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COVID-19’s Impact On Business Valuation

This is the second blog post co-authored by MDW Law Partner, Christine Doucet, and MDD Forensic Accountants Partner, Jarrett Reaume, addressing various aspects of COVID-19’s impact on business owners and family law issues.  Their first blog post was “Guideline Income for Business Owners in the Wake of COVID-19

The COVID-19 pandemic has negatively affected many businesses.  Restaurants, personal and wellness establishments and daycares (and other businesses) are just starting to reopen after almost three months of closure.  For many other businesses that have remained opened, sales are way down.  With many predicting that a vaccine will not be readily available for 12 to 18 months, the pandemic’s impact on business profits may last beyond a few months, possibly even years.

In addition to its serious effect on the cashflow of Nova Scotia businesses, the pandemic will also affect the value of many businesses, as well as impacting the viability of a sale in these uncertain times.  Changes in businesses valuation may impact the resolution of divorce cases involving business assets.

This is already an area of complexity in Nova Scotia law.  In Nova Scotia, a true “business asset” is not considered matrimonial property.  There are many circumstances that can result in a business being determined to be a matrimonial asset (such as a contribution by the non-owning spouse or an injection of family money into the business).  However, these are not simple determinations and require an analysis of the historic creation and operation of the business.  Even if a business is a true “business asset” and not matrimonial property, the non-owning spouse may seek an unequal share of the matrimonial property.  Valuations are therefore often carried out in divorce matters by one or both parties.

Business Valuations

The value of a business (i.e. Enterprise Value, or “EV”) is generally equal to the present value of its future after-tax cash flows.  Changes in value will be influenced by two main factors:

  • The amount of yearly after-tax cash flows; and,
  • The riskiness of those cash flows.

The level of risk is generally dealt with in selecting an appropriate capitalization rate to present value the future cash flows, which in the case of a stable, mature business are assumed to be constant into the future.  Holding all else constant, the capitalization rate and valuation conclusion move in opposite directions – the higher the capitalization rate the lower the resulting value and vice versa.

To illustrate, let’s consider two businesses: ABC Ltd. and XYZ Inc.  Both businesses operate automotive repair centers in Halifax, and as of December 31, 2019 both could be reasonably estimated to have sustaining annual after-tax cash flows of $100,000.  Whereas ABC services a wide variety of customers, XYZ earns most of its revenues from a few fleets.  Because of its customer concentration, XYZ’s cash flows are considered riskier than ABC’s.  As a result, let’s assume that appropriate capitalization rates are 20% for ABC and 22% for XYZ.  For the non-valuator, a capitalization rate is the inverse of a multiple.  So, a capitalization rate of 20% is the same as a multiple of 5x[1]. Below are the resulting EVs for ABC and XYZ:

This illustration demonstrates that two businesses operating in the same industry with the same amount of annual after-tax cash flows may not be worth the same amount.

Fast forward a few months to March 2020.  Let’s now assume that ABC’s after-tax cash flows for the next three years are now expected to be negative $50,000 in year one, break-even in year two, then recover back to $100,000 in year three and onwards.  Further, imagine that, due to the uncertainty associated with the road to economic recovery and the risk of a second wave (and perhaps even a third wave), an appropriate discount rate is now 23%.  The following demonstrates ABC’s revised EV based on these assumptions:

The above illustration demonstrates that ABC’s value has been cut in half in the space of a few months.  Even though ABC’s cash flows are expected to return to normal in three years’ time, a few rocky years combined with more uncertainty results in a much lower valuation conclusion.

Effect on Nova Scotia Divorce Cases

What does this mean for separated spouses in Nova Scotia?  It will add a layer of uncertainty to the already complex question of the proper valuation date for a business.

In some cases, the date of separation is determined to be the relevant date for valuation; in others the valuation date will be closer to the date of resolution (i.e. settlement or trial).  When the value of a business changes dramatically after the date of separation, parties may need to make a case for an entirely different valuation date that takes into account the new circumstances.  It is easy to foresee that this argument will arise regularly in the coming months.  Furthermore, when the pandemic hit this province in mid-March, many parties were already before the Nova Scotia courts.  In some of those cases, parties had submitted expert reports providing valuations of businesses, which by their nature provide evidence of value as of a specific point in time (such as the date of separation or the latest fiscal year-end).

Because a business is valued at a point in time without the benefit of hindsight, it is expected that a hot topic for a while will be determining when the financial impact of the pandemic was reasonably foreseeable.

As the value of a public company’s stock is generally accepted to be the present value of future cash flows associated with holding that stock (i.e. dividend payments), an objective assessment in terms of determining when the financial impact of the pandemic was reasonably foreseeable may be the S&P TSX Composite Index.  This index tracks around 250 companies and represents approximately 70% of the total value of equities traded on the TSX.  Below is a graphical depiction of the TSX’s performance over the past 6 months:

The TSX reached its peak at February 20, 2020, at which time China had around 75,000 documented COVID-19 cases and Canada had around 10.  Fast forward a few weeks and the TSX dropped around 1,200 points or approximately 7%.  Subsequently, the TSX experienced a significant decline in the latter part of the week of March 2, 2020, followed by a further decline which eventually bottomed out on March 23, 2020.

Thus, a reasonable argument may be that the full extent of the financial impact of the pandemic, insofar as it pertains to Canadian firms, was reasonably foreseeable during the first few weeks of March 2020, but not necessarily before.  Accordingly, it may be reasonable to assume that a valuation report for a business using a valuation date prior to March 2020 would not include any negative impact associated with the pandemic.  Therefore, two weeks can make a material difference in terms of selecting alternate valuation dates.

Conclusion

It is recommended that impacted parties seek legal advice and consult with a Chartered Business Valuator regarding the selection of a valuation date and the corresponding financial impact on value.  The COVID-19 pandemic will continue to have far-reaching effects in family law in Nova Scotia in the months to come.

By Jarrett Reaume and Christine Doucet, Partner at MDW Law.

  1. 1 / 20% = 5.

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