We have come a long way since the start of the Covid-19 pandemic in early 2020. In an effort to slow the spread of Covid-19, many states’ governors imposed forced closures of businesses, declared states of emergency and issued shelter in place/stay at home/home or work/safer at home orders starting in March 2020. Despite the ongoing risks of the pandemic, some states began phased reopening in mid-2020. Other states followed in 2020 and early 2021 after release of the various vaccines. However, some states remained largely shutdown well into 2021. As of September 2021, most states have fully reopened albeit with restrictions still in place while the discussion has shifted to vaccination requirements for businesses and customers.
The pandemic created many challenges for appraisers engaged to value businesses for SBA 7a business acquisition loans during 2020 and into 2021. Nearly all businesses, both essential and non-essential, have been impacted by the pandemic—some negatively and some positively. As of September 2021, appraisers still confront some challenges but now have greater insight as to the impact of the pandemic on businesses and the economy. In addition, appraisers have greater clarity regarding the economy and business activity going forward and the attending risks associated with the on-going pandemic.
While the economy continues to rebound sharply, there have been unanticipated consequences for business such as supply chain disruptions, labor shortages, changing consumer behavior, inflationary pressures, etc. These issues may well prove transitory, as suggested by the Federal Reserve, but some businesses continue to feel the impact in terms of lower revenues, higher expenses, and capacity constraints due to labor shortages and the inability to source materials. No one can predict with any certainty at this point when these pressures will ease and when or if business will return to a normal that resembles pre-pandemic activity.
Since our original article in June 2020, we have seen businesses negatively impacted by the pandemic, positively impacted by the pandemic and neither positively nor negatively impacted by the pandemic in terms of their financial performance. For example, CPA firms/tax return preparers in general saw no impact from the pandemic. Liquor stores, golf courses, and building contractors were positively impacted. Restaurants were mixed with some being negatively impacted (usually table service) while some like fast food were positively impacted. Gyms were generally negatively impacted.
For lenders attempting to close SBA 7a loans over the last eighteen months, the performance and outlook has been equally mixed. Opportunities for closing deals was limited during state shelter in place orders/lockdowns but seem to have increased as states reopened and economic activity improved. However, even now, there is considerable uncertainty regarding the sales of businesses and the ability to finance those transactions due to the pandemic’s impact on the willingness of buyers to acquire and secure financing, the willingness of sellers to sell as many opt to delay a liquidity event until they have restored the business to pre-pandemic performance, and quality deal flow.
Lenders and businesses are questioning how business values have been and will be impacted by the pandemic, and they want to know how appraisers will address this in valuations. Will businesses be penalized in terms of value due to circumstances beyond their control? Will the business’s performance during and after the pandemic weigh heavily on the valuation? Will appraisers adjust for the short-term nature of the pandemic’s impact? Will businesses continue to be held back due to variants of the coronavirus and will this negatively impact valuations?
We maintain our original position that the Covid-19 pandemic is a ‘Black Swan’ event. Investopedia explains a black swan event as follows:
A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, their severe impact, and the widespread insistence they were obvious in hindsight
- A black swan is an extremely rare event with severe consequences. It cannot be predicted beforehand, though many claim it should be predictable after the fact.
- Black swan events can cause catastrophic damage to an economy, and because they cannot be predicted, can only be prepared for by building robust systems.
- Reliance on standard forecasting tools can both fail to predict and potentially increase vulnerability to black swans by propagating risk and offering false security.
From a long-term perspective, this black swan event is likely to have a transitory impact on the economy and business values. Ultimately, we believe this is a blip on the radar of the long-term economy. We have already started to see many states return to normal in terms of business activity, and people are more comfortable going about their daily lives as a result of the vaccines available, increased awareness of the risks associated with the Covid-19 coronavirus, and a general desire to return to normal. The pandemic will end at some point. People are going back to work and getting on with their lives, as we suggested would happen in our original article from June 2020. Businesses have resumed operations, and the economy is rebounding nicely.
We felt it was inconceivable that businesses would operate at significantly reduced capacities in perpetuity. We didn’t believe that restaurants would permanently close their dining rooms and do just take out or permanently operate at 25% capacity. We didn’t believe that retailers were going to be permanently forced to limit the number of shoppers in their store at one time nor would entertainment venues, casinos, and theme parks perpetually operate at 20-30% capacity. Fans have returned to theme parks en masse, and football and baseball games are at full capacity in many cases. We have seen that the temporary adjustments made during the pandemic to stop the spread of Covid-19 were, in fact, temporary and are not going to remain in perpetuity. Most places are returning to some degree of normal. We will not be living in some altered reality where we live the rest of our lives always six feet apart from others, always wearing masks and always separated from others by plexiglass.
What does all of this mean from a valuation perspective? At the heart of the valuation of a business lie two fundamental concepts…cash flow and risk. Capitalizing net cash flow by a risk adjusted rate of return (reflecting risk factors) is one of the most common methods of valuing a business for lending purposes. This is known as the capitalization of earnings method and is usually applied to businesses that exhibit stable financial performance and cash flow. Generally, an examination of historic performance or a weighted average of historic performance of the business is used to develop an estimate of expected/normalized cash flow in perpetuity. The proxy of normalized, on-going cash flow is then capitalized by the risk adjusted rate of return, usually derived from the weighted average cost of capital (WACC) less the long-term sustainable growth rate.
As we suggested in our original article written during the height of the pandemic, appraisers can account for the pandemic’s impact on the value of a business in two ways: 1) consideration of the impact on the company’s cash flow, or 2) an adjustment to the risk profile via the company specific risk premium.
