Every four weeks or so, my dad would take me and my brother to the barber for haircuts to give my mom a morning to herself (something I didn’t appreciate at the time). This was also our opportunity to visit the baseball card store. At some point, the focus shifted from packs of cards to the Beckett Baseball Card Monthly pricing guide, a listing of the market value of every baseball card. For $2.95 you could look up every card in a collection and see the monthly movements in card prices and put a value on a collection. I remember sitting on the bedroom floor looking up the value of a Rickey Henderson rookie card for the 100th time when my dad walked in and gave me one of those great dad life lessons. I was excited to tell him the card is up $1 from the prior month, and he said “That’s great, but unless you are going to sell it, the value today doesn’t matter, and even then, it’s only worth what someone is willing to pay.” Amazing how our parents get wiser as we get older.
Fortunately/Unfortunately for business owners, there is no Beckett guide for private companies. The value a buyer is willing to pay depends on a multitude of factors, too many for this discussion. However, in this uncertain environment we are in and will continue to be in for the foreseeable future, having an experienced advisor that can help position the company’s financials will be key to optimizing valuations.
Even in normal times, prospective buyers adjust a company’s earnings to remove one-time/non-recurring items in order to arrive at a normalized earnings base upon which to value the business. The underlying premise is that COVID is a highly unusual event that is unlikely to recur – a characterization that is not likely to be controversial. The challenge will be quantifying and defending the financial adjustments in order to present how the company would have performed in a normal environment absent COVID. In practice, adjustments will likely be industry-, geography-, company-, and situation-specific. For example, small-ticket consumable product manufacturers will likely have a different approach than higher-ticket, more capital-intensive product manufacturers as the latter could experience deferred sales under COVID, which could be more likely to return. While the situations are too varied to try to cover in this piece, here are three ways we generally believe company financials may be presented in the near-term that balances optimizing valuations and maintaining credibility with buyers.
PRO FORMA ADJUSTED EBITDA
Adjusted EBITDA is not a new metric. With the widespread adoption of sell-side quality of earnings reports, adjusted EBITDA has become the standard for many M&A transactions. What will be different, however are the adjustments that are presented by sellers and ultimately accepted by buyers. We anticipate COVID-specific pro forma adjustments throughout the P&L, including:
- Quantifiable adjustments, such as cancelled orders or inability to fulfill orders (regardless of the reason) supported by a growing backlog is a prime example of a top-line adjustment we might see. In determining these adjustments, buyers will be very careful to avoid “double counting” sales, for example, if any canceled orders eventually returned and thus were already captured during the last twelve months period (“LTM”) prior to sale.
- Customer gains or losses as a result of COVID is a second area where we may see significant revenue adjustments. Volume changes due to customers consolidating suppliers or competitors that were forced out of business can have a material impact on company valuation that is not immediately visible in the near-term financial statements. In these instances, EBITDA could be adjusted to reflect the financial impact of these customer gains or losses over an entire 12-month period.
Cost of Goods Sold
- Changes to input costs can represent another potential adjustment if the company was forced to find alternative suppliers, so long as you can show the increase is truly temporary.
- Temporary wage increases to entice employees to continue to work rather than go on unemployment is a COGS adjustment we expect to see if the increase truly is temporary and we can show a return to historical wage rates.
- Increased freight costs due to higher demands on shipping companies could also be adjusted if we can show a return to normal, historical levels.
- Changes to employee headcount, salaries, or benefits may be a potential source for adjustments in either direction depending on the permanence of the changes. If the company reduced headcount and transitioned to temporary labor with the intent (and hopefully a demonstrated track record) of hiring back on a W2 basis, that could also be a source of potential addbacks.
- One-time costs to bring a facility/company into COVID compliance should certainly be considered non-recurring and therefore an add-back. Any new costs, such as more stringent cleaning, may be deemed recurring and therefore NOT an add-back, depending on the prevailing conditions at the time of sale.
An alternative presentation, one that often times works in conjunction with the Adjusted EBITDA approach, is the run-rate method. This approach looks at a period of normalcy less than a year (typically 3- or 6-months) and annualizes the results to show the company’s trajectory coming out of a period of uncertainty or turmoil. This is an approach typical of high growth companies but also an approach we saw coming out of the 2008 recession. This is a good approach for companies such as the small-ticket consumable manufacturer looking to sell before a “normal” year has passed.
NORMALIZED REVENUE & EBITDA
In this approach, there are a variety of ways the seller can present the financials as if COVID didn’t happen. These techniques can include using the prior year’s revenue for the impacted months and building out an adjusted P&L using that as the base. Another approach could entail analyzing the monthly revenue trajectory and trying to normalize the impacted months to match the months preceding and following COVID. From there, the seller and their advisors build a pro forma P&L around the normalized revenue with a focus on normalized EBITDA.
These three methods are tools your advisors can use in negotiations and are meant to work together to triangulate on baseline performance to help optimize valuation. While the exact timing of a COVID recovery is still very unclear, what we do know is that now more than ever, sellers will need experienced advisors that can walk that fine line between creativity and overreaching. Transaction structuring will also be critical in helping bridge valuation gaps and appropriately sharing risks, but that’s another topic for another day.