Ep. #296 - Pepperdine University Capital Markets Study on Private Company Valuations

Dr Craig Everett how are we and I said doctor because even though you said you don't have to I wanted to at least introduce you with the credentials you have how are we today doing great thanks for having me Ryan I am super excited I was just telling you before we hit record that uh I've been following your study and I've been referencing it to people in the presentations that I give just because is I mean I think the last report when I printed it off it was like 150 Pages or whatever I don't even know if I double-sided it but so much valuable information in it and you guys are just about ready to launch the most updated survey and a lot has happened since the last one that you guys had published um and a lot of the markets have changed but why don't you give everybody just kind of a flyby of you know your bio like what's your background and what's the study and then we'll go back and we'll unpack a bunch of it okay well uh my uh my day job is I'm uh I'm a finance professor at Pepperdine came into Academia a little bit late in life so I have actually a lot of you know real life experience both in in Consulting I was at north of Grumman for many years and at a couple of startups uh then went back and got my PhD uh actually a little bit late in life I was 40 when I when I started my PhD and uh and and that's yeah that has that's a little bit interesting because everybody else is in their mid 20s uh and uh I'm sitting there at 40 at 40 and so it uh it was it was it was quite the experience I I had a uh yeah it was uh all of my advanced math uh was on my transcript from my undergrad days but it' been like you know 20 years yeah and not just rusty see I thought it was going to be rusty I thought I was like oh this will all come back and I'll just I'll remember it just have to brush up a little bit but it didn't I had to relearn it from scratch all you know my the kind of the advanced calculus and beyond that linear algebra differential equation it was completely gone cuz I hadn't used them in my in my career so I actually had to to relearn those to be able to compete against these students uh you know especially ones from like Russia and China that already had phds and we doing a second PhD oh my good and uh and so it's like it was a it was a really stressful four years that was at that was at Purdue um why why why did you go back Craig interesting interesting story so my original plan when I graduated from uh from college was I I wanted to be a professor but then I kind of got sidetracked I got into Consulting you know that was interesting then I got married and I didn't want to be poor and go back to school again it's a solid sales pitch right and I go I'm just going to sit here not earn any income and just become smarter while you're taking care of everything exactly the uh and so it was when uh Northrup actually sent me back for an MBA and you know I was in you I was in management and such and the uh so I was sitting in class and look looking at these professors up talking to us the at the front of the class and remembered it's like hey that's what I wanted to do so basically that reignited that desire in me to to to be a professor and so once I had after my MBA when I fulfilled my 2-year obligation uh to the company after I finished uh I went back and uh and and uh and got a got a PhD I was very the even though I was very qualified on paper I was kind of too old for a for a pH and so a lot of the programs that you know I would have qualified for earlier in my life I didn't qualify anymore because of my age and uh oh really I did not know that I did not know phds were age related well I mean they're not not technically but look at this way it's it's a fair criticism essentially phds for the most part are free uh if you're in a full-time PhD program you know they give you a stipend and you know uh you know no tuition that that's the typical uh uh do doctoral program particularly a PhD program now DBA that's different um you know that you pay for but uh yeah phds it's a research degree and so the the university is actually investing in you and they want to invest in people that have a full career instead of half a career ahead of them so it's a it's just kind of a efficiency thing a half a career I I know I I can tell you what my partners wouldn't consider themselves halfway into a career but yes super fascinating so you know so that's the idea so I mean I was as you know as fortunate to get into the program that I got into it was a very good program and uh and yeah so that was my journey back into uh Academia and uh I really like it I mean I I I I liked northr a lot but I noticed my my kids were fairly young at the time and it seemed like as time goes went by and I went uh higher and higher in the in the company uh I was see my kids less and less and uh and so being a professor kind of gives me the flexibility to to spend time with my family and and organize my time the way I want to rather than uh the way somebody else wants to that's awesome so did you jump right into teaching right after you got your PhD then yes so I would love to and I don't know in the timeline where this study came from but I'm kind of curious and like and for the audience what is what are the topics that you teach why did you why did you pick those and then how did that transpire into what is now the pepperine study so um my both my research and teaching interests are uh entrepreneurial Finance private Capital markets uh I also teach entertainment Finance uh at uh at Pepperdine for the people who are doing a entertainment concentration um yeah entertainment Finance is fascinating actually because you know they use a lot of the same words that normal Finance is doing but they mean them completely differently oh super well I noticed that cuz I and you you I don't know where in your time if I'm already if I'm stealing part of your thunder from the future but you you've written children's books which I thought were so fascinating and I was like and like because I just think about me trying to teach my kids like what we're talking about like I don't even know where you'd start and you've got I think one of them is about entertainment financing and it's a book or it's an encyclopedia about jargon in the in the industry I don't know if that's a children's book that's the thing so when I teach my my entertainment finance class my main goal is for students that are interested in the you know film and television Industries in particular that I want them to be able to sit in a meeting uh discussing finance and be able to understand what the heck uh is being talked about and uh and you can't just look stuff up and and Google it and you know during a meeting because that makes you look like an idiot so uh you have to have you have to have some vocabulary uh you know and and uh you just one example you know something that's um that's that's different from entertainment finance and regular Finance term sheet so so you know most of us think of a term sheet in a particular way you know it lays out supposed to be in basic English um you know the the terms of the deal like a supposed to be but until the attorneys get in touch with it and then so both parties you know sign the term sheet uh but it's not legally binding in in normal finance that that goes that just demonstrates the understanding of both parties then it goes to the lawyers to write the actual investment contract uh and so in entertainment the term sheet is legally binding because that's usually as far as it goes um and uh and uh you know