Venture capital (VC) backed portfolio companies are highly susceptible to macroeconomic, industry and unique risks. In addition, VC fund ownership interests in portfolio companies are subject to risks, including market factors. How these parties address risks can significantly impact the value of companies and fund interests therein. An enterprise risk management (ERM) process involves identifying risks relative to an organization’s objectives, assessing them for likelihood and impact, developing a response strategy and monitoring progress. A well-defined ERM framework can protect and create value for the portfolio company and its parent VC fund.

“How a portfolio company addresses risk can have a significant impact on the harvest value of a business as well as interim mark-to-market valuations,” says John T. Alfonsi, CPA, ABV, CFF, CVA, CFE, a managing director of Cendrowski Selecky PC.

Smart Business spoke with Alfonsi about portfolio company risks and how they impact valuation.

Where is risk addressed in a portfolio company valuation?

The most common method of valuing a business is the ‘income approach,’ which requires a valuation analyst to project a business’s future cash flows, then calculate the present value of the sum of these cash flows by employing an appropriate discount rate.

When using the income approach, a valuation analyst must address risk in two primary areas: projected future cash flows and the discount rate. Effective ERM processes can help portfolio companies increase value by affecting the estimates for these quantities.

How does risk impact projected future cash flow?

Projections contain risk: There exists a risk that the portfolio company will not achieve the projected figures. As such, the process by which portfolio company management and the VC fund project future cash flows can impact a valuation analyst’s assessment of the business. A key risk is information integrity, the quality of information generated through monitoring and data assimilation. Information integrity allows management to make well-informed decisions and should provide a valuation analyst with greater confidence in a business’s projections.

Valuation analysts can analyze information integrity by examining historical projections and assessing elements of the internal control environment. While VC-backed companies are often nascent firms, the development of a robust internal control environment is an essential component to maximizing value.  Potential strategic and financial acquirers, as well as investment bankers who may take a portfolio company public, want to see control environments supported by strong culture focused on mitigating risks. This culture will be evaluated by valuation professionals when they examine projections.

In analyzing historical projections, a valuation analyst should examine the variance between historical projections and a business’s actual performance as well as the business’s ability to reach milestones in a timely manner. If a strong correlation exists between projected and actual performance, a valuation analyst can be confident in current projections, if the process employed by the organization in making projections remains constant. If a strong correlation does not exist, the analyst must examine the variance between past projections and actual performance to discern whether bias existed in past estimates and may exist in current projections.

What about risks in the discount rate?

The discount rate is the yield necessary to attract capital to a particular investment, given the risks associated with that investment. In determining the discount rate, there are two sources of risk to be quantified: systematic and unsystematic. Systematic risk is the risk one must bear for taking on a risky investment in the market, which encompasses all available risky investments, including public and private equities, real estate, foreign currencies, etc. However, systematic risk is estimated by calculating the return to public equities due to availability of data. The ERM process has little impact on systematic risk unless the business’s performance is heavily tied to market performance, as was the case with Lehman Brothers and Bear Stearns in their final days.

Unsystematic risk is sometimes broken down into two components, industry risk and company-specific risk. Industry risk reflects the risks identified with the industry in which a business operates. Company-specific risk encompasses all other risks, including (but not limited to) size, depth of management, geography of operations, customer and/or vendor concentration, competition and financial health. This last component of the discount rate is one that portfolio companies can impact, and commensurately increase or decrease their valuation. Identifying and minimizing company-specific risks through an ERM process can positively impact the value of a business, as a company subject to less risk is more valuable than one subject to greater risks.

How can ERM processes mitigate company-specific risks and increase value?

An ERM process should quickly gather and assimilate high-quality information for use in the organization’s decision-making process, allowing the organization to rapidly assess the impact and likelihood of risks associated with changes in its internal and external environments. Early assessment and mitigation can help preserve value and cash in the business as well as allow it to capitalize on risky events when competitors do not react as swiftly to environmental changes. By capitalizing on risky events, portfolio companies increase the chance of improving their market share or establishing an industry-leading position. The ability to successfully mitigate risky events should be recognized by a valuation analyst through lower estimates for company-specific risks, leading to higher valuation estimates.

