EP9 - Young Frankenstein - The Science of Business Valuation for ESOPs (part 2)

[0:10] Hey everybody welcome back this is the ESOP guy and we are on a journey to an ESOP so glad you could join us today. And wanted to say thank you again for everybody that's listening check out our podcast website at journey to an ESOP.com. You will see all the episodes there this podcast, is really a disease it's designed as a resource to help folks think about the ESOP think about the way that the Employee Stock ownership plan might work for their businesses whether it be a succession issue an exit issue a potential growth issue of using the ESOP and the tax benefits that you have so there's a lot to know about Aesop's we're on season three and, today we're going to be in this continuation which I love doing, multiple parts of sometimes doing like part 1 part 2 we're in part 2 of the continuation of young Frankenstein's, valuation of is it the science or is it an art and we got into a lot of issues last time I shared the last time we did this I shared the inspiration of this coming just from a lot of stuff where I get my my content is in meetings that we have and the the ideas or the things that kind of get talked about, in these meetings I just kind of like take some notes and say you know what I think that some people might think those things too and this is no different. [1:32] And I shared last time that that one that one meeting I had with an ESOP client we're looking at acquiring of, they're a potential client or potential company for them and going through the evaluation process to come up with a fair offer for that company, recently I've had some other meetings in business valuation has been kind of at the top of the list of things. That are coming up and being talked about when we're I do a lot of interviews with companies that are thinking about being becoming Aesop's so. One of the things that I see in those conversations repeatedly is just this idea of what is it. How does business valuation really work and even really well experienced people in different areas still I think struggle. With some of the some of the and the elements of that and so what I think there is even more over the last couple weeks inspiration to say you know this is a this is a good topic this is something that we want to do. Do our work on and today we're going to attempt to get through part 2 if we need to we'll go to part 3 but with that I wanted to start off with this. [2:39] Are you saying that I put an abnormal brain into a seven and a half foot long. [2:49] 54 inch wide. I wonder who that could be at this so. Great again great movie Young Frankenstein Gene Wilder is strangling Igor hold on it's coming back okay he's strangling Igor just. Lot of fun and what I why did I choose that clip well. Valuation it really does matter what you put into the model when we think about it and that's what we're going to get into today is like what we put in the model how does that really work with the parts and the Pieces Just Like An putting a Frankenstein together, and in this scene he's talking about this idea of an abnormal brain and obviously you get out of the model. What you put into it and like in the movie he gets basically an abnormal creature which of course is all just fun but for us it can be a little bit more than just fun because we're dealing with some buddies. He no value of what they've created in their business career their whole life so it's a lot more serious than that. [4:17] And I want to I want to that's why we're talking about it because I want you to be prepared to think about these components of what it looks like to. Put together the valuation and understand whether or not are you looking at this as a scientific process or you looking at it from a. Artistic process can I just do whatever I want that makes me feel good so we're going to obviously lean towards the science of valuation and, with that I would just start out what I would finish that this part of it and to say if you are really looking at Aesop's as you think about this podcast, Please Subscribe and if you think it might be helpful for somebody that you know that's looking at an ESOP police share it with a friend. We also have set have had a YouTube going for a little while with the interview portions of the podcast so check out the ESOP guy journey to an ESOP for the YouTube videos those are, helpful to kind of like just see you know who's out there and some of the other content that we have from there so. [5:18] With that as we go into the this episode. You know I've already kind of connected to the dots between the idea of the science evaluation and the idea behind really what you put into it is what you're going to get out of it and, in the last episode what I did in part one is we went back and we just kind of went through. [5:41] Terminology and background and Concepts as it relates to, business valuation and so we talked a little bit about the idea of. The mindset of things like subjective versus objective and independent sources advocacy and so the purpose of valuation strategic versus Financial what is the transaction value what are those types of things look like, so that you can be kind of the foundation was really kind of built so I don't want to get into any of that stuff again but I wanted to point out that that that's what part one looks like part 2, today is to really get into now a lot of the nuanced parts and pieces of what goes into what I would call, valuation model and the model itself is. [6:32] To me necessary when we think about the model we're basically