There is no doubt that the events of September 11th have had a dramatic impact on the United States. As a nation, we are still coming to grips with this tragedy, and we are struggling with a number of issues, including the impact that these events will have on our economy and capital markets. All of our clients and prospects have been asking us similar questions – “how do these tragedies impact the current atmosphere for M&A and what, if anything, should we be doing in light of the changed economic environment?” While every deal is unique, and certainly requires specific advice and guidance, we can speak loosely to those trends and factors that seem to be reverberating throughout the M&A and financing world.

The Environment

What has become clear is that the much hoped for economic rebound in the 3rd and 4th quarters probably isn’t going to happen. Most market strategists are pointing to a 1st and 2nd quarter 2002 rebound at best. Today one may hear lots of discussion whether or not we are looking at a V shaped or U shaped rebound. Unfortunately, somehow this seems to imply that the up slope will be similar to the down slope we have been experiencing since the March 2000 high. My guess is that this will not be the case; rather we will see a more gradual recovery, not returning to the previous market highs for some time. I think we may be looking at a significant period of a flat market, with gradual improvement in market fundamentals and valuations, and a gradual reopening of the IPO window.

Why do we think this way? It’s no secret that consumer spending has been keeping the economy afloat for some time now. A significant number of businesses, including some well-know technology companies in particular, were faced with huge inventories that they had to burn through precisely while their core businesses slowed. Other technology companies weren’t so lucky as their business models just fell out of favor. Seemingly overnight, these businesses and their corresponding business models ceased to be deemed viable, and were completely cut off from any form of capital. Despite the worsening overall business conditions, there was one column left standing strong in the economic picture, the consumer. Luckily that vast majority of consumers continued their spending habits relatively unscathed by the market meltdown. While we all witnessed the market downturn, and watched as our 401K’s, mutual funds, and other investments went into the proverbial toilet, there seemed to be the realization among the greter public that eventually these investments would recover (to some extent) and in the long run things would work themselves out. Overall the country was relatively healthy, the economy was still expanding, and job security wasn’t really an issue. So despite the market gyrations, people still purchased new cars, went out to eat, took expensive vacations, and made the expenditures that they would normally do.

Now, things aren’t as clear. While the long-term economic impacts of the attack and subsequent war on terrorism remain to be seen, one thing is sure, Americans aren’t as secure as before the attacks. Some initial reports are targeting the overall economic impact of the attacks as being as high as $100 billion in 2001 alone. Given this uncertainty, we can expect consumer confidence to falter (at least in the short term), thus shaking the lone pillar that was supporting the economy. The markets have seen this and have responded, as one would expect they would. For the period from September 10 to September 21, the DJIA was off 14.25 percent. Junk bond spreads (Ba1) are trading at 810 basis points higher than their government comparable, as investors made a flight to quality for the security of AAA US Government debt. While there has been some recent bounce back, the uncertainty is still being felt in the market, and will continue to do so in the short to mid term. Perhaps what is the most distressing is that no one seems to be capable of making a strong argument as to when is the proper time to get back into equities. Given the uncertainty and subsequent drop in fundamentals, leading equity strategists are divided in their opinions regarding recovery and appropriate asset allocation strategies.

Countering this drop has been some aggressive action by both the Federal Reserve Bank and the Federal Government. The Fed has gotten extremely aggressive in its efforts to boost the economy by attempting to wage its own war on interest rates. Additionally, the numerous announced government spending programs, including bailouts and a stepped up spending plan on homeland defense, will further help bolster a flagging economy.

Lower interest rates will certainly lead to increased refinancing of both consumer and commercial debt, thus increasing the amount of discretionary cash in the economy. But what remains to be seen is to what effect will the counterbalancing uncertainty have in determining how people will deploy this new free cash. Will issues regarding existing over-capacity and consumer confidence have more to do with economic recovery than do cheaper capital? Many people are asking themselves, what good is a lower mortgage rate if I don’t have a job to make the subsequent payments? Business managers are asking, why expand the shop floor with new capital equipment when the existing machinery is running at 70 percent capacity? As an economy we understand what cheap capital is about, and the hollowness of thinking that abundant or cheap capital can cure all of our economic ills.

