In this episode of What’s Next, Chase and Chris are talking about five of the major themes impacting business valuation and transactions in the global economy today, including interest rates, inflation impacts, and a few other major topics that are front of mind for everybody right now. Take a listen and let us know what you think at acuityadvisors.com/contact.
Transcript
Chase:
Hello, and welcome back to What’s Next, hosted by Acuity Advisors, the show where we help middle-market business owners understand and monetize the value of what they’ve built. I’m your host, Chase Hoover and I’m joined again today by my co-host Chris Kramer. Good morning, Chris.
Chris:
Good morning, Chase. How are you doing today?
Chase:
Very well. Very well. Thanks.
Chris:
Good. So for our listeners out there, what we’re going to do this morning is review some factors that we put together in an article that we wrote relative to evaluation drivers, especially in light of all the sort of craziness that we’re all experiencing, both post COVID as well as with the current geopolitical situation, etc. When we wrote the article, it was really geared towards our ESOP practice and the primary December 31st valuations that we’re in the middle of, and then of course, ongoing now through probably the middle of the summer. So some of this is relevant to that, but a lot of it is relevant to valuation more generally. And we thought that it’d be a good topic to kind of share with our listeners and kind of go through the issues.
Really the first one that we came up with that seems to be on everybody’s mind and has many implications beyond just the headline is really the supply chain and supply chain challenges that we’re all experiencing. Those extend to pricing, those extend to availability, those extend to company performance. And generally what we say is the company performance is the biggest driver of value and things like interest rates, things like the external climate are sort of second-order issues. But in this case, lots of the things we’re going to talk about are directly impactful to company performance. So with that, Chase, I’ll turn it back to you.
Chase:
Yeah, I think the supply chain is obviously dominating a lot of the sort of discussion share or just front of mind issue for a lot of people. And that’s certainly not going to get any closer to resolution in light of the recent geopolitical developments. I think at the start of the year, technically speaking from a valuation standpoint, we are in an ESOP context where we have this notion of a date of value, which is obviously far more relevant for that ESOP update context, but again, the same factor is impacting valuations across the board. I think these geopolitical developments, particularly obviously Russia and the Ukraine being the major one, serve to more underscore or maybe exacerbate these issues rather than reverse them or mitigate them.
So on the supply chain front, yeah, if you’re doing the majority of your work here in the United States, and you’re not necessarily importing a huge amount of goods. If you’re maybe a contractor or in a services business, it’s not likely that it’s going to directly impact your revenue, let’s say. But, from a contractor, just to use that in an example, you might have a record-high backlog at the end of 2021 and thinking that this is going to be a pretty robust 2022. But what we found in talking to a lot of our clients is there are key inputs, whether it’s to their work or to the work of another trade or subcontractor that’s in the chain or in the project timeline, that’s just going to hold it up. And so I think thinking about how the supply chain impacts you, but also those around you might change the way you sort of view and plan for the business, especially from a backlog perspective.
Chris:
Yeah. And that particular issue I don’t think is really that much influenced by the geopolitical climate currently. I think it’s still a hangover from the post-COVID situation. We are seeing though a number of clients to your point that are on either allocation for supply or are just experiencing delays or in some cases having an indeterminate delivery schedule. But, certainly, all the delivery seems to be getting pushed where a client might have promised a 12 or 15 week delivery, now it’s 20 to 24 or undetermined or indeterminate. So that’s kind of a real challenge when you’re trying to plan for the future.
Chase:
Sorry to cut you off, but I think an important thing when you think about delays is there’s this big question that comes to the front which is, are they really delayed or are they lost? So if you have a competitor or an alternative or a substitute that’s available to meet that need, is that customer that you’re unable to service going to be there in three months when the product comes in? In other words, do they have an alternative?
Chris:
Well, that’s exactly right. And depending on the industry, the question is really, does it matter? In other words, whether it’s supply chain emanating from global geopolitical turmoil or whether it’s post-pandemic issues or whether it’s any other issue, the fact is that at the end of the day, you got to deliver the numbers. I mean, all the intangible value, all the things that we factor in are important, but year after year, you’ve got to at some point deliver the numbers. And the challenge is there are a lot of business owners that think that, “Well, look, this is temporary, this is still COVID. And I should be paid on what we did two or three years ago when it was a normal situation.” And the fact is these are risk factors and risk is all about what might happen and the likelihood that it’s going to happen. But at some point, it happens and it’s real.