building something that has the ability. As a deliverable to be utilized from a planning perspective throughout the ESOP process. [6:45] As opposed to a report where you're like hey I've got so many to tell me what I think my multiple is and now I know a number, and so the model is going to not only give us an Enterprise Value number it's also going to help us to estimate the equity value which is what we talked about last time. [7:03] So the very first part of the model from a standpoint of what goes into that is going to be building out the historical Financial history of the company and, when we when we think about business valuation we're going to primarily be talking about the income approach valuation which is going. Center around the cash flow of the company and so, what we think about when we say cash flow I love this concept again it comes back to definitions what are we talking about I mean, you know we all business people kind of like II you know I understand cash flow it comes you know yeah it's your income that she make well it's not income, per se its income with ADD backs and so the more proper terminology for business valuation is ibadah. Now even a stands for earnings before interest taxes depreciation and amortization. [8:00] And when you think about earn like ibadah what you're going to start with of course is your net income. And then you're going to go through a series of adjustments to get what we call adjusted ibadah so we're going to add back depreciation and amortization we're going to add back interest expense. We're going to add back discretionary and non-recurring expenses. We're also going to reduce the ibadah for any non recurring income and I'll give you a quick example of that and that's going to get us an adjusted ibadah so when we're talking about cash flow. The first concept is we're going to be talking about this number, now in order to get adjusted ibadah to what we call free cash flow which is the cash flow after everything we're going to also want to reduce the model or reduce that number 4. Capital expenditures so those are the asset purchases of the company so you know in some cases. You know just pause on that for s in some cases the company some companies have a lot of capital assets that they have to purchase for the generation of Revenue so they might be very intense equipment that might be that need that might need to be purchased. And. [9:10] Don't you know just kind of pause and say the more assets the company has to have to generate Revenue one of the one of the things that we have to look at is what's the net asset value. Versus what is the cash flow value so we'll get into that a little bit I just wanted to point out that now fo if the company has very little assets you know they're much more of a service-based business. Then they may have very few capital capital expenditures as you go through the model. So going back through why do we add back depreciation why do we add back interest expense because we talked last time about this idea that this is a cash free debt free transaction so. What we're looking at is is non-cash items that come out of the income. That or non-cash until we want to we want to pull those back into the model and then we want to because we're not buying the debt. As the buyer the trustees not going to buy the debt we're going to go ahead and pull out the interest expense as well. [10:06] Now the other items in the cash flow that have to be evaluated our areas of discretionary and non-recurring expenses. And I have had other podcasts about just purely the normalization of the cash flow so I've spent time putting that together and I believe the episode that you're going to go to is Norm. The normalization expenses on a cash flow and it's in season 1 I believe if you go back and look at the other episodes and so. [10:41] Too kind of to just as we bring that current for everybody that's listening to this really what we're going to want to do is vat evaluate for that five-year history number one is what are the things that, would be discretionary per se in a cash flow the things that the owner has discretionary. [11:00] Payment judgment on like they're able to buy and spend money on things that may not be related to operational Revenue. So things like hey I bought season tickets to this game I'm a I'm a take company or client sometimes or I may not. Some of that gets run to the business and so as a hypothetical buyer of the company I would not necessarily need to worry about that type of expense anymore because once it's sold. Those expenses go away and so we get to basically put that back into the cash flow which is really important. For the valuation because a discretionary item that let's just say all in with our business valuation when once we get to the end of this. [11:48] We're at a six to seven times multiple so every dollar of discretionary expense is worth six bucks. So if I had a hundred thousand dollars of discretionary expenses that's like adding six hundred thousand dollars to the valuation so it's a very important point, there is guidance you probably need when you're going through building what I would call your, your schedule of normalization adjustments so that they're they're accurate. [12:17] They're documented in a way that somebody else can go back and review and make sure that they've they've agreed with you on those that there. A little bit more than hey I just think I'm about. You know 10% of all the credit card spending is the owners excess travel all right well that might be true. And that might be a significant number but we need