PriceNegotiation

Case:Printicomms Proposed
AcquisitionofDigitech:Negotiating
PriceandFormofPayment

WhyPriceGap?
Deterministic
Approach
Probabilistic
Approach

Deterministicanalysis(Exhibit:1)
Takesonepathofperformanceovertime
Ignoresuncertaintyaroundthatpath

Buyerandsellerhavedifferentoutlookaboutuncertainty
Sellerismoreoptimisticongrowthrateandmargins
Buyerislessoptimistic

Printicomm's View
Sales Growth Rate
High
Best guess
Low
Profit Margin
High
Best guess
Low

Digitech's View

15%
10%
5%

30%
20%
10%

15%
10%
5%

25%
20%
15%
2

HistoricalandProjectedIncome
StatementsandCashFlows
Actuals reported by Digitech
Sales

Forecast by Printicomm

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

15,350

10,633

11,313

6,747

7,400

18,651

23,450

28,140

32,361

36,244

39,506

-31%

6%

-40%

10%

152%

26%

20%

15%

12%

9%

Nominal Sales Growth

Cost of Goods Sold

9,655

8,700

8,890

5,096

3,850

14,800

16,850

21,867

24,868

27,539

30,018

S,G&A

2,500

1,900

1,950

2,200

2,400

2,600

2,600

3,374

3,837

4,249

4,632

55

55

55

55

65

65

65

84

96

106

116

Total Expenses

12,210

10,655

10,895

7,351

6,315

17,465

19,515

25,325

28,801

31,894

34,766

Operating Income

3,140

-22

418

-604

1,085

1,186

3,935

2,815

3,560

4,350

4,740

Operating Ratio

80%

100%

96%

109%

85%

94%

83%

90%

89%

88%

88%

1,689

2,136

2,610

2,844

Plus Depreciation and Amortization

84

96

106

116

Less Capital Expenditures (1% of Sales)

-281

-324

-362

-395

Less Additions to Wkg. Cap. (2% of Sales)

-563

-647

-725

-790

Free cash flow

929

1,261

1,629

1,775

Depreciation

Operating Income After Taxes (40% Tax)

Terminal value (Growth Rate: 5%, Discount Rate: 10%)

37274.92

Total free cash flow

928.80

1261.17 1628.86 39049.91

Present Value of FCF

844.36

1042.29 1223.79 26671.62

PV of Total Free Cash Flows

29,782

HistoricalandProjectedIncome
StatementsandCashFlows
Actuals reported by Digitech
Sales

Forecast by Digitech

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

15,350

10,633

11,313

6,747

7,400

18,651

23,450

28,609

34,331

40,167

45,389

-31%

6%

-40%

10%

152%

26%

22%

20%

17%

13%

Nominal Sales Growth

Cost of Goods Sold

9,655

8,700

8,890

5,096

3,850

14,800

16,850

21,985

25,789

30,173

34,096

S,G&A

2,500

1,900

1,950

2,200

2,400

2,600

2,600

3,392

3,979

4,656

5,261

55

55

55

55

65

65

65

85

99

116

132

Total Expenses

12,210

10,655

10,895

7,351

6,315

17,465

19,515

25,462

29,867

34,945

39,489

Operating Income

3,140

-22

418

-604

1,085

1,186

3,935

3,147

4,464

5,222

5,900

Operating Ratio

80%

100%

96%

109%

85%

94%

83%

89%

87%

87%

87%

1,888

2,678

3,133

3,540

85

99

116

132

Less Capital Expenditures (1% of Sales)

-286

-343

-402

-454

Less Additions to Wkg. Cap. (2% of Sales)

-572

-687

-803

-908

Free cash flow

1,115

1,747

2,044

2,310

Depreciation

Operating Income After Taxes (40% Tax)

Plus Depreciation and Amortization

Terminal value (Growth Rate: 5%, Discount Rate: 10%)

48,514

Total free cash flow

1,115

1,747

2,044

50,824

Present Value of FCF

1,014

1,444

1,536

34,714

PV of Total Free Cash Flows

38707.08

ValuationMethods
Bookvalue

MarketValue

DCFValues
withoutsynergies

DCFValueswith
Synergies

MarketMultiples
PE,PEG,EBITDA,
EBIT,Sales,CF,..

Comparable
Transaction
Multiples

TrueValueofanAcquisition

WhatisyourChoiceforthisDeal?

FixedPrice
Choice

5years
Earnout
3Years

IfyouareworkingwithPrinticomm whatwillyouprefer?

