My previous column dealt with risks in the valuation of companies, stressing in particular that the higher the risk associated with a company, the lower the value of that company. This is not static: investors’ perceptions of risks constantly evolve as they assess a company and the valuation process is consequently also evolving in tandem.

In the context of privately-owned companies, few things are more crucial than the due diligence process, when an investor reviews – in detail – all of a company’s title documents, financial records, contracts and the like. Because of this, it is in the interests of all owners to identify and manage risks well in advance of engaging in serious discussions with investors.

So what types of risks are we talking about? There is always the risk of a surprise, but here are just some of the types of risks about which investors are usually cautious.
Client risks – is a company’s client list well diversified, or does one client represent a disproportionate volume of revenues or profitability? What are the chances of losing the most profitable client(s)?

Technological or industry risks, namely what are the chances of a company being left behind by technological change? What other industry-related risks are there, such as possible changes in the business model in the industry.

Competitive risks – what is the probability of competition intensifying, whether through the entry of significant new players, or renewed efforts from existing players?
More visible than ever, financial risks are the cornerstone of any due diligence process. How high is the leverage of the company and what are the chances of default? If a company is listed on a stock exchange, what are the chances of a hostile takeover? What are the possible effects of currency exchange rate fluctuations on the company’s profitability? In the event of a change of control, what rights do the company’s banks or financiers have? What is the risk that there may be a mis-statement in the financial statements or tax returns?

And since you are investing in the talents of your staff, there are numerous human resources risks, such as the odds of losing key staff. How difficult would they be to replace? Is there an ample supply of blue collar labour? What are the chances of staff costs escalating rapidly? Does the company have one or more unions covering its labour pool? What risks might this entail?

Does the company have unfunded pension obligations? Do staff members have stock options that might have an acceleration clause regarding certain events such as a change of control? Will there be any extraordinary severance payments in the event of a change of control? Has the company regularly paid its social security and payroll taxes? If management receives a big payout under a liquidity event, will their motivation be diminished?

And what about the company’s supply line? Does the company have an ample supply of raw materials and other inputs it needs to carry on business? What are the chances of disruption?

Regulatory risks are always worth checking, to see whether any relevant laws or regulations are changing in a way that could have an adverse effect. Are there any ambiguities in laws or regulations that could be construed by government authorities or third parties against the company?

Environmental risks – has there been any water, air, or land pollution associated with the product or the property used or owned by the company? An increasing number of legal jurisdictions have strict liability provisions that do not ask questions about how the pollution was caused: if the pollution is on your land, you may be liable to remove it, even if you did not cause it.

And on the issue of liability, what are the chances of products being recalled, repaired or replaced? Similarly, if it is an advisory business, could there have been any errors or omissions that come back to haunt the company?

Finally, the intellectual property risks, such as whether your company has strong and valid rights to its intellectual property? Does it own patents or trademarks, for example? When do these expire?

In the third part of this series, which will appear on March 12, I will deal with the issue of how to deal with some of these risks, once they are identified.

*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.