By Gregory R. Caruso, JD, CPA, CVA
We all know the story: a business has a detailed cash flow projection that seems totally sensible. Then, something happens, and the company does not make those projections. The idea that a company might not make future projections represents a risk in business valuation, and something that as valuators we have to examine. Risk can come from many sources. It can also be quite pervasive in small business valuation. I want to review concentration risk, or where there might be limitations on revenue for a business. Concentration risk can occur in many places, some of which are not always immediately apparent. Here are six concentration risks.
Limited Market Risk
Where is a company selling? Sometimes, the market is only so big. For example, Hilton Hotels have a presence all over the world, which provides them a cushion from any one particular market (say Europe) having difficulty. However, a local franchisee is in one market, and if that market gets overbuilt or has many hotels in competition, it might be harder to find customers or recover.
Limited Product and Service Risk
What is a company offering or selling? A business can have a limitation based on what they sell. During the Covid pandemic, Costco was considered essential because it sold groceries. However, they also sell many other products including clothing and outdoor gear. A small retailer that only sold outdoor gear or clothing was not considered essential and forced to close. Similarly, an accounting firm that had a majority of clients in restaurants would have been more adversely affected by the pandemic than one that had clients in many different industries. Being concentrated in one product or service can be a risk.
Limited Management Risk
Who are the managers? The nature of a small business is that it is small. Most small businesses tend to have a limited number of managers. This means that the loss of any key person can disrupt the business.
Customer Concentration Risk
Who are the customers? Many small businesses can grow quickly by providing services to a few larger companies. However, if their revenue only comes from a small number of clients, then the loss of one of those clients could represent a significant amount of money. Too high customer concentration can be a risk.
Referral Concentrations Risk
Where does the business get new customers? This can be much harder to spot but just as deadly. In one instance, I saw a business with many customers but they all came through one or two referral relationships. If one or both of those relationships stopped referring new clients, where would the business get new clients? Clearly this can increase risk of loss of revenues.
Supplier Concentration Risk
Where does the company get their supply? Anytime a business has only one supplier–particularly if the supplier is hard to replace–that adds risk. For instance, a sole supplier in China that gives good prices is far riskier than many local suppliers.
How should we address these risks in our SBA business valuations, Estate and Gift tax business valuations, and Exit and Succession Planning business valuations?
In most instances, companies of a similar size can be searched and selected for comparison. Often these companies will be subject to the same concentrations and limitations. Therefore many of the concentrations I mention above will already have been factored into the multiplier. But you have to take care and examine the sample set. This helps you make sure that if there are outliers and factors that may create a variance, you take them into account and bump your ultimate selected multiplier up or down as appropriate. With experience this process becomes much easier, but in all cases it requires thought and judgment.
Data for the income method is primarily derived from public company information. Most public companies are very large (even “small” public companies are usually huge compared to private firms). They might also not have the above concentration risks, and definitely wouldn’t have them to the same degree as a small, one- or two-location business. For this reason, you must adjust for these factors in the Company Specific Risk Adjustment when using build-up methodologies to determine the discount or capitalization rate. Some valuators have tried to create a factor analysis to calculate the Company Specific Risk Factor, but to date on one has been successful. This adjustment contains a lot of professional judgment, where experience is key.
I am Gregory R. Caruso, JD, CPA, CVA, a Partner at Harvest Business Advisors where I have valued and brokered hundreds of small and mid-sized businesses. Learn more about my business valuation services.