Can You Delegate Your Due Diligence?
Business valuation (BV) experts have standards they have to follow during a business valuation engagement. The three most important standards are: The General and Ethical Standard, the Development Standard, and the Reporting Standard. The Development Standard of the National Association of Certified Valuators and Analysts (NACVA) sets the steps that every valuation expert should take to derive a conclusion of value that is replicable and trustworthy. The Reporting Standard on the other hand, determines what goes into the report to meet the requirements of a given type of valuation except litigation. The General and Ethical standard sets the overall values that must guide every expert in the exercise of his/her profession. One of the key steps in the Development Standard is the site visit and management interview. Some BV experts delegate this important responsibility to either their staff or a different BV analyst in their firm and believe it or not, in another unrelated firm. Is this acceptable? Is this ethical? Is this professional? My answers are No, No, and No.
My Opinions on Site Visits
I have been a business valuation expert since 2012 after getting my CVA from NACVA. I have done many valuations since then and strive to make sure I always abide by NACVA standards, not because I am obligated, which I am, but because I love the structure it provides for my engagements. In my opinion, the most exciting part of the engagement is not getting the engagement letter signed, but the site visit and management interview. I believe that it is the most important aspect of an engagement. Having the opportunity to visit the business location and interact with the employees, the lower and higher levels of management, as well as checking out the various machines, tools, environmental and safety aspects of the business, and everything else that helps the business run effectively. What puzzles me is that some BV experts delegate that responsibility to others in their firms and worse, to others outside their firms, and they do not find it unethical.
Facts and Case Law
I was asked by a friend and fellow BV expert to do a site visit for him in a restaurant that is not too far from where I live. I was first bewildered by the request, I started stuttering and became nervous as I asked him again if what he was asking me was to do a site visit for him? He confirmed that it was exactly what he was asking me. I said, “absolutely not.” That is not possible for various reasons:
It is his valuation engagement and he is paid to do his due diligence and not delegate this very critical task to anyone.
I consider the site visit to be a critical part of the valuation engagement and, thus, should be handled with the utmost care as this is our opportunity to share with management our concerns and get clarification on a variety of issues that are found during the analysis of the company’s tax returns, financial statements, and other documents.
It is natural to me to talk to business owners as a former banker who loves working with businesses to support their growth strategies. I always look forward to meeting the staff and management of a business but I understand why some experts may not be at ease interacting with them. Hence, the need to delegate their most important responsibility to a third party whether internal or external. Nonetheless, that may be unethical.
As I state in my book, 30 Frequently Asked Questions In Business Valuation (Ekeu, 2017), on page 52, Question 21:
“It is essential for the analyst to conduct a site visit because besides attesting to the physical existence of the business, the site visit also can enhance the understanding of such factors as the subject company’s operations, the efficiency of its plants, the condition of its equipment, the advantages and disadvantages of its location(s), the quality of its management, and its general and specific strengths and weaknesses.”
Shannon P. Pratt, when discussing the relative importance of site visits/management interviews in his book, Valuing Small Businesses and Professional Practices (Pratt, Reilly, and Schweihs, March 1, 1998) states:
“[F]or valuations subject to contrarian review (which most are), courts are becoming quite sensitive to the importance of site visits and management interviews. Many clients and attorneys dismiss or downplay the importance of a site visit and/or don’t want to incur the interruption or the cost of the analyst’s time for it. We prefer to make site visits and conduct management interviews. In our experience—as well as in many court cases—the site visit not only helps the analyst get a better perspective, it makes a difference in the analyst’s credibility in the eyes of the court.”
Dr. Pratt also addresses cases where the intended user of the report is unfamiliar with the business or has never seen the facilities in question. He indicates:
“If the analyst will need to communicate some description of the operations, facilities, or both to someone lacking the opportunity to visit the facilities, such as a judge in a court case, it may be desirable to take a set of pictures while on tour.”
It is widely accepted in the valuation profession that a site visit/management interview is a very important part of the valuation process, and is, in fact, imperative if an appraiser is to perform a complete analysis of the operations of the company being appraised.
To further understand how adequate due diligence is important, it is worth reading the Kohler v. Commissioner (2006), Tax Court case. There, the U.S. Tax Court criticized the IRS expert for limited due diligence related to site visits and short management interviews.
“we are convinced from his report and trial testimony that [the IRS expert] did not understand Kohler’s business. He spent only 2.5 hours meeting with management.”
Whereas the estate’s expert spent 3.5 days on a site meeting with employees and management. The Court stated that:
“[Estate’s experts] spent sufficient time with the company and management to understand the Kohler business.”
NACVA has standards that govern the site visits and management interviews.
The General and Ethical Standard stipulates that:
“A member shall perform professional services in compliance with the following principles: integrity and objectivity, professional competence, due professional care, understandings and communications with clients, planning and supervision, sufficient relevant data, confidentiality, acts discreditable, client interest, documentation, and financial interest.”
The Development and Reporting Standards in the “Scope Limitations” sections, give the expert the opportunity to share any limitations of the scope of work they encounter during their engagement and document them in this section of their report. That includes the inability to perform a site visit and/or management interview that could be material in determining the value of the company.
I firmly believe that this responsibility is very important and requires the BV expert to be present during this step and not delegate it to someone who may not understand the full picture of the business operations. Furthermore, the management interview not only helps understand the history of the business, its compensation policy, its market, and marketing policies and plans, its labor relations, its regulatory relations, its supplier relations, its inventory policy, its insurance coverage, its reasons for deviating from industry or guideline company norms, and its off-balance-sheet assets and/or liabilities; it also allows the valuation expert to investigate:
Management’s perspective on the company’s position in its industry;
Any internal or external facts that could cause the future results to differ materially from past results;
Prospects, if any, for the liquidity event (sale of the company, public offering of stocks, etc.);
Why the capital structure is organized as it is, and any plans to change it;
So, it is very clear to me that site visits are a critical aspect of a business valuation engagement that must not be delegated to anyone. The valuation expert must be present and accompanied by additional staff if necessary.
Ekeu, A. (2017). 30 Frequently Asked Questions In Business Valuation. Washington DC: The Washington Valuation Group.
Herbert V. Kohler, Jr., et Al., Petitioners v. Commissioner of Internal Revenue, Respondent, 4621- 03 (United States Tax Court July 25, 2006).
Pratt, S. P., Reilly, R., and Schweihs, R. (March 1, 1998). Valuing Small Businesses and Professional Practices. McGraw-Hill Education; 3rd Edition.
Achille Ekeu, MBA, CVA, is the President and CEO of The Washington Valuation Group, LLC who just arrived at the end of his three-year term serving on the Valuation Credentialing Board (VCB) of the National Association of Certified Valuators and Analysts (NACVA). He is currently the State Chapter President of NACVA for Maryland and Washington DC. Mr. Ekeu is the Author of a book titled “30 Frequently Asked Questions in Business Valuation”. He focuses on business valuations for tax, transaction, and litigation purposes. He was just recently appointed by Court Order on a big litigation case in Baltimore City, Maryland.
Mr. Ekeu can be contacted at (240) 274-9570 or by e-mail to firstname.lastname@example.org.
Note: This article was first published in the QuickRead Journal on June 24, 2021. QuickRead is a peer-reviewed professional journal of The National Association of Certified Valuators and Analysts (NACVA).