Valuing a private corporation in difficult economic times
It’s true Alberta is facing tough times, but with the exception of the 2008-09 downturn, the province had an extraordinary run of positive financial returns for the past decade. During these good times, potential investors were focused on cash flow and earnings – revenues were growing and with growth came excitement around anticipated financial returns. While I’d like to provide an optimistic outlook, the unfortunate reality is excitement over anticipated financial growth has ceased for many local companies, and many business owners remain genuinely concerned about the future. Wishful thinking has no place in these times, and the need for factual assessment and detailed analysis is more important than ever.
Broadly speaking, for most valuations, the fair market value of company shares or assets are based on:
- The cash flows or earnings generated by the business; or
- The market value of the underlying net tangible assets.
As mentioned, for many years, investors and professional business valuators relied upon cash flow and earnings as the key measure of value. However, many companies are currently not generating enough returns to justify their investment in capital assets and working capital. As a result, corporate goodwill values have rapidly diminished (witness public market stock prices for many smaller energy service providers). Valuing businesses that are facing economic uncertainty and diminishing returns requires a broader, two-step approach.
First, it is vital to focus on the balance sheet. Our recent observations show:
- Asset-based values play a far greater role in investor decision-making. For capital-intensive businesses, investors are focused on the inventory of capital assets – when were the capital assets acquired, are the capital assets being used efficiently, are there redundancies in the capital asset fleet, and what is the ongoing investment needed to maintain these capital assets? Unless capital assets were acquired during the current economic downturn, the past purchase price of assets is generally irrelevant. If a business is marginal, but still a going concern, then capital asset values may be closer to depreciated replacement cost.
- Off-balance sheet liabilities must not be overlooked. Contingent or unreported liabilities have often scuttled potential transactions. For example, are there future clean-up or reclamation liabilities to be dealt with? What are the ongoing lease commitments for real estate that is sitting empty? What financial commitments have been made to pay off debt?
- Debtholders and key shareholders are more assertive, especially if operating cash flows are declining and the debtholders and shareholders have competing interests.
The second focus is on a hard – and I mean truly hard – assessment of future cash flow expectations and exposure to risk.
At Welsh Valuation, we treat a valuation as if we were asked to invest in that business ourselves. We encourage face-to-face discussions with the business owner in order to see and feel the business. We go beyond the reported financial numbers to look such aspects as key customers, key suppliers, dependencies on outside parties, competition, and reliance on key management, just to name a few. A successful business should have a vision and niche they can exploit, and understanding those possibilities and associated risks cannot be done based on a cursory glance at numbers and off-the-cuff analysis.
I see many valuators/investors assessing cash flow based on history, but what relevance does history have when revenues drop materially? In one recent transaction that we were involved in, the vendor had lost a quarter of its sales revenue and over a third of its earnings before interest, taxes, depreciation, and amortization (EBITDA) during the past year. Despite the downturn, there were sophisticated and informed potential purchasers who would have gained significant market share through an acquisition, and the vendor’s management team was willing to remain in place for an appropriate period. Despite the greater historical profitability, the potential purchaser remained focused on the current profit and next year’s projections. Tough negotiations finally led to a closing, and up-front cash was paid for assets and some earnings potential. However, to bridge the gap between historical profitability and projected earnings, the vendor and purchaser agreed to future performance-based measurements that were easily measurable and still within the control of the vendor’s management team.
While you can’t change the economy or your company’s current situation, there are a few opportunities you can take advantage of right away. Although diminished values mean there are buying opportunities for investors, for private company shareholders with limited liquidity, many are choosing to wait for the possibility of better returns and more buyers in the future. Without the intention to sell, private company shareholders can instead take advantage of lower values to refreeze shares at a much lower amount than what may have been present at the time of the original freeze. It may also be a good time to pass on shares to other family members in a succession plan. Declining values do present tax planning opportunities.
When times are tough, it presents the chance to rethink, reset, and reposition your company. Working with an experienced professional business valuator will ensure you and your company are set for success.
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