YESTERDAY'S BUSINESS VALUATION IS NO LONGER RELEVANT.
Typically, buyers are worried about paying too much and sellers are worried about selling for too little. This concern rings truer today than previously.
As Central Bankers sharply increase rates to cool inflation, the rate that investors use to determine the present value of future cash flows also climbs higher. Future earnings are worth less in today's dollars than if they were calculated at a lower rate, which brings down investors' business valuation estimates for a company.
When the cost of capital is higher, buyers are expecting that sellers lower the price if they want to get the deal done, as a deal will no longer be able to accomplish a buyers return on their investment thesis If interest rates go up. In that instance, the cost of the target being acquired or invested in, must go down if both parties want to transact.
Adding to the rising interest rate environment, investors are placing less credence in the forecast of a company's future earnings due to a lack of certainty over the future top line revenue numbers, coupled with rising cost from suppliers to the company in question and rising costs of labour.
When buyers become unsure about the acquired company's future earnings and wants to still transact, they will hedge, which, because of the current economic environmental uncertainty —they can do via an earnout with the goal of holding back some proceeds of the deal. If the acquired company does not hit certain metrics, the buyer gets to keep what it is holding back through an earnout.
Another factor contributing to the greater use of these structures is the tight credit market. Debt for funding Acquisitions and/or buyouts has grown scarce as banks and nonbank lenders toughen lending standards. If buyers cannot fetch all the leverage they want from lenders, they must commit more equity to the deal. Some buyers would turn to sellers in the deal to fill the funding gap.
Earnouts
Are provisions that allow buyers to defer a portion of the purchase price and make the remaining payments only when the purchased company meets certain milestones, such as reaching an earnings target, getting a regulatory approval, or accomplishing a strategic sale.
Last year, 21% of private mergers and acquisitions in the US contained earnout provisions, up from 17% in 2021, according to an upcoming study from advisory firm SRS Acquiom. Twenty-three percent of these deals incorporated an earnout measured on an EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) target—a performance metric more favored by buyers than revenue—an increase from 16% recorded the year prior.
About 18% of M&A (Mergers & Acquisitions) deals involving PE (Private Equity) buyers had earnouts last year, up from 15% in the previous year. Among these deals, 44% had earnout provisions measured on EBITDA growth last year, compared with only 10% in 2021.
Seller Financing
Another structure appearing more frequently in company valuation's is the so-called “Seller Note”: a form of financing where the seller agrees to receive a portion of the acquisition proceeds as a series of debt payments.
A Seller Note ranks below the senior debt provided by banks or nonbank lenders to fund the acquisition. While the note is a form of subordinated debt, and hence carries more risk, it typically carries a higher rate than senior debt but lower than mezzanine debt,
An Example
In a recent example, an industrial company sold a majority stake in one of its business units to an investment fund. The deal included 31% in equity; 39% in debt funded by commercial banks and private debt lenders; and a 16% seller note supplied by the sellers at 5% interest.
The seller would own a minority stake in the business post-close and will receive additional cash proceeds upon repayment of the seller note and when it exits from its noncontrolling interest.
Who Will be Bridging the Gap?
To make a buyer comfortable with a higher valuation, sellers who agree to delay receiving part of the sale proceeds or make some of the consideration contingent on post-close performance, may still fetch the valuations that were common when geopolitics, inflation, supply chain uncertainty and rising cost of capital weren’t headline news, thereby mitigating some of their risk by no longer continuing to hold 100% of the business.
Alternatively, a seller may choose to not transact in this environment, take a100% of the future risk and hope for the headline news to improve.
Hope is not a strategy.
Conclusion
Selling a business for most owners is an event that happens only once in their career, it is therefore important to make sure that you are selling your business at the best possible price. Towards that goal be sure to learn and understand all the information in this article.
Furthermore, feel free to reach out directly to the author to learn more about the many nuances that this article is simply too short to convey and that might make or break the successful profitable sale of your business to a new owner.
Next Steps?
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- Preparing for a valuation.
- Valuation methodologies.
- Valuing intangible assets.
- Valuation mistakes to avoid.
- Price and or value.
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