Valuing a business: where are the risks?

Risks like these are one of the more difficult factors to evaluate when determining a company’s value.u2028 Some factors can be controlled, but the harsh reality is that most are beyond our control.

The good news is that while 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 vital processes will also ensure that critical information about the business is not held inside one person’s head.

However, all too often the owner is the key person without whom the business value could be compromised. 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. u2028

To identify the major areas of risk in your business, you need to carry out an evaluation exercise. For example, if one person manages your key customer accounts and they decided to leave, does that mean all your customers will walk away also?

To evaluate this risk, consider what would happen if they left. Which accounts might be kept and which are at risk? You can then estimate by how much your sales projections would have to be revised downwards.u2028u2028

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. u2028u2028

After assessing the impact that 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.

u2028u2028If the 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.u2028u2028As 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 its price by transferring strategic relationships over to the buyer.

However, this might not be possible in the case of an estate valuation where the owner is deceased. In such instance, 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.u2028u2028

Related Article: How to value a business

Terence Gale is a partner at Menzies LLP.

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