An earn-out bridges the gap between the two valuations

and requires the sellers ‘earn’ part of the purchase price based on how well the business performs after the sale.The seller will only receive this additional portion of money if the business performs at a level agreed to during the acquisition negotiations.

According to the results of the research conducted by  Ninon Kohers and James Ang, Earnouts in Mergers: Agreeing to Disagree and Agreeing to Stay, published by The Journal of Business, The University of Chicago Press, earn-outs serve two main functions in mergers: 1) as a risk-hedging mechanism for bidders in mergers with high information asymmetries, and  2) as a retention bonus for valuable target human capital.

Rationales for an Earn-out

The above mentioned research found that there are two main reasons to structure an earnout when buying a business:

Reducing asymmetric information

A two-part payment contract consisting of a partial up-front amount and a later earn-out payment that depends on ex post results may resolve disagreement between bidders and targets in mergers and acquisitions in expectations about the target’s true value.

Specifically, the initial up-front payment would reflect the agreed-on portion of the transaction value, while the size of the second-part payment would be a function of the extent of the disagreement between the target and the acquirer. Thus, the bidder bears no risk of overvaluation because the earnout contract acts as a risk-reducing mechanism to hedge against the risk of paying too much for the target.

Encouraging management retention

The human capital of target managers can be a valuable component of the target’s value and, thus, may be priced as part of the merger premium. Consequently, the value of the target in the merger may be conditional on retaining the manager.

Since the valuation of the target could depend on the target manager’s behavior during the transition period, earnout contracts would help to keep the target’s owner/manager ‘‘in line’’ by effectively requiring them to honor a non-compete contract and to exert the maximal effort to manage the business and deliver the promised results.

Users of Earn-out contracts

According to the results of the referred research, earn-out mergers tend to involve smaller, privately held targets and divested subsidiaries in high-tech industries, for example, computer technology and biotechnology, and business related service areas. Furthermore, the majority of takeovers using earn-outs are between acquirers and targets from different industries, often with little integration occurring between the bidder and target after the merger is completed.

Merger and Acquisitions situations with large information asymmetries may include acquisitions of firms with high-growth opportunities (e.g., high-tech firms), firms with low tangible assets (e.g., firms in service industries), or companies with little or no previously disclosed information (e.g., privately owned businesses or subsidiaries of other companies).

Also, the levels of asymmetric information would also be elevated for bidders making acquisitions in unfamiliar territories, such as in unrelated cross-industry or cross-country acquisitions.

Finally, bidders that can least afford to absorb misvaluation risk (such as smaller bidders) or bidders that face relatively large magnitudes of this risk (e.g., when the target’s transaction value is large relative to the size of bidder) would have the greatest need to use a contingent contract to hedge away the risk.

 Structuring the Earn-out deal

The results of the research by Kohers and Ang show that while earn-out contracts have the potential to reduce valuation problems, the high transaction costs or costs of implementation may prohibit the use of this payment method in many cases. For example, agreeing on the appropriate performance standard and then measuring the ex post results may pose serious difficulties. Furthermore, third-party verification of the results and enforcement of the contract through legal means, actions that may be necessary in some cases, would also seriously complicate the feasibility of using earnouts.

Thus, in addition to the existence of severe information asymmetry between the target and bidder and the presence of valuable target human capital, the feasibility of writing such a contract is also a necessary condition for observing earnouts in practice.

There are key factors to consider from the beginning when structuring an earn-out:

• Setting Realistic Expectations

When there is a gap between the target and a potential acquirer in the perceived value of a business, it is usually caused by the expected future growth of the company. Being equipped with solid expectations for the businesses success over the next five years can prepare target owners well for negotiating an earn-out. To make a good deal, it is necessary the terms of the deal involve realistic expectations of growth and profit.

• Planning on working harder after the acquisition

When structuring an earn-out for a business, the owners should be prepared for a stressful period during the transition where certain milestone need to be achieved within a 2-3 year time frame.  If they are not willing to stay on and run the place, all the while keeping the earn-out expectations in mind, then it’s time to look at other sale options.

• Some questions to be answered at early stage

 What portion of the sale price the owners are willing to risk, and to work for during the transition period? The length of the transition period, How long are the owners willing to stay on? Can they meet the milestones in that timeframe? There’s any range of terms that the acquirer and the seller might consider? For example, the buyer might agree to pay 80% of the total price upfront, with the remaining 20% paid in stock or cash after the transition period. Or the deal could split the sale price 50/50 over a 5-year period, which is the timeframe the target owners have to optimise the business’s performance.

• Keep it simple

Earn-outs are most effective as an incentive for the seller when the size of the payout is determined based upon one or two simple variables that are easy to understand, such as increased profits or customer base.

• Keep the key players

If other executives were integral to the company’s growth and success, will the company be able to function under new ownership without them? If not, it is necessary to lock them in, too.

• Make sure who has control

 Ensure that the contract expressly states who will oversee any departments that will be executing on the goals and standards set forth in the earn-out.

• Ensure that incentives are in place

The earn-out percentage should be high enough to keep sellers from losing interest, especially in the event of a setback. Also, make sure to create contingency plans to address the most unlikely of scenarios – especially if you’re entering into a long-term earn-out deal.

So long as it is structured correctly, an earn-out can be a beneficial agreement for both parties; the seller is able to prove the value of their business and achieve additional compensation in the process, while the buyer eliminates some of the risk associated with the purchase should the company fail to perform after the transaction. An earn-out gives the seller an added incentive to ensure the success of the business going forwards. Should the business not perform as the buyer expected then they have been given some protection against overpaying.

in M&A, acquirers in the most successful deals have specific, well-articulated value creation ideas going in.

