Higher Inflation Means Higher Interest Rates
During an economic cycle, the appearance of inflation causes the value of purchasing dollars to fall. Lenders then get paid in dollars that are worth less, and will in turn demand higher interest rates in order to combat depreciating effects of inflation. Since inflation seems to be an ever growing fact of life, it appears that we will face higher interest rates during the current economic cycle. For buyers of businesses, this means higher lending costs and lower risk premiums.
Higher Lending Costs for Business Buyers
Many business buyers seek external financing in order to fund business purchases. The Small Business Administration (SBA) plays a key role in backing most loans issued by banks for the purchase of businesses. The interest rate on an SBA loan may rise just as interest rates on all lending activities in a time of rising interest rates. Typically, the SBA term loan is ten years, with options for fixed or variable interest rate deals.
Example of Higher Lending Costs
- Let us say that Joe is seeking an SBA-backed loan for the purchase of an auto shop.
- The purchase price of the auto shop is $500,000, and Joe is assuming that the auto shop generates a profit of $15K/month.
- Joe is seeking a 10-year term $450K loan.
- With a 5% interest rate, Joe’s monthly loan payments would be $4,773.
- Yet with an 8% interest rate, Joe’s monthly loan payments would be $5,460.
- For Joe, the profit he expects from the auto shop after making the monthly principal and interest payments on the loan is $10,227/month ($15,000 – $4773) assuming a 5% interest rate and $9540/month ($15,000-$5470) assuming an 8% interest rate.
- There is significantly less cash flow at the higher interest rate, which may deter Joe from purchasing the business.
- Moreover, many SBA loans may have variable interest rates, resulting in potentially far higher interest rates over time.
Higher Opportunity Costs
Even cash buyers of businesses have ‘opportunity costs‘ of the alternate rate of return they otherwise would have received on the principal amount used to purchase the business. In a world of rising interest rates, opportunity costs generally rise. Rather than use the money to purchase a business, an investor may simply park their money in the bank or purchase government securities. The rate of return for this risk-free investment may be around 5% and increases along with interest rates. When weighing investment options, the rate of return for the purchase of a business must compare favorably with the opportunity cost of the purchase price.
Example of Higher Opportunity Costs
- Let us say that Joe is planning to purchase an auto shop in an all-cash deal for $500K.
- Joe realizes that rather than purchase the auto shop, he can also buy U.S. Treasury Bonds which yield 5%.
- Joe’s income from the T-Bonds from the $500K is $25K/year.
- This is his opportunity cost from the $500K he would use to purchase the auto shop.
- Conversely, Joe estimates that the auto shop generates $15K/month or $180K/year in profits.
- In this scenario, Joe’s expected rate of return from investing the $500K in the auto shop far outweighs his expected rate of return from investing the $500K in U.S. T-Bonds.
- Nevertheless, cash buyers of businesses are aware of how higher interest rates impact their opportunity costs.
Higher Interest Rates Means Lower Risk Premiums
A risk premium is what an asset (such as a business) is expected to return in excess of the risk-free rate of return. The risk-free rate of return may generally be a U.S. Treasury Bond which is considered free of default-risk. The risk premium is important for business sales – along with any investment activity – because investors receive lower risk premiums for the same business when interest rates rise. If the business (or asset) does not generate a sufficient level of risk premium to compensate for the higher risk-free rate of return available during times of higher interest rates, then the investor may not purchase the business.
Example of Lower Risk Premiums
- Let us say that Joe is deciding on whether to purchase an auto shop for $500K.
- Joe expects to receive $180K/year in profits from the auto shop, so thus has a 36% ($180K/$500K) expected rate of return.
- Suppose that the current risk-free rate of return from a U.S. Treasury Bond is 5%.
- Joe’s risk premium is thus 31% (36% – 5%).
- If interest rates were to rise dramatically, the risk-free rate of return from a U.S. Treasury Bond may be 10%.
- Joe’s risk premium in buying the same auto shop under this scenario would fall to 26% (36% – 10%).
Business Sales Still Typically Worthwhile Investment
The expected rate of return from a purchase of a business is far higher than from the purchase of commercial real estate. It is common for business to be purchased for around two or three times their annual profits. This translates into a 33 to 50% rate of return. Conversely, it is rare for a commercial real estate investor to expect more than a 10% rate of return. Higher costs of lending and lower risk premiums – both caused by higher interest rates – have less of an impact on higher yielding business investments. Of course, business buyers usually must actively participate in the business which is not a requirement for buyers of commercial real estate.
Business with Pricing Power Benefit from Inflation
A characteristic of a great business is the ability to pass along higher labor or input costs to customers in the form of higher prices. Companies with pricing power may indeed prosper during times of inflation and higher interest rates by increasing their overall margins. In a rationalized industry with limited competition, a business should in the long run be able to implement price increases so as to absorb inflationary costs their incur.
Prepare Your Business to Get Best Possible Purchase Price
Higher interest rates are generally not the friend of businesses nor of business owners looking to sell their businesses. Higher lending costs and lower risk premiums do make business transactions more difficult, which is why every business seller should do everything to prepare their business for sale in order to get the highest possible purchase price.
Give Martin at Five Star Business Brokers of Palm Beach County a call today for a FREE evaluation of your business.