EP19 - Bill and Ted's ESOP Adventure - 1+1=4

So glad that you could join us today. I am the ESOP guy and we are on this journey to an ESOP. This podcast is for those companies that are thinking they might want to consider an ESOP strategy. If this is your first time joining the, the podcast, I just wanted to say welcome and thank you for listening. If you have an interest in other episodes and other topics, uh, please go to journey to an ESOP.com and you will find all the episodes there. If you are an ESOP professional that is listening, And as we look at our industry, we are providing this podcast as really a resource to help educate um folks on the ESOP process. So if you have feedback for me, I would appreciate it. I would actually love it, um, as we work together to help create more resources for companies thinking about going ESOP. So today's episode is entitled Bill and Ted's ESOP Adventures, sometimes 1 + 1 equals 4. So the, the whole topic of this is going to be to deal with entity structure changes that happen prior to an ESOP transaction. So the issue we find is that owners of businesses have multiple entities. How do we deal with that in preparation for an ESOP? To optimize the valuation and really deal with specific risk mitiggans related to an ESOP valuation. If you like what you hear, please share it with a friend, uh, subscribe to the podcast, it's absolutely free. And as we start to to look at this issue, what I wanted to start with is. This idea behind um multiple entities. So we're gonna use the A very simplistic case example of Bill and Ted, and Bill and Ted both have been friends a long time, they met in high school, and they created their own company around a piece of time travel equipment. And they owned it because their buds, they own it 50%, you know, each individually. Now, Bill had an idea to found another company that was primarily in entertainment, and he did it on his own, and he owns 100% of that company. And what he uses is, is these historical figures to um go to entertainment venues and, and so he's been successful on that business as well. So we have two different entities owned by multiple by multiple owners. Now, if we start off, I wanted to start off with Bill and Ted, they go back in time and they travel back to the year 1200 AD. And in that year, there were 5 Native American Indian nations that united in a confederation, and this was known as the Iroquois Confederation. This unification took place under the Great Tree of Peace, and each nation gave its pledge not to war with other members. So it's primarily a peace treaty in terms of the alliance and really the, the combination of these, these, these tribes together. So as Bill and Ted travel to the 1720s, they find that there's actually another Native American Indian nation added to this group, so that now there's 6 Native American Indian tribes, and these are called the people of the Longhouse. And what they find is that this alliance gives these Native American Indian tribes a military advantage in the in America and a strategically strong position. Because of the alliance, they're able to travel beyond their own borders and conquer other Indian nations. Creating these other Indian nations as tributary nations or nations that provide tribute to the people of Longhouse. So, at one time, this was so successful that their domain reached north to the Sorell River in Canada, south to the Carolinas, west to the Mississippi and east to the Atlantic. These six nations were easily the dominant Indian Confederacy in the Northeast and Northwestern areas of America. Now, by the time that the Europeans arrived in the 1600s, what happens is there, the fur industry starts to boom. And because of this alliance that they had the this people along these 6 Native American, they also had not only a military advantage, they had a business competitive advantage and became main trading partners with the Dutch. And so then later that became um trading partners with England. And so the idea of this is the idea of mergers has been around a long time and, and ultimately, what you find is it provides opportunities for creating strength and strategic position. When it comes to ESOPs, um, mergers are, are very, you know, a big part of that idea. Now, we're not going to deal with external mergers. We're only going to talk about what we would call internal mergers because these are common issues that we find where companies, um, owners have multiple entities. And what we want to do is, is look at those issues early on in the process to create the ESOP strategy that maximizes um the elements of those, of those entities if it's possible. And so I want to start off just going with the very basic simple scenarios and then going to kind of our back to our scenario to explain how this process might work. And I want to start with a simple a simple scenario here is that you have one entity that goes through the ESOP process. With one shareholder or maybe one group of shareholders. Really not much to do here. We're gonna look at the Scorp C Corp um entity structure. We're going to look at their number of shares that they've authorized. We might clean up some stock certificates to get them ready for the transaction, but really not much to do with the entities because there really are none. The second is you have this multiple entities under one shareholder or a group of shareholders, but they're all the same exact ownership percentages. Now, in this case, You have um an entity that wants to sell to an ESOP. And in, in some cases, we have to deal with real estate. Now, um, the, the best scenario is we have um real estate that is held in a separate company, or separate entity, and it's leased back to the operating entity that we are trying to use, um, or we're trying to sell to the ESOP. So in that case, no problem, um, we're going to um look at the operating entity. But in some cases where we have real estate embedded in the operating entity, we're gonna have to work through how do we break that out and separate that um prior to the transaction. Now, in that, in that scenario too, you might have one entity with um sister companies or related companies, but they have the same ownership. In that case, we're going to really think about whether or not we combine those into a holding company or merge them together in some way. So that we take the one entity that we, we're um a composition of those multiple entities. Now, that's not that hard to do when you have the same ownership. It's just a matter of making sure that we've, we've put it in the right place in terms of, of the new entity structure, which we'll talk about in a second. The third scenario here is