EP52 - Inception Deception - Evaluating your business valuation

And here we are again. Thank you so much for joining today's episode on this journey to an ESOP. I am the ESOP guy and looking forward to spending a little time with you, whether you're driving your car or sitting at your computer, or wherever you might be, as we consider yet another topic on this journey to an ESOP. If you're interested in looking at any other episodes, if you're new to this podcast, please go to our website at journey to an ESOP.com and you'll find all of our episodes. So today I want to start this episode off with this. What's the most resilient parasite? An idea A single idea from the human mind. cities Can Rewrite all the rule Which is why I have to steal it. Recreate from your memory, always imagine new places. That's right. He's got to steal it, the idea. So, what a cool beginning of another episode. And I wanted to go into, as we talk about this movie trailer, you might have heard of it. It's called Inception. And so today's topic, the title of today's topic is going to be Inception, deception, evaluating the evaluation. So really, this is going to key in on this issue that we find for companies that are going towards an ESOP. Every company that's going towards an ESOP, let's just start off, say, you're gonna have to get a business valuation. Now, if you're going to go towards another direction, if you're going to go sell your company to a third party, if you're going to sell it to your managers, if you're gonna Uh, do something with your children and family gifted, you're still gonna have to get a business valuation. So this is going to be appropriate for any possible solution you have in terms of transacting or selling your business or giving your business to your children. And the reason is, in the business valuation world is, is so central to this is that you're going to be faced with the issue of reviewing the business valuation. So this episode is going to be really all about helping you better understand how to do that. And so, I know that this is a major issue and I think because I've done this for this business valuation uh process for so long. It's, it's like, I've seen so many different types of evaluation. So this is why this is gonna be such an interesting topic. So stay with us, please, if you like what you hear, subscribe to the podcast. And if you think it might help somebody that you know, particularly a friend, please share that, share this podcast with them and um And also, I guess I just want to say rate and review the podcast because um I know this is really more for the Apple phone people, um but rate and review the podcast because that's very helpful for people to, to see if it's a resource that they want to consider. With that, let's just jump in. This movie Inception stars Leonardo DiCaprio. And basically what you have in this movie is you got very smart people. They figure out a way. To hack into your mind as they go into people's dreams. And what they're able to do there, as he's talking about in the trailer, is, is plant false memories and put ideas into people's heads. So he's saying, I'm stealing ideas. What he's really doing is he's planting these ideas in people's heads, so as if they're their own ideas and, and he does it through putting memories and things in their dreams as if that's what they remember. And so when you get into that subconscious level of thought, it's very wide open. And I know it's a bit of a stretch, the movie is a bit of a stretch, but it feels when you watch it, it feels so plausible. And it's, you know, when you can let yourself go to that level of, hey, this is, this could be possible. Um, I think you can really, it's a really cool movie because it's, it's like a whole another level of reality that nobody ever really deals with in the movie world. So, In the movie, it gets really intense as they have to go into dreams and as they go in, they go into dreams within dreams and they go into different levels of dreams. So again, it's a little bit like, how do you even think about doing that? And they get to these very core levels of the subconscious, subconscious to in and plant these false memories. So I'm not gonna give away what's going to happen because I do believe you should see this movie because it is really Really cool if you haven't seen it. The special effects are crazy good, and it will keep you eating like all the popcorn if you're eating popcorn, um, whatever else you have around because it just goes fast and there's a lot going on. So just like the dream movie, what I wanted to do is talk about um where people have, you know, when in the dream movie, you know, they've got these false memories, how business valuation has the same impact. And you're gonna say, what, you're kind of pushing it, you know, ESOP guy. But what I'm gonna say here is that what business valuation does is it creates this emotional experience when it's your business. And when you get a evaluation report, the first thing we all do or we all would do is we're gonna go right to, well, tell me what it's worth, tell me what it's worth. So give me the number. And when the numbers more than you thought it was, there's this emotional um high that's gonna happen. I'm no scientist and I think that there's some kind of maybe dopamine effect where your brain just goes, whoa, whoa, my business is this, you start thinking about, you know, now that you can sell your business for X multiple, you know, you've now got your house in Colorado where you're skiing in the winter, you've got your house in in southern. France, where you've got all the different houses, you've got even your airplane, maybe even you've got, you know, um, you know, way more than that, you know, maybe you're, you're prepared now to run for president of the United States or something. Anyway, I'm sorry, it was bad, bad joke. Um, so, so kind of