S7EP35 - Foundations of Transition: Value Creation, Protection & Risk Awareness

I think what I want to uncover first is value creation and protection from the owner's lens, and how owners can learn to view the business through their own lens, but then also learn to view the business from an outside perspective—from the perspective of a buyer, a successor, or, of course, in our favorite topic and context, an ESOP trustee.</p><p><!--block-->So, we'll discuss where value is created, where it is leaking, and what could put that value at risk.</p><p><!--block--><b>Jason Miller — 2:07</b></p><p><!--block-->So, I'm excited to see where you're going to have me start.</p><p><!--block--><b>Makenzie Ragland — 2:10</b></p><p><!--block-->Yeah.</p><p><!--block--><b>Owner Lens vs. Buyer Lens</b></p><p><!--block--><b>Makenzie Ragland — 2:12</b></p><p><!--block-->So, kind of backing up to the perspective of the owner, who has their own lens that they're used to seeing their company through—years of history, relationships, and the effort they've put into their business—and then changing that perspective to that of an outside party: What would you say changes when an owner stops looking at their company as an operator and starts looking at it as an outside buyer?</p><p><!--block--><b>Jason Miller — 2:41</b></p><p><!--block-->That's a great question. As you were framing it up, the first thing that came to mind was the definition of success.</p><p><!--block-->When you say the owner is looking at the company as an operator, an operator looks at success as: Did we do it right? Did we get more customers? Did we keep our customers happy? Did we do good, quality work? Did it stay, or did it accomplish whatever it is that we do?</p><p><!--block-->If we build buildings, are they still there? If we perform a service, did that service serve its useful function for why people paid us for it?</p><p><!--block-->Then, the next layer is peeling back the success of operations to financial success. How much does an owner think in those terms? It's primarily revenue, costs, and profits.</p><p><!--block-->And then, if we're getting better as an organization, we might implement something like Traction or EOS to help us with the leadership component. We might want more financial literacy, like we've talked about with the Great Game of Business. We might implement KPIs and other performance metrics related to finances so that we get to determine what's successful for us as owners or as operators.</p><p><!--block-->And it doesn't always align.</p><p><!--block-->And, sorry, if you guys are watching on YouTube, that's my favorite thing. I talk with my hands, and I have this camera that tracks me. I'm trying my best not to talk with my hands in front of my face. Makenzie gave me this weird look because the camera moved.</p><p><!--block-->But it doesn't always connect the success of the business operating, the financial success, and then value.</p><p><!--block-->It's somewhat intuitive because it's like, "Well, if I'm doing good things, I'm going to have happy customers. I'm going to get more customers.

I'm going to be able to build a better product, build a better team that builds a better product, and it all just serves itself."</p><p><!--block-->But we get to a point where that business has to transition to someone else for value.</p><p><!--block-->So, what does a buyer look at?</p><p><!--block-->A buyer looks at a company as a source of cash flow. I'm buying future earnings, and then I'm taking risk to buy those future earnings, just like anyone would as they buy a stock on the stock market.</p><p><!--block-->It's: What do I think it's going to be worth? Is this a good time to invest? And what risk am I willing to take?</p><p><!--block-->So, I think that's the biggest bridge from owner to getting a perspective on how I should look at the value of my company. It's that transition of, "Okay, what are the future earnings that the other person believes they are purchasing in buying my equity, buying my stock, and buying my company? And then what kind of risk are they willing to take to do that versus where else could they put their money?"</p><p><!--block--><b>Makenzie Ragland — 6:01</b></p><p><!--block-->Yeah, I think you laid that out perfectly.</p><p><!--block-->I like how you mentioned that owners often view success as, "We did this." At the end of the year, they look back and say, "Oh, we were successful because this happened. We were able to do this. We hit this."</p><p><!--block-->As an owner, you may feel like you know exactly why your business is valuable based on those things. But I think the harder question is whether someone outside the business—a buyer—can see that, verify that, and believe that it will continue with or without you.</p><p><!--block-->Most often, it's going to be without you. Just for the sake of owners planning an exit, the goal is to exit.