The strategic rationale for an acquisition that creates value typically conforms to at least one of the following six archetypes:

1 Improving the performance of the target company, 2 Removing excess capacity from an industry, 3 Creating market access for products, 4 Acquiring skills or technologies more quickly or at lower  cost than they could be built in-house, 5 Exploiting a business’s industry-specific scalability, and  6 Picking winners early and helping them develop their businesses.

Furthermore, even if your acquisition is based on one of the archetypes below, it won’t create value if you overpay.

1 Improve the target company’s performance

Improving the performance of the target company is one of the most common value-creating acquisition strategies. Put simply, you buy a company and radically reduce costs to improve margins and cash flows. In some cases, the acquirer may also take steps to accelerate revenue growth. Pursuing this strategy is what the best private equity firms do.

Among successful private-equity acquisitions in which a target company was bought, improved, and sold, with no additional acquisitions along the way, operating-profit margins increased by an average of about 2.5 percentage points more than those at peer companies during the same period. This means that many of the transactions increased operating- profit margins even more.

2 Consolidate to remove excess capacity from industry

As industries mature, they typically develop excess capacity. The combination of higher production from existing capacity and new capacity from recent entrants often generates more supply than demand. It is in no individual competitor’s interest to shut a plant, however. Companies often find it easier to shut plants across the larger combined entity resulting from an acquisition than to shut their least productive plants without one and end up with a smaller company. Reducing excess in an industry can also extend to less tangible forms of capacity.  Consolidation  in the pharmaceutical industry, for example, has significantly reduced the capacity of the sales  force as the product portfolios of merged companies change and they rethink how to interact with doctors.

While there is substantial value to be created from removing excess capacity, as in most M&A activity the bulk of the value often accrues to the seller’s shareholders, not the buyer’s. In addition, all the other competitors in the industry may benefit  from the capacity reduction without having to take any action of their own (the free-rider problem).

3 Accelerate market access for the target’s (or buyer’s) products

Often, relatively small companies with innovative products have difficulty reaching the entire potential market for their products. IBM, for instance, has pursued this strategy in its software business. Between 2010 and 2013, IBM acquired 43 companies for an average of  $350 million each. By pushing the products of these companies through IBM’s global sales force, IBM estimated that it was able to substantially accelerate the acquired companies’ revenues, sometimes by more than 40 percent in the first two years after each acquisition.2

In some cases, the target can also help accelerate the acquirer’s revenue growth. In Procter & Gamble’s acquisition of Gillette, the combined company benefited because P&G had stronger sales in some emerging markets, Gillette in others. Working together, they introduced their products into new markets much more quickly.

4 Get skills or technologies faster or at lower cost than they can be built

Many technology-based companies buy other companies that have the technologies they need to enhance their own products. They do this because they can acquire the technology more quickly than developing it themselves, avoid royalty payments on patented technologies, and keep the technology away from competitors.

Cisco Systems, the network product and services company (with $49 billion in revenue in 2013), used acquisitions of key technologies to assemble a broad line of network-solution products during the frenzied Internet growth period. From 1993 to 2001, Cisco acquired 71 companies, at an average price of approximately $350 million. Cisco’s sales increased from $650 million in 1993 to $22 billion in 2001, with nearly 40 percent of its 2001 revenue coming directly from these acquisitions. By 2009, Cisco had more than $36 billion in revenues and a market cap of approximately $150 billion.

5 Exploit a business’s industry-specific scalability

Economies of scale are often cited as a key source of value creation in M&A. While they can be, you have to be very careful in justifying an acquisition by economies of scale, especially for large acquisitions. That’s because large companies are often already operating at scale. If two large companies are already operating that way, combining them will not likely lead to lower unit costs.

Economies of scale can be important sources of value in acquisitions when the unit of incremental capacity is large or when a larger company buys a subscale company. For example, the cost to develop a new car platform is enormous, so auto companies try to minimize the number of platforms they need. The combination of Volkswagen, Audi, and Porsche allows all three companies to share some platforms. For example, the VW Toureg, Audi Q7, and Porsche Cayenne are all based on the same underlying platform.

Some economies of scale are found in purchasing, especially when there are a small number of buyers in a market with differentiated products. An example is the market for television programming in the United States. Only a handful of cable companies, satellite-television companies, and telephone companies purchase all the television programming. As a result, the largest purchasers have substantial bargaining power and can achieve the lowest prices. Economies of scale must be unique to be large enough to justify an acquisition.

6 Pick winners early and help them develop their businesses

The final winning strategy involves making acquisitions early in the life cycle of a new industry or product line, long before most others recognize that it will grow significantly. Johnson & Johnson pursued this strategy in its early acquisitions of medical-device businesses. J&J purchased orthopedic-device manufacturer DePuy in 1998, when DePuy had $900 million of revenues. By 2010, DePuy’s revenues had grown to $5.6 billion, an annual growth rate of about 17 percent. (In 2011, J&J purchased Synthes, another orthopedic-device manufacturer, so more recent revenue numbers are not comparable.) This acquisition strategy requires a disciplined approach by management in three dimensions. First, you must be willing to make investments early, long before your competitors and the market see the industry’s or company’s potential. Second, you need to make multiple bets and to expect that some will fail.  Third, you need the skills and patience to nurture the acquired businesses.

Other strategies

Beyond the six main acquisition strategies we’ve explored, a handful of others can create value, though in our experience they do so relatively rarely.

Roll-up strategy

Roll-up strategies consolidate highly fragmented markets where the current competitors are too small to achieve scale economies. This strategy works when businesses as a group can realize substantial cost savings or achieve higher revenues than individual businesses can.  Clear Channel Communications rolled up the US market  for radio stations, eventually owning more  than 900. Size is not what creates a successful roll-up; what matters is the right kind of size.