To illustrate the possibilities and how this may impact a valuation, we consider different scenarios involving the same company as of August 2021. The first represents an assumption that business will normalize at a pre-pandemic level; this is likely applicable to businesses who were not negatively impacted by the pandemic or only slightly so. We then consider the value using pre-pandemic financial performance and increased company specific risk premium to account for the heightened business risks that remain; this would likely be most applicable for businesses negatively impacted by the pandemic and for those who may have a protracted recovery period or elevated risk factors. The third scenario would consider projections for the business being valued or a weighted average of pre-pandemic cash flow and pandemic level cash flows.
Please note that this is a simplistic example used to illustrate the possible ways an appraiser can address the pandemic’s impact on the value of a business. Ultimately, an appraiser must use reasoned and informed judgement considering the case-specific facts and circumstances surrounding the business in developing an opinion of value. This is not a recommendation to use any particular approach or method for a specific assignment. This is simply an illustration of how various scenarios may or may not impact the value of a business and offers appraisers potential adjustments to consider in these challenging valuation times.
Scenario #1: Pre-Covid-19 Pandemic
The calculation of the company’s weighted average adjusted free cash flow is presented below. This scenario assumes the pandemic is a black swan event and uses pre-pandemic cash flow to value the business, assuming a return to normal for the business. The appraiser must use caution when making this assumption and match the current facts and circumstances of the business to the likelihood of achieving pre-pandemic performance, current risk factors, etc. Remember, valuation is a forward-looking concept; the use of pre-pandemic financial performance presumes this historic performance represents a normalized base for the future.
The following table calculates the capitalization rate for the Company. The company specific risk premium of 10% represents the assumptions made based on information known and facts and circumstances that existed prior to the Covid-19 pandemic.
The following table illustrates the calculation of the enterprise fair market value using the capitalization of earnings method assuming pre-Covid 19 financial performance is indicative of normalized financial performance.
Scenario #2: Risk Premium Adjustment to Account for Covid-19 Pandemic Effects
For illustration purposes in this scenario, we will assume the valuation date is August 31, 2021. The scenario assumes that the Company’s historic performance before the Covid-19 pandemic is representative of the Company’s normalized performance and that the effects of the pandemic are transitory. The risk is being accounted for by increasing the company specific risk premium.
The following table calculates the capitalization rate. In this scenario we have adjusted the company specific risk premium to 20% to account for the uncertainty of the company’s financial performance created by the Covid-19 pandemic and lingering business risk issues. In addition to the many factors already considered in assessing the company specific risk premium, the appraiser may consider additional factors resulting from the Covid-19 pandemic that may contribute to an incremental increase in the company specific risk premiums. These additional risk considerations may include capacity constraints, lack of demand, consumer habits/changes to habits, potential regulatory changes (good or bad), supply chain issues, cost increases due to precautionary measures, additional staffing requirements, incremental financial risk stemming from weak cash flow, etc.
The analysis will be case specific based on the circumstances surrounding the business being valued. There is no blanket incremental increase in the risk premium. Many of the factors to be considered cannot be quantified and remain at the judgment/discretion of the appraiser using reasoned and informed judgment.
As a result of the increased company specific risk premium, the weighted average cost of capital increased to 11.7% as compared to the pre-pandemic weighted average cost of capital of 10.4%.
The calculation of the enterprise fair market value is illustrated in the table below.
Scenario #3: Projected Cash Flow/Alternative Weightings
Our third scenario involved using the discounted cash flow method and projections for the company’s net free cash flow to value the enterprise. This scenario would be based on projected performance from the date of valuation for the next three to five years and would take into account current operations and the time it takes the business to return to a normal level of performance, which may or may not be similar to pre-pandemic performance. This approach is useful only when reliable projections and/or guidance from management of the company is available. In the majority of cases we have seen since the start of the pandemic, sellers are unable or unwilling to forecast financial performance given on-going uncertainties and buyer projections have been overly optimistic or unrealistic in terms of timing a return to normal or what that normal looks like in light of supply chain disruptions, inflationary pressures, labor challenges, etc. For these reasons, we have seen this scenario used in very few instances. Those cases where it has been used are generally larger businesses with more sophisticated management and financial reporting structures that can produce detailed projections based on solid, well-founded assumption.
As an alternative, in some cases, the appraiser may decide to include financial performance in 2020 or annualized 2021 in the weighting used to arrive at a cash flow metric. This would be in cases where the appraiser has reason to believe the business may be prone to longer-term impact from the pandemic or cash flow may not return to a normalized level for the foreseeable future.
The company specific risk premium of 10% is the same as the pre-pandemic cash flows; the company specific risk premium is not increased in this scenario.
The following exhibit summarizes the calculation of the fair market value using the capitalization of earnings method in the pre-Covid 19 environment.
It is important to note that the decline in value of some businesses is a function of the here and now. As businesses return to normal in terms of cash flow generation and lower risk, the fair market value in the future would likely rise towards the pre-Covid value estimate. If the virus variants surge or the vaccines prove less effective on the variants business activity and consumer confidence may suffer; this could negatively impact the values of some businesses for an extended period.
There is no single “right way” for an appraiser to account for the impact of the Covid-19 pandemic in a business valuation. Our scenarios above are offered for consideration and comparison. They represent simplistic examples. Appraisers ultimately bear the responsibility of preparing an analysis and reaching an opinion of value that is based on facts and circumstances known or knowable at the valuation date and reasonable, informed judgment. There will be disagreements over how to address the impact of the Covid-19 pandemic in business valuations. However, we believe this is largely a short-term challenge.