So, believing it, as you said, is the big part of it.</p><p><!--block-->So, diving into where value is actually created, let's talk about what truly drives enterprise value, not just what may produce revenue today.</p><p><!--block--><b>Future Earnings and What Buyers Buy</b></p><p><!--block--><b>Jason Miller — 7:06</b></p><p><!--block-->Great. So, we'll expand on that last concept of future cash flows, future earnings of the company, and then the risk associated with what the buyer is willing to take.</p><p><!--block-->There are two parts to a formula to get to enterprise value. That's adjusted EBITDA—earnings before interest, taxes, depreciation, and amortization—which is a measurement of the operating performance or health of your company.</p><p><!--block-->What are you earning? What are your efforts earning? What is your success creating? What kind of cash is being distributed or able to be distributed to the new buyer? Why would they want your company? What is the monetary interest that they're buying?</p><p><!--block-->And we say "adjusted EBITDA" because every company is different. As a company scales, it usually goes beyond a lifestyle operation for a client or owner.</p><p><!--block-->Maybe I ran all of my expenses through the business. Maybe I took some vacations.

Maybe I have a hunting lodge and three boats that are all on the books that aren't an integral part of the business operations themselves, but that's just where those assets landed financially.</p><p><!--block-->They may or may not be producing revenue or expenses, but those need to get adjusted out, or up or down, in accordance with what the company is really producing that a new owner—or even the existing owner—is able to distribute.</p><p><!--block-->What is the monetary value of that?</p><p><!--block-->And then there are other adjustments. Do you pay yourself more than market? Do you pay yourself below market? And how does a buyer look at that?</p><p><!--block-->So, if you are a stellar CEO and president and you run a large company, and you're very—I'm trying to think of the right word, Makenzie. I don't want to say "frugal" or "generous." Those aren't the right ones. But let's just say that you're not interested in paying yourself very much every year.</p><p><!--block-->You pay yourself $100,000 for a company that makes $50 million of EBITDA. You'rea little out of market.</p><p><!--block-->So, if you leave, the new CEO is very unlikely to take a $100,000 salary for running a company that produces $50 million of distributable cash flow. So, there's going to be an adjustment that takes away from those earnings to attract the right talent to replace you in time.</p><p><!--block-->Those are some of the ways that we arrive at adjusted EBITDA, and that's how advisors and valuation firms arrive at it.</p><p><!--block-->So, then what's the other part?</p><p><!--block-->We have a number. We're going to pick a number. I used $50 million. I like that number. I hope many of you listening are doing that on an annual basis, or we'll get there soon.</p><p><!--block-->Every year is going to be different. No one knows what the future looks like. Forecasting is important. We're going to talk about that on another episode.</p><p><!--block-->But let's just say it's $50 million a year.

