Key Takeaways
Decide how to choose an appraiser before you need one: A selection mechanism should work even when the parties cannot agree.
Look beyond credentials: RIA disputes require both valuation expertise and genuine investment-management industry knowledge.
Design the process: transparency, symmetry, deadlines, review rights, and a clear decision mechanism can be as important as the appraisal itself.
When my late mother-in-law, Lily, was in high school, her dad bought her mother a new car: a brand-new 1958 Corvette. Beautiful blue exterior. Fuel injection under the hood. It could pass anything on the road, except a gas station or a tire store.
Was Lily’s mom impressed? In a word, no. She had four children, only one of whom was driving age, and the prospect of getting her kids around in a two-seat convertible was anything but useful. What her husband saw as an object of desire, she saw as a transportation problem.
Value is, at some level, a matter of individual perspective. That’s fine as long as there doesn’t have to be agreement. But sometimes, there does.
RIA owners occasionally find themselves in circumstances where an ownership interest has to change hands, and the parties don’t agree on what it’s worth. A retiring or departing partner may need to be bought out. A private equity sponsor may have the right to put its interest back to the firm. A divorce may require an ownership interest to be valued. Or two shareholders may simply agree that a transaction needs to happen without agreeing on the price.
Sometimes a shareholder agreement anticipates the situation and specifies an appraisal process. Sometimes the agreement provides considerably less guidance than everyone wishes it did once a dispute arises. And sometimes there is no predetermined process at all.
Whatever the circumstances, resolving a valuation dispute requires answering three questions:
How will the appraiser be chosen?
What qualifications should the appraiser have?
And what rules will govern the process?
Those questions sound straightforward. In our experience, they aren’t.
Choosing the Appraiser
The first challenge is deciding who gets to decide.
An agreement that says the parties will “mutually agree upon a qualified independent appraiser” sounds perfectly reasonable when everyone is getting along. It can sound considerably less helpful when the parties are already several million dollars apart on value. If they can’t agree on the price, there’s no particular reason to assume they’ll agree on the person who determines it.
There are several ways to address this. Each party might nominate qualified candidates and use a process of elimination to arrive at a neutral. Each party might retain its own appraiser, with those two appraisers charged with selecting a third. The agreement might provide another independent mechanism for making the appointment. The particular method matters less than having a method that doesn’t depend on cooperation when cooperation is already in short supply.
Whatever the selection process, independence matters. The investment management community is relatively small, and experienced RIA appraisers may have worked previously with one of the parties, their attorneys, or other professionals involved in the dispute. Prior contact doesn’t necessarily compromise independence, but relationships and potential conflicts should be disclosed and considered before the assignment begins.
Most importantly, the selection process should have an end point. Giving either party an effective veto over every candidate can turn the selection of the neutral into a preliminary round of the dispute itself. A good mechanism should produce an appraiser even if one or both parties would have preferred someone else.
After all, the objective isn’t to find your appraiser. It’s to find the appraiser.
Qualifications Matter
Once you have a process for selecting the appraiser, the next question is: what makes someone qualified to value an RIA?
That question is harder than it sounds. The investment management industry is both homogeneous and nuanced. Most firms generate revenue from the services they provide, have an expense base dominated by compensation, and distribute much of their profitability. From there, however, the similarities can end quickly. A wealth management firm is not an asset manager, which is not an independent trust company, which is not a broker-dealer. The economics, competitive dynamics, client relationships, and sources of risk can be quite different.
A traditional appraisal professional may be highly qualified in valuation and still have limited experience with investment management firms. Most business appraisers simply do not encounter enough RIAs over the course of their careers to develop the industry-specific pattern recognition that comes from repeated assignments. We have seen otherwise competent professionals confuse the economics of asset managers, wealth managers, broker-dealers, and even other financial businesses.
The opposite problem can arise with an industry expert, such as an investment banker. Investment bankers understand the RIA market exceptionally well. They know what buyers are looking for, how transactions are structured, and what firms have recently commanded in the marketplace. But transaction experience is not the same thing as appraisal expertise. The price paid for an especially attractive RIA in a competitive auction may tell us something about the market, but it does not necessarily tell us what a different RIA is worth. And the professional standards governing the development and reporting of a valuation opinion are different from those governing an investment banking transaction.
In an ideal world, the neutral appraiser would bring both perspectives to the assignment: deep valuation expertise and genuine investment-management experience. That combination is harder to find than most RIA owners probably realize.
And that is why choosing the person is not simply an administrative detail. When the valuation is disputed, the qualifications of the person making the judgment can be every bit as important as the formula used to get there.
