Many businesses rely heavily on a few key people or customers. Losing them would affect sales, profits and ultimately business value. But by how much? Risks like these are one of the more difficult factors to evaluate when determining a company’s value.
Some factors can be controlled, but the harsh reality is that most are beyond our control. However, the good news is that even though you cannot control the likelihood of an event occurring, you can create contingency plans to reduce its impact on the bottom line. This type of risk management can be used to increase the value of your business.
For example, say you rely heavily on one customer or supplier. You cannot force them to remain loyal to you, but you can become less reliant on them by broadening your customer or supplier base. Similarly, if the issue is over-reliance on one staff member, you can spread the workload across other staff. Additionally, documenting key processes will also ensure that business critical information is not held inside one person’s head.
However, all too often the business owner is the key person. If that is the case, create resilience by strengthening your management team and develop a succession plan to manage the transition for their exit from the business.
To identify the major areas of risk in your business, you need to carry out an evaluation exercise. For example, one person may manage your key customer accounts, but if they leave does that mean all your customers will walk? To evaluate this risk, consider what would happen if they left. Which accounts might be kept and which are at risk? Then estimate by how much your sales projections would have to be revised downwards.
Similarly, if you rely on one supplier it may be difficult to maintain profit margins if they change terms or prices. An honest evaluation of current and alternative supplier contracts will provide a basis for evaluating the strength of your cost base, and consequently your profit margins.
After assessing the impact these risks might pose to the business, you need to apply it to the valuation. How this is done will depend on the valuation method chosen.
If valuation is based on a multiple of earnings, risk might be factored in by decreasing future sales or gross profit margins to reduce maintainable earnings. Alternatively, if sufficiently accurate forecasts are not possible, risk could be factored in by applying a lower multiple to current earnings. Whichever is chosen, it is important to ensure that the impact is not duplicated.
As a final point, it should be remembered that the circumstances surrounding a valuation will come to bear on the risk analysis. For example, when an owner sells their business, they seek to maximise price by transferring strategic relationships over to the buyer. But in an estate valuation, the owner is deceased. Even if there was a succession plan, there may not have been time for an orderly transition of relationships prior to death, and this would have to be factored into any valuation.
Read the extended Business Valuations update here.
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