The Impact of COVID-19 on Merger and Acquisition Activity
The Landscape Is Changing for Business Owners Looking to Exit
An interview with Robert J. Zahner, CPA/ABV, ASA, CVA and Keith A. Veres, CPA, CGMA, CEPA - HBK CPAs & Consultants
Like most things, the buying and selling of businesses has taken a pause as the nation works its way through the COVID-19 crisis. Merger and acquisition (M&A) activity has slowed largely as a result of the considerable difficulty the experts are experiencing in arriving at valuation calculations that both buyers and sellers can agree on. In most cases, owners have put their intentions to sell on the back burner and are focused on getting their companies through the crisis and coming out on the other end intact. So how are the professionals who advise business owners on M&A activities looking at the issue and what are they recommending to their clients, especially those clients who before the onset of the pandemic were looking to sell as their exit strategy? We asked Keith Veres, CPA, CGMA, CEPA, a principal at HBK CPAs & Consultants, who, as director of the firm’s corporate finance division and a Certified Exit Planning Advisor helps clients looking to raise capital, acquire businesses or sell their business, and Robert Zahner, CPA/ABV, ASA, CVA, a senior manager with the HBK Valuation Group who executes valuations and related technical services for businesses looking to acquire or sell.
Q. How has COVID-19 slowed the pace of M&A?
Veres: The questions at the center of any M&A transaction revolve around the value attributed to the companies involved in the proposed transaction. How do you value a business in this climate, especially when companies are not yet certain just how much revenue they may be losing — or gaining, as is the case with some companies? A buyer will always look at historical information but is more interested in forward-looking projections, because anyone buying a business wants to know what’s it going to do when they own it. They’d want to determine how all facets of that business are going to be effected by the pandemic, including what has happened to suppliers and customers and the collectability of accounts receivable. To determine a price, you need to know what it’s worth now and what the value drivers and detractors are. Is the business transferable and attractive? Getting to the bottom of these critical questions required considerable effort under normal circumstances. What we are all dealing with now has added new levels of complexity to the business valuation process.
Zahner: There’s no question that the current crisis has put sellers at a disadvantage, even if some industries have been well positioned to react to COVID-19, including certain retailers, household staples manufacturers and technology companies. But for the most part, it’s advantage buyers. Many buyers, though, have also been forced to put their M&A activity on hold. Cash is short, and they likely have their own problems to tend to. However, companies with strong balance sheets and private equity groups with “dry powder” could be out in search of deals at a discount. Sellers are wary of this; if they aren’t, they should be. Many are taking a wait-and-see approach. Not many want to buy an enterprise that isn’t sure how to forecast its cash flows through the end of this year, let alone two to three years into the future. And, like Veres said, the uncertainty can lead to widely disparate valuations between buyers and sellers, which make deal-making difficult.
Veres: Many buyers of small businesses use SBA lenders, and most M&A activity through those channels has been put on pause for at least the next 30 to 60 days. Each business is unique — not only their business type and historical financial performance, but their ownership group, their employees, their community, their market. It’s why we say, “If you’ve seen one M&A transaction, you’ve seen one M&A transaction.” We’ve been talking with our strategic partners — attorneys, investment bankers and business brokers — and it’s unclear how the crisis will ultimately affect each business. Relationships as they exist between suppliers and customers will change. So many unknowns are having an impact on the valuation process right now.
It’s a very difficult time for business owners who have been contemplating their exit strategy because buyers understand that revenue is down, unemployment applications are what they are. What’s the fallout of all that? How do you value a company that for three decades has been performing in a fairly consistent and predictable manner? How will that valuation look in two to three years? It’s why you see the equities markets fluctuating like they are. They’re having difficulty following the value implication for companies all the way through to the end. Most buyers are pausing unless they think they can get a bargain. For business owners preparing to exit, it’s going to be very difficult, except under certain circumstances, to command the value they could have commanded three months ago.
Q. What should sellers being doing now during the crisis period?
Zahner: Unfortunately for many business owners contemplating an exit, current market dynamics have likely eroded value and put sellers at a disadvantage compared to just months ago. Therefore, a practical strategy for sellers may be to weather this storm the best they can, then look at it again on the other side. If your company has certain strengths that allow it to do so more effectively, like a nimble supply chain or easy scalability in either direction, now is the time to build on those strengths and tell the story once the crisis is through.
Veres: One thing we’re telling business owners is that it is important to go through the valuation process, if only to determine what it is that drives the value of their business and look at their business through a buyer’s perspective. They might not have done that level of analysis at least in the recent past, that is, put on a buyer’s glasses and see what things make the business valuable and what things might detract from the perceived value. A buyer will do their due diligence on your business and look for reasons to re-price what their initial letter of intent indicated as their offering price. That’s now standard operating procedure. So when we’re going through the process of looking at their business from the buyer’s perspective and uncovering real value drivers, it allows us to determine where business owners should be spending their time. Their time should be spent making their business as attractive and easily transferable as possible. Most things that will help a business get prepared for a sale are things that will also help them weather storms like the one we are in right now.
When a buyer is looking at a business, they’re looking at a risk-return proposition. Typically the lower the risk, the higher the value they will place on your business. If you can come out the other side of this pandemic and prove that you survived a historic attack on your business, that might prove a significant differentiator for you when it comes time to market your business to potential buyers.
There’s a wave of baby boomers contemplating their exit strategies. Some of them might use the crisis to take the steps to improve their business that they were dragging their feet on before.
