Valuation professionals are uniquely positioned to help clients identify opportunities and third parties that can take them to a proverbial next level. Business valuation is about more than just benchmarking and deriving a defensible conclusion of value, it should entail understanding the value and interplay of governance, risk, relationships, and knowledge.
Consider the two paths taken: An innovator with technology seeds an early stage company with angel investment and achieves milestones and then obtains the first, second, and, possibly, third round of venture capital.
During this time, his or her compensation and likely several other key parties have traded their time and knowledge to create a commercially viable idea or product that could be an industry game changer. For everyone who has taken this path that leads to financial success, the road is littered with 100 failures due to unsustainable burn rates and dumb money. They will need legal structure and potentially IP protection. They will likely need 409A valuation reports for the preferred (Series A through C or greater), common, options, warrants, convertible and debt financings. If they heed advice, they will consider taking some of their chips off the table during various successive rounds for liquidity. They will also consider and address some tax and possible estate planning issues. The "insider" may be a wealth, tax, or legal advisor to whom the founder(s) listens. Other than institutions like Silicon Valley Bank, most of these businesses are unbankable (until they are). Think Facebook or Twitter. Funding sources will insist on an exit strategy along with either a corporate development or private equity acquisition or initial public offering. The "truth" culled out of the "noise" and hype is that many of these companies don't create millionaires, decillionaires, centillionaires, or billionaires. Yet, they do foster a solid commercially viable company with decent margins.
The more traditional path is the person who likes to cook that starts in the kitchen and eventually shares or takes space for a retail or commercial eating establishment or bakery, or the gal who always enjoyed working with metal in the garage and, fast forward a decade, is financing several CNC machines to produce precision metal parts for the aerospace industry under a section 8(a) government program and is subcontractor for the likes of Halliburton, Curtis Wright, and General Dynamics. Many of her counterparts have capped out at $5 million in annual sales, and she is on her way to losing her 8(a) status as she surpasses $20 million and, in all probability, is marching her way to $50 million in sales.
The point of illustrating the two paths is that these folks are not normal. They are contrarians from the word "go." They don't follow the herd. If you are employed by an institution that has a culture that embraces sameness and does not condone risk taking to have upward mobility, it may offer the stable paycheck and potentially a seat in the C suite, but compliance is expected. As valuation professionals, we must understand that while we may study the numbers-not appreciating the intricacies of the concentrated risk of each path means-we're rendering a diagnosis by taking a pulse. Seldom is value or understanding found on financial statements.
I submit all value is found considering the acronym GRRK-governance, relationships, risk, and knowledge. Governance is understanding how the other three values (RRK) are managed, codified, and how they evolve together. Like the other three, it is dynamic, governance is not static. It establishes culture. Most successful mergers and early funding is based upon the who, belief systems, communication, structure, and experience. It involves whether there is a board and who populates it.
Yet, none of these elements are found on a financial statement. Relationships are based upon clients, vendors, professionals (bank, tax, legal, insurance, and wealth), staff, and even family. It is based upon duration and strategy. Since businesses are not static or risk perishing if they are, the nature of these relationships to provide something that is unique (product or service) needs to be identified. How these relationships are codified and managed usually creates the company's differentiator. Again, most of these relationships are not readily sought or found on financial statements.
Risk is what good valuators are paid to identify and quantify. There is entity and equity level risk. By simply applying an industry risk standard, whether Duff & Phelps, SBBI Ibbotson, or some other technique, I would argue the difference between a cookbook valuation report that follows the recipe, but does not understand the influence of the combined ingredients, creates what may be a compliant report, but may woefully undervalue or overvalue the entity and equity. Most wealth is based on concentrated risk that either hits homeruns and controls strikeouts, or produces steady doubles. Either way, one must do sufficient research and analysis of the market, industry, governance, relationships, and knowledge to assign the level of risk. While the word is readily recognizable and seems easy to understand, I'll illustrate. If the client and CPA sees risk as limiting his or her tax exposure, and the attorney understands risk to the asset, but not the risk within the asset, then what is the likelihood that value can be levered or created?
Finally, there is knowledge. None of the GRRK letters can exist independently of the other three and the "K", in many ways, is the most important. Does the entrepreneur codify the knowledge, such as process and procedures? Is he or she the first to market or skilled at building a better mousetrap? Have patents, trademarks, and copyrights been applied for and received to protect the intangible assets? How is knowledge shared within the organization? How often is it solicited and evaluated externally? If the knowledge is common and one can swap out the name of company A for company B and the same holds true, then the offering is likely of limited benefit and more so a commodity product or service.
Consider this: if we are unable to isolate how knowledge, relationships, and governance influence risk and create unique value, how are we legitimately able to measure, create, and defend value? So, when terms like "exit planning" are used, think carefully what this means to the entrepreneur. You are closing the book on what is in all likelihood the most important part of the entrepreneur's life. Transition suggests they are simply going to the next chapter in a story that has yet to be written. While it is legitimately death insurance, nobody would buy it; hence, it is life insurance. Phrasing matters.
So, what entrepreneurs need is to identify what they don't know and be shown who may be able to share or provide knowledge and options they need. Any provider who is a jack-of-all-trades is a master of none, so while visiting a primary physician for a pain may be all that is needed, it is unlikely they'll be able to assist with a heart murmur; hence, a cardiologist makes sense. We are all too afraid of stating, "I do not know," when it may best serve our clients by acknowledging our limitations and ensuring we make it our purpose to know the right specialists. This leads us back to the point about knowledge above.
So, transition planning may be primarily focused on baby boomer business owners contemplating partial or full liquidity events by transferring equity to family, staff, an employee stock ownership plan (ESOP), or even private equity; however, the role of the valuator could and should be so much more than simply benchmarking value.
Keep in mind, most of these entrepreneurs have distrust based upon not following a plan that everyone working for the relative safety of institutions expect of them when they began, and, likely, even fewer founders have a plan when they bring closure to this segment of their lives.
In order to exceed a client's expectations, think GRRK, and gain a better understanding of the concentrated risk the founder successfully achieved and how to best harness it based upon exploring the myriad of options they may have. Your fellow advisors and clients will thank you.
Carl Sheeler, PhD, ASA, CBA, AVA, has over 25 years of public and private company experience with business disputes/disruptions and well as transfers, transactions and transitions associated with Intergenerational Planning, Equity Transfers with Estate and Gift Tax issues, as well as Partial and Full Liquidity Event Options.
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