Episode Transcript
[00:00:00] Aznaur Midov: Sean, thank you very much for being on the podcast.
[00:00:02] Sean St. Germain: Thanks for having me. Excited to be here.
[00:00:04] Aznaur: Maybe we should start with you sharing your background and tell us a little bit about Alvarez & Marsal.
[00:00:11] Sean: That sounds great. For a quick introduction on me, I am a San Francisco-based partner in Alvarez & Marsal's Global Transaction Advisory Group. I sit in our software and technology industry vertical which means I spend all of my time working with private equity clients on buy and sell side transactions within that space.
On A&M, I'll probably zoom out a bit to give a high-level overview for those listeners that might not be as familiar with us. We are a global professional services firm that essentially serves three large types of clients. The first is restructuring, turnaround crisis management, which is really the original heritage of A&M as a firm dating back to the early 1980s. The second type is corporates, which we typically characterize as the Fortune 1000. Last, but certainly not least, is private equity and the M&A ecosystem which is the business unit where I sit.
Zooming back in probably a little bit under the private equity services umbrella, we're really a one-stop-shop to support private equity investors really across the entire life cycle of an investment. Our clients engage us for really various types of due diligence from financial, which is my area of expertise, as well as other areas like transaction analytics, tax, HR, IT, cyber, and maybe I'll just end this overview highlighting that we have teams that help clients with operational analysis, like things around cost savings, synergy assessments, and just other types of performance initiatives.
[00:01:42] Aznaur: Got it. All the synergies that you guys typically put into the reports, they're real?
[00:01:48] Sean: When vetted by an A&M professional, absolutely.
[00:01:52] Aznaur: We'll get to that point. What's the typical profile of the companies you typically work with?
[00:01:59] Sean: It's a pretty wide range. I'd say our client sweet spot tends to be PE investors that are investing in middle market and upper middle market which itself can be a pretty nebulous definition, so maybe I'll try to put a little bit of a box around it. The majority of software businesses that I look at generally have ARR somewhere between 25 million to 150 million. We definitely look at companies at each side of the range. I'd say that our buy-side projects really fill that whole range, but our sell-side projects probably tend to be towards the midpoint or maybe even the higher above that higher end of that range.
[00:02:35] Aznaur: You distinguished between buy-side and sell-side, can you elaborate on that?
[00:02:40] Sean: Our clients really do a mix and engage us for a mix of both when they're looking to buy and invest in a new platform investment or do an add-on or when they're looking to exit one of their investments. That's really where a lot of our deal flow comes. I think I mentioned earlier, a lot of our practice is anchored in our private equity relationships. That's how we get engaged and what really dictates a lot of our buy side or sell side.
We've also got relationships with several investment banks that we've developed over the years and partner with them on their sell-side mandates to do financial diligence. We've really found that building those relationships over time has been pretty nice because when you've built a few reps with the same banking team, it really makes the overall sales process run pretty smoothly as there's a fair amount of overlap for what we do in financial due diligence that interacts with investment bankers sell-side financial model.
[00:03:30] Aznaur: I'm going to put you on the spot here. If you are hired by investment bankers to put together the financial diligence of the company, isn't there a little bit of conflict?
[00:03:41] Sean: I'd say our relationships when they are reaching out to-- they get a client that signs them up to do the banking on the sell side, they will introduce a few different providers to the management team, and the management team or the company that's being sold and maybe their owners are the ones that are ultimately making that decision of who they engage with, but it's really, I think, that process of the relationship they've built over time where it's really like a warm introduction to the management team, but it's never really the investment bankers that are making the decision. It's really still the company or their owners that are ultimately making that decision of who to engage.
[00:04:15] Aznaur: During the transactions, both our sell side and buy side also have their own diligence. If there are some disagreements or some mismatches, have you ever had a discussion with the opposite team telling them that they did wrong?
[00:04:31] Sean: Yes. Financial due diligence is definitely more of an art than a science we like to say. I think as you look at a sell-side quality of earnings report for things that might be a gray area in terms of a judgmental area for an EBITDA adjustment, from the sell side, it's obviously going to paint it in the way that paints this company being sold in the best light possible, but then on the buy side, teams that are engaged by the potential buyers will be able to quickly go in, and part of what we do when we're on the buy side and there's a sell-side quality of earnings is highlight what are the more judgmental EBITDA adjustments and cash flow items that need to be thinking about and just take a different point of view at some point.
