I gave a presentation to my local estate planning council many years ago in an attempt to explain how the Specific Company Risk Premium is derived in a business appraisal. This group was fairly formal, such that the men always wore suits to each meeting; I had been attending regularly for several months by this time. The day of my presentation, however, I made an addition to my wardrobe. In addition to my suit and tie, I wore my John Deere ball cap. (This was in Idaho, a highly agricultural-based economy.) I made sure to arrive early and to sit at the head of the table, so all the attorneys would note my presence, and most importantly, the hat.
As everybody began to arrive, I saw them notice the hat, but no one actually ever mentioned it. When the time came, I launched my PowerPoint presentation and described how the build-up method works and where, in the then Ibbotson Associates book, the Equity Risk and Size Premiums were found and where they came from. A few slides in, came the time to discuss the Specific Company Risk Premium and where it comes from. I stopped right in front of everyone, took off my cap, and pulled from inside it a piece of paper upon which I had previously written the words, “a number”.
While that presentation did get their attention, I made sure to explain that while it may seem that business appraisers pull this figure out of our figurative hats, that there really is quite a bit of analysis that goes into the selection of this rate. For example, the financial ratio analysis tells us if the business we are appraising is more or less risky than the industry average. The economic analysis tells us if there are certain risk drivers that will impact the operations of the specific company either negatively or positively going forward. Our analysis of the industry the business operates in gives us similar insights, related specifically to the industry and potential competition. The quality of the financial statements we are provided also contribute to the magnitude of our selected Specific Company Risk Premium. Would a hypothetical, willing and knowledgeable buyer expect the same level of risk investing in a Company with CPA reviewed statements complete with accountant’s notes as investing in a Company where historical financial results have been recorded in pencil on the back of an envelope?
The selection of a Company’s specific associated risk has to be a subjective analysis, because of the large number of variables we have to consider in order to get inside our hypothetical, willing and knowledgeable buyer’s head. Are there any offsetting risks, are there any details that need to be considered that have an impact on the value that can’t be quantified? Is the business located on an exceptionally visible corner? Are the machines older, even though they are quite functional? Is the owner the key employee, and also in poor health? Is the Company well managed by a thorough and well-trained team of employees? Does the Company have a key customer that makes up 30% of total revenues; how about 15% of total revenues?
Selecting the appropriate Specific Company Risk Premium for use in the valuation of a privately held company is perhaps one of the most difficult, yet impactful tasks we perform in the entire valuation assignment. Make sure, your hat is not the only factor under consideration when selecting it.
Shawn M. Hyde, CBA, CMEA, BCA is the Executive Director of the International Society of Business Appraisers. He has 20 years of valuation and appraisal experience in numerous industries. He is a Certified Business Appraiser, a Certified Machinery & Equipment Appraiser, and a Business Certified Appraiser. He has written and taught courses for the Institute of Business Appraisers (IBA), for the National Association of Certified Valuators and Analysts, and for the International Society of Business Appraisers. He has served on the IBA’s Education Board, and the IBA’s Board of Governors, and is a past Editor in Chief of the IBA’s professional journal, Business Appraisal Practice.