What would you pay for a company that produces $50 million a year of distributable earnings?</p><p><!--block--><b>Makenzie Ragland — 10:09</b></p><p><!--block-->Depends.</p><p><!--block--><b>Jason Miller — 10:10</b></p><p><!--block-->It depends.</p><p><!--block--><b>Makenzie Ragland — 10:12</b></p><p><!--block-->That's our favorite answer.</p><p><!--block--><b>Jason Miller — 10:14</b></p><p><!--block-->And that's where the other side of it is, which is either the multiple or the cap rate—capitalization rate. How do we think about the earning potential of this company?</p><p><!--block-->And then, if we're projecting it into the future, we have to grab it and pull it back to today. That's called a discounted cash flow method.</p><p><!--block-->If we're looking at an income method, which we normally do for ESOPs, we're saying that the probability of the future, the further out it is, is less probable than tomorrow because we know more about the facts that are going to create tomorrow than we do about five, ten, fifteen, or twenty years from now.</p><p><!--block-->So, all of that boils down into a risk factor, a multiple, or, again, a discount rate or capitalization rate.</p><p><!--block-->We can talk about valuation stuff all we want. Then you put those two together, and you multiply them or divide them.</p><p><!--block--><b>Adjusted EBITDA and Valuation Multiples</b></p><p><!--block--><b>Jason Miller — 11:10</b></p><p><!--block-->So, if we've got a multiple of six times $50 million, then you have $300 million of value.</p><p><!--block-->How do those shift? Where does that come from?</p><p><!--block-->The inverse of the multiple is the capitalization rate, as we've talked about.</p><p><!--block--><b>Jason Miller — 11:27</b></p><p><!--block-->And a six-times multiple is what, Makenzie?</p><p><!--block--><b>Makenzie Ragland — 11:32</b></p><p><!--block-->You're the math guy.</p><p><!--block--><b>Jason Miller — 11:40</b></p><p><!--block-->And that's expressed as a percentage.</p><p><!--block-->So, if you think about that as an investor, if you were to go and buy a stock on the stock market, you would expect a 16.67% return in exchange for the money that you would use to buy ABC Company, which you're willing to pay $300 million for.</p><p><!--block-->If you could get more for the same risk, then you would do that instead of buying ABC Company.</p><p><!--block-->If you would get more, or if you would get less for more risk, you wouldn't.</p><p><!--block-->You'd think about it as, "What am I expecting my rate of return to be as a buyer, as an investor?"</p><p><!--block-->And if I say that it's going to be 16.67%, that's what I should have each year. So, I'm willing to pay $300 million today because, in perpetuity, I'm going to end up getting significantly more from my $50 million of distributable cash flows.</p><p><!--block-->You didn't stop me early enough.

I'm rambling on, but I think this is good stuff.</p><p><!--block--><b>Makenzie Ragland — 12:46</b></p><p><!--block-->No, I think it's good.</p><p><!--block-->I guess, to highlight the qualitative factors that go into that cap rate or multiple, however you want to look at it, we know that from a quantitative perspective, the distributable earnings of the company are important and create value.</p><p><!--block-->But from a qualitative perspective, how much value comes from factors like recurring revenue, pricing power, customer loyalty, and management depth?</p><p><!--block--><b>Jason Miller — 13:28</b></p><p><!--block-->So, the Exit Planning Institute has what's called the Value Acceleration Methodology. I'd encourage all of you to go to their website and check it out.</p><p><!--block-->The idea behind that is that not every company is saleable. Even a $50 million EBITDA-generating company may not be saleable today.</p><p><!--block-->What are the reasons why?</p><p><!--block--><b>Jason Miller — 13:51</b></p><p><!--block-->Well, maybe it doesn't have any management depth.</p><p><!--block--><b>Jason Miller — 13:53</b></p><p><!--block-->Maybe there are no repeat customers. Maybe there's a total concentration in the existing customer base that puts it at risk.</p><p><!--block-->Some things have to be addressed—not using "turnaround" in a turnaround sense, but in the sense that there are qualitative factors that will impair the future earnings of the company or its ability to continue to produce them.</p><p><!--block-->And it does get to all of the things that you had just mentioned.</p><p><!--block-->Now, what if they're in place?</p><p><!--block-->That means the company is minimally viable for sale. I don't necessarily have a concentration issue with customers. We've got some loyalty. Our average customer lifespan is [X], and our revenue per client is [X]. There are a lot of ways to look at that.</p><p><!--block-->We have a great management team. We've got a reporting structure. We've got an operating system. We've got an ERP that makes a lot of sense.</p><p><!--block-->Now we have all of the pieces required for the company to continue to operate. So, that's minimally viable.</p><p><!--block-->And then there's best-in-class on the other end, which is everything that you mentioned. It's like a dream when a new owner would walk in.</p><p><!--block-->It's turnkey. This is just a machine ready for you to literally put the key in and turn it, and it prints money.</p><p><!--block-->That's more valuable than, "I've got all the pieces, money comes out, but I don'tnecessarily understand how it all comes out." Or maybe sometimes it gets jammed and needs a little bit of work and some elbow grease every now and again. We'vegot to do this, and maybe shine it up a little bit.</p><p><!--block-->So, not every company is viable for sale. But when it is, it has those pieces, and that's minimally viable.</p><p><!--block-->Then, on the other end of that is turnkey, or best-in-class. People are going to pay more the closer you are to turnkey than they are for, "I've got the pieces lying around, and you're going to have to IKEA this yourself."</p><p><!--block--><b>Makenzie Ragland — 15:58</b></p><p><!--block-->Yeah.

