Professional Relevancy vs. Commoditization
Some of us near or past 50 years reflect on our choices. Not for nostalgia sake, but how we have made a difference. I wrestle with this mightily – almost daily. Those familiar with the actor Richard Dreyfus and his role as Glenn Holland in the movie Mr. Holland’s Opus may recall he was a high school music teacher.
He takes this teaching job to pay the rent while, in his 'spare time', he can strive to achieve his true goal - compose one memorable piece of music to leave his mark on the world. As Holland discovers 'Life is what happens to you while you're busy making other plans' and as the years unfold the joy of sharing his contagious passion for music with his students becomes his new definition of success. I disagree.
I know few folks performing full-time business valuation work who from a young age aspired to be doing this line of work. I, myself, thought I was going to be a fighter pilot, then a commercial airline pilot. I was fortunate to be nominated by both my U.S. congressman and senator to attend the US Air Force Academy, but then broke my wrist and waited to graduate college to join the US Marines. I still pursued the desire to be a pilot, but my eyesight had other ideas. I became a tank officer instead.
If nothing else, the USMC is an awesome “tribe”. Being part of a group that strives to maintain high standards and has esprit d’corp (unity forged by common purpose larger than oneself) is unlike anything I experienced before or after. It’s a calling. Leaving it behind is no small feat.
I bounced around in various executive operational, sales and finance positions in the corporate world, then was activated for Desert Storm. Events like that can have a profound impact on what you have done with your life and where you expect to head if you remain intact. It led me to not want to return to being one more fish in a giant pond. Instead I became an analyst and eventual owner of a boutique multi-disciplinary appraisal firm. Being an entrepreneur compensated on merit made sense to me.
Real estate appraisals were becoming a commodity then, where MAI designated commercial appraisers once commanded 5-figure fees for reports. Back in the day, the Appraisal Institute did a phenomenal job in positioning the MAI appraiser whereby most provisions in legal documents where a real estate appraisal was required called for the work to be performed by a MAI. (To some extent the AICPA has sought to do so for its ABV business appraisers.) Then licensing levelled the playing field, but diluted the market under the lowest common denominator - fee. High volume review work made sense and could be lucrative, but with automation even that work was becoming commoditized with fees ever lowering.
It made sense to focus our practice on business valuation work because some degree of intellectual rigor was necessary. It naturally followed there were associations holding themselves out to maintain these standards through education and accreditation. If the reader looks to the business of higher education, the goal is to capture student funds for a select period of time, push them through and confer a diploma certifying they know more than when they arrived (mind you two out of three adults don’t have a college degree). Then repeat. And, whom among us believes that being a newly minted bachelor’s degree holder makes us qualified management material?
So, it stands to reason the business model is one of volume and velocity, which begets more offerings and more students at the undergraduate and graduate levels. But where is the recurring revenue for professional bodies? Recertification which requires continuing education. I’d happily pay more for my valuation accreditations if these organizations dedicated more funds to educating the marketplace versus pursuit of an ever-shrinking number of potential Business Valuation members.
Your dollars are as good as mine. However, the majority of those who maintain their accreditation do not perform valuation full-time. In the Marines, you train, train and train some more. Why? You fight only as well as you train. Let’s say a full-time valuator in five years can perform 100 engagements and what of the part-timer who performs four per annum? It’ll take 25 years to have comparable skills.
I’m not too proud to acknowledge that if I reviewed my first 100 reports there are things I did not know that I did not know and wished I had. I also had a limited budget for data, so bought what I could afford versus what was needed for a more empirically well-supported work product.
Needless to say, I wanted to know what I did not know, so read everything published on valuation and built a fairly comprehensive library. I was convinced that if I knew what there was to know about being the very best practitioner, I would be set with clients beating down our door. I’m such a fool.
As an example, my first valuation report of a minority interest of a family limited partnership, I must have spent 200 hours and charged $4,000. That’s $20 per hour. However, I learned something very critical. For example, the various studies that are relied upon to substantiate the level of illiquidity/ marketability and control adjustments have weaknesses, which over-simplifies the process. A simple example is if the holdings and agreement provisions of two entities were exactly the same other than the date of value, it ought to be chance alone where the discounts were the same. Compare March 2009 to March 2012 for example. The stock market was at its lowest point and there was almost no liquidity in the system. In fact, there was a significant sell-off of less liquid assets at steep discounts.
Most valuators will take the real estate appraisal report, turn to the transmittal page and replace the book value with the market value of the real property. They’ll then go through the machinations to come up with a discount that is usually about 35%. Why? Because that’s what they were taught.
But here’s the problem. If Value is determined by developing the Economic Benefit and level of Risk, how many asset holding reports actually reflect this? In other words, say the 10% minority interest’s pro rata value is $1,000,000 (meaning the 100% equity value would be $10 million). Let’s say you apply a discount for lack of control of 15% and a discount for lack of marketability of 25%, which ought to get you a combined discount of 36.25%. How do you know the 36.25% is correct?
If you read the real estate appraisal report, you may have found the real estate appraiser assumes a steady state of income that may not be the case given the age and experience of the current General Partner versus the GP’s substitute. The real estate appraiser may have indicated a major tenant has a lease that is near expiration. She may have indicated the capitalization rate assumes an allocation of 70% debt to 30% equity, whereas the property held is not encumbered. Wouldn’t this impact the yield received by the partnership? Do we know the cost basis of the real estate and what its annual growth has been? If total return is what a notional investor seeks (and it is our job to determine what that is) wouldn’t we be expected to know what “typical” returns (growth and income) are for the asset class and whether the general partner is achieving this for which the limited partner is a beneficiary?
