Dave Lorenzo (00:00:00):
John Alfonsi is the managing director of Cendrowski Corporate Advisors, where he brings over 30 years of experience in tax and advisory services. He focuses his practice on business valuation and economic damages, as well as tax planning and consulting for pass-through entities. John is a recognized financial expert in federal and various state circuit courts, and he's also an adjunct professor where he teaches master's degree courses in taxation and valuation. He's a contributor to, the Value Examiner and various other publications, and he's appeared at numerous business conferences now straight from the ballroom in the Tangiers Hotel. Please put your hands together and welcome John Alfonsi, two, the high net worth advisor meeting. John, good morning and welcome back. Thank you for joining us again today.

John Alfonsi (00:00:56):
Good morning, Dave, and good morning. I guess it's still morning for everybody, even us here on the East Coast. Thank you for having me again. Hopefully, I didn't scare away too many people last month. I will try to be a little more succinct, Nicola today with my answers. So it's just once I get on a roll. I love this and I love talking about valuation.

Dave Lorenzo (00:01:21):
We've got nothing but positive feedback, John, and everybody has told us how the detail that you provided in the last interview was fantastic. So do not cut us. Do not sell us short. Do not cut things short. I'm going to let kick it off now. Nicola. Take it away.

Nicola Gelormino (00:01:37):
Good morning, John. Yes, please don't worry about being short. It is obvious that you are a professor in the way that you want to explain these concepts, and I think you did an excellent job the first time around. So we are looking forward to our discussion with you for part two. When we first met, you identified a business valuation as a determination of the present value of future economic benefits, and you really focused in on future cash flows in your discussion. So I'd like to start there. I'd like to start with cash flows, and I'd like to start with asking you why cash flows are so important and tell us what a cashflow analysis is as you perform it in the context of valuation.

John Alfonsi (00:02:17):
Sure. So a lot of times when you hear valuations of publicly held companies, it's always driven off of earnings. What the Wall Street people focus on is earnings. So you have a price earnings multiple when you're dealing with a closely held business, a privately held business. The single economic benefit that matters most to any business owner is how much cash can I take? How much cash can this generate? How much cash can I put in my pocket? So that's why we focus on cashflow rather than, I'll call it gap earnings as being that economic benefit. It truly is. Cash is king. That can't be any more true in a privately held business. So from a, what do we look at? So there's really three primary financial statements that we would look at an income statement or a p and l, a balance sheet, and the third one is that cashflow statement, which is an analysis of where the cash is coming from and where it's going.

(00:03:28):
So we talked about EBITDA last time, earnings before interest, taxes, depreciation, and amortization is kind of a proxy for cashflow from operations, but we have to make certain adjustments to that, especially if it's on an accrual basis because not every sale that you make generates immediate cashflow. So we have to look at accounts receivable. We don't typically pay all of our expenses as they come due, so there's some accounts payable. So the nets of those two plus inventory that has to be reinvested is what we refer to as working capital. So there's a working capital adjustment that has to be made to the cash flow, and that becomes important in the valuation because I'm not stealing your thunder, but I know there's a question later on. We were talking about working capital, but all of this kind of ties in together because when you're selling a business, a buyer has an expectation of receiving a certain amount of working capital that if I buy your business, I don't want to have to put any more money into it.

(00:04:35):
I need to know that it's going to generate cashflow 30 day periods, three month period, whatever timeframe that is in order to generate. So when you deliver a business, to me, there's an expectation of what that level of working capital is and working capital is going to be different for different businesses and for different people. So I'll leave the discussion of working capital a little bit of how we get to that or why that's particular of interest to a buyer, but that's one adjustment. We also look at how much borrowing, so how much does the company have to borrow in order to generate the cashflow in order to operate? If there's a large amount of borrowing that happens every single year, I don't want to call, it's a red flag, but it's something that needs to be factored into in the risk. And ultimately your capitalization or your discount rate, your cost of capital with respect to that.

(00:05:35):
And then where is the money going? Ultimately, we like to think that as much cashflow that the business can generate, hopefully from operations as possible, possible is going to be available for distribution. But there's another component that goes to that, which is capital expenditures. We have to reinvest back in the business. So ultimately what we're looking at, especially if you're valuing this, we talked about last time, valuing the business as a whole without regard to the capital structure of a particular business. So as we're comparing, so we look at debt-free cashflow, cashflow that's available not only to the debt holders, but cashflow available to the equity owners. And when we look at that, then the components then that we have to pull out is what do we expect to be reinvested back in the business as far as capital expenditures? That means how much is available truly to the debt holders and to the equity holders. Those two components are what we're looking at to determine the value of this business.

Nicola Gelormino (00:06:48):
So you've touched on already, John, that future cashflow component. So talk to us about how the historical versus the future cashflow components get factored into your analysis.

John Alfonsi (00:06:58):
Absolutely. So we will always start, especially if it's an existing business, we're going to look at historical cashflow and historical operations in order to get an idea of how the business has operated. So if the business is a mature business, then we'd like to look at historical information as a predictor of future results. And as any wealth advisor or stock trader going to tell you, future past results are no indication of future results, but we have to have a basis for doing that. But you need to ask the questions as well. We ask the business owner, is anything going to change? Did they introduce a new product? Did they discontinue a product so that historical cashflow isn't going to look the same? So we need to know, we can start with the baseline of what's happened historically, but then you can't just put your blinders on and say that's what's happened. That's what's going to happen in the future. You kind of ask the questions, does the business plan on growing? Is it organic growth? Is it acquisition growth? Are you curtailing something? Are you entering new markets? All of that plays into then looking at what had been done in the past and tweaking that, if you will, coming up with a financial model, both an income statement, a balance sheet and cashflow. Best way to figure out what the future is going to look like.

