Paul Giannamore: One thing you can do is give people the middle finger and say, “I'm putting at least a portion of my financial resources into a jurisdiction whereby there are legal institutions that protect it.” Unfortunately, that's not the United States anymore.”
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Patrick Baldwin: Paul, we've gone two weeks. A lot of people cried about not having The Boardroom Buzz. Yes, you, Dave Johnson. We've heard your whining and we're back. Paul, welcome back from your overseas travels.
Paul Giannamore: I appreciate that, PB. Back, two continents, poor countries. I am back here in Puerto Rico. Great to be home. I have to leave again for a 24-hour trip and then I got to go to Arizona. For those of you that are going out to the AZPPL, this will be my first time there. I told everyone that, in 2024, I was going to do more conferences and speak in both mornings. I’m looking forward to meeting a lot of folks out there.
Patrick Baldwin: You're preparing your talks this time. You're not going to wing it. This will be exciting.
Paul Giannamore: I shall, hopefully, prepare for it this time correctly. You were domestic this time.
Patrick Baldwin: I call it domestic, it was California. I don't know, Socialist Republic, if it's a different country or not, but I did not have to take my passport yet. I could say one nice thing, other than the client I hung out with, the weather is great, but I did get to see Nick Bartolo out there. It’s always a treat to see him, definitely a great resource, and, in this case, called in a favor and said, “Nick, we have a FRAXN client that doesn't like paying tax. Go figure. Can you help us get out of this situation here or help out with more planning in the future as cash continues to come out of the business?” Nick came in and definitely helped out in a big way. Thank you, Nick.
Paul Giannamore: That's great. I'll see him in Arizona.
Patrick Baldwin: Speaking of calling the favors, I had a FRAXN client that had some questions about valuation, in this case, it's got a partnership agreement. He was wondering, “What can I do in terms of keeping the value of the business updated where it's legit? How do I get there? What do I need to do? How often can I get this updated? How do I look at that?” I said, “That's a lot of questions all at once but I know a guy.” I got you connected with a client and you all had a pretty lengthy conversation so I'm told. I don't know the details, Paul, but I know that you did help him out.
Paul Giannamore: He is a sharp guy. I was impressed by his knowledge of the operating agreement and the various different aspects of what would go into an operating agreement. He clearly has an attorney and he spent some time. He may have over thought a few things but that's a good thing. He was very dialed in so I was impressed and I enjoyed my conversation with him.
For FRAXN clients that opt in, we, over here at Potomac, will do a valuation report on an annual basis. That provides a variety of different things, number one, it gives you an opportunity to understand where you are today in the market in terms of valuation. Also, it allows our team to address issues now when you have time to do something about it as opposed to years from now when you want to sell and it's too late.
The majority of FRAXN clients, thus far, have used the valuation solely for the purposes of saying, “Where am I today? If I were to sell this thing, what would I get? Where can I make improvements? What do you guys see that you don't like?” A lot of the discussions have generated more and more and more questions. This coming month, April 2024, Patrick will kick off that internal Ask Me Anything call. We'll have the Potomac team, myself included, answering questions for joint Potomac-FRAXN clients starting in April 2024.
The majority of the questions that we've got thus far were a little bit different than the FRAXN client I spoke to because he wasn't necessarily focused on his exit right now. His exit is a decade off. He did have a lot of questions about building value in his business. At the end of the day, he's in a partnership and he wants to make sure that if he and his partner are operating that business and one were to pass away, both having families, how do you deal with this fairly? How do you deal with the sale of the business or paying off buying out one partner? How does this all work?
We have talked about this on The Buzz before to a certain degree. There are two broad ways that an operating agreement or a buy-sell agreement deals with partnership buyouts, particularly upon death of one of the partners. One way to do it is specify that the business will get a third-party appraisal. You can do everything from choose an appraisal firm or appraiser right now, put that in writing, and say, “Joe Blow will do the appraisal, providing he's alive.” Or you can not name somebody and you can specify the standard of value.
It's a private body of law. It's a contract, you can put whatever you want in there. The ones that I typically see will be standard of value, fair market value, appraisal done by a third-party, and so on and so forth. The other way to do it and probably the more common way to do it, historically, particularly the pest control industry, has been through a predetermined calculation or mechanism in an operating agreement. You and I own Fat Pat and Paul's pest control business. I kicked the bucket.
Patrick Baldwin: Is that not ironic, by the way?
Paul Giannamore: What's that?
