How Inflation will Affect M&A and Funding

With all the new government initiatives in place, experts are expecting the United States money supply to increase by about 50% from the beginning of 2009 to the end of 2010. To provide you with some perspective, this is far greater than any other increase in money supply in recent history. You might remember from high school economics that increases in money supply generally take form in two ways: 1) economic growth, and 2) inflation. While no one is expecting 50% growth anytime soon, most economists agree that it is quite apparent that this increase in money supply will rear its ugly head in the form of major inflation. Although we are mostly likely to see the beginning of economic recovery take place either later this year or early next year, when hyperinflation occurs, we may end up being placed in a similar situation to what we are in right now.

Let’s look at what happens to the capital markets during inflation. In order to curb inflation, governments try to reduce the money supply by increasing interest rates and sometimes increasing taxes as well. When interest rates increase, the cost of financing an acquisition is much higher and such increased cost usually discourages buyers from acquiring. Secondly, most buyers use a valuation method that uses some form of a discounted cash flow model. When calculating the amount by which to discount your projected cash flow, the starting point is usually the Treasury rate (or risk-free rate). This means that when the Treasury rate is higher, the discount is higher because a buyer could safely park their money in a risk-free investment with high interest. The result is that buyers are likely to discount your company even more to accommodate the additional risk. Ultimately, all valuations will probably decrease if the interest rate is increased. Also, as you are likely aware, as taxes increase, investors decrease risk and don’t make as many efforts to generate money through investments. As taxes increase, business owners themselves are also less likely to cash out due to the increased tax consequences from any such sale.

Therefore, if we see significant inflation similar or greater to what we saw in the 1970’s, our capital markets will continue to be in a difficult situation. This will be terrible for corporate growth, funding for startups, and M&A and in general. Inflation, coupled with the large number of baby boomers that will need to exit their business within the next ten years, will most likely affect valuations. Because there will likely be “mini-M&A” wave coming later this year and next year as money supply increases, but before inflation hits, you should consider identifying your options for a timely exit, given that it generally takes 6 to 12 months to find a buyer. An M&A intermediary or an M&A advisor such as Orion Capital Group can assist owners of companies valued between $3 and $50 million plan their exit and find buyers. Visit our website at www.orioncg.com for more information.