It’s ESOP valuation season and forecasting earnings is at the heart of this strategic analysis exercise. In this uncertain economy, it’s worth refocusing on the methods, process, and approach that provide a sound basis for a prudent appraisal. In this podcast episode with guest Hillary Hughes of Prairie Capital Advisors, we explore the challenges and opportunities ESOP companies face when valuing their stock amidst economic uncertainty.
Transcript
Kevin:
When ESOP companies go through the annual process of valuing their stock or when they’re valuing their stock for the first time for the sake of doing an ESOP, is it looking into a crystal ball? Or is it an art and exercise in strategic analysis of company performance? Well, I certainly hope it’s the latter. As companies repeat the process, we think that they get better and better at it. But, what about today’s context of this crazy economy, where we’re trying to anticipate the new normal or the new abnormal? Because economic uncertainty is always the case.
Speaking of benefits, I’m Kevin Long. I was drawn to this topic recently by a wonderful article, “Forecasting in an Inflationary Environment,” written by today’s guest, Hillary Hughes. Hillary is a director at the financial advisory firm, Prairie, based in Chicago, Illinois. Prairie is a company that has been a real standout in the ESOP industry for many years. We’ve worked with people there, including Hillary, for many years. She’s an ASA appraiser with a lot of knowledge and experience in the industry.
Let’s jump right into the topic and discuss with Hillary the situation we’re in now and how it might be different. Then we’ll discuss a little more broadly about forecasting and what companies struggle with.
Hillary:
Sounds great. Thanks, Kevin.
Kevin:
Before we move on, is there anything about your illustrious career that we missed or your work at Prairie that you’d like to share with us?
Hillary:
At Prairie, we really focus on education for employee-owned companies, as well as owners of lower middle market companies. Many times we find that they just need more information about what are their options of transitioning their company and employee ownership. Whether they sold into an ESOP or are an executive or member of an ESOP committee, we have a lot of education topics to help them think forward and take their next steps for employee ownership.
Kevin:
Because you’re a full-blown advisory firm, you’re not just appraisers running around kicking out appraiser reports. As I see your information flooding the web, it’s really a broad spectrum of the whole continuum of what people need to know to be either in the ESOP realm or not.
Hillary:
Yes. We want to take a broad-based approach. ESOP might be the right exit opportunity for an owner or it might not fit their objectives or their company dynamics. We do have a traditional investment banking practice, ESOP advisory. We also advise on family transfer whether that’s valuation for gift and estate tax purposes or management buyouts. We have a financial reporting practice that does intangible impairment and purchase price allocation studies. We also have a consultancy advisory group that helps with executive comprehensive, equity-linked compensation, and business sustainability. Whether you are in an ESOP or not, how are you sustaining forward?
Kevin:
You’re bringing a broad perspective to the valuation process. Right now we’re still suffering from whiplash from COVID and we’re all wondering where things are going from here. If you can boil it down to a couple of key dynamics that you think everyone’s going to struggle with in this year’s valuation cycle, what do you think those are?
Hillary:
From a forecasting standpoint, thinking about volume versus value in terms of pricing. Whether that’s on the goods and services you’re selling or your inputs. We have had a very long cycle for the business cycle with no inflation. We have many managers and finance leaders that have not managed through that before. Separating those two, we’re not as nuanced as they are now. And really taking time to dissect that is important, but also challenging to really parse those effects in what we think might happen next.
Kevin:
Inflation, inflation, inflation, the big boogeyman that’s out there right now. And supply chain, supply chain and what we’ve been going through the last couple of years. How should your clients be dealing with that? How should they be addressing that?
Hillary:
That’s a great question. It’s going to be different depending on your business type and industry. Some have passed the supply chain issues and others have not. Some are deep in labor issues and others are seeing easing at this point. What do we see in terms of our inputs? Do we need to carry more or less? It’s going to influence working capital and then the cost associated with that. Do we see prices plateauing, increasing, or decreasing? And forming a view on that. Then doing the same with the good or service you’re selling. Do we need to have more of a defense stock or do we need to work through defense stock? Where do we see pricing? I think some companies got behind in increasing prices for inflation. We are going to continue in an inflationary environment for a while. So what’s your pricing strategy going forward as well? That needs to be not a set it and forget it, but a more regular cadence for most companies.
Kevin:
And to a certain extent, what you’re talking about is when you’re looking at these pressures, you’re kind of going back to the fundamentals of margins, aren’t you? Which is really what drives company profitability?
Hillary:
Yes, absolutely. Going to margins, but also whether you are a price-setter or a price-taker in the marketplace. If you see your cost increasing, are you going to increase your price? If so, can you do it to maintain that margin or are you going to be suffering some margin pressure or degradation? That’s part of the strategy and the question, what’s our view going into that forecast?
