EP7 - Young Frankenstein - The Science of Business Valuation For ESOPs (part 1)

[0:10] Hey everyone good day this is the ESOP guy and if you are listening this podcast th

en you are on a journey to an ESOP thank you so much for checking us out today this is your first visit to the podcast I wanted to say welcome we are in season 3, this podcast is a resource that we have put together that really is intended to try to help folks think about, Employee Stock ownership plans as a viable option and help them to navigate through all the different. Twists and turns of what is an ESOP and how could you possibly use it for your business so with that I wanted to say thank you and welcome if you have an interest in this podcast please go to our website at journey to an ESOP.com, you can find all the episodes of all the different seasons that we've done and hopefully that really helps you. [0:56] Inspiration today's inspiration for this podcast was really after this is a little bit ago but I had a zoom call, and if you're like me you're having zillions of Zoom calls you know because that's how life is done, and at a zoom call with a client who is an ESOP company that we helped him become you know create the ESOP and now they're looking to buy other companies and zoet my role in the call as an advisor was to really help. My client determine the value of the business that they wanted to buy. And we had this advisor call so that just means the advisors on both sides of the transaction where we're on the call and we're talking about the valuation itself and the gentleman on the call the adviser on the other side of the table in the sense. Says hey well you know you can make the evaluation anything you want it to be it's not like it's a science and I'm like dude. In my head I didn't say this but I said dude first of all I know you're a CPA so you probably know a lot of stuff right and you probably know how to do a tax return. But you probably don't know how to do a business valuation so that was just me being kind of defensive in my head so I stopped that and I said all right. [2:03] Professional manner I asked him some questions I said alright so tell me about this this and this. And they didn't really have any good answers for those things so that really kind of put the whole thing into light which is basically a you're not really you're not really equipped to do the evaluations although you have that responsibility, to do that for your client it was not it was clear that they didn't so. [2:27] The thing that I keyed in on as a some ideas that some people have and they throw it out to me in my and 18 years of doing business valuations which is. Hey you know you can make that business valuation anything you want business valuation is an art it's not a science and so I really wanted to kind of take this business valuation thing to from that angle and talk a little bit about that so. We're this is fundamentally important for your ESOP transaction is because before you plunge into the deep Waters of doing any sub transaction and before you spend, any money on people really serious money on people to do the transaction you want to make sure you know and feel comfortable, within some relative margin of error of what you think your business valuation is going to be so I think you know that I mean if you're if you're doing an ESOP transaction or you're in the middle of that I think you know that but I think it's a, very important thing to say so this episode is going to be really dedicated to the science of business valuations and I want to start off with this. [3:32] Music. [3:51] Life give my creation life okay so this is going to be a tough one, because this this movie was back in 1974 and everybody's like hey you're always doing 80s movies so this is an old movie This is called Young Frankenstein so the title of the pup the podcast podcast episode today is Young Frankenstein is this valuation a science or an art. [4:17] So before I jump into it I just want to say again I really appreciate those that are that are have been sharing this journey with us, please go to our website at journey to an ESOP.com for the other episodes if you like what you hear please subscribe to the podcast share it with a friend or somebody you think hey they may be going through an ESOP it might be really helpful, for them as well so so let's start off with this a young neurosurgeon. In this movie Gene Wilder inherits a castle of his grandfather now the very famous doctor Victor Von Frankenstein. In the castle. [4:58] Basically he inherits his castle and he comes in and it's a very big comedy it's a Mel Burke's comedy if you haven't seen it it's classic and it'll make you laugh probably because Gene Wilder is absolutely crazy. So when you think about this movie and you kind of connect it building a Frankenstein if you build a Frankenstein that just means you're building this. This human being out of body parts right and then you're putting lightning to them and then boom they become alive so. Building a Frankenstein is a lot like building a business valuation you put together all of these fragments of numbers from business historical futuristic you're applying scientific approaches and methodologies, and then you're going to lever all of that up to the roof on a rainy day and wait for lightning. Then drumroll boom boom boom it's alive so your valuation takes on life in that you're going to all the cells in your spreadsheets are all going to kind of make weight and you're going to hit that button and boom you're gonna have a number. [5:59] I think it's