On business and share acquisitions, we frequently encounter a valuation gap between what a seller is willing to accept and what a buyer is willing to pay to buy a business. There is always a gap but at present it has become something of a yawning canyon which has, in some cases, become difficult to bridge. In this article we discuss what sellers can expect from buyers in today’s market, how they can achieve an acceptable meeting point on price, and how the price can be funded, particularly where there may be a significant element of deferred or contingent consideration.
What is the valuation gap?
In light of the strong economic head winds (that is, stubborn inflationary pressures, rising interest rates, geopolitical instability, employee and supply chain difficulties as a result of Brexit, the pandemic, and wars in Ukraine and the Middle East) and in circumstances where debt funding of transactions has become more challenging (lower EBITDA multiple and a lower EBITDA value so a “double whammy” resulting in much less debt being offered to finance an acquisition), there is often a gap between what a seller expects and what the buyer is willing to pay, the so-called “valuation gap”.
Within healthcare there are some particular dynamics at play in that certain businesses were almost priced to perfection pre-Covid (and even post-Covid up to 18 months ago in the case of dental practices and pharmacists where NHS payments were maintained (or increased for pharmacies) during Covid but overheads (certainly for dentists) reduced). Some of this is now unwinding, resulting in further downward pressure on the valuation of these businesses.
What can sellers expect from buyers in today’s market and how can they achieve an acceptable meeting point on price? In addition, how can the price be funded (in particular by acquisition debt finance) especially where there may be a significant element of deferred or contingent consideration?
In today’s market environment valuations are often looked on very sceptically. Buyers lack confidence that historic revenues and levels of profit (or EBITDA) can be maintained and are unwilling to offer the same multiple as they might have paid one, two or even three years ago. Similarly, lenders have the same concerns and so are not willing to lend the same amount to a business. In addition, with higher interest rates, debt service has become a real issue and will also limit the debt capacity of a business. Accordingly, sellers should be prepared to discuss any solution that results in a lower initial payment being paid. The vendor might be willing to accept this provided the aggregate payment remains at an acceptable level.
One solution is to defer an element of the consideration for anything up to two years (possibly longer). We are seeing this used more often than not in share and business purchases we have been acting on in the past 12 months (and currently) and in pretty much every sector including care homes, dental practices, pharmacies and early years day care.
The amount of deferred consideration can be quite considerable, possibly as much as 40% of the total. This presents the following issues:
- The deferred consideration is in effect a debt owing by the buyer to the seller for a period of up to one or two years or more. This can be structured as a series of regular payments over the relevant term or could even be more formally structured as a vendor loan note.
- The seller may require security for this loan and will want to receive payments of principal and (possibly) interest (after all they want to be paid the agreed price, albeit over time).
- Obviously the seller will retain an interest in the business and may wish to protect this interest by asking for certain veto rights (for example no disposals or acquisitions, no borrowing, security or significant capex without seller approval). In any event there is not a completely clean break from seller to buyer.
- Any lender funding the acquisition will need to be happy with the structure, in particular with the level of vendor loan, any security and the deferred payments.
- The vendor loan will need to be subordinated to the senior acquisition debt but subject to permitted payments. There will need to be controls around those permitted payments (for example no default, compliance with financial covenants and look forward financial covenant compliance, typically for 12 months).
- The lender will need to be happy with the source of funding for the payment of deferred consideration. Often this will be funded by the lender. In such cases we see this being structured as an undrawn but committed term loan facility. The loan can be drawn when the deferred consideration is payable under the transaction documentation. Further controls can be introduced (for example no default, compliance with financial covenants and look forward financial covenant compliance typically for 12 months) but this will not be popular with the seller who will want to understand those controls because if they are not met, they will not receive the deferred payments.
- The funding could also come from the lender and the buyer in a pre-agreed proportion.
- The buyer will obviously not wish to draw the full amount of funds from the lender at the start and hold those funds pending payment of the deferred consideration. This is a very inefficient use of cash as they will lose money on the spread between interest payable and what they will receive on deposit. It would almost always be cheaper for them to pay the commitment fee (typically 30-40% of the margin). It should also be more advantageous to the lender to retain control of funds pending drawdown. In our experience most lenders accept this structure, subject to appropriate drawdown controls (as above).
