With global markets taking a hit, private companies founders are naturally asking themselves how have the past few months affected the valuations of these companies. The entrepreneurs looking to attract capital prepare for instance teasers and investment memorandums which include among others a valuation of the company. Should these be reviewed now? The short answer is “YES”. Below I discuss some reasons for which valuations of private companies are impacted by COVID and possible alternatives that sellers have.
1. Change in risk premiums
By way of an introduction, Discounted Cash Flow (DCF) is a way of valuing assets based on the present value of the expected cash flows; each of the projected cash flows is discounted using a return rate commensurate with the perceived risk. This method is commonly used for public and private companies. Another method used quite often relies on metrics such as Price to Equity, Enterprise Value to Sales etc and they are known as multiple valuation.
Currently, investors are likely to require higher returns for accepting a given level of risk than they were a quarter ago which means higher discount rates or lower valuation multiples. Indeed, the discount rate should reflect the risk perceived by the marginal investor in the company and that investor will be looking at the valuation of other assets to judge attractiveness. By all measures the valuations have cheapened lately
“You can’t expect bull market multiples and bull market valuations in bull markets and not expect bear market multiples and bear market valuations in more recessionary type markets.” (Hussein Kanji)
When using DCF, it is pertinent to assume a gradual normalisation of the risk premium rather than applying the same rate for all the cash flows (which is a rather common mistake).
2. Scenario analysis becomes more important
The discount rate should not be heightened to compensate for higher cash flow uncertainty. Instead it is much more informative to use simulations to vary the values of key inputs and see the effect on the valuation; the result would be a distribution of expected values instead of a single value which seeks to average risks. One should either use a risk adjusted discount rate and expected or certain cash-flows and a risk-free rate. As IVSC notes “Valuation uncertainty should not be confused with risk. Risk is the exposure that the owner of an asset has to potential future gains or losses. […] Valuation certainty and market risk are independent of each other. For example, a valuation of a highly liquid quoted stock has little uncertainty, but that stock may still be seen as carrying a high market risk.“ Market disruptions and economic shocks are likely to increase valuation uncertainty but this has to be addressed by analysis and scenarios not higher risk premiums (which relate to market risk).
3. Change in financial projections
Whatever you had projected 3 months ago is likely to have become obsolete. Your company might be impacted positively or negatively but it’s unlikely to see business as usual during and after the current shock.
You will have to consider the effect on: demand, supply chain, capital expenditure, inputs availability, cost structure, regulation, competition, marketing, pricing, sector, distribution channels. How has this shockwave affected these short term and possibly long term?
Many businesses experience an increase in days of sales outstanding and/or lower inventory turnover which can take a toll on cash flow generation if not offset by an increase in days of payables outstanding. This is know as working capital investment and will lower the valuation of the company.
4. Relevance of the valuation model
For stratups or cash strapped companies cash-flow projections are likely to become increasingly relevant. Even if the initial growth projections can be met with a delay, this will lower the valuation; promising 100EUR in 1 year is not equally valuable with promising 100EUR next quarter. In addition, there is the potential drag of additional cash burn in the meantime.
Multiple valuation generally becomes harder to justify since market conditions have changed in the meantime and company-specific risks have become more relevant.
5. Consistency checks become even more important for due diligence
With uncertainty increasing and assumptions revised it becomes even more important to ensure that workings are consistent. Common mistakes: - Growth rate not consistent with the planned investments (Capex) - Inconsistencies between three way financial statements (Balance sheet, cash-flow statement and P&L statement) or not preparing these - Currency of the discount rate is not the same as the currency of cash-flows - Modelling an increase in leverage with no effect on discount rate - Both cash flows and discount rates are adjusted to reflect the higher uncertainty - Growth rates that lead to hard-to-justify market shares - Stable high margins/growth rates in perpetuity which do not consider the risk of new competitors or disruptors - Using low risk free rates to build the discount rate and high growth rates in perpetuity
How can entrepreneurs reduce the valuation gap?
1. Business strategy Your best defense is having a detailed business plan which tackles all the relevant aspects in detail and with data-evidenced assumptions.
2. Earn Out Clauses
Such clauses commit the buyer to make additional payments to the seller following the closing of a deal, provided that certain performance metrics are achieved post closing. This is a good way to reduce investors’ anxiety and the ultimate risk premium paid if as an entrepreneur you are confident in your potential and vision.
3. Convertible debt
This is a way of sourcing the funding needed to pursuit your growth agenda whilst delaying actually valuing your company. Convertible debt are bond-like instruments which can be swapped for shares in the company if the valuation of the next round of financing reaches a certain threshold. For investors this structure means that their investment might convert into equity at a discount to the price paid by the next investor. In other words, convertible bonds pay a fixed return and offer a potential upside if the company’s valuation reaches a certain threshold.
These instruments give the buyer the option of buying additional shares in the company at a pre-set price. Therefore, if the company successfully overcomes the current crisis the investors can top-up their exposures at favourable prices thus increasing their gains. These instruments increase the attractiveness of an equity deal for a potential investor because the agreement leverages their investment and increase their return if the value of the company increases as hoped.
5. Minority stake sells
Maybe you are not happy to exit or sell a majority chunk at a diminished value, but what if you can sell just enough to provide you with the capital you need to support (and grow) your business till market conditions improve?
6. Look for strategic investors
Cash-rich companies are likely to see this period as opportune for putting excess cash at work to acquire other companies. Look to identify such companies and possible synergies you could earn and pitch your case. According to BCG “While acquiring targets in your core industry during a downturn creates value (one-year RTSR of 4.6%), you can benefit even more from non-core acquisitions (one-year RTSR of 8.5%).”
If you have alternative ways of meeting your immediate cash needs than it might be worth waiting it out. Meanwhile, focus on your growth agenda and look for ways of lessening your cash outflows. Useful read here and here