Hollywood's kind of Loosey Goosey and uh and and so you know so the term sheet is very different between the two You' think it' be the same thing same term but uh yeah but but it's not it's a it's actually the uh you know the the the the final agreement in a lot of cases particularly case yeah so what was your what was your passion Craig in finance and business finance and specifically like the private markets like I mean all the different places you could go Focus I mean especially with I can only imagine when in the timelines that you're getting this I mean the amount of Attraction towards Wall Street and private equity and all the big markets easy to make more money easy to you know find a niche and provide value that direction what was your interest in this particular Marketplace well I think it's because you my historically my family has been entreprene and like small business people and such and and uh you know starting with my my grandfather who had the Everett saw company and he made uh he made bucks saws and so you know we all know what you know what happened there is uh as the chainsaw kind of replaced the bucksaw and and little bit more effective so basically that you know bucksaw became obsolete but uh you know for a while he you for a long time you know his family survived on his his his saw company you know and my and my dad my sister myself it's like everybody's kind of been involved in the entrepreneurial space you know not necessarily like Tech space but just you know just regular small businesses you know restaurants and gas stations and car washes and real estate and and that and that sort of thing and so it's kind of in my blood you know my father is deceased but he would be very disappointed in me that I'm a professor and uh and and not doing real work oh come on well I'll tell you what and this is like when you before you and I hit record like you know my passion for finance Craig is like the it's such a backwards way that I got into it because like I was telling you a little bit of our background story and like the most of the challenges that we dealt with in the business were we were wrong or incorrectly financed and like the the access to the right kind of finan and the right kind of funds to support the growth and to understand what the hell we were doing besides just trying to sell more stuff and it was we just never got the translation to the stuff into the language and the useful information that you provide now so like mine was out a pure like almost a complete frustration and so like when you thought about jumping into finance and specifically business finance was there what was your intent with going into it like what what was the impact that you wanted to make well I think the impact that I wanted to make is I wanted to to help particularly entrepreneurs understand Finance understand how it impacts them understand the sources of finance and you know if there are always other avenues to go if if you don't qualify or don't get investment from one source of financing there will be ones that you do qualify for now as you go along that Continuum the uh the deal terms won't be as good and such but uh there's you know there's pretty much pretty much always uh money out there and it just kind of depends on what the terms are what is your um your experience with entrepreneurs knowing that um usually entrepreneurs don't know much about it in fact that's a question that we ask in our survey and and and generally uh the entrepreneurs don't know generally a lot about business they have an idea they have technical knowledge but if they're firsttime uh startup they usually don't know the business side very well and they don't know how to how to qualify for Capital they don't know what investors are looking uh for now we were talking about the private Capital markets project I also invol involved in the uh the director of the most fundable companies competition at at Pepperdine and and that's a specific goal of that program is to help educate entrepreneurs on what investors are looking for because usually they have no idea and they go through our process uh which is pretty rigorous and the biggest takeaway even if they don't make our winners list if is they learn what investors are looking for and what uh T's they have to cross and what eyes they have to dot uh before investors will consider uh making an investment in them well and that that topic right there that you just brought up I think is going to Beil to be a great place to continue to launch uh this conversation because before we hit record we were talking about you know people understanding value valuations and then like what actually creates more value and essentially thinking about it from an investor perspective and what have found over and over again Craig is that on on the podcast when I've interviewed people they learn what creates value after their biggest deal or their only deal is done so it's like this oh wouldn't that have been nice to been able to look at my business as an asset the whole time and then all the time and money I'm putting into this if it's actually growing it in value or not and like how the most effective way to grow it is and they just don't necessarily look at it from that lens so why don't you talk about like capital and maybe we just take that topic we were talking about cost of capital and like I don't know how to REM re-engineer what you said but like you want to take that and then just kind of complete what I was talking what you were saying about the cost of capital and how people view value sure so now with big public companies it's it's really easy to know the know the value the market value of the company you just you know take the uh stock price and multiply it by the uh number of shares is outstanding and add in your long-term debt and pretty much there you've got the value of the company and you can know that value at any moment in time so with private businesses it's not that easy the the only time you really know for sure the value of the company is at is at the time of of a transaction like an equity transaction so at that point in time you know exactly what the stock price is because somebody bought the stock at that price but other times most business owners have no idea whether what the value of their company is and whether that value is growing or shrinking and uh so that's one of the things that we're trying to get at with the with the private Capital markets uh report and project is that that that cost of capital and that and be able to use that for valuation because so this is the deal so if you if your company and this is kind of a very in a nutshell explanation if your company it's Roi return on investment is greater than your cost of capital you're growing your company the valuation is becoming larger if your Roi is less than your cost of capital then your bleeding value your your the value of your company is shrinking and so that's why it's really important to understand both what your cost of capital is and and and what your what Your returning is because then you know am am I doing a good job am I growing my company or am I shrinking my company that's so beautiful Craig I mean honestly like when you said in a nutshell like that and we're going to talk about how to figure that out and what that means but like like the amount of people that don't know that is so staggering we never did I mean like and to understand that in that simple terms of if we are exceeding the cost of capital then we're actually making progress because I think as so many people Craig like the pure frustration comes from am I on track or