Derisking is the process of removing risk factors from your business in order to make it more attractive to an outside investor or to an outside buyer. It is one of the most important factors in the grooming process in order to be an attractive company to invest in i.e. “Investor Ready”.
There are dozens of areas and hundreds of ways in which a business may be exposed without knowing it. In the normal course of business an owner may not worry about these factors, as they are within the “comfort zone” of operation. For an external party to get involved however, they need a much more transparent organisation so they are not confronted at a later date with skeletons in the closet.
It is important because businesses already face uncertainty. And while a venture capital investor may have a reasonable tolerance for risk, they will not welcome unnecessary risk. The goal is to control as many areas of risk as possible, so at least the risks are known. Most companies who have had an internal focus (i.e. have focused on sales, marketing and operations in order to grow) have not thought about all the areas in which they are vulnerable.
The process of derisking limits the areas of exposure, and therefore decreases exposure to uncertainty. It also increases the chance of success through improvements in clarity in almost all areas of the business.
Derisking falls into two areas – one is simply clarification (i.e. creating a contract where an informal arrangement was in place) and the other a change of substance i.e. changing a supplier because it lowers risks.
Some examples include:
- Formalising employee agreements. This may mean creating contracts for employees that have previously operated without one, or strengthening existing contracts. Particular issues would be with protection of IP, ownership of IP, confidentiality and restraint of trade after employees leave.
- Creating / clarifying written agreements with suppliers
- Creating/ clarifying agreements with customers
- Moving “ad hoc” sales to contracted revenue where possible
- Formalising and documenting internal processes
- Protection of IP – patents, designs, copyright and so on.
- Protection of data by limiting and monitoring access to key systems (CRM, accounts etc)
- Key employee insurance (including of the owners) in the event of death.
- Creating or clarifying credit terms and policies. Getting credit offered back within trading terms, and ensuring that all credit offered is documented with the correct application forms and personal guarantees.
- Removing reliance on key personnel, in particular vulnerability to information or relationships which may be lost on their departure. This may mean adding additional points of contact to key client accounts so individual relationships are less critical.
- Documenting key processes – getting the knowledge out of people’s heads
- Ensuring insurances of assets are up to date, and sufficient.
- Lowering legal exposure (liability). Ensuring insurances are held that cover product liabilities and so on.
- Ensuring compliance with all ATO and ASIC regulations. Creating systems for their ongoing compliance.
As you can see, this is a lengthy, but not even remotely exhaustive list. Often an audit is carried out which will highlight those areas which need further work. This might cost several thousand dollars, and lead on to significantly more expense than that. In some cases the process may take a year, and cost hundreds of thousands of dollars.
One of the important things to remember in raising capital is to build in the cost of raising the capital.
This falls into two main areas:
- Actual costs – such as hiring consultants – legal, accounting, corporate advisors, strategists etc
- Opportunity cost and change in focus. The process of raising capital for business can take anywhere from three months to a year (or more) of attention from key owners and managers of the business. During this time, it can be difficult to maintain a normal focus on things which are essential for survival – sales, marketing and operations for example. This cost can be significant, while at the same time be difficult to measure. In fact, this defocusing is a major impact for any growing company that is pursuing two goals – new business, and business funding (or preparing for a sale of the business).
The need to derisk is apparent if you place yourself in the shoes of a buyer contemplating a purchase of (or investment in) your company. Without going through the derisking process, your company could contain any one of a dozen hidden time bombs (key staff who could leave and set up in competition, unsettled legal issues, poor data security etc). By transparently documenting how you have examined, reduced or been able to totally eliminate risks in your business then you are showing a buyer that you understand their concerns.
The flip side of the coin is that your company is now a far more attractive proposition to purchase or invest in. You will have invested a significant amount of money in the derisking process, but the result will be a company that is now sellable (all other things being equal) compared to a mystery. This means first of all that you may achieve a sale when previously none would have taken place, and secondly that you are likely to achieve a far higher sale price than before.