In M&A, Price Is a Function of Risk. And Risk is Our Playground.

A deal is shaped and solidified by many factors and external and internal dynamics.
A complex deal ought to be explained in simple terms in order to work.
We suggest two reliable and time-tested formulas.
Price of asset = Opportunity (expected return) / Risk
Often called Risk – Reward Ratio.
In the sense of a M&A transaction, a deal is a sale of an asset/business or a part of it (shares/equity). In the eyes of the seller/founder what is being transferred is a (revenue generating or not yet) product or service which has a (sustainable) competitive advantage and a (feasible) growth potential (market share/revenue/profit).

What the seller transfers is an asset (a product or service) with a sustainable moat/competitive advantage and a growth potential. What the buyer acquires is all of that plus the potential for synergies, efficiencies, and financial upside from the business combination.

Price = (1) the present and projected value of the asset − (2) the combined quantified effect of the identified and potential risks + (3) the combined quantified positive effects of the combined/merged businesses

The risk is inherent in the information asymmetry. The buyer knows less about the target than the seller, and the sale process compressed in a short period of time (regardless how rigorous the due diligence is) cannot eliminate errors and omissions. That risk is factored into (i) the valuation, (ii) the deal structure, and (iii) the legal arrangements between the parties. The sell- and buy-side advisors’ role is to allocate and price the risk during the negotiations and help the parties agree on how to manage it (and pay for it) across the lifetime of the contract.

Risk management and risk allocation depend on choices – decisions how to use finite resources – people, money, time, and resolve conflicts. What will determine the outcome of the deal – good or bad: quantity and quality of data, speed of processing, decision-making and execution. And, legal basis – the preliminary and definitive contracts.

The transfer agreement in a fairly common M&A deal should set out the framework for risk management and allocation. For the sake of our thesis here, the relevant clauses may be clustered into 3 groups:

i. Price adjustment mechanism; locked-box or completion accounts, working capital adjustments etc. for changes between signing and closing

ii. Risk allocation mechanisms:

  • Warranties. W&I insurance has become an increasingly important facilitator. Indemnities, especially specific indemnities, e.g. tax indemnity. Disclosures.
  • Escrow and price retention
  • Limitation of liability – caps, baskets, de minimis, time limitations
  • MAC – rare but should be considered

iii. Upside protection/roadmap

  • Earn outs and price deferral – tool to bridge the valuation gap but also incentivise performance
  • Management and employee incentive plans
  • Retainment and hiring
  • Restructuring
  • Integration
  • Execution – resources, budgets, responsibilities (see above – incentives, earn out etc.)

Advisor selection matters and can reflect, or even determine, the final purchase price.

Expert advisors on both sides can significantly contribute to and influence each of the three price components mentioned above. The right teams surface risks, structure the risk allocation, and shape the narrative around value.

Choosing an advisor is, in itself, a pricing decision. Calculate who sits beside you at the negotiating table. Wouldn’t you choose people who lift you up?