going through that process, there's an emotional high to experiencing what your business valuation is. So, When you, when you come off of that. And you kind of say, all right, let me, let me look at, and now some people are probably way more skeptical than I'm leading on to or maybe more, um, you know, calmer about the, hey, this is the evaluation report. I don't trust anybody, so I'm just gonna do this thing and I'll really read it and review it. So, those, for those people, you know, this, this is definitely one of the things I, I want you to, to continue to listen because this is gonna help you to read and review these reports. When the idea of selling your business for a big number starts to wear on you, um, what you really have to ask the question and just kind of like in the dream world, is this real? Is this for real? After around 16 years, and that's really not a super long time, but it's long enough, um, of being in the business evaluation world. I've really put together um and doing my own evaluation work and reviewing a lot of other work. Um, one of the things that we do in the evaluation world for continuing education. And we have to get continuing education every 3 years is to review what we call a case analysis in person report, which honestly is probably the most fun part of the training because it's, it's interactive and you get to, to talk to other evaluation people and you know, take somebody's Report and you kind of break it up and talk through the, the strengths and weaknesses of the report. All the other training is you're sitting in the room and they're talking to you and you're kind of listening and you're trying to make sure you're, you're um focused. So this is fun, and this is why this is gonna be fun because that's kind of what we're gonna do today. This um part of it, you know, as I think about the ESOP work is so important. And one of the things that I've gotten to do over the, the, the last several years is review our own Clients who are ESOP companies and the outside valuation reports on those clients. So that's always been a very important thing for my own education of understanding how ESOPs are valued. But the, the role, the key thing we're doing when we're reviewing the reports is that we're wanting to know, you know, what the, the report is based upon and so anybody can come up with a number on anything. We can all pull together, um, you know, some idea of a multiple and basically put apply that multiple of some revenue figure or even a figure, but it's the why and how and what, how did they get there? So what was their roadmap and thinking? So, as we do that today, I'm gonna, I'm gonna walk through that, but before I get there, I want to talk about the concept behind business valuation and the idea behind, is this an art or a science. You might have heard this before from other people when people talk about business valuation, not being as black and white as say accounting when you have an accounting entry and that's really only one way to make that accounting entry. So, uh, when you think about this, and this is why this is so important, is that a business owners, um valuation is like most business owners, their, their main net network, their primary net worth is wrapped up in the business. So it's really literally the most valuable asset that they have on the planet, or at least financial asset. One mistake that business owners make is assuming that they already know what their value is and, and they'll go into this idea of what their business is worth, you know, and this is where the art versus the science comes in with what we call rule of thumb or some type of, say, multiple of earnings because they know someone who sold their business um to somebody else and they've gotten that information. Um, so they went golfing with their friend, or they went somewhere to dinner and somebody's talking about what they're selling their business for. And so they're basing what they think about their valuation on that. And so as we start peeling that away, um, there's, there's really a lot that goes into how those deals are structured and there's a lot of, of reality to what it, what goes into an actual deal. And so part of this is to make sure that the paradigm Of the business owner that's going to review the evaluation report is You know, based upon the reality and the methodology of real business valuation and not what they think that they heard, they thought it was. So there's really two possibilities when you go through a evaluation with a, with a business client. One is they could be, they like the number, it's either more than they thought it was worth, but for whatever reason, it's something they like or they don't like the number and it's too low. So those are your only two, your only two possibilities. So, As we go through this, the, the truth is that buying a business is really not always simple or straightforward. So as we go through it, the, what we do is we really want to put ourselves as the reviewer in the position of the potential buyer who would be saying, conducting due diligence to buy the business. So that might be hard to pull yourself out of the, the seat that you're in if you're the business owner and it's your business, but I really want to encourage you to to think about that type of paradigm. So you're now evaluating your own business from those types of things. And the really the first step in any business evaluation is to collect data. And so as we go through this idea that, that, you know, this is really more the science part of a business valuation and the data is gonna include things like your financial statements, it's gonna include a financial forecast, it's gonna include tax records, um, other industry information, um, minutes from board meetings. So there's this quantifiable financial data and then there's this qualitative data. And they're both used when we