Bridging the valuation gap – eight solutions

With contuining macro-economic uncertainty and a relatively high market volatility, valuation remains a material challenge in M&A deals. Nevertheless, there are different structures that can be used to bridge the gap and facilitate a deal, as MJ Hudson partner Eamon Devlin explains.

Vendor financing

Vendors can provide a loan from their own books to ease financing when selling assets, thereby reducing the amount of debt a bidder needs to obtain from the market and hence lowering leverage ratios.

At its most basic, vendor financing is the principals agreeing that part of the purchase price for the target is paid later. It can be structured as a traditional loan or a convertible one. The creditor ranking of the vendor financing will be key to any seller (often ranking behind external third party financing).

Earn out

Earn out is a variable part of the price paid for a business dependent on how the target performs during an agreed time period. The variable element is normally based on a pre-agreed formula, the most common being future profits.

Earn outs are also used as a mechanism to bridge the valuation gap when the buyer is wary of economic uncertainty or the seller sees the possibility of a future increase in the target’s profitability. Earn outs reduce the buyer’s risk of overpaying, but equally they will limit the chance of buyers purchasing companies for a bargain valuation (as the price will increase if the target performs particularly well). Sellers typically seek protection to ensure the target business’ performance is not artificially suppressed.  

Milestone payments

Milestone payments and contingent payment rights are also being utilised, especially in the US. Contingent payment rights increase the price paid if certain milestones are met, or upon the occurrence of certain business hurdles.

Escrow arrangement

This solution is most relevant where the principals agree on the price to be paid for the business, but they fail to agree on the financial impact of one or more identified risks which have been unearthed during the buyer’s due diligence process (examples include impending court litigation or investigation by the target’s regulator). The buyer deposits a certain portion of the deal consideration into escrow, which will then be paid if the said issues are remedied without financial damage to the target.      

Seller retaining a minority share

This involves the seller simply retaining part of its shareholding or alternatively investing in other types of instruments.  As a result, the seller will benefit from any increase in value.
 
Share-for-asset swap

The principals may not be able to agree a cash price for the target business, but it is possible that they may be able to agree on the relative values of the target and the buyer. If so, a swap of shares (or assets) may then be feasible.  

Anti-embarrassment protection

The  buyer and seller agree that if the buyer ‘flips’ the target business to a     third party within an agreed period of time (normally less than two years), the parties share, in portions to be agreed, any excess over the amount originally paid by the buyer. This may be appropriate where the seller is a ‘forced seller’, but feels that the price it is receiving is less than it is worth.  Governments often invoke this protection so as to avoid ‘political’ embarrassment of selling state assets ‘on the cheap’.

‘Asset carve-out light’

In this case, the buyer acquires, for example, specific intellectual property, R&D, distribution and customers, leaving behind other assets, such as the production site. The seller engages in interim manufacturing until the buyer’s production is fully operational. 

In conclusion, given the difficult financing environment, principals who show flexibility in M&A processes and employ innovative deal structures are likely to be more successful than those expecting the pre-crisis standard M&A transactions.

Eamon Devlin is a partner at law firm MJ Hudson.