Podcast: Figuring Out Your Cash Flow, an Interview with Ken Sanginario
Understanding what value drivers are so you can improve them and, therefore, your valuation.
About the Host
Ryan is an entrepreneur, podcast host of the show Life After Business and the co-owner of Solidity Financial. Having personally experienced the hazards of selling a business, he joined up with his friend Brandon Wood to educate others on the process. Through their business (Solidity Financial), they provide a platform for entrepreneurs called Growth and Exit Planning that helps in exit planning, value building and financial management.
About the Guest
Ken Sanginario is the Founder of Corporate Value Metrics, creator of the Value Opportunity Profile® (“VOP®”), and developer of the prestigious new Certified Value Growth Advisortm (“CVGAtm”) training and certification program.
Ken has more than 30 years of experience providing executive leadership and strategic advisory services to private middle market companies, developing and executing business improvement initiatives, turning around distressed operations, managing M&A transactions, valuing companies, and securing equity and debt growth capital.
He is an instructor in the training and certification programs of the Alliance of M&A Advisors, Pinnacle Equity Solutions, and the Exit Planning Institute, teaching about business value growth in each program. He also serves on the advisory board of the MidMarket Alliance as its educational leader, and serves on the Boards of Directors of several privately held companies.
Ken is a frequent speaker at national and regional conferences and private business owner functions, and has authored numerous articles on business value growth, corporate valuations, mergers & acquisitions, and turnaround management. He is also the Board President of Solutions at Work, a charitable organization focused on breaking the cycle of recurring poverty and homelessness.
If you listen, you will learn:
- Ken’s time as a business consultant.
- His experience as a CPA, CFO, and his multiple credentials.
- How Ken designed the Value Opportunity Profile.
- Why Ken felt the need to create a standardized process.
- The Company Specific Risk metric and what it means.
- The 3 traditional approaches of value assessment.
- Why the market approach is a shaky approach and multiples are meaningless.
- Why the income approach is considered the one true method.
- The pros and cons of value assessment approaches.
- The 3 parts of the discounted cash flow method.
- The 8 primary categories to create maximum value.
- The 50 subcategories that are based off the prime 8.
- How Ken’s system is connected to due diligence.
- The 2 components of cost of capital.
- What is intrinsic value?
- The difference between a financial and a strategic buyer.
- The baby boomer issue and how younger business owners can help.
- Run your company at the highest quality at all times.
Ken Sanginario: And we found that companies have the ability to double or triple the value. Most companies, most private companies anyway, have the ability to double or triple your values over a three to five year period if they really understand all of the risk factors that are constraining their growth and profitability and value, and they become focused and disciplined to improve those weaker areas.
Announcer: Welcome to Life After Business, the podcast where your host, Ryan Tansom brings you all the information you need to exit your company and explore what life can be like on the other side.
Ryan Tansom: Welcome back to the Life After Business podcast. This is episode 131, apologies for the cold. I've got my two little twins at home that are like little petri dishes. Good news is I recorded the episode a couple weeks ago, so I am just fine and I sound like a normal person in the actual episode. And this show and this specific episode will be one of the most important things I think you listened to. If you are a business owner and you're trying to understand how much your company's worth, whether you're a potential business buyer and you want to know on an identify how much you should pay for that future business and that future cash flow and if you're an advisor that works in the space of mergers and acquisitions, whether you're a CPA, a business valuation consultant of M&A attorney or an investment banker or broker.
Ryan Tansom: This episode with Ken Sanginario is so important because we completely unpack the world of business valuations. How do I identify the intrinsic value of that company and what is the value of that asset that kicks off that cash flow and then what are the specific things in that business which can identify as as company specific risk or future value opportunities to increase the value of that business by two or three X. and how do we identify what risk or what confidence we have in the growth of that future cashflow. And the reason that this episode is really important is because Ken, from the years of experience that he has in the masters in tax and master's in finance, is turnaround investment banking experience. Being the CFO of a public company really understands capital capital allocation and understanding that if I put money over here, what should be my internal rate of return and deploying that capital and most mid-market and lower market business owners don't look at their businesses like that.
Ryan Tansom: We go into our visionary meetings, whether we're running traction or scaling up, we come up with really good ideas that are based on gut or industry experience. And then we just make decisions without necessarily putting a layer and our perspective on saying we want to increase the value of this business and how do we build a company that can have sustainable, predictable growth in the future. Because if we got a couple million dollars in capital tied up in this company, what else could we be doing at that? Different industries, different companies. And then how do we protect this asset and this cash flow now and into the future. So Ken and I talk about why the current state of business valuations is not adequate for especially the underlying assumption that there's 4 million plus companies you need to be going to market in the next handful of years when the boomers, and if we do not address this world of business valuations correctly, how do we have a marketplace of buyers and sellers if there's not an adequate way to price these assets?
Ryan Tansom: I mean, it's kind of crazy when you think about it. So I think this episode is really important. If you are a current business owner and you want to increase the value of your company by getting it ready so that way no matter what exit you have, whether it's internal or external, you know the value of that business and then how you will reap the rewards of that asset when you go to pull the ripcord. And then if you're a potential business buyer, you should be identifying the value of a company based on the internal specific risks of that cash flow. And really identifying the future growth potential of that asset. So if we focus on the intrinsic rate of return of that asset, which is your business, then you're identifying your financial target, which is the second principle of the GEXP principles. If you know that no matter what the intrinsic value of your company is x, then no matter who you sell it to, you should be able to get that because that's what the rate of return is getting produced.
Ryan Tansom: Buy that asset. But if you go to the marketplace and now you, no matter what, you can hit your financial because you've got that internal rate of return of that asset. Then you can pick the right buyer for the right reasons. You can layer on a strategic synergies, potentially get more than the intrinsic value of that company B, because there's strategic reasons are going to provide a higher rate of return from that strategic buyer. If you're interested in the value opportunity profile, which is ken system, reach out to me or anybody on the GEXP team, reach out to Ken, send Generra, which all of his information is at the back of the episode. Tons of good information absolutely must listen to. If you're a current business owner or a future potential business owner, without further ado, here's Ken's engine area.
Announcer: This episode of Life After Business is sponsored by GEXP Collaborative. Their proven process gives you clarity on all of your exit options and how those options impact your financial success, timing and future happiness. Sell your company on your timeframe to the buyer of your choice at the price you want.
Ryan Tansom: Ken, how are you doing?
Ken Sanginario: Doing great, Ryan, thanks. How are you?
Ryan Tansom: Good. And we were just laughing because this is the second time you've been on the show and it's been about two years, which we, neither of us believed it was that long. So I know that it was three years ago that I met and it goes really fast. But you know, for the listeners that maybe have not listened to your episode, I would like you to maybe explain a little bit of your background again for the new, uh, the new listeners. Because I think by the time that you had done your episode, I was not having the momentum that I think we now have with our listeners. But in your background is important for this episode as you and I planted, taking a different approach of really educating everybody that's listening on business valuations, your background, and the just the, the, the inherent problems that are kind of going on with the baby boomers retiring and how business valuations are done and how to maximize the value of the company. So your background that led you to your expertise is super fascinating. So why don't you just kind of give our listeners like how did you get into this and what are the, how did your background led you to where you are today?
