Standard valuation methods, like standard portfolio advice, rely on the assumption that investors hold well-diversified portfolios. As discussed earlier, small business owners and corporate managers often cannot diversify. This suggests a source of conflict between the managers and shareholders of public companies. It also suggests that small business owners may be justified in assigning a higher price to risk than standard finance theory recommends.

While well-diversified shareholders prefer that managers ignore diversifiable risk in selecting investment projects, managers may behave otherwise because of their high personal exposure to company-specific risk. This can result in too conservative an investment policy that ultimately reduces shareholder value. I mention this to question the conventional wisdom that compensating executives with company stocks and options aligns the interests of shareholders and managers. While both prefer higher stock prices, they may strongly disagree about what types of risk should be avoided.

In the case of small business owners with majority equity stakes, the caveat is that textbook methods to estimate the cost of capital may not lead to the right answer. Models like the CAPM are premised on the idea that companies have well diversified shareholders who don’t care about the specific risk of the company. To the extent that companies are closely held, traditional theories are likely to understate the cost of capital by neglecting an important component of risk. Unfortunately, I know of no formula designed to correct this problem. Unless such tools are developed, small business owners will have to rely on the standard theory and subjective judgments in assessing their cost of capital.