Post-COVID-19 there will remain an abundance of private capital in the market to acquire closely held companies. This capital needs deployed. In order to deploy it, acquirers must find a way to solve questions and issues around valuation. There are several different ways to accomplish this, one of which I proposed in a previous article. But the bottom line is this. If acquirers punish business sellers for the performance of their companies during the time of a global health pandemic (via decreased valuations) sellers simply won’t sell. Deal flow will dry up and capital won’t be put to work. Big picture, this won’t happen. There’s no other place to achieve comparable returns. So, acquirers will figure out a means to support pre-shutdown level valuations and entice sellers to sell.
The way acquirers will support their valuations amid uncertainty is by reallocating risk. Meaning, sellers will need to assume more risk post-shutdown and post-closing than they had pre-shutdown. Most acquirers will get comfortable with an assumption that the economy will return to near pre-shutdown levels at some point. But, how quickly this happens is the great unknown. It will vary depending upon industry. But this risk will cause acquirers to seek sellers willing to share it post-closing.
The two simplest ways to share timing risk are seller financing and earn-outs. Seller financing is the receipt of money over time. With acquirers skeptical of the future, their willingness to absorb the entire purchase price at closing diminishes. To preserve cash at closing and sustain the business through what may be a prolonged recovery, acquirers will push part of the purchase price into the future. The good news, if you’re the seller, is that this is the equivalent of a loan to the acquirer. So, when negotiated properly, you’ll receive interest income in exchange for the use of your money in the deal, increasing your overall return.
Earn-outs on the other hand are additional purchase price contingent on the company’s performance post-closing. So, unlike seller financing in which payments and their magnitude are agreed to in advance, in an earn-out scenario, payments and their magnitude are tied to specific performance metrics. For example, X is paid at closing with an additional Y being paid once a certain gross profit milestone is reached and then an additional Z is paid when another gross profit milestone is reached. If the milestones are not reached, the additional payments are not made. This shifts some of the company’s future performance risk back to the seller. The good news for sellers is that when negotiated properly, in exchange for assuming this risk, sellers can oftentimes achieve additional upside. Meaning, if you’re penalized for the company’s future performance when lower than anticipated, you should negotiate additional benefits when the company’s performance exceeds expectations.
So, if you were planning on selling your company in 2020 or 2021 and are considering changing those plans as a result of the COVID-19 pandemic. I would advise you otherwise. Markets are driven by supply and demand. Demand and capital are still in abundant supply. Acquirers will find a way to achieve valuations in line with pre-shutdown levels in order to put capital to work and keep markets moving. However, as a seller you’ll need to adjust your expectations from all cash at close to money over time to support your required valuation.
River’s Edge Alliance Group is proud to have served the following clients: