We look at three measures of revenue for ESOP suitability purposes:
- Earnings before interest, taxes, depreciation, and amortization (EBITDA);
- Free cash flow; and,
- Taxes paid.
EBITDA is usually the most significant measure appraisers use to determine the value of the company. The higher the EBITDA, the higher the value of the company.
Here is a simple calculation example for discussion purposes:
Net Income Before Taxes:
(+) Amortization expense
(+) Interest expense
(=) Company Value
*The Multiplier is really the inverse of the rate of return an investor buying the stock would expect. For example, if a buyer, like an ESOP, expects the stock to yield a 20% return, the multiplier would be 5 times EBITDA.
Free Cash Flow
We like to say that the three rules of ESOP planning are cash flow, cash flow, and cash flow. You have to be able to fund the plan to pay for the ESOP transaction and the ESOPs benefits. If it’s a leveraged ESOP, the cash flowing through the ESOP must support the debt service. Free cash flow is the cash available to fund the plan after all of the company’s required capital investment and bonuses. It’s like buying a house – how much mortgage can you afford?
Here is the Free Cash Flow Calculation
(-) Principal & Interest on Existing Debt
(-) Expected Capital Expenditures
ADD BACKS (Some or All)
(+) Excess/Extraordinary Comp.
(+) Other Key Main Comp.
(+) Bonus Plans
(+) Existing Retirement Plan
(=) Free Cash Flow
If the company is not generating enough revenue to have a tax problem that it needs to solve, the company may be too small for an ESOP. If it has low tax expense, it may also be because of excess deductions or paying out taxable income. But if you make the above calculations to cash flow and the tax cost goes up, then there may be enough tax need for the ESOP.
The best way to assess all of this is to provide us a handful data points so we can look at your numbers and tell you whether the company has the EBITDA, free cash flow and tax costs that would support adopting an ESOP.