When the economy’s health is uncertain, the rules of the game change, and the participants in M&A transactions must be flexible enough to respond.
In today’s economy, financing the transaction is not the buyer’s only concern. Fundamentally, M&A transactions take place because the buyer thinks that it can do more with the business or its assets than the owner can. In other words, the buyer values the business at a level that is higher than the value the seller places on it. Accordingly, the buyer will want to have a clear idea about what will happen with the business following the closing. If the future is cloudy, it is difficult for buyers to project what will happen following the closing, thereby adding to the buyer’s uncertainty. Added uncertainty means greater risk, which quickly translates into a lower offering price.
Unfortunately for buyers, owners of privately held businesses are unlikely to be sympathetic with a buyer’s concern over the future. They often view their businesses not as investments, but rather as lifestyles, jobs and/or measures of their social status. Therefore, reaching a “meeting of the minds” on price will be difficult in uncertain economic times, unless the business needs to be sold for some reason.
The differing perspectives of potential buyers and sellers create what some refer to as the valuation gap. That is, sellers value their companies more highly than potential buyers do. To bridge that gap, potential buyers can resort to several different tools, including seller financing, earn-out provisions and seller participation in ownership following closing.
Each technique has its challenges. Nevertheless, given the current economic landscape, one or more of them are likely to be a part of most M&A transactions for some time to come.
Because the credit crunch has made it difficult for buyers to obtain sufficient leverage to finance their acquisitions, they are increasingly calling upon sellers to finance a portion of the purchase price. This tactic is especially prevalent among smaller transactions involving private sellers. Seller financing decreases the amount of equity that the buyer must provide and reduces the amount of senior debt that the buyer must obtain.
Another way in which buyers and sellers attempt to bridge the valuation gap is by making a portion of the purchase price contingent upon the target company’s achievement of certain specified performance targets. As with any such technique, there are pros and cons.
Normally, buyers like earn-out provisions. If a buyer intends to retain some of the company’s owners as employees of the target company following the closing, it will also provide an incentive for these employees to work toward reaching the specified performance targets.
The specified performance targets comprise the heart of the earn-out provision. Sellers usually prefer metrics that are high on the income statement, such as revenues or receipts, because they are less prone to manipulation by the buyer. Conversely, buyers prefer metrics that more accurately reflect value, such as earnings per share or EBITDA. The overall duration of an earn-out provision is also the subject of considerable negotiation, with buyers typically preferring periods as long as three years.
Seller participation in ownership following closing
Another tool that parties use to bridge the gap on valuation is to have the seller participate in the ownership following the closing. This ownership could be in the company that was sold or it could be in the acquisition entity. The stock that the seller holds is rarely the same as that which the seller held before closing.
If the seller participates in the ownership following the closing, the tax planning is crucial. If the transaction fails to qualify for tax-free reorganization treatment, the sellers would normally be subject to tax on the shares they receive, even though the shares might be illiquid or subject to transfer restrictions.