Your own worst enemy

If you don’t identify and address your firm’s problems, you could increase the measure of risk while decreasing value.

There is a four-letter word floating around out there that’s probably the first that comes to mind when someone is determining whether an investment is worthwhile. Guessed it yet? If you haven’t, then I’ll tell you: It’s risk.

Anyone with a pile of money looking to invest does not generally do so without first assessing the riskiness of an investment, the likelihood of receiving a return on that investment, and the level of risk present to determine how much return will be required.

People usually think of big, publicly traded companies when investing, and do not put as much emphasis on returns when dealing with private companies. In many cases, people investing in closely-held firms tend to look at it more from the perspective of lifestyle than a formal investment. That is, they see the “returns” more along the lines of independence, setting one’s own schedule, and discretion with money management. When it comes to valuing private company shares, the valuation exercise requires the development of rates of return and firm owners should expect not just a return of investment, but a return on investment.

A majority of private company valuations are performed under the premise of fair market value as defined in IRS Revenue Ruling 59-60. This is the ruling most commonly prescribed as a guide for the valuation of closely-held companies and their securities – the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both having reasonable knowledge of the relevant facts. Revenue Ruling 59-60 goes on to enumerate several factors for consideration, including the earning capacity of the business. Enter the income approach.

The income approach to valuing a business uses a financial return stream to develop an indication of value for the interest under consideration. In doing so, the appraiser must develop a discount rate that is the proxy required return for the hypothetical buyer. There is more than one technique for developing a discount rate, but I want to focus on the build-up methodology to demonstrate how the risk level present in a closely-held company can have an impact on value. A good rule to remember is a high level of risk equals a lower value and lower risk leads to higher values.

In the build-up methodology, the discount rate is “built-up” from empirical financial risk components derived from the public markets. In today’s economy that rate is around 15 to 17 percent for net cash flow to equity, or slightly higher if the appraiser determines that a size premium rate from the smallest of the small companies is warranted. One additional component is necessary to account for the fact that your closely-held firm is likely much different than a company traded on an exchange.

This last component is called the company-specific risk premium because it is specific to the subject business being valued. The specific company risk premium is of primary importance to you as a firm owner or principal because this is where the rubber meets the road in terms of driving firm value up or down. Take a minute to run down this list and ask yourself where you think you might stand:

  • Financial condition. How do you stack up against industry guidelines? When’s the last time any financial analysis has been done in your firm to determine performance levels such as liquidity, receivables collection, working capital, and debt burden, among others?
  • Asset risk. AEC firms have a significant amount of value wrapped up in intangible assets such as reputation and client base. Intangibles are high-risk assets that can erode quickly unless consistently nurtured. What are you doing to ensure and sustain a strong value for your firm’s goodwill?
  • Competition. What are your strengths and weaknesses when compared with the competition?
  • Management quality and depth. Do you have depth in your bench or is there a heavy reliance on only a few top players?
  • Diversification. Are you diversified in size, geography and customer base? If your firm relies upon a handful of clients for most of its revenue, the upward impact on risk is substantial.

To demonstrate the influence that a rate of return has on value, assume that a firm has net cash flow to equity of $500,000. That is the cash flow available to the shareholders which is free of working capital requirements and capital expenditures. Also assume that the rate we are using is inclusive of the company-specific risk premium and long-term growth has been accounted for.

Net cash flow to equity:

$500,000

$500,000

$500,000

Rate:

20%

23%

25%

Value indication:

$2,500,000

$2,174,000

$2,000,000

Based on the concluded rates, the spread in value indications is $500,000, or an entire year of cash flow!  Now, I know that no one likes “leaving money on the table.” Spending some time understanding your firm’s risk drivers and addressing those on the high end of the scale could very well be time wisely spent.

I am always pleased to talk with firm owners who are thinking ahead to an exit strategy and want to learn more about improving firm value. With time and sustained focus, problem areas of any firm can be corrected, and that should improve the measure of risk and increase value.

Tracey Eaves, MBA, CBA, CVA, BCA, CMEA is a member of the valuation consulting team at Zweig Group. She has been valuing privately held company interests for more than 18 years. Contact her at teaves@zweiggroup.com or directly at 505.258.8821.

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Posted in Articles | September 10th, 2018 by