Consolidate to improve competitive behavior

Many executives in highly competitive industries hope consolidation will lead competitors to focus less on price competition, thereby improving the ROIC of the industry. The evidence shows, however, that unless it consolidates to just three or four companies and can keep out new entrants, pricing behavior doesn’t change: smaller businesses or new entrants often have an incentive to gain share through lower prices. So in an industry with, say, ten companies, lots of deals must be done before the basis of competition changes.

 Enter into a transformational merger

Transformational mergers are rare, however, because the circumstances have to be just right, and the management team needs to execute the strategy well. Using the merger  as a catalyst for change, can be possible not only captured value in cost synergies but also redefined the company’s mission, strategy, portfolio, and organization, as well  as all key processes, from research to sales.

Buy cheap

The final way to create value from an acquisition is to buy cheap—in other words, at a price below a company’s intrinsic value. However, such opportunities are rare and relatively small. Nonetheless, although market values revert to intrinsic values over longer periods, there can be brief moments when the two fall out of alignment. Markets, for example, sometimes overreact to negative news, such as a criminal investigation of an executive or the failure of a single product in a portfolio with many strong ones.

Such moments are less rare in cyclical industries, where assets are often undervalued at the bottom of a cycle. We found that companies in cyclical industries could more than double their shareholder returns (relative to actual returns) if they acquired assets at the bottom of a cycle and sold at the top

To gain control of a target, acquirers must pay its shareholders a premium over the current market value. Although premiums can vary widely, the average ones for corporate control have been fairly stable: almost 30 percent of the preannouncement price of the target’s equity. For targets pursued by multiple acquirers, the premium rises dramatically, creating the so-called winner’s curse. If several companies evaluate a given target and all identify roughly the same potential synergies, the pursuer that overestimates them most will offer the highest price. Since it is based on an overestimation of the value to be created, the winner pays too much—and is ultimately a loser. A related problem is hubris, or the tendency of the acquirer’s management to overstate its ability to capture performance improvements from the acquisition.

The possibility that a company might pay too much when the market is inflated deserves serious consideration, because M&A activity seems to rise following periods of strong market performance.

If (and when) prices are artificially high, large improvements are necessary to justify an acquisition, even when the target can be purchased at no premium to market value.

By focusing on the types of acquisition strategies that have created value for acquirers in the past, managers can make it more likely that their acquisitions will create value for their shareholders

This is a summary of the original article “The six types of successful acquisitions” written by Marc Goedhart, Tim Koller, and David Wessels from McKinsey & Company in May 2017. You can read the full article https://www.transactionadvisors.com/insights/six-types-successful-acquisitions

To try to explain the reasons for these high rates of “failure” in the M&A market, professors Christensen, Alton, Rising and Waldeck at the Harvard Business School, propose a theory that in summary says: “Many M&A fail to meet expectations because the acquisition targets are not chosen properly and as a consequence, many companies pay the wrong price and integrate the acquired company in a wrong way”

The researchers establish two main reasons that lead a company to undertake an acquisition:

1.- To boost company´s current performance

a) to hold on to a premium position or b) to cut costs. An acquisition that delivers those benefits almost never changes the company´s trajectory in part because investors anticipate and therefore discount the performance improvements

2.- To reinvent the company´s business model and fundamentally redirect the company

Almost nobody understands how to identify the best targets to achieve that goal, how much to pay for them, and how or whether to integrate them

The following is a summary of the paper published on the Harvard Business Review, in which the implications of the theory mentioned above are explored and is intended as a guide to improve the selection of acquisition targets, pay the correct price in a transaction and  to properly integrate an acquisition in order to improve the success rate.

What are we acquiring?

The success or failure of an acquisition lies in integration. To foresee how integration will play out, we must be able to describe what are we buying. The best way to do so is to think of the target in terms of its business model. As defined by authors a business model consist in four interdependent elements that create value: 1) Customer value proposition 2) Profit formula 3) Resources and 4) Processes. According to this, two types of acquisitions are proposed: i) those aimed at appropriating the “resources” of another company (LBM “Leverage the business model” ) and ii) acquisitions that seek to acquire new business models (RBM “Reinvent the business model”).

The authors indicate that in the right circumstances, the element “resources” can be extracted from an acquired company and plugged into the parent´s business model, because the resources exist apart from the company. On the other hand, profit formulas and processes do not exist apart from the organization and they rarely survive its dissolution. But a company can buy another firm’s business model, operate it separately and use it as a platform for transformative growth.

 How to achieve the objectives of an acquisition?

To achieve the objectives in a purchase transaction, it is necessary to be clear about for what purpose a company is being acquired. The authors mention two 2 basic objectives: a) Improve the current performance of the company or b) Reinvent the business model of the company

Improve the current performance of the company

So many companies turn to LBM acquisitions to improve the output of their profit formulas, but the conditions under which an acquisition’s resources can help a company accomplish either goal are remarkably specific.

Acquiring resources to command premium prices

The surest way to command a price premium is to improve a product or service, in other words one whose customers are willing to pay for better functionality. Companies do so by purchasing improved components that are compatible with their own products or acquiring the needed technology and talent (IP). In this case it is necessary to ask:

• What are the critical measures of performance that customers value in your product (speed, durability, functionality)?
• Would most customers be willing to pay more if you improved the product on those measures? (Do they value the extra speed, longevity, or functionality enough to pay more for it?)
• Can the resources of the acquired company substantially improve your product in ways that customers would pay more for?

Acquiring resources to lower costs

An acquisition of resources whose objective is to reduce costs is based on the fact that the acquiring company “plugs” certain resources of the acquisition in its existing model, discarding the rest of the acquired model and shutting down, laying off or selling redundant resources. To determine whether an acquisition of resources will help reduce costs, it must be established whether the acquisition resources are compatible with those of the acquirer and its processes, and then estimate whether the scale increases will actually have the desired effect.

