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 Forbes.com 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.

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 pets.com, etoys.com and mp3.com.  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:

• “Google” – IPO valuation was over $24.0 billion in August 2004; current market capitalization is $163.7 billion,
• “PortalPlayer” – $376 million IPO valuation in November 2004; bought by NVIDIA for $362 million two years later, or
• “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….?

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 back.  Welcome 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.

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.”

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:

Differences

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.

Similarities

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!

Alright, I admit it, I didn’t think that I would get myself excited about these resolutions but to my surprise, they are keeping me busy.  I can honestly say that, with a smile on my face, these goals have already impacted my personal and professional lives.  Here’s how:

1. Invest in my Network – Following my own advice, I responded to a friend’s introduction to a job seeker with the invitation to meet and discuss his search.  I took the rational approach that I can’t recommend anyone I didn’t know or at least had met in person.  After meeting with him and confirming my original thought that he was someone I could recommend to my network, I got to work and facilitated three good leads for him that may lead to a specific opportunity but will certainly strengthen his network.  I have followed up on two other ideas to introduce good people into my network and “pay it forward” with solid opportunities for them to follow.  Regardless of what I get back in tangible leads or opportunities, my return to date has been simple.  I feel better about myself.  The rest will come in due time, if it comes at all.  At this point, the smile on my face doesn’t require much more support to stay there all day.
2. Ask the Question – OK, it may be a form of self-promotion (I have told several people to check out this specific resolution on my blog) but I have used this resolution at least a half dozen times including twice this morning.  I go into my enthusiastic “rant” that the only way to get a “yes” is to ask the question (bringing up the Wayne Gretzky quote that “You miss 100% of the shots you don’t take”) and I get immediate buy-in.  Without knowing it at the time, the statement crystallizes a logical and simple default that has worked wonders for me over the last three weeks.
3. Be Prepared – Nothing has really changed in my life over the last month on this one.  My scout training has always kept this default in my everyday life.  I hope that it is for others. 
4. More Balance, Less Juggling – I still haven’t worked out in January (I’m hoping to head to the gym tonight!) but I’m trying hard to keep this balanced approach front and center.  It is a bit harder at home with overactive 5-year old twin boys and a barking dog but my wife and I certainly see this default as the ultimate goal and continue to strengthen our partnership in being on the same page in getting there.  At work, I continue to work with my team and get them more responsibilities that, in the end, will create greater team balance and less fire drills.
5. Enjoy the Moment; then Move Forward – I’m working on this one as well.  No real specific successes in the last few weeks to savor other than the smile on my boys’ faces, the twinkle in my wife’s eye and the soulful enjoyment my dog gets in trying to give me a kiss.  I’m loved at home and respected at work and I have been enjoying these special moments knowing they will continue to come with hard work and appreciation for what I have.  Philosophical; yes.  Sappy; maybe.  The right way to live each day; absolutely.

More to come; let me know what you think.  Email is jorlando@frankrimerman.com.  Remember, “there are no stupid questions.”

I’m not in the habit of sticking to my personal resolutions each year.  The list always seems to be the same (lose weight, exercise more) and the effort usually breaks down by the middle of January.  However, this year, I’m refining my list to one that is both personally and professionally focused and includes goals that I can get excited about and embrace throughout the year.  Here it goes, my top five resolutions for 2010:

