1
Forecasting Profit & Loss for ESOP Valuation
Presented by:Dan Markowitz, CPABoulay PLLP7500 Flying Could Drive, Suite 800Minneapolis, MN [email protected]
Chip Brown, CPA, CFAFirst Bankers Trust Services, Inc.1230 Peachtree Street NE, Suite 1900Atlanta, GA [email protected]
Michael Yi, ASA, CPA, TEP, MBANewport Valuations, Inc.23 Corporate Plaza Dr. Suite 150 Newport Beach, CA [email protected]
• Introduction/Overview• Related court cases• Valuations methods• Forecasting profits and losses• Impacts of improper projections
Today’s Agenda
2
Overviews and Disclaimers
3
• A beginner session
• Provide a basic framework for understanding forecasting profit and loss
• Factors to consider
• NOT a legal update – More on common topics related to the projection
• Cases do provide insight into DOL focus on projections
Setting the Table
4
• Projections are the #1 issue in ESOP litigation• Majority of ESOP litigation involving valuation issues • Projections were the issues involved• Process/Settlement agreements focus heavily on projections
• Valuation of ESOP Companies • Most common is Discount Cash Flow Analysis• Relies on financial projections• The value of a company’s assets are the future cash flows
generated by those assets• The value of a company is based on the future (not the past)
DOL Perspective on Projections
5
Tim Hauser of the DOL:
“I see the use of aggressive and unrealistic projections as a chronic problem with ESOPs.”
“People need to think hard and perform some level of scrutiny related to the projections. And in the cases we bring, we just don’t see that.”
“We just see management projections getting plugged right in to the ESOP appraisal without a critical review. Everybody moves on and does their math based on these management projections without ‘kicking the tires.’”
DOL Perspective on Projections
6
Questions that should be asked about the projections:
• How do the projections compare to the performance and projections of the company’s peers?
• How do the projections compare to the historical performance of the company?
• How plausible is it that the company could really go forward with these projections?
• How volatile or sensitive are the projections to various assumptions?
• What happens if there is a recession?
Source: Tim Hauser of the DOL
Settlement Agreements with DOL
7
• Who is responsible for projections• Any conflicts of interest• Document the reasonableness of projections• Comparison to 5 year historical averages/medians for
company and comparable public companies:• Return on assets (ROA) and Return on Equity (ROE)• EBIT and EBITDA margins• Cap ex as a % of sales• Revenue growth rate• Ratio of free cash flows to sales
• Document any projection adjustments and why• Ability to service the debt
Projection Issues in ESOP Litigation
8
• Using financial performance estimates that are inconsistent with the actual financial performance of the company
• Aggressive and unsupportable growth projections• Competitive position not supportable• Failure to account for declining performance within
company and broader economy• Failure to consider customer concentration or cyclical
trends• Unduly optimistic operating margin projections, out of
line with projections within the most analogous industry
Conflicts of Interest
9
• Preparation of Projections • Financial advisor to seller prepares the projections• Projections prepared by the valuation firm (not ideal)
• Management Motivation • Incentive to provide overly optimistic projections
• Relying on Projections• Can still rely on projections where an apparent conflict of
interest may exist• Conflict should be examined and documented
• Documentation of Conflict of Interest • Document in writing• Trustee and Valuation advisor dealt with conflict of interest
Projection Issues in Recent ESOP Litigation
10
Projection Issue Tota
l (17
Cas
es)
Toba
cco
Rag
Sonn
ax
SJP
Sent
ry
Cact
us F
eede
rs
Rem
bar
Com
mod
ity C
ontr
ol
Grub
er
AIT
Parr
ot C
ellu
lar
Grap
hite
Sal
es
Mon
a Vi
e
Big
G Ex
pres
s
Brui
ster
Sier
ra A
lum
inum
Mar
an
Cons
telli
s
Customer Concentration 5 X X X X XInconsistent with Industry 8 X X X X X X X XInconsistent with Historical 9 X X X X X X X X XEconomy 3 X X XRevenue growth rates 11 X X X X X X X X X X XMargins 9 X X X X X X X X XCyclical 1 XLong-term growth rate 2 X XNo DCF 2 X XCompensation 3 X X XCapital Expenditures 1 X
Parrot Cellular - $4.2 millionTobacco Rag - $4.5 millionSonnax - $2.45 millionSJP - $8 millionRembar - $1.1 millionMaran - $6.6 millionGruber - $1.1 millionAIT - $7.1 millionCactus Feeders - $5.45 millionMona Vie - $19.8 millionBruister - $4.5 millionSierra Aluminum - $5.25 millionConstellis - $29.8 million
Settlements/Judgments Related to Projections
11
Management:• Prepare & take responsibility for projections• Develop support for key assumptions
Company/Seller Advisors:• Review for reasonableness before “published”• Help management substantiate key assumptions
ESOP Valuator:• Review, understand, question & scrutinize• Compare with past performance & industry trends• Assess level of conservatism & aggressiveness
Roles & Responsibilities
12
ESOP Trustee:• Review, question, understand & scrutinize• Understand valuator’s analysis of projections• Ultimately approve the value conclusion based on projections
and valuator assessment of them
CPA Firm:• Coaching on preparing transaction
Roles & Responsibilities
13
• Forecast should be prepared by the management team • Management is responsible for achieving the forecast • Seller or sell-side advisor is not held accountable
• General forecast rule of thumb• Not deviate significantly from past performance or • Not deviate from industry trends • Need compelling evidence to support deviations • Forecast should reflect a realistic probability of achieving• Include sufficient investment to accommodate growtho Personnel, CAPEX, working capital, etc.
