EP13 - Young Frankenstein - The Science of Business Valuation for ESOPs (part 4)

[0:11] Hey everyone this is the ESOP guy welcome again to the journey to an ESOP. This podcast is really been created to help folks think about an employee stock ownership plan as a viable option. When they're thinking about their business succession or exit of their of their business. As far as planning goes and how you might want to use an ESOP to go forward on that. [0:33] The podcast has been going on this is our third season so there's a lot of episodes if you have an interest in checking any of those out please go to our website at journey to an ESOP.com there's also a page where you can ask any questions you want I've gotten you know I routinely get questions from people, about specifics so that's always a resource for you that is available as you as you go through these types of things and so. Where we sit today is on this multi series episode on business valuation so we're going to continue that we're going to start off this episode with this clip real quick. [1:12] I know I'll never forget my old died when these things would happen to him the things he say to me. [1:22] What can I say what the hell you doing in the bathroom day and night what did you get out of there and give someone else a chance. [1:38] You gotta love Igor or I gor on Young Frankenstein so this is this is. This podcast episode is going to be titled Young Frankenstein business valuation is it a science or an art and this is part 4 of that episode. And first off as we go through the the this episode really wanted to go back to the beginning of the inspiration of why are we doing this there was a. [2:07] You know a lot of things I have experienced in working and talking to people we have a client that's an ESOP company that's, that's been looking to acquire other companies because these hops doing really well all the tax advantages that we talked about and so I got into the situation where I'm helping them look and value this company that they were looking to acquire and, on the other side of the table so to speak, in the zoom meeting I was kind of dealing with the advisors that were hired by the company that was looking to be acquired. And so a lot of the the discussions that we had about business valuation what you quickly realize is that some people are experts in certain things you know whether you're a CPA or you're an attorney. You kind of have some experience heavy experience in different things and so a lot of times people they have the requirement are the need by their client to be an expert at business valuation but you know clearly they're just they're just not and so. Partly this was that was the inspiration of doing this because what I really want to accomplish at the end of the day with with this series is to give people a very solid understanding of, business valuation and on and we'll really went through a lot of detail of going through a lot of the steps that we go through to create what I would call a valuation model. [3:21] For the ESOP process this is really the beginning step because the first question we always have to ask, with the client is what is this business going to transact for within that's an estimate because we don't know yet we have to negotiate that an ESOP process, so a lot of what we're what we're talking about if we go back to part 1 part 2 part 3 and this is part four, is really what is in that model and so it we've taken some time and really gone through the details which I which I'm hoping. As you go back and listen to some of these that you have a strong footing on what those are so that you can ask your advisors as you go through these kind of questions in it it may not even be soft related it may be something else that you're working through could be your. Your buy-sell agreement and the company and you want to make sure your valuation works it could be a lot of different aspects of just business valuation in general but. This is definitely tailored towards an ESOP. Transaction so that's that's I want to make sure we're clear on that so again welcome to the podcast we're excited that you're listening today. [4:25] As you go through it and you like if you like the podcast Please Subscribe and if you think it might be helpful to somebody that you know. Please share it with a friend as well so so with that I wanted to kind of kick off into part 4. And why did I play that weird movie clip about the bathroom I thought it was funny and I thought that it was like. What are we doing it was kind of something I was just thinking in my head what are we doing here talking about business valuations and we're in part for so why are we spending so much time. So to speak on this topic and. Like I said that's important to go through I think really all the details to make sure where you're prepared to ask the right questions and so you could have said Haywire what the heck are we doing spending this much time on in the bathroom of business valuation so anyway, that's a good launching Point towards what we're going to talk about so the first thing we're going to get into we're picking up from where we left off was what we left off with was. The forecasting step that we have to go through and that's a five-year forecasting step so part 3 was really dedicated towards really understanding that once we have that. We're going to make we're going to be able to take that forecasts and put it into a. [5:51] All with all the adjustments that the company might have with normalization and we're going to end up having an adjusted ibadah. [5:58] For the company and then we're going to use that then to populate the discounted cash flow and. [6:04] Well something we the first step of the discounted cash flow is we're going to have to take each of those five years of adjusted ibadah. [6:12] And we're going to have to tax affect them. Because we're using we're going to be using discount rates that were created from the capitalization rate that we've already talked about. And we're going to want to create a present value formula for the discounted cash flow so those rates that we're talking about we're after tax so we're going to tax, the cash flows going forward on our forecast. There may be other adjustments that might come about in the event that we have let's just say we have a very aggressive forecast and we're really going to grow Revenue well we may end up adjusting that those cash flows for an additional