Patrick Baldwin: Fat Pat and Skinny Paul and you go first.
Paul Giannamore: Stranger things have happened, Patrick. I probably live a more risky lifestyle than you.
Patrick Baldwin: I was going to say it's probably because you're walking and running miles and miles a day, you're more likely to get hit by a vehicle than me sitting on the couch.
Paul Giannamore: My plane is likely to go down. There are a lot of things. If I kick the bucket, my estate needs to be paid off. What does that look like? When you have a calculation of the operating agreement, it might say, “Upon the death of a partner, the business will be valued in such a manner.” In pest control, most guys took a revenue multiple approach. Historically, I've seen a lot of them, either dollar for dollar.
The pest control business will be worth 100% of the revenue on an LTM or trailing twelve-month basis on the date of death. That's a very easy calculation to do. However, it's not always extremely fair. The reason for that is we know there's been a lot of asset price inflation over the years. Pest control businesses are worth to strategic acquirers far more than they used to be on a relative basis. You end up getting a lot of guys now that I've seen over the years where you might have a past control business that's doing $7 or $8 million a year in revenue.
This is a real-life case. There were these partners in the pest control business worth roughly $30 million to an acquirer and the estate was bought out for $5 million or $7 million. The surviving partners turned around and sold that for $30 million. You could obviously make a lot of very straight face arguments that that's not fair to the estate or the surviving family of the person who died. It was fair at the time that they inked it but it was neglected, forgotten about, or just otherwise not paid attention to. Now, the business is worth $30 million and they're able to buy it out for $5 million, $6 million, or $7 million. You want to try to avoid that sort of stuff.
Patrick Baldwin: Did you really have this scenario?
Paul Giannamore: Yes.
Patrick Baldwin: This is recent?
Paul Giannamore: It was modern history recent in the last five years.
Patrick Baldwin: In theory, I've heard this. I didn't know this happened.
Paul Giannamore: This sort of stuff happens because it's a contractual agreement so you've got this buyout provision and it says, “One times revenue.” Let's say this thing sells for 4- or 5-times revenue or something ridiculous. You're able to turn around and buy out the estate at 1X and then turn around. You bought it from my estate, now you honor a percent of it.
It doesn't stop you from saying, “Paul's family, that's not right. Let me do the right thing and split it 50/50.” The question arises, let's say that it was dollar for dollar and you did buy me out but you ran it for a year before you sold it or you ran it for two years and then you got the higher multiple. At what point does that belong to you? You have this gray area.
Patrick Baldwin: You can taper, right?
Paul Giannamore: Yeah.
Patrick Baldwin: I don't know if that's what it's called.
Paul Giannamore: A very common way to do that is you might say 3 or 5 years and say it amortized over five years. The difference between the buyout price and the ultimate sales price taken over five years divided by 5 and 20% per year, that's how it amortizes so that's how it would work.
Patrick Baldwin: Is that similar to vesting then?
Paul Giannamore: Yeah, it would be like reverse vesting so to speak.
Patrick Baldwin: Explain the math then if we're talking $5 million and $30 million over a five-year time frame. You die. By the way, I would never push you in front of a bus, Paul. I adore you. That $25 million delta over five years, $5 million a year, if I was to sell it a year later, I'm looking at splitting the $20 million difference with the state.
Paul Giannamore: Correct.
Patrick Baldwin: $5 million per year.
Paul Giannamore: That's right. $5 million would come off the top and you split the rest 50/50. Another $5 million would come off the top and you split the rest 50/50. You can do it over 5 years, 10 years, or 2 years, it doesn't matter. You have to figure out what's a reasonable point. Let's go back for a second Patrick. We've got the operating agreement. The operating agreement has the buyout provisions within it and the buyout provision section can reference an appendix and the appendix can be updated every year and it could just be one sheet of paper.
The operating agreement could say, “Upon a triggering event, here's how the buyout or the partner will take place, see Appendix A.” Appendix A can be updated every year. This particular client did not need or, at this point in time, wanted a full-blown evaluation. He's like, “I need to get this operating agreement done. I need to know that every single year, this could be updated.” What he wanted to avoid is he wanted to avoid those stale buyout multiples. He wanted to avoid revenue multiples in general. He's like, “How do we get this so it's as accurate as possible?” It's fair.
To me, I wanted to be firm with my partner but is it revenue multiples? The question becomes you got a $10 million pest control business, it's growing at 20%, and then you compare it to a pest control business that's growing at 0% but it's a $10 million business not growing at all. That business might have a much higher cashflow. The one that's growing more rapidly might be reinvesting that and have lower cashflow. If the appendix is referencing an EBITDA multiple, how do you normalize that?