Nicola Gelormino (00:08:36):
So what about a business that doesn't have as much historical cashflow data as another one? We're talking about a mature business. What about those ones that aren't quite as mature? How are you looking at those when you don't have that data?

John Alfonsi (00:08:48):
Sure. I do quite a bit of valuations for, I'll call 'em startup companies, early stage, second stage type companies. I don't really care what's happened in the past for those companies because that has no basis, no predictor of what's going to happen in the future. So in that situation, I rely heavily on projections or forecasts for management, and if they don't have 'em, then I help them put those together because in that situation, I can't rely on the past. I can only rely on the future. And obviously in those types of companies, it factors into then the discount rate because there's additional risks in those types of companies. Not only do you have risks with respect to the company achieving the results or successfully launching their product or service, but then you've got projection risks as well. And there's different ways of handling projection or forecast risk.

(00:09:55):
You can do a probability weighted model or if somebody just gives you a number and you somehow have to say, okay, well there's lots of risks including in that, so that's why I'm going to have an extremely high discount rate. But in those instances, and in fact, I just did one where I asked the company for their old tax returns and he didn't want to give 'em to me. I mean, I'm assuming it's because it was going to look really, really bad, and I had to tell him, I don't really care what it looked like in the past. I get it. Every startup company loses money at the beginning. It's kind of that J curve you're going to go, and then hopefully it's going to curve on up. But I still like to know where are you spending your money? How much of it is in product launch beta versions of whatever it is that you're selling versus ongoing normal type of expenses. In the venture capital and PE world, we're all concerned about the burn rate. How much cashflow are you burning through on a regular basis?

Nicola Gelormino (00:11:04):
Well, John, cashflow is king, right? So how is that showing us when you're looking at cashflow, how is that showing us the health and the viability of business rather? What is it telling us about that?

John Alfonsi (00:11:16):
That was one of the points that I was saying. If you look at the cashflow statement, it's going to break it down typically in a gap basis, cashflow statement, there's three components. There's cashflow generated from operations. Well, if it's that's positive, then that's a good thing. That's telling me that there's cashflow that's being generated through its normal business operations. Even making all of those working capital adjustments. There's cashflow from investing activities that tells me how much cashflow has been reinvested back in the business with respect to CapEx, product development, things like that, where they otherwise get capitalized onto a balance sheet that tells me, and again, historically, they may have to have to spend a lot of money in the past, but they may not have to spend that much in the future, but you got to ask the questions, plus I need to know where they're at.

(00:12:16):
It helps us give us an idea. But the question I usually tell people is, if you had to put away money, kind of like a rainy day or a slush fund in order to fund your capital expenditures, how much would you have to set aside a year? That's important to me because on my future cashflow, then that's a drain that I otherwise have to take into consideration. That's cashflow. That's not available to the owners or to any of the capital holders, debt or equity because it's going to be reinvested back in the business. And then that third piece is cashflow from borrowing activities, and that's where we like to see how much do they have to borrow in order to fund operations? What are they borrowing for? Is it for the CapEx? Not necessarily a bad thing, as long as you're not overextending your credit, but if you have to borrow consistently and constantly in order to fund losses that are generated from operations, then that's a problem. That's telling me that it's a much riskier business, and then somehow even in my cashflow, I have to adjust my discount rate. Their rate reflects the risks. That says at some point you can't keep borrowing in order to fund operational losses. People just aren't going to have an open checkbook and just keep loaning you money at some point. That very first chunk has to be positive.

Nicola Gelormino (00:13:53):
John, you mentioned capital expenditures, so I'm going to turn this over to Dave. I know he wanted to ask a question about that since that has come up.

Dave Lorenzo (00:14:02):
Yes, I lie awake at night thinking about capital expenditures, so I'm glad that you've given me this opportunity to dispel some of my fears. What I'd like to do before we get into that is I want to take some questions from the chat because this is what's relevant to the people who are in our audience right now. So John, we talked in our last segment in the previous interview that you did, you talked about how the economy can have an impact on valuations. We also talked about the different valuation methodologies, right? And we talked about the fact that there's a difference, and those of you who have not had a chance to listen to the first interview yet, let me summarize for you, there's a huge difference between the way you value a business for a divorce than with the way a business is valued for the sale of that business.

(00:14:54):
And a business may be valued differently to a strategic buyer than it would be valued to say, a private equity fund who needs that business as a platform, even within a private equity fund. A business that's valued as a platform may be more valuable than a business in the same industry, the same type of business if it's a bolt-on. So valuation is art and science, but we have one question in the chat that's particularly interesting. So the question in the chat is that there are a number of different types of valuation reports using multiple methodologies. How do current economic conditions impact the valuation methodology and the overall valuation of the company?

John Alfonsi (00:15:42):
Great question. So there's typically three acceptable, not accepted, three primary ways of valuing a business, an income approach, a market approach, and an asset approach. Forget about the asset approach for right now, because typically for holding companies or companies that aren't generating positive cashflow, so typically we're looking at an income approach and a market approach. When we're using a market approach, we want to make sure that we're focusing on current multiples of what businesses are selling for because valuation is a value as a specific point in time. That's our valuation date. So we want to make sure that we're looking at sales that are occurring in a relatively nice timeframe if we can find those during that timeframe. So we have databases that we can go to. There's numerous firms that generate studies that accumulate that and publish all of that. And typically it's when I was in Miami speaking at the mid-market capital symposium, we talked about multiples, and what we were focusing on was what happened to those market multiples in 2023.