Ken Sanginario: Sure. Thanks. For the last 19 years, I've been a business consultant advising middle market and lower middle market private companies. And for most of those 19 years I was actually a turnaround consultant, one of the only about 500 certified turnaround practitioners in the US. And in those roles, uh, I would often take deep dives to take, actually take over the operation of a company at the request of sometimes the business owner, sometimes a private private equity firm that owned the company, sometimes a bank because the company was in workout and the bank wanted to have their own person running the company and I would take over and develop and execute a turnaround strategy and then either recapitalize or sell the company on the back end. So through that process, um, in those engagements, actually they would last anywhere from say six to 18 months. And through that process I got involved in business valuations and then mergers and acquisitions. So I ended up managing M&A transactions as well. And, um, those were often really deep dives, deep turnarounds of companies. And back during the recession, the recession in 2008, 2009, we were getting a lot of requests. My partners and I, uh, from some of the larger bank workout groups who were getting inundated with troubled companies being pushed into workout. And the banks didn't even have the bandwidth to properly triage these companies coming into work out, so they were engaging us to go spend a week or two in the field and assess these companies and write a report and come back and let the bank know is this company a train wreck that we need to fix right away?
Ken Sanginario: Or can it be put on the back burner, can it be fixed, and if so, how and can you help fix it. So we started doing a lot of those kinds of assessments and in doing them I started realizing I had three other partners at the time. I started realizing that we all did high quality work individually, but we all had our own approaches and if we were to take say 10 of our reports and lay them out on a conference table and each of us have done two or three our reports, we'd often look very different and we might get to the same answer on any particular engagement. But our process was our processes were different from each other. We would interview clients differently. We would write our reports differently, our just our sort of language that we use in our reports was different.
Ken Sanginario: The flow is different. We cover different issues in different sequences and different depths and so forth. Ultimately we'd probably get to the same answer on any given engagement, but we'd get there very differently and it started to concern me at first from a quality control standpoint. When I would. I would say to my partners, hey, you know, if we have one bank that engages us for 10 assessments, our reports need to have the same look and feel. They need to have the same flow and the same way, the same process that we follow so that the bank has confidence that they're not hiring four individuals, they're actually hiring a firm. And secondly, from our, our own quality control standpoint, we need to make sure that we have a process that can stand up under pressure and be used consistently so that we can scale our own practice and we can train the associates that might want to join us.
Ken Sanginario: How to actually do this kind of work. So that was one of the, the genesis of developing what has now evolved into our software platform called the Value Opportunity Profile, which I'll describe in a little bit more detail, but the second factor in starting to develop that kind of a software platform was my experience in the business valuation world. And um, it was interesting because I went through formal training from two different associations to get certified as a business valuator and both of them gave basically the same kind of training and in the training you're required to go through all of a whole lot of kind of deep dive due diligence on a company when you're, you're required to go through certain processes that you may know going into the engagement that some, some or all of these processes are not going to be valuable in the end product, your valuation conclusion or your valuation report.
Ken Sanginario: But you still have to go through the process just to document that you went through a process and it turned out that that certain approaches were not, were not relevant or were not credible for that particular kind of engagement. What struck me was that there's one section of the valuation process that has the absolute biggest impact on the value calculations of a company or on the conclusion of value of a company and it has absolutely the least amount of training around it and the least amount of field work required in order to make your conclusion around that factor. And it's a factor called company-specific risk, which has become sort of near and dear to everything that I do and the way I look at companies, the way I assess companies and the way I value them, the way I, the way I advise them all, uh, now surrounds this whole concept called company specific risk.
Ken Sanginario: And company specific risk is a process of identifying and understanding all of the qualitative factors of a company that can impact the company's future favorably or unfavorably. So think of it as, as any, any factor, any particular area of a company that might constrain the company's ability to grow, to become more profitable and to have cash flows in the future. We, we, we have three, sort of the three factors that I labeled cashflows to be the most valuable. Are they sustainable, are they predictable and are they transferable and so any qualitative factors on accompany any areas of a company that are not quite developed that could be constraints to the company's cash flows being sustainable, predictable or transferable impact the company specific risk factor. They are risk areas of a company, so any risk of the company impacts its future cashflows and impacts the value of that company.
Ken Sanginario: So that's kind of the ways that I started creating a standardized approach to be able to efficiently and comprehensively assess a company for purposes of these bank workout groups, but also to take that process into the business valuation world and improve the valuation process so that valuations could not only be used for compliance purposes, but they could also be used for strategic purposes. And by really understanding the constraints and the risk factors that impact the company's value, you can turn the whole process around and use it to help companies strategically help them improve, help them reduce their risk, improve their quality and increase their value. And we found that companies have the ability to double or triple the value. Most companies, most private companies anyway, have the ability to double or triple your values over a three to five year period if they really understand all of the risk factors that are constraining their growth and profitability and value and they become focused and disciplined to improve those weaker areas.
Ryan Tansom: Which I am so excited to dive into this because everybody's probably going, okay, how do I do that? And you know, we will be diving into your underlying methodology and some of the stuff and, and I'll be even given some of my own two cents because I went through your training on the system and your processes for the certified value growth advisor in December. And I just, that's why I wanted you on the show so bad because I think you're bringing transparency in a standard operating procedure behind. So like a world that is totally like one big black hole and even though we've had valuation experts on the show and we're going to be diving into some of the backend ways that you're doing this. But I think you know, your process Ken is based in finance, which I think is so crucial because right now there's a lot of these systems are different people that are popping up left and right that are, you know, that are trying to identify value drivers for the lower and mid market, which is absolutely fantastic. But you know, there is a lot of subjectivity to it or there's random numbers that come out of it, but there's not an actual stuff and they're not tied to evaluation and actual cashflow. So what, and that's why I just think it's so crucial what you've done and maybe explain that. So not only were you an investment banking/ turnaround conslutant, but you have a lot of acronyms behind your answer. Maybe you want to kind of give a little bit of overview on some of the credentials and I know you probably don't like to do this, but I think it's the Lens, some context to why this all has come to where it is today.
Ken Sanginario: Sure. I started my career as a CPA. Working in, went back then was the big eight accounting firms have coopers and lybrand for some people that may remember that that firm became then came the big six cooperson library and then became part of pricewaterhousecoopers, which is now PWC. So I was there back in the early and mid eighties and then I was a, a controller and then CFO for three companies, uh, one private and one public. And in my public cfo experienced, that's where I kind of cut my teeth in the turnaround world because this was a public company that had a whole series of operating divisions, several of which were deeply distressed. So I spent three years doing a grueling workout and turnaround of the distressed operations of a public company. So that was, that's where I learned the art of the turnaround first. So besides a CPA, I then got sort of trained and certified with two valuation credentials. One from an organization called NACVA, the National Association of certified valuators and analysts, and one from the American Institute of Cpas, the Ai CPA. So I have their two credentials, the CVA and the Abv, a certified valuation advisor, I guess they changed the name to and accredited in business valuation.
Ken Sanginario: That's the ABV. Then I have an M&A certification from the Alliance of merger and acquisition advisors, the AM&AA, and that credential is called a certified m and a advisor, see m and a and a. Then I have the turnaround credentialed CTP certified turnaround practitioner. That's from the turnaround management association, and of course I have the certified value growth advisor. That's our own credential that we started three years ago. Our training program, five day. Very rigorous training program that you went to, you just went through back in December and that is a accredited, I guess so to speak by the CPA industry, the National Association of State Boards of accountancy. It's all those state boards, state CPA boards all around the country approved programs so that you can grant continuing ed credits. So we have a very rigorous program that meets all the criteria, have a, have a real training and certification programs. So are cvg a credential, has been gaining traction and gaining recognition not only in the US but now internationally, as you may recall, just in our last session in December, we had several attendees from the Netherlands, from Bahrain, from Canada, we have a, from, uh, we have somebody coming from Mexico and our next and our upcoming session in March. So, um, it's, it's gaining now reputation and credibility outside the US as well. So I think I covered all the credits.
