Archive for the ‘My Business’ 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.

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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.
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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.

 

 

 

Bashing (capex) myths

November 20, 2008

Just got out of a client engagement in logistics vertical.  Had to bash up a lot of myths the founders were living with that brutally shaved off 20% of their Cap-Ex budget (pricked some vendor egos in the process!).  Now that I am 3 years into the business, there is lot less guilt after puncturing egos.  Gotten so much used to it now.  After all, reality often is daunting and folks recognize it eventually.  That’s where I get the guts to blog about it.  Future clients will know I mean business and nothing but business. I could share some of my observations here.

 

1. Value your capital – There’s bad news on liquidity. But it’s a fact. The world has 5 + billion of us now and there is not enough capital to go around.  Buy just what you need and stretch the buck. 

 

2. No spray paint, duct tape innovation – Use the recession to bring about low cost, radical innovation than the incremental ones.  When even the leaders in your industry screech to a halt, you’ve got to close in and catch up.  Be up to speed.  Learn how to drive straight with little gas.  Nobody has the luxury of losing way that yields a detour.

 

3. Don’t buy to build, just fill a gap – Look for functionality gaps in the products offered by the established big vendors (bulk cargo handlers here).  Make out a simple, straight forward solution at an affordable price that fixes 70% of the client problem, if not all of it.  In lean times, people stretch the buck and make do.  That’s the stuff the big vendors fear.  (It’s also likely that they will soon come around to buy you out!  So now you know what to build 🙂

 

4. Buy the core ecosystem – Remember this when you go shopping for solutions. Big vendors often standardize their product and buy customized applications from partner ecosystems and add it in.  Worse, they charge a premium for that hybrid. Recently a bird from Oracle tried to push her ERP cookie cutter Accounting and HR application to my client minus their core industry (logistics) application.  Being a capex item, I got called into the negotiations (I got them the series A and B investor!). Upon asking why would they not provide the core, the bird pointed to their partner ecosystem.  Now why would I buy the cookie cutter from her and then go integrate my core app with it, incurring further cost of system integration? I would rather do it other way round and ask the core system vendor to give us the bells and whistles. The bird said their customer list is so diverse that it is difficult to build separate vertical for such a disparate set.  I had a look at the cost, sat down with her to piece it out.  She knew she had lost us.

 

Life is a lot easy if you drill everything deep.  Never settle for what looks easy or what shows up first.  Badger everything and everybody down. The times are so bad and if they act up, just let go off them.  Be merciless.  When they recover their sanity, they’ll come back.  And if they don’t, you’ll soon be staring at their obituary (bankruptcy). 

 

[Just called the client up to check if everything works alright before signing off this post.  Amen, all’s well 😉 ]

 

Letting live

November 6, 2008

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In downturns, it is extraordinary how quickly people rediscover business virtues that appeared to have been forgotten in the good times. Today the cry is “preserve cash”. Cut unnecessary entertaining. End business class travel and five-star accommodation. Get out of the taxi and back on the bus.

The usual cycle of responses to a huge shock or upset – denial, anger, bargaining, depression and finally acceptance – is of limited use. Cut straight to acceptance, and then action. But what kind?

I suggest my clients to explore the realm of other possibilities than just twiddle and despair.  Commit to R&D seriously so that you have new products when sentiment reverses. With asset prices so low, it’s time to go shopping for acquisitions so long as there are significant synergies – as far as possible deal structures should facilitate cash neutral transactions (not necessarily stock swaps since it would mean diluting stakes at low valuations) with earnout milestones.  Of course, I use other aces up my sleeves like technology swaps for stake, project specific commitments, mezzanine arrangements etc. that involve deeper dives into subtle nuances of a transaction.

But I always advise them to remember the acquired virtues of austerity and carry them into better times for business as and when it comes.  But experience tells me they won’t.   

Why? That’s how they let people like me get a life 😉

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Reflections – At home, on Father’s Day

June 18, 2008

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Last nine months have been tough for global business and mine too suffered.  Deal velocity has significantly slowed down with the thawing market sentiment.  Family loves me because I spend more time at home now than ever.  We’ve had three week long outings already and I was home for my daughter to wish Father’s day for the first time – normally an event marked by a terse text message over mobile.  A rare event in my otherwise strung life.

