This is educational only. You must obtain professional advice when considering any M&A transaction.
Owners who are inexperienced at mergers and acquisitions (M&A) often focus on valuation – what’s the price I’m going to get or pay? This is understandable; obviously that’s an important number.
Missed the first M&A blog post? Check it Out Here >>
It’s equally important to understand the deal structure under which that price is going to be paid. For Buyer or Seller to be sure they’re going to get what they intend to, and manage the risk of not getting it, they should understand not only valuation but also deal structure. One without the other is pointless.
Valuation is price. Deal structure is the combination of specific conditions under which that price will be paid, and the currency with which it will be paid. Currency here could be cash, a loan from Seller to Buyer, stock in the acquiring company, and/or other variations of value conveyed.
During the negotiation, Buyer and Seller use valuation and deal structure as two tools to arrive at a mutually agreeable balance of risk and reward. Let’s look at a simple example of a negotiation.
Usually price is the first thing to be discussed, because that’s the quickest way for Buyer and Seller to at least broadly qualify each other. While a valuation number may be agreed to at this point, it is generally understood that number may change a bit during the subsequent conversations. If it changes too much, though, both parties are aware that one or the other may walk away. Fair enough.
For simplicity, let’s take as our example, a smaller transaction. The preliminary discussion arrives at about $5mm in valuation. (We’ll leave aside how that valuation was arrived at, for a later blog.)
Seller would like at least $5mm and perhaps ideally more. Buyer would like to pay no more than $4.8mm and perhaps ideally less. What follows is a simplistic version of a typical negotiation of price and deal structure:
- Buyer: “I know in our discussions you have indicated that you basically want an all cash deal. Based on my analysis of your firm, I’m willing to offer $3.5 million, all to be paid in cash at time of closing.
- Seller: “Yes, cash is important, but so is valuation. I’d like $5mm. That works for me and I think that’s a good deal for you.”
- Buyer: “Understood. However, I see several factors that make me uncomfortable.
- “A large part of your revenue comes from one account. If that account leaves, there will be little of the current profitability.
- “Also, you’ve had significant account attrition in the past six months, which worries me.
- “Lastly, you’ve indicated your preference would be to leave the business after a year, and I’m not convinced your management team can carry on successfully without you.
- “These things reduce my comfort that the assets I am buying will continue to perform as they have been. So, to balance my risk and reward, I have put forth an offer with a price of $3.5mm in cash.”
- Seller: “Thank you. I should have been clearer. I won’t accept any less than $5mm. But I understand your concern about risk. Let me see if I can help.
- “The big account is in Year 2 of a 5-year agreement and the termination clause, unless we fail to hit SLA, requires the client to pay 100% of the balance of the contract. The contract also has two 1-year automatic renewal periods which activate if the client doesn’t notify us in advance they’re terminating. You will have at least 3 years more from that account. There is some chance that the team will fail to meet the SLA, but that will largely be under your control. There is a remote but possible chance the client could conceivably declare bankruptcy and fail to pay the termination fee. The risk with this account is not zero but as you can see it’s less than you probably thought, and it even has some upside.
- “Yes, we have had higher than usual account attrition in the past size months but that’s actually a good thing. At the start of the year, the team initiated a planned strategy to terminate our 20 lowest-gross-margin customers. The team determined these clients won’t pay our current fee and generally have not adopted our technology standards and tend to not follow our advice. The team is gradually terminating them which has improved our profit dollars and percent even though it has reduced our revenue growth. The team will be done with that initiative in the next two months, and you can see their profitability has actually climbed since they started. Plus, the team has been able to take the time they were expending on these high-maintenance, low profit clients, and direct it to finding new, better clients, and as you can see, the pipeline looks good. So good, in fact, I was really thinking of asking $5.5mm, but I want to be reasonable. This has to work for both of us.”