A lot of times this is in the context of a competitive bank-led process. That ultimately might not be advisors talking to advisors disagreeing on terms, but it ultimately feeds into our client's valuation and their bids at different checkpoints in the bid process.
[00:05:27] Aznaur: What's unique about working with SaaS companies relative to other clients?
[00:05:31] Sean: I think one of the most unique and fun aspects of SaaS businesses from a diligence perspective is that the business models can really vary a lot depending on the end customer that's being served and how the technology is monetized. That complexity can drive just a lot of different analyses for what's important for the financial model or for our clients that are making that investment decision.
I'd say every time that we start a due diligence project, one of the first things that we do is a pretty detailed walk through a customer's order to cash cycle to make sure that we understand all the different types of revenue streams. The first bit is really understanding what is truly recurring revenue, what might be more reoccurring transactional or payments or non-recurring professional services. After that, just being able to make sure we walk away with understanding the contract terms, billing cycle, cash flows, and accounting policies that we're really clear on how transactions move through a balance sheet and income statement because really having a solid foundational understanding of this is very important before we get into the analysis.
[00:06:35] Aznaur: How do you diligence this information? Because technically the company gives you financial statements. How do you even know what numbers there is real?
[00:06:45] Sean: Yes, I think there are two parts to that question. To try to unpack it, I think first maybe I'll touch generally on financial diligence and then around ARR and related ARR analysis. One of the first steps in financial due diligence is getting comfortable with the baseline financials. Here I'm talking about the very detailed trial balances that come out of accounting systems NetSuite or QuickBooks.
When a company's audited, we'll reconcile those to the monthly trial balances to the audits. We really just do a line-by-line comparison to the income statements and balance sheets. Then depending on how recent the audit was performed, we may or may not do what we call a cash-proof exercise where we reconcile cash basis revenue and expenses to bank statements for the audited period. If a company isn't audited at all, we almost always do that cash-proof exercise for at least the last 12 months, just to get comfortable with the baseline financials and get comfort over what we're seeing in there.
From there, we do pretty detailed discussions with company management, just walking through the historical financials at a transaction level to understand not only the audited periods in totality, but the monthly trends and key business drivers and all that really hangs together from the financial side.
[00:07:58] Aznaur: When it comes to recurring revenue, can you define that?
[00:08:02] Sean: This can be a pretty complex question to unpack, and maybe a recent example I think will help highlight just some of the different business models that cause complexity of what is truly recurring versus reoccurring and transactional. When we talk about SaaS, I think the simple example is just where you've got a fixed contractual commitment for a period of time that you're recognizing revenue for evenly over that time. I think that's pretty easy for people to get their arms around.
Where it gets more complex is when you've got mixed types of business models. Last year I had a project where a SaaS company priced its technology with what had a fixed contractual minimum and then a volume-based component based on usage over that minimum. It's an example of a technology that behaves like standard SaaS because it's got that fixed contractual minimum and that fixed minimum was invoiced annually in advance, then also had the transactional business model where the volume-based component was invoice monthly in arrears.
When we come to our ARR and retention analysis, it got really complex because we had to look at it almost as just the fixed component by itself, looking at the fixed component with the variable component to understand what are the real trends, what is real ARR and the related retention rates and helping our clients and how to think through the model. I think there's also complicating factors in that business where some companies started out on just the variable price only and graduated over time to fix commitments.
There was a lot to unpack. I think that goes back to your last question of what makes diligence here so unique, is that it's very rare that we're talking about just a fixed SaaS middle-of-the-fairway recurring revenue commitment. It's typically more and more that companies are monetizing this technology in a variety of ways. That's what really adds complexity in how we analyze these businesses.
[00:10:02] Aznaur: Does it mean you have to go through every single contract of every single client to ensure that recurring revenue is shown accurately?
[00:10:12] Sean: Yes, I think back to-- similar to that concept where I was talking about the grounding, the detailed trial balances to the audited financial statements, when we talk about doing diligence on the customer side, the first step is really grounding source files in management's analysis to those same detailed financial records. As we do that detailed order to cash discussion that we had talked about, truly being able to isolate and identify in the trial balance level financial statements what is truly recurring revenue versus what might have more variable component to it, and then making sure that we can flip back and forth and reconcile from the trial balance level data to the customer level data to really get comfort over that information.