(00:16:56):
So yes, those are going to reflect current economic conditions. When we looked at those multiples, we saw that the first half of 2023 was much higher than the multiples in the last half of 2023. What happened in the middle of 2023, interest rates went through the roof. So the cost of borrowing became way more expensive. Your cost of capital became more expensive, which drove down values and those multiples. So we want to make sure that we're not looking at old stale data that is indicative of economic conditions as then if they're not comparable to what's going on now.

Dave Lorenzo (00:17:41):
Okay, so let's do this as well. So there's a couple of questions about specific types of assets, specific classes of assets and their impact on valuations. So I think it would be helpful. Again, you don't have to go into as much detail as you did in the first interview, but because it's come up again, I want us to make sure that we cover it right. First and foremost, I think we got about 30 intellectual property attorneys in the room here today. So I want you to talk about different specific types of assets and when you would separate them from the valuation of a company. Okay, we can talk about IP and then I want to talk specifically about the treatment of real estate as well. Do we treat real estate as a separate asset and valuation? Do we include it in the overall valuation of the business?

(00:18:31):
And then tertiary to that. The third part of this question, professor, is leased real estate versus owned real estate. So equity in the real estate versus not having equity in the real estate. But if the real estate is leased and it's essential to the business, how does that play into the value? I will guide you through each part of this question so that you can be comprehensive in your answer. Take the IP aspect of it first, IP central to the business, how is it valued? And then IP separate from the business, how would you value it?

John Alfonsi (00:19:01):
Sure. So when you say central to the business with any ip, there's going to be internal use ip, and there's going to be, I'll call it revenue generating ip in using an income method, the presumption is the cash flows that the business generates encompasses the value of all of the assets. So implicit in that is the value of the ip. I don't have to break out the IP specifically from the value of the overall

Dave Lorenzo (00:19:34):
Business. I think you need to say that again because that's so important, right? The cash flow encompasses the value of the ip. Yes,

John Alfonsi (00:19:42):
Absolutely. So many times I'm asked to separately value the ip, whether it be for a sale of that IP or when somebody purchases a business, whether it be for GAP or for tax purposes, sometimes we have to do what's called a purchase price allocation. That's when I have to allocate the value of what the business sold for that entire pot and then allocate it to specific classes of assets. That's where I would get in and specifically value the ip. A lot of times when we're looking at it though, from a market perspective, its value is couched in terms of usually two components, especially whether there's significant ip, a multiple of recurring revenue plus the ip. That's a common way of doing it from a market perspective. But if I looked at it from an income perspective, both of those are generating, as you said, Dave, that one pool of cashflow.

(00:20:50):
That's the generator of the value of the business. I don't need to know specifically where it came from unless somebody's doing an analysis of the business that says, am I utilizing my IP correctly? And this is, I think what I mentioned last time, I'll just again reiterate it. People always say, I need to protect my ip. Well, really you want to protect your valuable ip. So that's an instance where you'd want to know the value of each component of your ip, which ones are more valuable than that? If something is not necessary to run your business and you really don't see much value in it generating cashflow, why spend a lot of money trying to protect that focus on what's important.

Dave Lorenzo (00:21:42):
Now, let's talk specifically about real estate. Okay. Now, I think implicit in this question is the assumption that the underlying business owns the real estate. So let's start there. I know there's a separate question about lease real estate, and Sheldon makes a point, which I'll emphasize in the chat in a minute. Let's say the real estate is owned by the business, the real estate is an asset for the business. Is that real estate? Is it assumed as part of the cashflow that's part of the cash, the cash cashflow is inclusive of the value of the real estate as well, or is that broken out separately?

John Alfonsi (00:22:25):
Alright, so let me start by putting my tax hat on and saying, don't ever keep the real estate in the operating.

Dave Lorenzo (00:22:32):
I know, listen, we're not talking about for tax purposes, asset protection purposes. You always want to, of course, but

John Alfonsi (00:22:40):
That's part of the reason, and that gets to my answer, which is the value of the real estate is a separately conveyable asset that is separate and apart from the business because you can go and lease that real estate and still continue to operate your business. So it's not really necessary as a value of an asset, and typically real estate hopefully is an appreciating asset. So from a valuation perspective, what I would typically do is remove the expenses that relate to ownership of a real property and add in an expense for a reasonable or a market lease or rent rate, and then add the value of the real estate to the value of the business because there's really two separate valuable assets there, the operations of the business, which reflect lease rates for the real estate and then the true value of the real estate.

Dave Lorenzo (00:23:41):
Okay, so there's a separate question that as I'm reading the dissertation that people are posting in the chat. There's a separate issue that comes up. What happens if my business is dependent upon the ability to take down more real estate in order to grow the business and for whatever reason, I'm landlocked, right? I can't get more real estate, or the real estate that I'm going to be able to get is not going to become available for two or three years or five years, and that's going to hamper my growth. Is that taken into the present value of the business or there's no way to factor that into the present value of the business?

John Alfonsi (00:24:23):
No, absolutely you do. And that ties into Nicole's questions on cashflow, which is if this company is growing and you don't have the capacity with your existing facilities in order to support that growth, what more are you going to do? Is it going to be additional capital expenditures? Do you have to go out and buy new facilities or fund an expansion? Or can you go out and lease new facilities? That expense should be factored into that future cashflow for purposes of that valuation. So one of the questions that we always ask is, do you have capacity issues? If you think you're going to be growing 10, 15% a year for however long, do you have the necessary facilities and capital and equipment in place in order to fund that growth? If not, then yes, we have to factor in either a drag on cash flow for additional capital expenditures or drag on cashflow for additional lease operating expenses.

