The number one issue that the Department of Labor has been emphasizing to ESOP trustees recently is the importance of robust forecasting. Above and beyond any regulatory concerns, when done right, forecasting is part of good planning -- and better business planning ultimately leads to a better business.
All of this adds up to why we are so pleased to have Seth Webber from BerryDunn back on the podcast today. Seth is passionate about forecasting, and in this podcast he translates the forecasting process into plain English for our listeners.
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Episode 58 Transcript
Bitsy McCann: Welcome to The ESOP Podcast, brought to you by Captial Trustees, keeping you up-to-date on all things ESOP.
Bret Keisling: Hi, everybody, and thank you for tuning into The ESOP Podcast. This is Bret Keisling of Capital Trustees. It is my great pleasure to once again find myself in Portland, Maine at the offices of BerryDunn sitting here with Seth Webber. Seth, how are you?
Seth Webber: I'm great, Bret. Thanks for coming back up to Portland and thanks for the opportunity to sit down and talk.
Bret Keisling: Well, we're very lucky to be very busy up in the New England office and we're glad that, Seth, you've invited us. And one thing before we start with the podcast. We've been doing these for about 15 months now and if people have noticed in the last two or three months, BerryDunn's name might have come up quite a bit in the podcast and I just want to explain, a lot of times in our podcast, we'll take the time and explain the professional relationships between the firms. A lot of times valuation advisers might work for us, law firms and that kind of thing. BerryDunn, we certainly hope to do some stuff, but we actually don't have any business relationships at the moment, correct?
Seth Webber: That's correct. We have a couple things you guys have worked on that, from a valuation perspective, we were conflicted out and we had one great opportunity a couple of years back that unfortunately the folks got a better outside strategic offer and went that route.
Bret Keisling: So it wasn't that our work went down, they just chose not to go... but the point, Seth, and I want to thank you personally and Katie Whitehead on your staff and Sandra Smith and some other stuff we're doing. The fact of the matter is, you and the folks at BerryDunn on have kind of embraced what we're doing with ESOP podcast and you've reached out as often as I've reached out to you and just said, hey Bret, I've got this idea, and today came from you. So this isn't a Cap Trustees is trying to beef up BerryDunn. You guys aren't trying to beef up Capital Trustees. We just seem to be hitting off well on important topics.
Seth Webber: That's right. And one of the things that obviously is important to you guys at Capital Trustees and that's why you have the ESOP Podcasts, but BerryDunn as a firm, has knowledge sharing as really central to who we are as an organization. I mean, we're accountants, we're consultants, we're tax professionals, but really we spend a lot of time trying to figure out how do we translate all this information into plain English so that our clients can consume it and make better decisions with it. And so to the extent your podcast helps us get that message out we're happy to help out.
Bret Keisling: And I just wanted to very subtly make sure that you understood I ain't paying you to have these conversations now. [Laughter.] But no, we share the volunteering and the education and we appreciate it. So with that, Seth, the other thing about this podcast is that it's come about for the next couple of months. We are going to talk about forecasting and if we go back to an episode you had done in October of 2018 on feasibility studies, it might've actually been published in November of 2018, [in The ESOP Podcast Episode 53] we've got your background and BerryDunn's background. So we're just gonna get right into it. But the only thing by way of introduction is this wasn't a topic where I said, boy, we haven't done anything on forecasting. This is actually where you came up and said, I really like forecasting. I enjoy it. I'm thorough. I mean you're the real deal on forecasting.
Seth Webber: The forecasting is something near and dear to my heart, which is probably a subject of a totally different class of podcast for different day...
Bret Keisling: A psychological evaluation of what is important to each of us, but yours is forecasting and we will let that stand!
Seth Webber: Correct.
Bret Keisling: [Laughter.] All right.
Seth Webber: Yeah. There are some things ahead of it, but again we'll save that for a different day. [Laughter.] But, no, forecasting is something that comes up a lot for us because it's something that I have yet to find the client who loves the forecasting exercise. And yet there's so much great information that comes out of a good forecasting process that certainly is incredibly important for valuation, but really is important in helping organize and drive and align your organization. And it's very important within the ESOP community, but certainly, any business can benefit from a better forecasting process. And by better I mean more robust, well thought-out, annual forecasting process.
Bret Keisling: And Seth, to just build on that for one moment, the DoL and we've discussed it on some of our recent podcasts and they're certainly going to focus on in 2019, when the DoL is going after trustees for bad either transactions or if there's a bad company situation and it's employee owned. The number one issue that the Department of Labor has been hammering the trustees on has been not being robust with the forecast itself. So in the ESOP world we know that this is what has the government's attention. It's the number one cause. So we should address it in that sense.
