EP43 - Jurassic Park - due diligence on ESOP deals

[0:10] Hey everyone this is the ESOP guy we are deep into season 2 almost starting season three in January so hope you're having a wonderful year with a lot going on and the ESOP Community a lot going on before the end of the year so, if that's you and your deep in your ESOP. You know congratulations hopefully you'll get it close before the end of the year and you'll be new ESOP company if you are more on the interested side not sure what to do with it this podcast is really the right place for you because there's a lot of information here, that will help you on your journey to an ESOP so. If you haven't picked that up yet this is the resource that we've created to really help guide folks through the process of creating an employee ownership company. And how that works and really because there's so much information out there, this being another source of information what we're really trying to do is make it simple and so we have episodes podcast episodes and YouTube episodes as well. That really topically will take down like hopefully specific areas and you can start learning more and more about Aesop's oh, if you want to know more go to our website at journey to an ESOP.com, there's also a little form page you can put in how can we help you if you need some resources and we can guide you to the right place that's what we're all about so thanks so much again for listening. Today I'm going to start off this episode with this the danger inherent. [1:38] You're doing here genetic Powers most awesome Force the planets ever seen that you wield it like a kid that's found his dad's gun it's hardly appropriate start early and she said if I may. I'll tell you the problem with the scientific power that you're that you're using here it didn't require any discipline to attain. [1:56] You know your read what others had done and yet you took the next step you didn't earn the knowledge for yourselves so you don't take any responsibility. [2:04] For it you stood on the shoulders of geniuses to accomplish something as fast as you could and before you even knew what you had you you patent it. Packaged it and slapped it on a plastic lunch box and now selling it you're going to sell it well. [2:19] I don't think you're giving us our to credit our scientists have done things which nobody has ever done before yeah yeah but your scientists were so, it's whether or not they could they didn't stop to think if they should. [2:32] Awesome scene you might have guessed that it was Jeff Goldblum from the very famous movie Jurassic Park, in what I like about this scene is it's going to set us up perfectly today to talk about, what we want to talk about which is due diligence so they have this ultimate due diligence meeting. In this movie and what they're doing is they hire this team of experts to come to the island this is a little island off of Costa Rica. And they have a couple scientists we have a waiver mathematician we have a finance guy and then basically they're there to you look at before this crazy. Park opens which has live dinosaurs on it and so I thought this was a really good way to open up the concept of what are you preparing for when you look at specifically due diligence so the title of this podcast, is going to be Jurassic Park preparing for due diligence simple as that. [3:28] And going through the process of due diligence what I wanted to say for those that are thinking about the the process of going through an ESOP is it really does start at the very beginning and so what we're going to cover. In this episode is really what you should be preparing for you know with your advisors and what you should be gearing up for in the process of doing due diligence now as it relates to the ESOP process, of course there's a couple major things I think are important that would hopefully. You know be in the front of your mind as you're thinking about the of stepping in an into the ESOP process now one thing that we talk a lot about. Probably not enough about, we have touched on it here is the cost of an ESOP and so understanding the due diligence process and being prepared for due diligence has absolutely going to help you with how you manage the cost of due diligence as part of the process. And so the more streamlined you are the more prepared you are for that the better it's going to be. [4:28] Evaluation obviously the better the due diligence goes the better evaluation is going to be when you're negotiating for the fair market value it's going to definitely pay it play a role in all that. The other thing is just simply I think everybody's busy so the less disruption you have during during the due diligence process the better because everybody's going to. [4:49] Even though you're selling your company as an ESOP everybody's got a full-time job that they got to do so. So hopefully as you as you listen in to this episode you're going to gain some information that would help View and that and you're part of the in this part of the journey to an ESOP which I'm calling the due diligence phase. [5:07] Now. Coming back to the movie okay Jurassic Park is basically probably not for everybody but it is a very I think it's one of the all time blockbuster movies and it's because it just it's so out there you know, first off as we answer the question if you could bring back dinosaurs you know should you even do it right and so. Really interesting movie The based on Michael crichton's novel and just creates this idea behind like what would this even look like and. But I like what I like about it as I said it creates this like really intense due diligence process to determine what you know is this island really ready for visitors and. You know and they