Archive for the ‘M&A’ Category

Valuation during recession

January 14, 2009

 What characterizes a recession? When exacerbated by liquidity crunch and credit crisis, the R word becomes an obsessive national metric, that is two consecutive quarters of negative GDP growth.  We are now staring at one clearly.


In these times, the normal methods of valuation of businesses don’t fit.  Net Asset Value, Sum of Parts, Discounted cashflows, multiples of future revenues – nothing seems acceptable.  That is because business growth depends on resurgence of demand that depends on restoration of economic normalcy that still eludes the horizon.  It is a chain reaction that covers economic well being of your stakeholders one and all.  If your suppliers are well off, they extend good credit terms.  If your customers are doing well, they’ll place large orders and if you are doing well, you’ll get to hire the best in business by paying the top dollar.  But that wholesomeness is what is lacking today and nobody knows when it will get back to normal.  So, you don’t believe projections of target companies in your radar because things are so fluid.


Then why buy in murkier times ?


But then, that’s exactly when assets come cheap and you can bargain hard. With a bit of fine combing, the obscurity can be turned into an enormous opportunity.  Push for a calibrated mechanism where you don’t close valuation in one go, rather you let the target run its business and prove its projections at appropriate timelines.  (In good times, no seller will agree for stretching out deals; it’s often take it or leave it). This is known as `earn-out’ method – a deal financing mechanism where the buyer agrees to make future payments to the seller if certain agreed-upon financial or operating targets are reached after closing. The future payments are usually in addition to amounts paid at closing and can be in the form of cash, stock or bonds or some combination thereof. The performance targets are typically based on the future earnings or sales of the target in the one to five years after the deal.

Earnouts have been widely employed in a variety of industries and can be critical to getting a deal done when the parties’ views on the value of the target business are too divergent to agree on a price up front.


For example, that target company you’ve been eyeballing may be a privately-held start up with a patent portfolio that has promising, yet unproven, commercialization potential. The company’s founder may be more optimistic about its prospects than you but wants to sell today, perhaps because the company needs access to more capital to fund growth. He thinks the company is worth about $100 million. Nonetheless, while you’re intrigued by the company’s technology, you’re not convinced it will achieve broad enough market acceptance to yield a satisfactory return at the seller’s valuation. You would say a more realistic valuation is in the $75 million range.

So you compromise. You agree to an up-front cash payment of $50 million with as much as $50 million more if the target’s performance is consistent with the seller’s projections for the next three years. You call your lawyers and tell them to start working out the details.


The risks and metrics

But that, as the saying goes, is just where the devil is lurking. Failure to get the details right can transform your deal from accretive to ruinous. Post-closing disputes over earnouts are common, with disputes generally center around whether the performance target calculation was done properly and whether each party complied with any covenants that could have impacted the achievement of targets.

Consider what metric you’ll use for performance targets. You have a broad set of options, including revenues, sales (gross or net), gross profit, operating income (EBIT), operating cash flow (EBITDA), net income or the occurrence of specific contingencies, such as receipt of favorable regulatory approvals. The farther down the in-come statement the line items included in the earnout formula appear, the more susceptible the results are to accounting judgments and possible manipulation. On the other hand, the farther down the income statement you go, the better the line items reflect the actual financial benefit to the buyer of the acquired business.

The middle of the road

Limiting the parties’ ability to manipulate future financial results while enabling them to rely on performance measures that reflect real value to the buyer requires agreeing to detailed, well-defined formulas. So, to reduce the risk of earnout disputes, accounting methodologies should be consistent with those historically used by the seller, and, if practicable, audited financial statements should be used. The treatment of certain items should also be specified in the earnout formula, which may include one or more of the following:

a)  amortization of the goodwill resulting from the transaction;

b) the amount of overhead (i.e., accounting, legal, public relations, advertising and other shared expenses) charged to the acquired company;

c) R&D expenses;

d) Interest on the buyer’s capital contributions to the target;

e) capital gains;

f) capitalization of expenses;

g) affiliate transactions;

h) staff costs;

i) fixed asset depreciation;

j) income or charges from extraordinary or non-recurring items;


k) income derived from newly acquired operations financed by the buyer.


In addition, the earnout formula should address the treatment of contingencies, which could include a force majeure event, the buyer’s decision to sell the business before expiration of the earnout period, the target company’s failure to receive anticipated regulatory approvals, the departure of key personnel and so on.


Grey areas and complexities

Agreeing on the formula for calculating performance targets, however, mitigates only some of the risks inherent in using earnouts. Because the ultimate price payable through an earnout depends on future performance, the parties must enter into the transaction knowing how the business will be operated going forward.


