POST WRITTEN BY Trent Lee
Apr 21, 2020
Many businesses will have to close their doors temporarily. If your business remains open, your gross and net revenue for the year will likely be down significantly. To help you understand why this won’t affect your valuation as much as you might be expecting, let me give you a little background on understanding how business valuations work and how they are calculated.
In my experience as a business broker, there are two important aspects of business valuations to understand during unprecedented times:
1. Recasting The Financials
Recasting the financials means removing or adjusting items on your financial statements that are unrelated, unnecessary or unlikely to happen again to the ongoing business.
Let me give you an example so you’ll know why recasting is relevant to your business valuation: Following the advice of your CPA, you write off your family health insurance, business depreciation, amortization, meals over which you and your wife discussed the business, and your car, gas and auto insurance payments.
All of these lower your taxable income, thus lowering your business valuation. When recasting the financials, a good business broker or valuation analyst will “add back” those nonessential business expenses, as well as any discretionary or one-time expenses or income.
By adding them back, you are able to increase the seller’s discretionary earning (SDE), thus increasing the business value. As you can see, the expenses in this example fall under the removal of unnecessary expenses for the going concern of the business. They can be added back, or, from a valuation standpoint, you can pretend as if they never happened.
As an important side note, there are professional standards for determining and validating what can and cannot be added back. Everything must be documented, validated and noted. I will not get into those details in this article.
How is this relevant today? We’re facing an event that is not likely to occur again soon (let’s hope), so a business broker or valuation analyst can, for lack of a better way of explaining it, pretend like it never happened to your business.
If your business did $80,000 a month in gross revenue on average over the last three years, and assuming that revenue returns once the economy gets back on track, a business valuator can fill in those slow months when you were impacted by or closed due to COVID-19 and value the business as if it continued to operate at the monthly gross average of the last three years.
The opposite is also true. If, because your business has been impacted, your landlord provides a three month’s rent abatement or deferral and those rent payments are not reported on your financials, your business broker or valuation analyst must factor in those expenses as if they did in fact happen. The same is true for other areas that may be impacted by the current situation: increased shipping, labor, technology costs, etc. You must account both the positives and the negatives for a fair and accurate valuation.
2. Forward-Looking Business Valuations
When doing a business valuation, you do have to look backward (over the last three years of financials, as an example). However, business valuations are forward looking. In other words, a valuator has to take the knowledge they have from historical financials and apply it to the facts that they know about the future.
By “normalizing” historical financials for anything unrelated, unnecessary or unlikely to happen again, you can see that unprecedented events will have a major impact on your business gross and net revenue in that year, but they likely will not be as devastating to your valuation as you originally thought.
Most small businesses’ premise of value will be a going concern valuation. Going concern valuations expect that the business, at the time of the valuation, will continue in the foreseeable future, as opposed to being liquidated for its assets.
What is the single most important thing you can do to protect the value of your business during these unique times? Do whatever you possibly can to get your business revenue back on track to where it was prior to COVID-19. This will make it easier for a business broker, future buyer, lender and underwriter to justify and validate the normalizing or recasting of the financials as a singular, one-time event that is no longer relevant. However, it will depend on you to ensure your business revenue returns to historical averages.
In time, the economy will return to normal, as will the American Dream of building your business. Remember, others before you have weathered viruses, stock market crashes and wars without devasting effects on their business valuations.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.