Common Risks Often Missed During Due Diligence Reviewed by Momizat on . The impact on shareholder value Knowing the value of a business and delivering real value to a client company entails far more than using EBITDA multiples or go The impact on shareholder value Knowing the value of a business and delivering real value to a client company entails far more than using EBITDA multiples or go Rating: 0
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Common Risks Often Missed During Due Diligence

The impact on shareholder value

Knowing the value of a business and delivering real value to a client company entails far more than using EBITDA multiples or going along with a rule of thumb to keep the peace. As professionals, valuators must be far more rigorous in their engagements, and focus on delivering value. The obligation to identify, measure, manage, and mitigate the risks are their responsibility. In this candid analysis, Dr. Carl Sheeler shares some insights, based on his 1,000+ engagements, where he has found problems that led to disputes, misalignment of expectations, and company-specific risks that impair value and value creation.

Value-TargetIn addition to contributing to family and equity holder acrimony, the list below contains representative items that lead to disputes and shareholder value impairment, as well as client and advisor expectation misalignment.

Most items are not found on financial statements because a company is dynamic, and these do not lend themselves to quantification. These issues of operations and strategy require more than ad hoc knowledge of accounting and finance.

Both enterprise and equity level values must consider company-specific risks (listed below) in order to arrive at a reasonable investment rate of return! This requires intellectual rigor. It’s also expensive, but the costs are outweighed by the value to the entrepreneur.

The percentages shown on each line below reflect the approximate frequency of occurrence of each risk, as I experienced them during the 1,000+ engagements I have conducted during the past 20+ years. The opportunity to identify, measure, manage, and mitigate these risks are yours; you can add value for a company if you recognize these risks.

Examples of Due Diligence and Low-Lying Fruit

  • No documented or articulated strategy or business plan (90%)
  • Bylaws, Articles of Incorporation, other formation agreements may require updating (70%)
  • No agreements, poorly written agreements, or agreement provisions are not adhered to (60%)
  • Related party agreements are not complied with or not at market rates (50%)
  • Shares/units held do not reconcile between certificates and tax returns (10%)
  • The number of shares authorized or outstanding don’t reconcile (10%)
  • Common, preferred, warrants, and options are all treated the same (20%)
  • Property is not properly titled (10%)
  • Meeting minutes aren’t much more than boilerplate (90%)
  • The indicated number of board members is the correct number (25%)
  • Accrued dividends for preferred stock are not reflected (50%)
  • No effort to track research and development (60%)
  • No lines of credit or optimal debt levels (60%)
  • Loan interest rates are well above market rate (50%)
  • Transfers of equity and loans with no supporting documents (70%)
  • No budget or forecasts (80%)
  • No performance metrics and nominal knowledge of market or competitors (80%)
  • No annual review of insurance (90%)
  • No business, marketing, or succession plan (90%)
  • No understanding of the leverage of IT/HR functions (80%)
  • Failure to address lower gross margins or profits (65%)
  • Nominal effort to cull clients (80%)
  • No clear communications up, down, or across staff and management (65%)
  • No gain-sharing for innovation (90%)
  • Advisors and labor as a cost versus investment (70%)
  • Nominal correlation between executive pay and performance (60%)
  • Nominal employee reviews or turnover monitoring (70%)
  • Family with inadequate skills in critical roles (60%)
  • Lifestyle business and lowest taxes mindset (75%)
  • Culture is control, pervaded by a silo mentality, and tactical (80%)
  • Limited or no tracking of margins/profits across services/products (60%)
  • Banking relationship is solely transactional (80%)
  • Has no legal counsel (70%)
  • Board comprised of family, inside directors and/or friends (95%)
  • Limited or no involvement in own or client industry associations (80%)
  • Little to no cash management or understanding of cash flow (70%)
  • No knowledge of balance sheet, profit and loss, and growth norms for industry (90%)
  • No risk assessments/SWOT (strengths, weakness, opportunities, threats) analysis (80%)
  • No review of education, experience, age, and health of key personnel (80%)
  • Concentration of clients and vendors (80%)
  • Little to no leverage of trusted advisors (90%)
  • No independent advisory board (95%)
  • Little to no leverage of staff/management/vendor/client knowledge and relationships (90%)
  • No or limited tracking of client-buying patterns (70%)
  • No effort to identify, protect, and/or leverage intangible assets (80%)
  • Founder, management, and/or advisors have reached growth capacity (80%)
  • Absent or inadequate insurance (70%)
  • No review to optimize debt/capital structure (90%)
  • No price or distribution analysis (80%)
  • No supply chain analysis (90%)
  • Nominal processes or procedures (65%)
  • No stated performance standards (70%)
  • Intangible assets not reported or not protected (70%)
  • No review of optimized labor and occupancy (70%)
  • No independent and regular independent and qualified valuation (95%)
  • No consideration/knowledge of synergistic growth (80%)
  • Limited use or leverage of technology (75%)
  • Nominal cross-training of personnel (80%)
  • Nominal redundancy of key functions (80%)
  • Little or no training budget (80%)
  • Tracking and revising business development budget and results (70%)
  • No shareholder/key person/buy-sell agreements in place or agreements are not followed (80%)
  • Under-funded or unfunded buy-sell agreement (80%)
  • Lack of advisor/staff alignment (80%)
  • IT/HR functions are given nominal consideration/codification (50%)
  • No risk identification, measurement, management, and mitigation (90%)

