EP12 - Power Rangers - Roll Up Strategy for ESOPs

Power Rangers are an excellent example of strength in combining multiple superheroes on one team. On this episode we consider: What is your company worth?  What happens when we combine it with another then another? The value could significantly change for better multiples and for multiple reasons.  One of those would be a larger combined EBITDA with a reduction in redundant expenses.  Another could be the risk profile is reduced given larger geographic and higher diversification of revenue. Whether you sell to an ESOP or another buyer, through this podcast episode we discuss the multiple reasons to consider this approach. 

Transcript

[0:09] Hey everybody this is journey to an ESOP and Beyond podcast where we get into Employee Stock ownership plans and how they work and way more than that so that's the the and Beyond is if you're brand new to the podcast welcome, this podcast and also just for those that are continually listening or or take or tuning in at different times thank you for for sticking with us and we appreciate your time today so let's start off today with this.

[1:02] Oh my goodness okay you're you're not going to do this yes I am I'm going to do this this is the the Power Ranger episode oh man let's do it so um okay. At risk of losing people off our podcast let me just say this is perfect like the Power Ranger analogy is going to be perfect for the topic the topic iswhy you might want to consider. A roll up and we'll talk about what that is inin in looking at the possibility of doing an ESOP transaction.

[1:37] What I mean by Roll Up is I mean rolling up as like a private Equity would do is take in multiple companies putting them all together and then selling that that individual company after the roll up into an ESOP transaction so this is a this is a podcast today I would just kind of described as a potential strategy and it's going to touch on a lot of. Ideas around like what you have in your company and kind of answer some questions and I think there's some benefits here that I think are going to be interesting so we're going to get into um how that actually would work and what why would you even want to consider that um as you go through that so the topic again is is if you took 1 entity that you had and you were going to sell as an ESOP and instead of selling at 1 entity I actually merged those entities together meaning a roll up then I sold that company into an ESOP um what would be the the benefit of doing that and how would you do that so. Keep listening if that's something that is of interest to youfor those that are listening the podcast and you do have questions you're like hey I'm I really want to understand this better. Um please go to our website at journey to an esop.com there's a little form there you can just fill out and we will give you if you contact us we will contact you.

[2:55] For those that are are technically proficient and can rate and review the podcast give us give us a 5-star rating that's always helpful. I always tell people on the podcast if you know somebody that's thinking about doing an ESOP.

[3:08] Then this is a great way to help them and just share the link with them like hey this is a podcast that might help you um to understand it there's there's a lot of resources out there especially now that we've been doing this for a while however um sometimes it's just like just hard to kind of navigate through what are you talking about what is this how does this apply and all that so we try to be as. Helpful as we can in that in that area so again thank you for listening today we're excited to uh.

[3:35] Uh to discuss this topic the first thing I would start off with is just the the the basic things I just said initially was. Uh what is a rollup and what so what do we mean by that when we are actually thinking about this. Very commonly used in settings where you're a private Equity Firm and you're not maybe you're not a private Equity Firm but um wanting to buy companies at a lower multiple, then what they'll do is they'll take those companies they'll put them all together and a couple things that happen in that first off is that. The the companies they put all together in 1 area right become merged togetheris that we're going to be able to eliminate. Some redundant expenses so things that that would just be hey we already have this going on for all of those entities we're going to that's redundant so maybe we only need um maybe we can downsize the accounting department maybe we could um consolidate and streamline certain processes that each of these companies go through um maybe we're not relocating every 1 of these companies maybe they're going to keep their offices or maybe we are and we can eliminate some some rent expense so so obviously if we did that we're going to actually increase possibly increase cash flow.

[4:51] Um by the by the into the merged entity by pulling all these other entities together and so as a. A method and I would maybe even use the word scheme a scheme to kind of build more value um what's happening is.

[5:06] The agreement is that the yeah we'll buy your company we'll buy your company and all these companies get bought and then eventually the private Equity Firm will say all right now we have a more valuable entity with all those combined. And then from there we can go to the marketplace and go sell that now it's more valuable because of cash flow or ebita. It's also going to be more valuable because the size of the company has gone up proportionally right so as we've layered in um all these different.

