How to Increase Value by De-Risking Your Business

Increase Value by De-Risking Your Business

Business owners quite often receive information advising them how to increase the value of their business. In our experience, there is so much information that establishing priorities is overwhelming, leading to “paralysis by analysis.”

Focusing on de-risking the business relates to addressing issues that affect a buyer’s perception of risk, which then impact the discount rate applied to the earnings of the business. When valuing a business, buyers will evaluate the level of risk and establish a rate of return commensurate with that risk to be applied to the earnings of the business using the discounted cash flow method.

The most common risk factors evaluated in that discount rate are:

  • Solid reputation in the marketplace.
  • Sustainability of earnings and recurring revenue as a percent of total revenue.
  • Diversified customer base - Customer concentration is a significant value detractor.
  • Diversified base of suppliers.
  • Barriers to entry – capital, licensing, permits.
  • Excellent financial records, planning, and budgeting.
  • A strong, stable management team.

We have covered these factors in more detail in our blog post Ten Ways to Maximize the Value of Your Business. While improvement in those areas will result in a higher value, and possibly more interested acquirers, decreasing the risk profile of the business, and lowering the discount rate, will move the needle on valuation much more dramatically.

A business has value when it can exist separately and apart from its owners, when it has taken on a structure and culture of its own, or where there are processes, methods, products, property rights or anything else that allows the business to continue as a going concern as its own entity.

Most buyers are looking at multiple businesses in their search and becoming the most attractive business opportunity they are pursuing positions your business above other options and creates a competitive environment. Competition creates negotiating leverage for the seller, which adds value, helps with negotiating the terms of the transaction, the due diligence process and decreases the time to close. Almost all business acquisitions include some level of third-party financing, and lenders focus on the risk factors to underwrite the loan for the buyer. Favorable financing terms allows the buyer to have a higher rate of return on equity, again, increasing the price they will pay.

Here is an example of the impact of changing the discount rate:

De-risking a business

In this example, the business owner increased the price by $1 million or 20% by improving the risk profile. The initial valuation of 5x EBITDA (20% discount rate) is raised to 6x EBITDA (16.7% discount rate).

De-risking your business

How does a business owner begin the process of “de-risking” the business? An objective, third party assessment of how the business measures up against others in the industry on the above factors will be the first step. Some items may be obvious, others not so much. Professional advisors can prepare a valuation of the business and, in that process, ask questions that will uncover problems, and possible solutions that may be implemented. Our experience is that most buyers use an investment model that takes the factors outlined above into account in developing the discount rate to use for the DCF valuation.

Due to the time involved to correct these types of issues, the owners should begin this process at least two to three years before thinking of actually entering the market to sell the business. The first step is understanding how the factors will affect the buyer’s evaluation of the business. The second step is working with a professional to understand which of these will have the greatest impact on the discount rate, and focus on those areas. Knowledge of which areas that will have the greatest impact on the buyer’s evaluation of the risk is important.

The time and energy to reduce risk will pay enormous rewards to the business owner at the end of the day.