What Is Risk Premium?Definition and Examples

Risk premiums quantify the intuitive assessment that all investors make: 'How much more return do I need to invest in this asset versus putting my money in a safe government bond?' For a small business priced at $1,000,000 with a 25% implied cap rate, the investor is demanding $250,000 per year in earnings — a 25% return — to compensate for the risks of business ownership. If the same investor could earn 5% risk-free in Treasury bonds, the total risk premium is 20%, built up from market risk, size risk, and company-specific factors.

Understanding risk premiums helps business owners appreciate which aspects of their operation most impact valuation. The company-specific risk premium is the only component the owner can control. Equity market risk, size premiums, and industry risk premiums are determined by external factors. But the 5-15% range of the CSRP represents hundreds of thousands of dollars in valuation difference, and it is entirely within the owner's power to reduce through operational improvements, documentation, customer diversification, and management team development.

In formal valuation reports, the risk premium build-up must be documented and justified. Courts, the IRS, and sophisticated buyers will scrutinize each component to ensure the total discount rate is reasonable. Overly optimistic risk premiums (producing low discount rates and high valuations) are challenged by buyers, while overly conservative premiums (producing high discount rates and low valuations) may indicate that the business has addressable risk factors that should be remediated before the sale process begins.