EP33 - Forecasting for an ESOP: Planning for a Future You Can’t Predict

The best way to determine whether an ESOP plan holds up is simple—and uncomfortable: tell us where you think the company is headed and prove why. In this episode, Jason Miller and Makenzie Ragland explore how forecasting can help owners prepare for an ESOP transaction and make better decisions along the way. They explore the key inputs behind a reasonable forecast, including historical performance, business drivers, capacity, and other assumptions—and how those projections can influence valuation and transaction feasibility. They also discuss comparing forecasts to actual results, building different scenarios, and avoiding overly optimistic assumptions. how factors such as backlog, bonding capacity, working capital, labor, and margins can shape the outlook.

Ultimately, a strong forecast isn’t about getting every number right. It’s about giving owners a realistic view of where the business is going—and helping owners make informed decisions about what comes next.

Transcript

Why the Future Gets Questioned

Jason Miller: 0:00

As you entertain the idea of transitioning out of your company and looking at an ESOP transaction, one of the very first things that any of us are going to ask you for is what's your read on the future? Where do you think things are headed?

Welcome back, everyone, to the Journey to an ESOP and Beyond podcast, where we seek to make all things related to employee stock ownership plans both accessible and understandable. I'm your co-host today, Jason Miller.

Makenzie Ragland: 0:37

And I'm Makenzie Ragland.

Jason Miller: 0:39

And we are going to have fun talking about forecasting today.

Makenzie Ragland: 0:46

Who doesn't love predicting the future? 

Jason Miller: 0:50

I think we would probably have better luck predicting the future if we had better luck predicting the weather. I always like to joke about meteorologists being wrong half the time, which means they're right half the time. But I don't have the same luxury in my life of being wrong so often.

This is going to be a fun topic for you to discuss, Makenzie, as we go through forecasting.

I think, listeners, as you entertain the idea of transitioning out of your company and looking at an ESOP transaction, one of the very first things that any of us are going to ask you for is, "What's your read on the future? Where do you think things are headed, and what makes you think that you're going to get there?"

So, Makenzie, tell us why this matters to our listeners when they're thinking about an ESOP transaction.

Forecasts as the ESOP Foundation

Makenzie Ragland: 1:53

I think that when we speak to our clients and bring up the fact that a forecast is needed, we sometimes get responses like, "Oh, yeah, I have that. We track that. We prepare one." Others have never prepared a forecast, and they're like, "How can you expect me to come up with that?"

We know that a forecast is never going to be exactly right. However, when you think about an ESOP transaction, and you have your buyer, which is the ESOP trust represented by a trustee, what they're really purchasing is the future cash flows of the company.

They need to understand what the future cash flows of the company are projected to look like, since those cash flows will be paying off the debt that comes on as a result of the transaction.

Again, I think all parties involved realize that a forecast is never going to be right or 100% accurate. However, that doesn't mean you cannot come up with something that is reasonably accurate in terms of the assumptions you're baking in when you build your forecast.

Jason Miller: 3:27

We'll call it, "Why does that matter so much?"

Makenzie Ragland: 3:32

Well, you have a lot of people relying on it in the transaction.

It matters because, for example, in the typical process of determining whether an ESOP makes sense for your company, there is a feasibility analysis. You need to determine whether it is feasible for your company to go through with an ESOP transaction and sustain any debt that gets taken on through future cash flows.

Reasonable Assumptions and Capacity Reality

Jason Miller: 4:10

Yeah, there's a lot in there. You mentioned others relying on it.

The trustee, who is representing the employees and ultimately the trust, is trying to make a determination: Is your company going to be able to do what it says it's going to do? Is it believable that it can achieve what you predict its future to be?

The valuation firm is also going to assess the level of believability or reasonableness. Can the company realistically achieve this? Does the company have the wherewithal to do it?

That's going to change from company to company and from industry to industry.

If you're running a machine shop three shifts a day, 24 hours a day, seven days a week, and you're producing X amount of revenue and Y amount of EBITDA today, but your projections show that you're going to have a 20% year-over-year increase in revenue and output, that's probably going to require more machines, maybe a new location.

I don't know if any of you have discovered how to add extra hours to a day and throw in another shift on your existing machines, but if you have, that would be great.

If you're operating at capacity today, it might be unreasonable for someone to believe that you'll magically be able to achieve significantly better margins tomorrow from the same series of machines, producing the same output for the same clients.

Those items will show up and be tested throughout the process.

And then there's management. I think management is going to look different in every company as well. What targets are they given to hit? Are they operating targets, financial targets, or both?

And what value does a forecast have for management? I think we'll probably get into this a little later, specifically around an ESOP transaction, but I don't want to leave management out of the concept or the topic.

How do we get good at this? I'm sorry, Makenzie, I cut you off.

Makenzie Ragland: 6:23

No, I was just going to add that I think that's a good point. You mentioned that management has certain KPIs or targets that they're trying to hit.

What's unique about a forecast is that those targets you're giving to whoever it is—your salespeople, for example—are not necessarily the same as the targets you're going to reflect in a forecast.

It may not be the same because just because it's something that you want to hit doesn't mean that you can hit it, or that you're actually forecasting that you will hit it.

