Bridging the Valuation Gap in a Down Market: How Can Buyers and Sellers Meet Eye-to-Eye on Price?

Article written by?Croke Fairchild Duarte & Beres?Partner?Andrew Gilbert?

We have all seen the ebbs and flows of market activity and deal volume as the current buyer’s market has swiftly taken shape, a sharp contrast with the hot seller’s market of the past 12 to 18 months. This shift means buyers now have the upper hand in most aspects of deal negotiations, and parties face a significant valuation gap — the gulf between what sellers think their companies are worth and what buyers are willing to pay for them. Below, I discuss the causes of the valuation gap in a buyer’s market and a few strategies buyers and sellers can use to bridge that gap.

Understanding the Valuation Gap

In a buyer’s market, buyers have more options and can be more selective in their acquisitions. Companies that enter into a sale process during a buyer’s market are often times distressed or need to sell for one reason or another — otherwise, those sellers would simply hold out for better conditions. This mismatch — sellers need to sell more than buyers need to buy — means that buyers can generally demand more favorable terms, such as lower purchase prices or better representations and warranties. As a result, sellers often face a valuation gap, which is the difference between the purchase price they desire and the price the buyer is willing to pay.

Bridging the Valuation Gap

Depending on market conditions, a valuation gap can be significant, making it difficult for sellers to achieve their desired purchase price. Fortunately, there are several strategies that sellers can use to bridge the gap and maximize the value they receive from the sale of their companies. Here are just a few:

Earn-Outs

The most common option for maximizing value under unfavorable economic conditions is to use earn-outs, arrangements that tie a portion of the purchase price to future performance metrics. For example, the buyer may agree to pay an additional amount if the company achieves certain revenue targets in the years following the acquisition. Generally speaking, buyers tend to take the position that economic headwinds will cause the newly purchased company to underperform post-closing, but sellers often have a much more favorable outlook and believe the post-closing company will do better than the buyer expects.

Benefits: Earn-outs can provide sellers with the opportunity to realize more value if their company performs well after the acquisition. Alternatively, earn-outs provide the buyer protection if the company does not perform well after the acquisition. (Of course, how parties evaluate performance is complex, and below I get into some of the problems that can come up in this arena.)

Additionally, earn-outs can be structured in various ways to suit the needs of both parties. For instance, earn-outs can be based on revenue, earnings, or other performance metrics. Or the earn-out can be based on the achievement of a specific milestone, such as the successful launch of a new product, regulatory approvals, sale of key assets, etc.

Risks: However, earn-outs can also be complicated and create significant risks for sellers. For one, the future performance of the company is uncertain, and the buyer may set unrealistic performance targets. Additionally, the buyer and seller may disagree on which metrics they will use to measure performance, and that can lead to disputes over the earn-out payments. The incentives of the buyers and sellers are diametrically opposed: The buyer runs the company post-acquisition, but too much success will trigger additional earn-out payments the buyer would rather not pay. In some cases, buyers may even try to manipulate the company’s performance metrics or withhold information that could impact the performance of the company, leading to disputes over the earn-out payments.

Negotiating post-closing operational covenants for earn-outs is also highly contentious. The buyer will want full freedom to operate the company as it sees fit, and the flexibility to adapt to market conditions. However, the seller will demand operational covenants that require the buyer to provide adequate support, opportunities, employees, bonuses, salaries, etc. to allow the business to thrive. While it may not be market standard (whatever that means in the context of a negotiation!), my years of negotiating earn-outs have taught me that, on balance, the standard should generally follow some formulation of the below:

1. The buyer must make general efforts (e.g., commercially reasonable efforts, or some other negotiated standard).
2. The buyer should receive a carve-out to address any fiduciary duties owed to its equity holders.
3. The parties should agree to practical operational carve-outs to address material market conditions.
4. Parties should avoid including an “intent standard” (i.e., a covenant that says the buyer will take no action “with the intent” of reducing the earn-out) because intent is nearly impossible to prove in these cases.
5. Parties should agree to a series of concrete items that the company needs to operate and succeed (e.g., ?number of employees, set amount of funds for inventory, etc.), a negotiation that should include the business and operational teams to ensure they have what they need to succeed.