not Craig and if I can't tell you that I'm constantly living in limboland or the gut feeli and it's like this decision that it's a lot of I think that's where a lot of the flashy object syndrome comes from is just not knowing and not having a guiding nor star and so for the listeners if if we could if you could do me a favor and let's kind of break down like what do you even mean by cost of capital so like yeah just take take and run with it okay so I mean cost of capital generally what we're talking about is a like a weighted average cost of capital where if you have bank loans your cost of capital for those loans is the interest rate uh if it's an equity investor your cost of capital there is going to be the expected returns of the investor so the problem a lot of business owners and we ask this question and we as we ask private business owners just generally in our in our surveys okay what what's your cost of capital and it's amazing how many people will say zero now they say okay we don't have any loans we I don't have any outside investors therefore my cost of capital is zero that's not actually the case because you have your Capital invested in there and you have have opportunity cost you could have just take that money and invested in the S&P 500 and get you know an average of 10% return plus or minus you know over over time so your cost of capital has to be at least 10% because you could have invested your own money elsewhere um but of course your risk profile for your business is much higher much higher risk than a fully Diversified S&P 500 portfolio so you got to think okay my my cost of capital must actually be higher than that 10% S&P 500 because if I were to get outside investors they would have to be compensated for the extra risk so it' have to be they'd have to be getting that 10% S&P 500 return plus a lot more to compensate for the risk of of investing in a uh in a in a private business an individual business a liquid small Private Business a liquid small private business with huge idios idiosyncratic risk it's like so you know so most um Equity cost of capital estimates generally are kind of in the you know 25% or so that's from private Equity now Venture Capital tends to be a little bit higher where their expected returns are more like you know 35% 30 35% but uh so but most business owners have no clue about this and they don't they don't realize that opportunity cost uh piece of it where even they even they themselves could invest in something else uh if they wanted to instead of their own business so regardless of whether you have outside investors or loans you do have a cost of capital well and what I think is one of the big key components here Craig that I see as an issue of why this is the case is that what what one thing that I've I've gathered over the years is that a lot of entrepreneurs that are founders they when I think about a lifestyle business they like my dad and I running a lifestyle business where you're solving for annual income how much cash can I pull out of this company from Perks distribution Etc and it's a very expensive very stressful job and they don't view this thing called the asset which has equity and like so they kind of going back to what you're saying is that's someone can say it's zero because they don't see their company as an actual asset so they don't see the opportunity cost of even it might be worth a half a million bucks you could still put it in the S&P 500 if it's only half a million bucks so they're not even they don't even have that kind of clarity to even say what are my opportunity cost because they don't view it that way and so I don't know if that's something that you you've kind of gathered throughout the study or if you guys peel that back oh yes I mean and also from my uh you know from my my family history I know my my dad um you know his goal with his business wasn't wasn't necessarily the value of the company it was maximizing his own personal wealth and and so but that's and that's a will yield a very different strategy than if you're actually trying to sell your business um because most valuations of going concerned businesses profit profitable businesses they're going by some uh EA multiple uh EA earnings before interest taxes depreciation amortization fancy way of saying profit so some uh some multiple of the profit is what their company will be valued at well my dad was not trying to maximize profit because that would have maximized his taxes and so truth so he's trying to minimize taxes so he's trying to make sure that the company is as has as little profit as possible you know and he's kind of like you know you know sucking the business dry you know for certain trying to still stay in business but trying to take out as much as he can and so uh and and a lot of business owners are like that they're not necessarily trying to maximize profit because you know they're they're trying to maximize their lifestyle and minimize their taxes but if you're trying to sell your business you know you have to kind of reverse that and uh and and uh and start trying to maximize profit because that's what other people will look at when they're buying the business yep well and I think that that's that lens Craig is so helpful where you're looking at the business from the back end of within as an Investor's mindset which is what should the return of this thing be that we're creating wealth with and if unless you've unless you somehow have shifted your mindset been through transaction or like have you know gone through your courses and and in education is like how else do you understand that this thing is an asset and what those trade-offs are because I don't think you know using our word intentional I don't think anybody's in very few people I know have intentionally decided I'm either going to maximize personal wealth lifestyle business that's fine and my expectations are such versus I'm going to maximize the value of this company by funding it the right way to get the value that I want and and it's an intentional Choice it's usually I want to maximize my personal wealth and I want to have the highest valuation possible when I eventually go to sell it I don't know if you've got similar experiences yeah those are mutually exclusive um so what the so and that's one thing that VCS uh when they're looking at potential Investments they look at the founder and you know they have to make a determination is this guy is this try guy trying to maximize his lifestyle and you know and if so that's sends up red flags okay this this could turn into a lifestyle business in which case the VCS will be screwed uh and and so you know they're trying to make that determination is this person trying to grow the business as fast as they can for the next 5 years and then get out or do they want to be king and uh and and re over their their their business forever and if that's the case then the VCS will run away so interesting and when I think about um before we get into because I want to get into kind of the spectrum of funding and like how the different investors in because I think a lot of people have confusions on that and a lot a lot of your work um uh puts Clarity on that but I want to go back back to weighted average cost of capital because Craig in in our training we have a section in principle to and we're talking about valuations and deal structures like we say hey there's this thing called whack weighted average cost of capital and it's actually a mathematical equation that's part of a multiple because how many people I know and I was definitely guilty of this willy-nilly multiples right like oh you