[5:34] Companies together combined their cash flow reduced expenses so there's a bigger IBA and the bigger IBA is going to create um a higher multiple and that's going to give us even more bang for our buck when we're looking at it. Uh why are we why are we using Power Rangers by the way because Power Rangers when when you get down to combining all of the the strengths each 1 of these Power Rangers have, it's like they become stronger together than they were individually right and that's the same concept when we get down to the possibility of a roll up merger strategy so as we get deeper into the topic I want to get into now like um.

[6:14] The possibilities of this in terms of of what your company is and I'll just kind of I'm going to walk through some circumstances and maybe some some hypothetical case analyses around what that might look like just to generate some thoughts and ideas around that, I feel different so. Going into the merger thing let me let me start off with this as possibilities but I wanted to kind of kick in like this idea of is this going to feel a little different because first off as we think about the possibilities of doing a merger so we're just going to say a roll-up is a merger right so the possibilities of doing a merger, come along with all sorts of of. Of caveats and things of like the cautionary warnings um meaning thatum although we could so justify in a sense of updating and upgrading our merger.

[7:15] Or upgrading our valuation as we get into the idea of of pretty simplistically like hey we know if we have a big crash cash flow we know if we have a, you know a larger business geographically we're going to have a higher valuation so we kind of know that um but as we think about the possibilities of being merged into multiple entities. The first question that we have to really ask conceptually and even all throughout the process is. Who's running this company right the merged company who's who's in charge so we really need to take a little bit of a.

[7:49] I I kind of kind of look at this ina proforma approach of a proforma approach meaning that. We don't know what we're going to do yet but perform a wise we're thinking about what this will look like after the fact so in the post. Transaction phase when transaction meaning that there's really going to be a transaction where we roll these entities together and you can do that by contributing the entities into a holding company you can do that by taking 1 entity and contributing another entity in there so there's there's a a bit about legal uh organizational structures tax organizational structures that needs to be addressed but let's just assume we're going to have a 1 these multiple and a merger and a roll up you have multiple shareholders andthe reason that's important is because.

[8:40] Unlike the private Equity deal that we're talking about where they would just buy somebody buy somebody buy somebody roll them all up they're the ones that are M managing governing or whomever they're they're kind of building the management team as they build the rollup model. In this scenario what we're talking about is the merged entity is going to have to have a an organizational management structure that will help to make sure that everything's being done correctly and in accordance with what. They're what the purposes of this new company is and you can imagine if you took. Different businesses that had 5 different shareholders that had all kinds of personalities and culturesthe merging that together could be, um extremely difficult and because of the of the more like the. The end of the day that culture has to be 1 cultured has to be 1 leadership um so some in some cases let me just say that. There's there's a there's a proposition here that we could anticipate meaning that we do need to reduce who's in charge right so somebody's going to have to be in charge and that could be a classic.

[10:02] Company structure a c Suite structure you have a CEO you're going to have a CFO you're going to have the all the other C's right you're going to have possibly a COO operational person all of those. You know leadership responsibilities roles and responsibilities be kind of like graduated into a more of a seae executive team right that can be you can take what you have and merge it into that as long as the shareholders understand like their their role is going to change in that environment and a lot of times for a smaller entity.

[10:35] That we have an individual who's so used to making a like say all the decisions or really having a complete control um 1 of the 1 of the possibilities here is they may want to be done with that right and have and have this as be their option but but at the end of the day as uh consultant and advisor we have to walk through what that what that merged entity is going to look like how is it going to run and the starting point there is to understand it needs we need to have a good team in place to make sure we don't want. Um some type of like crazy in you know conflict of you know everybody's jumping out down each other's throats and nothing's getting done we don't want that obviously right so it has to be you have to build a succession plan around. You know the end end result andand sometimes that is. Going to be it's going to be pretty straight forward because everybody you know like yeah that we agreed that this is going to work now the other thing that's going to happen and again this is going to feel a little different because now you're part of a bigger ship right you're maybe you had a, a little skiff and the companies as they roll them all out together you're part of a bigger organization so it's going to be, how quick from the point that you merged then do you do the trans the ESOP transaction.

