Price Negotiation
Case: Printicomm’s Proposed Acquisition of Digitech: Negotiating
Price and Form of Payment
2
Printicomm's View Digitech's ViewSales Growth RateHigh 15% 30%Best guess 10% 20%Low 5% 10%Profit MarginHigh 15% 25%Best guess 10% 20%Low 5% 15%
• Deterministic analysis (Exhibit: 1)• Takes one path of performance over time• Ignores uncertainty around that path
Deterministic Approach
•Buyer and seller have different outlook about uncertainty• Seller is more optimistic on growth rate and margins• Buyer is less optimistic
Probabilistic Approach
Why Price Gap?
Historical and Projected Income Statements and Cash Flows
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002Sales 15,350 10,633 11,313 6,747 7,400 18,651 23,450 28,140 32,361 36,244 39,506Nominal Sales Growth -31% 6% -40% 10% 152% 26% 20% 15% 12% 9%Cost of Goods Sold 9,655 8,700 8,890 5,096 3,850 14,800 16,850 21,867 24,868 27,539 30,018S,G&A 2,500 1,900 1,950 2,200 2,400 2,600 2,600 3,374 3,837 4,249 4,632Depreciation 55 55 55 55 65 65 65 84 96 106 116Total Expenses 12,210 10,655 10,895 7,351 6,315 17,465 19,515 25,325 28,801 31,894 34,766Operating Income 3,140 -22 418 -604 1,085 1,186 3,935 2,815 3,560 4,350 4,740Operating Ratio 80% 100% 96% 109% 85% 94% 83% 90% 89% 88% 88%Operating Income After Taxes (40% Tax) 1,689 2,136 2,610 2,844Plus Depreciation and Amortization 84 96 106 116Less Capital Expenditures (1% of Sales) -281 -324 -362 -395Less Additions to Wkg. Cap. (2% of Sales) -563 -647 -725 -790Free cash flow 929 1,261 1,629 1,775Terminal value (Growth Rate: 5%, Discount Rate: 10%) 37274.92Total free cash flow 928.80 1261.17 1628.86 39049.91Present Value of FCF 844.36 1042.29 1223.79 26671.62PV of Total Free Cash Flows 29,782
Forecast by PrinticommActuals reported by Digitech
Historical and Projected Income Statements and Cash Flows
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002Sales 15,350 10,633 11,313 6,747 7,400 18,651 23,450 28,609 34,331 40,167 45,389Nominal Sales Growth -31% 6% -40% 10% 152% 26% 22% 20% 17% 13%Cost of Goods Sold 9,655 8,700 8,890 5,096 3,850 14,800 16,850 21,985 25,789 30,173 34,096S,G&A 2,500 1,900 1,950 2,200 2,400 2,600 2,600 3,392 3,979 4,656 5,261Depreciation 55 55 55 55 65 65 65 85 99 116 132Total Expenses 12,210 10,655 10,895 7,351 6,315 17,465 19,515 25,462 29,867 34,945 39,489Operating Income 3,140 -22 418 -604 1,085 1,186 3,935 3,147 4,464 5,222 5,900Operating Ratio 80% 100% 96% 109% 85% 94% 83% 89% 87% 87% 87%Operating Income After Taxes (40% Tax) 1,888 2,678 3,133 3,540Plus Depreciation and Amortization 85 99 116 132Less Capital Expenditures (1% of Sales) -286 -343 -402 -454Less Additions to Wkg. Cap. (2% of Sales) -572 -687 -803 -908Free cash flow 1,115 1,747 2,044 2,310Terminal value (Growth Rate: 5%, Discount Rate: 10%) 48,514Total free cash flow 1,115 1,747 2,044 50,824Present Value of FCF 1,014 1,444 1,536 34,714PV of Total Free Cash Flows 38707.08
Actuals reported by Digitech Forecast by Digitech
Valuation Methods
Book value Market Value
DCF Values without synergies
DCF Values with Synergies
Market Multiples –PE, PEG, EBITDA, EBIT, Sales, CF,..
Comparable Transaction Multiples
True Value of an Acquisition
What is your Choice for this Deal?
ChoiceFixed Price
Earnout5‐years
3‐Years
If you are working with Printicomm what will you prefer?
Earnout Structure
2.5
3 3
3.5 3.5
1999 2000 2001 2002 2003
5 ‐Year Earnout
Down Payment: $20 Million
2
2.5 2.5
1999 2000 2001
3 ‐Year Earnout
Down Payment: $28 Million
Seller will receive all operating profits exceeding trigger amounts over the life of the deal
Earnout Harms Printicomm
Affect post transaction integration
Corporate restructuring will
be difficult
No compulsion on the acquired firm’s management to
support
Accounting numbers can be easily managed
Ballooned credits sales
Selling below required ROA or
ROE
May not maintain the assets carefully
Fail to spend any sensible money in
Capex
Will not bother of customer loyalty
Earnout Harms Printicomm
May not have long term focus
Digitech having unlimited upside
Digitech will impose growth stimulating
behavior
Operating income ignores capital
spending
Step wise may not motivate Digitech
Digitic may cummulate and try to hit the target
once
Digitech may cannibalize products
What if there is no liquidity in business meet the payment
of Digitech?