Seth Webber: Absolutely. And what we're hearing sometimes I think in response to that DoL pressure is an increased resistance to, who does provide the forecast or what level of rigor do we put around the forecast. So my concern, and one of the reasons I wanted to have this conversation today, is that with the increased DoL pressure on forecasting people will actually back away from it rather than embrace it wholeheartedly. And so what we'd like to encourage people to do is just dig in deeper. And so what do we mean by that? Well, so Bret, you hit it. Some of it is the rigor that goes into analyzing the forecasts. So how do we develop a forecast? They're...
Bret Keisling: Well and even before -- Seth, I apologize -- even before we get to the how, let's extend the why. Because I also don't want people to be confused about the message we're sending with the DoL. Yes, it is very, very important in ESOP world. And you should do it for that reason, but that's not actually the reason to do it. There are good business reasons. So let's talk about the why. Not to get out of trouble with the DoL, but why are forecasts helpful to businesses?
Seth Webber: So where we see it being helpful to business. Let me step very deeply into my valuation world for a minute. And so for your listeners, a lot of them already have ESOPs or are involved in the ESOP process somewhere along the way. So there are three different approaches to value. There's an asset approach, an income approach, and a market approach. So the asset approach really starts with the balance sheet view, which is historic. And so an asset approach doesn't do a great job of capturing all the intangibles around the business. And those intangibles are really what drive a lot of value. So let's set that asset approach aside...
Bret Keisling: Toss out an intangible or two just to fill the example.
Seth Webber: Great. Customer list. Assembled workforce. Brand. Generally the Goodwill bucket. So all of the things that you do in your business where you take the assets and are actually using them to generate a profit. So let's take that asset approach and set that aside for a minute. On the other end of the spectrum, we have the market approach, which is, these are either we're taking information from publicly traded companies or we're taking information from the M and A, the mergers and acquisitions marketplace of completed transactions of whole companies and we're applying those to the subject company. So that's great information because it's out there and it's available. The problem is particularly when we look at the M and A space, we don't really know what the motivations of the buyers or the sellers are. So we have incomplete information, but we do have a lot of really good data that we can apply. So let's set the market approach aside for a minute.
Seth Webber: So that leaves us with the income approach. Well in the income approach, is really driven by the forecast. And so in our shop here at BerryDunn in the valuation group, we are in love with the income approach which is probably where my love of forecasting also comes from. But, one of the reasons we really like the income approach is we have something that we don't really have in the market approach, and that's access to the management team. So we can get in there and talk to the management team and really understand how does your business work? What's driving your financial performance? How do you think about the market, how are you positioned relative to competitors? And we can really get into this deep conversation about what's really driving the value of your business. And then all of that information, hopefully, kind of flows into a forecast of here's where we are and here's where we're going. And then we can assess the risk of that path forward, that where we're going, to come up with a value.
Bret Keisling: So Seth, take the comments you've just made and address them in the context of the DoL looking for more robust questioning of the forecast. What kind of questions would you ask? How does that flesh out?
Seth Webber: Yeah, Bret, great question. So when we think about, in that DoL context, it's really the questions that we should be asking anyway around the forecasting process. So one of the first areas is how does the forecast forward, or these future projections, link up to the historic performance? So does the growth in revenue make sense compared to what they've experienced historically? What do the margins look like compared to what they've experienced historically? So if there are gaps in those or if there is a large increase that's expected in revenue, say, then we want to start to ask some questions about, well where's that increase going to come from? Is it a new market, is it a new product line? Are you just finding...
Bret Keisling: Is it a gut feeling? Is that somebody says something. Which might be the answer, but it's not necessarily what you're looking for.
Seth Webber: Absolutely. And all of those are valid answers, but all of those may come with a different assessment of risk. So if it's, hey, we've been at this awhile and we are experiencing a breakthrough in the market and we've got the backlog to prove it, that's going to be a very different answer on where's that increase in revenue coming from than we are entering a new market with a new product and we are hoping for the best. Right?
Bret Keisling: So when we're talking about questions, let's just frame, first of all the purpose of the question. It's for better understanding, right? This isn't a sense of they're being misstated for nefarious purposes or there's anything untoward necessarily. The DoL is essentially saying that because the forecast is so integral to the valuation process that they want that question robust.
Seth Webber: Absolutely. And so you're right, Bret, we're not saying that anyone's doing anything intentionally wrong or doing it wrong on purpose. What we run into time and time again is people just simply don't love the forecasting process. Certainly not as much as I do. So it's something that they see rather to get through and get done with. So our job is to come in and understand, well, what's the logic that actually drove the numbers and to test out that logic. And I think that's what the DoL is asking us to do. But I think it's also what we ought to be doing in the normal course of events because it's things like as revenue continues to climb do you hit a constraint? Do you, if you're a manufacturing operation, at what point do you kind of max out your plant capacity? Or if you're maxing it out, are you maxing it out just on one shift or two shifts or are we really kind of straining at the seams? Because a lot of the forecasts that we look at they're based on the business as it's currently configured, it typically isn't taking into consideration, oh, once we get to this threshold, then we're building an additional plant. Now that may happen and that may be in the forecast horizon and if it is, there ought to be a business case developed around that plant expansion. All that capital expenditure is reflected the impact on cash flows, when do we expect to see a return, those kinds of things.
