In the first episode of our series of short videos on best practices in accounting for M&A transactions, PJ Patel, Charles Sapnas, and Ed Hamilton share their experience related to determining the purchase price allocation in an M&A transaction, the use of rollover equity and earnout structures as a tool to align the interests of buyer and seller in the deal.

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Video Chapters:
0:48 Determining the Purchase Price Allocation in M&A Transactions

1:32 Complexities in Valuing Earnout Structures

3:53 Valuation Considerations, Challenges for Rollover Equity in Private Equity Deals

7:54 Valuing Non-Controlling Interest in Private Equity Deals

9:30 Step Acquisitions and Purchase Price Allocations

10:24 Case Study: Non-Controlling Interest to Controlling Interest, Crosses Materiality Threshold

[Transcription]

Intro to Best Practices in Accounting for M&A Transactions

[PJ] I’m PJ Patel, co-CEO of Valuation Research Corp. We’re doing a short series of videos on best practices in accounting for M&A transactions.

VRC works on nearly 600 deals a year, and with that, we get to see a lot.

We’re going to share with you best practices we see in accounting for the transaction, and start simply with accounting for, or determining, the purchase price, valuing different assets and liabilities, as well as accounting for the transaction, post-transaction in terms of goodwill impairment.

Our goal with these videos is really to help share with you our experiences and best practices in accounting for M and A transactions.

Determining the Purchase Price Allocation in M&A Transactions

[PJ] I’m PJ Patel, co-CEO of VRC. I have my colleagues, Charles Sapnas and Ed Hamilton here with me. We’re going to talk a little bit about determining the purchase price in an M&A transaction. It seems like this should be a fairly basic item, and for the many of the transactions we work on, it is. However, from time to time, what we see is that determining the purchase price is actually fairly difficult to do. Ed, why don’t you talk a little bit about what you see with some of the public companies that you work with, and earnouts that are part of the purchase price, and the difficulties that you see in either valuing them or even identifying what the earnout is.

[Ed] Sure. So earnouts are a very interesting and useful tool. That being said, they can be pretty complex. There’s a number of issues in valuing them.

As we moved from a probability rating to more of a risk-neutral Black-Scholes, Monte Carlo, it’s much harder for management to understand the process, the math, and that causes some discomfort.

Also, the outcomes aren’t always as intuitive as they used to be. So we spend a lot more time helping them understand the math, giving them the language to understand and communicate with their stakeholders. Also, that the values tend to be a little lower than they intuitively expect, which when you combine that with the need to subsequently sort of accrete it up to future fair values can cause some discomfort.

[PJ] It’s interesting. I think we’re seeing more and more deals with an earnout in many ways in this market where prices are so high, not only with the stock market, but also the purchase price on companies.

It’s really being used as a bridge between buyer and seller to get the seller what they’re expecting, but it takes the risk away from the buyer.

[Ed] Oh, absolutely. Other than that there’s always a little bit of concern about subsequent treatment in terms of “can we agree in the future value and the metrics?” It definitely is a powerful tool in that manner. I’ve also found that it allows the buyer and seller to have subsequently their interests aligned post-transaction.

[PJ] In the deals that you’ve seen, is the earnout a material component of the transaction and is it a useful part of the exercise to determine?

[Ed] It is absolutely a material portion. And I would define material fairly broadly, meaning over 25% of the deal, one quarter. And yes, by definition, it’s critical because it has a big impact on the initial purchase price. And then also, as I said, you have to accrete up to the future fair value. So that has a real impact on earnings. So it’s a very high scrutiny input as well.

[PJ] Right. And Charles, on the PE side, I know you get to see earnouts from time to time as well, but you also see a lot of rollover equity. And so, first of all, what’s the purpose of that? Why is rollover equity part of the transaction? And then secondly, what are the challenges in valuing that?

[Charles] Sure. So rollover equity is a tool that in private equity transactions is used to align the interests of management and new ownership. In many cases, private equity investors are investing in management teams. They want to keep those management teams on board. They want to keep them invested and they want to keep everyone’s interests aligned in terms of increasing the value of the company, increasing equity value, and achieving certain long term targets. So rollover equity is very common in private equity transactions. It depends on a number of factors in terms of what that role of equity looks like, how big of a component of the purchase price it is.

