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Understanding Risk in Business Valuation

Much has been written about valuing a closely-held business. A frequent topic discussed is the income approach and the application of the valuation multiple to a normalized income stream.

The valuation multiple (also called capitalization rate) is comprised of a many factors, including the company’s specific risk. Risk is an expression of the business valuation analyst’s judgment, as no database can exist to measure the company-specific risk drivers. The valuation expert must identify these drivers and judge their magnitude in order to estimate the additional rate of return the market would require to offset the investor’s acceptance of additional risk. The factors will vary from company to company, among industries, and over time within the same company. These may include depth of management, importance of key personnel, stability of industry, diversification of product or service, geographic location, earnings margins, etc.

Risk is categorized by: business risk, financial risk and liquidity risk.

Business risk relates to all factors that may prevent the realization of forecasted earnings. Items which impact sales, cost of sales, or administrative and operating expenses, are a component of business risk. Business risk is company-specific. In evaluating business risk, the valuation specialist should obtain an understanding of the company to determine issues relating to: industry, competition, depth of management, adequate working capital, etc.

Financial risk is a narrower company-specific concept. Financial risk relates to interest expense, a factor that can also diminish forecasted earnings. Financial risk may be assessed by how the company’s asset base is financed. If the company is financed primarily by equity, financial risk is minimal. But if the company is financed with debt, financial risk can be significant.

Unlike business risk and financial risk, liquidity risk is not company specific. Liquidity risk relates to the uncertainty associated with disposing of a closely-held business at fair market value, and stems from the uncertain length of the disposition period (associated with the time value of money). Liquidity risk occurs when an investor desires to liquidate an investment. In a publicly-held business, an investor’s interest is liquidated after the execution of a sell order. This investment is converted into cash within a couple of days, and liquidity risk is nonexistent. In a closely-held business, a controlling equity interest is generally more liquid than a minority equity interest. As such, a controlling equity interest has less liquidity risk. (This risk is also sometimes referred to as a marketability risk.)

As the most subjective portion of the capitalization rate computation, the company-specific risk associated with the valuation may be cross-examined. Therefore, the valuation expert’s ability to articulate the pros and cons of the company’s industry, business, and financial components, becomes an integral part of the valuation report. The attorney’s ability to focus on these principles will certainly provide an advantage in articulating or discrediting the valuation results.

The aggregate specific risk premium for closely-held businesses is typically considered low, moderate, or high. Low risk is associated with a risk from zero to five percent. Moderate risk often falls between six and ten percent. A high risk premium is generally a rate in excess of ten percent. Since this amount is included in the computation of the capitalization rate, it has a large influence on the ultimate value of the company. One should also insure that the risk interpretation is not in other components of the valuation (i.e. normalized income stream, discounts, etc.) as that would duplicative.

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