Well, let's take a quick break and then we'll be right back with the Bill Worsama Economic Update here. So we'll take a quick break and we'll be right back. This is your host, Jacob. And thank you for listening to the show. If you're interested in selling your business and you'd like to work directly with me, you can go to Morgan and Westfield.com and you can schedule a free consultation. And like I mentioned, you'll work directly with me throughout the process. And now back to today's show. And welcome back to M&A Talk with Bill Worsama, Bill Supply Chain Issues. We saw a ton of supply chain issues, particularly in 21. I think we're maybe still seeing some of those issues. Of course, we saw some labor issues as well, but what impact did supply chain issues have and valuations? And to what degree can you make adjustments regarding that? Because of course, you have some anomalies there in terms of operational and financial results. Can you kind of ignore that and adjust that out? Or would you actually base part of the valuation on a year in which there were one-time supply chain issues due to a pandemic?

Excellent question. And part of my role is to try to dissect those types of issues, that type of noise that shows up in financial information. And typically, when you're talking about supply chain and you remember the escalation and freight, you're going from $2,500 per container to $25,000 per container. Tenfold increase. Crazy numbers. And to the degree that you weren't able to pass those along and to the degree that they do reverse and everyone knows that they did reverse, I'd say that that's a legitimate add back. I think the larger issue though is what happened just generally because of the supply shortages and supply chain in terms of inflation and pricing. And what I look at there is a tool I bring the bears called Price Volume Mix Analysis. And I don't want to bore people with all the technical details. Well, no, this actually sounds very exciting to me. But what it's supposed to do is dissect changes in your revenue from point A to point B. How did your revenue change? So it's a reconciliation of revenue. And sometimes what I find is that, let's say revenue is up by $5 million. I find that when I dissect how much is price and volume and mix, that of the $5 million increase, $7 million is actually price and the other two variables are negative. So that's how significant it can be. So that's the type of tool that I bring to bear. Price Volume Mix allows you to roll forward the revenue and see how much impact price actually had on it. And sometimes it's more than the growth and revenue that you see. And then beyond that, as I talked about at the outset, there are inflated unit margins. So because of a number of factors, one being that inflation in revenue and commodity, raw materials have gone up at one pace, whereas labor and overhead have gone down at a much lower pace. You're seeing crazy level unit margin, sometimes double what you would expect in the past. And certainly those are not sustainable. But what you need to do is be able to analyze what those are and quantify those. And part of the problem with that is not every company makes widgets, right? I mean, how are you going to come up with the unit? And sometimes I've done paper lately. I've done steel. Sometimes there are readily available common denominators that you can use, at least as estimates like hours or cases or pounds or sheets or orders or lineal feet, those types of things that you can use. And to the degree that you can't, it's going to give you a good handle on what unit margins look like. But you can always get more granular. There's nothing that stops you from doing that. You can look at things at a skew level and see how the margins have trended and therefore how sustainable are they. Because in the end, as you know, every market is limited to the degree of returns that it can make. If a market is generating abnormally or extraordinarily high returns and other entrants will come in, there's going to be competition. And in a free market, we're going to come back to a reasonable number. There will always be competitors that can come in and say, hey, we're going to bring those prices down because we can afford to. There's a lot of excess margin here. So you have to be careful. Once you've done that analysis on revenue and unit margin is to determine what normal looks like. What does a normal unit margin look like? What does a normal revenue look like? And that is really what you as a buyer should be paying for. And you as a company should be presenting, for example, to your bank when it comes to projections going forward because the worst thing you can do is over-promise and deliver to your

bank. If we really want to drive this point home, aren't you essentially trying to predict the future performance of the business? Because that's essentially what the buyer is buying. They're not buying the historical cash flows. They're buying the future cash flows. And that's what they're willing to pay for. And when it comes to valuing the business, that's what they're trying to estimate. The problem with that, of course, is that it's highly subjective. And in a risky environment with significant change, there's certainly a degree of risk to trying to predict the future. So how is that subjectivity impacting valuations in an uncertain environment like this? Right.