Ryan Tansom: Don't you hvae like a masters or something like that too?
Ken Sanginario: Oh, yeah, I have two master's degrees. I do have two master's degrees. I'm kind of a lifelong learner. And um, one was a master of master's in tax taxation, master of science in taxation. That was, um, really back when I got that. It really wasn't an MBA program that was a, that was an 18 course program, which really was an mba program with a concentration in corporate taxation. So, um, the degree back then was MSC master science and tech data taxation today that would, that would have been an mba with a concentration in taxation. And then I got a master of science and finance, which was a grueling, very rigorous, hugely valuable program that I went through as well.
Ryan Tansom: I can't believe you just forgot about those two things, which would be like a world life achievement and if they were to go through it and the, the reason that I wanted you to describe the alphabet soup that you have behind your name is because I think it is really important to understand your perspective on how you're looking at this stuff. And then we're going to be getting into getting into, kind of like how, what we call the buildup method and how you're actually identifying the, these value drivers and tying into the more in depth evaluation. And you know, my two cents, Ken, is that like what I've seen is that, you know, there's this whole world of, you know, the, the investment banking and that the, uh, the private equity and the big finance years, right? That understand capital and finance better than anybody else, right? They're approaching and always going for the 5 million Ebitda and above because they're big quote unquote, they call a company's assets, right? Because they want a return on their investment, so they're looking at literally like, like, like stocks or like asset, a asset classes and that whole world doesn't usually trickle down because the really, really, really smart people go up and they make big, big bucks at those different shops. But what you've done is you've taken your background and some and a standard system to bring that kind of level of sophistication down to a way where it all makes sense to everybody. But we're actually approaching this stuff from a world of finance and like what is the return on your investment of a business, which is what all owners should actually look at because it's a lot of risk and a lot of things that they've done. And how do you identify, going back to what you said, the company specific risk. So I think it's important for the listeners to know it's all based in money and capital and that is what I find very intriguing. And maybe, you know, before we kinda jump into what the buildup method is and how that fits into the, um, the company specific risk. But maybe explain how in the valuations right now, what they, you know, you called a safe harbor and how that's identified and maybe that kind of ties into the buildup method, so I don't know, however you want approach that, that makes the most logical sense, but I think it's a key function of really extending the, the rest of the interview.
Ken Sanginario: So let me give you the big picture of how valuations work. The evaluation process, whenever you, whenever a valuator is engaged to issue a, what they call a conclusion of value on a company that's the highest level of assurance the valuator can give in a valuation report called the conclusion of value. You have to go through three approaches to value the company. There the projects are called the asset approach, the market approach, the income approach. The asset approach is just an approach to look at all of the hard assets of the company and try to estimate what the replacement cost would be. A lot of those assets. So that basically becomes kind of a floor value if there's no marketability to the company and the company or the, or there's a or, or the, uh, the value based on the other. The second two approaches, um, is lower than the floor, then the floor becomes the conclusion of value. [Ryan interjects: Got It.] The second approach is the market approach. That's an approach where you'd go out to the, you go out to the marketplace by looking at databases that are subscription based and you try to find transactions in companies that are in the same or similar industries as your subject company and that are the same or similar sizes of your subjects company and maybe sometimes even in the same or similar regions of the country or the world as your subject company. And in, in the lower middle market, which we define as companies with about five to $100, million in revenue. Uh, so in the lower middle market, there are several databases that valuators use for that market approach. But the problem is most of the databases that they're very opaque transactions. First of all, you can't find enough transactions if you're looking at a company that's a $10,000,000 revenue company and they're in a certain niche manufacturing business, well that niche manufacturing business may be very different from other manufacturing businesses of similar size, and so it can be very difficult to find a database of transactions to find enough transactions in any database that are similar enough to your subject company that you can draw any credible correlations to. And so very often you're sort of stuck right there. You just can't find enough transactions in your market approach to rely on that approach to determine a value.
Ken Sanginario: If you can find the transactions, often they're so opaque that you don't know what was included in the transaction. So again, it's hard to draw in and correlations because was at an asset sale was of a stock sale. Was there a real estate involved? Was there, were there working capital adjustments involved in the transaction? Was it an all cash deal or did the owner take back some seller paper, uh, when, when selling it was, it, was there an earnout involved? Did the owner sell a hundred percent or did he sell, you know, 70 percent or 50 percent. I just. All of these factors that are not reported in the databases cause you cause the transaction to be solo paint that you can't dry any correlation. There's just not enough information.
Ryan Tansom: Well, and even Ken, like you don't even know why the person bought it. Right. Whether it was a true strategic sale or geographic. No reason why it's just a number, right? Right.
Ken Sanginario: Yeah. They give you some statistics and even even when they report multiples, which is kind of what everybody feels most comfortable discussing. Even though, you know, I could spend an hour on my get up on stand up on my desk, which I've been known to do in training programs to talk about the fallacies of multiples, using multiples for valuation. But even when people talk about multiples and you look at multiples in these databases, the multiples are... You don't know what's in the multiple and you don't even know if the. If the arena, you know when they. It's a multiple of earnings, but you don't even know if the earnings are calculated the same way among the companies that are in the database. Sometimes they use reported earning. Sometimes they use adjusted earnings, sometimes they use a earnings with the owners. Salaries added back, thank you. Know this thing called, you know, discretionary earnings, uh, owner discretionary earnings. Sometimes they use it, earnings that calculated with the earnings after owner salaries. You just don't know. And so the multiples can be kind of meaningless. In fact, I had an article I wrote awhile ago actually. It was probably about 18 years ago. I wrote an article called meaningless multiples, little heavier. I've been on this kick for a long time. So. And then the third approach, which I believe is the most credible approach to calculating the value of a company is called the income approach. And I'm not the only one that believes that there are people who are far more credible and established and authoritative deny people who have written textbooks and the actual, the sort of godfathers of the whole valuation industry.
Ken Sanginario: Talk about the income approach being the true way to calculate the value of a company in any other approach you use needs to be reconcilable to the income approach. So just because you find a company and a transactional database somewhere that says, hey, these, these companies sold for 50 times earnings, that doesn't mean that your subject company should sell for 50 times earnings unless it has the income, the cash flows to support that kind of multiple, which it rarely, which they rarely will. So the income approach, if you think about the value of a company, is really a collection of the values of the assets within that company and the value of any given asset. And this comes from the master of science in taxation program. We learned about how to value particular assets, individual assets, and where a company is just a collection of all those individual assets. And the value of any individual asset is only the value of the cash flows that that asset can generate in the future. So sometimes people will say, hey, I have this piece of machinery, um, I paid a million dollars for it. So it should be worth at least a million dollars. Well that's fine. The piece of machinery is obsolete, right? Are you using it? Not really. It's just all we still have it. It still works. It still runs or other ways to do that process. So we don't really. Okay. So what cashflows is that machine going to generate in the future? None. So that machine now has zero value. It might have some salvage value values are though, you know the weight of the metal, but that's probably about it. So if you think about a company being a collection of it's individual assets accompanies value basically is the value of the cash flows that that company can generate in the future.
