Sunday, September 24, 2006

Governance 101

We will leave it to the punditocracy and talking heads to pound Hewlett-Packard Co. (NYSE: HPQ) into the ground over the dust-up that culminated on Friday in the resignation of its non-executive chairman. Governance is an essential, but often ignored, aspect of closely-held businesses, which is where we hang out most of the time. Herewith, some pointers for small-business owners from the sorry saga at H-P:

1. Forget trying to muzzle employees, officers, and directors. If the President of the United States can't keep his closest aides zipped up, what makes you think that you can?

2. Get bad news out ASAP. The longer it drags out, the worse is the impact on the company, its people, its customers, and its operations.

3. Absent violations of the law, don't spy on your own people (compliance with email policies being the conspicuous and obvious exception to this admonition). Invading their privacy undermines trust, the strongest cultural characteristic that any organization can have. And when you're found out, as you invariably will be, even in a small company, you look ridiculous. If you want to know something, why not ask?

4. If you want to investigate your people, form a special committee. It should have a strong majority of outsiders who have no personal or political stake in the outcome. That ensures that the result can pass the straight-face test.

5. A non-executive chairman should be just thatnon-executive. That means that s/he doesn't get involved in policy decisions, except as part of the deliberations of the Board itself. It means that s/he doesn't collaborate with counsel (in-house or corporate) to hire private detectives.

6. If you haven't already done so, activate your own Board (or Council of Advisors). You'll be glad you did. Make sure there's a majority of outsiders, and be sure to put no more than one crony/bridge partner/golf buddy on it.

You will find the links below helpful.

The Board of Directors in the Closely-Held Business:
Part I Part II Part III Part IV

Owning a company gives you rights, of course. . .but it doesn't make you right. Big difference.

Thursday, September 07, 2006

Should PCAOB Pronouncements Be for All Public Companies, or Should There Be Different Rules, Depending on Size of Firm?

There are some breast-beating free-enterprise types out there these days who fancy themselves as defenders of capitalism. They're easy to spot because they want to exempt smaller public firms, at least for a while (they'd deny wanting the exemption to be permanent, but they'd be lying), from Sec. 404 of SOX. That is the section of the Sarbanes-Oxley Act of 2002 that sets out tough standards for internal controls to be assessed by independent outside consultants. These so-called free-market types argue that the standards are too onerous, compliance is too expensive, ad infinitum, ad nauseam. Heifer dust. Only those whose hat size exceeds their IQ will buy into that.

Here's why: hard data going back to 1926 from Ibbotson Associates ( show clearly that, on balance, smaller firms are far more risky than larger ones. Yes, in any large population, there are going to be outliers (exceptions), but that's just the nature of normal distributions. The magnitude of the risk difference, which, for sake of simplicity we will restrict only to Ibbotson's "size premium," is anywhere from 430 basis points to 983. That translates to a cost of capital that is anywhere from 41% to 94% higher. Since risk and value move in opposite directions, the effect of the size premium is, assuming efficient markets (no sure thing), to reduce a firm's value by anywhere from 29% to 48%, all things being equal.

The size premium is just one of four sources of "unsystematic risk." Unsystematic risk, a.k.a. "diversifiable risk," is not everything. It is, to borrow from Vince Lombardi, "the only thing." Small firms tend to have lots of unsystematic risk--not much in the way of slack resources to absorb unpleasant surprises, less talented managers (even though we assume they're well-intended), less in the way of rationalized infrastructure and IT systems, less-involved and question-asking directors, and so on. Big firms, in contrast, tend to have almost no unsystematic risk at all.

The solution of these misguided, self-styled defenders of small firms, then, is to increase their risk even more by not having their internal controls subjected to the same kind of rigorous examination and testing to which big firms' controls are. Only someone who's been inhaling the anti-business party line in some quarters would believe that the "little guy" is being picked on here. He's not. In fact, if anyone should be exempted from the PCAOB's regulations for a while, it's the BIG guys. They're no threat to most investors. Many smaller companies are--just look at the volume of restatements. What a concept.

Think about it: If most of the risk is in smaller companies, why not concentrate scarce regulatory and auditor resources there, where it's needed? To the extent that there are crooks in business, they appear in far greater numbers at the small end of the economic food chain than at the large end. Only phony populists, toadies, economic ignoramuses, and hack politicians believe otherwise.

Ignore 'em. They're worrying about their hairstyles when their feet are on fire. It's generally the same group of misguided flaks and suck-ups we saw in the late 1990s when FASB, supported by then-SEC Chairman Arthur Levitt, proposed quantifying the value of stock options. Silicon Valley and self-designated defenders of entrepreneurship went nuts. You'd've thought they called Mother Teresa a hooker. They said options weren't worth anything. (If that's true, then just hand 'em over to me. I'll bet I can find a use for them.) But if they're worth something, and they were given to an employee, then that's an expense where I come from.

I have lots of good company. None other than Warren Buffett has noted repeatedly, "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And if expenses shouldn't go into the calculation of earnings, where in the world should they go?" Hear, hear.

The FASB, supported by the courageous Bill Donaldson at the SEC, finally got with the program post-Enron and asserted what should have been de rigeur 20 years ago: most options do, by golly, have value. The fact that said value is tough to measure doesn't change a thing. Managements that don't understand the complexity (and the cost) of measurement shouldn't be using these tools in the first place. It's like giving guns to children. Ugly things happen to innocent people. Besides, TANSTAAFL (There Ain't No Such Thing As A Free Lunch)!

Sunday, August 13, 2006

Getting in at the Shallow End of the Blog Pool

I'm launching this little endeavor on a beautiful Sunday morning in mid-August 2006. I'm looking out my office window right now at 35 miles of the Blue Ridge stretching down a verdant and fertile valley. Joke-lahoma, from whence we fled in 1997, was never like this. Life is good.

This blog has several objectives:
  • to create a documentary trail for the evoluation of my thinking about the nexus of valuation and strategy;
  • to encourage participation and comments from serious valuation professionals and other informed observers; and
  • to comment on what I see as the commendable, as well as the not-commendable, developments occurring in our rapidly-changing professional space
Unfortunately valuation has approached "commodity status" in most contexts. It has done so for two primary reasons: (1) rapid growth in demand for valuation for compliance purposes (esp. for financial reporting) and (2) a large influx of individuals with almost no clue of what they're doing. Aided and abetted by certain professional organizations that care more about lining their own pockets with annuity streams of income than they do about serving clients, the latter cadre has so far escaped the malpractice actions they richly deserve because few clients are capable of distinguishing between competent and incompetent valuation work. I'll have more to say about this in later posts.

We strongly believe that the emphasis, whenever possible, in valuation services should be on adding value in excess of what we charge. Sometimes that's not feasible--when there is "opposing counsel," for instance. But most of the time it's doable if only the professional is capable of doing so. That is where we part company with most, but certainly not all, in this community. Too many CPAs think valuation is about accounting. It's not. To be sure, accounting knowledge is a great insight to have in valuation. . .but only if one does not think like an accountant. That's lethal and a disservice to clients.

The greatest reservoir of tools for adding value comes from the literatures of strategic management and, to a lesser extent, of industrial organization (a branch of economics) and of organization theory. We drew heavily on all three, as well as innovations that we have brought to our own practice of valuation, in creating the CAVSMVP course. Our thinking is not entirely fleshed out, though, and wanting a platform through which to do so is a major driver for the creation of this blog.

More to come.