Everything has its risks, even getting out of bed in the morning. But that is no excuse for not getting out of bed at all: you can also have a heart attack under the duvet, after all.
The same is true for companies. No company is risk-free and business owners need to identify and fully understand the specific risks facing their companies. This is fundamental to good management, building corporate value, and to any due diligence process a business owner may have with investors.
Investors as well understand that there is no such thing as a risk-free company. When they assess a company, they typically aim to do three things: identify and understand the risks; verify whether management has a good understanding of the risks and an effective strategy for dealing with them; determine whether the risks may be effectively handled, either with management’s strategy or with a strategy developed by the investors themselves.
As an owner considering the sale of your company, the worst thing you can do is stick your head in the sand and pretend the risks do not exists – the "ostrich approach". You need to fully understand the risks and develop strategies to deal with them and mitigate their effects. And you need to be prepared to communicate with investors about those risks.
You as an owner may have been living with these risks for quite some time and probably feel comfortable with most of them. The investor, on the other hand, is just getting to know your business and will have a tendency to look for "worst-case" scenarios: any advisors retained by the investor are paid to identify risks, and their internal risk management procedures generally require that they map out worst case scenarios. It will therefore take an investor some time to begin to become comfortable with the risks involved with your business.
One of the reasons that there is so often a price gap between buyers and sellers of businesses is that the sellers may be much more comfortable or used to dealing with the risks in the business than the buyers. Similarly, different investors will have different perceptions of the risks involved in your business, which similarly explains why different investors may give differing valuations for your company.
As a business owner, you must appreciate that an investor does not know your company, and potentially not even your industry or even your country of operation – in short, that there are many things that they simply do not know and many things they need to become comfortable with. One of the aims of the information memorandum and due diligence should be to remove investors’ anxiety as far as possible (but without giving a distorted picture of the company).
The riskier an investor thinks your business is, the higher the cost of capital they will apply to the valuation of your business, and the lower the price they will be prepared to offer. It is a basic rule of corporate finance that the price of an asset is inversely correlated with the risk associated with the asset.
Do not wait until you try to sell your business to implement these principles or risk management – the earlier you implement them the better.
So what are the types of risk associated with running a business, and how can a business owner reduce or manage risk? This will be the subject of the second part of this column, which will appear on February 26.
Les Nemethy is the CEO of Euro-Phoenix Financial Advisors Ltd. (www.europhoenix.com), a Central European corporate finance company focused on mergers and acquisitions. Follow him at twitter.com/lesnemethy.