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Will Business Valuations Decline?

Business Sales and M&A Specialists

A recent survey of business brokers and M&A advisors showed about a third of businesses on the M&A market temporarily closed their doors due to the pandemic.

According to the Q1 2020 Market Pulse Report published by the International Business Brokers Association, M&A Source, and the Pepperdine Private Capital Market Project, advisors reported that of the small and medium businesses currently for sale, about 35% had closed, 40% were operating at partial capacity, 4% had benefited, and 21% remained unaffected by COVID-19.

Not surprisingly, the pandemic caused a delay in business sales. Advisors indicated 46% of lower middle market deals were delayed in Q1 and 11% were canceled altogether.

For deal cancellations, 25% were attributed to sellers pulling their business off the market. Nearly half of the cancellations (46%) were due to buyers backing out, and 12% were due to changes in bank financing.

For business owners, the COVID-19 pandemic was like getting punched right between the eyes. It knocked people down. And even when someone could stand up again, their head was still spinning. But now, we’re starting to see those cobwebs clear.

In March, we saw an instantaneous drop in buy-side activity. Buyers with retainers for proprietary deal development stopped their accounts. In May, we started to see a resurgence.

Valuations

The question now, as buyers move forward with acquisition plans, is what will happen with valuations.

For those businesses that remained fully active, their valuations will likely stay solid. For businesses that partially closed or were negatively affected, business valuations may remain consistent. Businesses that were essential or otherwise able to pivot to an online or contactless business model will be attractive to buyers.

Most business sales are calculated as a multiple of adjusted cash flow or EBITDA and declining cash flows typically do impact business values. However, a typical part of the calculations involves “normalizing” cash flow. That means making adjustments for one-time expenses and unusual events.

As buyers and lenders value your business, they may apply the same normalizing adjustments to your financials for COVID-19, especially if you can recover quickly in Q3 or Q4.

Deal structure

In terms of deal structure, though, sellers who want to get full value from their business will likely have to carry more risk. Buyers may ask for more in seller financing, earnout, or equity rollover in order to lessen the risk of future declines.

Seller financing. Seller financing is the bridge between a buyer’s resources and the value they see in your business. Essentially, it is a loan from the seller, typically structured with monthly payments over a three to five-year period.

In the past year, seller financing has hovered between 10-15% for Main Street deals, and 6% or less for deals over $5 million, per the Market Pulse Report.

The larger the risk (e.g., COVID-19 closures), the more seller financing a buyer will request. So, I expect we’ll see these numbers climb in the year ahead.

Earnouts. An earnout is a commitment by the buyer to pay the seller a certain amount of money tied to future performance after a sale. If the business meets certain benchmarks, you get additional value.

Equity rollovers. In this arrangement, the seller maintains an ownership stake in the business. They roll a portion of their equity stake into the new capital structure in lieu of cash proceeds.

Buyers see Seller Financing and Earnouts as a sign that the seller has faith in that the business will continue without the Seller. Sellers who agree to an equity rollover get a second bite at the apple years down the road when the business sells again. If the new owner has successfully grown the business, the minority stake may be worth as much as, or more than, your original sale.

Deal structures will also be driven by lending activity in the months ahead. If lenders pull back, both buyers and sellers will be motivated to reach alternative financing agreements.