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ESOP Boot Camp, Part 6: ESOP Valuation Explained Simply

• Menke • Season 1 • Episode 8

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0:00 | 11:26

How is an ESOP valuation actually determined?

In Part 6 of the ESOP Boot Camp series, Trevor Gilmore and Ben Spadt break down ESOP valuation in simple, practical terms. This episode explains how fair market value works in an ESOP transaction, why cash flow drives value, and who ultimately determines the final price.

The discussion covers the difference between “price” and “value,” the role of independent valuation firms, and how trustees negotiate on behalf of employees to ensure transactions occur at arm’s length and at fair market value.

Topics covered include:

  • What it means for an ESOP to be a fair market value buyer
  • Why ESOPs are fundamentally cash flow buyers
  • How EBITDA multiples are built from cost of capital
  • The role of projections, financial history, and market comparables
  • Who sets ESOP value in a transaction
  • The trustee’s fiduciary responsibility
  • The difference between value and price

This episode is designed for owners, CEOs, and CFOs who want a clear framework for understanding how ESOP valuations are determined before entering negotiations.

Hi everyone. Welcome to the official ESOP Radio. Episode six of the ESOP Boot Camp. Today it's all about valuation, explained simply. I'm Trevor Gilmore, CEO of Menke. And I'm Ben Spadt, investment banking with Menke. Today we will discuss three things about valuation and help you understand what your company is worth. Those three things are number one, valuation basics. What type of buyer is in ESOP? Number two, how your cash flows drive value. And number three, who sets the value right. Then let's kick it off. What type of buyer is an Isa. Thanks, Trevor. And we've talked about it a number of times that an ESOP is a fair market value buyer. But what does that mean? And fair market value basically begins with we have a willing and able buyer and a willing and able seller having an arm's length negotiation over a company. In this case, or a portion of the company. And then the market essentially is the Esop itself. That's where the shares are going to exist after the transaction takes place. And we're based on reality. It's not some sort of hype or, any strategic buy or anything like that. And then that, that fair market value, we're not utilizing this approach where you arrive on a single number, that's the number you transact on. It is really a range. And that range, it's brought to the negotiation so that in that market we can have a conversation and create that arm's length transaction. And part of this is part and that's that back and forth to create that transaction. And then there's science which are the cash flows of the company in this case and how that company operates. And that leads us to number two, how those cash flows drive value. However, what do you want to say about that? Yes, I think spin and you gave us a nice background to set the stage on how an Esop transaction works. It's a fair market value. ARM's length negotiation here. Seller buyer negotiating on price and terms. So let's talk a bit about how cash flows drive value. So by and large Esop as a cash flow buyer. And that means that the valuation range that the Esop is going to trade in directly correlates with the company's cash flows. Because the Esop has to be able to sustain itself both to support the transaction and in the long term. And so it's very much rooted in a cash flow valuation model. When you take a look at cash flows from a valuation perspective, you typically start with the most recent five years, five completed years going back. And then also projections. We like to see five year, four looking projections, understand how those are developed, understand the marketplace of the company, its competitive moat and intangible aspects as well that you mentioned. And that's the art, that's management death. The company's unique products, services, macroeconomic conditions, micro economic conditions. How strong is the balance sheet, how long has a company been in existence? And also taking a look at market comps as well, above and beyond just the company cash flow, saying, okay, what a similar company is traded for with the financial buyer. If they're publishing and you know, there's databases out there, etc. that we subscribe to that have those transactions reported. Also, you take a look at this concept called cost of Capital. And for you listeners out there who have heard of multiples, you know, if I sold my company for seven times EBITDA, well, that multiple is built up by what's called cost of capital and some other considerations in there as well. Big part of cost of capital is interest. And then also the perceived equity cost for someone to invest in your company. And that's how you get a multiple and they're your brand and people. That's a huge component. We talked about that earlier. And all of this comes into play into what is called the valuation range. So Ben, any other insights there into cash flow buyer and Esop cash flow valuations? I think you made some great points about how important those cash flows are and getting those cash flows represented correctly. Sometimes you'll see, you know, income statements or financial statements that are presented, in a way that it might be confusing or something like that. So it's really important to make sure that those cash flows are telling the actual story of the company. And I think it's an incredibly strong point that all of that boils down to that cost of capital. How much would an investment in this company cost? And go ahead? Sorry. And as an informed seller, you want to know the value. Raise your company before you even decide to go down the seesaw path. That's where we always start with our clients. You saw analysis. What is your company worth? Minority basis. Control basis I do this complete exercise here. So you uncover what the value ranges. And two if it's interesting to move down that path I'll give a