Dave Lorenzo (00:25:23):
Alright, now John, let's talk a little bit about valuing businesses and the different elements of business value, the drivers of business value. So there's 10 drivers of business value that we focus on here at Exit Success Lab. Each one of them has an impact on the value of the business. So what I'd like to do is I'd like us to start first and foremost by discussing diversity in revenue and its impact on business valuation. So now I think of diversity of revenue, I think about it in three different ways, and I'm curious to hear how you think about it and how it impacts the valuation of a business. So the first thing I think about is our four types of business of revenue and the four types of revenue and diversity in each of those four types. So transactional revenue, basically ad hoc revenue, I think about repeat revenue and recurring revenue.

(00:26:24):
And I also think about passive revenue. So when I think about diversity in revenue, that's the first thing I think about those four types and how it impacts. I also think about industry diversity. So if all of my customers are coming from one particular industry, does that impact the valuation? I think about geographic diversity of revenue. So if all of my revenue comes from Florida and Florida's hit by a hurricane, is my business closed? Is it over? How does that impact the valuation of the business? So those are some of the things I think about when I think of diversity in revenue. Talk to us about how diversity in revenue impacts the overall evaluation of the business and how do you think about diversity in revenue?

John Alfonsi (00:27:08):
Sure. So I would view it the same way you do Dave, as far as the four components, but also geographic customer concentration, things like that. First off, how is that reflected in the forecast or the projection of cashflow that I'm otherwise utilizing from there though soon that everyone says, oh, I got great customer relationships, it's all great. There's obviously, IT factors into on the risk side, the discount rate, whether you capture it as a company specific risk premium. So when we're talking about a discount rate, let's just start with the baseline that we typically would use using a buildup approach, not in a market approach, but in an income approach is the cost of capital for a small cap publicly traded company. From there, we have to layer on the additional risks of the company, the subject company, and that's what we refer to as company specific risk premiums.

(00:28:18):
Here's where I have to try and capture those, which is if somebody tells me that it's transactional revenue, the majority of it versus recurring revenue, well I have to have risks associated with that. How am I going to make sure that, or how is the company going to make sure that that cashflow repeats itself or that transaction repeats itself? I've had to try people telling me that, well, my company's worthless because it's only value is what I've got currently going on after that. I have no idea where my revenue's going to come from. So this goes back to Nicole's point as well. Why do we look at historical? Well, geez, you've shown a pattern of being able to generate that revenue and replace it on a regular basis, so I need to factor that in. There's all sorts of discounts or things that we'd otherwise look at. Is it a key person, is there a process in place? Things like that. So recurring revenue has less risk than transactional revenue, so that's a plus side geographically limited. Your small cap publicly traded company in your industry probably isn't geographically limited. So to the extent you are, as you pointed out, hurricane comes, how does that affect my business? If every one of my customers is Miami based and something happens in southeast Florida, I may be screwed. It's a technical term.

(00:29:55):
The other part of it, again, is customer concentration. A lot of people think that that's great, yep, I'm the sole provider for X, Y, Z company. Well, do you have a long-term contract with them? If not, if it's cancelable within say on 30 days notice by either side, that's a risky cash flow basis. So all of it comes into, we may look at historical for that top line on the revenue, but then we have to assess that revenue and that gets built into our discount rate and that company specific risk premium, and that can be anywhere from zero. If you are a large privately held company that operates just like a closely, not a closely held a small cap, publicly traded company in your space, then yeah, there's probably little, if any additional risk. If I am a hundred percent owner of a business and I am limited to my customers in southeast Florida and I have two customers that represent 90% of my revenue, that's a pretty risky proposition, especially if I don't have that tied up in a contract or a long-term contract. So that gets into my discount rate. Again, how risky is the probability of generating that cashflow?

Dave Lorenzo (00:31:28):
Okay. I have a quick follow up and then I'm going to turn it over to Nicole that I pick up with the next question Paula asked in the chat, and this is a woman after my own heart efficient customer acquisition cost, right? I look at customer acquisition costs constantly because my job is to acquire high value customers and acquire them in a way that is either as efficient as possible or if I have to spend money to acquire them. If they're high net worth customers, then I want to make sure that my customer acquisition cost is a competitive advantage for me. In other words, if I have to spend a lot of money to acquire them, I better be able to extract an equally good value from those customers. How do you think of customer acquisition costs? How do you take into consideration customer acquisition costs when valuing a business? If a business is highly efficient and can acquire customers cheaper than its competitors, that makes the business more valuable, I would assume. So how does customer acquisition cost fall into the valuation perspective?

John Alfonsi (00:32:42):
No, absolutely. So when I'm doing a full valuation as compared to a calculation of value, one of the things that I always look at is benchmarking. So I'm comparing the subject company to industry averages. So I try to identify what N-A-I-C-S code they're in, what geographic markets do they operate in, what size of the company based on revenue, and I'm able to look at industry data narrow down to that type of things. Hopefully there's enough information and I'm going to compare operating efficiencies. I'm looking at cashflow, I'm looking at margins. I'm looking at EBITDA margins, I'm looking at capital expenditures, everything that they have as far as data metrics, I'm going to compare the subject company to. Sometimes I don't need to drill it down as far as customer acquisition costs, but if that's an important part of what they do, then yes, I'm going to look at it and if I see that my subject company profitability wise is not at that same industry average, I'm going to ask why or I'm going to delve into it.

(00:34:01):
And part of it may be, well, yes, we're not very good at our customer acquisition costs. We spend way too much money on that. That's going to factor into my discount rate. The reason I do this isn't because my industry standards tell me I have to do it When I'm doing industry research, I'm doing economic research and I'm doing benchmarking. It's all for the purpose of determining how much risks are inherent in this company, and how do I have to take that into consideration? Yes, that part of it ends up being subjective. I can't tell you that. Well, if you are one and a half times the cost of acquiring an asset as compared to the industry average, then that's an automatic 2% added to your company specific risk premium. You've got to look at it all together, and that's where the art of it comes in. It's a subjective as much as objective.

