How to value a failing business?

October 08, 2022

by a searcher in Los Angeles, CA, USA

A competitor has approached us and is looking for an exit. This company is experiencing cashflow issues due to excess inventory and slowing demand and at this point is unable to pay its supplier obligations. This company has also experienced gross margin deterioration due to elevated manufacturing and shipping costs resulting from supply chain issues - raising product prices would price the company out of the market, and slashing operating costs would require a 50% cut. If the company is not able to find a buyer, they plan to liquidate. The last time this company had healthy EBITDA was in###-###-#### ignoring 2020 results as it was a one-time bump in results).

How does one value such a company? Estimate the fair market value of the hard assets on the balance sheet (which is primarily inventory)? The alternative for us would be to allow the company to liquidate so that we can attempt to gain market share.

Reply by a searcher
from Tufts University in Jersey City, NJ, USA

There's other valuation methodologies that you can look at to value the goodwill of an unprofitable business, including multiple of revenue, asset value (i.e. liquidation value), or multiple of SDE (for a smaller, owner-driven business). The big question is what is the business worth to YOU as a strategic buyer. The physical assets of the business are more straightforward to arrive at a depreciated fair value, but there's other aspects of the business that might be worthwhile for you to acquire as a competitor that might not be valuable to an outside buyer, such as talent (employees with niche/industry-specific skills and knowledge), client lists, geographic presence in the marketplace, etc. Those are things that you can start attaching value to in order to present the seller with an offer that is more appealing to them than liquidation and something that everyone involved can hopefully feel is "fair". Given that the competitor's only other option is liquidation they will ideally be coming to the table with a constructive mindset and eager to arrive at any sort of valuation that is greater than the "floor" value of the physical assets of the business and allows you to easily acquire those intangible assets (goodwill, talent, client lists, etc) at a significant discount.

Reply by a searcher
from Georgetown University in São Paulo, State of São Paulo, Brazil

Fantastic comments above - would just add that in these stress/distress cases it is really important to understand the company's cap structure. (1) If the company is debt-free, I don't have many qualifying comments other than that in a liquidation there may be outstanding payables/off-balance sheet contingencies that will have first claim by law (e.g. labor, tax, regulatory, civil) that you should check on as you would in the DD of any company. (2) If the company has debt: (a) If you are just buying specific assets, you need to understand whether the assets are actually transferrable, or if the company's creditors have any claim to those assets. (b) If you are buying the equity, (a) also applies, and in addition: very smart to use 100% earnout model as others suggested, but also look up and down the capital structure, find the fulcrum security(ies), consider what those are worth based on a liquidation scenario, and consider whether you should buy that debt too. Not an exhaustive list here by any means. Speaking from experience in stress/distress deals in emerging markets/happy to chat further!

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