start pulling together all, all of the data, they're both used. To try to quantify. Either and if I make it simple, if you're quantifying cash flow, you're quantifying a risk um by by building up all this information and this data. So, you know, even the story of the company matters and that sounds, that might sound, you know, far-reaching, but it absolutely does. So we, so in the business value based business valuation world, I don't want anybody to think that somebody's just putting numbers in a spreadsheet and then saying, hey, spreadsheet says it's this, that's the number, that's not how it works. The companies that, um, you know, really have a, a strong history of accurate financial information, um, companies that have a, a real strong company in other layers, so like succession plan. And they've established the layers of key people in their company. And again, as your size of the company grows, this is more important. There's risk related to the lack of that that could be, could definitely impact the evaluation. Um, so if you learn in that structure of, if you start digging into the details of the story of the company and you really look at not just the, the organizational chart and you look at each of the people, but if you start learning, for instance, that, that there's a key person that is planning on leaving the business, What is that gonna do to the, the actual business valuation? It's going to increase the risk. And therefore it's gonna reduce the overall valuation. And so those, those things matter and that's why you can't just take the, the financials and say your ebi as this, let's just come up with a rule of thumb multiplier and boom, here's your number. Um, I think that's very deceptive for the, the business owner if somebody comes in and has that type of, let's just say pitch or sales pitch to the business owner. Um. So as your industry, as you start talking about the industry, industry absolutely matters, right? You know, and, and it doesn't take a lot to explain this point because, you know, if we go through a crisis like we have this year, the first thing I would say is hotel industry, travel industry, anything related to conferences. Has been totally wiped out and who would have predicted that would have happened at the level? Nobody, but it affected the entire industry. And if you're in the, in 2008 and 2009, if you were a home builder, their industry got decimated. And then those are the negative industries. I mean, there's positive industry stories as well. So certainly software companies and technology companies. Any video, um, Zoom kind of companies, those are all booming. And so there needs to be an analysis and an understanding of what's happening in the industry. What are the potential trends of the industry? Have, has the industry worked through its cycle of the, you know, of emerging companies and maturing and then maybe on a decline. Those really matter. And so how that factors into your business. Valuation is gonna be very important. Every industry is gonna have some level of competition. If there's an insane amount of competition, obviously, that's gonna matter because there's a lot of price sensitivity to your, to your subject company. So a lot of this is just really as we start building the groundwork, I wanted to give you kind of some, some thoughts about, about the structure and some of the importance and I can't hit all of the, the real nitty gritty details of all of these. I just want to give kind of a, a good overview. So as we go into the analysis and we start to review this report in this podcast, I want to give you some, some things to think about. Now, let me, let me kind of segue into something, and I hate to pick on M&A firms, firms that do merger and acquisition work, because there are definitely very solid firms in the marketplace and I don't want to like try to say, hey, they're, these are firms, these firms do all this, but I think that this is a classic example, when you start being approached as your business starts being approached by all sorts of M&A firms. Now, the thing to understand about an M&A firm is that their job is to sell the company because that's how they get paid. So what their, their inclination is gonna be is going to be to make sure that you as the business owner are excited emotionally about the possibility of selling your business. So, the more they can get you excited about that, then there's the, the buy the, the sale process is I'm created with my client as the M&A firm a sense of urgency. Um, I've created a sense of urgency by doing a couple of things by showing you the business valuation was pretty good, by showing you the trends and that we're at this peak of, of, of, you know, it's a seller's market and, and there's all kinds of opportunities and so I want to throw that out and I, I want to do it very carefully because I don't want to say that M&A firms are bad and they're very, very important and they're, there's so many excellent M&A firms, but there are M&A firms that come in with this strategy of Hey, you know, we're gonna get you to go sell, you know, we're gonna get you down this track so that we can, you know, that's our business to make money at, at doing what we do. So, You know, I'm gonna use this as an example. So as they do that, they may do the business valuation up front for free. And that sounds like a good idea, right? Because at least you know what your business is worth. So you're, you're taking in that type of thought process before you move forward. Now, does this assume that the evaluation that they're gonna do is, um, is going to be, you know, a, a valuation that you can depend on and that's what we're gonna talk about because I think it's gonna help you to ask the right questions. Um, So as we go through this, keep listening because it's really gonna be important to start thinking about, you know, how you're being approached