On top of that, we do look at customer contracts for a variety of purposes, not just to understand the background of the business, but also to just get comfort over some of the ARR for larger customers and understanding what does the contract say about the contractual provisions and the pricing and all of those types of things to help us really understand how sticky and recurring is a customer.
[00:11:18] Aznaur: When you think about the smaller companies, what type of mistakes do you find more often in their items such as ARR, maybe some expenses, what do they include that they shouldn't include and vice versa?
[00:11:30] Sean: Honestly, when you run into a lot of issues with the smaller companies, it's often a factor of a company being in growth mode and understandably being hyper-focused on growth. There might be and there can be at times an under-investment in finance and accounting infrastructure. For smaller companies, it's very common for accounting records to be on a cash basis or some non-GAAP type accounting basis because that's all that a founder really needed historically. We see a lot of smaller companies outsource CFOs to do some of the basic blocking and tackling, which can go a long way of just creating monthly accrual basis financial statements and can be a great starting point for our work.
Getting into a few specifics for your question, I'll probably just list through these quickly and not go too deep, but feel free to let me know if you want to double-click on any of them. First, on ARR, and we're talking about smaller companies, the key here is really having a clean breakout of revenue by type, and when I say by type, what we talked about between what is recurring versus non-recurring and those different buckets on both a revenue basis and having a viewpoint on ARR by customer.
Having that viewpoint of what's really middle of the fairway recurring versus might have more reoccurring or transactional type revenues is a great place for smaller companies to make sure you're cutting it and have clear delineation understanding of your data. I'd say maybe some bonus points if you're tracking it by product and just other levels of granularity because that's where especially PE investors spend a lot of their time because that's a lot of what's driving valuation.
[00:13:11] Aznaur: I want to actually double-click on that a little bit. Have you ever come across a situation when the company clearly has a fixed contractual term for part of a revenue, then there is a transactional revenue, but it's highly recurring even though contractual, it's not obligated? Do you consider that recurring revenue or it's one of those gray areas that you discussed earlier?
[00:13:35] Sean: I think what we would typically do in that situation is similar to the example I described where we'd do a "with and without" analysis, meaning we'd look at it-- if you looked at the customer base of just pure play recurring revenue, what is ARR, what is gross net retention rates, then do the same thing on just this highly reoccurring type revenue, I think what gets important there is just understanding when you're looking at the reoccurring revenue in isolation, is there any meaningful seasonality that comes into play, or is what's driving variability is just growth over time?
Because when there is seasonality in how we think about ARR, we might not want to take the monthly revenue times 12 like we would do in the fixed price SaaS. We might look at a trailing 12-month revenue and do a hybrid approach when looking at retention rates. I'd say next for just other areas for smaller companies to think about and focus on for what they might do wrong or might have tracked historically that they might want to think about breaking out differently in terms of a transaction, the first area is really around cost of sales and gross margin.
A lot of smaller companies will track their costs by natural account, and by that, I mean, reporting all of your salaries together, bringing out costs by vendor type, like software, rent, consultants, that type of thing, versus tracking these costs separately for each department, and specifically to cost of sales, what investors really like to understand and how they like to build their financial models is looking at gross margin by revenue types, so lining up recurring revenues with people costs and vendor costs, supporting those revenues, same with non-recurring revenues.
The last area that I'll maybe highlight for this question is similar to the cost of sales and gross margin, but just around OpEx and departmental reporting for expenses like R&D, G&A, sales and marketing, just having a clear view. A lot of times, these smaller companies, people can wear different hats and might be in cost of sales versus R&D, but just having a clear methodology for breaking out the cost structure can be helpful in the diligence exercise.
[00:15:39] Aznaur: What's a typical methodology? They assign a certain percentage to OpEx, a certain percentage to cost of sale?
[00:15:45] Sean: Exactly. I would say things sales and marketing and G&A tend to be more, you can just take a person and put it in that category. Between cost in sales and R&D, there are probably certain people that are easy to identify in one bucket or the other, but then there can be people that wear multiple hats. We'll see people do, I guess, one of two methodologies, I think especially for smaller companies. The simpler is better if people understand, if they want to take a different approach, people can move costs around.