somewhat interesting because it's an emotional experience and if somebody's never had their value of their business if they've ever had their business valued. In going through the process of doing business valuations for the last 18 years. You know it's always very interesting because there's a lot of different. Experiences that you have where people think they know what the number is and they, they think they have a good idea but they don't really know why they think they know what the multi I can multiple is and they don't really know where that comes from but you know they get very confused on a lot of it so and of course it's your baby it's you know you built this business. And in a lot of ways, the valuation firm is basically telling you what you have accomplished in your life so there's it's a bit of an emotional thing I think like that because, um some people in my experience it's like wow they thought their business was worth a lot more than it really is. And the way I do this valuation work as I really bring the client through a process of those methodologies and explain it in a lot of granular detail because I think it's I think it's really important and I always put myself on, their side of things and say you know what would I want to know how to how would I want to understand this. [7:18] So in other cases some people you know look at it and they're like okay that makes sense and what can we do though to build more value there's a lot of things that happen with business valuation and I think it's kind of a fun and exciting part of the profession. And doing esops to because it really does set us up to talk about the the ESOP plan, at the front end so that you can really kind of work on what is the next best Next Step because it's not always the best next step is not always to keep going towards your ESOP so that's kind of how important it is and as we go into this, I wanted to kind of start off with just betting some background on some of the other the other things that I see in business valuation and one of the discoveries that I've made. In providing each other up cell site advisory services that many times. When people get their valuation from other people they don't really go into the details so I kind of shared that with you and the details are really important and I think that's really where we're going to want to kind of hone in on in terms of this, of this episode. [8:24] I also discovered in this process of doing it is that some people claim that business valuation is really like I said not. Necessarily. [8:35] You know something that has any kind of Independents to it I mean it's and we're going to get we're going to talk about that in a second but in the sense that you if I'm selling if I'm helping my company like I said by a company then I'm just basically biased and I'm just going to make it make it whatever I want it to be, if somebody's going through a real messy divorce you know and they want to show their business to be worth nothing because they want to protect it from the attorney, you know there there are a lot of different thoughts and skin discussions on that but one of the things that I hope to accomplish in this episode is to is to talk through. Those specific specific steps that happen within valuation so that you can ask the right questions and make sure that that's not happening. [9:21] I also wanted to make a quick stop here and just say we're really on a very soft non-judgmental way. That some people call the evaluation and evaluation they just put an e in front of it and. So no big deal it's not a big deal but technically we're talking about this topic it's really a business valuation without the e now, within the valuation there is a process of evaluating things like numbers and management team and different things like that but but the evaluation is not the correct title so just kind of pointing that out, so as I think about the next couple things that we're going to go over in this episode. I'm going to just stop and say hey we're going to likely have then this is going to be a two-part podcast cuz I want to stop and instead of jumping into. A lot of the details on the methodology I want to go in and some of the background first so when I when I talk about the background I what I'm my goal in this for us is to have the same mindset when we think about business valuation. And not rush past these Concepts before in trying to get to the actual explanation on the methodologies. [10:35] So the first is this idea of subjective versus objective so the definition of subjective means it is something that we base on our personal feelings per taste or opinions objective is just the opposite I mean we're not there's no personal feelings involved we're just completely considering the facts now why is that important. [10:57] Well if I did a valuation where I was I was emotionally in you know you know motivated to do something a certain way. [11:07] Then I can't really trust my conclusions of value as much as I could if I'm objective so why would somebody be subjective and then this is going to overlap into another Concept in business valuation which is MI independent. And also the concept of advocacy when you think about the two the two different things so there the idea of I'm going to be. Objective and independent. And in within saying those two things what I'm really saying is that I will be a business valuator for the purposes of this. [11:46] Work that we're doing to identify and an estimate an appropriate business valuation now for the in this case again the context here is we're