Bret Keisling: So, Seth, let me just ask this. I speak and I'm sure you do as well with a lot of entrepreneurs and I mean outside of ESOP world where they've got an idea that they want to pursue the business idea. And when I kick around just informally, and this is somebody who's either new in the business or that sort of thing, they'll say, Hey, we make a product I think we're going to have $100,000 in sales. And I'll say something like, again, very informally and I don't do valuation work, but how long has it taken to make that product and 15 hours? And I'm like, well, you would have to work yourself 190 hours a week; like, it's not physically possible.
Seth Webber: Right.
Bret Keisling: Is that part of what you're saying, hey, we've got this forecast, dig down deeper and find out is it practical, but also is it doable?
Seth Webber: That's right. And that's exactly what we're digging into. So and what you just described, Bret is something that we think of as sort of a bottom up forecast, which is, okay, what does our product look like or what is our productive capacity? So if it's, if we're a professional service firm and we're projecting a certain amount of revenue, then the question is, well, what's our average rate per hour? And so if I divide my average rate per hour by the revenue, how many labor hours does that represent? And if it's 3,000 hours per person per year, then either I'm working my people really hard or I may want to think about getting some additional people in the door. Point of reference, 2,400 hours is, is the typical labor hours per year for somebody. So at 3,000, we're working people pretty hard.
Bret Keisling: Right.
Seth Webber: But, or you know, if it's a forecast that's based on a certain number of units that are being sold then it's a question of, well, how many units can I produce in a day or in a week or in a month? And then scale up the math and make sure that the logic, again, the logic all hangs together. So it really comes back to just understanding what drove the forecast? Was it some sort of a unit analysis or volume analysis or was it we're looking for some top line revenue growth, but when you're looking for the top line growth, which would be a bottom down forecast, so you'd start with a revenue number and then start to break that revenue down into, okay, how many units does that mean? Or how many projects or how many, whatever your unit of sale happens to be. You know, what does that world look like? So that's, again, we're looking for the logic that brings those together. And from a best practices perspective, we kind of like to do both if we can. So it's a question of, okay, if we start with a top down process, so last year we did X in revenue and this year we're looking for 5% growth, then we start to ask questions about, okay what kind of customer retention rate do you have? So how much of the revenue from last year do we count on again for this year? That gives us an idea of how big is the new revenue target. And then we start to ask the questions of, well, how do we go about finding that new revenue, who is in charge of it. Do you already have it booked? Is it yet to come?
Bret Keisling: Well, and a lot of the questions we have Seth become the chicken and the egg, you know, which comes first. And it seems to me the way that you just outlined it of what revenue do we need to hit? Now how are we going to do it? Is one approach. A reverse approach is simply let's start and figure out what we think we're going to do. So company thinks their sales reps are going to sell each 200,000 a year and it works out to 20 million and we're just making up these numbers. You have a sense now they kind of equate to goals. So it can be, Hey, we're going to hit 20 million. How do we do it? And I'm posing this as a question or this is what everybody expects to do and here's how it totals up.
Seth Webber: That's a great point. And that is what we see a lot. And it brings to mind another point that I want to make. So let me make that point first. And that is if we're talking in terms of sales people and the sales goals, we not infrequently will hear about sales goals that are higher than what the projected revenue for the next year is. And that always brings about a question of, well, geez, is that appropriate? Well from somebody who's been in a general management role and who now does valuation for a living, I'm going to say, yeah, I think sales goals above what the budgeted or targeted revenue number is, is entirely appropriate because you're trying to leave yourself some room there for what if we miss the sales targets. The forecast that we're talking about, and the forecast that we use in the income approach, and the forecast that DoL is talking about scrutiny of is what is the operational plan? And so it's entirely appropriate to have stretch sales goals. That having been said the forecast and that operational plan that we have -and by we, I mean the valuation firm - we are hoping is consistent throughout the organization and as communicated to other groups. Right? So a lot of times banks are interested in kind of like, where are you headed or where do you think you're headed? And the same forecast should work for both audiences.
