• Achille Ekeu, MBA, CVA

One of the issues facing the business valuation community as well as business owners is the newly created accounting metric called “EBITDAC” which stands for Earnings Before Interests, Taxes, Depreciation, Amortization, and Coronavirus. This is a Non-GAAP accounting metric used by some companies today to raise more debts from lending institutions by adjusting or recasting their financial statements to account for lost earnings incurred due to the coronavirus.


Many professionals believe it makes sense to add back those "potential" earnings due to this unique non-recurring or extraordinary event that is the pandemic, and others call for caution and advise not to go that route that could lead to potential issues that may not be fully understood at this point by all the stakeholders using this new accounting metric. Essentially the main issue here is, for those who believe in using that new metric, how to determine that lost earnings attributable to the coronavirus?


We know that the pandemic is still ongoing in many parts of the world and we have no idea when it will “disappear”, in fact, the World Health Organization (WHO) and China are even talking about a second wave that could be as devastating as the first if not more. We also know that business valuation is future-oriented with a future right now that is bleak or very uncertain to be more prudent. How can we recast, adjust, or create projections or forecasts that are defensible without them being referred to as voodoo[1] economics?


What is EBITDA?

It is an accounting principle that is vital for every business owner to understand post-pandemic. EBITDA is the metric that mergers and acquisition professionals use to recast or normalize the financial statements of a company by removing items that are not part of the normal operations of the business under new ownership. Some of those items include:

  • Losses due to fire

  • Losses due to employee embezzlement

  • Other business disruptions beyond your control (floods, earthquakes, tsunamis)

  • Cars, planes, and boats being expensed through the business for your personal use

  • Inactive family members on the payroll

  • Compensation for active family members on the payroll that were being paid well above fair market

  • Any of your compensation that was below or above fair market value

  • Memberships at country clubs, yacht clubs and gyms for your personal use

  • Travel and vacations for you and your family that the company expensed


But now to this list, you may be able to add loss of revenue and income due to the impact of the “C” (Coronavirus). However, when analyzing the impact of coronavirus add-backs, we see that the business earnings may be significantly increased, though difficult to explain, support, or defend. Keep in mind that those add-backs are “expected” or “estimated” earnings that never occurred.


How To Determine the “C” in EBITDAC?

This is where the trouble lies in adding back "estimated" losses due to coronavirus on EBITDA. Many BV experts consider this as a one-time, extraordinary or non-recurring event. Others think the event is still ongoing and cannot be considered “yet” a one time, or non-recurring event because there is still the possibility that it impacts businesses beyond one quarter and even two or three quarters. Nothing is clear at this point. Therefore, the use of this metric is unwarranted and may lead to unexpected consequences if the value of the company is overstated, particularly in a tax valuation.


Depending on the importance of the add-back, there is the possibility the experts’ exposure to liabilities from the IRS, the client, or other stakeholders of the valuation report like lending institutions, investors, shareholders, and others, may be greatly enhanced because of the difficulty to defend the use of a fictitious metric that has never been used before in a valuation. Many investors and regulators are against using that metric that will distort (reduce) the leverage ratio of a company and allow it to raise more debts than they can handle.


Still, some believe that by analyzing the trailing twelve months EBITDA, and other historical performance data, they can determine with a "reasonable degree of certainty" what those coronavirus add-backs should be. But that could be problematic if the pandemic persists longer than expected and becomes a “new normal”.



Conclusion

Whether you stand for or against the use of the coronavirus add back, one fact that remains certain is that a great number of experts, investors, accounting firms, federal agencies like the SEC, the European Leveraged Finance Association (ELFA) that represents investors in higher-risk corporate bonds and loans, are prohibiting the use of coronavirus add-backs. According to them, reliance on fictitious figures could lead to a downward spiral of companies raising money that they cannot repay. If this happens, many of those companies may default on their loans and declare bankruptcy and/or go out of business completely to the detriment of many stakeholders.




