Q&A … With J.B. Mason

The managing partner for O’Keeffe & O’Malley, one of the region’s biggest players in business valuations and related services, assesses a marketplace that is regaining traction after the run-up in interest rates.

Q: So as a quick scene-setter, we’d followed the sharp decline in mergers and acquisitions last year and seen reports of a bit of a rebound. What’s the overall landscape in that space halfway through 2023?

A: I think it’s important to note that my firm, O’Keeffe & O’Malley, serves businesses at the intersection of Main Street and the Lower Middle Market. These are companies that will sell for $1 to $50 million and reflects most of the business in the US. 

The massive transactions that you see on CNBC are fairly uncommon. It’s true these transactions have slowed down significantly due to a variety of factors including interest rates. Industry reports indicate that these deals are starting to pick back up.

Q: What about the market for Main Street and Lower Middle Market deals?

A: What we’ve seen in the small to midsize businesses is that the velocity has remained consistent. For quite a while, deals in this space were on an upward trend. That growth may have stabilized, but for reference, industry data indicates that deal velocity in that space was about the same as in previous years. Not growing, but not decreasing significantly. The market for deals in the $1 to $50 million valuation range is healthy. 

I believe this is driven by the tail-winds in the industry, specifically regarding the popularity of Acquisition Entrepreneurship. Over the next 10-20 years we expect millions of successful small businesses to transfer from one generation to the next which is going to be phenomenal for local economies and the next generation of business owners.

Q: Even with the run-up in interest rates since early 2022, aren’t we now just getting back to a place where rates have been as a historical measure?

A: It’s interesting looking at that return to historical levels—normalcy, almost. Historically, rates have averaged about 5 percent, even factoring in massively high rates of the 1980s, but if you look at the last 15 years, we’ve essentially operated in a free-money environment. That’s going to affect valuations; it’s what drove some of the insane IPOs we saw in recent years. But rates historically have been much more similar to what we’re seeing today.

Q: How has that impacted each side of the table during discussions about cutting deals?

A: Investors have to be a bit more disciplined and put more scrutiny on their deals, which means seller’s may need to rein in their valuation expectations. In the free-money environment valuations became bloated, but in the current state we won’t be seeing as many overpriced deals get across the finish line.

Q: Are the trends sector-specific? That is, are businesses in some industries faring better than others in this climate?

A: Businesses that are going to perform the best in any M&A environment are the ones where the seller has taken the time to plan for an exit. In an environment where there is extra scrutiny on a deal or a desire to take less risk, that will be exacerbated. That’s why it’s important to have a strong management bench, systems and processes, modern technology, and organized and consistent financials. Seller’s that have focused on building a transferrable business will have the most success when going to market.

Q: That concept—overpricing—seems odd; you’d think someone astute enough to make a strategic investment or a long-term financial investment would also be navigating toward the best price.

A: It’s important to consider the efficiency of a market. Public stock markets are some of the most inefficient markets in the world and it’s common to see mispriced companies. Look no further than public tech stock prices which have come crashing down in the last eighteen months. The biggest driver of the run-up and recent decline of the stock market was free-money. 

So, in a highly sophisticated market where multi-billion dollar companies are traded publicly it’s still possible for businesses to be overpriced. I highlight this example because we are talking about multi-million dollar companies traded on a private market so you can imagine the potential for pricing discrepancies is even higher.

Q: Can you expand on that a bit?

A: That might be the most sophisticated market, where multi-billion-dollar companies trade publicly, but here, we’re talking about multi-million-dollar companies trading privately, with various investor types—businesses buying out competitors, private equity, all have different goals for the transaction, different returns they’re required to hit internally.

Q: And there are some nonfinancial factors that are part of the discussion, aren’t there?

A: Exactly. We’re talking about owners selling a business that’s often been their life for 20 or 30 years or more. Sometimes, an owner’s expectation of valuation isn’t necessarily rooted in historical multiples or industry-standard multiples, but simply in the fact that they need to retire, and they have a price in mind.

