Business operations are subject to a number of risks from both internal and external factors. In addition, ownership interests in businesses are subject to risks, including market factors. How organizations and their owners address these risks can have a significant impact on the value of businesses and 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 organization and its owners.
“How a business addresses risk can have a significant impact on the value of a business,” says John T. Alfonsi, CPA, ABV, CFF, CVA, CFE, a managing director of Cendrowski Corporate Advisors LLC.
Smart Business spoke with Alfonsi about business risks and how they impact valuation.
Where is risk addressed in a business 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 businesses 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 organization will not achieve the projected figures. As such, the process by which management projects future cash flows can impact a valuation analyst’s assessment of the business. A key risk in the process 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. In analyzing historical projections, a valuation analyst should examine the variance between historical projections and a business’s actual performance. If a strong correlation exists, a valuation analyst can be highly 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. While valuation analysts are not experts in assessing internal controls, they can question management regarding how information integrity is maintained and business risks are assessed.
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. A project with relatively high risk will require a relatively high yield to compensate an investor for bearing these risks. 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 businesses 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.
Are there risks that a business can manage and some they cannot?
Yes. Businesses cannot generally control systematic risk. They can, however, control company-specific risks. Successful identification, analysis and mitigation of company-specific risks through effective ERM processes can commensurately bolster a business’s valuation.
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 capitalize on risky events when competitors do not react as swiftly to environmental changes. By capitalizing on risky events, businesses increase the chance of improving market share or maintaining an industry-leading position. ERM processes can also provide resilience to events including the loss of a leader or key customer. 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 Corporate Advisors LLC. Reach him at (866) 717-1607 or email@example.com.
You’ve spent years building your business and accumulating assets, but what are you doing to protect them?
An outside adviser can help you take the proper steps to avoid the many risks to which you’re exposed, says David Musser, a partner at Nichols Cauley & Associates LLC.
“A CPA can help you evaluate not only the tax consequences of your various ventures but also how your specific structure provides for maximization of asset protection,” says Musser.
Smart Business spoke with Musser about the steps you can take to protect your assets.
What is asset protection?
Asset protection is the set of legal techniques that individuals and entities use to protect their assets from civil money judgments. The goal of this planning is to insulate assets from creditor claims without tax concealment and tax evasion. Asset protection planning should be incorporated into both estate and tax planning and should be well diversified. In addition, using limited liability entities and trusts for protection yields a portfolio of wealth that is well protected from a variety of risks.
Timing is everything. By implementing a variety of asset protection strategies now, you can ensure that your wealth is protected before it becomes threatened.
What is the first line of defense in asset protection?
Insurance is the first line of defense against liability lawsuits. Attain coverage on personal assets, such as automobiles and houses, as well as business and rental real estate assets. Coverage should include liability, covering damages caused by you; property protection coverage, which covers sudden and accidental damages; and additional protection, such as umbrella coverage over your homeowner’s policy. But while liability insurance will give you a layer of protection against the loss of assets, it is not sufficient on its own to provide an effective protection plan.
What is the role of homestead protection?
The statutory homestead protection is a strong tool in asset protection planning, especially in those states that offer unlimited protection. The principal residence is often one of the most valuable assets needing protection against creditors, and there are a variety of homestead exemptions offered by the state of Georgia. However, there are limitations: The protection does not extend against federal and state liabilities and it only protects the primary residence, leaving vacation homes exposed.
How can family limited partnerships help protect assets?
Family limited partnerships can be formed to hold a family business or investments and, when used correctly, can be very powerful estate planning and asset protection tools. Not only do the limited partnership interests have the ability to receive significant discounts for estate and gift tax purposes, they may be subject to charging order protection in various states. This keeps the partnership interests and assets safe and potentially out of creditors’ reach.
The family limited partnership is a good solution for the very wealthy; those facing imminent problems, be they legal, financial or medical; and those with jobs that face a high risk of liability, such as in finance, law, construction or medical.
What other strategies are available?
The qualified personal residence trust is the most popular strategy for protecting a personal residence from claims. All of the advantages of home ownership are preserved under this strategy, and the family limited partnership can be designated the beneficiary of the trust, allowing for greater protection.
In addition, retirement accounts can also provide protection of assets. ERISA-qualified plans provide nearly absolute federal law protection against creditor claims, while IRAs offer only limited creditor protection. In addition, nearly all retirement funds are exempt assets in bankruptcy, although protection for IRAs and Roth IRAs is limited to $1 million.
Finally, asset protection trusts are irrevocable, meaning that they cannot be modified or terminated with beneficiary permission. The grantor essentially removes his or her rights of ownership of the assets. There are, however, more sophisticated trusts that may be established, which are deemed grantor trusts, allowing you to retain control over the assets.
What steps can a business owner take to protect both business and personal assets?
It is important for businesses to create a strategy that sufficiently protects personal and business assets from liability arising from lawsuits and business slowdowns. Failing to do so in an effective and timely fashion could create exposure to creditors, taxing authorities and courts.
As a result, the legal structure of the business is a key consideration when creating an effective asset protection plan. Several entities, such as corporations, LLCs and LPs, provide different levels of protection, and by using one or more of these, individuals can conduct business and continue to shield personal assets from claims against the business. Offshore entities can offer strong protection, but you must seek professional guidance due to the complexities involved.
In addition, these strategies also allow business and real estate assets to be protected from claims against individuals within the business, so it is important to separate liability-generating assets from one another in order to lower exposure risk of the overall asset profile.
By being proactive about protecting your assets, you will ensure that your exposure is minimal should any of the potential risks materialize.
For legal advice on the topic of asset protection, please consult with your attorney.
David Musser is a partner at Nichols Cauley & Associates LLC. Reach him at (800) 823-1224 or firstname.lastname@example.org.