I. Introduction
In the dynamic landscape of mergers and acquisitions (M&A), striking the right balance
between risk and return forms the cornerstone of successful deal-making. This paper
delves into the interplay of three crucial structural components in private M&A
transactions: cash up front, rollover equity, and earnouts. By examining how purchase
price can be apportioned among these components, this framework assigns value while
managing risk. The thesis argues that effectively leveraging a net present value (NPV)
framework is key to optimizing outcomes in negotiations.
II. Components of M&A Negotiations
A. Cash Up Front: Leveraging Historical Financials in Private M&A Transactions
Among the structural components of private M&A, cash up front holds a unique
significance as it represents immediate risk borne by the buyer. Using historical
financials under the principle that past is prologue provides a solid foundation for
valuing this component and managing that risk effectively.
The allocation of cash up front typically encapsulates the most predictable and stable
portion of a business’s value. Committing a significant amount of consideration at the
outset exposes the acquirer to immediate uncertainties, yet this stability often aligns
with the seller’s historical contributions and efforts.
The predictability inherent in historical financials makes them an invaluable tool in
mitigating the risks associated with cash up front. By anchoring value to adjusted
EBITDA and applying market multiples, negotiators can establish a defensible basis for
valuation. This approach ensures that the buyer’s immediate risks are balanced against
the seller’s demonstrated performance.
Ultimately, the strategic use of historical financials transforms uncertainties into
calculated risks, enabling both parties to proceed with greater confidence. This
component underscores the essence of balancing stability with risk when structuring an
M&A deal.
B. Rollover Equity: Managing Mutual Risk
Unlike cash up front or earnouts, rollover equity occupies a unique middle ground in risk
allocation. It reflects mutual risk, as both buyer and seller share responsibility for the
business’s future performance post-transaction. This component often presents the
greatest challenge in apportioning value.
The valuation of rollover equity depends on balancing historical performance with
synergies and operational contributions anticipated by the buyer. While cash up front
captures the stability of past performance, rollover equity is tied more closely to
forward-looking value and the buyer’s strategic initiatives.
A thoughtful approach to valuing rollover equity considers its dynamic nature. This
component captures both the seller’s vested interest in ongoing success and the
buyer’s operational vision. Striking this balance ensures alignment between the parties
and a mutually beneficial outcome.
Through careful negotiation, rollover equity can be structured to reflect shared
incentives, creating a foundation for collaboration and sustained value creation.
C. Earnouts: Negotiating Contingencies for Real Value
Earnouts, by design, shift a portion of risk onto the seller by tying a portion of the
purchase price to future performance metrics. While this approach allows the buyer to
mitigate uncertainties, it also demands careful negotiation to ensure the seller’s efforts
are rewarded fairly.
The success of an earnout hinges on defining achievable performance hurdles.
Unrealistic targets risk rendering this component ineffective, leaving the seller without a
viable path to realizing its value. Clear, reasonable milestones ensure that the seller
remains motivated and the buyer benefits from aligned incentives.
Earnouts are typically tied to new business opportunities or unproven revenue streams,
making them the most straightforward component to value. The NPV of these new cash
flows provides a logical basis for allocation, reflecting their contingent nature.
When structured thoughtfully, earnouts foster a collaborative environment in which both
parties can thrive. This component exemplifies the delicate interplay of risk and reward
in M&A transactions.
III. Net Present Value Framework
At the core of this framework lies the use of net present value (NPV) to determine the
appropriate allocation of purchase price among cash up front, rollover equity, and
earnouts. The NPV approach enables negotiators to assess the economic value of each
component within the broader context of risk and return.
Unlike traditional methods that rely solely on historical adjusted EBITDA multiples, the
NPV framework incorporates forward-looking performance indicators and risk-adjusted
discount rates. This dynamic approach facilitates a nuanced understanding of the
business’s potential value.