 

Nonetheless, entrepreneurship is indeed challenging and that’s what I like about it most.  Not one boring moment.  You are either hard pressed for time doing deals or you are busy thinking up next best way to sell.  For me, it’s business services like Private Equity fundraising, Business due diligence and research based deal making.  I hate analyst reports if I don’t see a deal at the end. Deals give me the high. This is the only filter I apply when I look for business relationships and the reason why I have so few.  Those I chose to drop off have all been gruesome brainsuckers. They try to feel you up and get their convictions examined with no specific goal.  It’s ok if you think you’re smart; but it’s something else if you don’t realize that it’s entirely arguable.  In the inscrutable world of business, nothing goes unresearched; everything is questioned. 

 

One thing that has always baffled me is why certain people hate capitalism so much. Aren’t they missing something? Ever since I was young I knew that being an entrepreneur was the most fun you could have with your clothes on – it is the greatest adventure modern life has to offer. And if you’re lucky and astute, you might even get rich in the process. Why is that so terrible? Yet all too often capitalism is blamed for many of the ills of modern life, from global warming to poverty.

 

One of the wonderful things about markets is that they self-correct ruthlessly: companies that fail to serve the customer will be overwhelmed by rivals – and go bust – and see their assets reallocated. But governments move slowly, ideologues can be stubborn and damaging legislation can take years to rescind.  Most people focus on the risks of free enterprise and are scared to join the ranks of the self-made. Some have learned to play the system of government and institutions like a game, and enjoy power, pension and profit from their position in the state sector. Why should they encourage choice and competition when they have such a safe haven as a bureaucrat, trade union official, academic, etc?

Churchill understood this when he said: “The inherent vice of capitalism is the unequal sharing of the blessings. The inherent blessing of socialism is the equal sharing of misery.”

You’ve to ride the wave as it comes. Growth is secondary. In this sort of environment question is of survival. Businesses don’t go bust because they make losses. They go bust because they run out of cash.  So manage your resources better. Stay liquid. A slowdown in the economy and rising unemployment might just stimulate more to start their own business as an alternative.  This is the only way to beat a looming recession fueled by liquidity crunch and oil price propelled inflation.  Go create wealth and pay your taxes.  No magic mantras.

 

Entrepreneurs, welcome aboard !

May 8, 2008

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My PE / VC consulting business is coming off age.  I want to make a difference just like you.

 

My take on Indian I-banking industry can be found here, here and here.  If you think like me and have put in over a decade in the industry, you know what I mean.  The markets are a lot sober now and deals are harder to come by because owners think their businesses are undervalued.  Now is the time when well intentioned and innovative deal structures (not far removed from the realm of common sense) are to be put to work.  The excitement and the reward are ours, up for grabs.  

  

So, I am about to enter my next phase in business.  My boutique proprietary business advisory (PE/VC consulting) outfit is maturing into a full blown business model and I am about to hire the best in business.  The entrepreneurially inclined, battle hardened I-bankers and operational whiz kids that have resurrected many a badly mauled, terminally ill enterprise.  [Not for me the 0.001% fee based deal makingLeave those crumbs for the rats!] 

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Would you like some piece of action?  You think you’ve got what it takes?  Namaste. Welcome aboard! 

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Get a hang of it here. 

 

 

On my other blog

April 30, 2008

 Run your mouse over the links below and just click to read my other recent posts.

Not alone, not at all

Buying a shell calls for skill

Why investors don’t trash deals I drive

April 5, 2008

One reason why VC firms earnestly look at deals that I drive is not just their faith in my level of competence, scrupulousness and fussy due diligence initiatives; they come with “I-know-the-entrepreneur” stamp.  Ho-Hum, how does that matter?  Read this.

