Valuation Principles and Working with Earnouts

0:28Hello, M &A scientists. library of templates. Coming soon, we're offering agile M &A diligence and integration certifications. Visit mascience.com slash academy to learn more. Firm Room is the world's most intuitive virtual data room that meets public company security standards at a fair price. We all know paying per page for a VDR is a scam. Firm Room has helped companies save over$80 million in VDR fees. We actually did the math. Don't let your investment bank dupe you into paying per page for a VDR. That's just dumb. Visit firmroom.com slash pricing to see how much you'll save when you switch to firmroom.

1:12And you could do a free trial right there on the spot and do a side-by-side comparison so you can see why it's a better product for a better price. Dealroom is a leading M &A lifecycle management platform. It manages your pipeline and combines diligence and integration into one process so that the integration is faster and easier. Even if an investment bank is driving the sale process, Dealroom helps you take over once the LOI is signed and drive better integration results. Learn more about Dealroom at dealroom.net. See why the best in M &A are using Dealroom. Now on to our interview. I'm Kisan Patel and you're listening to M &A Science, where we talk with deal professionals and learn valuable lessons from their experience.

2:01This podcast focuses on stories, strategies, and what actually happened during M &A deals.

2:15Welcome to M &A Science, where we curate knowledge from the best in M &A to continuously improve. If you're interested in keeping up with the latest from M &A Science, subscribe to our free newsletter at mascience.com. Every week we share highlights from our interviews, invitations to events, M &A role openings, and other resources as we build the greatest community of forward-thinking M &A practitioners. Again, that's mascience.com. I'm your host, Kisan Patel, CEO and founder of M &A Science. Joining me today is EJ Patel, co-CEO at Valuation Research Corporation. BRC is the largest privately held valuation firm in the U.S.

2:59Today, we're going to talk about valuation principles and working with earnouts. EJ, how are you doing? Good, Kassam. Happy to be here. Hey, thanks for taking the time. Can we kick things off with a little bit about your background? As you mentioned, I'm co-CEO of BRC. I've been in the role for about 10 years. I've been at VRC for about 21 years. I was an analyst working with clients, doing all of that sort of stuff, valuing companies for 10, 11 years at VRC, and then was at another firm for five years prior to that. So you've got a pretty long career, all focused on valuations. Yeah, 25 years.

3:34I've been doing this more than 25 years at this point. One, I got to give you a special thanks for letting me use your office space every time I come to Manhattan. It's just wonderful to have this opportunity to get a nice corner suite here. in Midtown. But the other thing I've noticed, hardly anybody comes to your office. I get pretty lonely here sometimes. You operate with a pretty remote environment. I take it your company's adopted to it. And then one of the things you mentioned to me prior was that you added 100 people to your company in the last two years. Tell me a little bit about that.

4:04I'm looking down Midtown and everybody's bringing people back to their office and they're filling them back up. You haven't done that. In some ways, it was strategic, Hassan. At the beginning of the pandemic or midway through the pandemic, maybe deal activity really started to heat up and we needed a lot of people and our people didn't want to come back to the office. Typically, what would happen if people would come into the office and shut their door and you wouldn't see them. What we found is that people were happy with the flexible work environments. All of our offices are open. They have been open for two years.

4:33They come in, people can come in when they want to, if they want to. But quite frankly, what we find is the vast majority of the people don't want to come in. And that's okay. Technology today with Zoom and Teams allows us to stay in touch, have face-to-face contact. It may not be in-person contact though. And so with that, we're able to do our job, do it effectively, but also have the flexibility to do the personal things that we want to be able to do. And it could be working out in the middle of the day or picking up a child from school or cooking dinner. We find for our people, this works. At the same time, given the environment we're in, last year, we worked on 1 ,200 deals.

