Back to Basics
COVID-19‚Äôs Impact on Micro and Small Business Valuation
As summer comes to an end, while COVID-19 remains a concern, business owners have resumed contemplating their succession and growth strategies. What have valuation analysts learned? In this article, the author shares additional questions that business valuation practitioners should be asking.
The hysteria from the huge unforeseen social and economic changes arising from COVID-19 is starting to fade. For business valuators that means we are seeing our normal valuation processes and procedures, with modifications, are sufficient to value micro and very small businesses with revenues under 10 million dollars. These modifications mean we need to add new questions, spend more time evaluating future cash flows, and apply more professional judgment to our risk adjustments as part of the valuation process.
Asking the Right Questions
Micro and small businesses require a high level of qualitative investigations because the quantitative data does not exist.[i] It would be nice if the management teams of these small businesses suddenly could produce more information than in the past, but that is not realistic. If they could not develop projections and forecasts in a period of stability, how can we expect them to do so now?
Therefore, in response, based on what we know today, we should be adding these questions to our matrix:
- How virile has COVID-19 been in the market area? Clearly this has been a rolling problem. Living outside the New York area, I have a very different view than people in the relatively unaffected West where I spend considerable time.
- Is the subject company in a winner, loser, or unclear outcome group due to COVID-19? Winners appear to be many technology companies; losers include sit-down restaurants and urban vacation destinations. Many companies fall into the unclear outcome, particularly if you believe that another recession is coming.[ii]
- What has the state and local government response been to date? Consider stay-at-home orders, shutdown orders, masks, school issues which affect everyone‚Äôs ability to work and customers‚Äô ability to buy. Again, in the Northeast the restrictions were severe and the implications are still being sorted out even as the virus has receded.
- How do the answers to the above questions impact the subject company‚Äôs cash flows to date?
- Does the subject company have a strong balance sheet or other source of resiliency to withstand unusual difficulties? When does a weak balance sheet increase going concern issues to where an asset approach may be the most suitable method for the business valuation?
- Is the subject company leveraged and what is the likelihood that the loans get called? Economic times like this are a witching hour for companies that treat short-term lines as long-term debt.
- If the outbreak has been materially reduced, or if there was a shutdown order or a stay-at-home order that impacted the company which has ended, what has happened since? Some companies ‚Äúbounce back‚ÄĚ and are making up the losses. Others, such as indoor sports centers or transportation services, cannot recoup lost revenues.
- How responsive has the government and citizens been to suggested virus control measures? This may directly impact future results due to the rolling nature of the virus. Some believe that the citizens in the New York area went into hiding before the shutdown orders upon learning that people they knew were sick.[iii] How might this impact areas with new virus spread?
- What economic support has the business received from the federal government or other places? Support may include direct Paycheck Protection Program (PPP) or similar loans, unemployment support for customers, loan deferrals, rent reductions, payroll cuts, renegotiation of contracts, etc. Are these continuing or likely to end or be reduced? How will that impact cash flows and risk?
The above questions can be answered as they focused on the past.
Next, we must address forward looking questions to project the future cash flows:
- What is the current situation and what is the likely future with the spread or contraction of the virus in our state and region?
- If the situation gets worse, what is the likely response of the government and company employees and customers?
- How is this likely to model out with the subject company?
- How will the subject company be impacted by the possible scenario of a severe recession and likely credit crunch[iv] following a reduction of economic supports for the overall economy by the Federal Government?
You may have a different set of questions. That is fine. Be certain to develop a process to address these new risks.
An overriding assumption that all valuators and managements must make at this time is how long this disruption is going to continue. Each of us will see details of this differently. But we must begin to talk about it as business valuation depends on a level of agreement. A large portion of professional judgement is agreement among experts.
