The rationale is pretty straightforward. For the buyer, keeping the seller involved in the business and incentivizing them to grow the business helps preserve its value and ensure a more successful ownership transition. For the seller, maintaining an equity stake provides for a “second bite at the apple” resulting from a further increase in the value of their rollover, if the business continues to grow and achieve success.
For transactions in which the post-closing equity held by the seller is the same class of equity as that acquired by the buyer, the benefits and risks to both parties are truly aligned. However, for deals that are structured in a dual or multi-class format (e.g., preferred and common stock, Class A and Class B units, etc.), the “value” of the equity rollover is frequently overstated, resulting in a relative windfall to the buyer, to the detriment of the seller. What is most surprising is how often sellers are unaware of this issue and unwittingly buy in to the “dirty math” of fully diluted valuation that is generally used in negotiating these types of deals.
Dirty math is what I like to call the shorthand method of valuing equity that extrapolates the value of preferred (or similar) stock to equal the value of the total equity in a company, including common (or equivalent) stock, based on the per-share value of the acquired preferred stock multiplied by the fully diluted shares outstanding. As a result, the common stock is assumed to have a value at the time of the transaction that is equal to the value of the preferred stock on a per-share basis. The fact that the common stock generally does not possess the same level of risk and/or cash flow as the preferred stock due to the typical risk/return enhancements of preferred securities should highlight the fact that preferred and common stock cannot have the same value.
The fully diluted method may yield reasonable results once the value of existing preferred stock has grown sufficiently above any liquidation preferences and preferred return (i.e., dividend) accruals for the holding period and, as a result, it is reasonably certain that all preferred stock will exercise the right to convert in to common stock. However, it is rarely appropriate to utilize this dirty math for purposes of estimating the value of common stock in a transaction involving new preferred capital. Given the seemingly obvious problems with this method, it is surprising how often it is utilized in the M&A world to estimate both the value of common equity and the total post-money equity value of companies.
This issue can be illustrated in the following example.
Assume that the value of a business is agreed to be $50 million (for simplicity, pre- and post-money debt have been assumed to be zero) and that the seller will maintain a 20% equity rollover interest after completion of the sale. Further assume that the buyer’s expected holding period is three years, after which both the buyer and current seller will exit their investments. The negotiated purchase price for the business is funded as follows:
- $40 million convertible preferred stock (buyer): Buyer receives 4,000,000 shares, at $10/share, that are convertible to common stock on a 1:1 ratio and have a $40 million total liquidation preference with no preferred return.
- $10 million common stock (seller): Seller receives 1,000,000 shares of common stock based on fully diluted shares of 5,000,000 (implies a common stock price of $10/share).
This example is fairly typical for a preferred/common structure. The first thing that should be apparent is that:
- the preferred stock is worth more than $40 million (amount being paid by the buyer);
- the common stock is worth less than $10 million (amount being “paid” by the founder); or
- a combination of A and B, neither of which is in the seller’s favor, all else being equal.
Why? Because only in successful future upside scenarios would the preferred stock convert to common and have a value equal to that of the common stock, and because the preferred stock is sheltered from losses (up to a point) in possible downside scenarios – a protection that common stock does not possess. Following this example, it can be seen that, even without a preferred return accrual, any reduction in the value of the business over the holding period is borne first by the common stock holder up to the point at which the value allocated to the common stock is zero.
This is just one example, and there are other frequently used features that can have an even greater favorable impact to the preferred stock (e.g., preferred returns, enhanced liquidation preferences, special voting rights, etc.) to the detriment of the rollover equity. In cases where preferred returns are accrued to preferred stock, even flat to low growth in the business can, over time, wipe out much or all of the equity rollover interest held by the seller. This is due to the preferred return eating away the rollover’s claim on the value of the business, if the business does not achieve a positive growth in value above the preferred return accrual.
Certainly, many of these deals are negotiated with a full understanding of the impact of the multiple equity class structure on the value of the rollover being retained by the seller. Such structures can even be useful in lieu of an earnout in certain cases where there is a valuation gap between the buyer and seller as a result of the payoff profile to the seller. However, too many of these deals are done without the seller understanding the true implications on the value of the retained rollover equity and lead to subsequent disputes once the realities are understood.
Not surprisingly, using an alternative valuation framework that incorporates the total business value, along with the specific rights and preferences of each class of equity, in the example above results in a value for the common stock that is significantly lower than the value that it would be ascribed using dirty math (i.e., fully diluted valuation). Based on a $50 million business value and other assumptions above, the true fair value of the common stock could easily be 25% lower than the implied value using fully diluted valuation (with the common stock value shortfall actually being value to the preferred stock), and 50% lower if we further assume that the preferred stock is entitled to a 10% annual preferred return over the holding period.
This example highlights the fact that following the dirty math of fully diluted valuation typically overstates the true value of an equity rollover and results in the seller getting less than the agreed-upon value for the company.
It is important to note that the actual value of a rollover interest is very sensitive to several assumptions, both objective (e.g., liquidation preference, preferred return, conversion or participation features of preferred) and subjective (e.g., expected holding period length and expected volatility over the holding period). Although the proper valuation of a rollover interest in a multi-class structure is complex and generally requires the assistance of a valuation professional experienced in such matters, it is very important that a seller understands the implications of all preferred stock features in any multi-class structure in order to actually receive the value that they think they are getting. Having this knowledge will better arm a seller to negotiate a fair deal.