This is Part 3 of a 3 Part series in which we explore bringing a business to market and offer a framework that owners can use to determine their optimal sale timing. Part 1 discusses the application of forecasts for sale timing, and Part 2 covers personal factors that often drive owners to consider selling a business.
Fundamental Factors Are Important For Sale Timing
In a perfect world, business sale timing in 2024 will coincide with peak performance across the economy, an industry, and an individual company. This alignment of factors will not only increase the odds that a deal is completed, it will also provide an optimal backdrop for achieving a most competitive valuation.
But as we covered in Part 1 of this series, economies are cyclical and attempting to time cycles is not an exercise for the faint of heart. Some of the world's best investors, for instance Warren Buffet of Berkshire Hathaway and Howard Marks of Oaktree Capital Management, contend that market timing is nearly impossible due to the unpredictable nature of future events.
Instead of attempting to pick market tops, sellers should endeavor to receive offers that represent a fair value for the business and that match the seller with the appropriate type of buyer.
Understanding the River Current: A Three Factor Framework for Assessing Sale Conditions
In this post we’ll use a simple framework to help identify conditions during which the odds of receiving a fair value offer, and closing a deal, are in the seller’s favor.
We can think of market cycles like a current in a river. When the current is behind us, we have good business sale conditions, and when the current is into us, we have more challenging sale conditions, albeit not always poor sale conditions. The odds of a favorable deal outcome increase when the current is behind us. Thus, understanding where an economy is in the cycle, but not predicting where it will go, will serve as an important input in the timing of a sale process. We'll use a top-down approach to assess high-level economic trends, then work down to industry level trends, and finally company level trends. The three factors that we'll use to measure the hypothetical current are:
Factor #1: The Broad Economy
Deal Activity is a Proxy For Macroeconomic Trends
The top-level of analysis takes place in the broad economy. Trends in the broad economy are a formidable force in determining how accommodative the market will be for a business sale. The list of factors that impact the economy are many and a proper assessment of these factors is best suited for a PhD dissertation rather than a guide to sale timing in 2024. Because a granular analysis of these factors is beyond the scope of this write-up, we’ll simplify the exercise of analyzing broad economic health by narrowing in on merger and acquisition activity as a measure of the prevailing economic trend.
Merger and acquisition activity is a key economic indicator that’s meaningful for owners contemplating a sale and that serves as a proxy for economic health. When an economic outlook sours, several factors create challenges for deal making. Corporate buyers and private equity buyers, concerned about taking excessive risk during periods of uncertainty, will slow the pace at which they acquire companies. Concurrently, transaction financing becomes harder to access as lenders, a key source of capital for acquisitions, shift to more stringent credit underwriting criteria.
When Bid-Ask Spreads Widen, Transaction Volume Slows
When an investor (corporate buyer, private equity buyer, lender, etc.) perceives elevated levels of risk, they will seek methods to address the risk. During an economic slowdown high levels of growth are not projected, so investors turn to valuation adjustments as a risk mitigant. By adjusting lower the price at which the investor is willing to transact, the investor is partially, or fully, offsetting the risk of investing with a weak economic backdrop.
In turn, if seller valuations have not declined to match the reduced buyer valuations, a gap is created between the price a buyer is willing to pay and the price a seller is willing to accept. This gap, known as a bid-ask spread, can cause in-flight sale processes to stall, or cause new sellers to forgo starting a sale process altogether. The net result is fewer completed M&A transactions. Using the river current analogy, a reduction in deal activity is analogous to lacking the support of the current.
Finding M&A Deal Data
Where can one find merger and acquisition deal volume data? A quick internet search will point to a myriad of investment banking reports and data vendors detailing trends in mergers and acquisitions. For those who would like direct access to data, White & Case, a global law firm with specialized merger and acquisition advisory experience, makes available a free M&A database here. Pitchbook is another data source frequently referenced by professionals in the M&A field. Although full access to Pitchbook’s research requires payment, the company offers a number of free reports.
