EP22 - Before it Erupts - Kaboom! Working through business volatility

Thank you so much for joining us today. I'm the ESOP guy and let's continue on this journey to an ESOP. Now, if you're just joining us today, and this is your first episode of the podcast series, this podcast is really designed to help individuals and business owners to better understand the ESOP process and they may want to use it to, uh, as a growth strategy in their business or a succession strategy or maybe even an exit strategy, um, you can, you can do a lot of different things with ESOPs. One of the things I've been doing with this podcast is I've been interviewing different ESOP professionals. Today I'm not going to be doing that, but I wanted to uh say that those interviews have been very, very informative. And if you are looking for a specific topic, I think there's specific perspectives from ESOP professionals that are really helpful, um, from the interview perspective. And for ESOP professionals that are listening to this podcast, I, I encourage you to give me feedback and reviews. The, uh, the goal of this podcast is really to provide a great resource to individuals and business owners to look at ESOP as a, as a potential strategy and to promote ESOPs as a very viable strategy in the marketplace. And we would love to work together if you were listening, so I just encourage you for your feedback. And if this is your first time joining the podcast today, again, go to journey to an ESOP.com for all of the episodes. The title of today's episode is before it rupts, Kaboom. We're going to get into one of the major problems for ESOPs or for companies trying to go towards an ESOP, and that is business volatility. And we're going to get into the solutions related to companies that are maybe not ready because of business volatility to go through the process, but still have a desire to do, to do just that. If you like what you hear, please subscribe to the podcast. It is absolutely free. And it really might be helpful to someone you know, so please share it with a friend. Mount Saint Helens is most notorious for its major eruption on May 18, 1980, the deadliest and most economically destructive volcanic event in US history. 57 people were killed, 250 homes, 47 bridges, 15 miles of railway, 185 miles of highway were destroyed. Mount Vesuvius on the west coast of Italy is one of the, is, is the only active volcano on mainland Europe. It is best known because of the eruption in 18079 that destroyed the cities of Pompeii and Herculaneum. Mount Vesuvius has erupted more than 50 times. One of our favorite movies in our household is called The Secret Life of Walter Mitty. And in the movie, Ben Stiller skateboards down a mountainous road right before a volcano is going to blow. When he gets to the bottom, a stranger tries to save him by saying, erection, erection, but he's really saying eruption. And so when Ben Stiller realizes this, he, um, jumps into the car and the both of them get away just barely surviving the volcano. So like a volcano, Sometimes a company erupts and has major issues and, you know, those could be given all kinds of circumstances and it could be just the economy and the economy caught up with all of us in certain ways with even COVID-19. Um, it could be they did a bad business deal and they're trying to work through it and that created a lot of uh financial disruption for, for a cer uh for a certain period of time. Uh, could be employee issues. They might have some major employee problem, they could have lost a key, key person. But, so what we do know is every business, no matter what. It's always working through issues. And the businesses that do that more successfully, you know, are usually more successful. And so, um, there are, as businesses don't work through those or they become piling up, sometimes it really does affect uh who they are. And sometimes you might have a financial history with, with disruption, but the issue's been really worked through and it's, and it may mean that you're still a viable candidate for an ESOP. So when we evaluate a company for going towards an ESOP, one of the things we are looking at is the history of the company. If we see that they have disruptive financial years and lots of volatility, then we know it's a major flag and and a negative, um, in terms of working towards an ESOP. Primarily, this is going to look, we're going to look primarily at the cash flow. So volatility of cash flows is going to be a main um issue that we're going to focus on. Because cash flow really does need to be fairly predictive. The issue that we look at on one side is you have an owner of a business, and they're kind of used to a lot of peaks and valleys. And for them, it's probably maybe a normal thing, and they usually work their way out of it. But the problem is the potential buyer in this case is. Is the trustee and the trustee, um, especially when looking at a leveraged transaction, is concerned with the, uh, the risk of that transaction based on who they represent, which are the shareholders of the ESOP. And so they're in a position not to try to take a risk, but they're in a position to try to mitigate the risk to make sure that they've made the right decision. And when you have uh the the payment stream of the debt obligation being volatile, Then it makes it much more difficult for them to put a deal together. And so that's why it becomes a major issue when we start focusing on it. Now, there are signs that the company is going to have volatility issues when you, when you look at the historicals, obviously, that's one indicator, but it's not always the indicator, even if you have a company that doesn't have any history of volatility, there may be other issues that would lend themselves to um thinking that the company may blow up based on on what might happen in the future. So a good example of this might be a company might have a very good product, very good service, a very good market, um, where they sell that product or service or product and the product itself is being derived from one main supplier, and the company has 0 other suppliers. Nobody else can produce what they're using. Now, clearly, that is a very high financial risk when you start thinking about it. So in the event that a supplier goes out of business, the whole, the whole business of your, of your uh client becomes very disrupted and could even go out of business. So one of the things that happens is when you work through an ESOP transaction is looking at those suppliers, making sure there, there are backup suppliers is going to be important. Um, and it, so there, there are indicators of potential volatility and then there's indicators of actual volatility. And so what we do is try to