Understanding Risk in Business Acquisitions: Why It’s Essential to Look Beyond the Surface
During a recent Region VIII committee meeting, Mark Ahern and I were asked about the trends we are currently seeing in the business acquisition landscape. One of the key areas we touched upon was the understatement of risk — particularly concerning supplier risk, customer concentration risk, financial performance risk, and management or key person risk. We’ve noticed a pattern: many business brokers are downplaying these risks, which can lead to serious consequences for buyers, lenders, and anyone involved in the transaction.
In the current business environment, SBA lenders need to be vigilant when underwriting loans. They must dig deeper into potential risks and not solely rely on the business broker’s assessment. Recently, one lender mentioned that the SBA has begun scrutinizing banks’ underwriting processes, especially regarding supplier risk. This scrutiny is a reminder that while assessing risk is never easy, it must be treated with the seriousness it deserves. As someone who has been involved in business valuation for years, I can attest that ignoring risks can lead to substantial problems down the road.
At Peak Business Valuation, we’ve experienced firsthand how failing to properly assess risk impacts businesses. In 2023, we worked on four liquidation valuations due to SBA loan defaults. In 2024, we have already completed 15, highlighting the increasing need for rigorous risk assessment. Whether you’re buying, brokering, valuing, or underwriting a business, dedicating significant time to understanding risk is crucial. It’s easy to focus on the positives, but overlooking the negatives can put both the buyer and the lender in a precarious situation. If you’re in need of a thorough, objective business valuation, reach out to Peak Business Valuation at https://peakbusinessvaluation.com/contact-2 or call 435–359–2684.
The Importance of Risk Assessment in Business Acquisitions
Assessing risk is one of the most critical components of any business acquisition. Yet, it’s an area that is often underestimated or misunderstood. Let’s break down why risk assessment is so vital and what specific risks you need to be aware of.
1. Supplier Risk
Supplier risk refers to the potential problems that can arise from a business’s reliance on specific suppliers. If a business depends heavily on a few key suppliers, it is vulnerable to disruptions in supply, price increases, or quality issues. For example, if a supplier goes out of business or decides to cut ties, the company may struggle to find a replacement, impacting its ability to meet customer demand.
Supplier risk is a growing concern, particularly in industries with tight supply chains or those affected by global events like pandemics or geopolitical conflicts. SBA lenders have been increasingly focused on understanding how these risks are managed in underwriting. It’s not enough to assume that supplier relationships are stable; lenders need to investigate the depth of these relationships and the contingency plans that are in place if things go wrong.
2. Customer Concentration Risk
Customer concentration risk occurs when a business derives a significant portion of its revenue from a small number of customers. This dependency can be dangerous because losing one or more key customers could result in a substantial drop in revenue, severely impacting the business’s profitability and sustainability.
For example, imagine a business that generates 60% of its revenue from two customers. If either of those customers leaves or reduces their orders, the business would face a severe financial shortfall. Unfortunately, many business brokers tend to downplay this risk, focusing instead on the overall revenue numbers without considering the stability of that revenue stream.
From an SBA lender’s perspective, understanding customer concentration risk is essential. It’s not just about how much revenue the business generates but how reliable and diversified that revenue is. If a business has a high customer concentration, the lender must dig deeper to assess the potential impact of losing a key customer.
3. Financial Performance Risk
Financial performance risk involves evaluating the stability and sustainability of a business’s financial performance over time. This includes analyzing revenue trends, profit margins, cash flow, debt levels, and other key financial metrics. A business that has experienced steady growth in the past may still carry significant risk if that growth is unsustainable or built on weak foundations.
Lately, we’ve observed that some business brokers have been presenting a rosy picture of financial performance without adequately disclosing potential risks. For example, they might highlight strong sales growth but fail to mention that the growth is driven by a few large, one-time contracts rather than a stable, recurring customer base.
SBA lenders need to be aware that financial performance risk is more than just a number on a balance sheet. It requires a comprehensive analysis of the business’s financial health, including understanding the factors driving growth and identifying any red flags that could indicate potential problems down the line.
