Figuring the Real Values of Acquisition Currencies

Shareholders entering into negotiations for a sale of their company are often confronted with competing offers from potential acquirers. In the interest of enhancing shareholder value, the competing offers have to be analyzed from a financial perspective to determine the net proceeds to the shareholders. Each offer may contain different structural elements that can have anywhere from a moderate to a significant impact on the net proceeds to the shareholders. As a result, it is in the shareholders’ best interests to analyze each offer from a financial perspective. This analysis should take into account the financial impact of the terms and the structure of the offer. This article discusses the many different types of transactional structures and their impact on the net proceeds available to the selling shareholders. Cash Payment In the simplest form of a transaction, an acquiring company purchases the target company for cash. The total cash purchase price is allocated among the stockholders according to class (e.g., preferred or common). The shareholders receive total cash payments equal to the total purchase price. For a company with a $50 million purchase price, paid in cash, the net transaction value to the target’s shareholders is $50 million. Payment in Notes Payable Some transactions include both a cash payment and a note payable to some or all of the target’s selling shareholders. As part of the transaction, the acquirer and target will negotiate the terms of the note, including the amount of time to maturity, the principal amortization, the interest rate, and the collateral (if any). While any form of a note may be negotiated, it is critical for the sellers to properly assess the negotiated terms within the context of the acquirer’s current capital structure. The note should be valued based on market conditions at the time of the transaction. The value will reflect the relative risk of the note in relation to the acquirer’s capital structure and collateral. The interest rate should be in the range of what the acquirer could obtain from an independent lender, given other comparable terms, or a discount may be appropriate. As either the payment structure (e.g., delayed principal payments) or the collateral security vary from typical bank terms, the interest rate should be adjusted to compensate the sellers for these additional risks. If the interest rate is not adjusted properly, the fair market value of the note may be adversely affected. For example, an unsecured note that is subordinated to all other senior debt should have an interest rate that is equivalent to subordinated debt rates in the market at the time of the transaction. If current market rates for unsecured, subordinated notes payable are in the range of 18% to 20%, and the parties negotiate a 12% interest rate, then the note payable would have an actual fair market value moderately to significantly lower than its face value. To determine the fair market value of the negotiated unsecured note with the 12% rate, an analyst would discount the projected cash flows at the market-related 20% interest rate. For a $10 million unsecured note with a five-year term, principal due at maturity, the fair market value of the note would be approximately $7.6 million. Figure 1 illustrates the difference in the face value and the fair market value for such a note. Therefore, a total transaction price of $50 million, composed of a $40 million cash payment and a $10 million subordinated note, results in a net transaction value to the sellers of only $47.6 million. This represents a net discount on the $50 million purchase price of approximately $2.4 million, or 4.8%. While this may be the best deal the target shareholders can negotiate, and it still may be higher than other offers, the sellers should at least be aware of the magnitude of the transaction price discount. One final note of caution regarding notes payable or deferred payments. In general, these notes may qualify for the installment method in recognizing the capital gain on the sale for federal income tax purposes. This allows the sellers to defer income taxes on the portion of the sale financed by the note until the payments are received. However, if the notes do not qualify as installment payments for federal income tax purposes, the sellers would be liable for the taxes on capital gains on the amount financed by the note. The sellers would have to immediately pay those taxes in cash from another source. Earn-Outs An earn-out is another form of deferred purchase price. In an earn-out, the final payments are dependent on the target’s performance in the years following the sale. An earn-out is an effective tool for negotiating and reconciling the acquirer’s and seller’s conflicting valuations of the target. In a typical earn-out, the sellers negotiate an additional payment based on certain financial goals of the company, such as profitability or revenues. The terms of the earn-out may include annual payments for a specified number of years, one final payment at the end of a measurement period (one or more years), or a combination of both. Typically, earn-out payments are in the form of cash. Since there is a contingent element to the payments, no income taxes are due until the cash is received. However, earn-out payments may be taxed as imputed interest. Therefore, earn-out payments may be taxed at ordinary income