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A New Valuation Term: EBITDA-C

COVID has transformed nearly every aspect of daily life, including the performance of privately held businesses. Nearly 5.2 million businesses in the U.S., the vast majority of which are privately held, received over $525 billion in PPP loans to help shore up cash flow needs. However, not all companies have been affected the same. Many industries, such as restaurants and retail, are suffering, while others including some tech and online retailers, are benefiting. As the financial performance of many businesses was significantly altered during this period, the question must be asked: how have their valuations been impacted?

In a previous article, What is Adjusted EBITDA?, we wrote about the various valuation methodologies for privately held companies, the most common of which is the market approach. This valuation method relies on using historical profitability metrics, usually EBITDA, to value the business. This becomes an issue if EBITDA has been altered by COVID and whether the results are expected to be temporary or permanent.

Valuations are not an exact science; they have always involved an element of subjectivity based on perceived risk. As a result, valuation ranges will likely widen as players in the M&A process seek clarity around risk vs. reward perceptions and when the impacts of COVID will likely end. Buyers, lenders, and valuation professionals are exploring how to evaluate these COVID impacts on EBITDA and how to apply them to valuations; a term being referred to as EBITDA-C.

Short Versus Long Term Results

Valuations will depend on whether the resulting performance on the bottom line is viewed as temporary or permanent.

·       If temporary, it will be helpful to try to quantify the impact on EBITDA as if COVID had not occurred. However, if COVID impacts continue to drag on, it may become more difficult to define what is “temporary”, and what may actually be more permanent than once thought.

·       If permanent, then it makes more sense to try to forecast the longer-term impacts on profitability. This includes changes to the company’s revenue and expenses as well as the competitive environment and the subject industry as a whole.

A recent performance of the business may be considered temporary if the demand and customer base are expected to return even though some business has been deferred as either “Non-Essential” or the product or service is discretionary. If sales and profits return to pre-COVID levels relatively quickly, then the temporary COVID impacts on EBITDA can reasonably be assumed to be non-recurring and can be adjusted to reflect performance in a more typical environment.

Adjustments can go both ways, and some temporary benefits may be considered non-recurring. This can include revenue adjustments if there is a temporary spike due to COVID, and it can include expenses such as temporary lease relief from landlords, payroll tax deferrals, and EIDL and PPP loans if they are ultimately treated as revenue.

Although it is critical to analyze COVID’s impacts in the current environment, it is even more important to try to understand long-term ramifications. This requires a deeper dive into the fundamentals of the business and the industry it operates in. Long-term changes can result from external shifts in the industry, customer base, supply chains, and competitive landscape that are mostly out of management’s control.  An example of this is the evolution of the retail industry which has experienced an accelerated shift towards more online shopping. Although this may harm physical retailers, it has greatly benefited e-Commerce companies. Lasting changes can also be the result of internal factors such as the addition or loss of key employees or signing favorable long-term lease or supply agreements to take advantage of incentives.

Focus on the Future

To some extent, most businesses will likely experience both temporary and longer-term financial ramifications, whether positive or negative. Understanding both the short-term and lasting impacts of COVID is important for valuation because investors ultimately value a business based on the future while using the past to help support their projections. Although COVID may have distorted much of 2020 and 2021, investors continue to maintain a focus on future financial performance.

In any business valuation, it is the responsibility of owners and managers to explain and quantify the potential opportunities and risks to would-be investors and stakeholders. Some goals for managers to work on now include:

·       Create (or update) your business plan with a focus on the next 5 years. An effective business plan that drives valuation includes: defensible competitive advantages, sustained growth, diversified revenue, and strong management teams;

·       Understand how the long-term ramifications of COVID may alter your customer base;

·       Develop a clear path to recovery supported by detailed forecasts. Forecasts should include a range of values for key inputs and should consider best, base, and worse case scenarios;

·       Start tracking the company’s Key Performance Indicators (KPI’s) based on what is appropriate for your industry;

·       Explain how the business is prepared for a prolonged COVID environment or a future pandemic, especially if the business is not considered essential;

·       Have contingency plans in place for supply chain options, particularly for manufacturers and distributors, especially given the current delays felt worldwide;

·       Invest in technology and cybersecurity so employees can effectively work from home if appropriate;

·       Think about taking advantage of the opportunity to expand. This could include hiring talent, investing in real estate, buying a competitor, investing in technology, and so on. There are well-capitalized investors currently looking to partner with existing ownership and management teams to take advantage of these opportunities.

While these are just a few examples, a detailed business plan that is specific to each company and industry should be developed sooner rather than later.

Valuations and the Current M&A Market

While business owners may consider changes in performance due to COVID to be fleeting, investors and other stakeholders will continue to evaluate the historical performance of any company over the past few years. This means that the impacts of COVID will be an important part of any discussion on valuation for the foreseeable future.

We have talked with business owners, investors, lenders, and other valuation professionals to get their perspective regarding the current environment, and the vast majority agree that a solid foundation with a persuasive and tangible forecast is the greatest value driver going forward.

The perception that M&A markets have come to a halt because of COVID is untrue. According to the latest Chinook Report for 1H 2021, global, U.S., and Pacific Northwest deal volume rebounded to record highs compared to 2020 (read more here). Investors have record amounts of cash that they are looking to put to use. Low interest rates and an active lending environment indicate that valuations should stay healthy.

The Chinook Team is happy to answer any valuation questions and provide updates on current M&A activity within a particular industry.