Clearly, we know that the business that's growing at 20% per year. Top line is worth more than the business that's not growing at all or, worse yet, that's actually declining. The simplest way to do this is use an EBITDA multiple or you can use EBITDA less CapEx. You can choose whatever the multiple is or you can just use EBIT. Irrespective, you choose whatever the metric of cashflow is.
On an annual basis, instead of doing a full-blown valuation, you have somebody experienced that looks at this and says, “Based on the subject company, based on the company that we're looking at, based on its growth rates, margins, location, and the whole nine yards, what would be an appropriate LTM multiple to put on the stream of cashflow?” It's very simple, you do the first quarter of every year and say, “In 2024, this is what the multiple is. In ’25, this is what the multiple is.”
One of the questions that came up, he said to me, “We're reinvesting a ton. We're trying to grow this thing. At some point, we're going to scale off. If we scale off the growth, our cashflow numbers, our margins are going to expand dramatically. We're going to kick off more cash because we're reinvesting less in the business. I'm not blowing a lot of money in advertising and all that but our growth rate will slow.” How do you compare those multiples apples to apples? What you have to do is you have to adjust that.
The reason why transaction multiples are in and of themselves dangerous is they look at one metric at one point in time. they don't take the context into consideration. A single multiple is a redux or it's a result of a discounted cashflow analysis. You're projecting into the future, you're determining what the growth rate is, the level of cashflow, the margin, and so on and so forth. You're projecting all that in the future, you're discounting it back, and then whatever the enterprise value is over that cashflow metric that provides you the multiple, but it doesn't tell you anything about growth rates or anything.
It's important in these things to think through that. This might be a little bit complicated for a podcast discussion but the reason why we're even talking about it is that your client had great questions. A lot of people have these sorts of questions. Patrick, of the FRAXN clients, how many would you say are not necessarily partnerships from any structure perspective but half operating partners?
Patrick Baldwin: At least 75% or a lot. Their spouse might be in the agreement and not being in the business. We have a lot of partnerships. Sorry. Does that make your job harder?
Paul Giannamore: No. This just became more of a relevant discussion than what I even thought because it’s a lot.
Patrick Baldwin: It’s easy 75%.
Paul Giannamore: We don't do formal appraisals here anymore for tax purposes or divorces or any of those sorts of things, we don't do those. We'll do this very work for operating agreements every day of the week but we don't do that stuff that's going to be litigated. As you well know, a lot of times when you're getting calls and I'm getting calls from folks, there's an email on my screen from a few hours ago talking about, “I'm trying to be bought out. I need to understand what the value of my equity is.” This is a very common and people don't often think about this when they enter into partnerships, what does the buyout provisions look like?
Patrick Baldwin: It’s much easier to do it on the front end than on the back end, all sorts of emotions and fighting over whatever can happen.
Paul Giannamore: You have to do it. It's not that hard, by the way. It looks daunting. It seems like it's a royal pain in the ass. You actually get a very good attorney. You can find somebody like Phil Reinhart who can put together an operating agreement. Buyout provisions can be dynamic, a one pager amendment to this thing every single year and you're always up to date. Yeah.
Patrick Baldwin: I call it Dr. Phil because he's a doctor. I have a little fun with Dr. Phil here. That's what he prescribes, once a year get it redone. That was a new thought when he first told me that. The more I've thought about it, in this case specifically, the value of the buyout is very relevant and the market is so dynamic and the business has changed all the time, more and more reasons to do it.
Paul Giannamore: You do not need to get an appraisal. I have seen multiple times where folks have gone out and they're getting appraisals every year for the purposes of an operating agreement or a buy-sell agreement. You can do that. You do not need to do that. One of the things you have to think about though is the standard of value you're going to use.
We've talked about it quite a bit on The Buzz before but let's look at an example. We've got our pest control business and our pest control business, let's pat ourselves on the back, we're doing $10 million in revenue and we're kicking off, I’ll make a round number, $2.5 million in adjusted EBITDA. We're growing it at a good rate. It's a quality business. We're doing everything right.
As we start to think about our operating agreement, we know that the fair market value or how a tax authority like the IRS will require a 59-60 valuation and there's a variety of reasons why you would get a fair market value assessment. That standard of value would probably clock our business at somewhere between $7 and $10 million in today's market.
