Favorable Conditions: Now is the Time to Sell Your Business

After soaring to all-time peaks in 2021, the global mergers and acquisitions market has seen a decrease of 12%.

“Although M&As have decreased from the previous year due to uncertainty, they’re in line with healthy, pre-pandemic levels,” said Koley Jessen Attorney Eric Oxley. “Geopolitical instability, spiking inflation, supply chain issues, skittish capital markets, regulatory changes and more are fueling uncertainty.”

Private equity deals continue to be a key driver to the growth in the United States. M&A represented $1.2 trillion of U.S. deal value in 2021. This trend is expected to continue as private equity funds raised a record $733 billion in 2021.

According to Jeff Herdzina, founder and president of ExitBig, M&As are increasing for three reasons.

First, many baby boomers continue to sell their businesses. Second, the COVID-19 pandemic — an unexpected event — affected the mindset of many business owners. Third, more information about M&A is available than in the past.

“I think a lot more professionals — CPAs, bankers, attorneys — are learning about M&A and educating their clients, so there’s a lot more talk about M&A than there was five or 10 years ago,” Herdzina said.

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Why Merge?

In the world of M&A, there are two types of mergers. A horizontal merger grows a company by acquiring another company in the same industry, such as a trucking firm buying another trucking firm. 

A vertical merger is when a company acquires another firm that operates in a different level of its supply chain, such as an automaker acquiring an electrical widget manufacturer.

“You’re likely to see the most M&A in the health care, technology, financial services and retail sectors,” said Maurice Johnson, senior counsel at Goosmann Law. “Usually it’s where small to medium-sized firms are trying to compete in the marketplace with a number of behemoths.”

In terms of financing, it’s harder to start a business from scratch than it is to acquire an existing business.

“If you go to a bank and ask what kind of financing you can get, you’ll most likely be able to finance it if the business is making money,” Herdzina said. “Bankers don’t get very excited about startups. They’ll do a loan on a personal guarantee and basically look at your personal financial strength, but [startups] are not as financeable. It also takes a lot longer to get a startup up and going.”

Buyers are looking to target companies that capitalize on economies of scale, increase market share or diversification, benefit from revenue synergies or increase their product/service offering, according to Mark Otte, M&A manager at Lutz.

“Over the last few years, I think small to medium-sized companies have become more aware of M&A opportunities as a solution for their business succession,” he said. “When the economy began to recover from COVID-19 and buyers became more aggressive in 2021, companies that initially were not looking to be acquired reconsidered their options due to recent strong valuation multiples for high-performing businesses.”

In a typical M&A cycle, deal volumes and values first decrease along with a downturn in the economy, which is frequently caused by an external event.

“As private equity companies and other investors reevaluate their portfolios and investment plans, the desire to acquire increases as more people start to sell,” Oxley said. “Lower valuations for targets during the cycle improve the chances for acquirers to see higher returns.”

The technology, media, and telecommunications sector has outperformed other industries, accounting for 30% of total deal value, lagging behind 2021’s 32% but nearly matching its 2020 performance of 31%.

The next two largest sectors in M&A sectors are real estate at 13% and industrials at 11%.

“At Lutz, our typical clients are in the lower to middle market, with industries spanning from manufacturing & distribution to software and professional services,” Otte said. “There has continued to be strong demand from buyers in these industries for high-performing sellers that have properly positioned themselves to be an acquisition target.”

Preparing for Success

A lack of management depth is one of the main operational issues Lutz sees in transactions.

“Buyers will become less interested if the selling owners are overly involved in the day-to-day operations or if they have too much influence over customer/vendor relationships,” Otte said. “Sometimes in this situation, the buyer will make a portion of the sale price contingent on the owner staying in the business for a period of time.”

A related issue is when the existing management team members are close to retirement, and replacements have not been trained or hired. Addressing these issues with the management team well in advance is important to a successful transaction.

