Getting Merger & Acquisition Deals Done In Challenging Markets

By Bill Quish, Mergers & Acquisitions Advisor and Certified Exit Planning Advisor (CEPA)

Oh how business owners approaching retirement wish it were twenty-four months ago in the mergers & acquisition market. Valuations then were higher supported by strong earnings, higher stock prices and solid M&A buyer demand. Merger & acquisition buyers were willing to pay better valuation multiples. The future looked optimistic and seemed to provide good revenue visibility and merger and acquisition deal structures were supported by aggressive lending and bullish equity markets.

Times have definitely changed. While we have seen an increase in M&A buyer interest, many sellers refuse to recognize that valuations have declined and have unrealistic valuation expectations given the current mergers and acquisitions environment. Many sellers want the M&A buyer to value their company based on future potential, which is difficult to determine in the current economy. Being entrepreneurs, business owners are naturally optimistic about their future earnings. Prudent merger & acquisition buyers tend to value a business based on the consistency of past earnings and their confidence in the future earnings or cash flow stream of the target.

When expectation impasses occur, there are three mechanisms that can potentially bridge M&A valuation gaps- earn-outs, seller notes, and seller retained equity. These can be used individually or in combination. For purposes of an example, let’s assume the following: Company X’s trailing twelve months earnings before interest, taxes, depreciation and amortization (“EBITDA”) is $4 million. The seller values the company at $20 million (a valuation multiple 5x EBITDA). The M&A buyer believes the valuation is $18 million (a valuation multiple of 4.5X EBITDA). The lower valuation is due to the buyer’s concern that future EBITDA might be less than $4 million. Therefore, the valuation gap between the seller and buyer is $2 million.


An earn-out is a risk bridging mechanism used in mergers & acquisitions whereby a portion of the purchase price that is paid after closing if the acquired company meets some pre-determined performance targets. Common types of earn-out based performance targets are revenue, gross margin, operating profits, EBITDA. Earn-out periods typically range from one to three years and structuring an earn-out that really works for both parties is tricky. Sellers prefer revenue and gross margin earn-outs because if properly structured, the acquiring company can do little to negatively impact the realization of the earn-out. Some earn-outs have a minimum earn-out (floor) to protect the seller and a maximum earn-out (cap)to protect the buyer. Following the merger and acquisition, payment of earn-outs earned can be in cash, notes or stock. Clear, specific earn-out language should be included in the Letter of Intent to avoid future conflict. Please note that earn-outs have a higher probably of being achieved if the company being acquired remains a stand-alone entity and the seller continues in an active senior management role over the earn-out period.

In the example above, the earn-out might be structured so that the Seller receives an earn-out payments of $1 million per year for two years should the adjusted EBITDA exceed$4 million for the year.

Seller Financing

In today’s mergers & acquisitions market, buyers of companies are unable to leverage (i.e., borrow from banks, junior capital sources) the purchase price as aggressively as they could a couple of years ago. This can create a gap between the cash desired by the seller and the amount of equity and leverage some M&A buyers can assemble to complete the transaction. As a result, in many merger & acquisition transactions, sellers are being asked to provide more financing than during the past, often by the buyer offering a promissory note payable over a period of three to five M&A Transactionsyears. Payment terms vary significantly. It might be monthly, quarterly, semi-annually or annually. Some notes are structured as interest only for the first year post close and thereafter principal payments kick-in. Other notes include a balloon payment. Interest rates are often similar to senior lenders. Payment on the note is typically subordinate to senior and junior lenders. Therefore, the final structure of the M&A buyer note will be subject to the approval of the senior and junior lenders.

The notes are most often unsecured because senior and junior lenders will likely have priority liens on the assets and stock of the company ahead the buyer note. Sellers should try and get a corporate guarantee from the industry or strategic buyer. Financial buyers such as private equity firms typically will not guaranty their notes. That being said, notes are less risky than earn-outs. Should a downturn occur and cash flow materially decrease, Seller’s would be in a position to receive payments on the note ahead of the earn-out payment.

Seller Equity Rollover

Another option for bridging the financing gap that is growing in popularity in mergers and acquisitions is the seller equity rollover. In this scenario, the seller rolls over (retains) equity in his/hers company’s stock or that of a holding company that is formed to acquire the assets or stock of the company. Retaining ownership sends a message to the M&A buyer and the other financing sources that the seller is confident about the future of the company! It is attractive to the buyer because it mutually aligns the interests of all the parties to make the acquired company successful. Over the years we have seen seller equity stakes in the acquired company range from 10% to 40%. Rolling over a significant equity percentage should entitle the original owners to some governance rights (e.g., one or more board seats, etc.) and a say in how the company will operate. Rollover equity usually comes with transfer restrictions. We recommend the seller consult with a tax advisor to make sure the rollover qualifies for tax-free treatment. The upside of a seller equity rollover is that the future value of  the rollover may become significantly greater than the cash received in the original Merger & Acquisition transaction for the majority of the company.

In closing, while there are risks to earn-outs, buyer notes and seller rollover equity, if you feel confident in the future direction of your company and have faith in the buyer, these proven tools can position you to sell your company today and potentially provide you with some upside beyond an all cash merger and acquisition deal.

Bill Quish is a Mergers and Acquisitions Advisor and Certified Exit Planning Advisor (CEPA). He is a Senior Managing Director at Lyons Solutions, LLC. He can be reached at 860-391-8672, or

Copyright 2010 Bill Quish Lyons. All Rights Reserved.