How is an increase in business value best achieved? Traditional strategy looks to increase sales and boost profits. However, what business owners should be striving to affect is the way in which their business is viewed; low-risk, with high potential as an investment opportunity. No matter what elements define a business best, the perceived risk of that business trumps all others.
Eliminating risk should be the number one priority for every business owner. Increasing value ultimately comes from positioning the business in a low risk situation, thus making it a more attractive investment opportunity. Opportunities are most often lost when risks are too high. Naturally, there is a correlation between risk and quality. A business that is perceived as exceptionally risky, is seen as lower in quality. Therefore the question is, identifying where a risk comes from, if it can be measured and controlled, and the direct relationship between risk and value.
Investment and valuation professionals specialize in all areas of company analysis: planning, marketing, operations, sales, people, leadership, finance and legal. These eight general categories can be further broken down into unique sub-categories, and used by some investment models to analyze the risk of a company. Each categories presents its own risk, all of which can be used to compare to a set of private company best practices. Some risks fall under the responsibility of the owner, while others do not. It is this practice of benchmarking that allows for the connection of the risk profile to valuation and investment quality. There are a variety of ways to understand the value of a privately held business, however, professional investors and buyers will associate the level of perceived risk with the cost of capital (discount rate) in a projected Discounted Cash Flow (DCF) and terminal value analysis. The greater the risk of a business, the greater the cost of capital or discount rate will be.
Private equity firms determine a hurdle rate based on their commitments to their funding partners, thus establishing a valuation. This information is then used to assess the chances of gaining that return. Regardless of what method is used, perceived risk plays a major part in the valuation process.
This leads back to the question; how can an owner eliminate risk in their business? An initial assessment made objectively and thoroughly helps determine where a business stands in relation to companies that perform best in class. Using this assessment, a risk and quality profile can be created and connected to a cost of capital or discount rate to determine the intrinsic value for the business. Areas that hold reasonable risk that can be quickly corrected should be adjusted first. In those areas that will require longer enhancement, a plan can be established. From start to finish, the process can take as long as one to three years. However, obtaining a high level of performance and a low level of risk can achieve exponential benefits in terms of increased value.
A strategy can be implemented, utilizing an advisor that works to eliminate risk, that lowers controllable risk (company specific risk) reduces the Weighted Average Cost of Capital (WACC). Reducing specific risk will inherently reduce the WACC and allow the value of the business to increase substantially. In some cases, reducing specific risk by just 10% can double the value of the business!
Perception is key when it comes to lenders, buyers, or investors, and perceived risk plays a large role in any assessment. A dramatic increase in sales or an expansion of margins, without reducing risk first, can leave a business in a state of lower value and increased risk. The implementation of a risk reduction program as a first step, followed with corresponding strategies to increase sales and expand margins will lead to a positive impact on value as a result of lower discount rate applied to higher cash flow. Increasing value in this way can happen without necessarily increasing staffing, working capital, equipment needs, etc.
Using a structured process, a strong financial model, and an independent assessment, business value has the potential to increase exponentially. It requires time and commitment from the share holders and management team, as well as the right advisors, but is well worth it. Bottom line, if you want to sell your business for maximum value you need to de-risk your business. Valuing your business for maximum impact requires digging deeply into a company specific risk.
An exit plan from The Leland Group addresses the risk elements for each individual business and establishes a tactical plan to eliminate risk in a business and achieve greater valuations.