You'll either go through the census and just tag people to one side or the other based off of what is the majority of the types of activities that they're performing, or just take a simple-- if you've got like a 50/50 allocation for people there, where it is a fairly even split, I think the key there is just having consistency over time and have a methodology that's just easy to follow.
[00:16:34] Aznaur: One of the sections of quarter earnings is EBITDA adjustments. Maybe you can tell potential buyers what adjustments should they be aware of. By the way, why are there so many?
[00:16:46] Sean: There's so many to keep us the QOB people employed. No. it's a really good question, I think we could spend a lot of time getting into the weeds on this topic. I think there's really two primary areas to dig into where we find more red flags than not. I think that's probably going to be the most relevant to your listeners.
For the first topic, and I'll generally characterize this as lender-adjusted EBITDA, which I'm sure is a topic that you can appreciate with one of the hats that you wear. Lender EBITDA can be especially confusing as it is really dictated by whatever terms the company is able to negotiate on an EBITDA-based loan with lender. What we'll see from time to time when reviewing a sell-side quality of earnings, there can be documentation where a sell-side advisor might note that they support an adjustment because the lender gives them credit for financing purposes. This isn't automatically a red flag, but it's definitely a flag for us, for an area to dig into and understand.
One of the most aggressive examples that we've seen probably two times the past year are people removing expenses related to sales commissions because it's capitalized and expense over time for three to five years and labeled as amortization within the financials, but it's a real operational expense. On the buy side, this is something that would be a red flag and that we would reverse on the buy side because it's a real true operational cost, different from a fixed asset property equipment type cost. That's the lender EBITDA topic.
The second area is probably around proforma adjustments, which I'll try to group into a few key areas around revenue headcount and non-headcount. For revenue adjustments, these aren't as common, but when there are proforma increases from revenue, those always get our attention to really understand any of the assumptions, any of those inputs.
We saw this a lot of the early days from COVID, sometimes it was easy like a temporary price concession, that was a concession for a few months, came back at full rates. Other times, it's an assumed price increase that's being rolled out or a volume-based revenue model where volumes dipped for a period of time, and it gets to be a lot more judgemental. That's where it gets really important just to dig into those inputs and understand the inputs and assumptions and how supportable those are, and just really diligence in those.
Revenue on the headcount side, say that here we really want to understand the areas where headcount was reduced and the related operational impact. It can be pretty easy to get your arms around cost savings for an add-on acquisition where you don't need multiple CFOs, I think everyone can get their arms around that pretty easily. It gets a lot more complex when you get into revenue-generating roles and the operational impact of headcount savings from a combined business for consulting professionals that are generating professional services, revenue sales and marketing people in those types of areas.
The last area that'll highlight around proforma adjustments is around non-headcount savings. I think the focus here is really around anything that's not yet achieved. I think a lot of times when we're doing a sell-side QOB or reading a sell-side QOB, people will summarize non-headcount savings into those that are executed and achieved versus not yet achieved.
Things like an office or a rent facility where 10 employees are going to work remote, again, easy to understand, easy diligence. Other times there can be vendor-level changes that have pretty meaningful differences to the cost structure or how revenue's really being delivered and can take multiple quarters to transition to fully get an appreciation for the real new run rate. Estimates for that can really just take time, and there's a lot of inputs and assumptions that might go into that, and that's where we might collaborate with some of our operational professionals or just other people that are doing diligence that have more that operator's hat and understanding and validating some of those non-headcount savings.
[00:20:44] Aznaur: When you do quality of earnings for the buy side, let's say you encountered this very gray area of synergies and you disagree with management on how long it's going to take and how much it's going to be cut, how do you approach it? Do you show what you think is correct and just mention that management think it's higher or you basically say, "Hey, whatever management says, they're out of their mind, here is the actual number"?
[00:21:10] Sean: I think it's typically a phased approach. Something that doesn't have a good story or good support behind it, I think the first step is just flagging this as a risk area to our client that really has risks to their future financial model from both either an achievability or a cost to achieve perspective. I think there can be two levers to it of the actual recurring cash savings or the one-time cost to achieve those savings.
