Creative ways to solve valuation differences in M&A negotiations.

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Often the only thing preventing a business from being sold is disagreement between the buyer and seller over price. Successful M&A deals don’t limit the discussion to price and cash paid at closing. Reframing the negotiation to be about total consideration can help bridge a valuation gap and make a deal possible that otherwise wouldn’t have worked out.

By expanding the discussion to total consideration, buyers and sellers can consider other forms of valuable cash and non-cash compensation that effectively increase the purchase price. These options range from contingent earnouts to employment agreements to company naming rights. William Ury and Roger Fisher, co-authors of the seminal book on negotiations, “Getting to Yes,” refer to this technique as expanding the pie or integrative bargaining.

There are numerous ways to creatively expand the pie when it comes to buying and selling small businesses. Below is a sample list of options buyers and sellers can explore before walking away from the next potential deal.

SELLER’S NOTE

A seller’s note is a loan made by the seller of the company to the buyer to assist the buyer in financing a portion of the sales price. Similar to other loans, a seller’s note represents a contract between the buyer (borrower) and the seller (lender) that requires the buyer pay back the seller principal and interest over time. Seller’s notes effectively reduce the amount of cash a buyer pays at closing and allows for the purchase price to be paid over time. The terms of a seller’s note are highly customizable. Maturities can range from 1 to 10 years, and interest rates can be at or slightly higher than prevailing bank rates. A carefully negotiated seller’s note can offer many benefits, including:

  • Higher Price – A seller’s note can serve as a mechanism to increase the total purchase price and address any shortfalls in traditional bank financing. As a practical matter, banks often limit the amount of debt they’ll lend to a buyer of a small business, which in turn limits the amount the buyer can pay.

  • Fixed Income and Tax Benefits – Once the business is sold, the seller must decide what to do with the sales proceeds. Receiving a seller’s note as consideration is effectively akin to a seller reinvesting the sales proceeds into fixed income securities. It can provide the seller with a source of fixed income stream post-sale and potentially defer taxes on some of the sales price.

CONTINGENT EARNOUT

A contingent earnout is a form of deferred compensation that results in additional payments to the seller should the business meet specific financial performance targets after the business is sold. Performance targets are typically tied to EBITDA or other measures of profitability. Incorporating an earnout into the total consideration paid can provide a potential solution to buyers and sellers who disagree on price and the business’s prospective earnings potential. Earnouts are mutually beneficial in that they allow sellers to receive additional compensation over time if the company continues to grow and be profitable. Similarly, earnouts protect buyers from overpaying for a business should the company materially underperform after the purchase.

ROLL-OVER EQUITY

Roll-over equity refers to situations in which the seller sells less than 100% of the business and continues to own a portion of the equity after the sale. It is often a win-win solution. The seller continues to own some of the company and thus will participate in future dividend payments and receive additional proceeds should the company appreciate in value and be sold again. In exchange, the buyer is able to pay less cash at closing. Maintaining equity ownership may be appropriate when a seller anticipates staying involved as a board member, executive, or consultant after the sale. By both owning stock, the buyer and seller are mutually incentivized to act in the long-term interest of the company.

OTHER FORMS OF CASH CONSIDERATION

Several other forms of cash consideration that effectively increase the total price of a business and thus can help bridge the valuation gap are as follows:

  • Employment Agreement or Consulting Contract – Another way to provide the seller with additional compensation is through an employment agreement or consulting contract. An employment agreement may be appropriate when the seller expects to be regularly involved in the business after the sale. A consulting contract could be appropriate if the seller is going to help transition the business to new ownership over a short period of time.

  • Health Insurance and Other Benefits – The seller might negotiate to have the buyer continue paying the seller’s health insurance costs or other personal benefits for an agreed period of time.

  • Royalty Agreement – In cases where a business has a significant degree of customer sales concentration or highly variable sales, the buyer and seller could agree to a royalty agreement. The royalty agreement can allow the seller to receive additional payments based on future sales to a specific customer(s).

  • Above-Market Rent Agreement – In instances where the seller owns affiliated real estate, additional consideration can come in the form of a long-term lease agreement at above-market rental rate.

NON-CASH CONSIDERATION

Not all forms of consideration are in cash. Some non-cash forms of payment that can be the difference between selling or not selling a business for buyers and sellers to consider are as follows:

  • Employee Matters – It may be important to a seller that certain management members and employees are retained after the business is sold. In these instances, the buyer and seller may include in their discussions any employment agreement and compensation package requirements (salary, benefits, stock compensation/co-investment opportunities, and severance packages).

  • Non-Compete and Non-Solicitation Agreements – It may be important to a deal that the seller agree to a non-compete agreement with respect to the industry, customer, and geography of the business and a non-solicitation agreement concerning any employee hired by the buyer.

  • Company Name and Location – In some instances, it may be meaningful to the seller that the company maintains the company name and stay headquartered in its current location.

SUMMARY

Many business sales negotiations breakdown due to disagreement between the buyer and seller over price. While price is a critical determinant in any transaction, focusing on price alone often leads to failed outcomes. To overcome this common pitfall, buyers and sellers should expand the discussion to include other forms of consideration and actively seek to understand what else is important to the other side in getting a deal done. Many kinds of cash and non-cash types of consideration other than cash at closing exist. By exploring these other options, buyers and sellers can often invent mutual gains to help bridge a valuation gap and make a deal possible that otherwise wouldn’t have worked out.

The partners at Cronkhite Capital have over 10 years of experience buying and selling small to medium-sized businesses across industries. If you are interested in learning more about the types of companies Cronkhite Capital buys or have questions about the typical sales process, please contact Ryan Hammon. Email - rhammon@cronkhitecapital.com Phone - (415) 847-8103. 

Sources:

Getting to Yes: Negotiating Agreement Without Giving In by William Ury and Roger Fisher

Seller Notes: Magical Capital by John Hammett of Corporate Finance Associates

Ways to Solve Valuation Differences in M&A Negotiation by Bill Snow of John Wiley & Sons