do is look at historical numbers, and validate that those historical numbers are being prepared in the way that you might want them, that there aren’t accounting mistakes in the way that the founder or the previous owner recorded them. A lot of it is, oftentimes when businesses change hands, there are things that change, and you want to be able to predict the impact of those changes. So, some of it is a framework for those forecasts, but it really is just understanding what was true before. What I would say is the lower the growth of the business, the more important the quality of earnings is because if it's a pretty stable business, that doesn't change much year over year, it's a lot easier to take what was true last year and just roll it forward. But, in a high growth business, or where there’s some transformation going on, that's where the historicals matter less, and the way that you build a good forecast model matters a lot more.
Will Fry: Yeah, that answers the question I was just about to ask in terms of what do you recommend buyers focus more on. It sounds like it depends a lot on the type of business that you're buying.
Craig Thompson: Yeah, and the type of buyers you're trying to attract. If you're trying to attract a financial buyer who has investors that have put money in them, there's minimum fiduciary responsibility where they need a forecast model. If you don't have one, they'll make one for you, and it's going to be really punitive. You're leaving a lot of money on the table if you let one of those financial buyers try to push you around for a really low valuation.
Will Fry: Sure. In terms of the time period that you're forecasting on, that’s one area that I’m curious to hear a bit more about because it's hard to know what's going to happen in the future in the world of small business, especially when the numbers can change a good bit year to year. Obviously, COVID was an anomaly. But for most of the businesses we've seen, 2020 dipped, but they also had other historic years where they had pretty sizable fluctuations without obvious macroeconomic indicators. So, I’m curious to hear what your recommendation is, for both buyers and sellers, when they go through a forecasting exercise.
Craig Thompson: We recommend doing five-year forecast models, some of that is because a lot of buyers think about these investments on a five-year time horizon, some of it is that even your fifth year is hard to predict but after year five, you really don't know. So, we tend to spend a lot of time focused on the next year, and in particular, the next three months, and then build a model that goes five years. The next year is important because that is what you're trying to get the buyer to underwrite to. If you're trying to convince them that your valuation should be three times next year's revenue, or, four times next year's EBITDA, or free cash flow, that is a number that you want to anchor them to. The next three months are really important because these processes can take time to close and if you can demonstrate that you are meeting or beating your numbers during the course of the process, that gives buyers a lot more confidence in the accuracy of your forecasts.
Will Fry: Sure. One anecdote that we've seen recently is that forecasting isn't as simple as taking the first nine months, and then assuming that the last three months are going to be the same.
Craig Thompson: Yeah. We really encourage what I'll call bottom-up modeling, as opposed to top-down modeling. So, if your forecast says, “Last year, our revenue was this. And things are going well, we think we're going to grow, we're going to grow 10%. So we'll apply a 10% growth rate.” If I'm a buyer trying to evaluate that, that really doesn't help me that much. Because I need to understand where the 10% is coming from. Depending on the type of business you have, let's say you only have eight customers, that customer concentration matters a lot, and I'd want to go customer by customer and say, “When did their contracts expire? What is the probability that they renew for another year or another few months after that contract expires? Historically, what does your churn rate look like?” We really emphasize bottom-up modeling because if you can start at that granular level, and build to a 10% growth rate, that tells your story a lot better than just saying 10% and hand waving why.
Will Fry: That's great. We spent a good amount of time digging into the use case for Consolidata, chatting through forecasting both from the buyer side, as well as the seller side, and what the pitfalls are there if you don't do it correctly. On the modeling side, would you mind just giving the difference between modeling and forecasting? And on the modeling side, what are some of those pitfalls or ways it could really help an owner?
Craig Thompson: I kind of use those interchangeably. A forecast doesn't have to have a model, but a model is reflective of a forecast. I think the really big pitfall that a lot of people fall into is that top-down assumption. People will spend a lot of time thinking about how their business is going to perform and then when they put pen to paper, they say 10% growth rate. That time invested to yield just a single number isn't going to get you the result that you want. Another common pitfall is just taking financial data, and running percent changes off of what's in your QuickBooks when there's all of this qualitative stuff and all of this non-financial stuff that's driving your business. You care about things like foot traffic if you have a brick-and-mortar store. You care about who your customers are. If your customers are high-risk startups, that matters to your projections, but it's not in your QuickBooks. Really good financial modeling is a little bit of storytelling art, where you're taking historical financials, historical data that might not be financial, and then something qualitatively that you feel about your business and taking those three factors and constructing a holistic story that articulates your vision to a buyer.
Will Fry: That's great advice. I've really enjoyed this conversation. I wanted to end on a note towards the finance being a foreign language and education concept. What are your favorite books for building financial literacy? If you had one book to recommend to owners and buyers?
Craig Thompson: I have a terrible answer to this, which is I don't know any. I think when I was trying to learn about finance, I spent a lot of time just trying to talk to people who knew it. I'd recommend phone calls because what I would do is every time they would say some jargon word, I would write down the word, write down the sentence it was used in, and then go on Investopedia afterward and just look up what the word meant. So for me, the best way I learned was conversations and building a glossary. Wall Street Oasis and Investopedia are good free online resources that give you access to stuff. And there are other sites like that. There’s just so much hidden information in this world. That's one of the things that I'm on a mission to correct.
Will Fry: Sure. Well, we're rooting for you as you democratize what the language means and also how you can use it to grow your business or buy one. All right, Craig. Well, thanks so much for coming on.
Craig Thompson: Of course. Thanks so much, Will.
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Will founded Beacon with the mission to help the current generation of owners to retire while enabling the next to unleash their entrepreneurial spirit. He comes from a business background having graduated from the Wharton School with a B.S. in Economics.
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