From there, I think we come up with a game plan. Sometimes they've got other operators within the private equity organization that can help really dig into and understand from an operator's hat just what is the real timeline and really kick the tires with management. That's where we'll bring in some of our operations team as well to really do that deeper dive analysis to really understand and come up with a point of view that we as financial diligence providers, we might not have that operational lens, and that's where we get to partner with others within the organization, within our clients to really collaborate on that type of analysis.
[00:22:15] Aznaur: There are two lines in financial statements and EBITDA adjustment. One of them you mentioned, two of the ones I'm curious about is capitalized software and capitalized commissions. I guess a two-part question. First, describe what those are, and second, how do you treat them for purposes of EBITDA?
[00:22:34] Sean: I think it's a topic that on both of these, they get a lot of attention as there are definitely differences between the cash profile and then the GAAP profile for both of these topics. Maybe let's start with capitalized commissions. A lot of people know that accounting rules around revenue recognition changed over the past couple of years, and with that came an alignment in the accounting for sales commissions.
Prior to that change, companies made an accounting and policy election to either recognize commission's expense when earned by a sales rep or spread it over some period, like an estimated useful life. The accounting rules changed over the past couple of years, and now the sales commissions, I'd say many of them get hung up on the balance sheet for SaaS companies.
I'm going to oversimplify the concept, but the general concept is that GAAP commission expense generally aligns with the related revenue recognition that gave rise to that commissionable event. Sometimes an expense paid for initial contract can actually extend past the initial contract term, similar to the old methodology, over an estimated customer life.
We're doing a quality of earnings analysis, when we present cash EBITDA, and I'll unpack that in a bit, but we're really talking about a common methodology within quality of earnings, it's looking at not only adjusted EBITDA but taking the change in deferred revenue, which effectively puts revenue on a billings basis versus a GAAP basis. What we'll often do on the commission side is also account for the change in deferred commissions, which effectively puts revenue and commissions expense on an as-incurred basis when we're talking about a cash EBITDA or billings-based EBITDA. I think the key there for commissions is whether it's an adjust EBITDA or billings-based EBITDA, you're getting to a consistent treatment between, or somewhat consistent treatment, I would say between cash versus GAAP.
The second piece you asked about is capitalized software. To quickly level set on this topic, all SaaS companies have R&D spend. For employees and third-party contractors, that spend might be on new products and new features that generally speaking are probably going to be revenue generating at a future date, whereas they'll have other R&D spend towards like bug fixes, minor upgrades, and maintenance. Really that's part of just maintaining the existing product portfolio that is currently revenue-generating.
For companies that follow the US GAAP, a company's required to put procedures in place to really try and quantify the time of that R&D spend on the new products, the new feature set. That's what's supposed to get capitalized to the balance sheet and then never really hits EBITDA, as it flows through as an amortization expense, just like other intangibles or other fixed assets.
It's an interesting area because we see diversity in practice, not just amongst small software companies. There are some very large companies that just don't have processes and procedures in place. When they don't have those processes in place, the others won't make them capitalize that to the balance sheet, which practically speaking is probably fine for smaller SaaS growth companies that are really focused on ARR, and that's where the evaluation is.
It's definitely something for growing software companies to be thinking about because that's when you get to scale and you get-- a PE investor puts some debt on the business. There are a lot of lenders today, and this has been a growing trend over the past five years or so that are giving EBITDA covenant credit for that capitalized cost.
[00:26:07] Aznaur: When you say give a credit, you mean technically you can overstate cash EBITDA by overcapitalizing your R&D?
[00:26:16] Sean: For sure. When I say credit, it means if you've got 10 million of R&D spend, 3 million of that is spend that's really on that new features and functionality. You're capitalizing that 3 million to the balance sheet. A lot of lenders for financing EBITDA covenants won't burden EBITDA for those related calculations for that 3 million. You've only got the 7 million that's burdening the income statement instead of the full 10. You've got an uplift to EBITDA in that perspective.
[00:26:45] Aznaur: When you look at the financials and you see the company capitalizing, let's say, 5% versus 50%, at what point you're like, 'You guys really taking this aggressively"?
