Wine as an Economic Indicator?

Here we are, back again after a very long and extended break from writing here.  To say my colleagues and I in the valuation and wine business services groups have been busy this past year would be an understatement.  That being said, people all over the country and even the world continue to struggle with low real estate prices, high unemployment and huge amounts of debt.  And in spite of all that, I do see some pockets of optimism.  Despite an uncertain and volatile economy, there are signs that the worst is behind us.  The wine industry appears to be one of those industries that is getting back on track.  The following are my personal observations:

1. Local tasting rooms have been packed on weekends, even in February!  Several I visited in Napa and Sonoma had no tours or tasting appointments available over the weekend.

2. Restaurants are busier – Sante in Sonoma and Bottega in Yountville both had no open reservations for dinner throughout the weekend (I tried making them on Thursday and Friday, but still…).

3. People seem to be starting to trade up in wine price – I even saw a guy buy a bottle of Cristal at Bottega a few weeks ago on a Sunday night.  On a Sunday night!

  1. I have also seen fewer people in general bring their own wines into restaurants in recent months, which may indicate people are starting to feel comfortable spending money on wine again (as opposed to the past few years).  If that is the case, I have a wine for you!

4. Value wine sales also appear to be increasing as Sutter Home, Gallo and The Wine Group’s sales are all reaching or at all-time highs, the majority of which come from wines under $10 per bottle.

5. Americans continue to drink more wine, consuming more than 3.7 billion bottles of vino in 2011, more than any other country in the world (according to Vinexpo and International Wine and Spirit Research).  Sales of wine over $10 per bottle grew 15% in 2011.

6. According to the recent USDA’s grape crush report California grape prices rose to a record high of $588.96 per ton for all varieties, up 9.5% year-over-year (YoY) from 2010.  Red wine grape prices increased 12% YoY while white wine grapes rose 8%.

  1. Grapes from Napa County, with the state’s highest grape prices, had an average price of $3,407.56 per ton, up 5% YoY.
  2. Part of the increase in overall grape pricing is likely due to lower yields; however, it also shows that wineries are back to buying grapes from growers and out on the spot market.  That would seem to indicate that wineries are starting to get more optimistic about the future demand for wine.

7. U.S. GDP grew 2.8% in Q4 2011, the 10th consecutive positive quarter-over-quarter (QoQ) increase and the largest since Q2 2010.

8. Wine auction prices appear to have recovered and have trended upward in recent months as well.  The Liv-ex Fine Wine 100 Index closed January with a rise of 1.4% QoQ (the majority of which were First Growth Bordeaux wines), its first increase since June 2011.  The Liv-ex Fine Wine 100 Index is the industry’s leading benchmark.  It represents the price movement of 100 of the most sought-after fine wines for which there is a strong secondary market and is calculated monthly.

9. Relative to 2008-2010, winery valuations and multiples increased in 2011, primarily for those wineries with strong operating margins and a solid tasting room/direct to consumer presence.

Now I’m not saying everything is all roses (except for today maybe), but from a somewhat basic quantitative and qualitative standpoint it seems like there are some strong tailwinds in the wine industry, which should continue driving increased wine sales.

A Wake-Up Call for Someone

When I woke up this past Saturday morning and heard the news that Standard & Poor’s downgraded U.S. debt to AA+ status, my fundamental valuation training kicked in and I immediately worked through the impact this decision would have on the risk-free rate in calculating the cost of equity.  I was a bit late to the station on this train of thought.  Steve Schaefer from wrote a great piece on this very topic BEFORE the downgrade.  He mentioned that we may need to look at other types of bonds, specifically municipal bonds, with AAA ratings that may represent a better indication of a “risk-free” investment.

While the idea of moving away from U.S. government debt to other AAA rated debt makes fundamental sense in an academic world where these fundamental theories assume “all other things being equal”, it lacks common sense.  Stepping back, I’m not sure how municipalities and their utility agencies can have less risk than the government that prints the money they use to pay down their debt.  I’m also not sure I can trust a rating agency that messed up so badly (starting at minute 2 in the Jon Stewart video) when it came to putting the same AAA rating on mortgage backed securities.  Even after adjusting for a $2 trillion mistake (yes that is with a “T”) brought up in “negotiations” with the U.S. Treasury, S&P stuck to their guns to downgrade U.S. debt based on its conclusion that it was now “pessimistic about the capacity of Congress and the administration to be able to leverage their agreement…into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics anytime soon.”

So what happened to the markets on the Monday after the downgrade?  Stock markets crashed and money went into (wait for it…) U.S. government securities.  This “flight to quality” perpetuated by the actions of S&P resulted in lowering (not increasing) the yield for government debt.  Maybe Moody’s and Fitch (the other two rating agencies) got it right when they maintained their ratings on U.S. government debt for now with the hope that the recent debt ceiling debate would be a wake-up call to control deficit spending.

No matter how you look at the last week, one thing is crystal clear; the financial world as we know it has changed.  Regardless of the intent or rationale, the consequence of a downgrade is clear.  For the first time in our history, the risk of default has been brought into the equation when it comes to investing in the United States.  Based on our recent spending history, I reluctantly agree that this outcome was all but certain.  But as is almost always the case, it is the means to the end that raises my eyebrows.  Why would our politicians play “chicken” with our credit rating and barely stable economy to push through partisan policy?  How could one rating agency, the leader of a broken system already in line for reform, go it alone on this downgrade and create such a panic selloff of equities (followed by panic buying and then more selloff and…)?  And how, in a financial world ripe for regulation of hedge funds, could investors profit from such a move?  Blogs point to an $850 million bet that was made on the Thursday before the downgrade that, at the end of trading on Monday may have been worth 10x the bet.

