The Price Doesn’t Seem Right: Valuations in the COVID Era

When asked to deal with numbers and valuations, most lawyers will say they went to law school for a reason—to avoid math at work. Nevertheless, valuations are an important part of any attorney’s practice. Whether arguing the value of a company’s common stock in a shareholder dispute, evaluating a potential acquisition target for a client, assigning value to assets held in trust, or attempting to determine the ability of a business to reorganize under the Bankruptcy Code, so many different variables must be reviewed and determined, and an attorney may quickly find themselves underwater. For instance, at what point in time should an asset be valued? What valuation methodology should be used? What weight should recent financial data be given compared to projections going forward? These and many other factors must be decided before any reputable valuation can be made, all while running complex calculations that attorneys typically hope to avoid.

With the rise and continued encumbrance of the COVID-19 pandemic, the questions facing those attempting to prove or argue a valuation have become even harder to resolve. For existing, pre-2020 valuations, practitioners must consider the new reality of the pandemic in assessing or disputing now-unrealistic valuations. For valuations completed during the pandemic, questions arise about whether a valuation can project a value of an asset that assumes a general emergence from pandemic depression or whether it instead should give greater weight to recent, concrete financial data (based on the idea that current economic trends are slowly becoming the new “normal” for the economy and markets).

These compounding questions, whether they arise in the middle of an acquisition, in preparation for trial, or in a bankruptcy case, can prove daunting. When faced today with a difficult valuation, there are a few key resources and considerations that attorneys can use to help them wrap their heads around the valuation questions they face. By keeping these resources and considerations in mind, attorneys can go forward more confident in their development or rebuttal of a valuation even in the heart of this seemingly endless pandemic.

If Possible, Hire a Financial Advisor or Valuation Expert

Valuations, particularly of complex assets in high-stakes litigation or acquisitions, are difficult, likely requiring the creation of discount rates, the identification of countless inputs, and in-depth knowledge of relevant industries. Such valuations can therefore quickly outstrip the training or expertise of most attorneys. Additionally, if involved in a valuation dispute preparing for summary judgment or trial, a definitive report, testimony, or additional evidence will likely be needed to prove the party’s proposed value of the asset or claim at issue. Therefore, to the extent possible, a party in need of a valuation (or a party preparing a rebutting valuation) should consider hiring an expert depending on the type of valuation needed—for instance, hiring a financial advisor to prepare projections and a business valuation, or hiring an appraiser for a real estate transaction.

Initially, this expert can lead the valuation process on behalf of the client to ensure the valuation’s efficacy and accuracy. Later, this individual can serve as a party’s expert witness if needed, providing expert testimony and creating a valuation report to submit to the factfinder to support the client’s valuation or refute an opposing party’s valuation.

Without expert assistance, an attorney runs the risk of relying on a questionable or inadequate valuation, lacking sufficient persuasive evidence, or, if the attorney prepares the valuation, being placed in the untenable situation of becoming a fact witness. While valuation experts certainly will cost clients additional funds, the benefit provided will normally outweigh such cost significantly.

Get the Cold, Hard Facts from Your Client

Regardless of whether a valuation expert is retained or the attorney intends to prove a valuation without an expert, an accurate valuation requires the client to disclose all of the cold, hard facts and documents related to the asset, claim, or potential target. Discovering and understanding each of these facts and documents helps to independently verify the actual value of the claim or asset instead of relying solely on the client’s word. While there may be no ill-intent, clients’ financial projections are routinely overly optimistic, and clients often lack a complete understanding of the value of individual assets and the various obligations that may encumber the assets and reduce the equity available. Without the underlying facts and information, an attorney runs the risk of depending on the client’s own projections or valuations.

Zombie companies are perfect examples of the dangers of relying on valuations based on inaccurate facts and underlying data. A “zombie company” is one that is economically unviable or unprofitable but limps along by leveraging various loans from banks and investors, low interest rates, and the leniency of its creditors. These zombie companies have a higher than realistic valuation based on pie-in-the-sky projections for the company that show its ability to pay its debts based on alleged future income. A thorough investigation of a zombie company would uncover red flags, such as leverage above the annual median for its industry, an interest coverage ratio (ICR) below one, or negative real sales growth over the prior three years. If present, a party opposing a valuation of a zombie company or targeting the zombie company for acquisition will not be tricked by the company’s optimistic but unrealistic valuation.

Additionally, accurate facts and information are vital to establishing a strong evidentiary basis for the valuation if the valuation is needed as part of litigation. Proving a valuation is similar to proving any other factual element that must be shown at trial: attorneys must determine what facts are needed to support the valuation, what witnesses will testify regarding those facts, and what exhibits may be used to support the witnesses’ testimony. Overall, when creating the valuation and any corresponding report, it is important to rely as much as possible on concrete facts and documents, such as financial statements, that provide actual data that can be used to prove the validity of the valuation and create a persuasive basis for a potential factfinder.

Consider Whether the Pandemic Economy is the New Normal

For valuations that occurred prior to the pandemic, the projections did not (and could not) incorporate the effects of the pandemic. Since then, during the pandemic, similar valuations have tended to predict a societal recovery from the pandemic’s lingering economic impacts with the main variation being how long the recovery will take. For the minority of businesses somehow unaffected by the pandemic, pre-2020 valuations may still be accurate. For other businesses, the pandemic’s effect on the business may have already (for the most part) subsided.

However, for the majority of businesses, these valuation scenarios occurring both before and after the start of the pandemic can lead to valuations that ignore present conditions and thus potentially result in overestimations of an asset’s or business’s actual value. Now that the pandemic is nearing its third year and with the next virulent strain seemingly always on the horizon, it begs the question whether the pandemic economy is actually the new “normal” that should be considered a constant in any valuation going forward. While this change in perspective may lead to more reserved valuations of assets or claims, in the long run it may prove more realistic and persuasive as prior valuations continue to underperform due to the pandemic’s sobering effects on the actual value of assets or claims. Unless global circumstances change drastically in the near term, it may not be long until present conditions are considered our new reality.

Conclusion

The valuation of assets or claims has never been an exact science within the legal profession. With the emergence and lingering presence of the COVID-19 pandemic, calculating a formula for an evaluation has grown even harder. Nonetheless, utilizing a financial expert, independently conducting due diligence on the asset or claim, and recognizing current economic reality can provide some clarity to the valuation process going forward. While not foolproof, these considerations create a sound base supporting a secured creditor’s alleged valuation of its claim, a litigant’s valuation of an asset at issue, or a potential purchaser’s valuation of a target company. Without these considerations, a party runs a real risk of falling victim to an unrealistic valuation that could cause significant issues and potential liability down the road.