Well, I'd say that you're absolutely right. We are trying to get at a good baseline. We're trying to look at history. It's no longer a matter of waiting this year more than that year and lining up the years and looking at a growth trajectory because things are way too peak in valley. We have record years, both highs and lows within the past three years. We're trying to come up with a normalization through these tools so that we can then adjust the most recent history and be able to look forward as to what the most likely case is. And we can do that conservatively. We can do that aggressively. So to the degree that there might be disagreement between parties, you're left with an ear now. You're left with trying to bridge that gap where if performance actually does continue as it did in 2022 or early 2023, then the seller will be compensated for that. It just doesn't seem likely in particularly if it's due to expansion in unit margins or pricing as I pointed out earlier. Those things are likely to go away and markets will normalize and suddenly margins will be back where they were and you're not going to see this type of continued off the charge performance. I had a client in the steel industry where they're even double and their volume really didn't change all that much. And it was all due to commodity pricing, which has subsequently started already to come down. So they're not going to see that going forward. And everyone acknowledges that.

Do most buyers assume that things will resettle to pre-pandemic levels? They should if they don't.

I guess there's two ways to look at growth. One is that it's growth and the trajectory will just keep going up and up and up. The other way is to try to see what's behind the growth. Is it actually inflation? Is it higher unit margins? And if so, very unlikely to continue. And most buyers, if they really set forth to analyze it, will come to that conclusion. But what they need is the tools. And that's what I'm trying to provide them with. The tools meaning, of course, you, Bill. Well, price volume mix. Price volume mix was one. And then unit margins is the other. Putting pen the paper and trying to lay it out.

Well, I want to point something out here that's important because if they're retaining somebody like you, what they're paying for is the ability to be able to view their business through a third party objective unbiased viewpoint. With somebody that has the capability of saying, okay, if you line up 100 sophisticated buyers, here's how the majority of these buyers are likely to view their business. And how much variability there do you think there is amongst a potential buyer group for a business, a middle market business?

Oh, yeah. It, no, it runs the gamut. Absolutely. I mean, but it depends again on the size of the company and so forth. As I said, individual buyers may be attracting more to the smaller businesses or that's what they're looking at. So there might be a wider variety there. When you get to larger businesses, you're talking about or just general middle market, you're talking about a more predominant presence of private equity. And again, as we were saying earlier, that's the financial side. Those folks are looking at things a bit more scientifically and it's likely that they will come to similar conclusions, maybe not precisely the same, but similar conclusions. But it's an amazing statistic that private equity ownership, even before the pandemic, was 50% of middle market companies and that 50% of middle market deals are between private equity groups. So pretty amazing how dominant that they

are. What do you think will change in the future in the next few years? Do you think we're going to settle down to the pre-pandemic norm or do you think there's new norms that we need to accept and that we're perhaps not quite prepared for?

Well, I think that it's hopefully there will be stability, barring anything unexpected. There's always things coming up, but hopefully there will be much more stability now going forward for the next several years. I mean, there are some economists that say because of all of the expenditures that were made by the government during the pandemic, the PPP program, the ERTC, all the subsidies that were made, that there will be a drag on the economy as it's paid back. So there will be somewhat diminished economic growth. But as I said, hopefully stability, which will enable people to start going back to the techniques that they had been using to value

businesses and assess performance and see real trajectories in businesses rather than artificial ones.

And so to be clear, you're not seeing a tremendous impact on valuations at this time. Are you?

No, except for the fact that there has to be this analysis taken into account. Ultimately, the adjustity, but that they work with needs to have proform adjustments, need to be normalized, needs to look ahead to projected performance. So I'd say there is probably more of a reliance on what's called discounted cash flow, that type of analysis than there has been in the past. It's just because the published multiples really don't mean anything anymore.

Why is

that? Because of the variability and certainly at the beginning of the pandemic, a lack of transaction activity and all. So it's starting to come back, but you just don't have the database you

had.