Some people have noted that given the recent market declines, this has to be the bottom, hence suggesting a buying opportunity. But we forget the herd mentality of the street. Many institutions seem to be saying, “Prove to me the worst is over, show me economic signs of a recovery and positive momentum in the market, then we can discuss getting back into equities.”

The Challenge

So what does this mean to folks looking to sell or get financed? Valuations (both M&A and private financings) are intrinsically linked to the public equities markets. Both the openness of the IPO window, and the overall health of the equities markets can serve as useful barometers for the health of private financings and M&A markets. Needless to say, until we have some more stability and visibility into these markets, we can expect valuations to be less predictable.

Entrepreneurs, investors and management teams are still struggling to get acclimated to the new environment we find ourselves in. While most people understand that the valuation bubble has popped, many have yet to figure out what the subsequent “fair” market valuation should be. Rather, what we are seeing is a return to those fundamental tenets about creating and driving value. The new rules for valuation in 2001 and 2002 are in fact the old rules. See below.

1. Customers count – the more the better.
2. Revenues are good – profits are even better
3. Cash profits count – GAAP earnings can’t be deposited in the payroll account

A few other things are accompanying this return to fundamentals. People now read business plans with great scrutiny. There is a renewed understanding that glossing over executive summaries is no substitute for due diligence. We are seeing investors and partners stress a need to understand what one’s value proposition is to customers; what are customers willing to pay for the product or service, and how defensible is the opportunity? What is the maturity of the space or technology? What does the exit look like, and what are the risks associated with that exit?

Additionally, there is a tremendous amount of scrutiny being placed on the financials of an opportunity. Not only are investors struggling to understand the economics of an opportunity, but often financial projections can serve as a litmus test to gauge management’s capabilities. A management team that presents unrealistic or unsupportable financials, may not have a firm grasp on the workings and dynamics of their industry.

In meetings we are hearing questions that reflect many of these concerns.

“Why do people buy your product or service?”
“How do you compete in this market?”
“Explain to me your cash position and comment on the company’s cash generating capabilities”

Not only are strategic acquirers asking these kinds of questions, but we are also hearing similar feedback from financial investors. Many private equity investors and VC’s are now focused inwards, dealing with their portfolio companies, trying to separate the wheat from the chaff, and having those heart-to-heart conversations with limited partners regarding the portfolio’s true value. In light of this inward focus, many funds are being extremely careful with their allocation of capital to new investments. Diligence is taking longer, valuations are not as rich, and terms can certainly be reflective of this buyer’s market.

The Response

So what does this all mean? Well, the obvious – only those companies with a truly credible reason to be going to market should do so. Deals are still happening, but only those that make sense, have a defensible value add, and are truly synergistic. The vetting process has become more thorough and more invasive, with a distinct focus on the economics of the transaction. Management teams need to understand this new landscape, and must anticipate the challenges that this presents.

Additionally, those seeking to execute transactions in this environment need to be agile, having a flexibility regarding what they deem to be a successful outcome. For the majority of transactions, valuations, terms, and conditions will not be what they were six or twelve months ago. Yet in spite of this, markets will continue to evolve, technologies will continue to be born and mature, and attractive opportunities will continue to present themselves.

Successful entrepreneurs and management teams are usually quite resourceful people, and have an ability to think out of the box, a talent that will be especially helpful in these volatile times. This market can be considered a true acid test, an open challenge to those management teams who posses the imagination and integrity necessary to successfully address this challenge. Just as our country is successfully addressing the hurdles put before it, I am sure a significant number of you will successfully address these obstacles as well.

Todd McMahon is a partner at RCW Mirus and heads up the firm's technology practice.  Please feel free to contact him at 617.338.1333.