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Business owners, hungry for the stabilization that many believe government stimulus will provide, are beginning to ask what will happen to valuations when the economy bottoms out and starts to recover. While the economic crisis has certainly impacted short-term valuations, both buyers and potential sellers are overestimating the impact that the recession will have on valuations once the economy starts to turn around.

Status of Valuations

One of the challenges for both buyers and sellers in this market is trying to determine a fair valuation. When final first quarter data becomes available this month, valuations will see a dramatic fall as most deals being completed are distressed transactions. While buyers think that these severely discounted valuations will become the new normal, some sellers believe valuations will return to the peak levels of 2007. These opposing views are both based on the misconceptions that lower-middle market valuations fluctuate like the stock market.

There are certainly short-term peaks and valleys in valuations at the extreme ends of an economic cycle; however, there is significant evidence to suggest lower-middle market valuations are not very volatile when historic anomalies are excluded. This means once the economy stabilizes after a traumatic event, multiples will quickly return to historical norms. We anticipate valuations to return to the historical norms of 6.0x EBITDA, when analyzed across all industries, by the fourth quarter this year. The long-term impact of an over leveraged economy that has played out over the last 6 months will not allow valuations to return to peaks of 2007 for the foreseeable future.

Sellers: Valuation Alternatives

Sellers need to avoid allowing the last two quarters to dictate their company’s valuation once the economy improves. Plain and simple, most valuation negotiations continue to revolve around examining a company’s trailing 12-month financial statements, determining the adjusted EBITDA and applying a multiple of EBITDA. However, this methodology will likely have a negative impact on any company’s valuations since the economy significantly slowed down in the fourth quarter of 2008 and the first quarter of 2009.

The other component of using this valuation method, using market comparables from recent transactions, will not positively impact sellers for the same reasons. Instead, business owners should consider the discounted cash flow methodology as a way to value their businesses. This commonly accepted methodology projects future cash flows and discounts them back to a net-present value. While it is important that the seller provide detailed and realistic evidence of how a company would achieve future cash flows, it diverts the conversation away from an anomaly in our economic cycle that has the potential to undervalue a business.

Buyers: Limited Discounts for Healthy Companies

The recent declines in valuations are not the new norm. Valuations have come down in the fourth quarter of 2008 and will continue to show a dynamic decline when first quarter data becomes available on May 15. However, this is a temporary overcorrection, and very few buyers are finding good companies selling at discounted rates. There are certainly plenty of high-risk distressed opportunities. Once again, these are the deals that are driving down the current average EBTIDA multiples. A savvy buyer is typically willing to pay a fair valuation for a company that has found their footing rather than risk jeopardizing their business with a distressed company just to get a depressed valuation.

Once the economy starts to rebound, valuations, while not bargain basement, will be reasonable. The upside for some buyers is that many had been priced out of the market in the run-up to the current recession will now have an opportunity to acquire. The challenge in this market for most buyers looking for healthy companies is finding sellers willing to listen to the pitch. Most sellers have their heads down, focused on their business and are hoping for better multiples by the end of the year. Buyers should plan for acquisition strategies to take twice as long as normal to execute, as it will take longer to identify healthy sells and secure bank debt.

Rethinking Deal Structures

Data shows that the money the government has been injecting into the banking systems has not yet made its way to businesses. The banks’ willingness to finance 60-80% of a deal will be limited for the next several years; however, they will be open to 30-50% of the financing with seller financing and equity from the buyer closing out the deal. This is advantageous for the seller or buyer with cash on hand. If a seller is willing to finance part of the purchase price, the seller may be able to get a bump in the valuation and at the very least a higher interest rate on the financed amount. For those buyers with cash to complete the acquisition without much need of financing, valuations become attractive very quickly.

Strategies for Buyers and Sellers

Wyatt Matas & Associates expects valuations to rebound to historical norms by the beginning of the 4th quarter of 2009 after a dramatic overcorrection in the first quarter of 2009. Owners considering selling in the next one to three years should focus on the fundamental strategic and personal decisions that best fit their exit strategy and not focus on chasing a market multiple based on a dramatic rebound in valuations. Buyers looking for a severely discounted valuation for healthy companies will be searching in vain in most cases, but will find good opportunities at fair valuations with diligence and persistence. To receive our research electronically, please email research@wyattmatas.com.

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Ihab Salloum