Kevin:
What you’re also suggesting is that companies need to have some awareness of where they are in the market and the industry. Because you can talk about whether you’re going to be a price leader or whatnot. You have to have a degree of market intelligence about your positioning. How many companies in the lower middle market do you think really have that or have the resources and take the steps to do that?
Hillary:
It’s been interesting to see that dynamic over the past year. For many companies who said, “We can never increase price because our customers will go away,” have been surprised of how much they can increase their price and potentially how often. I think everybody’s pricing dynamic has changed large and small across the board. It’s something that needs to have a much higher awareness of the management team. What you think about the pricing landscape today might very well be different tomorrow because you also have to recognize your competitors and other players are changing their strategy as well. That’s the real dynamic part of business where information is different and changing. But, even for lower middle market companies, they seem to have a good sense and a good pulse because a lot of times they do have really good relationships with their customers and suppliers.
Kevin:
So to engage in that process, even assuming they have those good relationships with their suppliers and whatnot, do all these companies have the tools for going deeper? Or what really distinguishes those companies that are well-equipped and positioned to do that kind of analysis? And looking at their internal data and saying, is it really going to play out this way? How does all of this intelligence play into the forecasting?
Hillary:
Forecasting in and of itself can be daunting because you know you’re going to be wrong. None of us have that crystal ball you mentioned at the beginning. It would be great if we did, but we don’t. So one is humbling yourself to the outcome. It’s likely not going to be exactly how you think it’s going to be. That allows you to move forward and start inviting other people into the process. To say, what are your insights? Who has the supplier connections that can tell you really how long that supply chain is or when it’s going to show up?
It’s the same thing on the customer side. What do they really need? Where is their inventory at? Talking with HR to understand the labor talent pool. It’s a start. From there, keep score. It’s not a do this once for the valuation, but really keep scores. Look at it on a more frequent basis – monthly and quarterly. Start asking, what better insights can we have? And that’s where it becomes more of the rhythm in looking at how can we improve this?
I find very few companies – small or large – that say, we’ve arrived at forecasting. We nailed this. It’s really a continuous process of taking in new information and making new assumptions.
Kevin:
When they’re doing that questioning and digging deep in those other areas, how does the company structure itself? Are you pointing towards management and governance to improve this process?
Hillary:
I think so. Thinking from an employee standpoint, how does this budget and forecast fit into our larger strategic plan? Is this just a one-year view or is this helping move us forward to where we want to be in four to five years in terms of our return on our investment from an employee standpoint. I also think it helps set the tone for succession, which hopefully the board is thinking about as well. Is everybody still going to be here in five years or do we have key positions we need to be thinking about over that time?
Kevin:
Which is very different than the genius founder of the company having his own perspective and not thinking about that. The company becomes a very different company as an ESOP, doesn’t it?
Hillary:
It does. The ESOP ownership is really looking to create this perpetual, sustained ownership, which means we’ve moved beyond the original owner or owners. We need to have a governance structure that can facilitate that succession of management. And that succession of management is really looking to the employees as well, of where do we have succession in the company? That’s where forecasting is a part of that succession plan. What’s our growth opportunity? And along the way, where do we need key talent to either replace, grow, or expand so that we remain relevant?
Kevin:
I love that. I love the way you tie forecasting together with governance. In the lower market/middle market, I don’t think there’s really any connection in their minds, at least initially, as to how those two things relate. We always tell companies that you need to evolve to have outside directors and need to have those outside directors to, as we put it, hold the king’s ear. Someone who’s a peer or more experienced than the CEO to bring those outside perspectives to the table and get them to think about the organization as an organism beyond them. This opens things up for what you’re talking about. It helps the company drill down to, say, the sales department and asking, how are you really going to do this? What are we selling and where are we going? The secret sauce when they started the company isn’t necessarily what they need now.
Hillary:
Yes. Spending time separate from working in the business and working on the business and having outside directors and good governance. They should be hands-off. Maybe nosing around and asking the right questions, but hands-off to the management team. Having that balance and perspective really allows, from a forecasting standpoint, to get those in-depth insights by involving others in the process that are intimate with the customer supplier and manufacturing employees to have a well-informed plan. Then connecting it to the broader strategy. Where do we want to be investing our time, energy, and capital to get the most return? Being able to direct the talent in that direction rather than just perpetuating what is occurring right now.
Kevin:
There are two topics I want to discuss. The first is what you mentioned in your article about top down versus bottom up. Are we saying that the less sophisticated companies or the ones that are CEO dominated are primarily top down, whereas they need to get to bottom up? Or am I kind of off the mark? Talk to us about how those two dynamics should be working and what they mean.
Hillary:
Top down really starts with what our addressable market is – our market position and market share. It starts building assumptions from that top level down to what we can sell and what we can make just at the simplest level. This can be a powerful approach for casting vision and strategy and looking for new areas of growth. The bottom up is really starting with here are all of the pieces that we think are going to add up and this is our revenue and profit derived from it. This is very insightful and very intimate to the business that you’re running. Sometimes though, you can lose the forest through the trees and maybe not see what the full potential is for the business to achieve. It’s when you combine those two and look at those two together that you have a much more dynamic picture of the business and the opportunity.