Several models I have seen and doctors I trust, believe that, for better or for worse, given the current path the U.S. is on, the direct effects of COVID-19 are going to last about two more years assuming immunity is permanent.[v] All hope for a quicker effective vaccine but that is viewed as a wild card. If you believe that, the length of time of the likely economic fallout may be even harder to predict.[vi] The Congressional Budget Office is saying it will take five years to get back to pre-pandemic employment levels and 10 years to fully absorb the lost growth.[vii] Clearly, projections are going to vary tremendously in different industries and locations.
Let us now apply our findings to the subject company cash flow. Certainly, in sophisticated companies‚Äô management can provide detailed projections and forecasts and tie it into experience, economic situations, and industry information. These figures can be analyzed and often directly used by valuation professionals. If the businesses you are valuing can do this, take advantage of that information. With micro and small businesses, if they can prepare a projection at all it is likely to be some variation of a guess and far less suitable as the basis of a future cash flow for a business valuation.
For instance, a recent general contractor I was valuing provided detailed projections. Yet, upon questioning, he had listed every possible construction start even though that had never happened in the history of his company. He had very limited data to assess the likelihood of a job starting. His model had estimated profits as a percentage of revenues so there was no way to analyze variable vs. fixed costs and develop a working understanding of how reductions in revenues would flow to the bottom line. One positive note was it became clear he had greatly understated profitability if he met his projected revenues. But, other than a valuable talking point with management to try to develop an understanding of what might happen, the contractor‚Äôs projection provided very little direct assistance in estimating a forecast of future cash flows at the firm. Frankly, most small and micro business owners and managers cannot provide even that limited data.
For the micro and small businesses that cannot prepare a projection or forecast, I am still preparing valuations with the single period capitalization model or often for smaller businesses, the market method. I certainly agree with the theory that different cash flows and different discount rates are likely to be ‚Äúmost probable‚ÄĚ over the next 3 to ten years. Yet, that is always the case particularly over longer timeframes– it is the effect of the economic cycle.
In the past, we were always able to reduce the cycle and future down to a single cash flow number and single risk adjustment, and I believe we can do so today. Unsupportable but detailed cash flow projections and varying but unsupportable future discount rates do not increase accuracy. Yes, I know the future is highly likely to unfold differently than what I have projected but my work is as accurate as possible with what is known and knowable at the time of the work. I will admit that I have begun to tell many clients that the value I find today is highly likely to be different in 6 months as the future unfolds. I still believe my work is accurate as of the valuation date.
In relevant cases I will estimate a cash flow projection for 3 to 5 years and use the discounted cash flow method as a sanity check. To date, I have applied this to estimate possible worst-case scenarios. I do not consider this a valuation method because the cash flows used are not supportable. Yet, I believe they help me and the report user understand the downside risk. It is reasonable as a sanity test but not as a basis for a valuation.
Once we have settled on a cash flow, we need to develop our risk adjustments.
Clearly, all our cash flow-based models have a problem adjusting to the extremely high level of short-term risk. The cost of capital models, if directly applied from traditional data sources, show capital becoming less expensive due to the flight to security and current Federal Reserve direct lending policies. While that may be true for large public companies (and the stock market at the moment appears to be supporting that view) that have been given direct access to the Federal Reserve window, it is not the case with smaller private companies.
Local bankers I talk to all are indicating careful review of loan portfolios and increased underwriting requirements. The Federal Reserve has a program to facilitate lending to smaller companies but that program requires personal guarantees which will greatly reduce its use by ‚Äúiffy‚ÄĚ businesses. Smart experienced owners will realize it is one thing to lose your ship, it is even worse to go down with it. Current personal bankruptcy laws are viewed by many as being highly punitive, therefore, personally guaranteed debt may be too risky for many owners.
The market method has the obvious problem that our comparables are not ‚Äúexact‚ÄĚ in that new sales have not been reported in the COVID-19 world.
But this is a new version of a recurring problem. Certainly, the recession of 2007‚Äď2008 was similar.[viii] In the income methods, we increased specific company premiums to reflect the difference between public and private companies. We also used specific company risk to adjust for the different risk in winner and loser industries and the risk in different market areas in past recessions. We can and are doing that now. While hard to explain and justify, this approach is the best that can be done with small companies where projections are, at best, conjecture.
