COVID-19 has been challenging for many businesses, as many are transitioning from survival to trying to budget and plan for success in a sustained pandemic environment. Until health care outcomes are clearer and government and consumer behaviours become more predicable, businesses struggle to forecast their revenue and expenses over the next few years.
This has a major impact on business valuations. Since valuations are often driven by EBIDTA and cash flow, businesses have been hit and are a challenge to forecast; business valuations will also need to reflect this uncertainty. As outlined in a recent publication by MNP (a leading national accounting, tax and business consulting firm in Canada):
With increased uncertainty due to COVID-19, business valuators are questioning if a reasonable, sustainable level of cash flow can now be determined. As the valuation multiple is determined considering the company’s financial outlook and risk, challenges exist in arriving at a valuation multiple.
When business valuations are challenged, business transitions can be affected. In particular, buying and selling a business in this environment can present some real challenges.
For those that are already in the midst of a transition, the seller will want to maintain the pre-agreed upon value, and price, of the business that was set pre-COVID-19. The purchaser may be more hesitant or actually disagree with that value faced with the current reality. This is especially true for companies that are very deeply hit such as retail operations or restaurants. There is no doubt that lawyers will be busy on both sides of these transactions protecting the interest of their respective clients as deals are challenged.
For businesses with multiple shareholders and partners, now is the time to review your shareholder or partnership agreements to ensure they are appropriate and have a mechanism for determining fair value of a business.
Shareholder and partnership agreements are legal contracts that should be put in place for every business that has more than one shareholder or partner. The intention of the document is to lay out the terms and conditions of a business relationship. It outlines what happens when, for example, a partner is disabled. What is the definition of disability? Surely, a partner does not want to be obligated to sell their shares if they break an ankle. On the other hand, if a partner becomes severely disabled and can no longer participate in the business, it may be important for the other partners to have a mechanism to buy them out. The partnership agreement should outline not just what disability means but also what mechanism should be used to establish a fair price.
Business valuation can be nuanced during simpler environments, but as mentioned above, can become very difficult to establish during uncertain times.
So, what should a business owner do now to test their shareholder or partnership agreements in pandemic times? Here are 3 steps to consider.
Step 1: Have an agreement
Ensure that you have a shareholder or partnership agreement established. It is important to note that the best time to establish these agreements is when shareholders and partners have good relationships. Trying to start it when deep friction has developed can create additional stress and hamper the ability for successfully completing the process.
Step 2: Review it
Ensure that the shareholder or partnership agreement is still relevant. It is important to make sure that there are clauses that protect the business, shareholders, and partners in case of dispute or disagreement. These should include as mentioned what should happen upon disability or death. It should also include what happens if a partner wants to sell their shares or wants the business to be sold. It should look at whether any mechanisms need to be in place if a partner is no longer active in the business or retires. In addition to the clauses mentioned here, there are many other clauses that should also be considered when drafting or reviewing these agreements.
Step 3: Back it up
Ensure that you are able to fund the requirements outlined in your partnership or shareholder agreement. We are often surprised to find buy/sell agreements that are clearly outlined but with no funding mechanism in place to support the requirements. For example, if upon the death of a partner, the remaining partners are required to buy out the shares of the deceased’s family within six months, what happens if no life insurance is in place? Who will come up with the cash to pay for those shares? If the deceased was a key contributor to the business and revenues are now challenged, the banks may not be willing to lend to support the execution of this requirement. What if the business has been impaired by COVID-19 or another health and economic crisis, and revenues are temporarily lower? The business cannot afford the drain on the extra cash flow requirement and, again, the banks will likely be unwilling to lend. Having life insurance and disability insurance in place has never been more important to ensure that requirements in the shareholder and partnership agreement can be honoured.
These are challenging times for many businesses. Ensuring you have a proper shareholder and partnership agreement in place with proper funding can be the lifeline that protects businesses when disagreements or disasters occur.
When was the last time your business life and disability insurance were reviewed? At Tall Oak Private Wealth, we look forward to working with you and your business as we help you in planning for continued success.