Bret Keisling: And Seth, from the trustee perspective, we very much would look at it as a red flag if we found out that forecasts were different, submitted differently to the bank versus the trustees' valuation firm just as every so often during a transaction or whatever, it will come across different balance sheets with the same date on them. And it's oftentimes it's sums in draft form. And again, we're being careful, we're not saying it's nefarious, but that's always a red flag. Is everybody getting the same information? Cause if the bank is being told one thing and the trustee is being told another, we want understand why there's different forecasts and there shouldn't be.
Seth Webber: Correct. Correct. And so one set of unified information is always much better. And you are mentioning it in terms of red flags, but in the valuation world we think of that as increased risk. Right? So if the information is not unified or there's not a good plan or not good logic or a good explanation, those are all things that lead to increased risk. And just...
Bret Keisling: Now we're saying the same thing - and I'm sorry to cut you off Seth - but we're saying increased risk except it might be risk from different ways. What increased risk are you referring to?
Seth Webber: Well, so I was going say, just when you think about valuation, I think it's interesting, hopefully instructive, to think about valuation as a, in your mind, picture a seesaw. So on one end of the seesaw we have company value and on the other end of the seesaw we have risk. So as risk goes up, our value is going to drop; as our risk drops, our value is going to increase. So very explicitly you're talking in terms of red flags and from a trustee perspective what you're looking for and documenting that and understanding what those areas of risk are. From a valuation perspective as we see increased risk that should be decreasing the value.
Bret Keisling: And I want to make clear that when I say that it's a red flag like so many things I put it in the category of we need to get more information to understand why there are different forecasts. If we say, "Oh, we sent that to the bank two months ago, you asked it for us today and we're going to send the bank an updated version based on this." We're good. You know, as long as we understand what's what. So it's not, it's a flag that we have to investigate. It's not a, Oh my Lord, bring out the guns, we have a problem.
Seth Webber: It's not necessarily a show-stopper. And the other thing is these are forecasts, right? So just like a weather forecast information on the ground changes. And so as that information changes, forecasts should be updated. And so one thing, for those who are listening if you don't do, this if you're preparing forecasts and send them out a good thing to do would be go into Excel, assuming that's what you're printing your forecast out of, and turn on the footer that allows you to put a time and a date stamp on it. Because that way if there's any question as one, was the forecast produced there'll always be a time and a date stamp on the bottom of it. And so it'll be easy to reconcile in your records. Hey, when did we produce this? Didn't we have later information that we thought was better? We have a company we're working with right now that is in a transaction phase and they had some meetings a few weeks ago with a couple of their top customers. And as a result of that, they have some revised forecast information that we have not yet published, but we'll be doing soon into a data room so that the valuation firm on the other side can see what that latest and greatest information is.
Bret Keisling: And Seth, the other thing is, again, we want to make clear that things aren't necessarily problematic it's the way things happen. You might give a forecast to a valuator, let's say December 15th, just so that it's before year end, you know, if you have a December 31st closing. And two days later you might get a call from your biggest supplier who says, "Hey, costs are going up 10%." Your forecast should change. And that's very understandable than it could. So when we're saying we want a true snapshot is what we're trying to get, it's not...
Seth Webber: Absolutely.
Bret Keisling: Updated as you get information.
Seth Webber: Yeah. So updated as you get information. Then the other thing that that happens is you put together a good forecast. It's been vetted, you've had conversations with the valuation firm about it, and then the business environment changes or factors that are external to your company change. There's a company here in Maine that as soon as the tariffs went through saw a 25% increase in their cost of raw materials. That has had a dramatic impact on their profitability this year. What it means long-term still remains to be seen. But that's the other thing. So once the forecast is done and vetted and baked in the next year somebody may come back and look at the forecast and you may have exceeded targets, you may have missed targets. Then the questions change a little bit to what's the rationale behind the miss? If there's good explanation that doesn't necessarily create a large problem it just means that the forecast wasn't as accurate as we'd like it to be. And but what it does mean is we'd like to see whatever that problem was or whatever that situation was, you know, if it was confined to the past year, great, then we would expect to see a return to historic levels or if it wasn't confined to the past year. How does that information inform this year's forecast and process?
Bret Keisling: Seth, the tariffs are a great example because it allows me to contrast two different things. Last year, Congress in late December, as you recall changed the tax structure dramatically, lowered taxes. And so there was a lot of robust conversation between trustees and valuation firms and, and valuation firms just everywhere, in terms of how to handle the tax effect. But there was also an understanding that we all understood that the tax rate change was going to last at least a couple of years until a new Congress comes in until, so moving forward for a finite period of time and perhaps infinite we have those tax rates.
Seth Webber: Right.
Bret Keisling: The tariffs, now, by contrast, President Trump, and not to talk politically, but gets up on a Sunday morning at 5:30 AM and tweets China bad, we're going to have tariffs. Nobody knew about an advance. It couldn't have been implicated in the current forecast. And it will take a little bit of time to play out. And unlike saying, hey, these are the tariffs, that's been a rolling target. Tariffs we're setting, tariffs China setting. So mid-year, how does that...
