For business owners facing the selling decision, there is a growing urgency to do it sooner rather than later. Here is why.
Private company values are still trading at historically high levels.
Private equity firms, family offices, public corporations, and other active institutional investors have enormous amounts of committed capital searching for private companies to own. Unquenchable demand, cheap borrowing costs, and a short supply of quality companies for sale have driven multiples beyond financial reason in some sectors. But…
Private company values are heading down – fast!
What goes up must come down, and economic gravity is weighing heavily on private company values. Every day, the front page of the Wall Street Journal cries out that economic conditions are getting worse. A recent survey of CFOs at public companies reported that 68% believe the U.S. will experience a recession within the next 12 months. Recession is no longer a silly notion. It is the natural byproduct of rampant inflation, disrupted supply chains, war, and dysfunctional governance.
Private company multiples of EBITDA (i.e., earnings before interest, taxes, depreciation, and amortization) are showing immediate effects from rising interest rates. All buyers, lenders, appraisers, and other capital providers rely on Discounted Value of Future Cash Flows (a.k.a., “DCF”) to determine private company values. The DCF formula identifies what value buyers should pay in today’s dollars for future benefit streams generated by a business using risk adjusted discount rates. The inverse of the discount rate is roughly the EBITDA multiple. If the discount rate is 10%, the EBITDA multiple is roughly 10X. If the discount rate is 20%, the multiple is 5X. As risk adjusted discount rates go up, multiples of EBITDA go down.
Buyers and appraisers determine the risk adjusted discount rates by using a buildup method that incorporates the risk-free rate (i.e., the 20-year U.S. Treasury Note) plus percentages for various kinds of risks. Using a highly simplified illustration, assume the risk adjusted discount rate on a valuation from January 3, 2022 was 16%:
Risk-free rate (U.S. 20-year Treasury Note) 2.05%
Equity risk premium 9.00%
Unique company risks 5.00%
Total Risk Adjusted Discount (Rounded) 16.0%
Here, the inverse of 16% is 6.25. So, the EBITDA multiple interpolated from the cost of capital is roughly 6.25X.
On June 10, 2022, the same business would have a higher risk adjusted discount rate accounting for risk-free rate increases and pervading economic risk factors as shown below.
20-year Treasury Note (risk-free rate) 3.45%
Equity 9.00%
Unique company 5.00%
New economic risks 1.60%
Total Risk Adjusted Discount (Rounded) 19.0%
The adjusted discount rate increased by three hundred basis points in just a few months due to inflation and the risk of recession. The inverse of 19% produces an EBITDA multiple of approximately 5.26X. The EBITDA multiple declined by 15.84% in just two months. Those are forces business owners have no control over.
But that’s not all. Recessions adversely affect business performance across many industries. Consequently, cash flow forecasts are also likely to decline.
Assume the company we appraised in January forecasted 2022 EBITDA at $2 million. If we re-ran the numbers in light of today’s economic realities, the forecast might be $1.8 million.
In January, the value of the business would have been 6.25 X $2 million = $12.5 million.
Now, with a revised EBITDA forecast and a reduced multiple, the value is $9.46 million ($1.8 million X 5.26). That is a 24%+ decline in value in only six months! The math shows private company values are falling before our eyes!
Lenders and institutional investors are showing signs of pulling back from the market. As the cost of capital increases, demand for private companies will decrease and lead to lower private company valuations.
What does this mean for business owners thinking about a sale?
While prices are still high, it would be better to sell today than tomorrow; better to sell this month than next month; better to sell this year than next year; better to sell sooner than later. With inflation at unprecedented levels, any decline in business value will have a double-barreled negative impact on owners’ net worth.
William “Bill” Loftis is Managing Partner and co-founder of Blue River. Mr. Loftis developed a passion for M&A as a transaction principal, and has assisted buy and sell-side clients through the M&A process in multiple industries. He earned a B.A. in Business Administration from Alma College and a Master of Science in Finance from Colorado State University. Bill’s full bio is available here.
About Blue River
Blue River Financial Group is a middle market merger and acquisition advisory firm headquartered in Bloomfield Hills, Michigan. It assists corporations, private equity groups and individuals in the sale and acquisition of businesses, and has completed assignments in multiple business segments. With over 20 years of experience spanning across 50 global industries, Blue River provides a suite of services to middle market clients including corporate development, private equity support, valuations and transaction consulting, placing a premium on relationship-centered transaction counsel and client focus.