Chase:
And well, “I want to get paid on what was a normal situation,” and it’s like okay, that’s a pretty ephemeral and nebulous concept now. Normal has changed. I think a lot of people are coming to grips with that slowly and still trying to figure out what is going to revert back to the old days, the pre-COVID normal? And what is now different in a more permanent or sustainable way?
Chris:
Yeah. And we’ll come back to the supply chain issue as it relates to pricing and other things here in a couple of minutes, but I’d like to move to talking about the labor force challenges that we’re all experiencing and not just the dynamic nature of whether people are coming to work, whether the cultural issues are coming to bear, vis-à-vis the remote workforce, etc., but just the availability of the labor force, the cost to maintain and to attract new people, and the ability to grow in light of these factors.
I talked to a recruiter friend of mine the other day. He does CFO and controller-level folks. And he said in those roles, he’s paying or the companies are having to pay, in some cases, 20, 25, 30% more than the incumbent is making in order to replace a retired or a transition type of a situation. So that’s a pretty material lift. And by the way, he used to talk to maybe 40 or 50 people to place one into one CFO position. Now he’s talking to 150 to 200. So that just tells you that the supply chain, as it relates to labor, is every bit as challenging as it is for goods and inputs.
Chase:
Well, and it’s so interesting because not all too long ago in the past, the conversation seemed to be centering around how is automation going to impact the workforce? And I think the general tenor of those discussions was that there was going to be a significant process or wave where sort of initially, let’s call them the low-skilled tasks, were going to be automated. And then gradually the automation would grow and increase in its complexity and its capability. And the big question was whose jobs are going to be threatened? And now all of a sudden with the way the last two years and the economy have behaved through the pandemic and now sort of where we are today, it seems like the number one question or at least a top-three question for most business owners and managers is where do I find talented people and how do I keep them around?
I think one other thing to keep in mind as we talk about these pretty unprecedented wage increases is wages tend to be sticky, right? It’s pretty hard to go back to an employee who you’ve given a 10 or a 15 or whatever the percent raise is and say, “Hey, given that the labor market has now regained some slack and loosened up a little bit, we’re going to cut your pay.” That’s a pretty tough pill to swallow. And so I think that’s sort of a long-term consideration for business owners to remain cognizant of because you’re paying your people more to keep them around and maybe the sales can support it right now. Odds are they can just given where the demand seems to be at, but over the long-term, those wage increases are sticky. And so the remedy is more likely to be that you may reduce the size of your workforce because it’s just an easier change to implement than a wage reduction.
Chris:
Yeah. The notion that inflation could even be transitory, I think is the word that they’re using, is not consistent with my experience. I’ve been in the work-
Chase:
I think they’ve even backed off that word.
Chris:
Well, I’ve been in the workforce north of 40 years and I’ve never seen inflation subside. I mean, the rate of it subsides, but I’ve never really seen deflation, at least not for very long and not in most cases. So to your point, yeah, it’s going to be pretty hard to back off of those input prices. What about on the demand side? Sort of backing up for just a minute, the sort of valuation lesson is valuation’s always forward-looking. I often say that we use the past as a prologue to the future, so what we don’t want to understand is why will the future be different? Why will it be better, worse, or flat?
Of course, one of the issues that we’re seeing now is whether some of the demand drivers that frankly spiked a lot of companies during COVID, industry-specific of course, but whether those are sustainable. Whether to your point, Chase, on some of the contractors in construction, is the backlog going to get prosecuted over time? Or is it ultimately going to dissipate? Are we going to see a continuation of the levels of demand that we have seen pretty much before COVID and then for the most part through COVID with a few notable exceptions? And that’s really a question that previews if you will, the future outlook for the company. So whether it’s an ESOP valuation as of 12/31 or whether it’s an M&A assignment currently where we’re trying to show a buyer why we’re going to recover from COVID in some cases or why we’re going to sustain the performance that we had, predicting the future on the demand side is a fundamental part of what we’re trying to do.
Chase:
Right. I think it all speaks to this sort of just assumption, because to your point, valuation is so future-driven. We often say with clients sort of two eyes on the windshield, one eye on the rearview. And so the question that either a buyer or a hypothetical buyer for evaluation purposes is inherently going to ask is, “Well, can you keep this up?” In other words, if you just had your best year ever, why was that, and is it sustainable? And so I think it’s probably a good exercise for owners and management teams, irrespective if you’re thinking about a transaction, just for planning and to get the sort of intel on your business, to try and get down to the brass tacks of why was it that we had such a great ’21, assuming you did?
