What’s Going on in the Small Business Transaction Market During the Pandemic

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As a broker member* of the International Business Broker’s Association, I receive its Market Pulse report each quarter. This report provides insights into main street (less than $2MM) and middle market ($2MM to $50MM) transactions and sentiment.

The most recent report for the second quarter of 2020 has some interesting insights:

  • For main street transactions that were pending going into Q2 2020, 16% were cancelled and 36% were delayed, with two-thirds of the delays being seller or bank related.

  • Advisors don’t expect the market to return to pre-2020 levels until the first or second quarter of 2021. Market sentiment for main street transactions dropped to levels not seen since 2012.

  • Lenders are overwhelmed by administering government assistance programs (primarily PPP loans). This is certainly borne out by my bank contacts.
  • Realized price on main street transactions dropped slightly from 90% of asking price in Q2 2019 to 89% in Q2 2020.

  • Median multiple of adjusted net (seller’s discretionary earnings) in small transactions (less than $500K), dropped to 1.8, falling below 2.0 for the first time in the history of transaction data.

  • Cash received by the seller at the closing in small transactions (buyer cash plus non-seller loans) fell from 87% in Q2 2019, to 76% in Q2 2020, with seller financing making up a small portion of the drop and earn out arrangements making up the greatest portion of the drop.

So, what does it all mean?

First, it is important to remember that this is data from Q2 during the lockdown and at the height of uncertainty. This represents a discontinuity – a non-linear occurrence. Therefore, reviewing the Q3 report will be necessary to see any trends or if this is just a blip. The advisors’ expectation that things won’t return to normal until 2021 suggest that the Q3 report should be similar to Q2. But only time will tell (stay tuned to this newsletter for that update).

Next, resources are still available for business purchase and sale transactions. Unlike 2008 -09, when cash and lending all but vanished, the banks are still making loans, albeit more slowly due to resources being applied to government assistance programs. And, although earn outs have become more prevalent (to reduce buyer risk in highly uncertain times), the cash at closing was still reasonably high at 76%.

Plus, buyers are still looking for acquisitions and have the cash to deploy. Alternative (less risky) investments aren’t providing sufficient returns in this interest rate environment. Therefore, buyers must find suitable transactions to deploy capital and maintain returns (though this is much less prevalent in smaller main street transactions).

Third, the drop in the cash-flow-to-price multiple for smaller main street transactions below 2.0 and the drop in sentiment are problematic but may be attributable to: (1) the panic of the second quarter, and (2) 17% of small transaction data being restaurants – one of the hardest pandemic hit sectors. It is interesting to view that statistic alongside the slight 1% drop in realized purchase price to asking price. Presumably, the asking price would have had to drop for the realized to asking ratio to remain essentially constant. Could this mean that seller’s panicked going into Q2?

The ultimate takeaways from the report are:

The ultimate takeaways from the report are:
  • Good businesses – steady and growing net income, with solid financial reporting and an in-place team – remain in demand. This is more so for greater than $1,000,000 transaction value.
  • Good businesses – steady and growing net income, with solid financial reporting and an in-place team – remain in demand. This is more so for greater than $1,000,000 transaction value.
  • Start early. The sale process may take longer than normal due to economic uncertainty and lender capacity issues.
  • If you’re looking to sell, it is more important now than at any time in the past 10 or 11 years to work with experienced advisors, to price your business properly, and to start early.
If you’re thinking of selling or putting in place a plan to sell in the future, feel free to give me a call. I’d be happy to discuss your situation and give you any insights I may have that would help you. *I am a licensee with FitzGibbon Alexander, Inc., my affiliated business intermediary, valuation, and consulting firm.

Why it’s Important to Pay Attention to the Invisible Party to Every Transaction

Most business owners think that, once they ink a deal, the only parties to be concerned about are those that sign the documents. However, two situations in the last couple of months show that there’s one other party to every deal. This party that doesn’t sign any documents or provide any services, but still gets its cut from the deal.

Of course, I’m talking about Uncle Sam. Taxes can have dramatic effects on the benefits and costs to the parties in every transaction. The parties’ failure to understand those effects can crater a transaction or cause one party to pay more than expected.

In the first situation – the sale of a manufacturing business with a large amount of equipment– the closing table was the scene of some last-minute negotiation. The buyer hadn’t sought advice about the tax ramifications of his purchase until the day before the closing.

His accountant suggested he restructure some terms to enable him to “write off” a much greater portion of the purchase price in the near term. So, as the closing began and just before the parties were to sign documents, the buyer said he had ‘one small issue’ he wanted to discuss.

I always appreciate when people characterize the issue as ‘small’ because I know what is coming will be a BIG problem.

The buyer’s proposed restructuring would have had a large negative effect on the seller – the seller would have to pay much more in taxes resulting in a lower net from the sale. Plus, the seller’s extra taxes wouldn’t have resulted in any additional tax benefit to the buyer – it would only have allowed the buyer to get that benefit sooner. The seller held firm and the transaction closed. However, the issue could have been properly addressed if it had been raised early – at the time the purchase contract was signed. But, because the buyer waited to get advice, he had no leverage to change the structure. In the second situation, two business partners, Bob and Sid, broke up in 2019, with Bob buying out Sid. The terms of the written purchase agreement required Bob to:
  1. File a tax return for the company for the time from January 1 through the buyout,
  2. Issue a K-1 statement to Sid within 75 days of the buyout for his “phantom” net income from the company, and
  3. Pay Sid the amount of that income.
Unfortunately, Bob failed to file the tax return or issue the K-1 within 75 days. Because of the pandemic delayed 2019 filing dates, the tax return wasn’t completed until last month. Sid’s K-1 showed a large phantom income from the company that Bob was obligated to pay to Sid. This problem could have been minimized if Bob had:
  • Prepared an estimated tax return before the deal was closed, and
  • Timely completed the tax return.
Though there would still have been phantom income for Sid that Bob would have to pay, Bob would have been able to negotiate to pay only for Sid’s tax liability and then put aside the cash for it. Luckily for Bob, Sid wasn’t concerned about getting a check for all of that income and offered to let Bob off the hook for just Sid’s tax liability. (A good example of why it’s important not to burn bridges on the way out.) Bob still had to come up with a significant amount of cash, but it was only about 30% of what he was obligated to pay. The bottom line for both of these situations is that the tax ramifications of a business transaction should be addressed early – usually before contracts are signed. Whether it is understanding how to structure the transaction to your benefit or a probable tax liability, getting a tax advisor involved at the outset will avoid nasty surprises that cannot be fixed.
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