EP11 - Young Frankenstein - The Science of Business Valuation for ESOPs (part 3)

[0:11] Hey everyone this is the ESOP guy and we are on a journey to an ESOP thank you so much for joining us today this podcast as a, point out this mostly on every every episode for those that are new we are doing a podcast really as a resource to help Point people in the right direction when it comes to Employee Stock ownership plans where there's a lot of confusion sometimes. There's a lot of confusion not only in the marketplace but also with advisers as far as how esops work I can tell you I spent a lot of my time. On a weekly basis talking to other Professionals in whether they're being banking insurance. Accounting legal aspects of all kinds of people to talk about what are ESOP so this is this podcast really is about that is to help people understand what is an ESOP how does it apply to your business. [1:06] The inspiration of this podcast this episode here specifically this is going to be part 3, in a series we've been doing on business valuation and the title of the episode is Young Frankenstein is this valuation a science or an art. So with that I wanted to start off with this. [1:32] What's the matter. [1:43] Free samples. First syllable sounds like this. It said. This Stacks up does he work he said. Give give him a sec again. This scene drives me crazy and I had to stop it because it was we're getting too too deep into it but it's so funny and it drives you crazy at the same time so Frankenstein. Who is played by Gene Wilder is trying to teach Frankenstein who he created. How to walk like a little kid whatever and anyway so, then Igor who call Zeigler lights a match to light up a cigarette which is against kind of silly and stupid but he lights a match and then. Frankenstein sees the fire and he freaks out until he starts choking. Dr. Frankenstein and anyway it's just Mayhem and then he's trying to do instead of be able to speak because he's being choked he tries to. Tell him you know how to like basically three syllables and he's trying to get them to guess this word and and again the word is sedative so what I like about this scene. [3:12] And where I would say it's funny and it applies to business valuation is is sometimes when you are doing the valuation for a client. And, you almost feel like they want to come across and just choked you because they aren't really happy with the number maybe you came up with so I think it's just it's kind of funny that doesn't really happen but it just made me think about that and the experience I've had in business valuation over the last 18 years, I've certainly had clients say hey I don't you know I thought my bat my thought my business was worth a lot more than that and, you know when I always come back and say alright let's tell me tell me why you know let's talk about the reasons why and and that's part of the reason I want to do this this episode, is to talk about the details behind it without. You know without having to get engaged to do the work for somebody so you understand you know what is business valuation all about and is it a science versus an. [4:12] And I keep coming back to this that it's so it's so much more of a science than it is an art as many people as we talk to that are like all you can make that valuation look like whatever you want. There are definitely some some, percentage margin of differences between one valuation to another but if you're if you're using the right numbers and we're using the right methodology which is what we're going to, prescribed in an ESOP for sure we're going to prescribe that with anything really as a business valuation person but, we're going to come up with a number that is relatively close, and that's going to be important for you to understand on your journey to an ESOP because that is really the beginning step when you start thinking about all the things about Aesop's what do I need to do first to really understand and I'm always going to come back to we need to know. What is your business going to be worth, in an ESOP transaction so this this podcast the episode itself was inspired by a meeting I had with a company an ESOP company that's a client of mine who were trying to help by another company and we were working through, a lot of the conversations not only with. The company my client but also with their acquirer acquired acquiree the company they're going to buy. [5:34] And their advisers and so I noticed a lot of things that were said in that so so that is really the inspiration behind it. [5:43] I will tell you all because it's just important like as we talked about things I did break my foot over the last, for weeks I've been in that the I've been doing a lot of couch work on my computer so it's been hard to get in here and get in you know do some episodes but, you know it's okay because with zoom and Technology pretty much you can work from anywhere but, but I am healing pretty well and you're going to probably wonder how I broke my foot which all I'll talk about later but, I feel I feel like Frankenstein because I've got to wear a boot and so there's just this other aspect of what this feels like this morning of coming in to do this episode. So with all of that again thank you for listening this is part 3 of Young Frankenstein is his valuation a science or an art. If you like the podcast please subscribe to it and share it with a friend also check out our YouTube videos we've been doing, on the interviews that you can actually see sometimes people like just to watch videos as opposed to so it's the same exact podcast, but the episodes for YouTube are the interviews that we have so check those out at the ESOP guy you can just Google them on Google I'm on YouTube and you'll find those. [6:55] So as I said how do we connect the dots between the movie and business