Patrick Baldwin: $10 million business kicking off $2.5 million in adjusted EBITDA is going to get somewhere between $7 million and $10 million in fair market value.
Paul Giannamore: That's what it would be. Maybe $7 million to $12 million but somewhere in that ballpark. You look at that and you say to yourself, “That's not what we would sell that thing for if we were to do a deal.” If we were to go out and sell that actual business to a third party, we would run a competitive process. The acquirer would ultimately end up paying their highest investment value if we've done our job correctly. We would hope to get 4, 5, to 6 times that fair market value number, tens of millions of dollars more than fair market value. That would be the investment value or strategic value standard. What standard of value do you use in an operating agreement? It depends on who died.
Patrick Baldwin: Minority versus majority shareholder?
Paul Giannamore: Not necessarily. That's a very good point and we should talk about that a little bit. Let's say you and I are 50/50 partners. If you kick the bucket, I would want fair market value because now I would turn around and write a $5 million check to your estate and call it a day and that'd be great.
Patrick Baldwin: Thanks, Paul.
Paul Giannamore: Vice versa, you, of course, would want strategic investment value. If it were an investment value, I would be forced to sell the business because I couldn't pay that. It's not possible for that business to support that amount of leverage. Now, I get a problem and we've seen this too. What's the appropriate number? It's one of the reasons why updating this every year becomes important.
When you talk about a dynamic market, fair market value is largely used for things like bank loans, given an estate tax purposes, IRS stuff, and things that are a lot more compliance-related. The appraisers for that don't have all the real-time market data that we have. What they use is they'll use SBA databases and so on and so forth so their data lags by multiple years. Typically, they use government source stuff.
The purpose of a fair market value is usually to understate value. Let me give you an example. You're gifting stock to your children and you need a valuation or an appraisal for tax purposes and it's a fair market value. You want the lowest defensible value because you want to impair the value of that business. Anyway, the fair market value tends to dramatically understate the value of the business versus what it would sell for in a strategic situation.
Years ago, there was not a very big difference between investment value and fair market value in the pest control industry. There was not at all. Very small. As the market has changed, what's been dynamic is the spectrum of investment value. Investment value is not one number, it's a spectrum. The investment value spectrum has changed dramatically and it continues to change dramatically on a month by month or year by year basis.
Fair market value is relatively static. You could reference fair market value and be pretty sure it's going to be relatively static. It's going to be pretty much the same this year or next year, for the most part. It might change by 10% or 20% percent but not material. It’s not going to change by 300% or 500% like investment value has. What do you choose?
Patrick Baldwin: I don't know. Fair market value, in my head, I'm penciling in is one times top-line revenue feels like the safe, conservative, and barely trending answer. It shouldn't be below one times revenue where investment values could be, like you said, a spectrum all over the board. It depends on who's kicking the bucket and whose favor I want this to be in.
Paul Giannamore: The larger the business and the higher the quality business is from an economic fundamentals perspective, the more important this question is because there's not a huge Delta in investment value and fair market value on a $1 million business. That's when guys use these operating agreements when they’re $1 million dollars and less. There's a massive difference in investment value and fair market value when a business is doing $10 million, $20 million, $50 million, or $100 million in revenue.
Patrick Baldwin: I wouldn't even say Dr. Phil's opposed to using an appraisal to sit in this situation. It slows the whole thing down.
Paul Giannamore: I tend to discourage people from referencing appraisals and these things for a lot of reasons. Number one, it's a waste of money doing it every year. Even if you don't do it every year and you have a provision in there that says, “If there's a triggering event, we'll go to a third-party appraiser and get an appraisal.” The problem with that is let's say that you had a partner in a business that you didn't really trust. You're fine but it's not like you trust him 100%.
You happen to pass away and now your family's stuck with dealing with this partner. Now, the partner can venue shop for an appraiser, the partner who's alive and intimately knows the business. Your wife and family may have any idea what's going on in your business but your partner does. He can impact the value of the appraisal. There are a lot of things he can do to impair that value of that business, one being, “I'm not doing anything for this business if it sells.”
An appraiser is going to ask questions and they're going to try to determine how important the partner is to the business. If their partner is like, “Hell with this, I'm out of here,” they can impair the value. It's a fact-based analysis. What I'm saying is if you have a partner in there who's not particularly playing nice, there are a lot of things he or she can do to influence the value of that appraisal and therefore influence how much money ultimately goes to your estate.
