Q&A . . . With John Korschot

Q: We’ve seen the stats suggesting two-thirds of small business owners plan to sell within the next two years. Is that in line with past rates of succession? If not, how is it differing?
A: That time frame seems too short. If  you’re thinking in terms of two-thirds, that’s probably going to require a longer time period. I don’t know that it will be all that many selling in two years. It’s possible, I would say that, but it takes time. A lot of times what happens with owners, if things are going really well, they don’t want to sell because ‘Hey, things are going so great, I’m making good money.’ But if things are going poorly, again, they don’t want to sell, because ‘things are going to get better, so I should wait to get a better price.’ It’s almost like they have to get to the point where they’re just exhausted and say ‘OK, I’m just going to get this done.’

Q: So there’s a risk for some of trying to extend their ownership until more favorable conditions emerge, at precisely the point in life where their energy levels and engagement may be diminished?
A: That does have an impact, and it works its way into succession planning issues. A lot of times, what we find is owners don’t want to hire high-enough-quality people to take the place of what they themselves have been able to do. They find themselves without succession management that’s where it needs to be. It puts them in a bad spot. They need to spend more time thinking about bringing people along capable of running the business. When they sell, in a lot of cases, buyers want to have that management continue in place. In other cases, if you think of private equity, they are going to come in and they’re going to turn it into a branch or part of another entity, so they’re not as concerned about management depth because they’re going to change everything. That happens a lot.”

Q: Within the Baby Boom generation, specifically, what are you seeing?
A: The Baby Boomers are retiring and so many of those business owners will need to sell or gift their company to the next generation. The time has slowed some for selling the businesses because of the delays due to (1) the pandemic, (2) the supply-chain disruptions and (3) the forecasted recession and interest rate hikes. Business transitions occur as circumstances for the business change (aging of the owners, market changes, rollups, etc.)  The amount of money in private equity is significant, so that has accelerated the interest in buying businesses. Private equity is more value oriented now vs. the past.

Q: Is there any change in the level of pushback some owners might have when they realize the up-front costs for the trusted advisers needed to do a deal—the accountants, the lawyers, the valuation specialists and the like?
A: Once they get serious about it, they will bite the bullet and interview folks and negotiate the best deal they can. Early in the process, it can be a bit shocking in terms of how much it’s going to cost between everybody involved. But if the owners are going to sell, they need to have great advisers, and at that point, generally they pay and should get a good value for the business.

Q: Has there been any change in the ratios of strategic vs. financial buyers’ motivations?
A: Not sure I see a lot there. Strategic buyers, public companies trying to add on acquisitions, or private equity doing rollups, they’re trying to find additional businesses to add, so they may pay more of a strategic price because it fills out a territory or footprint they’d like to be in. But a lot remain financial buyers, they look at how much leverage they can put on a business, they look at cash-flow generation, to provide that rate of return.

Q: How are valuations trending? Is the supply of potential acquisitions holding down prices?
A: Valuations remain strong, depending upon the business. Financing costs have increased, which tends to lower values, but the private equity money is considerable. The public market has been strong, which tends to support private valuations. Public company acquisitions of private companies have slowed down.

Q: Are you seeing some sectors that are strong performers right now?
A: We’re definitely seeing that. As an example, in the whole construction-related space, the architectural, the engineering, the construction companies, both general and specialty, all have record levels of backlog because of all the building going on, not necessarily in office, but data centers, EV battery plants and the like. Those values in the public market have gone up. That tends to push up prices in the private market, too.

Q: Any others?
A: Manufacturers, they seem to have held up nicely, with value multiples that are reasonable where the businesses are generally doing pretty good. As I mentioned, the rise in interest rates has slowed things down some, but nobody is really complaining about a recession, except for the trucking companies.

Q: Are those the ones hurting most?
A: They’re suffering because freight rates are coming down. They have trouble getting people; truck drivers are really hard to come by and keep. Those businesses with a high degree of financial leverage, a high degree of operating leverage, they have to be careful in a downturn in terms of how that’s affecting the business. Others are where you’ve seen a deterioration of  fundamentals. Example: Radio. Those public companies have been decimated in terms of valuation because of podcasts, Sirius, different avenues for people to listen to things. The overall media space is in tumultuous times. Major media companies are still trying to figure that out.

Q: Are there any innovations (employee ownership, etc.) that are trending up for owners that are having a hard time finding buyers?
A: ESOPs should always be a consideration for a change of ownership. They provide tremendous tax benefits, but they require patience and respect for the process to be successful. A sale to an S- corporation ESOP results in generally no corporate taxes being paid by the company post transaction. That increases the cash flow available to service debt. The seller can get installment sale treatment if they take back a note. A sale to an ESOP of a C-corporation allows the seller to elect 1042 treatment, which can result in a deferral of taxes on the gain. They can reinvest the proceeds in qualified domestic securities and the basis will carry over.

Q: Where’s the sweet spot for ESOPs?
A: Most companies with greater than $5 million in revenues and 20 or more employees should explore the ESOP opportunity. There are some challenges because of the Department of Labor’s scrutiny of these transactions. Get an ESOP attorney early on is a good suggestion.

Q: Some surveys suggest that two-thirds of owners do not have succession plans in place at all. Can you walk them through the first 1-2 key steps they have to take to start that process?
A: A succession plan is very important which takes a lot of thought. What does the owner hope to achieve by selling or gifting the business (their advisers can help in this process, CPA, Attorney, Valuation firm, etc.) The owners need to make sure they have good business records (a Review statement by a CPA firm would be helpful). They should run the company like a business so there are as few adjustments as possible to the financial statements. Determining the value of the business is important. An independent appraiser can assist in that by performing a calculation report that can be used as part of the negotiation process. Owners can hire a business broker or investment banker depending upon the size of the business or they may have some thoughts about who might be interested in the business and contact them.

Q: What can owners do (as with AI potential, for example) to position their company to sell to someone who can see the new opportunities that might exist, rather than the historical business model for that company?
A: Why do businesses exist in the first place? Basically, to find a need and fill it. I like the idea of a business that uses its expertise to expand in areas they know so they do not try to wander off into unrelated opportunities. AI will be used by businesses of all kinds, and we are just finding out what that might look like. Businesses are valued based on the future (cash flows are critical) so a plan for growing the business is so important. The historical performance is a track record, but the important thing is how they will perform in the future. Earnings power and stability of earnings are something investors are looking for. Companies need to be up to date on technology which may include AI in order to maximize the value of their business.

Q: Are you seeing any changes in the timetables for sales, from first listing to execution?
A: Deals can take a long time depending upon many factors. There may be some slowing because of financing that may be more of a challenge, economic uncertainty, interest rate levels, and the election. Due diligence is taking longer because CPA firms have some shortage of employees.

Q: Is there anything outside these areas that you believe owners and prospective buyers ought to be thinking about at this point in the business cycle?
A: Well, I think that the M&A environment will continue to gain strength after the election. With the decline in interest rates and a reasonable economy, it should be a good time to sell. If corporate tax rates increase, then valuations will be negatively impacted. Owners need to think about gifting their shares (if that is part of the plan) because the estate tax exemption will expire in 2025 so many business owners may be subject to estate taxes ($13.6 million vs. approximately $7 million beginning in 2026). All businesses are sold, whether the owner is alive or not.