requirement, for working capital which we're going to we're going to get into required working capital but assuming that we've had a pretty modest growth, we wouldn't have any adjustments so that's going to give us a net cash flow that we're going to use for the discounted cash flow purposes so the next thing we're going to do is we're going to take those cash flows, and for each of the periods of time for the next five years depending on where we fall in the year. Assuming that we are within a half of the year we're going to create, a present value formula that's going to include the discount rate which we go back to the cap rate stud study that we talked about originally this is really the same thing as the. Required return on Equity that was created by the capital asset build-up approach. [7:42] That we're going to have now when we go through that and we estimate a weighted average cost of capital what that's going to do is it's going to blend the 100% cost of equity with a some percentage of cost of debt so that could be a 9010 so that number itself would be the one we're going to use now. In some cases the valuation firm might take that discount discount rate and add something to it. Because of the the forecast so this is an area where they may bump up the discount rate which basically is going, reduce the value of the of the business because it's going to increase technically don't it'll increase the discount rate so it increases your present value Factor that's going to reduce the total cash flows, hopefully that that makes sense so. One question you would have is what discount rate did you use to create the present value formula and so we're going to use a normal present value formula and then we're going to apply that for each of the years and you'll you'll notice in the present value calculations that, based on finance that a dollar today is worth more than a dollar tomorrow so you'll see this present value summary going down don't you know the present value Factor going up and the cash flow is going down, respectively as you go through the five years so the first part of the discounted cash flow number is just simply going to be the summary the some of those, first five years of present value cash flow. [9:12] And then then we're going to go ahead and then take the next part of the equation which on the discounted cash flow is to calculate the terminal value. And so what happens is the company. Is what we're assuming is what we call and valuation as a going concern going concern just means the company is going to continue to go on and operations and there's this idea of the cash flows going out into what we call perpetuity, was just means that the come the company is going to continue to have cash flow going on in the future. Now nobody knows exactly what that cash flow is going to be an even five years of forecasting is difficult right so the best we can approximate what we're going to do in valuation is we're going to estimate the future value of those cash flows using a terminal value calculation. And the first step of that is to create what we call the stabilization period That's the next year's cash flow based on some growth rate and normally we're going to use. The sustainable growth rate that we used in the cap rate and so. If that's basically going to equate to something around the economic GDP growth rate so two-and-a-half to three percent that's the growth rate we're going to use on the cash flow going forward. [10:25] So when we multiply that growth rate times the last year's cash flow 1.03 or 1.0 25 then that's going to give us a new number for stabilization. And so that new cash flow what we're going to do is then capitalize it, by dividing that number by a cap rate which is going to be back to the discount rate minus the growth rate is going to equal a cap right now that's going to give us now a capitalized, value on the terminal or the Perpetual growth of the company and then we're going to Capital and then we're going to take the present value of that number and we're going to multiply that times to your present value factor that we had in the fifth year and then that's going to give us a terminal. [11:04] And so, if you follow what I'm saying again a lot of details as we go through it and it's a lot easier to see this in a in a model but I'm hoping you're getting the idea that there's really a common in the discounted cash flow, valuation there's really a combination of a sum of present values for the first five years, and then this Perpetual value of the terminal value that's going to be added together to give us the indicated Enterprise Value and we'll come back to that term in a second what we want is the Enterprise value of the business and. So one thing I'll pause and say when we think about what we've been doing over the iterations of each of these, series part 1 2 3 and 4 is that the discounted cash flow number is going to be the number that we are, most concerned about because it's going to have the heaviest weight when we get to actually negotiating the transaction itself so. [11:58] When I say the Enterprise Value from the discounted cash flow I'm saying that's that's going to be the one that we're really going to want to focus on and. Going back through the forecast you know multiple times and truing that up in a sense really getting comfortable with it is a really good idea it's a good idea because. What we're going to end up having to do at some point in the ESOP processes we're going to end up having to justify what we came up with in the forecast. [12:28] With a solid business plan that says these are the things that the company is going to be doing over the next five years now. [12:35] Nobody is expecting anybody to predict anything perfectly but what we want to do as best as we can is nail down the reasons why we feel like this is, this is the growth for the revenue company this is our new gross profit going forward this is our G & A expenses these need to be nailed down as best they can and so, the better we do that the stronger the forecast the stronger the forecast the stronger the discounted cash flow number so that Enterprise Value number is a critical number and the valuation model and as we go through those those steps that we just went through, once that's built and that's connected to the forecast now we can model, and do some planning that says what was our what if what happens if you know the company really grows a lot more