Last month Firmex, a leading provider of virtual data rooms and Mergermarket, a leading proprietary M&A intelligence vendor, released a fascinating analysis of factors currently impacting middle-market dealmaking. The two organizations assembled a panel of experienced dealmakers, equity firm professionals, and legal advisors to get a pulse of where the market for transactions is now and where it is heading through the end of the year.
Most interestingly, from the perspective of the panelists, one of the major issues impacting deal closings during the first part of this year has been a growing valuation gap between sellers and buyers. This tends to happen during “seller’s markets” as business owners with profitable, well run companies tend to hold out for the best offer as opposed to “buyer’s markets,” where a scarcity of buyers causes sellers to take any offer that comes their way. This is how a couple of the folks on the panel described the situation:
Joseph Feldman, President, Joseph Feldman Associates - From my perspective, the responsibility for the valuation gap is probably more on the sellers’ side than on the buyers’ side. In my discussions with business owners over the last year, fairly often I’ve encountered what I would say are unrealistic expectations about valuation multiples.
Andrew Lucano, Partner, Seyfarth Shaw - I definitely agree that there is a valuation gap going on. The biggest factor is that sellers’ expectations have been raised very high, as Joe mentioned, because they’re looking at the multiples in these mega-merger deals and then trying to apply those same multiples to their middle-market companies. But it doesn’t really always translate.
Andrew Hulsh, Partner, Pepper Hamilton - The current valuation gap that we’re seeing lately has resulted primary from the substantial competition among private equity sponsors and strategic buyers for high-quality investments and companies and the availability of relatively inexpensive financing.
This trend is both good and bad news for owners of middle-market businesses. On the plus side, significant buyer interest is creating substantial competition right now for good deals. The key here is the word “good.” Even with competition and relatively inexpensive financing available, professional buyers are still being selective and are doing extensive ROI (return on investment) analysis prior to making any acquisition.
Which leads us to the bad news: the valuation gap. And based on the input of the folks on the panel, which is obviously skewed from the buyer’s side of the equation, unrealistic valuation expectations on the part of sellers is the primary cause of the gap.
We have seen this time and time again in seller’s markets from the first year M&A statistics were kept. As the market heats up and demand for deals rises, so too do the expectation on the part of sellers to obtain top dollar for their businesses.
This is why the proven Generational Equity M&A process begins with a complete and thorough evaluation of a client’s business. Not only does this step allow us to determine the current business enterprise value, it also enables us to ensure that our client(s) have a realistic expectation of a value range prior to going to market. This is very, very important. Not every client agrees with our estimate of value. However, it does give each an important measurement of where the value most likely will end up.
If you are a business owner and will be approaching buyers without professional M&A representation, you need to be aware that there are some strategies you can use if offers you are getting are lower than what you think is fair (within reason of course). Be aware that each of these has some downside risk intrinsic to them, according to the Firmex and Mergermarket report:
Andrew Hulsh, Partner, Pepper Hamilton - There are three primary ways that sellers and buyers are able to effectively close the valuation gap and get a deal done. The first way is to structure a portion of the purchase price as an earn-out. The second is by requiring an even higher proportion of management equity rollover. So, where in the past we might have seen 15%-25% of the total equity rolled over by existing management one way to share that risk is by requiring management to roll over substantially more of their equity – for example, from 25% to as much as 45% of their equity in the target company. Finally, the third way is bringing in co-investors – taking a lesser portion of the entire transaction by bringing in co-investors.
Joseph Feldman, President, Joseph Feldman Associates - One way that I’ve seen the gap bridged is through a contingent payment. When a valuation gap is based on specific exposures, for example, we’re also seeing more deals done that have a general escrow and then a situation-specific escrow.
Essentially, one way to bridge a valuation gap with your transaction is to cross it via contingencies. That means you shoulder part of the risk of the success of the post-acquisition entity. And, if you are willing to accept this risk, agreeing to structure in a deal can actually provide you with an opportunity to obtain more for your business over the longer term.
If you have wisely hired a professional M&A firm, they will work diligently to help you achieve your personal financial goals in any deal created. If you are on your own, it is wise to learn as much as you can about deal structure before beginning negotiations with buyers. A great place to start your education process is by attending a Generational Equity exit planning workshop. The investment of a few hours of your time will reap tremendous benefits for you in the long run. Attendees of our seminars report that the information they learn surpasses what they anticipated and that they are much better positioned to close a deal with an optimal buyer.
Most importantly, listen to the market and its indications of value. If the offers you are receiving are all in the same valuation range, and this range is below your expectations, it would be wise to realize that perhaps professional buyers are telling you something: Your valuation hopes may be too high.
Carl Doerksen is the Director of Corporate Development at Generational Equity.
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