in the marketplace and what's gonna be important for you, um, if you do step into this idea of, hey, I'm gonna have an M&A firm, just do a quick a free valuation. So as we break down the fundamentals of evaluation and discuss each part, um, I just want you to, to think about um what you, what you, what your business looks like and how this might affect you. Um, the first thing I'm gonna do when I open up a valuation report, the very first thing I do in Um, it's just helpful is I'm gonna look at the table of contents. The table of contents are gonna give me a very quick summary of the approaches of value that that valuation firm went through. Now, in this case that we're gonna go through, there was no table of contents and because it really wasn't a fully developed valuation. But had it been, I could have looked quickly at the pages and as soon as I do see the pages that I want to go to, I'm gonna go to the financial sections um with the specific methods because that's really what's the most important part of it. So, as you go through that, the first, in this case, we're gonna go through it. The first thing we're gonna see in this sample case analysis that we're gonna go into is the kind of the overview. This is kind of, I, I don't wanna make it to like, You know, I don't want to be too negative about the report that we're, we're walking through, but it's gonna be the fluff of the report. It's gonna restate the obvious, this is your history, this is your, or this is your industry, this is where you are in terms of the industry. It should have some summary of the evaluation right at the front so you don't have to dig for it. Um, it's gonna include specifics about Not just your company, but it's also going to include something about hopefully the market and where you're the market that you're working in and just kind of a good overview. So in this case, they do all that and it's not too much narrative, it's just enough. um, and again, any good writer of any report, I mean, they're gonna have too much narrative because it it it eventually will just be like too much, you're not gonna read it. Um, but there will be enough in there to kind of make sure you know that there's enough detail in the narrative. That they know what they're doing. So it's more of a credibility piece and it probably is more of a regurgitation of, of facts that you already know about your business and you already know about your industry. The next thing you're probably gonna see are some really cool looking colorful graphs. So really cool looking colorful colorful graphs are important because what they do is they just kind of stand out and they might have some trends of M&A deal activity in your marketplace and multiples in that, in that market space. So it feels um like, first off, it, business people love graphs, we all know that. I love graphs and it pulls you, your attention to that and you From narrative to that, you might really draw in and say, wow, there's a lot going on in my industry and my the multiplier looks really good. So that it's kind of like, hey, I'm setting it up to get you to kind of like now, I'm gonna start kind of softening you to the idea that your business really is worth a lot of money and, and that's what we're gonna go into. So the, the first thing that we're gonna look at is what we're gonna call is a guideline company approach where we're taking public publicly traded data for these are public companies that are trading on NASDAQ or, you know, wherever in the marketplace and because they're trading on the market, and we can see them clearly all that data is available to us. So, This is data that's available to you, by the way, all you have to do is, is go into the market, find companies that do what you do, and then come up with some, some um analysis on that. But the problem is, is for most business valuations in the small to mid-size market, business market level, it's really hard to take a billion dollar company or billions of dollars of revenue, global operations, when they have layers of IP and technology and research and development and um you know, just incredible. Amounts of technology and access to capital that you don't have. It's, it's almost, I would say impossible to extract that. Now, you can, you can do that and you can try to create this. In this case, um, this, this kind of evaluation took all of the data for these billion dollar companies and they tried to mash that together into a report. That would show a multiple of EBITA. So this would be the terminology here would be your EV divided over your EBITA. So your enterprise value over the earnings before interest, taxes, depreciation and amortization. So from that, that gives me a, you know, a picture of, hey, those multiples are trading in the market, my multiple, you know, should be in that range somewhere. But again, you have to be able to as a evaluator. show how you have put that into your um subject company and adjust it accordingly based on the size. And so, if you don't do that, then you're just kind of um putting this up there and using it to over, I would say overvalue the company because they're a company that has, you know, billions of dollars of sales is definitely not like a company that has, you know, say $10 million or $50 million of sales. So without that, you need to immediately ask the question and, and get into the details with who, who did the report. So, I had, um, in, in reviewing this report, I had other reports in similar industries and it showed about half of those um multipliers on Ibita in terms of an actual report. And so I'm like, I know that this, you know, I'm just kind of using my own resources to kind of just determine and review this report and see if there's, you know, any Substantiation for using it. The next thing we're gonna talk about as we look at this report, we're gonna go into the the actual transactions. So these