Or why was it that we didn’t have such a great ’21? And if the answer is fairly low-hanging fruit, then so be it. But I think in a lot of contexts, it might be a little bit more complex than that. For example, if it drives off construction, did the Federal Reserve’s posture on interest rates really keep everybody at the table and keep the capital looking for, let’s say, real estate? Are you in a vertical that’s been really kind of suppressed in 2020, and then the pent-up demand in ’21, for something like, let’s say, travel or another another thing that just resurged with a vengeance from COVID? And really sort of have a gut check about, “Can we expect this to stick around or do we think this is going to subside to a more normal level?”
Chris:
Yeah. And so really one of the points or purposes of this podcast is to get business owners to sort of think through what measures are they taking or have they taken, and how have they been able to document, for lack of a better word, what happened and what might happen in the future so that they can support the future outlook, vis-à-vis budget or a forecast either to their ESOP valuation advisor, to their investment banker, or to anybody else that they’re trying to sort of pitch the future outlook to. Because whether it’s a third-party buyer in what I would call real due diligence, or whether it’s your valuation advisor, who’s trying to do that diligence in a more limited fashion, it’s super important to be able to kind of support, I don’t want to say contentions, but support the projections or future expectations with some data and with some thoughtful kind of introspection, if you will, about what happened, how did it happen, why did it happen, and what’s likely to happen.
So some of that’s a little bit easier said than done, but some of it really isn’t. Some of it’s just really undertaking an analysis of your business and many of you that are listening do that routinely. And some of you maybe don’t, and it might be advisable if you thought it through in that fashion.
Chase:
I think that sort of brings us to another thing that anybody would do in that exercise or just thinking about supporting projections and providing maybe tangible support or evidence for what they expect is going to have happened. Obviously, pretty clear on the horizon and at the front of everybody’s mind is the inflation that we’re seeing, which is fundamentally connected to and the result of these other factors that we’re highlighting, but it has some pretty tangible numbers on the page, impacts that business owners can think about, for example. When you forecast your budget for the business, typically that’s a function of two things among others, but price and quantity. What do you charge and how much are you going to do? Or how much are you going to sell?
And I think dis-aggregating or just allocating, “All right, here’s what we think we’re going to actually do, but let’s account for the fact that prices are going up. We think we’re going to be able to pass them on to customers, but we’re going to implement that at X date and it’s going to take a while to filter through the P&L.” I think just examining how such an aberrant change in costs, both on your revenue side, but also on your cost side, your inputs, is going to require some sober assessment this year as people think about where the results are actually going to come in.
Chris:
Yeah, that’s a great point. I mean, it’s pretty clear that in certain industries, volume measures are more relevant than revenue measures because you really want to see what the business is doing in the commodity business, for sure. The price can fluctuate, but in any business it’s really important to kind of show that to a buyer or to your valuation advisor. The other thing is we’ve seen, especially with contractors, the inability to sort of keep up with the price increases on the supply side or on the input side. So maybe a review of your contracts or your terms and conditions, contractor or not, where you’re going to get some protection for not only sudden, but rapid increases in inputs. We’ve had some industries where we’ve heard that suppliers are implementing three and four price increases inside of a year.
And very few people really predicted that and in many cases are not really protected from that. So again, that short-term performance, that first quarter, second quarter performance maybe is impacted by a more sudden shock to the pricing of your inputs, for example. You’ve got to have a way to explain why it either won’t continue at that level or we’ve changed our contracts, we’ve talked to our customers, we’ve put in change orders, we’ve had some way to protect against that happening in the future. And I think that’ll go a long way to either supporting, again, what you’re telling your valuation advisor, their ability to sort of buy off on the budget or forecast, and certainly with any buyer that’s doing any level of due diligence to be able to kind of get them off of the short-term underperformance if representing.
Chase:
Yeah, that’s exactly what I was going to go to is if that was a material factor in why 2021 or any recent period was maybe a little bit below expectations, then the question is what changes have you implemented strategically or structurally or contractually to get around that? I mean, I think the example we saw most frequently was we have contractor clients that bid a job and then the job starts six months later and they go to procure materials and they’re 20, 30, 40% more costly than they anticipated. And the developer or the building owner says, “That’s not what we agreed to.” And now the contract says, “Well, we may have the ability to adjust based on where pricing is when we ultimately go to procure,” but there’s a myriad of ways that changes in costs in certain buckets versus others can impact the business.
And I think Chris hit on the nail on the head. It’s not just about sort of the postmortem on what happened last year. It’s really about, well, why is it going to be different or more in your favor moving forward, sort of what have you done to respond to it.
