Strong demand, but business owners reluctant to sell

By  Ramsey Goodrich

Demand for quality companies is incredibly strong today, but most business owners are staying on the sidelines at the moment.

Recent conversations with reluctant business sellers have included a range of rationales for a delay in the sale of their businesses. Their justifications for waiting included everything from hopes of landing a contract from a potential new client to the European debt crisis to planning a birthday cruise for a wife.

Psychologically, business owners seem to be holding out to sell at the peak. While in general middle-market businesses have rebounded well since the 2008-2009 crisis, most owners seem to be holding out until they exceed their 2007 record highs in order to maximize value. Surprisingly, this strategy may not be the best answer in today”™s market.

The market demand

Within this recovering economy, businesses have increased their profitability and currently have higher cash balances than ever before. According to FactSet Research, there is more than $1.2 trillion in cash in the S&P 500 at the moment (not including the financial sector), the highest amount ever both in absolute dollars and as a percentage of assets. Strategic buyers, who are hungry for growth and innovation, are looking at M&A as a way to buy it rather than build it.

Private equity (PE) buyers also have hoards of cash. Pitchbook.com estimates that PE investors have more than $425 billion in unused capital, mainly in middle-market funds. With the dearth of dealmaking for the last couple of years, investors are facing increasing pressure to invest that capital.

There is a strong demand for companies with scale in today”™s market. Companies with more than $10 million in profits are being valued at higher multiples than smaller companies because of their stability and lower perceived risk. Middle-market PE investors are similarly seeking companies with at least $5 million in profits as new platform companies. Smaller companies have to demonstrate a strong strategic fit or compelling growth prospects to command a premium today.

Supply shortage

Deal flow has been sluggish for so far this year with dealmaking in North America down almost 10 percent in volume and 26 percent in total deal value, as reported on mergermarket.com. This is a result of business owners waiting on the sidelines. Interestingly, private equity firms selling their portfolio companies are on the rise. These professional investors, who buy and sell companies for a living, are divesting their businesses now and taking advantage of this increased demand.

Strategic buyers and private equity investors today are taking longer to close their acquisitions as they are performing more due diligence and being more careful. As a result, a disciplined sale process can take six months or more.

The supply and demand imbalance may not last long as most experts are predicting strong deal flow for the second half of the year. As the supply of deal flow increases, buyers are likely to become more selective and pass on mediocre opportunities or at least lower the valuations of their offers. These buyers and investors only have a fixed number of hours in their day to review opportunities and will be forced to focus only on the best deals on their desks.

Tax considerations

Absent an extension by Congress, today”™s unusually favorable tax environment is scheduled to end Dec. 31, 2012, when increased taxes on capital gains and unearned income and a range of new taxes go into effect. For certain business owners, selling in 2012 versus 2013 could mean saving as much as an extra $1 million in taxes for every $10 million in taxable gain. Unless Congress acts with purpose and is able to pass sweeping tax reforms immediately following the upcoming presidential election, owners can expect to pocket a lot less from their lifetime of work if they wait too long to act.

By waiting much longer, that birthday cruise may end up costing a lot more.

Ramsey Goodrich is managing director and partner at Carter Morse & Mathias in Southport and chairman of the Connecticut chapter of the Association for Corporate Growth. He can be reached at rgoodrich@cartermorse.com.