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The Importance of Company Specific Risk

Many times through the classes I facilitate in New Orleans or through my work with Emerge Dynamics, I am asked what the drivers of a business' value are.  There are many.  However, here I describe an often overlooked, yet very important driver: Company Specific Risk.

Whether my role is as a consultant or as an investor, I work closely with the companies I align myself with to identify and methodically reduce company specific risk, thereby increasing their valuation.  As described below, a company can increase its valuation by reducing Company Specific Risk, even without growing sales or profitability by one dollar.  But here's a nice perk.  When companies identify Company Specific Risk and then develop an implementation plan to reduce it, not only does that alone increase valuation, but sales and profitability usually increase as well.  A double bonus. I was facilitating a class this week during which the students were trying to understand the drivers of business valuation.  Because the class was made up entirely of business owners, they were naturally keen to understand how much their company might be worth.

Conveying the principles of relative valuation was, well, relatively easy.  And conveying the principles of discounted cash flow (DCF) also wasn't that difficult (properly utilizing these techniques takes a seasoned expert, but explaining the principles so that entrepreneurs can understand the drivers of their business value can happen relatively quickly).  It was that intangible Company Specific Risk that the entrepreneurs had a little trouble wrapping their brains around.

I proposed these scenarios to help explain:

Scenario 1 Consider Company A and Company B which are both in the exact same industry.

Company A $10,000,000 in sales $1,000,000 in net income The founder is an industry all star who is the rainmaker and can regularly make calls to his contacts and bring in new business.

Company B $10,000,000 in sales $1,000,000 in net income The founder is talented and is assisted by two general managers who were trained by the founder and follow a process of systematically finding and closing on new business.

Which one would you pay more to buy? A or B?

Scenario 2 Consider Company A and Company B which are both in the exact same industry.

Company A $10,000,000 in sales $1,000,000 in net income The founder of the company is proud of his new client which is a nationally recognized brand and makes up $4,000,000 of the $10,000,000 in sales.

Company B $10,000,000 in sales $1,000,000 in net income The company has numerous clients, none of which are larger than $1,000,000.

Which one would you pay more to buy? A or B?

These scenarios really helped get the point across.  It became clear that the value of a business involved more than just the business' cash flow. The riskiness of that cash flow is also an enormous factor in determining how much to pay for a company.

In Scenario 1, while Company A is run by an industry all star, a buyer will struggle to create value in an organization which revolves around a person who may no longer be there after a change in ownership.  In Scenario 2, while Company A may have a nationally recognized client, the departure of that client would be a disaster, therefore also rendering this Company's cash flow at a higher risk.

This phenomena is picked up in the Cost of Equity Formula that many may be familiar with as part of the Capital Asset Pricing Model (CAPM). A modified formula which often works well for private companies (the company's correlation with the market is not accounted for, Beta is assumed to be 1, and a variable is added in for riskiness of the specific company) is below:

E(Ri) = Rf + (Rm - Rf) + RPs + RPu

Where: Rf =  Risk-free rate Rm = Expected market return RPs = Size Premium RPu = Company Specific Risk (CSR) Premium

Current values for each of these variables can found from sources like the Duff & Phelps Valuation Handbook.  The Company Specific Risk Premium, however, is a measure of unsystematic risk and thus must be measured by examining the individual company being valued.  Here is where much of the "art" of valuation comes in. And because CSR can be as low as 2% or as high as 40%, this variable alone can overshadow the numerous other valuation variables that can be deduced by more scientific methods.

And there are many other scenarios than the two listed earlier in this post.  A buyer would be wise to spend a lot of time carefully understanding Company Specific Risk before arriving at a target's value and moving forward with an investment.  A seller would be wise to identify and mitigate Company Specific Risk in order to increase valuation before attempting to go to market.

Special thanks to Ken Sanginario of Corporate Value Metrics who was instrumental in my ability to articulate the importance of  Company Specific Risk in prepping a company for sale.

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