I think the key takeaway is that the value is stronger when it's understandable, transferable, and supported by evidence, and not just dependent on the current owner explaining why certain things work.</p><p><!--block-->So, let's get into the idea of where value could be leaking, or places where value quietly erodes.</p><p><!--block-->How can things like inconsistent margins and poor working capital management reduce value?</p><p><!--block--><b>What Makes a Business Saleable</b></p><p><!--block--><b>Jason Miller — 16:42</b></p><p><!--block-->The first thing that came to mind for me was working capital.</p><p><!--block-->And this is a component, listeners, that gets negotiated alongside enterprise value in determining how much working capital is required for the company to continue generating those distributable cash flows.</p><p><!--block-->There's a lot of room for improvement in many companies around working capital discipline.</p><p><!--block-->There are so many different ways to view it, but functionally, it's: How reliable are our accounts receivable? Do we have consistent bad debt or charge-offseach year? Is it a material amount? Why does that occur?</p><p><!--block-->Do we have good collection discipline? What are our AR days outstanding? Are we shrinking those? Are we making it easy for our customers to pay us when we have AR? Do we have enough people, systems, or processes to allow that to occur?</p><p><!--block-->And then the other side of that coin is not just collections and revenue, but payables and bills.</p><p><!--block-->What tools are you utilizing to manage your working capital? How far outstanding are your invoices for your payables?</p><p><!--block-->I don't want to say it's the worst part, but most successful operators don't like to owe anybody anything. They certainly don't like to owe banks anything, but they don't like owing anybody anything.</p><p><!--block-->It's a sign of health, mentally and psychologically, that, "Hey, when my bill comes in, we pay it. We make check runs every week, even though we're on net-30 terms or net-60 terms. We're going to pay the bill as soon as it comes in."</p><p><!--block-->And that is a use of cash.</p><p><!--block-->Actually, that's a source of cash. I got it backwards.</p><p><!--block-->That's a source of cash. If I'm able to rely on my vendor—the vendor says, "You don'thave to pay me for 30 days," but I pay you in seven—I gave up 23 days of free float.</p><p><!--block-->Which means there's a lot of stress now on my AR, the timeliness of that, and my cash balances.</p><p><!--block-->Those disciplines go together. How can I—if a vendor says it's okay to pay me in 30 days, they're not checking the mailbox on day eight to call you and say, "You've historically paid me on day seven, and now you're waiting. Where's my check?"</p><p><!--block-->And then you get to say, "It's net 30, so you told me I could wait 30 days. Let me wait the 30 days."</p><p><!--block-->But all of those are places where some value can leak because you require more cash if you're not borrowing from your vendors on the terms that they've given you.</p><p><!--block-->And then you are using cash by having it trapped in your balance sheet in AR and inventory.</p><p><!--block-->If you carry inventory, inventory turnover and your management system there need to be areas of focus.

