The American Institute of Certified Public Accountants has issued new guidance regarding the valuation of distressed or impaired businesses.
The guidance, which is presented as responses to frequently asked questions, distinguishes between distress, which may be a temporary condition, and impairment, which is usually permanent. The FAQs address the application of valuation adjustments and other considerations related to the coronavirus crisis.
The AICPA highlights both the perils of failing to consider the many implications of the pandemic and the risk of overcompensating for the effects of such an unprecedented event. In addition, it notes that the pandemic may have positive implications for some businesses, such as those that are able to increase market share as weaker competitors crumble.
There is a substantial amount of information out there about how small businesses should respond to the COVID-19 pandemic, and the fear and uncertainty about the virus and what comes next. It is not hard to find articles about how to protect employees, customers and suppliers from infection and how to talk about the virus. In this article, I will focus on what businesses and their lenders and stakeholders must do to minimize losses and maximize financial stability in this unprecedented time.
Businesses, even high performers, need to consider the detrimental impact on cash flow resulting from the steps taken to slow the spread of the virus and “flatten the curve” of new cases. Some businesses are completely closed, while others are suffering disruptions such as reduced hours due to government restrictions. Supply interruptions are hurting business as well. Regardless of the industry, the inability to generate adequate cash flow endangers the ability to meet obligations to lenders, trade creditors and investors. Here are some things owners can do to navigate the crisis.
While no one really wants to look, it is critically important that businesses recast operating cash flow projections or generate new ones. This includes revising assumptions, forecasts and business plans to reflect the new reality. Prepare projections that consider the best and worst cases for the next few months and longer.
If management hides its head in the sand, the company is likely not going to survive. Hiring an experienced restructuring advisor and legal counsel early can provide credibility when dealing with lenders, creditors and investors. It may also preserve business value.
Develop a New Financial and Operating Plan
Triage is important. Some businesses are proficient at managing operations in times of stress. However, few companies have ever faced a dramatic, escalating crisis like the current one. Businesses have little choice but to pivot meaningfully, and planning is key to survival. This planning must address the new reality reflected by revised and updated cash projections and should include these steps:
Protect working capital. This includes taking an inventory of existing working capital, drawing on existing lines of credit and developing and implementing a cost-reduction plan to achieve positive cash flow. Cash is king and needs to be preserved.
Identify any collateral that could secure additional financing. Seeking such financing may not be feasible in the current environment, but this may change. To the extent a company has unencumbered assets, additional liquidity may be easier to arrange. It is important to identify assets that might be available to secure financing, including real property, inventory and accounts receivable.
Monitor federal and state government relief initiatives.
Consider working with a professional financial advisor and legal counsel to open lender communications. Some business owners who need to obtain financing on an emergency basis think that engaging a professional is a sign of weakness or requires cash that the company would prefer not to use. In fact, involving professionals in the process provides significant credibility when asking creditors for relief. Lenders and stakeholders may be more willing to respond quickly and positively if provided with information that has been reviewed by the company’s financial advisors. Attempting to save money by not hiring a professional can put at risk the ultimate success of discussions with lenders and creditors.
What if maintaining existing financing is not viable?
Once management is aware of the business’s inability to perform, it must work with stakeholders to establish strategies for employees, lenders, suppliers, customers and investors. This strategy must include developing communication plans for each of these groups. Retaining advisors is critical to address potential debt defaults, contractual performance defaults and other obligations.
Management must have a plan in place to address these issues, and outside help may be necessary to weigh the options, minimize risk and maximize value. Management is accustomed to operating in a normal environment and may have no experience dealing these kinds of challenges. If the company has a board of directors, outside guidance is critical to its duty-of-care responsibility.
It is important to determine what requests for relief from lenders are necessary to allow the business to continue to operate in this unpredictable environment. Considerations include what is needed to avoid default on short- and long-term financing obligations and what is needed to maintain relationships with vendors and suppliers. This includes “asks” that reflect reduced operations. Relationships with lenders, investors and other creditors can be more easily maintained if communication is open and frank and if professional advisors help the company determine which “asks” are likely to be successful.
