How to Bridge an M&A Valuation Gap
Disagreements about the price of the company are sure to pop up in any M&A process. But you have a few options for reaching a valuation agreement, including structuring an earn-out, using a note, accepting stock, and selling only part of the company.
If you’re a Seller thinking about agreeing to any or all of these arrangements, be sure to get some cash at closing. Sellers who agree to put 100 percent of the sale proceeds in contingent payments (earn-out, note, stock) are effectively agreeing to put 100 percent of the sale price at risk. Get some dough at closing!
Use an earn-out to prove M&A valuation
The venerable earn-out is probably the most common method of bridging a valuation gap between Buyer and Seller.
The earn-out allows Seller to prove the company is worth a higher valuation by agreeing to get paid a higher price only if the company achieves certain agreed-to goals. Buyer pays that higher price only if the company achieves financial results that warrant a higher price, thus providing him some protection.
Essentially, Buyer tells Seller, Okay, if you really think the future prospects of the business are as rosy as you say, put your money where your mouth is.
The earn-out is especially useful for Sellers who want be paid for the future performance of the company. You can structure earn-outs in an almost unlimited manner.
Settle a valuation disagreement with a Seller note
Sellers can help Buyers with the financing by agreeing to take part or all of the proceeds in the form of a note that Buyer pays off at some future date. In addition to helping Buyer acquire the company with less money down, the note provides Buyer with the benefit of the time value of money.
In other words, $5 million in three years is worth less than $5 million today. A Seller willing to wait for payment is providing a benefit to Buyer.
Sell less than 100 percent of the company
Another possible solution is for Buyer to acquire less than 100 percent of the business. Selling a piece of the company allows Seller to take some chips off the table and create some liquidity right away while allowing her to participate in the future upside of the company.
Most Buyers want to have a control stake in the business, meaning they want to acquire at least 50 percent of the company. In rare situations a minority stake (less than 50 percent) may be palatable to Buyer.
A Seller agreeing to sell less than 100 percent of the company is wise to include a put option as part of the sale. A put option allows Seller to sell her remaining shares to Buyer at some future date and at some future price. Most often, that price is an agreed-upon formula based on some sort of financial performance of the company.
Pay for a company with stock
In certain circumstances, Buyer may want to use stock to pay for all or part of an acquisition. And in certain circumstances, Seller may be wise to accept that stock, though she should speak with her tax advisor about the tax ramifications of that arrangement.
Issuing stock allows Buyer to make an acquisition without using cash or borrowing money (or by using less cash and borrowing less money). The downside for Seller is that the stock obviously isn’t the same as cash. Seller has to convert that stock into cash by finding a Buyer for it.
Although Buyers may be tempted to issue more stock as a way of financing an acquisition, they should carefully consider the effects of diluting their stock in that way. Is issuing more stock really the best course of action, or does borrowing money to finance the acquisition make more sense?