are companies that either private or public have actually sold their companies and, and there's data available for business valuation firms to find the types of transactions that fit within your industry so that you can determine whether or not your company that you have that you're valuing is similar enough. To support that type of sale. And so in that what we're gonna do is we're gonna extract the ones that are most similar and determine what their actual sales price was. Um, we're gonna again, we're gonna use ebi, you can use revenue as well. There's gonna be ways to base those sales to determine, hey, are we on, are we very close or similar? So that should give me an indicator of some type of multiple that has transactional backup to it. Now, in this case, as we review the report, I will tell you going through it. One was not even in the same industry that these people were operating in. One was a transaction that was like 10 years old, roughly, and then the other one was quasi-similar, but They really relied basically on only one comp in this, in this study that they did. And I'm like, yeah, that's not enough, you know, to give me a good indicator of value. So it is work to do this type of work. I mean, it is work to review all of these potential transactions. And sometimes at the end of that work, you as the evaluator are going to determine, hey, there's not enough comparable data. And I think in this case, with what they showed in their sample, they probably should have came up with that conclusion as opposed to, let's just keep trying to like milk this to get something out of it. And again, it leans into what they've decided is a much higher multiple um than other reports of similar sized companies after I reviewed those. So, In this case, you know, it was much greater than, um, you know, than what the other company that I reviewed would be. So it just kind of kept me thinking like this, this is definitely um slanted towards um I'm an M&A firm and I'm gonna sell you on a big multiple so you can kind of work from there. So again, 222 methods we just talked about the guideline company which is publicly traded data to get a multiple. The next is a transaction company. The third method is just really the income approach method. And in this, the what they approached was this this kind of cash flow method, which is a very sound financial valuation method and it's definitely something I would recommend um you look at. Now, the problem as we go into the details with this specific report is that there, first off, there's no background in how they created. Their capitalization rate, which is going to affect what we're gonna call um in, in valuation world as your weighted average cost of capital. So how do I get to that number? And if I can't find the actual way, all they're doing in this report, unfortunately, is talking about um the industry and pulling out. Out of the industry, what they think the industry would reflect in the weighted average cost of capital. But that's really not going to give you as the reviewer enough information. What you should be able to do is track through the source of the information and the methodology of creating that, you know, that capitalization rate that goes into the weighted average cost of capital. Which, well, the discount rate, which is part of the, part of the buildup model of, of developing a capitalization rate. One very popular way of doing this is called the capital asset pricing model. And the capital asset pricing model, if you go through it, will show you step by step how they got to those specific numbers, and they should make sense and those numbers should tie to the current market situation. And so, without going into a ton of detail, as I look at this report, They just came up with a weighted average cost of capital. They didn't explain, you know, the percentage breakdown between the cost of equity and cost of debt. They just kind of roll it together. And so when I explain it, what I want to do is explain the definition of weighted average cost of capital before I get too deep into the actual application of this. So weighted average cost of capital really is broken down into two components. And the first, as I, as I alluded to, is your cost of equity. The cost of equity is what I as a business owner is going, are going to require for a return on my equity. And I said, one way to do that is this capital asset pricing model. The other part of the What weighted average cost of capital is your cost of debt. So how, what percentage can I borrow money for? And so when you combine those two, you're going to get a weighted average cost of capital, but you're combining them by weighting one. So you may have 80% of your weighted average cost of capital being towards the cost of equity and maybe 20% towards the debt depending on your industry. And when you use the weighted average cost of capital, You're gonna have to make sure um that you follow very specific guidelines. And so, and in this report, there really is, there's a couple of things that I saw right off the bat that were not being followed. And one is you're gonna have to tax effect the cash flow stream. That means whatever you get in the, in your forecasted cash flow is going to have to be tax effective so that you're accurately showing on your cost of capital and accurate reflection of your own cash flow. So in this case, because they didn't tax affect the cash flow, the company actually was way overvalued in my opinion, because you're adding excess cash to your model. And the other side of it is, is I didn't agree necessarily the weighted average cost of capital, even though they didn't show what they had. As I did other research, um, I looked at their rated average cost of capital as being probably 600 to 700 basis points lower than what other reports had shown for similar companies in that space. So the combination of