Venture capital (VC) backed portfolio companies are highly susceptible to macroeconomic, industry and unique risks. In addition, VC fund ownership interests in portfolio companies are subject to risks, including market factors. How these parties address risks can significantly impact the value of companies and fund interests therein. An enterprise risk management (ERM) process involves identifying risks relative to an organization’s objectives, assessing them for likelihood and impact, developing a response strategy and monitoring progress. A well-defined ERM framework can protect and create value for the portfolio company and its parent VC fund.
“How a portfolio company addresses risk can have a significant impact on the harvest value of a business as well as interim mark-to-market valuations,” says John T. Alfonsi, CPA, ABV, CFF, CVA, CFE, a managing director of Cendrowski Selecky PC.
Smart Business spoke with Alfonsi about portfolio company risks and how they impact valuation.
Where is risk addressed in a portfolio company valuation?
The most common method of valuing a business is the ‘income approach,’ which requires a valuation analyst to project a business’s future cash flows, then calculate the present value of the sum of these cash flows by employing an appropriate discount rate.
When using the income approach, a valuation analyst must address risk in two primary areas: projected future cash flows and the discount rate. Effective ERM processes can help portfolio companies increase value by affecting the estimates for these quantities.
How does risk impact projected future cash flow?
Projections contain risk: There exists a risk that the portfolio company will not achieve the projected figures. As such, the process by which portfolio company management and the VC fund project future cash flows can impact a valuation analyst’s assessment of the business. A key risk is information integrity, the quality of information generated through monitoring and data assimilation. Information integrity allows management to make well-informed decisions and should provide a valuation analyst with greater confidence in a business’s projections.
Valuation analysts can analyze information integrity by examining historical projections and assessing elements of the internal control environment. While VC-backed companies are often nascent firms, the development of a robust internal control environment is an essential component to maximizing value. Potential strategic and financial acquirers, as well as investment bankers who may take a portfolio company public, want to see control environments supported by strong culture focused on mitigating risks. This culture will be evaluated by valuation professionals when they examine projections.
In analyzing historical projections, a valuation analyst should examine the variance between historical projections and a business’s actual performance as well as the business’s ability to reach milestones in a timely manner. If a strong correlation exists between projected and actual performance, a valuation analyst can be confident in current projections, if the process employed by the organization in making projections remains constant. If a strong correlation does not exist, the analyst must examine the variance between past projections and actual performance to discern whether bias existed in past estimates and may exist in current projections.
What about risks in the discount rate?
The discount rate is the yield necessary to attract capital to a particular investment, given the risks associated with that investment. In determining the discount rate, there are two sources of risk to be quantified: systematic and unsystematic. Systematic risk is the risk one must bear for taking on a risky investment in the market, which encompasses all available risky investments, including public and private equities, real estate, foreign currencies, etc. However, systematic risk is estimated by calculating the return to public equities due to availability of data. The ERM process has little impact on systematic risk unless the business’s performance is heavily tied to market performance, as was the case with Lehman Brothers and Bear Stearns in their final days.
Unsystematic risk is sometimes broken down into two components, industry risk and company-specific risk. Industry risk reflects the risks identified with the industry in which a business operates. Company-specific risk encompasses all other risks, including (but not limited to) size, depth of management, geography of operations, customer and/or vendor concentration, competition and financial health. This last component of the discount rate is one that portfolio companies can impact, and commensurately increase or decrease their valuation. Identifying and minimizing company-specific risks through an ERM process can positively impact the value of a business, as a company subject to less risk is more valuable than one subject to greater risks.
How can ERM processes mitigate company-specific risks and increase value?
An ERM process should quickly gather and assimilate high-quality information for use in the organization’s decision-making process, allowing the organization to rapidly assess the impact and likelihood of risks associated with changes in its internal and external environments. Early assessment and mitigation can help preserve value and cash in the business as well as allow it to capitalize on risky events when competitors do not react as swiftly to environmental changes. By capitalizing on risky events, portfolio companies increase the chance of improving their market share or establishing an industry-leading position. The ability to successfully mitigate risky events should be recognized by a valuation analyst through lower estimates for company-specific risks, leading to higher valuation estimates.
John T. Alfonsi, CPA, ABV, CFF, CFE, CVA, is a managing director of Cendrowski Selecky PC. Reach him at (248) 540-5760 or firstname.lastname@example.org.