did a great job at the very beginning of the movie. Kind of wowing everybody with this is Finn if this is fantastic we can make a ton of money at this everybody's going to come there's nothing been like this in the history of man. But the other side of the this starts to go really bad right so the whole process the due diligence process, kind of explodes on them because of course they almost get well some people do get eaten so you know then they're like oh no this actually this was a really bad due diligence meeting at the end of it so. [6:24] Anyway, check it out it's a really cool movie if you haven't seen it I'll be surprised but I think it is really interesting when you start thinking about what questions get asked and comments and partly and what I wanted to bring this back to from an ESOP perspective is. [6:39] Is the owner of the island and the people like the scientists and all that they're like not they're like blind to their own success they're like blind to things that are being proposed and and the clip I played. Was really Jeff Goldblum kind of pointing out something that is obvious to him but it's not obvious to them and especially the guy the finance guy and they're like if we can make money at this why wouldn't we, and so I think that happens with some companies when you don't have a very good. You know advisory team I'm save or whoever your leadership team people that are kind of questioning what are you actually going to present and due diligence what are you going to present in your management presentation and so. Sometimes when you go through the due diligence information I think this is really important you got to get some objective opinions on what you actually are doing in your company what you think is a strength might be a weakness. What you think is when you know something that somebody else should look at and say oh this is the best thing ever. What you want it to happen early in the processes that people will actually challenge the people that you hire to help you will challenge what you actually have and tell you the truth and before you get into a process of doing due diligence. [7:54] So Having said all that what I wanted to do is jump into then the idea behind you know ESOP due diligence and we're going to put this in the right place just process why so we're all thinking about the. In the right place because you're not you're not going to jump in and do your ESOP and immediately go into to due diligence there's, definitely now this process might vary between cell site advisors but essentially the very beginning step you're going to have to go through is you're going to need, establish a valuation and feasibility model that helps to better understand really what you're selling, once you've done that you're going to try to like take that information and then create what you're actually going to do is it can include warrants is going to include SARS. And so once you've done that your sell-side advisor is going to want to invite some trustees to the table you're going to have these interviews with the trustees. And so when you select the trustee that's going to be the one that is going to hire the valuation firm. [8:59] Or the financial advisory firm that's going to support what they're doing then at that point you're going to you're going to pretty much once you've engaged them you're going to end up getting into now the due diligence phase and that's, so I would say that's kind of middle of the whole process and it's a obviously everything that you do in my mind with the ESOP process is going to be a critical step. But what I want to do in this podcast then is just really educate you and think through you know early on in the process what sort of things you need to be prepared for in due diligence. [9:32] So as we go through the process one of the things you're going to find is a, most of the time it's like a three-page checklist that you're going to be provided by the valuation firm that's hired by the trustee, and So within that three-page checklist there's going to be certain items that you're going to be responsible for so we're going to, we're going to walk through some of that those items and talk through a little bit of the background with one of the with each one of those types of items categorically so that you can be prepared so the first one is going to obviously be financial matters. The buyer here is going to be concerned with. [10:05] You know understanding the company's historical financial statements understanding the projections and how those make sense in relationship to the historical. Financial statements so they're going to obviously want to get the company's annual or Court well really annual statements first but then go back and look at possibly quarterly Xin certainly over the last 12 months look at the 12 month data as well. On a financial statement basis to see you know what's the performance what's the twelve trailing you know averages of cash flow, so they can go back through that and they're going to look at you know having an audit versus a review versus a compiled statement which is, the financial statements rather whether they've been independently prepared by a CPA firm definitely is going to play out in terms of a strength and a weakness in the, in the whole scope of your due diligence when it comes to financial matters in the reason that is is obvious but it's it's because, your numbers internally prepared have not been audited or reviewed or you know gone through over by a certified public accountant, under the financial accounting standards and because of that whether or not you've accounted for create things correctly within Gap generally accepted accounting principles is going to be part of