Understanding the difference between those two is important. What you're telling your people to strive toward versus what you think you can reasonably actually achieve may not look exactly the same.

Then, to your point about hitting those margins or growth percentages, you also have to incorporate the other pieces required to achieve them. That might mean more people, more capital expenditures, or other investments.

Building from History Plus True Drivers

Jason Miller: 7:31

So how do we get good at this?

I imagine there's a really terrible way of doing forecasting. If I can imagine that, others can, too. I'm just going to take what was there before, put my finger to the wind, see which way it's blowing, and go, "All right, great. It feels like 15% every year. I think we can do that."

I think there's probably a better way, but talk to us about that.

Makenzie Ragland: 8:06

Yeah. There are different approaches to building a forecast, but I think the easiest way, or the easiest place to start, is by looking at your historical performance.

Typically, I would say five years. I don't think you need to go beyond five years. Just start by looking at your historical performance and use that as your baseline.

If you've never hit $200 million in revenue, what makes you think you're going to do that next year? How close have you been to $200 million before? What have your historical growth percentages looked like, and what were the drivers of that growth?

I would say start by looking at your historical performance and thinking through your revenue drivers. What has gotten you to where you are now? What does your labor capacity look like? Then build your forecast from there.

When History Misleads and Optimism Hurts

Jason Miller: 9:11

When would that not work well? When would historical performance be a poor indicator of what's ahead?

Makenzie Ragland: 9:25

There could be a few things, but what immediately comes to mind is COVID.

If COVID impacted your company and there was a lag—for example, in the construction space, if it delayed jobs and those delays continued for years after COVID—then maybe those years were negatively impacted and aren't indicative of normal historical performance.

In that case, you wouldn't want to use those years as your baseline.

Or maybe there was just one year where you lost a really big customer or a big contract. Things that stick out as anomalies shouldn't necessarily be used as your baseline.

On the other hand, if you're able to somewhat see into the future based on contracts you've been awarded or things that you know for certain are in the pipeline, that can help you defend and rationalize a better year than you've ever seen historically, provided it's based on factors you know for certain will be there in the coming year.

Jason Miller: 10:51

We recently did an episode on what could go wrong with an ESOP. Inevitably, the topic of value comes up, as does the forecast itself, and I think we spent a good amount of time talking about the forecast there as well.

An overly optimistic forecast can create a lot of turbulence after a transaction.

Going back to how important management is in creating the forecast and their belief about its viability, a synthetic equity program is often put in place with performance targets based on the forecast provided in the ESOP transaction.

If those targets aren't met—if the company doesn't hit those performance targets—then that synthetic equity, such as stock appreciation rights or phantom equity, doesn't have any value.

That program can have the opposite effect of what was intended. Instead of incentivizing people, it can disincentivize them. They may think, "Great, I have more paper, but I have no way of achieving the targets I need to make this paper worth something."

Makenzie Ragland: 12:16 

Yeah, that goes back to having a reasonable forecast with reasonable assumptions.

Throughout the transaction process, you need to be able to defend your assumptions. In our role, we're giving you an expectation of what your value could be, but in an ESOP transaction, you go through negotiations and speak with a buy-side team that is going to scrutinize your forecasts and assumptions in much the same way that we intend to at the beginning of the process.

You need to be prepared for that.

Another important point is that, in the transaction year, if you're transacting in 2026, you may start the transaction process—or at least begin exploring the transaction—early in the year. You have a full-year forecast for 2026.

However, as we progress throughout the year and the transaction has not yet closed, the buy-side team wants to look at how you're tracking against that forecast based on actual performance as the year goes on.

That's an important piece as well: monitoring how well your forecast is performing against your actual results throughout the year.

Tracking Actuals During the Deal

Jason Miller: 13:40

I think that's a great point.

It gets back to having discipline or a habit around forecasting and not waiting until a transaction occurs—or until you're contemplating a transaction—for it to be the first time you've done it.

It's okay if it is. I don't want to dissuade you, listeners.

But the earlier you can adopt a mindset of really asking, "Where are we headed? How do we think we're going to get there?" and then put numbers to it, the better off you're going to be.

What do you think is most useful? Should you compare every line item of a P&L? Do you need to do pro forma balance sheets every month? Where should listeners focus if they decide to adopt a discipline of forecasting, Makenzie?

Makenzie Ragland: 14:35

If you're tracking it monthly, that's great. But if you've never done it at all, starting with something as simple as quarterly tracking would be a good approach.

In terms of tracking your forecast against actual performance, I don't think it's necessary to focus on every single P&L line item.

Focus on your big buckets—obviously revenue and cost of revenue, and then, in terms of SG&A, perhaps salaries, marketing, and other major expenses.

You're not necessarily going to need to look at every single line item. Just focus on what makes up the bulk of your expenses.

Maybe once you get into the habit and become great at forecasting, you can get down to a very granular level. But I wouldn't say that's necessary, and that's also not what buyers are looking at. They're focusing on the bigger buckets, not the immaterial pieces.

Contractor Forecasting with Backlog Tests

Jason Miller: 15:42

I like this list of questions for our contractor and contractor-adjacent listeners.

