Navigating Succession When Rates Move Lower
Succession planning is a critical element of a business’s exit strategy, but how do fluctuations in economic conditions impact the planning process? The Federal Reserve’s September 2024 rate cut lowered the Fed’s target rate by 50 basis points (one-half percent) to a range of 4.75% to 5.0% and is the first rate reduction since March 2020. In a declining interest rate environment there are a number of unique considerations for business owners who are contemplating succession. Declining interest rates can influence many aspects of a business sale, from valuations to financing and overall financial management. This post will explore three key considerations for navigating succession planning in such an environment.
Consideration 1: Financing Opportunities for Buyers
Impact of Lower Interest Rates on Financing
One of the most significant impacts of declining interest rates is the increased availability of affordable financing for buyers and successors. When interest rates are declining, the cost of borrowing decreases, which can open up a variety of financing options that may not be as accessible during periods of higher rates. This is especially relevant for business succession plans that involve the sale of the business, implying an acquirer will need to secure funding to buy the current owner’s equity.
Leveraged Buyout Activity May Increase
Just as the buyer of a house will use a mortgage and equity (i.e. their cash) to purchase a house, business buyers often rely on a loan and equity to purchase a company. In many cases, succession plans may involve the use of leverage to finance the purchase of the business regardless of whether the acquirer is internal, such as an employee, or external. Just as a mortgage borrower’s personal cash flow dictates the size of the loan, the business’s cash flow will be a key input for underwriting the acquisition loan. In a low-interest-rate environment, acquisitions become more attractive because the cost of servicing debt is lower, making it easier for the owner to find a successor to take over the company without placing undue financial strain on the business.
Seller Financing
Another financing option that becomes particularly attractive in a declining interest-rate environment is seller financing, which is a loan from the seller to the buyer. A recent survey shows that among transactions below $50M, seller financing represented a range of 5% to 16% of deal value. In a declining rate environment, sellers can offer financing at competitive rates while locking in those rates for the duration of the loan. As rates decline further, the seller benefits from having locked in a relatively higher rate. This strategy not only helps the acquirer by providing a flexible financing solution but also provides the seller with a reliable stream of income from the loan repayment at a rate that may not be available in the future as interest rates decline.
Consideration 2: Business Valuation
The Role of Interest Rates in Valuation
The second consideration for succession planning in a declining interest rate environment is the effect that lower rates can have on business valuation. In addition to the availability of acquisition financing, interest rates play a significant role in how businesses are valued. This is particularly true for a discounted cash flow (DCF) analysis, which is commonly used to determine the present value of future earnings. When interest rates are low, future cash flows are discounted less, which can increase the overall valuation of the business.
Timing the Business Sale
Given the relationship between cash flow discounting and interest rates, timing can be crucial for business owners looking to execute a successful exit strategy. Selling in a declining interest rate environment can be advantageous because if rates continue to decline, valuations may stave off a decline of their own (i.e. declining rates can lead to stable valuations). However, if rate declines pause or if rates begin to rise again, acquisitions may slow as acquirers use higher interest rate assumptions, leading to lower returns (which warrant lower valuations as an offset to higher rates). In the case of valuation gaps between sellers and buyers, a sale executed during a period of low and declining rates could prove to be well timed.
Caution on Overvaluation
While realizing a target valuation is important for sellers, especially those relying on sale proceeds to fund retirement, it’s important to note the risk inherent in optimizing only for the highest valuation. In a competitive merger and acquisition environment, acquirers may submit “stretch valuations” to win a letter-of-intent signature. Stretched valuations can lead to failed closing due to the underwriting perfection inherent in the purchase price. Peak valuations can place immense pressure on the due diligence process to produce stellar findings, lest the buyer uncover risks that diminish support for the elevated valuation. At a more reasonable valuation, these same risks may not lead to a failed deal due to the lack of pressure created by a thoughtful valuation. Since due diligence findings rarely come back flawless, business owners should be cautious and avoid letting artificially high valuations set unrealistic expectations that could derail the sale.
Consideration 3: Balance Sheet and Financial Management
Finally, business owners should consider the impact of declining interest rates on their company's balance sheet and financial management. As part of any succession planning process, it’s essential to review the company’s debt structure and overall cash allocation approach to ensure the business is positioned favorably for transition, and that the company remains financially healthy post-transition.
Review Cost of Debt and Consider Refinancing
In a declining interest rate environment, it’s a good time to review any existing debt on the company’s balance sheet and explore refinancing options. Lower interest rates can provide an opportunity to reduce borrowing costs and improve cash flow, which will be advantageous for both the current owner and the successor. Refinancing existing debt at lower rates can increase the cash flow of the business, making it more attractive to potential buyers, or providing extended runway for the current owner to continue operations while exploring the best succession option.
Adjust Cash Allocation
Additionally, business owners may consider adjusting their cash allocation strategy in response to declining interest rates. As savings rates decline, holding large amounts of cash becomes less attractive because it generates declining levels of return. Business owners should evaluate alternative ways to deploy cash. This might involve investing in growth opportunities, adding key management team members, or using the capital for other strategic purposes. For successors, proper cash allocation will be essential for maintaining business growth and ensuring long-term financial health.
Conclusion: A Declining Rate Environment Offers Many Benefits for Succession Planning
Navigating succession planning in a declining interest rate environment requires a strategic approach that takes into account financing opportunities, valuation timing, and prudent financial management. Lower interest rates can provide significant advantages, from easier access to financing for buyers to competitive business valuations and more favorable debt refinancing options. However, business owners must also remain cautious of overvaluation risks and ensure their financial strategies are aligned with the long-term success of the business.
For business owners considering an exit strategy or succession plan, the current environment could be good for action and to benefit from the transaction support provided by a declining interest rate environment. A well-timed and carefully executed business succession plan can increase the odds of a smooth transition and maximize value for both the seller and the successor.