valuation and again it it is much more of a science than it is an art there are some subjective things in the first part of this part 1, Young Frankenstein business valuation I went through just background of, what we should be understanding like this the concepts behind subjective versus objective Independence versus you know being biased or how does it how does it work to be an advocate for a client, what's the purpose of the valuation and what's the difference between a strategic versus Financial, the definitions we typed behind cash free debt free and Enterprise Value versus Equity value so all of those are I think a really important so we built we're building on that and then part 2 was. We went into some details on how do we actually start the process and and we start the process working through a capitalization of earnings method and we really start with cash flow and I went through some, background on what is what is cash flow as we Define it because I think we all. Well easily throw out ibadah as earnings before interest taxes depreciation and amortization as something everybody knows I mean it just makes Financial people business people that just makes sense. [8:16] But there's a normalization process what are the normalization in trees those kind of things so that's part 2 what is free cash flow and the process if we take out capex, so at the end of the day the buyer is buying a cash a stream of cash flow that's available for them going forward, and it's going to be net of all of those things so it's going to be really going to approximate that cash flow stream that we're valuing is going to approximate what we call the free cash flow. [8:44] And then we went into in part 2 we went into the the composition and the structure of the cap rate, and and how that works so that's important because when you think about income approach valuation what we're really doing is we're assigning a quantifiable cash flow and a quantifiable risk to that cash flow and we're going to, figure out then what is the value of that cash flow so the higher the risk of the cash flow the lower the value of that cash flow. And so so that's going to be the premise when we think about the wire or the logic behind how the valuation formula actually fits together when you, putting together the concept of a multiple what we're really doing is we're just. We're doing this from a cash flow divided by the cap rate as opposed to, flipping that over or inverting that and saying the multiple is is some derivation of the cash flow so so you're really getting the to the same number when we talk about multiples but, in valuation what you're doing is you're breaking that open and you're really looking at the parts and pieces of it so that you can understand like why would one company have a higher multiple than another company and it's going to come back to conceptually. [10:03] An empirically. The way that the the cap rate is structured so we dealt with that and part 2 part 3 as we launched into it is going to be going into the next pieces of it again will do as much as we can, if we have to go to part 4 we will and I wanted to kick off with as we as we, finish the cap rate discussion we were entering into the discussion of what is weighted average cost of capital. So what I was saying was in part two is that the the build-up approach to create the cap rate. Is going to get us to a number that's called the required return on equity which is the cost of equity the cost of equity is, um what the owner the buyer are the investor that that's what they're going to expect in, and that's what they're going to expect in return in so. When we think about cost of capital what we're really doing is we're saying really the composition of the cost of capital is broken into two categories, and that one category we just dealt with is the cost of equity, the other category is the cost of debt so what we have to do now is go and visit the balance sheet and think about what is on the balance sheet. [11:21] Now we know that some companies can capitalize their balance sheet with debt, or they can capitalize it with equity and so so I know clients that have like zero debt and that's great like at no debt I don't owe anybody you know for whatever reason that's how they structured their business because it's a. Closely held company they can do whatever they want with it, in the purest sense of valuation Theory what that means is I'm going to primarily be looking at the cost of equity as being my main driver. In my risk equation. However if I have the ability to borrow money which most companies do then I can actually say well if I bought the company I could blend the cost of capital between cost of equity and cost of debt now cost of debt, is going to be truly what the banks are going to be charging now interest rates are on the rise we're seeing the Fed. You know start to look at interest rates you know going up because inflation is going up and we all can understand that's the monetary policy of how they try to you know influence the economy and the best way they possibly can. [12:34] So so interest rates just say for instance a company can borrow money at 5% so when I start looking at my weighted average cost of capital. What I'm actually doing is I'm blending the cost of equity and I'm blending the cost of debt so that I can then, determine a blended rate now that could be a 90% cost of equity with a 9/10 percent cost of debt. [13:00] Or an 8020 75 you know 25 it can be a lot of different blending but so you're going to blend those two together and what's going to happen is your cost of equity. Or your cost of capital that you're going to apply to the the capitalization rate is going to actually bleep Blended down you know so you're going to you're going to actually reduce the cap the total cap rate by doing