Like a sailor manning a vessel in choppy storm waters, business owners cannot control the environment that impacts their marketplace.
Economic and political forces behave like the winds and tides that impact sailors, and sometimes the best that you can do as an owner is understand and work to navigate them. This is where the advice of a trusted advisor becomes critical.
Where are we now?
Events of the last three years have had a monumental impact on business operations. The emergence of COVID-19, and the lockdown that followed, reminded people of just how fragile businesses are, particularly in the face of a global pandemic.
The pandemic also led to an increase in the number of owners exiting their businesses due to burnout, liquidity, security, diversification, and prioritizing personal health and family. The Great Shutdown was the first event in many people’s lifetimes that caused a near-immediate cessation of economic and social activity in a way that caused many owners to think about the risks and exposure that their wealth has to the marketplace. In many respects, the pandemic differed from other recessions in terms of having an impact that caused immediate changes to the way that we conducted our daily lives.
Proposed Tax Changes Led to Record Level of Exit Activity
While vaccines to combat the pandemic arrived, so too did the April 2021 tax plan released by the Biden administration, proposing changes in taxation that would raise taxes for individuals earning above $400,000 and, most importantly, effectively eliminate the favorable long-term capital gains tax rate for taxpayers with taxable income above $1 million, which larger, middle-market business owners were looking to take advantage of when they sold their businesses. The tax proposal specifically aimed to increase the federal long-term capital gains rate to be the same as the tax rate on ordinary income for those taxpayers whose adjusted gross income is over $1 million.
That interest turned into action as there was a record level of transaction activity in the calendar year 2021 with many business owners looking to close their transactions in the 2021 tax year. While many owners accelerated their exit timelines to avoid potentially bigger taxes on their capital gains in 2021, we also see that momentum carrying into 2022.
Inflationary Pressure Builds
Higher interest rates help to combat inflation. Higher interest rates also lead to:
- Larger payments on the national debt
- Higher capital costs for the growing economy
- Lower business valuations due to the higher cost of financing
Since business buyers get the highest return on their equity when they can leverage their investment dollars with debt, rising interest rate increases the financial costs.
Challenges of Establishing Value or Price
When inflation is high and interest rates are expected to increase, the underlying cost of capital to finance business acquisitions also increases. Additionally, the value of a business may decrease as higher prices of raw materials, labor shortages, and costs of financing eat into margins. And ultimately, most market participants are expecting lower multiples in the coming year as the ‘frothiness’ of the record-setting M&A market in 2021 starts to slow down.
As appraisers know, the two primary components of most market valuations are
- Cash flow (commonly referred to as EBITDA) and
A multiple (say five or six ‘times’) is typically applied to EBITDA to get to an acquisition price. Of course, EBITDA multiples differ by industry and from one business to another.
So, higher interest rates and uncertainty in the market cause the cost of capital to go up while the risk parameters of a potential transaction often-times change as well. In turbulent times, investors begin to ask questions such as ‘How will your business perform during a recession?’ along with ‘How does your business grow in the face of labor and supply shortages?’. These are questions that impact the risk parameters and the overall pricing of a deal, driving valuations lower.
Hold and Grow or Sell and Go?
Some business owners are experiencing growth and feel as though they will achieve a higher valuation if they continue to show higher levels of profitability in the future. While a higher EBITDA is certainly helpful to a valuation, the reality is that the increased risks in the larger, global marketplace are also factors that may not have a business owner benefitting from increased cash flow by holding onto the business through uncertain times.
Business owners should consider this when planning their exit. Even if an owner chooses to hold onto and grow the cash flow of a business, the higher value may not be realized because of the increased risk and cost of capital—items outside of that owner’s direct control. If an owner’s exit window is beyond 18 months, these considerations may not be as vital. However, for that owner who entered 2022 thinking this is the year for their exit to occur, there are headwinds developing that should be considered.
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