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  • Business Sale Considerations in an Inflationary Economy

    May 17, 2022

    The inflation rate for the last twelve consecutive months (May 1, 2021 – April 30, 2022) was  reported to be 8.3%, continuing the trend that has existed throughout the year of the inflation rate equally or exceeding 7.5% in the United States (https://www.usinflationcalculator.com/inflation/current-inflation-rates/).  In an effort to slow domestic inflation, the Federal Reserve recently announced a half percentage point increase to its benchmark interest rate with similar increases being contemplated at the next two meetings on the short term horizon ( https://www.npr.org/2022/05/04/1096111642/federal-reserve-interest-rates-inflation-prices?msclkid=550f884bcff311ecaf89fd68149fb191). This inflationary environment has created a menu of important considerations in terms of business valuation, tax allocation, and negotiated elements in mergers and acquisition transactions which should be on the radar of all buyers & sellers in the business opportunity marketplace.

    IBA, a forty-seven-year-old, regional business brokerage and commercial real estate firm that emphasizes the importance of knowledge, experience, and professional negotiation and deal facilitation skills in the representation of owners of privately held companies and family businesses, recently held an in-house symposium focused on these considerations where our team of seasoned, industry experts identified and brainstormed practices & solutions to address business sale issues that have not been experienced in the Pacific Northwest for approximately forty years, a time period from which IBA is the only business brokerage firm in the region that served the entrepreneurial community then and now.

    The following are a few of the items identified that are worthy of discussion/negotiation between parties and their professional advisors:

    Inventory

    Traditionally inventory in a transaction involving a retail, distribution, or manufacturing company is valued at actual or replacement cost. In a normal economy, it is common for the legal verbiage to indicate the valuation will be at the lower of cost or replacement value.  Ordinarily, the delta between the two valuation techniques is negligible.  That assumption is no longer accurate, as today the difference in value can be substantial between acquisition value and present market value.

    This situation creates a couple of transactional issues.  First, the parties need to agree on how the inventory is going to be valued for the transaction.  Valuation at cost can shortchange the seller on the present value of the inventory asset and create an economic advantage for the buyer, if the business has adjusted pricing for inflation appropriately in the last year. Valuation at market value could create a capital gain over the balance sheet value for the seller that needs to be accounted for in the transaction.  It is also true in our present supply chain challenged world that having inventory can create a competitive advantage for the business in the marketplace.  IBA recently completed a transaction involving a company that sold and installed Generac and Kohler auxiliary power generators.  The fact that the business had a substantial inventory of product and a pipeline of replacement orders allowed the business to pick up market share from competition and increase the revenues & profitability of the company over the last two year period while competitors employing a “just-in-time” inventory strategy into the pandemic waited six to nine months to get product to satisfy customer demand.  A similar situation exists with a pleasure boating industry business we are presently staging to bring to market with summer ownership available to buyers.   As examples of sector increases in product values building materials prices have increased over 20% in the last twelve months (https://www.nahb.org/blog/2022/04/building-materials-prices-start-2022-with-8-percent-increase), apparel & footwear 5 – 6% (https://www.just-style.com/news/us-apparel-industry-suggests-policies-to-tackle-spiralling-inflation/), and food 11% (https://www.sfgate.com/shopping/article/Inflation-Is-Hitting-Groceries-Hard-With-Food-17165408.php).  The short answer is that inventory valuation warrants increased scrutiny in an inflationary economy.  It is also important to assess supplies and consumables as a valuation element in a transaction.  A readily available example is fuel in companies with fleets of vehicles. The cost of fuel increased 43.6% in the United States from May 1, 2021 to April 30, 2022 (https://www.usinflationcalculator.com/inflation/gasoline-inflation-in-the-united-states/).  This company asset should not be gifted to the buyer.  Consider the sale of company with a fleet of 20 semitrucks with an average fuel capacity of 135 gallons.  Sold with a fleet of half full tanks, the value given to the buyer in the transaction would be $6898.50 at a diesel fuel price of $5.11 per gallon.  Insider Tip: The easiest way to value fuel in a sale is to deliver the tanks full to the buyer and calculate the amount by multiplying the tank capacities by the present price at the pump.

    Equipment

    Similar to inventory, the value of used equipment is often appreciating rather than depreciating in 2022.  Used truck values were up 31.9% in Q1 2022 ( https://www.automotive-fleet.com/10170179/used-work-truck-prices-in-first-quarter-up-31-9) and agricultural equipment experienced a similar rise in value (https://www.dtnpf.com/agriculture/web/ag/equipment/article/2021/12/08/used-tractor-prices-27-surge-may).  This situation has created two M&A market dynamics.  First, it has increased buyer demand for asset heavy companies as an asset-based hedge against inflation.  Second, it has enhanced demand from buyers looking to grow through strategic acquisition as an approach to acquiring equipment not readily available in the marketplace, obtaining lot pricing for assets that is financially advantageous over purchasing individual units, and eliminating competition allowing for increased market share, profitability, and service capacity.

    From an accounting and tax perspective, appreciating tangible assets has the potential to result in the recapture of depreciation and a higher tax rate on sale of the business in an asset sale transaction than, if the value had been allocated to goodwill at a long-term capital gains tax rate.  This increased applicable tax rate has increased motivation to explore stock sale transactions at a long-term capital gains tax rate by business sellers.  The tax implication of appreciating assets is not limited to the seller.  In a state like Washington, increased value placed on furniture, fixtures, and equipment results in enhanced use tax being payable by the buyer at closing.

    Business Acumen

    The best position to be in an inflationary economy is ownership of a business.  If existing ownership is keeping pace with their marketplace in terms of product and service pricing, inflation can result in increased profitability for a business.  If ownership is not captaining the ship appropriately inflation can be detrimental to the value of a company and potentially even a death sentence.  Consider the following example.

    A construction industry company had revenues of $8.5 million in 2021.  Cost of goods for the business were 31%, labor 28%, and other operating costs 30.5% leaving EBITDA at 10.5% or approximately $900,000.  If revenues and expenses all increased 8% in 2022, the resulting EBITDA for the company would increase $63,900 to $963,900.  However, in reality in this scenario EBITDA would likely be greater than $1 million as many expenses lag inflation in their correction, such as rent rates set years in advance or insurance premiums paid on an annual basis.  Definitely a situation where it is good to be the owner.   Conversely, ownership that is slow to adjust the pricing of their products and services in an inflationary economy can be headed for bankruptcy.  In the scenario above, if costs climbed 8%, but ownership did not increase their pricing to customers the end result would be a company with a year end EBITDA of $315,012 in the worst-case scenario, a change that would result in a precipitous drop in company value.

    I consider business the ultimate competitive sport.  It is unforgiving to those who do not have the ability to problem solve in real time utilizing available information, experience, and their unique abilities.  COVID-19 and the inflationary economy that followed it have spotlighted the “best of the best” entrepreneurs in the United States with their performance being documented with increased market share, revenues, and profitability. IBA is proud to the be the business brokerage firm of choice for many of these individuals when they want to sell their successful companies.  IBA also has demonstrated over nearly 50 years and through over 4200 successfully completed transactions that we have unique knowledge, experience, and ability as professional, mergers & acquisitions intermediaries.  We have trained, learned, and performed for our clients in the inflationary economies of the early 1980’s and 2020’s.  If you want to hire an experienced professional advisor to sell your business in 2022, we would welcome the opportunity to provide an overview of our client services and interview for the job.  100% of IBA’s fees are paid on performance upon completion of the transaction.  All information shared with IBA is held in strict confidence.

    IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate  communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.

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