Forecasts are an essential part of any business, especially in an ESOP because they are a major component of the annual valuation.
A good forecast process ensures a more accurate valuation and provides a good line of defense against any challenges from the Department of Labor or potential private litigants. Forecasts have become the most important issue in these challenges, with litigants usually charging they have been excessively optimistic. Forecasts are the basis for many spending and strategic decisions an ESOP makes going forward. While most forecasts focus on financials, they often look at non-financial metrics such as anticipated changes in key personnel, technology, market conditions, and innovations.
A good forecast should not just be a single number, but rather a baseline expectation for the future you think you can foresee. This will vary by company. It might be one year for one company and five years for another. Forecasts should show a range of numbers for each key item, assessing the probability of the baseline, low range, and high range. The results provide those who use the forecasts with a more nuanced view of the business and help you prepare for predictable possible futures, not just one. The best forecasts are bottom up from each area with line-item responsibility, which are then reviewed, changed if needed, and aggregated in a management-reviewed overall projection. This process is not just more accurate, it also generates buy-in from more employee-owners.
The Department of Labor process agreements with several trustees provide guidance on how appraisers should assess forecasts, specifically:
Forecasts are not the same as budgets. A family might make a forecast about what it will earn the next year and what it will spend, but its budget is what it thinks it can and should spend in the coming year. Like families, companies use forecasts to inform budgets, which describe what the company needs to spend on essential capital, payroll, interest, repurchase obligation, administrative and other costs, and what it can spend on discretionary expenses such as incentive pay and growth.
To make accurate projections, several steps are essential:
Start with a strategic plan: Where do we want to be and how are we going to get there? The best strategic plans are bottom up from each cost and revenue center, then vetted by management and stress tested to show the probability of different outcomes.
Choose a time line: How many years out can you reasonably project costs and revenue? If your future forecasts are largely speculative, say so.
Decide how indicative past history is: For some companies the past is indeed prologue, but for others significant changes lie in the future. A major issue in litigation has been when forecasts project significant upward growth from prior experience. If you think the future will be different, document why.
Decide what to include: Forecasts should provide income statements, balance sheets, and statements of cash flow. Some forecasts show detailed month by month and/or department by department expenses; others just big picture revenue, cost of sales, operating expenses, net income, or anything in between. Discuss what you need with your advisors.
Examine repurchase obligations and debt service: Repurchase expectations should be based on a repurchase study done at least every few years.
Assess risks: These can include customer concentration, the loss (or acquisition) of key sales or other personnel, changes in the industry, new competition, potential litigation or regulatory changes, supply chain issues, capacity limitations, etc.
Assess costs: These include capital requirements, payroll, capital expenditures, new and replaced machinery and equipment, vehicles, facilities, etc., all normalized for unusual expenses.
Start-up of new operations: If you are embarking on a new endeavor, list working capital requirements, increases required in accounts receivable, inventory, changes in labor, warehousing, manufacturing, shipping costs, etc.
Impact of non-quantifiable factors: Examples include an aging employee base, expected retirements, the strength and longevity of management teams,
the stability of key customers and suppliers, etc.
Because your trustee is responsible for the valuation, it makes sense to discuss your forecast process in detail with the trustee and appraisal firm. Ideally, an ESOP can develop an annual checklist to help document that best practices have been utilized. Documentation can help protect against any future challenges.
It also makes sense to review the discussion of forecasts in the Department of Labor’s process agreements. The NCEO has a newly revised publication detailing these agreements by Ted Becker, Richard Pearl, and Alison Wilkerson, “The DOL Fiduciary Process Agreements for ESOP Transactions.”