If the resources of the target company are compatible with the resources and processes of the acquiring company, the acquisition is likely to improve turnover or use of assets and fixed costs. For companies in industries where fixed costs represent a large percentage of total costs, scaling up through acquisitions results in substantial cost savings in manufacturing, distribution and sales. But in industries where cost competitiveness can be achieved at relatively low levels of market share, a company that grows beyond that does not reduce its cost position, but replicates it. Acquisitions that are justified by economies of scale in administrative costs such as purchasing, human resources, or legal services often have disappointing effects on the profit formula.

Some critical questions posed by the authors of the research that should be formulated before an acquisition of this type:

Resources

• Will the acquisition´s products fit into my product catalog without creating confusion?
• Do its customers buy products like ours, and vice versa?
• Can the output of the acquisition´s factories be used with minimal adjustment by our supply chain and distributors?

Processes

• Can the acquisition´s offering be sold according to our sales cycle?
• Can my people readily service the acquired customers?
• Can its products be produced in our factories, and vice versa?
• Will the quality of its offerings be enhanced by our rules for managing procurement, IT systems, and quality control systems?

The temptation of one-stop shopping

The authors warn that in circumstances in which companies seek to increase the current benefit through LBM agreements aimed at the acquisition of new customers, the success stories identified include the fact of selling to customers “acquired” the products they were already buying before the acquisition. Purchases made for the purpose of cross-selling products succeed occasionally and only if customers need to buy those products at the same time and place.

They cite as an example the Citigroup case and the acquisitions that it made to create a kind of “financial supermarkets,” thinking that customers’ needs for credit cards, checking accounts, wealth management services, insurance, and stock brokerage could be furnished most efficiently and effectively by the same company. Those efforts have failed, over and over again. Each function fulfills a different job that arises at a different point in a customer’s life, so a single source for all of them holds no advantage. Cross-selling in circumstances like these will complicate and confuse, and will rarely reduce sales costs.

Reinventing the business model

The  groundwork for long-term growth is creating new ways of doing business, since the value of existing business models fades as competition and technological progress erode their profit potential, RBM acquisitions help managers tackle that task.

If cash flow groes at the rate the market expects, the firm’s share price will grow only at its cost of capital, because those expectations have already been factored into its current share price. To persistently create shareholder value at a greater rate, managers must do something that investors haven’t already taken into account—and they must do it again and again.

Acquiring a disruptive business model

The authors mention that the most reliable sources of unexpected growth in revenues and margins are disruptive products and business models. Disruptive companies are those whose initial products are simpler and more affordable than the established players’ offerings. They secure their foothold in the low end of the market and then move to higher-performance, higher-margin products, market tier by market tier. Although investment analysts can see a company’s potential in the market tier where it’s currently positioned, they fail to foresee how a disruptor will move upmarket as its offerings improve. So they persistently underestimate the growth potential of disruptive companies.

Acquiring to decommoditize

One of the most effective ways to use RBM acquisitions is as a defense against commoditization. Over time, the most profitable point in the value chain shifts as proprietary, integrated offering metamorphose into modular, undifferentiated ones. The innovative companies supplying the components start to capture the most attractive margins in the chain. Firms in this situation should instead migrate to “where the profits will be”—the point in the value chain that will capture the best margins in the future.

Some critical questions posed by the authors of the research that should be formulated before an acquisition of this type:

Can This Acquisition Change Your Company’s Growth Trajectory?

• Is the acquired company’s product or service simpler and more affordable than the established players’ offerings?
• Do this simplicity and affordability enable more people to own and use the product or service? Is it good enough to suit the needs of a variety of customers?
• Can the acquired company’s business model scale upmarket to yield a stream of progressively higher-capability products and services?
• Do established players and the company’s offering profitable enough to replicate, or is the company playing in low-end markets that incumbents are content to ignore?
• Does the acquired company reposition you to capture the most attractive (future) profts in the industry’s value chain?

 Paying the right price

The authors state that because RBM acquisitions increase the shareholder value creation rate more effectively, they should have a relatively higher price than LBM acquisitions.

They indicate that in some cases of LBM acquisitions, prices have been paid well above the level that could justify the cost synergies. For that kind of deals, they say, it is crucial to determine the target´s worth by calculating the impact on profits from the acquisition.

For LBM acquisitions, the correct comparables would be companies that make similar products in similar industries. For RBM acquisitions,however,  such comparables make disruptive companies seem overpriced, deterring companies from pursuing the very acquisitions they need for reinvention.  In fact, they say, the right comparables for disruptive companies are other disruptors, regardless of the industry.

Avoiding integration mistakes

Authors say the approach to integration should be determined almost entirely by the type of acquisition made. If another company is acquired for the purpose of improving the current business model’s effectiveness, it is generally necessary to dissolve the acquired model as its resources are folded into the acquiring operations. But if a company is being acquired for its business model, it’s important to keep the model intact, most commonly by operating it separately. Failing to understand where the value resides in what’s been bought, and therefore integrating incorrectly, has caused some of the biggest disasters in acquisitions history.

Companies can make acquisitions that allow them to command higher prices, but only in the same way they could have raised prices all along—by improving products that are not yet good enough for the majority of their customers.

And companies can acquire new business models to serve as platforms for transformative growth—just as they could if they developed new business models in-house.

At the end of the day, the decision to acquire is a question of whether it is faster and more economical to buy something that could, given enough time and resources, be

In the following link you can find the article including some illustrative examples for the topics discussed.

The results were presented in the 5th edition of the CMS European M&A Outlook released in the last quarter 2017.

Key findings

M&A set to rise

Over the 66% of respondents are expecting M&A in Europe to increase 2018, with the 90% suggesting that non-European buyers will be active acquirers across the continent.

Transformational deals on the cards

The 40% of corporates and nearly 50% of PE firms are seeking out large, transformational deals over 2018 saying that technology and IP are among the top two aspects under consideration when acquiring.

