Potential headwinds are coming — what this means for your business

An abundance of liquidity and market exuberance in the world’s recovery from COVID-19 have made this a promising time for transitioning a closely held business — and yet many owners are still failing to make the most of their business transactions. Of the 250,000 privately held U.S. middle market companies looking to exit by 2030, only 20% will be deemed “market ready,” and only 6% will transact at the desired value.

Planning and taking the proper precautions to achieve market readiness is key. While it can be easy to overlook these proactive tax planning strategies when the economy is hot, the market environment is ever-changing, and headwinds are coming. To plan for the future, it’s important first to understand how the current market is operating, before considering how things may change.

A perfect intersection

To put things simply, we are beyond where we would have anticipated being at this point in the current business cycle. We tend to see a 10-to-12-year window of economic expansion before a contraction, and we have surpassed this window since the last contraction spurred by the 2008/2009 financial crisis. This is due primarily to the Fed’s accommodative monetary policy to stave off what many feared would be a pandemic-induced recession. These policies have laid the groundwork for a fertile market environment, putting owners at the perfect intersection for transacting or transitioning a business for several reasons.

The current low interest rate environment has been favorable for many potential strategic buyers, and the historically low tax rate has made the situation favorable for sellers, too. Additionally, between 50 and 70% of all middle market closely held businesses in the U.S. are owned by Baby Boomers, which has resulted in an excess of owners looking to sell or transition their business to a successor in the near-term. This backdrop has expanded the market and driven significant deal flow.

As a result, we are witnessing record-breaking surge in M&A activity in 2021. PricewaterhouseCoopers reports that the first half of 2021 saw a continuation of the growth in deal size, contributing to record global deal values in excess of $1 trillion per quarter over the past 12 months. That said, to maximize value from a deal, there needs to be a greater focus on M&A strategies to accelerate growth and gain scale.

The question remains: Will the current environment last for much longer? And how can business owners prepare for any shifts that could be coming?

Potential headwinds

Several headwinds are coming that business owners must take note of and build into their planning:

Tax increases: Taxes and tax planning have always had an impact on transactions, and it’s likely to become more important in the future, both in the short- and long-term. Needless to say, this potential increase could make selling a business less desirable, and it would also increase the importance of tax strategy to maximizing what business owners walk away with from a deal.

Irregular business performance: The pandemic fundamentally altered how many businesses performed. Some industries were bolstered by the crisis (e.g., tech, healthcare, online retailers, pharma), while other sectors were pummeled (e.g., leisure, travel, restaurants). We have interacted with buyers that have questioned the performance sustainability among businesses that boomed during COVID-19. For instance, many buyers have asked, “How much was situational, and can growth at the pandemic pace continue?” On the flip side, we witnessed — and are continuing to witness — other situations where businesses saw their performance fall in COVID-19, leading to low-ball offers from acquirers. Accounting for this irregular performance will remain increasingly important for businesses looking to transact.

Liquidity drying up: As we emerge from COVID-19, we will likely see a pullback of the Fed’s accommodative monetary policy over the next year. In an unprecedented move, the Fed was able to keep the economy moving during the pandemic with low interest rates and their asset purchasing program which pumped liquidity into the market. Rising rates and the pullback of their asset purchases will mean less access to capital or debt for businesses, which could, in turn, lead to a potential economic slowdown. This slowdown could impact a buyer’s willingness to put up capital for deals, potentially leading to lower offer and cheaper deals, because the economy is causing sellers to move forward faster and take less offers.

Inflationary pressure: A pullback of this accommodative monetary policy would likely come with an interest rate hike that could impact the ability for business owners to get deals done, since most deals are leveraged buyouts. The prospect of high inflation in the near future, due in part to the supply chain disruptions and bottlenecks affecting many sectors, could also lead to the immediate impact of lower revenue on a balance sheet and a higher cost of goods, which could make selling undesirable.

How to prepare

Deals will still happen, despite these headwinds — the difference is that transactions could end up yielding smaller and less aggressive offers. With these factors in mind, a proactive approach to business succession planning to more important than ever before, including:

Strategize early – If you are thinking of selling your business in the next five years, you should start thinking through your strategy now — if you haven’t yet already. For many business owners, this thinking is often prompted by an unexpected offer. If that’s the case, consider whether the proposed deal is set up to maximize value.

Prioritize tax planning – It’s not so much about what you are actually offered in the deal; it’s what you take out after taxes that matters. With that in mind, taking the proper precautions and applying proactive tax strategies before new legislation takes hold will be key. This could include:

• Assessing the state and federal income tax that the business is paying and what will be paid when the business transacts.
• Optimizing corporate structure to minimize liability.
• Taking steps to drive down state income tax, such as moving business assets across state lines or classifying income as non-business to avoid state income taxes, while still residing in your home state.

Determine the optimal outcome – Doing your best to integrate personal and business strategy will allow you to carve out the best possible outcome in any situation, despite the impending headwinds. Ask yourself, “What is the number that I need to take home to sustain my desired lifestyle and create my legacy?” A financial advisor can help you determine this figure if you don’t know where to start or get stuck in the process.

If you are looking to sell or transition your business, take the opportunity connect with our team at Key Private Bank to help chart a roadmap.

Paul Kieffer CPA/PFS, CFP ®, CLU, CGMA, is senior vice president, regional planning strategist for Key Private Bank. He can be reached at (716) 819-5581 or [email protected].

Any opinions, projections or recommendations contained herein are subject to change without notice and are not intended as individual investment advice. This material is presented for informational purposes only and should not be construed as individual tax or financial advice. KeyBank does not provide legal advice. KeyBank is Member FDIC. KeyCorp. © 2022.         CFMA #220125-1411623

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