Inflation, Interest Rates, and Planning for the Sale of Your Business
For potential sellers, focusing on the future, knowing your objectives in selling, and understanding what motivates buyers can reveal the best time to put your business on the market.
If owning a business were easy, everybody would do it – and no one gets that better than you. You understand that business success involves ambition, effective decision-making and risk-taking, a keen sense of timing, and the ability to acknowledge conventional wisdom without cowing to it.
Those qualities have served you well in building your business, and you can trust them when it’s time to sell it. Is now that time? Conventional wisdom might cause you to say no. With interest rates on the rise, inflation squeezing profit margins, and the President invoking the R-word, there is more than the usual uncertainty in the market. But should conventional wisdom dictate the timing of perhaps the biggest decision of your life?
“Certainly, the fears of the unknown are there,” says Bob Latham, managing partner of IBG Business’s San Antonio office, “but buyers continue to look for good companies, many seeing it as a chance to buy ahead of the inevitable recovery.” Matt Frye, IBG’s managing partner in Tulsa, concurs. “There continues to be a strong market for well-managed, profitable companies. I have heard stories of lenders or buyers withdrawing post-due diligence, but those situations can occur in any environment.”
In short, things are not ideal (they rarely are), but despite the looming threats, valuations remain high, debt is still relatively inexpensive, and by no means is the sky falling.
What Buyers Are Thinking. Specific to the current climate, you might gain some useful perspective by stepping out of your ownership role and looking at the M&A world through the eyes of a sophisticated buyer who, like you, is keenly aware of rising inflation and interest rates. First, it helps to understand how a professional buyer structures a purchase.
“At IBG Business, 70% of our business sales are to private equity groups or professional buyers,” said Jim Afinowich of IBG’s Scottsdale office. “They typically leverage their purchases with 30%-50% in equity and the balance with debt. They must provide a certain rate of return for their investors, and as interest costs go up, the multiple they return to investors has to go down. Generally speaking, rising interest rates are going to reduce what a private equity group pays for a business.” That’s not what a seller wants to hear, but it’s mitigated by another important factor for PEGs: “dry powder” – the cash they have available for purchases – and the desire to put it to work.
“Pre-pandemic, there was $1.5 trillion in dry powder,” said Afinowich. “Post-pandemic, that estimated total has grown to over $2 trillion. PEGs accumulated a lot of capital to be invested, and there is still a huge capital overhang, with lots of money to be spent and more money than there are good businesses to buy. “That is the very definition of inflation, and sellers stand to benefit from it.” PEGs are attractive destinations for investor capital, as putting money into a PEG with professional operators will return 20%-30% on their money. “That’s two to three times better than the stock market has historically delivered, even in a bull market,” Afinowich noted, “but a PEG can generate those high rates of return only if they put their investors’ money to use in buying good companies.”
One might assume that high inflation and interest rates tend to depress business values and benefit buyers, and in theory that would be correct. However, in reality, that assumption does not account for the importance of “certainty” in how a business is likely to perform in the future. “In our experience,” said Afinowich, “professional buyers would rather pay a higher price for a business that projects certainty of value and future income than pay a lower price and have less certainty over how the acquisition is going to pay out. If buyers see a company with a predictable rate of return, they are going to be interested, and that’s true in any economy. “In uncertain times, businesses that are perceived to offer relative certainty are going to stand out and may be more valuable than before.”
Top Prospects. What kind of companies appeal to buyers today? Generally speaking, in a high-inflation and/or high-interest environment, businesses in certain industries may be more attractive than normal to a buyer:
• real estate (either engaged directly in the real estate industry or having significant real property holdings)
• financial services (banking, insurance, investments, etc.)
• consumer staples
• information technology
• SAAS (software as a service)
• growing industries in general.
Regardless of industry, businesses that possess certain traits are likely to be attractive to buyers regardless of the economy:
• good management
• well-defined business plans
• low capital expenditure requirements
• low debt loads
• steady cash flows
• solid, growing customer base
• located in a business-friendly state
• located in an area of population growth or business relocation.
Level Playing Field. While what buyers want and are willing to do is certainly important, they do not hold all of the cards. Sellers should be emboldened in knowing that, despite uncertain economic conditions, a good selling price is within their reach, for at least two reasons. First, a good company is a good company. Properly marketed, it should attract multiple buyers, competing offers, and a higher-than-expected price. Second, professional buyers that have a lot of dry powder are motivated to put their uncommitted cash to work, regardless of the economic climate. That’s not to say that the economy is a non-factor. To the extent that the buyer’s offer is affected by their expectations for future earnings, they are going to try to adjust their offer for uncertainty. That might discourage a seller, but it also creates a quandary for the buyer. “In that case,” says Afinowich, “a buyer has to work through two competing concerns. If I underestimate my adjustment for uncertainty, I won’t get the return I want. And if I overestimate my adjustment for uncertainty, I may lose out to another buyer. “In a competitive situation, that second risk helps keep buyers honest and their offers at a reasonable level.”
That’s not to say that, even in the purchase of a very attractive company, things won’t be more complicated. “Sellers should expect the due diligence phase to be more onerous and take longer,” says IBG’s Matt Frye, “as professional buyers dig deeper than usual. And sellers should brace themselves for more complex terms – such as seller-carried notes, earnouts, etc. – that reduce the cash up front and increase the deferred payment.”
Window of Opportunity. If you are just now starting to think seriously about selling your business but are bothered by what’s going on in the economy, your timing might be just right. We anticipate that, as 2023 progresses, inflation will head down and interest rates will stabilize. Both factors will help restore certainty and business value. Buyers understand that, also. Professional buyers are all about the future, both with regard to the state of the economy and how a potential acquisition is likely to perform.
So, as a potential seller, think like a buyer, and focus on the future.
Preparing a business for sale (and to bring top dollar) takes time – perhaps a year or two. If you decide that now is not the time to sell but agree that things will start looking up next year or the year after, the present time offers you a valuable window for getting your house in order (see our September 2022 article, “Thinking About Selling Your Business? Focus on Value, Not Price”).
Use this time to strengthen your business in ways that should project certainty to a buyer:
• solidify your management team and key employees;
• identify opportunities for growth (e.g., market area, product or service offerings, etc.);
• find ways to appeal to new customer groups; and
• in your product or service mix, focus on essentials for which demand is relatively immune to economic fluctuations and for which you can maintain your margins.
Enduring Truth. If you were looking for an ironclad recommendation as to the timing of your business sale, we are sorry to disappoint, but we are M&A advisors, not oracles.
What is ironclad is this enduring truth: The best time to sell is determined by the nature of your company and your objectives in selling.
Inflation and interest rates are factors to be considered, along with many others. An important part of our job is to help you fully examine those factors and focus on what you truly want to accomplish in selling your business, so that you can call the right play.
If you would like to start that process, contact an IBG Business M&A professional near you.