Are Your Financial Projections Pro Forma or Bull Sheeta?

I highly recommend Berkshire-Hathaway's annual report for your pleasure, amusement and education, even for those of you who don't enjoy reading business publications. More specifically, I recommend chairman Warren Buffet's annual message to shareholders.

Buffet always educates and illuminates. He doesn't offer excuses for performance shortfalls. There is only the brutal truth – good, bad, and in-between. If you have ever read his complete message, you've been impressed by his simplicity, straight talk and logic; no convoluted explanations of lofty concepts and abstract philosophies.

After re-reading last year's message, I thought about two incidents in my own past business life:

Several years ago, I considered pursuing a "roll-up" of small financial services firms. I had procured the help of an investment banker and spent about six months soliciting interest from potential sellers and combing through financial documents for many of those firms to assess the value of each.

One specific firm was particularly enticing. The principal and I hit it off immediately. He had built a company, completely organically, from zero to about $5 million in commission revenue in a very short time. The business was no longer dependent on him for survival or success. Because of a health situation, he wanted to throttle back. It couldn't have been a better scenario.

After our initial two meetings, he crafted a profile of the business for my review. That included three years of retrospective financial information and a two-year financial projection – a pro forma.

For the next two weeks, I spent every free moment combing through his financials. I concluded that his pro forma document was really a bull sheeta document. Here's why:

His projections depicted rosy scenarios across the board. Although his past growth had been impressive, his future growth projections were stratospheric: almost 100% in the following 24 months. When I questioned him, his reasoning was at best, flawed and at worst, delusional.

His expense projections were similarly "optimistic." I'm overly simplifying here, but it looked as if all of the expenses he incurred to grow the business to its (then) present day size would discontinue or very significantly diminish during the following 24 months. He evaded my pointed questions.

When all was said and done, my estimate of free cash flow during the 24 months to follow was about half that of his "bull sheeta" projection. Accordingly, I pegged the value of his business to be about half of his asking price. We never did the deal.

Did he really believe that I would succumb to his asking price? Did he think that I wouldn't do the appropriate amount of due diligence on his "story?" Did he believe that I would even consider doing business with a person who would stretch the limits of credulity with an outrageous set of numbers? Apparently so!

A year later, I was helping a $1 billion (revenue) financial services company craft its strategy. During my first one-on-one meeting with the CEO, I asked to review their current document. He handed it to me with some apparent unease. It consisted of some very lofty philosophical statements about being "the best they could be." As I scanned it, the president leaned over my shoulder and flipped the pages until he arrived at the pro-forma financial document. "This," he proclaimed, "is the meat of the document." I inquired, politely, if I could ask him some questions about the plan, and the process that produced it. He looked at me suspiciously, but said OK.

The bottom line: There was no evidence that they had considered how they would achieve the numbers they projected. So, their plan was a "credenza ornament," and the pro forma was really bull sheeta.

Here are some lessons, first from the initial example:

1. Don't assume that others will do business with you on the same (above board) basis upon which you will do business with them. Don't become cynical; do become discerning.

2. Don't conclude, when you've learned a tough lesson, that you should adjust your future approach because some others might cut ethical corners.

3. Conduct your transactions as if the other party is your clergyman. Be the example for others! Your reputation depends upon your credibility.

And, from the second example:

Business plans must:

• provide the linkages necessary between lofty and philosophical, on the one hand, and specific and quantifiable, on the other.
• result in specific people doing specific things, culminating in specific results, consuming specific resources, within specific periods of time. If they don't, you are wasting your time.
• create the focal point for an organization's reward systems. What gets rewarded, gets done. Reward systems must drive the achievement of planned results, not the number of Suzie's sick days or Fred's adherence to the dress code.
• create buyer value in measurable ways.
• be sufficiently creative and challenging so as to undermine the status quo.
• never merely extrapolate the past into the future.

Copyright 2014 Rand Golletz. All rights reserved.