Firmex and Mergermarket’s recent quarterly report on mid-market M&A focused on the valuation gap between buyers and sellers. At first glance, a valuation gap seems perfectly natural – buyers want to avoid overpaying for a company and sellers, of course, want the highest valuation they can. But the technology and biotech sectors were singled out by most interviewees for their above average valuation gaps, which has slowed down M&A activity in recent years. This all raises the question: What tactics can buyers and sellers employ to lower a valuation gap in their own deals?
Take a look at the report here and read our tips below.
1. Contracts for setting valuation terms
The first method we’ll explore are contractual solutions. These consist of clauses in the purchase contract which ensure a given level of pay-out and tend to be very mechanical in nature. The most common of these clauses is the earn-out – a target-dependent valuation whereupon payouts are increased as pre-set business targets are achieved. The benefit of this kind of solution is that their values are solidly based on measurable metrics, so there are no surprises. It also helps to align the incentive of the seller, if the management team is staying on. However, if they are replaced, this does introduce moral hazard if the buyers don’t want to pay out the full price later on.
It’s important to remember that these clauses can often result in lawsuits down the road, especially if targets and their fulfillment requirements are ill-defined, so it’s crucial to be meticulous. After all, nobody likes to feel ripped off. But when used properly, contractual solutions are like a saving grace for valuation discrepancies.
2. Prudent negotiation and expectation management
Of course, not everything has to be hashed out so rigidly in the contract – soft skills can also be utilized to decrease the valuation gap. These usually boil down to two things: Prudent negotiation and expectation management. While your startup may have value, not every company is a unicorn. As mentioned in the report, taking multiples that have been used in mega-cap deals and applying them to your startup is not a particularly reasonable thing to do – those deals almost always involve well-established companies that are the big fish in their respective ponds, which is not the case for the vast majority of completed deals.
It’s also important to remember that buy-side folks likely have far more experience in pricing companies than a startup founder. There’s no shame in this: They do this day-in, day-out, while a founder has been busy building a successful company from nothing. However, they’ll be trying to get the best price possible for themselves, so a solid understanding of how to properly value your company is essential, unless you have someone with that experience going to bat for you in the negotiation. These solutions tend to be more delicate, and if pursued too aggressively, could begin to derail the entire transaction. It’s important to be patient, and, again, meticulous.
3. Bring your company up to target valuation
However, if you’re very confident that you’re being low balled, there is one more way to close the valuation gap: Back away, grow your business, and improve the company’s valuation organically. While it could seem that your forecasts appear optimistic to outsiders, they are perhaps missing the value proposition your company brings to the table or the proverbial big picture. This is notorious in business lore for happening to industry stalwarts looking to acquire smaller firms. In 1999, the #2 search engine Excite infamously declined buying Google for $750,000, which would equate to a return today of over 68,000,000%! In 1979, Microsoft was turned down by Ross Perot’s Electronic Data Systems for a bargain of $40-$60 million. Perot has since called the refusal “one of the biggest business mistakes [he’d] ever made”. This phenomenon is not restricted to the tech sector – in the 1960s both CBS and NBC passed up the opportunity to show Monday Night Football, all but giving the rights to ABC – but the tech sector is particularly vulnerable to this kind of thinking. After all, it can be hard to see a game changer until after the game has changed.
In some cases, holding out for a number that more correctly reflects your company’s intrinsic value can be a fantastic decision. In fact, several companies have turned down potential suitors to great effect – WhatsApp declined a $10 billion valuation from Google before later selling for nearly twice that, Snapchat refused a $3 billion offer from Facebook in 2013, and has recently been valued at $16 billion, and Facebook turned a $1 billion buy-out valuation from Yahoo in 2006 and is now worth well over 300 times that amount.
However, this doesn’t happen without hard work. Understand that you company is only worth what someone will pay for it. If you don’t like your valuation, it’s on you to raise it.
Get to work – that valuation gap won’t close itself
Clearly, the valuation gap is not insurmountable – a deal can be struck if both sides are willing, and there are myriad ways to attempt to reconcile the values in mind on both sides of the table. Contractual legal clauses and shrewd negotiation skills have helped to do just that in numerous situations. On the other hand, if you really believe your business deserves more, don’t treat the valuation gap as a temporary injustice – take it as a cue to do better.