Earnout Structure
5YearEarnout
3.5
3

3YearEarnout
3.5

2.5

2.5

2000

2001

2.5

1999

2000

2001

2002

DownPayment:$20Million

2003

1999

DownPayment:$28Million

Sellerwillreceivealloperatingprofitsexceedingtriggeramountsoverthelifeofthedeal

Earnout HarmsPrinticomm
Affectpost
transaction
integration

Corporate
restructuringwill
bedifficult

Nocompulsionon
theacquiredfirms
managementto
support

Accounting
numberscanbe
easilymanaged

Balloonedcredits
sales

Sellingbelow
requiredROAor
ROE

Maynotmaintain
theassetscarefully

Failtospendany
sensiblemoneyin
Capex

Willnotbotherof
customerloyalty

Earnout HarmsPrinticomm
Digitechhaving
unlimitedupside

Digitechwillimpose
growthstimulating
behavior

Operatingincome
ignorescapital
spending

Stepwisemaynot
motivateDigitech

Digiticmay
cummulateandtry
tohitthetarget
once

Digitech may
cannibalize
products

Whatifthereisno
liquidityinbusiness
meetthepayment
ofDigitech?

Whowillspendon
commonproblems?

Maynothavelong
termfocus

Earnout HarmsPrinticomm
Howtobringinscaleand
scopebenefits?

Liquiditypreferenceofthe
sellersshareholderscould
dominatethedesireto
maximizepayment
throughanearnout

Overlyaggressive
performancegoals

WhatisyourChoiceforthisDeal?

FixedPrice
Choice

5years
Earnout
3Years

IfyouareworkingwithDigitech whatwillyouprefer?

ItalsoHarmsDigitech
Acquirermaynot
supportacquiredto
reachthetarget

Stepwisetargetcreates
doubtinthemindsof
Digitech

Printicommmaynot
encourageDigitech
products

Toomuchcontrolfrom
parents

Whatifparentsgo
againsttheinterestof
Digitechs
management?

Whatwillhappento
earnoutsonnon
existenceofthe
company?

Whatiftheacquired
firmiffailstohonorthe
claimsofearnout?

Buyerfailstoprovide
resourcesnecessaryto
actuallygrowthetarget
andmaximizevalue

Occursonpostmerger
integrationishandled
badly

ItalsoHarmsDigitech
Mayinvitelegalactionbythe
selleronperceived
measurementproblemsand
Lackofseniormanagement
supporttomaximize
performance

Whatisthelevelofseniority
treatmentonliquidationof
thefirm?

Howprinticommwillpayon
anyassitancetakenfrom
Digitech?

Whatwillbethetax
treatmentontheearnouts?

Whatifthereisamacro
economicshockonthefirm?

Whatisregulationchanges?

Whatiftaxissuespopsin?

Whatifindustrygoesthrough
structuralchanges?

Failsifmanagersdontowna
significantearnout claim

ItalsoHarmsDigitech
Whatiftaxissuespops
in?

Whatifindustrygoes
throughstructural
changes?

Failsifmanagersdont
ownasignificant
earnout claim

Acquirermayallotmore
Fixedcost,todiscourage
bookinghigher
operatingprofits

HowtheEarnouts canbeImprovedto
beMoreEffective?

Triggeramountshouldrise
moreaggressively

Yearbyyearpayment
encourageshortterm
thinking

Relativelyconstantseriesof
triggersenhancesprobability
offuturepayoff

Canhaveoneoveralltarget
forall5or3years

Pegearnouttothe
accumulatedperformance
overtime

Structuretheearnoutasa
lumpsumpaymentatthe
terminusoftheearnout
periodbasedon
performanceoverwhole
period

WhyEarnouts inthisDeal?
Usedtomovepotentialtransaction
forward
Additional
paymentsto
seller

Someportionofpurchasepriceof
Digitech tobepaidbyPrinticomm on
Digitech attainingcertainagreed
uponperformancegoalsafterclosing

Motivation
of
shareholders
/managers

Benefits

Madelotofsensefromaneconomic
perspective
Retentionof
shareholders
and
managers

Winwinsituation

Bridgethe
valuation
gap

FeaturesofEarnouts
Instrumentoran
agreementora
contract
Valuinganincentive
paymentrequires
accountingfor
optionality

Incentivepayment
plansareoptions

Longtheterm,
moretheuncertain
inpayment;will
havemorevalue

Itschallengingto
structure

Extremelyuseful
devicetobreak
deadlocksindeal
negotiations

Earnout
Time
period

Deductedas
expense(Lower
willbecost)

Key
Drivers

Tax
Treatment

Basedonachievable
performancegoals

Elements
ProvideDigitech
managementwith
requiredresources
andoperating
freedom

Digitechmanagement
shouldreceive
adequate
compensation
creatingthatvalue

Earnout
Targets

ValuingEarnout:Simulationbasedvaluationmodel
Expecteddistributionforvaluedrivers salesgrowth,profitmargin

Asdividend
(Paidfromafter
taxearnings)
conservative
View

WhythereisaNeedforEarnout inthis
Deal?

