Risky Business: The Impact of the Company-Specific Risk Premium

Written by: Megan Hoss, CPA

When valuing a business using an income approach, analysts must develop a discount rate or capitalization rate to apply to the expected ongoing income or cash flows of the company. The discount or capitalization rate (cost of capital) is essentially a rate of return expected by the prospective buyer for their investment in the company. In simpler terms, if a company is considered riskier in comparison to another company, the investor would require to be compensated in the form of a higher rate of return for investing in the riskier company. The higher the discount rate, the lower the value will be for the subject company.

Analysts use several methods to determine the cost of capital for a particular company. However, no matter the method used, analysts must consider the risks directly related to the characteristics of a specific company. The Company-Specific Risk Premium (“CSRP”) is a subjective adjustment made by an analyst based on the knowledge and understanding gathered about a company during the valuation process. The CSRP represents the additional risk premium required to compensate an investor for the uncertainty in investing in a particular private company.

Because the CSRP is based on a specific company’s risk, there is no database, empirical study, measurement model, or formula that valuation analysts can apply to calculate the CSRP for an individual investment. Therefore, the CSRP is ultimately a matter of the valuation analyst’s professional judgment and experience.

Some factors considered when determining the CSRP include:

·         Operating history and volatility of revenues and earnings

·         Depth of management team

·         Access to capital resources

·         Reliance on key persons

·         Geographic location

·         Customer diversification or dependencies

·         Diversification of products or services

·         Competition, existing or prospective

·         Pending regulatory changes

·         Pending litigation

Let’s take a look at some of these.

Operating History and Volatility of Revenues and Earnings

Lack of an operating history, or a history of volatile revenues or earnings, will tend to increase a company’s CSRP. A prospective buyer will not have a good sense of the company’s ability to generate a certain level of income year-over-year.

Reliance on Key Persons

Typically, in smaller companies, upper-level management is comprised of relatively few employees. In such circumstances, it is not unusual for a company’s future success and viability to hinge on the continued health, success, and contributions of an owner or founder. When a company is highly dependent on one or two individuals for its continuing success, it suffers from key person risk. 

Geographic Location

If a company solely operates in one city or geographic region, the company could suffer if the local economy lags the growth of the national economy.  Having operations in multiple locales would help reduce this risk. Also, geographic concentration may create a ceiling to potential growth and expansion.

Diversification of Customers or Products

A company which relies on a small number of customers for the majority of its revenues is riskier than a company that generates its revenues from a diverse number of customers. If a major customer is lost, what impact does that have on the ability of the company to generate the expected level of cash flows? The same can be said for product lines. If a company relies on the majority of its income from one or two products, what happens when the products become obsolete?

In summary, the CSRP is an important component in the cost of capital measurement for any private company valuation; and it is often a source of disagreement between analysts. Quantifying a CSRP is one of the most controversial and elusive areas of business valuations. In business valuations that may be scrutinized by courts and other potential adversaries, an expert’s experience and skills are invaluable.   At Cogence Group, our 30+ years of experience help us deliver a supportable and unbiased valuation. Count on the experience you can trust.