Patrick Baldwin: I'm thinking about the conflict of interest pulling back on growth, “Evaluation's coming. We're going to split up our partnership here. I'm not going to grow this thing as aggressively as we have in the past. I can see that I'm very good.”
Paul Giannamore: Somewhat of a mechanical process tends to be the lesser of those evils provided that you put thought into it and provided that you update it at least on an annual basis.
Patrick Baldwin: If you put a trigger to have an appraisal in the operating agreement, it's also a hurdle. Once a year, we have to go through this process.
Paul Giannamore: You could do it once a year but you could also just do it upon a triggering event. You can go blind and do it and say, “If somebody dies, it triggers the requirement to get an appraisal.” You're not doing it every year. You can put an absolute valuation in an operating agreement. You could basically get an appraisal every year. Get the business appraised. The one thing that appraisals are helpful for is if you're going to fund the buy-sell agreement with life insurance.
Patrick Baldwin: I hear this is key man insurance.
Paul Giannamore: It doesn't necessarily have to be key man but any sort of life insurance policy. Yes, this tends to be key man. What ultimately happens is you would get an appraisal and you would say, “The business is worth $2 million. Therefore, if I'm 50% and you're 50%, then I need at least a $1 million insurance policy and probably more. I might get a full $2 million life insurance policy.” If I die, the money is there to buy out my estate, to pay the family off, and say, “Here's Paul's portion.” That's done with an appraisal. You don't have to do that. Everyone's going to have an opinion.
I feel like the appraisal process is a pain in the balls and it costs money. You're getting a fair market value, standard of value anyway, so it's not extremely relevant to market terms, at least in these markets. Earlier on in the discussion, we talked about the fact that, over the past years, all the mechanics of this are focused on $0.50 on the dollar, $0.75 on the dollar, or dollar for dollar.
Now, what I'm seeing is I've seen guys go to the opposite end of the spectrum. Now, they're putting these ridiculously high multiples. If the market ultimately rolls over, we're going to have the reverse problem of this. Mechanical solutions can be very helpful. Formulaic solutions can be very helpful provided that they're assessed every year. I can see it in your eyes, you're about to scroll back to the investment versus fair market value from a formulaic perspective.
Patrick Baldwin: I am a little bit. In terms of that life insurance policy, let's go with that $2.5 million cash flowing business or adjust EBITDA business. Throw out a number or a range. Give me a rough number for a second.
Paul Giannamore: What would we sell that business for? You and I?
Patrick Baldwin: Yeah. It's got a great brand, by the way.
Paul Giannamore: We can pull a good $50 million for it.
Patrick Baldwin: If we went and got life insurance policies based on an appraisal for a second, you said $7 million to $12 million. If we get a $10 million appraisal done, fair market value, we have a $10 million insurance policy, I die, and we have $10 million but the business is worth $50 million at the time of my death. Then what? This is a similar conversation that you and I had. The banks and insurance companies don't understand the business very asset-light. They're looking to go get their hands and claw back something where that whole book of business they don't necessarily understand. What are the insurance companies going to underwrite this business for $50 million? There's no way.
Paul Giannamore: I can buy a $50 million policy on you in FRAXN.
Patrick Baldwin: Aren't they going to look at the business and say, “Wait a second, that's way over insurance. We're not going to underwrite that.”
Paul Giannamore: At the end of the day, when you think about insurance, it's an actuarial calculation based upon the likelihood of your death. How much premium do I need to pay? It's not the business in and of itself. It comes down to what's the triggering event for them and what's the likelihood they're going to have to pay.
Patrick Baldwin: When I got life insurance though, that was like, “How much are you asking for?” There's a certain point in which it doesn't make sense.
Paul Giannamore: Correct. You wouldn't want to get a $500 million policy on yourself. That makes sense.
Patrick Baldwin: Then I'm just asking to be run over.
Paul Giannamore: I'm not a life insurance expert. I don't have life insurance and I've never had it. I am self-insured, that's how I roll. I do think that the majority of people that have families look at it and say, “If I kick the bucket, my kids need this for school, and my wife needs all that sort of jazz.” They say, “It's at $1 million, $5 million, or what have you. They get the policy.” In situations like that, Patrick, you have to look back.
In 2024, our business fair market value, let's call it 10, investment value, let's call it 50.” We have to say to ourselves, “Patrick, let's look at a real scenario. One of us goes. What is the fair thing to do for the both of us?” What we might do is instead of using a multiple implied under the fair market value standard and instead of using a multiple implied under the investment value standard, we might take an average.