tax rates rather than at capital gains tax rates. Earn-outs are not effective in many transactions, particularly ones in which the sellers do not intend to remain involved as managers of the business. If profits (e.g., EBIT, EBIT-DA, operating income) are used as the measurement tool, the acquirer has less of an incentive to operate the business efficiently. This is because additional payments will become due to the sellers. In addition, the acquirer may initiate certain expenses such as research and development and marketing in the years following the transaction. These types of expenses improve the acquirer’s long-term investment value but reduce short-term profits – to the detriment of the seller’s earn-out payments. These types of issues should be carefully evaluated when entering into an earn-out payment arrangement. Other issues such as accounting methods for depreciation and allocation of overhead from a new parent corporation also can significantly affect earn-out payments. Ultimately, if an earn-out clause is negotiated as part of a transaction, the value of the earn-out to the sellers must be determined. The purchase price should be compared with other offers in comparable terms, that is, excluding all earn-outs. Then the additional value of an offer with an earn-out should be computed separately. To determine the value of an earn-out, the sellers should analyze multiple scenarios of projected performance for the company. Three common scenarios are: optimistic, realistic, and pessimistic. Under each scenario, the related earn-out payments can be computed. The stream of earn-out payments should be valued using a present value discount rate related to the risk of the company, such as the cost of capital. The discount rate should be further adjusted for the risk of each scenario. Finally, an additional risk factor may be included in the discount rate to account for the complexity of the earn-out and the likelihood of dispute, if necessary. Figure 2 illustrates the potential value of an earn-out payment stream. In this example, the sellers developed three scenarios for the company’s EBIT-DA over a three-year period – optimistic, realistic, and pessimistic. The negotiated earn-out payment is 10% of EBIT-DA above $10 million for each of the three years. Assuming that the company’s cost of capital is 15%, the discount rate is further adjusted for the optimistic and pessimistic scenarios. The present value of each potential earn-out stream is then determined. In this particular case, each scenario is weighted equally, to estimate the total value of the earn-out at $3.1 million. Therefore, for a proposed transaction of $50 million paid in cash, plus the earn-out, the net value of the total sale proceeds to the sellers is actually $53.1 million. Payment in Stock In many transactions, the consideration received by the sellers is stock in the acquiring company. This can have a dramatic impact on the actual value received by the sellers, depending on the liquidity of the acquirer’s stock and whether or not there are any restrictions on the securities. In general, shareholders pursuing a transaction desire liquidity for their interest, diversification of their wealth, or both. When the transaction consideration is in the form of acquiring company stock, both of these goals can be jeopardized. In a stock transaction, the purchase price for the target is negotiated. The sellers receive their consideration based on the number of acquirer’s shares that equal the value of the negotiated purchase price. The number of acquirer shares is fixed on the day of the transaction. This is typically based on a three-day or five-day average trading price up to the day of the deal closing. In general, the sellers will want to liquidate the acquirer’s shares they have received in the transaction for cash in the open market as soon as possible. The sellers then can use the cash proceeds to invest in diversified assets. Otherwise, the sellers are subject to price risk on the acquirer’s stock, which has not resolved their diversification goal. In the event of a significant decline in the stock price, the sellers will, in effect, have received a lower purchase price for the target. Preferably, any consideration in the form of stock should also be fully registered stock, or should have demand registration rights. If the stock is not fully registered, it is “restricted stock,” and the true value of the shares may be significantly below the current market trading price. Depending on the number of shares received by individual shareholders and their involvement with the acquiring company as insiders, the shares may be subject to additional restrictions, such as Securities and Exchange Commission (SEC) Rule 144. These restrictions would reduce the marketability of the shares to the sellers. Therefore, these restrictions would reduce the value to the sellers from the transaction purchase price. Studies that document the discounts in value for restricted stock and stock subject to SEC Rule 144 indicate that the discounts may be as large as 25% to 45%. Therefore, in negotiating the purchase price for the target, shareholders should understand the effect, if any, of any applicable SEC rules, such as Rule 144. Competing offers from potential acquirers can result in significantly different net values to shareholders as a result of this issue. If the shares are fully registered, the sellers will want to assess the