[11:55] So if I if I kind of just slow it down a little bit and describe the the merger itself what happens there and then we'll describe the ESOP transaction you know like there's 2 major uh steps here that we're kind of simplifying the merger itselfis taking those multiple entitiesand.

[12:16] What what needs to come about is what each shareholder in order to agree to the merger is going to need to agree to is what their fair market value Shares are worth. So somebody's going to need to orchestrate um a model that helps to.

[12:36] Evaluate or not evaluate but value each of their each of those separate entities and what they're actually worth. And I would just say that in general in our experience in doing that.

[12:48] Making obviously making sure that that the methodology that's being Incorporated is consistent across all of those fronts and.

[12:56] The the way that that happens is you want to make sure that you're staying in tune with with things like cash flow valuation. Um Market approach valuations can be applicable. But and what I mean by a market approach evaluation is is using some type of multiple of ibida multiple of Revenue.

[13:16] They're complicit because they don't anticipate the. Um the basic fundamentals of of an income approach evaluation which is um really the amount of cash flow each in the entities spin-off. But because when we're getting into that what has to happen is we need to normalize those cash flows.

[13:37] So we're not going to do the eliminations yet but and for each of these in individual entities what's going to happen we'll just keep with our our 5 company example we take each each of those 5 separate entities and we're going to build models around the historical cash flow.

[13:54] In the forecasted cash flowand the we're going to end up coming in especially with let's just assume everything's in the same industry but we're going to build capitalization rates. And weighted average cost of capital percentages around those Industries so that we can say conceptually and and from evaluation perspective actually the risk. Premiums on the cash flows for each of these entities um what those risk premiums are for a hypothetical buyer, and then and then deeper than that we're going to want to make sure that we've applied the same assumptions across the board for each of these entities so for instanceall of the entities we would um. Adjust for things like non-recurring expenses and non-recurring income meaning that. We're going to add back PPP if they got PPP income of this historical cash flows. If they got ERC income over those cash flows because that income is not recurring if there were some expenses that. Of course we're discretionary for each of those entities we're going to want to make sure that those schedules of non-operating non-recurring expenses are all consistent.

[15:07] So sometimes when you see a schedule of dawn recurring expenses um someone's, idea of what theirs is can be you know a little bit different like we're including. For instance non-recurring Consulting expenses that might have happened with a company we need to consider that for every single entity and so there's there needs to be for each of those 5 separate valuations a consistency of, what those would actually um those would be so that that it it's easily worked through and everything kind of, fits together so they don't make any majorly different assumptions.

[15:44] It was bad enoughhow do we fight them off guys we have to use all of our powers it's the only way right okay okay, do it ConorI summon the power of the gym all right for you Power Ranger loversafter you put all that together right now we're going to move into the the Consolidated entity and say all right well um. On a fundamental levelof course it's going to be worth more right so once we've done the valuation exercise for each of these individual companies what we have to make sure that we do. And for the merger itself of course we identified identifying what the entity is going to look like going forward as far as governance and management and that kind of thing but. What we have to make sure is the shareholders. That owned the individual companies in our hypothetical 5 company example are going to have the same amount of value going into the new entity.

[16:52] At the relative percentage so what we're doing is we're going to then now focus on. The valuation of the Consolidated entity so we we're going to have to take those 5 entities.

[17:04] And combine those in a Consolidated cash flow model that supports. Um all of the normalization everything that we did in the first level of of analysis and then when we put them into the 5 company 1 company analysis. Um we're going to use the same number of same amount of cash flows but what we're now we're going to do is go through and predict the change in the cash flow by reducing the the uh eliminating the things like redundant expenses and all of those things so somebody's going to have to go through all of that analysis to determine what how does this actual how does this actual company run if they were in existence over the last 5 years what would those 5 year cash flows look like. And now that they are in existence again perform a wise conceptually what would it look like for the next 5 years, now in that forecast for the Consolidated level right we're going to start with the forecast of the other 5 individual entities so as simplest way to look at that is hey yeah of course we're going to consider that on the revenue level.