This article merely scratches the surface of the complexities businesses face because of COVID-19. This disaster will likely rewrite the playbook for financial and operating restructuring. It is clear that credit providers and businesses, in order to survive, must be unified in focusing on preserving business value until the “new normal” emerges.
If you have questions about how to address your business’s financial difficulties, please contact the professionals at Advent Valuation Advisors.
It may be worthwhile to file a claim for coronavirus-related losses under your company’s business interruption insurance policy, even if the policy specifically excludes coverage for losses related to virus outbreaks.
A bill introduced in the New York State Assembly would require policies that include business interruption insurance to cover interruption claims incurred during the state emergency resulting from the coronavirus pandemic. The bill would apply to policies held by businesses with fewer than 250 eligible employees, defined as full-time employees who normally work 25 or more hours per week.
Business interruption insurance typically covers the loss of income that a business suffers due to the disaster-related closing of the business and the rebuilding process after a disaster. Coverage may include lost revenues, rent or utilities, among other things. A contingent business interruption provision generally provides coverage for a loss of income related to a problem experienced by a supplier or vendor.
Thousands of businesses in New York State have been forced to close as a result of the COVID-19 outbreak and the resulting state of emergency, which was declared by Governor Andrew Cuomo on March 7. The state has ordered nonessential businesses to close, and many businesses that continue to operate have been hampered by a combination of supply chain interruptions, staffing issues and plunging demand.
Insurers typically do not provide coverage for closures related to widespread illness. In fact, some insurers began to specifically exclude diseases from policies in response to the SARS outbreak of the early 2000s. The Assembly bill would nullify any policy provisions that allow insurers to deny coverage based on “a virus, bacterium, or other microorganism that causes disease, illness, or physical distress.”
Similar legislation has been introduced in several other states, including New Jersey and Pennsylvania.
Companies with 100 or fewer employees face business continuity losses of $255 billion to $431 billion per month because of the pandemic, according to the American Property Casualty Insurance Association, which opposes bills such as the one introduced in New York.
“Pandemic outbreaks are uninsured because they are uninsurable,” David Sampson, president and CEO of the association, said in a prepared statement. “Any action to fundamentally alter business interruption provisions specifically, or property insurance generally, to retroactively mandate insurance coverage for viruses by voiding those exclusions, would immediately subject insurers to claim payment liability that threatens solvency and the ability to make good on the actual promises made in existing insurance policies.”
New York’s bill was introduced March 27, 2020, and is currently before the Assembly’s Insurance Committee. It would apply to any policies in effect on and after March 7. It calls for any business interruption policies that expire during the period of the declared state emergency to be subject to an automatic renewal at the current premium. It would allow insurers to seek state reimbursement for business interruption payments. The state, in turn, would be permitted to raise funds for these reimbursements through a levy against all insurance companies doing business in the state.
The restrictions put in place to stop the spread of COVID-19 – such as limiting crowd size, closing restaurants and bars and canceling sporting events – are critically stressing many businesses.
One possible form of relief to this financial crisis is insurance coverage, including business interruption and contingent business interruption coverage. Business interruption insurance (also known as business income insurance) is a type of insurance that covers the loss of income that a business suffers after a disaster.
The loss of income covered may be due to disaster-related closing of the business facility or the rebuilding process after a disaster. Coverage may include lost revenues, rent or utilities, among other things. A contingent business interruption provision generally provides coverage for a loss of income related to a problem experienced by a supplier or vendor.
However, there are likely some hurdles to obtaining coverage based upon disruption from COVID-19. For example, a typical business interruption provision reads:
“We will pay for the actual loss of business income you sustain due to the necessary suspension of your ‘operations’ during the period of ‘restoration.’ The suspension must be caused by the direct physical loss, damage, or destruction to property. The loss or damage must be caused by or result from a covered cause of loss.”
