Nine solutions for bridging the COVID-19 valuation gap

What is the situation?

Despite the resurgence in dealmaking that saw M&A recover from the seismic impact of COVID-19 in the second half of 2020, one particular issue has emerged that could yet prove a sticking point in this recovery: the valuation gap.

According to a recent report by EY, a disconnect between buyer and seller valuations has been one of the core reasons behind many deals collapsing in 2020. EY’s report noted that, while this was a problem worldwide (with 55 per cent of executives polled globally failing to do a deal in 2020, 36 per cent of whom blamed a valuation gap), the issue was particularly problematic in the UK.

The report found that the majority of the 69 per cent of UK executives polled whose companies didn’t close a deal last year blamed the valuation gap. Some reports have suggested that, with UK targets in demand globally, international buyers have proven more willing than domestic bidders to close the valuation gap in M&A negotiations.

With UK M&A still looking to fully recover amid the improving, but still unpredictable and fluctuating, COVID-19 situation, what can buyers and sellers do to ensure that gaps in valuations don’t derail their deals?

Why has COVID created a valuation gap?

The valuation gap created by COVID-19 can largely be boiled down to one factor: uncertainty. The way dealmaking ground to a halt in Europe as the pandemic hit in March 2020 is well documented, but another effect was that, in the longer run, M&A switched from a seller’s market to a buyer’s market.

One reason for this, of course, is the fact that many businesses are being forced to sell due to the impact of COVID-19 on cashflow, putting buyers at an inherent advantage. But in any negotiations, (not just those where the target business is distressed) buyers can now cite the massive, ongoing unpredictability caused by COVID-19 as a challenge to the seller’s asking price, driving what has been labelled a “COVID chip” into the valuation.

This is not to say that this is purely a cynical, exploitative tactic designed exclusively to drive a fee down to the lowest valuation possible. With ongoing impediments of lockdown and travel restrictions, individual sectors and broader markets are far from predictable and, with no certainty of a rapid return to normality, future earnings (upon which many valuation models are based) are extremely hard to forecast.

Buyers and sellers may have completely different outlooks on the scale of the pandemic’s impact, the likely speed and timeframe of any recovery and the state of consumer sentiment post-pandemic.

This has resulted in serious gaps arising between buyer and seller valuations and, with ongoing risk-points such as new variants, growing vaccine disparities between countries and conflicts over the distribution and effectiveness of different vaccines, the problem of the valuation gap could be set to persist long after the worst of the virus has passed.

For parties on either side of a potential sale, then, seeking a constructive solution to a valuation gap could prove critical to closing a deal.

How can valuation gaps be bridged in M&A negotiations?

Earn-outs
Perhaps the most common method of closing a valuation gap in M&A negotiations is building an earn-out structure into the deal. An earn-out involves the deal going ahead for a lower initial sum, with future payouts agreed should the business meet or exceed certain expectations or performance indicators post-sale.

Earn-outs have an inherent fairness that makes them particularly attractive in negotiations where there is a gap in valuations, but a genuine desire to reach a deal. This is because, while the seller is able to provide certain metrics in order to set or justify a higher valuation, these metrics need to bear out in order for the full amount to be paid out.

The fundamental attractiveness of an earn-out is that buyers pay just a portion of the seller’s valuation up-front, with the rest coming through future earnings. While sellers are able to see a continuing cash flow post-sale and benefit from future growth.

However, a potential sticking point when negotiating an earn out-based acquisition is setting the metrics fairly and ensuring they are not subject to any manipulation.

Earn-outs have so far proven popular in M&A during COVID-19, with private equity firm Allen & Overy recently revealing that 20 per cent of the deals they were involved in during 2020 featured earn-outs, compared to 9 per cent in 2019.

With the potential for further COVID waves or lockdowns, however, negotiating the structure and agreeing on the metrics governing an earn out could prove difficult.



Ensuring fair calculations
In the case of a deal structured around an earn-out, for instance, one of the key challenges will be ensuring that the metrics for determining the final amount are calculated fairly. This could prove particularly troublesome in the uncertain environment of COVID-19.