5:13We valued 15 ,000 securities. So we're very busy. And our people take their jobs seriously. They're professionals. There is no nine to five in our environment. If there is no nine to five, you want to give people the opportunity to be able to do the things they want to be able to do. Personal things. Again, work out, take care of a family member, take care of chore, whatever it may be. The work from home environment really allows that. At the same time, though, I will say our offices are open. So there's a handful of people who do come in every day or a couple of times a week. Our offices are open for that.

5:47But quite frankly, we've outgrown all of our office space. And so if we were to bring everybody back in today, we'd probably need double the space. And so this is a really efficient and effective way to give people what they want. And in our business, our turnaround times are quick. And so there's no hiding. If somebody's not doing their job, you notice pretty quickly. Flexibility is a big part of your culture. Yeah. And you save some money, all the extra office space. We put it back though. We put it back into our people. We've signed up for virtual training programs, especially for the younger people who are coming into our industry.

6:19We do more get togethers where we bring everybody in. In some cases, people are flying in, driving in to catch up with the rest of the team or the rest of the group. And then we have team events as well. And they always hear about those team building events, quite frankly, that we probably weren't great about doing 5, 10, 15 years ago. But today, whether it's we're going to go to Topgolf or maybe play a round of golf or play some tennis, things like that, which help you build rapport with your team, we're doing and we're spending money on that. So it's not all just dropping to the bottom line, I would say.

6:50It's putting money back into our people, giving them the tools, giving them the resources to be successful here. And at the same time, maintaining our culture. I think that's a really important part of it. Less money to the landlords, more money to spend at the bars. Maybe a little bit. You're right. When people hit you up for deals, what's the expertise they're looking for? We provide an independent opinion of value. Okay. Now, why would you need that? Maybe an obvious reason is if you're doing a deal and you need a fairness opinion. So the board might be looking for somebody independently to provide a view on whether the deal is fair or not.

7:29We do some of that. A lot of our work though is done for statutory regulatory purposes. For accounting purposes, you may need to account for the purchase price. It's called the purchase price allocation. So we're valuing intangible assets, real property, machinery, equipment, inventory, complex securities that may be part of the structure of the deal. So we're valuing all of those things for accounting purposes. We may be valuing assets or entities for tax purposes. And then also a bigger part of our business, as I mentioned earlier, we valued 15 ,000 securities in 2022, is what we call portfolio valuation.

8:03So we're working with all kinds of asset managers, private equity, hedge funds, BDCs, mutual funds, in valuing their illiquid securities for them so they have a better understanding of what the value of those securities are. A lot of that work is quarterly. Some is monthly. Some is annual. We even have a few that are daily. We're experts on valuation. That's what we do. And when somebody wants an independent view on what's value, what the value is, that's when they come to us. Cool. All things valuation. Yeah. Tell me what's going on in the market today. I was talking to somebody in my network recently, and they were saying they've never seen such diverse opinions on where the economy is going.

8:44Where's inflation going? Where are interest rates going? And as a result of that, I think you see the impact in the stock market, in the valuations of companies, both public and private. There's a lot of uncertainty in the market, I would say. It does feel as though in the next six months or less, we should have more clarity on the market and where we're going. But there's always something. In valuation, again, I've been doing this for over 25 years. There's always something. There's always some reason for concern. There's always some reason to wonder, okay, are we at the top of the market or the bottom of the market?

9:16How long are we going to continue to go sideways? It's just there's always things to talk about, which makes it very interesting. It's been a phenomenal ride for 25 years, but there's always something I'd say. We've seen a pretty big correction with tech companies. But then when you look overall at deals happening now, some deals are being done in a high valuation. Others aren't. What are your thoughts on that? There's two things there. Number one, on the tech side, we saw through the pandemic that, hey, maybe the world has changed. And tech, where you don't necessarily have the same kind of in-person interactions, is the way to go.