get a 10 10x Revenue you over here get a 5x and they they talk to their friends at you know their dinner or the golf tournament and like they're just thrown out willy-nilly but there's actual logic that goes in it so if you could do me in the audience a huge favor is maybe just kind of a basic explanation of what whack is and then how that gets into what a multiple actually is sure so so wack like you said is weighted average cost of capital and you know the simplest way to explain that is if uh we'll use very uh very simple math here let's say your company is funded you know 50% with Equity investors and 50% with bank loans and let's say that your uh your interest rate for the bank loan is 10% and your cost of capital for the uh uh for the equity investment is 20% so basically you have half your Capital at 10% half your Capital at 20% so your weighted average cost of capital would be 15% uh now of course those weights aren't going to be 50/50 and you know those uh those numbers aren't going to aren't going to be exactly right but that's the way to understand it it's is basically taking a a weighted average of your various sources of capital and the and the and the returns the expected Returns on those um with the debt it's very easy because the expected returns are documented um and uh and the your interest rate uh but with the equity it's a little bit uh a little bit fuzzier uh so that's the way to average cost of capital and so that's what you have to look at if and the reason why that's important is because so every valuation method is is at least theoretically related to a discounted cash flow analysis and so when you're doing a multiples type calculation you're just kind of shortcutting but underneath that is a discounted cash flow There's real information like we were saying like it's not just made up so basically you know that's estimating your cash flows out into the future and then each of those cash flows out into the future of course you know $1,000 today is worth more than $1,000 a year from now and uh and then ,000 two years from now is worth even less but how much less that's what you use that cost of cap capital for is the discount rate is how much you're discounting that each year uh in order to get back to the present value right now and so so basically yeah any sort of multiples like an eitaa um again it's like that's a profit multiple um or a revenue multiple is is somehow ties into that discounted cash flow valuation that's happening underneath but it's just kind of giving you a ballpark um now that's how it's supposed to work uh right now the uh uh you know the multiples are just kind of like crazy and and seem crazy seem kind of random and the uh and so it's uh you know 10 years ago it seemed like it it it it worked a lot more predictably but right now let's put a pin in pin in this because I want to go back into like when we start talking about what is actually going on right now and why because I think you and I can have a fruitful conversation on that but before we move on so with the weighted average cost of capital and the the how you broke it down Craig with the 5050 it's very interesting kind of tying in your earlier comment if someone has no Bank financing which is 50% of the equation and they don't see their company as an asset which is the equity and the return on their Equity that they should get they truly are going to say nothing right that that that's how they got to the nothing answer which is I don't understand equity and what I should be getting for my own equity in my and I have no Bank financing so I have zero cost of capital right yeah that's what they think yeah so there's a I believe a mutual friend of ours who actually introduced me to to your study to begin with Ken sanginario and so he's the first person that told me what the heck whack means in his system which is uh our whole principal for about growing value by drisking cash flows is is founded on Ken's eight functional areas and he talks about company specific risk so I don't know if you want to speak speak I see the smile I love it so you want to kind of give your definition of company specific risk and how it plays into the to the example you just gave okay sure the uh so company specific risk is is something that's used in uh in something called the buildup method to to that that's a way of coming up with a cost of capital for a company and so the buildup method and it's very standard so uh but there's some there's some problems with it one is that is based on public company data and so it's kind of an apples and oranges thing with uh with private companies so what you're doing with the buildup method is you're you're starting with like the risk-free rate like a 10-year treasury bond uh interest rate you take that and you know and and you add certain things to it you you add Equity risk premium because we're talking about an equity valuation um which you know generally is you know over time around 6% so on average each year the you know the S&P 500 returns 6% more than uh the treasur the treasury bond rate and you're asking for just to clarify for the listeners you're asking for a bigger return because of the additional risk you're taking that's all when you're saying building up you're just building up to a bigger return right so so yeah the our goal here is to build up to what the cost of capital for a company is so we start with so using the buildup method buildup method you start with risk-free rate uh which 10year treasury a lot of people use add the equity risk premium uh generally around 6% it goes up up and down you add in a industry premium or discount so if your industry is generally has a higher cost of capital or a lower cost of capital you adjust for that size risk the larger the company the lower the risk so you add in a a premium or discount for the size risk yeah then at the uh then at the very end you throw in something called a company specific risk premium and uh and what you're trying to do is identify is this company you know riskier than normal or less risky than normal what I don't like about it is kind of a fudge factor and uh you know my apologies to valuation professionals who may disagree with me on that but uh but but essentially if if there's a if you have a Target in your mind what you think the cost of capital is that's where you that that's where you adjust it yeah well I I I totally agree Craig and it was so interesting when I was going through Ken's training years ago and I like was like what so like like and then there's a whole like kind of set of stipulations for valuation professionals like hey if it's above this you might be like flagged and potentially Li liable for the lawsuit if there's some dispute about this so there's kind of a range that they need to get it in like right down the Fairway every single time and it's like well it's like you said it's using this as kind of like the the junk drawer but there's a lot of reality inside of that where if you had two companies at the same Revenue same IA same industry their operations might be wildly different so there's there's truth in it but how it's used might be either not done correctly or completely used in a different form is that is that a fair fair statement oh yeah yeah I mean there's I mean there's there's reasons for doing that because there is there's company specific risk and such but uh yeah it's it's it's the one um yeah it's the one that you would use as your lover if uh if you uh if somehow the the rest of it is is coming up with something that's not rational so or you don't think is rational right and so if you can kind of well we