"RISK" The funders perspective
(14/1/2004) Previous PageInvestors are not necessarily deterred by risks. What they want to know is whether the structure of the deal makes the risks tolerable. Once the potential investors have satisfied themselves concerning the background behind the business, they will ultimately focus on the major risk areas. They will want to know about business risks, market risks, management risks and financial risks. There are many questions you can ask yourself to help them understand these four areas.
what are the business risks?- What key factors will determine success or failure?
- Is the product or service unique?
- Does it depend on a certain type of technology?
- Is the company located in a strong geographical position?
- Does the company have a strong management team with high quality strategy?
- Maybe the company has an acquisition or investment strategy that will place it in a healthy position?
For example, a logistics business or an airline needs a transport fleet to operate. How doesit finance this fleet and what impact does this have on its debt service obligations? What is the mix between fixed and variable costs, and how well does the proposed revenue stream cover these costs?
Is there concentration risk?- Is the company reliant on a handful of customers or is the customer base diverse?
- Does the company rely on one or two suppliers, and what happens if these suppliers go away?
- Does the company only produce one product or provide one service, and what happens if demand for this product or service suddenly dries up?
- Does the company rely on one piece of machinery or technology, and what happens in the event of a breakdown or obsolescence?
- Is there a danger that these channels might disappear?
- Are there any alternative channels of distribution through which the products and services may be delivered to market?
- Who are the competitors and how do they behave? For example, do you compete against Microsoft?
- How will competitors react to the company's initial success?
- What is the company's market share, is it measurable and is it sustainable?
- Is the market perception good?
- How quickly can a reputation be built up or dismantled?
- Does the company have an effective strategy for its proposition and what are the risks of changing the strategy? For example, many established businesses, such as Tesco and Iceland, are re-inventing themselves with internet strategies.
- How is the market defined?
- How is it structured?
- Is it comprised of a number of key players or is it highly fragmented?
- Is there a healthy level of competition? For example, are you proposing to launch a new operating platform for PCs to compete with Microsoft?
- What are the trends?
- Is the competition coming from abroad? For example, are you looking to finance a car manufacturing business in the UK to competewith European manufacturers?
- What are the key market drivers and constraints behind the supply and demand of the company's products or services?
- What are the business cycles, or is it seasonal? For example, does the company make Christmas decorations or fireworks?
- What about interest rates and inflation - How far can rates go up before the company can no longer pay its interest bill?
- Are a large percentage of sales or purchases made overseas, and is the company exposed to exchange rate risk?
- What is the likelihood of the technology becoming outdated?
- Has the chancellor introduced any prohibitive tax legislation in the sector?
- Are you thinking of going into cigarette manufacture?
- What about politics?
- Does the company provide products to, or operate in, a country experiencing conflict or political turmoil?
- Are you looking to build an agricultural farming business in Zimbabwe?
- What about tariffs, subsidies and embargoes? Does the overseas environment make it harder to compete either at home or abroad? For example, are you looking to be a British beef supplier to France?
- Does the company make all of its money from mowing lawns in the summer, and what happens if it's a wet summer?
- What happens if you're a domestic coal supplier during an extraordinarily warm winter?
- Is the company located on top of an old uranium mine, or does it produce dangerous waste or by-products?
- What experience does management have of running the business?
- Do they have a track record?
- Who will take over if a key member of the team leaves?
- Is there excessive reliance on one particular member of the management team? For example, if you are thinking of buying the Ferrari Formula 1 racing team, how much are you relying on Michael Schumacher for success?
Does management appear motivated and committed?
- Have the managers invested money in the business, and what do they stand to lose if the company is unsuccessful?
- Does the management team recognise it has any weaknesses?
- Importantly, has the management team been through a period of adversity before and how did they perform?
There is no greater test than how a management team performed when its backs were up against the wall.
Does the management team have strong references?
- Are there any skeletons in the cupboard?
- What valuable references can be provided to the banker to reinforce the glossy words in the CVs?
- Have you considered commissioning a recruitment specialist to undertake a formal management referencing exercise?
- Are there strong unions, and how will they react to a change of ownership and job cuts?
- Are you Alchemy trying to acquire Rover?
Financial risk assessment should determine the ability of the company to maintain adequate working capital, maintain productive assets, satisfy debt servicing commitments, pay reasonable dividends and maintain some borrowing power.
There are four basic areas that bankers review to understand the financial risks:- What is the current financial position?
- Does the company have sufficient liquid resources to operate effectively?
- How long will the company's cash last? In the US, many internet companies do not have sufficient cash resources to operate beyond this year and are relying on completing a fund-raising before the lights are turned out - a difficult proposition in a soft market.
Most companies require a core level of working capital to maintain operating capacity. Such working capital is determined the typical time lag between cash inflows and cash outflows. The time lag principally equates to the difference in the time it takes to collectsales (debtors or receivables) and the need to pay suppliers or creditors to meet production or consumer demand.
How reliable is the company's cash flow?- Is it based on a high quality recurring revenue stream, or is it opportunistic?
- Is the average age of the debtor book acceptable or are many debtors long overdue?
- Is the cash flow subject to seasonal or cyclical constraints? For example, the demand for luxury holidays tends to drop away in a recession but demand for caravan site holidays tends to remain fairly constant because of people trading up or down.
- What is the past operating performance of the company and how does it equate to the future?
- What are the underlying trends?
- Were there any substantial events or influences which impacted on performance? These may have been positive or negative.
- Were prior year revenues boosted by one-off asset sales or reduced by substantial development cost write-offs in the first year?
- What was the company's performance like in previous recessions or times of adversity?
- Was it able to adequately meet its commitments?
Factors such as sales, profitability and cash generation should be compared. What is the value of the business, both in terms of revenue multiples and the realisable value of its assets? If the business fails, what is the likely recovery amount when the vultures are circling?
What are the accounting practices?
- Does the company operate in accordance with international standard accounting practices?
- Are there any company-specific accounting practices which require further understanding or adjustment for effective analysis?
- Do these practices make it difficult for purposes of comparison? For example, if the business earns percentage fees on transaction revenues, does it account for the whole transaction in its revenues or just its own percentage share?
- Do actual revenues appear inflated by the accounting practice?
- Have there been any qualifying notes from the auditors?
- What was the tone of the last management letter?
- Are there any off-balance sheet items? If so, are they significant to the business? Are they captured by the structure of the transaction or the banks' security documentation?
- What is the potential for fraud?
- Can the future be projected?
- What financial assumptions are key to the company achieving its projections?
- Can these assumptions be projected into the future through sensitivity models?
- What is the likelihood of the assumptions being achieved? For example, is the management team hoping for a number of new supply contracts to be awarded to meet its break-even projections?
- By applying worst case scenarios to the key assumptions, are the financial obligations and commitments of the company still met?
- At what point below the managements' projections is the break-even point for the business?
- Would it take much of a negative impact on the business to reach this break-even point?
- How necessary is a large capital expenditure budget?
- Does the company need to replace its hardware every two years to remain competitive?
- How does the structure of the proposed transaction impact on the projected commitments of the company?
- Can the company meet debt repayments and dividend payments proposed under the structure?
