When the economy turns, whether up or down, there is always a lot of coverage about major corporations. In down times, the talk turns to layoffs and restructuring, and other Wall Street type issues. But what happens on Main Street? A recent study of Q2 business sales from bizbuysell, the largest business for sale database, looks at a wide range of metrics, and discusses what is happening in the marketplace.
After reviewing the data, I asked three well-known industry experts from the buy, sell, and lending sides of small business deals to comment on what they are experiencing as it relates to:
- Any significant trends or changes in valuations, multiples, or loan demand
- Impact of interest rate increases and inflation
- How past recessions affected small business sales
- Advice they would give to a buyer or seller in this market
While the information in the study was interesting, there was nothing overwhelmingly drastic that appears to be in play right now as far as overall activity. However, Andy Cagnetta, the CEO of Transworld Business Advisors, the country’s largest business brokerage, indicated that “while things seem to be holding nicely, we usually see our industry lags the macro economy.”
Small Business Sales Are Down Or Are They?
According to the report, small business sales slipped 3% in the quarter, but are up year-over-year. John Martinka of Martinka Consulting, a highly respected buy-side advisor and author of ‘Buying A Business That Makes You Rich’ told us “Generally, the buyers we see are still bullish. We have clients looking at manufacturing, testing labs, coffee roasters, alarm companies, and business services and they are all a bit cautious -more diligence, but it’s full speed ahead.” He also brought up an important point regarding how budding entrepreneurs see the economic landscape “I’ve seen some buyers go on hold but in general they feel safer with their own business than in the corporate world.”
One area that I have found effective to accurately measure the pulse of the business sale landscape, especially in the lower end Main Street type businesses, is the SBA loan activity. Since the criteria for an individual and a business to qualify is stringent, the number of prospective buyers in the loan pool is often a good indicator of what is truly happening in the trenches.
I asked Nimi Natan, the Division President and CEO of Gulf Coast Small Business Lending, a national Preferred SBA Lender, if his firm is seeing a decline in the number of loan applications for small business acquisitions. “We don’t. We see a decline in the number of transactions in the market, but because (a) borrowers are turning to SBA products as conventional lenders tighten up and (b) innovative products such as our fixed rate 7a address the concern of climbing interest rates, we are busier than ever.”
It seems clear that Cagnetta’s comment about the small business for sale market’s tendency to lag behind the overall economy may in fact be the case right now. My perspective when guiding potential buyers is to determine whether the overall activity matters to their individual circumstance. The focus should be on what the buyer wants to achieve, what they need to have in place in a potential business, what the near- and long-term future looks like, and then decide if and how to proceed.
Interest Rate Hikes Derail Some – True Entrepreneurs See It Differently
In the study, 39% of buyers indicated that interest rates are impacting their ability to finance the purchase and 49% indicated they are delaying a purchase because of rate hikes. Gulf Coast’s Natan brings up an interesting point. “Rate increases in the future are the major concern since most SBA lending is floating and pegged to the prime. We addressed that concern by offering a fixed-rate option.”
Natan’s comment is an important option for buyers; simply because rates are increasing, does not mean it is a deal killer. It is about getting creative. There are always options including:
- Lock in a fixed rate
- If debt service is increasing, get the seller to finance a larger part of the deal at a reduced rate
- Negotiate a price reduction to cover the additional debt service
What is Happening To Multiples?
The survey noted that revenue and cash flow multiples dipped by 6% and 3% respectively. This is a small decline, but a reduction nonetheless. One must also keep in mind the dollar impact since the study is truly small business focused – the median sales price of 2,342 business in the study was $315,000 for the quarter.
Multiples have increased at a torrid pace in some sectors over the last few years, especially in the middle market and above. The lower market has seen increases as well, and the market will be well-served to get these figures back in line to represent acceptable ROI levels for individual buyers. At Transworld, they have not seen a significant impact with multiples at 2.9 for the quarter compared to 3.0 in the prior period according to Cagnetta. John Martinka concurs with what others are seeing and stated: “I’m not seeing any difference”.
My take is more in line with ‘it’s coming’. Multiples have moved up too quickly which in turn drives unrealistic expectations amongst sellers. For the market to operate efficiently, multiples have to make sense financially. This is especially true with middle market and large companies. The rise in multiples as a result of tighter deal flow has led to an outsize number of bad investments, especially for the private equity world. The trickle-down effect to Main Street is a seller’s perception that their businesses are somehow worth similar multiples that they are reading about for billion- dollar transactions. Ultimately, it does not work at the upper end, and certainly not for those $300,000 business sales the study identified.
