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Maneuvering Around a Valuation Impasse

Buyers and sellers who disagree about a business valuation

Sellers who are seeking buyers for their businesses may curse the recession and slow recovery, not only for the damage it did to profits, but also the havoc it wreaked on their business valuations.

That depressed value that they see as only temporary may cause them to hold out on selling - a frustrating situation, as CFO magazine reports there is currently an abundance of equity money, with investors just waiting for operating companies they can buy.

Negotiations can come to a dispute when the seller refuses to accept a price lower than what he or she believes the company is worth, but a method for working around this is with an earnout. This pricing method measures part of the purchase price by tracking the selling company's performance after the sale is closed, and "rewards the seller only if the future performance actually matches the projections," the magazine reports.

With this technique, the buyer will not risk overpaying in the event that the seller's value projections were too high, and the seller does not have to lose his or her chance of sharing in future growth.

However, earnouts don’t always work in the seller’s favor, as Mark MacLeod, a partner at Real Ventures, writes for StartupCFO. In these scenarios, the buyer and seller are beginning their relationship at odds, disagreeing on the value of the asset rather than focusing on creating a strategic and long-term acquisition for the buyer, he says.

MacLeod adds that earnouts should be treated with the same skepticism as a lottery ticket, and that sellers should not expect the money if they do find themselves tied to one. He points to his firm’s sale of Terrascale to Rackable Systems as an example of how a seller can avoid the situation. Rather than agreeing to an earnout, the seller offered some intellectual property that wasn’t tied to its core product line, and six months later the buyer paid for the extra material. However, he notes that the additional IP was purchased not because the buyer had a particular plan for it, but rather in an effort to achieve alignment between the buying and selling companies.

"Avoid earnouts if at all possible," MacLeod advises. "This does not just mean accepting the buyer’s low price, but talking through the risk to alignment and realization of deal synergies for the buyer if there is an earnout. Help them realize that they don’t want an earnout and neither do you."