High interest rates in the financial markets are weighing on corporate valuations and purchase prices in cases of external business succession through the sale of a company.
The shift in interest rates on the financial markets was a necessary response by central banks to rising inflation. Most recently, the European Central Bank (ECB) raised its key interest rate to 4.5%, once again presenting the domestic economy with growing challenges. In addition to the immediate effects of the new interest rate environment—in the form of significantly higher financing costs—gradually emerging obstacles are becoming apparent in the areas of business succession and sales.
Illustrated with figures from the state of Bavaria:
Of the more than 500,000 family-owned businesses in Bavaria, approximately 30,000 will face the question of how to plan their business succession over the next three years (see the Bavarian State Ministry of Economic Affairs’ “Business Succession Initiative”). This makes a constructive succession culture all the more important for our regional businesses. In the best-case scenario, business owners can transfer their companies to the next generation within the family. If no successors are available, selling the business to an outside party is the obvious alternative; this trend is confirmed by the DIHK report “Business Succession 2022.”
Intra-family business succession is generally carried out primarily without consideration, meaning that the successors do not have to pay a purchase price that they would otherwise need to finance through bank loans. Nevertheless, intra-family business succession is often accompanied by extensive investments on the part of the successors if the transferors have postponed upcoming investments and maintenance. As a result, high interest rates often place a financial burden on intra-family transactions as well.
When business owners decide to sell their company, the key is to find the right buyer who can successfully carry on their “life’s work” or “family tradition.” The general range of potential buyers extends from startup founders to management buyouts (MBOs) to strategic competitors or financial investors (private equity, family offices, capital market funds). Once concrete prospective buyers are at the table, business owners are often confronted for the first time with the question of what market or enterprise value their company represents. Enterprise value is determined, in simplified terms, using statistically derived industry multiples applied to a sustainable financial metric, such as an EBIT multiple (a factor based on earnings before interest and taxes) of currently about 6.8 for so-called small- and mid-cap transactions in the plant and machinery manufacturing sector, or, for example, currently about 11.5 in the pharmaceutical/healthcare sector. In addition to this general valuation method, which often serves merely as an indicative estimate, individual company valuations in accordance with the accounting standards set by the Institute of Public Auditors in Germany (“IDW S 1 – Valuation”) are typically used for company sales, based on concrete financial plans. A company valuation in accordance with IDW S 1 is recognized in the “DACH” financial markets as a reliable method for determining the purchase price and a sound basis for negotiations.
Since a company’s value is derived primarily from its future earning power, i.e., its ability to generate sustainable financial surpluses, the most recent annual financial statements (balance sheet/income statement) and the current financial accounting records (BWA) are of the utmost importance as a basis for planning future earnings and as a benchmark for assessing their plausibility. If the company is classified as medium-sized or large under commercial law, the annual financial statements are audited annually by a certified public accountant to verify their accuracy. An unqualified audit opinion from the CPA further builds confidence in the financial figures of the company being sold. Therefore, even small companies are advised to consider a voluntary audit of their annual financial statements. Regardless of the company’s size, business owners should address early on in the sales process how to “spruce up the bride” from a legal, accounting, and tax perspective. Classic examples include renewing patents, cutting unnecessary costs, exercising accounting options, or—in certain industries—converting leases to financing arrangements.
In business valuations, the rise in borrowing costs must, on the one hand, be factored into the earnings and financial projections that determine value, thereby reducing profits. On the other hand, higher interest rates increase the discount factor (cost of equity) applied to future earnings as of the sale date, meaning that, for financial-mathematical reasons, company values generally decline as interest rates rise. This principle could be observed in a similar vein when stock prices (company values) fell dramatically following the “comeback” of fixed-income interest rates.
Fundamentally, high loan interest rates will make it more difficult to finance external business sales in the future and will significantly limit the options available, particularly for startup founders and MBOs. Public subsidy loans from the LFA or KFW help keep financing costs for successors at a manageable level. Alternative financing options in collaboration with venture capitalists, state-owned investment companies, funds, and private equity firms are also coming back into focus.
