Bridging Valuation Gaps Between Sellers & Investors in M&A Transactions

The divergence between sellers’ expectations and the terms offered by investors represents one of the most challenging aspects of merger and acquisition (M&A) transaction negotiations. The emotional and psychological dimensions of price expectation formation, particularly when sellers are company founders, can lead to overvaluation from the perspective of current owners, thereby impeding negotiations or ultimately resulting in deal failure.

Misaligned expectations between sellers and investors may stem from differing views on company valuation, as well as varying perspectives on the certainty of future financial performance, assessment of the enterprise’s condition, or divergent evaluation and perception of risks associated with the business operations, competitive landscape, and geopolitical environment in which the target operates.

Below are several mechanisms and solutions that have enabled us to bridge these gaps and ultimately construct a framework for aligning seller and investor expectations.

1. Earn-Out Provisions

This mechanism represents the most frequently employed tool for reconciling seller and investor expectations, particularly when the investor critically assesses the financial projections and growth plans of the target enterprise. The earn-out structure, referred to in the U.S. market as ‘good money, bad money,’ stipulates that a substantial portion of the transaction consideration (typically 65%-90%) is guaranteed and settled at closing, while the remaining portion is contingent upon the company achieving specified post-closing performance metrics, usually within a predetermined time horizon. The earn-out mechanism undoubtedly facilitates convergence of both parties’ expectations, as the seller remains incentivized to continue developing the business, while the buyer mitigates the risk of overpayment for unrealized promises.

Earn-out provisions may be structured based on various metrics, including: aggregate revenues, profitability, growth rates, industry-specific indicators (number of locations, user count), or a combination of such metrics.

2. Seller Financing

Another solution that may be implemented independently or in conjunction with earn-out mechanisms is seller financing, commonly referred to as Vendor Take Backs (VTB). A portion of the purchase price is deferred to a later date, albeit not contingent upon the company’s performance or fulfillment of future conditions. Seller financing is documented within the transaction documentation, typically secured by a pledge over the enterprise, trademarks, equity interests in the target company, or mortgage, for a term ranging from 1 to 5 years, on financial terms more favorable than those proposed by financial institutions such as banks.

The structuring of seller financing should also incorporate tax considerations, where deferral of taxation on a portion of proceeds from the divested enterprise may be achievable.

3. Pre-Transaction Spin-Off

Frequently, divergent price expectations can be overcome through the carve-out of specific business lines or material assets (e.g., real property) that are non-core to the investor or inconsistent with their investment strategy.

It is essential to note that pre-transaction restructuring may impact the pace and dynamics of the transaction process itself and requires comprehensive tax analysis. Typically, such restructuring activities are conducted concurrently with the transaction process, thereby increasing its complexity level.

4. Equity Rollover

This solution is frequently employed by private equity funds. Such structure entails the seller converting a portion of the received consideration into equity interests or shares in the divested enterprise or in the investor’s capital structure. Consequently, the seller participates in the future appreciation of the enterprise, while the investor reduces cash exposure in the transaction.

5. Independent Expert Valuation

The formation of price expectations by sellers who are founders of the target enterprise contains a significant emotional component. When a founder sells their company, particularly when perceiving it as their ‘legacy,’ substantial emotional and psychological factors influence price expectations. The company often symbolizes years of dedication, sacrifice, and constitutes part of the seller’s identity. Founders tend to overvalue their enterprise due to emotional attachment, viewing it as irreplaceable or as a reflection of their life achievements. This emotional influence can lead to unrealistic price expectations, frequently impeding negotiations.

Engagement of an independent valuation expert can assist in providing an objective perspective. An independent valuation can introduce objectivity into discussions and facilitate reaching consensus on fair market value that will ultimately be acceptable to both sellers and investors.

6. Majority Stake Acquisition

Similar to the equity rollover described above, the divestiture of a majority stake rather than a 100% equity package enables reaching agreement on ultimate pricing terms. Through application of this solution, the seller participates in future enterprise appreciation, while the investor limits cash exposure in the transaction.

7. Tax Modeling

The formation of price expectations by sellers typically focuses on the net-of-tax proceeds from the transaction. Supporting the transaction with a tax planning component frequently enables achievement of superior outcomes satisfactory to the seller in obtaining the expected after-tax consideration.

8. Combination of Solutions

Application of any of the aforementioned solutions does not preclude implementation of alternative solutions. A prudent and secure combination of solutions enables achievement of a transaction structure that satisfies both the investor and the seller.

Your Vision | Our Advisory

An M&A transaction typically represents a pivotal moment for sellers in their professional life, as well as their private and family life. Conversely, for the buyer acting as an investor, execution of an M&A transaction constitutes implementation of one of the enterprise’s growth strategies: organic growth versus growth through merger and acquisition transactions.

It is important to remember that each transaction carries substantial risks. To avoid missteps and ensure optimal transaction structuring, collaboration with an experienced team that understands not only the commercial aspects, but also the legal and tax dimensions of M&A transactions, is essential.

At CP, we operate in multidisciplinary teams to develop solutions tailored to your individual and unique circumstances. Should you wish to discuss practical aspects of bridging valuation gaps between sellers and investors in M&A transactions, please contact our CP experts directly.