Managing the ultimate corporate risk.

• Author: Leitner, Peter J.
• Position: PRIVATEcompanies

The biggest corporate risk, long ignored by most private firms, is impaired enterprise value. Damage may be caused by internal or external forces that are acute or chronic in nature, ranging from product failures to increased competition to litigation. Impairment makes it very difficult to fully satisfy customers' needs and remain competitive because it becomes too costly, if not impossible, to raise capital, pursue acquisitions and alliances, invest in R & D or retain talented employees; in extreme cases, it can lead to bankruptcy.

Many private-company executives believe that a constant or growing stream of revenue, profits or cash flow equates to increasing shareholder value, but this is not always true. Only by measuring enterprise value can one know for sure. This is why savvy executives do so at least once a year, usually as part of their strategic planning or performance review process, and the wisest tie executive and employee compensation to changes in enterprise value, not just traditional financial and operating benchmarks.

Once a private firm does indeed make enterprise value analysis a regular part of its planning and operating decisions, it can start measuring Value at Risk, or "VaR." Traders of securities and commodities use VaR to forecast their losses in specific circumstances, such as an interest rate hike or geopolitical event, and then hedge their positions accordingly. Securities analysts perform similar tests on publicly traded stocks, in essence, measuring how much value an investor will lose if a firm encounters trouble.

The principle of VaR applies to private corporations, too. One first measures the firm's enterprise value, and then uses probabilistic-driven scenarios to estimate how much value would be lost. Hedges are then identified, priced and acquired. Common examples include the death of key personnel (which "key man" insurance rarely covers fully), changes in raw material prices and the bankruptcy of a key vendor or competitor.

The importance of managing enterprise value risk is rising because firms are increasingly knowledge-based and, therefore, composed of intangible assets whose value evaporates almost instantly in a crisis. Even manufacturers have more intangibles than they used to, such as outsourcing agreements and alliances; this raises their operating risk and, thus, their enterprise value risk.

Most Assets Now Intangible

Unlike in the 19th and 20th centuries, when corporate assets were nearly all...