In brief:
- Valuation gaps between buyers and sellers on M&A transactions are not uncommon, in particular in the UAE market.
- In this article, we discuss some of the structures that can be deployed to bridge valuation gaps, bring parties together and get deals done.
- Provided that the parties are motivated to get a deal done and are willing to be flexible, it is possible to devise creative deal structures which effectively bridge these valuation gaps.
Valuation gaps between buyers and sellers on M&A transactions are not uncommon, in particular in the UAE market. A seller will generally be focused on the growth potential of its business and take an optimistic view of future performance, whereas a buyer will naturally be more pessimistic and place more of an emphasis on the potential downside and need to mitigate its risk. This frequently results in a gap between a seller’s valuation of its business and the price which a buyer is willing to pay for it.
Valuation gaps can stop potential M&A transactions from getting off the ground and cause existing transactions to abort. However, there are various structures that can be deployed to bridge valuation gaps, bring parties together and get deals done. Certain of these structures are discussed below. These are only examples as there are many different varieties.
Secured payments out of future profits
An effective method of bridging a valuation gap is to create a structure where all or part of the consideration payments are financed out of the future profits of the target business. This is particularly useful where a buyer is unable or unwilling to finance a transaction out of its own cash resources or borrowings.
Given that this structure involves deferred consideration, it is important (when acting for a seller) to ensure that the seller has appropriate security for such deferred consideration and other key protections. A well advised seller would typically benefit from the following:
- a share pledge, giving the seller the ability to resume ownership and control of the business if the buyer fails to make the deferred consideration payments;
- corporate guarantees from the target company and/or other group companies;
- personal guarantees from the buyer or the principal shareholders in any corporate buyer;
- rights to financial information (for example, audited accounts and management accounts); and
- veto rights over certain key matters which could affect the ability of the buyer to make the deferred consideration payments (for example, sale of assets and payment of dividends).
A buyer will be keen to ensure that the sale agreement contains robust non-compete and non-solicitation covenants from the seller. These are important on any acquisition, but are particularly relevant where this structure is used as any competition or solicitation could impact on the profitability of the target business and, as a result, the buyer’s ability to satisfy the deferred consideration payments.
Earn-out
An earn-out is an arrangement under which all or part of the purchase price on an acquisition is calculated by reference to the future performance of the business. It is commonly used as a management incentive where owner-managed businesses are sold and the managers continue to work in the business for an agreed period following the sale.
An earn-out can be an effective means of enabling a transaction to move forward in circumstances where a seller has placed a higher valuation on a business than a buyer. It allows a buyer to conserve cash at closing and protects it from overpaying for a business that fails to grow to the extent projected by the seller. However, earn-outs may also benefit sellers given that they allow them to potentially obtain a higher consideration than would be the case if the entire amount had been paid at closing.
However, one must bear in mind that earn-out payment terms are typically the subject of lengthy, and often contentious, negotiations due to the significant implications for both the buyer and the seller. This can have a time and cost impact. Earn-outs can also lead to disputes and claims in the future, although this risk can be mitigated by concise legal drafting which clearly sets out the commercial agreement between the parties.
Equity rollover
An equity rollover is where some or all of the sellers receive a portion of their sale consideration in the form of equity. Rollover participants usually include key management team members, and may also include founders and investors. When the sale closes, rollover participants shift from holding a controlling interest in the target company to being minority shareholders in the continuing business.
In addition to bridging valuation gaps, equity rollovers are an effective means of aligning the interests of buyers and management, with management having “skin in the game” and being personally invested in working towards a profitable exit.
Equity rollovers are often combined with earn-outs. Where this is the case, earn-outs may be paid in cash or in the form additional buyer equity, or a combination of both.
Consulting agreements
Business owners often perceive a sale of their business as a loss of a regular, stable income. This may be the case even where they receive significant sums at closing. They may, as a result, seek to drive up valuation to a level which the buyer does not view as realistic. However, if the deal structure involves a continuing stream of income for the owners by way of a consulting agreement, they will continue to be positively engaged with the business and should be more likely to accept a lower valuation. Consulting agreements are particularly useful in circumstances where an owner wishes to continue to be involved with the business but not as a full-time employee.
Conclusion
Valuation gaps can be a barrier to M&A activity. However, they are not insurmountable. Provided that the parties are motivated to get a deal done and are willing to be flexible, it is possible to devise creative deal structures which effectively bridge these valuation gaps. The most appropriate structure will depend on the specific circumstances of each transaction and it is important to proceed on a case-by-case basis and discern the best structure for each deal. The parties should consult closely with their legal and financial advisers who will be able to guide them through this process.