Favourable financing conditions

European companies now benefit from a range of financing options for their deals, from newly-emerging private credit funds that can provide an alternative or addition to bank finance, to more traditional private equity.

♦♦♦

Brexit negotiations and M&A

• “1) A“No deal“ scenary will increase the need for corporate restructuring across Europe. A further sharp fall in sterling will create opportunities to find value in UK assets or 2) A cooperative resolution of the negotiations will improve the growth outlook across Europe, boosting business confidence and the appetite to seek growth through acquisitions.”
• “When fog clouds the outlook, some will run for cover, but the more people’s views on the future differ, the greater are the opportunities for trade. The risk-averse owner of an asset will be willing to sell to someone more daring and willing to see the outcome as bright. A price that satisfies both sides can be easier to find.”

Europe rising tide

• 67% of respondents expect M&A in Europe to increase. 90% expect an increase in non-European acquisitions of European companies; 64% say that North American companies will be the most active inbound acquirers in Europe
• “Buyers from different markets based in the APAC and North America will continue acquiring companies in Europe because prices are low and the opportunities to gain market and technology are high,”
• “Another factor driving activity is a desire for companies to gain access to growth in the European market. “Cash-rich companies are turning to markets in Europe to reduce the risks faced in their existing markets.”

Digital innovation drives M&A

• Acqui-hiring. One deal driver in M&A is digitization. Corporations look for capture innovations and new technologies acquiring companies digital native to respond challenges that this area impose to their business models.
• Respondents believe technology, media and telecommunications (TMT) will be the most active sector for M&A (37%), followed by consumer (19%) and energy, mining and utilities (16%). E-commerce is the leader of the TMT pack, with deal value rising from €2.4bn in H1 2016 to €3.4bn in the same period for 2017.
• European e-commerce revenues increased by 15% with growth expected to remain at similar levels for 2018. The fragmented nature of the European e-commerce space and the uneven penetration of internet-based purchases across the region make the sector ripe for consolidation and future growth.

Dealmaker cash in

• 54% believe that cash-rich corporates will be behind acquisitions on the buy side, followed by consolidation plays, cited by 51%, while just 12% believe M&A will be driven by the relative weakness of European currencies. For sellers, growth is at the top of the agenda. Over half (51%) say that capital raising for expansion in faster growing areas is set to be the greatest driver of sellside M&A activity. This is supported by the second biggest driver identified by respondents, non-core sales of larger companies.

Spotlight on automotive and the Autonomous future

• The number of transactions in the automotive sector increased by 74% in 2016 compared with 2015. On the one hand, this increase is based on the fact that traditional car manufacturers and suppliers are purchasing digital know-how and, on the other, that traditional business divisions are being sold off as the automotive market goes digital.
• These profound structural changes mean leading car manufacturers need to fundamentally shift their business focus. Cars will no longer be sold based on driving features but due to their compatibility with other devices (i.e Internet of Things), their functionality and amenities.
• Car manufacturers are responding either by producing new technologies and giving them a competitive advantage, or by partnering or acquiring technology companies so that they can incorporate their expertise into their business.
• According to Mergermarket data, the top sector by both value and volume in H1 2017 was industrials and chemicals, with 667 deals worth €76.6bn. The automotive industry has emerged as the subsector to watch.
• Carmakers and technology companies are becoming increasingly intertwined – demonstrated by Uber and Daimler’s selfdriving car partnership, announced in January 2017. These trends are likely to drive further M&A in the sector, with automotive companies increasingly looking to acquire start-ups with promising technologies.

Spotlight on Consumer goods

• The sector was the second largest by value for European M&A activity in the first half of 2017, according to Mergermarket data, notching up a total deal value of €75.3bn.

♦♦♦

Deal dynamics

• 66% of respondents are currently considering M&A – either acquisitions, divestments or both; 68% of corporates cite the need to grow in new geographies and customer bases as their key driver for acquisitions; 73% of corporates consider technology/IP among their top two considerations.
• European valuations remain low compared to the peak of 2015. Recent economic volatility also appears to have convinced many buyers that diversification and increased efficiency through significant scale is an important strategic goal. Such transformational deals are boosting deal values across Europe.
• Rising automation of tasks and digitisation reducing the cost of many business and production processes. According to 86% of PE firms and 73% of corporates, technology and IP acquisition is one of the two most important aspects for buyers when looking at targets.
• Distribution channels are another key priority for buyers; In some cases there is a need to develop sales channels and expand into different markets.
• Despite record levels of dry powder, PE funds are increasingly doing deals alongside other PE houses. This reflects the trend towards larger deal sizes, as PE firms club together to avoid concentration risk in their portfolio – most have restrictions on the percentage of the fund that can be invested in a single asset. The role of family offices has become increasingly prominent in the European PE scene. Over half (51%) of respondents have undertaken an equity coinvestment with a family office over the past 12 months, and 44% expect to do so over 2018.
• Volatility in global capital markets will have the greatest negative impact on the performance of European businesses over the coming year.
• 43% believe that antitrust is the most challenging aspect also Financial regulations are stringent and increase legal and compliance costs, while individual country data protection laws are not sufficiently developed.