The inclusion of discounted cash flow (DCF) methodology allows advisors to model
multiple scenarios, layering historical and projected performance into the valuation
process. By incorporating these elements, negotiators can achieve a more precise
allocation of value that reflects the true economic impact of each structural component.
This approach represents a paradigm shift from simplistic valuation methods to a more
sophisticated, flexible strategy. By grounding negotiations in the NPV framework, parties
can achieve outcomes that are not only equitable but transformative.
IV. Elevating M&A Excellence: Greenwood Capital Advisors
At Greenwood Capital Advisors, we deliver Wall Street-level expertise tailored to the
unique challenges of middle-market transactions. Our approach transcends traditional
methodologies, blending analytical precision with a client-centric philosophy to create
exceptional value.
Key Differentiators:
Comprehensive Risk-Return Analysis:
○ We balance cash up front, rollover equity, and earnouts to align with the
risk profiles of both buyers and sellers.
Forward-Thinking Valuations:
○ By incorporating synergies and future growth into projection models, we
unlock value that conventional methods often overlook.
Expertise in Rollover Equity:
○ Our team structures rollover equity to reflect shared incentives, ensuring
mutually beneficial outcomes.
Earnout Strategies That Work:
○ We design earnouts with achievable milestones, maximizing their value for
all parties.
At Greenwood Capital Advisors, we redefine value in middle-market M&A, crafting
strategies that balance risk and reward to achieve lasting success.
V. Applying the Framework
Refined Hypothetical
Company XYZ (“The Company”), a private widgets manufacturer, generates $100mm in
Revenue with Adjusted EBITDA of $25mm (for simplicity, let’s assume FCF and
adjusted EBITDA are the same). Based on recent comparable transactions, companies
like The Company trade at 5x Adjusted EBITDA. Historically, The Company has grown
at a CAGR of 7% and expects to maintain this trajectory over the next 5–7 years without
operational changes.
However, the owner identifies untapped demand that could be captured by expanding
production through a new line. Preparations are underway, with projections of an
additional $6.25mm in revenue by the end of year 2. This new revenue stream is
expected to grow at the same rate as the existing business.
The Company has gone to market and received an offer of $125mm, which the owner
intends to accept. The acquirer anticipates synergies, including a 5% enhancement to
historical growth and margin improvements of 5% by the end of year 1 and 10% in
subsequent years. Both parties agree on a Weighted Average Cost of Capital (WACC)
of 20%.
Solution: Allocating Cash, Rollover Equity, and Earnout
Step 1: Calculate Total Enterprise NPV
The Total Enterprise NPV is calculated as the sum of baseline cash flows, synergies,
and the NPV of new business (earnout):
– Baseline Cash Flows (Historical Growth): $115,654,619
– Incremental Synergies: $15,290,561
– Revenue Synergies: $4,593,155
– Cost Synergies: $10,697,406
– New Business (Earnout): $27,558,927
Total Enterprise NPV = 115,654,619 + 15,290,561 + 27,558,927=158,504,107
Step 2: Earnout Allocation
The earnout allocation is based on the proportion of the NPV of new business to the
Total Enterprise NPV:
Earnout Allocation = 17.4% × 125,000,000 = 21,733,606
Step 3: Remaining Purchase Price Allocation
The remaining purchase price, after deducting the earnout, is:
Remaining Purchase Price = 125,000,000 − 21,733,606 = 103,266,394
Split Based on Proportions:
● Baseline Cash Flows %: 88.3%
● Synergies %: 11.7%
Allocation to Cash and Rollover equity based on defined %:
Cash Up Front: 103,266,394 × 88.3%=91,176,935
Rollover Equity: 103,266,394 × 11.7% = 12,089,459
Final Results
● Cash Up Front: $91,176,935
● Rollover Equity: $12,089,459
● Earnout: $21,733,606
This refined hypothetical demonstrates how the purchase price can be apportioned
thoughtfully using a risk-return framework. By considering historical performance,
synergies, and future opportunities, the framework provides a balanced and robust
method for structuring private M&A transactions.