number of shares received in the transaction compared with the acquirer’s typical trading volume. Let’s assume that the sellers will receive a significant number of shares relative to the acquirer’s average daily trading volume. The sellers, then, may not be able to liquidate their shares in the market without causing a decline in the market value of the stock. There are a number of public companies that are traded on the Nasdaq and other exchanges that have very thin trading activity. (These are often referred to as “pink sheet” companies.) In these cases, the market (i.e., the supply and demand) is so thin for the shares that any significant sell order will have a negative effect on the market price. This effect can be as large as a 20% to 30% decline in value. As a result, the sellers may actually receive a much lower price for their company than was negotiated in the transaction. For example, let’s consider two offers for the target, each for a nominal consideration of $50 million. In the first offer, the sellers receive fully registered shares of the acquirer, which is traded on the New York Stock Exchange. The total number of acquirer shares received by the sellers is insignificant when compared with the average daily trading volume. Therefore, it is anticipated that the sellers can liquidate their shares quickly and with very little price risk. The net value of this offer is $50 million. In the second offer, the sellers receive restricted shares of the acquirer and will be subject to Rule 144 limitations. As a result, the sellers will only be able to liquidate their shares in the open market over a lengthy period of time, such as two years or longer. As a result, the shares have a fair market value that is approximately 30% below the nominal value. Therefore, the net value to the sellers is approximately $35 million, rather than the $50 million purchase price. Finally, if the acquirer is a private company, and the stock is not marketable, the sellers will want to analyze the value of the acquirer’s stock. Specifically, the sellers should take into consideration appropriate discounts for lack of marketability. Furthermore, the sellers may want to consider negotiating some type of liquidity vehicle. Such vehicles could include a buy-sell agreement or a put option within a certain time period that would require the acquirer to effect a cash payment to the sellers. Noncompete Payments As part of the transaction, the acquirer may negotiate non-competition and non-solicitation agreements with certain members of the target’s management team. As compensation for entering into these agreements, the managers would receive cash payments, either in a lump sum or annual payments over the life of the agreement. From the acquirer’s perspective, these noncompete payments are part of the total cost of acquiring the target. Indeed, many acquisitions will not be consummated without these types of agreements, which primarily serve to protect the acquirer’s investment. However, from the seller’s perspective, such payments represent purchase price consideration that is being paid to certain individuals who may or may not also be shareholders. If the transaction includes consideration in the form of noncompete agreements, there may be significant allocation issues among the selling shareholders. For example, in many cases, the controlling shareholder is also the key manager. In a typical transaction, the total consideration is allocated pro rata among all shareholders. However, a noncompete agreement could provide significant value to one controlling shareholder, thereby reducing the sale proceeds to the noncontrolling shareholders. Figure 3 illustrates two contrasting cash offers – one that includes a noncompete agreement and one that does not. In the first offer, the total consideration of $50 million is composed of $45 million in the form of cash for shares, which is allocated pro rata among the shareholders, and a $5 million noncompete agreement, paid over five years, to the controlling shareholder/key manager. The second offer is for $48.8 million in cash. The $5 million noncompete agreement has a net present value of approximately $3.8 million, so offers A and B are essentially the same from the perspective of the two acquirers. However, the noncontrolling shareholder clearly prefers the second offer, because it maximizes proceeds to the noncontrolling shareholder, while the controlling shareholder prefers the first offer. Since the controlling shareholder most likely will be negotiating the terms of the transaction, noncontrolling shareholders will want to carefully evaluate any noncompete agreements that are negotiated. First, the agreements should be evaluated within the context of current market conditions – in other words, agreements negotiated between arm’s-length parties in other transactions occurring at the same time. Second, the noncompete payments should be considered in light of common practice in the target’s industry. Third, the magnitude of the noncompete payments, in relation to the total purchase price for the company, is another consideration. Fourth, the shareholders will want to assess the reasonableness of the noncompete agreements based on each individual’s potential impact on the business. Indemnification Most purchase agreements include indemnification sections that are often subject to extensive negotiations. Indemnification clauses indemnify the acquirer for