“Valuations are decreasing as the M&A cycle enters a trough. Combination of factors such as uncertain cash flows due to both recession and inflation; less availability of credit; realistic expectations among sellers and brokers; and the ‘best’ deals being pulled of the market as sellers prefer to wait out the cycle” according to Nimi Natan.
Learning From Past Recessions
Regardless of whether you agree with how the political brain trust is framing today’s economy – if we are in or heading to a recession or not, prudent buyers and sellers will be well served to examine similar historical events to have a basis of what may happen.
It is common to hear ‘this time it’s different’ and that may be correct. In my experience, the technical economist’s definition of a recession does not matter until the results of it start to impact small business owners and prospective buyers. The current climate can be considered a perfect storm – labor and supply chain shortages, interest rate hikes, a high-profile war, and certainly inflation. There is a lot going on. Despite this, as I wrote in a prior post, I do not feel the impact will be dramatic and specifically because there is a lot of available capital, and it must be deployed.
Natan has found that “So far, market reaction is more muted than previous ones, highlighting that (a) we might not be in a recession and (b) if we are, it’s a weird one as employment is stronger than ever. The M&A cycle and the economic cycle are correlated but are not the same.”
Lenders may get more stringent, but they will not stop lending. Institutional investors like private equity firms must buy businesses, or else they must return the money to their limited partners, and that is not going to happen. Entrepreneurs will always have that drive to acquire companies and will look at negotiation strategies, valuations, and deal terms to mitigate their risk.
Andy Cagnetta put it well: “We do think that there may be some hesitancy in the marketplace moving forward, but overall, the buyers and money supply are still plentiful, so good businesses will continue to sell. In the Great Recession business values dropped in half. Mostly because profits also fell, and the borrowing capacity of the banking system was nonexistent. Today, the banks are strong, SBA lending is still available, and most business profits remain steady or growing.”
What Buyers Should Do
John Martinka has an interesting outlook when he suggested to buyers – “Don’t slow down. By the time you locate, analyze, and structure a deal the chances are the downturn will be over as it’s predicted to be short and mild.”
John is not suggesting that buyers should not be diligent; rather it is a mindset that is not only compelling, but it also makes practical sense. After spending thirty plus years in the M & A field, I know that the individuals who wait for the right time to buy a business rarely, if ever, acquire one.
And What About Owners Who Are Thinking About Selling?
The BizBuySell report noted that 40% of owners believe they would have received a higher price had they sold last year. To this point, Gulf Coast’s Natan presents an option to consider. “We are also fortunate to have a strong presence in some of the fastest growing markets in the country which have not slowed down. The number of large deals is decreasing more markedly; sophisticated sellers are deciding to hold off selling until multiples and buyers return to 2019 levels.”
The report goes on to state that 38% of owners cite declining revenues as the reason for believing they would have sold for more last year. This data point is important and can be an exciting opportunity for owners. Solid, stable businesses, with good financial records that are appealing to a broad swath of buyers and can transition well to a new owner are always in demand, and even more so when there are less of them on the market. They sell. Valuations may adjust, deal terms can move around, but ultimately, good businesses that are properly priced are sought after regardless of the macro economy. Furthermore, if a business continues to do well during an economic downturn, it can be even more attractive to acquirers.
Martinka suggested: “If you have a mature, profitable business that hasn’t been affected by the economy, your value hasn’t decreased; the opposite is true if your business is or has been struggling. Expect a bit more due diligence by buyers and banks. There’s plenty of money out there.”
Projecting the economic future is anyone’s guess. If I knew for certain what it will look like for Main Street business sales, I would start to buy lottery tickets. History has proven that all cycles come to an end. Nobody knows for certain how long it will be.
Based upon the experienced and up-to-date comments from John Martinka, Nimi Natan, and Andy Cagnetta, the market is still very active, deals are getting done, and capital is available.
Buyers and sellers need to turn down the noise a bit and keep plowing ahead. Creatively structuring deals and bringing valuations in line are ways to address the market from both sides of the table. Buyers must continue to be comfortable with an element of risk, and sellers need to come down to Earth when it comes to the value of their businesses.
Certainly, the economy is reason to perhaps slow down the decision making for either side, but stop altogether? It simply does not make any sense as things stand right now.