From the letter to our clients this morning:
Hope you, your family, and your team are healthy and safe in these uncertain times. I am writing this email to clarify the impact of the recent events on your valuation work.
Without much doubt, valuations of business interests, assets, liabilities and financial instruments have changed. Stock market should be viewed as the primary indicator. The burden of proof is on those arguing that the current crisis does not affect their business.
The current environment will affect about every valuation model. However uncertain, new inputs are expected for:
♦ Market multiples,
♦ Financial forecasts,
♦ Discount rates, yields, and volatilities.
We expect that market multiples will be the leading indicators of valuation changes. While not readily observable, financial forecasts and discount rates will be affected as well. A proper analysis should find some degree of consistency in valuation estimates developed with different methods.
IRC 409A Valuations
The traditional rule of spacing valuations 12 months apart does not apply. Most valuation estimates completed before the financial market melt-down are now likely outdated for the purposes of future stock option grants. This applies to the companies that recently closed new financing rounds.
As values decrease, outdated valuations lead to overstated stock option strike prices and reduced real value of stock option grants. In financial reporting, stock based compensation expenses would be impacted as well. IRC 409A does not penalize for overpriced stock options.
Impairment Testing (Goodwill / Identifiable Intangibles)
Current financial market conditions are likely to trigger unscheduled impairment studies for both goodwill and acquired intangible assets. Public companies can easily check for the possibility of impairment by comparing their market capitalization to the current book value of equity. Private companies may need to have a new business valuation (or 409A) performed.
From my experience during 2008/2009, the situation has a silver lining. Depressed valuations may allow companies to write off goodwill completely and to never be required to do the study again. Note however, that other assets such as acquired intangibles, inventory, or PPE are tested first.
Unfinished Purchase Price Allocations
In theory, any valuation analysis prior to corona-virus should be unaffected. However, recent events may force an impairment study. Goodwill is tested at the reporting unit (not acquired business) level. However, a dimmed financial outlook may force re-evaluation of other assets. Companies and auditors may end up discussing purchase accounting and impairment at the same time.
Portfolio values are responsive to the values of their individual holdings and to the general financial market conditions. The lack of liquidity of the underlying assets does not insulate investors from valuation swings. It is just that values are not as easily observable as those of publicly traded securities.
Much work has gone into preparing 12/31/19 estimates. LPs will ask for 3/31/20 instead. The funds will have to include some last-minute disclosures in 12/31/19 statements to clarify the effects of the current market conditions. Initial estimates can be done on a top-line basis, i.e. thinking of value in terms of discount from 12/31/19 estimates. We expect most funds to do a mid-year or special situation valuation if the formal policy does not call for it until the end of 2020.
Financial market volatility is likely to persist for a while. We recommend active monitoring where companies:
Establish valuation check-up schedule. March 31, 2020 would be a good time to assess the broad market and industry specific performance year-to-date. Monthly or quarterly check-ups would make sense depending on the purpose of valuation work. Another check-up date could be when the aggressive social distancing / curve flattening measures start ramping down.
For companies with more immediate reporting needs March 31, 2020 valuation is likely to be necessary. However, if the report is not used immediately (e.g. to grant stock options) it may be sensible to wait for the volatility to subside.
Review industry specific indexes and market multiples on each check-up date as leading indicators of the valuation changes. Estimate materiality of the impact.
Work around your valuation needs. Financial reporting requirements are not as flexible, but stock option grants can be delayed.
Do it fast. If you need to do a valuation, do it fast to keep it as relevant to the specific valuation date or transaction as possible. When you talk about this valuation three months from now, they will ask why did you not foresee X, before it happened!
Finally, it is helpful to remember that valuations are only meaningful in the context of a specific point in time. 12/31/19 valuations are not wrong but may be outdated. Pre-COVID-19 tax valuations, purchase price allocations or portfolio valuations are not affected by the current market conditions. However, financial reporting disclosures may be necessary to reflect on the current events.