History shows us that for the most part huge global events DO NOT negatively affect business valuations.
While you would not be wrong for worrying that an uncommon-once-in-a-lifetime event such as a global pandemic would negatively affect your business valuation, surprisingly, it probably will be more of a small dent rather than a crater. To be sure, many businesses will be forced to shutter at least temporarily. For those businesses able to remain open, some may experience gross and net revenue reductions. For those businesses that actually thrive during this pandemic, they will obviously be considered even more desirable and enjoy higher business valuations. Since we are all in this together, for the majority of small business, the economic effects on valuations will be limited as if the pandemic never occurred.
Recasting Financial Statements
When business brokers prepare business valuations, they do so by “recasting the financials”. While business owners take as many deductions as possible to reduce their tax exposure, doing so also lowers business valuations. Recasting financial statements essentially involves looking for those deductions that are nonessential, discretionary and one-off events to add-back to the financial statement in order to provide a more accurate portrait of the business’ earnings. The recasted financials with the add-backs are known as the Seller’s Discretionary Earnings (SDE). Typical add-backs include deductions for excess vehicles unnecessary for business use (nonessential); family members’ cell phones who do not work in the business (discretionary); law suits or mold remediation (one-off events).
How we value businesses using the Discretionary Earnings model in light of this pandemic? Mostly we’ll ignore the pandemic assuming no substantial long-term impact to your business occurs due to the pandemic. Many experts anticipate ignoring 2019 and 2020 financial statements both because they are “outliers” due to broader economic distortions. 2019 financials will be ignored since gross and net earnings were augmented due to tax cuts. 2020 earnings were contracted due to the pandemic. Consequently, 2018 financial statements will be used as the baseline year for business valuations. Other experts indicate that financials will be based on the trailing 12 months prior to March, 2020 when the shifts from COVID-19 affected small businesses.
Rebounding Economy & Your Valuation
If your business rebounds once the economy gets back on track, neither income losses nor temporary relief (i.e. rent abatement or payment deferrals) will be counted. Similarly, adjusted, new or eliminated expenses pertaining to staffing, shipping inventory, etc., will be accounted for in the business valuations.
Essentially, Seller’s Discretionary Earnings seeks to normalize financial statements. Given the excess gains of 2019 and excess losses of 2020, there is nothing “normal” about those years that can be projected forward for a business valuation. Valuations are premised on a business as a going concern into the foreseeable future as opposed to asset liquidation. While we don’t know exactly how long this pandemic will impact small businesses, it is an anomaly that will diminish or end at some point.
Where Do We Go From Here?
Of course, if this pandemic goes on for years, then disruption may become pervasive and wide-spread. Business valuations will become much less accurate with so many ongoing we future uncertainties.
The best thing small business owners can do to protect their business value is to get back to status quo pre-pandemic. The quicker a small business can stabilize, then the easier it will be for lenders and buyers to dismiss the effects off the pandemic on the seller’s recasted financials. America’s small business have withstood wars, plagues, stock crashes, political fall-out, etc. On rebound, small businesses have sold without catastrophic impacts to business valuations. Patience and due time will inoculate your business from this virus too.
Despite the pandemic, it is still a good time to get a business valuation if you plan to sell in the near future. Getting a valuation using either 2018 or 2019 will provide you with a benchmark going forward. Contact us today if you’d like to discuss how you can use a valuation to keep your business and financial goals on track.
The information shared here is for informational purposes only and is not intended nor should be construed as investment, tax, financial or legal advice. Should you need professional advice, consult with a licensed professional concerning your specific situation.