What is a Valuation Gap?
A valuation gap arises when an individual wants to sell his company for more money than the buyer is willing to pay. Any individual who has had his firm appraised probably has an estimate of how much it is worth. It can, therefore, be frustrating when the person tries to sell his business only to realize that potential buyers are offering a much lower figure. The difference in Valuation between the seller and the buyer is the Valuation Gap.
Some valuation gaps are brought about by timing issues between the seller’s and buyer’s market. If the market is in favor of the buyer, then he will want to pay a pretty low amount than what the company owner wants. And, if it’s a seller’s market, the company owner will be asking for a much higher figure than what most buyers are offering.
Why Valuation Gaps Exist
According to a report published by the Business Enterprise Institute, one of the main causes of this problem arises from the fact that firm owners are in denial of the existence of a valuation gap. As such, the company owner he won’t make any effort or invest any resources in bridging the gap. Professor Howard Stevenson from Harvard Business School believes that the misperception arises because of a lack of knowledge and inherent optimism on the part of the seller.
Unfounded optimism and a lack of diligence are sure recipes for disaster, especially when an owner is asked to estimate:
- The present worth of his business and expected growth rate
- The anticipated performance of the company’s non-current assets
- The amount of money the owner is likely to spend following an exit from the company
Another aspect that causes valuation gaps is the owner’s tendency to focus on how much he put into the business when creating it. In doing so, such an individual is assuming that the benefits he has reaped from the venture so far are the same benefits the new company owner will get. Unfortunately, it is not the case. The new company executive may adopt new policies and practices, which will lead to entirely different results.
Bridging the Valuation Gap
Whenever an individual thinks of selling his business, he aims at getting the perfect alignment or zero gap between the different factors affecting the sale. For a majority of owners, it is often challenging, and it causes delays in the business sale for months. Fortunately, there are several ways that one can use to bridge the valuation gap. They include:
#1 Staged closings
One way to resolve the valuation dispute is to provide for several closings of the investment. In such a case, the company buyer must be willing to pay a portion of the price upfront. He can then pay the remaining amount once the company achieves certain milestones or before a specified date depending on how the firm performs.
For instance, the purchase contract can provide for an initial closing of 40%, meaning that the investor pays an initial cost of 40% of the price. The remaining 60% can be paid in stages based on the firm’s achievement of milestones. The milestones will be agreed upon by both parties, and they will consist of thresholds, which the investor deems necessary before he can invest the remaining portion.
Another technique for solving valuation gaps is issuing warrants. With such approach, the buyer concedes to the pre-money valuation being asked for by the owner but on one condition, that is, that the buyer has a warrant to buy more shares of the firm as a hedge. The warrant can be exercised anytime the business fails to achieve the pre-determined milestones.
If a company owner chooses to go this route, one factor he should determine beforehand is the exercise price. It is the price at which the investor would buy the said shares. The exercise price could be nominal, priced at the initial closing purchase value, or priced at the existing market value when the shares are being purchased.
#3 Sell less than 100% of the business
Another likely solution for valuation gaps is selling only a portion of the business. By selling part of the company, it means the owner still possesses certain assets of the firm, which he can liquidate and get cash. It also means that the owner has a right to participate in future activities relating to the firm.
#4 Escrow arrangement
In some cases, the buyer and seller may agree on the value of the business. However, they may not agree on the financial impacts that may arise from one or more of the identified risks. For example, if the company has a pending court case, it may difficult to estimate the financial liability that the lawsuit will cause on its performance.
In such situations, the buyer may agree to deposit a portion of the price in an escrow account. Once the pending issue or risk is solved without any financial damage, he then pays the remaining amount.
With the increasing macroeconomic uncertainty, it is not surprising that valuation gaps are still a challenge. In fact, it is very rare for company buyers and sellers to agree on the value of the business in question. Some of the techniques that can be used to close the gaps include staged closings, issuance of warrants, escrow arrangements, and selling only a portion of the company.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: