While most parts of the country have been experiencing record-breaking high temperatures, middle market businesses remain cool and cautious mid-year. According to our recent Manufacturing Pulse Survey, diminished optimism continues with manufacturing executives who cite interest rates and poor economic conditions as primary reasons. Despite the conditions, there are several tangible strategies that can be implemented now when planning for what’s next.
While economic conditions can be a complex topic, let’s first dig into several factors impacting businesses that are contributing to the uncertainty.
Interest rates rose again this week, marking a 22-year high, as inflation continues to exceed acceptable levels and stronger than expected employment rates. Higher interest rates will restrict the availability of financing for business combinations.
Student Loan Debt
In addition to interest rate increases, student loan repayments will resume this year. For those 46.6 million Americans who have outstanding student debt to repay, discretionary income will be significantly impacted.
COVID stimulus funds continue to support the economy, but at a decreasing rate against a backdrop of record-high consumer and corporate debt levels that will be refinanced at high interest levels. Commercial real estate values, especially office and retail properties, continue to adjust downward in response to remote work and online shopping trends. All these factors cause recessionary fears as we navigate the balance of 2023.
Succession planning strategies
This does not mean that business owners should ignore or delay relevant and necessary succession planning during this part of the economic cycle. Readiness for an exit is an ongoing process, regardless of the economic cycle. Here are four strategies to consider when planning for the future during the current economic environment:
1. Strengthen Your Balance Sheet.
Your balance sheet sends a message to investors and creditors. A strong balance sheet drives lower credit costs for borrowers and higher valuations for businesses considering a sale. A weaker balance sheet, or one cluttered with non-operating assets or aged assets, can send a message of vulnerability.
Here are some ways to strengthen your balance sheet:
- Preserve cash and monitor working capital metrics by managing accounts receivable at or below industry standards. Aged receivables can signal that a business has a weak customer concentration or poor business processes. Excess inventory above industry standard can also indicate poor management. Of course, there are exceptions as some businesses carry excess inventory to capture market opportunity or due to supply chain shortages. For liabilities, obtaining reasonable credit terms from suppliers is indicative of good cash flow management. Ultimately, a business should strive to operate with less cash investment and manage working capital closely.
- Liquidate or transfer assets. Related party receivables or non-operating assets can sometimes tie cash up. It may be prudent to retire those assets to present a clean balance sheet. Related party receivables can indicate to investors that the owner does not manage their personal cash wisely and may be overly reliant on the business to fund their lifestyle. These types of receivables also carry some level of tax risk as they could be reclassified to a dividend or distribution in the event of an audit. Non-operating assets can accumulate over time, ultimately confusing lenders or investors. Some examples include an investment unrelated to the business or a discontinued segment of the business with assets still on the balance sheet. Liquidating or transferring these assets can avoid confusion and present a cleaner balance sheet.
- Evaluate underperforming business segments and related assets. Credit can tighten in recessionary times and the business may not have the capacity to continue to invest in underperforming business units. It may be more practical to liquidate those assets and bolster the balance sheet with cash from the sale of these assets.
2. Evaluate Key Stakeholders.
Key customers, suppliers, and stakeholders should be subject to a continuous evaluation process. When there is risk of a downturn, the importance of this process is heightened. Often, a business will make investments based on anticipated growth, whether those investments are equipment, product development or inventory. If a key customer becomes financially weak, a business could subsequently carry excess inventory and need to negotiate terms on aged receivables. Here are some things to monitor for key stakeholder stability:
- If customers are slower to pay invoices or are asking for extended payment terms, this could be a sign of financial weakness.
- If suppliers are unable to ship products in a timely manner, or if they are asking for better terms, this could be something to monitor.
- Be sure to understand the strength of your banking relationship as well. There are publicly available resources on the FDIC website on member banks that can help you assess the bank’s financial stability. If you rely on other vendors for critical services, understand their business model and what risks they face.
3. Obtain a Business Valuation.
True or false: A business has only one value at any given time. False. The ultimate valuation depends upon the purpose of the valuation. While the principles of valuation remain the same, the way they are applied depends upon the rules associated with the purpose of the appraisal. The value of the business in a sale to a third party is different from the value used for estate planning or the sale to a key employee. The numerical conclusions are informative, but more importantly is the process by which they are derived. The process yields a large amount of information that will assist the owner in decision making and answers two important questions: what are drivers of value and what are the tax considerations? Solid and informed succession plans begin with business valuation that assumes a variety of scenarios.
4. Build Your Financial Reporting System.
As a seller, your company’s records will be the subject of intense scrutiny as part of the buyer’s due diligence process. And the larger the deal, the more intense the research. Readiness to provide large amounts of accurate data is essential, which usually requires upgrades to the company’s financial reporting system and includes upgrades to both technology and personnel. Oftentimes, this reporting must join sophisticated audited systems. The purchase price must be allocated among intangible assets that are not only identified, but have sufficient data associated to assign values. Strong systems will help support due diligence and ultimately a higher price. If this is a task that falls lower on your list, consider outsourcing the services needed to implement these systems as this is an item that will help drive value.
5. Transfer Ownership When the Business Valuation is Lower.
You read that right. If the business valuation is lower due to economic headwinds, it could be the perfect time to:
- Transfer shares to family members.
- Issue stock or restricted stock to key employees to reward and retain employees. (Stock compensation will be taxable to the employee, but at a lower valuation. Restricted stock is generally not taxable until the employee has vested.)
- Gift appreciating assets, like stock.
The estate tax exemption for 2023 is $12.92 million and continues to adjust for inflation until it sunsets in 2025. It will then revert to $5 million, adjusted for inflation, of which many business owners’ estates may exceed the exemption amount.
Although economic uncertainty can leave business owners feeling less optimistic or hopeless, there are several strategies that can be implemented to prepare yourself and your business for the headwinds. If you would like to learn more about these strategies or need assistance with your business succession plan or valuation, our team at Sikich is here to help.