4. Management and Key Person Risk
Management and key person risk refer to the potential impact on a business if a key individual — such as a founder, CEO, or other critical team members — leaves the company or is unable to perform their duties. This risk is especially significant in small businesses where the owner or a few key people play a vital role in daily operations and decision-making.
If the success of a business is heavily dependent on the skills, relationships, or knowledge of one or two individuals, it poses a considerable risk to buyers and lenders. A sudden departure or unexpected event affecting these individuals could disrupt operations, erode customer relationships, or even lead to the business’s collapse.
SBA lenders need to evaluate the depth and strength of the management team and consider succession plans to mitigate this risk. They should also assess the business’s dependency on key personnel and determine how prepared the business is to handle transitions in leadership.
Why SBA Lenders Need to Dig Deeper
Given these various risks, it is clear that SBA lenders should not rely solely on the business broker’s assessment when underwriting a loan. Business brokers often focus on highlighting the positives of a business to facilitate the sale, which can result in an understatement of risks. Lenders must conduct their own due diligence and dig deeper into the risks associated with any potential deal.
SBA Scrutiny and Supplier Risk
Recently, one of the lenders shared that the SBA is now questioning how banks are underwriting supplier risk. This heightened scrutiny is a clear signal that risk assessment is becoming increasingly important in the lending process. For lenders, this means taking a closer look at how suppliers are selected, the terms of supplier agreements, and the level of dependency on specific suppliers.
It’s not just about whether the suppliers are reputable; it’s about understanding the depth of the relationship and the potential impact on the business if something goes wrong. Are there alternative suppliers available? What contingency plans does the business have in place? These are the kinds of questions that need to be asked to properly assess supplier risk.
The Rising Need for Rigorous Risk Assessment
From our perspective at Peak Business Valuation, we’ve seen a growing need for more rigorous risk assessment in business valuations. Over the past year, we’ve worked with more banks each month to provide liquidation valuations due to loan defaults. In 2023, we completed four liquidation valuations related to SBA loan defaults. This year, in 2024, we are already at 15. This increase reflects a trend where risk assessment is not being given the attention it deserves.
When risks are understated or ignored, the consequences can be severe. Loan defaults lead to financial losses for lenders, legal complications, and a host of other challenges that can damage relationships and reputations. Proper risk assessment can help mitigate these risks, ensuring that both buyers and lenders are making sound decisions.
What Buyers, Brokers, and Lenders Should Do
If you are involved in buying, brokering, valuing, or underwriting a business, here’s what you need to do to ensure a comprehensive risk assessment:
1. Spend More Time Assessing Risk
Don’t rush through the risk assessment process. Spend significant time evaluating all aspects of the business, including its suppliers, customers, financial performance, and management team. Look beyond the surface and ask the tough questions.
2. Hire Independent Experts
Work with independent experts, such as business valuation firms, that have no vested interest in the transaction. An independent valuation provides an objective perspective on the business’s true value and risk profile, helping you make informed decisions.
3. Understand the SBA’s Focus
Stay informed about the areas that the SBA is currently focusing on, such as supplier risk. Understand that the SBA is increasingly scrutinizing underwriting processes to ensure that risks are adequately accounted for. Be prepared to provide detailed explanations and documentation to support your risk assessments.
4. Be Transparent About Risks
Transparency is key in any business transaction. Make sure all parties involved are aware of the risks and have a clear understanding of how they are being managed. Don’t gloss over potential issues — address them head-on to avoid surprises later.
Conclusion: Don’t Overlook the Risks
At the end of the day, whether you’re buying a business, brokering a sale, or underwriting a loan, it’s essential to take risk assessment seriously. Highlighting the positives is great, but failing to adequately consider the negatives can leave both the buyer and the lender in a difficult position.
As the number of SBA loan defaults rises, it’s clear that more needs to be done to ensure comprehensive risk assessment. If you need assistance with business valuation or risk analysis, reach out to Peak Business Valuation at https://peakbusinessvaluation.com/contact-2 or call 435–359–2684. We are here to help you navigate the complexities of business transactions with confidence and clarity.