If you just want to roll through these one at a time, Makenzie, I think that would be really valuable in light of thinking about what growth looks like for us as a construction company, as a builder, or as a CMR.

What are we doing, and how can we focus on getting to a more reasonable forecast?

Makenzie Ragland: 16:18

I think we all know in the contractor world that backlog is a big thing.

Being able to distinguish and evaluate backlog is important. Having backlog is great for forecasting because it gives you something concrete to make assumptions around.

But you still have to think about what happens when costs exceed what you initially projected, an awarded contract falls through, or the timing gets delayed.

There is still uncertainty, even though you have the benefit of creating a backlog through awarded contracts that start at a later time.

You want to be able to evaluate the quality of your backlog and not just look at a list with a dollar amount that you're banking on.

What am I missing?

Jason Miller: 17:35

Just a moment where my mind was empty. Everyone gets to witness that one.

Some of the things that you, again, contractors and listeners who are interested in forecasting, should ask yourself are:

Does the existing backlog support the first year?

How much into the future can you see based on the way your contracts are structured and your jobs are progressing?

That gives you a great base to start from. If you know what Year One looks like and what is going to trail into Year Two, then you can ask: How much new work needs to be awarded for you to support the second year?

Is that consistent with your historical bookings?

Does the company have the labor to support the additional work required to meet that particular forecast?

Does the company have the right bonding capacity to support that volume? What needs to change, if anything?

We talk a lot about the importance of working with our surety partners in advance of making a decision to move forward with an ESOP because everybody has to be on board. Otherwise, the company can't do this.

It would be great to do a 30% increase every year, but if you can't bond the jobs, then you're not going to increase by 30% every year, are you?

What happens to working capital as revenue grows?

And finally, are projected margins consistent with the types of projects you're pursuing?

You know this, our contractor friends, better than anyone else: You can grow the top line as much as you want if you take jobs that don't make you any money and stress out the people you have. That's going to squeeze everything on the bottom line for the sake of the top line.

If that's a deliberate growth strategy for a period of time, and there's a strategic reason for entering into that particular market, that's one thing.

But growing the top line while shrinking the margin on the bottom line is typically not a choice you would want to make in perpetuity.

Those are just some things to think about.

Base, Downside, and Upside Scenario Planning

Makenzie Ragland: 20:03

Yeah. With all the uncertainty involved in forecasting, both in the context of contractors and at any company in general, another piece that we haven't discussed is having different versions of your forecast and doing sensitivity analysis.

Typically, we'll call it three different versions or cases of your forecast.

You can have a base case, which is your middle-of-the-road scenario.

You can have a downside case, which is a worst-case scenario, or perhaps a scenario where you're not going to achieve the base-case year because certain factors prevent you from getting there.

And then you can have the opposite: an upside case, where you have a great year.

You have three different scenarios that you can use not only to assess which one is most likely, but also to see how each scenario can affect value.

Jason Miller: 21:15

I like that because it gives you room to understand what would need to be true for us to experience the upside case.

Then, what would we do if we experienced the downside case?

What's the first decision we're going to make if we move from what we expected to the worst-case scenario?

That type of financial planning is really important because those are questions that the valuation firm is going to ask.

What do we do in this scenario if you're off? What can you do?

It allows you to think through those options ahead of time and say, "Here's what we would do."

Now we understand the impact of how that would slow things from getting worse and how we can get ahead of whatever the circumstances are, as best we can, in order to get back on track to a base case or even an upside scenario.

So this is my favorite question: How useful is a tool that's always wrong, Makenzie?

Makenzie Ragland: 22:26

It is still pretty useful.

I think there's a difference between it being "always wrong" and it being completely wrong. It's not completely wrong. That's the purpose of the forecast. You're not creating something that is completely unreasonable and unattainable.

It needs to be reasonable enough that it is still a useful tool and helps with decision-making rather than simply trying to predict the future.

Forecasts as Decision Tools and Next Steps

Jason Miller: 23:00

So, if there's one thing you want our listeners to remember, what would it be?

Makenzie Ragland: 23:14

I would say that if you've never prepared a forecast before, really take the time to look at your historical performance and build your forecast based on true business drivers and what you've experienced through running the business—not just desired outcomes.

Going back to that point earlier, maybe you're giving your salespeople certain targets that may not be exactly what you should reflect in your forecast. Maybe they are, but just understand that there's a big difference between desired outcomes and what you can actually achieve.

Jason Miller: 23:54

I think that's really good advice.

The goal isn't necessarily to create a forecast that perfectly predicts the next five years. It's more about creating one that's reasonable enough for you to make decisions today and resilient enough that you can understand what happens when tomorrow looks different.

Listeners, that's our weather report for the day on forecasting.

I hope this was valuable for you. If there's anything we can do to help you, or if you have other questions related to forecasting for planning for a transition or an exit and need more detail, reach out to us. We're happy to interact with you in that regard.

Like, subscribe, and share this episode with a friend, and we will see you next time on the Journey to an ESOP and Beyond podcast.

Thank you.

Makenzie Ragland 24:55

Thank you.