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Valuation gap: breaking the impasse.

Many owners believe their companies are worth more than what buyers are prepared to pay. This generally is due to differing perceptions regarding the selling company's ability to realize its projected financial performance. Sellers do not want to leave money on the table related to anticipated future value, and buyers want to avoid overpaying for as yet unrealized value. Instead of an otherwise valuable transaction for both parties collapsing due to such valuation gap, creative transaction structuring can be employed to create a win-ran situation for both buyer and seller.

Custom-Made Resolutions

Structuring a transaction to bridge a valuation gap can include utilizing earn-out payments, contingency payments or the purchase of a minority interest with an option to acquire the remaining interest at a later date and other creative approaches. While an "earn-out" is a "contingent payment," an earn-out typically is tied to the achievement of financial forecasts, whereas a contingent payment is an obligation for payment (or perhaps a warrant position that becomes exercisable) upon the achievement of non-financial milestones, such as FDA approvals, the securing of significant customer orders, etc. The specific transaction structure used to bridge a valuation gap would be driven by the various business characteristics involved as well as unique seller and buyer objectives.

Sell an Option

Transaction structuring creativity is common in the orthopedics market, given its high growth characteristics and the significant investment required to develop, commercialize and market FDA-approved devices. Rather than sell significant ownership to venture capitalists to fund growth, a variety of transaction structures often are employed with larger strategic partners to accelerate value and reduce risk for both parties involved in a transaction. For instance, the acquisition of a minority stake (through an infusion of capital and/or the purchase of existing shares) with an option to buy can protect an acquirer from overpaying upfront for value that may not materialize and still enables a seller to both meet capital needs initially and valuation objectives ultimately if forecasts translate into reality. As an example, earlier this year Exactech exercised its option to acquire Altiva, which it had received as part of a strategic minority investment in Altiva in 2003.

Tied to Financial Performance

A traditional earn-out can be a good solution when a seller is confident about achieving hockey-stick forecasts. With an earn-out provision, the ultimate purchase price is, in part, based on how well the acquired company performs after closing and typically is tied to sales, gross profit or some measure of operating profit (or a mix thereof) generated over a defined period. The formulas that govern the earn-out amounts and their timing are virtually limitless.

The primary advantage of linking an earn-out to sales is that the operations of the two businesses can be consolidated while their respective revenue still can be tracked separately. Even if product bundling is a key part of the strategic rationale, provisions in the contract can be crafted to fairly monitor and measure the sales metric for the earn-out computation. While selling shareholders remaining with the business may be tempted to sacrifice margins to enhance sales, contractual provisions can specify margin parameters during the earn-out period. Likewise, the seller will want the buyer contractually committed to providing the requisite financial, sales, marketing and operational resources to support the growth of the acquired company's sales base.

Such earn-outs are not the exclusive providence of family-owned or entrepreneurial founded companies but also are used by venture capital and private equity financed companies. Rather than proceed with its then-pending initial public offering (IPO), St. Francis Medical Technologies (SFMT) withdrew its IPO registration and, instead, in December 2006 agreed to be acquired by Kyphon, and up to $200 million of transaction consideration--beyond the $525 million paid at closing--was in the form of an earn-out tied to sales to be generated during the second half of 2007 and first half of 2008. In July 2007, less than one month into SFMT's initial earn-out period, Medtronic announced a definitive agreement to acquire Kyphon. Prudently, SFMT's purchase agreement included an acceleration provision of its earn-out payments in the event of a change of control. Had SFMT insisted on trying to capture all of its perceived value upfront or had Kyphon not been willing to creatively structure an earn-out such that the potential of the expected synergies would be partly shared, the win-win transaction for both parties may never have occurred.

Tying an earn-out to profits can be an optimal approach, particularly when the target represents a new platform where the buyer intends to keep the operational structure of the acquired business distinct from the buyer's operations; conversely when the buyer intends to merge the operations of the two companies, tracking acquired profits can be exceedingly difficult and it is furthermore unlikely that the acquirer will be willing to pay for cost synergies realized under its ownership. When appropriate, however, profit-based earn-outs can align the incentives of selling shareholders remaining with the business with the objectives of the buyer. A careful balance must be struck between the seller's desire for continued input into how the acquired business is to be managed to achieve performance targets and the buyer's ability to guide the acquired business in the direction of its choosing. In all cases, earn-out criteria should be precisely defined in the purchase agreement, and they should be measurable and understood by both parties. Differences in accounting methodologies need to be determined upfront, and a process for reviewing and assessing performance must be clearly identified in the purchase agreement. As with those linked to sales, earn-outs tied to profits frequently include a sliding-scale rather than all-or-nothing payments. In January 2008, Greatbatch acquired Precimed for approximately $125 million in cash paid upfront plus an additional cash payment up to $10 million contingent on 2008 earnings. This earn-out includes minimum and maximum targeted operating profit figures, where results below the minimum produces no earn-out payment, results at or above yield the full earn-out amount and results in between are paid out on a pro-rata basis relative to performance goals. As is frequently the case, achieving its performance goals not only will result in maximum earn-out payment to Precimed but also might result in a reduced transaction multiple (eg, enterprise value to EBITDA) ultimately paid by Greatbatch.

Tied to Milestones

Finally, linking part of the transaction consideration to something other than the acquired company's future financial performance also may be appropriate. Payments upon achieving defined milestones sometimes can be more objective and less complex to manage and monitor. In December 2007, Synthes acquired N-Spine for a $30 million upfront cash payment plus future payments of up to $45 million for reaching certain milestones, in addition to other undisclosed payments for reaching certain sales targets.

Many would-be sellers feel that they are better off waiting until the investments they make in new products or near-term opportunities come to fruition. Likewise, many would-be acquirers deemphasize important acquisition opportunities when sellers expect full credit upfront for significant potential that has yet to materialize. Transactions employing earn-outs, contingency payments and other creative structures can advance the strategic and financial interests of both parties--though, given the complexity, implementation risks and tensions created by differing perceptions of value, such transactions require careful negotiation and comprehensive documentation to help achieve intended objectives.

Author's Note: Nothing contained in this article is to be considered the rendering of financial, investment or professional advice for specific circumstances Readers are responsible for obtaining such advice from professional advisors and are encouraged to do so.

David Reilly

Viant Capital LLC

David Reilly is a managing director of Viant Capital LLC, an investment banking firm that specializes in mergers and acquisitions; private placements; and financial advisory services. He runs the firm's healthcare practice, which has a focus on the orthopedic market. David can be reached at (203) 682-1880 or DReilly@ViantGroup.com.
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Title Annotation:FINANCIAL PERSPECTIVE
Author:Reilly, David
Publication:Orthopedic Design & Technology
Geographic Code:1USA
Date:May 1, 2008
Words:1305
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