9:51And maybe a lot of those companies hiring to support growth in their valuation, growth and demand. And now maybe a little bit of a reset. Valuations are still higher than maybe where they were three years ago, but not as high as they were maybe through the pandemic. In terms of other valuations, there's definitely a movement to quality. If you've got a good company with good fundamentals, good management, you're going to get a premium. You're going to continue to get a premium. On the other hand, if you're not that A player in your market, you might not get that kind of premium. You're definitely not going to get that kind of premium.

10:25But for a while, all companies seem to have a premium associated with them. And I think that's gone away. It really depends on where you are in the market. And there is an emphasis on quality right now. Yeah, that's a really good point. Do you think that's just overall within your sector, how you're positioned or the sector itself? What I have seen over time is that investors do seem to move as a group, as a herd into different areas. I mean, tech through the pandemic, but over my career, I've seen other industries where investors just seem to move as a group into and then out of. And that can cause dramatic shifts in supply and demand.

11:04And as a result, significant shifts in price. I need some advice. Yeah. Tell me as a founder, operator, how do I best position my company for the best valuation? It's about cashflow and earnings. Yeah. You call it EBITDA is a good indicator of cashflow. At different times, it can be different things. In the past few years, it may have been more about growth, revenue growth as an example, or users or something like that. But cash is king. Being positive from an EBITDA perspective is always good. Having growth from an EBITDA perspective is really good. Although at times we've seen, whether it's the dot-com time period in the late 90s or more recently through the pandemic, I think sometimes there can be an emphasis on something other than cash flow or something in addition to cash flow, which may result in a lot of enthusiasm, let's just say, in terms of people getting into one space or another.

11:59You know, as an operator, you have some level of control in how you run a business because you can invest in growth or you can optimize for cash flow. I can go from one extreme to the other. Where do you think is that prime spot? Because I can really run lean to mean and focus on bottom line cash flow or I can really focus on top line growth. There is never any right answer. In your role, my role, we've got to figure out where do we put our resources. And that's a big part of, I would imagine, your role. And I know it's a big part of my role is there is scarcity in resources. And how do you apply them?

12:36Certain environments, there's a huge opportunity in front of us. Let's put the money into growth. And at other times, it's kind of, okay, let's watch our pennies. Let's be a little bit more pragmatic on where we're spending and focus on profitability. I hate to say this, but it depends. But generally speaking, you've seen the pendulum shift from pure top-line growth to profitability. Cash is king. To the extent that you've got positive EBITDA, that's a good thing. If you've got growth in EBITDA, that's a good thing. If there's a potential for more growth in EBITDA, in some ways, that's the flight to quality.

13:11We hear in the news about these big rounds of funding because some founders maybe get a little envious of that. But when you look at it, I feel like there's this big element of storytelling that some founders are extremely good at. And that's partly what drives them to tell the story and achieve those big rounds of funding at high valuations. What are your thoughts on that? How much of the element of storytelling actually comes in play with valuations? You do need to be able to tell the story. The story needs to be consistent. It does need to be effective and efficient and able to get people excited about, hey, this is the place you want to be.

13:48Having said that, I think there is also an element of being in the right place at the right time. And we can think about the recent crypto-related bankruptcy. Some of those folks were just in the right spot at the right time. There was a lot of enthusiasm to be and a lot of fear of missing out, I would say, from an investor perspective. And creating demand maybe through storytelling is important. But if you're in an area that's maybe not quite as sexy, even if you're a great storyteller, there may not be a lot of interests. It's a combination of things like a lot of things in life, I would say.

14:19But I do think being able to tell a good story is important. How much of the valuation gets anchored by the investors and what they've invested in at their perception of valuation versus you coming in as a third party and ideally be more objective about what the value is? Because you can look at some of those companies, right? They got the, especially what we saw in the good times. How does that come in? Do you say, well, we've already know that Tiger and these other big VCs have invested in. We're going to account for that. And then we don't want a big discrepancy versus, no, this is what it's actually worth.