[18:09] We're going to be adding all those revenues now in the event that there was some inner company, customer relationships with those mergers meaning that a 1 company was working for another company that we have to eliminate those revenues right because they're not they're not going to be double counted in the analysis for the forecast, and also for the historical cash flows, however the other side of it is is as a larger entity um what can be predicted in the forecasted revenue is are we going to be able to strengthen our Revenue model going forward meaning that.

[18:43] Is there a strength to the entities that will allow us to take on more Revenue that we didn't have before for for whatever reason maybe it opened up the door. To um, a new opportunity that that individually weren't going to get so there's a lot of questions regarding in that forecast where the revenue is going to sit for each of those years out for the next 5 years.

[19:06] Are there any particular changes to gross margin are we again getting to have some advantages for maybe buying power if it's Direct.

[19:16] Materials um because we're a large entity and then work through that so gross margin um as a percentage again from the the 5 separate companies to the Consolidated company how is that going to be predicted in the futurethen layer and all the G&A expenses and again that this is where you might find some eliminations on um things that there are duplicated or redundant for each of those entities when you roll them all togetherum keep in mind all this is is predictive analysis and it's it's, when you do these kind of things it's helpful, to not get too caught up in the weeds and just make some make some assumptions that you feel good about that are reasonable now what what you're going to get then is a revenue minus cost to get sold each equals gross margin minus G and a equals net income net income with any potential other adjustments 1 of the adjustments might be now that we're transitioning the um, shareholders that were maybe owner operators maybe we're going to be putting some owner comp back in the adjustments for adjusted IBA um there's there's a lot of those types of things that just need to be vetted out so so clearly I'm spending a lot of time in the valuation section here but it's really important because this is where we're going to be able to kind of stabilize and and answer questions around why would a shareholder even want to do this right so at the end of the day.

[20:42] What their relative if you added up all those percentages of of. Revenue or percentage of valuation for each of those shareholders when you combine them together the relative percentages um they shouldn't be worth anything less than what they had before. Based on that so what we're wanting to do is now establish a cap table with the new ownership with the new entity again projected performa it's not like we've done anything we've not pulled the trigger on the merger we're just doing this to make sure that we have the right proper analysis for the for this potential roll up now that we've worked through that exercise I think that idea then is um what how do we go to take that into the marketplace for an ESOP and at this point. Um a couple things can happen you can say to yourself yes this makes sense I would do the merger and the roll up.

[21:35] Without doing the ESOPand or I would do this only if we do the ESOP. Why why is that really important well at this point what can happen is you could say well we want to give this a little time to integrate itself we want to give a little time to, work out the bugs so so there might be people that might think yeah let's do that let's do the merger the merger makes sense no matter if we do the ESOP or not because we we feel like there's other reasons to do it right the other reasons to do it might be the company um, it needs to have a stronger presence in the market so it's making them more competitive we may want to realize that um going into the next couple fiscal periods. So let's let the merger settle I've done that before where it's taken a couple years it settles yes now we're ready to go into a potential ESOP transaction. Now this is going to look.

[22:28] The ESOP transaction side after the merge entity is going to look very very similar if not exactly the same as a normal ESOP transaction.

[22:36] We've already done all the analysis on the valuation so all we need to do now is structure the ESOP transaction around this merge entity. And the the first part of that is going to be understanding the structure of financing that the company that new merged entity is going to take onnow.

[22:55] If this is all conceptualized and performant it's really kind of important and I would say a little complex to go to the banking market and say all right if this were the case what would the banks lend into as an ESOP transaction to um affect a an an amount of credit or amount of debt that they would be willing to extend for the term financing to to pay out the owners now um there's a couple thoughts here as you think about it there there's obviously always the option to sell. Part of the merged entity holds some of those shares and sell more down the road either in a um more more than 1 stage transaction or a tranche here tranche there and then down the road sell the rest of it or go right to the market so 100% of it use the bank financing to finance a portion of it the remaining portion of the financing would be picked up by the shareholders the new shareholders of the new entity are the shareholders of the new entity would take their own seller notes against that, now we're looking at again options related to the structure of the financing that include how much liquidity do we need at closing.

[24:06] How much does the uh the sellers um want to keep as seller notes if they are wanting to use warrants all of that analysis would need to be done. At this stageand. Partly then we can also start looking at whether or not we use stock appreciation rights we might have a whole new governance team or a management team that now is really responsible to make it happen that's where a stock appreciation rights program would be ideal.

