A Middle Market Growth Conversation: Mary S. Josephs, Verit Advisors
Middle Market Growth Editor Deborah Cohen interviewed Mary Josephs. Listen to the full conversation or read an edited and condensed version below.
MMG: How is the devaluation of China’s currency and subsequent worldwide stock market volatility impacting ESOPs?
Mary Josephs: It’s really interesting because there’s a perception that you don’t get fair market value if you sell to an ESOP. There’s a very prescribed valuation methodology to come up with fair market value when selling to an employee stock ownership plan. There are three things, really simple: public market comparables, comparable transactions and discounted cash flow.
So when you have this kind of market turmoil, it’s going to affect the public market comparables. The beauty of an ESOP is to sort of pull back and be rational. When you think about it, the buyer—the owner—is looking for a long-term return. It doesn’t need to make its return in three to five years. So it’s less sensitive to high volatility.
With respect to the current market fluctuations … if you’re not highly sensitive to oil and gas or China, it probably won’t make a drastic difference on your value. One of the companies we’re in the market with right now provides physical therapy services to nursing homes in the Midwest. That’s not going to be sensitive to what’s happening in China.
Another is a financial services consulting firm that provides services to the Fortune 1000 and some of the work is pre-IPO due diligence. If the market falls, there are going to be less IPOs; that probably will have some sensitivity on their valuation. So it’s a case-by-case situation.
MMG: So if a company wants to put an ESOP plan in place, it really has to take a long-term view on valuation?
MJ: Yes. One more comment on valuation: The third methodology, which is discounted cash flow, is actually the most highly weighted, for good reasons. We do the public market comps, but we’re working with privately held companies. There’s rarely a robust, appropriate set of comparable companies. So take the financial services company as an example. The large public financial services companies have dozens and dozens of services niches. This company only has three. And you’re comparing it to Navigant.
MMG: So what is the outlook for ESOPs against the backdrop of what’s been happening in the current markets?
MJ: What I’ve observed is that family businesses—in spite of the incredible (in my objective point of view) market dynamics out there, with trillions of dollars of undeployed capital, all the different flavors of private equity and family offices and the interest rate environment—it’s been surprising to me that family businesses haven’t presented themselves for sale in a more meaningful way than they have in the last few years.
What I have noticed anecdotally is, as they are thinking about it, they’re raising their hand and saying, “Is there another alternative?” So ESOPs are on the table for consideration. And that’s where they should be because of the tax benefits, the legacy benefits, the estate planning benefits: it should be among the considerations. ESOPs will always be less than 10 percent (of transactions) because you don’t get as much cash at close; you might not have leadership that can run the company; there are a lot of reasons.
But to your point on volatility, I didn’t wish for this; it’s kind of scary that we can still have that extreme sensitivity in what should be a rational market. But maybe that will loosen up this paralysis, that the market is going to keep getting better. And maybe it’s going to be the jolt that will encourage families, with their incredibly important asset, to think more rationally about if it is time to consider liquidity strategies. If family businesses are starting to enter into conversations, volatility is going to help them, because now you’ve got a fear factor. And, if that’s happening, ESOPs are going to be on the table; so there will be more ESOP transactions.