Now consider this is an asset holding company and arguably most of the time a lot easier to value than an operating business. So, what do we do as part of the check-the-box due diligence? We examine and spread sheet financial performance. We determine risk and we opine value. Not so fast.
Have you ever noticed that most capitalization rates tend to hover around the (4x to 6x) range of 17% - 25% and that growth is usually indicated at about 3% and company specific risk is 0% to 6%? But again here’s the potential issue. Assume two companies are identical in all respects except one. One has operated for five years with a phenomenal year-over-year growth rate and the other 20-years with a growth more consistent with the industry. By most measures, if a cap rate or price multiple is used will the valuation recognize just how relevant management is to the phenomenal growth of the first company? Further, how much time is actually expended to document company-specific risk given it’s the more elusive measure of business?
So, let’s examine the common issue of tax affecting. Is it worth knowing what percentage of public companies that comprise the build-up method (especially, the micro-cap where most valuation engagements of midmarket companies will be compared) do not report positive earnings? And, what is the effective tax rate of those that do actually pay taxes? If you guessed less than 40% you’d be correct on both measures. Second, do you know the amount of daily shares traded in the 10a to 10z category you have selected? If you guessed less than 50,000, you’d be correct. So, why is that relevant? If you’re making an adjustment for marketability and illiquidity and this impairment is already (at least in part) cooked into these thinly traded companies price multiples, wouldn’t you be double counting?
So, what does the above have to do with professional relevancy versus commoditization? By my count on a good day, there are about 5,000 accredited business appraisers that perform engagements full-time. This is not to say all have the same degree of competency or experience.
While the numbers vary, if we assume there are 10 million businesses operating in the U.S. and 5% (1 out of 20) need some type of valuation per annum that means about 500,000 engagements. Let’s say the 5,000 above appraisers are performing an average of 20 or 100,000 per annum. This means 80% (400,000) of the 500,000 are either performed by part-time or non-accredited business appraisers.
So, we have a problem. The largest number performing these 400,000 engagements are CPAs followed by economists and business brokers. As I have come to learn after 25 years, these non-designated valuators’ rationale is this work looks relatively straightforward, so why not keep client revenue in house? (While AICPA’s SSVS-1 has requirements covering valuations of all CPA’s and a code of conduct provision against “dabbling” needless to say enforcement and quality control is another issue.)
Now, I have hoped to share when a large volume of less than ideally qualified valuators are performing a large volume of engagements with limited know how and even less third party data sources, you often have software driven results that look as good as the work delivered by seasoned valuators. Since the values are often between 4x and 6x, what’s the issue (other than half-again difference in value)? This is my/our “profession”. Our valuation organizations have mixed priorities between membership, product and service sales growth and protecting the public from substandard work product.
The issue is since the end-user may often not know what “good” looks like, s/he will default to a selection based upon a variable s/he understands – fee. The thinking is since there’s a ubiquitous amount of software that generates legal documents, tax returns and financial statements, why wouldn’t it naturally follow the same would be true with valuation reports? And the newest crop of software is for exit planning and increasing the potential value of the business owner’s largest asset – their company…. And the training and designation revenues that follow. All standardized and ready to go off the shelf making S/W buyer “expert” and more money in the process. But do they really have the skills?
I may be a disenfranchised baby boomer. I obtained my credentials (even a PhD) to ensure I played an A-game and receive a premium for my work product because it was genuinely believed to offer a cut above the majority of what is produced. I joined dozens of professional associations to seek fellowship and see what issues directly and indirectly were impacting my and other professions’ service delivery.
Despite all that effort the sheer numbers and limited time to compete for attention of peers and fellow professionals is staggering. So, what I learned after 1,200+ engagements and testifying almost 180 times is being a professional is not solely having the certification that presumably reflects our learning.
It is expecting the conferring body and those with the letters following their name to adhere to a higher standard and expect to be paid a premium for doing so. In the military, the rank you have is not what earns you respect. It is how you comport yourself and serve in the position held.
So, my personal challenge is to see if the valuation profession can have more relevancy than what the market seems to suggest. This led me to write a Wiley Finance book called Equity Value Enhancement (“EVE”) and dig deep into the acronym “GRRK”. GRRK stands for Governance, Relationships, Risks and Knowledge. Each is intangible, but their influence is very concrete on business valuation and other professional advisors. In short, we will not find these measures on any financial statement because they reflect how human capital can differentiate our clients businesses from their peers.
Perhaps, it will also challenge professionals to take a deeper look at how we may do the same. If we choose to remain with business as usual is it any surprise that our prospects and clients will do the same? I choose the harder path of relevancy for fear of looking back as Mr. Holland had and not pursuing professionalism passionately. I had no idea how lonely a path it can be even if paved with good intentions.
_____
Carl Sheeler, PhD, ASA brings wisdom gained from his 25 years of strategic planning, governance, business
operations, finance and advanced analytics experiences to bring clarity to complex risk identification, measurement, management, and mitigation issues faced by family offices and businesses. He is the author of the John Wiley & Sons book titled Equity Valuation Enhancement, a treatise which addresses scaling 8- to 10-figure companies and has presented or published 200+ times for entities such as the American Institute of Certified Public Accountants, the American Bar Association, the Federal Bar Association and other organizations on value, strategy and governance. He can be reached at carl@carlsheeler.com or 424-253-0110