[00:26:55] Sean: Yes, I think it's very often-- and it definitely varies cause it really depends on what growth stage is the business in and what is their technology roadmap, how much they really investing in new features and new products. A lot of times that might fall into a gross R&D spend, maybe 25% to 50% is a pretty normal range. We will see high-growth stage companies that are investing a lot in the R&D org to be over that 50%.
I think where people do get comfort with it a lot of times, when those amounts are audited by a reputable audit auditor, there are procedures in place, it's like a real GAAP audited number versus when a company is not audited, and then you're seeing that higher range of cash costs being capitalized, you probably need to dig in a bit more to really understand just what's the true profile of what's being capitalized and ask some of the same questions that an auditor probably does of understanding what process is used to track capitalized activity. Is the R&D organization using Jira or some other systematic way to capture those types of capitalizable activities?
[00:28:08] Aznaur: You mentioned cash EBITDA. Can you elaborate on that?
[00:28:11] Sean: Absolutely. To level set, one of the beautiful cash flow dynamics of many enterprise SaaS businesses is the cash flow dynamic where a customer pays for one or more years in advance of the related term. To use a simple example, 120 ARR customers invoiced on October 1st for a one-year term through the next September. For GAAP purposes, that revenue recognized even lease, you'd have three months in that year, so 30 of revenue versus a full year of cash flow at 120.
From a cash EBITDA, we would look at that 120 from the EBITDA profile versus just the 30. In a growing business, you really always have this positive cash flow dynamic. Some smaller and growing SaaS businesses might appear to be cash break-even or negative on a GAAP revenue basis. When you look at billings or operating cash flow, it can actually be a cash-positive generating business.
In quality of earnings reports, what you'll often see is that we'll take adjusted EBITDA plus the change in deferred revenue, which is how through the financial statements you get to what the billings are in any given period. This isn't really just like a one-for-one with operating cash flow presentation but is the most common approach in the quality of earning reports.
[00:29:35] Aznaur: This is a non-GAAP metric, but it seems like it shows the economics of the business quite well.
[00:29:41] Sean: Totally agree. I know sometimes the question or the debate can come up of it gives you an idea of billings, but it's not real cash flow. Should we include change in accounts receivable? Because that's when the real cash comes in the door, but other changes of networking capital, and I think from every business that you look at, definitely need to look at if there's anything unique within the customer profile or other things in working capital that you would need to consider, like the capitalized commissions that we talked about earlier. When you're really just analyzing a business and looking at just the overall trend of the business, I think looking at billings basis is a good way to look at it for a lot of SaaS businesses that have the profile of that example I mentioned.
[00:30:25] Aznaur: If we're talking about cash EBITDA, do you mean we should also adjust it for capitalized commissions and capitalized software or not necessarily?
[00:30:35] Sean: Not necessarily. I think that is definitely a topic that is discussed in every project that we look at. When we're looking at cash EBITDA and we're looking at the change in deferred, I would say 9.9 times out of 10, if they're deferring sales commissions, we would burden cash EBITDA and account for that In terms of our cash EBITDA type calculation.
On the capitalized software side, when we're talking about a quality of earnings and EBITDA, it's most often not burdened within EBITDA for what we talked about earlier, in that a lot of lenders are giving like financing EBITDA credit and not burdening the P&L for that, but it's absolutely still an operational cash cost that an investor on the buy-side is going to model as part of its overall financial model, but it's burdened separately like in other CapEx type spend, separate from EBITDA.
[00:31:30] Aznaur: I might be obsessing over this capitalized commission a little bit, but I have another question on that. If the contract is one year and the company would renew it every year, it doesn't necessarily mean that capitalized commissions also assume that this commission going to be amortized over one year. It might be the life of the customer which they might assume whatever they think is the right number, right?
[00:31:54] Sean: Exactly. That's where you can have a bit of a mismatch in this cash EBITDA concept that I described because if you're invoiced net annually in advance, you're really getting the revenue just once a year, but for the commission, a lot of times when you're paying a new sales commission on a New Logo ARR, that's a very different profile than a renewal commission which is little to nothing in comparison. You might be spreading for GAAP purposes that commission out over three to five years because that's your "estimated benefit period", but then there is a little bit of a mismatch with the revenue from a billings basis.
[00:32:32] Aznaur: That's very helpful. When companies plan to hire you, how should they prepare for your arrival?