1. Invest in my Network – Having been on both sides of the “job transition” table in my career, I know how tough it is to find a job when you don’t have one.  My goal is to leverage my personal and professional network to sniff out opportunities where I can recommend good people who are currently out of work or looking to move on to new challenges.  What better return can you have on “investing” in your network than putting a qualified friend or previous co-worker in touch with a personal or professional contact who is looking for good people to hire?  A positive recommendation can strengthen the relationship and only make you look better to that individual and his/her firm.  The investment has risk (there may not be a match or, once hired, they may leave for another job after 6 months) but if you spend the time to think through the circumstances and potential for a match before you make the connection, the downside is minimal.  I successfully buy gifts the same way.
2. Ask the Question – While I try to live by the rule a high school teacher instilled that “there are no stupid questions”, reality has set in over the last 25 years and I found out that the world is full of them.  And sadly, there are answers to these stupid questions.  Sign up for a twitter account to find out the answer to that all-important question; what is Paris Hilton really thinking about today?   The trick to “asking the question”; having the confidence to ask it and not being afraid of “no.”  Can we set up a time to meet to discuss our firm and services that may be right for your company?  Are there any clients who you would feel comfortable recommending me and our firm?  What can we do to help you?
3. Be Prepared – Yes, the Boy Scouts of America motto.  As an Eagle Scout (once a Boy Scout, always an Eagle Scout), I sometimes live my life like I’m preparing to cook dinner over an open fire.  Have a menu and a plan but be prepared for anything and adapt to the conditions.  Preparing for any situation requires a combination of flexibility, confidence, humility and perseverance.  It doesn’t require thinking through every scenario in our head to the point of being overwhelmed.  This advice to myself means going into a meeting with an agenda, goals and planned takeaways but having the ability to ride the wave of conversation and go off point every now and then when needed.
4. More Balance, Less Juggling – I believe that balance requires an understanding of the big picture and juggling requires a focus on everything at once.  Watch a five year old ride a bike.  When they stop focusing on pedaling, steering, stopping, ringing the bell and looking ahead all at the same time, they move away from the requirements of the task and start riding the bike.  I continue to believe that balance in life requires a step outside the box, a walk around the block and sometimes a soundtrack to sing along to as we work and play.  There will always be deadlines and fire drills at home and work that make life hectic; understanding the big picture allows us to take a deep breath, ride the bike and have some fun.
5. Enjoy the Moment; then Move Forward – Success is a series of little victories that guide us down a path we hope to follow.  I often see these little victories as a means to a bigger end.  What I don’t do as often as I should is enjoy the victory before I move on.  I don’t think that it is selfish or inappropriate to do something extraordinary and then step back and tell yourself; “good job.”  These moments should be savored and they are the glue that makes our eventual success stand the test of time.  And the best victories are the ones we share with friends, family and co-workers.  Moving forward should focus on the “end” but recognize the “means” as the breeding ground for confidence, fun and eventual success.

That’s it.  I will let you know how closely I stick to these over the next 12 months.  May we all have a happy and healthy 2010.

As far back as 2007 (almost two full years ago!) when a bailout meant borrowing $1,000 from a buddy, the New York Times estimated in an article that “it is estimated that 1,000 people each have more than $5 million worth of Google shares from stock grants and stock options.”  At the time of the article (November 11, 2007) the stock price hovered around $665 per share.  It currently trades at around $575 or a decline of approximately 13.5%, which brings that $5 million down to a paltry $4.3 million.  However, over the last 12 months, the stock dipped to as low as $250 a share so hopefully these same employees got more options at lower prices to help soften the blow.

At the time, there were over 16,000 employees at Google, half of which had worked less than 12 months at the company.  Imagine if you worked at Google as one of the “unfortunate” employees to have options worth only $1 million.  I could see walking the halls with some of these thoughts going through my head;

1. Why are these people still working here?!
2. What possible incentive do any of us have to come into work every day?
3. Does this financial security put the company at risk when any one us us can just “retire” at any time?
4. Was Notorious B.I.G. right; mo’ money, mo’ problems?

I (and I’m sure many others) could also look at this situation in a much different way;

1. I work with “partners” who want me to have skin in the game and are incented to see the entire company succeed.
2. We are in control of our own financial destiny; as the company rises, we rise along with it.
3. My role at this company is a career and not a replaceable job based solely on salary.
4. I will do everything I can to spread the good word of our company to the rest of the world.

