Hiring, or promoting, a person into an executive role often requires the Founder to offer an equity incentive to the key employee. This requirement drives a need to understand what the firm is worth today, and how much of the future value should be shared with the key employee. On this episode, Michael Daoud, CEO at Visus LLC, discusses how he valued his firm, and how he structured the equity share with the key employee.
TRANSCRIPT
Greg Alexander [00:00:15] Welcome to the Pro Serve podcast with Collective 54, a podcast for leaders of thriving boutique professional services firms. For those that are not familiar with us, Collective 54 is the first mastermind community dedicated entirely to the needs of leaders of thriving boutique producer firms. My name’s Greg Alexander. I’m the founder and I’ll be host on. In this episode, we’re going to talk about negotiating an equity incentive for hiring an executive into your firm, something that we all run into a little bit of a tricky scenario and multiple ways to do it. And we’ve got a great role model with us today. Collective 54 member Michael Daoud. And Michael, as recently gone through this is going to share a little bit of his story with us. So with that, Michael, welcome. Good to see you. And please introduce yourself to everybody.
Michael Daoud [00:01:09] Thank you, Greg Yes, has a great side. I’m Michael Daoud. I’m the founder and CEO of Visus LLC. We are a professional services company focused on software development and our target market is mid-level enterprise companies and we help them improve their operational efficiency and customer experience. And we do that through developing custom applications, content management systems and business intelligence solutions.
Greg Alexander [00:01:37] So it’s Daoud. Not dowd.
Michael Daoud [00:01:40] Correct.
Greg Alexander [00:01:40] Okay. Sorry about that.
Michael Daoud [00:01:43] Problem.
Greg Alexander [00:01:44] Okay, So let’s set it up. So describe the situation. So as I understand it, you’re thinking about adding a member to your team in a pretty important role and you had a need to think about an equity incentive. So give us the backstory, please.
Michael Daoud [00:02:00] Yeah. So I’ve got an opportunity to bring on a very well experienced person, and that can help us with our growth and scale. And part of that incentive is to provide some sort of equity and or that process been trying to determine valuations and things like that. So can probably provide the right balance of things. Always have grown the company so far over the years and it has a certain value. And so we want to figure out what that value is today. So when the equity equation is figured out with this gentleman, then we can determine, you know, targets based on today’s valuation and future valuation.
Greg Alexander [00:02:42] Yeah. Okay. Very good. And that’s an important distinction. So for those that are struggling with the same issue, remember all the value that you created up to this point is yours because the executive coming into the company didn’t help you create that. So establishing what the firm is worth today and then what the firm might be worth in the future, and that gap between its valuation in the future and the valuation today, that’s the value that was created. And the question is how much of that value do you share with a new hire? So determining what the firm is worth today is a tricky thing. So my client is stand that you have an advisory board and they suggested to you that you get a valuation. So first, why did they think that that was worth doing? And then secondly, as you explored the possible ways of doing that, what were your options?
Michael Daoud [00:03:31] Yeah, that’s a great question. Great. So we have a fractional CFO that works with us, and he recently had a client go through an indication of value, so rather than a full valuation. Is this person here in town can do indications of value. Just to kind of give you a rough idea of what the valuation is. The reason the board pushed me to do that, because you and I spoke and you had shared some averages for software development companies in professional services. We have some pretty strong benchmarks. We have strong gross margins, strong EBIDTA. A lot of good processes in place and they felt those all those things put together would provide a stronger valuation. And so as a result, they said, well, maybe getting a good valuation done, and this is prior for me getting the collective 54 estimate, which we can talk about. They thought that it would be a more what’s the word I’m looking for, a more accurate to the actual valuation, if you would, just because of those strong numbers that we have. You know, we posted our numbers in collective 54 and always gotten good feedback of how really strong our margins and EBITDA are. And we work very hard at that every day. Yeah.
