Managing the ultimate corporate risk.

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 tangible--like inventory, plant, property and equipment--many firms today comprise patents, trademarks and relationships with customers, vendors and employees. Tangible assets may have only nominal value. Moreover, the biggest asset in many modern firms is unrecognized goodwill (that is, the difference between the firm's market value and its book value), which doesn't appear on the balance sheet or any other financial statement. When trouble occurs, such firms unravel before reorganization is possible, as the collapse of Arthur Andersen from the Enron scandal exemplifies.

Managing this risk should be a cooperative effort between the board of directors, which represents the shareholders' interests, and the management team (particularly the CFO), whose fiduciary duty is to preserve and enhance value. Indeed, both leadership tiers share this duty. But enterprise value risk is rarely well managed because most private firms have less-than-robust boards and few senior managers even know their firm's enterprise value.

A balanced, independent and seasoned board of directors is essential because a private company usually has limited leadership resources, both in management ranks and on the board. This often stems from its small size and a closely held or family ownership structure.

A strong board reinforces management, particularly now that many domestic competitors are turbocharged with private equity and new low-cost foreign competitors appear daily. Indeed, without such leadership, a firm is less apt to avoid a crisis or manage it well, thereby damaging its value. While building a strong board and achieving good governance takes time and diligence, it is an investment that pays considerable dividends well into the future.

Measuring a private firm's enterprise value is easier than board-building, though few apparently bother. A recent survey by Waterford Advisors LLC revealed that 40 percent of senior financial executives in private companies don't know what their firms are worth, and most of the remaining 60 percent provided responses suggesting that they may not really know, either. This is troubling because private firms, just like their public brethren, will become cannon fodder for competitors if their enterprise value fails to grow appropriately over time.

Managing the risks inherent to enterprise value is fundamental, but requires private firms to embrace best practices in corporate governance, value measurement and hedging to ensure that investor and stakeholder interests are protected and enhanced.

Peter J. Leitner is the CEO of Numeria Management LLC, a Princeton, N.J., firm engaged in market-based pricing of private firms and closely held corporate interests. He can be reached at pleit [e-mail].