How to Bridge Valuation Gaps in M&A

24:20And And they should be, right, if the earn out is structured properly. There's quite a bit of variable then. Is there like a common range that you see percentage-wise of how much gets put in an earn out? Yeah, I think you could probably see about a third of the closing date consideration pushed to the post-closing period to the measurement period. That's probably been trending up a little bit and maybe not even that high. Maybe it's a 25 % of enterprise value. But I think that's probably a good rule of thumb. In terms of measurement periods, if it's financial, you usually would see just one year, maybe two.

24:52If you pivot and think about from a milestone related or an event driven burnout, those could be much longer in duration, five, seven, I've even seen nine or 10 years. Wow. But there's some real upside to some of those that are going to take a while and need significant resources to be invested in and lofty goals, but big payments too. So that's why there's more time, especially on the healthcare side. When government's involved and reimbursement rates are involved, it's not easy to get on an approved list or a reimbursement list or get something through commercial development. That takes time.

25:26Whereas financially driven metrics are usually, say, one, two, three years in duration. And even of the frequency among them, shorter, it would skew towards year one and potentially maybe even 18 months. We have a big range that we got on this end as well in terms of how long these could go for. Anything else to be really mindful of when negotiating earnouts? It sounds like clarity is the key in just being as clear as possible of what the milestones are going to be. Clarity is key. If it's a longer duration, like the commercial development of a drug discovery or there's some patent litigation or something like that, information tends to be helpful and a lot different than the information that would be obtained through the financial metrics.

26:10So you might want a consultation right or some sort of board right or an ability to talk to management and just understand how things are going or what's the probability of this being hit or achieved. And so that consultation tends to be a lot more helpful than just reading the financial statements. Whereas the financial statements, if you're being measured off the financial statements off EBITDA or revenue, that sort of normal course information package is perfectly helpful. You don't know that. When it tends to be more bespoke, and my examples, again, are the litigation or commercial development or patent infringement case, those consultation rights tend to be softer, but probably more helpful or useful information.

26:47Would you want to have some of those conversations before you put an LOI out there? Could you dig into the management team and try to get that level of certainty that, hey, these are the milestones that we're looking to put together? When buyers, especially private equity groups, most of them look to partner with management. they tend to back management teams and the direction they're going with their investment thesis. So they might not get into that level of detail on those sorts of conversations, but you bet your bottom dollar they've done background checks. They've done referral type calls, maybe even brought in a third party consultancy to do some evaluation and talk to other management teams that they've either previously worked with or their existing colleagues to understand the direction that they're going.

27:28But a lot of these relationships between management teams and private equity buyers or even public company buyers, they've known each other for years, sometimes longer, either through industry or second and third acts or a few companies ago. So these aren't relationships that are forged in one management meeting. They've been having a number of conversations over the years. They've been keeping tabs on the companies that develop some trust in terms of understand your company's not in market. We'd love the opportunity to bid when it is up for sale. We'd like to preempt this process. So you have private equity buyers trying to squeeze in there and get something before it goes to market.

28:05So probably not paying as perhaps as rich of a premium. A lot of private equity groups try to partner with management, team up with management teams and use that to advantage, gain that trust. And also it helps them. How are we going to take this to the next level? What is it through organic growth? We're going to spend dollars to invest in you. How are we doing that? Is it through a new product offering, a new scalable piece of software? Is it because we need to invest in a new role, whether it's a CTO, a CIO, a consumer, some sort of software development role? What does it take to get to that next level of growth?

28:39And it could be through add-on acquisitions, and that's a lot of private equity groups, bread and butter. But it's sort of having those conversations, those dinners and fireside chats and industry groups and just networking over a number of years that forge those relationships and those trust. So going back to your very first question, I don't think you get into that level of detail early on, but it will come up in the course. It sounds like it's a lot of alignment around the strategy itself against the investment thesis. Let's talk about seller financing. What are the different structures possible?