We do see a bit more rollover equity in transactions where there is a bit more risk because it is also used as a risk-sharing tool similar to an earnout. And so, high customer concentration is a situation where you might see a rollover as a larger component of the total. Things that you need to consider with respect to rollover equity really revolve around the attributes of the security that the rollover shareholder is getting.

So the typical structure is with respect to an initial private equity transaction. There’s an investment vehicle, which is essentially funded by the private equity fund. There’s a transaction in which the private equity funds are purchasing equity from shareholders. And then, at the same time, certain shareholders are essentially exchanging their equity in the old company to equity in the new company. And that is what a rollover is, at the end of the transaction, you end up with a different security than you had at the beginning of the transaction.

[PJ] And I think that’s a really important point, because a lot of times I think there’s this feeling that “Oh, I still have a share in the company” but it’s a new share. And I think an important part of this is that the capital structure is different many times… pre- and post-transaction. Right? There’s leverage that’s being added. And so the value of that share pre-deal and post-deal may not be the same.

[Charles] Exactly. And the share and how it sits within the overall capital structure can be very different. Many transactions, you’ll see a rollover security being in the same class of securities as the primary buyer. But then it is not uncommon to see that that security that is the rollover being something different. And typically different means it sits lower in the capital structure in terms of how that share will participate in future exit events. And that is the number one consideration that we look at in terms of “what do we need to do with that rollover security” in terms of estimating purchase price. And that is where it can become much more complicated in terms of determining what the total purchase price is.

[PJ] Right. Right. So it’s interesting to me, do you think of this as sort of a fairly basic item? You go to the purchase agreement and have what the purchase price is yet, what I find in practice is that it’s a lot more complicated than that.

[Charles] Yes.

[PJ] And in so many of our deals, you’ve got to figure out what the size of the pie is and whether it’s rollover or earnout. So you’ve got to know what the size of the pie is and valuing them, I think, is a critical part of the process.

[Charles] I agree.

Valuing Non-Controlling Interest in Private Equity and Public Company Transactions

[PJ] So, Charles, another item that we’re seeing more regularly today is where the seller is retaining a piece of the company going forward, and we’re seeing that on the private equity side, as well as on the public company side, as well. On the public company side, it’s non-controlling interest that needs to be valued and that sort of thing. But maybe you can touch first on private equity and what you see in that space.

 [Charles] Yeah, I think it’s less common in private equity, but we are seeing it in certain industries and certain types of deal structures. So, with respect to a non-controlling interest versus rollover equity, the key consideration is “what is the security that those shareholders have post-transaction?” With a rollover, the shareholders that are rolling equity have a different security, they have a security in a new company, once they roll.

In a non-controlling interest, the shareholders retain equity, so they have the same stock that they had before the transaction. And the valuation considerations, when we look at rollover equity versus a non-controlling interest, can be very different.

[PJ] It’s interesting, because I feel like, at least in the PE space, we rarely saw that five or ten years ago. But today, in this environment, we’re seeing that a lot more frequently. And I think on the public company side, we’re seeing that from time to time as well. And for public companies, there’s a requirement to fair value that non-controlling interest. Do you want to touch on that at all?

[Ed] I think it’s idiosyncratic. I, personally, haven’t seen it in several years. The vast majority of transactions are outright control. I think of other ones I’ve seen around here and have been familiar with, and it has generally been transactions where it’s not necessarily non-controlling interest but more of a step acquisition where, for one reason or another, the transaction did not take place at one point in time, but 5% and none that I’ve personally been involved with.

[PJ] But you did bring up an interesting point there on step acquisitions. That’s another item that is critical to understand and determine the purchase price. I had a situation a couple of years ago, where the company thought they were doing a transaction that was immaterial. But it was they were going from a non-controlling interest to a controlling interest, and that was crossing the materiality threshold. And, all of the sudden, they had to do a purchase price allocation, account for the transaction, and so what they thought was, in that situation, maybe a $5,000,000 transaction was actually over a $50,000,000 transaction.