A “direct physical loss” has been held to exclude economic losses unaccompanied by a distinct and demonstrable loss of the physical use of the business property. Furthermore, after the SARS epidemic in the early 2000s, insurance companies began to exclude viral outbreaks from typical coverage, though exclusions for losses in connection with viruses may not be ironclad.
Coverage depends on the particular policy, and a policy review may prove useful. Not all insurance policies are identical in the coverage they provide.
You will likely find that more expensive policies often provide better coverage than lower-cost policies. Also, coverage for COVID-19 related losses might be contingent on whether the policy provides business interruption coverage as a basic term of the policy or as an endorsement. An endorsement will often provide broader coverage than the base policy because of the additional premium for the endorsement.
Insurance companies will certainly oppose paying business interruption losses in connection with COVID-19, though with advice from your insurance broker and/or attorney, filing a claim may be a good first step. In addition to filing the claim, Advent believes business owners ought to:
Analyze your policy and review the law. Don’t be afraid to consult your company attorney if you have questions. For example, if the policy does not adequately define “physical damage” (which can be required to recover business interruption losses) and that term presents ambiguity in the specific context of your company’s loss, you may be covered.
Make note of virus exclusions. One can imagine this law is undeveloped and there is not clear precedent on coverage. Also, some policies may contain civil authority provisions, which could offer coverage for losses suffered in connection with government-ordered shutdowns.
Stay informed regarding legislative developments and any other pertinent changes. Finding every possible basis for recovery under your business’s policy will only enhance any potential recovery.
To learn more about the quantification of lost profits, please contact one of the experienced professionals here at Advent.
When a business is sold, it often sells for more (or less) than the appraised value. This may come as a surprise to laypeople, but valuators understand that there are many valid reasons that “price” and “value” may differ. Businesses that understand this subtlety are better positioned to make informed decisions.
Price is specific to an individual buyer and seller. It’s the amount of cash (or its equivalent) for which anything is bought, sold or offered for sale. It requires an offer to sell, an acceptance of that offer and an exchange of money (or other property). Some strategic or financial buyers may be willing to pay more than others because they can benefit from economies of scale or synergies that aren’t available to all potential buyers.
The term “value” often refers to “fair market value” in a business valuation context. The International Glossary of Business Valuation Terms defines fair market value as:
The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
Fair market value is essentially a consensus of what the universe of potential buyers would agree to pay for a business, a business interest or an asset. In the real world, sales may occur for more (or less) than fair market value, because the individual parties have their own perceptions of the investment’s risk and return, are under duress to buy (or sell), or lack relevant knowledge about the transaction or the subject company.
Another reason that value and price frequently differ is timing. In many cases, a valuator’s work is done months or years before the company is sold. Differences in market conditions or the company’s financial performance between the two dates could cause the company’s selling price to vary from its appraised value.
Real World Example
To illustrate how price and value may differ, consider the sale of a medical practice. There are primarily three potential buying groups for medical practices:
A physician group, or
To determine fair market value, a valuator would consider potential transactions to purchase the practice by all three of these groups, under the cost, market and income approaches. But in the real world, only one specific buyer would make an offer. So, for example, the analyses involving a physician or physician group wouldn’t be relevant if a hospital is buying the practice.
Price and Value Aren’t Synonymous
It’s critical for buyers and sellers to understand that the appraised value of a business interest may not reflect its future selling price. Value can vary substantially, depending on the effective date and the purpose(s) specified in the appraiser’s report.
When the purpose of a valuation is to establish an asking (or offer) price, valuators may provide a range of values that considers various buyers and transaction scenarios. This range can help a buyer and seller arrive at a reasonable selling price that’s based on the individual parties’ expectations of risk and return.
If you’re planning to buy or sell a business interest, the professionals at Advent Valuation Advisors are here to help.
Lost profits claims are difficult to prove under New York law. This is particularly true for a new business, or an existing business entering a new market or line of business.