29:08When a buyer is looking to capitalize a new platform company, and I'll just continue to use private equity as an example, because that's where I spend the lion's share of my time representing sponsors and platform deals and add-on acquisitions. And they bring equity capital to the table and they bring debt capital, debt providers. They usually have a stable of private lender relationships or financial institution parties that they can bring to bear. But again, in these mismatched valuation situations where seller wants a multiple of X on the EBITDA that their business is generating and buyer is recalcitrant to spend that, either because financing has gotten more expensive, going back to the rising rate environment I mentioned, or they're just worried that the growth trajectory won't be as strong as it was.

29:53They're worried about that recession case or that base case and not being in a always hockey stick upward growth trajectory. So you get some of those valuation disconnects. One way to bridge it is to say, seller provide a debt financing in the form of a note that the company will pay out or the buyer will pay out over time, the seller$10 million or whatever. In an example, that's subordinated to the senior loan agreement or even the second lien or Mez loan agreement. It's just another ability to provide additional financing to give them enough juice to pay that higher premium. Seller's happy to take that.

30:30They're just effectively usually happy. They're getting their cash dribbled out over time. They're not getting that. They'd otherwise get that money right at closing. We've seen other, I would say, even more creative situations where when buyers setting up its financing for the old co, we've seen the exiting sellers set up a tranche, a layer of security, where they're the first money out when buyer goes to sell that company in five years. So it might not even have any current pay, any coupon pay, like a traditional debt product. It's just the first money out. For whatever reason, buyer was unwilling to make that last X dollar of payment.

31:07It's called$25 million. Buyer didn't want to stretch, but what they did say is we'll deliver that to you, so to speak, sellers, but you don't get that money out until we exit when we go to our change of control at that future exit scenario. We've seen that employed, I won't say with a lot of frequency, but the flexibility to know that there's equity structures that allow the sellers to reap proceeds along the way, either all along the way, like a seller note, typical debt-like payment or at some future exit that the private equity group has. And I think in a lot of the equity structures, it tends not to be cash pay on exit.

31:46But we've seen some really exotic structures that have cash come back to the seller after certain return that the buyer had. If the buyer has gotten this much money off the table, the next 50 million of proceeds goes back to the sellers because of whatever the commercial deal is, they should get that next tranche of money. And then it picks up and goes back to the buyer. We've seen some really exotic ways that splice the distribution waterfall in the go-forward platform holding company capitalization table. And we're facile with those structures from a corporate M &A, equity perspective, and tax perspective.

32:22We always use very sophisticated and smart tax advisors at Canel Gates on our deals to help make sure we're not falling into any traps for the unwary there. So I think those are some ways we've seen seller financing both sort of bridge the valuation gap on the debt front and the equity front. The third product, and I'll just push you there, is when third parties step into that preferred equity structure. We've seen that with greater frequency the last two and a half years. With the free flow of debt capital markets, preferred equity structures, there wasn't really much need for them. There was plenty of debt capital.

32:54There was plenty of GP sponsor capital available to make platform deals. and if necessary for add-on deals, private equity groups usually look to use their existing debt capital to reach for add-on opportunities. But what we've seen as credit has tightened, institutional asset lenders, life insurance companies, sophisticated parties that provide private credit solutions have stepped in and filled the void that might have normally come through a MezDep product or a hold code pick note, which we won't necessarily need to get into details. But they've turned the stripes from debt to equity. And it's the first equity that is returned out of the equity structure.

33:34It has debt-like features, but it's not debt. It's equity. You're like, what's the difference? What the hell is this? That equity might have a 14 % coupon on it. Okay, it's accruing, but it's not cash pay. They get out once there's cash distribution. So the first cash distributions that the company makes would be to pay down this debt. And it might be redeemable in seven years or eight years, whatever the terms are. You're not making any payments against this. Not making any payment. I like this. Tell me more. It's bridging the gap. You're not making any payments, but it's expensive paper. It's accruing, but it's not hurting the company's cash burn.

34:07It's accruing the same way debt would. Absolutely. But it's usually paid in kind or pick. You don't pay a lot of compound interest on that. That's right. And so we see interest rates for that product probably stretch from 12 to 19. It's like a high-teen, mezzish product. It's an expensive debt product, but it's wearing the sheep as equity. This is a preferred equity. What's really interesting or cool about it is if we're engaged either on the sponsor side or we do have institutional LP clients who are using this product, doing private credit solutions. Some of our first questions, if we're on the lender side, we'll wear a lender hat for a second, even though it's preferred equity.