Geographical round up

• UK & Ireland continue to lead European M&A activity in terms of value and volume. Dealmakers will increasingly use Ireland as a base from which to gain access to the European market.
• The Nordics achieved the second highest deal volume in the region.
• German M&A has almost doubled in value compared to last year, powered by activity within the industrials and chemicals sector within the German market “not only are returns strong but demand is growing.“

Percentage changes compare figures for H1 2017 with the same period of the previous year

Sovereign states that are most frequently included in the SEE region are, in alphabetical order: Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Greece, Kosovo, Macedonia, Montenegro, Romania, Serbia, and Slovenia

CEE Czech Republic, Hungary, Poland, the Slovak Republic, and the three Baltic States: Estonia, Latvia and Lithuania

The lending landscape

• 88% of respondents are expecting similar or more favourable financing conditions over the coming year; 89% predict that restructurings will increase; There are many financing options :Interest rates are low and the number of lenders high, making it easy to access capital.”
• The biggest challenge to financing acquisitions is expected to be company performance, There are still uncertainties in a few major markets, growth rates are slow and some sectors are already bearing the brunt of changes in economic conditions. Stock markets are still very volatile and companies are taking time paying off debts
• With an abundance of capital at their disposal, it is unsurprising that PE firms are expected to be the most active source of capital over 2018 (stated by 57% of respondents). This is followed by cash reserves, mentioned by 55% of respondents. Alternative forms of debt finance, such as credit funds came in third place, with over a quarter (28%) saying this will provide the most available form of funding, ahead of bank lending (23%).
• Respondents expect restructuring to feature heavily among transaction types over 2018, with 89% predicting that restructuring deals will increase over 2018. Refinancings also feature high on the dealmaker agenda; According to S&P Global fixed income research, €3.7tn of rated companies’ debt is scheduled to mature between mid-2017 and the end of 2022, which is set to cause a flurry of refinancing activity.

To take away

Look for disruption

There are a number of disruptive forces at play, from global economic and market volatility and technological development to the eventual effects of Brexit across a number of sectors. Take a leaf out of the PE playbook and seek out opportunities in markets that are perhaps undervalued or are undergoing rapid transformation, and target businesses that are set to benefit from the changes.

Focus on core growth areas

These disruptive forces are driving buyers to diversify their exposure to manage volatility. For sellers, this means that their non-core business units may well be highly valued by acquirers that can gain synergies or economies of scale or are willing to invest in unloved assets to develop and improve them.

Take advantage of financing conditions

There is strong competitive tension between the rising numbers of financing options available to European companies. Debt funds and banks are vying to provide credit in many sectors and PE firms have record amounts of dry powder to invest, increasingly seeking buy and build opportunities to achieve businesses of scale.

More details in Changing tides: European M&A Outlook 2017, A study of European M&A activity, September, 2017. CMS in cooperation with Mergermarket

Origins and evolution of family offices

In the past, wealth and possession were almost always connected to rulers and the ruling class because they were the only ones with the power and means to amass vast wealth. Some examples are Emperor August Caesar, who ruled the Roman Empire from 27 BC-14 AD, Emperor Shenzong (1048-1085) of China’s Song Dynasty, Alan Rufus (1040-1093) the first Lord of Richmond, and others.  There was a common trait in those examples– they shared their wealth with a trusted inner circle comprised of high-ranking officials and local representatives, who took on roles that are reminiscent of family office staff members today. The differences with modern FO chiefly exist in what made people wealthy and the strategic allocation of their assets.

More recently, American industrialist, philanthropist, and private entrepreneur, John D.Rockefeller Sr., is often referred to as a crucial figure in the history of family offices. His fortune stood at $1.4 billion at his death in 1937, accounting for more than 1.5% of the US economy. Equivalent to approximately $255 billion today, Rockefeller’s wealth is considered to be one of the greatest in history. In 1882, Rockefeller established an office of professionals to organize his complex business operations and manage his family’s growing investment needs. Generational planning formed an essential part of Rockefeller’s wealth management, as did his enormous engagement in philanthropic causes. Most of the family assets were organized under trusts over time, most of which still exist today.

It was only in the late 20th century that single-family offices grew in number and multi-family offices began taking shape. There are many reasons people consider setting up a family office, but the central goals usually include ensuring effective wealth management, superior investment results, and a smooth transfer of assets between generations.

Family offices are now arguably the fastest growing investment vehicle worldwide. This growth is evidence of the advantages of a family office in managing, protecting and distributing wealth within families with large fortunes.

What they are and what added-value they bring?

Often a family office works as an investment arm for a family. This can be managed in traditional securities investments or through family-owned business interests.  In addition to investment expertise, family offices generally help find co-investment opportunities, they help transition business control (not just legal, but effective control), help train the next generation of family on the responsibilities of wealth, help manage the family’s philanthropic efforts, and much more. A family office can:

• provide increased privacy and confidentiality of financial dealings, which can help protect family members from unwanted attention.
• act as a gatekeeper that protects family members from unwanted solicitations for a myriad of matters.
• deliver services in coordinated and customized manner to the individual family members being served.

Single family offices and Multifamily offices

Interestingly, single-family offices often do not carry the title of ‘family office’ and it is not uncommon that a family does not realise that the services they have lined-up fall under the umbrella of family office services. This includes business-owning families that require one or more members of their corporate staff to support them with a wide range of personal matters.  An inclusive definition of a single-family office is the following:

• A single-family office is a privately controlled (group of) staff employed within or outside a dedicated structure that supports an affluent family with the organisation, management, and maintenance of all or parts of their assets, needs, and wishes.

In the other hand, multi-family offices are almost always commercially operated companies that aim to generate profit for themselves in addition to the families they work with. A good definition could be:

• A multi-family office is a privately controlled and commercially operated organisation that employs staff to support a number of affluent families with the organisation, management, and maintenance of parts of their assets, needs, and wishes.

There are about as many variants of the family office as there are families. For a smaller family whose principal asset is a family business, the family office may simply be a personal assistant who, as well as dealing with business administration, assists family members with more domestic matters such as paying the cleaner and gardener, and making travel arrangements. At the other end of the scale, a large family with significant wealth may have a family office with staff ranging from investment advisers, lawyers, property managers and philanthropy directors.