We might call it a $25 million business. We call up our insurance folks and they're like, “Guys, for a $25 million policy, this is what it's going to cost you.” We might look at it and say, “That's a lot of money to pay for that insurance. We don't need $25 million.” You and I would say, “What would be a fair thing to do? Would it be a $10 million payment to the family and the rest gets paid out over time?” If either one of us sell within twelve months of one of us kicking the bucket, we split the proceeds with the family. Fair is fair.
After that twelve-month period, it amortizes. That tapering, as you referred to earlier, is a good term. That number would taper. We'd share less and less of that. Whether it's 5 years, 10 years, or whatever it is, at some point, there's no longer any additional money owed to the family. All of what this does here is it focuses your attention and my attention on the business saying, “What is it likely worth on market value standard? What's it worth on the investment standard?
Let's get realistic about what we're dealing with here. What is the value of our asset? If we were to croak, how would we want to handle it? What would be an appropriate amount of money to be paid up front? Could the company afford to pay it out over time? You have that discussion. That discussion, is it a five-minute discussion, a two-hour discussion, or a week discussion? It's a relatively short discussion. You never find yourself in a situation where somebody dies and gets paid $5 million for a business that's worth $40 million.
One partner walks away with $35 million and the other partner's family walks away with $5 million or a partner is forced to sell the business because this wasn't figured out. Somebody goes out and gets an appraisal, the appraiser comes back and says, “Patrick, that business is worth $50 million.” You're like, “It's not $50 million.” The appraiser, “There's no standard of value specified in the operating agreement and this is investment value.
I've talked to all these investment bankers and that's what this thing is worth.” You, my friend, “Paul’s family, $25 million. I can't possibly pay that?” “You got to sell the business.” “I don't want to sell the business?” Tough luck. Not that you can be forced to sell the business. The state law is different and there's all sorts of things. We can't talk about all the different scenarios here. It is a nightmare situation all the way around. The two decades I've been doing this, I've been involved in a lot of things that are very easy to settle up front with a little bit of thought.
Patrick Baldwin: I don't know why Weekend at Bernie’s flashed in my head carrying around your cadaver to make sure that I don't have to pay out your family. Sorry, Paul.
Paul Giannamore: There you go, Patrick. That kind of stuff happens.
Patrick Baldwin: Paul, you mentioned taking Appendix A, stapling something once a year, you're going to look at certain numbers, and they put that and file it away with their operating agreement. What are you looking at in terms of giving them something to walk away with to give them some valuation for the year, at least?
Paul Giannamore: That sort of discussion is a whole lot easier than doing a full-blown valuation. What we'd like to look at is three years of historical financial information and then have a discussion. It comes down into a lot of Q&A about the operations to really get a sense for is it a growth business? Is it not? Is it declining? What's the quality of the revenue stream? All those sorts of things that we would do in a normal valuation that we don't have to get too deep into the weeds because it's really the 80/20 principle here.
None of this stuff is perfect. Where people make a mistake is they say, “I've got a $3 million business. What's the multiple?” The multiple for what? For what standard of value? What are the fundamentals of the business? Is it declining sales 7% per year and with 12% EBITDA margins versus growing at 15% a year with 25% margins? The multiple doesn't tell you that and the multiple is just a multiple of cashflow, it doesn't look at any of the specifics. That's why you can't just throw a multiple. You have to adjust that based upon almost looking at like peg ratio or price earnings over growth. There are things that you would want to be a little bit more sophisticated about.
The good part about it is, in partnerships, usually, both parties are impacted the same when you talk about these certain seeding clauses. I die and you die. How my family is dealt with is the same way your family is dealt with. Our interests are somewhat aligned here, unless I'm 40 years older than you and I know that I'm going out the door and you get those sorts of nuances but, fortunately, I am not. If you're relatively the same age, your interests tend to be aligned.
Patrick Baldwin: The peg ratio, does that come up a lot? I don't hear that term thrown around much.
Paul Giannamore: No, it doesn't come up a lot. It's one of the things that I would want to think about when I'm using one transaction multiple to describe a buyout provision meaning if I'm using an EBITDA multiple, that multiple will be adjusted or normalized based upon the fundamentals of the business. Let me give you an example of this. When you look at a $5 million business growing at 20% versus a $5 million business and not growing at all.
