Valuation discrepancies at LOI stage

March 20, 2022

by a searcher from Pennsylvania State University in Philadelphia, PA, USA

Hi guys - I just submitted an LOI on Friday that will most likely get turned down due to value and I am thinking through my options on a response. The seller and broker are asking 3.91x 2021 SDE / 4.95x 2021 Adj. EBITDA, but my SBA lenders do not believe the business will appraise at this value. They are taking a 3-year average of SDE and the business had a large pop in growth in 2020 and backed it up with another very good###-###-#### The problem is 2019 numbers were significantly lower and are bringing down the lenders' value by a wide margin. Underwriting a Covid-affected business (positive or negative) could be a whole separate conversation, but in short I believe their current EBITDA levels will be sustainable.

My initial bid came in at 2.93x SDE /3.71x 2021 Adj.EBITDA and I would be comfortable moving up to###-###-#### 2x Adj. EBITDA, but at that price I will most likely lose support of my lenders. I think that higher price is fair, and I am actually putting two companies together, so with synergies it's really a pretty good price.

Has anyone wanted to bid higher on a company but their lenders were holding them back a bit? I've starting thinking through alternative means of financing but it will certainly come at a higher cost. I think I could get the deal signed at###-###-#### 2x but will lose my financing. Any thoughts or ideas? Thanks in advance.

Reply by a searcher
from University of Pennsylvania in San Francisco, CA, USA

A few thoughts:

The bank may be offering you helpful "guardrails" on the deal. Ignore their counsel at your own peril. That being said, if you are confident in the deal, you may consider a consulting agreement like this:

A consulting contract for 24 months with the following stipulations: 1. The contract will be valued at $XXX in exchange for *Seller consulting. The contract can be paid in full anytime during the first 12 months with no interest. After the 12 month anniversary of the closing date, the remaining balance will be adjusted based on a percentage of gross revenue increase from a benchmark of $XXX revenue. IE Gross Revenue for 12 months following closing: $XXX (current baseline) Interest applied to remaining balance will be 0% $XXX (current baseline) + 10% Interest applied to remaining balance will be 30% $XXX (current baseline) + 20% Interest applied to remaining balance will be 50% $XXX (current baseline) -50% Interest applied to remaining balance will be -50%

Lots of ways to set this up but this may align incentives and move the deal forward. Interested in others' comments as well.

Reply by a searcher
from University of Toronto in Toronto, ON, Canada

Shawn, I let go of a deal where I was in a similar situation. My feedback is similar to ^redacted‌. . Unless you are a strategic acquirer who has a strong handle on synergies and market prospects, it would be prudent to value the business "as-is". Offering the 0.5x as a contingent consideration (non-cash) is saying "we believe you can get there, but we need to prioritize paying the lender back. The problem you can run into is if you dial up the multiple too high at the LOI stage, then you won't leave room for any adjustments that will become apparent during due diligence (e.g. working capital, AR write-downs, etc.). The multiple can start ratcheting up quickly to a point that the returns won't make sense anymore, or you would have to assume a growth rate that is difficult to achieve. I would also get 1 or 2 more banks to look at the deal. If you really like the deal, then it can be in the searcher's best interest to bring in more equity rather than more expensive debt to alleviate drag on cash flow (model it out).

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