When valuing a business using an income approach, a valuation analyst will develop a discount rate or capitalization rate to apply to the expected ongoing income or cash flows of the Company. The discount or capitalization rate (cost of capital) is essentially a rate of return expected by the potential buyer for the investment in the Company. The rate determined should represent Company Specific Risk, the risk associated with investing in the Company.
Analysts use several methods to determine the cost of capital for a particular company, which will not be covered in depth in this discussion. No matter the method, the analyst must consider the risks related directly to aspects of a specific company. Company Specific Risk (CSR) is a subjective adjustment made by the valuation analyst based on the knowledge and understanding gathered about the company during the valuation process. Some factors considered when determining CSR include:
- Operating history, volatility of revenues and earnings
- Depth of management team
- Access to capital resources
- Reliance on key persons
- Geographic location
- Customer diversification
- Diversification of product line
- Competition, existing or prospective
- Pending regulatory changes
- Pending litigation
Let’s take a look at some of these.
Operating history, volatility
Lack of an operating history, or a history of volatile revenues or earnings, will tend to increase Company Specific Risk. A prospective buyer will not have a good sense of the company’s ability to generate a certain level of income year over year.
Depth of management team
Lack of a competent management team or lack of appropriate personnel who can step up to fill in for management will increase risk. A company run by a skeleton crew poses a risk that losing one person will impact operations.
Reliance on key persons
A company that relies on one or two key persons to either generate revenues or perform services related to those revenues is riskier than a company which has a staff of sales personnel and employees to meet the revenue demand. Oftentimes a business owner feels they can do it best themselves, but this poses a risk if something happens to them and they are unable to meet the needs of the Company.
Diversification of customers or product line
A company which relies on a small number of customers for the majority of its revenues is riskier than a company that generates its revenues from a diverse number of customers. If one customer is lost, what impact does that have on the ability of the company to generate the expected level of cash flows? The same can be said for product line. If a company relies on the majority of its income from one or two products, what happens when the products become obsolete? This is a risk to some companies.
The higher the Company Specific Risk, the higher the cost of capital. The higher the cost of capital, the lower the value of the business.
Business owners, especially those considering a future sale, should consider how their company is viewed in terms of risk by a prospective buyer. Reducing risk can pay off in a higher selling price in the future.
Melissa E. Loughlin-Sines, CPA, CFE, CVA, CFF, ABV