that. And so. What will happen mathematically is you would take a weighted average so you're going to take say it's 90% you're gonna take 90% of the cost of equity and you're going to take 10% of the cost of debt after tax benefits of reducing the companies, because we can write off interest expense, you're going to have a reduced cost of debt so that's going to blend so you could have a cost of equity for instance at 20% blend it down to something like 18% because you Blended the two and different Pro rata, percentages so hopefully that makes sense so it's really important as we apply the weighted average cost of capital to model what's going to happen is we're going to end up. Taking in the capitalization of earnings method we're going to take that cash flow that we just created on a on a normal. [14:18] Methodology for business valuation for fair market value we're not going to take the last 12 months of cash flow we're going to take the last. Say five years averages of cash flow in. Intuitively we know that's going to be a number that's going to be somewhat less than my could be less than if I just had a great year right. Um could be more if I had a terrible year so the reason you do averages in valuation theory is that we're going to want to include the normal business Cycles over a five-year period so that you're not overstating. Possibly over saying that cash flow. [14:57] So coming back to our definitions this is this is the way a financial evaluation is done this is the way when we think about financial valuations were, um we're not a buyer that's a private Equity buyer or a strategic buyer or third-party buyer that's a no I'm going to give you the last year you know last 12 months of cash flow. So anyway that's going to be we're going to average that on a five-year basis you have the ability to do a weighted average maybe weight some years more than others. You're going to tax effect that cash flow which means you're going to reduce the cash flow by the appropriate. Tax that the company would have and because, everybody would have the potential to convert to a c-corporation you're going to use because c-corporations right now have lower a lower tax burden, depending on what state you're in we're going to use just assume some type of C Corp tax rate which would, just say it's roughly around 25% so we're going to reduce the company's average Cash Flow by the. [16:04] Taxes in the reason we do that is called tax affecting the cash flow is because what's happening is we're using a cap rate study. [16:14] With returns and premiums that are built around after-tax data and so we need to do is compare our cash flow. On an Apple Apple comparison so we want to make sure that those are those are in line so that's why we tax effect it so once that's done then we're going to take four capitalization of earnings method we're going to take and divide, the net cash flow after-tax after all the adjustments that have been made, and we're going to we're going to divide that by the cap rate so the cap rate was the number that we created using the weighted average cost of capital that we just talked about. [16:50] So that would be that would have been reduced for the long-term sustainable growth rate which if you recall from part two that's really the economic growth rate a sustainable growth rate of where the economy is and how that how that affects our subject company. And then we're going to as we divide it we're going to end up getting a number which would be an indicator of Enterprise Value. And that number then would be discounted, for whatever appropriate discount so if we have a hundred percent controlling interest we wouldn't have a lack of control, but we would have a marketability discount for esops that discount for marketability is going to be 5 percent. [17:34] It because there is. Um in general that that discount for lack of marketability is built around the concept of the company not being publicly traded and not having an active buyer or a ready and available buyer to buy those shares so, because an ESOP represents a buyer. That is readily available in a sense through a transaction there's going to be a smaller discount than what we would have if we didn't have an ESOP so hopefully that makes sense, there are a lot of discussions in the ESOP Community about that, really not really being necessary but for the most part every ESOP deal I've ever done is a five percent lack of marketability discounts. [18:17] So that's going to reduce our Enterprise Value now if we do have a non-controlling interest which means we're selling something less than the 51% controlling interest then we're also going to have, a lack of control discount and that's going to vary depending on, the valuation in the numbers and how we built control or non control into the numbers, but in general let's just say that's another ten percent just for purposes of discussion so so one of the things you have to do when you think about. The valuation is in this at this step all we're doing is we're estimating the Enterprise Value with the capitalization of earnings method and we're basically to getting an Enterprise Value indicator the way that we just did the math and then we're going to reduce that for the appropriate discounts. So from there we're now going to shift over into the next part because. [19:13] One of the things about Aesop's is that as much as we want to look at the capitalization of earnings method because it's going to give us a good indicator of historically what the valuation would have been with using historical numbers and it will help us then. Evaluate the discounted cash flow method which is what we're moving into now. [19:33] In the very first step of doing a discounted cash flow is first off is just understanding the difference between the two the two models from an income