The most challenging businesses to valuate are start-up and distressed entities. The two extremes of the business life cycle. This blog is focused on the valuation of challenged / distressed entities. The core underpinning of accounting and valuation is the theory of “going concern.” Going Concern being defined as a term for a company that has the resources needed in order to continue to operate indefinitely. Obviously, a distressed entity does not have this fundamental underpinning associated with the entity. The probability of a distressed entity having an ability to operate indefinitely is significantly less than 100%.
Business valuation is more an “art than a science”. We are all aware of the number of subjective adjustments / discounted factors for a “normal” business valuation. The valuation for a distressed adds another dimension of complexity to the valuation process. Distressed entities must include weight for other distressed entities in this industry, currency, time associated with possible liquidation, ability to raise additional capital, ad infinitum.
When there is a significant likelihood that the entity will not survive the immediate future (next few years), traditional valuation models will yield an over-optimistic estimate of value. In a Discounted Cash Flow (“DCF”) valuation, distress can essentially truncate the cash flows well before you reach “nirvana” (terminal value). A multiple based upon comparable entities may be set higher for entities that have continuing earnings than for one where there is a significant chance that these earnings will end (as a consequence of bankruptcy). Accordingly, the DCF and the multiple methods are in their purest form unacceptable. What needs to happen is for the valuator to account for the probability that the distress factors will curtail the profitability or totally cease the earning potential (bankruptcy).
In its simplest format this equates to [distress-adjusted value = relative value based upon healthy firms (1 -probability of distress) + distress sale proceeds (probability of distress)].