Irrational Ex-Uber-ance

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In case you missed it, there has recently been some uber-interesting valuation discourse around the blogosphere regarding Uber, the company whose smart phone app connects drivers with those wanting rides. The buzz is about Uber’s pre-money valuation, $17 billion, implicit in its latest round of financing. It all seems, shall we say, a bit aggressive for a company with an estimated $300 million in annual revenue and little if any operating income.

Most prominently in the skeptics’ corner is Aswath Damodaran, a finance professor at NYU, who recently published a detailed analysis and valuation that trimmed the Uber valuation down by about 2/3rds to $5.9 billion.

Most prominently in the advocates’ corner is a Series A investor and current board member of the company named Bill Gurley. Gurley posits an eloquent defense that Damodaran’s numbers are off by a country mile factor of 25 times and that, as the latest group of investors has freely determined, the company is worth every penny of its $17 billion valuation if not more.

There’s tons of interesting stuff and debatable points in both of these analyses (the impending doom of the world’s “car ownership culture”?!?), but, to me, the heart of the issue is something both gentlemen are calling “disruption” aka category-killing. Effectively, Gurley says that Damodaran is missing the boat because he doesn’t understand that Uber is in the process of killing off multiple categories at once and, because of this, the TAM (Total Available Market) is bigger, by orders of magnitude, than Damodaran has considered. Check out this little historical I-told-you-so gem cited by Gurley:

“In 1980, McKinsey & Company was commissioned by AT&T (whose Bell Labs had invented cellular telephony) to forecast cell phone penetration in the U.S. by 2000. The consultant’s prediction, 900,000 subscribers, was less than 1% of the actual figure, 109 Million. Based on this legendary mistake, AT&T decided there was not much future to these toys. A decade later, to rejoin the cellular market, AT&T had to acquire McCaw Cellular for $12.6 Billion. By 2011, the number of subscribers worldwide had surpassed 5 Billion and cellular communication had become an unprecedented technological revolution.”

Damodaran, for his part, says the divergence between his narrative and Bill Gurley’s lies broadly in how their valuations address the “probable”, the “plausible”, and, for good measure, the “possible”.

So where do I stand on Uber’s valuation? I confess to a certain amount of fence-straddling in this particular situation. I know and expect that there are measures of both art and science in any valuation. I stand with Damodaran in trying to factually dissect and understand what is driving this frothy valuation. I stand with Gurley in promulgating huge, radical ideas that break down barriers and ultimately change the world. The verdict awaits.

Posted by: Mory Watkins

Inside/Outside

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As I’ve said before, taxes and tax attributes play a major role in M&A negotiations. Recall that, unfortunately, deal structuring is usually a zero-sum game, and a deal structure that favors one party tax-wise is usually to the other party’s detriment. An easy way to consider the tax consequences of different deal structures is to use a simplified inside/outside tax basis framework.

First though, a small refresher on tax basis and gains. The tax basis of assets is usually analogous to the book or accounting value of assets except where it has diverged over time due to depreciation or amortization methodologies. A gain occurs on the difference between the purchase price and the tax basis (a loss occurs if the tax basis exceeds the purchase price). Lots of additional factors effect the size and nature of a gain – ordinary or capital gain, the tax status of seller, holding period, tax rate, etc.

Now to the inside versus outside tax basis framework. Inside basis refers to the basis a company has in its own assets. Outside basis is the basis that a shareholder has in the shares of another company. Deal structure will dictate how the inside and outside gains or losses occur.

Deals are structured as either asset or stock deals:

  • In a taxable asset deal, the seller is taxed on its inside asset basis and its shareholders are taxed on the gains of these sales proceeds. This is two levels of tax. The purchaser of the assets acquires a stepped up (fair value) basis in the assets and the new, greater depreciation and amortization are tax deductible.
  • In a taxable stock deal, seller shareholders are taxed on their outside basis in the seller’s stock (only); there is no tax liability incurred in connection with the assets. This is one level of tax. The purchaser gets a stepped up (fair value) basis in the stock and a carry-over basis in the assets.

