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October 29, 2006Sorry Sir; but your baby is ugly!
Nobody wants to hear that their baby is ugly and as the father of a three year old, you just might lose your front teeth. My little girl has the sweetest smile, the cutest nose, and quite frankly is a princess; she has the tiara to prove it. However, it is quite possible that no one has a vested interest in telling me any differently. You see, I am hoping, but not counting on, my daughter to graduate from the best ivy league school, marry an honest man, growing up to be the President, and what the heck, change the world. But that's what I am hoping for. It doesn't have to happen. In fact, all I really want is that she be happy. For right now though, no one needs to tell me that it ain't gonna happen.
A parallel occurs every day in the business world. Unfortunately, the truth sometimes has to be told. You see, as an independent, third party valuation firm, we often have to sit down with the management team, or founder of a company and say. "Sir, I am sorry, but your baby is ugly!" (Sometimes really ugly). Read another way, "your business model does not make any sense" or "you are three years behind the competition" or even "your projections don't account for required working capital to finance future growth". Unfortunately, as a third party, we have a vested interest (or even a requirement) in 'being straight' with the many companies we value. And sometimes, I fear I am going to lose my front teeth, no matter how hard I try to soften the message.
For many early stage companies, you can expect this straight talk from few third parties. It won't come from your attorney; it simply is not his or her role. Not your accountant, they tend to look backwards at what happened versus where you are headed. Your friends and family? They actually probably gave you money at some point and are hoping that it wasn't a gift. Consultants are actually in just the opposite position. Once hired, they have a vested interest in finding something or 'anything' to justify their fee. Probably the only third party that will give you the straight talk is 1) your investors and 2) your valuation firm. Your investors want you to get it right. If it already is right, there's little to say other than 'keep up the good work.' If you are an early stage company though, these hard conversations are likely to occur and it's best just to take it all in, but don't take it personal. Brad Feld of Mobius recently wrote in his blog that many times people get angry with him and after years of experience, he simply becomes amused. It isn't personal, it's business and quite frankly, without being frank, your business could continue down the wrong path and in the not too distant future you will be on to the next idea.
A third party valuation professional has to discern between realistic projections and someone's late night creativity with an Excel spreadsheet. They need to know that when you say you have an advantage over the competition, that they can see it, and possibly even measure it. I don't care what anybody tells me, if you have negative gross margins, you can't make money by selling more. Just close the doors! If your revenue has grown by 5% for the last three years, there better be a damn good reason it is going to grow by 20% next year. Or if your distribution model depends on "some guy" you're just not operating with a solid business model. And somebody needs to tell you that. If you are planning on an IPO in the next year, hit the refresh button. There are very few companies going public today. The IPO process used to take about 3 months, today, expect at least 6 months for the S-1 process and probably more if you have made considerable stock option grants in recent years. As a result, most VC groups (i.e. your board members) are targeting a strategic sale. So make nice with your current competition, they may be your business partners one day.
For those of you who do not yet have outside investors, consider this observation. I recently attended a conference and one of the keynote speakers pointed out, "if you are trying to raise money and you haven't been able to; in this cash rich environment, you may want to consider a new business idea." That is to say, if your idea works, investors will want in. There isn't much selling to do. But, if you can't raise the capital, well, I am sorry sir, but your baby is ugly. Now, please don't punch me in the mouth.
October 28, 2006The Psychology of Buyers and Sellers
As we all watch the weakness of the housing market, it's fascinating to
consider the psychology of both buyers and sellers. In fact the lead story
in yesterday's USA Today told of how home buyers were quickly dropping their
prices in San Diego and losing faith in their ability to sell. Obviously
some homeowners have an immediate need for liquidity and may be forced to
drop their home price sharply to stimulate demand. Others are willing to
ride the wave, whether it continues to fall or quite possibly rebounds.
Buyers, as we all know, are not interested in purchasing depreciating assets,
therefore they are willing to wait out the declines and purchase at very
favorable prices (unless they too are under compulsion). The same psychology
applies to buying companies, and especially buying non-controlling interests
in companies. Poor performance and in particular, losses lead to steeper
discounts, as buyers sit on the sidelines and wait. Sellers then struggle
with a declining stock price and question how low they will have to go.
Buyers often sense weakness and may very well sit on the sidelines and wait
for the real estate agent to get fired. These trends are how steep
irrational declines happen in all markets.
