One of the most crucial, yet subjective, aspects of any business valuation is determining the specific company risk premium of the business being appraised. The specific company risk premium varies with each company and is intended to be an adjustment to reflect a variety of circumstances inherent in the company and its industry.
For a business valuation analyst engaged in determining an appropriate specific company risk premium, the following factors should be considered (at a minimum) when considering an exit strategy:
- Economic and Industry Conditions – National, regional, and local economic conditions can have a dramatic impact on a company. In addition, the industry in which the company operates may have more or less risk than the average of other companies.
- Financial Benchmarking – A financial benchmark compares the company’s financial performance against companies of similar size within its respective industry. A comprehensive financial analysis addresses the strengths and weaknesses of the company in terms of size, growth, liquidity, profitability, asset management, and leverage.
- Management Team – A company that is highly dependent upon the knowledge and expertise of a single person is considerably more risky than a company that has several key managers. In addition, the relationships between members of the management team can have a dramatic impact on risk.
- Competition – The level of competition in the company’s market can have a dramatic impact on risk. Does the company operate in a competitive market? What are the company’s strengths and weaknesses when compared to competition?
- Customer Base – The diversification of the company’s customer base can directly affect risk. How strong is the customer base? Does the Company depend upon only a few customers or a main customer for a majority of its revenue?
- Diversity of Company’s Products/Services – The diversification of the company’s product line or service line can directly affect risk. Are profits highly dependent upon a specific product line or service line?
- Government Regulation – Is the business highly regulated? Are there areas of future government regulations that could significantly impact the company’s operations going forward?
- Suppliers – Is the company heavily reliant upon a few suppliers that could have an adverse effect if relationships became difficult?
When quantifying the specific company risk premium, it is important for the valuation analyst to consider the above factors and any other business valuation items that are truly unique to the subject company. As a result, the selected specific company risk premium is based on the judgment of the valuation analyst and should reflect the level of risk within the subject company and its industry.