That’s it. There is a special case to be considered when the acquisition target is a corporate subsidiary and is at least 80% owned by its parent. In this case, the target can sell assets and distribute their proceeds to the parent shareholders without actually incurring a 2nd layer of tax (because, technically, the distribution of proceeds should qualify as a tax-free liquidation). In deals like this, the main consideration is the difference between inside and outside bases.

Also, there are several tax-free structures where the major determinant is the form of consideration paid by the buyer (cash or stock) rather than the structure (asset or stock). Essentially, if around 50% of the purchase price is paid in stock of the purchaser the deal may be tax-free because deals that use an abundance of buyer stock can qualify as “reorganizations”.

For a more detailed approach to tax repercussions of different deal structures, go to my prior blog posting here.

Deals are often scuttled due to tax considerations and, more specifically, failure to account for a deal structure’s impact on the sellers’ after tax proceeds. Understand the inside/outside tax bases, analyze, and win more deals.

Posted by: Mory Watkins

Hit Making is Hard

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Doing deals is tough. But do you think it’s as hard to find “hits” in corporate M&A as it is in other professions?

According to Nielsen, from data provided by managers at Nielsen SoundScan, of the eight million unique digital music tracks sold in 2011 (the large majority for $0.99 or $1.29 through the iTunes Store), 94 percent – 7.5 million tracks – sold fewer than one hundred units. And 32 percent sold only one copy. Yes, that’s right: of all the tracks that sold at least one copy, about a third sold EXACTLY one copy. Thanks for your patronage, Mom.

Equally amazing: In 2011, 102 tracks sold more than a million units each, accounting for 15 percent of total sales. That’s right: about 1/1000th of the eight million tracks sold that year generated ALMOST ONE SIXTH of all sales.

Tough business.

Posted by: Mory Watkins

Betting on Cash Flow

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Mind if today we call corporate development what it really is – a bet, albeit a big and fancy one, on cash flow?

Come to think of it, any investment is really just a bet on cash flow. The endless ways money is made, and the creative techniques people use to invest in a series of cash flows (i.e., bet), are the things that really drew me into corporate development, M&A, and investing in the first place. I don’t care if the cash in question comes from tulips or tomahawks. Show me any series of cash payments, give me a reasonable indication of their consistency and growth characteristics, and we can begin to spin a deal.

Just the other day, I noticed a new type of offering I hadn’t seen before, and it got me thinking. The opportunity involves investing, literally, in an individual’s personal cash flows in a way that kind of resembles playing fantasy sports (i.e., fantasy football). Well, maybe it would be more accurate to say that it most closely resembles investing in a “human” business, but, whatever — it definitely represents a noteworthy, new way for US investors to place a bet on a cash flow stream.

Allow me to further explain.

New securities rules in the JOBS Act have eliminated the ban on general solicitation to investors, and some very, shall we say, “innovative” companies are now coming to market. A new US company called Fantex allows investors to purchase shares that reflect the value of a professional athlete’s brand income, including salary, endorsements and investment opportunities, via up-front payments. A NFL player named Arian Foster is currently the first (and only) player to list with Fantex . If Fantex succeeds in its plan to sell $10 million of his “equity”, he’ll pocket 100% of the proceeds from his personal athlete IPO in exchange for paying out 20% of his lifetime earnings to Fantex.

But is Foster a good investment? Well, under his current contract, Foster will still be short a good $20+ million on Fantex’s break-even earnings (even if he doesn’t get injured and endorsements remain steady). In fact, the whole deal hinges on Foster earning a second big contract in 2017, when he will be 31 years old – a pretty rare occurrence for a running back.

Fine, but what do outside investors who pay $10 million for Foster get? Here’s where it really gets ugly. They actually don’t get anything even close to cash flow — they get no dividends and don’t directly share in any liquidity from Foster’s earnings at all. All they get is a “tracking stock” pegged to Foster’s value in Fantex that they can only trade in a marketplace created and maintained by Fantex. You can find all the salient details and an absolutely scathing assessment of Fantex here.

