There are so many timely and topical valuation issues today that it’s difficult to focus on a single subject. Many topics remain timely month after month, like the importance of establishing the value of a company for purposes of buying cross-purchase life insurance. Some topics are always important, but become more timely because of economic conditions, like the increased ability to transfer assets for estate planning purposes while valuations are depressed (as we’ve been saying for some time, the current economic environment provides an outstanding opportunity in the estate planning realm). Another topic that is always important is consideration of entity selection for companies. A number of factors make this topic even more important today.

The recent M&A market has been defined by many different types of buyers, but the most publicized has been the consolidators. The consolidation of the financial industry has dominated the headlines, only rivaled in press coverage by the reorganization of the auto industry. Step away from the public markets and the headlines and you see similar behavior taking place amongst privately-held companies. Whether a company is unable to survive in this economy or an owner wants to relieve some management responsibility, many business owners are seeking to sell their company or merge with strong partners. Due to the significant tax advantages that are provided to companies that have Employee Stock Ownership Plans (ESOPs), they often fill this position of strong partner and end up as consolidators.

We are in the midst of one of the most dynamic periods of “creative destruction” (a borrowed phrase made famous by economist Joseph Schumpeter) as a result of our current recession, or depression if you have been severely impacted, as many have. This is the time to replace old ways with a new paradigm.

The challenges that many of the country’s banks are experiencing are very well publicized and are affecting financing for companies of all sizes and across all industries. Some companies that were once coveted credits of the banking industry are now having trouble renewing senior facilities or are having them renewed under more onerous terms in spite of continued performance. Banks have also pulled back on the amount of financing they are extending to buyers of companies that want to rely on financing to support the purchase (exhibit 1). This has had several effects on the M&A market; lower transaction multiples, more reliance on equity as capital for the acquisition and higher return expectations on investments.

Merger and acquisition activity began to pick up in 2Q09 as markets bounced back from the low experienced in 1Q09. After the substantial drop off from 4Q08 to 1Q09, M&A activity increased as more buyers and sellers tested the market. Financial and strategic acquirers began to actively seek opportunities across nearly all sectors due to the widely held assumption that transaction values have decreased, providing the opportunity for higher returns. This belief, coupled with substantial capital waiting to be deployed, should help increase activity in the coming months. Additionally, business owners, having lowered their valuation expectations, should see an opportunity to affiliate with a well capitalized partner that can help position their company’s future growth when the economy rebounds, as well as pull some money out of their company.

The dramatic decline in M&A activity over the past 12 months has seen an equally precipitous drop in Private Equity’s (PE’s) share in the M&A market. As the chart below highlights, M&A transaction volume peaked in 2007 with over 12,000 transactions and $1.7 trillion in value.

Statement of Financial Accounting Standards No. 157 (FAS 157) first impacted financial statements issued for years beginning after November 15, 2007. Its effect on the most recent round of year-end financials issued by companies, underscores the critical role of independent appraisers with market knowledge when navigating these new financial reporting guidelines.

Analysis of the American Recovery and Reinvestment Act of 2009

As an owner of a privately held business, you have significant personal wealth already invested in your company. When reviewing the annual returns your business delivers, it’s easy to calculate returns based on the book value of the company. For example, book value of $4 million and pre-tax earnings of $1 million generates an attractive 25% return. However, you certainly wouldn’t sell your company for book value, so the returns on the “investment” you have in your private business should be based on market value. (Market value of $20 million with the same $1 million of earnings generates a less impressive 5% return.)

Across almost every aerospace industry segment, pricing multiples are down, and owners of middle-market businesses considering the sale of their businesses are anxious over the recession’s impact on upcoming decisions to sell.