it. Second part of it is that you know do your as a company if you've not had your financials really tested you don't know the weaknesses of the financials and so. [11:33] They're going to be more reliable. In a sense if they're going to be audited and reviewed now this will relate itself to strengths and weaknesses that come back to risk right so if I have. Better quality financial information I'm going to have in a sense lower risk to the financial buyer because they can rely more on those historical financials to provide a basis, of what the company can Aaron in profitability and Revenue, and what the balance sheets are and the other thing an audited statement does is it provides a good disclosures that can be can really help explain the company's historical, that those disclosures can include loans in the debt schedules they can help explain. [12:19] The way that the companies can compensation matters work with 401k accounts just a whole Litany of things that Financial disclosures that are that are required under fasb's and GAP do for the buyer and so. Clearly if you are walking into thinking about an ESOP for next year and you have the key you know you have the question whether or not should I get an audit should I get a review, I'm certainly when you think about the difference between a review and an audit audit is going to be always more expensive. The bigger their your your valuation is going to be I'm going to say the more you're going to lean towards getting an. In the middle of the road would be a review and certainly a compilation is prepared by the CPA but it's not going to have the same weight as a review and audit so just thinking about those things. [13:10] The other parts it is you want to make sure that your financial statements are completely. Inaccurate and one of the things I get into and due diligence in this category that I think is really important, is is and it sounds kind of for a bigger company probably not as big of a deal but for a smaller company this can be a bigger deal which is can your company produce a monthly Financial. [13:33] That is accurate that has in and sometimes they don't have this but has the ability to provide the correct accruals like if your, you're going to have an annual bonus for instance is your does your interim financial statements account for that accrual that's important. Because on the tan a due diligence process what they're normally with the valuation firms are normally going to be asking for is the most current. Interim financial data now if your company every year has has a lot of adjustments towards you know the end of the year between what they're doing internally. And what they're doing through their CPA then that might be an area you want to definitely work on and think about prior to doing due diligence. [14:17] One of the things you'll look at in the financial you know statements and just a historical analysis is looking at your benchmarking in this area before you get there, what are your ratio showing you and part of the advisory work that I think needs to be done is that you, your advisor really needs to evaluate and this is part of the this should be part of their value the valuation anyways but they want you want to evaluate how your company Stacks up. Relative to. Financial ratios for instance like Leverage ratios deck to worth how does it look in your industry where your where's your company at relationship to that. Liquidity ratio measures profitability measures in, really just thinking through like some of the things you might have been exposed to is your company outperforming or underperforming in the marketplace when it comes to Pure financials that's definitely going to be a direct connection to, what I would say is in valuation world is specific company. So you can look at the margins and all the other parts of what your financial is present to a potential buyer but you want to you want to look at it from that scope as well. [15:30] Is your are your when you get into the projections of the financial part of it, did you do the projections and again this is this is step one in the ESOP process anyways right because the projections are going to help us to determine what your valuation is going to be. And understanding what those projections yield in a discounted cash flow is going to be important but going on opening the projections and thinking about them realistically. Do they really represent. The historical position of performance of the company or is it you know are the projection showing something that hasn't happened before and if that's the case does it make any sense, from a business planning standpoint when you're when you're being thought when you're thinking about the questions that you're going to have and due diligence how are you going to going to explain those projections. [16:22] Looking at Financial the financial part of it too we're going to want to evaluate and due diligence what your working capital. One way to do this for your own benefit is to do like a 12-month working capital and look at the average working capital your company has had for the last 12 months. That's going to be a good indicator what your target working capital might be when you're thinking about the actual ESOP. Transaction that's going to be a negotiated amount and so in due diligence they're going to want to verify what that is now. When we talk about working capital within East the ESOP world most of the time what we're talking about is what we call a cat we call it cash free debt free transaction which just means. That the cash is the is the sellers and then the debt the buyers not buying the death. And so as it relates to working capital most the time we're actually looking at non-cash working