Addressing Risk in Business Valuations/Determining Your Business True Net Worth

Addressing Risk in Business Valuations/Determining Your Business True Net Worth

There are at least three approaches to determining the value of a company. The Company Analysis ("CA") should typically include three valuation methods: a comparable transaction analysis, an asset valuation and a discounted cash flow valuation. A single valuation method will usually provide a price that is questionable. The most commonly used method in a CA is the discounted cash flow (DCF) valuation that presents the amount of cash the business will typically produce each year going forward.

When a qualified professional writes a CA for a client, the writer typically covers risk factors that could be raised by an acquiring party in a merger or acquisition of a company. Risk factors evoked when reading a CA are exclamations of disagreement or opposition to information being presented. A well written CA addresses or answers the risk factors with three readers in mind. The logical reader wants the facts, with risk factors answered factually. The emotional reader seeks information based on an emotional need to know or understand. The practical reader receives information as it is presented and asks questions when necessary. Regardless, the CA should identify and answer risk factors based on the anticipated questions raised by the three types of readers.

Risk Factors are divided into Tangible Risk Factors and Subjective Risk Factors.

TANGIBLE RISK FACTORS

1. Needs. An entrepreneur, investor group, or a company in the market to merge or acquire a company is searching for ways to increase earnings. The CA must clearly identify who the company is, what is being offered and the benefits of ownership. The CA is an engaging document that compels the reader to look beyond the graphs and charts.
2. Value. The financials provide a historical justification for the listing price and are typically based on past performance. A Quality CA documents sustained value created during past company operations and documents the future potential for upside growth.
3. Benefits. A sustainable valued company will have desirable products and a defensible market position. The CA includes a historical perspective & sites the company's position in poor and favorable economic conditions.
4. Opportunity/Challenge. Grow or die is the only rule in business. A CA identifies the competitors, risk factors and strengths for portfolio growth.
5. Sustainable. Objections typically include questions about cash flow, depth of management, diversification of customer base, obsolescence of product, barriers to entry, and rollup potential. A quality CA identifies sustainable growth opportunities.

SUBJECTIVE RISK FACTORS

Subjective risk factors are usually based on an experiences or expertise of individuals or values held by the company. The following are the most common subjective risk factors raised during the due diligence process and should be addressed in the CA. This is NOT an all inclusive list.

1. Depth of Management. A company should have someone other than the owner who manages the day to day operations of a company. When the owner manages the operations a prospective acquirer raises the questions related to sustainable customer loyalty after the company changes hands.
2. Owner Level of Involvement. A single owner - operator carries a risk of limited operational documentation, employee loyalty to a new owner, and uncovered information.
3. Diversification of Customer Base. What percentage of customers generates a majority of the company's revenue? At least 80% of the customer base should generate a majority of the company' revenue.
4. Obsolescence of Products. Customer demand for products reflects the past. Customer demands for continued purchases should be projected and supported with customer satisfaction surveys.
5. Changes in Distribution Patterns. An evaluation of sales typically reveals customer purchases by product lines. The CA should project market demand for a company's products for a five year cycle.
6. Demographics. Will the company's product continue to attract a broad range of consumers by age groups or are new products required to shore up the revenue during the next five years?
7. Economic Trends. The CA should document trends in the economy, both past and future, and make projections on future purchase decisions for the company's products.

8. Consumer Demands. The margins should be flexible in order to support a downturn in consumer demand during poor and good economies.

9. Proprietary Products. Are the products legally transferrable? Are the products restricted or copyright protected by contract from being transferred to a new owner?

10 Rollup Strategy. Will the merger or acquisition benefit the entrepreneur, investor group, or a company's five year plan?

Each transaction typically produces a different set of Tangible and Subjective Risk Factors. A quality CA document should cover all the Tangible and Subjective Risk Factors listed in this article. As the Acquisition Team of a prospective acquirer or merging company raises new questions, the Intermediary should document each risk factor and explain the impact on the potential influence on the company.

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Award Winning CPA John Dillard is an Christian Speaker/Author and Certified Public Accountant in Duluth, GA. To See how he takes Christ along with him to work visit http://www.hiscpa.com/  and for his latest book Overcoming Life's 9/11's: Job's Journey and a Voice of One: Nehemiah's Prayer visit http://www.john-dillard.com/  (All Rights Reserved) Dare to Attempt Something so Great for the Kingdom of God that it is doomed to failure, lest Christ be in it!