Whether this uncertainty persists over the coming years is difficult to forecast, given the fluctuating nature of the pandemic, the question of whether vaccines will end it or whether evasive new variants will emerge. Such factors make forecasting a business’ post-sale performance problematic.

Therefore, in order to ensure that such deal structures are viable and further valuation disputes are avoided, is to use the fairest possible metrics to give peace of mind on both sides of negotiations.

Using neutral criteria to calculate the full figure and specific triggers and thresholds for when the earn-out is activated could prove crucial. Parties could refer to previous economic downturns, looking at what factors impacted the industry or sector then and whether these are likely to reoccur.

Looking at the macro influences impacting the business’ specific sector, with reference to performance data such as sales volumes, can help calculate the price and how it may be adjusted over time in a more judicious manner.

Milestone payments or CVRs
Alternatively, if this structure risks too much uncertainty with COVID-19 still very much present, an approach in which a portion of the acquisition fee is paid out upon the hitting of certain milestones or thresholds could be more attractive.

Buyers will be eager to not be tied into paying a significant sum even if their post-acquisition trading is, for example, impacted by a resurgence of the pandemic. By the same token, sellers will be keen to avoid a situation in which the business performs slowly for a few years post-sale, potentially impacting the earn out they receive, before going on to flourish afterwards.

Milestone payments could help to avoid either situation by having the remainder paid out based on performance during more normal trading. A milestone payment structure could, for example, see additional payments made to the seller when certain sales or profit targets are hit.



In this type of scenario, sellers will be well advised to have in place very clear definitions of how net profits will be calculated and the accounting standards and conventions used. Furthermore, there may be a risk attached to having the remainder of the payment contingent upon future successes, especially in the current uncertain climate. However, this could perhaps be offset by having a higher initial purchase price or by incentivising a milestone structure by diversifying the kinds of potential payments. For example, as well as payments for sales targets being hit, there could also be additional payouts for a future sale of the business or for successful product launches.

A common form of milestone payment in the USA are CVRs (Contingent Payment/Value Rights). In the case of an acquisition, a CVR would represent a right given to the selling party entitling them to an additional consideration at a later date, be it in cash, stock or a combination of the two, should a certain payment trigger be activated.

Seller financing
Another common method of bridging valuation gaps is seller financing. This is particularly useful in situations where a seller may have a preferred buyer who does not necessarily have the capital available to meet their valuation.

In a seller financing arrangement, a lower up-front purchase price is agreed, with the remainder of the financing provided from the seller to the buyer, often in the form of a high interest loan.

For a motivated seller, this has the advantage of both facilitating a sale and providing additional revenue in the form of interest on the remainder of the purchase price. However, in the current climate, there are perhaps numerous drawbacks to structuring a deal in this way.

Firstly, there is the simple fact that many (perhaps even the majority) of business sales occurring at the moment will be happening with the business concerned in some form of financial distress. This could mean that sellers may not be in a position to provide financing to facilitate a sale at a lower initial price. Secondly, with ongoing uncertainties rife, buyers may not have the confidence to accept a deal structure in which they repay financing at a high interest rate.

Partial acquisition/minority share retention
In this instance, the buyer simply acquires less than 100 per cent of the company to begin with, perhaps somewhere from 20 to 80 per cent of the equity, with the remainder deferred to a later date and perhaps subject to a predetermined formula to calculate the remaining payment.

While the seller will have to settle for a lower purchase price until the remainder of the company is acquired, this is offset by receiving an ongoing source of cash flow in the interim as a result of retaining a minority share.

This is an approach that may prove appealing during and after COVID-19. For one, the formula to determine the price the remaining share is acquired at could reflect the impact of COVID-19, should the impact prove to be persistent.

Secondly, having such criteria in place ensures both buyer and seller are protected from a situation in which the deal structure leads to them significantly losing out.

For buyers, they are protected from paying over the odds for the remainder of the company should the impact of the pandemic persist and performance lags. For sellers, they are protected from losing out on the financial reward they will feel they are due should the business see a significant post-COVID recovery.

Non-cash consideration
In the event of a valuation gap, the buying party could seek to drive down the cash value of the deal by satisfying a portion (or even a majority) of the deal through non-cash considerations.