I don’t know much about football, but as I’ve said before I do understand something about how to value the strength, consistency, and growth prospects of cash flow streams. Let me just say this: from a cash flow perspective, Fantex is a fumble of epic proportions.

Posted by: Mory Watkins

M&A Tax Checklist

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After valuation, one of the most important negotiated numbers in an M&A transaction is tax. Tax in corporate M&A is pretty much a “zero-sum” game — tax impact from a deal structure that is tax-beneficial to the seller will usually be tax-adverse to the buyer, and vice versa.

Today, I’m going to offer up a concise M&A tax planning checklist. The basic idea here is to gather the info and run the numbers to analyze both the present and future tax effects of each deal structure under consideration; that is, a) the immediate taxes associated with the acquisition, and b) the future taxes and benefits associated with realizable basis step-ups, NOL carryovers, and so forth over time. Both present and future details must be analyzed for all deal structures. Only then can a negotiation ensue where buyer and seller compare figures and divide up perceived costs and benefits…ideally, equitably.

If you’re a competent financial modeler, you can easily do your own back of the envelope tax analyses. You can find a good explanation of NOLs and a template to run different transaction scenarios here. A tax professional is needed, of course, to crunch the definitive numbers.*

Here is the information you’ll need to run your analyses:

  1. Stock and asset basis
  2. Seller plans for proceeds (i.e., “individual shareholders to receive proceeds and hold purchaser stock for negotiated period”, etc.)
  3. Applicable tax rates for all parties (target, target shareholders, purchaser)
  4. Depreciation and amortization schedules for acquired assets
  5. Tax status of sellers (suspended losses, special tax status, relevant estate planning considerations, etc.)
  6. Management participation and compensation related to deal structure (if any)
  7. Planned asset dispositions (if any)
  8. Available target NOLs and other loss/credit carryovers
  9. Purchaser NOLs (may limit target gains)
  10. Availability and timing of taxable income vis a vis applicable deductions/loss carryovers

Understanding tax implications of deal structures from the seller’s perspective frequently means the difference between closing and not closing a strategic acquisition. Use this checklist and methodology to balance your motivations with your seller’s chief concern and goal: maximizing after tax proceeds from selling the business.

Posted by: Mory Watkins

*This posting doesn’t constitute tax advice; always seek tax guidance from a tax professional.

Watchdog or Lapdog?

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Take a guess how many corporate accounting fraud cases the SEC has prosecuted through the first half of this year.

Give up? The answer is 79. And that’s the lowest level in over a decade, according to the Wall Street Journal.

A couple months ago, Craig M. Lewis, who heads the SEC’s risk division, unveiled the SEC’s “new”, pro-active approach – an accounting quality model that helps “assess the degree to which registrants’ financial statements appear anomalous.” The analysis will also look at the wording in financial reports concerning companies’ results and future prospects, particularly those under “management discussion and analysis.”

Sounds like a good idea, but…this is “new”?  I’m a bit surprised no one has thought of this before, but apparently that is the case. The SEC acknowledges that its previous means of uncovering fraud have been primarily passive and market-based (i.e., trading irregularities). Really? Isn’t that akin to always closing the stable door after the horse has bolted? Even my $30 tax software has an algorithm that alerts me to audit risk, based on the numbers in my return, before I file my taxes.

I don’t mean to cast stones. I appreciate that accounting fraud is actually very difficult to find, prove, and successfully prosecute. Gathering evidence requires detailed, often forensic accounting work to see whether a company has failed to report its results according to the then prevailing “accounting rules” (my emphasis). And proving there actually was a violation – most often relative to generally accepted accounting principles (GAAP) – includes an additional layer of difficulty because GAAP itself is often vague and malleable.

