A financial advisor, like a lawyer, may be an effective advocate of a client’s interests and provide valuable advice that can make the difference between success or failure of a transaction, or provide advice whose implications may be measured in the many millions of euros. And yet there seems to be a pattern of questions and expectations that reveals a lack of understanding of the limitations surrounding the role of financial advisors. I summarize these in the following three “DON’TS” to bear in mind when hiring a financial advisor:
1. Don’t expect an advisor to estimate the value of your company before you hire him
The potential for error in such a rapid, back-of-the-envelope valuation is enormous. A thorough valuation usually requires use of multiple methods (Discounted Cash Flow or applying appropriate multiples). A quick valuation is done solely on the basis of multiples, making it usually much less reliable than Discounted Cash Flow. Furthermore, when you apply multiples to perform a valuation, there is a risk of magnifying the error if you are multiplying the wrong number. For example, if a business is valued at six times cash flow and the company’s owner pays himself a salary that is EUR 100,000 below market salary, the company will be overvalued by approximately EUR 600,000. The financial statements of a company must be carefully examined before applying multiples.
Furthermore, there may be a number of factors unknown to an advisor who has not had the chance to look at a company thoroughly. What if there is litigation or a threat of litigation against the company? What if the company is about to lose its most important client? What if there is new technology on the horizon that is about to disrupt the industry? In any of these cases, a quick valuation is likely to be highly inaccurate.
So how should a client handle the issue of valuation when hiring an advisor? Ask questions that ensure your potential advisor thoroughly understands the principles of valuation and has experience in the subject. If your decision to proceed with a transaction or not depends on valuation, the first few weeks of a mandate should permit an advisor to provide an estimate of valuation and the client’s decision to proceed with a transaction could be conditional on the advisor arriving at a threshold valuation.
2. Don’t ask an advisor to introduce an investor before you give him a mandate
All too often, a client will ask an advisor to bring a potential investor to the table before giving him a mandate and proceeding with a transaction. This is usually an error, for two reasons:
First, in the event that the investor is interested, the company will typically be completely unprepared to follow through ( i.e. it will be unable to provide the interested investor with the huge amount of information he is likely to require, a disclosure which typically requires months of preparation).
Second, if the company starts down the road of negotiating with one investor, it becomes more and more difficult to bring other potential investors into the process. In this way, the company foregoes the possibility of entering into a truly competitive process, a process which usually has the effect of driving up price, improving the terms and conditions of a transaction and improving the likelihood of closing a transaction (please refer to our previous column on this subject).
So what should the owner of a company do? Simple: allow an advisor to prepare the company appropriately, then bring multiple investors to the table in a competitive process.
3. Don’t expect an advisor to work for a success fee only
As the saying goes: if you pay peanuts, you’ll get monkeys. As with any hiring situation, ensure that the individual or company you are hiring is appropriately motivated. Given that a client usually has the liberty, at any point in a transaction, of refusing any offer, or indeed even calling off a transaction, an advisor working on a success fee alone is unlikely to invest the time necessary to do a thorough job or may be motivated only to “skim the cream” (e.g. try to opportunistically close a transaction with just the bare minimum of preparation or proactive marketing). This is seldom in the client’s best interest.
Under the socialist regime, tangible items had value; intangibles, including advisory services, were seldom if ever attributed value. Central Europe is rapidly evolving towards a capitalist market system, where it is becoming increasingly acknowledged that intangibles, including advisory services, are often at least as valuable as tangibles. While this understanding has evolved considerably over the past two decades, there is still a fair distance to travel.