Ordinarily, buyers manage the business post-closing, but sellers will expect the business to be operated in the ordinary course consistent with past practice or otherwise be compensated for losses attributed to deviations. Sellers may also request approval rights or other involvement in major business decisions, such as expansion plans, hiring or firing key personnel, capitalization, dividend policy or combining the business with other businesses. Although buyers will of course resist perceived encroachments on their ability to manage acquired companies, it is pru-dent to agree upon reasonable, objective parameters for operations during the earnout period to avoid grounds for later disputes.
These and other complexities associated with earnouts must be managed carefully and with due regard for their susceptibility to dispute. Learning to do so can make the earnout a useful tool in your implementation of successful M&A transactions in uncertain times.  
PS – This article does not constitute legal advice. If further explanation of the subject matter is required, please contact the author.





Industry expectation from I-Bankers

March 17, 2008

IDC, the global IT industry tracker brings out some insights on what the industry expects from IT vendors.  The top 3 expectations are (a) very competitive pricing (2) support for industry standards (3) industry/vertical knowledge. 

I wish there were some trackers for India’s half baked business advisory firms that masquerade as investment bankers.  So I imagine what business would expect from such crass performers.  Here’s my wish list.

Ok, stuffed suits, hear me out. Be something more than just –

a) EPS calculators and BS aggregators [BS – I mean `balance sheet’ here; not the popular expansion though it fits better contextually 🙂 ] ;

b)  template runners; Dump that smug one-size-fits-all assumption.  Don’t take the mandate if you are not sure how to go about the transaction.  Don’t screw up.

c)  pushers of outrageous merger proposals; we know your slogan is “anything so long as it earns us fees”.

d) crass creators of PowerPoint slides throwing back at us not much more than what we had discussed with you;  we know you are too dumb to learn about our business.  We just use you to run some errands for us. Can’t you do that bit nicely, mate…?

e)   compliance service providers; we know how to file forms with regulators.

f)  pretenders of industry knowledge; do some research and bring back some useful insights adding value to our business.

g) fawning client-pleasers ; No we don’t want you to grovel. Make sure the transaction is not just earnings accretive, it should result in customer delight as well.

The points (a)-(f) is general industry perception (including PE fund managers) about quality of I-Bankers and their deteriorating service levels while (g) above is an insider perception from fellow I-Bankers. I’d discussed about this to some champion advisors.  They all had agreed it’s a valid point yet they have no choice in this dog eat dog world.  When I checked last, each of their last transaction had destroyed phenomenal value for both shareholders and customers.  I have blogged about other potential value destroying FCCB transactions here in detail.


Inadvertence is sin

February 20, 2008

During my career spanning over a couple decades, I’ve come across several carelessly drafted legal documents. It takes painfully close combing and sanitizing to weed out the malcontent and a pair of wide open eyes to build in seemingly innocuous omissions before presenting a clean set of documents for clients to sign on.  Often on my way back home after such clean up efforts, I meditate over its outcome had the slip up gone undetected.  But then it takes a callous client to sign a document before it’s sufficiently vetted.

Here we have one such outcome. SET India, (of which SONY Japan is a 61% majority holder) which operates channels like Sony, MAX, SAB TV and AXN, recently asked its minority shareholders (32%) to infuse fresh equity of $40 million (Rs 156 crore), which they turned down. Now they are considering suing SET India terming the capital call illegal. The capital is to finance SET’s commitments to the upcoming Indian Premier League tournament, for which the company has won the broadcasting rights with another agency. 

I say this is the silliest of omissions on the part of minority shareholders. Silly because, they got into bed with a monster not expecting to get screwed.  This is normally the route taken by majority shareholders to buyout minority holders on the cheap. This is precisely why in most JV agreements, you’ll find a clause that mandates unanimous shareholder approval BEFORE critical decisions are taken on proposals for major new investments. There will also be mitigating covenants like “all dissenting shareholder(s) be protected by a call/put option at pre-agreed premia or should be exempted from participating in the fresh round [with] or [without] anti-dilution guarantee or that a new class of shares be issued to raise fresh funds without altering the rights/status of dissenters”. 

In this agreement between SET India and its minority shareholders, I suspect inadvertence. They will go thro legal hell.  Deservedly.


Brushing up on Economics

July 12, 2007

Two major airline deals (Jet-Sahara, Kingfisher-AirDeccan) have since been closed and India’s analyst clan (a *know-all* breed that feigns mastery over every business) weren’t reacting as they normally would. I checked and confirmed – No, they don’t recognize modesty as a virtue just yet ….

Here they come – Jet, Deccan shares may soar on oligopoly.

Ah…Oligopoly…reminds me of Economics – a super bore.  I’ve never been a fan of its theories except oneconsumer surplus”.

That said, consolidation in any industry is bad for the consumer. Wish there were some sort of a permanent anarchy 🙂  I fear the large players will quickly concur to drive fares up and slap it on passengers who have fewer choices now. I grudgingly recall a couple of its theories as possibilities – one of perfect competition between sellers in an industry that’s getting fiercely organized and another of dead weight loss, fear of which could force cheapskates like me running an ROI check on each trip ahead…