[24:32] And as we look at those those scenarios it it's going to be these options between how much um liquidity we really need it closing versus how much do we want um to spread out in the seller note and use um use that warrant. And synthetic Equity to help kind of build a maybe a stronger deal for multiple levels so all of that is being anticipated herethe other thing that's being anticipated is um because of all the different reorg structures that we just went through we're going to have the option to be a C Corp or an S corp and the first the first thing I'll say about this from an analysis perspective and this is going to be just true whether you merged entity roll up entity or not is is make sure that you do analysis on both s and c I think a lot of times I see in the market for the ESOP industry is that a lot of times everybody's just assuming you're going to want to see Corp you're going to want to do a 1042 and the reason that is so popular is because the people that are selling you that strategy are are making money on the 1042 this is about it's as simple as I can I can say itand ifthere if they're making money on the 1042 they're going to be. Um excited to sell you that right and they're not going to want to show you the S Corp analysis so do the do the have them do the work of doing S Corp cash flows against Corp cash flows.

[25:58] For both the company and the shareholders so when when we're doing in that is. Everybody knows that there's I mean everybody knows but the idea that if you're an S corp you're exempt from income tax as a company. That creates more cash flow to pay off the loans and it also creates more cash flow um that creates more value to the employees and it creates more value because we're paying off debt sooner um to the Tsar participants in indirectly more value to the warrant holders so that's not a bad strategy and I'm I'm I'm shocked sometimes that nobody like that doesn't even get considered.

[26:34] The ccourt might be like yeah we definitely don't want to pick Apple gains we want to use the CCP we want to use the 10 for you nothing wrong with it but do do the analysis so as you get deeper into that, the idea is really lay that out now, 1 of the things about the merged entity that we're hoping for right is that we have more okay more value and then maybe we also have more borrowing capacity because the borrowing entity now has has a combined cash flow that was stronger and it combined um future cash flow that is stronger and when you when you talk about Bank financing where we're we're always going to want to gravitate to is the quality of the cash flow. The quality of the cash flow meaning the predictability of Revenue.

[27:19] Which gets strengthened with the um multiple entities being merged togetherwith the. You know Geographic footprint being stronger so there's a lot of like I could go deeper and deeper in that but I'm not going to but the bottom line there is that you're going to have more borrowing capacity and a bigger entity than you would otherwiseuh the other part of this whole equation that. Um we want to think aboutis the exit plan the succession plan um who's getting what and so it analyzing that for a shareholder perspective might be different so you in a merged entity you certainly might have this scenario 5 companies they all come together maybe 1 or 2 or 3 of the companies the the owners were in their 40s and 50s maybe in a couple of companies the owners are in their 60s or 70swho's getting out first, right the nice thing about this structure of an ESOP this is true for every company so if you're a company that has multiple shareholders you can Flex into that where you could meet the the objectives and the goals and objectives of a 65 75 year old person um and also meet the objectives and the goals and direction of maybe a 45 50 year old personage is important and it's relevant in the planning stage because we want to make sure that we've designed something.

[28:41] Um and I'll say this kind of just generically but again the The Details Matter we design something that is a win-win for everybody the shareholder side and the company side the key people side and also the employees right so as we as we dig into the the shareholder side we know that there's there's going to be multiple shareholders a lot of times.

[29:02] And we want to make sure that that each get what they need to get out of the deal and how you structure it so there is a lot of flexibility in that. The younger people may be like yeah we're we're we want to do this because a lot of reasons um we want to be part of the company we may hold back some of our shares we don't even sell them into these up so keep in mind all of that can be can be worked through in the analysis phase before you finalize anything of course or pull the trigger on anything uh

[29:32] So a couple a couple thoughts on this as we think about it I wanted to share kind of like as this applies itself to your ESOP planmy life may be normal but trust me, and will never be the same.

[29:55] Your life will never be the same after this merger so I love this as we finish this podcast I wanted to kind of finish with that um.

[30:05] There's so many potential possibilities here that I think are really interesting and of course what I've. What I started off with and when I'm kind of finishing with is this idea that a lot of planning.

