The State of the Economy

How will the economy impact the value and sale of your business? Let’s take a look at two primary economic factors that can affect the level of interest in your company and the price you may receive – unemployment rates and interest rates.

Unemployment Rates

If the bottleneck in your business is finding talent, a low unemployment rate may negatively affect its value. In some economic cycles, the primary limitation for businesses is hiring skilled workers. In these cycles, many businesses can’t find experienced people at a reasonable cost, which could hamper expansion. If your business struggles with growth because it’s in a talent-driven industry, low unemployment will only make this more of a challenge when selling it.

Sophisticated buyers may also consider a high unemployment rate a warning sign. Unemployment rates are a lagging economic indicator. Most sophisticated investors view an increase in unemployment as a sign of a weak economy and will remain cautious – unless you own a recession-resistant business, such as healthcare or pets.

If your wages are high as a percentage of revenue, a decrease in unemployment rates will negatively affect the value of your business. Consistently low unemployment rates tend to lead to increasing wages over time. If this happens in your business, wages as a percentage of revenue will increase, resulting in decreased earnings and a decline in the value of your business.

If your business is payroll-heavy, a low unemployment rate will cause a dip in its value. This means a market with higher unemployment may be a good time to sell. For example, if you own a business with gross revenues of $50 million per year, EBITDA of $7 million per year, and your payroll is 30% of revenue ($15 million per year), a 10% increase in wages (to $16.5 million from $15 million) will cause a 21% decrease in your EBITDA ($7 million – $1.5 million from increased wages = $5.5 million EBITDA). 

Let’s assume you could receive a 7.0 multiple for your business if the unemployment rate is 8% and a 6.5 multiple if the unemployment rate decreases to 4%. Here’s how the change would impact the value of your business:

  • Before: $7 million EBITDA x 7.0 multiple = $49 million value of business
  • After: $5.5 million EBITDA x 6.5 multiple = $35.75 million value of business
  • Result: a 27% decrease in the value of your business

Note: This level of impact would only be seen in businesses in which payroll constitutes a significantly high percentage of revenue. How high is high? The percentage varies drastically by industry. According to FreshBooks, an accounting software company, service-based businesses may spend as much as half of their gross revenue on labor costs. For most businesses, however, 15% to 30% is the norm.

High unemployment rates also weigh on the value of consumer businesses because they usually correlate to dampening consumer spending. If you have a business that caters to consumers, such as a high-end retail store, an increase in the unemployment rate will negatively affect the value of your business, especially if the trend is expected to worsen over time. For example, if you own a chain of jewelry stores, a high unemployment rate will serve as an indication that the economy isn’t doing well, especially if your products are discretionary. Weak consumer sentiment will only serve to make this situation worse. 

If your business is in a trendy or luxury industry that caters to consumers, a high unemployment rate will cause a dip in the value of your business. This means a market with lower unemployment may be an excellent time to sell.

There’s no general rule for how unemployment rates affect acquisition rates overall. Many factors and variables are at play, and these factors can also “stack” in certain industries. For example, you may have one positive factor in your business and one negative factor that cancel each other out. In other industries, a moderate change in the unemployment rate may have little impact. In still others, a significant change in the unemployment rate may signal doom for all but the best performers. As a result, it’s important to take all of these factors into consideration when you’re valuing your company.

Interest Rates

Interest rates can also impact the value of your business and overall acquisition activity. As interest rates rise, the value of businesses generally decreases. Why? There are two main reasons:

  1. The Cost of Money Increases: Because most acquirers use debt when purchasing a company, an increase in interest rates increases their monthly payments on that debt and therefore decreases their cash flow. The value of the business must be lowered to compensate for the inflated cost of borrowing.
  2. Compete with Higher Rates: When interest rates are high, other investment opportunities may become more attractive. Because of this, your business must perform better in order to compete.