you have multiple entities with, with um shareholders that have different ownership in each entity. So, uh, clearly what we're looking to do is, is try to to transact just one entity for the ESOP. Now, the advantages of doing this, of getting through this are that you're going to have a, a stronger entity at the end, you're gonna have a stronger business. Um, it's going to be stronger because it's going to have inherently lower risk. It's going to have lower risk related to Um, having more diversification of revenue. It's going to have stronger risk because it's going to have more customers and less concentration of customers. You might even have multiple sales processes or different types of sales processes that, that work together in tandem to strengthen the whole business. You might have a larger footprint geographically, you might have, um, you know, really less dependence on one or two key people because you're gonna have a stronger management group, or maybe a deeper management group than you had before. Um, that's always, management is always an issue, transition of management is always an issue in ESOPs. If you check out podcast 2 and 3, you'll talk, we, we talk a lot about the process of doing management transition. So in the end, we have some really some strategic benefits of merging these entities, but the problem we are left with is you have, um, you have two different, you have owners that have different shares and what we want to do is try to bring them together in a fair proposition. So the first thing we need to do is understand what we're actually trying to accomplish and that the process of a merger, in this case can be either an absorption or a consolidation. An absorption happens when one entity loses its identity. So what we're doing is we're combining that entity with an already existing company. And as we go through that, the other entity is going to be liquidated and lose its identity completely. Now, the other way to do this is a consolidation. So what we're going to do is actually merge the entities into a new company, and we will form a, you know, a brand new entity. Now, some of the issues related to that are That we're not going to get into in too much detail is just what this, what this entity will do at the end. And in some cases, for instance, there are, um, one entity has maybe contracts that need to be continued in the same entity EIN number. So we may not be able to just get rid of it. We might have to, you know, put it together in a, in a, in a consolidation, but what we want to do is make sure we think about what that should look like at the end, um, to make sure we're going down the right path. So, the way that we look at it and the issue that we're we're dealing with again is, is how do we treat each of the shareholders fairly in this process. The model that we create for the business valuation is going to be very useful to help understand or analyze the two different companies and provide for um whether it's an absorption or consolidation, the value per share, so that the merge entity at the end um fairly represents the percentage ownership of each of the, of the owners. So, specifically, what we're looking at is um related to the multiple shareholders in different entities. Um, the complication here is that the expectation that one owner might have in terms of their evaluation might really be a problem when you get to try to pull that together and you do not want that to be a problem at the end, you want everybody to be on the same page. So, and, and in the end, what's gonna happen is, is you're going to have one company with this group of shareholders, and that's the entity that we're going to transact towards an ESOP. So how do we get the new shares reallocated? What's going to happen next is we're going to take each of the entities separately, and we're going to value those in their own valuation models. And We're gonna utilize um the two different methods, but basically under the income approach method and, and we're not gonna get too deep into these methods, but one is the capitalization of earnings method where we're going to look at the historical cash flow of each of the entities and we're going to value that cash flow stream using current capitalization rates. The other method is going to be using the discounted cash flow method and we're going to, um, for each entity, we're going to want to provide a forecast for um where their um revenues are going to be in the future and, and income so we can derive cash flow models from that and we're gonna take those cash flows and present value of them back to um using a discounted cash flow model. So then we're gonna have two different models with each of those entities valued. And so if we start looking at this with our, with our example, you're gonna have in the first case, we're gonna have Bill and Ted who own 50/50, the um time travel company. And let's just assume, for instance, that this company um was valued at a million dollars. And so, Bill and Ted each own a per share value of that company at 50%. When we apply that 50% times the million, we know that simply we're going to have $500,000 of individual ownership of that, of that entity based on the valuation model. Now, I'm really simplifying it because typically your capitalization of earnings method is gonna be um lower than the discounted cash flow, assuming your forecast is gonna have growth. Um, but let's just assume both of those converge at the same million dollar number so we can keep the model simple. Now, one step here is that your, if your business owners have less than 50% you know, ownership, You're going to have also to apply a discount for lack of control for that minority ownership, so that the owner who has more than 50% is treated with a control premium. So we don't, we're not going to worry about that right now, but it needs to be mentioned in terms of the steps that we go through. So the other model presents another valuation for Bill by himself, that is a 100% owner, and that's his entertainment company, if you remember the example. And we're going to simplify that and say that's a million dollars of evaluation too. So now we have two entities, both with a million dollars evaluation, and simply um Bill's valuation for the first is $500,000 and for his other entity, it's a million dollars. So Bill's combined valuation is $1.5 million. Ted's valuation is $500,000. So what we're, what we're concerned about is treating Ted fairly. And where Ted might feel, um, you know, because where we're going with this kind of intuitively, we know. That when you merge these entities together, Bill's ownership in the first entity is going to go up, and Ted's