Risky Business – The Failed Crypto Exchange FTX
Investment Risk in Private Company Valuation
“…One interesting question is whether this is due in part to the unregulated nature of crypto markets. Nothing screams caveat emptor like buying invented digital tokens that lack any history of stability. Perhaps a regulated crypto industry would look safer even if it isn’t…” WSJ Opinion Dec. 14, 2022
It is hard to imagine that sophisticated investors put their money and their backing behind financial schemes that (after the fact) appear to be so blatantly fraudulent? Most of the rest of us are working on the principle that if we invest our capital, either our money and/or our blood sweat, and tears, we are doing so to create more capital. That additional capital or profit will be impacted by the risk it is exposed to.
The degree of uncertainty in the amount and timing of your expected return is the risk. There are many types of risk which include:
- Inflation risk
- Interest rate risk
- Inventory risk
- Political risk
- Repayment risk
- And others.
An underlying principle of valuation is that risk will be reflected in the valuation of capital. The higher the risk, the greater the return will need to be, and vice versa. The greater the risk (real or perceived) of owning an investment, the greater the return will need to be to compensate the investors for the risk.
Financial markets consider several government securities to be the closest equivalent of a risk-free rate. They include:
- The rate for Treasury bills,
- The rate for ten-year Treasury bonds *most common
- The rate for thirty-year Treasury Bonds.
*The 10-year Treasury bond is the most frequently used rate in valuing businesses since it matches the period for the likely investment. Otherwise, the 3-month U. S. Treasury Bill is benchmarked as the “risk-free” rate for investors since it is a direct obligation of the U.S. government, and the term is short enough to minimize the risks of inflation and market interest rate changes. So, for example, a speculative investment like stock in a newly formed company would be expected to provide a higher potential return than a more conservative investment such as a bond or T-bill. To avoid the risk, you will be giving up the return.
So, less risk, and less return on investment. More risk, more return on investment expected.
The value of an investment is in the future stream of payments related to that investment. The greater the risk related to owning that investment, the greater the return that the investor would expect to receive on that investment. The “premium” return on dollars invested is the reason that investors expect to earn a certain return on their investments. The stream of future payments generated by that investment will be converted to a number that is the net present value of that future stream of payments. The risk attached to that future stream of payments is the degree of uncertainty there is in terms of realizing expected returns in both the amount and the timing of payments.
Did the investors in FTX know that their money was at risk? Of course. All investments carry some amount of risk. The problem, in this case, appears to be the lack of scrutiny applied to the company. I wonder what kind of return was illustrated for their investors. We’ve seen it happen before in bubbles like the crash of 2008 and with individual bad actors like Madoff. I’ve heard arguments on both sides about whether additional regulation would protect investors from these situations. It doesn’t appear that spectacular failures are at risk of completely disappearing.
If you’d like to discuss how risk factors might impact the value of your business, please reach out. Have you evaluated your options for the ultimate transition of your business and have a solid plan of how to get from where you are now to where you want to be in the future? If you’d like to review that or begin that process, feel free to call or email me. I can be reached at 224-688-8838 and [email protected] We’re here to help you Harvest Your Potential!