“A business owner will spend 30 or more years working on a business, and selling it is so important to many of their retirement goals,” Herdzina said. “The No. 1 thing they should do when preparing for an M&A is to get the professionals involved — their CPA, banker, attorney and an M&A professional.”

The firm should clean up its finances.

“Many smaller businesses run lots of their personal expenses through the company,” Herdzina said. “I recommend not doing that for a minimum of three years. That will get the seller the best number. It will be easier to sort through the finances.”

Document processes so that the business doesn’t hit a speed bump if an employee who has all of the information about running a division leaves. A new hire could come in, read the process document, and be brought up to speed.

“Talk to an M&A adviser,” Herdzina said. “It doesn’t mean you have to sell your business; it’s just information. Most sellers I talk to for the first time don’t really know how the process works. Having that information available for them so they can make a good decision is key.”

Hire experienced financial and legal experts to plan for and facilitate the transaction. The legal team should include not only seasoned M&A attorneys but also experts in appropriate specialty areas such as tax, compensation and benefits, employee matters, real estate, intellectual property, data privacy and litigation.

“Insist on a nondisclosure agreement,” Johnson said. “Sign that when talking with a potential acquirer. Also, attempt to incorporate an employee non-solicitation provision.”

An investment banker can be helpful in finding buyers and acting as an intermediary. Have an M&A counsel hired by the selling company.

“The CEO should not negotiate the terms,” Johnson said. “He or she might have a conflict, so usually you might want to have a committee of the board. Then you want to have a letter of intent that kind of locks up the deal while you’re negotiating things and gets some of the niceties out of the way with regard for warranties, indemnifications, provisions [and other things].”

Make sure you have complete files of your contracts, corporate records and stock options information. You might want to set up an online data room where potential buyers can see all those documents.

Prepare a disclosure schedule that discloses the key contracts, equity holders, options litigations and intellectual property.

“[The disclosure schedule is] difficult and time-consuming to prepare and sometimes that can delay things, but it can prevent a lot of problems down the line,” Johnson said. “If you have any leases or any key contracts that are not assignable, you’ll have to negotiate with that lease-holder — for instance, if you’re getting ready to turn over the lease on your building.”

There’s a lot of due diligence on the firm’s projections as to what they’re saying and what is true. There are also employee issues. For instance, what is their plan for retention and motivation of employees? How will they deal with stock options and will they need to carve out some pay to the employees after closing?

“Some of the contentious deal terms might be what’s the amount of escrow you’ll agree to, conditions to closing, adjustments to price, negotiating the representations and warranties of the buyer and seller and just keeping your eye on the ball while you’re trying to run the company at the same time,” Johnson said. “It can be kind of distracting.”

Some deals can take over a year if the initial buyer backs out and the sale process needs to be restarted. One of the benefits of running a full competitive sales process is that all potential buyers are kept on a timeline. If the selected buyer backs out, other buyers who made strong offers can be re-approached.

“If a target company decides to only explore selling to one buyer, there is a risk the buyer can back out, and the sale process would be delayed if they choose to go-to market again,” Otte said.

Smaller M&A deals will typically take one to three months, although most deals range from three to six months, but can take up to 12 months. Larger deals could take up to two years or more.

“Some factors that determine the length of time for an M&A deal include whether the deal is part of an auction process or a single buyer deal, the buyer’s diligence process, the type of business, the location of the business, the structure/organization of the deal, and the amount of time it takes to respond to requests,” Oxley said.

Interest Rate Impact 

Because of the Fed’s recent interest rate increases, servicing debt on buying a business is more expensive today than it was a year or two ago, according to Herdzina.

“I believe that high interest rates are going to drive prices down,” he said.

Because interest rates make everything more expensive, the buyer can’t pay as much for the business, and with more businesses up for sale, it is a seller’s market.

“As more supply of businesses come online, buyers will have more options, therefore driving prices down,” Herdzina said. “If you’re thinking about selling your business, there may not be a better time than right now.”