Tips on interviewing valuation firms
Readers frequently request guidance on how to evaluate advisory firms. This series of articles presents information on how to interview and compare advisers in a variety of disciplines.
As family businesses mature, the reasons for developing an ongoing relationship with a valuation firm multiply. Whether you are establishing a valuation process for a shareholder redemption program, contemplating an employee stock ownership plan (ESOP) or facilitating estate planning for family shareholders, a credible, well-reasoned valuation is an essential component of your strategy for promoting positive shareholder engagement. While you might feel comfortable selecting an attorney or CPA based on your past experiences, many families have never hired a valuation firm before and, as a result, might not be sure how to go about selecting a valuation firm.
Do your homework
• Make sure your family shareholders agree on why you need a valuation. This is important, because it is probably one of the first questions that a potential valuation firm will ask you. Valuing a business for purposes of estate planning is a different exercise than valuing the same business to resolve a disputed buy-sell agreement. If the purpose of the valuation is to set the price for an ongoing shareholder redemption program, that will call for a different perspective than the one used for measuring the value of the business in anticipation of negotiating a sale to a strategic acquirer.
• Determine who should be involved in the selection process. The reason for the valuation helps determine who needs to participate in the process. If the purpose is estate planning, you probably want to solicit feedback from your tax attorney or accountant as you assess potential valuation firms. If the purpose is establishing a shareholder redemption program, it may be advisable to include a representative from the family council in the vetting process. If, instead, there is an existing or potential valuation dispute, it may be appropriate to solicit input from the adverse parties so that the selected valuation firm is viewed as genuinely independent and not biased toward one party or the other.
• Gather your financial statements and consult your attorney. In addition to a clear statement of the valuation’s purpose, a prospective valuation analyst will also ask to review a recent copy of the company’s financial statements. Reviewing the financial statements is the best way for a valuation analyst to identify what issues and challenges are likely to come up when valuing your business. You and your legal team should be prepared for this request. While reputable valuation firms are zealous about the confidentiality needs of their current and prospective clients, you should decide whether you want potential valuation firms to execute a non-disclosure agreement prior to providing financial statements. If you do, have a copy of your preferred form ready to send.
Understand the business model
You will get the most out of your conversations with potential valuation firms if you have a basic understanding of what a valuation firm does. At the most fundamental level, a valuation consists of developing credible answers to the following three questions about your family business.
1. What is the current market value of the business’s assets and liabilities? This is the heart of the asset-based approach. It may involve assessing whether there are assets or liabilities that do not appear on the company’s balance sheet and evaluating whether there are assets whose current market value differs from that recorded on the balance sheet (such as real estate that has been owned for decades).
2. What are the expected future cash flows of the family business, and how risky are those cash flows? This is the income approach to valuation, and it involves a careful analysis of the historical earnings of the family business, and the future outlook for the economy, relevant industry, and the family business itself.
3. What can be inferred from transactions in reasonably similar businesses? This is the essence of the market approach, and it involves searching for and analyzing comparable public companies and/or transactions involving comparable private companies.
Developing well-reasoned answers to these questions requires due diligence, research and analysis, all of which take time. Most valuation engagements are performed for a fixed professional fee. An experienced valuation analyst will be able to estimate how much time will be required to perform a typical valuation engagement, and quoting a fixed fee provides the client with certainty as to the expected cost. In some circumstances — if, for example, the valuation will be used in litigation, with expert testimony expected — it may be difficult to develop a reasonable time estimate before the engagement begins. In those cases, a fee arrangement under which the valuation firm bills on an hourly basis will be appropriate.
Under either billing arrangement, the two factors influencing cost are time invested and effective billing rate.
• Time invested. Answering the three valuation questions well takes time. The time required is a function of the complexity of the subject business and the circumstances giving rise to the valuation. Complexity is influenced by factors like size, geographic diversity, number of operating divisions, the presence of unusual assets or liabilities, and other complicating factors. The circumstances giving rise to the valuation can influence how much time will be needed to prepare supporting documentation proper to the purpose of the valuation.
• Effective billing rate. Depending on how many employees they have, valuation firms have a limited number of hours to devote to client engagements during a year. The demand for a particular firm’s services determines the effective billing rate. That demand is ultimately a function of the reputation, expertise and experience of the firm and its professionals.
When evaluating professional fee quotes, it is important to keep these two factors in mind. A lower fee quote might signal an intention to spend less time on the project, or to staff the project with less experienced professionals (or those whose expertise is less relevant). In contrast, a higher fee quote may reflect inefficiencies in execution, or an unnecessary allocation of more expensive professionals to the job.
Questions to ask
Consider asking these questions when interviewing prospective valuation firms:
1. What credentials do your senior professionals hold? What professional standards does your firm adhere to? In contrast to the accounting and legal professions, there are no licensing requirements for valuation firms. However, there are a few professional organizations (the American Society of Appraisers, the American Institute of Certified Public Accountants and the Royal Institute of Chartered Surveyors) that certify their members as to education, competence and adherence to ethical and professional standards for business valuation. You should ensure that the valuation analyst you are speaking to is a member in good standing of at least one of these organizations.
2. What is your experience with this type of valuation? Not all valuation firms perform valuations for all purposes. You should clarify that the prospective valuation analyst has experience performing the type of valuation you need. For example, someone focused on transaction advisory services for ESOPs may not be well equipped to provide a valuation for estate planning.
3. Have you valued a company like ours before? We are occasionally asked if we think industry expertise or valuation expertise is more important. Both are. Some industries, like healthcare, banking and automobile dealerships, are specialized enough that having a valuation analyst with relevant industry expertise is important. However, sacrificing valuation expertise to obtain perceived expertise in your industry can be short-sighted. For example, if your family business operates in a narrower niche, you may be better off with a valuation expert who can demonstrate a capacity to learn your specific niche and the factors that influence the value of your family business.
4. How long will your valuation process take? You should not just assume that you know how long the valuation process will take. Instead, ask the prospective valuation firm to describe its process and include likely timelines. You can then compare those that meet your expectations/needs to help determine if there is a good fit. If you have very specific timing needs, share them with the valuation firm to see if the firm can develop a strategy to provide a credible work product before the desired date.
5. Will we have an opportunity to review the report prior to the conclusion of the project? A process for draft report review is important to help ensure there have not been any misunderstandings or miscommunications that would undermine the credibility of the conclusions in the valuation report. You should have the opportunity to carefully read a draft report to assess whether the valuation analyst developed a balanced and informed view of the industry and the company. You should be able to recognize your company in the valuation report. If you don’t, the draft review process should allow you to discuss those concerns with the valuation analyst.
6. Can you provide references? Confidentiality and discretion are important attributes of a valuation firm. As a result, you should not expect to see a long client list on the valuation firm’s website (and if you do, you should probably be wary). However, it is entirely appropriate to ask to speak to one or two of the firm’s other clients. Speaking with a client can be a great way for you to get a better sense of what it is really like to do business with that firm.
Seek out the right partner
A trusted valuation firm can become an important member of the external advisory team for your family business. It tends to work better for all parties in the long run if those relationships are stable and enduring, so investing the time and effort to find the right firm for your family business can pay dividends for years to come.
Travis W. Harms is senior vice president at Mercer Capital (www.mercercapital.com).
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