Example : Manufacturer

“Think of the untapped potential. If you could demonstrate to a client not only what their value was, but why and what could be done to change the result, now that’s real value!”

Company owner thinks that a $25-million-annual-sales business is worth $20 million. The controlling shareholder has no knowledge of whether revenue growth has been from higher sales due to costs passed on to clients or if the company has been losing 10 percent of recurring business and gaining a net 5 percent growth, of which most was from weaker competitors going out of business or their clients going elsewhere. In the past no effort has been made by consultants or the attorney(s) to dissuade the controlling shareholder from using rules of thumb or the golf-buddy’s own price multiple, based on a 2006 sale. Furthermore, the controlling shareholder is unable to provide a rationale as to the reinvestment of discretionary cash, the type and amount of insurance purchased, or verbalize what is the optimal amount of debt. If that is not enough, this controlling shareholder has not had a discussion with his or her accountant or attorney as to future plans. Unbelievable, but this is all too common.

Based upon historic and forecast performance multiples for the past five to 10 years, the price multiples ranged from 20 percent to 80 percent of revenues and 2.5 times to 7.5 times for EBITDA. In my experience, the appropriate multiple is unlikely to be the median (midpoint) pricing of 50 percent of revenues and 5 times of EBITDA; yet again, that is all too commonly done. Equally, there are those pesky issues of market and operational performance—growth rate, existence of debt, and whether the buyer is synergistic or financial, as well as the terms of sale and tax planning. Just plugging in the numbers without identifying the whole host of considerations and understanding the buyer pool is a disservice to this controlling shareholder.

Company purchase price is based upon as is, not based upon what it could be under new ownership, except for synergistic buyers. The synergistic buyer will endeavor to gain economies of scale and reduce redundant operational costs; otherwise, the buyer has overpaid. Both entity and equity level values must consider company-specific risks in order to arrive at a reasonable investment rate of return!

The above list of risks and the pseudo rationale of selecting medians and means will likely harm clients, the immediate advisors (attorneys and accounting firms that stand by), and our profession. The purpose of the Income and Market Approaches and the methods and techniques applied is to capture the perceived level of risk of the notional investor as of a specific period of time. A paragraph or two and sometimes three or fewer sentences are all that is expended to express how the level of risk impacts the discount/capitalization rate and price multiples. I believe that this type of analysis demonstrates inadequate intellectual rigor. Purchasing books on discounts and premiums or cost of capital can’t replace the genuine need to understand how operations, finance and strategy are the three legs of what makes a company tick (or not). Think of the untapped potential. If you could demonstrate to a client not only what their value was, but why and what could be done to change the result, now that’s real value!

Dr. Carl Sheeler, PhD, ASA, CVA, CBA, is a director at Berkeley Research Group, LLC, a global 650+ staff business litigation and advisory firm, where he focuses his practice on eight to ten figure family businesses/offices and their concentrated risk holdings. Dr. Sheeler has completed 1,000+ IRS/court-qualified valuation engagements and testified 160+ times. He has authored valuation chapters for the New York and California bars as well as the AICPA. Dr. Sheeler serves on the boards of two national business valuation associations. He is currently writing Value Creation: It’s GRRK to Me! for John Wiley & Sons where he posits that governance, relationships, risk, and knowledge are essential and interconnected in better measuring and creating value. He has applied this philosophy for private and public companies creating +$10 billion during his 25+ year career. Dr. Sheeler may be reached at (800) 286-6635, ext. 211, or csheeler@brg-expert.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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