Abandonmentnot
desirable good
strategicand
organizational
motivesforthe
deal

Negotiation
reachedan
impasseoverprice

Havetowalkawayfromthe
dealinabsenceofcreative
alternative

HowthePerformanceGoalsinthe
Earnout canbeImproved?
Clearly
defined

Easily
measurable

Elements

Attainable

Mutually
understood

SuitabilityofPerformanceGoalsinEarnouts
TargetVariable

Suitability
Integratingoperationsoftwocompanies

Revenue

Whentargetmanagementisnotexpectedto
bewiththecompany

GrossMargin

Targettobeprofitable

PreTaxProfit

Targetbusinesstoperformwellinallrespects

Cashflow orEBITDA

WhenEBITDAmultipleusedtovaluethe
target
Whenbuyerisshortofcash

RiskInvolved
Sellingproductsatlowmargin
Capacitylimitations

Buyerwilldictateonexpenses

Discouragesintegration
Requiresfreedomofoperationsforthetarget

Willnotworkonafirmwithaccrualconcept
ofaccounting

Milestone

Nonfinancialrequirements R&D,new
product,licensing,IPR

Measuringthemilestoneachievementmay
beambiguous

CombinationofAbove

Attachingappropriateweightforeach
variable

Veyconfusingandtoomuchpressureon
Targetfirm

WhataretheCriticalIssuesthatPrinticomm
ShouldConsiderWhileDesigningtheEarnout?
Accountingpolicies
oftargetfirm

Availabilityof
financing

Management
processes

Changein
ownershipduring
earnoutperiod

Liquidityand
transferabilityof
earnout
agreements

Impactonbuyers
financialstructure
(asleverage)

Taxandaccounting
consideration

ValuingEarnouts
Simulation

Simulationdrawsassumptionsregardingsales
growthratesandoperatingprofitmarginfrom
theirownuncertaindistributions

Probability
ofNPV

Repeating probabilityofNPVdistribution
Mean,medianandmode
SDandrange

Probability
ofNPV

Cumulativedistributionlefttozeroon
horizontalaxis
Dealwoulddestroyvalue

ValuingEarnouts

Workslikeacall
option

Likelytobe
valuable,evenif
theyareoutof
themoneytoday

Notfreeto
buyer;very
costly

Tailormadefor
situationsof
greatuncertainty

Bridgesthe
differences
betweenan
optimisticseller
andapessimistic
buyer

ApproachestoEarnout Valuation

Simulation
Valuation
Approaches
CallOption
Approach

SimulationApproach
Identifytherelationship
betweenRevenueandExpense
Variable

TakeadecisiononVariableto
beSimulated

Usetheparametersas
describedbythebuyersand
sellersandsimulate(Monte
CarloSimulation)theselected
variableseries(maybe1000
times)

AddDownpayment+Vlaue of
Earnout togetalistofpossible
totalvaluefortheseller/
buyer

Estimatingthepresentvalueof
Earnouts ateachpointand
summinguptogetthetotal
valueofearnouts

EstimatetheValueofEarnout
oneachsimulatedpoint(Using
definedtargetforeachyear)

Evaluatethedistribution
structureofthetotalvalueof
thoseEarnouts byconstructing
aFrequencyDistributionChart

InferthelikelyvalueofEarnout

0.04
0.02

0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
$2
0,
00
$2 0
0,
46
$2 1
0,
92
1
$2
1,
38
$2 2
1,
84
$2 2
2,
30
3
$2
2,
76
$2 3
3,
22
$2 4
3,
68
4
$2
4,
14
5

0.14
0.14

0.12
0.1
0.12
0.1

PROBABILITY

0.06

PROBABILITY

$2
8,
00
$2 0
8,
47
$2 6
8,
95
$2 2
9,
42
$2 8
9,
90
$3 3
0,
37
$3 9
0,
85
$3 5
1,
33
$3 1
1,
80
$3 7
2,
28
3

PROBABILITY
0.08

Digitech Valuation of 3 Year Earnout

$3
3,
55
$3 0
5,
36
$3 6
7,
18
$3 3
9,
00
$4 0
0,
81
$4 7
2,
63
$4 4
4,
45
$4 0
6,
26
$4 7
8,
08
$4 4
9,
90
1