October 26, 2006Selling to a Private Equity Group
Today I attended the Faegre & Benson Private Equity & M&A conference in
Minneapolis. Yes, the weather is better here than in Denver. The first
session was a panel discussion moderated by Bruce Engler from Faegre &
Benson featuring James Andersen, IWCO Direct, Gary Obermiller, Goldner Hawn,
and Craig Petermeier, Jacobson Companies. The first question posed to the
panel was "What were the lessons learned from selling to a private equity
firm?". Here are some of the highlights:
1) Time - the process always takes longer than you expect - five months plus
to close the deal;
2) Don't miss your numbers while in the sales process - as CEO your time
will be monopolized during the process and your management team must meet
your projections without you (especially EBITDA);
3) It is easy to underestimate the role of banks in the LBO process - bank
debt will often play an important role in the transaction;
4) Selling an ESOP company can be very complicated and in some instances
worse than an IPO;
5) Investment banker selection is critical;
6) Alleviating the fears of the employees can be difficult - when and how
you communicate why all these people keep showing up in rental cars is very
important (see #2);
7) Board meetings are no longer held over a Budweiser;
8) Accounting requirements and staff will increase dramatically along with
reporting requirements; and
9) A strong private equity firm will really help you identify new
acquisition targets.
The panel was then asked "What was the downside of selling to a private
equity firm?". The group had two minor complaints, the first being that it
was exhausting and time consuming to continuously explain the business model
and the second being that often board meetings were too theoretical. Times
are definitely good!
October 25, 2006Fair Value of Contingent Liabilities
One aspect of the trend towards fair value accounting is a requirement for companies to record the fair value of contingent liabilities, such as lawsuits, on their balance sheets. This used to be a footnote disclosure, unless the contingent liability met two criteria: 1) It is probable that the liability has been incurred (in practice meaning > 50%) and 2) the amount of loss can be reasonably measured. The new approach will require a probability weighted calculation of the expected value of the loss. As an example, if a company has a lawsuit against it, and there is a 75% chance it will prevail (i.e., no liability) and 25% chance it will lose $40 million, the company would have to book a $10 million liability. However, after the lawsuit is over, and assuming that the company prevailed, it would actually recognize income of $10 million (because the liability would go away). This may give companies an incentive to over estimate the value of the liability, especially in the case where the contingency gets on the company's books due to an acquisition, with the expectation that they will be less likely to recognize a loss down the road, and possibly realize a large gain on their income statement for doing nothing!
October 25, 2006A "Bubble" of Cash Flow Positive Companies?
Given the pace over the last 18 months of "merger mania", we are all looking
for signs of the 'bubble'. DOW at 12k+ anyone? It hasn't shown up in the public markets, yet is
it simply a wolf in sheep's clothing? We all look at the public markets and
say that the craziness has definitely not returned to the NASDAQ, the public
markets remain basically closed and year over year equity returns are within
a reasonable range. However, I tend to wonder if the 'bubble' of today's
market is simply a 'bubble' of cash flow positive companies - brick and mortar
companies with consistent revenue growth. The very companies that everyone
has been chasing since the crash in 2000. The tech bubble was driven by
strategic acquirers and everyone could watch the craziness in the stock
market. Today's bubble may well be a silent killer, less visible as the
acquirers are not publicly held entities but rather financial buyers chasing
returns and putting capital to work. If the roles were reversed would we all
be buying puts?
October 24, 2006Isn't It Ironic?
While private equity continues on a record pace and dollars are pouring into
investments, we all begin to ask ourselves if there may well be a "new
paradigm". Is it time to rewrite the classic asset allocation guidelines -
cat and dog living together? The proof may well be in whether private equity
groups move towards a classic exit or hold on to more of the companies that
they recently purchased for longer. Ultimately, the homerun return for most
private equity groups is either an IPO or sale to a strategic acquirer. The
very exit scenarios that today can't compete with the pricing power of
today's private equity community.
October 20, 2006Fair Value Measurements - SFAS 157
Last month the FASB released its final take on fair value measurements (SFAS
157), which will take effect in 2007. However, the landscape of fair value
measurements has already begun to change and evolve in accordance with the
statement. Here are a few thoughts to consider:
- 157 will in effect be issued as an exposure draft for IASB, as the two
bodies are moving to convergence. Convergence is happening in the accounting
world as the FASB continues to push principles-based accounting, which we
hope in the end means that defensible positions rule the day rather than, "this is the
process that you have to follow."
