This article, originally published in Wealth Professional, discusses the importance of differentiating between business risks and financial risks. The story is told from the perspective of a wealth advisor and a prospective small business owner, Cindy.

Your client, Cindy, is considering purchasing a business. Cindy thinks she’s getting a steal of a deal because, among other reasons, she only needs to invest $50,000 cash to buy the company.  The remainder of the $1,000,000 purchase price would be financed by a combination of third-party lender financing  and through a vendor-take-back (VTB) provided by the seller. What are some of the things Cindy should consider as she evaluates this opportunity?

First, Cindy needs to remember that her at-risk capital is not limited to her $50,000 cash investment because, irrespective of how the business performs, Cindy must repay her lenders. Although this may not be a problem if Cindy’s projections play out as planned, what happens if things go sideways? Does Cindy have the financial resources to satisfy shortfalls that may arise if the business struggles?

Second, Cindy should understand that financial risk and business risk are related yet distinct concepts. Financial risk arises when an investor uses debt to finance an investment. All else equal, more debt means more financial risk due to a higher probability of defaulting on loan payments. In contrast, business risk relates to supply and demand for the company’s products and services, changes in the regulatory environment that may harm its prospects, and many other factors, all of which are unrelated to the company’s capital structure.

A simple analogy using a house as an example can help explain the difference between financial risk and business risk. The value of a house at a specific point in time depends on housing inventory levels, current and anticipated population growth, current and forecasted employment levels and various other demographic and economic factors. These factors are analogous to business risks insofar as they influence the value of the home. Conversely, how a particular homeowner chooses to finance her/his home does not affect its value because the outstanding debt on the home reflects financial risk, not business risk. In other words, the “house is worth what the house is worth” because anyone purchasing the house can choose to finance the acquisition how (s)he sees fit. One person may be wiling to take on more debt, and hence financial risk, than the next person; however, this has no bearing on the home’s value.

In theory, the optimal amount of financial leverage and the resultant overall cost of capital for a specific investment is a function of the investment, not the investor. Generally speaking, businesses with tangible assets and stable cash flows can service more debt than those with fewer tangible assets and erratic cash flows. While estimating the ‘optimal’ amount of financial leverage for a specific investment is a complex exercise, what is clear is that excessive debt increases the risk of bankruptcy. In summary, financial leverage is akin to a double-edged sword in that it cuts both ways. Just as greater leverage magnifies equity returns when an investment performs well, losses can also widen in cases where targeted returns (cash flows) fail to materialize. How much and on what terms debt should be used to finance an investment will vary from company to company; however, investors must remember the expected reward for accepting greater financial risk should adequately compensate them for the added risk of doing so. The proposed purchase price and capital structure in Cindy’s case may or may not be reasonable, but differentiating between business and financial risk will help Cindy evaluate her options and make an informed decision.

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