34:46Is it more like equity or is it more like debt? Tell me about the covenant package, the debt covenant package. because if it was a more traditional debt, there'd be relief or cushions in the same sort of covenants that are in the senior documents. But I think in preferred equity structures, we've seen the covenant packages for them really run the gamut. And I think it just depends on the industry and the quality of the credit down below of the performing target company, what industry it is, how's its cashflow, how comfortable are you with it? But there's some, frankly, challenging conversations about what are your remedies in that situation on a failure to pay, what happens on an event of default?

35:23What happens if there's a failure to redeem? If it's a seven year product, what happens on a failure to redeem? Because there's not a traditional foreclosure, like a debt or an ability to take over the asset. There's some other ways that lenders and sponsors get comfortable with it where there's, yes, we'll try to take you out. There might be a penalty interest rate or not, but at some point leads to a sale or some sort of forced process where there's liquidity for everybody is where it ends up probably eight times out of 10 or perhaps even more. It's an interesting sort of hybrid product. And it does bridge that valuation gap because it's not a participating preferred equity, like in maybe some emerging growth companies that people have.

36:04Oh, it participates along the side of the common. No, it is just the first money out. It's a 14 % piece of paper. Pretty cool. I had no idea about that. Can we go back to just a traditional seller financing. And can you give me a sense of terms that you would see or what's the range between the interest, the duration? In terms of the interest rate, you're probably seeing a function of some sort of base rate, whether that's prime, LIBOR is gone, but a function of prime plus X percent. Sometimes you see where it's done a lot cheaper, where a sponsor has a lot more leverage, or sometimes it's triggered off what the senior your loan documents are.

36:43But there's tax reasons where it needs to have an interest rate, at least in the United States, over what the applicable federal funds rate is. You're typically seeing it floating over fixed? Yes, typically. I'm sure there's instances where fixed works just fine, but as long as it's calculable and measurable and not overly complicated, I think people can get comfortable with it floating. Again, in the last three years with the higher rate environment, I think you're going to see a lot of flight to people moving to a floating interest rate, Whereas before, Fed funds rate was low forever, and everybody just got used to this low rate environment.

37:19So people were fine. Sure, 5%, 3 % or whatever. Fixed rates were fine, but there wasn't much interest rate expense at that time. But now with the way the Fed has moved rates up and is battling inflation, I just don't think sellers would be as comfortable with a fixed rate. Fair enough. Duration. Duration, it's a commercial point, but varies probably between one to five years. Just depends on how much and over how much period of time. Some of the negotiated features you'll think about is that if there's a change of control, does it become due and accelerated at that point or time? There's features like that, that sophisticated sellers or advising sellers, like thinking through those nuances can be helpful.

38:02Obviously, sellers want as short a duration as possible, get as much of their capital back as they can. and buyers want to dribble that out. Pretty sizable range there. Let's talk about the equity. What do the structures look like if we were to build something more as an equity structure to bridge the gap? Yeah, in terms of the equity structures, it crosses a number of types of entities, whether it's limited partnerships or limited liability companies. There's a lot of flexibilities in those types of entities to craft a distribution waterfall or a payment waterfall that works for all the parties.

38:35There's probably even more flexibility in those types of entities where there's more choice points than in a traditional Delaware corporation where there's classes of stock and common stock and preferred stock. That said, they can be done in those structures. I just think we typically see them in limited partnerships or limited liability companies where it's true creature of contract. When I say creature of contract, that really allows the M &A practitioners to be flexible to customize it for that deal. There's a lot of sponsor groups that have a preferred common structure. That's their preference in terms of where they always tend to couple it on a one-to-one basis in terms of how they do and structure deals.

39:15And that's a little bit of remnant of doing deals through corporations. There are other sponsor groups that just have a single class of equity and it's just common. So when we're talking about the preferred equity, that's this solution for bridging evaluation gap. We're really talking about super preferred that sits above the common return. And that is the first distribution waterfall to the equity holders, whether it's for that 15%. And that usually isn't paid until there's an exit or a dividend recap. It has to be a significant sort of watershed event where there's money flowing out to the equity holders.

