Chapter 21

Ten Possible Ways to Solve Valuation Differences

In This Chapter

arrow Exploring ideas for earn-outs

arrow Looking at ways to provide consideration other than cash at closing

Valuation is always the million-dollar question — well, often the multimillion-dollar question. The stereotypical negotiation impasse has Seller asking for a high price and Buyer offering a low price, with each side digging in their heels and insisting that the other side totally capitulate to their demands. But that strategy rarely results in a closed deal.

In the spirit of getting deals done, in this chapter I provide a few ideas on ways Buyers and Sellers can settle valuation disagreements and move forward to a closing.

Payments over Time

If Seller wants a certain price for the company, Buyer may be willing to pay that price over a period of time. Buyer has the benefit of the time value of money (today’s dollars are worth more than tomorrow’s dollars, so paying today’s debts with tomorrow’s dollars is a benefit to Buyer), and Seller gets to tell everyone that he was able to get the valuation he wanted.

tip.eps If Seller agrees to accept payments over time, I suggest using a note to officially and legally document Buyer’s obligation to Seller just in case the arrangement comes into question later.

Earn-Out Based on Revenues

The venerable earn-out (see Chapter 12) is a favorite deal component for Buyers because it allows the Seller to prove the company’s profitability. If the company achieves the goals Buyer and Seller agree to, Seller gets the earn-out. Keeping the earn-out metric simple and easy to measure reduces the chances of a dispute down the line. Basing the earn-out on revenues is usually the most straightforward approach.

remember.eps Earn-outs shouldn’t be an all-or-nothing proposition. If the company falls short of the earnings goal, perhaps the Seller is still eligible for some of the earn-out. A dollar-for-dollar reduction in the earn-out based on how far short of the projection the company falls is often the solution. Say the earn-out was worth $2 million if the company achieved a certain revenue goal. If the revenue was $1.5 million short of that goal but the earn-out didn’t require all-or-nothing success, Seller still receives $500,000 ($2 million minus $1.5 million).

Earn-Out Based on Earnings

This option is a cousin to the earn-out based on revenue (see the preceding section). It functions exactly the same, except that the metric for the earn-out is based on some measurement of earnings. Both sides need to very precisely determine how they’ll measure earnings (EBITDA, net income, and so on).

warning_bomb.eps Sellers should be wary of Buyers applying some overhead from the parent company’s books to the acquired company’s books. This accounting treatment may artificially lower the acquired company’s earnings (because now expenses the company didn’t incur are eating up its profits), thus reducing or eliminating the Seller’s earn-out.

Earn-Out Based on Gross Profit

Another metric for an earn-out is to base the earn-out on the business’s gross profit, or its profit after deducting the cost of sales but before deducting operating expenses. This method can be a great way to settle a valuation difference in an environment where pricing is falling (thus resulting in lower revenue) and the cost of sales is falling, too. And because the earn-out takes the profit before operating expenses, this technique eliminates the risk of Buyer adding applied overhead to the company’s operating expenses, a trick I note in the preceding section.

Valuation Based on a Future Year

A multiyear earn-out may result in Seller not earning all the available money in some of the years. Basing the final valuation on a future year and provid-ing Seller with advances against that future-year valuation helps eliminate that occurrence. Effectively, this strategy gives Seller a make-up clause. If the company falls short of its goals in the early years, Seller can still get 100 percent of the earn-out as long as the company achieves the goals in the final year.

tip.eps Sellers, make sure the purchase agreement defines all advance payments as nonrefundable. Doing so prevents Buyer from trying to reclaim some of the advance payments if the company falls short of the final goal of the earn-out.

Partial Buyout

If a Buyer and Seller can’t agree on a valuation for a full buyout, a partial buyout is often the solution. Seller retains an ownership interest and can sell her remaining shares at some future date and hopefully at a higher valuation. In M&A lingo, this later sale is called a second bite of the apple.

Most Buyers want a control stake in the business, meaning they acquire more than 50 percent of the company’s equity. Depending on the situation (and how the purchase agreement is written), however, Buyer may be amenable to buying a minority position.

tip.eps Sellers who retain a minority position should make sure a put option is part of the deal so that they can sell the remaining equity to Buyer at some future date at some future calculation. If Buyer ends up taking a minority position, Buyer should make sure the deal contains a call option; in other words, Buyer can buy the remaining equity from Seller at some future date at some future calculation.

Stock and Stock Options

Stock can be a great way for a Buyer to help finance an acquisition. If Buyer and Seller disagree over valuation, Seller may be receptive to taking stock in the parent company. The situation is often win-win: Buyer has to lay out less cash at closing, and Seller has the upside potential of stock appreciating in value.

warning_bomb.eps Buyer should carefully consider the dilutive effect (owning less of the company) that comes as a result of providing equity to Seller. Also, Seller should consider the marketability of that stock; in other words, does the stock trade on a public exchange, and is the average daily volume sufficient enough to allow Seller to unload his position? Flip to Chapter 12 for more on stock deal considerations.

Consulting Contract

Another way Buyers can provide Sellers with added dollars is by including a consulting contract in the purchase agreement. Buyers have the benefit of the Seller’s advice and counsel, and Sellers get the benefit of increased deal value.

warning_bomb.eps Sellers, consult with your tax advisor if a consulting contract is on the table. Pushing proceeds into a consulting agreement may result in those dollars being taxed at a higher marginal income tax rate rather than the lower capital gains rate.

Stay Bonus

If a Buyer wants a Seller to stay on board for some period of time after the deal closes, offering Seller a bonus for not leaving can be another way to bridge a valuation gap. Buyer gets the security of knowing he won’t have to pay the bonus if Seller resigns early, and Seller knows she’ll receive added money by simply staying put.

tip.eps Buyers, consider including a clause in the agreement stipulating that you can fire the Seller for cause, such as theft, embezzlement, conviction of a felony, and so on. That way, if Seller engages in egregious behavior that harms the company, you can limit damages without having to pay out even more money to the person.

Combo Package

Be creative! Don’t think of the ideas in the preceding sections as being mutually exclusive. You can offer a little more earn-out and less stock, or a larger note and a consulting agreement. You can increase the length of the earn-out term or consulting agreement. The only limit is your creativity.

If you consider these options as knobs of a stereo, you can twist the dials in unlimited ways. A creative deal-maker has unlimited ways to bridge a valuation gap.