Your client has surprised you with a signed deal to sell his company. Is it too late to engage in effective transfer planning? The answer is, “no.”
Of course, more benefits could have been derived if your client had spoken with you before hiring an investment banker to find buyers for his company, or at least before he’d signed a letter of intent to sell. Even so, there remain opportunities for meaningful transfer planning. Until the deal is done, there are several discounts that affect the fair market value (FMV) of shares of stock in a company that has agreed to be sold at a stated price.
When a publicly traded company is being merged or sold, the announced sale price generally reflects a premium over the price of the stock before the deal. The acquired company’s share price usually rises in response to the announcement, but generally falls short of 100 percent of the announced deal price. That’s because the market guesses that the deal may be postponed, be renegotiated, or fall through. This pattern usually holds true for private company sales as well. And therein lies the planning opportunity.
In assessing the FMV of the stock when a company’s sale is pending, two basic scenarios exist: “deal” or “no deal.” This dichotomy calls for a determination of a probability-weighted adjusted value reflecting the possibilities associated with deal risk, that is to say, the differences in value of the stock if the deal goes through or collapses. A further discount adjustment for post-tender risk or merger arbitrage1 is necessary for attaining the probability-weighted adjusted expected value versus the lower pre-deal value. (See “What Price?” this page.)
So let’s look at an example of deal terms. Say that a purchase agreement provides for a $100 million purchase price. Almost always in private company transactions, a portion of this amount is contingent on future events and payable at a future date. The transaction may be structured to provide for $80 million due at closing, of which $5 million is held in an escrow account and the other $20 million is to be earned over the next couple of years (based on expected performance of the business.) An escrow amount is payable to the seller over a period of time, provided certain conditions are satisfied. Half of the escrow may be payable 12 months after closing, if no environmental or product liability issues surface. The remainder of the escrow is payable 24 months after closing, provided no representations or warranties are breached.
An earnout provision for the final $20 million of the purchase price also is paid over time, after achieving certain performance benchmarks. An example of this provision might call for $10 million to be paid the first calendar year after closing, if a certain projected level of earnings is achieved. Similarly, the final $10 million becomes payable to the seller, if a second earnings benchmark is reached after the second calendar year.
There are at least three significant valuation issues that arise at the outset of such an agreement that contribute to a discount from the best case scenario of the seller receiving $100 million. The foremost issue is whether the sale will go through at all. The second issue is how much is the $5 million escrow currently worth, because the amount is subject to cutbacks based on subsequent findings by the seller and is payable in the future. The third issue is the value of the potential for $20 million of earnout payments given: (1) the uncertainty of future performance, and (2) the value of future dollars.
The time frame for the process of selling a private business from letter of intent and purchase agreement to closing is normally several months. This time is needed by the buyer for due diligence work and to secure financing. In the first few paragraphs of the purchase agreement, the purchase price will be presented. What follows are many pages of conditions, requirements and contingencies that must be met to close the deal. Looking past the prominently listed purchase price to the many other paragraphs of the purchase agreement provides the details that justify a discounted value for pre-closing transfers of equity interests.
Both escrows and earnouts are payable in future dollars, which lead to a present value determination. Escrows may accrue at a modest level of interest, but earnouts are generally fixed dollar amounts. In both cases, each of these components of the purchase price should be discounted to present value to compensate for the risk involved in receiving the expected payments at future dates. The appropriate rate of return for the present value discount is the risk-adjusted rate of return appropriate for the company being sold, which rate frequently will be in the teens. It is company-specific factors and performance that determine how much of the escrow and/or the earnout will be paid to the seller. The discounted present value of future payments reduces the stated value of the deal. It would be the rare instance in our hypothetical case that the maximum value of the deal would be $100 million. Accordingly, in our example, the maximum present value of our deal is $95 million, taking into account only the amount of future cash payments and no cutbacks to the escrow or earnout payments.
To estimate the expected value of the stock, an appropriate weight or probability must be determined for the deal going through as planned (the “transaction scenario”) and the deal not taking place (the “non-transaction scenario.”) The transaction scenario will incorporate an assessment of how much of the best case maximum scenario is expected to be collected, reduced by potential claims against the escrowed funds, ease or difficulty in reaching the earnout benchmarks, and present value of future dollars. The seller’s candid input and expectations are extremely important in assessing whether the best case scenario is realistic. In many cases, collecting the maximum amount presented in the purchase agreement is unrealistic and the transaction scenario value should be reduced accordingly.