Ken Sanginario: And so we, we talk about the value of the assets sort of being determined by the, again the sustainability, the predictability and the transferability of those future cashflows. Sustainability means is if you think about things like okay a to let's say a company has, they only company only has two customers and one customer is 90 percent and the other customer is 10 percent and that's all the customers the company has. Well, how sustainable do you think that unless they, unless that 90 percent is on contract with the US government, a 50 year contract or something, then there's no reliability. You can't. You can't rely on the cash flows from that contract are going to be sustainable because the customer could cancel the contract, the customer could go out of business and the the company's cash flow would just disappear overnight. Right, so it's. So that's one kind of factor, customer concentration. I use customer concentration as a common factor because that's one that a lot of people are I'm familiar with so but there are 100 other factors that might impact the sustainability of a company. Do they? Is the owner 90 years old and in poor health and all of the knowledge, all of the secret sauce of the company's in the owner's head. Well, how sustainable do you think their revenues are? If that owner dies or becomes incapable of running it, the revenues could disappear overnight. Those are extreme examples, but what happens if the company doesn't have really good systems and processes and people, they're weak in different areas. What happens if they don't do a good job with risk management? What happens if you know they have no planning involved in the company and just all of these factors that could impact the sustainability of the cash flows.
Ryan Tansom: Well, what's interesting, Ken, is that when you actually, because a lot of this stuff has to do with, you know, like the, the height that's going on in the market of transferability and the owner being reliance on all of this stuff is starting to kind of bubble up. But I think when you say, and I want to peel back the income approach a little bit without getting too technical and that kind of ties up into, you know, this next of the buildup and then the actual valuations, stuff like that you're looking at, like you just boiled it down to that, how much cash is this thing going to kick out? How, like how, what's the risk of that? If you're ever looking at it from an investment perspective, whether that's the culture of the people, all the different genetic makeup of that business. How does it kick out that cash?
Ryan Tansom: Which you know, the, the income approach, you know, and you kind of tied into the discounted cash flow. That's like literally finance, right? So you look at the internal rate of return of a bond or the internal rate of, I think all the listeners here have investments in their 401k or they're looking at cap rates in real estate. So people are familiar with this stuff. It's never just been overly generalize or, or accepted by the, the, the lower mid market businesses because they don't, there's no way, no way to do that. So maybe kind of explain the discounted cash flow method and like, and I don't know what order you want to do with that, build up how you determine this stuff from a financial perspective going, okay great. But there's a lot of factors that go into what you're talking about.
Ken Sanginario: Okay, great. So if you think about a company's future cashflows, first of all, a company has to be able to predict its future cash flows. And most companies in the lower middle market in particular, or even smaller into the micromarket, they almost never have projections, but most companies in the lower middle market did not have credible projections of their businesses because they have no credible planning function within the companies. So they don't do strategic planning and you have no idea. I have clients that say, you know, we, we plan, we do a lot of planning, but it's all one year. It's all the current year plan. It's really a tactical plan. It's not a strategic plan. So they're not planning about what markets, you know, how they want to grow, how big do they want to grow and how will they get there? What markets do they want to penetrate, buy products and services that I want to bring to the market.
Ken Sanginario: How do they want to expand? When do they want to expand, how will they go about achieving that? They have no planning so they can't prepare credible projections of the future cashflows of the company. So what ends up happening is anybody who's looking at a company's cash flows, they can only use the historical cashflows. And the proxy for the future, well in most cases of a company is growing, looking at historical cashflows will penalize the value of the company because the future cash flows will be greater than the historical cashflows if they're growing and they're profitable. So that's the predictability. I said, sustainability, predictability and transferability. The transfer... And to finish that thought the transferability has to do with has the secret sauce of the company been institutionalized across the whole company so that if something happens to be the owner or a CEO or anybody in the leadership team, the secret sauce won't leave the company with that person and a company can continue to run the value of the company is transferable to a buyer because it is institutionalized.
Ken Sanginario: It doesn't arrest in one or two a few key people. So that's the sustainability and predictability transferability. So the cash flows. If a company does have projections, then it's a matter of, okay, well what are those future cash flows worth today? And so the, the ability to value those, that's the crux of the income approach. And in order to value those cash flows, you have to look at the riskiness of the company's ability to achieve those cash flows. We do that by assessing all of the qualitative elements of the company across the whole enterprise. You know our process. We've identified what we believe to be the eight primary categories that every company has to have in place, fully developed and very importantly imbalanced with each other in order for the company to reach peak performance and achieve maximum value. And the eight categories. There's science behind the aide. I won't really go into too much into that, but the eight categories are planning, leadership, sales, marketing, people, operations, finance and legal. And those are the functional categories that every company has to have fully developed. And we've taken those eight categories. We didn't make them up there, science behind them, but we've taken those eight categories and broken them down into subcategories. So we end up with nearly 50 sub categories in our, in our. The way we look at a company in our assessment process, and we assess each of those roughly 50 categories, sub categories against a theoretical best in class standard, so we're trying to assess how well developed is the company in each category against a best in class standard and we've tapped industry experts and functional experts for each of those sub categories in order to determine what a best in class standard would look like. So different industries and different functional categories have different best in class standards. We've built a suite of basically best in class standards across industries and across functional areas using experts not only relying on our own knowledge.
Ryan Tansom: Well, and what's interesting too is, and I don't know if you're going to go this way and I'm interjecting, but your time, all of these until he just for the listeners who you know, so John Warrillow's got eight key categories too, but you know that what's different about Ken's or any of these other valuation ones are they're tying in by the way, like we're using this for our clients and Canada. I've been working on some clients together that they're very specific of like, this is kind of what I was saying earlier that the private equity firms and investment bankers have been analyzing this stuff, so in due diligence or if someone's buying it, these PE firms or financial buyers, they know this stuff because they got a team of finance years that are going in looking at the internal rate of return of a business of why they're going to buy it because if they're in a $15 million dollars in their company, they want a return on that investment.
Ryan Tansom: Right. Just like in real estate in real estate, they've got, you know, people have ways of identifying what the, you know, the sustainability, predictability, transferability of that real estate is written. So they, they in kind of. This is my own two cents, Ken, is these. Every PE for all these different financers have come to, like you said, they kind of all operate like you and your partners did. Were they all kind of. They all know exactly what they're looking for because they got the spreadsheets and they understand business, but there's been no way to systematize that into ways that actually make sense without a huge team of people. And so your tying these different subcategories all towards that company's specific risk and valuation. Right. So it's not just completely made up.
Ken Sanginario: No, absolutely. I mean we've, we've essentially taken the due diligence process, so my whole approach, and you know you, you asked earlier about my background, my credentials and things like that, but I, I studied those areas, those bases for a reason and the reason was to bring those knowledge bases together because very often they're disparate knowledge bases. There's overlap among all of them. There's overlap between M&A and business valuation and turnaround management, but nobody's ever brought them all together before and I've taken those knowledge bases and put them into a platform so that the due diligence of accompany company is directly tied to the value of that company. So I take a due diligence process, make it very efficient, but very comprehensive. And I have private equity, individual private equity investors who are investors in my company as well. And what they really liked about our process was just that they said, you've, you've, you've taken something that we do, it's taken us years and years to learn individually and we all do it our own way. We all get to the same answer, but we have a hard time.
