How to Estimate Company-Specific Risk
Company-Specific Risk
Business valuation is determined by the expected rate of return for the “risk” that the investor is taking to purchase the business and the future earnings of the acquired company. In essence, the purchaser is giving up the opportunity cost to invest that money elsewhere.
To determine the appropriate amount of risk and value of the company, valuation professionals and investors compare all the business risks to other available investments and other companies that could be acquired. Investors want to be compensated in the form of a higher rate of return for investing in a riskier company. The more risk, the greater return the investor expects which ultimately results in a lower value for the subject company.
There are basically two main categories of risk: External and Internal. External risks cannot be controlled by the business owner while internal risks fall under the control and influence of the entrepreneur. In formal finance terms, external risks are referred to as systematic or aggregate risks. These include risks like the general economy, the industry, regulations, technology, political environment and others. They are risks that impact every business and cannot be changed by an individual business owner.
While an entrepreneur can do little to control external factors, internal risks or “Company-specific” risks are the ones under the entrepreneur’s control. This is especially true when given adequate time to develop a plan to eliminate or mitigate the risks.
These risk factors contribute the most to increasing relative value between similar businesses and are what form the basis of a plan to maximize value. To maximize value, strategies must be developed to mitigate Company Specific Risks such as:
Business dependency on the owner
Customer concentration
Diversification of customer base
Contracted vs. non-contracted revenue
Supplier relationships / concentration
Threats of technology
Incomplete financial records
Online Reputation
Patents and Intellectual Property
Lack of verifiable, clean financials
Lack of long-term customer or supplier contracts
Lack of employment contracts, non-competes, non-solicitation agreements
Negative reputation, online presence
Poor financial health, capital structure risks
Restrictions on assignability of leases/contracts
Partnership disputes, disgruntled shareholder
Liability exposure, lawsuits
Outdated inventory and equipment, technological obsolescence
Here is a link to additional guidance on the Impact of Company Specific Risk and reach out to us at anytime!
Best Practices for Estimating the Company-Specific Risk Premium