Zahner: The two things that have arguably impacted value the most are supply chain disruption and the demand shock with everyone staying home. A lot of businesses will be looking at their supply chains with the idea of tweaking them to make their companies more attractive. Do they have the proper contingencies in place? Should they be looking at different geographic regions or keeping things closer to home? What is the best strategy to maximize responsiveness? Also, it’s important to think about how business activity will be forever changed on the other side of the COVID-19 pandemic. Strong, flexible IT environments will be more important than ever, as will changing customer preferences. I believe that the current crisis has accelerated shifts that were already in motion; telemedicine, grocery delivery/pickup, how we get our hands-on essential household products.
Veres: Also a lot of businesses will reconsider how much they spend on brick and mortar given that distance working is proving to be an option like distance learning in the educational system is. Businesses owners will learn that they didn’t miss too many beats having 80 or 90 percent of their people working from home. So maybe 30 or 40 percent of their workforce could continue working at home, thus reducing the square footage required to house their employees.
Q. What do you see on the other side of this crisis for M&A activity?
Veres: Sellers are going to have to be creative. In deal making, that’s going to be a necessity because there are so many unknowns moving forward. There will likely be more deals with an earn-out attached to them. Getting a buyer and seller to come together over a value is going to be more difficult; there’s plenty of ammunition on both sides to dispute attaching a definitive value to a business that is in transition. So we’ll see concessions being made that allow for a valuation to play itself out in terms of future revenues and profits. Sellers might also be asked to take on larger notes receivable from buyers instead of having the buyer come up with 90 percent at closing. Sellers might need to take on some additional risk. There’s going to be more consternation on both sides, but when you have a willing buyer and seller, you should be able to work it out. Deals are still going to happen.
Zahner: I think there will be fewer buyers and sellers for a period of time. How long that goes is anyone’s guess. No one is sure when the recovery will start, or if values will rebound to pre-crisis levels, but once the virus has been controlled and self-isolation mandates are lifted, business and consumer confidence will rise, and possibly quickly. But for now, everything’s against the seller. Any influx of capital will be more for operations and working capital than deal making. Earn-outs and “holding the paper” on deals might get the buyer to pay more in the long run, but the deck is stacked against the seller at this time. So if you don’t have to sell, you’ll likely want to wait.
Q. Do you have deals in the making for any of your clients now?
Veres: Yes. There are some deals in the due diligence process where legal documents have been signed. Contracts may include a force majeure clause that allows the buyer to step away from the deal under extraordinary circumstances. A deal without that clause could still be enforceable. There are other contractual issues that can cause the sale to be delayed, like deals that were scheduled to be SBA financed that are now on hold. Some businesses are more protected from societal and economic turmoil and may see their deals still go through. Again, every deal is unique, but most are taking a deep breath and pausing.
There was a lot of money out here looking for a market correction, but who would have thought of a pandemic and a Saudi-Russian oil war happening at the same time? We had expected a pull back from such a long period of increasing business values, and there was a lot of money on the sidelines waiting for that. I believe activity will ramp up when there’s a recovery — there is a lot of dry powder looking for an opportunity.
Zahner: From a valuation perspective, there are a lot of things we’re dealing with now that don’t have much to do with transactions. What we’re doing as a valuation group is addressing cash flow issues and market conditions and working with our clients to try to quantify the impact as accurately as possible. The valuation date plays an important role in this. Was the crisis known or knowable as of a certain date in time? Once it was knowable, what were the cash flow impacts? How long will they persist, and how quickly will things return to normal? These are all very difficult questions, some of which are unanswerable. When we don’t know those things, we have to incorporate the impact of the crisis in other ways. We can adjust our selected rates of return and apply lower-value multiples based on revised market capitalizations. We just have to be careful not to double-count certain factors. For example, it’s probably inappropriate to apply depressed earnings multiples to recast projections that have already incorporated negative performance. But, in general, the transaction process won’t re-start until we get back to some normalcy.
Q. What are your recommendations to owners planning their exit strategies?
Veres: We’re recommending to anyone contemplating what is likely the most significant transaction of their lives — the sale of their business — to assemble their team of advisors who will help them through the process. Businesses owners had become a little complacent about having accurate valuations for their businesses. They were getting comfortable applying vague “rule-of-thumb” calculations to estimate value. Moving forward, the valuation process is going to be much more complicated than that. You need a qualified professional advisory team — investment banker or business broker, attorney, CPA, financial advisor and a valuation expert.
Whether it’s an internal or external exit strategy, you want to understand all your options. A vast majority of business owners are not aware of all of their options. They think it’s either sell or close the doors. It will be important to talk about other options. Are there opportunities for joint ventures? Might you consider making some of your own acquisitions? There are thoughtful conversations to be had with buyers and sellers to consider their options.
Zahner: If you don’t look at it from a selling perspective, you might consider passing the business on to the next generation. Strategies like gifting are very attractive now, especially with a taxable estate. With market conditions as they are and uncertainty swirling, fair market value has dropped, and transfers can be made at supportably lower values. I want to be clear that we aren’t suggesting that values are artificially low. Risk profiles are growing. Cash flow is plummeting. These are real concerns for our business owners, and value will be impacted accordingly. Therefore, it could be a good time to get with your estate planning professionals to see if the timing might be right.
Veres: Many of our clients had originally anticipated that their kids would take over the business when mom and dad were ready to retire. Many of those same business owners later became aware of the fact that their kids had other plans for themselves. Those other plans may no longer be available and it might be time to reconsider keeping the business in the family. Maybe some of the togetherness during this crisis will percolate that thinking. Mom and dad’s original intent for the business might happen after all. If this is an option, get the valuation experts to work and have the tax and financial planners help you craft the best plan to keep the business in the family.
Owners are optimistic people. They are entrepreneurs and have shouldered risk and responsibility for many years. Their expectations are that they’re going to come out on the other side better for it and still execute their exit plan at some point. They may now have more time for a thoughtful approach to the process. Most business owners have a passionate relationship with their business. They have probably invested the vast majority of their time and money into their businesses and they will do everything they can to get through this.