We take a look at how COVID-19 may impact a company’s value
There are few, if any, businesses that are immune to the effects of the current COVID-19 outbreak. In the midst of the chaos, however, divorce proceedings continue. Where the assets of the parties include a business there is now an added complexity – what about the impact of COVID-19?
In this article we take a look at how COVID-19 may impact a company’s value, liquidity and the sustainable income that the owners may draw (the matters we are commonly instructed to address as SJE). We also consider what additional instructions solicitors should be putting to their SJE in these unprecedented times.
First of all, instructing solicitors need to consider whether a valuation can be prepared in current circumstances. Most valuations contain an element of uncertainty – in general a business is valued by reference to possible (rather than known) future performance. But solicitors (and SJEs) need to consider whether the uncertainty caused by COVID-19 is so significant such that a valuation cannot or should not be prepared.
In considering this, attention needs to be given to the company’s customer base (remembering that, if a company’s customers go bust, the company will have no income) and supply chain (will the company still be able to source its stock/services). Even if it is concluded that the valuation should continue, it may be necessary to adopt a number of
Consideration must be given as to whether a valuation could or should actually be prepared
The week before the UK lockdown started we valued a company that manufactures and sells a high end kitchen appliance. The appliance was manufactured in China with its most unique component being sourced from Northern Italy.
Whilst the business had exhibited ‘hockey stick’ growth and was a prime target for a Dragons’ Den type investment it only held stock to cover four weeks’ sales and was clearly going to be unable to replenish that stock in the short term.
Assuming the valuation should continue…
Our instructions usually include commenting on the value of a company, its liquidity (what the parties can extract now) and the sustainable income that the parties could draw on a recurring basis in each year.
The COVID-19 outbreak and the impact that it may have on a business means that, if we were asked these questions in isolation, we may provide the court with the wrong answer, or at least one that becomes outdated pretty quickly (assuming that the outbreak can be brought under control relatively swiftly).
Taking the kitchen appliance manufacturer – by now the company will have no stock to sell and has no prospect of acquiring more stock in the short term. In isolation a business with no stock and no prospect of generating sales is given a low value by reference to its assets.
The timing of a valuation can be critical and now, versus in six months’, may be very different
However, if we were instructed to ignore the effects of COVID-19 this would almost definitely give the wrong answer through overvaluing the business. It is reasonable to assume that most trading businesses will be impacted in some way or another by reduced sales or increased costs (or both).
What should you be asking?
While it is definitely relevant to pose the usual instructions and get an understanding of the current position of a company, you should also ask your SJE to assess the impact of COVID-19. If there are specific scenarios that need to be considered these should be set out in the letter of instruction.
The impact on value
Our corporate finance colleagues tell us that transactional activity in the market has all but ceased – no one wants to buy a business in the current uncertain climate and, in any event, it’s all hands on deck to secure the future of businesses already owned. Any transactions that are continuing are doing so on adjusted terms to take into account the uncertainty of future profits – sales consideration is being deferred and made contingent on future performance as purchasers do not want to take the risk of poor performance during COVID-19.
So is the answer that the current value of most companies is £nil?
That is unlikely to be the case even if the company isn’t producing soap or hand sanitiser. We have previously discussed the impact of timing on a valuation and the current situation clearly demonstrates that the timing of a valuation can be critical. If you are trying to negotiate the terms of a divorce settlement it may be difficult to get both parties on board with a value that is temporarily (we hope) suppressed.
Different valuation techniques such as DCF analysis are more relevant now
The solution, and one which some of our instructing solicitors have already identified, is to instruct us to consider the value in say 3-6 months assuming the company survives the COVID-19 pandemic. This approach does not ignore the current outbreak but seeks to understand the impact on the business and prevent the inevitable need to revisit a valuation once COVID-19 is behind us.
The solution is not quite that straight forward though. In order for us to address our instructions, we will need more information from the parties detailing the impact already sustained, forecasts of the future impact and the actions being taken by the directors to mitigate this. As usual, this information needs to be robust and we can’t just rely on unsupported statements. The difficulty here is that no-one has faced anything like COVID-19 before so even the best forecasters have no solid base to start from in estimating future performance. That said, if forecasts have been prepared the SJE can assess these and consider whether the underlying assumptions appear to be reliable and how the outcome would change if these prove to be incorrect.