Contingent consideration (very commonly an earn out mechanism)
An earn-out structure is a form of deferred consideration which is contingent upon the future performance of the business. This can be helpful in enabling a deal to be agreed on price between seller and buyer in that the seller is backing the future performance of the business. The buyer pays less if the business underperforms and may end up paying more if the business outperforms. Either way, the initial price is reduced. This de-risks the acquisition for the buyer.
Earn outs are peculiar to the business being sold and will need to be drafted with a full understanding of the commercial deal that has been struck, including primarily:
- the length of the earn out period;
- whether the earn out will be a single payment or multiple staged payments;
- the financial/ operational metrics against which the earn-out will be calculated;
- anti-manipulation protections;
- as per the put/ call option discussed below under “partial acquisitions”, an independent expert determination of any disputed valuation; and
- earn-outs therefore need to be aligned with seller warranties and remedies (to avoid a double dip in protections).
Certain forms of contingent consideration are also being increasingly utilised, including those focused on the realisation of value of a specific asset within a target business. Where a seller is more confident than a buyer of the value represented by such an asset, a contingent consideration mechanism can allow for this value to be shared without a buyer being exposed if such value is not ultimately realised – e.g., the use of contingent consideration mechanisms in relation to the realisation of certain tax assets.
An earn-out raises some of the same issues as deferred consideration (indeed it is a form of deferred consideration, albeit contingent upon future performance) but is probably simpler to deal with for a funding lender. The debt owing by the buyer to the seller only arises when the performance condition has occurred (typically delivery of annual audited accounts and a certificate from an expert) and is reliant upon the business performing well (or even out-performing the agreed business plan). If this is the case the increased price/ deferred consideration may well be self-funded (the business generates more cash which can be used to pay the seller).
Roll-over arrangements are where sellers invest a percentage of the proceeds from the sale of the business back into that business. This structure is typically used in private equity transactions where the sellers are effectively co-investing with the private equity investors in the process. Sellers can also roll-over into loan notes alongside their equity stake.
- These arrangements enable sellers to benefit from the growth in value of a business post-acquisition.
- From a buyer’s perspective, the mechanism also helps address cases where they do not have access to all the cash proceeds necessary to meet the sellers’ valuation. The roll-over can be used as a means of bridging that gap, by allowing management to take less cash off the table on completion, but giving them a greater equity stake in the business going forward.
Sellers would ordinarily expect a 100% acquisition (i.e., a purchase of 100% of the shares or assets of the target business). However, we are seeing certain buyers adopt a more cautious approach by acquiring an initial (albeit majority) holding together with a put/ call option or similar mechanic in respect of the minority.
For a seller this means:
- receiving less completion monies at closing;
- no “clean break” on Day 1; and
- effectively being “locked in” as a minority shareholder without full control for the put/ call option exercise period.
The put/ call option documents will need to address the following principal commercial issues and be drafted carefully to reflect the intention of the parties:
- the length of the option exercise period;
- how the option price will be calculated and whether it is subject to a floor/ cap or any other deal-specific requirements;
- a robust dispute resolution mechanism in respect of the valuation; and
- the seller will also want to ensure a certain level of control in respect of the business, which may (typically linked to the size of the retained stake) include observer/ director appointment rights, reserved matter vetoes and information rights.
Majority acquisitions will require the parties to enter into a shareholders’ agreement in addition to an acquisition agreement so the negotiation of this document will need to be factored into any deal timetable.
This structure will be far less attractive to a funding lender. The buyer (borrower) will not own 100% of the shares or business. This means that security over the target business may not be available (or a share charge can only be taken over less than 100% of the target shares or business). This probably makes the transaction unbankable.
Anti-embarrassment provisions can be included in the principal transaction documentation to effectively spare a seller from embarrassment in the event the buyer sells the business or shares at a much higher price within a short period after completion (typically 12 months or so).
Typically, the anti-embarrassment clause provides that the buyer pays additional consideration to a seller in the event the buyer sells on the business for a profit within a specified timeframe post-transaction. Again, this clause needs to be drafted carefully, particularly the valuation mechanism.