than we predicted we can predict a new valuation based on that, what happens if it's a little less than that so so it's all going to tie us together so that we can do some I think very important planning up to up front. And the important part of this is that nothing's really happened, that we can't go back and forth on because nothing's been decided you know submitted to a trustee at this phase we're just getting our heads around what could this business what is this business really truly worth. Based on all of these assumptions including the forecast but also really looking at the potential for for normalization add backs so. Now this is an Enterprise Value before any discounts so we're going to get to the discounts in a minute. [14:02] The next thing we got to do is work into the balance sheet and what we're doing in the balance sheet. Is a couple things first off we're going to make sure we want to go through the balance sheet and fair market value any potential changes in the assets so this could include you know, fair market value on current asset adjustment for things like account receivable that might have. You know gone down because of a significant amount of uncollected or uncollectible accounts receivable so so what we're going to do is we're going to take the balance sheet at the most point than the most recent point in time. And we're going to adjust that balance sheet accordingly to make sure that all those accounts are good to go there might be inventory that needs to be written off there might be something in the the assets that we just you know. Thinking about now on the long-term assets there might be there might be land and buildings there might be appreciable assets as well that are going to be part of the ESOP deal now, this is where we want to make sure that we have a solid appraisal amount on those assets to support any adjustment because on the balance sheet they're going to be truly just. [15:07] Posted as you know the cost of the of those assets so from a fair market value standpoint we want to make sure that those are adjusted accordingly. [15:18] - when you take about the the fair market value of assets minus the debt - any liabilities related to those assets it's going to give us you know your normal Equity or your your normal Book value which. Would if on a fair market value adjustment that's going to really translate to what we would call the net asset value and we're just going to want to look at that number and compare it to the cash flow valuation, just to see what the differences are if it's lower or higher and then go from there but in this case let's just assume it's kind of lower and there's not a lot of assets just normal current assets on the balance sheet. The second thing we're going to do on the balance sheet is we're going to re-evaluate the working capital, now there's a couple different ways to do this one quick and dirty way that we do we use is basically taking the financial ratios. That create that are created in what we would call the cash conversion cycle so working capital from a business perspective is just the amount of. [16:13] Assets whether they're in liquid form or converting like receivables that converts to cash inventory that converts to receivables that converts to cash, - the accounts payable or other accrued accrued types of liabilities that could exist accrued payroll. So working capital itself is a concept that's important for any any transaction that's going to happen whether it be an image classic third-party buyout. Or a sale from from that perspective there needs to be. For the company that is being bought for the buyer there needs to be a level of working capital that's necessary if it's deficient if that working capital is less than what is required, then what happens is the buyer actually has to inject more money in the company in order for it to. Have the to produce the amount of Revenue and cash flow that we just created in this discounted cash flow model so. [17:12] What we do is we'll do a financial ratio study that says the a our days the a the inventory days in the AP days when you look at those financial ratios are going to equate to a net conversion cash conversion cycle of number of days, and when you multiply those days times, the cost of goods sold you're going to end up getting a net working capital requirement now this is a good indicator a lot of when I talk about required working capital, this is where it gets a little bit like all over the place where some people use a lot of different ways you know when you're doing transaction some people say well you know it's just ten percent of the total revenue, yeah that's what we that's what we're comfortable with in. Cases where we have a company that has a bonding relationship we're going to want to talk to the bonding company and find out what is there what is there or working capital requirement it because if it's if it's something that is. It's something that we're going to want to continue right in the bonding company are the bonding relationship we want to probably adhere to that as well. [18:14] And then another way to do it is probably the most popular it's just taking the last monthly balance sheets over the last 12 months 18 months even 24 months and doing an average of that working capital. And so you can kind of see what the company is now used now the problem with that is sometimes the company has like in the contractor case, they just keep a lot of cash on the balance sheet just makes it easier for the bonding company so what we really want is we want to nail down what we think that real true net required working capital is going to be so that's going to be important, and those are the methods that we would use and so as we then move to the final part of the model what we're going to be doing. Now taking all those numbers and now using them to to find out what we believe the transaction value would be. At a point in time in the future and so the first thing we're going to do in this last part which were calling the transaction value, model is going to take both of the both of the income approach methods that included the capitalization of earnings method if you go back to the Beginning Witch, is a. [19:25] A historical income approach methodology which says hey well we're going to Value the business based on a five year average normally that's the standard Cash Flow and so that's going to give us. A indication of Enterprise value for the