price negotiation

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


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?


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


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


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


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

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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


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


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


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


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


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

price negotiation

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