Some of my favorite principles in screening deals –

a.   Premium on experience – I avoid teams that has just youthful enthusiasm.  I would any day place a premium on experience.  A venture backed by a mature team that has deep domain skills and expertise is always, always better than a bunch of upstarts with hollow passion.  The youthful team may certainly have some `cool’ quotient about it, but I would settle for teams that have a higher chance of hitting big time.  Youth loses its cheer after first few setbacks that can’t be wished away; experience is more resilient. “It’s my investors’ money on the line; that’s as good as my own.”

b.   Fee Filter“Can’t afford $2500?  Don’t suck up.” That’s pretty much in-the-face, right?  I wouldn’t have it any other way. Teams that start up with scanty bootstrap will not survive to see beta, is what I think. No point in wasting precious time with teams that want `FREE’ consulting; “brainsuckers” as I call them.  So I quote my engagement fee upfront that gets rid of a lot of milk babies and some nags. Most beavers don’t ping back (and serious teams do sign up).  Seldom do they get far in their venture if they can’t engage a $2500 independent professional to scan their faint idea, vet up the opportunity, run viability checks, beef up with industry survey, forge out a sound business plan after several rounds of brainstorming and vouch for the team before connecting them with an investor that has a fair grip over the domain.  All of this costs money, pal. So, call me only when you’re ready.”

c.   Technology that sells – Most founders begin with a big fuss over their technology.  Scratch the surface and you’ll find that it is the 25th idea with the same theme.  I tell them openly it’s of no use unless their business model screams customers. Keep your tech to yourself; give the customer a sexy application that rids him of worries, costs and complexities. “Does your tech do something of the kind?  Then let’s get talking.”

d.   No investor bets on vaccum – Technology business is not loaded with physical assets to salvage sunk capital. No large swathes of land, building or fixed assets as in a standard manufacturing operation. The big bet is on the juicy idea and execution skills of the team.  If your project is meaty on these lines, you’re sure to get funded as well. I don’t mince words. I advise them to save up, start something small and then pitch for the next big thing.  Do yourself a favor; stick with that sucky job.”

e.  Track record – “How many deals have you closed?”  This question makes me smirk.  You don’t close startup deals with investors as fast as you do large Private Equity deals.  PE deals are closed faster because it is done with listed companies that have a track record. To that extent, the risk is limited. Investors get to control a real business. They can replace the sloppy CEO with the best-of-breed that can turn fortunes around. But startups are concept bets. They take time to mature, undergo cycles of refinement that makes the diligence process tighter and hence, tardier. I don’t let them pitch unless I am satisfied of their pitch worthiness. Then investors come up with their own set of observations that make them go back to the drawing board.  It’s an iterative process.  It’s gotta’ be, because in the end somebody is gonna’ put his money on the line.  “Remember, your parents refused to bet their farm!”

f.    People traits – I co-habit with the founding team for quite a while when I prepare them for the pitch.  It helps me in getting to know them personally upclose.  That awareness is essential since it yields early clues into their lifestyles, habits and attitudes which are equally important to an investor as are their domain strengths.  “Can I trust this team with my capital?  I realize it would’ve been yielding fair returns elsewhere and I’d better give them a good reason to take it out and invest in a startup. If you move closely with the team and influenze them positively as much as I do, you most likely will get the answer – “Trust them with the best you’ve got.

So now you know why investors don’t trash the deals I drive; why fewer deals qualify!

 

 

In control of my destiny

March 26, 2008

Old chums meet is a lot fun.  I look forward to it especially after delivering up on weary assignments.  Last weekend I met up with a couple friends from college days and we had a go at a nearby watering hole.  We caught up on a lot of things but given our age and times, it centered mostly on our careers and life in general.

They all envy me. No office policy enslaves me, no boss to rankle me.  I decide what to do, how to do, every day.  I am at liberty to pick and choose my clients.  I operate singly and have a home office for added comfort. No long and tiring daily city travel.  A very lucky man – as they see it!

While I have some of those liberties, my hassles are more from a business angle.

Lack of institutional steam:  Clients want big names. They are not ready to suspend their disbelief that individuals are capable of driving PE deals.  My first 15 minutes are invariably spent on convincing them that even in big firms, they operate as silos.  PE firms have no problem.  In fact they are kinder because I am available 24x7x365 as opposed to big firm executives that stick to workdays.  I now even get tipped by them on deal prospects over after dinner chats.  But I lose deals as well for this apparent old fashioned one-on-one work model, that some see as lacking in glamour.