doing it. When we get into the third idea here is the idea of what is the purpose of what of how we're doing it as we connect these three ideas. [12:05] The purpose of doing it is to help someone plan for there. [12:14] ESOP transaction in a way that gives them very accurate. Detail when it comes to really the most I think the most important part of planning which is what is your business worth in the setting of an ESOP transaction, so I need to be. [12:33] Objective I need to be independent I can like I want to make sure that this is this is really very clear I can be an advocate for the company and still be. In advocacy basically says I'm I'm building this around and support of what you're trying to accomplish it doesn't mean that I'm, I'm biased in in subjective in my emotion to try to make this be something now let me point out something that I think it's very important for. The ESOP community. [13:07] And I think it's important because it had ties back to the problems that we have in our industry when it comes to esops. Becoming an issue with the Department of Labor. And the problems are if you read anything that the ESOP was actually overvalued and the transaction itself. Wasn't really supportive of the data and so how did they get there like how did that happen you know so let's go back to our points subjective. Emotionally motivated ESOP valuation is going to be something where somebody. Has some reason to be subjective right and so in an ESOP Transaction what would what would that be if they really do then now trip the wire on their independence, and become more than an advocate but they become a partner, to try to figure out how I can get the most out of the situation in emotionally that is going to be that's going to happen because they're going to get paid a lot of money to do that. And so I think it's important to understand that our industry for Aesop's and the way that an ESOP transactions put together when there is a conflict of interest. [14:21] That creates the atmosphere for somebody to become subjective and create, an ESOP valuation that is over least overstated why would they do that because in this in this in the case of an ESOP transaction where they're going to get paid a lot of money. For that where does that happen in an ESOP transaction well if the if the. The fees that are generated from the transaction are going to be built around the highest possible valuation and the vat in the investment banking firm that's doing the ESOP transaction as a cell site advisor. [14:58] Is going to get paid the most amount of money for that well clearly you're going to have issues with accomplish what I would say is a conflict of interest with with a party that you are hiring as your advisor. To be objective but they're really they really are subjective and so I think that's a really important thing to understand as we go into the concepts behind and the background behind the esops. Now if you choose to work with, with a party that has that does get paid at the end of the transaction a percentage of whatever you end up negotiating it seems right because that that's the way I am a deal works but as I've said before another podcast. This is not like another ma deal because the buyer is is a transaction trustee who has to follow the dll process. And if they don't they're putting themselves In Harm's Way and interestingly enough the investment banking firms don't have any. [16:01] Liability at all because because the Department of Labor has no jurisdiction over what they're doing and so so they have this this idea that is an opportunity, for them too, to really pump up the valuation to be something that maybe not so so those are really important points and I'm tying them back to the ESOP Community I'm tying back to what I think is a real issue, that you need to know so you can ask the right questions and feel really comfortable that you have the advisor that you need and. You know I clearly am not saying what I'm not saying is that, everybody's out to get you in this in this community no absolutely not they're all they're great people there they're educated they're there they know what they're doing but. [16:44] These points of being subjective versus objective in being an independent versus not independent having a conflict of interest, and then and then understanding that how that relates to again in the background of what you're trying to build a, business valuation that has a purpose of giving you an accurate picture. [17:06] Of what it should look like as you work through the transaction so that you're not putting yourself In Harm's Way, which you won't know until after the transaction is is done and the Department of Labor knocks on your door and says hey we were not really comfortable with with the way this transaction was structured so I think that's part of part of our mission on this podcast is to, help identify that and that's really, not the main point of doing this episode on the value business valuation but I think it's an important point that I think I have the responsibility to bring out and make sure we we understand that the to get deeper into the purposes of valuation one of the things that you if you go through valuation training early on, they drill this into you like the purpose of the valuation is very is very important, and when I first received all my valuation training bike 18 years ago. [18:02] One of my business partners had said hey I want you to go to this attorney's office they have a they have a valuation case they want you to too. You know work on I'm like alright well just go