$3
5,
57
$3 1
6,
51
$3 9
7,
46
$3 6
8,
41
$3 3
9,
36
$4 1
0,
30
$4 8
1,
25
$4 5
2,
20
$4 3
3,
15
$4 0
4,
09
7

PROBABILITY

Printicomm Valuation of 3 Year Earnout

Printicomm Valuation of 5 Year Earnout

0.08

0.06

0.04
0.02
0

Digitech Valuation of 5 Year Earnout

0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0

TotalValuetoBuyers/SellersusingSimulationMethod

Earnout vs.StockOption
ComparisonofEarnoutandCallOptionsonCommonStock
CallOptioninCommonStock
Earnouts
ImplicationforValueofEarnouts
Someindexoffinancialoroperating
performance
Revenues
Earnings
Cashflows
Underlyingasset
Shares
Marketshareorproductintroduction
Earnoutisaderivativesecurity
Exerciseprice
Statedstrikeprice
Benchmark,hurdleortriggeringevent
Lowerthebenchmark;greaterthevalueoferanout
levelofindex
Highertheperformance;greaterthevalue
Priceoftheunderlyingasset Stockpriceofunderlying
Revenues,Earnings,Cashflows
Interimpayouts
Dividends
Interimcashflowsassociatedwithearnouts Highertheinterimpayout;lowerthevalueofearnout
Termoftheoption
Termofthecontract
Max.of5years
Longerthelife;morevaluable
Unceratinity
Volailityofunderlyingstocksreturn Uncertainityofunderlying
Greatertheuncertainity;morevaluabletheearnout

PriceNegotiationTips
1

DetectingEscalationontheotherside
Avoidinducingbold,firmstatementsfromanopponent

Dontletacquisitionsynergytomovetotheopponent

Considertheothersidesposition,beforedivingheadfirst
intoanegotiation
Thinkthroughthemotivationsoftheotherdecisionmakers

32

PriceNegotiationTips
4

Recognizehowattractiveistheauctiontoyouandaswellas
toothers

Ignoresunkcost
Money,time,andenergyyouvespentinthepastshould
rarelyaffectyourfuturecommitments

Seekthecounselofawiseadviser,onewithoutavested
stakeinyourdecision
Listenopenlytotoughadviceandfollowthroughonit

33

PriceNegotiationTips
7

Discourageothersfromescalating
Communicationcanbeaveryeffectivetool

Stayoutofthetrap
Identifynegotiationasatrapbeforeitevenbegins

Relationshipbetweenthesizeofthepremiumand
thesuccessofthedealisnotlinear

34

PriceNegotiationTips
10

11

12

Rightpriceisrelative,notabsolute!

Theremaybeavastdifferencebetweenthepriceone
companycanpayforanacquisitionandthepriceanother
canpay

Itsthelastdealofitskind, Myth

35

PriceNegotiationTips
13

14

15

Assetsunavailabletodaycouldeasilybeupforsale
tomorrow

Ifyoudontacquireatarget,amajorcompetitorwill ,
ifthenumbersdontworkforyou,youshouldletyour
rivalhavethetargetcompany

Userealoptionanddecisiontreesifrequired

PriceNegotiationTips
16

Usesimulationtoestimatein
uncertainty

17

Neverallowthemangerinvolvedin
negotiationtofixtheprice

18

Establishstringenttimeboundpost
acquisitiontargets

PriceNegotiationTips
19

20

21

Comparethevaluecreatedbytheacquisitiontothevalue
thatcouldbecreatedbybuyingbackyourownshares

Routinelyrevieweachcompletedacquisitionrigorouslyto
betterunderstandwhatmakesforsuccessorfailure

Keepdataontheperformanceofpreviousacquisitionsto
help
thempricefuturedeals

PriceNegotiationTips
22

23

24

Useposttransactionmonitoringprocesstotrackhowwellthe
acquisitionormergerwasperformingrelativetoexpectationsand
todrawlessonsaboutwhatshouldbedonedifferentlyinthefuture

Ensurethatanalyticalrigortriumphsoveremotionandego

Doathoroughriskanalysis

PriceNegotiationTips
25

Thepriceofmakingamistakeisgreaterthanthepriceof
missinganopportunity

26

Doagoodjobofcommunicatingwithemployees,both
beforeandafterthe
dealcloses

27

Improveexternalcommunicationtothecapitalmarkets,
customers,suppliers,regulatorybodies,andgeographic
communities

PriceNegotiationTips

28

29

Explaintoexternalstakeholderswhatthe
benefitsofthedealareandhowthe
stakeholderswillbeaffected,bothpositivelyand
negatively

Quantifyingthevalueofexpectedsynergiesand
reporttheprogressmadeinachievingthem