Introduction

Mergers and acquisitions (M&A) are complex transactions that often involve significant valuation challenges.  Bridging the gap in valuation between the acquiring and target companies is crucial for successful deals.  Various methods can be employed to address these discrepancies, including roll-over, earn-outs, revenue sharing, contingent value rights, purchase price adjustments, vendor financing and a combination of cash and shares consideration.  Each method serves to align the interests of both parties while managing risk.  Set out below is a brief introduction of roll-over, earn-outs, revenue sharing, and contingent value rights involved:

Roll-Over

Roll-over occur when the selling shareholders reinvest a portion of their proceeds into the acquiring company, effectively maintaining a stake in the combined entity. This method is particularly useful in transactions where the seller believes in the future potential of the acquirer. By rolling over equity, sellers can benefit from future growth while also demonstrating confidence in the transaction’s viability. This approach helps mitigate valuation gaps by allowing sellers to share in the upside potential of the merged entity, thus aligning their interests with those of the acquirer.  However, a roll-over can be relatively complex as it usually requires negotiation of a shareholders’ agreement and would include call and put options to facilitate an exit, implications of pre-emptive rights, impact of any drag and tag. 

Earn-Outs

Earn-outs are contingent payments made to sellers based on the future performance of the acquired business. This structure allows buyers to pay a lower upfront price, with additional payments tied to specific performance metrics, such as revenue targets or profit margins, over a defined period. Earn-outs can effectively bridge valuation gaps by enabling sellers to receive a higher total compensation if they meet or exceed performance expectations post-acquisition. However, this method can lead to disputes regarding performance measurement and management practices, necessitating clear definitions and agreement on metrics beforehand.  Earn-out payment could be drafted to trigger upon: revenue, EBITDA or profit; approval to enter into a new market/sector; number of customers or subscribers; other milestones.  A earn-out provision would usually contain clear, objective and measurable targets.  However, one should consider the management and governance of the target company during the earn-out period, whilst ensuring that the buyer would have an autonomy on the running of the acquired business.

Revenue Sharing

Revenue sharing agreements allow both parties to benefit from future revenues generated by the acquired business.  In this model, a percentage of revenue is allocated to the sellers for a specified period after the acquisition. This approach aligns incentives as both parties work towards maximizing revenue generation. Revenue sharing can be particularly appealing in industries where future earnings are uncertain but expected to grow significantly post-merger. Like earn-outs, revenue sharing requires careful structuring to ensure clarity on revenue definitions and distribution mechanisms.

Contingent Value Rights (CVRs)

CVRs are structured as rights that provide additional compensation to shareholders of the acquired company upon the occurrence of specific events or milestones post-acquisition. These events are often regulatory approvals or product sales milestones. Unlike earn-outs, CVRs can be settled in cash, stock, or a combination and typically have a shorter duration tied to specific events, making them more straightforward in terms of payout triggers.

Considerations in Choosing Methods

When selecting among these methods, several factors should be considered:

• Risk Appetite: The seller’s willingness to accept risk plays a crucial role. If they are confident in their business’s future performance, they may prefer earn-outs or roll-over.
• Valuation Discrepancies: The extent of valuation differences will influence which method is most appropriate. Larger discrepancies may necessitate more complex structures like earn-outs.
• Industry Norms: Certain industries may favor specific methods based on typical practices and investor expectations.
• Negotiation Dynamics: The relationship between the buyer and seller can impact which settlement method is chosen. A collaborative relationship may facilitate more flexible arrangements like revenue sharing.
• Tax Implications:  Both the sellers and the buyers would have to identify the structure that would optimise both tax and accounting considerations.

Conclusion

Bridging valuation gaps in M&A transactions is essential for achieving successful outcomes. Methods such as roll-over, earn-outs, revenue sharing, and contingent value rights provide mechanisms for aligning interests and managing risks associated with differing valuations. Choosing between these methods depends on various factors including industry context, the nature of the target business, and the preferences of both buyers and sellers regarding risk tolerance and potential rewards.  In industries like technology companies and life sciences where future outcomes are uncertain yet critical for valuation, roll-over, earn-outs, revenue sharing, and contingent value rights offer ways to align interests and manage risk effectively.  At the end, proper planning and negotiation are keys to ensuring that all parties feel valued and secure in their investment decisions.

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Contact us for more information on how we can help in your M&A deal, and advice on the pitfalls in implementing these solutions to your deal.

Alfred Leung, Partner

(E: alfredleung@hkytl.com T: +852 3468 7202)

This article is introductory in nature. Its content is current at the date of publication.  It does not constitute legal advice and should not be relied upon as such. You should always obtain legal advice based on your specific circumstances before taking any action relating to matters covered by this article. Some information may have been obtained from external sources, and we cannot guarantee the accuracy or currency of any such information