As an appraiser of every type and size business, my experience and training has helped me develop several key defaults to value, the biggest of which is as follows;
Value is driven by three key inputs; risk, growth and cash flows
In other online forums and presentations, I’ve represented this truth as a three-legged stool that provides structure and support to an opinion of value for tax, financial reporting, planning and strategic purposes. I’ve explained that the relationship between these three inputs is a simple one based on the direction of the input (with all other inputs unchanged) directly correlated to an increase in value, in this case, an increase where;
- Risk – The lower the risk the higher the value;
- Growth – The higher the growth, the higher the value; and
- Cash Flows – The higher the cash flows, the higher the value.
I believe that any business owner or individual with some finance background can understand how an increase in growth and cash flows increases the value of a business. In this blog, I want to talk specifically about how risk impacts value and how a company or business owner can lower or mitigate risk (i.e. “de-risk”) to increases value.
The easiest way for me to explain de-risking is to discuss the concept of insurance.
“Insurance is a contract, represented by a policy, in which an individual or entity receives financial protection or reimbursement against losses.”
In the case of a business, an owner/operator who is vital to an organization puts his/her business at considerable risk every day he/she walks out of the office. A bus, heart attack or accident can be a fatal blow to the owner but also the business. To protect against this loss, the company helps mitigate this risk through Key Person Insurance where the beneficiary is the business and the amount of insurance is at or above the value of the business or the determined impact that person has on the business.
While key person risk is one that can easily be mitigated through insurance, other risks are more difficult to lower or eliminate. Below is a list of risk factors that I believe any business has to manage. Each risk has a “de-risk opportunity” that management can consider in mitigating this risk. Their ability to de-risk the business through operational and strategic initiatives or investment help the business drive value by lowering its overall risk. And, based on the simple math above, lowering risk increases value.
Industry risk is associated with the market in which the company competes and how volatile it is compared to the overall market. Consider the recent pandemic and two industries; grocery stores and restaurants. One was considered essential (grocery stores) and the other was shut down (restaurants).
De-Risk Opportunity: The best way to mitigate or de-risk the business for this factor is diversification. Restaurants who survived the pandemic used delivery and to-go opportunities as a way to diversify its business model.
Execution risk is based on how well the company has performed in the past in meeting its budgets (top and bottom-line metrics) and the overall strength of the management team.
De-Risk Opportunity: A company can hire specialized personnel to help fill holes in the management team. Other opportunities include building out the board of directors or creating an advisory board to provide checks and balances and accountability.
Technology risk is most commonly associated with technology tools that lead to higher efficiencies and productivity.
De-Risk Opportunity: Along with hiring specialized personnel, the company can invest in software tools to help with financial planning, manufacturing, point-of-sale, and other programs that can turn hard data into management tools and dashboards.
|Supply Chain Risk||
In a post-COVID recovery, the term “supply chain” is now the catchphrase for defining risk associated with low to no supply of products and the delay in getting available products to the end-user. That Peloton bike is now six weeks out instead of four because they are having a problem securing the video screens from China…
De-Risk Opportunity: The best way for a company to de-risk supply chain issues is adding additional suppliers to the mix and increasing its inventory when it can to add a few months of extra supply to combat extended turnaround times.
While retail stores have minimal customer concentration, a construction firm and government contractor may have 70% of its business with the Department of Defense.
De-Risk Opportunity: Diversification in both product and service offerings allows for any company to manage this concentration risk by focusing selling efforts on new industries or new customers.
This risk is associated with an expected change of control or selling the business. There may be issues with transferring licenses, key contracts (see above) management transition of key people.
De-Risk Opportunity: Overall, this risk is highly correlated all of the others above. For owner-operated companies, putting together an operations manual that defines management roles and outlines key responsibilities will help eliminate “key person” risk. In selling a company, that risk may only be mitigated through consulting agreement that keeps the prior owner or top management in an active or shadow role or involved with a minority equity stake (as is the case with private equity purchases and “rollover” equity that allows the seller to participate again in another sale of the business.
What Does This All Mean?
Focusing on and managing these company-specific risks prior to an exit event will help increase the value of the business and provide the eventual buyer with a stronger basis by which to run the business going forward. Think about it as a homeowner de-risking the sale of their home by renovating the kitchen, replacing the roof or cleaning up the landscaping and curb appeal. While all of these activities involve an investment (some more than others) the eventual return should come in the form of a quicker sale with more potential buyers which correlates with a higher sale price that, almost certainly, will exceed the cost of the investment. The same is true with your business; there will likely be a tradeoff of value in de-risking the business through an increased cost structure (insurance, technology tools, increased staff). Remember, a decline in cash flows equates to a decline in value. However, the real challenge for management is to either eliminate other, more marginal costs and/or find leverage in these incremental costs to increase revenue and profits.
Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, strategic purposes. If you’d like help in this regard or have any related questions, you can reach Joe Orlando, ASA at 503-925-5510 or firstname.lastname@example.org.