Case in point…in a recent accounting fraud prosecution in California involving a high-tech company, the United States Court of Appeals for the Ninth Circuit overturned the conviction of the company’s chief financial officer because the government could not prove that his aggressive accounting in recognizing revenue violated GAAP. On the contrary, the appeals court actually opined that the government’s evidence showed he was “doing his job diligently” by skating right up to the line.

Mary Jo White, the SEC’s new chairwoman, has said that she wants to turn the agency’s attention back to what was once seen as its core mission: policing corporate disclosure to ensure everyone is protected. I wish her luck. It’s a crazy world out there, and there’s not much active oversight. Caveat emptor, my buyside brethren. Good thing I’ve got my trusty copy of Financial Shenanigans handy…

Posted by: Mory Watkins

More On Overhang…

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A couple weeks ago, I posted that the overhang of unsold private equity portfolio companies has never been higher in the history of the asset class. Today, I want to share more about the massive global private equity overhang, and its implications for corporate/strategic M&A.

First, a great graphic that essentially tells the whole PE story, globally, in one picture:

https://i0.wp.com/b-i.forbesimg.com/baininsights/files/2013/04/pe-report-forbes-52.gif (source)

  • The global overhang of private equity assets waiting to be sold is now approaching $2 trillion.
  • Three-quarters of the blockage is related to PE funds with a vintage between 2005 and 2008.
  • 90% of PE funds with a vintage between 2006 and 2008 have yet to return any capital to their LPs.

So there is an outsized supply of companies ready to be sold, to say the least.

But what about demand?

Market conditions are also converging for corporate buyers (the largest and most important channel for private equity exits) to drive strong demand:

  • As previously mentioned, corporate balance sheets are stronger than they’ve been in a long time. Cash balances are at all time highs.
  • External capital too is more than plentiful, and US markets, in particular, are awash. World financial assets are now nearly 10 times the value of the global output of all goods and services. Global capital has swollen past $600 trillion, tripling over the past two decades.
  • Public equity market gains, albeit chiefly in the US, are providing renewed appetite for growth, currency for deals, and a pathway for exits. The Dow and the S&P 500 have both regained pre-meltdown losses and have hit new all-time highs. If sustained, equity market gains will bode well for deal-making; increased M&A activity has always historically followed significant public market gains.

Important elements have thus aligned — flush balance sheets, cheap and available financing, and improved equities markets – to create real demand-side momentum.

Get ready for increased near term corporate/strategic deal-doing. I am confident that all the pieces are in place.

Posted by: Mory Watkins

Where’s The Incentive?

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I’m always fascinated by methods employers use to incentivize their employees…

Did you hear that Goldman Sachs is considering retreating from Europe, given the Eurozone’s stance on enforcing bonus caps? Under the new bonus cap laws that were just approved, banks are most likely going to be banned from awarding bonuses in excess of salary. Exceptions can be made if shareholders agree, in which case the cap could be up to 200% of the salary.

Goldman President and COO Gary Cohn recently said, “We have to be thinking about moving. If we cannot attract the best people, that is a big hindrance to our business.”

He’s actually got a point…The US has a much higher bonus-to-salary ratio than Europe, and, in 2012, U.S. investment banker bonuses were 60% higher than those of their European counterparts. Also, European investment firms were responsible for only 23% of global investment banking revenue. Hard to see why Goldman would want to stay (or how they’d fairly incentivize an employee to live in Europe).

And while it’s odd to think of Goldman completely pulling out of Europe, it’s even more odd to consider that governments can now tell private industry how and how much they can pay their employees…?!?!?

Posted by: Mory Watkins

Earnouts (Part Two)

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Some while ago, I posted about earnouts and how a quarter of all business acquisitions have an earnout component in one form or another. I examined the difficulty of creating a good earnout, and I offered up a couple choice pieces of advice.

Today, I’d like to take another look at earnouts, but this time concentrating more on seller implications. Sellers aren’t always rational during the sales process, but for the most part they are dialed into concerns related to the after-tax proceeds from the sale of their business. It gets a little trickier than you might think when the sale involves earnouts, so both buyer and seller would do well to understand the fundamentals of earnout tax considerations*.