[1] Voodoo Economics an economic policy perceived as being unrealistic and ill-advised, in particular a policy of maintaining or increasing levels of public spending while reducing taxation.



On Tuesday, May 5, 2020, I was the moderator of a virtual Town Hall meeting on the topic of: Impact of COVID-19 on Business Valuation. This Town Hall was organized by myself as the State Chapter President of The National Association of Certified Valuators and Analysts (NACVA) in Maryland and Washington DC in partnership with NACVA's Headquarters in Salt Lake City, Utah.

Here is the video of the Virtual Town Hall.


Moderator: Achille Ekeu, MBA, CVA, President & CEO, The Washington Valuation Group


Here are the Panelists:











Click below to watch the entire Town Hall Meeting.



The coronavirus pandemic is wreaking havoc on the global economy as we’ve seen last week with the stock market crash that compares to what we saw in 2008 during the financial crisis. Many businesses, big and small have lost an incredible amount of money last week alone. And may still lose more the coming weeks if the spread of the virus is not contained quickly.

According to the New York Times:


Goldman Sachs economists expect global growth to slump to around 2 percent for the full year, down from their previous 3 percent forecast, but said in a note Friday that there are risks of a worldwide recession if the virus becomes a more severe global pandemic.”


So what will be the impact of this virus on the valuation of small businesses?


To answer this question we need to understand that valuation is based on three main factors: cash flow, growth, and risks. Assuming that growth is stable, the Gordon Growth Model calculates value as: Present Value = Cash Flow x (1+growth)/ (Discount Rate - growth).


So let’s analyze the impact of this coronavirus on small businesses through these three value drivers.


Impact Of The Corona Virus On Cash Flow

The cash flow of a company depends on its net income or profit. The net income depends on revenues generated by the company minus its expenses. When the revenues are reduced due to clients’ fear of virus contamination, the impact is immediate on your profit or net income. You will see a reduction in your profit, which in turn will reduce your cash flow. This cash flow reduction will adversely affect the value of your company.


Impact of the Corona Virus on company’s Projected Growth

The valuation of a company takes into account the projected growth of the company for the foreseeable future. This is important for investors as they seek to understand the long-term viability of the company they are looking to invest their money into. When a pandemic like the coronavirus is taken into account, it's hard not to lower the industry and the national economic perspectives on growth in the short-term (less than a year), medium-term (1 to 3 years) and long-term (4 to 5+ years). Therefore, the revised industry and national economic growth projections will have an immediate negative impact on any company’s growth forecast.

Because of that lower growth forecast, the company becomes less attractive to investors as the uncertainties mount over time. This has an impact on the value of the company.


Impact Of The Corona Virus On The Risks Of The Company

There are environmental or external risks as well as operational or internal risks in any company. They constitute together all the risks associated with doing business. The environmental or external risks are all these risks a company cannot control but that has an impact on the well-being of a company. They are mostly risks associated with the type of industry as well as the national, regional, or local economy.


When the economy is not doing well due to the impact of the coronavirus or when the industry in which the company operates is considered a high-risk industry, that has an impact on the value of the company as it is considered high risk for investors. The same is true when operational or internal risks are deemed high by investors due for example to the fact that a company has very few clients (no diversification), one key person running the company (no cross-trained employees), poor customers and/or employees satisfaction, low-profit margins, etc.


Conclusion

The valuation of small businesses will be lower to significantly lower if the virus continues to grow as projected by World Health Organization experts. It is hard to predict the real impact of the coronavirus on the national, regional or local economy at this point, but we are certain that if the disease continues to expand, that could install fear in communities, customers, employees and other stakeholders involved in a company’s well being.

The impact on small businesses could be catastrophic in the medium or long term. We see this happening in China already where businesses only have 2 months' worth of cash reserves to use in case of emergencies. After that, they will start closing doors and laying off employees. At that point, the company has no value what so ever.



Achille Ekeu