Ken Sanginario: They send the same thing. We have a hard time training new associates in the farm. They just have to hang around one of us for, you know, a decade. And eventually they, you know, they learn how we get to the conclusions that we get to. But your system has taking that in sort of short circuit and the whole process so that we can get there a lot quicker and it can be scalable in our firm. So that's what they, that's what they like about it, but it, it essentially takes all of the risk elements that are private equity firm would look at it as a financial buyer and converts those risk elements into a risk factor that then flows into to the valuation of those future cash flows. So just think about it. It makes perfect sense. The higher quality and lower risk the company is in all of these qualitative functional areas, the higher the value of future cash flows will be today. If a company is projecting cash flows in the future, but they have a very underdeveloped company, the risk of the company achieving those future cash flows is a high, high risk. High risk means lower value today of those future cash flows.
Ryan Tansom: It's so interesting Ken as I was going through the system and like it because again, it's stuff that we did at imaging path before my dad and I sold it, but it was all like no, just gut or like talking to people and just kinda like. And then how do you prioritize, you know, so if you got a million dollars and retained earnings this year and you want to deploy your capital, how are you going to spend it? Right. And I think that's again, what happens on the big public companies is they have people understanding like literally finance teams talking about how to allocate their capital for next year. Right. So I dunno it just some basic examples and then I'm sure you've got plenty of Moore's law as I was going through, whether it's understanding the leadership team, which everybody talks about, but then also like whether it's the forecasting or are they using, are all of their technology systems separate or the integrated like, you know what I mean? It's just common sense stuff, but you're putting it together and then you should be able to identify because so many people and like even like the vistage's or the CEO peer groups, people just randomly decide what they're gonna do and when they're going to do it and how they spend their money.
Ken Sanginario: Absolutely. And what we find is most companies our strongest in the functional categories that reflect the background of the owner or a CEO of the company. So if the owner is an engineer by background, then there'll be strongest in the technical areas of the company. There'll be strongest and operations. They'll probably be strongest, strong and finance. They'll be strong and legal and kind of the compliance type areas. There'll be weak and the natural opposite areas. What's the natural opposite area of say an engineer? It's the marketing side. Sales, marketing and people. Right. Those are the sort of natural, weaker areas for somebody that's a technical, technically focused person, technically educated and technically focused. So, but. But the interesting thing is when we then asked them where they are, where they're investing all of their time and energy and resources, human resources and financial resources to grow and expand the company, they're putting it all in the areas where they're already strongest. It's not getting them one dime of incremental value because the weaker areas are the constraints. So we try to push them out of your comfort zone, call her attention to the weaker areas, redirect some of their investment of time and resources into the weak areas to create more balance in the company so the company can then grow in a balanced manner and not have the constraints and not have the weak areas. It's, it's like a chain is only as strong as its weakest link. So in my turnaround career, a lot of my companies, a lot of my clients came to me as turnaround clients because they grew so fast, they basically imploded under their own success. They grew so fast, they didn't have the infrastructure properly developed to support the growth. And then they imploded, they stopped, you know, they would have quality control problems or delivery problems. They would start losing customers because they were delivering late, they couldn't meet deadlines, the suppliers couldn't keep up with their demand. So they had all these problems they could sell, they could sell like, you know, thanks. They could sell faster than they could deliver and that ended up, um, causing them to go into distress.
Ryan Tansom: Well, explain which makes a ton of sense and so that Kinda ties back to the eight categories and why they all need to be balanced and how that impacts your cost of equity in. I'm sorry, may I, you and I were talking about it like kind of get a couple of these interchange but there's the cost of equity and the cost of capital because capital is a big constraint for these for mid market companies too, right? So they're, they're trying to look to grow efficiently, allocate their capital in the right way, reduce the risk, and so how do the eight, how did the science of the eight categories identify that this is the well rounded and then how does that impact the cost of equity and capital?
Ken Sanginario: So the way our process works is each one of the, each subcategory gets a quality score and the quality score, the flip side of quality is, is a risk factor and so every one of our roughly 50 categories gets a quality and risk factor and those all roll up together. Two creating quality score for each of the eight primary categories. And then those roll up to create a quality score for the overall company and the the flip side of the quality is a risk profile. So they got a quality profile, a risk profile file, and the risk profile is a risk score, turns into a risk score and the risk score flows into cost of capital of a company. So if you think about the company's future cash flows and how they're valued today, there they are discounted to today's value using a discount rate. The discount rate is a essentially the company's cost of capital. The cost of capital is - it important to know that the cost of capital is comprised of two components, it's the cost of equity and the cost of debt and it's the blend of equity and debt in the companies capital structure and the way that they finance their business and the cost of equity and the cost of debt are from the perspective of an outsider looking in. They're from the perspective of a buyer. Not yet from the perspective of the owner inside thinking about those factors themselves. So it's how an outsider would view the company from a quality and risk standpoint and how an outsider would be able to finance the acquisition of the company, given the company's current risk and quality profiles. And without a, without a buyer, adding any credit enhancements such as personal guarantees or additional assets, assets as collateral that may be unrelated to the company, something like that. So it's how could they finance the company just on the company's own merits and they'll, they'll finance it, some with equity, someone's debt and what's the cost of each of those and what's the blend of the two and the higher the quality the company and the more predictable, sustainable and transferable the cashflows, the more the company could finance it with debt because it makes sense. The more sustainable the cash loans, the more debt within parameters of course, and more the more debt you can put on the company because ... debt doesn't go away when there's a downturn. Debt keeps coming after the owner. So. So you have to have really sustainable cash flows to financed with debt and they. The higher the quality, the lower the cost of debt, so if you. I mean it makes sense. You think this bag, south prime rates, they have preferred rates. They have, you know, they'll lend to some companies that are prime for light bar, the lend to other companies that prime minus a half a point, the lender, some other companies at prime plus two or prime plus five and then you can always have non bank lenders that might be lending at, you know, interest rates up in up in the mid and high teens even until the twenties and you have factoring companies that are lending to the company at an effective cost of debt. Sometimes they're north of 50 percent. When you really figure out the cost of the debt.
Ryan Tansom: I have no idea what that was like. Right?
Ken Sanginario: I mean it's, it's unbelievable.
Ryan Tansom: That's probably a lot for the listeners, but I think if they like for the listeners, the reason we're getting into this because it's time to dive into the technical stuff of this and it's so important for you to understand because this is what's going to level up because this is what the private equity firms and buyers that have any two cents are going to be doing, right? They're going to go look and say, okay, this is. I don't want to. Because the stuff that we're talking about right now are people that are there doing these purchases for return on investment versus someone that wants to go buy your business for a job. Right? So that's. They're buying a salary that's complete different. And so maybe I can. Because I think in the, you know, you and I were talking you, a lot of people understand real estate, so how can you maybe, I don't know if there's an example or a scenario off the top of your head that you can make it. You can boil it down into like rent rates, cap rates, and like the value of, you know, of how that all works in real estate because I think a lot of people are familiar with that. I mean, I don't know if, if it makes sense to give that example?