That's a place where you can find some leakage.</p><p><!--block-->And where that will hurt you isn't just, "Hey, how much excess is here on the balance sheet that isn't needed to operate the business?"</p><p><!--block-->If it's inefficient, then each dollar of growth requires more working capital.99 clients that make up the other 10%, I think you probably know where your headaches are—until that one client that takes 90% of your revenue buys one of your competitors and insources the work that you were doing, same measurement or notoriety of your particular choices. During due diligence, they are going to ask about your history and some things that you're going to have to disclose and that are going to have. Therefore, it diminishes the value just a little bit.</p><p><!--block-->So, it's kind of a two-for-one hit.</p><p><!--block--><b>Makenzie Ragland — 20:20</b></p><p><!--block-->Yep. That's exactly where I was going.</p><p><!--block-->If you're in an era of focusing on value creation and growth, then managing your working capital is something to really focus on and understand.</p><p><!--block-->And one thing that came to mind that is something that could quietly erode your value, too, is the data that you're analyzing—your financials in general.</p><p><!--block-->Do you have strong financial reporting? Is it something that you're only looking at quarterly? Are you monitoring it monthly?</p><p><!--block-->Those are other areas that are maybe not as obvious, but you need to make sure you have decent financial reporting so that you're able to monitor your working capital and make sure you are managing it appropriately.</p><p><!--block--><b>Hidden Value Leaks in Working Capital</b></p><p><!--block--><b>Jason Miller — 21:23</b></p><p><!--block-->I think a really good question to ask yourselves, listeners, isn't, "Oh, well, I already do that," or, "I do do that," or, "I think we have our arms around it."</p><p><!--block-->It's: Now that I know what to look for, where can we get even better?</p><p><!--block-->Now that we know that optimizing working capital leads to a leaner but more valuable company, what can we do there?</p><p><!--block-->And the same goes for our reporting.</p><p><!--block-->"Well, we have great reporting. We have a great ERP system. We have an audit every year, so we know that everything's fine."</p><p><!--block-->It's: What more can we do so that we are protecting that value from leaking out, so that we can acknowledge where it is and then prove it to someone else?</p><p><!--block--><b>Makenzie Ragland — 22:11</b></p><p><!--block-->I think that is a nice segue into our next area here: risk awareness in relation to value and the overall company in general.</p><p><!--block-->How does that translate to value?

What risks would you say tend to concern an outside party—a buyer or a trustee?</p><p><!--block--><b>Risks Buyers Fear Most</b></p><p><!--block--><b>Jason Miller — 22:38</b></p><p><!--block-->The first one that comes to mind, and we've mentioned it a couple of times, is concentration risk.</p><p><!--block-->If my entire revenue stream relies on one or two clients that have the same economic cycle, and it is only protected by an individual relationship, then the risk is very, very high.</p><p><!--block-->We've talked before about owners not being bottlenecks, about processes and the key parts of relationships being handed off and distributed equally within an organization to protect against a move from a client that represents a significant portion of revenue.</p><p><!--block-->Because if you have 90% of your business with one client, and then you have 99 clients that make up the other 10%, I think you probably know where your headaches are—until that one client that takes 90% of your revenue buys one of your competitors and insources the work that you were doing.</p><p><!--block-->Now that becomes a very large headache for you.</p><p><!--block-->And that's a risk that you have no idea how it's going to happen.</p><p><!--block-->Do they shutter? Do they buy someone? Do they find an alternative path to what you were providing to them?</p><p><!--block-->There's always customer risk. There just is.</p><p><!--block-->But how much does your company as a whole bear for that customer risk? And then what do you do to minimize it?</p><p><!--block-->So, that's the first one that comes to mind.</p><p><!--block--><b>Makenzie Ragland — 24:17</b></p><p><!--block-->I just want to add to that that I think it's important to distinguish customer concentration.</p><p><!--block-->As you mentioned, maybe that customer is there because it has a great relationship with the current owner.</p><p><!--block-->Customer concentration can be seen as a normal business risk, but distinguishing the risk that could impair the actual transaction is important.</p><p><!--block-->In a transaction where the owner is eventually exiting, that's a different type of risk. It's not only that there is customer concentration, but also that the customer is there solely because it has a relationship with the owner.</p><p><!--block-->That kind of all goes back to the key-person dependency that we've talked about before.</p><p><!--block-->I think I threw off your train of thought there.</p><p><!--block--><b>Jason Miller — 25:18</b></p><p><!--block-->I think, no, that was great, and what you added was important.</p><p><!--block-->I'm just trying to go back to what you had listed out at the beginning because there was something else that came to mind when you were talking, and I can't retrieve it.</p><p><!--block-->It must not be important for this episode. We'll pick it up on another one.</p><p><!--block-->Other—other—other—oh, I remember what it is now. Okay, so it is for this episode after all.</p><p><!--block-->Listeners, you're not going to miss anything.</p><p><!--block-->One of the things that I think folks would think is softer, and it doesn't often happen, but it is out there, is reputational risk.</p><p><!--block-->If you think about your reputation as an individual and your reputation as a company, they're two different things.