approach to both income approach. The income approach method for capitalization of earnings as I had said its historical cash flow, the income approach method for the discounted cash flow is based on forecasted cash flow. And if I pause for a second and say look the discounted cash flow method is going to be given the more weight in an ESOP transaction. Because that is what the Department of Labor and what what the industry and how, the trustees and evaluation firms are looking at it and so, when we're doing evaluation for an ESOP we have to be thinking for again for the client we're doing this we're creating this valuation model. [20:27] To support the planning side so we want to make sure we stay in the right lane and do it according to the methodology that we're going to have to be exposed to as we go through the transaction so hopefully that makes sense. [20:41] So the very beginning step of a discounted cash flows we're going to have to do a forecast now what's the problem with doing a forecast is most companies don't do they usually have one year a one-year plan, I'm going to have X amount of Revenue next year these are what I think my expenses are some companies have a pretty good budget that they can use. A lot of companies in the mid-market level are probably not going to have a full on Five-Year forecast. With all the bells and whistles that we're going to want in the process of doing an ESOP. [21:14] And so we know that and I'm going to have to spend a little time talking about the forecast side because I think it's going to be the next building block to keep us moving down this road of what makes a good business valuation. So if you don't have a fork a five-year forecast let me just point out for a second number one. You're going to you definitely need to know and be able to explain to when we think about the ESOP process be able to explain with your advisor. To a a potential trustee down the road and their valuation firm what this business has the capability of doing over the next five years. [21:56] We're going to want to communicate a business plan. And the forecast itself is our is our opportunity to do that and because it's going to take a business plan and it's going to create the numerical or the number part of the story like what are we doing so, the first thing I always start with when talking about forecasts. [22:16] Is really making sure that we're not just hey just fill out the spreadsheet or you know just just ballpark what you think in the next 5 years where you're going to be and. The reason is because I know that we're going to want to go into and be able to talk about that forecast it's going to affect the the whole ESOP process not just, not just our valuation but it's also going to affect the very next step that we get out of when we get out of valuation planning it's going to be part of the feasibility planning we're going to use that forecast estimate future cash flows they're going to be used to pay off. Possibly acquisition debt depending on how we structure these are. [22:58] So that's one of the reasons important now one thing is I just think about this I did an episode in season 1 I did episode 5 called nortre Dame has, I went into a much deeper dive in forecasting I'd highly recommend you if you want to go back and listen to that one, I just went through a lot of like what I would say in the nuances of doing forecasting and I'm not going to go into that today I just want to go through the, what we should expect and why and how we can we're going to include that now in the discounted cash flow model. [23:29] So the the I gave a client like basically four steps to go through forecast if they haven't done one. [23:37] And the first step is populate your historical financial statements which we're doing anyways with the capitalization of earning so all that data is usually there. The one difference is is what I want them to do is populate the ga expenses the general administrative expenses so. What over the last 5 years have you spent on insurance and rent in marketing and. Um Jean a payroll and all of those categorically so that we can look at it line by line making sure that we have thought through. [24:10] Historically what those numbers were because history predicts the future in a sense and so that's the very first step the Second Step I'm going to have them do. Is I'm going to have them take a look at the Historical Revenue line. I'm gonna have them take a look at their backlog if they have a backlog if they have existing contracts if they have. Some predictive measurement of what revenue is going to be over the next say two to three years. [24:37] Kind of a break a break this down in a five-year forecast I'm going to try to, do a two to three year pretty solid Revenue forecasts based on him as much empirical data as we had as we can now sometimes in some businesses that's that's just so difficult and so we're going to base a lot of that sometimes on the historical part, of the company's growth rate what they've been able to do, when I look at Revenue I'm look when I'm looking at Revenue forecasting I'm putting myself in the seat of the trustee and the valuation firm that we're going to be talking to you later down the road and I'm asking myself the question is this is this growth rate really sustainable. So let me give you an example if my company's growth rate over the last 5 years was on a compounded annual growth rate was actually three percent a year. But suddenly in the in the forecast we're going to predict a growth rate of 25 to 30 percent a year. [25:33] I need to have a very solid substantiation for why is the company going to grow at that level so. Um and there are absolutely reasons that companies can go from a three to five percent growth rate up to double-digit up to something in 20s. But if there's not