to document that so that when we do hire the trustee and they hire the valuation firm that want that's going to be one of the questions that are going to be wanting to understand and due diligence has, his show us kind of how that those numbers came about and so they're going to need to sign off on that for the trustee so you might as well, in this stage of things which were what where we're at with this is really at the very beginning of ESOP planning so you might as well go ahead and document it if you if you're serious about it and whether or not you do an ESOP are not these are still very important to have for if you're going to sell it to a strategic buyer. [13:21] Now non-discretionary are non-recurring type of expenses are also valid at acts in these are going to be areas where we're adding back, expenses that were incurred that no longer need to be incurred it could be we had a one-time legal expense that the company. [13:40] Went through the process of having either been sued or had been suing somebody, and the case is over there that we need to understand the story behind it like why is this not ever going to occur in the future so if your company has a routine history of having to deal with legal issues because of the way that their business functions then you're going to have that might not be a non-recurring expense. [14:07] Other things might be and again they're the nice part about this is that it takes a little thought and it takes a little conversation to go and Unearthed some of these. Another one might be hey I just installed some software my company over the last two years I spent a lot of money on Consulting. I will not need to do that again because all that I have I'm going to have a maintenance cost of that software we're going to keep that as a recurring expense but I'm not going to have to incur any more expenses related to the Consulting to install an Implement that software. [14:39] So things like non recurring income though would also have to be taken out so recently over the last couple of years we've had this PP money coming into companies. So so as a as a valuation guideline you're going to end up pulling all of that non-recurring in come back out. And as much as I feel like it should be in there the reality is that that is not going to recur in the future and even though. Here's here's the one side of the argument even though the company could have. You know kept on the people are would not have kept the people because they didn't have the pp so they would have maybe more income in that in that regard. [15:24] They're still there's not an argument for keeping the recurring income so we have to just take it all out and then look at that as. Extenuating circumstances when you're looking at the each of those years from a cash flow standpoint so so we're really just right now as we start thinking about the very first thing is we're going to want for the historical cash flow. A five-year historical average and we're going to want to really understand each of the those fiscal periods now. One thing I'll comment on that I really look at heavily in this first step is looking at. [15:59] The trends behind the company because that's going to really be important to think about what what is. What's the real nominal what's the real normalized annual cash flow of the company which is the number we're really hoping to try to get to now in some cases, some companies over the last five years have experienced a steady increasing growth on the revenue and a steady increase in growth on their ibadah now. Ultimately what I care about a lot is the steady increase in Gross on growth on ibadah but of course revenue is going to play a role in terms of the composition of that Revenue. The concentration of that revenue and thinking about what is it what's made up there and some of the other observations will make in that five-year historical is also the. The gross percentage of margin of the gross profit in making sure you know what is that coming up you know as a company becoming more efficient at, in their management of those projects or in managing cost of goods sold or less efficient or is it is it highly volatile and if it is what's going on so so there's there's really a lot to know and think about from a from a, understanding what's behind the numbers. [17:16] That is important to I'd say glean in the very beginning steps because it's going to help us as we as we go through the other steps to really understand, the composition of the company and the ability of the company to move on to the next step when we get into the forecasting part of it, which I think is is critical element of the valuation for an ESOP. We're going to we're going to use a lot of this data and we're going to use a lot of the observations that we're making right in this stage to validate and also prepare us to do an adequate job, to prepare forecast which is like I said very critical so then the other things are at this point, just thinking about a little bit about your GNA expense in the percentage of your DNA to revenue so we're just again making some high level of observations and we're we're getting comfortable with. The the accuracy of those numbers now one of the things that I mentioned before in the part one of this episode. [18:22] Was the in this is coming back to Young Frankenstein the the best the the quality. Components obviously if you have quality components when you're putting these types of things together you're going to get a higher quality valuation model. And what matters when we look at this, is that we have to we start