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 have that money invested somewhere else. 

To determine the appropriate amount of risk and value of the company, valuation professionals and investors compare all the risks of the business 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

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Best Practices for Estimating the Company-Specific Risk Premium