• Beware of “recency bias” • Building a forecast off last year• Last year was the best/worst/ year ever• Consider past historical performance trends
• Impact of industry trends & cyclicality
Management Projections
14
Risks of Not Preparing Projections
15
• Projections need for DCF method • DCF is the preferred valuation method by the DOL • DCF cannot be utilized without projections
• Growth outlook of company in selecting multiples• Cases with DOL criticism for failure to use a DCF
method (as discussed)• Questions to be answered
• Should a prudent process include getting and analyzing projections?
• Would a hypothetical buyer purchase the stock without projections?
• Creating projections not just a valuation exercise, but also can be a corporate planning and budgeting exercise
• Not just a valuation exercise• Strategic/Corporate planning
• 1, 3, 5 year planning • Understand what is happening in the business
• Cash flow Needs• Future cash flowing planning• Acquisitions, Capital Assets, Organic Growth, etc.
Benefits of Preparing Projections
16
Analysis of Projections
17
EXHIBIT 1ABC COMPANY, INC.
YEAR-OVER-YEAR COMPARISON OF MANAGEMENT PROJECTIONS
Fiscal Years Ended on or Near December 31,Financial Valuation 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023Fundamental Date $000 $000 $000 $000 $000 $000 $000 $000 $000 $000
Revenue Dec-13 112,003 121,842 128,992 138,490 147,802 Dec-14 110,986 118,290 126,399 141,321 151,232 162,948 Dec-15 124,320 131,873 144,212 153,800 164,889 172,092 Dec-16 130,231 152,242 158,373 172,092 176,921 187,366 Dec-17 155,653 160,343 175,634 180,343 195,245 202,340 Dec-18 162,342 178,345 184,334 197,345 204,523 210,424
EBITDA Dec-13 10,234 10,834 11,123 12,563 13,245 Dec-14 9,823 10,201 11,023 13,241 13,743 14,039 Dec-15 11,034 11,287 13,878 14,213 14,989 15,632 Dec-16 12,322 14,234 14,388 15,434 16,342 16,776 Dec-17 14,987 14,034 15,678 16,898 17,982 18,234 Dec-18 14,894 15,989 17,369 18,453 18,878 19,324
*Actual results are highlighted.
• Growth Rate Assumptions:• Historical• Industry projections• Comp projections• Capticity to grow
• Customer Concentrations:• Terms of Contract o Termination clause
• Can the customer be replaced• Financial stability of customer o Review of their financial statements
Analysis of Projections
18
• Industry Trends:• Is there a shift in the industry?• Long-term industry forecasto Trade publication, economic indicators, etc.
• Status of industry business cycle• Industry competition o Barriers to enter
• Political effect or national election
• Business Segments:• Discontinue of segment • Profitability by segment
Analysis of Projections
19
• Business Trends • One-time vs. recurring revenue streams • Payments terms on revenue stream • Fixed vs. variable costs
• Talent • Current capacity • Ability to hire additional people o How long will take
• Impact of retirements
Analysis of Projections
20
• Suppliers• Key Suppler agreements• Can the Supplier be replaced?• Termination provisions • Can supplier handle growtho What is the suppliers capticity?
• Financial stability of supplier
• Risk Adjusting Financial Projections:• Who prepared them • History with projections • Any warning signs about the projections?
Analysis of Projections
21
• Gross profit • Inline historical trends
• Capital expenditures• Support growth of the projections• Capacity availability
• Corporate tax rate • Valuation as if a C-Corp • Tax rates matter even 100% S-Corp
• ESOP Compensation • Normalized retirement benefit level
Analysis of Projections
22
• Executive compensation/employment agreements• Need to ensure that these are reflected properly in
projections
• Deferred compensation agreements• If not in the projections, need to be reflected somewhere in
the valuation
• Stock appreciation rights/stock options • Current debate about whether SARs/stock options issued as
part of transaction should be included/reflected in valuation. DOL says yes.
• ESOP contribution expense • Arises post-transaction for annual update valuation. Question
is whether to normalize and if so at what level
Projected Compensation
23
• Parrot Cellular – projections used in valuation failed to include a $12MM deferred compensation agreement to seller
• Laser Skin & Surgery – projections used “market level” of compensation for selling shareholder, which was significantly lower than employment agreement entered into with seller at time of transaction
• Sentry Equipment – expert dispute related to projected compensation. DOL expert failed to normalize lower executive compensation expected post transaction.
