Many private investment transactions do not close due to issues about how future business risks are allocated between the parties. Investors often want to take as little risk as possible, which leads to them offering lower entry company valuation. Company owners, on the other hand, often reject low company valuation on the ground that they do not capture the company’s future growth potential.
Rather than let these often opposing perspectives derail investment transactions, creative deal structuring can allow future business risk to be shared between the parties in a way that allows deals to get done and company valuation based on forward-looking risk analyses to be replaced with actual business performance.
How Does Risk Affect Investment Terms?
Investment risk has a major impact on investment terms. In many types of investments in companies, investment terms are based on company valuations. Company valuations, in turn, are often determined based on a company’s future cash flows, which are discounted back to the present through a consideration of the perceived risks related to those cash flows. The higher the risk is perceived to be, the lower the company valuation.
This is a major problem in investment negotiations, because apart from the natural economic inclination of parties to approach valuation in a way that favors their own interests, valuation is significantly complicated by the fact that no one can predict the future. This unavoidable inability leads to investors as well as company owners trying to convert the unknown future into an often rigid valuation formula, a process which in pure financial terms almost invariably works to the detriment of one of the parties.
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While one might take the view that investment terms upside or downside that results from inefficiencies in valuation is an unavoidable part of the investment process, the reality is that, rather than causing one party to leave money on the table, these uncertainties often lead to investment transactions not closing. This is a problem that has significant negative implications, not only for companies and investors, but also the capital distribution infrastructure that lies at the base of every economy.
Risk-Sharing Formulas
An alternative to the zero-sum approach to risk allocation in discussing deal conditions is to design investment terms around formulas that allow risk to be shared rather than unilaterally assumed by one of the parties.
One common risk sharing formula is an earn-out. With an earn-out, a portion of the deal consideration price is deferred to the future and paid upon the company reaching certain agreed milestones, such as with respect to sales, EBITDA or net income. With this type of approach, the seller can effectively receive a much higher entry valuation based on strong company growth if the company can actually achieve that growth. If it can’t, the investor will not overpay for forecasted business performance that never occurred.
In addition to the earn-out, another approach that can be used is bonus or incentive payments that reward management in the event that agreed financial or operational thresholds are met. These types of formulas can allow the economic benefits of higher valuations to be replicated without putting in place complicated post-closing terms and conditions that can create legal and practical issues down the road.
Issues to Keep in Mind
Risk-sharing formulas such as earn-outs can be powerful tools to help bridge valuation disagreements in private investment transactions but there are issues to keep in mind to make sure that these formulas solve valuation challenges rather than create new ones.
Simplicity. The first issue is to make sure that the risk-sharing formulas that are used are simple, clear and easy to apply. The more complex that risk-sharing formulas are, the greater the risk that they will lead to disputes in the future.
Control. The second issue is level of control of the parties over risk-sharing formula drivers. If formulas are based on results that can be manipulated through operational or accounting techniques, the benefits of risk-sharing formulas can easily be lost.
Timing. A third issue to keep in mind is the timing of the implementation of risk-sharing formulas. Future risk is of course not fixed, and as the business moves forward in time the risks its faces will change, rise and fall. Accordingly, the further out in time a risk-sharing formula is structured, the greater the likelihood its utility as a mechanism to apportion risk and the economic benefits related to future business performance will fall.
While they need to be applied with care, risk sharing formulas can be helpful ways to bridge valuation disagreements in private investment transactions and increase the likelihood, not only that deals get done, but that get done on terms that are fair for all parties.
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This article was written by Darin Bifani. The photo for this article was taken by Leio McLaren on Unsplash.