any breaches of representations, warranties, and covenants in the purchase agreement, as well as for other claims, such as tax liabilities or environmental liabilities, that may occur after closing. From the acquirer’s perspective, the indemnification sections provide protection from financial exposure for future liabilities. The acquirer negotiates from the position that, had these liabilities been certain as of the date of the transaction, it would have negotiated a lower purchase price. The indemnification clause provides a mechanism for the acquirer to adjust the purchase price after the closing, i.e., when the liabilities become identified. One of the most common examples of an item covered by an indemnification section is environmental liabilities. For example, consider an acquirer purchasing the stock of a target that is a chemical manufacturer with numerous plants and the owner of all of the real estate at each plant. Without any indemnification provisions, the acquirer would become liable for any environmental cleanup on any of the properties. This is true even if the environmental damages had occurred prior to the acquirer’s ownership of the target. In the indemnification section, the acquirer may negotiate for the sellers to retain the liability for any environmental damages that are identified within a certain time period after the deal closing, such as five years. Both parties will negotiate the terms of the indemnification based on their own assessment of the potential future risks and the potential financial liability of those risks. Other items that are typically covered in an indemnification section include licensing issues, lawsuits, and income tax liabilities. The indemnification section will specify the terms of the indemnification, including: * The definitions of indemnification events; * A limit, if any, on the total financial exposure to the sellers; * Procedures for resolving post-transaction indemnification claims; and * The length of time of the liability to the sellers. Indemnification and Escrow Agreements In many cases, the acquirer may require that the sellers place a certain amount of the total purchase price in escrow for satisfaction of future indemnification claims. Typically, the escrow is established to pay out to the acquirer, in the event of an indemnification claim, or to the sellers, at the expiration of the indemnification period. Escrows are typically established for the funds to be invested in low-risk assets, such as money market funds or bond funds. Alternatively, if the consideration is in the acquirer’s stock, the escrow can also hold shares that can be liquidated if there is an indemnification claim or at the expiration of the indemnification. However, in the case of shares, the total value of the escrow fund is subject to price risk, so negotiations should involve contingencies for a decline in the value of the assets held in escrow. Indemnification and Transaction Value From a valuation perspective, the sellers need to assess the negotiated terms of the indemnification. The length of time, total amount of exposure, and probability that an indemnification claim will occur all affect the value of this potential liability to the sellers. For example, consider two competing offers for the target. The first offer is for $48 million in cash, with no indemnification provisions for environmental damages. The second offer is for $50 million, composed of $40 million in cash plus $10 million in cash held in escrow for three years for indemnification against potential environmental damages. Let’s assume that in the second year after the transaction closes, environmental damages requiring $3.5 million in cleanup costs are identified on the target’s property. If they had accepted the first offer, the sellers would have received $48 million in cash, with no future claims. If the sellers had accepted the second offer, the acquirer would file a $3.5 million claim for environmental cleanup, which would be paid out of the escrow. Therefore, the net proceeds to the sellers would be only $46.5 million. In this case, the sellers would have been better off accepting the first offer. One of the most difficult aspects in negotiating indemnification provisions is that these negotiations may not occur until very late in the transaction process – as legal documents are being written. In many cases, competing buyers already will have been told that their offer was not accepted. And, it may be difficult, if not impossible, to resurrect any of the other offers. In rare cases, the sellers may also consider the indemnification a net gain in value. This can occur if they believe that the total risks for an event occurring, such as an environmental cleanup, are greater than the exposure negotiated in the indemnification with the acquirer. Comparison of Competing Offers Figure 4 summarizes the variety of transaction structures described in this article. As shown below, the net transaction value to the sellers varies significantly, even though the nominal purchase prices are similar. These examples are fairly simple, and actual transaction offers may combine many of the elements described in this article in concert. In addition, the effect of income taxes on each of these different offers would illustrate additional variability in the net transaction value to the sellers. Susan E. Gould is a senior manager in the Chicago office of Willamette Management Associates.