Exit opportunities for manufacturing companies require planning, diligence, and patience. The manufacturing industry has had it rough over the past few years. Supply chain challenges stemming from the pandemic have lingered, rising costs of materials and borrowing have tightened budgets, and workforce challenges have made staffing difficult, leading to significant backlogs for some companies. Given these concerns, it is easy to defer planning. But now is the time to plan for ownership and leadership transition, which are essential for business continuity.

National and regional surveys show that about 51% of businesses are owned by boomers, and about 53% of those businesses expect to go to market, with about 47% transitioning to internal buyers, like employees. Nationally, about 83% of those businesses either do not have a transition plan or the plan is not documented and communicated. In addition, companies with higher revenues tend to have plans and shorter windows to transition, and companies with smaller revenues tend not to have plans and have longer windows. Regional manufacturing companies have been more proactive in planning than other industries. Recent surveys suggest that the percentage of manufacturers in Oregon and Washington with plans for the transition of executive leadership or ownership increased from 41% in 2018 to 51% in 2021, and 60% of respondents expect some transition within two years.[1] Focusing on preparation and planning is essential in today’s changing M&A market.

Timing and Market Conditions

The 2023 market is different from the last few years. There are fewer large transactions, more caution, a slower pace to close, declining valuations, and buyers requiring more rigorous due diligence and alternative financing arrangements. On the other hand, there is uninvested capital in private equity funds and a strong cash position of many strategic buyers, coupled with a pipeline of sellers, sell-side private-equity firm activity and carve-outs. The M&A landscape for manufacturing companies is changing and may be an opportunity or a challenge for a buyer or a seller, depending on outlook and expectations.

Despite the market differences, M&A activity in manufacturing has remained steady.  However, there is a lack of consistency in transactions in today’s market. The lack of consistency is driven by the wide variety of lower-middle market manufacturing companies in various states of readiness for an exit. Some companies emerged from the pandemic in a good cash position due to PPP loans and financial restraints, while others have struggled financially and operationally. Also, many buyers are skeptical of pandemic financial and trend information and require some “normalizing” to support valuations. And the continuing overlay of inflation and recession threats have not helped.

Readiness and Patience is Key

Buyers are spending more time on due diligence and want to get comfortable with the target rather than pushing deals through. Sellers that are prepared for extensive due diligence and exercise patience are more likely to have successful transactions. Owners should be prepared in case they ever need or want to exit the company to allow for an exit on the best terms and overall outcome.

In 2023, buyers are focused on due diligence that covers:

• licensing and compliance
• product liability and safety
• material contracts and project compliance
• customer and supply chain relationships
• quantity and quality of assets and equipment
• employees and employee benefits
• union relationships
• employee restrictive covenants
• governmental contracting status and requirements
• legal claims and litigation
• warranties
• insurance
• financial verifications like the quality of earnings reports and audited financials
• cybersecurity
• immigration and I-9s
• real estate
• environmental compliance; trademark and other intellectual property
• corporate records (even in asset deals); accounts receivable collectability
• inventory valuation
• taxes, including state sales taxes and tax impacts (both for the company and the owner)

Sellers should be ready for this type of review, which requires advanced preparation and resources, especially if tax and estate planning are critical.

Perhaps more than anything, financial buyers, such as private equity, value consistency in the target’s financial reporting and accounting processes. A target with consistently poor performance may even be more attractive than a target with extreme fluctuations in performance or poor financial controls. A buyer will conduct comprehensive legal, financial, and operational due diligence on every target. Transparency can be an effective strategy for a seller. A buyer’s biggest fear is that the selling owners are hiding, exaggerating, or minimizing something regarding the condition of the business.

Turn Risk Factors Into Value Drivers

In addition to having a strong cash position, sellers can create value in a sale by being prepared to show how certain perceived risk factors are actually positives. For example, some lower-middle market manufacturing companies have traditionally had a high concentration of customers where the only relationship is with the selling owner. Buyers are increasingly finding that customer concentration is not necessarily bad for a lower to middle-market company—the customers may be excellent and loyal, and if the selling owners can transition that loyalty to the buyer, then the customer concentration may be valuable. Owners that effectively manage the transition of core customers will have more successful transactions, especially where an earn-out provision is involved.

Another example of a perceived risk factor is a company’s supply chain. The pandemic exposed nearly every manufacturer’s supply chain vulnerabilities, particularly for those who sourced significantly from abroad. Since the height of the pandemic, more companies have brought back contract manufacturing in the U.S. to improve the supply chain. Buyers may be wary of companies that moved too quickly to source production within the U.S., and how that impacts operations and risks, particularly if that strategy required increased capital and expensive real estate. Sellers with a documented supply chain strategy and appropriate contracts with key suppliers and vendors will be best positioned to make supply chain a value enhancement instead of a risk.

Real estate is another major risk factor in today’s environment that can affect value and salability. How much real estate is in or used by the company, and do the sellers want to keep or include it in a sale? It is not uncommon for owners to own the real estate and lease to the manufacturing company. Many sellers are unsure whether or not to keep the real estate, which complicates valuation and transaction structure. From the buyer’s perspective, holding commercial real estate may be volatile, and valuations are difficult because of the uncertainty of commercial real estate in many markets. Default rates on commercial real estate are growing, and tightening lending conditions are spreading, which can add stress to acquisition financing. An owner needs to be clear on whether the real estate is included and what the expected terms are, and how that impacts the overall valuation package.

Be prepared to address questions on the company’s environmental, social, and corporate governance (“ESG”) practices. Buyers and investors are increasingly asking for disclosure around sustainability, and ESG may be a priority for strategic buyers and some financial buyers. Even if a company does not have a formal ESG program, management’s attention to climate, environmental, and social matters can help a company manage risks and generate new revenue, which helps maximize the value of a sale.

Know the Value

Buyers and sellers need to articulate a defensible and realistic valuation methodology and valuation in both internal and external transitions. Good financial information, including normalized cash flow, is essential, and a third-party valuation expert may be helpful. The valuation includes the company’s operational structure, whether a standalone business or a family enterprise, and whether or not real estate is included. Understanding the company’s value is essential to evaluating and acting quickly on offers or opportunities that arise.

Align Estate and Tax Planning with Exit Strategy

Taxes may drive many transactions and need to be analyzed from the perspective of the company, the owners personally, and the buyer. The structure of the transaction will likely depend heavily on the tax implications, including income, state, and estate taxes. Advanced planning, including estate and gift planning, is often vital. Good communication among an owners’ estate planning attorney, corporate counsel, and accountant are key to ensuring alignment in strategy and documentation.

Looking Ahead

The dealmaking environment for manufacturers is expected to be relatively stable until 2025, when current tax cuts may expire, and election year volatility will ease. This presents a runway to go to market for owners that are considering selling in the next 17 months. It is expected that private equity groups looking to make add-on acquisitions in the manufacturing sector will be active in 2023 and 2024, and generally have capital to deploy for attractive target companies. Strategic buyers with good cash balances or access to credit will continue looking to make the right acquisitions.

Planning is essential for growth, an interim transition, or an exit. The manufacturing industry is no exception.

This article summarizes opinions that are solely those of the author’s, and this article does not constitute legal advice. For legal advice for ‎your situation, you should contact an attorney.

Matt Bisturis and Carmen Calzacorta are lawyers at Schwabe, Williamson & Wyatt, P.C. Contact Carmen at 503-796-2994 or ccalzacorta@schwabe.com or Matt at 360-905-1113 or mbisturis@schwabe.com. 

[1] This is from our 2021 State of Manufacturing Survey.