Consider These Risks Before You Acquire a Closely Held Business

How can you tell if a closely held business carries excessive risk? Some companies have vulnerabilities that aren’t visible at first glance, so potential buyers should always consider certain risk factors as part of due diligence before making an offer on a target company. What you discover can help you protect yourself from costly mistakes and set a fair price.

What’s Your Risk Tolerance?

Every business involves some risk, of course. But anything beyond normal, market-based risk can mean that the company’s current earnings might be unsustainable if and when circumstances change.

It’s critical that buyers identify and assess excessive risk before deciding whether to move forward with the acquisition. Common risk areas for closely held businesses include data quality issues, commodity dependence, ownership interest, key-person concerns, over-concentration, revenue volatility, and marketability.

Data Quality Problems

As data drives more and more business decisions, obsolete technology or other factors that contribute to poor-quality data become increasingly problematic. Additional risk can rise from poor data practices, such as lost or misfiled receipts, contracts, or transactions; insufficient internal controls that allow data to be misreported; inadequate documentation to support financial statements; and much more.

Smaller companies sometimes don’t prioritize bookkeeping or even perform regular account reconciliation, so financial records may be out of date. Even when a company’s data practices are rigorous, older systems may not allow the kind of tracking and data capture that leaders need to make timely decisions and ensure full regulatory compliance.

Be sure to factor in the costs of bringing systems and records up to date. Remember, too, that missing, messy, or misleading data can hide a multitude of problems. Prospective buyers should also be aware that poor data practices can sometimes reflect inadequate separation between the company and personal finances. A wispy corporate veil invites piercing by courts.

Commodity Dependence

Does the company depend on one or more raw materials that are subject to price fluctuations? Inflation can squeeze margins for most businesses, but those that rely heavily on commodities are at increased risk from market-driven economic factors. Metals, grains, and other basic commodities can experience dramatic price swings, negatively impacting gross revenue for a business that revolves around these resources.

Pass-through pricing or surcharges can limit the impact in some cases; other organizations rely on forward purchase contracts or bulk stockpiling of materials while prices are down. Look closely at the strategies that any potential acquisition uses, as well as others that may be available to mitigate price volatility for key inputs.

Ownership Structure

It’s also important to consider the type of ownership interest that the buyer is acquiring. Taking over the reins as a partial owner is very different than assuming full ownership of a going concern. If the buyer is a minority shareholder, the minority owner will be limited in terms of day-to-day management decisions, strategic input, and control of cash flow — especially if there is a single majority owner or a family or close group that controls the majority shares.

To mitigate this risk, buyers should understand the distribution of ownership interests and the relationship, if any, between other partial owners. Explore how decisions are made and look at the historical level of involvement of all other owners before taking the plunge. How much input from the buyer will be welcome, expected, or valued? If limited ability to steer decisions for a particular business will cause stress or anxiety, it’s probably best to pass on the acquisition.

Key-Person Concerns

The skills and knowledge of experienced employees constitute a valuable business asset, but they can also pose a risk when they’re limited to one or two key players. If business depends on one person’s relationships or skillsets that would be difficult or impossible to replace, the company could face disaster should that person die, become disabled, or simply move on.

Key-person concerns can become a threat even without overly specialized skills or relationships; this kind of risk exists anytime the bulk of institutional knowledge resides with too few people. If losing one or two team members would leave the business unable to operate effectively, then it’s important to address this vulnerability.

Key-person life insurance is one valuable tool to mitigate risk. Prospective buyers should also obtain contractual protections before closing on a closely held business acquisition. Be sure to include legally binding employment agreements with clauses to ensure confidentiality, non-competition, and non-solicitation.

Over-Concentration

Holding too many eggs in the same basket can present problems that aren’t limited to key-person concerns. Revenue for a closely held business sometimes hinges on a single:

• Client
• Vendor
• Product
• Service
• Technology
• Source country
• Patent
• Distribution channel

In recent years, countless businesses have suffered crippling economic damage as a result of global supply chain disruptions. Those painful experiences vividly illustrate the challenges that can follow a break in the expected flow of mission-critical resources or customers. It’s helpful to observe that organizations with more flexible networks of suppliers, sources, and distribution channels can typically withstand supply chain disruptions more easily, whether they stem from a global pandemic, changing tariff paradigms, natural disasters, or any other cause.

Over-reliance on a single area signals unusual risk, whether it’s a person, a product, or anything else. Whatever it may be, if its disappearance would threaten the company’s revenue or continued operations, then the associated risk must be recognized, quantified, and mitigated — and factored into the price of a potential transaction.

Revenue Volatility and High Operating Costs

A target company should exhibit acceptable cash flow, even considering normal seasonal variations or other cyclical revenue patterns. Businesses with less stable revenue deserve extra scrutiny when it comes to cash flow, and it’s even more critical for businesses with relatively high fixed costs.

The combination of higher revenue volatility and higher operating costs dramatically increases financial risk, as cash flow may be insufficient if revenue drops. These businesses must maintain adequate liquidity to weather unexpected financial demands even during an extended period of lower revenue. Significant cash reserves, pre-established lines of credit, and other financial tools can help provide a buffer against a perfect economic storm.

Marketability

The future marketability of the business interest is another factor that buyers should consider. Unlike a publicly traded stock, shares of a closely held business do not have a readily available market. When the time comes to sell, you will need to seek out potential buyers. During that process, if you are a noncontrolling owner, you will have no control over the cash flow to shareholders. That’s not to say closely held companies aren’t wise investments — just that it’s important to be aware of potential marketability challenges later and factor this risk into the decision.

Buying a closely held business offers abundant opportunity and unique challenges. Due diligence before you commit to the acquisition helps you avoid unpleasant surprises. Your CRI advisor can help you evaluate a target company to determine whether it’s an attractive prospect or a problem waiting to occur.