Ken Sanginario: Well, I mean I'll just make up one and hopefully it'll make sense. When you have a, um, let's suppose you have a high a skyscraper in midtown Manhattan and it's fully leased with grade AAA tenants who in there, everybody's under 15 year leases. Pretty high-quality piece of real estate. So an investor would look at the cash flows associated with that, look at the quality of the underlying quality of the tenants, of the length of the contracts and so forth. The, the area where the company or the rent they piece of real estate is located and they will capitalize those cashflows, the annual cash flows. So they'll, they may say, I'm just gonna make up a note number, won't relate to a skyscraper, but so let's say they have $10,000,000 of cash cashflows annually, and they made, they capitalize. They may put a cap rate of 10 percent on that. So a cap rate is the inverse of a multiple. So if they put a cap rate of 10 percent, it means it's a 10 times multiple, 10 times $10,000,000, $100 million in that case would be the value say of, of a particular building. Take, take another building. Let's say it's the same size, but it's in a, it's in a, uh, it's in Detroit, right? It's in downtown Detroit and um, and it's, it's in an area where it may be there, you know, a lot of businesses have gone out of business because of the auto and the US auto industry. I'm doing, again, I'm just making up the fact pattern and you have you have a lot of tenants, but the leases are shorter because companies don't want to commit for the long-term and maybe it's not AAA grade tenants, maybe they're, you know, single, single A grade tenants and so forth. And you don't know what's going to happen in that region economically. Whether it's going to continue to be depressed or whether it might come back. Well, if somebody wants to buy that building and let's say it has $10,000,000 of annual cash flows, instead of if it's in a depressed area like that, that a buyer might not be putting a 10 percent cap rate on it. They might be putting a 20 percent cap rate on a 20 percent would be a five times multiple. So five times 10 million only be $50 million, it would have half the value of the building that's in St Midtown Manhattan. So it is higher risk, higher value.
Ryan Tansom: Well what's interesting too, because I mean it just correlated to stocks to junk bonds at 15 percent rate of return, right? Versus know us treasuries in. And what is interesting about that when you are talking about your cost to capital, which is the blend of equity and debt, like a bank's not going to go give you a huge loan to finance that Detroit office because it's too risky, right? So you're going to have to, you know, literally purchase it if you want that, but you're taking the risk on yourself in order to get that cash flow.
Ken Sanginario: Yeah. The higher the risk, the more equity is needed to make the acquisition. And equity has a much higher cost than debt typically.
Ryan Tansom: Well, what's interesting to Ken, if you think about these private equity firms and family offices who are deploying their capital, when that you know and that everybody's talking about the trillions of dollars, I think you and I talked to, it's up to $2,000,000,000,000 of dry powder, which is non deployed capital, which is essentially money that has not bought investments out of family offices. Private equity firms and corporations is if you've got a private equity for a military, they got $25,000,000 fund. They're, you know, they can go buy more high valued companies because they use more debt versus if I, if, if I have to go put five companies with 5 million bucks and I could buy five, five companies versus if I have to put $10,000,000 and I can only buy two and a half, absolutely. They can leverage their fund.
Ken Sanginario: That's why come. That's why private equity firms typically like to buy high quality companies, leverage them up and then step on the gas pedal. Right. And really grow them well.
Ryan Tansom: And I think it also ties into that which is why they, the, the bigger the company is the less risk that those cash flows are going to go away. So that's why I think there is no real help for the lower mid market, which is the people where they can't sustain big issues because you know, they can't put a bunch of debt on there. The finance, the financial buyers are not as a or a predominant because there's just too much risk and they can't leverage the thing. Versus like having someone that's going to come in and do it more like a turnaround, like you were, which then they can then harvest the value. So I mean it's just a huge open spot in the marketplace that just doesn't get the help in the understanding of the stuff that we're talking about.
Ken Sanginario: It's a very disjointed, dysfunctional, fragmented marketplace. The lower middle market.
Ryan Tansom: Um, well, and can you explain like the, the, I don't know if we want to get this, some detail of the cost of equity, of the buildup method of like what people should be and I don't know if we want to get into that, but I think that's where it, it, it, it, it clearly shows where the VRP system and identifying your valuation and your company-specific risk fits into that whole picture.
Ken Sanginario: Well, let me see if I can do it in a simplified manner. So if you think about people, people invest in the public stock markets and historically if you look back over the last 50 years, the stock market has generated an annual return of about 10 percent. Okay? So 10 percent becomes the kind of, again, as an example, the required return for, for a private investor to invest in the stock market, they pretty much expect about a 10 percent annual return on their investment. If you think about now investing instead of into the stock market, you're investing into an individual private company, a much riskier proposition. So clearly you're going to expect a much higher return than you would from your diversified public company, you know, 401k, um, index fund or something like that. So how much is that incremental required return, how much additional return is necessary to attract an investor to invest into a private company where there are kind of two big pieces that explain the incremental required return. One is a size premium because most private companies are smaller than most public companies and public companies, as you mentioned, larger companies as you mentioned, and they're better able to withstand shocks to the, to their company, to their industry or to the economy. Um, so smaller private companies don't have as much wiggle room or as much ability to withstand shocks. So investors just based purely on size, they want a bigger return for that additional risk.
Ryan Tansom: And there's no public market for you to just to, you know, drop your shares on someone else.
Ken Sanginario: There's no liquidity. There's no, there's a liquid, there's a, there's a size premium and illiquidity premium is actually three components on the right thing for the liquidity piece is a, is a second piece, um, because you can't, if you want to sell your private investment, you know, good luck to maybe you can do it in a year or so. Um, public companies of course have immediate liquidity, so, um, so size and liquidity account for about a third to a half as much as a half of the incremental required return that an investor would would require in order to invest in a private company. But the third component of third factor is a factor called company specific risk, which is what we've been talking about. All of these qualitative factors in private companies and pop. They exist in public companies too. But it's a much lower risk in a private company than a public company. And I'll explain that in a minute, but so company specific risk could be anything. It could add anywhere from two or three additional points of required return to as much as maybe 25 points of required return. So if you think about an investor who's investing into the public markets looking for a 10 percent annual required return to a private company where I'm the company specific risk factor alone can push that 10 percent up to 30 percent or 45 percent or you know, plus an additional premium for the size and for the liquidity. So it's not unusual. That's why venture firms, venture capital investor firms, you know, they have required returns in their investments that are sometimes north 40 percent private equity firms are in the 35 percent range. That's why it's because of the risk factors that exist in the companies in which they are investing. So why? Well, I do private companies have such a higher company specific risks than public companies? Because public companies are constantly under the scrutiny of all of these outside independent entities. These stuck in on us and bond analyst, the SCC, the independent board of directors, independent auditors, all making sure that the public companies are the lowest risk they possibly can be, that they have all these qualitative attributes fully in place, fully developed, fully functioning at all times to keep the risk low so that they sustainability predictability, transferability of future cash flows is at its peak.
Ken Sanginario: Private companies don't have any of that outside independent oversight, so they and they not educated about it, so they ignore all of these company specific risk factors and those factors come home to roost. When these owners decide they want to go sell their companies. If you look at the statistics, the success or failure statistics of private owners who try to sell their companies, it is absolutely staggering and it's. It's mostly all related to that company-specific risk factors. All of these elements, whether you call it due diligence factors or qualitative factors, risk factors, whatever you want to call them. It's all of these internal factors. We call them intrinsic. We call it intrinsic value because it's all these internal factors that are largely within the owner's control. They can improve those factors, they can increase the quality and reduce the risk of their companies and capture a lot of that value that is being depressed or constrained or eroded by all of these, these risk factors. They have the ability to do it. They have to be shown where the factors are, where the risks are, where they need to a focus, their time and resources.
Ryan Tansom: Well and so well said. And I in you can tell there's decades of passion coming out and uh, and it's the same thing that I like. This is why you and I have been getting so close over the last couple of years because they're like, there is no rule book, right? For the privately held companies in like if I have, I think about just how ridiculous it is in common sense. Words is, you know, from my old industry, you could have two companies, same size, same all this, but like one of them uses the worst erp system ever and one of them doesn't. And one of them has the best in breed and all that stuff, so like the, those are the internal factors, but it's painful stuff that they do and when and how you spend your money and all those different things. So I think now there's getting to be a rule book of understanding what and how to do this stuff. But the, the uh, it just is so the, the, the value that should be harvested should be the owner who created and took all the risks is kind of where I come from, where it's like, yeah, like, like not only with a future investor pay more because they want it. But like you now have the roadmap, like you said, to double or triple your company value because you just, you know, what people are looking for. You've leveled the game.
