Private Businesses are Risky Assets
By Thomas Insalaco, CFA, CVA, Manager, Advisory Services
In the last issue, we discussed calculating returns on investments for private businesses and started to talk about volatility of those returns due to concentration risks. In this issue, we will delve deeper into the topic of concentration risks.
Many different types of risks exist that can cause a sudden or significant decrease in the value of a private business. Some of these are not controllable, such as general economic conditions or industry trends. However, there are common risks that many private businesses face that can be controlled, at least to some extent. One of the most common of these is concentration risks; in layman’s terms, too much of something is a risk if that one thing goes away or is lost.
One of the most common concentration risks faced by private businesses is according too much management responsibility to one individual; doubling the concentration risk occurs when that same individual is also the controlling shareholder. What happens if something suddenly happens to that individual, that renders them unable to run the business?
In quantifying that risk, a potential buyer would likely deeply discount their offer if they identified such reliance or control held by one individual, particularly if they thought that person was likely to leave the employ of the business after change of ownership.
Fortunately, this risk can be reduced. Succession plans can be designed and implemented. Responsibilities for relationships with customers and suppliers and oversight of daily operations can be distributed to other individuals. Other major responsibilities and control can be spread to other shareholders. To maximize a potential selling price, the goal should include the ability of the majority owner or manager of the business to discontinue employment with the business with little to no impact to operations.
Other common concentration risks to consider are:
- Concentration of a large portion of revenues with one or a few customers;
- Concentration of purchases with one or a few suppliers;
- Dependence on one or a few key employees;
- Dependence on one geographical area; and,
- Dependence on one product or service.
Attention needs to be paid to these types of risks. You wouldn’t want to lose a key supplier, have the only product you sell become obsolete, or lose your top salesperson right before you plan to sell your business.
By going through the process of having a thorough business valuation preformed, the valuation analyst will be able to help you identify which of these risks exist, which are controllable, and which would have the greatest impact on value if they were reduced.
We have talked about measuring returns on private businesses and concentration risks that can cause sudden or significant decreases in business value. In the next issue, we will discuss incorporating your private business into your asset portfolio.