Valuation Deal Making

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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
The terms can create incentives and disincentives that affect the
future actions and possibly CF
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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)
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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 AEs 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 AEs 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
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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
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Deal Making
Earnout A portion of the purchase price is to be
paid in the future contingent on the realization of the
targets 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 buyers upfront financial commitment
Useful in valuing pvt. firms for acquisition - information sharing and
due diligence is critical

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 sellers
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

been increasing
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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 4th year equal to
1* EBITDA

R-II would assume Power Tracks 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 4th
year, Owens would receive the contingent payment and retire
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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-IIS corporate tax rate is 40%
Mr. Owens is confident that under his management and with the
support of R-II, Power Tracks 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
the sale
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Numerical 9
As the investment banker of TUV-TUV systems, you are
working on TUV-TUVs 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 3rd 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.
Jones staying as its president with a competitive salary for 3
years, at the end of which he would retire

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Numerical 9
Additionally, you have the following information:
TUV-TUV would assume Balkans net debt of $15 million
TUV-TUV has expressed willingness to pay for Balkans equity
nine times EBITDA of $4 million minus assumed net debt
TUV-TUVs outstanding debt is priced to yield 9% and its tax
rate is 40%
The WACC of companies similar to Balkan is about 13%
Balkans 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
How high a multiple of 3rd-year EBITDA would be acceptable to
TUV-TUV?
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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.

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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

Conceptually explain what could be happening

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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)

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
scenarios
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Thank you!

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