The Department of Labor has made it clear in its various process agreements with ESOP fiduciaries that it wants ESOP companies to be more prudent in how they prepare forecasts for appraisals.
The DOL has been especially concerned with forecasts at the time of an ESOP transaction that present an excessively optimistic scenario and thus a higher price for the seller. But forecasts matter on an ongoing basis as well. An overoptimistic forecast will artificially inflate stock prices, leading to an unrealistic repurchase obligation. Excessively conservative forecasts can mean departing employees get too little and the company may become more vulnerable to unwanted outside offers at more realistic prices. Banks, of course, also rely on forecasts. So what makes for a good forecast?
A key issue to consider is what level of detail is appropriate for the intended purpose of the forecast. A good forecast must include a synchronized balance sheet, profit and loss, cash flow, and forecast statement presentation consistent with generally accepted accounting principles (or GAAP). (If the forecast reflects an “internal” non- GAAP presentation format, can you bridge it to GAAP?) You also need a summary of assumptions that identify critical variables and your approach to forecasting each. For example, you should show a forecasted percentage sales growth resulting in dollar annual growth in sales and a forecast of inventory turns resulting in absolute dollar inventory.
Your income statement, balance sheet, and cash flow statements should be supported with appropriate analytics and trend analysis. Include a tracking of EBITDA margins, secured financial debt to EBITDA margin, and fixed charge coverage. If supporting detail is helpful, include it as an addendum, such as:
Your forecast is often a critical part of the bank’s underwriting process. Your forecast needs to be clear enough so that the banker can communicate it internally. Make sure to explain the basis for your assumptions, and the rationale for significant changes in historical and forecast results and variance from industry norms. Certainty and achievability can be measured by the sensitivity of results to forecast variables. Include both upside and downside forecasts as well as a base case.
Forecasts should also demonstrate covenant compliance and ability to service debt under each forecast scenario. Explain and show what management’s options are in the downside. How quickly can the company adjust to a shock in the business? Are there other potential claims on assets and income? These can include seller note repayment, warrant payouts, and repurchase obligation. In the event of a forecast “miss” lenders will seek to understand the situation with a forward-looking emphasis on next steps and how and when the bank will get repaid.
Your forecast is a critical part of the transaction valuation and the trustee’s annual update. Supported by its advisor, your trustee is an equity investor with no secondary exit. As such the trustee’s due diligence is often somewhat more in-depth and you should expect a high degree of scrutiny. The trustee should be able to communicate your forecast effectively to the board and possibly the DOL. Spell out the basis for your assumptions, the rationale for significant changes in historical and forecast results, and the rationale for significant assumption variances from industry norms. Understand that the relative certainty of results may drive the appropriate discount rate. Make sure to consider the value growth trajectory and repurchase liability. In the event of a forecast “miss” the DOL may seek to understand the situation with an emphasis on what went wrong and if it should or could have been anticipated in the valuation. Carefully document your assumptions and rationale for those assumptions at the time the forecast was prepared. This documentation standard should be employed even if the trustee is an insider.
Forecasts are also critical, of course, for strategic planning, acquisitions, and communicating goals to employees. Forecasts often reflect either the most likely or best case outcomes. Understanding the difference between these two is important for management and for the users of the forecast. Understand what it will take to make it and what it would take to break it, and communicate that clearly to all users.
Companies use a variety of approaches to forecasting, from something just the CFO does to a more collaborative process. Ideally, forecasts should be built from the bottom up, with department and sales managers actively involved, leading to discussions with top management to come up with a consensus approach. Documenting this process will be helpful in showing the DOL that forecasts have been thorough and realistic.