Tech M&A in 2024: Insights for Bridging Valuation Gaps

In this article, partners Chris Grey, Jonathan Cohen and Stuart Dullard from Ashurst's global Tech M&A group provide practical guidance on bridging valuation gaps when putting together deals in the technology sector.  This article is the first of Ashurst's new Tech M&A series highlighting key issues, opportunities and risks for investors, companies and founders from a global perspective, starting with the UK.

Deal-making in the technology sector

Technology M&A activity in 2024 has started on an optimistic note, with a steady stream of investors and advisors suggesting that there is a substantial backlog of portfolio assets for sale and a new appetite from buyers and sellers to explore agreement on revised valuations for assets. Tech sector growth has been a steady long-term trend, even disregarding the valuations during the exceptionally low interest rates of 2020-2022. There have been reports that LPs are stepping up pressure on their fund managers to return cash, even as a pre-requisite to follow-on funding of new funds.  Public markets are continuing to show record valuations for large global tech groups.

What challenges do we anticipate for the year ahead? Technology companies can be particularly difficult to value given their value often relies upon projected growth and they operate in markets defined by innovation and disruption. Their businesses also rely upon intangible assets like software and other IP. One challenge this year will be helping buyers and sellers find common ground on prices in a fast-moving market. In other words: bridging a valuation gap. A lot of this gap can be bridged with a thorough diligence on a target's financial situation, its IP portfolio, its legal and regulatory risks.  But often what is required is lateral thinking and deal-making solutions. Fortunately, there are a number of structures available in the Tech M&A toolkit that can be deployed to help bridge valuation gaps where there are differing views or contingencies, by sharing risks and aligning interests between parties to reach a deal.