a good reason behind it then I'm going to probably. Push that back and say our client let's let's get let's get into the details and talk about it, tell me more about your business plan tell me more about your business development process tell me more about how your backlog is going to produce x amount of growth. And they and I've had cases where the clients like yeah well we just bought a new company I had an ESOP client where we bought a new company in the year prior to. [26:22] Doing the ESOP that was fully fully expense they decided all the acquisition in one year. [26:30] In that company the new new business they bought put a million dollars of new revenue and into the revenue side that was brand new Revenue, that I could say I can draw a line and say that's where it came from I can go back to the income statement and I could say all right this is what it cost us that's non-recurring now and we're basically just having a normal operational expenses related to that Revenue. [26:52] So there's a lot of reasons why I'm just got a contract that you know pushed us up another level so the salt the more solid the background in the business plan. The better it is in terms of making our presentation to the trustee and they're going to they're the higher love higher likelihood there they're going to buy off on what we just said and say all right that we believe that now. Just understand this on the revenue forecasting side they'll more. Loftier it is in the higher so basically we're as we get down to the discounted cash flow method, the what we're going to intuitively know is that the higher the revenue forecast is hopefully we're actually making more money on it. That is going to lead to a higher valuation so the more loftier that is the less and less substantiation the more likely it is that you're going to have. An urn out clawbacks scenario and deal structure. [27:47] That the trustee is not going to want to take the risk on so so when we talk about Revenue forecasting those are the all the things that I'm thinking about when we're helping a client do their forecasting model. And once we get comfortable with it now that Revenue piece we're ready to go to step 2 or step 3, which is analyzing the cost of goods sold and what we're going to do and the cost of goods sold is we're going to analyze the gross profit margin number and look at historically what has. [28:14] I've had situations where the number is going up it's going down in different ways what's the reason one of the things that we're dealing with right now is how is it company, working through the supply chain issues and inflation and are we building and like we know cost of goods sold intuitively is going to grow. If they have a lot of materials or, beavan labor of course direct labor is going to be more right so we have we have a lot of inflationary issues so we have to deal with that in the gross profit side, again it's the same same kind of thing we have to think about how we actually presenting this to the trustee and their valuation firm. And so the stronger the understanding of how they've been dealing with gross profit the better it is so. One scenario might be, hey we are going to keep a very consistent gross profit but we are also we're also going to successfully or we have successfully negotiated higher prices so that really we're not ex-mate estimating a decline in Gross. [29:22] In some cases there's a lag in that they haven't gotten the price increases approved and so we may have a little bit of a dip in the five-year forecast and then we're going to come back up as we're able to negotiate, successful price increases so so it's a very interesting time and I would say that one forecasting that's what's always very interesting about it, is because we got to think about the financial Trends the economic Trends and we got to be rational about how those are actually you know put in place and so, sometimes there are companies where their gross margin is increasing because they've implemented strategies, business strategies that actually are reducing and become and creating more efficiencies in their in their cost of goods sold. [30:04] And if they're doing that wonderful because we get to take that information and make that part of the big presentation and show and show the trustee in evaluation form actually. You know how that's actually working you know and so again one of the things about valuation is exciting as you get to get into these kind of conversations about the. Of what we can do to a company's potential valuation down the road if we can adjust now if you can reduce your gross profit or your cost of goods sold or increase your gross margin by 1%. You're going to see this incredible increase in your bottom line so there's a lot of potential impact to improve the valuation. We talked about this a little bit last in part 2 like we can if we can get in and really look at how we D risk the company we can reduce the cap rate. And then increase the valuation on this side if we can actually increase the cash flow by reducing and becoming more efficient in our cost of goods sold, some companies might have a tremendous amount of rework, you know like they're they do a project they have to do it again and so they're losing money on it and so there's little ways that you can consult and make sure that the company is getting the as much value as they can and so that's 11 I think very interesting side of doing all that. [31:26] So so the third that's the third step is really estimating the gross margin now I've had this where we've. For project used the we've gotten so granular on this where we taken by project but of the gross profits and we've roll that up to an overall gross margin so I'd say you don't necessarily have to be that granular but it certainly the more you are the, the more impact