Strategies
Valuation & Forensic StrategiesRisk in Business Valuation
Much has been written and said about the mechanics of valuing a closely-held business. A frequent topic discussed is the income approach and the application of the valuation multiple to a normalized income stream.
The valuation multiple (also referred to as the “capitalization rate”), is comprised of a number of factors, including the subject company’s specific risk. Risk is an expression of the analyst's judgment, as no empirical evidence or database exists, or can exist, to measure the company-specific risk drivers. In fact, the need to identify the company's specific risk drivers generally is relevant only when a private company is valued. The valuator must identify material, specific company risk drivers and judge their magnitude in order to estimate the additional incremental rate of return the market would require to offset the acceptance by the investor of that additional risk. The factors will vary from company to company, among industries, and over time within the same company. In general terms, these factors may include depth of management, importance of key personnel, stability of industry, diversification of product or service, diversification and/or stability of vendors, geographic location, earnings margins, etc.
Risk is categorized into three major groupings: business risk, financial risk and liquidity risk.
Business risk is a broad concept, as it relates to all factors that may prevent the realization of forecasted earnings. In other words, any item which can impact sales, cost of sales, or administrative and operating expenses, is a component of business risk. Business risk is generally considered to be company-specific. In evaluating business risk, the valuator should obtain a sufficient understanding of the subject company to determine various economic factors relating to: industry, competition, dept of management, adequate working capital, etc.
Financial risk is also a company-specific concept, but much narrower by definition. Financial risk relates mainly to interest expense, the lone factor capable of diminishing forecasted, pre-income tax earnings. Financial risk may be assessed by the manner in which the company’s asset base is financed. If the subject company is financed primarily by equity, financial risk is minimal. But if the subject company is financed primarily with debt, financial risk can be significant.
Unlike business risk and financial risk, Liquidity risk is not company specific; nor does it have any relation to the realization of some level of income. Liquidity risk relates to the uncertainty associated with disposing of a closely-held business at fair market value, and stems from the uncertain length of the disposition period (associated with the time value of money). Liquidity risk occurs when an investor desires to liquidate an investment.
In a publicly-held business, an investor’s interest is liquidated after the execution of a sell order. This investment is generally converted into cash within a couple of days, and liquidity risk is nonexistent. In a closely-held business, a controlling equity interest is generally more liquid than a minority equity interest. As such, a controlling equity interest has less liquidity risk. (This risk is also sometimes referred to as a marketability risk.)
As the most subjective portion of the capitalization rate computation, the company-specific risk associated with the valuation conclusion may be targeted in a cross-examination. Therefore, the valuator’s ability to articulate the pros and cons of the subject company’s industry, the advantages and disadvantages of the subject company’s business, and an analysis of the subject company’s financial components, becomes an integral part of the valuation report. The attorney’s ability to focus on these principles will certainly provide an advantage in articulating or discrediting the valuation results.
The aggregate specific risk premium for closely-held businesses is typically considered low, moderate, or high. Low risk is commonly associated with a specific company risk from zero to five percent. Moderate company risk often falls between six and ten percent. A high company risk premium is generally associated with a rate in excess of ten percent. Since this amount is included in the computation of the of the capitalization rate, it has a tremendous influence on the ultimate value of the subject company. One should be cautious to insure that the risk interpretation is not also contained in other components of the valuation model (i.e. normalized income stream, discounts, etc.) as that would duplicative.
In preparing a case involving the value of a closely held business, an attorney should pay close attention to the development of the specific company risk.
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