Nicola Gelormino (00:34:59):
So John, much like intellectual property, what we were discussing with how that can really add to the value of a company and be valued even as part of a valuation analysis. I want to focus on brand. Brand can add significant value to a business. And I want to lead in with talking about, we opened this meeting discussing Dunkin Donuts, and I think that's such a great example of a powerful brand because remember when years ago, Dunkin Donuts had a complete rebrand. Nobody thought they would end up being competitor to a Starbucks in the market, and they came out with a significant rebranding, completely changed their image. We see now a power from tagline. Everyone knows that America runs on Dunkin. We see the bright colors, we see the strong brand. So talk to us about how you can value a brand as part of a business

John Alfonsi (00:35:46):
Same way, Nicola as the ip. I lump those all into one large category, which I would call intangible assets. And I would view each one of those intangible assets and a brand same thing. If I otherwise wanted to use a similar type or lease that tagline or some sort of a brand, what kind of a royalty would I otherwise pay? But it is the same concept as the IP for Dunking. They went from Dunking Donuts to Dunking and part of the rebranding strategy, we all laughed when IHOP was going to become jokingly International House of Burgers. It was high hop or something like that. But those are value drivers. And yes, they mean a lot of it gets to when I have to identify the goodwill of the business, and sometimes it's because I have to differentiate how much of it is business goodwill versus personal goodwill.

(00:36:53):
And so that's where branding comes into play is branding is a thing. It's a driver of business goodwill, and goodwill is just the value of the business above and beyond the specifically identifiable, tangible and intangible assets. It's everything else. After you've identified all of those assets that drive value or generate revenues, goodwill is everything that's left over. Some people view assembled workforce as part of goodwill. Under our standards for gap purposes for large companies, assembled workforce is a separate asset. There's something there that allows you to generate revenue beyond a normal return, like say on the ip. And that would kind of fall into the value of the brand, which you could value it as a copyright, as a trademark. How much value is it to that or does it fall to that bottom line and just is part of the goodwill value of the business?

(00:38:04):
The fact that they've done a great job of building that brand and just by, do I go to Dunking Donuts for my coffee when I'm in Chicago because America runs on Dunking? No, I happen to like their coffee and it's convenient, but if I saw mom and pop coffee shop versus a Dunking, there's a known brand. I know the quality's going to be there. I'm going to go to Dunking. It's the whole idea of how McDonald's built their value, which is you can go to McDonald's in any city or state across the United States and your Big Mac, your Quarter Pounder, your double OU is going to be identical. Hopefully the quality, it's going to be the exact same. So that's part of that branding, which is you're creating something that people know and then are going to rely on as a value or a revenue generator.

(00:39:07):
I typically don't value a brand specifically, again, unless I'm valuing the pieces of the business and I have to allocate something specifically to that. And part of that is when I asked the business owner, why did you acquire the business? Is there anything that you thought or that you were acquiring above and beyond the normal operations of the business? And a lot of times they'll tell me, yes, they have a brand that fits in well with what we do. So that would be a specifically identifiable and tangible asset that I would then try to leverage off of. Otherwise, I don't really have to value that brand and it falls into what I'd otherwise say would be goodwill. But hopefully there is goodwill that the business isn't just generating a return on its identifiable, call it tangible assets. There's got to be something more there. So

Nicola Gelormino (00:40:05):
I'd like to talk about another key driver that should come as no surprise to you is of particular interest to me, given my legal background. So key driver being legal, risk exposure, legal risk and exposure. Now, most people are thinking, why is that a key driver of value? So for example, companies may have litigation that's pending at the time. They're already thinking about valuing company. Companies may have claims that have already been made and haven't been resolved. They may have active disputes at the time. So tell us, John, what impact those issues can have on a valuation while you are performing it.

John Alfonsi (00:40:41):
Sure. Two specific one is if there's no litigation, I have to assess the probability. Let's assume, I'm assuming in this case that the subject company is a defendant, but it also flips on the other side if they're otherwise a plaintiff, what's the probability of success of the lawsuit and how is that going to impact my cash flows? That's an immediate hit that I otherwise have to take into consideration, like capital expenditures. If I know that two years from now there's a 50% chance that I'm going to have to shill out 5 million in settlement of a lawsuit, then I need to take that into consideration, especially if it's not going to be covered by insurance, even if it is going to be covered by insurance, then I have to think, do my insurance rates go up? Am I understating my operating expenses? The other, is there a history of being sued?

(00:41:37):
Because now there's a lot of risk that go into this. Do I want to buy a business that's been riddled with lawsuits? For some businesses, it's their business strategy here, bill Davidson, he's passed away. I can talk negatively about him. It's not even negatively. He told me this. His company I interviewed at the company way back when he owned Guardian Glass. It was an automotive and it's a glass manufacturing business. They didn't create anything of value themselves. They stole and infringed on every patent that they could otherwise find because they told me it's cheaper for me to defend a lawsuit than it is to invest in creating new technology or new way of doing things. It was just their way of doing business. Is that a viable long-term business strategy? I mean, obviously it has been for guarding, but I would hope that somewhere along the line they realized I've got to do something.