39:50Investors know that, whether it's sellers who are providing that tranche or some of these third-party institutional asset managers that I mentioned that are providing this tranche. We've seen it on larger deals where there's some stretch or for some reasons didn't want to take on that much debt. We've even seen it in some regulatory environments where for certain calculations under the government regs, whether it's in educational institutions, what have you, that the targets can't have that much pure debt. So this has been a way to provide financing to the target to help it grow, but still meet its debt requirements under whatever applicable regulations.

40:24So we've seen it employed to both meet regulatory tests, but also bridge valuation gaps. Would options be a thing to utilize? To me, an option feels like contingent consideration or like an earn out. If this hits, then this pays out. Are you talking about options in the public company markets? Well, it's saying in a private deal, it's, hey, we're going to put some options as part of the consideration in the deal as opposed to carving out a streak. I guess it goes back to the tax implication. If I'm doing this and we're providing this, whatever, preferred equity, is there some tax liability that's triggered as opposed to saying, hey, we'll provide you options of this much value?

41:03That's a really great point is stepping back. What are ways to incentivize your management team to help grow your enterprise? Whether it's a public company that has an existing compensation package and philosophy or a private equity group, there are ways to incentivize the management team. And so within these private company structures, a lot of times in these LLCs or limited partnerships, there is a class of equity, often called profits interest, that can be issued with, frankly, a$0 strike price and allows them to participate in the future profits of the enterprise at certain inflection points.

41:38Those often have time-based or performance-based vesting criteria about when they can come into the money and start participating, taking dollars alongside the common equity holders. But those are other ways to incentivize the management and maybe not bridge valuation gaps as between buyer and seller at the deal table, but certainly to help grow the enterprise during the hold period. and frankly align the management team with the goals of the equity investors to grow the entire enterprise in organic growth through organic initiatives and so forth. So that's definitely profits interest. Yes, if it's a corporation stock options or stock option plan, restricted stock, we've seen phantom stock plans, stock appreciation awards.

42:19There's a variety of ways. All of them are different. There's different tax and corporate features to all of them that sort of make sense in the various scenarios. They're all designed to align interest to grow the enterprise. Yeah, there's a lot. We're not going to get into those. I think we ended up creating a SARS for our company, but you do need to have your tax advisor involved, work with you to be able to put that stuff together. Absolutely. And a lot of times there's an omnibus incentive plan. So there's really a menu of types of awards that work for different situations. It does depend on how big your enterprise is and what you already have.

42:56and what can you do within the existing framework of your company or your company group or your jurisdiction because there's different rules between the U.S. and frankly, the non-U.S. enterprises. Those are some of the value that your tax advisors can bring, but also your legal advisor. We always recommend calling them early and often. Yep. Can't count on them enough. Let's say I'm working on my first M &A deal, small deal. It's like$10 million. Being first time, small private company, I want to hold on my cash because cash is king and we're a growth company. I can put that cash to work and it just keeps multiplying.

43:34Let's walk through stacking these things together, like really using all of them. Can I do that? Can I put together earn out seller financing and equity in the package to really minimize the amount of cash I need to put in the deal? I know it sounds crazy. No, I think there is. it's a little bit of choose your own adventure about how far you can push each lever or lever and get them all to work together. I certainly think it's within the art of the possible. Your goal is to conserve your cash outlay. So you put the earn out on the table and say, I like your business, but I can't pay this much.

44:08But if you meet these financial metrics over the next two years, we can pay you another million dollars at the end of year one and another million and a half at the end of year two. Again, subject to you delivering or exceeding the revenue or EBITDA thresholds at those points in time. That helps you save money. All right. So what are you talking about? 10 million. We want to put what? 3 million in there now? Yeah, that'd be great. What else can you do? So can we get the seller instead of cash outlay of seven, let's have you trickle money out over time in the form of a seller note. So we'll deliver them a note.

