Value Driver Two: Lower Risk

Nov 19, 2019

Every valuation considers the element of risk. In the context of creating value, we are referring to lowering the kind of risk that can be managed through business strategies, not the categories of risk that are insurable. Did you know you can reduce the inherent risk within your organization without buying an insurance policy? (A strong risk management program absolutely requires insurance – this is not a recommendation to cancel your insurance policies!)

From an investor’s perspective, enterprise risk, or business model risk, includes structural elements like unpredictable cash flow, customer concentration, and reliance on key management. By designing and implementing strategies to address these areas, owners and managers can increase value.

Cash Flow
By nature, some companies enjoy predictable cash flow while others must work to win every project. This dynamic often depends on the industry in which a company operates. Consider a consumer-packaged goods (CPG) company compared to a construction company. CPG companies often benefit from established retailer relationships and a broad customer base while the nature of construction often necessitates bidding on new projects with new clients on an ongoing basis. Which type of company generally enjoys a more predictable revenue stream? You guessed it – the CPG company.

With that in mind, the good news is that an enterprise is not entirely at the mercy of the industry in which it operates. CPG companies can increase predictability in revenue, and thus cash flow, by implementing a subscription model. Numerous examples of successful subscription services exist in the market, such as men’s razors, beauty boxes, and wine shipments, to name a few. The successful application of a subscription model is not limited to CPG companies, nor is it limited to business-to-consumer companies. In fact, construction companies also have the ability to benefit from this strategy. By introducing monitoring and maintenance services, along with a traditional design and build offering, a construction company can also generate recurring revenue, and thus enjoy a more predictable stream of cash flow.

Customer Lists
Customer concentration refers to the percentage of sales a company generates from its top customers. High customer concentration carries greater risk, because the loss of a top customer represents the absence of a substantial portion of sales. On the other hand, customer diversification occurs when sales are derived from a broad customer base. Companies with diversified customer lists are better positioned to compensate for the loss of a key customer.

Suppose you were to purchase a company, and months later, that company’s top customer files for bankruptcy, resulting in a loss of 30% of the revenue stream. Surely you would not have been willing to pay the same price had you known the risk associated with that one customer. A diversified customer base adds value because it lowers the risk of this exact scenario. Even if your current plans do not involve a sale, diversifying your customer base now will provide long-term benefits.

Along with customer diversification, industry diversification provides similar benefits. A customer list comprised of accounts across numerous industries reduces exposure to industry cyclicality.

Management Depth
A strong management team reduces enterprise risk by increasing the likelihood that an organization would be able to continue operations and retain customer relationships in the event that the president or CEO were no longer involved in the business. True, you can purchase key man insurance, however a cash payout in a worst-case-scenario situation cannot compensate for the resulting leadership void. The only way to protect against day-to-day key man risk and enhance value is to invest in management depth.

For valuation purposes, we evaluate management depth by considering planning processes, decision-making roles, and key relationships. We assess a higher level of risk in a fact pattern where the founder is the primary visionary, decision-maker, and go-to person for key customer accounts. In comparison, a company with management depth often utilizes a strategic planning process with input from the senior leadership team, decision-making takes place in a more de-centralized fashion, and multiple personnel are responsible for key customer and industry relationships. Over time, empowering a leadership team increases the value of an organization along with other more near-term benefits such as diversity of experience and ideas.

To read more:
Value Driver: Higher Profits and Cash Flow
Value Driver: Higher Growth Potential

If you are interested in learning more about value drivers and ways to improve valuation, drop us a note. We’d be glad to provide an independent perspective into areas where you can lower business model risk.

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