What is all this talk and worry about interest rates? Why does every investor and business owner anxiously await the decision of each FOMC (Federal Open Market Committee) meeting, the monthly jobs report, the unemployment rate, quarterly GDP and so on? All of this economic data and more provide information to the FOMC for purposes of adjusting short-term interest rates (the Federal Funds Rate).
As a business owner, you would be wise to keep your eye on the Federal Reserve. Rising short-term interest rates can have devastating effects on the value of a business. Many business owners who have no debt on their balance sheets think that they are not affected by rising short-term interest rates. The fact of the matter is that interest rates have an indirect relationship to valuation multiples. As interest rates rise, valuation multiples fall. As valuation multiples fall so falls the value of your business. Accordingly, the decisions made by the FOMC can have lasting effects on all businesses if you are not prepared.
In December of 2005, the FOMC again raised the federal funds rate to 4.25 percent in response to the most recent economic data available. On December 13, 2005, the FOMC released the minutes of their meeting. Included in the minutes was this statement, "Although future action would depend on the incoming data …the outlook for policy was seen by most members as indicating that, given the information now in hand, the number of additional firming steps required probably would not be large." My analysis of this statement concludes that these guys might be getting to a stopping point on raising short-term interest rates, otherwise known as a neutral stance. However, anybody who has ever followed FOMC activity knows that the FOMC has always tightened short-term interest rates more than was necessary. Hopefully for the typical business owner, he or she will truly depend on incoming economic data and not history.
How does all of this economic data affect the typical business owner? At some point in time, a business owner must consider the value of the business as well as the timing on cashing in on this value. Interest rates, as we have already discussed, have an inverse relationship to value. When the FOMC is in an interest rate tightening cycle, the marketplace compresses price multiples, which are used in valuing business entities. Essentially an investor is going to pay less for a dollar of earnings as interest rates move higher. Conversely, in periods of lower interest rates, the marketplace will expand the price multiple used in valuing business entities. As we all know it is difficult to be able to get the timing right on predicting where interest rates will be or what the state of the economy will be in future years. If the economy is acting poorly a business could lose major customers. If the economy is doing great a business may see rising costs of raw materials and commodities, which, will negatively affect profit margins. So, what should a business owner be thinking about with regard to the value of the business and the timing of when to put the business on the market? The key word is planning.
Every business should have an operating plan that, among other things, addresses potential exit strategies. In my experience, I have seen many exit strategy plans that outline the basic idea that when the business owner reaches a certain retirement age, the company will be sold. Amazing as this sounds, that is the extent of the planning in many middle market companies. As you might expect the process is not that simple. I advise all of my clients to have an operating exit strategy in place otherwise known as a pre-sale plan. In this type of planning, the business owner is constantly being challenged to hit certain benchmarks in sales, profit margins, cash flow, valuation etc. Most importantly, the plan does not necessarily hinge on selling the company at a pre-determined age level of the owners or top management. The plan is designed to highlight the positive and negative factors that currently exist and how to address each item to create maximum value. The plan will also identify a range of time necessary to market the business to realize the best possible value. The business owner should consider some of the following items in a typical pre-sale plan:
1) Management Tenure
2) Capital Structure
3) Related Party Involvement
4) Product Lines
5) Relevant Company Divisions
6) Customer Base
7) Cyclicality of the Business
8) Technology
9) Interest Rates
10) Inflation
11) Market Share
12) Customer Concentration
13) Government Regulation
14) Plant Capacity
15) Capital Needs
16) Valuation
As we have discussed earlier in this article, there are many factors that can influence the value of a business that the business owner has little or no control over. In this article, the FOMC and the current debate on where interest rates will go is an example of an external influence that a business owner does not have any control over. A pre-sale plan would have addressed this issue very early in the economic cycle giving the business owner an edge on protecting the value of the business.
