Tag Archives: M&A tax

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.

The Role of the Board…

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Large financial decisions are the purview of Boards of Directors, and few business decisions are bigger (or have more repercussions) than corporate acquisitions and divestitures. Today’s BODs want to be kept apprised of all material strategic developments, and want more information and more frequent updates than ever before. Considering that 93% of all acquisitions valued over $100 million now result in litigation, I can’t say I blame them.

Today, I’m going to share some thoughts about the interaction between BODs and their corporate dealmakers.

Before I begin, it’d be helpful to first understand a little bit about how BODs work. Boards walk a fine line between protecting and growing corporate assets, and they have a legal duty called the duty of care to make decisions about M&A on behalf of their companies that are “reasonably informed, in good faith and rational judgment, without the presence of a conflict of interest.” The words reasonably informed are key, and the BOD takes this part of its duty especially seriously.

In today’s market, deal professionals can expect lots of questions, a certain amount of conservatism, and even some resistance to acquisitions from their Directors. Communications between the two parties may be further strained by varying degrees of acquisition experience and gaps in M&A knowledge among board members. In short, it can sometimes feel for deal professionals very much like an uphill battle to get a deal approved.

There is no sure-fire recipe for successful interaction with a Board, but I can at least offer some advice on what information they need and some best practices for communicating.

First, let’s address the contents of a standard deal package for Directors. In my experience, there are five principal pieces of deal information that a Board needs and asks for from its Corporate Development staff (roughly in order of importance):

  • Deal Rationale: As a corporate development professional presenting to a BOD, you should always lead with your deal rationale, including relevant info regarding valuation, management, strategy, products/services, market size, etc.  You should describe your deal in the most concise and cogent manner possible. In plain English, you’re trying to answer, “Why should we do this?” Please re-confirm all the points of your deal hypothesis each and every time you bring the Board up to date.
  • Financial Impact Analysis: The near term financial impact of any proposed acquisition will be foremost on the Board’s mind as it listens and evaluates. Here, you must provide just one thing to address the Board’s needs: an accretion analysis. Recall that Directors are notoriously myopic, and near term financial impact will probably be the single most important, and sometimes the only, factor in determining whether your acquisition will go forward or not. Sorry, but that’s life.
  • Process/Timeline Update: You should comment directly on the deal process and anticipated timeline for completing the acquisition. Buying a company is a large, complicated project, and project management of key corporate affairs happens to also be a duty of the Board. Timing is a major deal consideration for the BOD; don’t under estimate its importance.
  • Due Diligence Update: You should provide an update on due diligence. Make it brief if there are no issues, but be sure to mention anything material that has popped up during your inquiries (it’s your duty to keep them informed) and link your comments to details about potential impediments to closing (see above, Timeline).
  • Alternatives: Lastly, and very importantly, you should always provide a couple alternatives to your proposed transaction. “Huh?!?”, you might say. “But why…?” Well, in a nutshell, in corporate development your job is to provide a way to get from point “A” to point “B” via outside (inorganic) means. You must furnish several viable paths to strategic success; everything can’t be riding on one deal or one strategy. Lots of people forget to do this, but by showing the Board several different potential approaches and solutions, you are actually both doing yourself a favor and helping the Board meet its fiduciary duty of care responsibilities.

So those are the key pieces of information the BOD needs…but any deal professional will tell you that the manner in which deal information is conveyed is awfully important too. Here is my advice on how to effectively communicate with your Directors:

  • Simplify, Simplify, Simplify: In all cases where numbers are needed, you should provide high level, much-simplified financial models and analyses to help the Board quickly grasp your point without getting lost in the details. Provide only the big-picture model or analysis, but make sure to mention that full details are available for those desiring more information.
  • Provide Key Assumptions: Yes, I’ve advised simplifying models and analyses above, but that doesn’t absolve you from responsibility for explaining the key assumptions you’ve made running those high level numbers. Include all the relevant assumptions as well as the facts supporting those assumptions.

Market conditions have intensified pressure on BODs, and they are more fully engaged and hands-on in managing enterprise risks, including those in and around strategic M&A. At the same time, however, Directors understand that deal making drives earnings growth and that acquisitions are increasingly necessary in this slow economy. As a deal professional, you can help your Board manage these disparate duties by understanding their information needs and communicating accordingly.

Posted by: Mory Watkins