Today we got our answer:  The SEC announced that they will investigate S&P over its downgrade.  Now, having my thoughts distracted away from the fundamental issues surrounding risk-free rates, I’m going to head to the microwave, put in some popcorn and watch the drama that will unfold as the plot thickens to one of political wrangling among a debt “super committee” charged with future budget cuts or, quite possibly, the biggest insider trading scandal in the history of financial markets.  Either way, the mood looks pretty sober for the next few years until we digest the events of one crazy summer in 2011.

Foam with Your Coffee

It has been another seven months since my last post and life moves on with excitement (our Giants won the World Series!), political drama (the Republicans wrestled back control of the House), the absurd (Judgment Day on May 21, 2011 came and went without notice) and the silly (a new, live action Smurfs movie).  In the valuation world the silly came in the form of astounding valuations.  The Huffington Post sold for $315 million, LinkedIn went public at $45.00 a share and now trades at a market capitalization of $7.1 billion or 24.0x trailing twelve month revenue and 185.0x trailing twelve month EBITDA and Groupon, which was founded in 2008 is looking for a valuation double that of LinkedIn at $15.0 billion.  Not a bad three year ride.  Are we headed for another technology bubble?  Does the future of our economy ride in the clouds of social networking, iPads and groundbreaking technology?

The short answer is absolutely.  Our economy is so focused on smartphones (talking with our thumbs, updating our Facebook pages and tweeting the details of our last meal) that we can’t get enough technology in our lives.  Does this mean that there is a valuation bubble in our future?  It depends on how you like your coffee.  Let me explain…

It is my feeling that a market bubble occurs when fundamentals are replaced by froth.  By “froth” I mean the alternative definition of “being unsubstantial, worthless, or light and airy.”  The froth of a bull market hides the lack of fundamental value.  As a result, the investor makes a bet that the valuation of a company will either catch up to its value today (i.e. over time LinkedIn should be worth $7.0 billion but at that point, will it be trading for $14.0 billion?), sell for more than they paid for it (i.e. the Greater Fool Theory) or provide them with a capital loss to offset other gains.

So what is this about coffee?  I see fundamental valuation as a cup of black coffee, no sugar, no milk.  In the words of Bill Belichick “it is what it is”; just coffee.  A value based on fundamentals has the support of its underlying assets, its earnings capacity and its comparison to the market in which it competes.  A frothy market is a cappuccino; one third espresso, one third milk and one third foam.  The one-third espresso is fundamental but in concentrated form needs the milk to be mellow it out.  The foam is the “light and airy” component that sets the stage and helps tell the story of what is below.  But once the foam dissipates, your left with just a half cup of milky coffee.

Market froth expands valuation in a similar way.  Over time, once it dissipates, the $45 IPO will trade on its fundamentals which may not support that $45 price tag.  The IPO graveyard from the .com bubble is filled with deflated cappuccinos like, and  Some of their exits were able to capture some fundamental value for its investors while others just faded away.  So when the “foam” settles five years from now which one of these current IPO hot shots will exceed its IPO value?  Will they be a:

1. “Google” – IPO valuation was over $24.0 billion in August 2004; current market capitalization is $163.7 billion,

2. “PortalPlayer” – $376 million IPO valuation in November 2004; bought by NVIDIA for $362 million two years later, or

3. “Arbinet” – $423 million IPO valuation in December 2004; merged with Primus Telecom in an all stock transaction valued at $28 million.

Time will tell how much foam is in their coffee….?

Welcome Back

It has been a while.  My last blog was posted more than seven months ago.  Seven months!  Wow.  I would have thought that I would have had something (anything!) to say over a seven month span.  But like most Americans over that period, I have had my head down focused on the day-to-day ups and downs of a recovering economy.  Yes, the recession has ended and it was one for the record books.  Labeled the “Great Recession”, this one lasted almost two years.  Before this recession officially ended in June 2009, a few things happened; we got a new President, the New Orleans Saints won the Super Bowl (and Brett Favre retired and unretired twice), we lost Michael Jackson, Farah Fawcett and Patrick Swayze, and we were slowly moving our way into what President Obama declared the “New Normal.”

If you are older than 40, you remember the New Normal as the Old Normal.  That Old Normal is the daily default for a good percentage of our population.  My 95 year-old grandmother lived through a Great Depression, two World Wars but not a credit card to her name and a perpetual smile on her face.  Her husband was injured in World War II and lived the rest of his life with a brace on his right leg, care of a bullet that severed his sciatic nerve and sent him home on a stretcher.  My father’s parents emigrated from Italy and his father took whatever work he could to raise his family of eight in a house he owned outright at the time of his death.  My parents lived under this umbrella of fiscal responsibility and simple common sense; don’t spend what you don’t have.  Somewhere along the way, my generation, and others that followed, missed that lesson.  We over extended ourselves with credit cards, homes we couldn’t afford, stuff that we didn’t need and little concern for how to pay for it.  We saw our savings rate dip below 0%!

Granted, that excess fueled a great boom in our economy but it also filled the air for the technology bubble in the beginning of the last decade and the real estate bubble in the middle of it.  Our government followed suit (or maybe even led us down the path).  Except for a flash of sanity at the end of the Clinton administration through to the beginning of the GW Bush administration, we have been funding growth (and paying for simultaneous wars) with debt since JFK (our parent’s President).  The future doesn’t look any better.  And while the Great Recession is over, the hangover is still felt today.  The recovery is jobless and while the numbers don’t support it; there is still a fear of a double dip recession.  And you only need to look as far as the price of gold to see how investors have responded.  Gold prices are at all-time highs but more disturbing is the desire of high net-worth individuals to have that gold close to them.  JP Morgan has just reopened gold vaults that were closed in the late 1980’s and, as the Financial Times reports a crisp confirmation of our generation’s focus on excess, “Many historic vaults cannot be reopened as they have been converted into restaurants: one New York vault built in 1902 for John Pierpont Morgan is now home to a steakhouse.”