As Capital Has Flowed to M&A, Deal Volume Has Benefited
The past ten years of merger and acquisition activity have benefited from an expanding pool of capital, particularly as private equity led transactions have grown as a percentage of total transactions. According to data from Pitchbook, North American deal volume reached a record high in 2021, with 20,234 transactions completed that year, totaling $3.0 trillion in value. Although 2022’s 18,158 transactions represent a year-over-year decline in deal volume, activity in 2022 remained above pre-pandemic levels. As prospective sellers contemplate when to bring a business to market, analyzing trends in M&A activity to form an opinion about whether the hypothetical current is with them, or against them, will help the seller increase the odds of closing a transaction.
Trends in quarterly deal volume, both year-over-year and quarter-to-quarter trends, are a good place to start. Due to some volatility in deal data, the absolute level of deal volume is also an important metric to consider. The top figure below displays quarterly merger and acquisition activity in North America, and the bottom figure displays the year-over-year change in North American quarterly merger and acquisition activity.
Factor #2: Sector and Industry
The Difference Between an Industry and Sector
The next focus in our top-down approach is on the seller’s industry. But before we discuss industries, let’s briefly touch on sectors. An economy is split into sectors, examples of which are technology, financial services, manufacturing, and energy. Sectors represent large swaths of an economy. For instance, according to the Department of Commerce, in 2021 the manufacturing sector contributed $2.3 trillion to US gross domestic product (GDP), or 12% of GDP. Gross domestic product is a comprehensive measure of total US economic activity.
Sector level analysis is useful but sector trends may mirror those of the broad economy. We desire a more granular level of analysis that’s focused on a specific portion of a sector, which brings us to industries. Investors are typically analyzing trends at the industry level. Industries are a component of a sector. Examples of industries within the manufacturing sector are furniture manufacturing, automotive manufacturing, and computer manufacturing. These industries can be further divided for even more focused analysis. For instance, furniture manufacturers can be divided into those groups manufacturing for the retail market (think home furniture), versus those manufacturing for the business market (think cubicles and other office furniture).
The Importance of Relative and Absolute Performance
Each industry will have unique trends and forecasts. Sellers should understand the absolute performance of an industry, as well as the relative performance of the industry. Absolute comparisons measure an industry's current performance against that industry’s past performance. Relative performance measures the industry against adjacent industries within a sector, for instance comparing retail furniture manufacturers to office furniture manufacturers. Absolute and relative measures of performance offer insight into two key factors required to understand the industry’s river current.
A standalone industry that’s growing and receiving institutional investment is likely to have consistent levels of merger and acquisition activity. This activity can produce a supportive backdrop for a sale process.
An industry that is outperforming other industries within the sector will further warrant consideration from investors who seek the highest return on investment.
Industry Profitability Plays an Important Role in Investor Thesis Development
An analysis of industry profitability will also yield important information for sellers. Not only do profit levels have implications on valuation, but they will also dictate the types of investors that may be suitable for a specific industry. Technology investors, for example, have long supported software businesses that are not profitable. The reason some technology investors are comfortable funding cash-burn (lack of profit) stems from software’s unique unit economics. Software has high gross margins and low incremental capital investment requirements per dollar of new revenue. Stated plainly, software is built once but can be sold thousands of times.
Some investors are comfortable with a lack of profit early in the life of a software business because the expectation is that superior unit economics (low cost of producing an incremental unit) will swing these businesses to profitability as they scale. This profile is unique and attracts venture capital investment and some late-stage growth equity investment. Conversely, a traditional private equity fund would prefer industries that are cash generating given private equity’s use of debt to fund acquisitions, and the need to service interest and principal payment using cash flow.
Resources Used to Conduct Industry Analysis
How can prospective sellers analyze an industry? Banks publish several useful quarterly updates that detail industry performance, including deal activity within an industry, valuation trends within an industry, and key factors that are driving the performance of the industry. A Google search for these reports will yield a number of results, primarily from investment banks.
For sector level performance, a useful benchmark are the sector ETFs offered by SPDR. ETFs are Exchange Traded Funds that offer a balance of liquidity, diverse investment exposure, and lower fees than mutual funds. Sector ETFs are baskets of related companies, and the performance of these ETFs can serve as a proxy for absolute and relative performance. The chart below shows the one-year performance of 11 sector ETFs through December 2023.
Industries that are growing, profitable and have favorable supporting performance factors are akin to having the current at the seller’s back.
