Bridging the valuation gap in times of uncertainty
Global | Publication | January 2023
Rising interest rates, long-lasting inflation, supply chain uncertainty, regulatory changes, pressure for business transformation, geopolitical instability, economists predicting a global recession – dealmakers are increasingly confronted with extremely challenging conditions that affect their M&A-roadmaps. Against a backdrop where funding of transactions has become more difficult and where there can be a gap between what a seller expects and the buyer is willing to pay, “bridging the valuation gap” has become a hot topic. So, what should sellers be prepared to expect from buyers in 2023?
Sellers will need to anticipate a considerable amount of buyer scepticism with regard to valuation and be ready to discuss earn-out structures. In a market environment that is affected by an economic downturn, thoroughly diligencing the valuation of the business to be sold and having substantive arguments readily available to defend the business plan of the target business has become much more important. An earn-out may be a way to enable the parties to agree a deal even if there is a substantive gap between seller and buyer expectations of the future financial performance of the business.
However, experience shows that earn-outs often result in post-transaction disputes if not properly structured and drafted. Every earn-out is unique to the business - there is no one size fits all approach that can be taken to formulating key earn-out parameters, and the drafting of these must be crystal clear. Key areas of consideration include the financial or operational benchmark against which the earn-out will be calculated, the period during which the seller can earn the additional consideration if the business performs well, whether the earn-out will work as one single fixed payment or multiple payments, if there is a need to obtain security for the earn-out, how the earn-out is actually determined (e.g. based on annual accounts or specially prepared earn-out accounts and underlying reward formula), as well as protection mechanisms to avoid manipulation and, in the event of dispute, with independent expert determination of the disputed valuation.
Vendor financing structures
Rising interest rates have made acquisition finance particularly challenging. Especially in smaller and mid-sized M&A-transactions, many buyers find it necessary to require an element of vendor financing to support their acquisition financing. Sellers should therefore give thought to whether they would accept this form of financing (and, if so, to what extent), including in light of the buyer’s solvency, and what form of security (e.g. parent guarantees or pledges over shares and/or assets) they will need from the buyer in return for financial support that will be subordinate to the buyer’s financing banks.
Sellers would typically expect a full buy-out, but in uncertain times buyers may take a more cautious approach and prefer to share risk by acquiring an initial majority holding coupled with put and call options exercisable in the future in respect of the minority. From a seller’s perspective this will mean receiving less funds at closing, no clean break from the divested business and being locked in as a minority shareholder without full control for a set period of time (often between two and five years).
As with earn-outs, the nature of any put and call structure will be unique to the business in question. Careful consideration is needed of key elements such as how the option price is calculated, whether it involves a minimum price (floor) and is subject to a cap (ceiling) or not, the period of time during which the options can be exercised, and the need for independent expert valuation to avoid post-transaction disputes. In terms of governance, the seller as minority shareholder will also want to ensure a level of control in respect of the business, which may (depending on the size of the retained stake) include having the right to appoint a director, veto on major matters and comprehensive information rights.
Mind the gaps in transaction documents
Earn-outs, vendor financing and majority acquisitions are key elements of dealmakers’ toolboxes these days and there is room for creative solutions to get deals over the finish line.
But care is needed when these structures are used - whether separately or in combination – and the transaction documents will become much more complex as a result. For example, earn-out structures need to be aligned with seller warranties and remedies (to avoid a double dip in protections), majority acquisitions will come hand in hand with a supporting shareholders’ agreement, vendor financing will usually be linked to a security package, and a greater understanding of the business plan will be required when translating the commercial terms of the transaction into the SPA. Above all, buyers will intensify their due diligence, sellers will need to consider the impact of potentially extended transaction timelines, and all parties will be focused on how to ensure deal certainty in uncertain times.
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