So welcome backWelcome back to the Old Normal where hyper-growth seemed like science fiction; saving for a rainy day wasn’t so “un-cool;” individual, corporate and government fiscal responsibility were the ultimate goals; and nothing was taken for granted.  Welcome back to a time where businesses are valued on actual, not forecasted, cash flows and market multiples are down as a result of slower growth and an extended recovery from the last Great Recession.

Selling Wine Direct to Customers – Harder Then It Sounds

Wow, I can’t believe how quickly the summer flew by.  Alas, summer is over, both fall and crush are here and it’s time for some more of my unsolicited thoughts on the wine industry.  There is a lot to discuss so I’m planning to split up some of my thoughts on several meetings and conferences I attended recently over multiple entries.  Initially though, I would like to focus on selling wine direct.  In case you have been stuck in a wine cave somewhere, the ironically-named HR 5034 “C.A.R.E.” bill is still being considered by Congress and its potential impact on destroying direct wine sales has not improved.  If anything, the bill has gained some momentum in garnering support within Congress and is best described in up-to-date detail on the Stop H.R. 5034 website.  I urge all wineries and wine lovers alike to join the movement to stop the passage of this bill.

Ok, politics aside, let’s get to the meeting I took part in a while back with several ultra-premium Napa and Sonoma winery owners and operators.  The topic du jour was selling direct, specifically to consumers and also trade.  To sum it up, everyone obviously wants to sell more direct because of the financial merits, but many wineries are finding it is not as easy as it sounds (or to simply model out).  Due to these tough economic times wineries are being forced to get creative and come up with different marketing programs other than the usual case/price discounting and free shipping to generate increased direct sales.  More wineries are becoming (and need to become) more involved with their current and prospective customers.  Exclusive events like winemaker dinners and wine club soirées are more popular, but also new programs like concierge services and VIP referrals are being used.  The bottom line though seemed to be that everyone I talked to was basically trying to get more involved in the customer experience and more closely track what programs and channels are working.

Increasing the number of customer touch points seems to be everyone’s modus operandi.  Or at least it needs to be.  Wineries need to continue furthering their brand image and the easiest way to do that is keep doing what they do best and stay consistent.  Consistency in communication, winemaking, customer service — in everything.  Consumers want to feel special.  We want to feel like we are important and at the same time get that warm fuzzy feeling of finding a great deal or talking directly to the owner or winemaker.  We need to be drawn in and trust that you will give us a great bottle of wine and possibly even a great experience, either on-premise at the winery or tasting room, or just at home with your wine.  As one person put it, “if you don’t have a value exchange, you have nothing.”  This lends itself to more interactive experiences such as special consumer events, VIP programs, phone calls, pouring at public wine events, by-the-glass programs and not surprisingly, an increase in social media outreach.

It seems that practically every winery is on Facebook or Twitter these days, but the reality is that many are not effective in their use of social media.  Several of the owners I heard from mentioned they either “don’t get it” or “don’t believe it’s a good use of their time.”  The underutilization and misuse of social media is only one reason some wineries are struggling to generate increased sales in this uber-competitive market where consumers are constantly bombarded with new labels and new wines.  One big allure of wine is this notion of romanticism and the opportunity for a consumer to get to really know a winery and its wines on a more personal level.  People want to share in this wonderful wine country lifestyle that combines beautiful surroundings, great food, terrific people and of course, superb wine.  Social media is one easy way to accomplish this.

The biggest disconnect I see though is that many wineries don’t embrace the concept of the “aspirational consumer.”  Using social media is widely viewed “a kid’s activity” and “not important for my target demographic.”  However, the fact that slips by many owners is that these younger social media users in their twenties (Millennials) are the same people that are not only driving increased wine consumption in the US but are going to be the target demographic in the future if you are an ultra-premium winery selling expensive wine.  Wineries would be wise in spending more time reaching out to these consumers that are maybe drinking cheaper wines right now and building brand equity in anticipation of these individuals moving up in economic and social status.  It is comparable to sports teams scouting young athletes at an early age when there is a lot of unrealized potential there.  They are making a bet that these athletes will continue to develop and reach a point of maximum utility, where there will be many more suitors and more opportunities for them.  The best minute one can spend is the one you invest in people.  What better people to spend time with than people who love wine?!

The SOX Exemption Passed – Now What?

Perhaps you’ve heard that the Reform Act was passed this summer which granted a permanent exemption from the audit attestation requirements of SOX 404(b) to the non-accelerated filers, which are those public companies with a market capitalization under $75 million.  I know those companies affected are breathing a sigh of relief, but let’s look at what this really means.

Non-accelerated filers must measure their market capitalization on the last business day of the end of their second fiscal quarter.  If the market cap is below $75M, they are considered non-accelerated filers and therefore not subject to the SOX 404(b) requirements, which require a company’s external auditor provide an opinion on the design and effectiveness of internal controls.   If your company is hovering near the $75M mark mid-year then planning for an internal controls audit is wise.

However, non-accelerated filers have been complying with SOX 404(a) for many years, which requires management’s assessment of internal controls, and they must continue to provide this assessment.  For many smaller companies this assessment was a rudimentary review of controls accompanied by a memo, at best.  But the requirements for 404(a) clearly state that a company must document its control structure and test the effectiveness of those controls.  In the past, the SEC has not commented on the thoroughness of management’s assessment based on the understanding that eventually an audit of the control structure would occur.  However now, with the exemption passed, it is likely that a non-accelerated filer will receive some evaluation from the SEC on the completeness of this work.

