Sealing the Value Gap in Your M&A Deal
In a healthcare M&A transaction there are times when the value of the selling business is not on the same level as both the buyer and the seller. Perhaps things were missed in due diligence, or the buyer cannot raise the funds the seller is asking for. Regardless, these issues occur, and The Ambulatory M&A Advisor shows the different ways that sellers and buyers can potentially bridge the value gap and seal a deal with minimal roadblocks.
Peter Greenbaum, Business Law and Healthcare Attorney for Wilentz says that a valuation gap mean between a seller and a buyer is all about perception and expectation.
“A seller perceives their business to be worth more than a third party perceives it to be; it gets back to perception. It’s not uncommon that sellers want as much as they can and buyers want to pay as little as they need to. You have a natural conflict in the way money works, and it oftentimes results in a gap in the valuation,” Greenbaum says.
“You would like to believe that if you have a reasonable buyer and a reasonable seller, you are going to have a gap that is not too drastic. When you have one party that may be out of line with what the market is bearing that is when you are going to have a bigger gap. As long as everybody comes in with eyes open and aligned with what the market can provide and with the way they value the business, there will usually be some sort of gap but a gap that the businesses can work through.”
Alex Kajan, Director, Business Valuation with Pinnacle Healthcare Consulting believes that the most effective way to bridge this gap is to find ways to grow revenue, reduce expenses, or reduce the riskiness of an investment in the selling company during the years leading up to the sale of the business.
“There are a number of ways to do this and all of these are taken into account in determining the fair market value of a business. Adding ancillary services to the business can enhance revenue potential. Utilizing mid-level providers or negotiating better contracts with vendors can both help reduce expenses and enhance profitability. These are the issues that most business owners easily identify, but often neglect to consider the riskiness of an investment in their business. Concentration of referral and revenue sources, key person risk, lack of geographical diversification, and poor payor mix are common risks identified in the valuation process,” Kajan says.
Kajan adds that if an owner did not focus on growing revenue, reducing expenses, or reducing the riskiness of an investment in the business prior to initiating their exit strategy, other methods can be employed depending on the facts and circumstances of the transaction. For example, does the owner wish to retire or is there potential to remain engaged in operating the business to some extent.
Greenbaum goes on to explain that there are many ways that a buyer and seller can bridge the gap between the differences in value that may arise. According to Greenbaum, the earn out provision is a very typical way of bridging that gap because typically in an earn out, the buyer can reward the seller slightly more than they otherwise would have. It allows the seller to, while taking some risk, get a greater upside. At the same time, from the buyer’s perspective, the buyer has a comfort level that the business and revenue stream that it is buying, is in fact there. Therefore, often times in the earn out, a buyer will share more than they would otherwise would have been paid if it was a straight up purchase price.
Brian Berlandi, managing partner, Berlandi, Nussbaum & Reitzas LLP adds that an earn out is also the kind of gesture a seller makes for a buyer who might have difficulty getting traditional financing from a bank therefore, pushing a value of the business that the seller does not see as fair. Berlandi says that this is one of the benefits involved in the deal for the buyer.
“The seller may have a buyer who wants to buy the property, but the buyer is having trouble getting traditional financing. The seller doesn’t want that to kill the deal, so it offers to finance the property for the buyer to get the deal done. It’s usually not the first choice of a seller to do that, but if it doesn’t have a better option and wants to keep the deal intact, a seller will offer it,” Berlandi says. “For buyers, if you can’t get traditional financing, which will usually have better interest rates, you are still able to consummate the deal because the seller is financing it for you. It’s good for the seller and good for the buyer to keep the deal intact.”
Kajan explains that earn out provisions can be useful if a seller believes the current fair market value is not representative of what the fair market value would be over the next several years. Generally, with an earn out provision, there is an upfront payment for the business and an additional payment (or payments) that the seller will receive contingent upon achieving predetermined financial goals after the transaction closes.
“If the seller believes the business is truly worth more than the current fair market value, this is a way for the seller to capitalize on the future success of the business should the financial goals be achieved. I would note that to the extent the earn out provisions are aligned with services referred from the seller to buyer post-transaction, legal counsel should be consulted as the earn out could be viewed as a payment for future referrals,” he says.
Kajan says another way to bridge the gap is through seller notes.
He says a seller note allows the buyer to pay for the business over time. If the seller is willing to forgo a large portion of the upfront payment, the note can provide interest for the seller over time. This could be an attractive option for a business owner who is willing to shoulder this additional risk in hopes of a greater return. Additionally, as dollars in the future are worth less than dollars today, this could be attractive to the buyer if the interest rate on the note is manageable.
Greenbaum says that from a buyer’s perspective, the seller holding the paper will give the buyer a little more comfort that the seller will stand behind the business.
“A buyer’s fear is that the seller’s representation in terms of the revenue stream among other things, may not materialize. If the seller is willing to hold paper, it will give the buyer a little more comfort that the seller will stand behind what the seller has in fact said the economics are. If it’s not there, then the seller is not going to get paid. It’s a way of keeping the seller’s skin in the game that otherwise would not have been there if it was an all cash deal where the buyer either had their cash in pocket or from a third party bank. Once that happens there is no real skin in the game from the seller’s perspective, and that is when the buyers become concerned,” Greenbaum says.
Although selling less control of the company to a buyer is a way of addressing the bridging of the gap in a sale, Greenbaum says more often than not, it can create problems.
“When a buyer comes in and wants to buy a company, they typically want to buy one hundred percent of the company; they do not want a partner. They do often keep the sellers around or need the sellers to stay around, whether for employment related reasons or from a transitioning perspective in the sense that the sellers are the ones knowing how to run the business and therefore need to effectively teach the buyer,” he says.
“Beyond the service component, whether it is a long-term employment relationship or just a short-term transitioning relationship, moreoften than not, having buyers and sellers remain partners post-closing, that is not the objective of either side. You have a seller that wants to cash out and move on typically, therefore, remaining on as co-owners or partners after a closing doesn’t necessarily achieve that goal.”
Kajan says the success of this strategy really depends on the seller’s willingness to remain engaged with the business over time.
“Buyers are generally seeking to gain control of a business. To the extent a seller is willing to sell a controlling interest in their business and a buyer is willing to allow a seller to remain engaged as a minority interest holder, there could be value to positive changes the buyer could make to the business after the transaction occurs. This can come in the form of greater geographical reach, economies of scale leading to more favorable contracts, etc. The issue this can create for a seller is that they now have a minority interest in a company that is more difficult to liquidate and they also now lack control should disagreements come about in the future. A seller really has to consider what benefits the buyer could bring to the table post-transaction and whether or not they want to remain onboard with a business they no longer control,” Kajan says.
If you have an interest in learning more about the subject matter covered in this article, the M&A process or desire to discuss your current situation, please contact Blayne Rush, Investment Banker at 469-385-7792 or Blayne@AmbulatoryAlliances.com.