Practical solutions to achieve common ground

1. Roll-over / re-investment:  When a seller wants to take some money off the table without a 100% disposal, it may decide to structure a transaction to include a roll-over or re-investment of sale proceeds by the seller into the post-closing equity of the target, often through a new vehicle.  Re-investing is a means for the seller to "put its money where its mouth is" and creates strong economic alignment between the seller and buyer who both share in the upside of the post-closing business, while also giving the seller (whether a financial investor or a tech founder) the ability to cash-out part of its stake. For some Private Equity funds, this may be a requirement in order to implement the transaction. This mechanic achieves similar alignment between parties as in a revenue sharing or earn-out structure (see below), however the buyer will retain significant control over the target company after completion.  A roll-over can be relatively complex compared to an earn-out as it usually requires negotiation of a shareholders' agreement and may include call and put options to facilitate an exit. Care is needed in structuring these transactions, especially with regard to taxation, the impact on any "drag and tag" sale process and the governance for the period following completion.
2. Earn-outs:  An earn out is a common structure where a portion of the purchase price is paid at completion and a portion is paid in the future (typically over a 1–3 year period) with the amount of such "earn out payments" depending on financial or non-financial performance metrics of the target company after completion. These are bespoke and highly negotiated contractual provisions that depend on the business and financial performance of each business. This is especially relevant for a technology company whose value are usually driven by its rate of growth (measured in e.g., revenues, users, or customers) as well as achieving complex technical and commercial milestones.  For example, an earn-out payment could be drafted to trigger upon (i) revenue, EBITDA or profit (ii) receiving regulatory approval to enter a new market (e.g., financial regulatory approvals, banking licenses for a fintech), (iii) customer or subscriber milestones (e.g., a SaaS business), (iv) technical milestones (e.g., an artificial intelligence model). The earn out payments can also be linked to retention of key talent (e.g., founders, specialist engineers) post-completion. Typically, the earn out metric is linked to the buyer's financial model for the acquisition (e.g., if the purchase price is based on a multiple of revenue, then the earn out target or metric is typically based on revenues over the earn out period). Earn-out provisions can be a key way in bridging a gap between the seller's (at times optimistic) expectations for price and future performance and the Buyer's (at times conservative) concern that the anticipated growth will actually eventuate and can clear the way for a transaction to proceed without increasing execution risk by introducing additional conditions precedent, addressing the points as a post-closing financial true-up once the conditions are satisfied. An earn-out needs to be drafted with care so that there are clear, objective and measurable targets. Care also needs to be taken as to the governance of the target company during the earnout period. The buyer will need to have a reasonable degree of autonomy and the seller will require protections so as to ensure the performance of the business is not distorted during the earn out period – a balance which is always hotly contested. Finally, despite the parties' best intentions an earn-out will also require a clear dispute resolution mechanic.  Overall, earn outs are a flexible tool that creates alignment between the buyer and seller which can bridge the valuation gap. A earn-out gives the buyer a degree of protection against over-paying for projected revenues. It may also be a tool for a buyer to finance the deferred price using cash generated by the target. The fact of their complexity means these provisions can open up significant additional negotiation around the appropriate triggers, their determination and anti-avoidance mechanisms.
3. Contingent Value Rights (CVRs): In essence, the CVR is a cousin of the earn-out with all of the pros and cons described above but in the form of a transferable instrument that the buyer issues to the seller at closing, giving a right to additional payments based on the achievement of specified milestones. Although sometimes used in a private M&A transaction, it is better known in public M&A where e.g., a target is a health tech or life sciences company that is pending FDA approval for a medical product. If the approval is obtained prior to an agreed deadline, then the sellers will be paid an additional uplift to the purchase price. An advantage of this structure is that it provides additional contingent value to shareholders and a minority seller can sell the CVR to other sellers or, for a listed instrument, on the market.  However, there is unlikely to be a highly liquid market for a CVR given the complexity in their pricing (based on an assessment of the likelihood of trigger).
4. Escrow: An escrow provision requires the buyer to deposit a percentage of the purchase price due to the seller into an "escrow account" (a bank account in the name of a third-party escrow agent) for a set period of time. Typically, the escrow period is the same as the claims period for warranties or indemnities. The escrow agent is paid a fee to hold the funds and to only release them upon satisfaction of specific and narrowly drafted conditions pre-stipulated by the parties. Typically, the escrow agent will not accept risk of releasing funds except where it has received a written notice in pre-agreed form from one or both parties. This can be especially useful in technology transactions where there are a number of smaller sellers (e.g. founders and employees holding shares) as it simplifies the enforcement mechanic and mitigates the credit risk (e.g. pursuing the assets of an employee shareholder post-closing) should the buyer need to pursue a post-closing claim against the seller(s) for breach of warranty or under an indemnity. Escrow has many of the same downsides to the seller as the earn-out: it defers payment of the full purchase price until post-closing and, should there be any post-closing dispute, escrow may give the buyer leverage to hold-up release of those funds until the dispute is settled.
5. Revenue sharing: This is a contractual arrangement between the parties to share a percentage of the target company's future revenues between the buyer and the seller (e.g., 10%, 20%). This is helpful in technology transactions where alignment in the post-closing working relationship is critical, for example where the seller continues to jointly develop IP with the target, or licences IP or supplies services to the target, or where the target otherwise becomes a customer of the seller. This can also be useful where the buyer does not have sufficient cash on hand to pay the full purchase price up front, as a form of vendor financing (e.g., in a founder buy-out).  This has many of the same pros and cons as the earn-out, however there is significant flexibility (e.g., this can be tailored to track a revenue stream for a specific product or service) but with greater complexity comes greater potential for disputes.
6. Purchase price adjustments: Purchase price adjustments are a standard feature of M&A transaction. Typically, these adjustments are based on net debt and working capital, but they can also be tailored to include bespoke adjustments to the price, and this is often used to address value drivers that remain contingent between signing and closing. This approach only works where the value of the contingency can be determined at the time of the closing or the closing accounts.
7. Anti-embarrassment provisions: A face-saving option for a seller who is not satisfied that the valuation it has shaken hands on with the buyer reflects the long-term prospects of the company is to include a so-called 'anti-embarrassment' provision in the transaction documents. If the buyer 'flips' (on-sells) the target business within a certain post-closing period (e.g., 1 to 3 years) for a higher price than the original sale price, this triggers an additional top-up payment from the original buyer to the original seller that reflects a portion of that gain. This can be particularly useful for companies that have been unable to run a full competitive sale process to test the market with satisfactory 'price discovery'. This can happen where there is a fluctuating market, a distressed sale, or any other scenario where the seller needs to divest an asset due to factors outside their control.
8. Mixed cash and paper consideration: Where the buyer is a growing technology company, a classic method for a buyer to 'sweeten' the deal for the seller without reaching into cash reserves is to pay a portion of the consideration in the form of shares in the buyer. This is more appealing where the buyer is a listed company, no seller wants to be left holding illiquid shares and certain sellers will be unable to do so. Mixed consideration creates alignment between the parties where they believe in the overall synergies and future growth potential of the target business in the hands of its new owners. Share consideration can be particularly helpful in allaying any concerns of a seller that they are selling at the low point in a market cycle because the buyer is offering shares in the same market.
9. Vendor financing: This approach has the buyer pay the seller with deferred consideration in the form of repayment over time of a 'vendor loan' granted by the seller to the buyer. There is significant flexibility in the terms of these vendor financing arrangements, and they can be as simple as an interest-bearing term loan or as complex as a structured preferred equity instruments that has been optimised for tax and accounting considerations.  The risk for the seller is the credit risk of a buyer, particularly if the financing is unsecured or subordinate to the buyer's senior debt, that defaults on the loan or otherwise fails to repay the loan in full. 

Looking ahead

Effectively bridging the valuation gap in technology M&A often demands a combination of financial and legal lateral thinking. We have successfully leveraged variants of these strategies to facilitate deal-making in the rapidly changing technology sector. Our experts would be more than happy to discuss how these can be tailored to your transactions in the coming year. Our next article in this series will provide practical advice on the key pitfalls in implementing and adapting certain of these solutions to the specifics of each deal.