simple example here. Recent transaction. We did a 100% Esop transition company as a consulting firm adjusted EBITDA was about 3 million. And overall the negotiation took place in that 5 to 6.5 x Ebit range. Company had a clean balance sheet, you know, so on. So often you'll hear EBITDA multipliers when people discuss value because it's easier to explain that, you know, it's the one metric that is super easy to understand, but it's both art and science. A lot of factors go into it to create what that ultimate value range is. Let's move on here and talk about point number three. Who sets the Esop value. Then walk us through a transaction and what it looks like when you get ready to negotiate and what that arm's length process looks like. That value is not set by you or I. It is set by the market. And in this case that Esop is the market. And it just has to be an arm's length negotiation and it for a market value. So from the seller side, there's some work that is done to create, a range of a range of value or a calculation of a range of value. But additionally, the trustee that's hired to negotiate on behalf of the Esop hires a valuation firm that is independent and will utilize those qualitative and quantitative aspects of the company to derive that range of value and that's one of the goalposts in which you're negotiating to arrive at that final transaction price. And the biggest thing is the difference between price and value here, that value set by the market. But an important distinction is the price is what at the end of the transaction, when it's time to close and all the money's wired, what is that dollar figure that was exchanged that consideration for these shares. But value is how much is the company worth worth to me as a seller, but also worth what's the company worth to the buyer? The Esop. And that's where that range comes in. So it's an important distinction. But that range is where we start and sort of drill down from there to get to that transaction price and, and, and close the transaction. And that trustee that I spoke about, they're a fiduciary and they have a fiduciary duty and responsibility on behalf of the Esop, on behalf of the buyer and ultimately, the soon to be shareholders, which are the employees of the company, to make sure that they are transacting at fair market value and getting the deal that they signed up for so that it's not, you know, a minuscule benefit to the employees or they're not paying too high a price where it really hamstrings the company. Exactly. It's always that fine line with these Esop transactions, fair market value, ensuring that everything transacts at a arm's length price through that negotiation and you know the price you end up settling on, that can be different than the value. Because price and value are two different things. A price is part of the negotiation that has other aspects, you know, and there might in there, neglected to mention was the amount of regulation from the Department of Labor, Orissa, from even the IRS. You know, they're all looking at this transaction. So to have it be that arm's length transaction that you spoke about, that's incredibly important. Exactly. So in summary, we hope you learned something new today. Number one, an escort is a fair market value buyer, which means it's rooted in reality to your cash flows. So this does not come in and pay, you know, some insane multiple of revenue that you'll see. You know I right now I hard so you see these air companies with no revenue and maybe no forecasting revenue achieving valuations of 100 billion, you know, etc.. So not the case because it has to pay for itself. Company cash flows have to make sense in that values. Very strong emphasis on cash flows. And two it's an arm's length negotiation as well. So being armed going in to the negotiation, knowing what your company value is essential. You know, and things change, you know for tips a lot of clients who hey, we've done the initial value work in say January, February and now we're gearing up for the transaction in Q2 or Q3. And the company has won a lot of large contracts between now and then. Right. You know, so the backlog and overall outlook has changed drastically. So it is a moving target a bit. But it is always rooted in reality, which is cash flows and then never underestimate as well the art and science components of this too. So intrinsic value that's it. You know big part of this as well. You know when you think, hey, what is this company truly worth? So then yes, you're an accredited business, evaluator. What do you love most about valuation? What do I love most? I would say it's learning about all of these different companies that makes America what it is. You know, we hear about the big players, all the Fang companies, you know, Facebook, Apple, Amazon, the companies like that. But realistically, getting to meet these business owners, these CEOs. And I don't really have to say much initially. I say, tell me about your business. Tell me about how you grew this business. And they love telling you about how they started, you know, some of the early struggles and then how they're successful now. And I think that's amazing because that's what they make, makes America tick and makes us grow as a country. And it's really exciting them for those owners that are excited about their company, who then become excited about selling to their employees. And it goes back to our whole culture conversation, things like that. It's just really exciting hearing the stories of the business owners. That is one thing that really excites me as well with our client base and what we do. Hearing the story of the company during their journey. It's fun and smart. Valuation codifies all of that. You know, makes for a smart day. Absolutely. So I hope everyone learned something new today. Reach out to us on LinkedIn. Trevor Gillmor, Ben Spadt Menke page. Also check out Menke.com We have a lot of client case studies up there, Esop news, and so on. Interested in talking directly? Reach out. We can talk about ESOP, fit, etc. have an awesome year and join us for episode seven. But.