By Justin Johnson, Valuation Research Corp
Many private equity platform acquisitions and some add-on deals feature what is referred to as rollover equity.
Rollover equity arises when certain equity holders in the target company, including founders and key members of management, roll part of their ownership stakes into the new equity-capital structure put in place by the acquiring PE firm, in lieu of receiving cash proceeds.
This arrangement is attractive to PE investors because it reduces their cash outlay and helps align investor and management-team objectives, as the latter will continue to have skin in the game after the acquisition.
The arrangement is also appealing to those rolling their equity because they can receive partial liquidity for their investment and still participate in further upside. And rolling equity may be attractive to the sellers from a tax perspective.
A potential valuation issue arises, however, when management receives a different class of equity than that invested in by the PE firm. In these cases, the rollover security may need to be valued to establish the allocable purchase under ASC 805.
Consider a transaction with the below sources and uses, where the amount of rollover equity is material to the transaction.
Further assume that:
- the PE investor receives Preferred A shares (“A”) for its $40 million investment and that it pays $1,000 per share;
- the rollover equity holders receive Preferred B shares (“B”) for their investment valued at $1,000 per share, and,
- the A and the B shares have identical terms, except the A shares are senior to the B shares in liquidation.
Under this fact pattern, the different seniority creates a material economic difference between the A and B. Thus, while the price assigned to the B shares in the transaction is the same as for the A shares, it may not represent the fair value of the B shares for ASC 805 valuation purposes.
Using OPM to establish fair value
To establish the fair value of the B shares for purposes of determining the allocable purchase price under ASC 805, best practices call for running an option pricing method, or OPM, equity allocation model. The OPM entails running a series of option calculations to allocate equity value.
The model treats common stock and preferred stock as call options on the company’s equity value, with exercise prices based on the liquidation preference of the preferred stock.
In the model, the exercise price is based on a comparison with the total equity value rather than, as in the case of a “regular” call option, a comparison with a per-share stock price.
OPM commonly uses the Black-Scholes model to price the options. (A complete description of this valuation method, as well as detailed examples, are included in the AICPA practice aid, “Valuation of Privately Held Company Equity Securities Issued as Compensation.”)
In our example, we would back-solve the OPM equity allocation model by calculating the total equity value that would yield a $1,000 per share value of the A shares. It is generally accepted that the price for the A shares in the transaction is indicative of their fair value, as the price and terms result from arms-length negotiations.
The OPM model is set up to allocate the total equity value to the A, B, and common shares, as well as any options that will exist in the new capital structure. The other inputs to the model include the risk-free rate, the expected investment term (usually five years for PE deals) and the volatility.
In estimating the correct volatility input, it is essential to consider the PE firm’s use of leverage to finance the purchase. Equity volatility increases as leverage increases. Generally accepted quantitative methods for estimating the volatility input for leveraged companies have been developed and refined over the past several years.
Generally, volatility is estimated by referencing the standard deviation of historical closing stock prices for select publicly traded comparable companies. Since these companies are likely to have a different level of leverage (usually less), it is important to normalize the equity volatility to asset volatility.
This asset volatility can then be adjusted (re-levered) to equity volatility that reflects the specific proportion of equity and debt used by the acquiring PE firm.
This approach effectively captures the upside that the equity base may experience should the overall enterprise value grow as expected. (See AICPA practice aid “Valuation of Privately Held Company Equity Securities Issued as Compensation,” Sections 7.31 and 7.32, which discuss this concept in more detail.)
In our example (and in many actual transactions), the result of running the OPM equity allocation model is that the value of the rollover equity shares is lower than the price of the A shares.
This should not be a surprising result as the A shares are senior in liquidation to the B shares, one of the economic factors that the OPM model is designed to capture in allocating value.
What this means in practice, though, is that the value of the rollover equity would need to be adjusted in order to establish the allocable purchase price as of the acquisition date, even if the value assigned to the B in the transaction by the investors is $1,000 per share.
So, for example, if the value the OPM indicates for the B shares were $800 per share, the fair value of the rollover equity would be $16 million, instead of $20 million, which means the purchase price would be $91 million instead of $95 million.
Rollover equity in add-ons
We also see rollover equity for add-on deals.
The valuation considerations for these types of deals can be more involved if the acquirer has a complex capital structure.
Generally, in those situations, to value the shares in the acquirer into which the sellers are rolling their equity, the total equity value of the acquirer must first be established by performing a fundamentals-based valuation analysis (i.e., DCF analysis, comparable public company analysis, and comparable acquisitions analysis, etc.).
That equity value is then allocated using OPM to isolate the value of the preferred or common shares given to the sellers.
An additional consideration in valuing rollover equity shares is the application of a discount for lack of marketability, or DLOM. Such a discount may or may not be appropriate depending on facts and circumstances.
If the rollover equity is preferred stock in an original platform deal, then we believe no DLOM would be appropriate.
Going back to our example, since we are back-solving to the price of the A shares in arriving at the value of the B shares, and since the A shares are an illiquid security for which there is no active market, it is our view that applying a DLOM to the B shares would be appropriate.
In the case of an add-on acquisition where the sellers will receive common stock and where the equity value of the acquirer is established based on fundamentals analysis, we believe it may be appropriate to apply a DLOM to those shares.
- A potential valuation issue arises when rollover equity received by management is not the same class as that invested in by the PE firm.
- It may be necessary to value rollover securities to establish the allocable purchase price under ASC 805.
- In valuing rollover equity, use of the OPM is a common valuation model, but care should be taken to select a volatility input that reflects the higher leverage of PE portfolio companies.
- In the case of add-on deals, the total value of the acquirer must be established using fundamental analysis before the OPM can be applied to rollover equity.
- Application of a DLOM to rollover equity may or may not be appropriate and will depend on facts and circumstances.
Justin Johnson, CFA, is co-CEO and senior managing director of Valuation Research Corp., the San Francisco-based valuation and advisory services firm. He sits on the board and is a member of the firm’s private equity industry group and financial opinions committee. Reach him at +1 415-277-1803 or JJohnson@ValuationResearch.com.
Justin Johnson, CEO, Valuation Research Corp. Photo courtesy of the firm.