It’s no surprise the volatile changes in the economy are impacting more than just the cost of eggs. Rising interest rates, limited access to debt, inflation and economic uncertainty are all contributing to an expanding valuation gap between buyers and sellers in the M&A market. To compensate for the current environment, we’re seeing buyers reduce their valuations. With peak valuations from 2021 and 2022 still top-of-mind for sellers, we’re also seeing that they don’t want to settle for anything less. This is creating a strong disconnect; one that can be upwards of two times EBITDA. But, as they say, the show must go on, and a willing buyer and seller will find a way to make their deal work.
To secure a deal that satisfies both parties, buyers and sellers must concentrate on bridging the valuation gap. ‘How?’, you may ask. By getting creative around shifting risk and economic structure through:
- Seller notes
- Equity rollover
- Other future financial considerations
Let’s dig in:
Avoiding Valuation Burnout with Earn-Outs
Sellers, who are typically founders and entrepreneurs, tend to be bullish about their underlying business and are often prepared to bet on themselves. Earn-outs allow a seller to prove a higher value by performing to future metrics. In doing so, a seller and buyer will mutually agree to performance targets (think: revenue, EBITDA, contribution margins). When these targets are realized, the seller gets paid additional consideration.
Set targets can be static (all or nothing) or paid on a range. Whichever route taken, ensuring mutual understanding and documenting the metrics is critical in avoiding future litigation. We’re talking defining the actual financial metrics and establishing an understanding of future operations and sales support – at a minimum. But even the successor accounting treatment can have a significant impact. As we know, simple changes to revenue recognition, accruals and reserve assumptions can actually dramatically alter targeted financial goals.
Seller Notes (Grab Your Pen)
Arguably one of the easiest methods to bridging a valuation gap in a fluctuating economic environment is with a seller note. Seller notes can fill a void between the amount of traditional capital a buyer can access (or is willing to assume) and the purchase price. Seller notes, in essence, defer payment and are subordinated to senior debt – creating limited risk to the primary lenders. Major selling point: the cost of this approach is advantageous to both sellers and buyers, as the interest rate is usually higher than senior debt but less expensive than equity.
With an equity rollover, sellers retain a material interest in the company, responsible for ensuring all parties’ interests align and that key drivers of past success remain incentivized to continue. Traditional equity rollovers, in prior years, may have targeted 20% material interest. Rollovers in the current environment can increase to 30 or 40%; in some cases, a seller can even retain a majority of the company.
You might be thinking – how does this benefit a buyer? The primary advantage of an equity rollover for a buyer is less cash outlay, meaning less risk in a potential future second transaction as economic conditions stabilize. The seller, at the end of the day, monetizes a portion of the equity value to minimize risk, while still maintaining a significant interest in the future success of the business, creating another opportunity for a second payout at a higher valuation.
Other financial considerations based on performance
Buyers and sellers realistically have countless other options to bridge the valuation gap, customizable to their end goal. However, the options all have one element in common: deferred payments to the seller as a way to lower buyer risk and current cash outflow. For example:
- Consulting agreements
- Unique bonus arrangements
- Management incentive plans
- Equity incentives
When you need someone to guide you through
One thing is certain: the M&A market is resilient. At the end of the day, buyers and sellers will continue to perform deals. Determining how to effectively bridge the valuation gap can move deals along quicker. Our team at Sikich knows transactions and can find and create value for our clients. To get in touch with our team before your next deal, contact us today.