Bridging the business valuation gap

It is not uncommon to see a business valuation gap between what a seller is willing to accept and what a buyer is willing to pay to buy a business. Amanda Brockwell looks at what sellers can expect from buyers in today’s market, how they can achieve an acceptable meeting point on price, and how the price can be funded, particularly where there may be a significant element of deferred or contingent consideration.

Business valuation gaps – Possible solutions

In light of inflationary pressures, interest rates that have yet to fall, geopolitical instability and employee and supply chain difficulties and in circumstances where debt funding of transactions has become more challenging, there is often a business valuation gap between what a seller wants to receive and what the buyer is willing to pay.

Valuations are often looked on very sceptically. Buyers lack confidence that historic revenues and levels of profit (or EBITDA) can be maintained and are unwilling to offer the same multiple as they might have paid one, two or even five years ago. Lenders also have similar concerns and so are not willing to lend the same amount. In addition, with higher interest rates, debt service has become a real issue and will also limit the debt capacity of a business. Therefore, sellers should consider other solutions that result in a lower initial payment being paid provided the aggregate payment remains at an acceptable level.

Deferring an element of the sale price

One solution is to defer an element of the price but this does create the following issues:

• In reality, the deferred element of the price is a debt owing by the buyer to the seller for a period of up to one or two years . This can be structured as a series of regular payments over the relevant term or could even be more formally structured as a vendor loan note.
• The seller may require security for this debt and may want to receive periodic payments of principal and (possibly) interest.
• As the seller will retain an interest in the ongoing performance of the business, it may look to protect this by requiring certain veto rights (for example no disposals or acquisitions of other businesses or subsidiaries, no borrowing, security or significant capex without seller approval).
• Any lender funding the acquisition will need to be happy with the structure, in particular with the level of seller loan, any security and the deferred payments. Documenting this can be time consuming and adds a layer of expense. The seller loan will need to be subordinated to the senior acquisition debt but may be subject to permitted payments.
• The lender will need to be happy with the source of funding for the payment of the deferred price. More often than not it will have to come from the profits of the trading target.
• The funding could also come from the lender and the buyer in a pre-agreed proportion.

Earn-out structure

Alternatively, an earn-out structure where  additional price is payable which is conditional on the future performance of the business should be considered. In real terms the seller is backing the future performance of the business. The buyer pays less if the business underperforms and may end up paying more if the business outperforms. This de-risks the acquisition for the buyer.

Earn-outs are specific to the business being sold but would include:

• the length of the earn-out period;
• whether the earn-out will be a single payment or a number of staged payments;
• the financial metrics against which the earn-out will be calculated;
• protections for the seller to prevent the buyer from artificially manipulating financial performance; and
• an independent expert determination in the event of any disputed valuation.

An earn-out raises some of the same issues as deferred consideration (indeed it is a form of deferred consideration, albeit contingent upon future performance) but is probably simpler to deal with for a funding lender. The debt owing by the buyer to the seller only arises when the performance condition has occurred (typically delivery of annual audited accounts and a certificate from an expert) and is reliant upon the business performing well (or even out-performing the agreed business plan). If this is the case the increased price/deferred consideration may well be self-funded (the business generates more cash which can be used).

Sometimes sellers can be persuaded to invest a percentage of the proceeds from the sale of the target back into that business – known as a “rollover”; often used in private equity transactions where the sellers are co-investing with the private equity investors in the process. Sellers can also roll-over into loan notes alongside their equity stake. They enable sellers to benefit from the growth in value of a business post-acquisition and help buyers address cases where they do not have access to all the cash proceeds necessary to meet the sellers’ valuation. Partial acquisition sellers would ordinarily expect to sell all of the shares in their company. Sometimes buyers adopt a more cautious approach by acquiring a majority holding plus a put/call option for the minority retained shares.

For a seller this means:

• receiving less completion monies at closing;
• no “clean break” on Day 1; and
• being “locked in” as a minority shareholder without full control for the put/call option exercise period.

The put/call option documents will need to include:

• the length of the option exercise period;
• how the option price will be calculated and whether it is subject to a floor/cap or any other deal-specific requirements;
• a robust dispute resolution mechanism in respect of the valuation; and
• seller control rights in respect of the business, which include observer/director appointment rights, reserved matter vetoes and information rights.

Majority of acquisitions will require the parties to enter into a shareholders’ agreement in addition to an acquisition agreement so the negotiation of this document will need to be factored into any deal timetable.

If you would like to talk through the options when there is a business valuation gap on your proposed sale, contact a member of the Corporate team.  To see all of the services we can offer businesses, visit the Corporate section of our website.

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