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How business risk impacts valuation

KEY ARTICLE TAKEAWAYS

Learn how buyers value target businesses

Understand how a buyer’s perceived risk within a business can impact valuation  

Explore some of the most common business risks and how to go about solving them  

How are businesses valued?

Businesses can be valued for several different reasons (pre-sale planning, estate planning, buy/sell agreements, equity plans for employees, etc.), and the specific reasons will dictate how the business is valued. In our post, we explain in detail how to answer the question, “How much is my business worth?”

For our purposes here, we are going to focus on how buyers value target companies (companies they seek to acquire).

Business valuation factors

How does a buyer’s perception of risk impact valuation? They will typically look at two principal factors:

  1. The target company’s forecasted revenues and cash flows over the next 3-5 years
  2. The level of company, industry, and market risks inherent in the target company

The higher the forecasted cash flows and the lower the perceived risk in a business, the higher its valuation will be by buyers. Conversely, lower cash flows and higher perceived risk will lead to lower valuations.

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Adding to the complexity, different buyers will forecast different cash flows for the same target company, and different buyers will perceive different levels of risk in a target company. This can lead to significant variation in valuations for the same company.

The chart below shows just how much variability there can be in a buyer’s assessment of company valuation – as you can see in some of these transactions, the highest bidder, looking at the same materials and information, valued the target company at nearly three times the valuation of the lowest bidder.

Business valuation services

Some company owners seeking to understand the value of their business might look for the services of a firm performing business or company valuations. While these services are particularly useful when performing valuations for estate planning or tax planning that need to withstand IRS scrutiny, they might be overkill or even conservative when assessing how a company is likely to be valued by buyers, and therefore less useful.

For owners looking to understand how buyers would likely value their business, it will be more useful to talk with investment bankers who are in the market every day, talking with buyers. Especially if an investment bank has relevant experience in your industry, it will be able to give you a decent valuation range.

Risk vs. value

For an investor, more perceived risk in a company’s future cash flows means those cash flows are less valuable. If there are two companies with identical forecasted cash flows over the next few years, but one company’s revenues are heavily concentrated in just a few customers and the other company’s revenues are spread across many customers, all other things being equal, the second company will be more valuable.

If you are planning to sell your own company, it's wise to understand what risks in your business an outside investor might see as detrimental to your company’s overall valuation. Once you understand those risks, executing a disciplined plan to reduce or eliminate those risks will lead to a higher valuation for your company.

Typical company risks

We have had hundreds of companies take our business risk assessment, CoPilot. CoPilot asks users to answer about 120 questions (takes about 25 minutes), and then generates a report that identifies and prioritizes a company’s risk factors. From this report, across all companies taking CoPilot, we have identified some of the most common risk factors inherent in private companies.

Owner dependence:

The most common risk among CoPilot users is that the business is too dependent on its owner(s). This can result from the owner being the primary salesperson, operations lead or product development lead. It can also result from the owner having to spend too much time in the business to make the trains run on time, or if the owner controls too many of the customer relationships.

In addition, in the majority of CoPilot companies, there is no formal succession plan in place for the owner or other key executives, and this can lead to there being a single point of failure in the business (meaning, if a specific person left or was incapacitated, there is no other person who can fulfill those duties in the business). This risk is important because sophisticated buyers know that once an owner cashes their check from the sale of the company, their motivations and performance on the job will likely be different post-closing, often to the detriment of the company.

Customer and/or lead source concentration:

Another common risk among CoPilot users is that the business has too much of its revenues coming from one or just a handful of customers (or from one or a few lead sources). This customer and lead source concentration makes the business more risky because if one or more of those customers or lead sources decided to switch to another provider it could have a devastating effect on the company’s operations.

Financial controls:

Most CoPilot users report not having adequate financial controls. This can appear when an owner is not regularly reviewing check runs, or customer or vendor lists, or when the business does not perform regular bank reconciliations to the financial statements. These risks will reflect poorly on the overall company’s operating controls, and can increase the risks for fraud or financial mismanagement.

How to complete a business risk sssessment

As a business owner, how can you best evaluate and prioritize the risks in your business? In other words, which risks will have the greatest impact on your company’s valuation? Moreover, how can you best prioritize which risks to work on first (i.e., where will your efforts have the best “bang for the buck”)?

One solution for business owners is to hire an outside consultant to do a top to bottom assessment of your business, focusing on identifying specific risk factors in your business. You might also simply convene your executive team and have them identify the top risk factors in your business that they perceive (they will often have a different perspective from you).

Another solution is our CoPilot business risk assessment, which we offer free to business owners. CoPilot is the online assessment we developed to standardize the automate the process of identifying and prioritizing risks in a business. CoPilot also offers users advice on how to address specific risks that show up in their business.

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You’ve identified your risks – now what?

For some business owners, they may opt to self-medicate the risks identified in their CoPilot report using the suggested risk solution and mitigation options outlined in the report. For business owners looking to maximize valuation prior to a sale, Class VI also offers our Pathfinder program to qualified business owners. Through our Pathfinder offering, our team will work with you and your management team to develop and execute a detailed plan customized to your company’s needs and your personal timeline as you prepare for a sale. If you think you may be a fit for our Pathfinder program and would like to learn more, please send a message to [email protected] for more details.
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