How Economic Business Cycles Influence Your Business Value
There are many factors that go into your decision to exit your business and retire. One of the least understood factors is how the economic cycle works, what influences it and how it can impact your business value. This article explores the basics of macroeconomics using the business cycle model to explain when the best time is to sell and when it is not the best time.
The business cycle model measures Real GDP on the vertical axis and time on the horizontal axis. This cycle can be months, years or even decades.
Real GDP is a macroeconomic statistic that measures the value of the goods and services produced by an economy in a specific period, adjusted for price changes. Essentially, it measures a country's total economic output, taking price changes into account—whether they are due to inflation or deflation.
There are 4 phases of an economic or business cycle (refer to the chart below):
BUSINESS CYCLE MODEL:
These phases are defined by where the economy is as it relates to the long-term economic growth trend
1. Expansion – The economy grows faster than its long-term economic growth (the LT Trend line) until it reaches a peak.
2. Peaks – Where the economy reaches the highest point on a wave then starts to contract (goes down).
3. Contractions – is when real GDP decreases over time – this is a recession until Real GDP reaches a trough,
4. Troughs – is the lowest point in a wave-then it will turn upward again and start over with a period of expansion (also called an economic recovery).
More Definitions:
Economic Recovery – is when Real GDP expands (or increases to the point of the long-term trend line.
Boom Period – expansion that surpasses the LT trend line. This is an inflationary period where prices rise and unemployment decreases.
Bust Period – When the boom is no longer sustainable, the economy goes into a contraction – this is the “Bust” where a deflationary period starts, and unemployment rises.
Levers of the Economy:
It is important to understand that personnel changes in the White House will NOT immediately change the business cycle and economy.
Many people think that the Presidency has major control over the U.S. economy. The office does have influence, but it is quite limited in a Market Economy such as the U.S. The presidents tend to get too much credit when the economy does well and too much blame when it slumps.
The Federal Reserve, which is designed to be independent of political influence, has the most control. The President can appoint the Federal Reserve Chair if the spot is vacant. While the Chair is the spokesperson for the Federal Reserve, the seat only has one vote on the Board of Governors who sets fiscal policy. There are 7 seats on the Board of Governors that serve a 14-year term. By design, the presidency can only replace two seats on the Board of Governors per term with the approval of the Senate.
This leaves the presidency with limited control over Tax, Tariffs and Job Creation to shape the economy, where changes must be approved by both the House and Senate.
Key Economic Levers In a Market Economy:
· Interest Rates (Federal Reserve/Central Bank)
· Money Supply (Federal Reserve/Central Bank)
· Tax Changes (Executive Branch)
· Tariffs on Foreign Imports – which is really a tax to influence buying USA (Executive Branch)
· Job Creation through Federally funded projects (Executive Branch)
The Macroeconomic objectives are to have long-term economic growth, price stability and low unemployment. Governments will attempt to smooth the business cycle curve using the levers to achieve the objectives and have less dramatic peaks and troughs. This represents a “stable economy” where the more pronounced peaks and troughs represents an “unstable economy”.
How Do Business Cycles Impact M&A
An unstable economy will clearly impact the M&A volume. If interest rates are high, money is more expensive and decreased access to financing. When the economy is uncertain, future company performance has more uncertainty and this drives down both deal volume and multiples paid for a business. These deflationary periods will register a notable decrease in M&A volume. The cause can be on both sides of the fence. The sellers may pull back because they are not getting the desired business valuation. Buyers may pull back due to the uncertainty of future financial performance and decreased ROI on a deal. In reaction, Investors tend to hold cash and build reserves.
The sectors that are impacted the most by recession are:
1. Product and commodity related businesses and more prevalent in consumer products.
2. Cyclical Industries such as real estate, manufacturing and tourism.
3. Arts and entertainment
4. Warehousing
5. Accommodation and food services
Certain sectors like power, water and other utilities are inelastic meaning they may see some volume fluctuations but tend to be inflation and deflation resistant and there would be little impact on their business valuation.
Other industries that tend to be recession resilient are:
1. Healthcare and pharmaceuticals
2. Technology
3. Defense and government contracting
4. Financial Services
5. Infrastructure and construction if funded by a Federal economic recovery strategy
When is the right time to sell your business?
After spending years, your blood sweat and tears and probably a lot of your own money, there comes a time when you consider if it is the right time to sell your business. When the economy is booming, M&A activity is very high, many will rush for the exit to try to get the highest multiple for their business. In an uncertain economy like we are in now, the conclusion is likely to retreat and hold your business.
Can you time your exit based on the business cycle? The answer is maybe. If, for example, you are 60 years old, the economy is booming, but you are not quite ready to retire. You may or may not be able to wait out the cycle to get to the next boom period. You may be forced to try to sell in a bust period and receive less than maximum value for your business. This can be dangerous because you may not have adequate funds to fuel your retirement plan.
In reality, economic and industry cycles are only one factor driving your exit strategy. You will be best served by taking a wholistic approach to ensure you sell at the right time for you at the right price.
The decision to sell your business is usually a slow process influenced by several factors. Most business owners don’t wake up one day and say – “I AM READY TO SELL MY BUSINESS NOW”. The decision should not be based solely on economic cycles. It is a very emotional decision. You should first look internally and ask yourself several questions and set goals.
See our article on Exit Strategy Readiness for a complete list of what questions you should have answers to that determines if you are ready to sell. Typical questions are:
1. Do you want a legacy, or do you want a check?
2. How do you feel about your employees and their future at your company?
3. How do you feel about working for a period at your company once you sold it?
4. What value do I need from selling my company to fund my desired retirement lifestyle or new business venture?
5. What is my company worth today from the perspective of a buyer and how marketable is my business?
If you have clearly defined goals and have answered the top ten questions related to exit strategy readiness, the economic cycle matters less if you can get the desired price for your business in a down turning economic cycle.
Let BFS prepare a business valuation and market readiness assessment to help you decide the timing of your Exit Strategy.
Written by: Richard J. Burke, CPA, CGMA, CM&AA, MBA
Call Burke Financial Services at 630-707-3059 or email to: Info@bfs-cpa.com