The details will of course vary from one deal to another, but this standard is a good place to begin.

Rollover Equity

Another option for bridging the valuation gap is to roll over equity into the new company. This allows sellers to maintain a stake in the company and benefit from any future appreciation in value. Theoretically, rolling over equity can result in outcomes similar to an earn-out, but with rollovers the seller derives their upside based on the increased value of their equity in the purchaser post-closing (i.e., if the purchaser operations do well, then your equity value will increase) rather than directly receiving additional purchase price/earn-out payments down the road if the sold entity does well).

Benefits: Depending on the facts, circumstances, and general operational outlook, it is possible that rollover equity could be more valuable to a seller than an earn-out. This is particularly relevant in vertical mergers where the two businesses combined will have substantial synergistic value. Additionally, equity rollovers can provide sellers with the opportunity to negotiate better terms for their equity, such as preferential treatment in the distribution of proceeds in the event of a sale or liquidation.

Risks: There are downsides and complications with rollover equity as well. Some of the more common issues result from post-closing adjustments or payments between the buyer and sellers. For example, if there is a post-closing indemnification claim but one of the sellers rolled over 100% of their equity, they could end up having to pay a large amount of money when they received no liquidity in the sale transaction. To bridge this gap, often times the rollover equity is subject to clawback by the seller if there is a payment due to the buyer (or the rollover equity can be held in escrow or issued later (e.g., after the release of a cash based escrow), but then the rollover seller does not get the economic value of that rollover equity until potentially much later post-closing). However, if the rollover equity is subject to a clawback, there will be substantial negotiation around what the “per share” price should be at the time of the clawback (i.e., should it be the original value of the equity or, if the equity has appreciated in value since closing, should it be fair market value, or something in between). This gets particularly contentious if the industry is generally headed downward and there is a risk of the rollover equity actually losing value between closing and any clawback.

Additionally, buyers will often require the rollover equity to only participate in the initial payment at closing (i.e., the seller can only roll equity based on whatever the closing date payment is) and may not agree to issue equity for any earn-out payments (which, depending on the deal structure, could be a large portion of the consideration paid for the company). Again, the issues with respect to valuation of units at the time of the earn-out payments (which can be years after the closing) make earn-out rollover payments much less appetizing to the buyer.

Hybrid Rollover Equity

Several of our more acquisitive clients have also started using a hybrid rollover structure, where the sellers roll over all or some portion of their equity into the buyer’s parent or acquiring entity and give the sellers a “put-right” for all or some portion of the rollover equity. In effect, this allows the sellers to force the buyer to buy them out of the rollover equity at some point in the future (the trigger for the put-right is heavily negotiated and is often tied to either a period of employment, revenue targets, or passage of time).

Benefits: The interesting aspect of this structure is that the buyer can get quite creative in the put-right triggers and can create a strong alignment of incentives (similar to incentive equity vesting considerations).

Risks: The success of this strategy depends on the details, and how skillfully the seller’s advisors manage the negotiation to ensure their interests are protected.

There are other strategies that sellers can use to bridge the valuation gap, such as negotiating more favorable terms on the purchase price, a higher multiple, or a lower discount rate. Additionally, sellers can explore alternative deal structures, such as “earn-in arrangements,” which allow buyers to acquire a smaller stake in the company initially, with the option to acquire additional stakes in the future as performance targets are met (this is kind of the mirror opposite of the put-right hybrid option above).

It is important to remember that all types of equity rollovers have their own set of risks and drawbacks. For one, sellers may be exposed to additional risk if the new company fails to perform as expected. Additionally, equity rollovers can create conflicts of interest between the seller and the new owners of the company, and result in less cash to the seller at the time of closing (which can cause liquidity issues). Sellers may also be reluctant to make difficult decisions that could negatively impact the value of their equity, which could create tension with the new owners of the company.

Ultimately, the best strategy for bridging the valuation gap will depend on the specific circumstances of the transaction. Sellers must carefully consider the risks and benefits of each strategy. Additionally, sellers must work closely with experienced legal and financial advisors throughout the transaction process to ensure that their interests are protected and that they receive maximum value from the sale of their companies.