can close the loop on this of taken the that weighted average cost of Capal that discount and then say how does that how does that actually Factor underneath the multiple like or inside the multiple like you Des that your describing earlier so basically multiples um and again it's it's there are other factors that I think are driving multiples more than uh than fundamentals um right now but uh you know the idea is that it's kind of an inverse relationship so the uh so you know the the the higher the the higher the discount rate the higher the cost of capital you know the lower the the lower the multiple but um yeah it's so I mean right now for example um take a 20% 20% weighted average cost scaper something like how would that get into the multiple so let's see the um I mean So 20% I mean the the simplest way to look at and you know there are people with different opinions on this but you know just uh you know take the you know 20% uh 20% cost of capital would you know just take the inverse of that and that would be you know a 5x multiple that's that's the simplest way of of looking at it that's not really that accurate anymore more I mean that but that's generally how it's you know so why why do you say that well cuz right now we have other things going on uh like um like a lot of dry powder in in private equity and uh venture capital and even Angel Investing and such and so there's more competition to get into deals which basically means that uh um professional investors and fund managers and such are willing to uh overpay uh to to get into get into deals and that's messing everything up so multiples are just a lot higher now than they really should be pure inflation right I mean it's inflation on the assets I mean it's people trying to deploy their Capital get a return somehow and competing for it there's that I mean certainly certainly inflation businesses are assets so as assets uh inflate and the like the dollar devalues obviously the uh uh the asset's going to be worth more but what I'm talking about is beyond that what I'm talking about is because you have multiple investors competing for deals they're just and you know yeah you can look at inflation that way as like too many dollars chasing uh too too few goods it's like yes that's that's a economic cycle approach to inflation so that's one way that uh people the the assets inflate the other way is that too much money basically you know the uh um it's not just a demand thing it's just it's it's a printing press thing and so as a currency devalues you also get inflation that way and that so that's um so those kind of two different and politicians conflate the two um but uh you know those are two different approaches so what I'm saying is like the yeah VCS in particular they're they're they're chasing these deals and uh and competing against each other and so the the percentage of the company they're willing to take for a certain investment you know gets uh bid down and the amount of money they're willing to pay gets bid up and so this is kind of messing up I mean you never used to have you know early stage like post Revenue companies you know the uh meaning they already have they're already selling their you know I mean the revenue multiples are crazy like you know it's insane Craig I I have no 11% 12% 15% 20% it's like okay this is crazy for Revenue m I remember when Revenue multiples were like were like 2x not 15x and so the uh so it's um yeah so it's kind of crazy right now and and it's mostly because uh there's too much money chasing too few deals the other thing is uh you know related to that is that the so in 1980 when when VC and private Equity Funds took off because of uh they were never a very big thing and then 1980 and thereabouts the couple years more or less than that a couple things happened so the uh the capital gains tax rate uh changed and so capital gains capital gains used to be taxed like regular income then in 1980 you know it it went way down and so um so back when they were they were taxed the same as income there was no real advantage to invest in uh in in smaller companies because it was a lot higher risk and capital gains which is most of what you get from investment in a smaller company was taxed the same as dividends and so um so basically Equity investors tended to invest in Blue Chip dividend paying stocks especially institutions like uh you know like Pension funds and insurance funds and such so when so when the tax rate changed it was a it was it became very advantageous to invest in in smaller companies because you were taxed on capital gains at a small at a lower rate now the other thing that happened back then is that what was called at the time The Prudent man rule U now it's called the prudent person rule but that was a rule from Department of Labor uh an orisa uh rule that uh basically said that you couldn't make any investment if you if you were managing you had fiduciary duty you were managing like the Insurance Fund or p fund the department of lab labor cares more about Pension funds but basically you really couldn't invest in small in small private companies if you were a big uh fund manager like pension fund manager because that was considered imprudent unwise because of the risk profile well in 1980 they changed that to be able to look at Investments as a portfolio rather than on an individual basis so as we all know from portfolio Theory uh is that uh as you increase the number of your investments in your portfolio particularly if they're uncorrelated you can diversify away your idiosyncratic risk of that the individual Investments within that portfolio and just be left with the the overall systematic risk of the the entire portfolio so that allowed Pension funds and such to start investing in private Equity Funds and Venture Capital funds because those were portfolios uh instead of individual Investments so the upshot of all this why getting this well then this is where because just to interject there enter the scene KKR Blackstone all in the 80s I mean king of capital that like that book like it was like like oh my God I mean Steve schwarzman and Pete uh can't remember Pete's last name Pete Peterson I don't know if it's but anyways both of those two I mean they started and they're like I mean they they're like systemic risk to the whole world now because of how big Blackstone is I mean it's ridiculous but they started in the 80s didn't they somewhere around there yeah so this all started uh so basically both private equity and Venture Capital just exploded after that and generally yeah they're yeah so lots of capital started flowing into venture capital and private equity for that for that reason and over time the so Venture Capital started out actually investing in new Ventures that's where the uh the the name came from but then since then they've moved away from uh startup investing in into Growth Company investing uh so people that are more on the later stage of of a of a new Venture where actually have profit that are even if they don't have profit they have very very high growth um so the reason why I bring that up is the situation right now is it's gotten so competitive to for these VC firms uh to actually deploy their Capital to actually make investments and you know limited partners are investing in their funds um but the money's just sitting there cuz they can't find anything to invest so now VCS are actually kind of moving back uh earlier to earlier stage companies for the main reason is because if you if you get in early on a company in an early round then you generally have rights of first refusal on the later rounds so now