As the latest Omicron surge passes, health experts are fairly in agreement that the beginning of the end of the pandemic is near, and soon the endemic portion of the pandemic will be here. Throughout the highs and lows of the various COVID-19 surges since March of 2020 to the expectation of a “new normal” being on the horizon, one thing is clear, the global economy and businesses will never be the same. Some business models have skyrocketed during the pandemic, while other businesses’ impacts from COVID-19 range from slightly significant or even devastating.
For business owners who rely on the valuation of their business to meet credit needs, seek business partners, and acquire other companies to remain competitive or survive, the pandemic has flipped the script on traditional business valuation methods.
Traditional Business Valuation
There are three basic approaches to business valuation:
- Income: Considers anticipated cash flow and required rate of ROI. The required rate of return is largely dependent on the risk associated with the future cash flows you expect from your business. The higher the required rate of return, the lower the value of your business.
The risk to investors has increased during this time of uncertainty. As a result, their required rate of return on investment has increased, driving down the value of many businesses. However, the extent of that impact is specific to your own business and its corresponding industry.
- Market: Using this approach, we look to similar companies sold (“guideline companies”) for guidance. To determine the value of a business, we apply a multiple to earnings before interest, tax, depreciation, and amortization (EBITDA), to arrive at the value of your business.
But we are using historical data that does not accurately reflect current economic conditions. It is often difficult for businesses to know what their EBITDA will be in the future, which makes it difficult to use historical EBITDA as a measure of future performance. Investors may view this uncertainty as risk, causing multiples to dip to compensate investors for taking on additional risk.
- Asset: The asset approach is most often used when the liquidation value of a business is greater than the value of an operating business, as would be the case when a company has no remaining potential for future growth.
Estimating future earnings is a crucial part of both the income and market approach. The COVID-19 pandemic has increased the difficulty in estimating future earnings due to the uncertainty surrounding overall economic conditions. In addition, an inherent weakness of the market approach is that it assumes one level of earnings for a business. When valuing a business, the historical income is usually not appropriate because it does not forecast the future profitability of a business. Using future income may not be appropriate as well, because you may expect your business to recover in a matter of time. The income approach will capture the value of most businesses today and can incorporate changes in future profitability.
It appears that the traditional methods of valuing a business are being replaced by DCF analysis in the “new normal” post covid world. Comparable company analysis compares a company’s performance with that of similar businesses, while historical transaction analysis uses the price paid for similar assets in past transactions as a basis for determining value. Both methods use readily available data and are relatively simple. However, the DCF method provides a way of business valuation that provides a discount rate that is adjusted by risk. The DCF method may offer a possible solution, however, the following questions remain:
- How do valuators, lenders, and businesses evaluate risk which did not exist just two years ago?
- How do they value or assess risks which may no longer exist, or which have been significantly transformed due to covid?
- How do they value or assess the risk of current domestic and global market forces such as The Great Resignation, employee shortages due to COVID-19, seismic shift in consumer and business spending behavior, as well global inflation, and supply chain issues?
Each one of these issues can greatly impact how valuators and business owners value their business. The answer may lie in the business owner’s handling of their business through the pandemic and ability to advocate for their businesses’ value in terms of mitigation of the new risk and how the company’s resilience will translate into better future earnings and stability.
The effects of changes in business valuations post COVID-19 have primarily impacted businesses in the following areas:
When negotiating purchase or loan agreements over the next five years, purchasers, and creditors will have additional concerns that business owners should know the answer to, and which may help increase the value of their business:
- How has your business been affected by COVID-19?
- Did your business shut down? For how long?
- What steps did you or the seller take to maneuver through the challenges
the pandemic presented, financially and operations-wise?
- What long-term effects do you expect industry-wide?
- Did you or the seller change the business model?
These are all valid concerns, and with the US and global economy seeing unprecedented inflation and crimpling supply chain issues across almost all industries, it’s impossible to guess the prospects for recovery. This pandemic recession affects growth prospects not only for individual businesses but for industries as a whole. Understanding the effects of COVID-19 and the pandemic-related recession on your industry will be a critical factor to consider when negotiating buy-sell agreements.
Lenders want assurances you are fully aware of the impact on your industry, and you have a positive plan to counteract any negative effects. Business owners who take the time to assess their financial forecast and present a strong case are more likely to differentiate themselves from buyers and lenders.
Purchase agreements negotiated for private businesses in today’s economy will probably address the impact COVID-19 has had on the business such as supply chain issues, inventory, and even your customer relationships. It is also important for business owners to distinguish their business and how well it has done during COVID-19 and why it will continue to do well in a post-COVID-19 world to avoid significant discounting of the purchase price of their business.
Invariably, COVID-19 has also brought about sharp declines in shares prices, along with wild instability. This has forced many shareholders and members to reassess their holdings, transactions and explore different avenues by using creative strategies to renegotiate contract terms or an exit. A significant decline in a company’s valuation may trigger other unintended actions or provisions contained in buy-sell agreements, stock options, and other debt and equity instruments of the company.
Business owners need to be aware of those triggers and get ahead of any shareholder or member situations. It is also imperative to work with the valuators to avoid unnecessary or harsh discounting for risks factors that may not be present long term, or which can be further mitigated by the company to preserve the value of your company and avoid additional shareholder or member issues.
COVID-19 looks to be resulting in a prolonged economic downturn with a difficult recovery. Many private businesses will suffer. So, you need some creative solutions to balance the effects of COVID-19 on your business valuations.
- The recent decline in market valuations provides an opportunity to transfer business assets without a taxable estate and to gift assets using your lifetime exemption, which may have otherwise been taxed before the decline.
- Focus on your cash flow channels, discount rate, and growing your business. Creative strategies are required now that COVID-19 has flipped the script on your business valuation. What risk elements were applied to your discount rate? What risks were included in achieving your cash flows at the initial business valuation? How can you mitigate these risks? The recovery is predicted to come in a “U” or “W” shape, and some industries will recover much quicker than others. Recovery and growth are predicted to come much slower and possibly driven by whether basic customer demand remains favorable long-term.
- Be aware of your business valuation date. Consider the valuation of your business on December 31, 2019, versus March 31, 2020. In December, COVID-19 was still unknown, making it a “subsequent event”—an occurrence that doesn’t happen until after the initial valuation date. The occurrence of a subsequent event should be accounted for in the period in which it occurs. COVID-19 is a subsequent event, that has no impact on December 31, 2019, valuations, and should not be factored into December 31, 2019 valuations. However, it should be factored into a valuation as of March 31, 2020, when the value of COVID-19 became known, and more profound risks and uncertainty could affect the valuation.
- Be your company’s greatest advocate and voice as to its value.
Our firm offers in-person and virtual consults, if you have any questions or concerns about the topic of this Article or any corporate, commercial, or complex family law issue, please feel free to call our office at 305-460-0145 or to schedule a consult here.