make sure, um, and really analyze each of those, which is, is really important. Now, why is this such an issue? Um, you know, and I'll get into a little more specifics just so it can be better understood. If we are leveraging the company, which means we're adding debt to the company to buy out the, the owners. Typically that leverage is going to be a substantial um burden for the company to work through and One of the, the value of values of doing an ESOP, especially as an S corp, is that we're, we're entering into a tax-free entity and using those tax payments or that tax that was paid to the government now to actually pay those, those debt payments. So it provides a um a mechanism. So when you don't have positive income, so you definitely don't have positive income tax, it's going to be added back in the model. So that's one of the reasons when you look at Having your payment structure built around the cash flows, and those cash flows are are volatile, then it becomes difficult to actually build the ESOP and make it and make it a good case. The valuation is going to be based um as we base it fundamentally on cash flow. So if the valuation, um, or if the cash flow is less and impaired, then we're also gonna have a lower valuation. So, um, that would actually be a hindrance when we impair valuation to the selling shareholders saying I actually want, want to transact. So, so that's gonna be another issue and reason that we're gonna be looking at this as a, as a major issue. So what can you do about it? And, and we really want to focus this, the next part of the episode really on the solutions related to managing through this issue. Now, the first thing to say about this is that if you're trying to do a transaction in the next year and you have business volatility, a business volatility issue, then I don't think that that's going to be, you know, a feasible situation for you. And And what we need is time. And so a lot of times we, we go through uh the uh uh a seminar or some type of webinar or some type of, of information, what we're saying is give us, give us 5 years before you start planning out your ESOP. And the 5 years gives us opportunities to work through these issues and it, and it may be in a 5-year plan, you're not even ready to do it within, you know, that 5 years, but Um, we know that working towards this really does a lot of things. It may be even that you don't have a volatility issue, or maybe you have one that's, it's kind of a volatile issue, but it's not as, as extreme as others. All the work that you do in that very early planning helps to do multiple things. It helps to increase your valuation and it helps to um have a better predictable cash flow, reduce risk, um, and make the transaction a lot more feasible and Um, make that process when you go through your knees up a lot more fun as well. So if you want to have fun, just go through pre-planning on on ESOPs. Anyway, so looking at um the solutions related to business volatility, the first thing I'm going to start with is, is in general, and then work our way down kind of specific. The, the business model has to be really considered. It has, you have to start breaking apart. What are the major issues related to your business volatility. And I think sometimes what happens with companies is, is they keep moving forward in what they do and they don't take the time to stop and do a strategic plan or business plan. Uh, they don't take time to really evaluate these issues because they're getting by and they're and they're it it's working, at least it's working in their minds. And so I think that's incredibly important is to stop and really consider the business model. As a business consultant, one of the areas that I get involved in is helping companies address their strategic and business planning process. And what I do is I go right to the 5 key areas of business and I'm going to focus in on finance, marketing. Human resources, technology and equipment, and their operations. And we're gonna go and we're gonna assess each one of these uh key business areas, because what we're looking for. Uh iss issues related. To the whole business model that become disruptive or could potentially become disruptive. So it could be, for instance, we examine the marketing area and we find um that there the sales process that they're, they're under right now doesn't maximize the potential. And when you, when you ask the question, how many outbound sales calls is your sales department making? And the, the sales department is really just following up on leads that they generate from their website. Well, we know that there's potentially opportunity to grow the business. Because their sales program could be enhanced with uh a new process and a different process that continues what they're doing, but what, but expands the other. It may be that we look at the financial area and we look at the business' cost of goods sold, and we realize their gross margin is way lower than what the industry is showing and there might be opportunities there. So we help to try to help isolate those issues. Um, so in the event that if we have a lower gross margin, we might look at how is their pricing done and is there a potential for the business to increase their price. And how would that affect their overall revenue? So if we would increase prices, we may have less revenue in in the model, and then we need to go back to the GNA expenses and start to determine what potential overhead is not essential. And then we would examine the suppliers and the direct labor to determine can we reduce cost of goods sold. So if you, if you're, you're basically walking through that. To determine what areas really are able to work on. And I would, I would strongly encourage you if you don't have, um, you know, as your leadership team meets, if you don't have retreats and strategic retreats, I, I would strongly encourage you to do those. I would strongly encourage you to hire the business advisors, the consultants that can help you focus on those types of business goals. I think a business advisor's strength is that they come in from an independent perspective and that they, they're not, um, jaded by the past, they're not biased. They don't have connections between your team members and, and if they're really good, I think they can help you isolate the issues. I'd be aware, but be wary of coming in and having someone doing a big consulting report for you. Um, I think that those types of engagements are difficult because you have to sort through what they think and a lot of times what they're using is some kind of consulting program. I think what, what my experience is is it's much more valuable to have a collaborative consulting engagement with your advisors