If you own a business, you want it to be as valuable as possible. One way to do this is by performing a business risk assessment. This means looking at all the things that could go wrong and finding ways to prevent them. By lowering the risks, you make your business more attractive to investors and increase its overall value—sometimes by huge amounts. For example, if the capitalization rate (cap rate) for a risky business is 30%, reducing the risk and changing the capital structure can lower the cap rate to 10%. This change alone can increase your business’s value by 300%.
Let’s break down how a business risk assessment, as provided by a certified business appraiser, can help in four key areas: Financial Stability, Management and Employees, Market Position and Customer Relationships, and Governance and Internal Controls.
1. Financial Stability
Financial Performance and Stability
A business that has been running steadily for a long time is generally seen as less risky. If your business is new or has had many ups and downs in its performance, investors might worry more and ask for a higher return on their investment. In financial terms, a higher return requirement means your business is valued lower. By keeping your financial performance steady through a business risk assessment, you reduce perceived risk, which can significantly increase your business’s value.
Consistent money coming in and stable profits show that your business can keep making money over time. If your earnings are unpredictable, investors might see your business as riskier and want a higher return. This higher return lowers your business’s price when you sell. By focusing on steady growth and reducing financial ups and downs through a business risk assessment, you can make your business more appealing and valuable.
How to Improve:
- Maintain Consistent Sales and Profits: Strive for steady revenue streams and avoid large, unpredictable expenses.
- Diversify Income Streams: After growing your initial book of business, ensure that your business doesn’t rely on a single source of income, which can make your income stream more volatile.
- Implement Reliable Sales Processes: Create systems that generate more predictable sales.
- Monitor and Control Expenses: Keep a close eye on where your money is going to prevent unnecessary costs.
Capital Structure
Having the right mix of borrowed money (debt) and owned money (equity) is crucial for your business. An optimal capital structure means using both types of funding in a way that lowers your capitalization rate and boosts your returns. Conducting a business risk assessment helps you determine the best balance between debt and equity. When your business can consistently earn more from its investments than it costs to borrow money, you are creating value. This positive spread means your business is efficiently using its funds to grow and generate returns.
Moreover, it’s important to match how you finance your assets with their expected useful lives. For example, if you buy equipment that lasts five years, it makes sense to finance it with a loan that you can pay off over the same period. This alignment prevents you from going underwater and helps keep your finances stable, as identified during a business risk assessment.
Finding the right balance between debt and equity not only makes your business more profitable but also makes it more attractive to investors. When your capital structure is optimized through a business risk assessment, investors see your business as a smart investment, which can lower the return they expect and increase your business’s overall value.
How to Improve:
- Use a Stable Mix of Debt and Equity Financing: Balance your funding sources to optimize costs.
- Keep Debt Levels Manageable: Avoid taking on too much debt that could strain your finances.
- Smart Financing: Match your loan terms with the expected useful lives of your assets.
Liquidity and Access to Capital
Having enough cash on hand and easy access to more money when needed reduces financial risk. A business risk assessment helps you evaluate your liquidity and access to capital. Businesses that can quickly handle their bills and invest in growth are seen as less risky. Regularly checking your cash flow and strengthening your access to funds helps protect your business and increase its value by ensuring you can weather unexpected financial challenges.
However, it’s not just about avoiding too much debt. Sometimes, having too little debt can be problematic, especially for smaller businesses. If a business is too cautious with borrowing during good times, it might not build the credit needed to secure financing during tough times. When challenges arise, businesses without a solid credit history may find it difficult to obtain necessary funds, leading to financial distress or even bankruptcy. Therefore, a balanced approach to debt is essential—not so much that you’re overwhelmed by repayments, but enough to build a healthy credit profile that can support your business when it needs it most, as identified in a business risk assessment.
How to Improve:
- Maintain a Healthy Cash Reserve: Keep enough cash to cover short-term obligations.
- Build Strong Relationships with Banks and Investors: Ensure you have reliable sources of additional funding.
- Plan for Future Financial Needs with Clear Budgeting: Anticipate and prepare for upcoming financial requirements.
- Strategically Use Debt to Build Credit: Take on manageable debt during stable periods to establish a good credit history, which can be crucial during downturns.
2. Management and Employees
Management Strength and Reducing Dependence on Key Persons
For smaller businesses, the strength and depth of your management team are often the biggest risks. Conducting a business risk assessment helps you identify these risks. If your business relies too heavily on a few key individuals, the departure or unavailability of these people can severely disrupt operations. Imagine if the person who brings in most of the clients suddenly leaves—can your business continue to run smoothly without them? If the answer is no, then your business has a significant key person discount, meaning it’s valued lower because of this risk.
To avoid this, it’s essential to build a strong, well-rounded management team and reduce dependence on any single individual. This means hiring experienced managers who can take over essential roles if needed and ensuring that knowledge and responsibilities are shared among multiple team members. By doing so, your business can continue to operate normally even if a key person is no longer part of the team, making it a safer and more attractive investment.
