When you invest in something, it’s more than likely because you expect to see a return. This is no different when acquiring a new business, however, investments come with inherent risks, and that’s especially true when taking over a new company.
You’ve no doubt heard the phrase, “No risk, no reward,” but only the savviest investors actually know how to properly measure risk, and how much risk is too much. If you underestimate the dangers, you could be setting yourself up for failure. In the same way, unless you have a realistic understanding of a company’s risk, you won’t be able to maximize your return on investment.
This is why an accurate risk assessment is so absolutely crucial during business valuations. There are several factors that need to be accounted for that affect a company’s risk profile, including:
Are there enough people to fill the jobs? Are potential employees hard to find? What are the skill and degree requirements for doing these jobs and can they be adjusted? Technical companies often hire more specialized individuals, who are part of a small pool in their fields. With few options, it may be difficult to grow the company. Of course, that’s just one labor issue to consider.
You may also want to account for longtime or key employees due for a salary increase, as well as determining if the business brings significant liability. Are on-site accidents and injuries commonplace, like in construction? Has sufficient employee training been implemented? It is also important to ask for an accident history report for any company vehicles.
What are the age demographics of the management staff? If they are nearing retirement age, it is possible that they may retire when ownership changes. Will the new owner need to hire new management, or will they promote from within?
How is management’s performance? Has the company outgrown its managers? Do they possess the skill sets to help take the company to a higher level?
Risk management for small company valuations can often be difficult, as many small businesses are family-owned. Are the managers related to the current owner, and will they leave with new ownership? Will there be any managers left after the deal concludes?
Is the company financially stable, or are they fudging their numbers? While there are many questions that one should ask during risk assessment, ultimately, risk is quantified by two factors: discount rate and capitalization rate. Discount rate is the rate of return that justifies the business acquisition. In other words, the investment made must be lesser than the amount received. The company will need three to five years worth of income statements and balance sheets to perform the business valuation.
Capitalization rate is the discount rate adjusted for annual growth. This projection gives the buyer a better idea of how the business will perform long-term. While a company may be stable now, will their performance carry over in the coming months, or will they dip into the red?
Are the business’ suppliers diverse? If they only receive shipments from one company, that company can raise prices at any time. With more suppliers, sales become more competitive.
How much longer does the lease extend? Will it be renewed? Is the business likely to outgrow its space?
Diversity of Accounts
Like suppliers, a company should have a wide range of accounts. If one account is responsible for a large portion of revenue, then the company could easily go out of business. If the company has larger accounts, they should be under several-year contracts.
Is this business an innovator or pioneer, or do they have many competitors? It’s also important to understand how emerging technology will affect the business.
Have the company’s financial numbers been consistent? If not, the new owner won’t be able to understand what they should expect in the future.
What is the company’s purpose and will they remain relevant? Would other buyers be interested? Are the customers loyal or are they more likely going to move on when something else steps onto the market?
The purpose of business valuation services are to analyze the financial prospects of the company. If the valuation results indicate instability or uncertainty ahead, that should raise a major red flag. Public attitude, new technology and developments, as well as policy can all affect a business’ future. Be sure to consider all of these factors.
Each of these risk factors must be evaluated and put under strict scrutiny in order to assess the benefits of a particular business acquisition. A small business valuation can help investors determine the value of a business and, considering the risk factors mentioned above, can paint a clear picture of your investment opportunities. Start your free trial of Banker Valuation today and get the tools you need to run a small business valuation in just minutes.