John T. Alfonsi, CPA, ABV, CFF, CFE, CVA, is a managing director of Cendrowski Selecky PC. Reach him at (248) 540-5760 or jta@cendsel.com.

Published in Detroit

Once strategic objectives are set by a company’s executive team and its board of directors, managers must move to enable the business’s operations to achieve these goals.

All businesses face risks in pursuing objectives. Operational assessments assist businesses in mitigating process design and execution risks associated with the achievement of the operational objectives.

“Operational assessments assist organizations in achieving their objectives by ensuring that strategic goals are appropriately translated into process design and execution objectives, and that the risks associated with the achievement of these operational objectives are mitigated,” says James P. Martin, CMA, CIA, CFE, managing director of Cendrowski Selecky PC. “Different procedures must be followed depending on which of these assessments is being performed.”

Operational assessments, however, are not without their own pitfalls. This month’s issue concludes a three-part series of interviews with Martin by examining frequent operational assessment pitfalls. Pitfalls pertaining to both process design and execution assessments are addressed.

Interested readers are encouraged to view Cendrowski Corporate Advisors’ Operational Assessment Guide, included in this month’s issue of Smart Business, as well as previous months’ interviews with Martin at www.cca-advisors.com/articles.php.

Smart Business spoke with Martin about pitfalls commonly encountered in process execution assessments and process design assessments.

What are some common pitfalls in process execution assessments?

One of the first steps in performing process execution assessments is interviewing employees. By conducting interviews, an assessor can determine the tasks that are performed by process operators, as well as the risk mitigation procedures they follow in performing those tasks.

Interviews, however, can present an assessor with misleading information and a potential false sense of security. For instance, an employee may be able to readily identify risk mitigation procedures associated with his or her tasks; whether or not the employee actually follows these procedures is a different story.

In order to guard against this issue, an assessor should not only interview process operators but also observe them as they perform their tasks. Observation will, preferably, occur after a professional rapport has developed between the assessor and the process operator, and the process operator feels comfortable in the presence of the assessor. If an operator is fully conscience of an assessor’s observation, and is uncomfortable with the observing party, he or she may alter usual behavior.

This is undesirable, as an assessor most wants to observe how a process operator conducts himself in the absence of out-of-the-ordinary supervision.

What are some common pitfalls in process design assessments?

A process design assessment examines risks that prevent the achievement of process design objectives and, indirectly, strategic objectives. A portion of this assessment involves the evaluation of the impact and likelihood of process design risks by process designers. (The impact associated with a risk represents organizational consequences in the event that the risk is realized, while the likelihood represents the chance or probability that the risk will occur.) Process designers may have differing views regarding the impact and likelihood of risks, and in some instances these differences may be significant.

When an assessor encounters such differences, it is essential that he take the time to examine the discrepancies, as well as consensus impact and likelihood values. When a process designer views a risk differently from his peers, he may have unique knowledge of a risk. This knowledge may arise from the designer’s intimate involvement with a process, his knowledge of the organization’s internal environment, or through other means.

No matter why they occur, discrepancies in risk estimates represent an important component of operational assessments, and one that assessors must carefully analyze and not gloss over.

Once an assessment has concluded, how can those who conducted an operational assessment ensure that recommendations and improvement plans are followed subsequent to the assessment’s conclusion?

Follow-through on recommendations and plans begins with the assignment of clear roles and responsibilities to team members who take charge of the improvement effort.  The success of an improvement initiative depends on the success of each individual team member; if one fails to achieve his or her individual goals, this failure may derail the entire improvement plan.

Monitoring by higher-level managers and/or the board of directors serves to mitigate this risk. In addition to monitoring, merit pay tied to the achievement of improvement items may be awarded to further incentivize leaders to achieve established goals.

What additional resources exist for organizations looking to perform operational assessments?

Interested parties should sign up to receive Cendrowski Corporate Advisors’ complementary Operational Assessment Guide at www.cca-advisors.com/operational-

assessments-overview.php. It’s an excellent starting point for any organization looking to perform an operational assessment.

James P. Martin, CMA, CIA, CFE, is managing director for Cendrowski Selecky PC. Reach him at jpm@cendsel.com or (248) 540-5760.