But as ingrained as you are with your company, sometimes they're hard to separate.</p><p><!--block-->It gets more pronounced in larger companies, especially when founders or owners are very visible.</p><p><!--block-->If you think about a large publicly traded company—and I think we all can—and who the face of those companies are, whichever one you're picking in your mind right now, think about something bad happening involving that individual.</p><p><!--block-->Pick your favorite CEO of your favorite company, and then imagine a really terrible thing that would either happen to them or that they would choose to do.</p><p><!--block-->Makenzie, what do you think would happen to that publicly traded company's share price the next day if that individual who is responsible for leading that company made a horrible mistake and was charged with a felony?</p><p><!--block--><b>Makenzie Ragland — 27:21</b></p><p><!--block-->I would think it would go down.</p><p><!--block--><b>Jason Miller — 27:23</b></p><p><!--block-->It would probably go down, at least for the day, right? Maybe for an extended period of time.</p><p><!--block-->And while in a private company, you don't have that same measurement or notoriety of your particular choices; during due diligence, they are going to ask about your history and some things that you're going to have to disclose and that are going to have to be vetted out.</p><p><!--block-->So, in the middle of your due diligence phase—actually, no, at any time—do not commit any crimes.</p><p><!--block-->So, let me put that out there.</p><p><!--block--><b>Makenzie Ragland — 28:13</b></p><p><!--block-->Good advice.</p><p><!--block--><b>Jason Miller — 28:15</b></p><p><!--block-->Man, really delicate topic.</p><p><!--block-->But just to frame up the idea of reputational risk in a dramatic way, any criminality has a bearing on how your company is viewed, and any buyer is going to think about that.</p><p><!--block-->Other elements of reputational risk are more subtle, and I don't think people consciously think about them a lot.</p><p><!--block-->People typically think about, "How do people think about the things that we make or the service that we provide?"</p><p><!--block-->But they think less about, "Who are the people that we are working with, and how are they living life in a way that supports the values we believe they support, and what we're buying from them?"</p><p><!--block--><b>Jason Miller — 28:43</b></p><p><!--block-->So, a little chain of connection that is a risk nonetheless.</p><p><!--block--><b>Makenzie Ragland — 28:52</b></p><p><!--block-->So, I think it's important, when you're considering a transaction—whether you'realready in the process or preparing for it—to identify your risks earlier rather than having something discovered during due diligence.</p><p><!--block-->And I think even if there is a risk, having a known risk with a good mitigation plan is easier for an outside party to accept than a risk that management has never identified or thought about.</p><p><!--block-->Would you agree with that?</p><p><!--block--><b>Prepare Early Before Due Diligence</b></p><p><!--block--><b>Jason Miller — 29:26</b></p><p><!--block-->I think you had mentioned key-person risk.

That can be very damaging.</p><p><!--block-->And so, that will lead to another topic of ours that we'll cover in the next few weeks around incentive and compensation, how that aligns with the goals of the company, and how that contributes to a more successful ESOP and an ownership mindset.</p><p><!--block-->Those are things that every buyer, every trustee, and every valuation firm are going to look at for every transaction.</p><p><!--block--><b>Makenzie Ragland — 30:05</b></p><p><!--block-->Well, I think we covered a lot of good stuff today through value creation, protection, and overall risk awareness.</p><p><!--block-->I would say the big takeaway is that the best time to discover what an outside buyer might question about your business is not during the transaction and not during the due diligence process.</p><p><!--block-->It's while you still have time to strengthen your answers.</p><p><!--block-->So, thank you, listeners, for joining us for another Foundation of Transition.</p><p><!--block-->And if you are enjoying our series, please stay tuned for the next one—our 10th—in October.</p><p><!--block-->And if you are just listening for the first time, go back and listen to the first eight.</p><p><!--block-->Thank you for joining us.</p><p><!--block--><b>Jason Miller — 30:51</b></p><p><!--block-->Thank you.</p>