A recent survey of M&A advisors and business brokers showed that of all small and medium businesses on the market at the end of Q1, about 35% had closed (temporarily at least), 40% were operating at partial capacity, 4% had benefited, and 21% remained unaffected by COVID-19. Not surprisingly, advisors indicated that 46% of lower middle market deals were delayed at the end of Q1 and 11% had been cancelled altogether. For deal cancellations, 25% were attributed to sellers pulling out, 46% due to buyers backing out, and 12% due to changes in bank financing.
For business owners, the COVID-19 pandemic was like getting punched between the eyes. It knocked people down. And even when they could stand up again, their head was still spinning. But now, we’re starting to see the cobwebs clear.
Advisors like us saw an instant drop in buy-side activity in March. We had some new buyer conversations in April, but nothing solid. By early June, though, we started to see a resurgence.
Affect on Valuations
The question now, as buyers move forward with acquisition plans, is what will happen with business valuations?
For those businesses that remained fully active, their valuations will likely stay solid. Even businesses that partially closed or were negatively affected may find that valuations remain consistent. Businesses that were essential or able to pivot to an online or contactless model will be attractive to buyers.
And while declining cash flows typically do impact business values, we may see special considerations granted for the pandemic. Most businesses trade on a multiple of “normalized” historical cash flow or EBITDA. Normalizing financials includes making adjustments for one-time and unusual events. As buyers and lenders evaluate your business, they may accept normalization adjustments due to COVID-19, after your business recovers.
Affect on Deal Structures
In terms of deal structures, though, sellers who want to receive full value for their businesses should be prepared to carry more risk. Buyers will be seeking more of the purchase consideration in the form of seller financing, earn outs, or equity rollover. Here’s what that might look like for sellers:
Seller financing can bridge a buyer’s resources with the value they see in your business. Essentially, it’s a loan from you, typically structured with monthly payments over a number of years.
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 Survey. The more perceived risk (e.g., COVID-19 closures and declines), the more seller financing buyers tend to request. So, we expect we’ll see these numbers climb in the year ahead.
An earnout is a commitment by the buyer to pay you a certain amount of money tied to future business performance after a sale. If the business meets certain benchmarks, you receive additional value. An earnout is a way of sharing risk.
In an equity rollover, the seller maintains an ownership stake in the business. They roll a portion of their equity into the new capital structure in lieu of cash proceeds.
Rollovers are common with financial buyers, such as private equity groups. These buyers generally acquire businesses with the intention of holding them for five to seven years before reselling at a profit. Financial buyers often want sellers to receive a portion of their consideration as equity. It’s part of their financing model and it demonstrates the seller’s faith in the business.
Rolling over some of your equity gives you get a second bite at the apple when the business sells again. If the new owner successfully grows the business, that minority stake could be worth as much 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 arrangements.
For further information on M&A market conditions or to discuss a current need, contact Al Statz, 707-781-8580.