In other words, a simple internal control memo may not be enough for the non-accelerated company.

Effective Winery Business Plans

I was fortunate enough to take part in a great discussion recently about business plans in the wine industry and what constitutes a good one (or doesn’t for that matter).  Keep in mind I was in a room with well-seasoned wine industry professionals, many of which own or operate as executives at a winery.  I am highlighting the key points of our discourse below.

  • The finance contingent of the group, representing commercial banks and private equity and debt investors, all agreed that they don’t often see a complete, detailed business plan in the wine industry.  When they do, these plans usually do not include an analysis of the industry or market or contain detailed marketing and development/production plans.  While most of the winery executives represented have a budget or financial plan, rarely do these forecast beyond two to three years in a detailed, financial model that addresses income statement or balance sheet metrics, such as a proper calculation of cost of wine sold. 
  • The process of creating a detailed, written business plan is an onerous one, especially in light of the need for integrated marketing, production and financial plans.  However, future success is often associated with the work and thought considered during the business planning process. 
  • The discussion of long-term forecasts centered on the discipline and intellectual exercise of the process rather than the success of meeting long-term targets.  This discipline presents the winery owner with the opportunity to understand key revenue drivers, optimal cost structures and financial levers when managing their business over time.
    • This understanding of key business metrics in the current economic downturn and constant revisiting of the plan on an annual basis will allow a winery to capitalize on its successes.  Simultaneously, the winery can learn from its failures, identify opportunities and avoid overreaction to market gyrations.
  • There is significant value in creating a 5-year (at a minimum) financial forecast model because it forces the winery to consider the effects of the industry’s multi-year operating cycles and make decisions now that will affect its business 3-5 years in the future.
    • Similar to writing a comprehensive business plan, the discipline and process of Management analyzing their business can help identify key issues and quickly serve as a warning in case anything goes wrong.  This could be the difference between surviving (or thriving in) the current economic downturn in the wine industry and possible dissolution.
  • Successful financial models incorporate the following characteristics:
    • Done on both a cash and accrual accounting basis
    • Tracked against a budget and updated on a consistent basis, but not changed entirely to continually start over (to always hit your budgets)
    • Includes all facets of your business (accounting policies, revenues, costs, inventory, financing, sales channels, etc.)
      • Need to consider how sales grow and where customers will come from as well as incorporating a marketing plan or strategy into your model
      • Don’t plan on borrowing more than a projected borrowing base will allow
    • Show your model to others – CPAs, consultants, bankers
    • Plan for a worst case scenario – maybe an obvious statement now, but not so obvious two years ago
  • It’s never too early to think about or plan for a potential exit, whether that is a sale, cashing out current investors or a generational transfer.  Successful transactions often involve wineries that started the transaction readiness process sooner rather than later, ultimately maximizing value or at a minimum, achieving liquidity.

For your benefit, this link provides a list of some very helpful resources for writing/updating winery business plans.  In terms of financial forecast models, we develop those for many winery clients at Frank, Rimerman + Co. so please contact me directly at with any questions or requests for our assistance.

Succeeding in the Wine Industry

First and foremost, let me quickly comment on this ridiculous direct shipping bill introduced to Congress last week. A lot has been said about the so-called HR 5034 “CARE” bill (good overview/analysis here), but this bill, if passed, will effectively cripple the wine industry, destroying virtually every small winery that relies heavily on its direct-to-consumer business. Throw in the fact that the wine industry is already an extremely difficult business to operate in and we are looking at potentially thousands of wineries closing up shop for good. Not to mention it would eliminate consumer wine choices, stunt economic growth and provides further proof of something the American public largely already knows; that with enough money, power and influence, anything is possible. Conspiracy theorists would quickly agree and bring up the JFK assassination and the second shooter (or spitter), the “Frozen Envelope” rigging the Knicks’ selection of Patrick Ewing in the 1985 NBA draft, etc. But I digress. I truly believe this bill will decimate the wine industry (particularly California) and is the second most laughable idea currently being discussed politically (I’ll leave this up to your imagination).

Moving on, I had the opportunity to attend the Napa Valley Grapegrowers “Ahead of the Curve” seminar at Solage in Calistoga, CA. I won’t reiterate everything discussed there as it was one of the more gloomy seminars I’ve been to, but I want to highlight some of the takeaways regarding key success factors for the future of the US wine industry, California specifically. I have listed them below.
•Wineries need to brand themselves better. In an increasingly competitive and global marketplace, the use of the internet and social media to market and better disseminate key information to potential customers is critical. ◦Napa Valley in particular needs better brand recognition outside of the U.S. Most Americans equate Napa Valley to great wine, but internationally, Napa is just one of many great wine regions. Bordeaux has done this quite successfully – better than any other wine region in the world.

•US wineries need to be more cognizant of the increased globalization of the wine industry and the overall impact on its constituents. Wineries may want to consider spending more time focusing on exporting wine (or at leat planning for it), particularly to countries like China that are showing increased interest in making and consuming wine. Currently, China only consumes rougly .7 liters of wine annually per adult, as opposed to the US where we consume approximately 10 liters per adult, or 3 liters per person (#3 globally behind France and Italy). ◦Additionally, the current exchange rate works out favorably in terms of international demand as the Euro represents approximately 30% more purchasing power when buying American products like wine.

•More winery owners need to run their wineries as professional businesses, as opposed to hobbies. I mentioned this in a previous post and it still amazes me that many wineries do not operate with maximum economic returns as one of their primary goals. Of course, I’m a finance guy first and wine guy second, so that probably explains my ignorance here. ◦The wine industry is uber-competitive (there are over 7,000 wineries in North America alone). If that is something winery owners or grape growers do not want to do or cannot do, then achieving success is probably going to be quite difficult.
◦In order to effectively compete, especially on an international scale, there needs to be a certain amount of cooperation with fellow competitors to successfully penetrate new markets (See: Silicon Valley, Bordeaux, the music industry). It will be interesting to see if the wine industry ever comes around to this fact.