uh VCS are are shotgunning money out to these uh uh to these earlier startups um they know only one of one out of 10 is going to make it into a you know into a growth company but it's worth it to them just to have a foot in the door so they can you know they still are interested in growth stage mostly but they invest in the early stage more and more these days in order to get their foot in the door and be able to have access to the the growth stage Investments um which and probably to be able to also close the door on other people and protect the cap table for themselves would be my guess yeah so it's basically it's a it's it's a defensive move and uh and because they're having a hard time getting their dollars invested because they can't find the good deals to do that and the best way to do that is to kind of seed these earlier stage companies so they have you know so they have access to them later on well and I think about as we continue this and that's by and by the way that's that's another thing that's driving up these multiples is uh is basically it's this there all this dry powder or money sitting in these Venture funds that isn't invested that's what's dry powder well let's let's take let's take just the math cig like if it's two trillion dollars that everybody's saying are give or take a trillion I I've heard you know varying degrees but let's say it's two trillion and VCS and private Equity firms who traditionally do the 2 and 20 2% management fee and the 20% on the upside of the carried interest yeah and it's they're getting charged 2% on nondeployed money that's just sitting there so like what's 2% of two trillion is that is that 200 is that 200 million or is that two billion I don't even know is that two billion probably yeah I I don't do math during interviews yeah well I shouldn't do that I should save that for my team no matter what but like that's my but to your what I'm doing is trying to reinforce your point which is it's they're charging their investors 2% of the money they haven't spent yet so at some point like if you and I had the $100 million fund and we haven't spent it it's been two years we bought anything our investors are going to be going why Craig and Ryan have you not bought something yet go find a deal and then we're going to end up overpaying just to continue the cycle well what one way that that's handled in a lot of funds um is you know if it's a 10-year fund and most of these funds are 10-year funds they will at the first part at the first few years or maybe even the first five years of the fund the management fee will be based on committed Capital um and so yeah so they're going to be get paid 2% based on on that but at somewhere along the point like at year five it'll transition to invested Capital because you know the first year of the fund of course you know all the capital isn't going to be invested they're still looking for Investments and such so you know you're as an investor you're giving them a chance you they have to be able to run their com their their Venture firm and and keep the lights on so it'll be based on committed Capital but then at some point it will transition to invested Capital so they'll only get the management fee based on what's actually been invested so a lot of funds work that way which again if you're in year four spend the money so you can because otherwise your your cash FL runs out as a fir so they're desperate to spend the money and so you you just wonder they have a little bit of a you know a moral hazard there yeah the uh you know basically to to take um to take bad bad deals or maybe just suboptimal deals uh in order to get their money out uh because they have to do that and they're and and generally overpay um which you know overpaying for an asset works out fine as long as the people buying it from you are also overpaying on on the back end um but if if or not if it's a it's a fair valuation then you've just cut your Investor's returns by uh by overpaying on the front end and that's that musical chairs and you just want to make sure that when the Music Stops that you're not the one holding the bag right or without the chair and exactly so I I think what what's so refreshing and fascinating about this conversation Craig is like I didn't know any of this stuff years ago like at all running a business with all these high impact decisions we have to make every day which is why I've been gravitated towards have gravitated towards the study that you bring because we can go look up CNBC we go to Wall Street uh journal and get Public Market information this is what Ken San Jero just beat into my head is that is not the same as privately held companies because I know after interviewing 17 Banks trying to get new financing in 2012 it's not the same as saying hey we have another percentage of the company we're willing to sell and just boom a bunch of money comes into our account so like how did after you start teaching kind of maybe give us the birth story of the study and what was your intent with the study and kind of what's in the guts of the study okay so so I did not start it I I I joined pepperd in 2011 and it already been this had already been going on for a few years at that when was the first first study that when they go out uh first one was 2009 um and and so uh yeah I had been a pepper9 about a year uh so it was about 2012 that I took over um because uh my my predecessor John paga who uh who who came up with this whole project got you know got promoted and he needed somebody to take over for him so so I did because it was right up my alley as far as uh my uh my research interest and teaching interest and so I've been doing it since 2012 got it so and for the listeners what what is the so for pepperd and for the your predecessor like what was the purpose of it and like and kind of walk us through the methodology of the study and what's in it because I think the whole goal and we're going to be giving adding links to the in the show notes for people because I think it provides a completely different lens of information that people don't get elsewhere and hopefully through this podcast and the exposure that we'll be getting we can continue to um increase the reach that you guys have okay so uh and I hinted at this earlier but so the report has a lot of data um on industry Trends and financing Trends and all that but when it comes down to it the main purpose of it is is determining cost of capital and making it easy like table one in the report every year you know summarizes cost of capital from various deal sizes and various sources and so that's the you know that's the money table um the uh what most people look at table one um but the uh but and the reason for that is because of uh you John paga and u he was working with at the time uh Rob SLE um just felt that the buildup method which we talked about earlier um was flawed and and that that's not the that's not the best way that the problem is be because you're using public market data and you have that whole company specific risk premium thing going on it's like okay this is uh you're kind of backing into your um uh to your result uh using the buildup method so the idea here the they okay so they want to come up with a different approach to determining cost of capital and so since cost of capital is an opportunity cost uh it means uh investors uh and private businesses they have a broad range of possibilities that they can invest in so they have to be convinced to invest in your company rather than all the other uh possibilities they have whether it's uh you know public company stocks or bonds or other private