Ken Sanginario: Absolutely. Absolutely. And too often owners, they remain uneducated about all of the, all of this until the time that they go to market. And then they get an indication of interest for their company and they get off pumped up about it and they accept indication they sign. They might sign an exclusive exclusivity with a potential buyer or whatnot. They get into what I call the due diligence slaughterhouse. All of these factors start surfacing and due diligence might last four or five, six months, eight months sometimes, and the, the, the buyers were down, the seller's, um, by continually raising these kinds of issues and flushing out all of these issues that actually do exist. So nothing against the buyers, but it takes them time to flush out all of this stuff. And then in the ultimate result is, well, we'll still either one of two things, either we'll still buy your company, but not at that price, not the price that we initially indicated. As of all these, we have to now invest into all of these areas to strengthen the company. So we're gonna deduct value for all of all of that because we have to bring that value to the company. So sometimes don't. They may cut the value by, you know, who knows how, you know, a lot or like.
Ryan Tansom: Yeah, or the. And this is where the dynamics are so skewed. There's such a in the, what'd you call it? Asymmetrical power. Yeah. We shouldn't because you know you have someone that knows everything that walks in and all of this stuff that should've been being done. You just, you're, you're such at a disadvantage. And what's interesting candidate that I wanted to, like you and I have rallied around a couple of these different additional points that a lot of people that when these owners are talking and the listeners, you sit down in front of your peer group or your other owners and people talk about, oh, so and so's sold for this much. You know, maybe you can get, I'll give my definition. You give yours have.
Ryan Tansom: There's a big difference. And actually my partner Jim, at GEXP who's an m and a attorney has talked about this because he deals with, you know over the years has been dealing with transaction value. So that's the stuff that's in the databases that you're talking about where there might be a strategic reason to buy it right there. Just the rate of return is going to happen outside of the cash flows. It's going to be through cross selling customers or whatever it might be, so a lot of people talk about the transaction value, which tends to lean towards a strategic, but the intrinsic value is what the owner can control, which is the rate of return on the capital and equity that's tied in their business. Then if they do that stuff correctly, then they can go fetch the buyer that they want to capitalize more on a strategic transaction value. But I think there's a huge difference between those two and a lot of people don't understand that.
Ken Sanginario: Think of intrinsic value is more closely related to the value that a financial buyer would pay for our company. So a financial buyer that will not gain any synergies or anything by buying that company or a financial buyer might be just an individual operator who, as you mentioned earlier, is buying the company because they want to buy themselves a career, a job. They want to buy themselves a CEO position so they get a bad. They get a financial backer and they come and buy the company because they want to run it. Um, intrinsic value is closer to what they would pay in a lot of times those, a transaction value from a financial buyer will be very close to the intrinsic value of the company. A strategic buyer is, you know, of course a buyer that has the ability to gain synergies through the acquisition synergies by eliminating duplicate overheads or synergies by taking the seller's business into the buyer's customer base and marketplace. And therefore growing it a lot faster. So, so they are typically willing, if there are synergies that, that are available, they're typically willing to pay more than what a financial buyer will pay. Um, they may not give the seller total credit for all the synergies, but they'll give them some credit.
Ryan Tansom: Well, and this is so, I think what's so interesting about how this all ties in together, ken is like, you know, a lot of this whole exit planning way that's been going on in some of the value building. That's why like for us, I wanted to tie it all together because if the owner, like for example, and I think though that the listeners have heard me say this a lot, but wheat for us to get the dollar amount that we needed in order to make the sale worth it, we had to sell to a strategic buyer that then we had lots of duplicate and overhead and all this stuff. So we had to quote unquote kind of got the company in order to hit our dollar amount for the value that we wanted to harvest out of that. Which the outcome of that was not as not what I wanted, you know, versus, you know, my dad had a little bit different opinion on it. But um, you know, but what happens is if the, if the... I think that's what happened to a lot of people go from that Loi to like, okay, in order to do this and then they start, you know, essentially, you know, making a Frankenstein out of their company to get the dollar amount, you know, because they're solving from the dollar amount instead of what they want. Which leads to a lot of these unhappy events versus going, okay, if you took a system like yours and you had all your starting to do in your tax planning or estate planning, you're doing all the technical stuff on the outside, but in the intrinsic value to say, let's say you wanted to make sure that you netted 5 million bucks. You make sure that you get that no matter what by doing what you're talking about, and then you can pick your buyer 100 percent and make sure that you have the now it's the all the additional, you know, more soft stuff that's important to you, like the type of buyer, what they're gonna do to Your Business afterwards and you've got to stay to it versus just being like totally whiplash with the process.
Ken Sanginario: Now that's a great point. If you are at the highest intrinsic value that you can achieve, your options on exit are much more wide open to so you can be appealing to financial buyers, strategic buyers, individual operators. Your options are more open. You'll have more competition for the, for the transaction, and you'll, you will achieve the highest possible transaction value for wherever it transaction values are at that point in time in the marketplace as you, as you know, transaction values kind of go up and down in different economic cycles.
Ryan Tansom: It's interesting because even the correlate that to public companies, you know, all the specs, that's the speculation, right? There's a lot of speculation that goes on in the marketplaces which has all the day trading and all that stuff versus, you know, even in the ups and downs of the markets each day. That's fine. But the companies are still making what they're making. You know what I mean? This is what it is. So you and I also, as we're kind of winding down here, you, we both have a deep passion and a heart out for kind of the wave that's happening and you know, you in the training and some of the stuff we've been talking about over the years is kind of the sheer numbers that's going to happen. And I don't know what your two senses or if you want to kind of rattle off kind of the segments have been using your us segments, um, graphic on like the various sections of companies and kind of the average age, what you kind of see happening over the next five to 10 years.
Ryan Tansom: Well, yeah, so I'll stick to the lower middle market for that purpose. So roughly 350,000 companies in the US private companies that fall into the lower middle market, five to $100, million in annual revenue. And about, there's a book that was written by one of the, one of the sort of, I'll call them, I'll call them that one of the godfathers of the exit planning industry. Peter Christman, who realized in his, through his research for his book that 70 percent of those companies are owned by baby boomer owners. And so over the next 10 to 15 years and that window has shifted. It's still seems like a 10 to 15 year window now over the next 10 to 15 years. About 70 percent of those owners will need to transfer the ownership of their companies to a new owner, whether that's an internal transference to management to their family or an outside transfer through a sale. They will need to transfer. Well and Ken for the listeners, I'm actually looking at that slide. I'm just going to read these off because I think it's. People just don't really get this because it's. Again, it's not like there's a Zillow out there for this stuff, but there's 27 million incorporated companies, right? That does 30 trillion and sales and all of those incorrect because this is your side, but there's 21 million, 21 point 7 million companies do a trillion of those sales that are non-employee, so they're the solo prenuer is the freelancers that don't have employees, but it's not a sellable company is a job. $6 million left in 21,000. Actually, I had someone correct me recently that said that's probably a couple of years old because there's only 18,000. He said that are over 100 million, so those are the people that are getting accenture, Ernst and Young, kpmg type level help every. All the advisors flocked to them because they've got a lot of cash flow, so they employ $56 million employees and they're 20 trillion of sales and then lower middle market, which is you said five to 100 is 350, which is five point 8 trillion and sales and $30 million employees. And then the micromarket which you said is under $5 million is five point 6 million companies that employee $35 million employees. So like when I look at this Ken, I'm like that's 65 million employees out of our 320 million Americans that are employed by small and mid market companies that are owned by baby boomers. [Ken interjects: Exactly. Yeah.] And like in what I find, and I don't know what your thoughts are on this is like, and the people that are under 5 million in revenue,
Ryan Tansom: that's very difficult to find buyers that, you know, you're getting business broker level how boards, so it's listed on a website. You're not getting financial help like we're talking about and it's just difficult were they taken massive amounts of wealth that are going to potentially be eroded and I don't know, I like I've been kind of calling up like anybody that's in my, you know, in the thirties age bracket or even lower millennials and stuff like start stepping up and like buying a business or and like, I don't know, like pretty much it needs to be a full fledged effort to help these people. I don't know how. It'll be interesting to see how it all turns out.