44:39And instead of paying them cash up front, we'll pay them a million dollars over the first year post-closing. Can we do$5 million over the next five years? You can probably tell I'm pretty Indian by now. I, you know, just negotiate and you pretend to start off with asking for the world. You can ask for the world. You have to pay something at the closing table. I'll tell you that, Kisan. Do we? I think you do. But yeah, you can play around with how much that outlay is and over what time. All right. So I got$5 million in debt financing, which leaves me with$2 million. Ambitious goals. Let's pretend the seller is going to stay on with you and execute this line of business or this product offering or what have you and integrate.

45:21So we have the earn out. We have some seller financing. In your ecosystem, we are going to amend your organizational documents, your LLC. You're an S-corp. We're going to do an F-re-org and a whole bunch of stuff. We're going to make it so that that seller is participating in your equity capital at your future exit. And let's be cheap and not give them an interest rate and just say, yeah, we'll give you a million when we go ahead and sell this entire enterprise. It's not that 15%. We're not paying them anything during the hold period. We'll just say it's just delayed gratification in the sense that they get their dollars when you go to exit.

45:54One million worth of equity in the post company. That leaves us with one million. We need to put cash on the table. Can I get third-party financing on that one million? Absolutely. All right. So what does that look like these days? What's LTV? 80, 20, 70, 30? The banks are going to have so many questions. How leverage are you now? How much cash do you have? What are cash flows like? What is the cash flows of this business? But you're going to certainly want the ratios to play in your favor. 70, 30 means we got about 300K we got to put in this deal. This is great. I can tell you're going to love working with me.

46:26I can tell John already. Let's talk about the LOI. Can you tell me what's this going to look like in an LOI when you spell out the terms that we just talked through? Where it's captured in the LOIs, the buyer presents sources and uses. So this is, yes, here's our headline price. Here's what we think the enterprise value of this business is on a cash-free, debt-free basis. So it's a$100 million bid on a cash-free, debt-free basis. To the extent that the seller had an existing$20 million senior credit facility, we expect that to be paid off. There's only 80 million of net proceeds available to ultimately the distribution.

47:02We are paying you for the cash on hand if there is any, but we certainly don't want to over-equitize for cash. So we're going to actively monitor how much cash you have on the books. In terms of sources and uses, a lot of times buyers will present their debt financing partners, their equity partners, either their partners or what they expect in terms of the dollars to equal to the$100 million of purchase price in my example, in the enterprise value example. Other times like public company buyers will say, yes, we're going to finance this 75 % cash, 25 % equity. We're publicly traded. We're going to issue you some restricted shares from our universal shelf for that 35 % and we'll pay you cash, all that.

47:42So if you get that from a public company buyer, you might not ever mention a credit facility. They might have an unsecured credit facility because they're such a credit worthy party. But you want to know, and the sellers want to know, what's my mix of consideration? Is it a cash deal? I'm getting stock in it. How do I feel about the buyer's public company stock? Do you have conviction that it will continue to appreciate during your hold period? And at what point can you liquidate it and monetize it if you don't have that same conviction? Those are some considerations when you see in the LOI, the sources and uses are being brought to the table.

48:13In our LOI, we're offering$10 million. And then we would spell out, hey, we're going to have$3 million of this in an earn out over three years. We got$5 million of seller financing. That's at 5 % over five years. Right. Then we're going to have$1 million that's going to get rolled over into the equity post-close. We got$1 million out of that. We're going to put our debt contingency in there or do we just not mention that? It's going to be simultaneous sign and close probably at a deal that small. So I probably wouldn't. We're bringing you a million dollars. It's going to be in your pocket of closing.

48:44That's right. All right. This is great. Let's get this thing drafted up and get it put together. Yeah. I think you've hit it all. of debt, equity, the earn-out bridge, and the financing bridge, and then the cash that you're bringing to close. And then it's just a handshake at that point. Exactly. Then somehow I'll get them to pay your fees. This will be perfect. This has been great. I'm trying to think, is there any other advice you give somebody? Any other things that you've come across from your experience that are, hey, just kind of look out for these things when you're doing deals and trying to bridge financing gaps?