capitalization of earnings method that we're going to include in the transaction model, if the company has I had said before is you know having a lower historical average cash flow of course the Enterprise Value. Under the capitalization of earnings is going to be lower than the discounted cash flow model I mean it's just kind of a normal thing, that's why if the forecast is showing has to show sustainable cash flows going forward, so so that's our first number on the transaction value models the Enterprise Value so then what we'll do is we'll do a comparative as we go across you know this this model so we'll say right now the Enterprise Value again before discounts for the discounted cash flow is going to be, a different amount of money based on the model we just talked about. [20:29] The next thing we're going to do in the model is we're going to take both of those values as soon a prize values and we're going to add the existing cash on the balance sheet because what we're contemplating in the transaction is. A non, Akash free debt free transaction so we're going to end up adding the cash that's going to increase the purchase price or increase the Enterprise Value and more what we're moving through on the transaction value is Enterprise Value all the way through to equity value so we're going to add back cash, and then the next thing we're going to do is we're going to then adjust the model. For the working capital requirement and so what we're going to do is we're going to take the non-cash. [21:10] Assets current assets of the company so the non-cash. Assets would include a our inventory anything that was it was a current asset that really needs to be included in there so it could be, for four different companies it could be some retainage receivables it could be anything but it's going to be a current needs to be a current asset to be included in that list, then we're going to go ahead and add up all of the current liabilities that are non what we call non debt liability so anything that would be long-term debt related at this point. [21:45] Or a current portion of long-term debt that would be stuck in the current liability section won't be included here so that would most likely be your your accounts payable and, the Anika payroll accrual or any of that type of accrued liability that you have it could be customer deposits as well so all of that's going to be included in the. Working capital or that the liability section of the working capital so so at some point in time. Which would be take their just in general our last month's balance sheet then, we're going to use that as our estimate so what we're really doing here is we're estimating what cash will be at the closing we're going to estimate what working capital will be net so once we know the net non-cash non debt working capital number we're going to then offset that with. [22:32] The actual working capital requirement that we had come up with a net working capital study so. So for purposes of just using some numbers we could just say that cash was a million dollars. The net working capital before the adjustment was a million dollars but the requirement for working capital was two million dollars. So in this case we would have we would add back a million. And then we would have a negative million-dollar adjustment so so really what would happen is the cash in the net working capital requirement would just wash out and so the purchase price at this point in the model, I would simply just be the Enterprise Value before discounts as we get through the whole the next steps so the next thing we're going to do is we're going to then take if the company has any, debts owed be anything that they owe that that debt within dollar-for-dollar come out of the model so as we go through capitalization of earnings and Debt Service our debt discounted cash flow. We're going to pretty much be making the same exact adjustments because all we're doing is taking the companies. Indicated Enterprise Value through the exact balance sheet that we have to estimate a transaction value. [23:43] So at this point what we have in the model is really a. An estimate of equity value after we've taken the dead out before any other adjustments now one adjustment that we might make, depending on the type of company it is if it's an S corporation and depending on what might be there is a what we call a AAA adjustment in the AAA, is a tax terminology which is stands for accumulated adjustment account and so for an S corporation. What would happen is is each K1 holder or each shareholder of an S corporation is going to have their own accumulated adjustment account and so if we were doing this specific to one shareholder, we may take part of that company sell part of that company we may just take their AAA at that point or if we're doing this for multiple shareholders we're going to just aggregate the AAA and so what's going to happen is we're going to have this Equity value before AAA. [24:46] And we're going to end up taking that out of the equity value because it will reduce the purchase price for the amount of money, that's being sold because they're basically going to have this composition of. Redemption a Redemption amount for the stock they're selling and then an amount for the AAA distribution when you add those back up they're going to come back to the the amount of the equity value before the AAA adjustment so hopefully that makes sense to you. [25:17] The point is that we extract AAA out of a transaction because in S Corp tax. When we're going through a normal S Corp that AAA really represents the tax retained earnings the tax basis for the shareholder that they've already paid taxes on. And so that money is money that they need to pull out of the company to reduce the Redemption note so on an S corporation ESOP what's happening is they're going to get under the current tax, um You know rates they're going to have say roughly a 20 percent tax rate on the capital gain side so purchase price - bases equals the net taxes in this case what we're doing is we're just reducing the Redemption, by the total AAA balance so that that portion of AAA that they kick out of the company, are out of the actual transaction would not have any taxes attached to it so the remaining portion would have a twenty percent tax on. [26:13] So that's how that works now we would normally not completely. Distribute AAA at the time of closing because we're going to need to