M&A Monday*: Bridging a Valuation Gap

Almost all deals have a valuation gap. Seller thinks the business is worth more than Buyer does. There are many ways to value a business - sometimes sellers do not care about any valuation method. Often, when discussing valuation, Sellers say, this is just my walk-away number.

Here are some tools I have found to bridge a valuation gap. These can be suggested by both buyers and sellers.

1. Explain Valuation Mechanics. First, try to explain how we arrived at this valuation. I usually include a paragraph in my buyer's LOIs outlining the valuation mechanics. This adds transparency and makes a later purchase adjustment discussion easier.

2. Earn Out. An earn-out is a portion of the purchase price that is paid at a future date if certain profitability or revenue is hit. This allows for a higher net purchase price to the seller, but only if the business performs after closing (the metrics are negotiated and vary widely). There is a significant risk to the sellers that these metrics will not be achieved, and the buyer is essentially paying a higher purchase price for the growth buyer achieves after closing. An earn-out introduces a ton of complications and potential issues, so good lawyering on both buy and sell side is paramount. Note: an earn-out is not allowed if financing with an SBA 7a loan.

3. Subordinated Seller Note. A gap can be bridged by a subordinated seller note (seller loans part of the purchase price to buyer). This note is subordinate to the senior debt and can have no payments for a period of time. This creates a higher purchase price, but it can be paid off over time or at a future date.

4. Forgivable Seller Note. Forgivable seller notes are one of my favorite tools. This is a seller note that is contingent on post-closing metrics (like a seller note and an earn out). If metrics are not met, the seller note (or a portion) is forgiven. Forgivable notes are flexible and can be based on any risk that a buyer wants to account for after closing (i.e., key customers or employees). Note: for SBA 7a loans, the forgivable note metric cannot be based on achieving higher revenue/profit; but only on continuing to achieve historical targets.

5. Alternative Compensation. We can get creative about compensating seller without changing the purchase price. Examples: the seller is offered a consulting agreement or higher salary for helping the business transition; seller is offered bonuses for bringing in new client relationships; or seller retains certain accounts receivable or personal property. Note: SBA 7a does not allow for a seller to remain an employee and cannot be a consultant for more than a year after closing.

6. Rollover. Rollover is when part of the seller's proceeds are rolled into equity in the post-closing company. Sometimes, offering a bit higher price, but requiring seller to roll more equity can resolve a valuation gap. SBA 7a Note: Partial acquisition of ownership (which is technically not rollover) requires seller to personally guarantee the SBA loan (according to current understanding, but not at all clear or resolved).

7. The Retrade. This is the last resort. This is when buyer offers a price knowing that the deal will be retraded. While I do not advocate submitting an LOI with the intention to retrade a deal, there are times when a seller is miscalculating financials or the condition of the business. Thus, Buyer can communicate that they are offering $ X if the seller is correct, but if the seller is not correct there will have to be a price adjustment. I wrote about how to raise a purchase price adjustment in a past episode.

*I have not written M&A Monday posts since October 7, 2023. It pains me to go back to writing substantive M&A posts while over 210 civilians are held by Hamas in Gaza. But our resilience is our strength. This post is dedicated to Ohad Munder-Zichri currently being held captive. Today is his 9th birthday.