Here is an excerpt from Shareholder Representative Services’ new 3rd Edition of “Tales from the M&A Trenches“:

Many shareholders think that when you sell a company, each security holder simply gets their percentage of the proceeds. In reality, however, the formulas are often much more complicated and mistakes are frequently made. SRS 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. A friend of ours who is 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 in connection with M&A transactions. He said the errors or adjustments amounted to millions of dollars that would have been misallocated. In SRS’ experience, we find that upwards of a third of the spreadsheets we receive 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 we see 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. We have 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 one can see how determining who should receive payouts from the escrow is more complex. You can also see how this answer 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?

We have 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 deal and whether it 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.