•Keep investing in R&D and innovation. Innovation breeds success. Things like solar panels, sustainable farming practices, oak alternatives and winery CRM software have all benefitted the industry. This kind of forward-thinking approach to continually improving quality and overall processes can consequently lead to lower costs and carbon footprints as well.
•Last, and probably the most important point: wineries need to not lose sight of what they do best. That is, keep making great wine and focusing on quality. These days, if you do not have a quality product, you will not even get invited to the party, let alone have a seat at the table.

These ideas are by no means all-inclusive or the end all be all, but other winery owners I have spoken with recently seem to more or less agree. Now, if we can just get them to agree on who makes the best wine!

Internal Controls – Just Do It!

Can it really be true?  Is it finally time for non-accelerated filers to comply with the Sarbanes-Oxley Act?

So far, there has been no further extension for SOX from the SEC or Congress and the current bill from Senator Dodd doesn’t even mention an exemption from the SOX Act.  There is still a chance for amendments to be made to the current Senate bill but will that happen before the June 2010 deadline, it’s doubtful.  Keep a close eye on the Dodd bill for updates, which is summarized on Senator Dodd’s website.

To be honest, I think every company should employ good internal controls.

I have seen the affects of well controlled companies getting rewarded, starting early in my career.  I worked during college at a VC backed start-up company and in typical fashion I wore many hats – receptionist, office manager, accountant, and executive assistant.  I distinctly remember the breaking point when the company grew big enough to require more structure and my role focused on accounting only.  A CFO was hired and I was trained by him to implement controls.  Oh, the drama of telling people they needed approval for purchases. Gone were the days of yelling across the hall for verbal approval of a $10,000 check (works fine when there are 10 employees, not so good when there are 100 employees). Adding these procedures while the company was growing was not a huge additional expense and controls quickly became embedded in the culture of the company and now the company was ready for an exit – be it IPO or acquisition.  In the end, the company was acquired by a Fortune 500 company.  Would this have happened without the strong control environment—maybe.  But was the acquisition process easier, was the value of the company higher, was the buyer more confident—definitely!

So what’s all the fuss about Sarbanes-Oxley, good controls have been around for a long time?  The SOX requirement to document and test the controls takes time, and auditor review of those controls causes companies big headaches, the end result is increased costs.  But believe it or not, control documentation can be done efficiently.  Start early with control optimization and use the right people and the right compliance tool, and the process is painless!  Experience really counts when documenting controls since experts are familiar with 1) focusing on the risk of misstatement; 2) documenting controls succinctly; 3) using a tool for testing, workflow, and reporting; and most importantly, 4) interacting with auditors.

Whether you’re public or private, get started now on a good control environment – just do it!

Virtual Wineries

I would like to talk about a topic that has been given more publicity recently, but is definitely not a new concept: the “virtual winery.”  As many of you probably know, virtual wineries have been around for a while now, but they are becoming more and more in vogue due to some of the unique features they have relative to more traditional bonded wineries.  To cut to the chase, it can be substantially quicker, less riskier and cheaper to start a virtual winery and still compete/sell effectively.  In fact, some of the best known wineries in Napa and Sonoma Valley started out originally as virtual wineries.

First, it would help to define what I mean by a virtual winery.  Depending on who you ask, the definition may vary, but my take is that virtual wineries are those that do not actually own any vineyards or grapes and have no tasting room.  Instead, they typically source grapes or juice from other wineries or grapegrowers, sometimes locking in contracts if they are fortunate enough.

There are several reasons why these types of wineries are becoming more popular, but the most appealing is that they offer a much more affordable alternative to starting a fully licensed and bonded winery.  Those require a substantial amount of start-up capital for vineyards and equipment and a business plan that, depending upon the varietal, can take five to seven years from unplanted land to first revenue dollar.  Essentially one can start a virtual winery by simply writing a check to the production facility and ensuring it is properly licensed and permitted to sell and market wine by the ABC and TTB. Virtual wineries often have little overhead, little to no vineyard ownership/maintenance and (potentially) no production equipment. They frequently start out using custom crush facilities to make their first vintage(s).

What is interesting about virtual wineries is that not only can they be created quickly and sell wine effectively, there is legitimate value (mostly in the form of brand and direct to consumer wine club member lists) that can be created as the winery grow and establish themselves in the industry.  Generally, there are three key stages of development for virtual wineries.

Stage 1:  New winery created with very little start-up money.  There are likely no production facilities as wine is often made at a custom crush facility from “bin to bottle” with little revenue, no initial brand presence and probably only one or two varietals.  The greatest challenge for these wineries is taking the next step from a small hobby to a sustainable and profitable business.  Examples include wineries like Three Rights Left (early stage) and Athair (later stage).

Stage 2:  Expansion of an existing brand or wine label, where market presence is established and sizeable revenues are generated.  These wineries likely have a few varietals with potential contracts with vineyard sources and possibly leased/owned production facilities.  It is at this point where these wineries will start to ramp up production significantly and expand margins (or become profitable) by leveraging economies of scale.  Creating a meaningful wine club or mailing list is a strong possibility and often the winery’s majority source of revenue.  Carefully managing grape sources is critical to ensuring consistent and exceptional quality grapes.  This challenge is usually handled by the head winemaker who is often the sole or majority owner.  It is quite possible additional capital may be needed to fund the growth needed to build the brand.  Successful examples include Auteur, Wind Gap Wines and Carlisle.

