Merger and Acquisition Advisor - Bridging the Valuation Gap
Posted by jason wilcox on Wed, May 05, 2010 @ 06:58 AM
As a merger and acquisition advisor for private businesses, the valuation gap between a buyer and seller is a common issue in today's environment.
How are buyers and sellers bridging the valuation gap?
There are many creative ways to structure a deal to bridge a valuation gap. Below are a few of the most widely used in which buyers and sellers can benefit.
Cash plus earn-out. Obtaining 100% cash is typically most desirable. However, tying a portion of the purchase price, through a contingent payment, to future performance is one way to bridge a valuation gap. In a cash plus earn-out structure, a seller takes some risk out of the deal by receiving cash today, but can still receive future payments that increase the ultimate price received. The buyer takes out some risk because part of the purchase price is tied to positive future financial performance. If the company achieves its goals, the buyer is happy to pay the earn-out. Note that earn-outs can be tricky, so the KISS principle (keep it simple stupid) applies in spades.
Cash plus seller financing. Another way to bridge a valuation gap is for the seller to receive a portion of the purchase price in a note that pays principal and interest over time. The seller receives an interest rate higher than he can achieve elsewhere and the buyer is able to structure flexible capital that allows him to pay a higher price.
Cash plus buyer stock. For buyers who are willing to use stock in a purchase, a seller can take a portion of the purchase price in cash and close the gap by taking the buyer's stock. The seller will need to perform his own due diligence on the buyer in order to get comfortable with holding stock, as well as the various securities restrictions. Also, depending on the characteristics of the buyer's stock, there may be some hedging mechanisms (ex. collars) a seller can employ to increase the probability of cashing out in the future at an appealing price and/or reduce the risk of the stock value dropping.
Seller rollover. As in many private equity backed transactions, the seller will "rollover" or contribute some of his equity into the new entity. In exchange, he will receive new equity securities and will continue to be a meaningful owner. In a typical private equity recapitalization, the seller may end up owning 20%-40% of the equity in the new entity.
Structured equity. Another way to bridge the valuation gap is to structure a "back-end" payment tied to a hurdle rate of return. This typically applies to a private equity backed transaction. If over the life of the investment, the private equity group achieves a rate of return above an agreed upon hurdle rate, the seller shares in any incremental upside. For example, if the buyer and seller agree to a 20% annual rate of return hurdle and the investment results in a 30% rate of return, the seller would be paid a portion of the incremental 10%.
In conclusion, the valuation gap is real and pronounced in this environment. For companies with the right qualities, and through creative deal structuring, sellers can still execute fair deals.