Seth Webber: It's a great point, Bret. So one of the things first in terms of tax rates, so the Tax Cuts and Job Act [of 2017] was enacted sometime late December. I think the date was the 20th, it might've been the 21st of December . It might have been a Christmas present to lots of business owners out there, but it was decidedly not a Christmas present to the professionals because it left very little time to do any planning or understand the implications before December 31st rolled around. And one of the things we always try to do is put ourselves in the shoes of the valuation date. So what's known and knowable as of that valuation date. So as of December 31st we did know Tax Cuts and Job Act is here. It was in effect. And we know what those rates are expected to be per legislation. So there's speculation, might they change sooner? They might, but that's not what we know and that's not what's currently written into law. So we go with the law as it's currently written and configured. As it relates to tariffs in these outside forces that we don't have any control over, you're right, we don't have any control. They weren't baked into forecasts last year. The interesting thing will be to see what happens this year, and by this year I'm meaning 2019. So as these changes kind of roiled through our industries in 2018, what if anything has it done to change the way that we're doing our planning for 2019? Is it changing the way we're writing customer contracts so that it's kind of more of a cost plus. So if base materials increase that we get to maintain the same profit margins. Are we operating in industries where that's not an opportunity we have and so we're forecasting some margin erosion because now that we've seen these swings back and forth, we're worried about what's going to happen to profitability for the next year. Are we forecasting that there's going to be a couple of years of profit dislocation and then we're going to figure out one way or another to squeeze expenses and other areas of our business to get back to the margins that we expected. So there, there are no standard answers to this as hopefully some of the questions I'm posing, that it comes across in some of the questions I'm posing. But this is the logic that we want to pry into and understand because what we, what I, have found in my practice is that margins do tend to return over time. And so, if it's not there in cost of goods, people are going to find other areas where they can scrimp and save and manage their expenses a little better to get back to what they've enjoyed historically. That having been said, there are other industries that are under constant margin pressure and they should be forecasting some erosion in margins if that's what they've experienced in the past.
Bret Keisling: We have a client, Seth, that is involved in an industry that has eroding margins and to the point where the company is very profitable and there's added revenue but the margins are lower. And they got an offer from a big conglomerate that actually has crazy low margins. And what was interesting to me is this big conglomerate was like... Whereas my client company is saying, "Oh my God, our margins have eroded!" Big conglomerates saying, "We'd like some of those healthy margins!" So it's in the eye of the perspective. If you are normally getting six or seven percent margins, or have six or seven percent margins, we wouldn't necessarily say that's robust, but if you find somebody who always got one and a half percent...
Seth Webber: That looks pretty good.
Bret Keisling: Yeah!
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Bret Keisling: So, Seth, in big picture, and first of all the questions that we're asking, again, it's characterized, you made the point a moment ago, of we're not saying these are bad questions or tough questions, they're just questions. And the answers aren't necessarily wrong, we just have to understand. As I've said on a lot of different podcasts and the valuation has -- the valuation adviser has -- the same situation. We don't make value judgments 99% of the time. We're not looking over management shoulder and second guessing them. We just need to understand. So is it correct to say that across the board on the financials, I don't know if it's just top line, but salaries, are you planning to give any raises? You don't need to go through 200 employees and decide. But generally what have you done? Like everything across the board, suppliers, employees, benefits, things outside of your control. You want to look at everything.
Seth Webber: Absolutely. And we do. Now how granular do we get? It depends a lot on the company and it depends on what their forecasting process looks like. So, benefits as healthcare continues to be more and more expensive, what are you doing around benefits and what have you plugged into your forecast? Cost of goods. What do you have programmed in? What are you seeing in terms of raw material inputs? What are you seeing in terms of labor inputs? As unemployment is low and it's harder to find people and wages are going up, what impact is that having on your business and on your forecast and on your expected profitability? Executive compensation, are there changes that are coming that are planned? And if there are, are they baked into the forecast? So it's, we go through item by item...
Bret Keisling: If you lease your facilities. If you own them but your mortgage just changed. Every single thing that's going to go, you want a thorough look.
Seth Webber: Absolutely.
Bret Keisling: Seth, you -- we had actually chatted at the Las Vegas conference. And you shared an anecdote, and I may have the words wrong, but the difference between accuracy and precision.
