PCB acquisitions in the U.S. are down so far in the first five months of 2017, with only two announced deals (HT Global Circuits’ acquisition of Pho-Tronics in April; American Standard Circuits’ acquisition of Camtech in May); and one anonymous deal that I am aware of that has not been announced. This compares with 11 announced deals in 2016. There are a variety of reasons for the decline, but one reason could certainly be the valuation gap between buyer and seller. In my experience, sellers often estimate a value that is higher than market, either due to higher expectations, or a need to obtain a certain amount for retirement, to pay off debt, or for return-on-investment.
There is an old saying: “You name the price, and I’ll name the terms.” This phrase was probably uttered by traders in ancient Babylon, and it can still be useful today. Some of the main ways of plugging the gap between buyer and seller are earnouts, seller notes, royalties, at- or above-market leases, consulting fees, stay bonuses, carry-over equity, and other methods.
One of the important things to consider are the reasons for the valuation gap. It could be that the business is growing quickly, and the buyer will pay more if the business continues to grow. On the other hand, the gap may be due to the risks involved with the business, such as customer concentration, key-person risk, legal and environmental issues, etc. Another reason for a gap is financing, that is, a buyer may not be able to borrow enough to finance the transaction. In this case, the buyer may ask the seller to hold a promissory note for several years. Often, the main reason for a valuation gap is a difference in value perception between buyer and seller. Depending on the cause for the gap, a variety of solutions may be used to help seal the deal.
Earnouts are often used to bridge the gap. Sellers prefer short earnouts based on sales, with low hurdles. Buyers prefer longer earnouts, based on profits or EBITDA, with rising hurdles. Earnouts based on sales are easier to monitor and less subject to argument, although the parties may even dispute the definition of ‘revenues.’ In a consolidation, in which the seller’s business is going to be moved into the buyer’s facility, the only way to base an earnout may be on future sales to the seller’s customers. The seller must be prepared to trust the buyer’s reporting system, which is made easier if the seller is still involved in the business during the earnout period. A straight royalty on sales is sometimes used, which can be a simple way to track and pay deferred payments.
Buyers typically prefer for earnouts to be based on profit goals, such as net profit, EBITDA, gross profit, etc. The lower the goal is on the Profit and Loss statement, the more difficult it is to monitor, and the more open things are to manipulation and dispute. However, a profit-based earnout is generally acceptable if the seller is going to be involved in the business during the earnout period, and if the buyer agrees to allow the seller to review the books (and to not materially change business practices). If the buyer has a history of good relations with previous sellers, this could help the seller feel more comfortable.
Seller notes are a popular way to bridge a valuation and/or financing gap. Typically, interest rates are higher than bank CDs, so sellers may see it as a way to have some income post-sale, and to defer taxes. If a buyer is also using bank or other debt to finance the deal, the term of the seller note usually must be at least 3−5 years, and often amortization cannot begin for several years. The seller must review the credit worthiness of the buyer, and it increases the complexity of the deal.
There are several income-related ways to bridge the valuation gap, which can be in the form of on-going employment, consulting fees, transition services, stay bonuses, leases that are at-market or above market, continued health insurance or other payments, etc. One problem with these solutions is that the payments are often taxed at personal income rates, which are usually higher than capital gains rates.
Carry-over equity is when the seller continues to hold a share of the business after the sale. This method can be used to ensure that the owner fully assists with the transition. Perhaps the owner believes that the business can grow under new ownership, but the owner does not wish to be involved full-time. Both buyer and seller need to agree on an operating agreement and buy/sell provisions. If the buyer is a public company or ESOP, they may use stock options or stock appreciation rights (SARs) as part of the deal. A privately-owned buyer may use their stock as payment, and this might be acceptable if the seller believes that the combined companies have a good chance to grow.
Many buyers will be open to alternative tax structures to help the seller reduce taxes. Sellers should consult with a tax advisor early in the process to identify various tax strategies. While Cash is King in any transaction, a seller should really be concerned with net proceeds after taxes. The right strategy may allow a seller to accept a lower offer that is all or mostly cash, rather than a higher offer that has more deferred compensation.
Depending on the concerns of the buyer and the needs of the seller, there are a wide variety of ways to bridge the valuation gap. As long as both parties are willing to cooperate, we can usually find a solution.