How Much is a Business Continuity Plan Worth (Part 2)
In part 1 we developed the optimal strategy for a radio show game. The game was quite simple: a list of increasing prize amounts was read out and the caller had to call Stop to win the last amount called out. The catch was that an alarm clock had been set for an unknown time. The longer the player delayed before calling Stop, the more he or she won. But if the alarm clock went off before the caller called Stop, the caller would end up with nothing. We likened delays on the part of the caller to the decision to defer developing a Business Continuity Plan, and the effect of the alarm clock going off to the occurrence of an incident which would wipe out the company,
In this second part we look in more detail at how much a Business Continuity Plan is worth.
Suppose we have two identical companies, one with a Business Continuity Plan in place, and one without. What is the difference in value? If we can answer this question, then we can answer the question of how much the Business Continuity Plan is worth.
Conventional methods of valuing companies are generally based upon one of two methods. In the first method, which is closely aligned with what is known as the bigger fool theory, the value of a company is simply the amount of cash you can sell it for. The value of a company therefore depends upon finding someone who values the company more than you do. You think a share in the company is worth $x, someone else thinks it is worth more than $x. Because of this difference of opinion the sale takes place and, because the buyer and the seller can't both be right in their valuation, one must be a bigger fool than the other.
Of course, some people will buy shares based on the belief that someone else will be prepared to buy the shares from them for even more – this is the strict interpretation of the bigger fool theory. The psychology of this, and of market bubbles that result, is beyond the scope of this article. Suffice it to say that approaches based upon market capitalization (the sum of the value of all shares) are subject to the fashions of the day. (Witness the Internet bubble of the 1990's). Using such methods the value of a Business Continuity Plan will depend upon the degree to which the idea appeals to shareholders and prospective shareholders – something that cannot be calculated.
The other major approach to valuing a company looks at its expected cash flows, discounted to the current date. For example, if a company returns a dividend of $10 million a year, the current interest rate is 2% (in real terms), and the company can be expected to continue operating in this way indefinitely, the value is the Net Present Value of an infinite stream of $10 million a year at a discount rate of 2%: which in this case works out at exactly $500 million.
But what if the company is not standing still, but growing? If we discount an infinite stream of future payments for a company growing at 3% where the interest rate is only 2%, we get an infinite amount!
So why are growing companies so cheap? Why doesn't a growing company have infinite value?
- It cannot grow for ever. No market is infinite. A conservative assumption of zero growth in real terms is often made.
- In the real world, at some point the company will fail.
Like the bell in the radio game, nobody really knows in advance when (2) will happen, but we know that at some point it will happen. Of the twelve companies that made up the original Dow Jones index, (the biggest and brightest companies of the day), only one, General Electric, is still there. The Avedis Zildjian Company may have been manufacturing cymbals and drumsticks since 1618, and the Hudson Bay Company may have been in existence since 1670, but we know of these companies because they are the exception, not the rule.
What we really have when we own a company is a stream of income which will disappear at some point in the future, but we're not really sure when.
For example, assume that there is a 5% chance of a company failing in any year. Then there is a:
(1-5/100) = | 95% | chance of the company lasting more than 1 year. |
(1-5/100)^{2} = | 90.25% | chance of the company lasting more than 2 years. |
(1-5/100)^{3} = | 85.7% | chance of the company lasting more than 3 years. |
(1-5/100)^{10} = | 59.9% | chance of the company lasting more than 10 years. |
... and so on |
Adjusting for this probability in our present value calculations and allowing for inflation, our hypothetical company with a $10 million dividend, a 6% growth in earnings (3% real growth), a 5% interest, a 3% rate of inflation, and a 5% chance of failure is worth a very finite $136 million.
So what is the effect of Business Continuity Management and a good Business Continuity Plan?
A good Business Continuity Plan reduces the probability of failure due to many events. Let's assume that it reduces the probability of failure from 5% to 4% – the remaining 4% being due to market forces and unrecoverable disasters. Then our example company is now worth $160 million. The value of our Business Continuity Management program is worth the difference between these two valuations, or $24 million.
Is a reduction of failure probability from 5% to 4% unrealistic? Say the reduction is only from 5% to 4.9%. The value with the BCP program in place is now $137 million, and the value of the Business Continuity program is $2 million.
Now for the purposes of this article I made many simplifying assumptions. I assumed:
- The company consists of a single business unit. If it fails, the entire company fails and everything is lost. There are no remaining assets.
- All earnings are paid out as a dividend: retained earnings aren't lost if the company fails.
- The inflation rate is constant.
- Interest rates and growth rates remain constant over time.
- The probability of failure remains constant over time.
- The probability of an incident that would destroy an unprepared company, but not a prepared one is 1%.
If we adjust the probabilites, we can see how Business Continuity Planning is less important for a startup. It is often reported that 80% of startups fail within their first five years. Assume a corresponding annual probability of failure of 27% rather than the 5% value, and assume that the Business Continuity Plan reduces failure to 26%. Scale down the earnings to $1 million a year, and the value reduces to a much more modest $125,401.
Making Alternative Assumptions
You can play around with your own figures with the above simplifying assumptions using our BCP value calculator.
Contact me if you would like me to repeat these calculations for your company with more general assumptions specific to your company, but note that I do have to charge for my time.
But Don't Forget
In most regulated industries legislation requires companies to adopt a Risk Management and a Business Continuity Management approach. Whatever the benefits, there is no choice. Business Continuity Management is simply part of the cost of doing business. If you don't have a Business Continuity Plan in place you don't even get to play the game...
Michael Z. Bell
June, 2006