Rising interest rates will lower the value of your business. Why? Because valuation multiples are based on interest rates; let me explain…
Interest rates in the United States reached an all time high of 20 percent in March of 1980 and then declined to a record low of 0.25 percent in December of 2008. Since late 2015, they have been rising to where today, the federal funds rate target is now 2 .00 to 2.25 percent.
The price buyers are willing to pay for a business is one that adequately rewards them for the risk in light of all other alternatives. As an example, say you could buy a guaranteed investment certificate (a GIC which holds no risk other than inflation risk) and earn 2% per annum on your investment, or, you can buy a small business with an expectation of earning 4%. Which one would you pick? I think a 100% of investors would rather sleep at night than assume small business risk for an incremental two percent. However, improve the small business’ expected return to 15%-20% and investor appetite changes substantially. There are many investment choices with various risk profiles as I illustrate in “Why Are Private Companies Valued Lower Than Their Public Company Peers?”
Higher Interest Rates Move the Risk Return Curve Up
So how do higher interest rates affect valuation? It moves the risk return curve up and likely steepens it as well, as a riskier environment affects smaller companies more than safer, larger companies (in the markets this is called a flight to quality). When the Fed moves rates from near zero up to 2% for short term borrowing, this will likely result in a larger uptick for long term rates and still more for riskier small illiquid investments. Let’s say the required ROI for a small business, as a result, moves from 20% to 25%. This means a business generating $2 million in EBITDA, originally valued at $10 million is now valued at $8 million. The multiple of 5 times EBITDA generating a 20% return on investment per annum reduces to 4 times, generating 25% per annum. Of course there are many other variables at play, but fundamentally this math rings true and in some cases (like the Fall of 2008) this adjustment in perspective can happen in a matter of one month. While interest rates will likely creep up in small increments, once the market appreciates the potential impact, the valuation scenario can change very quickly.
Markets Are Cyclical
Interest rates will go up and multiples will come down. It is just a matter of when. Based on the fact that the bull market is now eight years on – the 4th longest of the 24 bull markets of the last 113 years – and has risen almost 320% since March of 2009, the pundits are saying we have one to two years left (they will be saying this at the peak as well). The bottom line is, given that a company sale can take several years to fully complete, now may prove to be a very good time to consider transitioning a business.
Recommended Further Reading
For more on private company valuations, see: Why Are Private Companies Valued Lower Than Their Public Company Peers?
To familiarize yourself with the documentation used in the M&A process, see: Terminology and Documentation