and your consultants where you're working in together on these issues. And it needs to make sense, right? So, so always try to, to bring back this within reason. So if I, if I change these certain things in my business, how would that affect my, my plan? And then ultimately what you're gonna want to do is put that together into a financial pro forma so you can predict the potential results of the changes. So everything that you do conceptually, try to move that into a financial model so that you can truly see the effect and the changes on your business. Now, there's so much to talk about with business consulting and and I wouldn't have time to go into everyone, but I wanted to give you kind of a quick example of that. I want to also address the other side of things in terms of a company that says, you know, we do have some disruption. We don't, we're not ready for a leverage transaction. So recently, I did a podcast with David Joffe from Nashville, who is an ESOP attorney, and we discussed the idea of doing a non-leveraged ESOP. And so one of the solutions I wanted to um contribute to the podcast episode today was to just talk about a non-leverage GSOP as being a potential solution for a company that has, has a bit of disruption, but isn't ready to take on debt. So in this case, what happens is a non-leveraged ESOP does not borrow money. So that's why it's non-leverage. There's no debt. Um, they could either do a redemption of that stock from the shareholders, or they could issue new stock. In this case, what I would say is, is the company issues stock. And and now the event of that of doing that is going to be, it's going to dilute the existing shareholders value. But in this case, where you have a company that has some disruption, their value is already lower than it needs to be anyways. And so, The value of doing this and let's just say we did it for a company that had a financial disaster or disruption, and they were just trying to get back on track. One of the key advantages is that we move the company towards an employee owned mindset and we're we um are communicating culturally to the company's employees. This is um our company. And I think it's a very powerful message and it's, and it's certainly something that I'm going to dig into in these episodes going forward. But how do we, how do we positively affect the message? But once you start that process, one of the major benefits of getting the ESOP started is you're going to retain really good people. You're going to motivate those people towards a a business goal that everybody um will be able to, to join in on so that everybody will share at the end of the rewards of that business goal. So it starts the process that I think is so important. So if we, if the non-leverage ESOP basically gives us the opportunity to begin as opposed to waiting and waiting and waiting and telling people it's coming, it's coming, it's coming. Um, so I think that's one valuable benefit of it. The second valuable benefit of, of doing a non-leveraged ESOP in this case would be to take advantage of the tax benefits related to the portion of the company that goes ESOP. So let's just say we only did a 10% non-leveraged ESOP. Well, 10% of the company now is not paying any taxes. That's going to free up some cash that we can use to fund the plan that we just talked about and we may be, we've expanded the sales department, so we need to hire some key sales people. It may be that we did some key marketing on in certain areas with uh with the website. It may be that we have um redone our processes and our facilities and that cost us money as well. So, So obviously in business capital is such an important element of, of success. So what that does from a tax standpoint is it frees up capital for you and your company to, to work towards a more successful um uh company strategy. And then once that's set up and you start to build some success. I think the idea then too is how do I use this ESOP strategy towards other goals. So it may be you become, um, and the goal here is to remove business volatility, but once you work through that issue, now you're in a, in a key position. To affect growth, succession, and exit of, of existing owners. So, so now what we can do, we might want to maybe do a bigger ESOP, and we could always do a leveraged ESOP down the road. So, so one of the things that a non-leveraged ESOP does is it doesn't preclude us or exclude us from doing a leveraged ESOP. Um, we may do as we get more and more money in this, and we may contribute more and more shares and So there's a lot of, a lot of options when it comes to starting the process. And I, that's why I thought, you know, as we, as we think about a disruptive company, sometimes we just dismiss that as even an option. And I, and I think that that would be um The wrong thing to do as an ESOP professional or adviser as you start thinking about your clients is that, is let's look at all the options on the table. And there are sometimes we just work towards some business consulting to get them on, on track and they, they don't do anything, say, with the non-leveraged ESOP, but working through the processes are really important. And just knowing and believing in that those processes is essential as any business owner, you have to believe in it. So, as we look at this issue, I wanted to finish with um one of the greatest volcanoes that I could come up with in all my research, um, and it is pronounced Krakatoa, and Krakatoa, in 1883, this volcano on the Indonesian island of Krakatoa erupted with 13,000 times the power of an atomic bomb. The sound of spewing smoke and rock was reportedly heard thousands of miles away as far as islands off the eastern coast of Africa. Hundreds in a nearby Sumatran town died almost instantly when flaming ashes incinerated their homes, and many more were washed away by subsequent mega tsunamis. An estimated 36,000 or so perished in total. Krakatoa itself then slumped into the boiling depths of the ocean, but a new island at the site was spotted in 1927 and it still occasionally spits lava into the sky. And so If you think about the, the largest volcano that I could come up with, um, the encouragement behind this is our businesses are, um, obviously never gonna be as destructive as that, but it is, um, To understand that we can make a choice to change the way things happen in our business going forward, looking for these signs of, of eruptions and disruptions in our business, um, and go towards those places where you have financial goals and business goals. So good planning and forward thinking go a long way in business. So with all of that, if you like what you've heard, please share it with a friend and subscribe to the podcast and have a great day.