How to Improve:
- Hire Experienced Managers: Bring in leaders with a proven track record.
- Provide Ongoing Training and Development: Ensure your team stays updated with the latest skills and knowledge.
- Create a Succession Plan for Key Roles: Prepare for future leadership transitions to maintain stability.
- Distribute Responsibilities Among Multiple Team Members: Avoid concentrating too much power or knowledge in a few individuals.
- Develop a Strong Team That Can Operate Independently: Ensure that your business can function effectively even if key personnel are unavailable.
- Encourage Knowledge Sharing and Collaboration: Foster a culture where information is freely shared among team members.
Additional Tip: Business owners should focus on building a brand around the business itself rather than themselves. This way, the earnings power of the business remains strong even if the owner steps back.
3. Market Position and Customer Relationships
Geographic Location
Operating your business in just one area can be risky, as its success is often dependent on the success of the region. If that region faces economic problems, natural disasters, or other local issues, your entire business could suffer. A business risk assessment helps you understand and mitigate these geographic risks, making your business appear less risky to investors, leading them to expect a lower return on their investment.
To those who may doubt the importance of geographic diversification, consider what happened to businesses in Detroit when the auto industry declined, in West Virginia when coal mining shrank, or in San Francisco during the downturn in big tech. These regional challenges didn’t just affect large companies—smaller businesses were hit very hard too. When a key industry disappears from an area, many local businesses struggle to survive, highlighting the dangers of relying too heavily on a single geographic location.
By expanding to different locations, you spread out the risk and open up new opportunities. This can make your business more stable and increase its overall value because it’s not dependent on the success of a single region, as identified in your business risk assessment.
How to Improve:
- Adapt Your Offerings to Different Geographic Needs: Customize your products or services to meet the specific demands of various regions, ensuring they appeal to a wider customer base.
- Explore New Markets and Regions: Look for opportunities in different geographic areas to spread your risk.
- Develop an Online Presence to Reach a Broader Audience: Utilize digital platforms to expand your reach beyond your local area.
Customer Diversification
Relying too much on a single customer can put your business in a very risky spot. If one customer brings in a large chunk of your revenue and decides to stop doing business with you, your income can drop sharply, and your business might struggle or even fail. Additionally, if that major customer faces financial problems, it can directly affect your business’s finances. Conducting a business risk assessment helps you recognize the importance of having many different customers. By spreading out your revenue among various clients, your business becomes more stable and less vulnerable to losing any one customer. This stability makes your business more attractive to investors and increases its overall value.
How to Improve:
- Target Different Customer Segments: Diversify your customer base to include various demographics.
- Implement Marketing Strategies to Reach New Audiences: Use different marketing channels to attract a broader range of customers.
- Build Strong Relationships with a Diverse Client Base: Foster loyalty among a wide variety of customers to ensure stability.
Product/Service Diversity
Offering different products or services protects your business from changes in the market. If one product isn’t selling well, others can keep your business running. A business risk assessment highlights the need for diversity in your offerings, making your business less risky and more valuable by ensuring multiple revenue streams.
How to Improve:
- Develop New Products or Services: Continuously innovate to add new offerings.
- Innovate to Meet Changing Customer Needs: Stay ahead of market trends by adapting your products or services.
- Test and Expand Your Offerings Based on Market Demand: Use customer feedback and market research to guide your expansion efforts.
Competitive Advantages
If your business isn’t as strong as others, it faces more risks, which can lower its value. Competitive advantages are unique strengths that set your business apart from others. These advantages are hard for competitors to copy and include:
- Supply-Based Advantages: These relate to how you produce your goods or services. Examples include:
- Patents: Protect your unique products or processes.
- Preferential Access to Critical Inputs: Secure important materials before your competitors.
- Subsidies: Receive financial support that lowers your costs.
- Economies of Scale: Produce large quantities to reduce costs per unit.
- Demand-Based Barriers: These relate to your customers and market demand. Examples include:
- Customer Habits and Behaviors: Create customer captivity through consistent quality or a great customer experience.
- Switching Costs: Make it difficult or expensive for customers to switch to another company.
- Network Effects: Increase the value of your product as more people use it.
Advantages like having a strong brand or being the first to enter the market aren’t always lasting. Most businesses don’t have these strong advantages, so the best way to increase your business’s value is to focus on being efficient and running your operations smoothly to stay competitive. If your business does have strong competitive advantages, it’s important to recognize them and protect them from competitors who might try to take advantage, as identified in your business risk assessment.
How to Improve:
- Identify and Strengthen Your Unique Selling Points: Find out what makes your business special and make it even better.
- Protect Your Innovations and Intellectual Property: Make sure your unique ideas and products are legally protected.
- Continuously Monitor the Market and Adapt to Changes: Keep an eye on what’s happening in your industry and adjust your strategies to stay ahead.