(00:42:42):
I've talked to drug manufacturing companies, pharma, a lot of 'em don't do their own development of new drugs, and I'm saying they're infringing, but what they'll otherwise go do is acquire companies that develop drugs that says it's cheaper for me to buy the company once they got to a certain level as compared to creating or trying to develop itself. But so my point is, if you've got a history of always being sued, even if it's employees harassment, sexual harassment, wrongful termination, that's telling me a story, that there's a culture there that is possibly toxic that I need to take into consideration in, again, my discount rate. It may not translate all the time into that top line or maybe even in cash flows, but it's something that a buyer is going to take into consideration that says, geez, do I really want to take on the risks, especially if I'm going to keep key management in place, that they are continuously being sued for harassment or for wrongful termination, that is a negative driver, and that's something that I do take into consideration.

Nicola Gelormino (00:44:01):
Thank you. I'm glad you mentioned whether it's a strategic call by the company, and I've seen this in other industries, John, so I agree with you. Sometimes having lawsuits as part of your business is actually strategic, and whether it's strategic or whether it is as a result of poor decisions or management that has resulted in those lawsuits, all that becomes a factor in the valuation that you're doing. So thank you for highlighting that because it won't always be reviewed in due diligence unless you've got something that's active or you've got somebody like you who is really looking at that and thinking about it.

John Alfonsi (00:44:33):
Yeah. Just real quick, because we have a lot of IP attorneys, and an IP attorney told me this one time, and I may have mentioned this before, he was defended patent infringement cases, and he said, anytime you come up with damages, the maximum amount of damages can't be any more than the design around costs that every patent could probably be designed around. So if you're coming in and asking for a billion dollars of damages, but it would only cost you $10 million to design around that patent that you're being accused of infringing or that ip, then your damages can't be any more than that $10 million. So yeah, there's people that will otherwise use that as part of their business strategy, but yes, it needs to be considered in the value of the business, and most importantly, the risks going forward

Nicola Gelormino (00:45:30):
And certainly something to focus on the front end is reducing that legal risk and exposure. Another significant component is cybersecurity risk. Dave, let me turn this over to you. I know this is a topic that you enjoy. Let's talk a little bit more about that.

Dave Lorenzo (00:45:45):
Yes, I enjoy watching people's entire life's work get littered away because they did not create enough protection inside their business from a cybersecurity perspective. So alright, John, talk about how you value a business if it is vulnerable when it comes to cybersecurity. Is this something that you look at? Do you look at the customer data and how it's stored and how much customer data is aggregated, employee data, how it's stored and how much employee data is aggregated and the handling procedures of all of that data and the exposure that the company may have and the steps they've taken to mitigate that exposure? Because this is keeping a lot of CEOs up at night right now. Does this factor into the overall valuation of the company?

John Alfonsi (00:46:46):
Absolutely. So cybersecurity risk is a subset of a much broader category, which I would call internal controls. So the internal controls of a business are extremely important and it is a value driver. A lot of people just view internal controls as making sure that I've got belts and suspenders, and it's a looking back kind of a scenario, whereas especially with cybersecurity, since it's on, how many times do I get probably a letter or two a month telling me that, oh, our data was breached, and you may have been one of the people that their information is out there strong internal. There was an old study probably about 20 years ago, but they did, I forget the company, but they said a company with strong internal controls generally has a 15% higher value than a company with poor internal controls. So yes, that factors in where on my discount rate, the risks of the company, how much risks are inherent in saying that that revenue string your customers data is going to be compromised and potentially you're going to lose customers, you're going to lose patients, you're going to lose somehow.

(00:48:12):
So yes, we will assess the internal controls, including cybersecurity. Part of my checklist of items we ask what systems do they use, how are they protected? Jim Martin of my office, my IT guru, he's the guy that I'll bring in to do those types of interviews to find out how much exposure is there. And a lot of times our company, and Jim does this is a, call it an operational assessment, but a lot of it is an internal control assessment to see how much risk is inherent in there. I don't need to do that full amount, but yeah, I've got to ask the questions. I've got to find out where are the potential risks and how does that factor in? Again, if you have two identical companies, at least they appear identical from bottom line results and you've got one that doesn't have cybersecurity as a priority and one that does, which one do you think is going to be more valuable? Who would you rather buy? Yes, the one that prioritizes cybersecurity. Absolutely,

Dave Lorenzo (00:49:22):
And that's where Nicola was going with this whole thing. I'm big on focusing on making sure that there's a robust cybersecurity plan in place, and I take the opportunity to point this out whenever I can. As the business owner, what I want to do is first and foremost, I want to go out and hire outside counsel. So I want to hire an attorney who understands how to defend claims that would be brought against my company for cybersecurity issues. And then I want to have that outside counsel, hire a technology company to do an audit of my business from a cybersecurity perspective, and I want the results of that audit delivered to the attorney, and I want the attorney and the company to sit down with me together and review those results because I will pay the attorney, the attorney will pay the company. And the reason I want it done that way is because no matter what happens moving forward, the results of that audit are now protected by attorney client privilege.

(00:50:30):
That's one of these things where it's like a mantra for me when I work with my clients and I look at their cybersecurity risk, I say to them, you're not to have any conversations about your exposure with any vendor until you have an attorney in place. And those conversations then take place through your counsel because you want all of that protected by privilege. Because if you have a huge breach and hundreds of thousands of dollars go out the door, somebody's got all kinds of exposure and they're going to sue you as a result of that breach. You don't want that report and your action or inaction being able to be disclosed in a deposition or God forbid, as part of the suit in any way. So for me, that's one of those things that I hammer on, and that's why Nicole has said I was being funny.

