Vetting a Client’s Projection

A Process

As valuation professionals, we sometimes serve dual roles. In this article, the author shares a step-by-step listing of his vetting process. This checklist is meant as his guide but is also used to help clients start the projection process. The guide is for anyone using a projection as a guide to a valuation analysis.

Business valuators are typically provided with a client’s budget or financial projection which can help when preparing the eventual valuation. In most situations, these are optimistic and are usually intended to convince a lender or investor to make a positive decision, so it needs to be reviewed with a degree of skepticism.

Many times, we have dual roles that occasionally morph together. As appraisers, our role is to provide an independent view of the value of a business. As advisors, our role would be to help the client with that projection while also indicating value drivers and ways the business’ value could be enhanced and presented in a more favorable manner.

As professionals, we often skirt both roles, especially when we are engaged by the client in a non-litigious situation. I feel the best way to advise clients is to have them clearly articulate what they want to accomplish and then help them achieve what they say they want. This includes my belief that their goals and the method they will use to proceed appear reasonable. Further, an important part of my role is to keep them on track.

I have been involved in many situations when the client just will not be able to attain their goals; many times this was because of unrealistic goals based on their present situation, their existing trajectory, and embedded legacy culture. Speaking outright does not elicit confidence and, more importantly, get buy-in in my ability to steer the client toward their goals or to make them understand the reality of the situation.

I could go on with many illustrations, but I feel the best way to fulfil my role is to vet the client’s thoughts and dreams as reflected in the projections they set forth. Sometimes I am presented with completed projections and other times I am given notes with each part of the “future” dreams described. My approach has been to start somewhere, usually with the projected sales, and try to have the client present a reasonable justification for what they say will happen. This leads to further discussion such as the ability to finance the expanded sales, maintain the production quantity or ability to purchase the products, or perform the services, where the customers or clients would be generated from, the personnel and facilities to handle the demand, the quality control, and the overall management of the entire operation.

What follows is a suggested method that is adapted from what has evolved from what I have been doing. I am amazed that no matter how well I think I developed a plan and great “checklist”, that something new always arises for the “first time.” Businesses are dynamic and ever changing and ever developing or declining, the changes are unique for that entity. This causes adaptability and also makes one wonder of the myriads of ways something could be done. Therefore, use this as a guide, or starting point, and use your keen ability to listen, observe, analyze, and apply your experience to the situation at hand. Also keep forefront in mind that while this might be another interesting engagement for you, it is, for the moments the client spends working with you, the single most important thing for them and could affect their entire future personally and financially. Treat it with that same importance.

Occasionally, I present them with this checklist before they proceed, along with written instructions I have on preparing a business plan, which can be cannibalized for ideas. I present these with the caveat that I will not be involved in the preparation process but only will use what they provide as an added guide to the valuation I have been engaged to prepare. When I am not involved in any manner with the client, this is a checklist for my own guidance and I do not share it with the client.

Here is my method; a step-by-step listing of my vetting process. This checklist is meant as my guide but is also used to help clients start the projection process (which I typically am not involved in unless I am engaged specifically for that purpose). Because of this, the manner I wrote it in could be a prod to me or in the form of an instruction to the client. Either way, it is an excellent guide for me and hopefully for anyone using a projection as a guide to a valuation analysis.