Who will spend on common problems?
Earnout Harms Printicomm
How to bring in scale and scope benefits?
Liquidity preference of the seller’s shareholders could dominate the desire to maximize payment through an earnout
Overly aggressive performance goals
What is your Choice for this Deal?
ChoiceFixed Price
Earnout5‐years
3‐Years
If you are working with Digitech what will you prefer?
It also Harms Digitech
Acquirer may not support acquired to reach the target
Stepwise target creates doubt in the minds of
Digitech
Printicomm may not encourage Digitech
products
Too much control from parents
What if parents go agains t the interest of
Digitech’s management?
What will happen to earnouts on non‐existence of the
company?
What if the acquired firm if fails to honor the
claims of earnout?
Buyer fails to provide resources necessary to actually grow the target and maximize value
Occurs on postmerger integration is handled
badly
It also Harms DigitechMay invite legal action by the
seller on perceived measurement problems and Lack of senior‐management
support to maximize performance
What is the level of seniority treatment on liquidation of
the firm?
How printicomm will pay on any assitance taken from
Digitech?
What will be the tax treatment on the earnouts?
What if there is a macro economic shock on the firm? What is regulation changes?
What if tax issues pops in? What if industry goes through structural changes?
Fails if manager’s don’t own a significant earnout claim
It also Harms Digitech
What if tax issues pops in?
What if industry goes through structural
changes?
Fails if manager’s don’t own a significant earnout claim
Acquirer may allot more Fixed cost, to discourage
booking higher operating profits
How the Earnouts can be Improved to be More Effective?
Trigger amount should rise more aggressively
Relatively constant series of triggers enhances probability
of future payoff
Can have one overall target for all 5 or 3 years
Year‐by‐year payment encourage short‐term
thinking
Peg earnout to the accumulated performance
over time
Structure the earnout as a lump‐sum payment at the terminus of the earnout
period based on performance over whole
period
Why Earnouts in this Deal?
Used to move potential transaction forward
Some portion of purchase price of Digitech to be paid by Printicomm on Digitech attaining certain agreed‐
upon performance goals after closing
Made lot of sense from an economic perspective
Win‐win situation
Benefits
Additional payments to
seller
Bridge the valuation
gap
Retention of shareholders
and managers
Motivation of
shareholders / managers
Features of Earnouts
Instrument or an agreement or a
contract
Incentive payment plans are options
Long the term, more the uncertain in payment; will have more value
Valuing an incentive payment requires accounting for optionality
Its challenging to structure
Extremely useful device to break deadlocks in deal negotiations
Earnout
Elements
Based on achievable performance goals
Digitech management should receive adequate
compensation creating that value
Provide Digitech management with required resources and operating
freedom
Key Drivers
Time period
EarnoutTargets
Tax Treatment
Deducted as expense (Lower will be cost)
As dividend (Paid from after‐tax earnings) –conservative
View
Valuing Earnout: Simulation based valuation modelExpected distribution for value drivers ‐ sales growth, profit margin
Why there is a Need for Earnout in this Deal?
Negotiation reached an
impasse over price
Have to walk away from the deal in absence of creative
alternative
Abandonment not desirable – good strategic and organizational motives for the
deal
How the Performance Goals in the Earnout can be Improved?
Elements
Clearly defined
Mutually understood
Attainable
Easily measurable
Suitability of Performance Goals in Earnouts
Target Variable
Revenue
Gross Margin
Pre‐Tax Profit
Cashflow or EBITDA
Milestone
Combination of Above
Suitability
Integrating operations of two companiesWhen target management is not expected to
be with the company
Target to be profitable
Target business to perform well in all respects
When EBITDA multiple used to value the target
When buyer is short of cash
Non‐financial requirements – R&D, new product, licensing, IPR
Attaching appropriate weight for each variable
Risk Involved
Selling products at low marginCapacity limitations
Buyer will dictate on expenses
Discourages integrationRequires freedom of operations for the target
Will not work on a firm with accrual concept of accounting
Measuring the milestone achievement may be ambiguous
Vey confusing and too much pressure on Target firm
What are the Critical Issues that PrinticommShould Consider While Designing the Earnout?