14:53Especially with early stage companies, those valuations are hard. The range of potential values is significant. If you can point a real market transaction where people have put money in and invested in the company, that's a really good fact pattern. So, of course, you're going to rely on that. And that's important. Now, we do also do a lot of work, probably the best majority of our work in more mature industries where the valuations are a little bit easier and the bookends aren't quite as far apart. You're always looking for market evidence of what the value of the company is. You may look to the market to see recent transactions.

15:30You may look to public comps where they're available to see where they're trading at and use some sort of metric, usually EBITDA. But if they're pre-EBITDA, maybe it's revenue or something else. And then you do a cash flow model and you look at what do we expect from this company going forward? And as I said, certain companies are easier to project than others, right? So if you've got an earlier stage company, it's just really hard to project. And there's a lot of risk in getting from 100 people to 500 people to 1 ,000 people to are you going to be able to do that? And does management have the ability to scale the company like that?

16:03It's difficult. Yeah, there's a lot of interesting variables when it comes to valuation. It sounds like you got this ability to storytell and build some demand around it. And then how you forecast your numbers partly falls in play of how you get valued. The two have to be consistent with each other. I would say as we go in to talk with companies, we want to hear the story. We're going to judge the people that we're talking to based on the story that we hear and the numbers we see. And look, the vast majority of times, the stories align. The stories with the numbers and the people, it's like, okay, great.

16:40This is the A team. They know what they're doing. We feel comfortable. But I will say over my career, every once in a while, you walk out of a meeting and go, wow, this is not going to work. There's no way. The numbers are wrong or the people, it's the wrong people or maybe both. Anytime you're talking about valuation, number one, you're talking about people. Can you trust them? And do you believe what they're saying? I think that's an important part of what we do is we're talking to management, talking to the investing group and looking at the numbers they're projecting. How about advice on what not to do as an operator?

17:13It depends on what stage the company is at. But one of the things that we do see from time to time with maybe earlier stage companies is that they're not focused enough. They see this opportunity, that opportunity, they want to grab them all. And so just being laser focused on who you are and what you want to focus on is really important. Once you show that you can execute that plan, be able to deliver the results that you said you could, then I think there's an opportunity to maybe diversify and move on to other areas. But be focused. Who are you? What are you? Where do you want to be? How do you define success?

17:48I think all of that is really important. I can see that as a thing that could be a challenge for some founders. Obviously, don't get too diversified where you're not focused. It's one element. Anything else, I know keeping clean books is probably important. keeping clean books is really important because the more other stuff you have going through your books, the harder it is to see if you're actually meeting your goals and whether you're actually achieving what you said you're going to achieve. I think that's really important. Beyond that, do you have a plan? This is what we want to do, but is it reasonable?

18:22You have the skill set to do it. Do you have the people and resources around you to help you to execute that plan and to get to the finish line. A lot of times in your role, my role, I mean, it's not even about you and me. It's about all of the other people on our team. And there's lots of areas where you've just got to rely on the team around you and have that solid team around you. It's one that you can trust. I think trust is a real important element for me. DJ, you got to give me more. I need the hacks, the tips and tricks around valuation. What are some of these things that you really would be good for somebody?

18:55Maybe first time doing M &A. hey, maybe there's these impairment things or these other things, but what are some of these things that you can try to get ahead of that you've seen as common first mistakes, first time doing a deal? Too much optimism is probably the number one mistake that I've seen. When you look at what are the drivers of value, it's revenue and growth of revenue, it's margins, it's cash flow, it's also risk. And the risk comes up in the form of the discount rate. Sometimes there's this view of, hey, we're going to take over the world. We're on a rocket ship. But the reality is that there's so many hurdles to overcome to get that.

