Bridging the Valuation Gap: Understanding Buyer-Seller Disconnects Amid Rising Interest Rates

Topic: Insights Reading Time: 7 min

Valuing a company is one of the most critical stages in any mergers and acquisitions (M&A) process. The goal is to reach an agreement on a fair price between the buyer and seller. However, this is often easier said than done. A frequent issue that arises is the “valuation disconnect” — a situation where the seller believes their company is worth more than what the buyer is willing to pay. This disconnect can cause negotiations to stall or collapse, especially during periods of economic turbulence or rising interest rates.

In this article, we will explore why such valuation gaps exist, the role rising interest rates play in exacerbating them, and potential strategies to bridge this divide. Understanding these factors is crucial for both buyers and sellers to navigate the complexities of deal-making in a shifting economic landscape.

Understanding the Basics of Company Valuation

Before diving into the reasons behind valuation disconnects, it’s essential to understand how companies are valued in M&A. Valuation methods typically fall into one of the following categories:

• Discounted Cash Flow (DCF): This method involves forecasting a company’s future cash flows and discounting them to the present value, using a discount rate that accounts for risk and cost of capital.
• Comparable Company Analysis (Comps): In this approach, a company is valued by comparing it to other companies in the same industry, adjusting for differences in size, growth, and risk.
• Precedent Transactions: This method compares the target company to other similar companies that have recently been bought or sold, providing a real-world benchmark.
• Market Valuation: For publicly traded companies, the market capitalization provides an immediate valuation based on stock price, though M&A transactions often involve a premium above the market value.

Buyers and sellers use these tools to estimate a fair price. Yet, despite the availability of these methods, valuation disagreements are common.

The Valuation Disconnect: What is It?

The valuation disconnect occurs when the seller’s perceived value of their company is higher than what the buyer is willing to offer. In theory, both parties should have access to the same data and use similar methods for calculating value. However, differences in expectations, motivations, and external market conditions often lead to divergent views on the company’s worth.

For sellers, their valuation might be influenced by:

• Emotional Attachment: Particularly for founders or family-owned businesses, sellers may feel an emotional connection to the company, overestimating its value.
• Growth Potential: Sellers might focus on the potential future growth of their company and price it accordingly, while buyers may take a more conservative approach.
• Strategic Value: A seller may feel their company offers unique synergies or strategic advantages that justify a premium, even if these advantages are not immediately quantifiable.

For buyers, their valuation may be driven by:

• Financial Metrics: Buyers are often more focused on the financial fundamentals of the company, such as profitability, cash flow, and debt levels.
• Risk Aversion: Especially in uncertain economic environments, buyers may be more conservative in their valuations, applying higher discount rates to account for risks.
• Return on Investment: Buyers typically calculate whether they can generate an adequate return on their investment, which can lead to more cautious pricing.

This disconnect becomes especially pronounced during periods of rising interest rates.

How Rising Interest Rates Widen the Valuation Gap

One of the key macroeconomic factors that exacerbate the valuation disconnect is rising interest rates. When central banks raise interest rates, it impacts both buyers and sellers in several ways:

1. Higher Discount Rates in Valuation Models

In valuation methodologies like Discounted Cash Flow (DCF), the discount rate reflects the cost of capital. As interest rates rise, the cost of capital for the buyer increases, leading to higher discount rates. When future cash flows are discounted at higher rates, the present value of those cash flows decreases, lowering the buyer’s valuation of the company. On the other hand, the seller may not adjust their expectations accordingly, leading to a mismatch in valuations.

2. Financing Becomes More Expensive for Buyers

Rising interest rates also make debt financing more costly. In many M&A transactions, buyers rely on debt to finance the acquisition. As borrowing costs rise, the buyer’s ability to offer a higher purchase price diminishes. This can create a situation where even if the buyer is interested in the target company, they are financially constrained from offering a price that matches the seller’s expectations.

3. Macro Uncertainty and Risk Aversion

Periods of rising interest rates are often accompanied by economic uncertainty or slowing growth. Buyers may become more risk-averse, focusing on short-term profitability rather than long-term strategic value. This conservatism can cause buyers to value companies more cautiously, leading to a disconnect with sellers who are more optimistic about their company’s future prospects.

How to Address the Valuation Disconnect

Navigating the valuation gap requires a combination of negotiation skills, creative deal structuring, and market awareness. Here are some strategies that can help bridge the disconnect:

1. Earnouts

Earnouts are a common tool used to bridge the valuation gap. In an earnout structure, the seller receives part of the payment upfront and the rest contingent on the future performance of the company. This allows the buyer to hedge their risk while giving the seller the potential for additional compensation if the company performs as well as they expect.

2. Seller Financing

In some cases, the seller may agree to finance part of the transaction by lending money to the buyer. This can reduce the buyer’s upfront cost, making the deal more affordable. Seller financing also shows that the seller has confidence in the company’s future performance.

3. Contingent Value Rights

Similar to earnouts, contingent value rights (CVRs) are structured as additional payments that are triggered by specific future events, such as hitting revenue or profitability targets. This can help align the interests of both parties.

4. Third-Party Valuation

Bringing in an independent third-party valuation expert can help mediate disputes over value. This neutral perspective may provide a more objective basis for negotiation and help both sides converge on a fair price.

5. Transparent Communication

Both parties should maintain open lines of communication throughout the negotiation process. Buyers should explain how rising interest rates impact their cost of capital and ability to finance the deal. Sellers, on the other hand, should provide a clear rationale for their valuation, backed by solid data on the company’s growth prospects, market position, and potential synergies.

Importance of Addressing the Disconnect

The valuation disconnect is a common stumbling block in M&A transactions. If left unaddressed, it can lead to a complete breakdown in negotiations, causing the deal to fall through. For example, in 2020, the acquisition of Victoria’s Secret by Sycamore Partners fell apart due to a valuation dispute. The COVID-19 pandemic caused a sudden economic downturn, which made Sycamore reevaluate its offer. The private equity firm sought to lower the valuation due to the increased risk and uncertainty, but the seller, L Brands, was unwilling to accept a reduced price, leading to the termination of the deal.

While it’s natural for buyers and sellers to start with different views on value, it’s essential to recognize that the disconnect is not an insurmountable obstacle. With the right approach and willingness to compromise, both parties can work towards a solution that meets their needs.

Conclusion: Bridging the Valuation Disconnect in a Changing Economic Landscape

Valuation disconnects are a common challenge in M&A transactions, particularly in times of rising interest rates. Buyers become more conservative as the cost of capital increases, while sellers may maintain higher expectations based on past performance and future growth potential. However, this gap is not an inevitable deal-breaker. With tools like earnouts, contingent value rights, and transparent communication, buyers and sellers can find common ground.

As interest rates remain high, it’s critical for both parties to stay flexible and open to creative deal structures. Have you ever experienced a valuation disconnect in a transaction? How did you resolve it, or did it lead to a failed deal? Share your thoughts in the comments below!