Bridging Valuation Gaps

​Business sellers often think their business is worth more than what a buyer is willing to pay for it; at least, what they will pay as an upfront payment of “all cash.”  That’s not to say that either party is right or wrong, it’s just both parties view the risk/reward balance from a different frame of reference. Deal negotiations almost always involve some degree of compromise. This blog article outlines some ideas that can be used to help bridge differences of opinion between buyers and sellers on business value.
 
Earnout
The use of an earnout is one common mechanism buyers and sellers of private businesses can use to simultaneously satisfy both parties differing viewpoints on business value and its growth potential. Since buyers often remain skeptical of the sellers’ projections, particularly when there are a lot of market uncertainties, the earnout can help mitigate those concerns, as payment is made when expected results materialize. Earnouts are usually based on meeting certain future financial metrics, such as sales, or EBITDA.
 
Milestone payment
Similar to the earnout, a milestone payment is when a buyer agrees to make additional cash payments to the business seller(s) after the transaction closes, contingent on the occurrence of a certain agreed-upon event(s). Normally, it applies to situations where the seller has laid the groundwork for a significant event that will positively impact the business and thereby negotiates a cash payment should that event occur under new ownership within a given time frame. For example, if the business obtains a new “game-changing” customer, a patent is granted, a new product is granted regulatory approval, etc.
 
Holdback in escrow
When the buyer and seller disagree about the potential financial impact or risk associated with a potential future event, the parties can agree to place a portion of the purchase price in escrow, subject to payout to the seller if the event remedies itself, or repaid to the buyer if it doesn’t, within an agreed-upon time. Examples could include the outcome of a lawsuit or a product regulatory review. Holdbacks are standard practice in the M&A negotiation process as protection for the buyer against misrepresentations by the seller, but can also be used as a tool to bridge differences in perspective of the likelihood of certain negative events occurring in the future.
 
Seller financing or vendor take-back (VTB)
Sometimes the simplest solution for a value gap can be solved when the seller agrees to help finance the deal with a vendor take-back note secured by the company’s assets and/or personally by the buyer. It helps the buyer acquire the business based on the future cash flow it generates. This is very common with “main street” deals and in the lower-middle market, as access to competitive financing is often less robust for smaller buyers. It also demonstrates confidence in the business and its outlook by the seller. While there are many ways in which deals with owner-financing can be structured, in general, most sellers will want to stay involved in the business to some degree to keep an eye on their ongoing investment and the ability of the buyer to eventually pay out the VTB.
 
Equity rolls
Like the VTB, when a seller agrees to re-invest proceeds as equity back into the business, it demonstrates confidence in its future potential and therefore can be a means of obtaining a higher valuation. Unlike the typical VTB, it allows the seller to share in the upside potential of the business, however, the seller will also share in the relative risk associated with the business.
 
Equity rolls are common in PE-sponsored deals, but less common when the buyer is another industry participant (strategics). Full liquidity of the investment normally comes naturally when the PE-sponsored acquirer sells the business (usually 3-7 years after its initial investment) but it can be a little trickier in strategic buyer equity rolls. When a future sale of the entire business is not anticipated in the foreseeable future “Put Options” can be a solution. This is when the seller negotiates an option to sell some or all of its rolled equity to its equity partner at fair market value during an agreed-upon period in the future.
 
Discounts to an ongoing commercial relationship
In some cases, buyers and/or sellers may be able to negotiate a preferential business relationship to help bridge differences in value. For example, the seller could provide products or services to the buyer at preferred rates for an agreed-upon period, in turn for paying a more attractive price for the business.
 
Retention of real estate
Many buyers are more interested in the operating business than any real estate that is owned by the business. Sellers can sometimes retain the real estate and lease it back to the new owner, thereby reducing the purchase price for the buyer and gaining a stream of future income. This approach can also potentially defer some taxes for the seller.
 
Anti-embarrassment protection
Some sellers are afraid that a buyer will acquire their business and simply “flip” it in a year or two at a much higher value. On occasion, it may be possible to use an “anti-embarrassment” provision whereby if a flip were to occur within an agreed-upon time, the buyer is required to share a portion of the proceeds with the original seller. This is used mostly when the seller is forced to sell for some reason.
 
Product line or business unit carveouts
Buyers often have specific reasons why they want to acquire a business, whether it is gaining market share, scaling operations, capturing synergies, or simply putting capital to work. However, there is usually no perfect business that meets all its objectives. Sellers need to be keenly aware of the attributes of their business in which the potential buyer sees the most value, and conversely the aspects of their business in which the buyer sees little value. Sometimes, it may be possible to carve out those components of the business in which the buyer places little value, to retain or sell to another buyer in the future. For example, there may be patents, products in development, products/product-lines, business units, facilities, etc. in which a carveout could bridge a valuation gap.
 
Transition plan
A large part of the value of any transaction lies in the retention of key people, often including the owner and/or management team. Sellers that are open to working with the new owner through a transition period can help reduce the risk for the buyer and thereby bridge valuation gaps.

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