Greg Alexander [00:04:59] Yeah. And you’ve got your board gave me great advice because you’re right. Given your performance, your firm is probably worth a premium over similar sized firms because of your outstanding performance and therefore you don’t want to give that value away. You created it. So getting kind of an accurate value is really important. Now, there’s a lot of ways to do this. You can hire a professional appraisal firm, which if you have the money I recommend this is what they do for a living and they’re fantastic at it. That can run. Yeah, they get a really good one done. What you would want to do for a situation like this, since it’s going to dilute your own ownership percentage or potentially dilute it, it’s going to run you around 15 grand. In my experience, the ones that are cheaper than that aren’t really great. So if you’re going to spend the money, my opinion is, is do it right now. If you don’t want to spend the money and you’re looking for, you know, let’s say call it an educated guess, I guess we have a tool collective 54 does called the Firm estimate and it’s free. Now, I want to caution you, it’s not a professional appraisal. It’s an estimate. And, you know, you can use it and determine whether it’s worth anything or not. And Michael and I are going to go over some of the basics of it today, just as a way to help everybody think through this and also just use this as a outline for the broader conversation on on negotiating equity incentives with a new hire. So the inspiration for this was the Zestimate. I don’t know if any of you have used the website Zillow, but you can go to Zillow and you can plug in your home address and they give you a Zestimate, which is, you know, the word estimate with the letter Z on the front of it to represent that it came from Zillow and it’s shockingly fairly accurate. And then if you’re looking to move and you want to maybe make an offer on a home, they can do the same thing for you. So I said to my team, Well, let’s build the equivalent of that in the principles where it’s got to be super easy. So let me walk you through just real high level what it is. And then, Michael, I’d like to get your thoughts on some of this.
Michael Daoud [00:07:05] Sure.
Greg Alexander [00:07:06] So first off, our estimate pivots off of EBITDA. And for those that aren’t familiar with the term EBIT, it’s simply pretax profits. And we establish a range. The range starts at five times EBIDTA and taps out of 15 times EBITA and everything pivots off the EBITDA multiple. There are a series of variables that add to or subtract from the multiple multiple of EBITA and the addition and subtraction are done in one times EBITDA increments per variable. So for example, one of the questions is revenue growth. So if you are growing your top line 30% plus, then you get an extra point of EBIDTA. If you’re growing your firm less than 30%, it’s neutral. You don’t get a subtraction, but it’s neutral. Another example, profit margin. So if you a pretax profit margin is 30 plus percent, you get an extra point of view. But no, if it’s between ten and 30%, it’s neutral and it’s less than 10%. You subtract the point of EBITA and the dimensions we look at are EBITA revenue growth, profit margin. Recurring revenue as in what percentage of your revenue is recurring? Client concentration. Client tenure. Employee tenure. The dependency the firm has on the founder. In the age of the founder, there’s ten variables, that’s all. And you plug those, you answer those questions and out pops an estimate as to what your firm is worth. And then you can play around with those variables. Let’s say you plug them in and you don’t like what what the answer is. And you can say, Well, if I fix this and I fix that, what does it do to me? Or you plug it in and you say, Holy cow, my firm’s worth a ton of money. Maybe you don’t believe it. And then maybe you go back and play around with it. That’s kind of the concept. So Michael, I know, is a little short notice, and I’m not sure if you’ve had a chance to kind of use that tool yet, but did you mess around with it at all? And what did it what did it reveal?
Michael Daoud [00:09:09] I did and it was great. I really enjoyed it because it confirms some things that were doing well. And and I highlighted some of the things that we need to do better. Right? So I know over a collective 54, I’ve heard people having valuations that are companies, as you said, anywhere between five and 15. I even heard 17 ones. But in general, somewhere in that range and five being conservative. But it was a pleasant surprise to me that when we plugged in our numbers, our multiple was seven. So, you know, I was using five and it was nice to see that. And so I think once we put it in. So on the revenue growth rate. You know, that highlighted how much more we need to spend on sales and marketing to for accelerated revenue. And that’s part of the of the offer with this executive to come on board to help with that. But with our strong gross profit margins and other numbers in here, it really helps. One thing that it did highlight for me, we’ve been getting more and more into recurring revenue. Yeah, through support contracts. But you know, having to do the calculation, put it in here. I didn’t realize how small it was compared to the overall revenue, even though it’s been kind of front of mind to work on that. So that’s an opportunity for us to do even better in our multiple by adding more and more of those support contracts.