With the market method, we certainly have the tools and knowledge to adjust for recessionary times vs. good times. Clearly, multipliers should be reduced.
I am a strong believer in the market method for micro and very small businesses. The challenge we have, looking back at prior recessions, is sales almost stop for many industries until the economy begins again. But, as we are often told, sales price is not value. A marketability discount to deal with the lack of marketability for the next year or so is justified. While the questions may be different, a weighted factor Mandelbaum-type approach can be used to estimate a discount for the risk from the delay. The same logic can be applied directly to estimating an adjustment to reduce the historic multiplier.
Clearly COVID-19 created rapid and unforeseen economic change that brought huge disruption to the economy and many industries.
Due to the rolling nature of the pandemic, many new questions must be investigated from a regional perspective. Where possible, comparison of the effects of COVID-19 in hard hit areas that are recovering might be used to evaluate regions that appear to be going into the worst of the effects of the virus.
In all cases, we must review the business in the face of a likely recession, now or sometime next year, as Federal economic supports are reduced or removed and the effects of a projected 10 percent unemployment rate at year-end take hold. All of these factors have required an increase in our use of professional judgment.
It is a back-to-basics approach. We must evaluate future cash flows and the risk of obtaining the cash flow from more angles. But the traditional methods applied with professional judgement can generate supportable, compliant, even accurate business valuations in the time of COVID-19.
[i] Micro and very small businesses have less financial and management information and much of it is deficient by GAAP or other standards. Therefore valuators must do more qualitative review and apply more professional judgment. ‚ÄúThe Art of Business Valuation, Accurately Valuing a Small Business‚ÄĚ p.29 www.theartofbusinessvaluation.com
[ii] Markets Insider, August 11, 2020, JPMorgan CEO Jamie Dimon says ‚Äúnormal effects of recession‚ÄĚ will be delayed until late this year or early next. https://markets.businessinsider.com/news/stocks/economic-outlook-recession-jpmorgan-jamie-dimon-normal-effects-delayed-coronavirus-2020-8-1029493456
[iv] Banks Facing Potentially Hefty Volume of Troubled CRE Loans, National Real Estate Investor, July 21, 2020 https://www.nreionline.com/distressed/banks-facing-potentially-hefty-volume-troubled-cre-loans
[v] Nature, August 5, 2020, https://www.nature.com/articles/d41586-020-02278-5
[vi] Market Watch, Goldman Sachs cuts 2020 U.S. economy‚Äôs growth outlook as COVID-19 cases soar. https://www.marketwatch.com/story/goldman-sachs-cuts-2020-us-growth-outlook-as-COVID-19-cases-soar-2020-07-06
[vii] CBO, July, 2020, An Update to the Economic Outlook: 2020 to 2030, https://www.cbo.gov/system/files/2020-07/56442-CBO-update-economic-outlook.pdf
[viii] Vox, The Fed and the 2008 financial crisis, May 13, 2015, https://www.vox.com/2014/6/20/18079946/fed-vs-crisis
Gregory R. Caruso, JD, CPA, CVA, is the author of ‚ÄúThe Art of Business Valuation: Accurately Valuing a Small Business‚ÄĚ which starts from the premise, ‚ÄúDoes this make sense?‚ÄĚ to get to the heart of the process to develop, review, or use credible business valuations. This book is unique in that the focus is only on valuing micro and very small businesses with revenues under $10 million. Clear instruction is provided on applying the best valuation methods as they pertain to these small businesses. Additional chapters cover increasing value prior to an exit, overseeing a market sale process, and how to review a business valuation. Supplementary websites provide templates and more. Published by Wiley and Sons and available everywhere. www.theartofbusinessvaluation.com.
Mr. Caruso can be contacted at (609) 664-7955 or by e-mail to email@example.com.