thinking about the quality of the historical financial data and I had mentioned this before an obviously a CPA prepared audit is going to be, I think the highest quality we can get an independent CPA firm who has done the work the correct work in doing an audit or, some are from a lesser extent a review and then I would say as we go down the Spectrum working through valuation with. Cash basis tax returns are much more difficult and so we not that we can't do it and to be honest with you it's it doesn't really, at the end of the day I'm not that concerned about it it's just something I want to point out let's just say that the there on the tax return cash basis, accounting there's a lot of accounting from a tax method that's being employed to do what to reduce taxes. On a financial statement the idea behind the financial statement is to accurately State the financials from a generally accepted accounting principles standpoint so. [19:45] One of the things that you do in this first step to estimate annual cash flow on a normalized basis is really think about, and connect the dots on the financial information that you have from a not just a quality standpoint but an accuracy standpoint as well so it's, important that we at least sit dressed that as a possible you know issue going through it and what we want what we want to do as we get into the goal of one of the goals that we have with valuation as we want it clearly and accurately state. What is actually happening in this company and what somebody who's going to buy the company could depend on to make sure that their cash flow that they're buying is really there so that's that's really the first goal and then those those steps that I just went through our really. That I would say that there's not the numbers of the numbers I mean there's no there's no art in taking those numbers in doing anything different with them except to properly present them. And to make sure you've done the the job to normalize those expenses correctly. And then present those as they are what they are right and IT company historically, you know the nice thing about historical financial statements is we don't have to guess that that's what that's what happened right and we don't have to try to worry about whether or not we've overstated or understated the cash flow because it really is what it is. [21:14] Now the second part of this is you start thinking about it which connects to everything else is now we have to figure out. What is the risk of that cash flow going in to the Future and so understanding how risk is created with a business valuation theirs. For a cash flow valuation or an income approach valuation what's happening is we have to quantify. The risk rating or the risk premiums specific to the subject company. And the first place that you're going to start with this in doing what we in the valuation world will call a build up approach which is in some cases there's a lot of different means to do this. There's a process called the capital asset pricing model for instance which is going to take in layer risk premiums that are available in the marketplace. [22:12] To this subject comparative to the subject company so that we can properly estimate there. End all cap rate the capitalization rate so what is a cap rate a cap rate is what the. [22:27] Financial Risk or the market risk and reward would be for that cash flow Stream So if I purchased an invested my money in a in some type of investment whether that be a small stock company, or invested in into us treasuries are invested into junk bonds there's an Associated risk with each one of those types of Investments now the higher the risk for an investment. The higher the expected return should be on somebody investing in that company. In a cap rate is basically estimating that for a buyer and they're estimating how much risk that cash flow that we just evaluated. [23:12] Is going to. [23:16] Is going to be required to give the investor a return so those two numbers in finance are the expected rate of return is going to be equivalent to the actual risk of that investment and that's what we're doing quantifiably and a cap rate model that what we're building. [23:31] So what will happen is then then the build-up approach is going to now have to identify specific components. And the first one will talk about that are going to be added together is the risk free rate of return. Now the risk free rate of return is the return that an investor should get in the marketplace that would be. [23:54] Not necessarily A don't think about it as a savings account like my savings account gets paid I get paid hardly anything on it right. But at risk free rate of return in the marketplace would be it may be a portfolio of Investments that would pretty much be risk-free you know like more like a treasury. And so. So that's going to have the lowest risk premium intuitively right and then other risks that you're going to have to modify so the buyer is going to have the opportunity to go buy a risk free rate of return or this company so we're going to get at least that number back. [24:29] And so the next rate that we're going to have to deal with is the equity risk premium this would be the market Equity risk premium that's generally measured on more of a large cat basis so, so the data sources that evaluation firm would go to are going to want to look at the specific industry. [24:48] And and make sure that they're within some relative range of the industry that the company is operating at so if it's constructive Construction Company, there's going to be Market Equity