How are interest rates and inflation impacting small business valuations?
March 26, 2023 ⋅ 7 min read
The media has recently been filled with doom and gloom articles about inflation, rising interest rates, and a looming recession. Some small businesses are already beginning to feel the impacts of these changing economic dynamics while others are thinking about what the next 12-24 months might hold if consumer spending tightens.
I own and operate dog daycares. Macroeconomic trends have wildly impacted our business in the past year; so much so that I recently spoke to the New York Times and Business Insider about my experience dealing with rising rates and inflation.
As such, I wanted to share my thoughts here as you are considering how economic trends might impact your business overall and what it’s worth if you choose to get a free valuation from Baton and/or explore potentially selling.
What do rising interest rates mean for small businesses?
Many small business owners take on loans from the SBA or other lenders based on a variable interest rate pegged to prime interest rates. Since the financial crisis in 2011, prime interest rates have been extremely low, so borrowing money has been cheap. At the start of 2021, rates were set at 3.25% and that’s more than doubled to 7.5% today with more increases expected through this year. On a 10-year, $1,000,000 loan, that’s an increase of over $200,000 in interest expense over the term of the loan, and the loan payments have nearly doubled.
The bad news for small business
If you need to borrow money for an expansion or you have a variable rate loan, the price to borrow money has gotten much more expensive. It’s important as you think about your growth plans to consider how these rate changes will impact your ability to pay off new or existing debt your business may take on. Before taking on new debt, explore with a financial professional or CPA how that debt will impact your cash flow.
I’m in the middle of building out a new dog daycare. We took out a line of credit to help finance that development, and when we did that last year, our rate was about 4%. Now it’s at 7.5%. So yeah…our development just got a lot more expensive. We have some fixed debt that we don’t need to pay off yet, so we’re holding that and using cash flow to fund the development instead of paying it down. It’s worth looking at any existing debt you have and avoiding paying more than you need to if it’s cheaper than taking on new debt.
Case in point: if you have a house or a car that you re-financed when rates were cheap 18 months ago, the last thing you want to do is sell that house or car to buy something new with much higher rates today.
The good news for small business
The whole point of raising rates is to try and slow down inflation and the overall economy. When the federal reserve sets interest rates, they’re generally looking at two pieces of data: unemployment rates and inflation.
Historically, the higher the interest rates, the higher unemployment, as businesses all tighten their belts because debt has gotten so expensive. And when unemployment goes up, people generally have less disposable income and they’re fearful of getting laid off, so they spend less, reducing inflation.
While that reduction in spend may hurt your business, every small business owner knows that finding labor over the last several years has been as hard as it has been in recent memory. The team at Baton reports this as being the #1 issue the small business owners they talk to actively deal with.
But the labor market is already starting to tighten. In the last few weeks, we’ve seen major tech companies laying off hundreds of thousands of employees. Underneath those public layoffs, smaller companies of all shapes and sizes are already tightening their belts. At my business, we’re seeing more and better applicants in the last month than we’ve seen since the start of COVID.
How do rising interest rates impact business buyers?
Business buyers also experience the impact of rising interest rates. If someone is trying to buy your business and you don’t have any debt, they will likely need to take out a loan to buy it. If your business doesn’t generate enough income to support that loan and their income as a buyer taking over for you, they may not be able to afford to purchase your company.
Are rising interest rates bad for my valuation?
With rising rates, buyers need to come up with more cash themselves to buy a business that generates the kind of income they are looking for. This can lead to “multiple compression”: because debt is more expensive, businesses need to get cheaper for buyers to be able to afford the types of businesses they want to buy. If enough buyers feel that way, valuations may decrease as buyers overall look to purchase businesses for lower multiples.
The good news is that there are plenty of buyers out there that still have plenty of cash and may be unimpacted by interest rate hikes. This is especially true of larger institutional buyers like private equity firms or strategic buyers (other similar companies to yours).
One thing we’ve seen with many business buyers is that they are trying to work with sellers to negotiate larger and more favorable seller notes - meaning you as the seller of a business act as the bank. The buyer pays you back using profits from the business over time, and you (instead of a bank) collect the interest.
If you don’t need a bulk payment, you may be able to negotiate a higher purchase price and a lower interest payment for the buyer. Most SBA loans are roughly 9.5% at the moment. If you offer a buyer a 6% seller note, they’ll be able to pay you more for the business than they would be paying the SBA in interest.
Altogether, rising interest rates don’t help you sell your business for more money. However, you may be able to get creative on putting the deal together. A quick plug - Baton’s valuations are constantly being updated as interest rates change. If you are thinking about selling - Baton has a team of transaction advisors that are extremely reasonable and can help craft an ideal deal.
How is inflation impacting small businesses?
I recently bought a gallon of fresh-squeezed orange juice…for $16.50. That is insane. That is inflation.
Regardless of where you live, what business you’re in, or your personal spending habits, we’ve all noticed how prices on just about everything are increasing. While the feds raising rates will hopefully combat inflation and slow things down, I wouldn’t expect prices to go down that much. Things will hopefully stagnate soon though, allowing you to better predict your costs for the next two years.
The bad news for small business
I’d expect much of the increase in costs you saw in 2022 to remain where they are moving forward. Historically, there have been few deflationary periods in US history. You may also continue to see some increases in costs while the fed continues to fight inflation with rising rates.
The good news for small business
You can increase your prices to combat inflation. It can often be a hard pill to swallow, but you should be passing your increased costs on to your customers.
We raise prices every year on January 1st. This year we had less pushback than we’ve ever had before, primarily because everyone knows how much orange juice costs.
Can I still sell my business this year?
Small business sales have continued to increase over the last several years, and there is no sign of that cooling down regardless of what happens with the broader macroeconomic environment. More people than ever before are approaching entrepreneurship through business acquisitions. I’m in countless groups where young people coming from tech, corporate jobs, or wall street are all looking for great businesses they can acquire and operate.
Similarly, there are more private equity firms and strategic buyers for small businesses. As the stock market has cooled over the last year, many investors are looking for private investments into funds that invest in small businesses and to acquire small businesses directly. That is keeping demand for businesses high.
The team at Baton can help you get started if you’re considering selling - it all begins with a no strings attached, free valuation.