Greg Alexander [00:10:42] Okay, good. So I’m glad that it was, you know, a reasonable estimates and it confirms your belief that your firm is worth more than five times. The tool says seven times, maybe it’s eight, maybe it’s six. I don’t know. But, you know, it did confirm that belief for a lot of the reasons. Now, what would happen from here, whether you use a free tool and you kind of back of the envelope, it’s like what we’re talking about now. Or if you hire an appraisal firm as now you go back to the executive and say, okay, this is our jumping off point. So just to use easy math, our firm’s worth $10 million and I’m going to hire you, Mr. Executive. And over the next five years, we’re going to go on a journey together. And our hope is at the end of those five years, we double the value of the firm. So let’s say it’s worth $20 million. So therefore, $10 million of value was created. The $20 million end state minus the $10 million jumping off point is 10 million. And then the conversation with the executive coming in is what percentage of that 10 million do you think is fair to share with that executive? And this is where it gets really hard because sometimes there’s not clear attribution as to the executive’s contribution to an extra $10 Million in Value creation. And this is where it gets tricky. So Michael, do you have any thoughts on kind of what a an approach might be to figure out how much of the extra value created should be shared with the executive?
Michael Daoud [00:12:08] Yeah. I mean, you know, in thinking about this and, you know, preparing, you know, some kind of package. You have I as a founder, reflect on say, okay, can I do this on my own without this person? Yeah, probably answer probably is yes. And I believe in myself that I can do it. So what what is the what will this person help me achieve that will get achieved a little bit faster? I think the answer to that is yes as well. So what’s the value for achieving that faster? And, you know, I’ve discussed this with him as well. And I feel that, you know, 10% of that value is fair or that acceleration. And so that’s kind of where we can come to. Yeah.
Greg Alexander [00:12:56] Okay. So I think 10% is fair in your in your situation. And I think the insight that you just share with us is you feel that it’s worth it because this is the key component of Michael story, is that this executive can help him get there faster as he stated, he can do it on his own. He can get there. But this executive might help him get there faster. And then then it’s a judgment call for the entrepreneur or the founder. Do you want to get there faster? Well, if you’re 25 years old, you might not care. If you’re 55, you might kill a lot. So this is where the tradeoff comes in. And 10% is actually generous. You know, if if this was a corporation and somebody was issued stock options as an example, you know, the employee that’s going to get stock options might get, I don’t know, 1% to 2% of the company. And they would vest over time. So 10% is is pretty generous but fair. You know, given what Michael is trying to get done now, as you share this information with this executive, who was it well received? Was there a disagreement? Was it a point of negotiation? Like how did you approach this?
Michael Daoud [00:14:08] Yeah, that’s a great question. So when we start our talks some time ago and it’s been some time it was proposed by him at first as to what he believes his value would be. And in exchange for that and, you know, I felt from day one when he did that, that it was fair, especially for he brings a lot of technical know how and can help us, you know, not only accelerate through the valuation but accelerating some of those some service lines that would help us attain that valuation we’re looking for.
Greg Alexander [00:14:44] Okay. Very good. All right. Well, listen, we’re at our 15 minute mark here. We’re going to continue this conversation and go in much greater depth on our member Q&A sessions with happen on Friday. And I’m sure because I get asked this question all the time by members, I’m sure that’ll be a well attended session. Michael, you’re a great member. You’re always contributing to the collective installing knowledge into our knowledge bank. You did that again here today. So on behalf of the members, I just wanted to publicly thank you for your contributions and for being part of our community.
Michael Daoud [00:15:17] Thank you, Greg, and thank you for starting Collective 54. It’s been an awesome journey to be together with you and the other members.
Greg Alexander [00:15:24] Okay, Awesome. All right. Let me give you a couple of calls to action. So if you’re a member, go play around with the firm estimate at all. Attend Michael’s Q&A session on the Friday when it gets scheduled. If you’re a nonmember again, this tool is free. You can download it off of our website, collective 54 dot come under resources. And then also if that type of content is of interest to you, you can subscribe to collective 54 insights, and if you do so, you’ll get three things per week. You’ll get a blog on Monday, a podcast on Wednesday and a chart on Friday. And if you want to skip all that and just become a member and you want to apply, fill out the Contact Us form on collective 54 icon and somebody will get in contact with you. But great episode today and thanks for listening. And until next time, good luck to you and we’ll talk to you on the next show.