businesses or whatever so you have to attract their company their their Capital to your business and so in theory and in principle uh cost of capital is is an opportunity cost and so the expected returns of the investors has to equal on average and over time your the cost of capital to the business because if you if you don't you know return uh what the investors are expecting they'll take their money elsewhere uh and such and let's put I want to interject right there because if business owners are not thinking like an investor they're never going to even think about the question you just proposed yeah it's true and and the majority don't think of it on their own um you know they have to be uh somebody has to tell them it's like hey you know this is how it works and then they go oh yeah that makes sense so so the idea here is that okay so we need to get at what the expected returns from the investors are whether it's the investor is a bank issuing a loan or an angel investor or Venture Capital uh fund or whatever we have to get what the expected returns are how do we do that so the uh so John and and Rob originally came up with the idea well why don't we ask them uh novel idea right so that's where the that's where the survey came from is is just asking all these various Capital providers hey what are your expected returns uh and then and then that is you know by uh uh this idea that cost capital is an opportunity cost we're that's how we're getting at what the cost of capital is for these various types by asking the investors themselves I love it it's just like the customer like feedback it's like hey why don't you just ask your customers what they want you're G to get a lot of good information so so the idea here isn't to replace the buildup method um it's basically to to do a real world checkpoint against it and so so that's how a lot of people how a a lot of valuation professionals use our report but it's generally as a as a check against what they're what they're doing because the buildup method is well established in the courts and such and so you know they're not going to go away from that but they do want to do a reality check I love it and I think what you just described from the from your survey and the buildup method is I want to I want to I want to hear your response to this concept that we've been playing with in our training Craig and it's because I I think it has to do with in principle three we talk about exit options so we kind of build up in our in our training of like hey what do you want from the business here are your financial targets how valuations and whack and all this stuff work and then here are the exit options then what do you do with it you grow value to create the choices that you want so you can pretty much pre- engineer exactly what you want but then there's this whole like depending on your exit so let's take two examples like an ESOP versus like a strategic sale so like with an ESOP it's going to be based on that the Value method the primarily buildup method discounted cash flow is going to be based on the risk of the cash flow and how that cash flow can service the seller and the and the senior lender like to to your point what are the returns that they need for that risk of the cash but it's going to be mainly based on like it's got to the company's got to pay for the debt I mean pretty much to pay for the buyout so that there's like a direct correlation between the cash flow and that value strategic buyers can overpay for all the reasons we talked about and then you throw on the fact that that strategic buyer might be backed by a private Equity Firm with all of the assumptions that you mentioned and the Strategic nature of deploying someone's product or service through 3,000 customers that they wouldn't have had to be able to cross sell to so there's a there's a premium difference between like this what we what we call and here's what I was looking for feedback on is we call it intrinsic Financial value pulling from a lot of Ken San Jar's work like here's the risk of the cash flow and the value associated with it and then over here we call it strategic transaction value where it's that one point in time where the company switched hands for a variety of reasons that are above and beyond the risk of the cash flow and so what I and the reason I'm bringing this up is because when we talk to people and I do this in the presentations that we do is we say you can control the cash flow risk of your operations and you can pretty much pre-engineered on if you're going to go to a bank or an ESOP you can pretty much knowns that you don't know from the industry what's hot what's not all the stuff that's going on that I have suggested to people they go to your survey to say hey this is what's happening on the Strategic transaction value so they can directionally go hey I might have a 30% premium if I selling to a third party but I'm going to have to gut it there I have no control over it and is it worth it or not for them that's like what we're trying to give them is the the data point but we've never been able to get any information that's super legit outside you know for comp so it's like hey go to the Pepperdine study because just will give you an idea Industries you know multiples ranges sizes that is different than just looking at the buildup method so that's how we've been using it and I I just appreciate what you guys have been putting together because of I mean it's a how many pages like I said it's 100 120 usually yeah it's not small what are your thoughts about how how we're using it in in our discussions yeah I mean that's uh that's exactly right like yeah there's a huge difference between a valuation done for an ESOP esops have to do they legally are required to do evaluation every year and such and they use the fair market value uh method and that's generally and they're using a buildup method and you know and uh you know very according to a certain formula and such which is uh well supported in the courts and such that's not the same valuation that you're going to get if you're actually um selling the company uh and so the you know on the market and generally well just to give you examp say on the market is a is a really important distinction there because and just just to for some clarification when we say you know you can you can monetize your business through an ESOP and still be the the CEO which is your wage and your job so those are we have to differentiate those two because this is why I hate the word exit planning because people don't even know what they mean and it's like well technically in ESOP you're monetizing your business but you could still be the CEO so like when you say I want out out of what I'm not sure and so that it gets all conflated versus saying like hey I want a third party sale and these are kind of the attributes with a third party sale yeah I mean another popular solution if you just wanted to uh uh monetize and and uh is do a equity Rec capitalization you know Equity Recaps that's a private Equity deal where where you generally you you sell like 55% or 60% of your company to a private Equity Fund and then you keep you know the 40% you stay on a CEO and then get a second bite at the Apple later on a few years down the road the idea is a private Equity Firm is going to help you increase the value of your company during that time and then you know when you sell your remaining 40% you know you'll uh you'll actually make more off of that second sale than you did did off the first one so that's an equity recapitalization so you know that's a way to do it to monetize without actually