Today, a number of single-family offices are establishing separate multi-family office entities while their single-family office continues to service their own family in a Hybrid model. Another variation is the hub-and-spoke model, where the parent’s single-family office provides the administrative support, advanced planning expertise and lifestyle services. The inheritors, meanwhile, are taking their monies and investing independent of the parents. The inheritors set up “satellite” offices focused on managing their investments. This results in the inheritors maintaining many of the advantages of a full-service single-family office without having to duplicate a variety of desired services.

Using a mixture of in-house and outsourced services can provide a useful check on the dependency of the family on their family office. Whether it is small or large, managed in-house or outsourced, a family office should always be driven by its ultimate goal: to align interests, make it easier for the family to manage its assets, and enhance communication and cooperation.

What’s clear is that single-family offices are going to continue to evolve. While they’ll likely maintain their core structure and deliverables, the way they can be configured will enable them to stay at the cutting-edge in the service of the ultra-affluent. Succession and next generation planning will become important topics of discussion and  families will begin to look for a holistic approach to wealth management.

This post is based in the article Family Offices A History and Definition by Jan van Bueren

Firms established in the market have confronted the threat of becoming obsolete by opening their innovation strategy to increase their exchanges with the startups ecosystem. Collaboration between corporations and startups has become crucial to innovate and accelerate disruptive and changing products and services; Corporate venturing is a rout to incorporate innovation into an organization in a relatively fast way.

According to the Business Dictionary Corporate Venturing is the “practice where a large firm takes an equity stake in a small but innovative or specialist firm, to which it may also provide management and marketing expertise; the objective is to gain a specific competitive advantage”

The current increase in Corporate Venturing activity is a fact and there are many reasons that explain this growth: Cyclical improvements in the balance sheets  of corporates since the financial crisis of 2008, Faster cycles of innovation and technology adoption have led to the rapid demise of certain incumbents  in various sectors and, the growing awareness that commitment and external investment in R & D activities and open innovation are key to innovation in companies due to the fact that often R &D  internal initiatives can be slow. Google, BMW and General Mills among other corporations, have complemented traditional R & D activities with their own Corporate venture capital funds by joining other investors to invest in promising startups.

Companies that have the objective of acquiring new capabilities and agility in their innovation processes through Corporate Venturing can obtain many benefits from this activity. Some of these potential benefits are:

Faster Responses

Corporate Venturing can allow a firm to respond quickly to market transformations.  It is likely that developing new technological capabilities on their own could take companies for longer and more expensive. In a study of 71 venture initiatives by biopharmaceutical firms from 1985 to 2005, Hyunsung Daniel Kang and Vikram K. Nanda of Georgia Tech found that companies that made financially successful investments also experienced greater success in drug development.

Better View of Threats

A Corporate Venture Capital fund can serve as an intelligence-gathering initiative, helping a company protect itself from emerging competitive threats. Create a venture program to invest in competing technologies with the goal to gather strategic information at relatively low cost could be a tool that favors the business value of the company.

Easier disengagement

It gives executives a faster way to disengage from investments that seem to be going nowhere. Many companies find it difficult to abandon the not-quite-good-enough innovations that sometimes come out of internal labs. The arm’s-length relationship between companies and their venture funds offers advantages in this regard: The best funds tend to be quicker on the trigger than their corporate parents. Even if a corporation is unwilling to terminate an unpromising initiative, the presence of co-investors may force the decision.

A bigger bang

By combining its own capital with that of other Venture Capitals Funds, a corporate venture capital fund can magnify the impact of its investments. This is particularly beneficial when technological uncertainty is high; In 2008, the $100 million fund  iFund  and VC firm Kleiner Perkins Caufield & Byers co-invested in companies developing games and tools, on the day when outside developers were first allowed to begin working on apps for the iPhone. In this way, Apple rapidly built a critical mass of applications for its new phone while spending very little.

Increased demand

By encouraging the development of technologies that rely on the parent corporation’s platform, venture investments can help increase demand for the corporation’s own products. Intel Capital took this approach in late 1998, when it established a fund that would help speed the entry of Intel’s next-generation semiconductor chip into the market. Fund managers invested in many software and hardware makers (often Intel competitors) whose products capitalized on the new chip’s power. Those investments accelerated the chip’s adoption by several months, according to Intel.

Higher returns

For corporate venture capital funds, gaining strategic benefits is usually the main goal; historically, profits from venturing typically haven´t been significant enough to matter to the parent company’s bottom line; Many of today’s leading CVCs are structured with the clear objective of maximizing financial return.  CVCs have been structured with a critical set of features – returns-orientation, independent decision-making, strategic relevance and evergreen capital – that foster longevity for the CVC and trust with the start-up community.

Although the CVC have been operating for several decades, the today´s value proposition a CV offers to a corporation who wants to innovate is undeniable. CVCs develop a stronger network of business leaders, greater credibility and deeper domain expertise in focus areas,  serving as a bridge between the startups ecosystem and corporations and acting creatively and strategically by leveraging corporate assets to capture innovation outside the corporation.

This post is based on the article Corporate venturing published in the HBR https://hbr.org/2013/10/corporate-venturing

Here is a list of some of the actions that potential sellers should consider before embarking on a sales process:

1.Estate planning

For many shareholders of privately held and family owned businesses, effective  planning can reduce or defer the amount of tax to be paid by the selling shareholders. In some  cases, these actions must be completed well in advance of a sale process in order to achieve the  desired effect. An experienced estate planning attorney or other advisor with expertise in this  area can provide guidance. The benefits of this planning will in all likelihood far outweigh the cost.