The bottom up from an ESOP perspective is powerful in that you’re engaging more employee owners in the process. You’re engaging your frontline experts to give you the most timely information back.
Kevin:
That’s a great linkage because there’s all this talk in the people’s republic of ESOPs, a circle of thought that employee owners run the business or employees help the business work better. I mentioned in an earlier podcast with Bill Fotsch, a great book I’m digressing titled “Partners on the Payroll.” It talks about the real practicalities of how that works. In the forecasting arena, I think what you’re saying is, there are real dollars and cents and measurable impact of that process and you have a way to really harness it on a quantitative level.
Hillary:
There is a way to harness it on that level involving your people. In terms of quantitative, I will say we have seen companies look more into what their accounting software is. How does that tie into business analytics? What opportunities do they have for getting customer or market data back from their customers and suppliers? And really using that to make more informed decisions whether that’s from a cost-based accounting level or using business analytics software, such as Power BI, to drive some more insightful information. Even then, it’s a progression that might not work for all companies or be a meaningful investment. For other companies, they might invest in it. If it’s not necessarily good information or good leaders providing insights back, it can just be misinterpreted numbers as well.
Kevin:
This gets to the resources area. What we’ve discussed in prior conversations is that there are more likely than not, tools already embedded in the systems that they’re using and they’re being underutilized to a great degree.
Hillary:
It’s also looking at forecasting as this is my task I just have to do for the ESOP valuation. That is really unfortunate in that they’re missing the opportunity to really draw more from that exercise and really tie it into keeping score. What is our strategic plan? What does this mean for succession planning? But, also engagement of key leaders. Many times we hear employees want to know more about purpose, mission, and how their work has value. Being able to say, you influenced this line item and you’re helping us win and meet our forecast. This is a way of translating back worth, value, and success for them and their career as well.
Kevin:
With our time limits, I can choose between two more topics and I’d rather end on a positive note than a negative note. We can discuss either about the Department of Labor and their role in looking at valuation reports or we can talk about something I think will really help people understand how you work in this situation and what the reality is of your role. Because you come in as the appraiser for the trustee, you don’t work for the company. You are the appraiser for the buyer and you’re setting the price. Our firm, we are on the front line with clients and we’re introducing them to the concept. That is, if you’re not there as the initial advisor.
We’re telling them, we’re going to bring them this trustee and they’re going to bring their appraiser. We’re going to bring in this horrible Hillary Hughes, who is going to look at their numbers. Business owners, they sometimes get nervous and put off by the notion that I know this company better than they do. We have to get them to understand how you work.
The one thing I think that’s the titular issue for them is, is the trustee and the appraiser, are the two of them are going to be overly conservative? What are they going to think about our numbers? What are they going to think about our companies? Are we always going to get something that’s too conservative? Speak to us a little bit about that relationship and your view. How you have to look at the forecast that you’re being given to do your work.
Hillary:
In reviewing the forecast, it’s really assessing risk and return. This is fundamental to how you see securities being priced in the public market. Just because a company makes a certain forecast doesn’t mean that the market is going to fully price or believe that forecast. A lot of times when a business owner is looking at the forecast, they need to keep in mind that it’s just one forecast. It’s their forecast and their view of future outcome.
I completely respect that they are the expert on their business, but we’re also looking at this forecast in light of many other forecasts. Businesses in the similar industry or similar size. We’re comparing what their view of the forecast is to that of the broader economy and industry that they’re in. Are their expectations more robust? If so, why? Is there a special contract customer or niche market?
I would also share the perspective that we, as well as the ESOP trustees, have experience with several companies making forecasts in their industry and specific size and seeing how they perform to forecast. That’s where I think we can be a bit more sensitive to what is the risk and the pitfalls associated with forecasting.
Kevin:
It’s not that you’re just coming in there to beat them down on the number. Right, Hillary?
Hillary:
No, not exactly. We do want to understand why and how they got to the number.
Kevin:
As we California lawyers would say, dude, this has been totally awesome. I’ve gotten a lot out of it. It’s helped me put some of the things that I’ve been telling ESOP companies for the last 35 years in trying desperately to explain what you do. It’s been great for me to get more in-depth information to draw on.
Hillary:
Thank you, I really appreciate it. It’s a fun and dynamic topic to talk about.
Kevin:
For us ESOP nerds, Hillary, we love talking about things like forecasting. I still think of it as a dynamic topic. Please read Hillary’s article and some of the other resources on her company’s website that will help you get a broader perspective on ESOPs.
This podcast is for general informational purposes only. It does not create an attorney-client relationship between Employee Benefits Law Group and the listener or reader, and does not constitute legal advice for a specific situation.