I am a big fan of stock option plans and not for the obvious reason that our practice is hired to value the per share common stock values of private companies for the purpose of granting options (IRC 409A).  I am a big fan because strong, professional managers gravitate towards companies that share the upside of growth and prosperity with their employees.  As simple question; would Google be Google if its stock option plan didn’t trickle down to every employee?  Said another way; what makes Google a market leader?  Answer: its people.  I strongly believe that in a hiring situation where a strong candidate has two similar opportunities, he/she will always pick the one with the better stock option plan and not for just for the financial upside but for the simple fact that top management wants its employees to share in its good fortunes.

On the flip side, in the current market environment where struggling firms need professionals with the ability to turn around a difficult situation, the upside (i.e. lower strike prices on options and possibly more actual share grants) is even greater.  Clearly, within the technology industry in San Francisco, Silicon Valley and the South Bay, option grants influence hiring decisions and strong management teams for both quantitative and qualitative reasons.

However, these plans don’t come without risk.  Anyone who has worked at a public company whose stock is going in the wrong direction knows the impact stock price has on employee morale.  It is sometimes the last straw for employees to jump ship (“my options are out of the money anyway”).  These logical responses fueled by simple human nature may lead to high turnover, poor work quality and low efficiency, which can spiral an already bad situation to one beyond repair.  Add in the nebulous nature of private company stock options where exit opportunities aren’t a matter of calling your broker and you can see why some industries don’t employ these plans at all.

Over the next few blogs, I will discuss this topic within a predominantly family run industry that has little to no support for these plans: the wine industry.  With very few public companies and an industry predominantly comprised of multi-generational, family run wineries, these plans may not make sense.  Or do they?

I would imagine that business valuation proposals start out the same way as other service related assignments;

     1. Define the scope;
     2. Estimate the process by which you will arrive at a conclusion;
     3. Figure out a budget of time needed to complete the work; and
     4. Determine a range of fee to bid the work.

The work is then won on reputation, brand, recommendations, fair pricing and other key qualitative and quantitative inputs that clients use in making a decision to go with one firm over the other. Sounds fair, right? Yes, if you compete in an ideal business environment where the price is not the number one “utility” that differentiates service providers. But, at the same time that business valuation evolves its status as a profession, disruptive competitors have won recent battles by focusing on a low price, high volume approach.

I have found that unless there is a strong recommendation from an auditor, board member, investor, lawyer or other advisor for getting our firm involved, the sale process will almost always default to our fee and there is always someone out there that is lower. I believe that in the world of selling, it is always easiest to defend the lowest price, especially if you argue that there is no correlation between price and quality. So selling a higher fee for a product that may be perceived by the buyer as a commodity is simply a tough sell.

As I mentioned in my last blog, in addition to selling the quality of our platform and brand, we frame our service as part of a bigger solution and focus on “all-in” fees. This focus allows us to fight a perception of fundamental valuation as a commodity and introduce the real and time related costs associated with a lack of quality. In doing so, our argument is based on a simple assumption that more often than not, you get what you pay for. This assumption may be unfair to some service providers who provide good work at lower fees, but it is based on my experiences with auditors who bring us into a situation after they have kicked out a low-cost provider’s work product for a lack of quality.

So, now back to ROI. We make a simple case for a higher ROI for our solution by first highlighting the investment in fees (tangible) and management time (intangible) instead of focusing on the return. In most cases, the return for such an engagement should always be the same; sign-off on our valuation and the assurance (or rather insurance) that our report will stand up to scrutiny of current (Board and auditors) and future (the IRS, the SEC) readers and reviewers. So if the return remains relatively constant regardless of the provider, the focus on “all-in” fees clearly drives the ROI. Any firm with a high quality product and strong audit relationships should be able to win this argument on all-in fees.

Case in point; a low-cost provider who is NOT kicked out of a situation by an auditor will eventually get audit sign-off. However, the means to that end will involve significant (and at times uncapped) fees that the auditors incur by getting their valuation team comfortable with a low quality valuation. My last blog mentioned that these reviews more often than not take the form of “replicating and reconciling” rather than testing. Therefore, when the audit firm is not comfortable with the quality of a valuation report, the client is, in effect, paying for two valuations and the additional step of reconciliation. I have heard from clients that their review fees have been a multiple of the original valuation fee.