A recent decision in a case heard in Arizona District Court – but involving a supply agreement governed by New York law – provides some insight into the hurdles faced by such claims.
In IceMOS Technology Corporation v. Omron Corporation (2:17-cv-02575) , the plaintiff, a business that sells semiconductor components, sued the defendant alleging breach of the supply agreement. The plaintiff’s claims included lost profits. The defendant countersued, and the case is ongoing.
In November, the court granted the defendant’s motion to dismiss the lost profits claim, finding that the plaintiff did not establish lost profit damages with reasonable certainty.
As explained in the decision, under New York law, there are two broad categories of damages that can result from a breach of contract. The first is the general damages that are the natural and probable consequence of the breach. The second is special or extraordinary damages that do not flow directly from the breach. A claim for lost profits is an example of a claim for special or extraordinary damages. New York uses a three-part test to determine if a party is entitled to recover lost profits:
The damages must be caused by the breach of contract.
The loss must be proven with reasonable certainty.
The party making the claim must demonstrate that the lost profits were foreseeable, that they were in “the contemplation of the parties at the time the contract was made.”
For a new business, the bar is set even higher. In order to establish reasonable certainty, a new business making a lost-profits claim must generally support the claim “with evidence of a history of profit or comparison of the new business with other comparable and profitable businesses.”
In addition, a new company must consider general market risks that might hurt its future profits, such as new competitors, technological or regulatory changes, or general market movements.
The hurdles for new businesses also apply to existing businesses entering new markets. This was the case for IceMOS, which reached an agreement with Omron Corporation in 2011 under which Omron would fabricate semiconductor wafers for IceMOS over several years. IceMOS purchased just a small fraction of the agreed-upon quantity. The court found that the plaintiff was a new business, as IceMOS was entering a new market, and held it to the higher standard.
The plaintiff’s lost profits claim relied on projections by the company’s president and a pair of experts. The plaintiff did not show a history of profits or any comparisons with profits of similar businesses. The court noted that, in New York, projections are generally not sufficient to establish lost profits with reasonable certainty. “Without a history of profit or evidence showing the profitability of other like-businesses, Plaintiff cannot establish lost profit damages with the reasonable certainty New York law requires for new businesses.”
The decision builds upon a series of earlier rulings that address aspects of the three-part test and the heightened evidentiary burden for new businesses. You can read the decision here.
Please contact us if you have questions about the determination of lost profits or the calculation of other types of damages.
You wouldn’t perform a surgery on yourself. The same holds true when buying a business. Unless you’re well-versed in performing a comprehensive financial analysis of a business, it doesn’t make sense to buy one without using a due diligence and valuation specialist. A due diligence report:
Verifies the accuracy of the seller’s
Outlines a detailed understanding of the
Contains vital information that can be used for
negotiating the transaction, obtaining financing, establishing the tax and
accounting basis of the assets, and integrating the acquired entity into the
Most of all, due diligence identifies possible deal-breakers. A seller may “prepare” a business for sale, making it look better than it really is, in order to obtain a higher price. A professional due diligence review guards against the overstatement of assets and understatement of liabilities. It also provides an analysis of historic earnings and the likelihood that forecasted operations can be met.
One crucial, but often overlooked, part of due diligence
involves the tax consequences of the proposed transaction. Depending on the
operating structure of the acquiring company and the target (for example, a C
corporation, S corporation or partnership), it may be better to receive assets
versus stock. Keep in mind that a badly structured sale can result in a tax disaster.
Contact Advent Valuation Advisors to learn how due diligence can keep a sale from resulting in costly errors.
When you need to know how much your business is worth, one of the first questions to ask is, how much work – and how much expense – will it take to get the job done?
In many circumstances, a comprehensive valuation is required or preferred. Sometimes, however, a relatively straightforward, and less costly, calculation of value may be sufficient. The purpose of the valuation will often dictate the scope of work that is appropriate.