(00:51:23):
That's why Nicola said it's a big focus of mine, because to me, there's two things, and we're going to talk about the second one now. And then before we wrap, wrap up the interview, I have a couple of specific logistical questions for you, John. So don't let me forget that. There's two things that I think have to be first and foremost in the mind of a business owner when they're thinking about their valuation, right? Everybody thinks about getting their financials in order, and they'll hire a fractional CFO to help them get their financials in order. They'll call you guys to get their financials in their financials in order before evaluation, but what they don't think about is the potential for cybersecurity risk, legal exposure, and they also don't think about the quality of the management team and the potential succession plan they have in place. Before we wrap up this interview, I want you to spend a couple of minutes talking about the quality of the management team and their ability to pick up and run the business with or without the CEO at the helm and how that plays into the overall valuation of the business.

John Alfonsi (00:52:41):
So ties together, again, two things. Going back to the cybersecurity and internal controls in general, every company should be safeguarding its assets, it's important assets, your information that you store, anything that somebody has as far as customer, personal information, that's an asset. You need to protect that, and that's why cybersecurity comes into play even more. So in today's business environment where everybody is struggling to find people, one of the key assets, and a lot of people forget about this, is your workforce, your key employees, key management. It doesn't even have to be management. If you've got somebody that's important to the operation of your business, one of the top things that numerous studies have said, because at the top of every acquirer's list is turnover of key management or key employees. That's huge. A lot of people would like to think that if I do everything that's job security, that's the wrong attitude from my perspective.

(00:53:56):
I always want to be able to do my boss's job and I want somebody to be able to do my job, otherwise I'm not going anywhere. If you rely on one person, two people, and if those two people get hit by the proverbial bus, then yes, your business is doomed because nobody else is going to be able to take over and do those specific things. So we will absolutely assess management. We're looking at who they are, their age, their health, how long have they been there, what kind of a background do they have? Is it something new? Are they new to the industry? Are they taking a skillset from one industry and trying to translate it to another industry? How important are they? How replaceable are they? Key management, key employees is one of the most overlooked things that people think about when they're valuing their business or they need to have the value of a business. If somebody tells me, yes, I'm chief cook and bottle washer, then I have a problem with that. That's going to be, we refer to it as a key person discount. That's a nick on value. If it's highly reliant on one or a handful of people that can't be easily replaced. Having a succession plan, not just with respect to ownership of the business, but from operation of the business should be one of the top priorities for any business that is trying to survive.

Dave Lorenzo (00:55:33):
So in the previous interview we discussed, and my words, not John's, we discussed the fakes, phonies and charlatans out there who do business evaluations and went to the Harpo Sluggo school evaluation and now have a certificate on their wall, and they'll come in and they'll say, I can value your business for you. We discussed those people in a previous interview. So I'm not going to go out there and bash everybody who's out there certifying the barber today as the valuation expert of tomorrow. I'm not going to continue to bash those people. You all know how I feel about them. If you are a serious person and you seriously want to know what a business is like, you need hire a serious valuation expert, somebody like John to value your business. Somebody who this is what they do, and the reason you're looking for the valuation will also play into the prospect of who you're going to hire to do your valuation.

(00:56:39):
So John, I guess in my making the case for you and you in demonstrating your brilliance, you did such a good job that I'm getting inundated with questions about how much does it cost to hire John Alfon, and it must be really expensive to work with John Alfonso. Let me preface it by saying, John is refreshingly expensive, okay? You want John to be expensive because you want a comprehensive job. Now that being said, alright, if your client is going to get a 10 x multiple for their business, they shouldn't care what they pay. John John Alfon is like the tool in the carpenter's toolbox to help you build that beautiful dream home. But John, for the purposes of giving people some context, would you mind sharing how you charge for your services? Because in the words of my friend Sheldon Pont, I want to be able to convince my clients not to be cheapskates and hire the best. That is literally what Sheldon has asked me. So I need to know how you charge for your services and talk about, I can do it for you, but I'd rather have you do it. Talk about how you make the case for using a credentialed CP, a really good professional versus somebody that went to Joe Smith School of Barbering and yesterday and now today they're out doing valuations.

John Alfonsi (00:58:04):
Sure. So dealing with the latter, hopefully everyone has a good sense that I ask a lot of questions, whether it be in person or in an information or a document request. There's always going to be follow-up. I need to know the business, I need to know the people. That's key, and that's lacking in a lot of these times that says, oh, just give me your last three years financial. I'll tell you what your business is worth. They have no idea who these people are or what's going on at the business on that side. So with respect to fees, I typically charge if it's, I'll call it non-litigation if it's a straight up valuation type project. It depends on the scope of the project. So literally, I have two levels of valuation work that I can provide. One is called a calculation engagement. The other is a valuation engagement.

(00:59:06):
So let's start with the valuation engagement. That entails everything that we've been talking about. I am going to analyze historical financial statements. I'm going to look at what's going on in the economy. I'm going to look at what's going on in the industry. I'm going to look at benchmarking. I'm going to do a company management interview. I'm going to do a site visit. I am going to assess all of this and eventually come up and I'm going to consider all three valuation methods and come approach, asset approach, market approach, and I am going to come up with what's referred to as a conclusion of value, which is my opinion. It's what I go to the IRS with. That's what I go to court with. That's what I testify. This is me speaking to that. Typically a valuation engagement, a lot of it's going to depend on how complicated the capital structure is.

(01:00:03):
Most privately held businesses don't have complicated capital structures where there's all sorts of preferred stock. A lot of times we'll see it in LLCs or partnerships where there's different preferred interests, things like that. So just in general, if I had to value the business in its entirety, a valuation engagement with a, here's another summary report versus a detailed report summary report has enough information for the reader to understand the basis of my conclusions. A detailed report explains every single calculation and Greek symbol in Latin term that's fraught throughout that. That typically is going to run 18 to $25,000 for a full valuation engagement. And depending whether it's a summary report or a detailed report, if somebody doesn't need an exact number but says, I just need to know. I have to have an opinion, I have to have a thought. What do you think this business is worth? That's where I do a calculation engagement. A calculation engagement is almost like a valuation light, but it is not going to include everything that I just described, either. It's somebody that's going to say it's typically because there's a scope limitation that says, here's literally five years worth of tax returns. Tell me what you think this business is worth.