Stage 3: Significant revenue generation, brand recognition and a well-established wine club/mailing list have created significant value as production is thousands of cases by this point.  It is at this stage where wineries often consider a potential sale of the brand or look to achieve liquidity for its owners and original investors by carving out equity for new investors.  There are few great examples of wineries that have truly succeeded in building significant enough brand equity to sell a winery without any vineyards, but the most obvious and glowing example is that of Kosta Browne, who recently sold a majority of its winery to Vincraft after building it from scratch just over ten years earlier.

We will continue to see more of these kinds of wineries for the reasons discussed above, particularly in this tough economic environment.  It remains an attractive option for people looking to build their own brand on the cheap and evolve to either a more traditional model or later stage virtual winery.  The “I could do that” mentality is actually feasible as companies like Crushpad have created a user-friendly blueprint for making wine and creating your own brand.  This business model has now been replicated by other companies across the U.S. (Judd’s Hill in Napa and City Winery in New York to name a few), marking an increased interest in this kind of winemaking process.  Who knows, the next great cult wine may be getting made right now…

Making the Case for Stock Option Plans in the Wine Industry

First and foremost, let me start by saying that I love wine.  I love everything about it:  the vibrant colors, the tantalizing aromas, and the “it opened a whole new world to me” impact of trying a previously undiscovered wine.  I love how there are so many different varietals to enjoy with each offering something special to anyone with a few minutes and an open mind.  And then there’s the food…pairing an Alsatian Riesling with fresh crab, a zesty Zin with some BBQ or a vintage Port with some hazelnut gelato?!  It is all good.  Most importantly though, I love how wine continues to evolve – in the barrel, in the bottle, in your mouth.  It never ceases to amaze me how different the same wine can be depending on when, where and how you drink it.  To me, that experience is what the wine industry is all about.  We need to remember that change is a good thing and if we are not moving forward, we are moving backward.

I mention the concept of change and evolution because it is one aspect of the wine industry that will define its future success.  This belief has recently become more important than ever with different winemaking and grape growing methods and the emergence of both social media and technology (Wine Library TV).  So I wonder why the capital structures of wineries can’t ride that wave of change in the 21st century and beyond.  How come almost all wineries continue to be owned by a small group of family members and a few key executives, but they rely on so many more to ensure the company succeeds?  It would seem to me that motivation breeds success and there is no greater motivation than potential financial gain in the form of annual cash flows or the eventual sale to the next “generation” of owners.  For proof, look up capitalism and the rise of the United States or listen to Gordon Gekko’s speech in Wall Street

Let me step back for a second and add a disclaimer that may help you understand where I’m coming from.  I was trained as an investment banker out of college and currently focus most of my time on fundamentally valuing companies, several of which are technology companies located in Silicon Valley.  I constantly work with companies backed by venture capitalists that often have complex capital structures involving preferred shares, warrants and stock options.  And honestly, this approach seems to work out pretty well for the technology industry in terms of creating a desire to succeed and continually innovate.  I do not see why a simpler version of that structure could not work in the wine industry.

Let’s take a hypothetical situation where a seasoned executive or well-trained professional in another industry is considering taking a new position at a winery and has two separate job offers.  Both wineries are successful family-run businesses with a long history in the industry.  Let’s say the only difference between the two is that one offers a stock option, employee ownership or profit sharing plan where current and prospective employees are granted or otherwise given the opportunity to purchase a small piece of ownership of the winery.  If the wineries are virtually identical, the candidate would likely take the offer from the winery with the option/ownership plan nine times out of ten, even if it included a salary lower than the competing offer.  With this assumption in mind, the option plan then becomes a key differentiator in terms of recruitment at only a marginal cost to the winery itself (depending on how many shares offered versus how many shares are outstanding).  With a structure like this in place, a winery essentially increases its chances of hiring the best and brightest among the candidates available.  Furthermore, it incents the new employees to work harder by giving them an ownership stake.  It is true that employees would likely only realize an eventual return upon a specific liquidity event, but I’m sure if you asked people whether they’d love to own a piece of a business that could be worth some money one day (in return for work they are already doing or going to do), the answer almost unanimously would be yes.  Finally, it is a fact that many wineries are actually created as a result of winemakers not having any upside or financial interest in the success of a previous winery where they worked.  As a result, they start their own winery and often compete directly with their former employer.  I know for a fact that several of these enterprising winemakers would have stayed with their former wineries had they been offered stock or profit ownership.

Now, let’s dig a little deeper into this concept of recruiting and differentiation.  It seems pretty apparent to me that one of the things that separate the wine industry from most other industries is that it largely continues to be operated and embraced here in the US as a family-run, cottage industry despite its overall size and vast number of competitors.  While Northern California is home to some of the best wineries in the world, the majority are purchased as lifestyle choices, third or fourth careers or inherited or purchased from a prior generation.  They are operated professionally with dedicated winemaking and operational staff but in most cases run as a small business.  While most businesses are created and designed to maximize profits, the “return” to an owner (or family members) are salaries and annual distributions.  If profitable, capital is not usually “retained” and is reinvested in the business.

If wineries want to grow and build a financial (or family) legacy they will need to realize that there comes a point of inflection where they need to open up the opportunity of growth and share the success with their investors and employees.  Equity ownership and stock option plans facilitate this end game and as mentioned earlier, you only have to drive around Silicon Valley to see that the model works.

In light of today’s global recession, now, more than ever, it is important for every business (wineries especially) to begin thinking of new ways to spur growth, creativity and continue paving the way for future success.  As Ralph Waldo Emerson once said, “Do not go where the path may lead, go instead where there is no path and leave a trail.

SOX for non-accelerated filers – another extension?

Sarbanes-Oxley Section 404(b) currently requires all non-accelerated public companies to get an outside auditor review of internal controls, effective for companies with fiscal year-ends on or after June 15, 2010.  This means those non-accelerated filers who have previously received extensions to this requirement year after year, finally must comply with an internal control audit.  Or do they?