Both the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA) have defined the scope of various assignments used to value a business, business ownership interest, security or intangible asset. In its Business Valuation Standards, The American Society of Appraisers (ASA) defines three types of engagements:
An appraisal engagement is the most comprehensive. It considers all relevant information as of the appraisal date and results in the expression of an unambiguous opinion of value, which is supported by all procedures the appraiser deems relevant.
A limited appraisal engagement is based on consideration of limited relevant information and limited procedures deemed necessary by the appraiser. It results in an estimate of value.
In a calculation engagement, the appraiser and the client may agree on the procedure or procedures to be performed. The appraiser collects limited information, performs limited procedures and provides an approximate indication of value.
The American Institute of Certified Public Accountants defines two types of engagements:
In a valuation engagement, the valuation analyst applies the approaches he or she deems appropriate. The result is a conclusion of value.
In a calculation engagement, the analyst and the client agree ahead of time on the procedures the analyst will perform, and these procedures are generally more limited than in a valuation engagement. The result is a calculation of value.
A full appraisal or valuation engagement will generally result in the production of a comprehensive report that describes in detail the procedures performed, while a calculation may result in an estimate, with limited additional information provided to the client. In any of the engagements described above, the resulting value may be a single amount or a range.
So, how does a business owner determine which type of engagement is appropriate?
The right tool for the job
There are times when a calculation may be sufficient. For instance, a small business owner who receives an offer to sell his or her business may simply want to gauge the fairness of that offer. According to the AICPA’s Statements on Standards, a calculation engagement also may be acceptable when acting as a neutral party in a dispute. For a matter involving the IRS or the Tax Court, a full valuation resulting in an opinion/conclusion of value is generally preferred.
The use of calculations in court matters has become a contentious matter. In a piece in the November 2019 issue of Business Valuation Update, Michael Paschall, an accredited senior appraiser and attorney, criticizes a phenomenon he terms “calculation creep,” the increased use of calculation engagements in litigation settings.
He claims the “incomplete and potentially biased aspects of calculation engagements represent a dumbing down of the valuation process and profession,” and calls on the governing bodies in business valuation to bar calculations for litigation, ESOPs, IRS purposes “or any other context where a reliable opinion of value is needed or third-party reliance is present.”
In Hanley v. Hanley, a case decided in June 2019 in New York State Supreme Court in Albany, the court rejected a value calculation produced by an accountant retained by one of the parties. The decision cites several concerns, including questions about the independence of the valuation professional and the lack of documentation in the valuation report, which did not describe the limited procedures or approaches used in the calculation.
At the end of the day, any valuation is only as credible as the professional who renders it. The judgment of the valuation professional is a key ingredient in every phase of the assignment, from determining the appropriate scope to selecting the best methods, reconciling the results of different procedures and, ultimately, deriving the indicated value.
Advent’s valuation professionals can walk you through the process and help you determine what type of engagement will best meet your goals.
Business brokers say fear of a recession and uncertainty over the upcoming presidential election may be driving down business valuations, according to the third-quarter edition of Market Pulse, the quarterly survey of business brokers conducted by the International Business Brokers Association and M&A Source.
Fifty-three percent of business brokers surveyed cited the prospect of a recession as the biggest concern affecting U.S. business valuations, followed by the presidential election and the trade war with China.
“Small business owners are worried that a recession is coming, and trade issues are causing volatility. All that nervous energy means buyers are dialing back a bit – particularly on the smaller market deals.” said Craig Everett, PhD. Everett is director of the Pepperdine Capital Markets Project at the Pepperdine Graziado Business School, which compiled the survey results.
The national survey is intended to capture market conditions for businesses sold for less than $50 million. It divides that market into three classes of main street businesses with values of $2 million or less, and two lower middle-market ones in the $2 million to $50 million range.
The survey found that businesses selling for $5 million to $50 million garnered a 9 percent premium over asking price during the third quarter, while the smallest main street businesses, those worth less than $500,000, sold for just 85 percent of asking price, the lowest percentage in four years.