Ken Sanginario: Well, if you look at the historical statistics to have companies in those size brackets that try to go to market, some of it is anecdotal through just talking with a lot of private equity firms or research that comes out of associations like the alliance of m and a advisors. When when these private owners try to go to market, they approached an intermediary or a broker or somebody to help them. About 80 percent of the time they're turned away. They're told their company is not high enough quality and it's not. It's not sellable. So you look at say in the lower middle market, 350,000 companies, which I think is kind of where there is a, um, you know, it's a, it's sort of the sweet spot for making a lot of the kinds of improvements that we're talking about because companies have enough bandwidth to be in, do it. Some of them, a lot of the micro market companies are really small and they don't have the bandwidth of team. They don't have the resources to be able to make a lot of improvements. The lower middle market companies typically do, but 80 percent of those companies get turned away. Then only that, that's roughly. That's okay. Roughly means only about, uh, well first of all is 70 percent of them try to go to market, that would be about $250,000 trying to go to market over the next 10 to 15 years. If 80 percent of those 250,000 get turned away. Only about 50,000. Well actually be brought to market. Then you're done. You look at the statistics that come out of Pepperdine University, which indicate that when companies do go to market, there's about a 40 percent transaction failure rate, which means they either don't get any offers so they weren't ready in the first place or they get indications of interest. They get offers. Then they get into the due diligence slaughterhouse and the deal falls apart, which happens about half the time it just falls apart and doesn't close. Um, they have to grant seller concessions to get the deal to close. And so only about six or seven percent, something like that, of companies that go to that try to go to market actually close on timing and terms that are appealing to them.
Ryan Tansom: Well, which is just like so crazy. And the seller's concessions, you're know, you're talking about, you get, you go through this six months of due diligence, you wanted 10 million, now you're getting $3 million up front, $3, million in earnouts for sales projections, keeping your employees...
Ken Sanginario: And the concessions part is what's really painful. That's where a lot of the seller remorse comes from because they get an indication of interest, they get all fired up about it, their families know about it, their friends know about it. Eventually the employees know about it, too many people know about it and then it drags on and against kind of blown up and due diligence and now they, the owner can't really back out of the transaction because they're trying to save, save face. They, you know, their families have often already committed the proceeds of the sales and some, you know, other endeavor, something like that. They still, they can't back out, back out of it and they're sort of stuck between a rock and a hard place and they ended up taking a deal that they would never have taken if they knew that was the deal at the outset. They take it to just finally get it done, get it closed and get out. And then they have reseller remorse after that. They feel like they got, they got shafted.
Ryan Tansom: So to the listener's going, okay, don't want that to be me. And, you know, based on all the stuff we've talked about, you know, what would be your big takeaway for listeners that are, you know, listening to this thinking proactively, like what would be the thing you want to leave with the listeners?
Ken Sanginario: I think the takeaway, the big takeaway message is you want to run your company at the highest quality you possibly can at all times. You don't want to start improving the quality only to prepare for a sale you want... Because then you may never get to the sale transaction. Um, and if opportunities come along to sell the company in the meantime, you may not be able to take advantage. You want to run the company in a continuous improvement process. Get yourselves onto a focused, disciplined way to run your company and, and just start running it that way as soon as you can. And if you ended up running it at a high level for 10 or 12 years, if you have that kind of runway ahead of you, well then great, you'll be able to take advantage of opportunities as they may arise.
Ryan Tansom: And make a bunch of money and have a lot of fun.
Ken Sanginario: Have more fun, less stress, more more work enjoyment, better work life balance, and you'll be able to sell your company on time, timing and terms that, that are appealing to you. So just start early and um, got it. Can, it doesn't have to be a grueling process. Continuous improvement can be a slow and steady improvement. But when you go through that kind of a, you go through a continuous improvement process for say three or four or five years or longer. Even if you're doing it a little bit at a time, you look backwards at the end of that time period. And you can't believe I had. I've had many turnaround clients over the years, two years, a year and a half, two years into a turnaround. When they say to me, I cannot believe while we were doing in our company before this turnaround process, I can't believe well and well we weren't doing year and a half and two years ago.
Ryan Tansom: I love it. So if the listeners want to get in touch with you, looking at your, the VRP system, which is also going to be integrated in our services, but also look, get the certification, whatever it is, what's the best way to get in touch with ya?
Ken Sanginario: Well our website is corporate value.net, just like it sounds, corporate value. And my email is okay for Ken, my last name. So it's k then? Yeah. Sandra scenario s a N G I n a R I o. So Ken Sanginario @corporatevalue.net office number five. Oh Eight, eight seven. Oh five, eight. Oh five. And I'd be happy to chat with anybody who's interested. Love talking about this stuff we've gone on for longer than an hour. We could go another hour. I'm good. Well they cut it off but um, yeah. Not that anybody who's interested.
Ryan Tansom: It's been so fun having this back on. Having you back on the show and diving into this stuff, I think it's going to be just with the listeners want, so I hope everybody enjoyed it and I thank you very much for coming on the show.
Ken Sanginario: Thanks for having me. It was a lot of fun.
Ryan Tansom: I hope you enjoy that episode. If there's a couple of big takeaways, I'm assuming you had a lot of them, but if you're an owner right now, you should for sure take the value opportunity profile. Reach out to the GEXP team, we'll set you up with an assessment, but if you focus on that intrinsic value of your business and focus on making sure that you are really healthy and all these different categories of the business, you could two to three x the value of your company, but no matter what your intrinsic value should be, the target that you're managing to because when you go to sell that business, you have security and confidence that you can get that number no matter what and no matter who you sell to. Then anything above and beyond that, if you took it to the marketplace, is strategic. Additional value from that specific buyer, but it also gives you options to pick the right person for the right reasons and it also gives you walk away ability because you know that no matter what your companies worth exactly what you thought it was going to be, worth what you should be doing right now as you take the vop, identify the categories that you are weak on and then what you should be focusing on.
Ryan Tansom: Then you implement all this stuff using traction and your internal management. Operating Systems. Don't rely on your gut to pick the different projects that you're doing. Focus on value creation and then I can almost guarantee you're going to go get what you want because you've done the right things. If you liked this episode, please go into itunes. It's a pain in the ass, but we really appreciate the ratings because we're trying to continue to bring better guest to you. If you have a topic or a specific person or guests that you think that I should have on my show, please don't hesitate to reach out because I'm always looking for great people to bring onto the show for you. So with that, I will see you next week.