Rules of Engagement
Having the right appraiser is important, but even a highly qualified neutral can struggle if the process is poorly designed. The objective should be to give both parties a fair opportunity to present their perspectives while preserving the appraiser’s independence.
That starts with transparency. Both parties should understand what information the appraiser is considering, what additional information has been requested, and where the process stands. Each party should have a comparable opportunity to explain its position. That does not mean the appraiser becomes an advocate for either side. It means neither party should feel that the other had a private channel to influence the valuation.
A review process can also be useful. Depending on the assignment, the parties might receive a draft report and have an opportunity to identify factual errors or omissions. There may even be value in allowing each party to see the other’s comments and respond. But there should be a clear distinction between correcting facts and lobbying the appraiser to reach a particular conclusion. Otherwise, a process intended to promote fairness can become an extended negotiation over the report.
Time matters, too. A dispute-resolution process without deadlines can become an open-ended exercise. The parties should know when information is due, when comments are due, when the report will be issued, and when the process ends. Otherwise, delay can become another tactic in the dispute.
Payment deserves similar attention. Fees should be established in advance and paid according to predetermined milestones rather than in a manner that could create even the appearance that compensation depends on the appraiser’s conclusion.
In our experience, it helps enormously when the neutral who is designing the valuation process has done this sort of work before. The job is not simply to prepare a valuation. It is to administer a process that is fair, orderly, independent, and capable of reaching a conclusion.
Even a Good Process has Drawbacks
One approach to resolving a valuation dispute borrows from baseball arbitration. Each party hires an appraiser, each appraiser prepares a valuation, and a neutral third appraiser is asked to choose the more reasonable of the two. The neutral does not split the difference or develop a third value. One appraisal wins.
There is a certain elegance to this approach. Knowing that the neutral must choose one of the two conclusions gives each appraiser an incentive to stay within the bounds of reason. A valuation that is obviously aggressive may be difficult for the neutral to select, even if it supports the interests of the party who commissioned it. In theory, the process should produce two reasonably defensible valuations and make the neutral's job relatively straightforward.
But nothing’s perfect. We once served as the neutral appraiser in an assignment structured this way. For illustration, assume one appraisal concluded that the subject interest was worth $5 million and the other concluded $9 million. The difference was substantial, but both were serious appraisal reports prepared by qualified professionals.
We carefully reviewed the assumptions and analysis underlying both valuations. We found mistakes in each. After reconciling the two analyses with what we would have done ourselves, our own conclusion was that a reasonable value was just over $7 million.
But that wasn’t our assignment.
We were instructed to select, without explanation, the more reasonable of the two appraisals. So we did. We concluded that the $9 million appraisal was more reasonable.
That was the right answer to the question we had been asked. It also illustrated the limitation of the process. Of any process.
Our independent judgment was that the value was a little over $7 million, yet the process required us to choose either $5 million or $9 million. A relatively small difference in our assessment of the competing analyses could have caused us to select the other appraisal, producing a $4 million swing in the transaction value without anything approaching a $4 million change in our underlying view of value.
I don’t think that makes the mechanism a bad one. Its simplicity is valuable, and the incentives it creates can be useful. But parties using this approach should understand what they are asking the neutral to do. The question isn’t “What is the interest worth?” It is “Which of these two answers is more reasonable (or least un-reasonable)?”
Those are not always the same question.
Agreeing on How to Disagree
There are other ways to resolve valuation disputes. None is perfect. The more important point is to have a process that everyone understands before the dispute begins—and ideally before anyone knows whether they will ultimately be the buyer or the seller.
For RIA owners reviewing shareholder agreements or contemplating an internal transaction, we would focus on three things. First, establish a mechanism for selecting a neutral that cannot be indefinitely frustrated by either party. Second, require qualifications that encompass both valuation expertise and meaningful experience with investment management firms. Finally, establish rules of engagement that give both parties a fair opportunity to be heard while providing the appraiser with the independence, information, and authority necessary to finish the job.
Valuation disputes are, by definition, situations in which reasonable people may have different perspectives on value. The goal of a good dispute-resolution process isn’t to eliminate those differences. It is to provide a credible way to resolve them.
By the way, Lily’s parents ultimately resolved their disagreement over the Corvette by trading it in on a Corvair. More practical, perhaps, but famously “unsafe at any speed.” Again, not every dispute resolves perfectly.
About Mercer Capital
We are a valuation and advisory firm organized by industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, private equity firms, and alternative managers.