Customer Contracts
Having long-term agreements with customers provides steady income and reduces uncertainty. Without these contracts, your revenue can be unpredictable, making your business riskier. Securing long-term deals can make your business more stable and valuable, depending on if these deals are viable.
When you have long-term contracts, you know you’ll receive consistent payments over time. This stability allows you to plan for the future, invest in growth, and manage your expenses more effectively. Without these agreements, your income can fluctuate, making it harder to keep your business running smoothly. For example, if a major customer decides to leave, your revenue could drop significantly, putting your business at risk.
Long-term contracts also build trust with your customers. They show that your customers are committed to your business, which can attract more investors and make your company appear more reliable. This reliability increases your business’s value because investors feel more confident that your company will continue to generate income.
How to Improve:
- Maintain High Customer Satisfaction to Encourage Renewals: Ensure your customers are happy with your products or services. Happy customers are more likely to renew their contracts, providing ongoing stability for your business.
- Negotiate Long-Term Contracts with Key Customers: Aim for agreements that lock in revenue for extended periods. This ensures you have a steady income stream and reduces the risk of sudden revenue loss.
- Offer Incentives for Customers to Commit to Longer Terms: Provide discounts, added services, or other benefits to encourage customers to sign long-term deals. These incentives make long-term agreements more attractive to your customers.
4. Governance and Internal Controls
Good Record-Keeping, Controls, and Documentation
Keeping accurate records and having strong internal controls are essential for preventing fraud and avoiding mistakes. A business risk assessment helps you identify areas where your record-keeping and controls can be improved. When your business maintains good records, it becomes easier to track finances, monitor performance, and ensure that everything is running smoothly. On the other hand, poor record-keeping can lead to big problems, such as financial losses, legal issues, and a loss of trust from customers and investors. By improving these areas through a business risk assessment, you make your business more transparent and trustworthy, which boosts its value.
Additionally, having proper documentation like formation documents, buy/sell agreements, and contracts is crucial. These documents outline the structure of your business, the roles of each owner, and the terms of agreements with customers and partners. They help protect your business in case of disputes and provide clear guidelines for how the business should operate.
How to Improve:
- Maintain Detailed and Organized Financial Records: Keep all financial documents up to date and well-organized. This includes invoices, receipts, bank statements, and financial statements.
- Establish Strong Internal Controls: Implement procedures to monitor and approve financial transactions. This helps prevent unauthorized activities and ensures accuracy in your financial reporting.
- Ensure All Legal and Operational Documents Are Up to Date: Regularly review and update important documents such as formation documents, buy/sell agreements, contracts with customers and suppliers, and employee agreements. This ensures that your business is protected and operates smoothly.
Pending Legal and Regulatory Issues
Legal problems or regulatory challenges can lead to fines, restrictions, and other penalties, increasing the risks your business faces. A business risk assessment helps you proactively handle these issues through compliance programs and seeking legal advice, thereby reducing uncertainty and protecting your business’s value.
Ignoring or mishandling legal and regulatory requirements can result in serious consequences, including costly lawsuits or regulatory actions. Therefore, it’s important to stay on top of relevant laws and regulations that apply to your industry and ensure that your business adheres to them.
How to Improve:
- Maintain Proper Documentation: Keep all necessary legal documents, such as licenses, permits, and contracts, organized and up-to-date. Proper documentation ensures that you can quickly respond to regulatory inquiries and avoid fines or penalties.
- Stay Informed About Relevant Laws and Regulations: Keep up-to-date with the laws and regulations that affect your business to ensure compliance. Subscribe to industry newsletters, attend workshops, or join professional associations to stay informed.
- Implement Compliance Programs: Develop and maintain programs that ensure your business follows all legal requirements. This includes training employees on compliance issues, regularly reviewing company policies, and establishing clear procedures for handling regulatory matters.
- Consult with Legal Professionals: Seek advice from lawyers or legal experts to navigate complex legal challenges and ensure that your business practices are compliant. Having a trusted legal advisor can help you address issues before they become major problems.
Get A Business Risk Assessment
Conducting a business risk assessment is a smart way to enhance your company’s value. By addressing risks in financial stability, management and employees, market position and customer relationships, and governance and internal controls, you make your business safer and more attractive to investors. This increased stability can lead to higher valuations and greater growth opportunities.
Reducing risks not only protects your business during tough times but also builds confidence among stakeholders, paving the way for long-term success. A business risk assessment helps you identify and mitigate potential threats, ensuring your business can thrive even in challenging conditions. Don’t underestimate the power of understanding and managing risks—embrace a risk assessment to unlock your business’s full potential and secure its future.
Our Business Value Builder program is designed to reduce the risk of your business and increase business valuations by more than 50%. A certified business valuation will determine if your business qualifies for the Business Value Builder program. To schedule a free consultation, click here.