Valuation gaps are frequently encountered in RIA transactions. Buyers and sellers naturally have different perspectives that lead to different opinions on value: Where a seller sees a strong management team, a buyer sees key person risk. "Long-term client relationships" in the eyes of a seller translates to “aging client base” in the eyes of a buyer. When a seller touts a strong growth trajectory, the buyer wonders if that will continue.
These different perspectives on the same firm, unsurprisingly, lead to different opinions on value, and the gap can be substantial. Bridging that gap is key to getting a deal done. Below, we address four ways that buyers and sellers can bridge a valuation gap.
1. Earnout
Earnouts are a common way to bridge a valuation gap. Through an earnout structure, the buyer pays one price at closing and makes additional payments over time contingent on the achievement of certain performance thresholds. If, for example, a seller thinks that a firm is worth $100 and the buyer thinks the firm is worth $70, the deal might be structured such that $70 is paid at closing and an additional $30 is paid over time if certain growth targets are met.
Through an earnout structure, if the seller’s optimistic vision for the future of the firm materializes, the price ultimately paid reflects that. Likewise, if the downside scenario envisioned by the buyer materializes, the hurdles for the earnout payment will likely not be met, and the price will reflect that reality. Rather than hoping they get what they pay for, the buyer pays for what they get. Similarly, sellers are compensated for what the firm actually delivers.
2. Staged Transaction
If an RIA is being sold internally to next-generation management, then selling the firm in multiple stages is one way to help bridge valuation gaps. This is partly because it’s easier to come to an agreement on valuation when the stakes are smaller. But there’s also many potentially value-enhancing benefits to internal sales which take time to realize. Through internal transactions, founders get to hand pick their own successors and incentivize them to grow the firm through equity ownership. The buyers (next generation management) have a pathway to advance their career and increase the economic benefit they receive from their efforts.
However, if an internal transaction is done all at once, the owner does not have time to benefit from the growth incentives management hoped the transaction would provide. By structuring the transaction over time, subsequent transactions will take place at higher valuations that reflect the growth that results from the alignment of next gen management’s incentives with existing ownership. As a result, sellers in internal transactions may be willing to come down on price for early transactions to incentivize employees to grow the business, while buyers may be willing to come up in price for the opportunity to become an equity partner in the business and participate in the upside.
Selling an interest over time also lessens the capital requirement for the buyer, which is often a barrier in internal transactions where the buyer may not have the financial resources to purchase a large block of the company at one time.
3. Deal Financing
Beyond the price, how the purchase price is paid can make a significant difference in the perceived economics of the deal. While external buyers will generally pay cash or stock at closing (with possible future earnout payments as discussed above), internal transactions are often seller-financed.
We’ve seen a number of internal transactions where an otherwise attractive valuation was offset by payment terms that were extremely favorable to the buyer such as seller notes with low interest rates and long repayment terms. Similar to earnouts, such favorable payment terms allow the seller to feel like they are getting full value for the business while making the higher purchase price more palatable for the buyer.
4. Mitigate Risk Factors Before You Sell
Sellers can mitigate potential valuation gaps in advance of a transaction by addressing aspects of the firm that could be concerning to potential buyers. Consider an outsider’s perspective on your firm, and take action to address the perceived risk factors that lower value. For example, if transitioning the firm internally, distinguishing owner compensation and regular distributions of excess capital prior to a sale will decrease the buyer’s concern about liquidity and marketability of the investment and increase the perceived value of equity ownership.
Similarly, focusing on staff development in client-facing roles, increasing the number of client contacts with the firm, and creating an internal pipeline of talent to manage the business will all serve to reduce key person risk from the perspective of a buyer, thereby increasing the value that the buyer ascribes to the firm.
About Mercer Capital
We are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.
