Pro-Rata Shares: The Dos and Don’ts in M&A Transactions

Pro-Rata Shares in M&A Transactions

Managing pro-rata shares in M&A transactions can often be a challenge to a smooth payment process. In all M&A transactions, it is important that proceeds and post-closing payments be distributed quickly and efficiently to the selling party’s securityholders. Carefully matching definitions in the purchase agreement with the allocation spreadsheet can reduce delays and unintended consequences when making payouts.  In this article, the SRS Acquiom team offers tips on the “dos and don’ts” of calculating pro-rata shares for distribution purposes in M&A transactions to streamline payments. 

What Is a Pro-Rata Share? 

Determining each securityholder’s pro-rata share ensures fairness and equitable treatment of all securityholders when distributing M&A deal proceeds. This determination is essentially a calculation that considers the total amount of deal consideration weighed against each securityholder’s proportional ownership.

Determining pro-rata share in an M&A transaction can seem like a straightforward calculation. However, the formulas can get very complicated and are error prone. For example, standard organizational and corporate records, such as equity capitalization tables, often do not adequately capture liquidation preferences for preferred stock, the treatment of options or unvested stock, or management carveout plans.  The deal parties must be certain the information they are using to do the calculations accurately reflects the rights of each securityholder as stated in the corporate governance documents, and is accurately reflected in the M&A agreement’s distribution provisions and allocation spreadsheets.

How Will a Securityholder’s Pro-Rata Ownership Percentage Be Determined? 

Methods of allocating sales proceeds to securityholders may differ depending on whether there are preferred securityholders, option holders, or other specialized securityholders, along with the common stockholders or if the selling entity’s organizational documents include liquidation preferences.  These nuances should be accurately addressed in all the deal documents and provide distribution and payment instructions in reasonable detail.   

Three Ways to Allocate Ownership Percentage for Each Securityholder 

1. Cash received at closing/Total cash distributed at closing to all securityholders 
2. Number of shares held on a fully diluted basis/Total shares on a fully diluted basis held by all securityholders 
3. In accordance with organizational liquidation preferences 

If liquidation preferences do not apply, the deal parties can select between the first two allocation methods. Both these calculations are made for the closing distribution and the determined pro-rata shares will likely remain the same for any post-closing distributions.    

If the seller’s organizational documents provide for liquidation preferences for certain securityholders, calculation #3 must be followed unless the securities subject to liquidation preferences are not included as part of the deal consideration.   Deal parties should be aware that calculation #3 may be a dynamic process: it may require pro-rata shares to be recalculated for each post-closing release to consider liquidation and other payment obligations that were met at closing or in prior post-closing distributions. If using equity ownership as the basis for the calculation, such as in methods #2 and #3, parties may have to account for equity vesting schedules that play out post-closing. 

Whichever method is selected, the purchase agreement definitions must be carefully drafted to avoid errors and disputes when distributing the funds.  

Drafting Tips for Timely Distributions  

Attention to clear drafting and coordination of the seller’s corporate charter requirements, the purchase agreement’s closing and post-closing distribution requirements, and the allocation spreadsheet is critical. Failing to reconcile all this information can result in inaccurate allocations, disputes, and delays in distribution of proceeds.   

The M&A deal parties should ensure that the defined terms for ownership percentages in the purchase agreement match those used in the allocation spreadsheet and make sense based on the seller’s charter, type of securityholders, and any liquidation preferences, and account for any necessary recalculations for post-closing releases.  In addition, the deal parties should consider and address in the purchase agreement practical issues around the calculation process, payment mechanics, and the deal parties’ and securityholders’ rights and remedies if there is a calculation error. 

For example, if liquidation preferences must be calculated, the purchase agreement should specify which party or service provider will calculate pro-rata share for both closing and post-closing releases, how and when the calculation will be performed, the audit rights of the parties, and remedies if there is an error.  Regardless of the calculation method used, if distributions are paid in error, which party is responsible for correcting the error or recouping amounts paid incorrectly?   

How Option or Preferred Holders Impact Calculations 

If there are preferred or option holders, warrants, convertible debt, restricted stock, or liquidation preferences in a deal, failure to consider the rights of every applicable type of securityholder when drafting can cause a serious disparity in distribution amounts.   

To provide examples, the following information addresses how the rights of option holders and preferred holders can impact calculations: 

• Net exercise of options 
  An option holder often has the right to request a “net exercise” of their options, meaning the option holder surrenders the number of shares necessary to pay the exercise price rather than paying cash.  If the option holder exercises this right, the net exercise must be factored into the pro-rata share calculation.   

  Whether or not the option holder elects a net exercise, their distribution is typically reduced by the exercise price for each vested option, making the value per vested option less than the value per common stock share.

  If the purchase agreement definition calculates pro-rata share using the number of shares or options held, while the allocation spreadsheet calculates the distributions using the cash received at closing, the option holders’ allocation percentages will be significantly lower than the option holder’s deemed equity ownership. If the opposite situation occurs, the option holders’ allocation percentage will be artificially higher. 

• Receipt of additional funds 
  If a preferred holder received additional funds at closing due to their liquidation preference, their pro-rata share will be unfairly inflated if calculated based on cash received at closing versus shares held on an as-converted basis. As mentioned above, that is why the “dynamic” calculation 3 method is used here and requires careful consideration to ensure accuracy for all distributions.

The team at SRS Acquiom has learned that failing to address these issues clearly and consistently in the deal documents can cause payment release delays or distribution disparities between different types of securityholders.  At best, payments will be delayed while the issue is discussed among the deal parties, the allocation spreadsheet is amended, and distributions agreed.  At worst, the securityholders will be disappointed and may bring action against one or both deal parties.  

Addressing these issues upfront and making sure the defined terms in the purchase agreement are being applied accurately to the allocation spreadsheet benefits all the deal parties.