Published in Detroit

Expert witnesses are frequently used by attorneys in the courtroom.  While many qualified experts exist, the “right” expert can greatly assist counsel and the litigation with his testimony.

“An expert witness can offer testimony about a scientific, technical, or professional issue in a court case,” says John T. Alfonsi, CPA, ABV, CFF, CFE, CVA, managing director of Cendrowski Selecky PC. “Finding the ‘right’ expert is often a difficult task, but our experience demonstrates that attorneys generally look for several attributes when selecting an expert witness.”

Smart Business spoke with Alfonsi about what attributes attorneys generally look for in an expert witness.

What are some key attributes that an expert witness should possess?

In our experience, attorneys generally seek an expert witness (aka ‘expert’) who possesses at least four attributes: 1) relevant professional experience; 2) a history of testimony in which that person has represented both plaintiffs and defendants; 3) active involvement in his or her field of expertise; and 4) credentials.

Why are a track record of professional experience and a history of testimony for both plaintiffs and defendants essential qualities of an expert witness?

Opposing counsel may try to discredit an expert witness by demonstrating a lack of relevant business and/or courtroom experience. Though a potential expert may have years of experience, this does not necessarily mean he has a high level of expertise in the specific area of the case, or that his experience demonstrates the requisite unbiased nature that an expert must possess.

For example, some experts have only provided their services on behalf of either the defendant or plaintiff. Such a track record might be used by opposing counsel to infer a bias on the part of the expert, even if the bias does not exist; the appearance of bias in and of itself may undermine the expert’s testimony.

Why is active involvement an essential quality of an expert witness?

Active involvement often manifests itself in an expert’s writing and speech; both are key elements of his testimony. Experts who contribute to their field generally pride themselves on having a thorough understanding of the subject matter. They may be most up to date on recent rulings and opinions regarding relevant analytical techniques, and will generally ensure their testimony complies with these items.

Active involvement may also manifest itself on the stand in the expert’s ability to convey findings to nontechnicians, such as a judge or jury members. Experts primarily work with individuals who readily understand the technical terms and analytical methods of the field.  This peer group may be quite different from a judge or jury pool.

Involved experts will recognize this difference and have a profound understanding of their area of expertise, permitting them to successfully articulate their findings.

Do attorneys generally look for specific credentials in selecting an expert witness?

Attorneys generally engage experts who hold credentials in their field requiring the expert to pass rigorous tests, participate in continuing education programs, and/or possess significant, related experience.  In some instances, multiple credentials adhering to such criteria might exist within a given field.

For instance, business valuation credentials fitting the previously mentioned criteria include Accredited in Business Valuation (ABV), Certified Valuation Analyst (CVA), Certified Business Appraiser (CBA), and Accredited Senior Appraiser (ASA). No one credential is generally better than the other, but credentials generally emphasize the expert’s commitment to his profession and understanding of the technical issues.

Is analytical ability the most important attribute of an expert?

It is a key attribute, but sometimes not the most important. Though an expert may have strong analytical abilities, it is important that he be able to articulate his findings in a clear and concise manner, both on the stand and in written testimony.

In a recent U.S. Tax Court case, Estate of Gallagher v. Commissioner, the presiding judge faulted the taxpayer’s expert witness numerous times for failing to adequately explain his analytical methods and resultant conclusions included in his business valuation. Thus, in spite of the expert’s analytical methods, the court found his arguments less persuasive than those of the opposing IRS expert.

To specifically address this issue, some experts purposefully make liberal use of visual tools, including graphs and flowcharts, in reports and include detailed explanations to ensure findings are well articulated and written at a level that non-business professionals can fully comprehend.  These experts might also assume a reader has little-to-no prior knowledge of the technical aspects of the case, or of the analytical methods employed.

This strategy helps ensure a reader or listener will not be confused by necessary technical jargon or methods that might otherwise be nonintuitive to a layperson.

John T. Alfonsi, CPA, ABV, CFF, CFE, CVA, is a managing director of Cendrowski Selecky PC. Reach him at (248) 540-5760 or jta@cendsel.com.

Published in Detroit

When President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) on July 21, 2010, it was one of the most sweeping changes to financial regulation in the United States since the Great Depression.