The best way to think of an earnout is that it is a type of “installment” sale, but with contingent payments (I’ll get to the latter part in a moment). An installment sale is a sale in which at least one payment will be received after the close of the taxable year in which the sale occurs. The key feature of an installment sale is, of course, that it essentially recognizes taxable gain as payments are received, rather than all at once in the year of disposition. Loss of installment sale status accelerates tax payments so that tax may even be due before the actual cash is collected (note that the installment method will automatically apply by default unless the seller elects out).

Okay, special installment rules apply where there is a contingent payment (i.e., earnout) that occurs as part of the sale because the aggregate selling price cannot be determined by the close of the taxable year in which the sale occurs. The tax man will determine which of three categories the sale falls under — 1) a sale with a stated maximum selling price, 2) a sale with a fixed period, or 3) a sale with neither a stated maximum selling price nor a fixed period:

  • A sale with a stated maximum selling price will assume that all contingencies are met such that it maximizes the payments to the seller and accelerates payments to the earliest date or dates under the purchase agreement.
  • For a sale where the maximum selling price cannot be determined but the maximum period over which payments may be received can, the seller has to recover the basis ratably over that period. Then, if the actual payment received is less than the amount of basis that should be recovered, the taxpayer usually doesn’t recognize a loss, but instead the excess is carried forward (and the loss may be recognized in the final year).
  • For a sale with neither a stated maximum selling price nor a fixed period, the IRS will closely scrutinize whether a sale has actually occurred (the seller may be just receiving rent or royalties). If a sale is deemed to have occurred, the seller usually must recover his basis in equal annual installments over a period of 15 years.

Lastly, three common situations to watch out for…

  1. In cases where the earnout numbers get kind of crazy (very large contingent payments that are “difficult” to achieve), be aware that the maximum selling price rules above can both accelerate recognition of and change the timing and nature of gains.
  2. In cases where the earnout numbers get “lumpy” (an earnout gain is recognized in early years, but little or no earnout gain is earned later), the seller may be ultimately left with a large capital loss that can be hard to deduct.
  3. Stock sales with a Section 338(h)(10) election that include an earnout deserve special consideration due to a common trap that results in excess gain recognition in the year of sale.

Buyers and sellers are increasingly using earnouts to bridge the valuation gap and get deals done. Becoming more aware of seller-side tax treatment of earnout arrangements can help strategic buyers inject additional value into transactions.

Posted by: Mory Watkins

*This posting doesn’t constitute tax advice; always seek tax guidance from a tax professional.

Overhang

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Attention, corporate development executives: the overhang of unsold private equity portfolio companies has never been higher.

It’s true — private equity firms are sitting on the largest collection of unsold portfolio companies (“overhang”) in the history of the asset class…and the glut is enormous: an estimated 6,500 unsold portfolio companies as of year end, representing almost 70% of private equity firms’ total assets under management as of Sept. 30 of last year. That is the highest number of unsold portfolio companies ever recorded.

“The overhang that is not sufficiently talked about is not the overhang of capital, but the overhang of older portfolio companies and older funds that have not been sold and need to be sold. What ends up happening to this glut of unsold portfolio companies could have a big impact on the entire private equity industry. Firms can’t sell their portfolio companies because they are worth less than their original investment,” says Michael G. Fisch, president and CEO of American Securities LLC.

And PE firms can’t play the waiting game forever. GPs may gain slightly on the multiple by holding out for a better price, but it will also dilute the time-based math of the internal rate of return, a key factor for PE fund raising. A fine balance must be struck.

What will happen to all these private equity portfolio companies…will strategics step in to buy them? When will they get sold? Will the realized PE returns affect the size and viability of the private equity industry? Stay tuned…

Posted by: Mory Watkins; portions excerpted from a recent article in Pensions and Investing Magazine by Arleen Jacobius