(01:01:40):
I can do that, but it's not going to be that same level of confidence that I would have in evaluation engagement. I'd like to dot the i's and crossed the T's and say, had I done valuation engagement, I probably would've come up with something pretty darn close to a calculation engagement. Otherwise, the number I'm giving you is going to be absolutely worthless. I'm not doing my customer, my client any good, and that's not going to be any good to them. So a calculation engagement is probably going to be in the five to $8,000 range. But with that, there's going to be a caveat and people always freak out that says, I have to include this in my report. This is a calculation engagement, not evaluation engagement. Had I done everything that was required of evaluation engagement, the result may have been different just between us.

(01:02:35):
I will tell you, it's probably not going to be that much different, but at some point, yes, I got to refine it. There are certain things that I will not skimp on, even kind of in a calculation engagement, which is I'm still going to do some benchmarking. I'm still going to do some industry and economic research. Maybe I don't get the full management interview. Maybe the attorney or somebody that I'm working for is going to say, this is what they said, or have given me enough information that I can rely on, but I may not do a site visit. I'm not going to go out there and look at the business, or even if it's via Zoom, have 'em walk me around or do whatever. So from a cost perspective, calculation engagements are typically five to eight grand. A full valuation could be anywhere from 18 to 25 grand.

Dave Lorenzo (01:03:28):
Okay, well, there you go. That was very specific. Thank you, John. And listen, it depends on the size of the business and what you need the valuation for, right? I got a question about a smaller business. Let's say there was a business that's less than a million dollars in annual revenue. Yeah, you're probably not going to spend $25,000 on a valuation for a business that's less than a million bucks in annual revenue. But a calculation would be helpful if you want to make sure that you're getting all the value you can be. It would be good to know what that business is worth. Typically, how long does a valuation take, John? If you get everything you need, right? You give me the checklist, I have a good accounting team, and maybe I'm working with a fractional CFO, now they can pull everything together from a reporting standpoint that you need. How long does that typically take?

John Alfonsi (01:04:19):
Yeah, so one of the key drivers, especially on cost, is going to be not only the quantity of information, but the quality of that information. So typically what I tell people is for a calculation engagement, two to three weeks from the time I receive the information that I've asked for a full valuation engagement, I tell people typically four to six weeks in order to do it correctly

Dave Lorenzo (01:04:45):
All right, Nicola, what do you have so that we can wrap up? And then I see there's a hand raised. If you have questions for John, raise your hands and we'll get to you. Nicola, what do you got for John?

Nicola Gelormino (01:04:56):
So first, John, just thank you for sharing so much information with us today. We really appreciate it. It's been a wealth of information on valuations. I want to add to the types of services you were describing. I've worked with John. He is thorough any aspect of evaluation that he is performing, so it really does depend upon the reason that you need it and he'll help guide you. He's really great in that regard. John, let me end with this. If folks are out there, they're thinking about getting a valuation done, give them the top three questions in your opinion that they should ask someone they're interviewing as a valuation expert to consider using them.

John Alfonsi (01:05:30):
Sure. I would say at the bottom of the list would be how much is it going to cost? I mean, it's obviously going to be a consideration, but it shouldn't be one of the top threes. First one would be what type of valuation credentials, if any, do you have? What makes you think that you're able to do this? The IRS has qualified appraiser requirements. You have to have some sort of a certification. I'm not saying that just a CPA can't do what I do, but they're otherwise not going to be considered a qualified appraiser. So finding out, do they have a valuation designation? Part of that is how long have you been doing this? Are you brand new to the game, or, I've been doing this for over 30 years now. And the third is, and this is even less. So, I don't want to say, do you have experience in this business? But have you done something similar? I've shared the story before where somebody, I was being interviewed to do a evaluation and it was a restaurant, and they asked me going through the questions, do I have any experience doing valuing restaurants? And I said, yes. And they said, aha. But have you ever valued a Greek restaurant?

(01:06:57):
I'm pretty sure they operate just like any other sort of a restaurant. There's nothing. But we can lump businesses in by very high level type things. Is it a manufacturing business? Is it a distribution business? Is it a professional service business? Have I done things in those areas? Yeah, absolutely. Have I valued a developer of a statin drug? No. But have I valued companies that do drug development? Absolutely. But the one thing that I'll tell people when they ask me those types of questions is what I need to do as part of my valuation is learn everything there is to know about your company and the industry that you operate in. Which is why I love what I do, because I get to learn about a lot of different companies. So I would say yes. What kind of certification, if any, how long have you been doing this, and do you have relevant experience?

(01:08:03):
I don't want to say exact experience, but do you have relevant experience? For instance, I don't do any valuations in the oil and gas industry. I've never done anything. I don't practice in that. Never have somebody came to me and needed to have a valuation of something in the oil and gas industry. I'm going to refer them to somebody else. I turned down an engagement because somebody needed a valuation of a community bank. I've done those in the past. There's somebody out there that could do that a lot better and more efficient than me. I'm going to turn that work down. So yes, those are the types of questions that you should be asking.

Dave Lorenzo (01:08:43):
All right, John, I echo Nicole's. Thanks. Thank you so much. These two sessions together, were a graduate level course on business valuation, so put your hands together, folks to thank John Alfon for being our interview subject today. I will be sending out to all of you John's contact info so that you can reach out to him if you want to get in touch with him.