risk premiums for a construction company that are going to differ if you have a, like a bioscience company or a manufacturing company or a distributor those Industries are going to have their own Market Equity risk premiums now this data is, sourced from publicly traded data which is going to be important when we pull this whole thing together because it those are after tax. Published data so the the idea behind it is that the investor the buyer the person who's possibly going to buy the company, has the ability to now of course get the risk free rate of return and they're also going to want to get the market Equity risk premium back as well and so what the what happens is on a capital asset pricing model we're going to we're going to get an equity risk premium but we're also going to have, a beta that's a quantifiable metric as well now that beta, it's going to be x times that Equity risk premium to either increase it or decrease it the beta is going to measure for the publicly traded data. The amount of volatility that is going on in that industry and so. [26:07] Some Industries might be going through a lot of growth and you know not not as much, um buying and selling where the prices are going up and down heavily the volatility would increase, the premium that the buyer the investor is going to need to get on it so those are going to be in order to get the market Equity risk premium we're going to want to go through, the mass of the sourcing of that of that data plus than the math of coming up with an all-in Market Equity risk premium. [26:36] Then the next layered risk rating that we're going to have to equity risk premium that we're going to have to identify and source is going to be the small stock, and the small stock premium is kind of what it like sounds like it's like as we think about moving from risk free rate of return to large-cap we're going to go down to another layer, of small stock in the same industry and we're going to layer even another layer of risk premium on your capitalization rate model and so you can see. Um is a pause for a second there really isn't a lot of. There's not a lot of art here right because I'm all we're doing is pulling data. From sources that everybody else is pulling data from sources that are basically created by companies that do this math all the time, and help help the you know. Valuation people understand and come up with these appropriate levels of risk premium so they can be applied so so just to kind of pause for a second that's basically, not up to us we haven't done anything in this we've gotten the number so far, we've gone to the to this data sources there's really not anything at this point that we're going to see it while we've manipulated the number at all and higher or lower whatever we just got what we got now. [28:00] The small small stock premium what happens is that data normally is listed out in deciles and so what you're trying to do is find a decile, the data sources that find themselves close to the market cap of your subject company, and so we're going to move down from the highest decile which is larger companies that one decibels down to 10 into 10 be deciles in the in the in the data sources that we're going to use. What we're going to look for is where do we fit within the the estimated market cap the estimated business valuation to come up with the appropriate Dessau. [28:35] And so from that we're going to come up with a with a premium and then we're going to again layer that I'm going to add that to the total of all the other premiums now so those first three numbers the risk free rate of return the market Equity risk premium and the small stock premium, are all published from some data sources that do change over time they change based on the volatility of the industries stock price moving up and down, which does change the increases and decreases in those Equity risk premiums now as long as you got your Industry Source correctly. [29:07] Then you should be pretty good to go now the next layer of risk that we have to, adjust for is the specific company risk now this is for any and all companies there's going to be some level of, of what we call unsystematic risk in companies where you know what are the particular situations of that companies like for instance Revenue in powders their revenue from a concentration standpoint, compared to other companies do we have one major customer do we have you know a lot of different Industries and a lot of different niches, are there is that company super smaller they larger you know as the company have a very deep bench with management and if there were something that happened they that they might lose a key person how would that affect the business, are their family members in the business and what does that do is there a high level of family dysfunction in the company or is there you know everybody functions pretty high. You know well together. [30:08] Does the company operate off of very good reporting or is it difficult for them to know on a monthly basis where they where they stand so these are all risk factors that we're going to identify now. When you when you break out valuation work the you're going to see a lot of valuation people look at this in a lot of different ways I can tell you if you're doing this for 18 years. You know identifying and quantifying this is definitely a difficult thing I think the one of the best things that has happened in the valuation world is at this is can be somewhat subjective and. In that people can look at valuation analysts in firms that do valuation can look at this