capital. And then or when we go through the modeling for the valuation we're going to take Enterprise Value add that cash adjust for the Target working capital with what your existing working capital is. [17:27] Subtract all the debt and then that's going to give us a good indicator of what we call Equity value. [17:33] So then deeper in the balance sheet when you start thinking beyond the working capital you're going to think about the what's on the balance sheet with rose relative to assets. Now when you get to the assets and what the composition of assets are. Clearly you know if your company has receivables and inventory those are all going to be part of the working capital but when you get into long-term assets one of the questions is is do you have land and building on the on the balance sheet. If you do. What's the market value of that land and building and are you trying to sell it within the ESOP and that would be really important in due diligence to no way perlier on it's going to be a big integral part of what we what we think the valuation is going to be as well, so clearly identifying that in the financial part is going to be important and then how how you're planning for that to come out of the balance sheet if you're not going to be, you know putting that as part of the sale prices that that's what you've had. [18:30] So then going through the other parts of the financials is just the, understanding like the the liability side what is the company need in terms of financing what do they have existing in financing before they do any acquisition debt. And what would they want to maintain if they have an existing line of credit. Or you know obviously termed that's going to be subtract from the valuation but what are the what's the requirement of the company in order to continue to buy a capital expenditures, those kind of things so we want to think about the balance sheet from that point of view as well so as we get into this next part of the conversation on due diligence I wanted to start off with this here. You should hold onto your butts. So hold onto your butts I'm just kidding that was fun no I think all of it's going to be important, if you start thinking about what's going on here the next thing that we talked about financials can be so and I don't why I broke it up with a little bit of Comedy, financials can be so like you know you're killing me there are other things that are not Financial so the next part is customers sales things that are just probably qualitative in really descriptive of your companies. True one of its true strength is like what is what's going on when it comes to the customer so one of the things you'll probably going to have to put together. [19:53] If you don't have this already you should probably put it together now if you're thinking about going to an ESOP is a top 20 top 10 customer, in relationship to the revenues that are generated from them and so the question underneath asking for that document as what's what's the customer concentration risk related to the company and so, going through that and you might have you know a company with a lot of, different customers so that might not be as important but certainly some companies that have maybe one major customer likes a 80% of their revenues built around that that one company, that one customer that's going to be screaming concentration risk so so be prepared to provide that in the due diligence process. [20:40] Will there be any issues if there's going to be a change like so saying say for instance the change of control will there be any issues with the existing owners leaving the company or phasing out of the company, when it comes to the transition of those customers into the you know on the ongoing continuing basis hey they were working with bob bobs not going to be here in a couple years how do we transition that too, Frank I'm just throwing out these numbers are these names just because, how satisfied are the customers with their relationship with the company and sometimes there just be quite there will be questions and won't necessarily be things you can provide for that but there are, one of the things that I think is really important the last couple of years has been doing a customer satisfaction survey and the more you can document things the better, so the most you know popular right now is the net promoter score, if you haven't looked at that as an option definitely Google that look at the net promoter score it's pretty easy to do, as customer survey anymore and having that data for due diligence is just very powerful plus it just gives you some really important information. We did it recently in our firm and we found like just by asking the question there was an issue with a customer. [21:58] Frankly we were like surprised the numbers were really high for our firm like we were at nine point three or nine point five I think is the net promoter score is like 0 or 1 to 10 or whatever. And it's all about. [22:11] You know would you recommend us to somebody else but but we got one that was like a three and so we were able to call that customer and say what's going on and really work on and repair that relationship so, anyway just quick sidebar on that so that's really important to be thinking about are there any warranty issues with current or former customers things that are be like they would be liability to the company down the road that would be definitely something to be thinking about. Are there any potential, issues with the policies that the company has with their sales so returns exchanges those kinds of things, how are the sales people motivated how are they compensated what are the financial incentives if you have a sales department be able to describe