When it comes to selling a business, the perception of risk significantly impacts value. The less risk involved, the higher the selling price will be. One way to think of it, says Ted Collins, CPA, ABV, manager of business valuation for Vicenti, Lloyd & Stutzman LLP, is to think of the home buying process. You hire a home inspector to assess the condition of the house and tell you what needs fixing. You then notify the seller that your offer is less than asking price because of the leaking roof, termites and cracked driveway.
“Had the seller fixed the problems ahead of time, the buyer might not have had as many reasons to ask for a reduced price,” explains Collins.
Smart Business spoke with Collins about how risk impacts value, how business valuation professionals determine risk and why identifying risk is important even if an owner is not planning on selling his or her business.
Why is risk an important concept for private companies?
Each day in the public marketplace, companies are either rewarded for achieving their target profits or punished for falling short. Managers of public companies have a public scorecard of shareholder value, which is reflected in the stock price. Private companies, on the other hand, don’t have this type of scorecard until the time of sale. If a private company waits until then to focus on the perception of risk, much value can be lost.
How does risk impact value?
Risk impacts value by changing the perception of an investor or acquirer. Whenever an investment is deemed riskier than another, an investor demands a greater return on that investment. Investors are essentially buying the future potential of a business to generate the required return.
The financial theory of present value holds that future dollars are worth less than today’s dollars because you can invest today’s dollars and earn a return. To determine what to pay for a business, an investor uses a required return on investment to discount those future dollars to present day value. The more risk involved in the business, the higher the rate of return, which then discounts the value of the business further.
How do business valuation professionals look at risk?
Risk is very subjective in nature. Valuation professionals attempt to look at it from a hypothetical investor’s perspective in order to reduce some of that subjectivity. We look at risk through three windows: the macro environment, industry and the company-specific risk.
In the macro environment, we consider risks such as the direction of interest rates, trade policies and demographics.
Questions that will be raised about the industry include: Is competition increasing? Are customers leaving to new industries and technologies?
Finally, we consider the company itself. How well do the data benchmarks compare with the industry? How are its systems used to generate revenue? Are the systems operating efficiently? What makes this company different from its competition?
A valuation professional then makes a determination of what a hypothetical investor might expect as a return, given all of the known risks.
What steps should a private company take to minimize risk?
The purpose of minimizing risk for a privately held company is to build value for an eventual sale. If the owner is thinking of selling the business in the next five years, the company must develop a strategy to minimize a buyer’s perception of risk.
Owners of privately held companies may have issues that they’ve always been meaning to correct, but they’ve never identified them as a high priority. There may also be issues that have never been considered. To paraphrase the poet Robert Burns, ‘There is power in seeing ourselves as others see us.’
A valuation professional can help a business owner see his or her business from a buyer’s prospective and point out issues that may affect value before a buyer gets a chance to. Given enough time, the owner can either fix the issue or mitigate it on their terms and timetable, rather than at a stressful sale time when the risk of losing a buyer is present.
What if the owner is not planning on selling?
This process is useful even if an owner is not planning on selling, because it serves to strengthen the company for the day when it will be transferred to either an heir or to key employees.
Identifying risk is not an abstract idea; it often gets to the core of what makes a business thrive. This is why you see companies with chief value officers in charge of managing value. Outside of servicing customer needs and enhancing employee effectiveness, protecting and building the value of a company is critical to its long-term success.
TED COLLINS, CPA, ABV, is manager in the Business Valuation Group for Vicenti, Lloyd & Stutzman LLP. Reach him at (626) 857-7300 or TCollins@VLSLLP.com.