Written by W. Michael Wolfe, CPA/ABV, CVA, Valuation Services Partner
COVID-19 has changed life as we know it. The operation and value of closely held businesses is no exception. For valuations at 12/31/19, there was no effect on value because the pandemic was not “known or knowable” at that date. Fast forward a few months to March 2020, and now the economy is closed down, there are stay-at-home orders in place, revenue disappears, employees are laid off, and the future is uncertain. How does all this impact the value of closely held businesses?
Decline or Fluctuation in Revenue, Profitability, and Cash Flows
Whether this is temporary or permanent, future profitability and cash flow are the main drivers of business value. Business buyers generally base their price on an expected future economic benefit and that is the basic premise of business valuation. When these key value drivers go down, a decline in business value follows.
Additional Debt from Paycheck Protection Program (PPP), Economic Injury Disaster Loan (EIDL), or other Pandemic-Related Loans
As an example, a company’s enterprise value may normally be valued by buyers at 4x EBITDA. The debt must be subtracted from that enterprise value to arrive at the value of the business (equity value). Therefore, a $2 million PPP loan will reduce the equity value of the business by $2 million. The impact of the additional debt drives down business value.
Business Risk Has Gone Up
COVID-19 has increased the risk of doing business due to the future uncertainty of how each business will be impacted. Risk is usually reflected in discount rates utilized in Income Approaches to valuation such as the Capitalization of Historical Cash Flow Method or the Discounted Future Cash Flows Method. As the risk rate goes up, business value declines.
Although it is too early to tell what impact COVID-19 will have on potential M&A transaction values, many buyers and sellers are simply taking a wait and see approach. Adjustment to financial performance for COVID-19 will undoubtedly become part of the discussions in every deal and those adjustments will impact deal values. Sellers are well advised to provide buyers with financial forecasts reflecting the ongoing impact of COVID-19, including what a post COVID-19 environment is most likely to look like.
Many companies who issue GAAP financial statements and carry Goodwill and Long-Lived Assets on their balance sheets may find that the fair value of these assets has been impaired due to the decline in overall business value resulting from COVID-19. This may be considered a triggering event under ASC 350 and require testing between the dates of the company’s annual impairment testing. Impairment charges may result.
Estate Planning Opportunities
On the positive side, now may be the best time ever for wealth transfers of closely held company interests to family members or trusts. COVID-19 presents a unique opportunity for individuals to take advantage of low business valuations to minimize estate and gift taxes. This, combined with an upcoming Presidential election and uncertainty of what might happen to the estate and gift tax exemption levels, creates an unusual opportunity to transfer wealth while minimizing estate and gift taxes.