When the Federal Reserve started raising interest rates in 2022, the small business acquisition community quickly recognized the potential ramifications of this decision. Our conversation with Jared Johnson highlighted the initial reactions, and today, over a year later, we have enough perspective to re-evaluate how the small business acquisition landscape adjusted to the new paradigm.
The impact of rising interest rates has been particularly pronounced in the real estate sector. The resurgence of 8% mortgage rates has triggered the lowest mortgage demand in three decades, a situation that is further exacerbated by the historical under-building that followed the 2008 financial crisis, creating a supply shortage. Potential buyers have been hesitant to accept such high rates, while sellers are reluctant to trade low-rate mortgages for higher ones. While there are numerous underlying reasons for the sluggish market facing real estate investors (and many high-quality articles have been written on the subject), our expertise is in the small business M&A market, where activity has been stronger.
How the SMB Buyers Adapted
While the small business acquisitions sector has certainly seen its share of challenges related to rising interest rates. Loans that would have easily met debt service coverage tests in 2021 are no longer viable in the current environment. Additionally, the availability of strong yields on treasury bonds has anecdotally cooled investor interest in riskier investments. However, buyers have adapted their strategies and expectations, supporting resilience not seen in other segments of the economy. The market is witnessing growth in innovative deal structures, supported by changes to SBA rules, which are helping offset the impact of high interest rates in our industry.
The IBBA Q3 report notices a significant rise in alternative financing methods like seller financing, earn outs, and retained equity, often at rates more favorable than those offered by banks. While broker confidence has declined, reflecting broader market uncertainties, the stability in transaction multiples and increased client pipelines indicate that the market is adapting effectively. Multiples remained stable overall, with minor fluctuations within specific transaction ranges. Intermediaries anticipate business valuation multiples to either remain unchanged or rise, which could suggest that the divergence between buyer and seller expectations will continue.
The Rise of Seller Financing in a High Interest Rate Environment
Seller financing, a form of financing where the seller acts as a lender to the buyer, has emerged as a lifeline for small business acquisitions. For example, on a $3,000,000 business, a buyer would have had to likely put down 10% from personal and/or investor funds and finance the remainder with an SBA 7a loan. This year, depending on the amount of cash flow available to pay debt service in the business, high interest rates make the buyer’s debt service payments higher on the same $2.7 million loan than they would have been two years ago. In some cases, this means that the forecasted debt service coverage fails to meet bank requirements, which can be 1.25 or even 1.5 times in order to make a loan. Seller financing can provide help for deals on the edge. If the buyer and seller agree to do $1 million of seller financing for this deal at an interest rate lower than the bank rate, the the monthly debt service payments on a $1.7 million SBA loan would be lower versus the full SBA loan scenario with 10% down.
There are ways to make this process even more accessible, such as the use of full standby seller financing. In cases where a seller is struggling to close their deal, they may agree to defer all payments on their seller note until the maturity of the SBA loan, even further reducing debt service payments during the life of the loan.
Buyers can now use seller financing to cover the 10% down payment requirement, according to the changes to the SBA 7a program rules, as long as that portion of the seller financing is deferred for 2 years. While this seems to indicate that it would be possible to buy a business with “zero down”, many SBA lenders will shy away from these structures unless debt service coverage projections indicate that the business can cover the full loan, despite the deferral. We recommend that buyers engage multiple SBA lenders and be transparent with sellers on deal structure as early as possible. If you plan on using seller financing, be prepared for seller due diligence efforts on the buyer, which might include credit checks, reviewing business experience, and even securing personal assets as collateral.
Sellers are incentivized to opt for seller financing since this can bring several advantages for them, like lower taxes, as they’re only taxed on received payments, a higher selling price (up to 20%-30% more than all-cash deals), and a faster sale process. Amortization in this context refers to the structured repayment of this loan over time. Seller financing becomes a strategic option for both buyers and sellers to facilitate sales and maintain market dynamism despite financial constraints, being particularly influential in sectors with fluctuating prices, like manufacturing, which saw a 28% rise in median sale price (partly due to a shift to domestic production). In contrast, the retail sector experienced an 18% drop in median sale prices, with entrepreneurs using seller financing to manage costs and weaker performance.
As the market adapts to these conditions, seller financing is seen as a way to bridge the gap between buyer and seller expectations, providing assurance to both parties and facilitating smoother transitions. The trend of business owner retirements is expected to increase the adoption of seller financing, helping seamless business transitions.
Increased Pressure on Price
Another adaptation of the small business acquisition market is on acquisition multiples. According to some sources, they are currently averaging between 3.2x to 4x, lower than the previous 5x highs. While strong businesses with robust fundamentals continue to garner higher valuations, the mid-market segment faces challenges coming from complex debt structures and rising operational costs. The market is quieter in the under $3MM EBITDA space, partly due to owners having higher valuation expectations from previous offers. Acquirers are adjusting, seeking to compensate for previous overvaluations, with competitive buyers offering more strategic terms to entice sellers.
Practical Takeaways for SMB Buyers
Considering this context, let’s extract some practical and strategic solutions that can help buyers to effectively navigate high interest rates in the current SMB acquisitions landscape:
- Creative Financing: Along with seller financing, it is worth exploring earn outs and retained equity. Earn outs involve additional payments to the seller based on the business’s future performance, aligning the sale price with actual results. Retained equity allows sellers to keep a stake in the business, offering potential future gains while reducing the upfront cost for the buyer. All these options can potentially provide more favorable terms than traditional bank loans.
- Valuation Expectations: Cash-rich buyers can seize opportunities in the current market. While expectations for multiples continue to be high, depending on how long the high interest rate environment continues, sellers may become more motivated to sell, and buyers with substantial liquidity or favorable acquisition structures may be able to acquire assets at lower valuations.
- Strategic Positioning: Especially for buyers targeting the $1-3MM EBITDA range, adopting a strategic approach can bring benefits in the current landscape. This means offering clear, straightforward terms that reduce the complexity often associated with financing deals. This approach is beneficial in a market where stressed-out sellers might be seeking certainty and ease in transactions.
- Opportunistic Prioritization: Prioritize businesses with strong key performance indicators (KPIs), as they are more likely to sustain higher bank payments, providing post-acquisition stability and reducing the risk of financial strain or bankruptcy. However, keep an eye for great opportunities among businesses adjusting to lower valuations in the current market.
- Adapting to Market Dynamics: Stay informed about sector-specific trends, particularly in real estate, manufacturing, and retail. Especially in the current times of rapid new developments and trends, being aware of the market context becomes even more important for anticipating and navigating potential surprises in the SMB acquisition process.
As always, please do your own research and consult with investment professionals, as well as accountants and lawyers before making any major financial decisions. These articles are provided for informational purposes only and do not constitute financial or legal advice.