ownership is going to go down. And so how does TE feel about that? And because we want to make sure that they're both in agreement, we're going to walk through the, the way these models work so that both of them understand they're not being treated unfairly. And what's happening really is that The valuation that was established by Bill alone and his one entity had nothing to do with Ted. And in this case, um, Ted didn't own it, so it really doesn't have anything to do with what he's doing. So he doesn't really have any rights to that valuation. But now, when we start putting them together and we combine the values, what's going to happen is we're going to have a total value. Now, we're going to simplify this a lot because, you know, in consolidating these two companies, they're all types of entries that happen. That could eliminate things and, and so we're not going to worry about any of that. We're just going to say, we've done the math, we've consolidated the two entities, and we know that combined, they're worth $2 million. So, if I come back to the model, what that, what we're gonna then be able to do. I then look at what is um Bill's new ownership percentage and then what is Ted's new ownership percentage to, to better understand um how we should um create the merger with the new ownership percentages. So very simply, what that model is going to do is going to allow us to justify that bill's total valuation is $1.5 million of a total valuation of the combined entities of $2 million. So simply, if you do the math, he's gonna own 75% of the new entity. And Ted is gonna own if, if he has $500,000 and we're going to divide that by $2 million he's gonna own 25% of the new entity. And so, When we meet with Ted and Bill and Ted, and we explain that to him, um, Ted's gonna realize, first off, OK, he's been treated fairly because he still has the same amount of valuation. He hasn't lost anything. He still has the 500,000. So this is very, a very key issue because when you look at sometimes, um, the, uh, the impact of saying, oh, now I've moved down in my ownership percentage and, you know, I think that if, if business owners understand what's behind it, really, what's happening is you have You have a bigger pie and you're getting a smaller piece, you know, technically the percentage of the pie, but it's still worth more or still worth the same as it was before. The other thing to point out for Ted in this is that he now also has the opportunity that he didn't have before, which is this, which when you combine these entities, they um they have the potential to be worth more in the end. Now, because I wanted to keep my math simple, I kept it all at $2 million but the reality is, is that my my new entity would, would likely be worth more when you combine them because I'm going to have those um those risk, those less risk, um, in this new entity that was there before. So, so really, I would have more value, um, but I don't, I didn't want to confuse it and going into the example to make sure it was, it was simple in nature. So as we start off the ESOP transaction for both Bill and Ted, we're really gonna go into The ESOP transaction now to sell, OK, if it's a 100% ESOP sale, we're going to have Bill's going to sell 75% and he's going to get 75% piece and, and Ted's going to get 25% piece. And so that helps. Now, in some cases, we're doing a partial ASOP and the owners are selling only a portion. So that makes it, you know, really important because each of them maybe on a pro rata basis, are going to give up some percentage. And so this model is really important. And, and I think the next piece of it is to understand what we, what we did is we valued these at a point in time. And so up to the point of the actual date of the merger, that model would have to be updated to make sure that we've treated them, um, you know, um, fairly at the point of, of, um, the transaction date. So the difference between the evaluation date of when we did the evaluation for the modeling purposes and the transaction date of the merger are gonna be important to make sure we've addressed. And so we address that when we talk through the evaluation model, we're gonna go through each of those examples and say what could change in the next um 30 days or 6 months depending on when we pull the trigger on the merger so that they know that those percentages are, are estimated at that and they could change based on the change in the evaluation. So that kind of help helps to kind of wrap up the idea of, of what is an internal merger look like with the one issue of having multiple shareholders and how do you get them treated fairly within their percentages. So to close, I just wanted to close with a couple um um ideas behind um how this works in business and from a, um, you know, a evaluation standpoint and from, you know, uh a value standpoint. And so, Some of the most successful mergers include Disney and Pixar, um, and when you look at Disney and Pixar, um, certainly one of, um, you know, if you, you look at this entertainment company, um, they acquired Pixar in 2006 for $7.4 billion. And since then, they created movies such as Finding Dory, Toy Story 3, and WA-E. They've generated billions of dollars in revenue. And so in 3 years after the Pixar acquisition, um, they also set out to acquire Marvel for $4 billion. And so, again, you know, as we, as we think about what Disney's done, and it, and we know the movies and we know what they've created with these buying these different entertainment companies, they're really been merging those into the um The larger uh Disney entertainment company and becoming um so much stronger. So, considering that, um, after the merger, they made 11 Marvel movies, um, that has brought in by itself 3.5 billion. Um, since the acquisition. Um, you look at that and when they paid $4 billion for it, it's been such a successful, successful acquisition. And it's because it comes back to the same concept. When you put, put these things together, 1 + 1 is going to be more than 2. Obviously, it's going to be, and I put 1 + 1 equals 4. That's um not only Bill and Ted's math, but it's really the way that mergers work is you get more out of a merger in the end. So, I hope that really makes sense and really the, the point of it was to try to illustrate the, the, the step by step process we go through when we have multiple entities and how that works towards um transacting in ESOP. So thank you again for listening to the podcast. And I hope this was helpful. Um, again, if you like what you hear, please subscribe to the podcast um and share it with a friend. Um, and we'll look forward to our next time with you. Thank you so much.