Valuation – Valuation – Deal Deal Making This is only a summary. summary. Please read the text book and assigned readings for details. Removal Rem oval of errors and omissions, o missions, if any, any, in this ppt are your responsibility.
Deal Making In most mergers there is an exchange of CF – what price, when, how much, sharing of risk etc. - It is a deal A deal distributes CF among the parties participating in the transaction and depends on the each parties appraisal of value and negotiation power All parties have to believe that the deal makes them better off The difference in value assessment comes in • CF are uncertain and difficult to estimate • Impact to each party could be different due to wealth, tax considerations, portfolio composition etc. • Information asymmetry – including not sharing pertinent information to influence the size and risk sharing
Deal Making Even with very different estimate of future CF the deal takes place, often with contingent contracts based on future measurable outcomes It can be a form of risk shifting Valuation of contingent deals needs a background in option valuation
Deal Making Consider the following example Delmarva of DE and Atlantic Energy of NJ (a regulated utility) announced their agreement to merge into a new holding co. in 1996 - Conectiv Term of the agreement: 1. D shareholders would receive one share of common stock in the new holding company for each D share they own 2. AE shareholders would receive 0.75 share of the holding company for each AE share they own plus 3. 0.125 shares in class A stock for each share they held of AE (called tracking stocks)
Deal Making The merger did not share CF proportionally • All merged shareholders were to benefit from the earnings of D, the first 40m of AE and the 70% remaining above the 40m • Only the original AE shareholders got the 30% of earnings of AE in excess of 40m Such a deal helped resolved the difference of opinion regarding future performance
Deal Making • D did not value AE as highly as it doubted AE’s ability to maintain profits as NJ planned to deregulate power supply • AE had ‘stranded costs’ based on above-market contracts that it had entered into prior to deregulation • A simple swap of common shares would have necessitated paying AE shareholders more than 0.75 of the holding company • D gave up 30% of AE’s upside potential but in return gave up fewer shares • AE believed in their performance and were able to get a larger chunk of their upside potential but also the risk
Deal Making Non proportional sharing of CF has some advantages • It screens out sellers who do not believe in their own information • It provides a strong incentive for the seller to achieve the upside especially when thy remain involved in the operations of the target The class A shares a type of call option with a strike price of 40m – needs appropriate valuation methodology
Deal Making Earnout – A portion of the purchase price is to be paid in the future contingent on the realization of the target’s future earnings. Overcomes valuation differences and motivates performance Shifts some of the risk of under performance to the seller Earnouts possible advantages: • • • • •
Closes the bid and ask gap Protect the buyer from surprises Screens out mis-representation from sellers Provides incentives to the seller who may stay on as manager Reduces the buyer’s upfront financial commitment
Deal Making Designing an earnout agreement is not easy - it should be a function of observable and measurable metrics Difficulties in implementing earnouts are often due to • No clear definition of earnings, cost, what is included and not included • What accounting standards to apply • Issues in integrating the two businesses, esp. when the seller’s success depends on the buyers actions • Lack of mgmt. commitment to ensure timelines and thus outcomes • The buyer faces sudden financial difficulties and cannot honor the earnout
Despite difficulties in implementation earnouts have
Numerical 8 Consider the acquisition of the Power Track, a privately owned manufacturer of aerobic and body building machines. By R-II Inc. At closing on December 31, 2007, Conrad Owens, owner of Power Track would receive the following consideration from R-II Inc. a) A cash payment of $3million (b) An 8% annual coupon 4 year subordinated note issued by R-II for $5 million principal payable in four annual installments of $1,650, $1,550, $1,450 and $1,350 in the following four years (c) A contingent payment to take effect at the end of 4 th year equal to 1* EBITDA R-II would assume Power Track’s net debt of $6.2 million. Under the terms proposed by R-II, Power Track would become a wholly owned subsidiary of the R-II, and Mr. Owens would stay as it manager with a 4- year contract and competitive compensation. At the end of the 4 th
Numerical 8 In addition, the following information is available • The current Revenues and EBITDA margin of Power Track are $ 98,680 and 4.05% respectively • R-II’ outstanding subordinated notes are priced to yield 9% • R-II’S corporate tax rate is 40% • Mr. Owens is confident that under his management and with the support of R-II, Power Track’s EBITDA would grow at 20% per year during the following 4 years from its current level. The projected revenues, EBITDA margins and relevant information over the 4 years of the earnout is shown • The WACC of companies similar to Power Track is around 12% • The earnout payment is made with after tax dollar
• Estimate the cost of the offer to R-II • What is the trailing EBITDA multiple at the time of
Numerical 9 As the investment banker of TUV-TUV systems, you are working on TUV-TUV’s purchase of Balkan Audio from the sole owner Mr. Jones. After several meetings with Mr. Jones, you have arrived at the following preliminary purchase terms: Mr. Jones would receive from TUV-TUV • A cash payment of $8 million at closing. • A 10-year $40,000 annuity. • A lump-sum payment at the end of the 3 rd year equal to a multiple of 3rd year EBITDA. This multiple is still subject to negotiation. Balkan Audio would become a subsidiary of TUV-TUV with Mr.
Numerical 9 Additionally, you have the following information: • TUV-TUV would assume Balkan’s net debt of $15 million • TUV-TUV has expressed willingness to pay for Balkan’s equity nine times EBITDA of $4 million minus assumed net debt • TUV-TUV’s outstanding debt is priced to yield 9% and its tax rate is 40% • The WACC of companies similar to Balkan is about 13% • Balkan’s EBITDA is expected to increase at 20% per year during the following 3 years, and its fixed cost are small At this point, you are adding the final touches to the earnout agreement rd
Deal Making Stage financing • Investment in stages to help overcome the uncertainty • Over time one is able to get a better idea of what is going on and then invest accordingly • This is also an option - option to expand, wait, abandon, change product mix etc.
Numerical 10 Consider the financing of hotmail – an example of stage financing • The pre financing valuation of the firm was $1,685,000 with 10,490,272 shares outstanding • The VC agreed to provide $315,000 for a 15.75% stake in stage I of the financing • In stage II financing a year from today, the VC offered to provide $1.5m financing for a 33.33% stake • The founders accepted the stage I financing but negotiated the stage II wherein they agreed to $750,000 financing for a 10.53% stake Compute the per share valuation under stage I and both cases of stage II financing
Numerical 11 Consider a start up requiring $1,000 initial funding and a VC who expects to attain 40% return. Further more the VC estimates that the venture would yield low CF with probability p = 0.75 and high CF with probability 0.25. The three year projection is as shown Year 0 Cash flow (1000) p = 0.75 1 - p = 0.25 Expected cash flow (1000)
1
2
3
0 0
0 0
900 10,000 3,175
The VC is given a deal where he has the fixed payment of $1000 plus a certain number of options that can be of converted to common equity with a strike price of 1000 Discuss proportional and non-proportional risk sharing
Thank you!