49:14Yeah, I think it's important to think about the tax impact. The corporate deal is one piece of it for sure. But just to know what the art of the possible is. We work within deal teams here at Canel Gates and not every deal is the same for sure in terms of industry and size and speed and what the objectives are. When the facts change, it's important to test some of your assumptions again. And that includes like structuring. And if there's, you know, making sure your tax advisor is, making sure you're not doing anything untoward that creates a bad outcome, whether for the buyer or the seller, because a lot of times, again, it's a partnership with some of these acquisitions and you don't want to be living with those negative consequences if they could have been avoided.

49:55That's probably one thing I'd say. Are you a good lawyer? Yeah, are you a good advisor? Absolutely. Now, what's the craziest thing you've seen in M &A? One of the craziest is, I'll take you back to COVID in October, 2020. We had a earnings call for one of our public company clients. And on that day, they announced, they announced basically three items, which was incredible right before an earnings call. They announced a$2.1 billion acquisition of a U.S. company that does, it's for a healthcare company, and all this is public. It's for Exact Sciences Corporation. Their healthcare company focused on cancer diagnostics.

50:32They bought a blood biopsy corporation, a blood diagnostics corporation that is looking to detect cancer in blood samples. And it was a$1.7 billion deal at closing with an earn out that was in excess of$450 million. That was one item that was announced that day. It didn't close. It was announced. There was an acquisition in Europe for a genomics company that spun out of Oxford that also was announced that day. And then there was a$800 million equity raise and infusion into Exact Sciences where our capital markets team went and attracted additional capital for Exact Sciences. Not necessarily to pay for the acquisition, but it was a good time for them to raise money.

51:15So we had two very sophisticated large deal teams going on two continents. and we had a capital markets team raising money and we had a corporate governance team interfacing with board of directors on all of these things and they all were announced on that same day in advance of the earnings call. And it was during COVID and it was like a crazy time, but it was an awesome earnings call. The market loved it. But more importantly, we got some nice thank you notes from the CEO about the deal teams and the value that Canel Gates added across all of those fronts in terms of M &A, the capital markets and the corporate governance piece.

51:49And it was a proud day. Hey, that's a way to keep earning call days. Exciting. Drop everything then. Yeah, absolutely. One of the craziest things I've ever seen, this is just a funny anecdote. We were dealing with a snack food company and the seller wanted free snacks for life for a product she developed and she got it. And it's a product that you would see in the grocery store. I smile every time I walk by it, knowing that she has free snacks for life. That's funny. You think the whole thing, you work at the restaurant, you don't really eat there because you get sick of it. But no. They loved their creation.

52:22She loved her product. And frankly, our family loves the product. So I don't blame her. It's just a funny ask when you're in the moment. You're just like, really? You want free X for life? Okay. Do you have to spell the terms and how much of that? Is there a limit? Because you could be wholesaling the mound or selling them. I don't think she's redistributing, but I'm sure there was some delivery requirements on what the quota or what the amounts were. I'd have my kids peddling that in the neighborhood. So those are some crazy things. One, I think the Kay and Elgate story just showcases the breadth of the M &A expertise and to be able to deliver for a client on a number of fronts.

52:58And it all happened to coalesce in one day. And that was what was uncanny about it from my perspective, because there were moments where we weren't sure all of the pieces would fall together. So we had contingency plans B and C, should one of these acquisitions not get to the same point in time. There's some level of control, but deals also involve third parties too. and you don't necessarily control that and you still are running up against an earnings call and a finite deadline to the capital markets. So it was a proud day and showcased some of our core competencies for our clients. And it's a great company with a great mission and we're happy to partner with them on their desire to change the world and rid the world of cancer.

53:37Great stories. Now, this has been great. I really appreciate and value you spending some time with me, helping me become a better M &A scientist. Thanks, Kisan. It was a pleasure. Those of you still listening in, thank you. Till next time. Till next time. Here's to the deal.

54:16M &A function or optimizing one that you already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email, Kisan, K-I-S-O-N, at mascience.com, or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit mascience.com for a lot more content and resources. That's where you can You can also subscribe to our newsletter. Again, that's mascience.com. Here's to the deal.

55:01Views and opinions expressed on M &A Science reflect only those individuals and do not reflect the views of any company or entity mentioned or affiliated with any individual. This podcast is purely educational.