When considering a company valuation, investors expect a greater return when there is a greater level of risk. Risk level is going to be different for every business because several factors must be evaluated. Using an income approach, valuation can be determined by applying a future-return discount rate or capitalization rate (cost of capital) to the cash flow of the company. This rate represents Company Specific Risk (CSR), which is basically the risk associated with investing in the company. Any risks related directly to different aspects of the business must be considered based on information gathered about the company during the due diligence process of valuation.
Factors for Determining CSR
CSR will increase based on either a lack of an operating history or a history of volatile revenues or earnings because it leads to the inability to gauge the company’s future income year over year.
The location of the company and its global footprint can affect risk. Some developing countries offer greater potential for growth than developed economies, and at the same time, they can present elevated risk. Considerations can include unfavorable currency fluctuations, and unstable geopolitical factors or financial markets. For a company with multiple locations, high-growth regions can offset the effects of lower-growth regions.
The competitive landscape in your specific sector or market can impact your CSR. How much competition there is and how well they are performing will indicate if they pose a threat to your customer base. It is important if your business is filling a niche that others cannot. It is also vital to understand how easily your services could be replaced. You will also need to be aware of what competition may be waiting on the horizon and if you are prepared to meet the challenge.
Management Team Depth
A proficient management team is key to the valuation of a company. A lack of the right people and depth at key positions will increase CSR. No prospective buyer wants to run the risk that losing one key team member will adversely and largely affect the company’s performance, especially if that person is directly responsible for generating revenue. There should be adequate staffing to meet revenue demand. In the cases of many smaller businesses, it is common for there to be an over-reliance on the business owner, which increases risk in the event that something happens to them and they can no longer run the company.
Access to Capital
If a company has little or no access to capital, it can have a negative impact on CSR, especially if the business is young and not well established. Businesses in their early stages often rely on capital assistance to finance their day-to-day operations. The sources of this capital will also be a factor (equity, loans, grants, etc.).
Diverse Customer Base and Product Lines
If a company relies on a small number of customers to account for the majority of its cash flow, it increases the CSR. It’s never a good sign when the idea of losing one customer will greatly impact the company’s revenue. The same goes for the business’s product line. One or two products can perform well and keep a company going but there may be risk that they could become replaced by a newer product and fall out of demand. Keeping new innovations in the pipeline can decrease this level of risk.
In today’s society, legal issues are not uncommon. Obviously, if your company is involved in pending litigation, it can increase your CSR. But there are several factors that influence the level of impact on CSR. These include the materiality of the litigation, the potential for future lawsuits, and the connection between the legal action and the business plan. It is also critical that the cost and timeline of the litigation is compared with available funds in order to assess bankruptcy risk. Additionally, if the litigation were to end badly, can the company can survive the financial aftermath.
Any possibility of regulatory changes that could directly impact the business’s ability to operate and generate revenue could pose a risk to value. These factors include trade and tariff policies, tax reform, labor and wage laws, and financial regulations regarding divestitures, disclosures and liquidity.
Know Your CSR
Every business owner should consider their company’s specific risk factors and how they can impact value. Finding solutions for reducing risk can result in a higher company valuation and a higher price in the event of a sale.