Comment: Engineering efficient exits

This is the first of three articles by UK-based law firm MJ Hudson looking at how to ensure you make smart exits for your portfolio companies.

After a promising start to the year, global merger and acquisition (M&A) deal values fell by 12.7% from the third to the fourth quarter of 2013, according to the Mergermarket M&A Trend Report 2013, one of many indicators that the market remains difficult and unpredictable for acquisitions and exits across the board. In the context of a challenging market, adequate preparation for an exit is key, not only for current ventures, but also for future projects (see box).

Our focus is on overcoming any gap between the parties’ valuations – the subject of this article – and preventing subsequent price erosion, for example as a result of unexpected due diligence adjustments or costly separation issues – dealt with in the next two articles.

The first step in maximising proceeds is to ensure the venture’s valuation is credible and robust, and its financial advisers will be able to stress-test the valuation method and assumptions and provide market comparisons. But if, despite thorough groundwork, the parties are unable to agree a price, the following mechanisms may help bridge that gap and facilitate a deal.

Deferred consideration

Vendor financing: The selling corporate group may help reduce a buyer’s reliance on external funding by providing a loan to the buyer from its own books. Most commonly this means deferring part of the purchase price, and structuring the deferred payment as an interest-bearing loan. The selling corporate will want this loan to rank ahead of all other liabilities of the venture, though it would typically rank behind third-party debt funding, and may also request information rights and restrictions on changes to the buyer group’s structure in order to monitor and protect its interests.

Contingent consideration

Earn-outs: A buyer may agree to increase the purchase price if the venture’s financial performance exceeds specified targets – often related to earnings – over an agreed period. Earn-outs can be particularly useful where the par-ties cannot agree on the extent of future growth. The targets will be pre-agreed, but the selling corporate will want rights to monitor the venture until the last payments are due, and to veto any acts that would hinder the venture’s achievement of those targets.

Milestone payments: Milestone payments are additional, often fixed, payments due on the occurrence of a particular event, such as a product regulatory approval or achievement of a financial target.

Downside protections

Protections: If a buyer identifies a specific risk to the target business but is unable to quantify, and therefore price, that risk, the seller may agree to deposit part of the pur- chase price in an escrow account held by a third party. The escrowed amounts are available as security for the buyer against any loss or cost caused by that specified risk, and released to the seller if the issue in question is resolved without financial impact on the target, or after an agreed long-stop date.

Seller retains minority stake: From a buyer’s perspective, having the selling corporate retain some “skin in the game” reduces the buyer’s acquisition cost and reassures the buyer that financial projections are credible. Such a structure also allows the seller to realise most of the value of its investment in the venture, while enjoying a possible upside from any future increase in value. Retention of a minority stake may be particularly attractive if the venture’s former corporate group is likely to have a continuing commercial relationship with the venture – a stake in the fortunes of the venture should strengthen this link.

Partial asset carve-out: If the parties have struggled to agree a valuation for the whole of a business, the selling corporate may agree to sell certain key assets, such as a production division, and retain others, such as a distribution division, providing the related services to the buyer for an agreed period.

Anti-embarrassment: A selling corporate may ask for an anti-embarrassment clause where it fears an asset is being sold for less than it is worth. It can take the form of a prohibition on reselling – “flipping” – the asset within a specified period, or a requirement that a top-slice of the proceeds of a flip be shared between the original buyer and seller. This may be particularly attractive to a high-profile corporate seller concerned about adverse publicity or one that has felt compelled to sell, in particular if the selling corporate or the venture itself is supported by public or charitable funds.

In the next article we consider how thorough sale preparations and due diligence can reduce the risk of the dreaded “price chip”.

Efficient exits – what’s at stake?

A credible and well-structured exit process is critical to:
Maximising aggregate proceeds.
Minimising delay, and disruption to the venture’s day-to-day operations.
Confirming the market’s perception of the corporate venture as a sound investment – think future funding rounds.
Strengthening the track record of the venture’s management team.

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