When discussing the current extension, which was granted October 2009, SEC Chair Mary L. Schapiro clearly stated “there will be no further Commission extensions.”  But in November 2009 the House of Representatives passed a bill giving non-accelerated filers a permanent extension to the auditor attestation requirements.   For the bill to become law it must be approved by the Senate and that is where it currently sits. It seems the possibility of the Senate passing the bill by June 15 is unlikely, the Republicans are not interested in reform and the Democrats have a weak effort to push the bill along.  If this bill passes at all, it will probably be later in the year.

So, what is the non-accelerated filer to do?  My advice to them, get ready for a controls audit but wait one more month to bring in the auditors.  If the SEC Chair goes against her own words and issues another extension, it will be granted very soon to affect the June filers.

The small public filers have been complying for years with the management assessment requirement of Sarbanes-Oxley Section 404(a) and should have key controls defined and assessed, ready for audit.  If this documentation is less than formal, make sure to document those controls now.   Bring in the auditors in Q4 if, and when, attestation is assured.

Words to Live By

We certainly live in a world of clichés, inspirational mantras and advertising slogans.  “Time is money.”  “All is fair in love and war.”  “You are what you eat.”  “Just do it.”  “Serenity now.”  While I appreciate the wisdom of Frank Constanza, I tend to avoid clichés as a rule.  I just can’t rally around a poster of kitten hanging from a branch to inspire me to “hang in there.”  But I do consider myself a man of faith and do believe in some words to live by.  One of my favorite quotes, that I keep in right near the tip of my tongue in tough times or points of inflection in my life, always seem to inspire me.

“It is not what you know but what you do with what you know that makes a difference.”

My twin brother Rocco had this quote under his picture in our senior class yearbook.  I have always liked it for not only this personal reason but because it crystallizes my position many things, especially the difference between intelligence and smarts.  It is clearly personified in the hundreds of entrepreneurs who have harnessed a good idea into a great company.  The two are not as highly correlated as you might think.

From the early technology entrepreneurs of Edison and Tesla, inventors parlayed their patents into financial success, some more than others.  Edison left a legacy of stature and wealth while Tesla died penniless.  Look at any successful technology company in the world today and you rarely find the “first mover” as the market leader.  Microsoft created the first operating system for personal computers for IBM’s PC but retained the right to market MS DOS separately.  Google was maybe ninth to the table for web based search.  Apple certainly wasn’t first to the party for personal computers but has certainly adapted well and survived based on its ability to understand the consumer.  Check this picture of the Apple II from 1977!

The current class of successful entrepreneurs have taken a basic concept (let’s say people getting to know each other), applied technological solutions already in use (networking, web interface, security), created an application for a specialized niche (oh, I don’t know, maybe college students at Harvard University) and  then gave the world Facebook.  At the time it was founded, February 2004, the world already had Napster, Friendster, MySpace and LinkedIn.   Then, a few years later in 2006, an upstart comes along with a business model based on a word that founder Jack Dorsey found in the dictionary to mean “a short burst of inconsequential information.”  Twitter was born and like the word “Google” has become engrained into our hip technology vernacular.

The common denominator in all of these success stories is the ability to see a good idea as the beginning of a great company.  Throw in some bravado with realistic humility (knowing your limitations and hiring or partnering with the team that can get you to the Promised Land) and you see the difference between inventors and entrepreneurs, intelligence and smarts, Einstein and Tesla.  Sure, some, if not most, of this recipe for success is the ability to market and sell a product (Sony’s Betamax was a much better format than JVC’s VHS but we all know who won the video format war.)  But a successful idea learns to live and breathe on its own.  In my world of discounted cash flows, the value of an idea will only have a terminal value equal to what it would take to recreate it.  Build a successful company around it that can generate cash flows, intangible assets such as brand, customer relationships and goodwill and this success will change lives and build legacies.

In my other world of wine and spirits, I leave you with another success story; “When life gives you lemons, make Limoncello.”

Risk Assessments – A Strategic Resource

In the dynamic world of audit and audit related services an often overlooked benefit is the risk assessment process.  In the world of the Internal Auditor it’s not only used to create the annual audit plan; the risk assessment creates a flexible framework to identify the keys to achieving an organization’s success.  The process to create the framework, if done properly, should help build consensus across organizations, enable executive management to make more informed decisions and foster greater cooperation on audits.

The complexity of risk assessments is tied to industry and Internal Audit department maturity.  An established IA department in a heavily regulated or highly complex industry, like banking, may use more complex risk assessment processes and tools.  To contrast, a recently formed IA department for a retailer could most likely execute the risk assessment using Word and Excel.  In both cases the final results are the same; a risk based assessment of a company’s processes.

Executive management, as always, plays the pivotal role.  Think of the framework as the picture of a company.  Individual’s pictures vary depending on level and position and it’s the CAE’s responsiblility to co-development with management a picture that fits (on at least some level) into a picture that everyone can easily understand.  This is the basis for communication regarding risk, controls, how the company’s strategy ties into the framework, and the risk assessment results.  When executive management understands the risk assessment framework and process they are more likely to support audits of sensitive areas and in some cases, actually ask for audits for processes under their supervision.

Coming Soon: Crushing It!

