How PE/VC firms and potential targets should go about bridging the valuation gap
Ashesh Shah and Sahil Dhawan

Differences in valuation between company management and investors is the main reason why venture capital and private equity transactions fall through. 

Owners and founders expect a high valuation for the growth potential they are creating. Investors, however, demand a “margin of safety” for the risks they are taking by investing in the company. The ability to bridge this valuation gap is crucial for completing a successful transaction.

Valuation is a blend of art and science, and therefore subject to differences in perception between buyers and sellers. It is important to understand that the “best value” for a transaction consists of two components: quantity (amount) and quality (terms associated) of the investment. 

The best value for the company is an optimal blend of both quantity and quality. Those who do not understand this fall into the trap of “highest value” rather than the “best value” for their companies. Bridging the valuation gap is much easier when the companies and the investors understand this concept of best value.

Below are some of the key reasons for gaps between companies and investors, along with mechanisms for bridging them by utilising innovative terms and structures to reach a mutually acceptable best value.

Expectations of future performance

Business projections are the basis of valuation. These are estimates of the future performance, based on the assumptions of the management. Actual performance can be substantially different from the projections, and hence a cause of concern for the investors. 

Instruments that factor future performance into valuation, such as convertible instruments or warrants, can provide the seller higher valuation for strong performance and at the same time protect the investor from overpaying in case of poor performance. 

Similarly, tranche or milestone-based payment plans can additionally allow the investor to manage risk, while giving the business access to capital when required.

Market volatility and exit risks

Uncertain market conditions at the time of exit make investors cautious about paying high value at the time of entry. 

Transaction structures that lower the exit risk for investors can improve the chances of closing a transaction. Provisions such as liquidation preference and waterfall distributions prioritising payouts to investors can improve valuations of the business. These mechanisms give comfort to the investors for entry valuations and allow the seller to partake in the gains in the event of an attractive exit.

Contingent or non-quantifiable liabilities

Investors have to factor in the liabilities that are difficult to ascertain at the time of the transaction, such as pending litigations, quantum of bad-debts etc. 

Placing a portion of the funds in escrow to meet such contingent liabilities can help in bridging the valuation gap. 

As an alternative, sellers can offer indemnities to the investors, ensuring them an adjustment to valuation in the event any additional past liabilities arise.

Existence of non-core assets

In certain instances, companies may have non-core assets or may possess some intellectual property that are distinct from the business being considered by the investor. Carving out such assets or transferring them for the benefit of the company/owners may enhance valuation for both the investor and the company. 

For example, assets like prime real-estate that may have significant asset value but may not be critical for the growth or success of the business can be carved out to help with closure of the deal. 

In such cases, earnings should be normalised to factor in corresponding costs (such as additional rent) that may be incurred by the business.

Most PE/VC investors would be willing to sacrifice some of their returns in lieu of lower risk, while most entrepreneurs would prefer to have higher upside at the cost of higher risk. 

Where parties to a transaction are reasonable and have the ability to see the bigger picture, a negotiated settlement to bridge the valuation gap is always possible – especially with the help of a trusted advisor with a creative head on his/her shoulder.

Thus, by combining the monetary valuation with the terms of the investment, companies and investors can close the valuation gap and ensure a successful transaction.

Ashesh Shah is managing director and Sahil Dhowan is associate director at Trans-Continental Capital Advisors. The views expressed are personal.

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