By: Wesley Legg
Have you ever visited a friend or family member who lives in a city with major traffic congestion? I live in a smaller city. When hunger strikes my wife and me, and there is no desirable food in the pantry, we get in our car and we go out to eat. That decision is not so simple in congested cities. When visiting family in Atlanta for instance, every discussion about going somewhere turns into a 15-20 minute intense strategy session. We debate when and how to go, not based the internal desires of the group, but on one very powerful external factor, TRAFFIC.
Most business owners plan to sell their company when they are ready. That usually means it is based on an internal desire or factors, such as owner energy, business performance, business lifecycle, retirement, personal needs of the shareholder, etc. These are all internal factors that should definitely be considered when deciding when to sell. However, like traffic in the example above, there are powerful external factors that should be considered as well. Some of those external factors include:
- Government policy
- Capital markets
- Macro-economic forces
- Industry life-cycle
- The Company’s life-cycle
- Personal needs and desires of the owner
Each one of these factors is important to consider, but credit markets have historically proven to be one of the most powerful external forces in both inflating and deflating valuations.
There are two reasons why:
Rate of Return
In the world of investing, return is commensurate with risk. The greater the risk, the higher the need for return. Economic risk is measured by determining the rate of return required for an equivalent investment facing an equivalent level of risk. This rate of return is called the “discount rate”. The capital used to buy a company is typically a combination of debt and equity. Equity can be in the form of either company stock or cash, and debt is borrowed money the acquiring firm/company pays interest on.
Each source of funds is obtained at a different cost, so the “weighted average cost of capital” is used to determining the discount rate. As interest rates go down, present values go up, making valuations higher. A small change in the discount rate can result in large changes in valuation. Summed up simply, when paying higher interest rates, the investor requires a higher rate of return, which makes valuations go down, and vice versa.
Money supply also heavily influences business valuations. When the economy sputters, the fed lowers interest rates to stimulate the economy. When money is cheap and the economy bottoms out, capital markets begin to loosen the purse strings. Early investors buy cheap, but more money competing for a limited number of assets drives valuations higher, and investors, emboldened by their access to debt and lower discount rates, start to take on more risk.
Early investors start to see good returns and those on the sidelines, not wanting to miss out, come in to drive valuations even higher. Sometimes, fundamentals yield to speculation and for a period “the sky is the limit.” But then, fundamentals return, companies default on their debt, capital markets get scared and stop lending, and in a small fraction of the time it took to inflate, asset values crater.
Market cycles are real and are primarily driven by the availability and cost of debt. Market cycles have historically lasted on average 5-8 years. When markets are on the upswing, valuations rise as investors are willing to take more risk and pay higher multiples. When markets crest and move down, investors pay less if they buy at all. Understanding this external force is important when deciding when to sell or recapitalize your company. That said timing your transaction at the peak of the market is tough.
Timing the market can be compared trying to take the perfect picture while riding the London Eye (the giant Ferris wheel). You know you can get the best picture of the London skyline at the peak, but if you miss your opportunity because your batteries went dead or you got distracted by an incoming email, you have to wait a long time before that same opportunity comes back around. It is the same with selling all or part of your company. If you miss the upcycle, you may have to wait 5-8 years to see a similar valuation for your business. Like navigating traffic in Atlanta, the risk of missing your optimal selling window warrants strategic planning.
If you would like to discuss optimal timing for your company, we are happy to talk with you. Please schedule a time.