You’re considering purchasing a business and there are two companies that interest you. Both generated $1 million last year, but one has a more consistent track record of earnings than the other. There may be less risk inherent in the more consistent company, and you may be willing to pay a higher price as a result. But before signing on the dotted line, you first need to examine the business risks. Good appraisal reports should contain a thorough evaluation of business risks. Looking at a company’s existing and potential problems is a crucial step for any purchaser.

A risk assessment is important at many junctures. Whether business risks are examined for estate tax purposes, litigation, sale and purchase, or divorce, a valuator should consider more than just numbers. To a large degree, studying business risks is a qualitative process.

Each business has a unique mix of management, employees, customers, suppliers, competition, industry, and other internal and external factors that affects its profits and survival. The valuator’s job is to identify how these key elements affect a specific company from a hypothetical buyer’s perspective. Whether through a management interview or through deposition in the litigation process, a valuator should look at a number of factors that affect risk, including:

• Background and history. Businesses with track records of consistent earnings are less risky than companies that have more cyclical and unpredictable earnings.
• Products/services. Check to see, for instance, if a company has a patent from which it derives considerable revenue. A patent that is expiring soon increases the business risk.
• Marketing activities. How is the company marketing itself? Is there a price war going on that may damage earnings power?
• Customers. Are one or two customers responsible for most of the business? If so, what will happen if the company loses one or both key customers?
• Suppliers. If the company is a manufacturer, identify its suppliers for critical components. If there are just one or two, then the company’s business risk is tied to the survival and/or continued relationship with these key suppliers.
• Management. Is there high turnover in management? Are managers experienced? Are they nearing retirement? Do they have health problems?
• Employees. Are there irreplaceable employees? How is the labor pool affecting turnover and hiring? Will costs be driven up because higher wages are necessary to attract good employees?
• Competitors. Is the company a small player in a big industry or vice versa? Who is the competition, and how savvy are they? Are the competitors big companies with deep pockets?
• Industry. Where is the industry going? Will expected technology developments or other changes have a negative impact on the company?
• Financial results, projections, and forecasts. Examine the financial history of the company, as well as projections.
• Financing. Look at the debt load of the company. The health of the balance sheet is important because you want to know if the company will be able to qualify for loans.
• Existing or contemplated contracts. When do existing contracts expire? How successful is the company in entering new contracts? What are the business prospects of the company?
• Existing or potential litigation. Examine the litigation history of the company. Are there any outstanding lawsuits? Are there potential ones (i.e., environmental, employment)?

In assessing a business’s value, remember that the company’s income stream can be affected positively or negatively by the business risks that exist. Any number of factors can influence the well-being of a company. A good business risk analysis should look at all factors that can increase or decrease the risk to a business.