This could come in the form of shares or a convertible loan note in the buyer’s company. Alternatively, if the buyer is an asset-rich company and the seller is an operator in a similar industry, then the buyer could look to include assets as part of their bid.

An approach in which non-cash considerations form a core part of a business sale could be extremely attractive to buyers during a situation like the ongoing pandemic, where the cash to meet a seller’s valuation may be hard to come by.



However, this method has some drawbacks, not least that the two companies’ valuations of stocks or assets could lead to further divergences. Though this could be mitigated by both parties agreeing to the appointment of an impartial asset valuer. Furthermore, deciding whether to take on stocks or assets from the buying company adds another complex layer of due diligence for the selling party. With the due diligence process one of the elements of dealmaking most affected by COVID-19, this could add further difficulty.

Anti-embarrassment protection
For parties looking to sell a business while COVID-19 remains a factor, there is the considerable difficulty of navigating low buyer valuations, while bearing in mind that coming down from their own valuation could mean leaving themselves exposed to missing out should the business benefit from a post-COVID bounce.

With this in mind, buyers can reassure sellers while still keeping the up-front cost of the deal closer to their valuation by agreeing to some form of anti-embarrassment protection.

Anti-embarrassment protection involves the stipulation of a recalculation or addition to the purchase price in the event of certain events occurring and guards a selling party against losing out should the company’s post-sale performance significantly exceed expectations or if the buyer goes on to sell the company at a higher price within a pre-agreed timeframe.

At a time of such uncertainty, anti-embarrassment protection has appealing benefits for both sides of a business sale. For the seller, it helps to facilitate the deal while ensuring that a post-COVID bounce that sees the company recover or even grow doesn’t leave them red-faced having settled for a pandemic-impacted price.

For buyers meanwhile, it helps to keep the initial purchase price closer to their valuation (which has likely been lowered by COVID uncertainty), with a higher price only payable if their acquisition proves to be successful.

Consulting provision
Including a consulting provision in a takeover deal is another way that buyers may seek to lower the purchase price and involves keeping the former owner or managing director on in a consulting capacity for a pre-agreed period.

This may be attractive for sellers in that they will retain a stake in the business and hold an important role, ensuring a continuing stream of revenue as well as a further payout if and when they sell their remaining stake. However, this option is of course only really feasible if the seller is willing to remain involved and is not set on making a full exit post-sale.

For buyers, there is the obvious advantage of a lower initial sale price, while keeping a former owner on in a consulting capacity for advice and guidance could prove valuable in helping to ensure a smooth transition and successful integration post-takeover.

Asset-based acquisition
If there is a continuing disconnect between a buyer and seller valuation, then a possible method to bridge this is for the buyer to acquire certain key assets of the business, rather than taking over the entire company. In this situation, the buyer may decide that the seller’s valuation of the business as a whole is unrealistic and that they could achieve their strategic goals by acquiring assets at a lower price.

This may involve acquiring things like intellectual property, a particular division of the business, portfolios of clients or contracts. At this point, the seller would be left with the remainder of the business and could negotiate a deferred takeover of the rest with the buyer or seek to offset it to another buyer.

While the latter instance may be unattractive to the seller due to the work involved in running a second sale process, selling the constituent parts of the business in multiple different deals may help to bring the overall sale price closer to their initial valuation.

It’s hard to discuss the impact of COVID-19 on any facet of life without mentioning the “new normal” and it would be remiss for those involved in M&A to not acknowledge that the pandemic has wrought fundamental changes to dealmaking.

Chief among those, arguably, is the impact on valuations, with the uncertainty of the pandemic having upended the usual metrics by which valuations are calculated. It is understandable that this will cause a persistent disconnect between buyer and seller valuations. But, as with adjusting to the “new normal” elsewhere in life, some element of cooperation and compromise may be needed in order to make sure deals don’t flounder.

M&A activity will be crucial as businesses look to both recover and grow following the pandemic. Working to bridge valuation gaps when they occur and making a concerted effort to agree on a structure that satisfies both parties, rather than simply abandoning negotiations, will be vital to facilitating this.

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