Factor #3: The Specific Company
Arguably the Most Important Consideration
The lowest level consideration in our top-down analysis requires an exploration of the specific company. In a top-down framework, one may find it odd that the company, which is the reason you’re here at all, is the lowest level factor. In this case, lowest level doesn’t mean least important, but instead is a testament to the way many investors approach investment selection.
Institutional investors tend to be thematic, meaning they narrow focus on a select number of industries that have favorable conditions for growth or cash generation. Just as a business sale process is best supported by favorable economic and industry conditions, an investor's return prospects are similarly enhanced by seeking alignment with favorable economic and industry trends. If an industry is facing particularly challenging headwinds, investors are less likely to get comfortable with contemplating a deal at the company level.
An Object in Motion Stays in Motion
Industry trends aside, the company’s recent performance, typically defined as the past three years, is a key component of assessing whether a business is well positioned to go to market. Revenue growth will ideally be steady and compounding, with sticky customers and limited levels of customer concentration. Cash generation, measured via a metric known as earnings before interest taxes depreciation and amortization, or EBITDA, should be steady, or expanding as revenue scales.
Just as absolute and relative performance are important for industry analysis, these two measures are also a key input in assessing the health of a business. Absolute performance will measure the business against its historical results, while relative performance compares the company to others in its industry. This is especially important when comparing your business to competitors that are similar in size and that serve a similar set of customers. If investors are analyzing two businesses with similar profiles and that are operating in the same industry, they will likely opt to explore the higher performing business of the two.
Management Depth is a Big Positive for Acquirers
In addition to fundamental performance, a company should assess management depth and operating systems when contemplating sale readiness. A lack of management depth creates key person risk, meaning that when the owner goes, so too may the key ingredient in the business’s success. Preparing a bench of talent is very important for a business that’s contemplating a sale, especially when considering a private equity partner.
A business with favorable financial trends, such as consistent year over year revenue growth and steady, or growing, levels of cash generation, checks an important box for sale readiness. Furthermore, if that business has sound management depth and strong operating processes, then the company can gain conviction that the odds of a sale process benefiting from the hypothetical river current are increased.
Tying Together Economic Factors
If the economy, the industry, and the company are all facing adverse currents, a seller must step back and ask if a deal is realistic, and if so, if the seller can achieve a fair value for the company. If one of the three currents is favorable, the odds begin to shift positively. If two of the three currents are favorable, the odds are further increased, while if all three are favorable then the odds are greatest that the economic timing for a sale is appropriate.
Outcomes Are Not Always Indicative of Process Quality
It's important to note that a perfect confluence of economic factors does not guarantee that a deal will be completed. Selling a business is a challenging endeavor. One of the difficult realities of the sale process is that the outcome is not always indicative of the quality of decisions related to the sale process. Even with the best timing, there’s no guarantee that a transaction at a fair value will take place. Thus, the best course of action is preparation, plus an attempt to understand when the odds are in the seller’s favor and to act while the odds are favorable.
Although preparing for a sale and understanding currents does not guarantee success, it does mean that the seller ran a disciplined process and took the right steps to put the odds in their favor. This is the appropriate path to take and, although a broken deal process is painful, should provide comfort to the seller that the known variables were thoughtfully considered.
Closing Thoughts on Selling a Business in 2024
In Part 1 we explored the challenges associated with forecasting the year ahead. Even the most qualified economists and analysts have historically struggled to predict economic outcomes. Thus, we submit that owners are best served by assessing personal factors, preparing in advance for the sale process, and analyzing economic and industry trends to assess the health of the backdrop for the sale process.
In Part 2 we covered five personal factors that may drive owners to consider selling a business. While personal factors are often not glamorously regarded like some economic factors, they are a crucial input for sellers due the implication on timing. If an owner has a sudden personal need to sell and should the business not be prepared for a sale process, a failed attempt to sell a business can have grave implications on factors such as retirement or saving for expenses (college tuition, healthcare, etc).
Finally, in Part 3 we introduced a framework that owners can use to assess the economic backdrop and to decide how this affects the odds of completing a sale. The broad economy, the industry, and the business are the three components that dictate our hypothetical river current. The more factors in the seller’s favor, the stronger the current and the higher the odds are that fundamental factors support the deal process.