Scott Bushkie, managing partner of Cornerstone Business Services, told Market Pulse that falling business confidence has slowed the activity of the individual buyers who account for most main street business acquisitions.
“Confidence always gets shaky as we enter an election season,” said Bushkie, whose firm has an office in Iowa, where the first caucus of the 2020 presidential campaign will be held February 3. “There’s this general escalation of reports pointing out economic weaknesses and policy flaws, and people sometimes internalize that negativity. I think we may be feeling that even earlier than normal this time around.”
Market Pulse found that sellers provided roughly 10 percent of the buyer’s financing in deals that closed during the third quarter. Earn-outs and retained equity were less common.
“Lenders always like to see sellers keep some skin in the game,” said Justin Sandridge of Murphy Business Sales-Baltimore East. “When sellers aren’t willing to finance any of the purchase price, that sends warning signals to buyers and lenders alike. Refusing to provide seller financing is like holding up a giant ‘no confidence’ sign, and it’s likely to scare other parties away from the deal.”
Market Pulse’s third-quarter survey of 236 business brokers and M&A advisors was conducted from October 1-15. The respondents reported completing 210 transactions during the third quarter.
Small business sales during the third quarter of 2019 yielded EBITDA multiples about 26 percent lower than a year before, according to the latest edition of DealStats Value Index. It’s one of several developments noted in the report that point to an emerging buyer’s market.
The median EBITDA multiple – the ratio of selling price to earnings before interest, taxes, depreciation and amortization – slid to 3.7 for transactions completed in the third quarter, down from 4.0 during the preceding quarter and the peak of 5.0 reached during the third quarter of 2018. The EBITDA multiple during the third-quarter of 2018 was the highest quarterly mark since at least 2013.
DealStats is a database of private-company transactions maintained by Business Valuation Resources. The database is used by business appraisers when applying the market approach to valuation. Multiples such as sale price-to-EBITDA can be derived from transactions involving similar businesses and used to estimate the value of a company, subject to adjustments for unique characteristics of the business being valued.
Over the longer term, DealStats notes that EBITDA multiples have generally trended downward since 2017, falling to a six-year low in 2019.
It’s important to bear in mind that DealStats data only reflects transactions reported to the service, and the data is subject to revision as additional sales are reported. For instance, the median EBITDA multiple for the April-June quarter was initially reported as 4.2. That was revised to 4.0 in the latest report. The spike to 5.0 during the third quarter of 2018 was previously reported as 4.4 and 4.5.
The delays in reporting may limit the value of information regarding trends gleaned from the quarter-to-quarter gyrations of multiples.
EBITDA margins decline
Businesses sold in 2019 have tended to be less profitable than those sold in recent years, according to the DealStats data. The median EBITDA margin (measured as a percentage of revenue) was just below 11 percent during the third quarter, up slightly from the second quarter, but down from 12 percent in the first three months of the year. EBITDA margins have generally trended lower since 2013.
A long time to sell
Businesses are taking longer to sell, according to DealStats. The median number of days for private businesses to sell was 221 for deals closed during the first half of 2019. That marked the fifth straight half-year period (dating back to the first half of 2017) where the median exceeded 200. From 2013 to 2016, the median never topped 200 days.
Revenue multiple falls
DealStats reports that the median sale price-to-revenue multiple this year is 0.45, down from 0.49 in 2018 and the lowest multiple in at least a decade. Businesses in the finance/insurance sector garnered the highest multiple, at 1.75, followed by information at 1.70 and professional, scientific and technical services at 0.89.
The highest EBITDA multiple was noted in the information sector, at 11.1, followed by mining, quarrying and oil and gas extraction, at 8.5. The lowest multiple was 2.6 for the accommodation and food service industry.
Business valuation professionals use transactions such as those collected by DealStats to derive a business’s market value. If you have questions about how comparable sales influence the value of your business, or how much your business is worth, please contact us.