Parts I and II of this mini-series dealt with the concept of risk as it applies to the valuation of companies and identified a number of types of risk which investors are sensitive to and which affect their perception of risk. I advocated that anyone wishing to sell his or her company or raise equity should identify the particular risks involved and manage them, to the extent possible, well prior to entering into discussions with potential investors. This article outlines some of the common steps that owners of businesses can take to manage risk, thereby maximizing valuation, as well as increasing the chances of a successful transaction.
Managing risk starts with knowing your company well: are there any skeletons in your corporate closet? Try to catalogue the ten most important risks facing your company and list them from an investor’s perspective. Some examples of types of risk and how you might handle them include:
Client Risks: If one client accounts for more than 10-15% of your sales or a similar percentage of your profits, try to diversify away from that client. Generally, it is in your interest to sign your clients up on long-term contracts, assuming the contracts are favourable.
Financial Risks: (a) leverage: if your company is highly leveraged, it might make sense to pay down some of that leverage, switch from variable to fixed rate financing or enter into a new, long-term loan with your bank. (b) exchange risk: If your company exports and imports, the chances are that it is has risks associated with currency fluctuations. Would your profits be greatly diminished by a currency fluctuation? Try matching your imports and exports in the same currency, to diminish that risk, or consider purchasing a currency hedging contract.
HR Risks: Do your best to ensure that your staff are well motivated and planning to stay for the long-term. Do they have adequate financial incentives (e.g. bonuses or equity) to ensure that motivation and do they have appropriate non-compete and confidentiality clauses in their contracts?
Disasters: There are certain types of risk against which it may make sense to insure, such as professional liability or against natural disasters. You may also consider “key man” insurance, which can bring your company cash flow in the event of an interruption being caused by the death or disability of the CEO or another key member of the management teams. Also, you need to ask whether you have an appropriate disaster recovery plan in place, for your IT and other systems.
Of course, any step pertaining to risk management generally also has its costs. You need to carefully analyze the cost/benefit of each risk management option you are considering. If you have not taken steps to deal with certain types of risk, an investor may want to include the costs for risk management into the operating costs of the company when determining the valuation.
One of the best ways to protect yourself is to have your house in order. This helps to ensure the accuracy of financial statements, tax returns and other reporting systems in the company, thereby serving as an early warning system in identifying unusual patterns that could increase your company’s risk (from overstocking of inventory to delayed collection of receivables, to name a few). Investors will look at the quality of your systems in diagnosing risks and the capacity of your company to take action (e.g. more effort to collect receivables).
I am not advocating that you run a risk-free business. There is no such thing. What I am advocating is that you take the time to systematically identify possible risks and develop strategies for dealing with them. Business is all about taking intelligent risks.