Accounting policies of target firm
Availability of financing
Management processes
Change in ownership during earnout period
Liquidity and transferability of
earnout agreements
Impact on buyer’s financial structure
(as leverage)
Tax and accounting consideration
Valuing Earnouts
• Simulation draws assumptions regarding sales‐growth rates and operating‐profit margin from their own uncertain distributions
Simulation
• Repeating – probability of NPV distribution• Mean, median and mode• SD and range
Probability of NPV
• Cumulative distribution left to zero on horizontal axis
• Deal would destroy value
Probability of –NPV
Valuing Earnouts
Works like a call option
Likely to be valuable, even if they are out‐of‐the‐money today
Not free to buyer; very
costly
Tailor‐made for situations of
great uncertainty
Bridges the differences between an
optimistic seller and a pessimistic
buyer
Approaches to Earnout Valuation
Valuation Approaches
Simulation
Call Option Approach
Simulation Approach
Identify the relationship between Revenue and Expense
Variable
Take a decision on Variable to be Simulated
Use the parameters as described by the buyers and sellers and simulate (Monte Carlo Simulation) the selected variable series (may be 1000
times)
Estimate the Value of Earnouton each simulated point (Using defined target for each year)
Estimating the present value of Earnouts at each point and summing up to get the total
value of earnouts
Add Down payment + Vlaue of Earnout to get a list of possible
total value for the seller / buyer
Evaluate the distribution structure of the total value of those Earnouts by constructing a Frequency Distribution Chart
Infer the likely value of Earnout
Total Value to Buyers / Sellers using Simulation Method
Printicomm Valuation of 3 Year Earnout
00.020.040.060.080.1
0.120.14
$28,0
00
$28,4
76
$28,9
52
$29,4
28
$29,9
03
$30,3
79
$30,8
55
$31,3
31
$31,8
07
$32,2
83
PRO
BABI
LITY
Printicomm Valuation of 5 Year Earnout
00.020.040.060.080.1
0.120.14
$20,0
00
$20,4
61
$20,9
21
$21,3
82
$21,8
42
$22,3
03
$22,7
63
$23,2
24
$23,6
84
$24,1
45
PRO
BABI
LITY
Digitech Valuation of 5 Year Earnout
00.020.040.060.080.1
0.120.140.16
$33,5
50
$35,3
66
$37,1
83
$39,0
00
$40,8
17
$42,6
34
$44,4
50
$46,2
67
$48,0
84
$49,9
01
PRO
BABI
LITY
Digitech Valuation of 3 Year Earnout
00.020.040.060.080.1
0.120.140.16
$35,5
71
$36,5
19
$37,4
66
$38,4
13
$39,3
61
$40,3
08
$41,2
55
$42,2
03
$43,1
50
$44,0
97
PRO
BABI
LITY
Earnout vs. Stock Option
Call Option in Common Stock Earnouts Implication for Value of Earnouts
Underlying asset Shares
Some index of financial or operating performanceRevenuesEarningsCashflowsMarket share or product introduction Earnout is a derivative security
Exercise price Stated strike price Benchmark, hurdle or triggering event Lower the benchmark; greater the value of eranout
Price of the underlying asset Stock price of underlyinglevel of indexRevenues, Earnings, Cashflows Higher the performance; greater the value
Interim payouts Dividends Interim cashflows associated with earnouts Higher the interim payout; lower the value of earnoutTerm of the option Term of the contract Max. of 5 years Longer the life; more valuableUnceratinity Volaility of underlying stocks return Uncertainity of underlying Greater the uncertainity; more valuable the earnout
Comparison of Earnout and Call Options on Common Stock
Price Negotiation Tips
1• Detecting Escalation on the other side• Avoid inducing bold, firm statements from an opponent
2• Don’t let acquisition synergy to move to the opponent
3
• Consider the other side’s position, before diving headfirst into a negotiation
• Think through the motivations of the other decision makers
32
Price Negotiation Tips
4• Recognize how attractive is the auction to you and as well as to others
5
• Ignore sunk cost• Money, time, and energy you’ve spent in the past should rarely affect your future commitments
6
• Seek the counsel of a wise adviser, one without a vested stake in your decision
• Listen openly to tough advice and follow through on it
33
Price Negotiation Tips
7• Discourage others from escalating• Communication can be a very effective tool
8• Stay out of the trap• Identify negotiation as a trap before it even begins
9• Relationship between the size of the premium and the success of the deal is not linear
34
Price Negotiation Tips
10• Right price is relative, not absolute!
11• There may be a vast difference between the price one company can pay for an acquisition and the price another can pay
12• “It’s the last deal of its kind,” ‐Myth
35
Price Negotiation Tips
13• Assets unavailable today could easily be up for sale tomorrow
14• “If you don’t acquire a target, a major competitor will” ‐ , if the numbers don’t work for you, you should let your rival have the target company
15• Use real option and decision trees if required
Price Negotiation Tips
16• Use simulation to estimate in uncertainty
17• Never allow the manger involved in negotiation to fix the price
18• Establish stringent time bound post acquisition targets
Price Negotiation Tips
19• Compare the value created by the acquisition to the value that could be created by buying back your own shares
20• Routinely review each completed acquisition rigorously to better understand what makes for success or failure
21
• Keep data on the performance of previous acquisitions to helpthem price future deals
Price Negotiation Tips
22• Use post transaction monitoring process to track how well the acquisition or merger was performing relative to expectations and to draw lessons about what should be done differently in the future
23• Ensure that analytical rigor triumphs over emotion and ego
24• Do a thorough risk analysis
Price Negotiation Tips
25• The price of making a mistake is greater than the price of missing an opportunity
26
• Do a good job of communicating with employees, both before and after thedeal closes
27• Improve external communication to the capital markets, customers, suppliers, regulatory bodies, and geographic communities
Price Negotiation Tips
28
• Explain to external stakeholders what the benefits of the deal are and how the stakeholders will be affected, both positively and negatively
29• Quantifying the value of expected synergies and report the progress made in achieving them