We’ve written extensively on our blog and created a YouTube video about valuing a business in a divorce. As the COVID-19 pandemic continues to change our economic structure, a common question we're hearing is: How are small businesses valued, taking into account the COVID-19 pandemic?
Valuation Methodology – The Income Approach
As a reminder, generally speaking, businesses are valued by expert appraisers considering three different methodologies:
- The Market Approach
- The Asset Approach
- The Income Approach
The market approach is the rarest as it generally looks at comparable sales in the market. The asset approach is used when a business is not an ongoing concern, meaning the business is too new to support an asset-backed or income-based valuation, is currently no longer existing or functioning, or is otherwise ineligible for the other approaches.
Most commonly, particularly for successful businesses, the business valuator is using the income approach. As we’ve discussed in our business owners blog series and video, the income approach looks at the historic income of a business, applies a capitalization ratio to that income, applies discounts (e.g. marketability discount), and then backs out personal goodwill.
As you can imagine, a major component of the income approach is the valuator figuring out the following: What exactly is the historic income of a business? This may not be as simple as you think.
The following complications can arise:
- What if the company has ups and downs, e.g. two good years, and one bad year?
- What personal expenses are run through the business?
- Is all income reported, or are there unreported cash transactions?
- Is the business operating at its full potential?
How COVID-19 Affects Income
Let’s say everyone is able to get relatively on the same page on what the historic income of the business is. Now here’s a more complicated question: Who cares what the historic income is if COVID-19 is fundamentally reshaping, and in many times devastating, small businesses across the state and country?
Valuators often consider the RAIDS phenomenon when valuing a business. R.A.I.D.S. stands for “Recently Acquired Income Deficiency Syndrome.” Often used sarcastically, it is most frequently used to describe a spouse who owns a business suddenly dropping in income when a divorce is imminent or has started. It is common in a divorce to hear “the sky is falling” from the business owner, meaning the projections coming from the business owner often fall on deaf ears.
But what if the sky really is falling? Businesses across the state are experiencing RAIDS not because the owners are planning for divorce, but because the COVID-19 pandemic and shutdown is negatively affecting the business in an unprecedented way.
How the COVID-19 Pandemic Affects Income Projections
Clearly the COVID-19 pandemic may affect the business’s income in the year of a divorce. But how does it affect income projections? Is it fair to look at a business’s historic income to predict future income given the pandemic? If a business was expected to grow at the end of 2019, is it still expected to grow? How do we know? How can anyone predict the future effect before the pandemic is even over?
The long and short of it is this question: How does the COVID-19 pandemic affect business valuations? The consistent answer we are receiving from business valuators, at least at this time, is this: We do not know.
Important Factors to Consider
Although nobody can predict exactly how the COVID-19 pandemic will affect small businesses, here are some important factors to consider:
How is the industry affected by the shutdown?
COVID-19 obviously affects different businesses in different ways. Own a liquor store? You’re probably doing OK. Own a restaurant? Times are very tough. Understanding the individual industry a business is situated in is more important than ever in business valuations. And what is most fascinating (and unnerving!) is there is no historical data to look at.
Will the industry bounce back after the shutdown?
Assuming the shutdown ends someday, will the business bounce back from the shutdown of the business? Is the demand for services pausing or disappearing? For example, look at a dental office. People are not going to stop having their children’s teeth treated; they may just be waiting for the end of the pandemic to go see the dentist. So, will business be greater post-pandemic than it was pre-pandemic? Or, is the business simply gone and people have adapted to figure out a different way to provide for their needs? If business is simply paused, can the business handle a post-pandemic boom? If the business is gone, can the business adapt and pivot?
How has Paycheck Protection Program money saved or at least sustained the business?
In April 2020, the Paycheck Protection Program was passed into law. The PPP program provided for loans to small businesses that will be forgiven if the loan is used for payroll, rent, or other qualified expenses and all employees are kept on the payroll for eight weeks. Virtually every small business in the United States applied for and received the PPP loan.
From a business valuation perspective, did the PPP loan save the business? How can you determine if the business can sustain itself through the pandemic if the numbers are bolstered by what may be a one-time only bail out from the federal government? Once the forgiveness period lapses, will the business let employees go? For some businesses, was the PPP loan actually a windfall for the business? Are future loans coming?
At the end of the day, business valuation comes back to one simple question: Hypothetically, what would a willing buyer be willing to pay a willing seller for the business? Businesses are still being sold during the pandemic and will continue to be sold after the pandemic. While the subjectivity of the valuation process may have greatly increased given the current global situation, the process does continue and divorces still happen.
The more subjective the factors in valuing a business, the more important it is to have a strong and knowledgeable advocate who understands business valuations and can point out the strengths in his or her valuator’s approach and point out the weaknesses in the opposing approach. The difference in advocacy could literally amount to a difference of millions of dollars depending on the business. Regardless if you own a small business or your spouse does, the importance of hiring the right experts to advocate for you has never been greater.