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In M&A, it’s very common for buyers and sellers to disagree on the value of the business. If both parties cannot agree on the price, the deal could fall apart. However there are certain strategies and tools that both parties can use to compromise and be happy during closing. In this article, John Blair, Partner M&A Attorney at K&L Gates, shares best practices on how to bridge valuation gaps in M&A.
“If people can execute and deliver on these earnout goals, buyers are happy to pay out because they're reaping the successes. The metric achieved means more cash, a stronger balance sheet for the company bought, and ultimately a higher equity value. It's a win-win situation.” - John Blair
Earnouts
Earnouts are a great way to bridge the valuation gap between both parties. It involve paying the seller more money later on, if the business does well after the sale, based on certain agreed upon metrics. In this type of arrangement, the seller gets their desired price, while the buyer ensures performance and doesn't have to pay as much upfront. There are three crucial variables that are heavily negotiated in an earnout. the size of the payment, the duration, and what it's measured against.
There are two main types of earnouts: financially driven metrics like revenue or EBITDA, and milestone related or event-driven earnouts. For milestone-related or event-driven earnouts, the duration could be much longer, like five to ten years. Financially driven metrics are typically one to three years in duration, with a skew towards year one or potentially even 18 months.
According to John, milestones need to be tied to the investment thesis, which is why the legal team must be involved at the LOI phase. If they are involved any later, they can't add as much value because the terms are pretty much cemented.
Seller financing
Another way to bridge the valuation gap is seller financing, or sellers note. It’s where the seller provides debt financing in the form of a note that the company or buyer will pay out over time. Sellers are usually happy to take this, as they get their cash over time, rather than all at closing.
The buyer, on the other hand, will ensure that the seller is invested in the business's future success, without paying too much upfront.
Equity structures
When talking about preferred equity as a solution for bridging a valuation gap, we're referring to a super preferred equity that sits above the common return. This is the first in the distribution waterfall to equity holders, and is usually not paid until there's an exit or a dividend recap.
It is important to note that all of these do not overlap with one another, and can all be used in a single deal, if both parties agreed to.
Advice for first timers
Each of these strategies to bridge valuation gaps in M&A has tax implications. Ensuring the tax advisor is involved is key to avoid any untoward outcomes that create a bad result for either the buyer or the seller. Having good advisors, including a good lawyer, is absolutely essential.