Measuring Risk in Privately-Held Businesses

Given the recent difficulties in the U.S. financial markets, this Exit Strategies Newsletter is focused on helping business owners assess the risk inherent in owning and running a privately held business.  Understanding this risk measurement is critical to building an exit strategy plan because it helps an exiting owner understand the value that a buyer or successor will place on that business.

There is an old saying that 'there is no return without risk.'  This is taught in finance classes around the country and intuitively understood by every business owner.  Risk is measured in many different ways including default risks, credit risks, country risks, volatility risks, as well as 'opportunity cost' risks - to name a few.  These risks exist for publicly traded, liquid securities as well as for privately held, illiquid business interests.  However, there are two risks that are measured differently.

First, many business owners believe that the risk in their business is 'controlled' because they run the business.  This is, in part, true. However, the riskiness of any business, as a whole, should be measured more accurately by examining what a buyer or successor would be willing to pay for a controlling stake in that privately held business.

An exiting owner should ask: What would my businesses return on investment be to another buyer? 

Often times it is surprising to see that buyers are looking for an annualized average return on investment from the business of fourteen (14) to thirty-five (35) percent; sometimes greater returns are required for earlier stage companies. When there are higher perceived risks [to the buyer/successor] there will be lower offers (i.e. lower value) for the business. 

Another way to look at this is to see that the 14% to 35% expected returns translate into selling multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) of approximately 2.8 times to 7.1 times - for a majority / controlling stake of the business.

So why does the buyer of a privately-held company require a 14% to 35% return from owning privately held stock?

The primary reason is due to the illiquid nature of privately-held businesses. Unlike publicly traded companies, there is no 'ready market' for the trading of shares of private businesses. Therefore, there is no liquidity for these investments - which raises the risk associated with owning the business. 

Next, unlike publicly traded companies that disclose all 'material' items to their shareholders creating information transparency, privately-held businesses have no requirement to disclose such information.  In fact, it is up to the buyer or successor of any privately-held business to uncover those issues during a 'due diligence' process that accompanies a transfer of ownership. 

Also unlike publicly traded companies that have ready access to capital - either in the form of equity (stock) or in the form of debt (bonds) that are issued to the public, private companies need to pursue their own means of financing their growth projects.

Therefore, the main contributors to private company risks are the lack of liquidity, transparency, and access to capital. Knowing these risks of your privately-held business is a critical step in developing an exit strategy plan that meets your personal goals. 

You will need to choose from various exit options when you design your exit strategy plan. Once you are armed with such knowledge, you can choose either an 'internal' path which may measure certain risks one way - yielding you an exit that likely occurs over a longer period of time.  Or, you can entertain an 'external' transaction whereby you will engage in a process of arguing the risks of ownership with an outside buyer.  In this case, you are well served in knowing what this outside buyer is thinking in terms of the risks that they perceive in your business.  They will use this information to argue for a lower price (value) for your business. 

If your risk analysis is well documented, you stand a better chance of increasing the price that is received for your business.  And, regardless of the ultimate exit option that you choose, you will be well informed heading into the transaction.
In conclusion, exit strategy planning can be a complex endeavor for many exiting owners. These plans are not a part of the typical 'business building' that many exiting owners are so good at achieving.

Exit strategy plans do not have to be hard to design or properly execute if you can apply some of the basic concepts of finance to your privately-held business. We are pleased that you are continuing your pro-active interest in exit strategy planning because a pro-active approach to an Exit Strategy is the only approach to a successful Exit Strategy.