By Brian K. Lorberbaum
The value of a privately-held government contracting business is a function of three components: expected cash flows, anticipated growth, and perceived risk. It is our experience that business owners typically attempt to drive value by focusing on increasing cash flows and future growth; they often fail to consider what they can do to reduce risk.
The value of a government contracting business can be thought of as the product of a measure of current cash flow and an appropriate multiple which incorporates expectations for business risk. By focusing only on improving cash flow and growth, the business owner is missing part of the equation. Failing to reduce the perceived risk of future cash flow results in a reduced valuation. For government contracting businesses, there are a myriad of pitfalls, including environmental and government spending risk. However, we will focus on three issues that we often see ignored: customer concentration risk, supplier concentration risk, and management risk.
A company with a significant portion of its total sales concentrated in one or only a few primary customers has an increased exposure to customer concentration risk. An obvious remedy to customer concentration risk is to increase the size of the customer base. For government contractors, however, increasing the number of customers is difficult, because the primary (and sometimes only) customer is the government. Even if a government contractor has only the government as a customer, the expansion of the product and service offerings can mitigate the perceived risk associated with the customer base. Investors view the existence of multiple contracts for multiple products and/or services as an indicator of overall satisfaction and therefore a reduced level of risk.
Supplier concentration risk is the uncertainty associated with the ability to purchase key production inputs. The termination of, or adverse change in, the relationship between a government contractor and its suppliers can have a detrimental impact on the ongoing operations and sustainability of the company. An obvious remedy to supplier concentration risk is to find additional sources of supply. To a potential investor, a limited number of suppliers may suggest a lack of price control over production inputs. In addition, a single source of supply for a key production input raises the question of whether that supplier may later become a competitor.
Management risk is the uncertainty associated with the impact of the loss of a single (or a small group of) managers. In many small businesses, the owner has all of the customer relationships, manages the production process, and performs almost all management functions. The value of a potential investment is decreased if the departure of a manager (owner, or otherwise) would adversely affect the ongoing operations of the business or the relationships that have been established with its suppliers or customers. The most effective remedy for management risk is an established management team that operates independently of, but in coordination with, the owner(s) of the business. A management team should take responsibility for the effective execution of daily operations, and should guide the current supplier/customer relationships. This separation of management and ownership reduces dependency on the owner, and mitigates the damage that will be done by the departure of a single individual.
Decosimo Advisory Services has helped entrepreneurs in a variety of industries start, finance, grow, and sell their businesses since 1971. If you would like to discuss ways to reduce the perceived risk of your business in order to maximize its value, please call us at 423.756.7100.