Making sense of business valuations in tough economic times

Content Summary

Mark Story | September 2020

This article was current at the time of publication.

While business valuation activity remains flat, there's mounting speculation that the new year will herald a soar in demand as wage subsidies, the bank loan repayment holiday and other stimulus measures taper off, leaving businesses with insufficient cash flow.

Given the overhang COVID-19 is placing on many businesses, director of Active Business Advisory Brent Kirchner CPA is expecting an uptick in businesses looking for a non-aggressive partial sale to known parties who will be complementary to the business (aka friendlies), rather than sell in distress or face complete collapse.

"Being more creative around how deals are done is where valuations need to change," Kirchner says.

"By March 2021, many SMEs will have little choice but to contemplate taking on additional equity partners [like management who know the business] in exchange for working capital needed to ensure the company's doors remain open," he says.

Based on the uncertainties COVID-19 has created around calculating future maintainable earnings, principal of Rob Knights & Co Michelle Knights suspects businesses are extremely unlikely to receive pre-COVID valuation multiples.

Knights says that while all valuations will be down, deciphering how much lower will be on a case-by-case basis, with some industries — including transport, travel and entertainment — likely to be the hardest hit.

"The most amicable deal for many SMEs will be where both parties leave something on the table — be it price or other considerations, and have a clear understanding of what happens if things go pear-shaped," she says.

"One of the key issues for SMEs wanting to do 'friendlies' is whether interested parties are in a position to do a deal immediately."

Profitable client relationships

In the accounting profession, which represents the lion's share of Knights' valuation work, goodwill is generally the single largest asset.

From a valuation perspective, the trouble right now is that while goodwill should eventually translate into future earnings, the jury is still out on how many clients some accounting firms will have when the COVID-19 dust settles.

To ensure valuations are not unduly influenced by the short-term impacts of the pandemic, Knights recommends looking at value over a longer time frame.

"Value will always be driven by revenue and profitability, and what concerns accountants is not only how many clients they'll have post-COVID-19, but how many will have the ability to pay — and on time," she says.

"With most professional services firms continuing operations with all their staff, they can't afford to give clients too much of a holiday on paying fees."

When buying equity in a professional services firm — as with most businesses — what you're getting is the right to receive profits from the core business, based on ongoing client relationships.

One of the current key risks is maintaining those relationships, and in the event of a new management, Knights says this could also be a major issue, depending on how it's handled.

"Firms with the best succession plans will know when older partners will sell and given that new partners have the proven skills and expertise, risks shouldn't be elevated," Knights says.

However, she reminds all SMEs that if they are looking at transacting equity, it is essential to determine value up-front.

She suggests establishing if earnings before interest, taxes, depreciation and amortisation (EBITDA) are factual and whether salaries are reasonable.

"Short-term dynamics like JobKeeper [Australia's wage subsidy] are not showstoppers [because] as valuers we're more interested in what's happening to revenue within primary services areas," Knights says.

"But once JobKeeper and other measures end, establishing the sustainability of future earnings will be a lingering concern."

Future maintainable earnings

While it has always been an issue, Kirchner says COVID-19 has only created more uncertainty around which industry multiple is being used to confirm the value of equity.

While specialist firms have this data, he says it remains an issue for non-specialist valuers such as public practitioners.

"Should future maintainable earnings not be achieved, all parties need to be aware of the calculations, and the risk factor [is included]," he says.

In the absence of reliable future cash flow forecasts — which most SMEs lack — forensic accountant Jacqueline Woods, director of BRI Ferrier, says a valuer typically uses the latest available (and historic) financial accounts to assess future maintainable earnings. Even so, given that a valuer can't use historic results to reliably assess future maintainable profits during COVID-19, Woods says the impact on revenue will only be detectable over time.

"Hopefully, it will represent an 'abnormal' business event, like winning or losing a one-off contract and adjusted accordingly."

Beyond profit

With future profits derived from more than revenue alone, Woods says the valuer must scrutinise changes to cost structures during the COVID-19 crisis.

This means taking account of cost cutting measures, including standing down staff and negotiating rent waivers or deferrals, plus the potential benefits from government subsidies and economic stimulus measures.

Also, there is the issue of the co-dependency businesses have on the success of other businesses in the supply chain, which Woods advises should not be overlooked when considering valuations.

While it is ultimately a matter of judgement, she emphasises an appropriate earnings multiple should certainly reflect the expected risk involved in achieving anticipated future maintainable earnings.

While that appears to be higher now than it was pre-COVID-19, she expects the relevant risk to take time to crystallise.

"Whether any subsequent events should be taken into account in the valuation depends on whether they were reasonably foreseeable at the valuation date," she says.

Steps to consider

Should the valuation of an SME be required in the short to medium term, Woods urges management to prepare and/or amend budgets (if not cash flow forecasts) for the current financial year and the year ending 30 June 2021, using explanatory assumptions.

"Consider establishing specific income and expense account codes within bookkeeping systems to record COVID-specific transactions and write a plan to navigate the storm and recovery on the other side," she says.

Before buyers come knocking, Mark Whittaker, a partner with BDO, recommends SMEs prepare a well-supported documents pack, including insights into earnings drivers, a future work pipeline and highlight management's track record meeting previous budgets.

Given the difficulty of getting cash flow right in a post-COVID-19 environment, Whittaker urges sellers to spend more time ensuring growth projections are supportable.

"An SME's need for liquidity will determine what kind of equity they need to trade," he says.

"One of the benefits of selling to internal management is their understanding of current earnings and future growth potential."