those two things really will be to really overvalue the company. The, the third thing I saw in their approach that didn't make a lot of sense was just in the way that they went through their math and anybody should be able to pick up a valuation report and be able to calculate how you got from A to B to C to D all the way through the math to say I got this was my total cash flow, and then I use that cash flow and I valued it with this, you know, maybe present value factor, and then from there I was able to come up with a conclusion of value. So that that's definitely suspect. When you can't just do the math and say, you know, that makes sense. I got, I figured out how they got from one place to another. Now, this is what I do for, for a living. So, you know, when I couldn't do it, I'm like, hey, this is definitely um Something's not exactly right here. So, going into that part of it, so then as they as they pull all of this together in their conclusion, What they, what they really do is they kind of come back and they say, well, the, uh, the main um focus or emphasis would be that this kind of cash flow model. We're still gonna allow the first model which we have these billion dollar company multiples, and we're gonna also allow the transaction company model. And so what we want to do to show that we've, we've treated every model fairly is we're gonna blend all those together. And create this, um, you know, this total conclusion of value, which when you look at it, that seems like they did a good job because hey, they did, they considered all these different models, but when you really went down and you broke down each one, there were very big problems within each one of those areas. And so, As we, as we start thinking about the conclusion here, and, and I think just to kind of end that they, they ended up percentage weighting each one and that that they thought is, is, I don't think, I mean, definitely having somebody review it for you makes a ton of sense. So, you know, if you, if you're building and basing a very big financial decision on this report, and I'm gonna tell you, I think most business owners that are going into potentially selling their company, whether that's being a third party. Um, maybe that's uh strategic buyer, or maybe you're selling it to your managers or you're actually going down this journey to an ESOP. You want to make sure at the very front end of your process that you feel absolutely confident about your business valuation. And I, I would say that in our industry as far as the ESOP goes, there's a lot of different variety of reports out there that people are doing, um, and it really kind of is up to you. It's like my, my wife would say this, you really do have to be your own doctor, especially nowadays. And not that I'm gonna understand everything that I Google about my physical health, but I really am responsible ultimately to make sure that I've done my due diligence. So, you might have had a good recommendation for the people that you're using, but definitely get a second opinion on your business evaluation before you start to make the decisions to move forward and engage people on the, the track that you are. So that's, that's my first advice and The second is Um, you know, is, is, first off, you know, I think sometime in our, in our model of doing ESOP work. As we've gone through it, one of the things that we always do at the very front end, even if somebody already has a evaluation report, is we're always gonna do the evaluation and, and, you know, report ourselves in the evaluation model. I believe that is the most conservative way to go before you jump into any potential deal. Um, and now what happens is a lot of times, sometimes you get approached by potential buyers and you're like ready to go. When that happens, my, my advice is to just kind of say, you know what, I need to, I need to do my own business valuation before you get into that conversation with the letter of intent or anything outside of that. Um, the process of going through an ESOP, you really do want to slow it down and look at that and understand all the factors that go into it. And a good valuation firm is gonna be able to explain as they go through the, the model, the report with you, the drivers of your company's value, and they're your consultant, and they really do need to help you walk through that. Now, this is not the same valuation firm that's going to do work for the trustee as you go through the ESOP process. The trustee, when you get to that stage of things which were really early on in the process was, as I'm recommending. The trustee is gonna have their own valuation firm and what they're doing for the trustee is what I'm telling you, you need somebody to do for you, because you need to understand the uh the impact, say for instance, your forecast is gonna have on your total valuation. You need to understand the impact of how succession planning and management transition have on your business valuation. You need to understand the concentration of customer issue and all the other things that go into it which we continue to explore on this podcast. But just overall, my biggest advice is find um a partner in that a company or an advisor where you feel really comfortable like they know what they're doing. I think that's the bottom line. Now, going into the report, hopefully you've heard enough to understand, hey, this is what I need to be looking for when I'm doing a review of the, of the evaluation report that was done for you. So with that, I want to thank you again for, for hanging out with us today. And this is again, this is so much fun for me to be, to me, for me to be doing. Um, if you like the podcast, please rate and review it on, if you're on the Apple phones. Um, subscribe to the podcast and please send it over to your, your friends if you think it might help them. We will see you next time on this.