Most M&A pricing efforts are focused on valuing an acquired business. It is easy to overlook the true worth of the consideration the acquirer is giving up (or seller receiving) in a transaction. We will attempt to clarify some of these issues.
Case Study 1: Sorbus was hired to value a business client intended to acquire. Our valuation of total equity interest in the target entity came to $50 million. The client closed the deal at about the same amount and declared that our valuation was spot-on.
While assisting the client with valuing intangible assets for purchase accounting, we made a surprising discovery. In addition to $50 million cash, the client agreed to significant earn-out payments. In their view, no additional value was transferred to the seller because earn-out payments were conditional.
Under purchase accounting, the fair value of the earn-out (which is a liability) came to $10 million, i.e. the amount the client overpaid for the deal.
Many Ways To Pay For a Business
Apart from upfront payments of cash and publicly traded stock, about every other form of payment requires valuation. Some of such forms of payment, generally in order of complexity, include:
> Deferred cash payments,
> Installment plan,
> Illiquid equity shares,
> Earn-outs,
> Derivative instruments, and
> Rollover equity.
Unconditional cash payments, current or deferred, are mostly intuitive. However, installments (i.e. bonds) or assumed financial liabilities begin drifting into a gray area. Such liabilities can only be taken at face value if they also require interest accrual consistent with the credit quality of the instrument and without derivative-like conversion features. Otherwise, the face value is not the actual fair value.
An acquirer may offer to pay with its own illiquid equity shares. In some situations, an entirely new capital structure is established when the new owner, often private equity, takes over. Both parties would be well advised to understand the true fair value of their equity stake on day one after transaction closing.
Valuing illiquid equity securities does not have to be complex, but beware of dangerous shortcuts. Most mistakes arise when a combined entity ends up with more than one class of equity. For example, a seller may receive a certain amount of preferred stock but the seller treats it as common, basing its value on its recent IRC 409(a) valuation report. In cases where a brand new capitalization table is created, values of most equity classes are actually unknown.
Earn-Outs And Other Contingencies
Future payments, contingent or not, almost always have a present value, which increases the price the acquirer is paying. The fact that a contingency is not currently met does not make an earn-out worthless.
Earn-outs can be evaluated with a simplistic scenario analysis or using more advanced valuation methods such as option pricing methods, binomial lattices, or Monte Carlo simulation. Earn-out valuation is a requirement in purchase accounting. Companies frequently involve a valuation specialist to assess earn-out terms and use the same model in purchase accounting after the closing of the deal.
Finally, certain post-closing payments or transactions may be contingent upon a selling company’s valuation. Again, these options are not worthless simply because the contingency is not met yet. Depending on the structure of such derivative arrangement, a total purchase consideration transferred will be affected.
Cast Study #2: Sorbus’ client sold a large e-commerce company. In addition to a cash consideration, the seller received the right for an additional consideration based on the future value of the company. The valuation was necessary for tax restructuring purposes of the selling entity.
Initially, the client contacted us to procure a memo that would value the right as de minimis. A conservative finance executive, the client did not think it was prudent to build expectations around a promise of uncertain payment.
The reality, however, was that the right was a valuable financial derivative similar to a stock option. While the price that triggered the payment was rather high, it was difficult to argue that the probability of the additional payment was negligible.
In the end, we found the client to be receptive to our logic. As it turned out, the seller did, in fact, utilize the right to bridge the valuation gap when negotiating the deal.
In Conclusion
Transaction pricing involves valuing both business operations and purchase consideration. A buyer will overpay if earn-outs are ignored. A seller will be left underpaid if the earn-out is considered at its total face value without discounting for associated business risks. The value of installment payments depends on the interest rate, while rollover equity in a PE deal is often less valuable, on a per-unit basis than the equity received by the PE firm.
Too often the economics of purchase consideration language is not scrutinized. That is until after the deal closes and the company performs purchase price allocation for financial reporting purposes. This disconnect is not without consequence when a formal accounting exercise reveals sub-optimal deal pricing.