1. Purpose of the projection. The client should have prepared a one paragraph description of their purpose for preparing the projection. Nothing elaborate. Just a succinct reason. If they cannot explain it in two or three short sentences, then it is possible they are not clear about what they want. As a CPA I love to see projections, but if they are not thought through and do not relate to a specific benefit for that effort, I become skeptical about the cost and time of proceeding with it or even accepting the engagement. I am always reluctant to do something that will not provide real value to the client.
2. Description of the product or service. Get a memo with everything, good and bad, about the product. It is important not to have anything left out and especially something bad about the business or product. If an investor doing his or her own research or due diligence discovers something negative, the deal could be terminated because of that. Always have the client be up-front about the downside of their business. Also needed is information about whether there are patents or if the product is patentable, what intangibles there are, and any “secret” processes or formulas.
3. Who the projection was prepared for. This pretty much goes with the purpose. Is it for the organization’s managers, bankers, investors, or as part of an internal strategic plan?
4. Organization chart. I always like to see this. It also helps me identify the people I talk with at the business. If a company does not have one, it is an indication that it might not be as organized as it should be or that the people at the top have not delegated properly.
5. Ownership structure. This should be evident from the tax return, but if it is not indicated there, then ask about it. Review copies of the ownership documents such as the stock register, shareholders’, members, or partnership agreements.
6. Executive summary of the projection’s results. Another short paragraph of what the projection indicates. Will the projection show a need for future financing or added personnel or a different type of staffing or management, a path to growth or the businesses’ viability in its industry and/or overall economy?
7. The top and bottom lines. A quick look at the top and bottom lines in the last year covered by the projection provides a framework of the growth and profitability, and the projected size of the company. I like to review five-year projections, but many times the client only has its projection for one year and occasionally it is in the form of a budget. These are OK to review. I do not believe they are as good as a five-year projection, but I work with what the client has, and in these situations, I accept what they provide without asking them to add or change anything. I want to vet what they have and not participate in any manner in its preparation. I want to maintain my independence. In most non-valuation report engagements independence is not a primary issue, but it is always an issue and a possibility. Further, preparing projections, and even one year budgets, is a complicated and involved process; and unless I am specifically engaged to assist in its preparation, I will not have the data I would need to do a proper job. I find it is best to completely refrain from assisting in any manner and that includes making one of two “simple” suggestions. If I cannot do it completely right, I do not want to give any appearance that I participated in the preparation in any manner.
8. Cash flow. It is always good to see substantial profit but cash is a business’s life blood. How will the cash flow be managed, and what are its lowest points, and how will that be covered and when. It is not reasonable to have a strategy of hope that cash sources will miraculously appear when they are needed. I believe that initial arrangements for the availability of the appropriate amount of cash need to be firmed up before the plan represented in the projection is commenced. I have seen too many very successful businesses fail because of a shortage of that last $10,000 to make a weekly payroll. Planning means having the sources of cash committed beforehand. If debt is part of the plan, then the cash flow projection should reflect the debt service and the balance sheet should indicate that typical loan covenant ratios would not be violated.
9. Balance sheet. At the end of the projection period, the balance sheet will indicate how thought out the entire projection is. Do the accounts receivable, inventory, and accounts payable seem reasonable with the annual sales and equity, and loans provided for? This will need a little ratio analysis, i.e., working capital ratio, number of days sales in accounts receivable, number of days purchases in inventory and accounts payable, and long-term debt to equity ratios. Nothing ethereal, just a few quick ratios most accountants and appraisers could do in their heads.
10. Sales and ability to handle the volume. Review identities of the probable customers and amount of sales to each one in dollars and units. Alternatively, review monthly sales figures projected forward (which should have already been provided in the projection), types of customers, average sales per customer and average number of units per sale, frequency of orders, timetable from receipt of order to shipment to customer to payment. While you are at this, you should also question the inventory requirements, selling price and cost of raw materials, gross margins, sales commissions, shipping costs, number of employees, salaries, the number of square feet of space needed, and the estimated cost per square foot. Along with this there should be some sort of marketing plan. I usually just look to see that they have a marketing plan and the costs are reflected on the projection.
11. Prior financial statements. I am embarrassed to include this since I cannot believe anyone appraising a business would not have this, so I will not spend any more time on it. Although maybe I will add something here since some readers might not be appraisers. A minimum of three years’ statements should be obtained, but I try to get five years. If the client does not have financial statements, then get the tax returns. Even when I get the financial statements, I want the last two years’ tax returns and compare them to the financial statements. You would be very surprised how many times I received tax returns that did not tie into the financial statements. Basic ratio analyses should be applied to these statements and you should look for trends. This would be interesting and might provide some revealing information, but this project should be more concerned with the projections you are tasked to vet.
12. Related party transactions. Find out if there will be any such transactions including whether the owner rents property to the company. If there is more than one owner, I ask for employment agreements and leases. If the financial statements reflect loans with owners, I like to see copies of notes with clear repayment terms and the interest rates charged.
13. Identity of preparer. If the preparer is identified, I will make note of that, but I do not give much credence to this. Projections are prognostications of future events which means everything is made it. My job is to determine if the assumptions and how they are applied are reasonable for the purposes of my engagement, and not to opine on the reasonableness, accuracy, or veracity of the conclusions. Reviewing the projections is part of a process to either prepare a valuation or otherwise advise a client and serve as a guide to assist me in what I have been engaged to do. When confronted with voluminous data, there is a tendency to overstep our role and get mired in the details of what we are provided with. I try to stick religiously to the terms of my engagement. I spend considerable time and effort to scope the engagement and determine the fee. If anything is added to the scope or if the client’s expectations exceed what we agreed to, I call that to their attention as soon as I can, and certainly before I do anything extra. A “gratuitous” comment [something I usually advise against] is that when the scope is exceeded and additional work is necessary, and where you expect to be paid for that added work, it will always be uncomfortable to bring up the subject of added payment. It will always be uncomfortable. However, when you perform the services and then ask for added payment, you will be less likely to be paid fully for that work. If you ask for payment before you do any work, you are putting the client in the position of making the decision and that empowerment will ensure getting a go-ahead and the proper fee. This is the same uncomfortable action and never the right time to bring it up, but an empowered client always feels they are making the decision. By the way, if they do not want the added services performed or they feel they could get it elsewhere for less money, then pull back and wait for it or work without it. See I digressed and added some time working on this article to give some “free” advice. Anyway, do not do this type of stuff when you are engaged for a specific project.  

This listing appears more involved than it would seem it should be. However, if you would be relying on the projections to any extent, it is incumbent on you to vet the projections in some manner. Further, while you do not need to prepare an analysis of what you did or even a memo, you should document in your file what you did. That documentation could be notes or jottings on the projections in any way that makes you comfortable. I do this and scan and include in my file. Think of the process you follow when a client hands you a valuation report and asks you if it seems reasonable. Then compare that to what you would do if you were asked to prepare a rebuttal. Notice the huge difference in time and focus between the two situations. Your vetting should be similar to that first process and not bordering on the efforts and exactitude needed with a rebuttal.

I have been doing this a long time and have gotten into the habit of quick vetting of the projection and build that into my time budget. Keep in mind that with the projection, you will be given everything, with no expectations of you performing any added services on it. Just give it a quick oversight looking for glaring inconsistencies or absences of pertinent data. Vetting a projection is not a project and do not make it so.

If you are going to do something, you need to do it right. Vetting is necessary when it is provided to you. Do enough work to be satisfied with its reasonableness. If you cannot feel that way, then perhaps you should pass on that engagement.

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Edward Mendlowitz, CPA, PFS, ABV, CFF, is an emeritus partner at Withum. He has been designated by Forbes as one of the 200 Best CPAs in America in 2024. Mr. Mendlowitz is the author of 32 books and has created and presented over 350 CPE programs. He is an adjunct lecturer at Baruch College.

Mr. Mendlowitz can be contacted at (732) 890-3344 or by e-mail to emendlowitz@hotmail.com.