When a market is more favorable for sellers of private companies

The past year has been unusual for many reasons, including that we have been experiencing an extraordinarily robust market for acquisitions and sales of privately held companies. Those who watch this industry have seen this activity accelerate over the course of the year and expect a record level of acquisition and sale activity in the fourth quarter of 2021.

There are a number of factors that are driving this trend.

First, the overall economic climate and overall consumer demand is strong, with the country continuing to recover from the pandemic, although the economy is feeling the strains caused by labor shortages and supply chain issues.

Second, interest rates continue to be favorable and present those who are looking to buy a business using borrowed money with a good opportunity.

Third, private equity firms need to deploy capital and add on and roll up transactions have increased during 2021.

Fourth, potential tax increases are encouraging sellers who are considering a transaction to move forward with the transaction in order to take advantage of the current tax environment.

This increase in activity has led to a situation where there are more buyers of private companies than there are sellers, which has resulted in a favorable market for business owners looking to sell their business. This is often referred to as a seller’s market.

It is generally understood that a seller’s market shifts the overall negotiating leverage towards the seller. This shift can have a significant impact on a number of aspects of the transaction and impact the overall outcome for the parties involved.

Market conditions are often a leading factor with sellers when deciding to pursue a transaction. For many business owners, their business represents their single largest asset and they look to maximize its value. This is best done when market conditions present sellers with a favorable valuation environment that will enable the owner to generate a purchase price that meets his/her needs.

Business owners recognize that the broad economy, and industries within the economy, go up and down, and correspondingly the market for private company transactions also fluctuates. We have seen down cycles, and business owners understand the risks associated with selling, or being forced to sell, a company in a down market. For some businesses the variance in valuation and purchase price can be dramatic based on the economic conditions. Business owners recognize that favorable economic and market conditions present a prime opportunity to engage in a transaction, and that these conditions can change quickly.

In a seller’s market, a business owner is presented with a higher likelihood of receiving multiple offers from potential buyers, and financial buyers (most often private equity firms) compete with strategic buyers for assets in growing industries. This competition often leads to an auction process with multiple bidders making offers that can lead to a higher purchase price for the business.

With multiple potential acquirers, the business owner has a greater ability to be selective and select a buyer who is a good fit for the business and aligns with the seller’s interests in the continuity of the business after the sale.

A competitive bid landscape also provides the seller with the opportunity to negotiate more favorable non-economic terms. With competing bids, the seller can place more demands on the buyers with regard to the structure of the transaction, the level of transactional risk that will be assumed by the buyer, and other terms that may be important to the selling business owner, such as retaining the business’s workforce or maintaining operations at its current location.

In a seller’s market, buyers also are often more willing to agree to transaction structures that favor the seller.

An example of this would be buyers being more willing to agree to equity transactions that are often more favorable to the seller for tax reasons and shift more risk to the buyers. These transactions are often easier to complete, which can result in a shorter time to get to a closing. Sellers can also place demands on when the transaction will close and how long the buyers will have to evaluate the business.

A seller’s market also gives the seller a greater ability to limit ongoing risks associated with a transaction. In a seller’s market, the overall scope of the indemnification that a seller will be responsible for after a closing is often lower. This has been confirmed in multiple studies of transaction activity, which show that over the past several years, these limitations have come down.

In addition, the length of the indemnification following the closing is being shortened in this seller-favorable environment.

The scope of the representations and warranties (the statements that are made regarding the condition of the business) that sellers are asked to make as part of the transaction process are also reduced in this environment where sellers have more leverage to push back on demands being made by a buyer.

In these seller-favorable environments, there are some factors that keep the transaction terms in check. First, in many instances, financing is required to fund the transaction. In order for this funding to be secured, a buyer will be working with a lender who will review the transaction terms. If the terms are too far out of line, the lender may elect not to fund the transaction, which could put the transaction at risk.

Another significant, and related, factor that must be considered is that the transaction must be financially viable for the buyer. If the buyer determines that the transaction is not financially viable, the buyer is unlikely to ultimately move forward with the transaction.

While market conditions are constantly changing, the seller’s market gives owners of businesses an opportunity to pursue a transaction in which they may be able to maximize the value that they receive, obtain favorable business terms and significantly mitigate their risk following the closing. Sometimes these periods are fleeting, and owners should look to take advantage of favorable conditions when they present themselves.

Understanding what options are available to sellers to best take advantage of this type of environment can provide them with a significant advantage and can lead to a significantly better outcome.

Patrick Closson, a director at McLane Middleton and chair of the firm’s Corporate Department, can be reached at 603-628-1457 or patrick.closson@mclane.com.

In a seller’s market, a business owner is presented with a higher likelihood of receiving multiple offers from potential buyers