[30:18] Needs to go into what we're what we're talking about here right and there and and, and just this is my own experience right I I and I'm saying this from the perspective of putting putting a lot of deals together over the years not only for esops but also for um my own company. Um it's hard merges are hard you know they're they're not easy because. A lot I bring shareholders together that have their own businesses and are used to a certain um.

[30:48] Control or freedom of like I'm making decisions and doing whatever so um there needs to be. A lot of work to make sure the financial analysis is done which is I spent a ton of time on in this in this episode.

[31:04] The the another layer is just a lot of time of I would just say kind of soul searching does this make sense does this make sense for a lot of reasons.

[31:14] Um and I would I think I would Center on as I as I talked about that this is much more directed towards the shareholders who own these companies that are potentially looking to merge into. Um a larger entity would be what is it and you're where your life goals are how does that match up with what you've built in your business. And how does this look going forward because going forward there you know I think the the underlying um benefit of this that I'm kind of trying to get to is is you're worth more.

[31:48] When you combine all these entities from a valuation perspective and you're also reducing your overall risk with these ends so there's a lot of good reasons to. To do this but in the event of course an emerger um the first thing you want to do is make sure you've never ever ever. Anticipate um. Are not anticipate you never never never want to potentially have to get into a place of litigation with people that you are doing business with right and. You know of litigation is ugly it's expensive the only people that win in litigation are the attorneys when you get down to it right so so kind of the idea is is preempt all of those possibilities. Um how do you avoid litigation in the future well you put a really good deal together everything I talked about earlier is important. Um obviously some real strong understanding um of the legal agreements everybody's making. Um legal agreements themselves with really good attorneys. Help predict any possibilities of things that can come up down the road right so in the event that you are an existing shareholder of the merge entity you don't sell all of it to the ESOP so now you have a very strong Buy sell agreement.

[33:07] Accounts for things that would that can happen in real life so a lot of these agreements that are put together are to avoid.

[33:15] Possibility of litigation and dealing with all kinds of problems in the future so as you as you do that you know we we want to tread lightly we want to make good decisions we want to do our homework we want to do our analysis you need what I would say overall is you really need somebody that can quarterback through that whole process. To make sure that you've asked all the right questions you've taken it 1 Step at a Time. Um this strategy that I'm referring to you know I would say it takes time, and it I I think that's true for any ESOP plan anyways is take your time make sure you've analyzed all the data correctly. Um certainly there might be reasons to get you know things done earlier than later but at the same time. You need to take your time to make good decisions um the 1 warning I would say is is don't get too caught up in um.

[34:10] In trying to get to this big big valuation number you know and the reason I say that. Or you know let's just say a couple things around that right not the big big valuation number not the big big big tax incentives not the big big big all these different things that could. Um be great shiny lures you need to avoid making a decision a business decision based on um. You know or I would call it a backwards decision I I'm trying to not pay taxes anymore so I'm going to do an ESOP or I'm trying to get this this and this done make a good business decision and then look at the implications of that business decision um based on all those factors and then come back as a shareholder to what I wouldencourage you to do is written a written goals and objectives list for you and it could be.

[35:00] Anything and everything it could be what is it what does this mean for my family what does this mean for my business in the future what does this mean for my employees what does this mean for. Um my estate in in all the things that would you know my kids my grandkids and all that generationally so there's just you know do some soul searching from that perspective I like writing stuff down.

[35:20] Um because it helps to kind of visualize and ask those questions as you as you work with really good advisors. Which is kind of my final Point work with really good advisors obviously people that know and understand esops work with people that are not trying to get your money, out of the deal they should get paid fairly but they're not motivated by just putting a deal together um they need to give you good advice and have you and I know people do like you have trusted advisors already integrate them into the process people that know you um, and you need you need support you know whether that's your CPA or really good attorney or a really good investment advisor or whoever you're you're working with um integrate them into the process as much as you can even though they might not be ESOP experts they do know you and can be another you know sounding board so having said all that um I know this is my first ever Power Rangers it may be my last but it works for me hopefully it works for you enjoy your day and I'm looking forward to our next step on this journey so.