- The statement defines fair value as "the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date". The important
takeaways to remember are that orderly transaction does not mean a forced
liquidation or a distressed sale, value should be considered from the eyes
of a market participant and we can't use entity specific assumptions.
- Value is defined within a highest and best use framework meaning that we
again must consider the use of the asset from the perspective of market
participants even if the acquirer has different plans (yes this gets
tricky).
- The valuation hierarchy is clearly laid out in the statement, which
prioritizes the inputs. As always, highest priority is given to active
markets (e.g. stock price) and the lowest priority is given to unobservable
inputs (e.g. discounted cash flows). Unobservable inputs are basically
management projections, which we all know can be difficult to validate.
While 157 gives us some new insight, the valuation world has been digesting
the new directives formalized in the statement for the past couple of years.
October 13, 2006The Downside of Pushing Back IRC 409A Compliance
Just what the market needs is a little time to sort out unclear rules and to
speculate on which ones might stick. Pushing back compliance of 409A helps
from a tax standpoint on an issue that is quite frankly not much of a tax
issue. While the "potential" tax exposure is "clear as mud" according to the
proposed regulations, the larger issues appear on the audit and transaction
side for companies with significant option plans. On the audit side, key
inputs to calculating the option expense on the income statement under SFAS
123R are the price at which the option is granted and the current strike
price of the stock, both obviously are outputs of the original and current
409A valuations. On the transaction side, the issue remains foggy from a tax
exposure side for both the SEC and a potential acquirer. Pushing back
compliance, I believe actually works against private companies considering a
near term exit. Uncertain rules lead to higher exposure and attention during
the S-1 process from both an accounting and potential tax liability
standpoint, as has been evidenced by the SEC's attention to option pricing
this past year. From an M&A perspective, a poorly priced option plan with
uncertain rules tilts the scale of power to the buyer and may cause sellers
to indemnify an uncertain outcome, which could result in uncertain exposure.
In the end, par for the course as practicality and IRS regulations appear to
be oil and water.
October 13, 2006Adverse Market Conditions with the DOW nearly at 12,000?
The IPO market remains tough despite the Dow flirting with 12,000. This week or early next might well be the day that we look back upon as the day that we broke the 12,000 barrier with the Dow. Ironically, yesterday three IPOs were pulled from the market citing "adverse market conditions." Its interesting how we are setting new peaks on the Dow without the classic fuel of new IPOs. According to the WSJ, so far in 2006 51 deals have been "yanked or delayed" compared to 45 last year. Simply making an S-1 filing as an emerging private company is only part of the battle as the markets continue to be difficult for an IPO exit.
October 06, 2006Private Equity - Enough Good Deals Out There?
Private equity is on pace to exceed its all-time annual capital raise by 30% in 2006 reaching approximately $225 billion (Wall Street Journal October 6, 2006). The word is out and the number of funds chasing deals is unbelievable. In fact, after attending the ACG conferences in Seattle and Los Angeles this year, the numbers are quite staggering. There were over 50 funds in Seattle (less than 10 were local) trying to meet intermediaries and chase a handful of deals in the Pacific Northwest. The LA conference had over 150 private equity groups. While the majority of private equity groups are able to clearly differentiate their investment philosophy based on track record, industry focus, and/or deal structure, some seem like 'the cobbler's children'. Its interesting how they clearly understand that the clients that they invest in have a true competitive advantage in the market place, unqiue positioning and a strong management team, yet their own shoes have holes.
October 02, 2006High Stakes for Harrah's
The private equity market's appetite seems insatiable. Now Harrah's (NYSE: HET)? How far can the private equity market really stretch? Do we all really believe the same old arguments that "a deal would allow management to operate outside the minute-to-minute scrutiny of the financial markets" and "place bets on its capital investments without facing rebuke from shareholders"(WSJ 10/2/06)(paid subscription to access). Has the public market gotten so inefficient that a $12 billion market cap company that is trading at a 36 times P/E and being followed by every major institutional investor in the world is just too "short sighted"?
While the terms of a deal have not been announced, it will be interesting to see if the multiples are higher than Harrah's paid just two years ago for Caesars. The true question is are we betting on Black or is this truly a case of Craps.
