The incidence of COVID-19 has caused global economic and social crises the likes of which have never been experienced. However, the world still turns, the wheels of economic activity continue to spin and the incidence of economic disagreement remains, and may indeed increase.
Contract terms may now be breached, financial covenants defaulted and family businesses subjected to family law property proceedings at unprecedented levels, and all because of the worldwide measures taken to slow the spread of the "coronavirus".
So what will this do to the fair market valuation of small to medium privately held enterprises (SMEs) operating businesses intended to continue as a going concern? Recent discussions with lawyers suggest four key valuation issues are worthy of comment.
- I need a valuation for proceedings commenced in November 2019. Mediation is set down for 27 April 2020. What should be the date of valuation?
Notwithstanding that for the purpose of legal proceedings a valuation should reflect the assessed value as close to the hearing date as possible, generally a valuer will assess value at a date on which properly prepared and reconciled financial accounts are prepared, as close to the hearing date as possible. At the date of writing this article, the latest available suitable financial accounts may be those for the year ended 30 June 2019 or, at best, management accounts for the six months ended 31 December 2019.
However, the latest available financials will not reflect trading results occurring during the COVID-19 crisis and, perhaps more importantly, the subsequent recovery period. Similarly, management accounts soon prepared for the nine months to 31 March 2020 may only reflect two or three weeks of COVID-19 affected trading.
The circumstances may require an adjournment of the mediation date. We can help develop a strategy to support the seeking of an adjournment.
- How will the valuer determine future earnings?
In the absence of reliable future cash flow forecasts (which are notably absent for most SMEs), a valuer will utilise the latest available (and historic) suitable financial accounts to make an assessment of future maintainable earnings (profits).
As the available financials will not reflect trading results occurring during the COVID-19 crisis and beyond, it follows that it is not possible for a valuer to utilise historic results to make a reliable assessment of future maintainable profits at this point in time.
The financial impact of COVID-19 will, over time, be detectable in revenue results, and hopefully will represent an isolated event in the same way as winning or losing a one-off customer contract can be identified as an "abnormal" business event and adjusted accordingly.
However, future profits result not only from revenue. A valuer will need to carefully scrutinise changes to cost structures during the impact of COVID-19 as businesses take drastic cost cutting measures, including standing down staff and negotiating rent waivers or deferrals, and potentially benefiting from government subsidies and other economic stimulus measures.
- My instructions are to obtain a valuation as at 31 December 2019 but the business was "mothballed" on 20 March 2020. How will this affect the valuation?
Importantly, valuation theory prescribes that the valuer may only take account of information that was "known or knowable" at the valuation date. Whatever the impact of COVID-19, it is an event subsequent to 30 June 2019 and 31 December 2019 and therefore cannot be built into a valuation at those dates. The question of whether a valuation should take into account subsequent events ultimately turns on the foreseeability of the events at the valuation date.
There will generally be a time lag between the valuation date (dictated by the date of the most recent available financial accounts) and the preparation of a valuation report. The valuer should make enquiries as to any subsequent events and consider whether they could (and should) affect the value on the valuation date. Whether those events should be taken into account in the valuation depends on whether they were reasonably foreseeable at the valuation date. For example, if a significant customer contract expired two months after the valuation date and valuer enquiries led to discovery that renewal negotiations underway at the valuation date were not promising, the valuer would build the loss of the contract into their valuation as the likelihood of losing the contract was foreseeable at the valuation date.
The possible impact of COVID-19 was not known or knowable at 31 December 2019. It follows that the valuer is unable to make informed earnings adjustments in determination of future maintainable earnings as at 31 December 2019.
- How will COVID-19 affect earnings multiples?
An appropriate earnings multiple, although ultimately a matter of judgment of the valuer, should reflect, amongst other things, the expected risk involved in achieving the anticipated future maintainable earnings. Clearly, a "current" valuation of a business, which we now understand will be adversely affected by the COVID-19 economy, may utilise future maintainable earnings determined largely on historic results, while the risk of achieving those earnings may be higher than it was pre-COVID-19. It follows that the capitalisation rate adopted should incorporate additional risk not otherwise relevant, and thus an appropriate multiple may be lower than would be considered appropriate pre-COVID-19. However, the appropriate risk will only become apparent over time.
It may be thought that the recent fluctuations in the publicly listed stock market could give valuers an indication of valuation risk. However, in my opinion the stock market reactions to the COVID-19 crisis do not represent fluctuation in value of SMEs. Listed companies are generally not closely comparable to SMEs and their stock prices are subject to market forces not necessarily relevant to smaller businesses.
So what do we do?
There is no "one size fits all" approach in these unprecedented times and the facts and circumstances specific to each business must be considered on a stand-alone basis. Many businesses are co-dependent on the success of other businesses within the supply chain, which must also be considered in a valuation (for example, there may be ongoing strong retail demand for a business' product, but if the future supply of required parts/raw materials is scarce, any forecast turnover will require consideration in that light).
Should a valuation of a SME be required for any reason in the short to medium term, management would be well advised to:
- Prepare and/or amend budgets (if not cash flow forecasts) for the current financial year and the year ending 30 June 2021 using assumptions capable of explanation and, where possible and unfolding over time, demonstration;
- Set up specific income and expense account codes within their bookkeeping systems to record COVID-19 specific transactions; and
- Have a (written) plan in place to navigate the storm and recover on the other side.
Legal advisers should also consider whether we should just wait and see.
In the interests of achieving a just and equitable outcome in circumstances of value dispute (whether that be shareholder oppression, family law property settlement or breach of contract causing damage to value) maybe we need to let the COVID-19 economy run its course and assess the impact in hindsight. Whether a wait and see approach is possible or advisable depends on the nature of the dispute. We can help legal advisers in their deliberations as to the best course of action.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.