The Problems with Pro Ratas in Mergers and Acquisitions

Many M&A shareholders think that when they sell a company, each securityholder simply gets their percentage of the proceeds. In reality, however, the pro rata formulas are often much more complicated and mistakes are made.

SRS Acquiom has worked on numerous transactions in which the spreadsheet delivered at closing contains inaccuracies, does not match the formula contained in the document, or fails to account for potential changes to distribution pro rata percentages. While most attorneys are aware of these issues, the M&A community may not realize the magnitude and frequency of the problem. The general counsel of a large investment fund told us that the greatest value he provided to the fund in his early years on the job was identifying mistakes or unresolved issues in capitalization tables with respect to M&A transactions. He said the errors or adjustments amounted to millions of dollars that would have been misallocated. Based on SRS Acquiom’s experience, upward of a third of the spreadsheets received have issues that require further clarification before distributions can be accurately made. There are several common reasons for this, such as the complications of taking into account the liquidation preferences and participation caps attributable to the preferred stock, whether and to what extent holders of options or unvested stock participate in various distributions, and the often complicated terms of management carveout plans.

Below is a summary of some of the major challenges in M&A transactions that SRS  Acquiom sees with these calculations and payouts.

Are the parties that participate in the closing payment the same as those that participate in the escrows or other future payments, and are the percentages the same?

This can be a complicated issue that is often missed. SRS Acquiom has seen several agreements that have a single definition of “pro rata” when that is not what is intended. As an example, suppose a company that has raised $20M is sold in a transaction that pays $19M at closing with a $5M escrow. If the investors are entitled to their money back first, but no more, there is a complicated question of which shareholders “own” the escrow and in which percentages and to what extent. The preferred investors will presumably take all of the $19M paid at closing, but determining who should receive payouts from the escrow is more complex. The “pro rata percentages might change based on how much of the escrow is paid out to the shareholders. Payment caps or forfeiture provisions in management incentive plans or in individual agreements with continuing employees may also result in a recalculation of post-closing distribution percentages that is not accurately reflected on the closing spreadsheet or in the deal documents.

When employees participate in the escrow, are their contributions pre-tax or net of withholding for purposes of determining pro rata allocations?

SRS Acquiom has seen it done both ways, and it may depend on the source of the contribution (options or employee bonus/management carve-out), the tax treatment of the M&A deal and whether the escrow account is an indemnification escrow or the establishment of an expense fund. In most cases, contributions to indemnification escrows are subject to substantial risk of forfeiture (i.e., indemnification claims) and therefore no taxable event occurs until the escrow is released. In this case, the contribution to the escrow is most likely considered to have been made on a pre-tax basis for purposes of pro rata calculations.
With expense funds, whether contributions are considered pre-tax or after-tax typically depends on the agreement between the buyer and the sellers. If the buyer agrees to treat the expense fund as part of the installment sale, then contributions to expense funds from employees are typically considered to be done pre-tax. If the sellers do not want the buyer involved in treatment of the expense funds, however, then the gross proceeds typically are deemed distributed at closing and the expense fund is established on an after-tax basis.

Will the pro rata percentages change if certain events occur such as employees leaving prior to the end of the escrow period or if there are payment caps under relevant management incentive plans?

Some agreements will say that option holders or holders of unvested stock (or related phantom or derivative units) will only participate in disbursements if they are still employed at the time the applicable payment becomes due. If they leave, there is a question as to whether their portion of future payments should be reallocated among the other securities holders (which gives an odd incentive to encourage co-workers to exit) or should go back to the buyer. Either way, the pro rata percentages can shift as one goes along, making the calculation of final payout amounts and splits complicated. Similar issues are raised when there are payment caps under management incentive plans because the pro rata percentages change with respect to distributions in excess of the cap.

What happens if a pro rata mistake is discovered after closing?

If mistakes in pro rata calculations are discovered after closing, a question arises as to how to determine what the parties intended to do and whether the shareholder representative has the power to make appropriate adjustments. This can take the parties into tricky territory, because the shareholder representative likely has the authority to make clarifying or correcting amendments, but may lack the authority to change the fundamental deal terms without prior stockholder approval.