your presentation is going to have at the end the more credibility of presentations going to have. [31:55] So then the the fourth step is going to be we're going to go line by line through the. Did the DNA expenses we're going to ask ourselves questions like hey in in my salary side my GNA celery over the next five years, what are my if I go back to my accountability chart my org chart what are my Souls what am I gaps. [32:18] Um do I have to hire a new controller or not a new controler but maybe some companies are looking to upgrade to a CFO and what's that going to do to my officer salary or my total pull total. Compensation at the end of the day am I going to have do I need a marketing director you know so payroll is going to be a big function of that and I always like to, analyze historical payroll as a percentage of sales because I think that's a good number to look at it's not always going to be correlative with growth and revenue or you're going to have this continued growth but, we all know that in that companies that grow need more infrastructure so there's going to be a sense of talking through the existing org chart who's going to be needed in the future to grow that and sometimes. [33:09] The company has already invested in infrastructure they already have the people so they're really not going to have a high impact on G and a payroll expense but that's usually for the most part one of the bigger items that we're going to deal with and so in GNA, expense forecasting what I'm doing is I'm going to take the big numbers first and I'm going to wrestle through all of the big numbers it's typically its Insurance payroll, rent software marketing so and we're going to talk through, what we spent historically and then we're going to talk through what we need to spend going forward to support the company's revenue forecast in the business plan so you see that there's a very important puzzle piece as we put it all together it's not, three percent every year of inflationary growth or 5% we're going to look at inflation of course we're going to look at all those aspects of it but it's not. [34:04] So in the forecast what's that's going to do it's going to get us down to now a 5-year net income, then we're going to go back to the net income we're going to go back and adjust it for a normalization entry so, things that we have identified originally in the capitalization of normal capitulation of earnings method normal is it normalization in trees are going to now apply themselves to the forecast. And so there's really two ways you can show that you can either embed that into the forecast so if my. Um officer if my owners leaving the company are phasing out and we're going to have owner compensation add vax I'm going to I could include that in the payroll side or I can include that on the bottom line. [34:44] Are in my bottom adjustments. I would say I prefer to put it in my adjustment so that it's really crystal clear for the people that are evaluating this forecast, one of the one of the people that are going to look at the forecast and likely if you're going to do Bank financing as the bank who or banks that are and you know understanding and underwriting you're potentially sauce. [35:07] So That's going to really be important to to work through and make sure that you've done that so so now we've go from net income into your adjusted ibadah, which is after all of those add backs. [35:21] And then after adjusted ibadah what we're going to end up doing is looking at all the fixed asset Acquisitions for historically, and then the potential for capital capital expenditures going forward so that we can get to a free cash flow number and that free cash flow number is where we're going to kind of finish this podcast today, but that free cash flow number is going to be our 5-year free cash flow and just did put this into perspective as we as we. Leave this and we're coming back to doing part for what I want to leave you with is what you should. Um intuitively look at it as if the company has grown, in five years so your historical let's say the company was doing a million dollars in the first year of their of their 5-year historical, averages and at the end of five years they were they had just continue to step up and keep it up that's sustainable and there are five million now that company could have an average ebit of three million dollars of ibadah might just look The Five-Year historical. [36:21] But going forward we really feel like that's a really a five million dollar five million ibadah company and I can show that you know obviously I'm going to show that in a. Um it should play out that way a lot of times because the company has grown you know companies tend to grow, and hopefully they're not Contracting now there are companies that go through a lot of volatility you're come in here and they go up and then another year they come down, but what we're looking for in an ESOP candidate is a company that has a very predictable cash flows so we want to estimate. Appropriately what those five year free cash flows are going to be and we're going to build and design not only the valuation but also the whole ESOP around that so that's why that's so important I spent so much, so much time going into that so when we come back to part 4 we're going to go into the Calvin the discounted cash flow model puts that together, and then I think at that point will have time to pull together the balance sheet conversation required working capital and transaction value so with all that again I appreciate you listening today and we look forward to our next time, on this journey to an ESOP keep on keeping on and if you like the podcast please share it with a friend, And subscribe and have a great day I will talk to you soon thanks.

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