keep the balance sheet in place so many times in a tree stock transaction what's going to happen is that the company is going to. If it was just straight up seller financing would issue a note to the to the cellar for the Redemption of their stock plus a note, for the distribution of that AAA and so that those notes would have maybe different amortization Xin but you'd probably want to do is take the AAA out faster you know have a shorter amortization for that piece than you would for the Redemption of. [26:55] So now that we've gotten through the adjustments for we've got cash. [27:01] Working capital debt in AAA we're going to have an equity value in the company now that Equity value then is going to be discounted if we are selling a controlling interest in the company which means we've sold to the ESOP. [27:15] More than 51 percent of the company that means they have control of the company, from a voting standpoint then we are not going to have any discounts for lack of control so what we would have at this point is just simply. A discount for lack of marketability on the total Enterprise or the total Equity value that we just calculated so that would be applied to that discount will be applied to that Equity value and then we're going to have a. Equity value after all the discounts to be an estimate for what we would actually look at as a potential transaction value. Now if we're deciding now we're going to instead of doing 100% ESOP or a controlling interest if we decide that we are going to actually do. [28:00] A non-controlling interest something less than that 51 percent then we're going to also want to apply a discount for lack of control, for that so so we want to estimate a real good number there and so just kind of 44 Ball parking purposes this is not guaranteed but most of the time the discount for lack of marketability is around 5%. And so that's going to be the number for a discount for lack of control you could use something like 10% as, a possible discount but there might be a lot of extenuating circumstances to the control discount so you can't just kind of take that and say that's that's always the case. But in general it's important to know I had done a podcast, with an ESOP attorney a little while ago in one of the one of the issues that he had on this on his ESOP transaction was that the client didn't understand the discounts, and when all of it was was netted out at closing. It was about a million dollar discount and he was not super happy with the situation and and I think in his story the deal still closed but it created a tremendous amount of stress and. Anxiety and all kinds of frustrations that could have been avoided you know again that's one of the reasons we're doing all this is to help people to know a lot of the inner workings of how this the math gets done. [29:27] But what we have at the end of the day at the was we finish this in conclusion is we have a transaction value that we've estimated now of course this number is going to change right because our balance sheet is changing every single month every single day right so when we talk about balance sheets from a financial perspective we always say that this is just a point in time. Which means tomorrow my cash might be more or less in one of the questions that gets asked I think quite frequently is that we. [29:57] What happens if I distribute all the money like right now I mean if I just say hey I'm going to take out you know I've got eight million dollars in the balance sheet can cash I'm just going to take out four million bucks well it's all going to wash out in this in this transaction valuation which is adjusting for whatever current cash is, adjusting for current working capital so what happens in a transaction is we end up negotiating that top number that we just talked about we end up negotiating that Enterprise Value number, and everything else will just flow from there to determine the net amount, that's going to be available when everything is trued up so the important part is that you need have a model evaluation model that predicts, accurately what that transaction value is going to be and it needs to be updated as you go through the process of doing your ESOP so all of the parts and pieces that we covered over the neck of the last. Four part series are part of how we would construct evaluation model and as I said at the very beginning this is really going to to lean very heavily. On what we would call the income approach valuation methodology. [31:07] The value of doing this when we think about the value to the client of doing this an ESOP planning is that they're going to be able to predict. What they think the number is going to be and they're going to understand what to me is the most important thing is understand the background of what what really is going on. [31:24] Because that gives them a lot more understanding of how when we start thinking about negotiation and we start thinking about the other parts of the process which is. [31:34] Presenting to the trustee in the valuation firm in the come from confidential information memorandum or the presentation of the site visit, it's going to make a lot of sense because what we're doing is we're supporting all of the details that we just created in the valuation model so so that hopefully brings that that step together because it's a really critical step in the process, and one I would say that doesn't you don't want to skip through that to quickly do you need to do the details as, maybe granular as at we've kind of gone through my opinion is yeah because it really helps the client to really understand it and it gives us a better understanding of how we want to go about negotiating the transaction. But it is an absolutely necessary maybe not you can still do a transaction but I think it makes it a better better transaction so with all that I wanted to say you know thinking thank you again for listening today I know we went through a lot of detail we spend a lot of time, so to speak at the beginning of we talked about it in the bathroom on this thing but hopefully it was worth it and as you go through it you might want to go back and listen to some of the other, episodes Part 1 2 3 and 4 if this is the first one you're picking up so you can look at all of it together so with all that thank you guys so much again and we'll look forward to seeing you next time on this journey to an ESOP.

All content © 2022 The Journey to an ESOP.