Projected Compensation Issues in Litigation
24
Valuation - Income Approach
25
• Discounted Cash Flow (DCF) Method:• Estimated future cash flows are discounted to
present value at an appropriate rate of return• Free cash flow, usually 5 years• Weighted Average Cost of Capital (Discount
Rate)• Capitalization of Earnings Method (single period)
• Opportunity Cost• Rate of Return, or Yield• Cost of Capital
Valuation - Discount Rate
26
Valuation - Income Approach- DCF
27
XYZ CONSTRUCTION, INC.
FYE FYE FYE FYE FYE12/31/2018 12/31/2019 12/31/2020 12/31/2021 12/31/2022
DEBT FREE NET CASH FLOW 1,569 5.9% 1,877 6.8% 1,973 6.9% 2,131 7.2% 1,803DISCOUNT FACTOR 0.9366 0.8216 0.7207 0.6322 0.5545
PRESENT VALUE OF CASH FLOWS 1,470$ 1,542$ 1,422$ 1,347$ 1,000$
PRESENT VALUE - FORECAST PERIOD 6,781$
PRESENT VALUE - RESIDUAL PERIOD 9,856$
VALUE INDICATION - CONTROL BASIS (ROUNDED) 16,640$
LESS: INTEREST BEARING DEBT (6,516)$ INDICATED VALUE, MARKETABLE EQUITY INTEREST 10,124
LESS: MARKETABILITY DISCOUNT (10%) 10.0% (1,012) INDICATED VALUE, NON-MARKETABLE EQUITY INTEREST 9,112
ADD: WORKING CAPITAL SURPLUS (DEFICIT) (600) ADD: CAPTIVE INSURANCE RECEIVABLE 572
INDICATED NON-MARKETABLE, EQUITY INTEREST VALUE (ROUNDED) 9,100$
DISCOUNTED NET CASH FLOW
Valuation - Alternative Approaches
28
• Market Approach• Select comparable transactions
• Obtain transaction multiples
• Adjust multiples for risk factors, growth rates
• Select appropriate multiples
• Apply to subject company financial data
• Asset-Based Approach • Assets and liabilities are restated from historical cost to
fair market value
• Real estate included within ESOP
Initial transaction• Guidance in settlement agreements on projections relates to
purchase transactions by the ESOP • Higher risk for conflict of interest issues if sell side advisor
prepares projections• Higher level of scrutiny and litigation risk• Can choose not to do the deal if issues with projections that
cannot be resolved• Typically no history of company ability to meet projection
Annual update• No guidance from DOL• Typically have a history of company ability to meet projections• Treatment of projected ESOP contribution expense• Lower level of scrutiny and litigation risk, but can cause problems
if second stage transaction or if company is later sold
Annual Update vs. Initial Transaction
29
• Trustee• Working capital adjustmento Target working capital threshold
• Earnout • Clawback• Seller financing
• Financial Advisor • Identify aggressive projections • Sensitivity analysis • Adjustment of discount rate
• CPA Firm• Reliable reviewed and audit financial statements
Transaction Risk - Projections
30
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$140,000
$160,000
$180,000
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Fiscal Year Ending April 30,
Revenue EBIT EBIT %
Example of Issues with Projections
31
• Valuation increased by 50% due to Projections • Year of transaction EBITDA = $2.4 million • Previous 5 years = $1.2 to $1.6 million of EBITDA • Post transaction EBTIDA $1.3 million to $1.7 Million
• Factors Not Considered • One customer accounted for 50% of revenue • Majority customer puts out a 5 year capital improvement
plan o Year of transaction was the highest capital improvement
(one-time project)
• Financial Projections • Projections grew revenue at 3% to 5% from year of
transaction vs. historical levels
Example of Issues with Projections
32
• Transaction Issues • Trendline of EBITDA not factored • Used highest revenue year and grew revenue from there• Capital improvement plan is public information
• Post Transaction • Company is unable to service the debt • Drop in stock price• Negotiate a purchase price reduction
Example of Issues with Projections
33
• Understating or overstating growth rates• Failure to properly normalize earnings (for non-
recurring, non-operating, GAAP adjustments)• Control vs. non-control cash flows• Applying a discount rate inconsistent with estimated
future cash flows• Not applying midyear convention• Not adding or properly adjusting for non-operating
assets• Working capital deficiency• Cap Ex and Depreciation not reconciled
Common Mistakes
34
• Be in your projections • Understand the risk factors • Consistence with the historical, industry and economic
trends• Process and documentation
• Document build-up to projections
• Significant litigation related to aggressive projections
Concluding Thoughts
35
Questions ?
36
Dan Markowitz, CPABoulay PLLP7500 Flying Could Drive, Suite 800Minneapolis, MN [email protected]
Chip BrownFirst Bankers Trust Services, [email protected]
Michael Yi, ASA, CPA, TEP, MBANewport Valuations, Inc.23 Corporate Plaza Dr. Suite 150 Newport Beach, CA [email protected]
Please fill out your evaluation for this session
You can find it in the Conference App or ask for a paper version
Don’t Forget!
37
Top Related