Knowledge is a curse: Before approaching any client, I do a complete top-down and bottom-up research of its business and its industry.  Then I compare with global and local peers, last few transactions done by others, inter-firm comparison, cyclical nature of industry and apprise myself of its prospects in the short, medium and long term. This knowledge often is a baggage. I give presentations of case studies why a client should do a deal only after he goes a few notches up over competition that could be easily achieved with some minor tweaks to his operations. Clients are desperate sometimes to get into a transaction that is clearly against their interests.  Wary investors seize this moment and offer pittance seeing the client’s level of desperation. A couple weeks later, I get enquiry from another investor for that price I had indicated earlier but the deal is no longer there. The client had sold out in a hurry.

Dilution issues: In India, majority holdings in most enterprises are held by one or two families, sometimes over generations. It takes a lot of convincing to explain that it makes sense to cede control if it entails holding 40% stake in a Rs.100 crore ($25 MM) Company than holding 100% stake in a Rs.25 crore ($6 MM) business that took  generations to build.  Believe me, I’ve lost a lot of deals on this count alone.  Sometimes I get excited seeing their successors returning to business with advanced B-school degrees from Wharton or Harvard.  But after a couple years, they go the elders’ way instead of turning the elders around.

Valuation mismatch: “Big firms can fetch us better valuations”, clients say. I tell them “go try”. I follow up after a couple weeks, status quo. I pay another visit with hopes of getting “defogged” signal after illusions get dispelled. Some do come around.  Others settle for big firms for the same or lower valuation than I had indicated, grudgingly bearing a 4x fees than what I had quoted.

Does it read like a sales pitch?  So be it.  Who can stop me?! 🙂

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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.

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The subtle shift in Private Equity

February 28, 2008

So I notice this subtle shift happening in the PE industry.

As more and more funds enter the Indian market, it gets tougher and tougher to find “diamonds in the rough.”  Coupled with rapidly deteriorating global cues, PE funds are cagey about signing deals and don’t hesitate to pull out, a practice that was once considered sacrilege. Already we’ve noticed even the frontliners reneging on commitments.  But this can’t go on; a solution has to be found. What could be that?

I suggest looking at the problem from a different angle.  Before the next opportunity shock springs up, make a new beginning by avoiding some pitfalls.

a) Stop competing with other funds:  Control investment ego. In terms of exit and capital return (to LP investors) decisions, the funds that faced tough competition while making their investments take longer to mature.  Often funds under pressure to invest make more marginal investments that take longer to liquidate.

b) Raise funds when markets lag:  The corollary is never raise funds during a boom era.  This reduces the psychological pressure of having to invest while valuations are stretched. Most real estate and infrastructure funds face this problem. In the end, investors will supply capital to PE funds until their risk adjusted expected returns equal the opportunity cost of capital. So scan the worth of other opportunities available to the investor.

c) Commitment v.drawdown – Research has shown that most funds can draw only about 16%, 20%, 20% of the committed capital during the first 3 years before they slow down, why then accept large commitments upfront? By the end of its cycle, it is seen that even some of the best soak up only about 93% of committed capital on an average. Not all LP investors would see this as prudence, they recognize it as inept judgment if not gawky fund management.

d) Develop strategic skills fast: Learn on the run – from every roadshow, every investment and every exit. PE fund managers (arguably though) are expected to possess unique venture skills that are not duplicated overnight.  The skills in question include screening investments and monitoring managements. Steven Cohen, Carl Icahn, John Doerr, Michael Moritz, Stephen Schwarzman, Steve Bondermann all keep a hawk eye over their portfolio companies.  It’s worse than a public company undergoing SEC or SOX watch, yet for all the right reasons. The message is clear – never dither on shareholder commitments. Ed Zander of Motorola learnt it the hard way.

e) Dump that slack – Returns are rewards. They don’t come without extracting sweat. Fund managers give scant respect to reports from portfolio companies and read them only on the eve of a board meeting. While they arm themselves with questions, they have little to offer by way of solutions. They develop this distinct `slack’ post investment and pick it up only a few years down the line, when it’s time to return capital. By then, even Viagra can’t get it up for you!

Act while you can. Develop innovative deal scouting skills.  Go do some propreitary research. Have your skin in the game.  Trust me. I talk from experience.

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