a lot of different ways and, I had like for instance in my story for part 1 one of the things I was talking about was we had done a I think a pretty decent job of analyzing this the company that we were trying to buy their specific company risk now when we went through the advisory meeting. In on the other side of the table the valuation people quote unquote for the for the seller basically said hey that specific company risk is 0 and we're like. [31:22] There's no way that your company that did I think they did a couple million dollars of Revenue there's no way that that specific company risk is zero. [31:32] So it's going to be something you know and it has to be something because not every company it you know unless you've got this incredible machine that functions and has no issues risk wise, at those levels you're not going to have a zero there so it's going to be something now one of the ways that we go about it I think is very helpful is to, Benchmark the financial performance of the company at this stage to determine, where the the company is performing against the industry in a where I would say the major ratios that we're going to clean too, are things like liquidity ratios leverage ratios. Profitability ratios efficiency ratios and just see where does the company Stack Up financially and either either going to be above average or below average if you've done your industry studies correct and you have the right industry in the benchmark. [32:25] And again what we've done there is we've taken I think a very I think the most subjective portion of the capitalization rate. Build-up method and we've continued to reduce it by being much more empirical about the data and assigning value quantity quantifiable values to those to those pieces and then there are going to be other things are going to be somewhat interpretive, but they need to be thought through. And I think there's a whole lot of work in some companies to do a risk analysis of the company and really evaluate one of the best things I like about doing valuation work is, as a business consultant you are it you are in a good position to advise the client and terms of how do you D risk the company. [33:09] So if I fast forward a little bit I would say that one of the money if you look at these variables cash flow and risk. You're able to increase cash flow you're going to increase the valuation if you're able to reduce the cap rate reduce the risk of a company, you're going to increase the valuation so one of the areas that you get to advise on is let's analyze some of the areas that we see some heavy risk in and let's quantify those now. And then I'm from a planning standpoint I think what's really cool is that you can then take that. [33:41] And say now maybe we're not going to do the ESOP immediately or maybe we are but how do we help the company become more valuable over a period of time, well these are the areas where we feel like is the primary risk areas that we have to identify within specific company risk as those come down that risk rating comes down my valuation goes up. So as we think about that I think it just kind of makes sense to go through that whole process now once we've done that we're going to end up having what we call the required return on equity. So we're going to we're going to add risk free rate of return we're going to add the market Equity risk premium the small stock premium the specific company risk premium and that's going to give us a required return on Equity now that term is also going to be what we call the cost of equity for the owners. Now the next thing we're going to do to get the capitalization rate is we're going to reduce that number by the sustainable growth rate, so that we can which is going to subtract itself from that to get the cap rate because the higher the sustainable growth rate which is going to be, primarily an indicator of the economic growth of the of what's happened in the economy, when we think about sustainable growth we're not talking about annual growth for the particular entity will really getting into is with their actual, sustainable growth which is going to if you bring that out on a long-term timeline it's going to sustain itself at whatever the economy is growing over a period of time so so that's going to get us to a cap rate. [35:09] The next thing we're going to want to do then is go back and really look at, now the cost of equity and the cap rate versus the the weighted average cost of capital which is what we're going to pick up and, part 3 I knew we wouldn't have enough time to finish all of this today but, in part 3 we're going to get into that and then we're gonna start putting some of the other components together so that we can build again build the valuation model to properly, estimate the value of the ESOP company, um are the ESOP transaction so that the selling shareholder can really understand what it's worth in going into that transaction so so we're getting there as we go through it we're going to just take our time to to work through each of these steps I hope this was, helpful for you today because I do think that there's a lot of confusion in this area and, as we start putting it all together it hopefully you're geared up and you have the right questions to ask the people that are helping you, so with all of that I wanted to say thanks again so much for listening today, everybody keep on keeping on and I hope to talk to you soon about your ESOP if that's coming up and we will see you on the next step on this journey to a ESOP.

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