M&A Monday: Bridging a Valuation Gap

Seller and Buyer often disagree on valuation - here is how to close the gap and close your deal.

Almost every deal I have closed had, at one time, a valuation gap. Seller thinks the business is worth more than Buyer does. There are many ways to value a business - sometimes seller uses a different valuation and sometimes sellers do not even care about the valuation method. Dozens of times, I have heard sellers say, I do not care, this is the number I need to retire.

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 and multiple of EBITDA (if using that method). This adds transparency and makes a later purchase-price 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 all-in 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. [SBA 7a Note: earn-out is not allowed and a forgivable promissory note has to be based on historically achievable financials.]

3. Subordinate 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 and may have no payments for a period. This creates a higher purchase price, but can be paid off at a future date. Often, a higher purchase price can be offered by increasing the promissory note amount, but also making the terms more buyer-favorable (e.g., increasing term or payment period). [SBA 7a Note: SBA lenders like to see promissory notes and by having a period of two years with no payments or adjustments (but interest accruing) and no balloon payments, a buyer can use the promissory note toward their 10% required equity injection.

See also: Ingredients of the Purchase Price; and How to Get a Seller Comfortable with a Promissory Note.

4. Forgivable Seller Note. Forgivable notes are a favorite tool. This is a note contingent on post-closing metrics (think a note + earn-out). If metrics are not met, the note (or a portion) is forgiven. Forgivable notes are flexible and can account for any risk after closing (i.e., key customers or employees) [SBA 7a: the metric cannot be based on higher revenue/profit; but only rooted in historicals]. See: M&A Monday: The Forgivable Seller Note.

5. Alternative Compensation. We can be creative compensating seller without changing price. Example: seller gets a consulting agreement or salary for helping the transition; bonuses for bringing in new client relationships [SBA 7a: Seller cannot be an employee and cannot be a consultant for more than a year after closing].

6. Retrade. Last resort. This is when buyer offers a price knowing the deal will be retraded. While, I do not advocate for this, there are times a seller is miscalculating financials or the business. Thus, Buyer can communicate they are offering $X if seller is correct, but if not there will be a price adjustment (see the episode on how to raise a retrade).

If you are looking for an M&A lawyer or Tax counsel (through our Transactional Tax team) for your deal, you can reach out to me directly at Eli@albrecht.law.