In our example, it is assumed that a $5 million reduction in the deal value is supported by the present value calculation of expected future dollars to be received over the next two-plus years. The non-transaction scenario will reflect the estimated value of the company if the deal collapses and everything is reset to business as usual. The probability of each scenario is based on a multitude of factors, including general market conditions, company-specific factors, due diligence, the motivations of the seller to sell and the buyer to buy, the reasonableness of expectations concerning the sales price, etc. The transaction scenario is the most likely, because both buyer and seller have indicated their desires by executing the sale agreement.
For illustrative purposes then, the best case scenario present value of proceeds to the seller is $95 million. (See “Deal or No Deal,” this page.) The transaction scenario is assigned a probability as of the valuation date of 75 percent. This probability rises as the closing date draws closer because presumably more items on the deal contingency list are checked off by both parties to the deal. Also the present value discount shrinks, because there are fewer months until receipt of expected escrow and earnout dollars are received. The non-transaction scenario is assigned the residual 25 percent probability. For establishing the value for the non-transaction scenario, we assume that the transaction scenario price represents about a 35 percent premium over the value of the company before the sale was negotiated. The probability allocation between the two scenarios is based on a number of factors that may impede the consummation of the transaction, including (among an unlimited number of other things):
The probability-weighted expected value of our $95 million transaction scenario and $70 million non-transaction scenario is $88.75 million.
The expected value of $88.75 million is estimated based on an assessment of the likelihood of the transaction occurring. However, the closure of the transaction is ultimately absolute, meaning it will either occur or it will not occur. Each outcome results in a materially different return from the expected value. In this analysis, if the transaction scenario occurs, the value would be $95 million. However, if the non-transaction scenario occurs, the value would only be $70 million. This deviation in realized value implies that significant risk exists.
Using the estimated expected value as the price a willing buyer would pay, the buyer would then expect one of two outcomes to be realized by this investment. If the transaction scenario were realized and the transaction did indeed occur, a return of approximately 7.0 percent2 would be earned by the buyer. However, if the transaction were not to occur, the buyer’s return would be negative 21.1 percent. 3 If a buyer paid the expected value of $88.75 million based on these probabilities, his expected return is 0.0 percent. This would not be acceptable for the downside risk that the buyer assumes. Accordingly, to be compensated for the deviation in return or risk, the buyer would require an additional discount from the calculated probability-weighted expected value.
The types of returns demanded by investors in risk arbitrage investments such as this are consistent with venture capital rates of return when the required rates of return can be 40 percent on an annualized basis. In our example, an annualized return of 40 percent is used, based on the assumption that a buyer who consistently invests in investments in which there exists a substantial deviation in potential outcomes expects to earn a 40 percent annualized rate of return over time. The expected closing date used in our transaction scenario analysis is three months away; thus, we assume a three-month holding period for purposes of the risk arbitrage discount (that is to say, the number of months between the expected closing date and the valuation date.) The return that the arbitrage investor seeks is that three-month return over the amount at risk that is equivalent to a 40 percent return had he earned the same return for an entire 12-month period.
The 8.1 percent discount4 used in our example is applied only to the $18.75 million5 incremental investment that would be required above and beyond the non-transaction scenario in order to participate in the upside potential of the transaction. This is because the non-transaction scenario represents a floor value and only that amount invested above the floor value is at risk for the investor. If the transaction were not consummated, a buyer’s asset would be worth $70 million. Application of the 8.1 percent discount rate to the incremental $18.75 million investment results in a risk arbitrage discount.
Subtracting the risk arbitrage discount from the expected value yields an FMV of $87.2 million. If the deal closes in three months as planned, transferring shares before the deal is done provides planning opportunities to remove $12.8 million6 from the seller’s estate when compared to the $100 million price in the purchase agreement.
A deal is never a deal until the money changes hands. Many transactions that appear to be sure things fall apart in the eleventh hour. There are abundant risks that render the final transaction value uncertain and the FMV less than the dollar amount prominently displayed in the purchase agreement or letter of intent. Discounts for time value of money held in escrow balances, earnout probabilities and risk arbitrage of the deal happening provide meaningful opportunities for transfer planning up to the time the deal closes. However, as with many other planning opportunities, the sooner in the process your client takes action, the greater the benefits.
1. Risk or merger arbitrage is a strategy of providing liquidity to owners of a stock that is currently the target of an announced acquisition.
2. [$95 million -$88.75 million] / $88.75 million.
3. [$70 million -$88.75 million] / $88.75 million.
4. This discount of 8.1 percent is equivalent to an 8.8 percent return for the three-month period [1/(1-.081)] -1 = 8.8 percent. An 8.8 percent return per quarter compounded over four quarters generates a 40 percent annual rate of return.
5. $88.75 million less $70 million equals $18.75 million.
6. $100 million less $87.2 million.