Structural Financial Risk

By Maurie Cashman

Identifying risk in business has been a theme I have been working with in the past couple of weeks. Last week we discussed Five Ways to Reduce Business Risk but how can you reduce risk if you don’t properly identify the risks that exist?

In a recent study on risk identification conducted by global consulting firm Protiviti and North Carolina State University’s ERM Initiative, [an] organizations’ culture may not sufficiently encourage the timely identification and escalation of risk issues that have the potential to significantly affect core operations and achievement of strategic objectives.

Over the next few weeks we’ll look at some risks that are often hidden or overlooked by business owners – but are hugely important in an ownership transition. These forms of risk are often miscalculated, particularly given today’s economic environment. This week let’s look at an example of structural financial risk.

Structural Financial Risk

Many business ownership transitions involve some form of seller finance or continuing risk exposure. This might include a seller note, structured financing such as balloon notes, an earn-out, a consulting agreement an escrow for specific risks or transfer of stock via incentive plans, sale to key employees, ESOP’s, or gift.

Example: John wants to sell his stock to his business partner, Pete. John is receiving a seven year consulting agreement for $100,000 per year. John is also providing a note of $350,000 at 5.5% interest for seven years. Pete currently owns 50% of the stock and the buy-sell agreement does not define the mechanism for pricing the stock or financing the purchase of the stock between the partners. The partners have a very good relationship and the business is quite successful. The company has no debt.

A natural reaction to this structure might be “wait a second, John is essentially providing $450,000 in financing but getting no interest for $350,000 of that financing. Upon further analysis, if we put both pieces of the deal together John is actually receiving 2.0% interest on the entire $450,000 (a bit more since he is receiving a fixed payment on the consulting agreement instead of an amortized payment). Not great but not bad.

But here is the kicker: the parties agreed to sell for slightly less than an outside, independent valuation at about 14 times EBITDA. OK, pick up your eyeballs and stick with me. John is receiving a good and fair price from Pete rather than what might occur if he had to try to sell his interest to another buyer.

The true risk is not interest rates or tax impacts but whether or not John will receive these payments. The consulting agreement is, by definition, part of the general assets of the corporation and subject to creditors. If Pete gets in trouble for any reason, the majority of this payment may be jeopardized. The advice I would give is to not worry about the interest rate risk but rather the risk of collection. A way to manage this might be to establish an order of payment in the buy-out wherein John receives his monthly consulting payment first and the note payment second. Then place a first mortgage on the note. In this way, John is going to get an early warning if the consulting ever shows up late and can take quick action to help Pete right the ship before it is too late.

This is only one form of structural financial risk that may exist. What others do you have questions about?