[00:32:39] Sean: First of all, whether it's us or whatever, any other advisor, the best advice is calling early. I would say a well-planned project can always help a process run smoothly and minimize business disruption, which is really always the goal. In terms of preparing for our arrival, there's really two key things, and it's probably going to summarize a bit of what I talked about in other areas of discussion.
First and foremost is the customer file, and here we're talking about the support file that's going to be the basis for what we're using for ARR and just other customer-level trending. A lot of times for a quality of earnings analysis, we might look at 30 to 36 months of data. For customer analysis, especially within the private equity and investor area, a lot of times we'll try to go back almost as far as we can, just look at trends over time, maybe we'll back 5 years or more if possible.
A lot of times you run into data limitations, but a lot of times we'll start with the ask of trying to look back at five years. From there with the customer file, just doing that first exercise of making sure somebody can understand how that customer file ties back into your historical results. Doesn't have to be a complete dollar-for-dollar reconciliation, but just directionally to make sure that somebody can understand that it's grounded in historical data.
The second piece I would say is detailed and consistent trial balance level reporting on a monthly basis, and there's probably a couple of things to highlight here that can cause bumps in the road, and that really relates to when there's a system conversion. If you're going from QuickBooks to NetSuite, your chart of accounts changes, just making sure that you've got a clear path over time so that somebody can really piece that together over a three-year period. Similar concept, when you're doing an add-on and if you're doing pretty active in the M&A space, just having clear proforma reporting where you're pulling in the pre-acquisition detailed financial information into your chart of accounts really goes a long way to having somebody be able to do comparable trend analysis over time.
[00:34:51] Aznaur: Does it make sense for a company that's not for sale or not trying to sell themselves to hire you, or it's usually for M&A transactions only?
[00:35:00] Sean: For us, specifically within the transaction advisory group, by its nature, I think having some sort of transaction makes the most sense. I think where it might not be an outright sale, but if you're looking to do an add-on or even a capital raise, it's been a growing trend the past couple of years where bankers that are just doing the next series of a capital raise to do a quality of earnings as the pre-acquisition diligence that goes into that work from the private equity ecosystem, it is very similar if somebody's going to do an outright buy. Those are probably the two areas outside of an outright sale where it makes sense for somebody to give us a call.
[00:35:44] Aznaur: When they give you a call and you go through the whole process, have you ever had a situation where you found some major misstatements?
[00:35:55] Sean: For the financial diligence team, I would say if we find something that truly derails a transaction, it's typically around the calculation of ARR and related retention rates. I think there are many examples to pick from, but one quick example comes to mind because it's recent. I'll try to keep it a little generic but still make the point. We are in the buy-side in this example. It's very common in a competitive process for early customer data to be anonymized.
When we're looking at a business and after we've gotten to exclusivity, we got our hands on the unblinded customer data. With the unblinded data, we realized that we actually had a handful of customers that we originally thought were-- that actually separately rolled up-- sorry, separate customers rolled up to the same parent company and was actually the same decision maker. When it aggregated, it actually comprised a fairly meaningful concentration of ARR. As we dug in a bit more, our client dug in a bit more, they were having their own market operational diligence. There was some real questions around the renewal with that customer. That was one where our client actually ended up stepping away just to see how it played out because I think the renewal risk around that larger customer ended up being pretty significant.
[00:37:13] Aznaur: That's interesting. Glad they hired you.
[00:37:16] Sean: I like that example though because it is so common in what we do in these banker processes that are almost every process we're looking at on the buy side when we get anonymized data, and then you get to that exclusivity phase and you start to get the real data in the confirmatory phase. It can be often where a lot of times people are trying to move really fast during that confirmatory phase, but there's a lot to still unpack during that where it might not be as confirmatory and check the box as it can sometimes sound.
[00:37:47] Aznaur: If someone wants to work with you, how can they find you?
[00:37:51] Sean: For finding me or really any members of my team, you can find all of our contact information at our company's website, so alvarezandmarsal.com, and then just search for us by name. It has links to our email, and from their LinkedIn profiles, bios, and even our professional headshots, which are fun to look at.
[00:38:10] Aznaur: That's actually how I found you. Well, Sean, thanks very much for being on the podcast. It was very helpful.
[00:38:17] Sean: Yes, thanks for having me.
