Generally, expert appraisers value businesses by considering three different methodologies:
- The Market Approach
- The Asset Approach
- The Income Approach
The market approach-the rarest form-generally observes comparable sales in the market.
The asset approach gains preference when a business voids ongoing concern-meaning the business is too new to support an asset-backed or income-based valuation, no longer functions or exists, or is otherwise ineligible for the other approaches.
The most common approach used by business valuators-particularly for successful businesses-the income approach. The income approach studies the historic income of a business, applies a capitalization ratio to that income, administers 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 concerns can arise and further highlight complications:
- 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 imagine a scenario where everyone agrees on the historic income of a business to some measure.
Now consider this 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 (“Recently Acquired Income Deficiency Syndrome”) phenomenon when valuing a business. Often used with a level of sarcasm, it describes a spouse who owns a business suddenly dropping in income when a divorce lays on the horizon. 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? Since the beginning of last year, businesses across the state have been 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, widespread societal fear, and mandatory shutdowns may affect the business’s income. But how does it affect income projections? Is it reasonable 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 2021, is it still expected to grow? How do we know? How can anyone predict the future effect before the pandemic is even over?
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/was 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 is there is no historical data to look at!
Will the industry bounce back after these shutdowns? Assuming the shutdowns end 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 pediatric 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 children’s 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 passed into law and provided loans to small businesses. These loans will be forgiven if 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 viably determine business sustainability through the pandemic if the numbers are boosted by what may be a one-time only aid from the federal government? Once the forgiveness period lapses, will the business begin letting employees go? For some businesses, was the PPP loan actually a windfall for the business? Are future loans coming? What does the business look like then?
At the end of the day, business valuation dissolves down to one simple question: 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 sell long after the pandemic. While the subjectivity of the valuation process may have greatly increased given the current global situation, the process does continue.
The complexity surrounding the Covid-19 effects and governmental financial aid on business valuations questions the authentic abilities of your company. If you’re looking to gain an accurate understanding of the value of your business, obtain investment, identify weaknesses, etc., you may be considering a business valuation. A complicated financial analysis, valuations should be tackled by a qualified professional with appropriate credentials and viable experience. While many business owners favor lower cost options, they miss out on all of the benefits provided by a thorough valuation. Contact our team here at MCDA CCG, INC. to reinforce your business with a comprehensive analysis-placing you in a position of strength whether you wish to negotiate a sale of business, minimize the financial risk in litigation, minimize potential tax in the situation of a gift, or other reason. Located in Placentia, Orange County, California, our experts will provide you with the quality service at a cost-effective price. Don’t wait, contact us today!