Buyer feels better about the big account, though it’s certainly not zero risk. On the topic of attrition, Buyer is feeling better about the source of it and is in fact impressed with the strategy and the care with which it is being carried out. Buyer didn’t fail to notice that Seller ascribed this successful strategy to the team, which if accurate, provides a bit of additional comfort about how the team might perform after Seller leaves. Though not totally convinced, Buyer is feeling more comfortable that the assets will continue to perform as they have been.
- Buyer: “That’s helpful, thanks. I understand your goal and with that additional insight about your business I’m willing to move closer. Here is my revised offer:
- “I’ll pay you $3.5mm in cash up front and $500,000 more at the end of the first year if the year’s services revenue hits the mark we previously agreed to. But you won’t be paid any of the additional $500,000 if the service revenue target is not achieved.
- For every 1% that service revenue exceeds our agreed mark, I’ll pay you 2% more than the $500,000 to reward you for the pipeline if it turns out to be as productive as you believe it will be.
- That’s $4.0mm with the possibility of an upside. That’s made possible by me not having 100% of the risk associated with the business’ future performance and it is what I think is fair and prudent to do.”
Seller is detecting that Buyer probably only has $3.5mm in cash, of which possibly some or all might be in the form of a loan from one source or another. Seller is confident of the agreed first-year service revenue number but Buyer’s offer is risky: if the revenue falls even one dollar short of the target, none of the $500,000 earn-out will be paid. Seller is also confident of the management team, the pipeline and Buyer’s ability to manage the combined company.
- Seller: “Thank you. I think we’re making progress. Let me suggest this. Let’s agree on a price of $5.1mm, with this deal structure:
- “$3.5mm in cash up front.
- “$500,000 earn-out in cash over two years.
- “$350,000 of this at the end of year one, of which $280,000 is paid if we hit 80% of the agreed services revenue goal, and it increases by 1% for every 1% we attain towards the goal, and 2% if we exceed the goal. If we attain less than 80% of the goal you pay $0.
- “$150,000 of this at the end of year two, of which $120,000 is paid at 80% attainment with the same structure as the first $350,000.
- “That’s $4.00mm with some upside for me. Additionally, I’ll loan you $500,000 over seven years at prime plus 3%. I think you and our combined management teams are going to perform well. That gets me $4.5mm plus some upside which I will accept, and if the revenue fails to hit 80% of goal, you’re fully protected on the $500,000.”
- Buyer: “Directionally your proposed deal structure is making sense but a lot depends on your management team. I think I might agree to this but I’d have to meet the management team first.”
- Seller: “Sure. If you will, memorialize this in a Letter of Intent to me. If we can sign that, we’ll go into due diligence. Once you’re reasonably satisfied with the due diligence results, and we both put our attorneys on writing the purchase agreement, I’ll arrange for you to meet with each of the management team members. They’ve known for several years that I’ve planned to sell the company, and they’ll be excited to know we’re going down that path with you. I think you’re both going to be impressed with the skills of the combined team and the compatibilities of our two companies’ cultures.”
This is a simplistic example of a negotiation of valuation (price) which arrived at $4.5mm, and deal structure that makes that price possible, which took the form of cash up front, a cash earn-out, and a note.
In real life, this would likely have been a considerably more detailed and incremental negotiation that took place over time as Buyer and Seller learned more about the assets and each other’s goals and abilities. There would likely also have been other items, such as an escrowed amount for one or two years, against the representations and warranties made by Seller.
In addition, for the sake of blog space and simplicity, we don’t provide insight into how the initial $5mm valuation was arrived at, nor do we know the size and cash flow of Seller’s company. We also don’t know each party’s ultimate goals and abilities. As a result, we can’t gauge whether this is a wise deal for Buyer or Seller. However, it is a simple example of how Buyer and Seller use both sides of the coin – valuation and deal structure – to arrive at a balance of risk and reward which results in a successful deal.
Don’t miss Paul Dippell and other IT experts speak at IT Nation!