Seth Webber: So Bret, this may be more related to my background as a recovering engineer, but I often talk with my team about the difference between accuracy and precision. And so it's a little tough to do on a podcast without visuals, but imagine if you will, a bullseye. And what I'd actually like you to do is imagine four different bullseyes. So if we have high accuracy and high precision, if we take four shots of that bullseye, those bullets are all going to pass through the exact same hole. If we have high precision but low accuracy, I may put four bullets through the same hole, but that hole is nowhere near the bullseye. And that, from a valuation perspective and from a forecasting perspective, is the very situation we're trying to avoid, where we have something that's very precise, but it's nowhere near on the mark of what we expect operations and performance to look like. When we have low accuracy and low precision that frankly looks like when I try to go shooting for target practice because the bullets are kind of sprayed all over the target. But what we can have, which is interesting is we can be very accurate but not precise. And so what that might look like, if you'd imagine four shots at a bullseye and none of them is in the center ring. None of the four shots is in the center ring. But if you were to average those four shots that it would intersect directly with the bull's-eye, that might be a very accurate but imprecise forecast. And that from a valuation perspective, this may be a little bit of a bold stance to take, but I'm going to say it anyway. That's okay. As long as it's accurate. It's not the precision that's required for our forecasting purposes and to get a good number on the valuation. But it does have to be accurate. And so what does that look like? So if you have a share price that's being done to the thousandth of a penny that is very precise, it may or may not be accurate.
Bret Keisling: Well, if the trustee sets it, it is accurate, sir. [Laughter.]
Seth Webber: It is both then, accurate and precise. [Laughter.]
Bret Keisling: No, no, but your point, and I was making the joke regarding the trustee having that fiduciary level to be accurate so I couldn't... but your point is very well taken. I've kind of also thought of it in an example in terms of the forecasting, Seth, the process is the difference between we expect payroll to go up 8% is accurate. Here's a list of who's getting raises that's precise. We don't want... Is that a good analogy?
Seth Webber: That's a great analogy. And we may or may not need that level of precision of the actual employee census and here is the, here's the exact plan of who's getting what for an increase. But if your historic precedent has been to give on average 5% increases and that's your plan for the year going forward, then that's what we'd want to see reflected. Now who exactly gets what portion of that 5% increase in salary. From a valuation perspective, I'm not that concerned. From a trustee perspective, if all of that five percent is going to one or two people, you may be!
Bret Keisling: Your point is very well taken and we'll save that for another podcast because I don't want to confuse the issue. Generally speaking, if there's nothing that's untoward and it doesn't put out the high paying, the highly compensated, and that kind of thing, there's not a concern with who's getting it.
Seth Webber: I would agree with that. And it's the same thing on back to like direct labor inputs. If you generally have an idea of what you're expecting to see in the upcoming year but you're a little worried that one or two or three positions may be more expensive to fill and you're a 300 person organization, those three positions being a little bit more expensive to fill is probably not going to have a material impact to where we're headed with the valuation.
Bret Keisling: Conversely, your national sales manager just passed away unexpectedly, a relatively young person. And it's a very important position and a little bit of a crisis mode if company hasn't done success[ion] planning that kind of thing. So maybe they have to go out and drop a hundred grand on a search firm or something. But now, there, we want to be a little bit careful because I just gave an unexpected situation which can't necessarily be forecasted.
Seth Webber: Well, so this is actually an interesting point. So let's say halfway through the past year you ran into that unfortunate event, national sales manager passed away. It was unexpected. And so you as an organization incurred an extra, $100,000 of expense to a search firm, or maybe half of it was in 2018 and half of it's going to be paid in 2019 when they fill the position. Now, both from an accounting and a valuation perspective, we're expecting that hopefully to be a nonrecurring event. So the a hundred thousand dollar expense, different folks are going treat it differently, but it, when we're looking at comparing historic performance that hundred thousand, we may add back in because that's not something you'd expect to see each and every year. So that has more to do with the historic analytics of it.
Seth Webber: Now to the forecast. Let's say that person, that national sales manager has not yet been replaced. The forecast for next year probably is gonna have a little bit more softness in revenue at least at the outset of the year because that key leadership position isn't filled or where we would expect to see that anyway. And conversely, let's say that it doesn't, let's say that the revenue for last year -- or for next year -- looks a lot like it did for last year, but we know that this event has happened. So my practice would not be to go in and adjust that revenue number down. Because if we've spoken to management and they've said, look, we understand where you're coming from, but we have high hopes that we have enough momentum to carry us over this hump. We have a candidate identified, they're going to be on board beginning of February, so we're really only hoping to lose January. You know, those are all factors that would mitigate risk, but if there's not really much of a plan and we have heard from the search firm that this may be a six month process to identify that replacement and we know there's going to be some learning curve time to get that replacement up to speed. I'm certainly going to be taking a hard look at company-specific risk and whether or not value, given that forecast, whether or not value has to go down as a result of these, these increased risk items for the company.
