In my last article I discussed how busy all the valuation professionals I know have been during 2021. With the high level of valuation activity in 2021 I have had the opportunity to propose on many valuation projects. Part of my proposal process is asking for several years of financial information, tax returns and/or financial statements, so I can “scope out” the project. I believe this is a necessary step. A review of several years financial information can highlight items that make the project more involved and complex. Related party transactions, non-operating assets and liabilities, recent acquisitions or sales of assets, litigation, and non-recurring transactions are just a few things that can add time and expense to a valuation project. I can also determine if the project is simple, straightforward, and my quote can reflect that fact.
During the past year I had multiple requests for quick “down and dirty” estimates for the cost of a project without having any financial information other than revenue and net income. Each time I responded that I couldn’t do that without looking at recent financial information including balance sheets and income statements. Ultimately, I was able to obtain what I needed, gave appropriate quotes for the work, and when needed, I was able to explain why the costs might be higher than expected.
Earlier this year I learned a lesson that I will never forget and want to share with you. I was approached to give a quote for a valuation project, and I asked for recent financial information to scope out the project. I received the information requested and gave a quote for the work. I received the go ahead to prepare an engagement letter and begin the project. However, I soon learned that I neglected to ask a very important question as part of my “scoping out” due diligence.
Future Cash Flow
In many of my previous articles I have pointed out that business valuation is a forward-looking exercise. Future cash flow is a primary input used to determine the value of any business. Historical cash flow can be a good indicator of future cash flow, but not always. There are many factors that can cause cash flow in the future to be different than historical cash flow. A few of these factors can expand the scope of a business valuation project dramatically. What I failed to ask during my due diligence was “are there any plans in place that could/would materially impact future operations.” What I learned after beginning this project was that the subject company had begun negotiations for the acquisition of two related businesses that would be completed within the upcoming year and would materially impact future operations. Considerable additional time would need to be spent on the projections of cash flow and the treatment of the acquisition debt associated with the purchases. I completely whiffed on the estimate of time and effort needed for the project.
It didn’t take me long to utilize the lesson that I learned with this project on another opportunity. I was asked to give a quote for a valuation project and this time I asked, “Are there any plans in place that could/would materially impact future operations?” I learned that the company had entered into an agreement for the construction and financing of a new production facility that would double the company’s capacity over the next two years. I was able to explain the impact this would have on the valuation process and that additional time would be needed to account for the expansion. The client understood and agreed with my quote.
The future cash flow to be generated by a business is critically important in determining value. Differences between historical cash flow and future cash flow have an impact on the value of any business. Understanding how and why future cash flow may be different than historical cash flow is a part of every business valuation. And, as I have learned, it should be part of the due diligence performed before the start of any valuation project.