Recently, a relatively young firm was in the news for an initial public offer (IPO) it made. The economics of the business was quite attractive, which made me read its financial statements, specifically its IPO prospectus document. The section on risk factors caught my attention.
There were 56 risks listed. As a firm, it had achieved a certain scale that could absorb the downside associated with these risks. However, for small entrepreneurs, these risks could wipe out a substantial portion of their wealth, or put them out of business.
A few risks are inherent to any equity investment. For example, one of the risks highlighted was, “our revenues and profits are difficult to predict and can vary significantly from quarter to quarter.” Every equity investor understands this and, unfortunately, has limited recourse on this aspect. Similarly, another risk outlined was, “our business will suffer if we fail to keep pace with the rapid changes in technology and the industries on which we focus.” The only hedge against such a risk is for the management to work hard and build a team with a proven track record. But then there were risks that could be insured.
Insuring risks to infrastructure
“We do not maintain business interruption insurance,” said the prospectus. If there is a material damage to one of the offices, say, due to fire, business interruption insurance covers the loss of profit and standing expenses for the period of disruption.
For an IT firm, with large stocks of computers, a fire is likely to create havoc. Without computers and servers, the firm would be severely handicapped. Typically, an IT firm’s billing is based on the man-days staffed. If the infrastructure is down, the company would lose billing for that period. Their standing expenses such as employee salaries and rent will still need to be paid regularly. In the absence of insurance, a businessman would have to let go of productive employees and cut down expenditure substantially.
Insurance can help cover this outage. The cost of business interruption insurance is nominal. Insuring Rs 1 crore of profit costs less than ten thousand rupees.
Covering key personnel
The management of the company mentioned earlier further states, “we do not maintain key-man life insurance for any of the senior members of our management team.” Key-man insurance pays a lump sum to the company in case the concerned key person dies, either due to natural or accidental death. The objective is that a business is dependent on its key personnel. Their death would directly affect the bottom line. According to the prospectus, “the loss of any of the members of our senior management or other key personnel may adversely affect our business, financial condition, and results of operation.”
For a partnership-based advisory firm, the death of a partner can erode a large portion of firm’s revenues. With financial obligations remaining intact, such losses can be difficult to recover from. A key-man insurance policy gives a short-term cash relief to tide over this exigency. Cost of insuring a 35-year old key person for Rs 1 crore is less than Rs 8000.
“Delays or defaults in client payments could result in a reduction of our profits.” Unless, you enjoy a monopoly in your business, delays in collection are routine. Several businesses have to continue supplying goods and services, as a break would mean customer default. Credit insurance is a way out of this. Insurers help in credit evaluation of potential clients and set a credit limit. In case of prolong delays, the policy pays the outstanding amount. Apart from fending losses, the system can help avoid extending bad credit. Assurance of safety of capital can boost the sales of the business. Typical rates for credit insurance are around 0.3 per cent of the turnover.
An early stage firm routinely grapples with cost reduction to improve its P&L. In this process, it tends to be oblivious of several risks that threaten its balance sheet. It is important to take a step back and, as they say, ‘stand and stare.’ It would be difficult to make a sudden reform. However, if some of these insurance policies are purchased gradually, firms will adapt to the revised cost structure and become more resilient in the process.