Risk and Reward in Business Valuations

ByKelly Deis

 

In its simplest form, the value of a business can be boiled down to just two components: risk and reward.

Although a significant amount of thought and rigor is required to determine the value of a specific business, the underlying concept remains the same: the value of a business is equal to the economic benefit (earnings or cash flow) that it generates divided by the risk it takes to generate those benefits.

Value = Earnings (or Cash Flow)
Risk

Think of it this way. If two companies generate the same amount of cash, which one is more attractive (valuable) to investors?

A) a Fortune 500 company in business for 35 years with revenues locked in for the next 5 years

B) a start-up with an untested management team, dubious business plan and volatile revenue stream

Of course, the right answer is A).

So, while earnings are important, don’t forget to focus on risk as well. They both play an important part in the value equation.

Increase Earnings

No need to belabor this part of the equation. Most business owners and leaders are well aware of the importance of the bottom line and focus almost incessantly on it. The levers are well known:

  • Sales: Increase price and/or volume
  • Costs: Improve margins, and/or decrease overhead and other variable costs
  • Efficiency: Increase throughput with the same level of effort and/or improve performance.

Industry benchmarks for operating margins are publicized and good managers strive to attain “Best in Class” status.  Of course, getting to “Best in Class” is easier said than done. It requires a compelling value-proposition, well-conceived strategy, comprehensive business plan, great management, flawless execution, and a lot of hard work.

That said, good financial performance is irrefutable. Improving and sustaining a solid bottom line will absolutely increase the value of your company.

But there are two pieces of this puzzle.

Decrease Risk

Mitigating risk is often overlooked, but can have the same impact on value as increasing earnings. Think of some of these factors:

  • Revenue Quality: Strive for strong customer loyalty and/or significant recurring revenue. Subscription-based revenue is even better. Multiple revenue streams (or product lines) also decrease risk.
  • Diversification: Endeavor for zero reliance on any one customer or supplier. The top ten customers should not account for more than 20% of revenue. Same is true for suppliers.
  • Litigation: Any litigation – no matter what the circumstances, appears risky to an outsider. Get any open or pending litigation behind you as quickly as possible.
  • Management depth and strength: Your business should not be overly reliant on any one person – including you. Like any good team, strong bench strength is critical in case the star player can’t play.
  • Financial records: Messy financial records project an appearance of poor management (and therefore risk). Ideally, an outsider should be able to accurately assess your financial situation without any additional commentary.

If you would like to increase the value of your business – either through increased earnings or decreased risk, please give me a call. I would be happy to help.