Government shut downs, stock market volatility, interest rate increases and trade wars. It seems like our country is buffeted by breaking news with an unknown impact on our future economy. Additionally, most economists feel we are overdue for a recession or market correction in the next 6-18 months. How do these indicators factor in to a plan to exit a business or acquire a new one?
A pending market correction won’t halt M&A activity, but it can create three issues that make it more difficult to close a deal and require creativity:
Buyer Concerns. First, why would anyone buy a business prior to, or during, an economic downturn? In 2009 many buyers were dislocated corporate management who realized they would rather work for themselves than put another decade into someone else’s company. Likewise, other people affected by a recession may take the opportunity to become self-employed and buy a business. So, while there are many good reasons for people to buy a business, even in a downturn, the business price and terms may need to be modified to reflect economic uncertainty. This however, doesn’t necessarily mean a simple price reduction.
Seller Concerns. Unfortunately, some business owners may have to sell or exit their business due to unforeseen personal issues, health problems or financial challenges. Combined with a softening of the economy it may seem like the owner will be forced to sell their business at a discount. In many cases the proceeds of a discounted sale won’t meet the seller’s needs, leaving them in a catch 22 situation.
Lack of third-party financing. The first casualty of a downturn will be pullback in the financial markets. Banks will look to re-allocate or balance loan portfolios, lending criteria will tighten up and lines of credit will be more difficult to secure. Buyers may be forced to borrow at higher interest rates adding additional risk to the acquisition.
Any one of these concerns can be a significant roadblock so both buyers and sellers need to be prepared to identify these issues if or when they arise. Creative solutions by both parties will enable a successful closing but buyers and sellers must be willing to compromise. What are some flexible solutions to bridge the gap between buyer and seller concerns?
Earn-outs. A type of seller financing, earn-outs calculate payments and total payout based on the future performance of the business using a selected benchmark: gross revenue, gross margin, units sold etc. Typically earn-outs are structured over 2-6 years and will still be active after a downturn and recovery. That can allow the seller to realize the full value of their business over time. For a buyer, an earn-out can push higher acquisition costs down the road when the economy improves. For both, an earn-out shares risk: if the business under-performs, the buyer pays less; but if it over-performs the seller can realize a higher value for their business.
Seller notes. Invariably, almost any downturn will require a business owner to shoulder risk by providing seller financing. Seller notes, like traditional bank financing, will require personal guarantees by the borrower, legal execution of a note and pledged collateral. Even with those sureties, providing seller financing creates some risk. A seller is going to be compensated for this risk with a higher than market interest rate and perhaps realize a full asking price of the business.
Amortization/Balloon Payments. Buyers and Sellers can agree to adjust straight amortization schedules on Seller notes with either “interest only” payments for a short period, a different amortization than the loan term or minimum payments with a large balloon payment in the future. All of these techniques can lower principal and/or interest payments to reduce the debt burden on the buyer during a slow economic cycle.
These are just a few strategies to bridge the gap between sellers and buyers and overcome obstacles with bank financing. As we anticipate an eventual market correction it can be helpful to utilize creative tools to get to a successful closing.