If I used, I'm going to make this up, ten times as the EBITDA multiple, are those companies at the same value? Furthermore, the one that's growing at 20% because the company is reinvesting a lot back into operations and growth, maybe it's kicking off $1 million in cashflow whereas the other one's kicking off $2 million. Now, I'm saying, well, “Company B that's not growing at all is worth 2X of what company a is worth, how does that make sense?”
I strongly discourage people to just throw multiples in that they haven't thought through the implications of what they actually mean. That multiple is nothing more than shorthand for a discounted cashflow analysis, which would take into consideration the stream of free cashflow and the growth rate in that stream of cashflow. If you can do a DCF, you're discounting that cashflow back to the future, and you determine what that multiple is, it's going to be far more accurate than if you just use random market statistics or comps that you pull out of thin air.
Patrick Baldwin: Tell me, Paul, how often are operating agreements getting updated with the Appendix A?
Paul Giannamore: I've seen a handful of people that are very religious about this.
Patrick Baldwin: It helps give peace of mind. Thinking about the industry, probably the easiest thing you could do is get this updated so you're protecting yourself, your assets, or your partnership.
Paul Giannamore: I am going to do an Ask Me Anything call for FRAXN clients one of these days. If we can find a FRAXN client that says, “I want to go over my financial statements. I want to see live how you would use a DCF to come up with these transaction multiples in the current market and then apply it to my business on one of those sorts of exhibits.” I would do that. I'd do that live.
Patrick Baldwin: They know how to reach me, Patrick@FRAXN.com. Paul, this got me thinking. I know we're talking about operating agreements. I danced around the asset protection. That's come up a few times with a few clients, asset protection, like, “I am growing this business. It is kicking off a lot of cash. I'm thinking a lot about my family.” Are there recommendations you have as far as asset protection or managing their assets?
Paul Giannamore: Depending on your level of resources, there are a lot of things that you can do from an asset protection perspective. Especially to American listeners, our audience is largely here in the United States but we do have a lot of foreign listeners. The US is an extremely litigious society. Although we talk about the land of the free, the federal register is massive. There is a lot of administrative law in the United States that gives government authorities the right to confiscate your assets without a fair trial.
Here in the land of the free, the IRS can take money out of your bank account, they don't have to ask any questions, and don't need a warrant, nothing. They just start doing a bank draft. Local and state police can take your money. You could have an accident, no fault of your own, harm somebody, and then find yourself staring down the barrel of a $20 million lawsuit where they're going to take everything and you won't have any say in that. You have a lot of risks on the horizon.
I always say, for me, one of the most important things anyone that can do that has a good amount of assets is an offshore trust, establishing a trust in an offshore jurisdiction that no one can touch, not even the United States government. No one can touch it. Everyone always is like, “You put money overseas. What do you have to hide? That's what terrorists do and all this sort of jazz.”
At the end of the day, it's one form of protecting your family. There are a lot of people that I know that are worth hundreds of millions of dollars plus and every single one of them has some sort of an offshore trust. The US court system can't touch it. If you want to get real hardcore, an offshore trust would be a good way to go.
Patrick Baldwin: It's not to be shady. It's just to be predictive.
Paul Giannamore: I don't think there's anything shady about it at all. It's hard to be shady with offshore trusts, at the end of the day, because there's transparency stuff and you have to report it. If you tender assets to an offshore trust, you have to file with the internal revenue service and let them know that you have this offshore. You've got FinCEN forms and FATCA forms. You've got a lot of filing requirements. You're not doing anything nefarious but what you're telling them is, “I'm taking these assets and I'm moving them and tendering them into a trust in an offshore jurisdiction and no one can touch it.”
Patrick Baldwin: Does that change your tax liability or tax jurisdiction?
Paul Giannamore: No, it does not. If you're the beneficiary, it would flow through right to you on your tax return and you would file and report it. Let's say that you get into an accident and you harm somebody and you're like, “I owe this person hospital bills and stuff. I owe this person $500,000. I would pay for this because it was my screw up.” You get sued for $20 million and you lose and then the court says, “For punitive damages, another $20 million.” That's now $40 million and there's a federal judgment and they're able to go after everything.
I don't think good people use offshore trusts to run away from their obligations. They use offshore trust to say, “I'm not paying $40 million for this. I'll pay what's right and just.” That's not going to be some nitwits in the US federal court making that decision. You now can decide what you want to pay. That's one example. I see a lot of it in divorce situations where people put money in offshore trusts. You can't touch that stuff.
