How Has COVID-19 Affected Business Valuations?

If you are an owner of a closely held business, and if you are contemplating a sale or other strategic move that calls for a business valuation (which is important in many situations), then you might wonder just what effect the coronavirus pandemic has had on assessments of value.

In a nutshell, COVID-19 has complicated the ability to evaluate risk and future benefits — the cornerstone of business valuation. Understanding current drivers of risk and other valuation factors lets you position your business to deliver as much value as possible when you decide to transition out.

Revisit Your Exit Strategy

Even before the coronavirus pandemic, many business owners of the baby-boom generation were thinking about an exit. For many, the disruption caused by the pandemic — and by the government mandates designed to contain it — accelerated those plans.

Many business owners are thinking that now may be an ideal time to sell, especially those in industry sectors that are seeing a rise in business valuations. But valuations vary widely — both across industry sectors and among businesses. And with valuations that can be quite different than they were just a couple years ago, long-established exit plans may not make sense anymore.

Primer on Valuation Methods

Valuators have different ways to value a business. The three most common are:

• Asset-based
• Market-based
• Income-based

The asset-based approach is used for companies with significant capital assets, or those that are not eligible for other approaches (e.g., new businesses). The market-based approach is used when comparable market data (such as public company stock prices and private company transactions) is readily available.

Small and mid-sized businesses are often valued using the income-based approach, in which the valuator attempts to answer the question of how much income (or benefit) the business will produce over its useful life.

The Coronavirus Pandemic Effect

Under normal circumstances, valuators look at historical earnings to understand what will be possible going forward. As riskiness increases, the investors’ required rate of return increases, and the value of the business decreases. In other words, there’s an inverse relationship between rate of return (or capitalization rate) and valuation. One reason valuations are so different today is that COVID affected both the predictability of the business’s future benefit stream and the investors’ required rate of return.

Early in the pandemic, the data used to determine capitalization rates was affected by the riskiness of the investments and returns. While these rates have for the most part returned to the norm, uncertainty remains. Similarly, during the pandemic, most businesses have performed differently than their historic norms. Whether that variation means the business performed better or worse than usual, its anomalous nature makes it very difficult for valuators to make reliable financial projections.

Reduce Risk to Enhance Company Value

It’s impossible to know how long pandemic-related uncertainty (or the pandemic itself) will last. But one thing is certain: Any sort of uncertainty elevates risk, and risk reduces value.

A proactive stance toward risk management helps position your business optimally for a future sale and boost performance in the short term — helping you improve your balance sheet, create positive cash flows, and strengthen financial statements.

To keep building value through turbulent times, work with a trusted advisor to assess risk and formulate effective strategies to mitigate each potential threat. The following are just a few potential areas of risk to consider:

• Are collections slow? Look for ways to increase the value of the company by speeding up collections while stretching out payables.
• Do you have a high concentration of customers in one industry, or does your business rely on too few suppliers or vendors? Holding too many eggs in one basket harms a business’s value.
• Do you have an established and experienced management team that will remain with the business? Similarly, do you have an appropriate staffing model for your type of business — or do business operations rely too heavily on owners and managers?
• Do you have processes in place so that new owners can jump in and hit the ground running?
• Are financial statements in good shape, and does the business have operating cash flow to pay outstanding liabilities, such as tax bills?

What About Market Timing?

Efforts to identify and minimize risks will help you move quickly and seize the moment when the time is right to sell. But how do you know when it’s the right time?

For businesses in industries that have been less impacted — or positively impacted — by the pandemic, now might be a great time to get the business on the market for a sale. However, for owners who continue to see risk associated with COVID and are concerned about when the recovery will be complete, it may be wiser to stay in the game a bit longer to better position the company for market down the road.

In any industry niche, revisiting your exit strategy is crucial during times of rapid change. Keep the end in mind and take a holistic view of risks and challenges as you reassess your plans.

Considering an exit or other strategic move? Work with your CRI advisor to formulate a strategy unique to your situation, so the business you’ve given so much to over the years can deliver the most value for you.