Q: How does that play out during the negotiations?

A: There are a few factors to consider, but let’s come back to the interest rates discussion. Imagine a buyer who is committed to purchasing a business, but the seller’s asking for too high of a valuation. In a low interest rate environment, a buyer may be willing to overpay a bit because they can get competitive financing. However, at current rates, buyers have a much lower willingness or ability to overpay. 

It should be noted that this is a bit of a simplistic way to look at things as price is only one piece of the deal-making puzzle. If either party is sacrificing on price then usually the discrepancy is made up in the terms.

Q: You’ve mentioned the need for longer-range planning on a sale by owners, but when economic fundamentals change the way they have in a comparatively short time, might those efforts become moot?

A: In a rapidly changing economic environment I would argue that planning for your exit is even more important. Timing is a game for the public markets—selling stock, going public, or mega mergers. Selling a small to medium sized business isn’t as much about timing as it is planning. The best thing an owner can do to set themselves up for a successful exit is to build a transferrable business and to start planning their exit. 

Q: What kinds of other factors might not be market-driven?

A: Usually, that’s because you’ve lost a big client, spent too much on a test product that didn’t go well, or just taking your eye off the ball. While an investor will look at the previous five years, the price is usually going to be based off of the most recent 12 months, with a multiple of that performance. If you’ve been consistent the last few years, and steadily improving, that will lead to a higher multiple. If you’ve been inconsistent, with up and down years, that could be worrisome to an investor and may command a lower multiple.

Q: Have current fundamentals changed motivations for sellers to do a deal now, rather than wait, or to wait, hoping for better conditions?

A: As we’ve talked about, rates are just one consideration when selling your business. Honestly, the impact rates will have on the value of a transaction are miniscule compared to the positive effects of properly planning for an exit.

Business owners rarely ever approach us because they’re trying to time the market. Seller’s are usually looking to exit because they want to spend more time with family or pursue a new venture. 

I will point out that timing your exit around business success is an excellent strategy. Some of the most successful exits happen after an owner has spent years executing a strategic growth and then goes to market. Showing years of consistent and improving performance should result in a favorable valuation.

Q: How is all that shaking out with valuations this year?

A: I can be put on a transaction, without getting too deep into the minimum debt-service coverage ratios required. When rates are up, loan payments go up and maximum valuation multiples decrease because buyers must be able to pay the debt with the businesses cash flow. This is only one of many considerations when determining valuation multiples. 

An additional, and in my opinion more important, consideration is the quality of financial performance. Companies with consistent financial performance that’s easy to understand should command higher valuation multiples. I should note that small businesses are usually priced on a multiple of cash flow. So, when I talk about financial performance I am referring to the bottom line. 

However, the biggest issue regarding valuations are still the seller’s expectations. It’s very common, especially in the first few meetings with an owner, for expectations to be a little higher than what the market would command. That’s why we encourage all owners to work with an M&A advisor to get an estimate of their businesses value. That way, there aren’t any surprises when we go to market.

Q: How do you handle owners who feel that, given economic concerns, they might have waited too long to sell?

A: You always want to avoid a situation where an owner is forced to sell. That’s agnostic of the market. You don’t want to be in a situation where the owner wakes up and maybe has a terrible medical condition and has to sell or has been dealing with burnout for years and just wants to go to market. Even in that situation, a good adviser will do everything to maximize the value of the deal. And a good business will sell at a solid multiple. 

It’s important to understand that it will take nine to 15 months to execute a sale, from the initial consultation to closing the deal. Considering an owner is often asked to stay on for a transition period, that could push to 24 months. Sellers could start the process in a bear market and by the time they’ve exited it could be a bull market. Timing is a game for the public markets. Selling small to mid-size companies is not about timing, but about planning. That’s the best thing an owner can do to set up a successful exit: Start planning.