Inflation, Valuation, and Selling Your Business

I have had nearly the same question in my last three meetings with business owners, “how will inflation/potential inflation impact the sale of my business?”  This question can be tricky, and at times, the answer depends on the type of business in question. This conversation can be complicated, sometimes starting out as an economic discussion and then morphing into a political one — which I have no interest in having.  But let’s try to lay out the impacts without getting too deep in economics and avoiding politics altogether, shall we?

Busines owners have had to deal with a lot recently.  When we sell a business we need to try to eliminate the impacts of COVID, PPP loans, and we need to talk about how supply chain issues impact the business.  Now there is a new issue to think about — inflation. Most businesses have probably felt the impact of inflation or, if not, will feel it soon.

Classic economics tells us that anytime you pour money into the economy you will have inflationary pressure. During COVID, the economy had lots of “free” money through relief programs, the government buying securities (more money in the system), the ability to obtain loans were plentiful, and there were subsidies.  There was/is a LOT of money floating around to buy things. The aim of these policies is to keep interest rates low while encouraging economic growth. Growth happens because more money = more demand.

Add to this an environment where factories have experienced supply chain issues, labor shortages, and higher commodity prices creating production slowdowns or stoppages = less supply.

Finally, there is a lot of evidence that suggests that when people weren’t traveling or going out to eat, they saved a lot of money. COVID restricted this type of spending and people instead have decided to spend that money on “things” instead. Even MORE demand.

And now we have the perfect petri dish for inflation.

Inflation has a very negative connotation. In the 1970’s, mortgage rates in the high teens and Latin American horror stories, have some of us experiencing inflation-related PTSD.  However, inflation balancing out growth is part of having a strong economy, and it isn’t always a bad thing.

Now to the question of inflation and M&A — “what does all this mean for me, the business owner who is thinking about selling?”

1. Remember that we are selling future profits when we sell a business

Higher margin businesses sell for higher prices. The more profit a business makes, the more it will be worth. If inflation is impacting your profits and you are not able to pass price increases along to customers, your business will be worth less.

2.  Businesses are worth more when they are growing

If inflation, labor shortages, or commodity prices have caused your business to grow more slowly or flatten out, this could negatively affect the projected growth rate that is applied to your business. Given that the single most sensitive cell in our valuation model is the projected growth rate, this will result in your business being worth less. 

3. Valuations are ultimately driven by expected returns to the buyer

Right now, interest rates are very low, so investors aren’t putting their money in bonds and there aren’t as many places to put capital with low levels of risk. Buyers are willing to accept lower rates of return on other investments when there are few places to get a decent return at all (low return for them is created when they pay a higher price for a business with an expected set of cash flows).  When interest rates increase, however, they will begin to demand higher returns on other investments, and that is created by paying less upfront for companies that they buy.

4. Lower interest rates mean cheap debt

Central banks combat inflation by raising interest rates. You have probably heard chatter about this recently. Central banks keep rates low when they want to encourage growth. During COVID and the recovery, governments wanted growth — so they kept the rates very low. All signs point to the Fed keeping interest rates low through the next couple of quarters, but eventually they will have to increase them.  

Low interest rates mean cheap debt — and before you say, “who cares about debt?” — let me stop you and say, “buyers care about debt — a LOT.” Buyers use debt to finance the purchase of businesses, and when it is more expensive, their returns go down. And how do they combat low returns? They pay less for companies.  

5.  All valuations are based on the buyer’s thoughts on the future

Most buyers (unless they are hedge fund wiz kids) are not terribly creative with their thinking about businesses. If buyers see the economy growing, they think businesses will generally grow. If they see economic turmoil, they bring that thinking to their valuations. If inflation causes the Fed to raise interest rates and slow down its quantitative easing policies, growth could slow, bringing the current high valuation vibe to a halt.   

To summarize, this is an excellent time to sell a business — valuations are high, debt is still relatively cheap, and the economy is growing.  However, inflation can quickly cause this environment to erode. Also, remember that the process of selling a business (done the right way) takes about 6 to 8 months. All this points to moving quickly to sell your business if you were thinking about it in the next year or so. Some businesses, those with very steady cash flows and in an industry that continually grows even if inflation persists (think I.T., SAAS, telecom, some inelastic food items), should continue to enjoy high valuations.  However, most businesses, especially those with heavy capital expenditure requirements, will feel a material valuation change in an inflationary environment.