It is unlikely to be advisable to extract any funds for making a divorce settlement given the current economic uncertainty
Often we find that the most recent financial information available to us is a few months old. Given how rapidly COVID-19 has spread this information is unlikely to show the impact of the virus (which may in any event still be unknown). As a result more work may be required by the parties (in providing more up-todate information) and by ourselves (in determining the extent to which we can rely on this information).
You should expect to see some different valuation techniques being adopted in the current environment. Discounted cash flow (DCF) valuations will be used in conjunction with earnings multiples and asset based valuations. This is because DCF focuses heavily on cash flows and can readily be used to assess trading losses in the immediate future.
The impact on liquidity
We are frequently instructed to consider the liquidity of a company with a view to identifying how much the parties can extract to fund a financial settlement. Keeping it brief, unless a company is sitting on a massive pile of cash, it will be difficult to conclude that the parties will be able to extract any funds at present, not least because it is prudent to save resources for both current and future rainy days.
Should the company fail to survive and the parties have taken money out, they could also be leaving themselves vulnerable to insolvency litigation if their actions are viewed to be in their own best interests rather than those of the company.
It may be that this instruction needs to be revisited by the SJE closer to the date of the final hearing.
The impact on sustainable income
A similar approach to instructions regarding valuation may need to be adopted when considering sustainable income. It may be pragmatic to consider what is the position now and what will the position be in a year’s time?
The obvious reason for this is that if a company’s income stream has been interrupted there will be lower profits for the parties to extract. This position will hopefully be resolved (to some extent) in the next few months, increasing the cash available to the parties on an ongoing basis.
Another reason, however, relates again to protecting the parties against litigation should the company fail. It is common in owner managed businesses for the owner/manager to pay themselves a small salary and take the majority of their income as dividends. However, if a company fails and an insolvency practitioner is appointed the payment of dividends
can be considered to be preferring the interests of the shareholders above those of the company (and its creditors). In the current climate, it may therefore be more appropriate to temporarily extract a greater proportion of income as salary rather than dividends. This has an impact on the amount of net income receivable as dividends attract lower tax rates than salary.
The impact of government assistance
The government has announced a number of initiatives aimed at helping businesses to survive. We set out below a very brief summary of the impact of some of these initiatives on our instructions.
Job retention scheme – this scheme allows employers to furlough staff (effectively “pause” their employment) who would otherwise have been made redundant. Where a company has furloughed staff because its income has dropped its costs will also be temporarily reduced – limiting losses but not completely offsetting the impact of lower sales income.
Cash grants – available to companies operating in certain industries (e.g. retail and hospitality). Government grants are intended to help businesses meet their ongoing costs whilst income streams are interrupted. These nonrefundable grants are not a source of income for the parties but will help to fund costs which would otherwise have been funded by the company, thereby plugging some of the gap caused by losses resulting from reduced income.
Loans – the government has announced three loan schemes, the most relevant to our clients being the COVID-19 Business Interruption Loan Scheme (CBILS) and Bounce Back Loans scheme. A new loan will not have an impact on the value or liquidity of a business on day 1 but it will impact the sustainable income of the parties as the company will need to fund capital and interest payments in the future. Assuming a loan is taken out to fund trading losses the debt due in future years will reduce the value of the company.
What about recent valuations?
What if your SJE released their report just prior to the COVID-19 outbreak? It is probable that company valuations will have declined.
The expert’s declaration requires the SJE to inform their instructing solicitors if their report requires any correction or qualification. Should SJEs therefore be contacting all solicitors from whom they have received instructions and to whom they have issued reports in the last few months?
It is difficult to know. First of all, how does the SJE know if any correction is required without further discussion with the business owner? However, and perhaps on a more practical note, the SJE is rarely informed about whether matters have settled (in which case there is unlikely to be an obligation on the part of the SJE) or if they are still in progress. We know that there are numerous factors driving the decisions and settlement discussions of the parties to a divorce. Before running back to your SJE and asking them to re-do their valuation, it may be sensible to give some consideration to the expected impact of COVID-19 and how long lasting the effects may be.
In the event that a settlement has already been reached, there is still the possibility that an update may be appropriate if the COVID-19 outbreak and subsequent impact on the valuation of the business constitutes a ‘Barder event’. Far be it from us to comment on the application of UK case law but we do expect to see more instructions arising from applications to vary court orders going forward.