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May 2009: state of the market

surviving a recession

The market of buying and selling companies fell off a cliff during the fourth quarter of 2008.

The blame is widespread; lack of financing, investors losing their capital in the marketplace, business revenues declining, etc. The fact remains the market had a radical change in 2008, and it has continued into the first half of 2009.

If you are a medical company, or one that supplies to the government, you were probably not affected by any of these factors to a large degree.

Your company can still be sold for the valuations afforded businesses in 2007-2008, and your buyers can still get funding. But for the other 90% of small businesses, you are in a different world.

Is there a market?

There is good news and bad news. First the good news - the need for some to buy, and others to sell, small businesses has not disappeared, and if anything is growing since more parties are entering into it on both sides of that equation. The marketplace is not dead, and will never be.

The effect that the Baby Boomers will have on the marketplace has yet to materialize, but be sure that it will. The first Baby Boomer turned 60 in 2006. It is estimated that 54% of the Baby Boomers own their own business. With the number of Baby Boomers at somewhere around 80 million, that is a lot of business owners that will retire over the next 20 years.

The amount of businesses that transitioned during the 4th Quarter of 2008 and the 1stquarter of 2009 was definitely lower. But what happens to those businesses? Most of them would still like to sell or transition. Most will eventually be involved in a merger or acquisition. That is a pent up demand that will eventually come flooding onto the market. These sellers waiting on the sidelines combined with the baby boomers could mean a tremendous oversupply of businesses on the market for a long duration.

Is There Money Available for Financing?

Lack of Credit certainly helped the decline in activity and remains as an obstacle for the market to recover. Here is the good news - there are a number of entities such as banks and other investor groups, which make their living by providing loans to businesses. These entities still exist, and they exist to make money. They will only make money if they lend money.

Investors and Financial Institutions are skittish about entering into the marketplace right now, and for good reason. No one knows for sure where the bottom is, and the future of any particular business.

But eventually they will have no choice. They will be forced to open up the spigots and put their cash to work, or face certain death themselves. We believe this pressure will get the credit flowing more than anything else.

When Will the Market Activity Rebound?

The bad news is that valuations for most businesses are down.

But, whereas most buyers are seeking to buy businesses at valuations down 50% or more from where they were at the peak, which is simply not where the market value is for most businesses. A recent study by Babson College found the multiple used for valuations had decreased by .5 to 1.5 x's which is significant, but certainly not 50%.

On the other side, many business owners will not compromise, and want the valuation a similar business received when the market was at its peak. In addition, many of these business owners purchased or built their business using all their cash and personal credit, and they expect to be paid in full upon closing.

Right now we have a number of standoffs between the buyers and sellers. Both sides are waiting for the other side to budge. Both sides want the other side to be more "realistic".

The market will only rebound when both sides are willing to be more flexible. Neither side has all the leverage. The buyers are not making any money so long as they are not invested in a business, and those cashflows continue to go to the current owner as long as the buyers hold out. The sellers could be waiting a long long time for the market to return. Even when activity picks up, the pent up demand could flood the marketplace and therefore keep valuations low.

What to do?

Buyers and sellers both need to stop looking for the "deal of the century". Trying to time the market is typically not a winning strategy. Typically when buyers purchase a company at a bargain basement price, they get what they pay for. Most buyers who purchase a business at a "distressed" valuation will regret not paying fair value for a better, more stable, company. On the other hand, sellers that hold out for that ultimate offer typically miss out on what would be a great deal.

Both buyers and sellers need to determine why they are buying/selling a business, and work to get a price and deal structure that gets them to that goal. Buyers need to go into a deal with a realistic return on investment target in mind, and work to value the deal according to that target. Sellers and shareholders need to determine what they require in terms of value from the deal to meet their needs. That could mean income over a long period, enough cash to purchase an annuity, or money to fund a trust account.

Stop thinking about the valuation of the company for a moment, and concentrate on these goals. If you are far off and feel either party is completely unrealistic, it is probably best to walk away and stop wasting time. But, if it is just a matter of one party needing more cash up front, whereas the other party determines that is too much risk due to uncertainty in the marketplace, try to get a professional involved who can help. Are there tax advantages the right accountant might find that get the seller the cash they need?

Buyers can also mitigate their risk as well. If they really think revenue is going to disappear over the next year or two, they should not buy the business. A lot of companies have seen a decline in revenues over the last six months. Buyers need to look back over the last 3-5 years to get a realistic picture of what the business will look like going forward.

To mitigate the risk, the buyer should structure the deal so that they are protected on the downside, using some type of earn-out or note tied to the revenue of the company. To be fair, (and get the deal done), they also need to let the owner share in the upside of this arrangement. If the company realizes growth over the next 5 years, the seller deserves a high multiple.

Sellers need to understand there is uncertainty in the marketplace right now, but that does not mean they will be better off waiting to sell their company. The marketplace could get saturated with businesses over the next couple of years, keeping valuations low. The idea is to structure it so that your goals as a seller are met, and you may be able to realize a premium if you agree to take less cash immediately and take the payout over a couple of years. Show the buyer how they can realize a premium, and stand behind it by offering to take a little risk.

Going Forward

To state the obvious, both sides of any M & A transaction are seeking to get a great deal, and the perception is that gain will come at the expense of the opposite side. But so long as both sides remain dug in to this position, nothing will happen, and neither side will win.

Buyers and Sellers need to be more flexible to get activity in the market restarted, and to create a market that will help them realize their goals. This will equate to both sides "winning".

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