What Is A Valuation Gap And What Does It Mean For Your Business?

Business valuations are complex, and their outcome can make a huge difference to an enterprise. In today’s market, many analysts and investors are especially concerned about the accuracy of business valuations. More and more enterprises are entering the once-mythical category of the unicorn: That is, a startup that achieves a valuation of $1 billion or more.

Unicorns are typically companies in software or technology whose chief asset is their intellectual property. It may be difficult to estimate how widely their products will be adopted in the long run and what amount of staying power they will actually have.

Not all companies are unicorns, of course, and many sectors are more conservative than tech. However, the massive growth in unicorns has definitely changed how experienced investors look at valuations.

In short, it takes more effort for seasoned VCs to be confident that a valuation is truly accurate. Perhaps most importantly, are more likely to consider large valuations to be somewhat suspect. That makes it all the more difficult when their expectations clash with those of sellers trying to make a profitable exit.

A valuation gap happens when there is an appreciable difference in the market value of a company and the amount an owner intends to sell it for to meet their own financial objectives.

Valuation gaps doom many mid-market transactions. They can be quite high in situations where a business is not expected to generate adequate returns to offset the real cost of capital expenses.

However, a valuation gap does not necessarily mean a transaction is destined to fail.

Three Ways To Address Valuation Gaps
There are certain methods for resolving valuation gaps without repeating the entire process of business valuations. Traditional methods include earn-outs, vendor financing, and rolled equity.

Let’s consider each:

Earn-Outs
In an earn-out, the seller gets additional payments based on the future performance of the firm under its new owners. This option is preferred in situations where new capital is needed to ramp up production or introducing services to the market is expected to take some time.

Vendor Financing
Vendor financing describes any scenario where a vendor lends money to a customer who then uses it exclusively to buy the vendor’s inventory. In a major transaction, this can take the form of a transfer of shares from a borrowing company to a vendor.

Rolled Equity Structures
Rolled equity allows buyers to put down some of their own shares as part of the consideration for the purchase of a company. It enables transactions where obtaining additional funding from conventional lenders would be difficult or time-consuming but where both parties expect strong short-term gains.

Accurate Business Valuations From Experts Help You Prevent Valuation Gaps
A strategic, comprehensive approach to value creation adopted far in advance of an anticipated transaction is the best way to avoid these complications. Business valuations must be performed by leading experts in the field who can clearly communicate their findings to all stakeholders.

Performing business valuations early and efficiently will prepare owners with the knowledge they need to ensure a fruitful transaction for everyone involved. The earlier that starts, the better.

Flagler Financial has helped enterprises of all sizes, across a wide range of industries, get started on the road to a successful transaction aligned with the exit plans of key stakeholders.

To find out more or get started, contact us today.