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 [email protected].