how that happens, are you concentrated with maybe one really good salesperson employee why so we haven't talked about employees yet but certainly just thinking about that on the other side of it. Is if I lose if I lost that employee that's really good what would happen with the company. A lot of the due diligence when you think start thinking about it it's just really common sense right what would happen if this happens what would happen if that happens. And it goes beyond just the presentation of your financials because the buyers truly thinking about how all of that fits together. [23:28] And what would be the impact if if and when certain situations happen. Certainly there are many companies that are under a seasonal type of business cycle so what is the seasonality if there is any, with that what are the working capital requirements that will support ass he's more of a seasonal business so, in a certain part of the year maybe for the fourth quarter maybe the companies are really going to borrow up on their line of credit and so have we built that into the total working capital requirement is going to be what the buyers thinking. [24:01] So let's move on and I can die one of the things I know about the podcast is it's hard to hit every single. You know solitary topic of due diligence we're going to do our best to cover the bigger the general areas. Employee management issues clearly to me is a major issue for Aesop's and the reason this is such an issue is because, what we want to do is we want to and part of this as assessing early on in the process where are you guys at as a business when it comes to, employee issues related to the leadership and succession and transition, how does it look if somebody were objectively look at your management organizational chart. How would it look for from an outside perspective looking in and going through due diligence they're going to evaluate, the the skill sets and the management depth of what you guys have as a leadership. And really understanding what also risks that potentially presents to the buyer in this case the trustee. [25:08] So the way that they do that is they are going to review employment and Consulting agreements or non-disclosure are not non-disclosure agreements non-compete agreements or non-solicitation agreements any kind of employment agreements that might exist now if you don't have any employment agreements, certainly something to be thinking about and you're working through the process of becoming an ESOP. There are many times as we go through the process of creating these app will actually create employment agreements as part of the ESOP especially if we have stock appreciation rights programs where we're going to keep people on, in the leadership group and we want to we want to incent them, if you have you know employment agreements they need to be coordinated really well with the management incentive plan that's existing now and then coordinated really well with what you're putting together, for the overall ESOP so then. [26:02] Looking at understanding the management incentive plan itself you're going to want to make sure that the work has been done too. Maybe fold that back into it needs to be put back into the forecast, and make sure that that does numbers that you're providing in this section of it coordinate and connect well with the other part of it which is the financial review. There might be things that the trustee and the valuation firm are going to look at in relationship to the current management policies that employment manuals might give them, you know they're looking for key issues when it comes down to. What happens if you know your employees violate a certain rule what is what is the total benefit package and employee gets and just some of that is just over just overall understanding you know, what is the opportunity for the employees to stay there and part of that will be picked up in the in the question related to what is the company's turnover and how many people you know did you have this year and last year and how many people are you hiring currently. With the fork the forecast in the projections one of the other comments and questions are is going to be what's the ability of the company to hire, to fill to fill the empty seats that the company has as the company continues to grow. [27:31] So all of those would be under the category of employee matters and again there's probably a lot of other things that we could get into but. The next topic would be just litigation what what legal issues that are there in relationship to the company right now and, if it's 0 how I got no legal issues in great Willis check the box off if there are or have been legal matters that have been either. Where the company has been the plaintiff or the company has been the defendant we need to really understand and document well what does legal concerns were now. If there were legal matters that happened and I would say that they were in relevance to, the the cash flow in the valuation because hey that can cost a lot of money in historical then we can go back and look at those and possibly even have some non recurring expenses, if we can really understand that that was not a recurring event that's not something that the company has happen all the time. [28:34] Every company is going to have some kind of legal issue at some point not not maybe to the gravity of some others but certainly there's something there that we want to make sure we've prepared for way early on in the process of actually going through the planning for the ESOP. [28:48] There might be some things on the tax side that need to be dealt with primarily I'd say what happens a lot of times is if the company isn't. Compliant with