leaving um and yeah like you said the ESOP is another way people uh people do that but uh yeah exit strategies as a as a whole um now it's interesting the uh so traditionally your um your best bet was to sell to uh sell your business to a public company that in a strategic sale that was what would get you the highest price then after that you know sell to another private company that would get you a little bit less and then like third was a financial sale like to a private Equity Firm or something that was like that was that was number three you know way way down the list because you get your best prices public company private company then private Equity well now that's flipped I was just going to say that is not what that's not what I see yeah so so now because private Equity firms are just grotesquely overpaying for companies because because of the comp competition your best bet right now is selling to a private uh you know a private Equity Fund um and uh and you know then probably a a public company to a public company then to to a priv private company but yeah it used to be that the you know the private Equity deals were the ones you know the they were the they were the people with the sharpest pencils were trying to like you know ring every possible dollar out of you and and pay the least and and now they're being super generous because you know they have a lot of dry powder again and uh have to get these dollars invested so right now private Equity is the best you know other thing that's interesting um just on along those lines is we always asked this every year in the in the survey is if you could qualify for doing an IPO or selling to a private Equity Fund uh which would you which would you do um and it's uh and let's see it's always it's always been the the case that people have chosen since we started started the survey uh private Equity over IPO um and so the uh the so let me go up to the yeah yeah I'm I'm on that edge of my seat waiting for your waiting for your answer too okay so this year I'm going to tell you the uh you know the the numbers for that so uh 56% uh picked p uh of owners picked private Equity over IPO 177% basically 56% said they'd go private Equity 17% said they'd go IPO now that's that's a real change from like you know from historically where IPO was always the brass ring that was reaching for and such and and so and now they just look at private Equity as okay you can you can get really rich off a private Equity deal uh without all the hassle of being a public company yeah isn't that it's it's so crazy watching these these shifts happen and like and that's why and I think so much like the the complete Paradigm has shifted since 2020 when all the money got pumped in and all the I mean there's just so much stuff happening and the volatility it's I mean it's things change from day to day and but I think like what what can we take out out of all this I I think like you some of your descriptions of like hey if your cost of capital if your business is growing higher than your cost of capital you're winning if it's not you're not and like and this about I think Craig like for myself thinking about myself a decade ago to the people listening is like what can I control and then what do I do about it that's what we're trying to get to and so like what when you I don't know if there's anything if there's even a question in there it's more of just like you there's so much that we've Ted talked about but like there's so many actionable things to do about it but it's even just keeping people pointed in the right direction so when you guys walk through your walk through the the survey methodology because I not only should everybody participate next year but then also like what you you're just launching the the 202 is it 2021 one that you're launching or is it 2022 so we already we finished the survey for 2022 now and we're just compiling the report and that'll be out in uh in a within a couple of weeks um hopefully a little bit earlier than that uh so that's the 2022 we've done the 2022 survey we're doing the 2022 report yeah the way it works is uh you know for and and essentially what we've done over the years we've built up these these survey panels and and uh always looking for new people to to to join in the uh so that's uh so very important for people to do that uh and then you know we put them out there right now um essentially from 2021 all the way back through history those reports are are free and you know there's a there's a link to them if you go to private cap.org um all one word private cap uh.org then you have access to all the reports so the 2021 and before so it's always the current year we charge for and started doing that a couple years ago um just because we we we lost the funding going yeah we lost our internal funding um and but uh so the current one you have to pay for current year but all the previous ones are free for download uh so yeah just go to private it's a nominal it's a nominal fee too it's like a little bit over 100 bucks or something like that yeah this year it's 125 for the 2022 and we'll put the links in in the show notes for everybody because I think that the goal is to use this directionally to say hey like what does it mean what does it mean to the listeners right and I think it's just a great source of data that you can't just pull up the TV and see a bunch of information about private markets it just doesn't exist yeah it's it's really opaque that whole whole area I mean that's why every Finance textbook you read in an MBA program or what have you it's all going to be talking about public company valuation um and why is that even though that um the number of private companies dwarfs the number of public companies yet uh um it's because of data you just don't uh the public companies have data so that that therefore every all academic stuff uh really defaults to public companies uh because availability of data and so private companies is a lot harder so hopefully we are making that easier uh by providing uh you know data about priv private companies Craig this has been an absolute blast and I appreciate how how simple you've brought all this information to everybody um the two questions I like to ask as we wrap up um the first one is what the word intentional means to you because it's the name of the show and I think there's a lot lot of meat behind everybody's uh different ways that they Define it but what does the word intentional mean for you it means instead of just going forward and hoping for the best actually having a plan again you just you just dro the dro the simple bomb again I love it that's seriously amazing and then you've already uh the second question is where do people get in touch with you the reports you get you said it again but um any any main areas you'd like people to go uh sure I mean my email address is craig. Everett pepperdine.edu uh on LinkedIn my uh uh my um handle is Craig Everett all one word let's see and on uh on Twitter it's Craig Everett I thought you were GNA bust up Tik Tock or SnapChat no yeah I was doing some Tik Tok uh last year just doing like Snippets uh you know talking points from the report and things that I could do in under a minute oh cool and uh so I and probably once this report comes out I'll I'll do a little bit Tik Tok um that's awesome not you're above me man no no dancing uh you know noing no cooking I may involve my dog in it somehow you know because that seems to be popular but I was I have this vision of Craig cooking and talking about whack Craig thank you so much for coming on this show this has been a blast well thank you Ryan