Among other things, the act created the Financial Stability Oversight Council, whose role is to identify and respond to emerging risks that may pose a threat to the U.S. financial system. Members of the council will include the secretary of the Treasury, the Federal Reserve Board and SEC administrators.

Dodd-Frank applies to all public, nonbank financial companies, as well as larger public bank holding companies. However, the act’s implications can and should be used as best practices in other types of organizations. For example, private companies can benefit by implementing risk management processes in the same vein as those discussed in the act. Dodd-Frank also affects all federal financial regulatory agencies and almost every aspect of the nation’s financial services industry.

On May 25, 2011, the SEC adopted final rules implementing whistleblower provisions of Dodd-Frank. While politicians and practitioners have touted the Dodd-Frank provisions as an advancement in corporate governance, these provisions may provide less incentive for whistleblowers to come forward in tax-related matters than the existing rules on which they are based, the Internal Revenue Code, says James P. Martin, CMA, CIA, CFE, managing director of Cendrowski Selecky PC.

“More specifically, whistleblowers may elect to report unlawful actions to the IRS as opposed to the SEC due to greater perceived anonymity and monetary rewards, a lower materiality threshold for tax assessments than financial statements and the administrative structure of the IRS and SEC whistleblower programs,” says Martin.

Smart Business spoke with Martin about Dodd-Frank and how it affects whistleblowers.

What types of pressures do whistleblowers face?

Whistleblowers often face significant pressure to remain quiet rather than report unlawful actions. Recent studies indicate that between 82 and 90 percent of whistleblowers are fired, quit under duress, or are demoted. Competitive employers have blacklisted more than 60 percent of whistleblowers.

For individuals working in a geographical area with few employers, or in an industry with little competition, the effects of whistleblowing can be substantial. Whistleblowers may find themselves ostracized by local, regional and national businesses for their actions. They may also face adverse social consequences.

How are these pressures mitigated by legislation?

Many whistleblower laws have anti-retaliation provisions. For example, whistleblower provisions of Dodd-Frank provide for anti-retaliation protection and state that the SEC will protect the identity of the whistleblower to the largest extent possible. However, a whistleblower must satisfy numerous conditions to receive these benefits — arguably more conditions than the Internal Revenue Code on which Dodd-Frank is based.

Many whistleblowers may not come forward because they might assume they will eventually be exposed. Whistleblower laws also incentivize individuals to come forward by offering them a bounty reward in the event that a governmental body successfully recovers monies.

How does Dodd-Frank compare to existing IRS whistleblower laws?

With respect to Dodd-Frank, the SEC must pay an award of between 10 and 30 percent to eligible whistleblowers. Section 7623 of the Internal Revenue Code, however, mandates a whistleblower award of between 15 and 30 percent of the amount recovered by the IRS. Thus, the IRS is required to minimally pay a 50 percent larger award than the SEC for information resulting in successful enforcement of unlawful actions.

Existing IRS whistleblower laws are also more favorable than Dodd-Frank due to the concept of materiality. In enforcing securities laws (including the Sarbanes-Oxley Act of 2002), the SEC is largely concerned with matters that are material to financial statements. The concept of materiality thus constrains the SEC’s actions. If the SEC feels an item is immaterial, it may forego investigation of the issue, and the whistleblower will not receive a monetary reward. The concept of materiality, however, largely does not apply to tax assessments.

As such, a whistleblower with knowledge of tax issues is incentivized to report the issue to the IRS as he or she is unconstrained by the concept of the materiality; the IRS may elect to investigate an issue that the SEC would otherwise not investigate.

How do the SEC and IRS differ in their administration of whistleblower claims?

Currently, the SEC lacks an independent whistleblower office to handle tips, whereas the IRS has a separate, independent whistleblower office, which serves as the central repository for all whistleblower claims. The director of this independent office reports to the IRS commissioner, decreasing the possibility that a claim remains uninvestigated by lower-level IRS managers. The IRS’s organizational structure, with its separate whistleblower office, may incentivize potential whistleblowers to report their concerns to the IRS as opposed to the SEC.

James P. Martin, CMA, CIA, CFE, is managing director for Cendrowski Selecky PC. Reach him at (248) 540-5760 or jpm@cendsel.com.

Published in Detroit