Without sounding schizophrenic, I live in two different worlds.  No, I don’t have a secret Avatar life; but I do claim some expertise in two very different industries.  I lead valuation engagements for technology companies and wineries.  Sounds a bit strange, even as I write it, but it makes absolute sense to me.  Let’s take a look at the obvious differences before I enlighten you on the not so obvious similarities:


  1. Assets – This may not be the most obvious difference to most, but to me it is the biggest difference between these two industries.  While a winery’s brand is at times its strongest and most valuable asset, a winery’s day to day focus is on real, tangible assets that someone can come in and count and touch with their own hands: cases and barrels of wine, land, machinery and equipment for crushing, pressing and storing wine and that old Ford truck the head wine maker drives.  A technology firm’s assets are much more intangible: software code, patents, that little “Intel Inside” logo on every computer.  A technology firm’s assets walk in and out the door every day and intellectual property is by far the biggest driver in this industry.
  2. Owners – The wine business is one of the few remaining family generational industries.  The owners usually see their last name (or maiden name) on the product they sell and don’t venture too far off the family tree for investors or other owners.  Technology firms are rarely family owned.  They are mostly venture capital funded and ownership is shared among the entire employee base; everyone has skin in the game in most technology firms.
  3. Transparency – It seems like benchmarking in the wine industry is only done on the very rare occasion in broad and vague language by winery owners over a glass of cabernet at a charity auction.  Most wineries don’t know what their competitors are really doing in terms of sales, margins, spending by category or profitability.  In all honesty, I think that every winery would love to be able to benchmark themselves against others in their industry, but only under the condition that they don’t share their own information.  The technology industry embraces transparency and benchmarking because both facilitate the life blood of private and public capital investment.  For example, real and significant value is placed on audited financial statements when you need to file a prospectus with the SEC in order to do an IPO or a private placement memorandum.


  1. The People – Both industries, especially here in California, are home to some of the most passionate and brightest business men and women our country has to offer.  A good percentage of the world’s best wine is made within a 30 mile radius of my office in St. Helena, California.  And some of the greatest entrepreneurs the world has ever seen live and work within a 30 mile radius of our firm’s headquarters in Palo Alto, California.  Northern California hasn’t cornered the market on passion in the workplace but it is surely a common denominator for successful firms in both the wine and technology industries.
  2. Consumer Focus – Yes, this one may seem simple but people who buy iPods also buy a Napa Valley Cabernet Sauvignon.  The focus of both industries is the end consumer and creating and enhancing a lifestyle that is both technologically savvy and appreciative of the good things in life.  While the wine industry has been slower to embrace technology, the overlaps between these two industries is becoming clearer with the use of social networking and the slow embrace of software tools like CRM (Customer Relationship Management) software.
  3. Zero Revenue Models – This one isn’t so obvious.  However, during my professional life in both worlds, I see a strong similarity between startup wineries and technology firms.  Both have very similar characteristics with respect funding early stage losses for long-term gains.  A piece of unplanted land in Napa Valley has similar business model hurdles to a life science startup in Silicon Valley.  The only difference is that the investment for the winery is in tangible assets (planting vines, building a winery and tasting room) while the life science startup invests in people in the form of research and development, usually out of a sublet, non-descript commercial office.  Both business models require patience (it can take up to seven years, depending on the varietal, to see any revenue from newly planted vines) and regulatory hurdles (there is about a 10% probability of getting a drug from clinical testing to FDA approval).

So, where do all these differences and similarities get us to?  Good question.  We believe that the answer is in the form of our new blog; Crushing It!  Derek Groff (who also lives in both worlds) will take command of a new blog over the next month that tackles some of the following topics:

  1. Stock Option Plans – Do they make sense in the wine industry?
  2. Virtual Wineries – How do they work and why is it the right path for some winemakers?
  3. Technology – Will the industry embrace technologies that can improve the quality of wine, reduce a carbon footprint and enhance processes and controls?
  4. Winery Valuations – What are wineries worth?  What are the impacts on generational transfers?  What drives value?
  5. Alternative Sources of Capital – In an industry dominated by family-run businesses, how do wineries obtain capital in the form of private or public equity and alternative forms of debt?
  6. Benchmarking – Yup, we’ll try to tackle this one with some interesting observations and well-thought out suggestions.

Sound good?  Tune in here soon for Crushing It!

Effective Communication

Communication skills are dynamic and in the business environment they are very difficult to measure and are often undervalued.  Effective communication not only minimizes time, cost and workflow, it also leads to increased client satisfaction.  Communication includes tone, style, and format and is most often the determining factor in failed audits.  Here is the problem; people communicate differently from one another and often times are polar opposites.  Below are a few thoughts on communication protocols and communication styles.

A strong service delivery methodology lays the foundation for an audit team to communicate consistently and effectively across all engagements.  Key steps that include a scope meeting and standardized documents like the scope memo create structure and are tools of communication between the audit team and business owners.   For example at an audit’s inception the audit objectives, high-level procedures, and deliverables are documented and agreed upon.  With a clear understanding held by both the audit team and the business owners the likelihood of the audit succeeding is vastly improved.

Communication style includes format and tone and is the second key to executing audits, especially Internal Audit audits.  In most instances a formal report is written and presented to executive management, the BOD and possibly the actual business owners.  However, at each level there is a different style of communication with varying amounts of detail.  For example, typically during the course of an audit smaller findings are not included in the formal report.  These informal findings often times are communicated verbally to the business owner, but not necessarily to executive management and probably never to the BOD.

Be careful with Email!  Email is not the preferred method to communicate issues, especially technical issues.  First, let’s not confuse email with a formal written report.  The processes to write an email compared to an audit report is the difference between making a paper airplane and a real one.  Emails are also more difficult to control.  I don’t know how many times I’ve seen simple issues turn into catastrophes because either an email was written in haste or misunderstood.  Often times it was a combination of both.  As an auditor a little courage must be exercised to pick up the phone or conduct a meeting to discuss issues face to face.

Without the proper protocols or effective means of communication Internal Audit projects can become painful experiences for both the auditee and the auditor.  With them, sucess is more likely and easier to achieve.