Bret Keisling: Let's talk about the philosophy of the folks who are putting the forecast together. I hear sometimes, and I'm sure you do, well we were conservative with our forecast or we're a little bit liberal and one of the threshold questions we have is, is it attainable? But how do you, what's your approach if someone says, Hey, we're a little bit conservative, a little bit liberal, what... We want accuracy. How do you fit in that mindset?
Seth Webber: You know, we do, we want accuracy. And, but coming from a background of corporate finance and valuation and all that good stuff, there's also a very different reaction generally speaking to positive surprises than there is to negative surprises.
Bret Keisling: We'd rather exceed a little bit than miss a little bit.
Seth Webber: Absolutely. And so we often see, so one of the things we do is we actually measure forecast accuracy on both a revenue and an EBITDA basis for our recurring clients year over year. Which is interesting, cause we're plugging in their historic numbers, we're plugging in the latest forecast and then we're plugging in the series of successively old forecasts to see kind of what are the trends. We've got a draft report we completed recently that over the years their revenue has continued to climb and the revenue has continued to outpace the revenue that they had in the forecast.
Seth Webber: But what's interesting is year over year as we look at these successive forecasts, the successive forecast for revenue have increased. So not only for the next year but the out years because they do want to be conservative and yet they recognize that as they're growing as an organization, they're out in their field more and they're attracting attention and attracting, more and more opportunities. And so the forecasts in successive years reflects that. Now on the profitability side, it's been much more variable, but again, over the years we're monitoring that. And so sometimes we hear from trustees or other folks of, well, a 20% miss on the low side, so under forecasting revenue by 20%, versus a 20% miss. We were still off 20%, isn't that true? Yes, that is true. But again, markets investors and a whole lot of other people react very differently to negative surprises rather than positive ones. So we think there is a little bit of philosophy on being conservative with forecast, the thing from a valuation perspective that we need to be careful about is if we have a conservative forecast, we don't want to build in a whole lot of risk in our cost of equity that has risk of missing the forecast because then we'd be double counting and really depressing the value of a company.
Bret Keisling: And that's the interplay that I wanted to spend just a moment for, because the effect of the forecasting, first of all, it's very much part of the valuation and there are things that can't necessarily be quantified directly that are addressed through the company specific risks that you use. At a certain point, and again we've talked about, can management explain what things have happened? If we take your example where they missed the forecast by 20%, first of all, that would be bad. But if it's understandable, manufacturers shutdown unexpectedly, whatever it might be, then we understand it. If they're exceeding the forecast by 20%, my concern is the practical effect could be to depress value, could be one of those things where it was intentional because sometimes management of ESOP companies don't look at share value the same as if they were the sole shareholder. So you depress it, it lowers repurchase obligations and that sort of thing. But, and this is where the company-specific risk comes in. If it's simply -- and 20% is not being conservative, in my opinion, that's being wrong -- and at a certain point, the valuation firm I would expect would increase the company-specific risk simply because the numbers are better. But is there a question that management doesn't really know how to forecast?
Seth Webber: The question of the increase of company-specific risk, I think very much relates to which way is the miss happening. Because if the company is consistently over-performing their forecast and we layered in a lot of company-specific risk, we would be looking at a forecast based on a lower set of numbers and we'd be increasing the risk, which would really be driving the value down. I think if that were the case, you'd be more likely to see a conversation that would take that company-specific risk and maybe bifurcate the explanation of the company-specific risk. And what you might see would be something that says, the company-specific risk encompasses a wide range of things. Part of which is our assessment of whether or not management can attain the forecast, given historic performance we feel there's very little risk to company missing their forecast which argues for a lower company-specific risk. So it would still be saying, we think there's some concern here with forecast accuracy, but if you were to increase company-specific risk because that wasn't a robust process my concern would be that we might be really punitive to share price. But again, it, and this is where I play lawyer and say, but it's all dependent on the facts and circumstances.
Bret Keisling: Well, and that's valid for valuation advisers and as well as lawyers, but not too good for mechanical engineers. "Eh. Maybe, maybe the bridge will be okay!" But Seth, isn't it -- I guess, and let me change the fact of the hypothetical that I'd given you a little bit, because if a company just misses the forecast in a given year, again, we look for explanations or whatever, but it's a given year, right? If historically, and let's just say that you've been doing the valuation for the last three or four years, so BerryDunn has perspective on this and every year they've missed it by 20%. So now, you know, that's the way it is. The challenge is not even necessarily the forecast for this year, but presumably all the outlying forecasts, if they're all off 20%, you're looking at a pretty good miss in valuation based on the forecast.
Seth Webber: Absolutely. And, you know, I'm knocking on wood as I say this, Bret we've been fortunate to not have that in fact pattern amongst our recurring ESOP clients. What has been more common is kind of a reaction slash overreaction cycle that you see in clients sometimes. And what I mean by that is if they had a forecast in one year where they underperformed, the following year forecast might be all baselined on that miss.