19:32And some of the biggest ones are just the people issues that you have to deal with to be able to get to where you want to go. And you're going to have setbacks. You're going to have issues. And maybe the individuals that help you as a startup aren't the ones that help you as you get to the next level. We know where we want to go. Do we have the pieces of the puzzle to be able to get there. Whether it's a startup or let's say you're working on your first deal, there tends to be a lot of optimism around the forecast that's put together, the growth, the margins, the synergies, maybe underestimating risk, which also increases value.

20:11Those are some of the things I see. And look, it's not unusual for us when we're working with deal teams that they present a very optimistic view of what a transaction is going to do. And oftentimes we're working with the accounting group subsequent to that to test for impairment. And the forecast there looks very different. And the risk profile looks very different. There's often a resetting of lens, I would say, as you move from the deal team to the corporate team. Let's say we did that. First deal, inevitable, rosy glasses on. It looks great. We paid through the nose for this company. And then afterwards, what are the issues that come up?

20:49Is this impairment thing, I don't understand it. You're going to have to teach me this stuff because what's the big deal about that? Why do you have to go through that? It's a big deal for a public company. And instead of 20 million, maybe we're talking 200 million or 2 billion in size, a public company is doing a deal. The way these things typically go, in my opinion, is it's almost like buying a house. You start looking at the house and then you fall in love with the house and say, we really want this house. And so as you're putting together the model, the model changes from a reasonable outlook for what growth and margins and things of that would look like, as well as the risk profile to something where it's, no, we've got synergies, we've got opportunities that will lead to higher growth, higher margins, and less risk.

21:32And all of that points to more value. The price that you pay increases, again, because in some ways you've fallen in love with it, now you've got to support it. A year afterwards, you've got to now test it for impairment. You hear lots of things in the press about deals being bad for companies and all that. I can't say that. I've worked on a lot of deals, probably into the thousands of deals over my career. Definitely hundreds, if not thousands. Deals are good. They help diversify a company's revenues, diversify their product lines, diversify their customer base, lower risk. They're all really good.

22:04But when you're in this impairment situation a year after the deal is done and the deal model is really optimistic, again, because you've fallen in love with the company and you really want to get the deal done, there is pressure to make sure that there's no impairment. And the accounting rules require you to test for this. Okay. So you got to redo the calculation and see, okay, what does the value look like today versus what it was at time of acquisition? What's the difference between an impairment and a write down? No, it's the same thing. Same thing. Just different words. Yeah. Yeah. So impairment of goodwill is a write down of goodwill.

22:36If I want to impress more of the valuation people, I'll tell them it's an impairment. Use that word versus... That's the accounting. That's the accounting term. My deal folks, we'll talk about write-downs. Okay. But when we go through that impairment, how do you go about it if you buy a company and then you fully integrate this company? How are you even supposed to measure that? Goodwill is tested at what's called reporting unit level. A reporting unit is either a segment or it's a level just below a segment. If you integrate it, Okay, you don't test it necessarily at the acquisition level. You test the reporting unit.

23:10Or if it's just the segment, then you test at the segment level. There's lots of confusion on that, to be honest with you. The rules have been around for 21 years, maybe 22 years, yet there is still confusion on, okay, how do we test for impairments? It's at this level called a reporting unit, which is probably, in many cases, it's more than just the acquisition. It may be as much as the entire segment, or it might be what's called a reporting unit. If you ended up doing a write-down, what's the implications of all that? Usually when there's a write-down, it's a write-down of goodwill. We overpaid.

23:43Goodwill is the excess purchase price. At the time of the transaction, we're going to adjust the goodwill on our books. It's a non-cash item. So from a cash flow perspective, it's not overly meaningful. But from a reputation perspective, I would say it's meaningful. The management is saying, hey, we overpaid on this acquisition. I don't know of many CEOs or CFOs that want to make that admission. So it's something where there's a lot of work that's done around it, a lot of scrubbing of the forecast, lots of discussion to make sure that if there is an impairment, there truly is an impairment that we did overpay and that the value of the company today or the reporting unit today or the acquisition is less than what we paid for.