their taxes now when we think about taxes think federal state and local taxes. Federal normally isn't a major issue sometimes the issues that we see in due diligence is the company has. Offices all over the place and because of that they might have some some Nexus or multi-state tax issues, that they want to make sure that those are cleaned up and they're compliant with and then there's not any potential for some tax liability. [29:29] The other area would be you know some larger companies would have so say International concerns they may have some transfer pricing issues with, relationships with with different countries with different types of tax treaties that might might have tax liability so it's it's really under you know unearthing some of these potential issues really early in the process that makes a lot of sense so that you don't have any major issues going down the road, or prior to trying to get the ESOP put together insurance is a category that would say just kind of check off the Box simile is just to see if, all these policies are current and if there's any issues with related to those policies going into it so there could be things like your general liability policy or d&o insurance, if you have intellectual property insurance car insurance on your vehicle's health insurance key man insurance. Employee liability insurance worker comp insurance. Umbrella policies all of those be thinking about and Beyond to provide those are going to be important part of the due diligence process. There are some other. General areas that just need to be thought through that in due diligence that might come up but some of this for a lot of companies is because they're going to have some. [30:49] Old maybe some some agreements that they've made with employees so some things sometimes they've had Phantom stock agreements or some other prior to the ESOP stock appreciation rights agreement, they might have had even some warrants that they have fav have outstanding or, I'm some convertible debt so so when you get into this one of the things that needs to happen early on in the process before you even get to due diligence is you need to look at that Equity part of the balance sheet, and really understand who owns this company. [31:19] And how clean is that and if there's some some areas there that need to be cleaned up my advice is to do that really early on in the process, and not in the due diligence process so that when you're in due diligence you're not kind of walking around trying to figure out who's got what stock certificate or who is the company going to 0 in the event if there's a change in control. So that's going to be important is the company and does the company have any kind of environmental issues is it is there any liabilities in the company's history from, environmental standpoint where they made of polluted job site and is the company on the hook for that, so kind of makes just some common sense there's a lot of aspects of environmental that you could get into but just in general be thinking about that in terms of. What the company has and what they need to have in order for them not to have an issue for the buyer to have to have a liability down the road. [32:13] I think that is probably the major things one of the things in due diligence that we like to, just kind of lighter information would be you know provide marketing materials as much as you possibly can if your company has, obviously an online presence that's going to be easy you know with website but really all the related products are services that might be put into marketing information that's going to be super helpful for people to understand, I'm some of the strategic planning information gets brought up a lot and due diligence so your strengths weaknesses opportunities and threats type of organized information, for companies that do traction I love putting in the documents the vision traction organizer, if you have a one-year business plan if you have an executive, summary plan how do you communicate what you're doing that's going to be really helpful these are kind of like I said lighter issues a lighter things that would just be really good and they're going to be usually listed on that checklist anyways. [33:15] And then the other stuff is just more like being being prepared to address what is the competition in your industry, and so it's hard sometimes for some companies to know exactly who their competitors are you will be asked those questions to see first off who are they, what's the if you can get there what's the market share with what you have and what they have what are the advantages that you have in your company over the the competition and I've done some podcast related to really building out your competitive landscape, I think that's really helpful to be thinking about when you're, you know again just as general generally all this stuff is good to think about from a business standpoint but going into an ESOP due diligence you're going to want to have some of that information ready to go. [33:57] So again that's that's a probably a lot and a good week we covered a lot of detail but again I think there would be also other things that you'd want to be thinking about, and that I may have not addressed because it's just more or less to be kind of getting your mind thinking about let's talk about due diligence and make sure that you're prepared for that before you get too deep into the ESOP process. So with all that I wanted to say to everybody listening I hope you have a wonderful happy holiday and a merry Christmas we don't if we don't have something out before then and looking forward to our next time on this journey to an ESOP.

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