When mergers and acquisitions transactions stalled one year ago, at the beginning of the COVID-19 pandemic, no one could have predicted the robust recovery in deal volume that would begin in the second half of 2020 and extend into 2021. The general consensus was that the economic collapse fueled by the pandemic would lead to severe strain on the financial markets and significant destruction of capital, exceeding the losses of the Great Recession of 2008. Amazingly, our worst fears were never realized. Instead, several factors materialized to mitigate the damage to the financial markets, including record intervention by central banks and government spending, buttressed by a stronger-than-expected stock market and an opportunistic private equity market.
Despite this and given the overall confidence and optimism that exists in the capital markets, COVID-19 still presents significant fundamental challenges to acquirers evaluating potential acquisition targets. The two questions facing acquirers are: (a) what is a normal non-COVID-19 affected operating environment for the target, and (b) what are the target’s normalized earnings? While the answers to these questions are more challenging than ever, they remain critical to determining an appropriate purchase price for the target.
Traditionally, one method of valuing a target is to calculate a purchase price based on a multiple of normalized Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”). In the context of mergers and acquisitions, normalized earnings represent the future cash flows that the target is expected to generate in the hands of the acquirer. Typical normalization adjustments include reducing owner’s compensation exceeding a market rate of compensation for a similar position, and non-recurring (one-time) income1 and expenses. For example, if a target had unadjusted EBITDA of $2 million and $1 million of positive normalization adjustments, its normalized EBITDA would be $3 million. Assuming valuation of five times normalized EBITDA, the target would have a total enterprise value2 of $15 million.
Below, we describe two areas that currently present particular challenges for estimating the normalized EBITDA of a target.
2020 Revenue May Not Be Comparable to Future Periods
In quantifying normalized EBITDA, an acquirer will typically use the most recent Trailing Twelve Months (“TTM”) financial results for the prior two or three years. For example, if a target had TTM financial results through March 31, 2021, an acquirer may choose to calculate normalized EBITDA for the TTM period ended March 31, 2020 (April 1, 2019-March 31, 2020) and the TTM period ended March 31, 2021 (April 1, 2020-March 31, 2021). However, both the TTM periods ended March 31, 2020 and March 31, 2021 include one or more months where many industries were adversely impacted by national shutdowns, store closures, and general consumer anxiety. The acquirer could instead choose to evaluate the target’s results for periods prior to 2020, but given that those financial results are more than a year old, they may not be useful in estimating normalized earnings on a go-forward basis, particularly for a high growth company or a company experiencing significant changes in its business model.3
Given the conundrum faced by a potential buyer, one alternative approach is to analyze the target’s monthly revenue trends to identify potential outliers. Let’s look at an example. For purposes of simplicity, let’s assume that a company has a non-seasonal business and relatively stable monthly recurring revenue prior to January 2020. Subsequent to January 2020 and as a direct result of the pandemic, the company experiences revenue declines in comparison to January 2020 sales of 20% in February, 60% in March and 30% in April, respectively. The company recovers to its January 2020 sales level in May 2020 and revenue remains stable for the remainder of the year. Accordingly, if the company’s January 2020 sales were $1,000,000, February, March, and April 2020 sales would be $800,000, $400,000, and $700,000, respectively, representing lost sales of $1,100,000 attributable to the pandemic. In 2021, the company’s sales for January, February and March 2021 are 5% above January 2020 sales, signifying that the company returned to growth in 2021. For purposes of the TTM periods ended March 31, 2020 and March 31, 2021 normalized earnings analysis, the acquirer makes pro forma adjustments to the February, March and April 2020 revenues (total increase of $1,100,000)4 in order to present the revenues excluding the impact of COVID-19. In addition, the acquirer makes pro forma adjustments to the February, March and April 2020 cost of goods sold (total increase of $550,000)5. As a result, the target’s normalized EBITDA increases by $550,000 for February, March and April 2020.
The illustrative example above may appear simple and straightforward. In practice, acquirers will almost certainly encounter more complex scenarios and variables to contend with. For example, many companies have seasonality to them, making it more difficult to isolate sales declines that are attributable primarily to the pandemic. Furthermore, many companies’ sales, while having recovered from a low in March or April of 2020, are still below the peaks reached in the fourth quarter of 2019. Therefore, an acquirer may need to place greater weight than usual on a company’s projections. However, given that projections are highly sensitive to changes in assumptions, other data should also be considered, such as additional quantitative and qualitative data to determine what the company’s long-term revenues may look like. This data may include economic data, COVID-19 trends on new infections and vaccinations and general consumer sentiment.
2020 Expenses May Be Understated for Certain Categories
One of the simpler normalization adjustments to quantify is expenses related to COVID-19. For example, a company should be able to quantify the costs related to the purchase of masks, COVID-19 test kits, cleaning disinfectant products and other costs incurred directly as a result of the pandemic.
What becomes challenging is determining what cost savings a company achieved because of its austerity measures and the new work-from-home environment that may not re-occur in the future. For example, a company’s marketing and travel expenses may have declined significantly in the past year, and the use of the company’s office space may have been limited due to employees working remotely; thus, allowing the company to realize significant cost savings on utilities, office cleaning, maintenance and other expenses. In addition, a company may have been able to trim its payroll costs by eliminating bonuses, forgoing raises or implementing a hiring freeze. While such cost savings may not have impacted a company’s sales in 2020, one would eventually expect a company’s cost structure to revert back to pre-pandemic levels. Therefore, in quantifying a target’s normalized earnings for the TTM periods ended March 31, 2020 and March 31, 2021, an acquirer should consider making adjustments to expenses to present them, as a percentage of sales, at pre-pandemic levels.
Most market indicators suggest that there is significant enthusiasm and confidence in the reopening of the economy. This is certainly good news for businesses and the capital markets. However, there is still much we do not know about what a reopening will bring and what will be the “new normal.” Will employees go back to the office or continue to work from home? Will people return to travel, both for business and leisure, at the same levels as before the pandemic? Right now, we do not know the answers to those questions and, unfortunately, we probably will not know for quite some time. Therefore, it is critical that acquirers continue to exercise an appropriate level of caution and properly structure their transactions as they evaluate a company’s future prospects. Earn-out provisions, which provide for the ultimate purchase price to be determined in part by future operating results, are one means of helping to ensure that acquirers do not overpay for acquisitions. We are seeing an increase in the use of such provisions inasmuch as it is extremely difficult to normalize EBITDA or any other measure of expected cash flows as our country emerges from this pandemic.
If you have any questions about your pending, proposed or prospective transactions, please contact a Friedman professional today.
1 One example of one-time income that many companies are encountering now is with respect to Paycheck Protection Program (“PPP”) loan proceeds. To the extent that PPP loan proceeds are forgiven or are expected to be forgiven, it may be appropriate for a company to recognize the amount of loan forgiveness as income. However, this income is a one-time benefit and would be eliminated in calculating the company’s normalized earnings.
2 Enterprise value is the total market capitalization of a company (includes the value of both equity and debt). Calculating value using a pre-debt service measure of expected income, such as EBITDA, results in an enterprise, as opposed to an equity, valuation.
3 The purchaser is buying the future (or expected) cash flows of the business. Expected in finance theory is a probability-weighted estimate of the future cash flows of the business being acquired.
4 The $1,100,000 comprises $200,000, $600,000, and $300,000 for February, March and April 2020, respectively.
5 We assume a 50% cost of goods sold percentage.