ahead and do it and it turned out to be a divorce case, and I remember sitting there with the attorney and then the spouse who is being going to win going to be divorced and. I thought no way you know because I sat there for four hours while this person cried and they went through you know this emotional rollercoaster of course they are because they're in a divorce and now a divorce, value business valuation number one is going to have to include, I'm very specific statutory elements for that divorce valuation to work it's going to the purpose of the valuation of course is going to be centered around that now. [18:55] Purposes of valuation for Aesop's again are going to be centered around the transaction and making sure that your methodologies are going to match up with how the trustees, valuation people are going to match up so purpose is very important one of the things I've seen before, in working with clients is that they might have received evaluation for a different purpose. Maybe a gift and estate purpose and then they're like hey that's the you know that's what we've there were used to and so we kind of have to reconcile. In in this business valuation. [19:28] Um with a client with with what they've received in the past and trying to make sure they understand the purposes of what we're doing and make sure we've tied that out pretty clearly so. So again the background in this is to keep our minds around the foundation of business valuation and we're really going to be conceptual and the in this in this episode so, you know we're going to get into some meat in the next episode but I want to make sure we've laid the groundwork so it's going to be really important that we do that so we've talked about, the idea of subjective versus objective Independence and and the idea of being an advocate conflict of interest we've talked about the purpose of the valuation the next thing would be just the timing and evaluation when, when you think about this for a second there's a couple points for the ESOP that are important I as a as a ESOP, advisor that I'm helping my client plan for a future transaction I need to understand that what we're building in valuation has a has to be. [20:28] Able to be updated as as time goes on and so when we get into the to some of the details in. The next couple parts of definitions we need to understand that the timing of the valuation has a couple issues to it. [20:44] That when we estimate evaluation right now we have the maybe at the end of the year data that we're using. Maybe we have some Financial interim data over the next couple months that are going to be incorporated into that from. Cash flow Howard of deriving cash flow and you know annual cash flow and versus, the our historical annual Cash Flow versus the forecasted cash flow, so timing is important one of the questions gets asked like what it makes sense to do the valuation now or should I wait till the end of the year and and I just answer that question real simply it really doesn't matter at all it's more about, making sure the data is good and making sure that we've done our homework on making sure that the cash flow makes sense, both from a historical and a forecasted standpoint utilizing the interims to kind of build the, the estimated new cash flows for the 12 months of the trailing average so hopefully that makes sense but timing timing is important too because then we think about, if we did this work right now in six months what would it look like so so part of that we need to understand that we're going to need to think about. [21:56] The definitions of Enterprise Value versus Equity value. And the other concept here is the idea that we have a cash free debt free transaction and so, what were wanting to do is estimate based on the financial records. And based on the analysis of risk for the business. What is the Enterprise Value and we're going to go into this super deep in the next in the next episode but I want to make sure the terminology makes sense as we as we do that and so. In order for us to have the transaction in a future time period, we're going to have to incorporate what we have from Enterprise Value through the X the current Equity value of the business, and then update that as we go forward and the way that happens in a transaction is you have a an Enterprise Value. That is going to be because it's a cash free debt free transaction we're going to end up adjusting that valuation. For an ad back for whatever the cash is so it's a cash free debt free transaction as we use that as a terminology of the type of East but the type of transaction we have. [23:07] And we add that cash then we're going to take away to adjust we're getting from Enterprise Value to equity value we're going to add or subtract excess or deficit working capital so we're going to. We're going to add that cash to that Enterprise Value we're going to take away or add to it Xs or our deficit working capital what we have to do there is we have to estimate. What did the targeted working capital would be for the transaction so that happens that has to happen early on. [23:37] Then we're going to take out because it's a debt free transaction we're going to reduce that purchase that Enterprise Value to equity value by by eliminating, in reducing that number for all the debt that could be current portion of long-term debt that could be the line of credit that could be the, Capital leases that are on the books that could be a termed at that could be whatever bank that the company has or or any other type of debt that they have that needs to come