Let's say that you get a federal judgment, you had that lawsuit or state judgment or what have you against you. If you're in the state of Florida and you lose a lawsuit and you get a money judgment against you, let's say it's a federal judgment that can be executed in any state. As part of the union of a judgment in Florida, it can be executed in Texas and so on and so forth. Most countries on the planet have treaties and agreements with regard to the execution of judgments.
You might get a judgment in the United States and through some paperwork and so on and so forth. You can get it executed in France, Italy, or England. That stuff happens. In a lot of the offshore jurisdictions, if there's a judgment in the state of Florida, those foreign jurisdictions where the trusts are located don't recognize those judgments. They say, “Guess what? It's great you got a judgment but if you want to try to attach this trust, you're going to have to file that lawsuit de novo.”
From scratch, here in our jurisdiction, you're going to have to fight it. Now, the plaintiff has to hire local counsel 10,000 miles away and wage another court battle in that offshore jurisdiction and, by the way, using that offshore jurisdiction's laws. In the United States, you might have a statute of limitation on contract and a state for six years and that offshore jurisdiction might be six months. Better file quickly. That's the cornerstone for asset protection, our offshore trust.
By the way, I'm not an expert. I've got an attorney that does this down in Florida. He's brilliant, he's old, and he's been at this forever. He's a phenomenally good guy and he knows his stuff. He's flying in and I’m going to sit down with him with one of the clients of ours who's in process because he's going to be selling his business. He immediately wants to put some of these proceeds into an offshore trust so that no one can touch it. Of course, you have a variety of different trust vehicles domestically that you can use. You could use charging order protected entities. There are a lot of different things that you can do.
I do think asset protection is a very important topic, especially as you start to plan for an exit. Let's say you got $1 million in your bank account today and you're like, “I'm doing good.” What's $1 million anymore? Who wants to go after me for $1 million? You're selling a business and you're going to have $100 million, $50 million, or whatever. Is it a bad idea to have $5 million in precious metals somewhere in another country protected in an offshore trust that no one can touch that gets bestowed upon your heirs? It's not a bad idea.
Patrick Baldwin: That is helpful because the lawsuit thing was on the mind for a few people. Seeing more and more that trend.
Paul Giannamore: I hear about it all the time, especially out on the West Coast. Unfortunately, the United States is getting difficult to do business now. Every time I turn around, you got union issues in pest control. I'm shocked. I've heard five union issues in the last few months, tons of lawsuits. This whole episode is about thinking ahead and planning for those things that are outside of your control, things like your death, and things like lawsuits. Offshore trusts get a bad name and they get a bad name by legislators because legislators want to be in control of your money. Folks don't like anyone who's worked hard in their life and who's been a productive member of society and has amassed wealth. Those people are the enemy.
Patrick Baldwin: You're villainized.
Paul Giannamore: One thing you can do is give people the middle finger and say, “I'm putting at least a portion of my financial resources into a jurisdiction whereby there are legal institutions that protect it.” Unfortunately, that's not the United States anymore. It's a reality of the situation. People are going, “Paul, you're not a patriot.” As a matter of fact, I am a patriot. I sound more like one of the founding fathers than you do. Not you, Patrick, but some of these guys out there who stick to party-line politics.
Patrick Baldwin: This is super helpful.
Paul Giannamore: Patrick, I feel like we were not planned for this particular episode. I fear that my discussion on the operating agreement and the valuation was confusing. If anyone needs any clarification, we are certainly happy to do a follow up on this one because it's not an easy topic.
Patrick Baldwin: I look forward to the Ask Me Anything where we're going to run through one of my client’s financials. That'll be fun.
Paul Giannamore: Make sure it's a good one, Patrick.
Patrick Baldwin: Yes, sir.
Paul Giannamore: If it's a dumpster fire, you know I’m going to say it on the air. \
Patrick Baldwin: I'm afraid when you talk about having your Potomac team on there, it might be someone more than just you.
Paul Giannamore: I'm giving strong consideration to bringing him on as a cameo. You've heard him talk about the financial statements before.
Patrick Baldwin: That'll be fun.
Paul Giannamore: “These thing suck”
Patrick Baldwin: I don't know what to expect.
Paul Giannamore: Alright, my friend. Until next week, brother.
Patrick Baldwin: Awesome. Thanks, Paul.
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Dylan Seals: Thank you so much as always for supporting us at The Boardroom Buzz. We know your time is valuable and the fact that you spend 45 minutes or an hour with us means the world. All the media that we put out from Potomac is meant to honor and celebrate you, the service industry owner. As Paul would say, “Yee who toil in the pest control vineyards.”
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