So battles may be won on price but in the end, the war is won on quality and focusing in on all-in fees. The takeaways here are simple but strong;

     1. Good work at fair prices creates opportunities to do more good work;
     2. Any service that depends on the knowledge of an expert is not a commodity; and
     3. If a low price sounds too good to be true, it probably is.

As an investment banker, I was never subject to external review of my work other than the public’s response to the value of an M&A deal or IPO pricing.  However, as a fundamental valuation expert, external review is an important and respected part of the process, specifically when an opinion of value is used for financial reporting purposes.  Over the past few weeks, I have had the unique opportunity of being on both sides of an audit review and found the experience both interesting and challenging.

The process of audit review of valuation reports is one of identifying and reconciling “red flags” in terms of both inputs and outputs.  Is a subjective input supported by quantitative analysis and management discussion?  Does the conclusion make sense relative to prior valuations, company growth, increased market concern or the decline in public markets?  The ASA’s culminating Business Valuation course (BV204) focuses on the reconciliation of methods and making sense of an answer.

In support of our audit team, I recently reviewed two reports that opined to values of common stock and found myself asking the same questions I ask during an internal review of our own valuations.  My recent experience in creating and responding to these questions left me with the following takeaways;

1. Tone defines the question.  Reviews go much easier when the reviewer doesn’t go into a review discussion with a strong opinion of what the value “should” be.  Once that feeling of “this is what I think you should have done” comes across, I start to become defensive and the conversation starts to get terse with “yes” and “no” answers.
2. Stay away from asking too many questions.  The most frustrating reviews for me have been when the auditors ask every question from their template without reviewing the report and answering and eliminating these questions prior to a discussion.  For me, the most frustrating response to a review question is “see page xx of the report.”  That response leads me to believe that the auditors have not read the report and just reviewed the exhibits.
3. The wording of the questions means everything.  My worst experiences with review from the valuation expert side occurred when I felt like the word “dummy” should have been at the end of every question.  I have always used the term that valuation is a “grey science;” not black and white.  I also believe that if you put 10 valuation experts in a room with the same information, they will come up with 10 different but defendable answers.  If a question is worded in a way that makes the assumption that the conclusion or input is wrong, the eventual conversation will more often than not head south from the start.
4. The goal on the audit side is comfort.  I believe that in order to get comfortable with a report, you need to ask quantitative AND qualitative questions.  You should ask about a cost of debt but also ask how the conversations went with management and if the expert talked to other groups within their firm or colleagues about key inputs.  I also believe that the goal on the audit side is not to run up fees, ever.  I may do some quantitative testing if my comfort level is low about a certain input but I will never default to recreating a valuation and testing for materiality or how different my valuation is from the one I am reviewing.  That process just reinforces the “dummy” experience above when I feel that the audit review team needs to recreate a valuation in order to get comfortable.
5. Leave on good terms.  I know that I will never be on the other side of a review with an independent valuation firm that is not part of an accounting firm.  Still, a simple thank you for walking me through your report and “I appreciate your time” goes a long way in creating a strong on-going relationship.
6.  Picking up the phone does wonders.  I find that calls, not emails, work the best in communicating with each other.  Context and tone are left for interpretation in email and phone calls break through any mysterious intent that may be hidden in emails.
7. Preventative maintenance does wonders.  Knowing that a report will be reviewed and having a call between the two parties PRIOR to a valuation makes for a much smoother process that eventually will benefit the client in terms of speed of process and “all-in” fees for the valuation or the cost for the valuation plus the review.  Strong relationships within the industry have a way of negating all of the negative possibilities above.

In the end, reviews benefit everyone involved and they don’t need to be painful.  But when they get painful, it can be the worst part of the day.  I try to keep an open mind to review and find that this “high road” works the best for everyone involved.