Business owners often-times see exit planning as a complicated, overwhelming, and emotional process. Accordingly, few owners adequately prepare for this significant event. However, an exit plan is essential to help business owners manage the illiquid wealth in their businesses, particularly in turbulent times such as these marked by strife that is present in local and global economies, national and international politics, and market disruption. The International Exit Planning Association sees the present challenges as an opportunity to provide advice to these owners considering an exit. This article discusses the dynamics of the marketplace for owner exits, the major factors that impact the decision to pursue an exit, and how the professional advisors can assist business owners navigating what potentially lies ahead to outrun inflation to achieve a successful exit.
Against the backdrop of a war in Ukraine, supply chain issues, aging baby boomers, a change in the administration last year, mid-term elections, a post-COVID-19 economy, and inflation recharacterized from ‘transitory’ to more likely permanent, the Fed and Jay Powell, Chairman of the Federal Reserve, recently raised interest rates by 25 basis points and indicated the possibility of more to raise rates and a more neutral level or even higher to restore price stability. Business owners should be aware that higher interest rates may correlate with a lower value for their privately held business and, perhaps, a more difficult environment to complete a successful exit. If a business owner is thinking about exiting their privately held business in the next 12 to 18 months, all the factors listed above should be taken into consideration.
Business owners often-times see exit planning as a complicated, overwhelming, and emotional process. Accordingly, few owners adequately prepare for this significant event. However, an exit plan is essential to help business owners manage the illiquid wealth in their businesses, particularly in turbulent times such as these where there is both local and global economic, political, and market uncertainty. The International Exit Planning Association sees the present challenges as an opportunity to provide advice to these owners considering an exit.
This article discusses the dynamics of the marketplace for owner exits, what impacts the decisions made during an exit, and how the professional advisor can assist business owners with navigating what potentially lies ahead to outrun inflation to achieve a successful exit.
Aging Boomers, Rising Levels of High Mental Readiness for Exit
Approximately 70% of business owners are from the Baby Boom generation; the same generation that has largely held onto their businesses over the past decade as these owners ignored ‘traditional retirement age’ in favor of continuing to work in and run their businesses.
The International Exit Planning Association (IEPA) created a proprietary Business Exit Readiness Index (BERI) survey tool that approximately 3,000 business owners have taken over the past eight years. The BERI survey measures an owners’ mental readiness for an exit. Mental readiness is simply an indicator of how much longer a business owner wants to continue working in their business (NOTE: if you would like to take the BERI survey, you can do so by clicking this link https://berireport.com/Survey/Register/16332E2E_18).
In 2022, the BERI survey showed that 82% of owners are not mentally ready to exit their business, while 18% are ready to move on. Since 2020, however, the overall level of mental readiness has been increasing. Despite holding on and remaining active, business owners appear to be participating in what is being dubbed “the great resignation”. Many boomers, having had the time to reflect on their risk and work levels during COVID-19, simply do not appear to have the willingness to continue running their businesses. Many of these owners are looking to sell their business in the next year or so.
Inflation, Interest Rates, and the Impact on Valuation
Heading into 2022, geopolitical and macroeconomic events appear to be setting up to significantly effect business owners who are looking for a near-term exit. At the IEPA, we like to say that business owners can control or influence many elements of their operations and strategy and, to some extent, a company’s results. Still, like a sailor manning a vessel in the choppy storm waters, business owners cannot control the environment that impacts their marketplace. These 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. And this is where the advice of a trusted advisor becomes critical.
Events of the last three years have had a monumental impact on business operations. The emergence of COVID-19 in late 2019 into 2020, and the lockdown that followed, reminded people of just how fragile businesses are, particularly in the face of a global pandemic. 2021 saw the transition of power from President Trump to President Biden, whose administration was open to implementing changes to the capital gains tax and estate taxes to increase taxes on the wealthy. And while these changes have yet to be passed into law, that possibility has impacted how many wealthy business owners will plan their exit.
COVID-19 and The Great Shutdown
Coronavirus was a catalyst for dramatic economic and social disruptions; every business owner experienced it differently, some thrived and others withered economically. One of the most significant impacts of COVID-19 has been a reminder that businesses can be very fragile and can quickly lose value and wealth. The pandemic also led to an increase in the number of owners exiting their business for reasons including burn out, liquidity, security, diversification, and prioritizing personal health and family. The Great Shutdown was the first event in all participants 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.
President Joe Biden’s Proposed Tax Plan in 2021 Led to a 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.
For a wealthy business owner considering the sale of their business, these proposed changes spurred a lot of interest in selling sooner rather than later. That interest turned into action as there was a record level of transaction activity in calendar year 2021 with many business owners looking to close their transaction in the 2021 tax year. While many owners accelerated their exit timelines to avoid potentially bigger taxes on their capital gains in 2021, IEPA also sees that momentum carrying into 2022.
What Happens When Inflationary Pressure Builds
As mentioned, higher interest rates help to combat inflation. Higher interest rates also lead to:
Since business buyers get the highest return on their equity when they can leverage their investment dollars with debt, rising interest rates increases the financial costs involved. This raises the cost of capital and causes the valuations of the business to decrease. Equally important are the global risk factors that business buyers consider when acquiring. Just like with rising interest rates, as illustrated below, increased risks also reduce valuations.
Challenges of Establishing Value or Price
As mentioned, 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 (i) cash flow (commonly referred to as EBITDA) and (ii) risk. 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 causes 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?
As mentioned above, 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 owners’ direct control. If an owners’ 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.
The average business sale transaction takes eight to nine months. With the Federal Reserve signaling its intent to raise interest rates further, to a neutral or restrictive level, there are many business owners who are considering an exit in the next year who are looking for advice. These owners are truly outrunning inflation to achieve a successful exit.
On the heels of a record-setting year for M&A activity in 2021, there are some significant headwinds in 2022. We hope that this article helps you see where the challenges lie ahead as well as where the opportunity is for advising owners on their exit planning.
John M. Leonetti, Esq., M.S. Finance, CM&AA, and a Certified Business Exit Consultant®, is the founder and CEO of the International Exit Planning Association. He is a nationally recognized leader in the exit planning field and has been interviewed on ABC News Now, NECN, and numerous national radio programs, including being quoted in the Wall Street Journal on a number of occasions. In addition, Mr. Leonetti is the author of the highly publicized book “Exiting Your Business, Protecting Your Wealth: A Strategic Guide for Owners and their Advisors”. His book has been the hot topic for many national industry and business owner publications. The IEPA also offers the Certified Business Exit Consultant® professional designation program for advisors who want to assist business owners with their exit planning.
Mr. Leonetti may be contacted at (781) 821-2608 or by e-mail to email@example.com.