It's Getting Harder to Sell a Business
With interest rates skyrocketing over the last year, most of the attention about the tough borrowing environment has been on the buyer side of the equation. Consider the challenge for would-be homebuyers right now: the median sales price in June 2023 according to the National Association of Realtors was $410,200, which is up from $363,300 two years ago in June 2021. That is an increase of 12.9%, which is actually a bit of a slower pace in home price growth than it was over the previous two years, which were particularly wild. However, the average 30-year fixed mortgage rate today is hovering around 6.9%. In comparison, in June 2021, the rate was 2.9%.
Assuming a 10% down payment on the median purchase price in each time period at those rates, the average mortgage payment in June 2021 would have been $1,361/month. In June 2023, the average monthly payment would be $2,431. That is a difference of $1,070 in two years. It is no wonder, then, that the number of home purchases was just 4.15 million in June 2023 as compared to 5.87 million in June 2021, a decline of nearly 30%. Buyers are pulling back in the face of higher borrowing costs, but also because many simply no longer qualify at these higher prices and with these high rates. Many other existing homeowners are simply staying put, not wanting to give up their pre-2022 mortgage rates.
But this is, in fact, not an article about buyers. The rate environment is also proving to be a challenge for sellers, particularly of businesses. The frustration is being felt most acutely by motivated sellers of cash-flow businesses who are suddenly bereft of buyers.
Among the variables a would-be buyer must consider when buying a business are industry outlook, competition, the legal and regulatory framework, brand value, and, of course, cash flow. Higher rates are hitting the cash flow number hard, as the cost of borrowing is such a major input in the overall expenses related to running a business. This goes for both acquisition costs but also the cost of capital for expansions or new investment.
It seems like once a week these days I am speaking to a business owner who wants to sell but either cannot find a buyer or can’t find a buyer who is anywhere close to them on price. And that is because the buyer, more often than not, has to factor in loan payments in their overall costs of running the business whereas sellers either do not (because they have no debt) or their debt payments are much lower (because their debt has been paid down considerably over time and/or it was obtained in a lower rate environment). Buyers and sellers are therefore coming up with two completely different calculations of cash flow, which extrapolates to two different valuations for business. Depending on the size of the business, the difference can be in the millions.
I spoke to one owner of a retail-oriented business just this past week who said they had been planning to sell prior to COVID. In the early days of COVID, there were no buyers because of how perilous the economy was; the atmosphere to buy was just dismal. But then this business owner (and many like her) were kept afloat through PPP loans and other emergency relief measures, and, of course, as the customers came back business started to stabilize. Business was so good from 2021 onward that it did not even make sense to sell. But now this person is 4-5 years out from their pre-COVID thoughts of selling, and they are also 4-5 years older. To enjoy life and the fruits of ones labor is the goal for many long-time business owners now including this person, which makes it the time to sell. Potential buyers including many who expressed specific interest in acquiring this woman’s business are now fading into the bushes Homer Simpson style, backing away from previous discussions and sometimes even from verbal commitments. Some of these sellers may, in fact, be backing away simply because they no longer qualify for financing at such high rates.
What Comes Next
Fortunately for sellers at the moment, the economy is still strong enough that there are enough eager buyers out there. Transactions are still taking place. True, listings for both real estate and non-real estate businesses are on the market for longer and the competition is not quite as fierce, but there are still a lot of buyers out there.
Buyers are frustrated, too, as the high rates can sometimes jeopardize the viability of a deal. But buyers have more power in the negotiations at this point. What I am seeing happen is that buyers will literally show existing business owners their analysis of how the debt payments impact cash flow and then will use it to to bargain prices down. This goes for both businesses like restaurants, retail, and things like convenience stores and food producers, but also for real estate like rental properties and large housing complexes.
The real challenges will come for sellers who need to sell because they are being forced into it by various circumstances, financial or otherwise. Maybe they have fallen behind on their own loan payments and the bank has lost patience, or maybe there is a health issue or some other family dynamic at play that is triggering a sale. A lot of homeowners found themselves in trouble in 2008 needing to sell but either 1) not having a buyer or 2) not having a buyer willing to pay the price the seller required. The same situation for many sellers may be on the horizon today, if not already here.
So what’s a seller to do? Sellers need to be realistic about the environment right now. Many will need to recalibrate their thinking on what their business is truly worth. Some sellers may have become psychologically anchored to a price they think their business is worth, and they may need to rethink that.
The unicorn buyer is someone who doesn’t need financing and therefore is not subject to interest rates, but those are few and far between and anyone strong enough to not need financing is also likely to be savvy enough to leverage that very fact in negotiations.
Otherwise, many sellers will need to wait until rates decline, which will encourage would-be buyers back into the pool. I wrote about when rates might decline just last week, which you can read here. The short answer: we are probably looking at May 2024 before rates start to tick down, and another 6-12 months beyond that before there is any meaningful decline. Sellers who are set on a specific price may need to be patient. On the one hand, it is possible during this “waiting period” that the economy continues to grow and a person’s business may actually become even more valuable, providing the seller with the twin benefits of a higher sale price and more potential buyers. But if the economy falters and sales decline, the benefits of lower rates may only accrue to would-be buyers, who could then also leverage transaction prices down as a result of lower multiples of declining revenues. So sellers are, indeed, in a tricky position right now.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. © Ben Sprague 2023.
No weekly-round up this week because I was off for most of the week and was not online much. More next week! See you then.