With the continuation of uncertainty in macro-economic conditions and a relatively high level of market volatility, valuation remains a big challenge for corporate venturers in closing merger and acquisition (M&A) deals. Nevertheless, provided the valuation gap is not too wide, there are different structures that can be utilised to help bridge the gap, thereby enabling the deal to be feasible.
1. Vendor financing
With the continuation of tight credit markets, companies targeted by corporate venturing businesses are playing a greater role in financing their own acquisitions in an attempt to increase deal flow. Vendors can provide a loan from their own books to ease financing when selling assets to reduce the amount of debt a bidder needs to obtain from the market and thereby lowing leverage ratios.
At its most basic, vendor financing is the principals agreeing that part of the purchase price for the target is paid later. It can be structured as a traditional loan or a convertible.
The creditor ranking of the vendor financing will be key to any seller (often ranking behind external third party financing).
2. Earn out
Earn out is a variable part of the price paid for a business dependent on how the target performs during an agreed time period. The variable element is normally based on a pre- agreed formula, the most common being future profits.
Earn outs are also used as a mechanism to bridge the valuation gap when the buyer is wary of economic uncertainty or the seller sees future increase possibility in the target’s profitability. Earn outs reduce the buyer’s risk of overpaying, but equally it will limit the chances of buyers purchasing companies for a ‘good bargain’ (as the price will increase if the target performs particularly well). Sellers seek protection to ensure that the target businesses’ performance is not artificially suppressed.
3. Milestone Payments
Milestone payments and contingent payment rights are also being utilised, especially in the US. Contingent payment rights are those that enhance consideration if certain milestones are met, or upon the occurrence of certain business hurdles.
4. Escrow Arrangement
This solution is most relevant where the principals agree on the price to be paid for the business, but they fail to agree on the financial impact of one or more identified risks which have been unearthed during the buyer’s due diligence process (examples include impending court litigation or investigation by the target’s regulator). The buyer deposits a certain portion of the deal consideration into escrow, which will then be paid if the said issues are remedied without financial damage to the target.
5. Seller Retaining a Minority Share
This involves the seller simply retaining part of its shareholding or alternatively investing in other types of instruments. As a result, the seller will benefit from any increase in value.
6. Share-for-Asset Swap
The principals may not be able to agree a cash price for the target business, but it is possible that they may be able to agree on the relative values of the target and the buyer. If so, a swap of shares (or assets) may then be feasible.
7. Anti-embarrassment Protection
The buyer and seller agree that if the buyer flips the target business to a third party within an agreed period of time (normally less than two years), the parties share, in portions to be agreed, any excess over the amount originally paid by the buyer. This may be appropriate where the seller is a forced seller, but feels that the price it is receiving is less than it is worth. Governments often invoke this protection so as to avoid political embarrassment of selling state assets on the cheap.
8. Asset carve-out light
In this case, the buyer acquires, for example, specific intellectual property, research and development, distribution and customers, leaving behind other assets, such as the production site. The seller engages in interim manufacturing until the buyer’s production is fully operational.
Close:
Principals that show flexibility in M&A processes and employ innovative deal structures are likely to be more successful than those expecting the pre-crisis standard M&A transactions.