Chris:
Yeah. And it’s always the more you can support it, the more you can kind of show some evidence or some analysis, a rational argument for what you’re kind of projecting, I think, goes a long way. So a lot of people look at the inflation impacts and say to themselves, “Well, what will the Fed do?” Or, “What is this going to lead to as far as interest rates, etc?” We all know that over the last three, four years, we’ve kind of been experiencing record low-interest rates and it’s pretty hard to get them any lower than they’ve been historically. What’s happened recently is they’re ticking up, right? So what happens in the next year or two as inflation rears its ugly head and we see rising interest rates?
Well, there are a couple of impacts. One, from a pure modeling perspective, higher interest rates lead to lower values. That’s true in real estate, that’s true in the business valuation, and it’s true really in any cashflow driven asset analysis. The other thing that happens is the rates of return, they sort of increase for the investor base. So again, the same factor. If they need a higher rate of return, they will pay you less for the business. The fear is over a medium-term that it will put a bit of a governor on let’s say multiples that private equity funds will pay, etc. I don’t think it’s time to panic on that yet. I don’t think the window is closing rapidly on that in terms of it being effectively a seller’s market. I think the biggest reason for that is there’s still a big overhang of capital, there’s still a lot of money chasing fewer and fewer good companies, but it’s certainly something to keep your eye on.
Chase:
The economic reality of rising interest rates also places a bit of a governor on their ability, they meaning the Fed, but just sort of the economy overall to rapidly hike interest rates. So to your point, yeah, I certainly don’t see this as a, “Oh my goodness, the rates are going to go up to a debilitating extent. And so the party’s over, so to speak.” There’s a lot of leverage out there in the system and the rates have been low for a long time. And so the act of increasing them amid this inflationary environment is going to be carefully done and I think done over a more gradual period of time than maybe the most hawkish Fed chairs would like to see implemented. But, yet to your point, I mean, I think it might be a bit of a disconnect or something that business owners maybe don’t have an intuitive sense of, that even if your company has no debt and, therefore, is not going to pay more interest on that debt as rates go up or be a constraint on your ability to reinvest to grow the business.
The approach to value in business is sort of capital theory of valuation exercise is really fundamentally dependent on, “Well, what is the discount rate? What is the rate of return that a buyer, whether it’s a private equity group or a large strategic buyer, or an ESOP, is available or is able to pay rather based on their rate of return hurdles or what they want to see in terms of their investment growth?”
Chris:
It’s an example of where the macro factor, the external factor, may or may not have a direct result on your specific company’s performance. In many cases, high-interest rates or rising interest rates do if you’re in a leverage situation or you’re financing your inventory or any number of other situations, but just because you don’t have any debt doesn’t mean that the rising rates don’t impact your value. And I guess that was kind of Chase’s point.
Chase:
Yes, you’re either a mortgage lender, in which case you know exactly how rising interest rates impact your business. Or you don’t have any debt and you don’t do anything that’s particularly exposed to let’s say the housing market or something of that nature, but, nonetheless, as rates rise, it may impact consumer spending, it may impact the flow of capital from one sector to another. And so I guess, to put a punctuation mark on that point, I would just say something I’m fond of saying, which is that there are two types of people in this world. Those who don’t know where interest rates are going and those who don’t know that they don’t know where interest rates are going. And so I always approach this topic with a fairly large grain of salt because something like the current geopolitical tensions can arise and radically change what the current intentions or thinking are around policy directions or rate hikes or whatever it may be.
Chris:
Yeah. And I guess I would say in closing these factors are obviously very interrelated. And so if you’re thinking about selling your business, make sure you’re working with a competent investment banker. If you’re thinking about transferring ownership in some other way and need an evaluation opinion, make sure your evaluation advisor is astute and factoring in all these things. And obviously, if you’re in the process of getting your 2021 ESOP valuation done, make sure you have good and deep preparation, and then conversations with your advisor to make sure that these factors are adequately addressed in the valuation.
Chase:
Yeah, I think that’s right. Thanks everybody for tuning in. And if you want to read the written version of this podcast, the article is published on acuityadvisors.com, entitled Valuation Updates in a Post-Pandemic Economy. Quick fine print. This podcast is for general informational purposes only. It does not create an advisor-client relationship between Acuity Advisors and the listener or reader, and is not intended as advice for a specific situation. As always, thank you very much to our wonderful sponsor, Acuity Advisors. Hope you’re all doing well. Tune in next time. And until then, take care, everybody.