out of that estimate as well, and now that's going to give us Equity value and what happens is we're able to now, look at that at the beginning planning step for what the transaction value would look like from a from a futuristic standpoint so at that point we can kind of estimate if we have changes in our balance sheet. Then we can incorporate those changes in the balance sheet for a future transaction Equity value so hopefully that makes sense it's going to those are going to begin building blocks of things that we're going to need, evaluate as we go through the process and see I said evaluate not for the business valuation we're going to evaluate evaluate. [24:41] Glass couple points here I want to make is that when we do a valuation for an ESOP transaction. We need to be correct on our terminology this is what we call a financial valuation and it is going to be. Based on and focused in on the financials of the company to derive the cash flow of the company that's. [25:05] Which we'll talk about as well as we go through the process which just basically means all the. Um from a hypothetical buyer standpoint all the cash flows that are available to the buyer are there available so any non recurring expenses any discretionary expenses have been adjusted so that we have a true cash flow. Now this number, may not be the Strategic valuation a strategic valuation by definition is what a strategic buyer is willing to pay and that could be in Far excess depending, what the company is doing and what the Strategic buyer is looking for and it may not have been a lot of focus on the actual cash flow value it may be for some other reason they see a strategic reason to purchase the company. So for instance we have a client that has an opportunity to sell their business for thirty times ibadah that's clearly a strategic valuation their numbers would no way support that your capitalization rate would no way support that, and so it's really important to understand that what we're going to go to and plan for is a fair market value under the financial valuation concept so I want to make sure that's clear. [26:15] And then the final Point here for us is to think about. They like the idea of what we're actually using to base the valuation and make sure that we're looking at. The proper information so when we start off doing the valuation work we're going to end up issuing a checklist for the. And that checklist is going to request financials now clearly as you do business there's there are different levels and quality of financial statements. [26:45] Now when you think about the very best possible scenario the the best possible financial statements are going to be the financial statements that. Are audited because by an independent CPA firm hopefully their audit is you know it's a high-quality CPA firms let's just assume that they are. The audit is going to give us, financial statements on a balance sheet and a PL that are really that had been confirmed and that have been worked through from a financial accounting standards. And so we're going to have a lot of Reliance on that they're also going to be accrual-based financials so that we can properly estimate there the appropriate work in capitals Target working capital for the balance sheet. There's Revenue recognition issues in financial statements that that will come into play for Industries there's, there's new lease pronouncements that are going to that are going to go and go into play so I'm going to just say this and I think it's obvious but audits are clearly better than everything you know when you think about your business selling to any company, most of the advisers were going to tell you hey get an audit so your numbers are good and reliable. [27:53] The second level is going to be reviewed quality financial statements still independent just like the audit little less in the the amount of, work in confirmations there's more like limited testing for reviewed financial statements so that's not as good as an audit but I mean it is still pretty good and so as you go through the the tears there what you're going to find is that there's. [28:18] As we go closer and closer down to say an internally prepared financial statement that's based on a cash basis statement for tax returns. [28:27] Again we can still do it and we do a lot of you know we look at a lot of small companies that that's that's the best option it's just not as as reliable as when you start thinking about doing this and we want we want in the quality side of financial statements is we want something that is, highly reliable that we can use in you know in terms of predicting, and estimating the the actual real value so so those are all really important concept as we think as we think about it look for us too, I do part two of The Young Frankenstein, science versus art valuation coming up I also wanted to reach out and to say hey look for a webinar coming up, it's going to be a on March 30th at the end of the month, and it's going to be at 11 o'clock Eastern time with a panel of ESOP advisor so go to our website at journey to an ESOP.com to check that out it's going to be a what we call in the anatomy of an ESOP deal it's going to be really a I think an exciting and a very educational webinar so if you're interested in finding out more about that just go to our website at journey to an ESOP.com. And with all that I wanted to say thank you so much for listening today have a wonderful day and we'll see you on our on this the next step on this journey to an ESOP.

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