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Bridging the Valuation Gap in Small Business M&A: Beyond Earn-Outs and Owner Financing

Main Idea Over the past two years, enterprising dealmakers like you and I have faced a tough run of challenges. Interest rate volatility, non-transitory inflation, a decoupling of private company valuations from comparable public company valuations, and many other issues have created a predictable result: a valuation gap. Sellers often do not adjust to changing market conditions as quickly as we do.

Therefore, we need to be creative—really creative—to get deals across the finish line. If we do our job well, creative approaches can help align the interests of buyers and sellers, providing flexibility and managing risks effectively.

Key Data Points

• Valuation gaps are a persistent issue due to economic volatility and differing expectations of future performance.

• Earn-outs and owner financing are common but not the only options available.

• Creative solutions such as revenue sharing, sale leasebacks, and inventory consignment are increasingly utilized in the market.

Approaches and Scenarios

Detailed Analysis

Let’s say you own a high-end lemonade stand called Potomac Lemonade. It’s a family-run business known for its premium lemonades and has grown to become a staple in the DC area. With prime real estate locations and a loyal customer base, the business has significant value. Through your contacts at the Defense Department you discover that a huge lemonade RFP is about to be published and Potomac Lemonade is the only company that could fulfill an order of that size. So you’re excited.

During negotiations to buy the business, you arrive at a $10 million valuation gap.

Step 1: Inventory Consignment

• Current Inventory Value: $10 million

• Consignment Percentage: 50%

• Consigned Inventory Value: $5 million

To bridge this gap, you start to pick apart the assets line-by-line. You observe that the inventory of premium lemonade syrups and mixes, valued at $10 million, could be moved to consignment, freeing up $5 million in cash. Next, you consider the real estate. The properties, with an asking price of $15 million, are ideal candidates for a sale-leaseback. Given the prime locations, you negotiate a sale-leaseback at a 33% premium, bringing in $20 million. Allocating $5 million from this deal helps bridge the remaining valuation gap.

Step 2: Sale Leaseback

• Property Asking Price: $15 million

• Sale-Leaseback Valuation: $20 million (33% above asking price)

• Value Freed Up: $5 million

By leveraging these creative solutions, you successfully close the deal, securing the desired valuation for Potomac Lemonade and putting you in position to compete for the government contract.

Conclusion As an operator in small business M&A, using innovative strategies like inventory consignment and sale-leasebacks can bridge the valuation gap in M&A transactions. These methods align interests and manage risks, offering viable solutions to achieve mutually beneficial outcomes in a dynamic market environment. By leveraging these approaches, you can secure a fair value for your business while meeting the buyer’s financial constraints.