Bret Keisling: Once bitten, twice shy kind of thing.
Seth Webber: Exactly. Once bitten, twice shy. So they may have pulled down both that year and the out years. And then the next year they might have seen a return to a more common historic performance. So they overperforming forecast. So then they kind of pull back up. And so you see this kind of two or three year kind of swing to what the forecast looks like. And that's where I think some dialogue between the valuation firm and the management team can be really valuable. One of the analogies I use is if you think back to when you first learned to drive what we want to do is make sure we're not aiming for six inches off the front bumper. Because if we do, we're overcorrecting a lot. And as we overcorrect, we're swinging the car, back and forth, which in the best of circumstances is a choppy ride and in the worst of circumstances is just downright dangerous. And so then apply that analogy out to the forecast for your company. So what we really want to do with that forecast is take that longer term view and that's the beauty of doing a five year forecast. So maybe there's a dislocation this year by dislocation -- customer problem, a vendor problem.
Bret Keisling: I killed off the sales manager, we had tariffs....
Seth Webber: Bret killed off the sales manager and now we have to replace him. But that's something that should have an impact on a finite period of time. And then we'd see recovery. And so a five year forecast gives us enough time to see that impact on margin and then recovery to some sort of a steady state operation or you're in a cyclical industry. So what year are we predicting a down year and then recovery. So if we're taking that long-term view, that's often the first conversation we have with folks about the forecast. If there is a miss, what led to the miss, where are we at? How are we reacting, recovering? And then the question is, and what does this do to our long-term view? And if it's these were isolated events and here's why and there's a good explanation, then, maybe the long-term direction is accurate. If something has changed on the ground, the faster that's reflected in the forecast, the better it is for all involved.
Bret Keisling: Absolutely. You'd mentioned five years just now, when you're requesting a forecast, three years, five years longer? What do you look for?
Seth Webber: So we typically ask for five years. We hear from people, we can only look out 18 months. Three years makes us really uncomfortable. There are situations where we've done a three year forecast but we really do push people to think about five because again, as we were just discussing, that that gives you enough time to kind of see what's the short term impact on what's our long-term plan for recovery. You know, if you've got that kind of a situation. And I realize it's uncomfortable when people don't love to do it. But the flip side is, understand that a lot of, at least our clients, a lot of them are buying five years, seven year, ten year equipment. And so on some level you are making forecasts and judgments as to where you're expecting yourself and your company to be five, seven, 10 years from now.
Bret Keisling: And that ties in. We would want the forecast, as you said, just to reflect on ROI on a major capital expenditure. You know, something along those lines so that it's not just, you know, examples I use in other podcasts is, management has just bought a $3 million yacht and they're based in Montana with no water around.
Seth Webber: That ROI is going to be difficult to justify.
Bret Keisling: That's exactly right. So what the forecasting really is, if you look at the totality. And ultimately Seth, your passion for the forecasting, you need them and I need them as tools in what we do. But it appears to be that it's just solid business management.
Seth Webber: Well it's good business planning and it, it gives you a sense of as we talked about some of the top down and bottom up pieces, it gives you a sense of where's the revenue coming from? Do we have the right parts and pieces in place? Do we have a plan to go out and achieve our objectives for this next year? And all of that, better planning leads to running better businesses.
Bret Keisling: Seth, thank you very much for taking the time today to talk to us about forecasting. The importance of it is very clear and you've helped shed some light in a topic that I think jams up a lot of managers in terms of, "Oh, how do we do this?" And at least you provided some insight into why we find it important.
Seth Webber: Thank you. And thank you for the time. And if this is something that I like talking about and I'm sure we'll be talking about this in the future in other roundtables.
Bret Keisling: You just forecasted that we'll talk about forecasting.
Seth Webber: Exactly!
Bret Keisling: Yes. And if you look for Seth Webber on LinkedIn and through BerryDunn's website, you can get your contact information. I imagine Seth if there was anybody who had forecasting questions for you, you'd be happy to talk and if they wanted to hire BerryDunn, you'd be amenable to that as well.
Seth Webber: Both would be welcome. Thank you Bret.
Bret Keisling: Seth, thanks for joining us today and thanks for everything as always.
Seth Webber: Thank you.
Bret Keisling: Alright, and listeners, thanks for joining us. We'll look for your next week on The ESOP Podcast. Have a great day.
Brian Keisling: Do you have feedback about this or any other episode of The ESOP Podcast? Do you have a topic you'd like for us to discuss on the show? Would you like to appear on the podcast as a featured guest or a panelist in a group presentation? Then we want to hear from you. Send us an email at firstname.lastname@example.org. Thanks for listening!
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