2.Financial Information

A target company’s financial information will of course be a critical part of the diligence process. If a company which does not have bank financing or other shareholder reporting obligations requiring audited financials has not previously obtained an audit, it might be appropriate to at least consider obtaining one. Public company buyers and buyers who rely on debt financing to finance the purchase price may require that a seller have audited financial statements. Also, to the extent that family or other personal arrangements with shareholders or other affiliates run through the financial statements of the company, pro forma adjustments will need to be made to remove these items from the historical numbers in order to normalizeearnings for purposes of arriving at a purchase price that accurately reflects the post-closing operation of the business. While in many cases there are tax or other reasons for these affiliate arrangements, to the extent that arrangements which are not essential to the business can be eliminated, that will help to simplify the financial diligence process when prospective buyers look at a business from the perspective of how it would be operated on a post-closing basis. Also, if a company has unprofitable contracts or above-market expenses, they may be best dealt with in advance of a sale process so as not to be a drag on earnings.

3.Incentives for Management that Align Interests

Recognizing that buyers will vary in the extent of their desire for post-closing involvement from existing management, it is worthwhile to consider whether adopting any particular management incentive arrangements (or making any adjustments to existing incentives) could help to better align the interests of management with those of the selling shareholders, both in the period leading up to a sale and also during a postclosing transition period. For example, providing for a change of control bonus arrangement that vests and becomes payable at some point following the closing of a sale transaction (e.g., six months after a closing), assuming continued employment through the payment date, should help to ensure a smoother transition of ownership. Other incentives can be designed to fit the particular circumstances of the relationship with management and likely buyers.

4.Protect IP Rights

While this issue is more relevant in some industries than others, review and confirm that employees, consultants and/or other developers who might in the future claim rights in proprietary IP and software of the target business have assigned these rights to the company. Consider having all new hires and applicable existing employees sign non-disclosure and assignment of invention agreements in forms that are sufficient to provide enforceable rights in favor of the company and a buyer. A seasoned buyer will, at a minimum, want to be indemnified by the sellers for any post-closing problems that might arise regarding its ownership of IP rights.

5.Change of Control/Assignment Provisions

While they cannot be avoided in many circumstances, where a future sale or liquidity event transaction is anticipated, when possible, try to resist including “change of control” provisions (i.e., provisions in an agreement which give the other party the right to terminate the agreement upon a change in ownership–and which therefore require the consent of the counterparty to do a deal) in contracts and agreements. If a consent provision cannot be avoided, it may be possible to draft the language so that it is more flexible.

While thee are differences driven by the transaction structure (i.e., stock vs. asset sale) that will impact how these provisions are interpreted, any change of control or assignment provision that requires a third party’s consent can complicate a sale process and give a counterparty with a consent right leverage, including to ask for payment of a fee or changes to deal terms in exchange for its consent. Similarly, be aware of how change of control language in loan documents can impact a sale if debt will not be paid out at closing.

6.Corporate Records and Housekeeping

Minute books and other corporate records should be kept current. Minutes of board meetings which demonstrate that a board has met regularly and properly discharged its fiduciary duties and oversight functions should help to ensure that the separate existence of the entity is respected, and therefore help to protect shareholders in the case of a lawsuit or claim or other action by a creditor against the company. Poorly maintained or deficient corporate records can, at the very least, give a buyer a negative impression about a target company and cause it and its advisors to be more cautious in their due diligence in other areas. Minutes should not be transcripts of board meetings, but they should be sufficient to show that the board engaged in a thoughtful and deliberative discourse with respect to matters it considered.

If some arrangements that are important to a business have traditionally been done on a “handshake” basis or through an oral understanding (without a written contract), consider putting these understandings in writing so that they can be better understood by and assigned to a buyer. Memorializing these arrangements prior to a sale process can also identify any misunderstandings regarding terms prior to involvement from a buyer.

Also, make sure that any key corporate documents, such as stock ledger records and shareholder agreements, are up to date and signed by all relevant parties, including minority shareholders. Depending upon the composition of a company’s shareholder group, it is a good idea for the principal shareholders to understand how any “drag-along” or other shareholder agreements work well in advance of embarking on a sale process, particularly where there might be different goals and objectives within the shareholder group in structuring a sale.

7.Director Indemnification Agreements

Consider entering into director indemnification agreements between the company and directors with survival periods that extend for the applicable statute of limitations. If a sale transaction is structured as a stock sale or a merger, indemnification 3 agreements will give directors additional comfort that the surviving company will have an obligation to indemnify them for any claims that might be brought against a former director after a deal closes.

This post is based on the article “8 Ways to Plan Ahead for the Sale of a Business”  of Karl M. Ahlm published in www.transactionadvisors.com

I.- Brand valuation based on market research

These models are based primarily on market research to determine the performance of brands. They measure, among other things, the behavior and attitudes of consumers that have an impact on the economic performance of brands. They attempt to explain, interpret, and measure consumer perceptions that influence buying behavior. This approach generally fails to establish the link between specific marketing indicators and financial performance of brands because the variables analyzed, are not integrated into an economic model and are insufficient to establish the economic value of brands.

II.- Brand valuation based on financial models

Within this category the various existing methodologies try to incorporate the market variables in a financial model that allows measuring the performance of the brand in economic terms. Under this approach there are several methods:

Historical costs

It define the value of a brand as the aggregate of all historical and replacement costs, that has been invested to bring the brand to the current market level (sum of all development costs, marketing, advertising and other communication costs, among others. ). This methodology does not establish the direct correlation between financial investment and value added by the brand; Nor does it incorporate the value of money over time.

Comparables

This methodology proposes to establish the brand value based on comparing it with other brands. This comparison is particularly difficult because, by definition, brands seek to differentiate and not be comparable with others. Moreover, the creation of value of a brand in the same sectoral category can be different even if many other aspects of business are similar between brands of the same sector. However, this method can be useful for cross-checking with results achieved with other methodologies.

Price premiums

In this method, the value of the brand is calculated as the net present value of the price premiums that a branded product would have on a similar generic product or equivalent. However, the goal of many branded products is to achieve higher levels of demand rather than premiums over price. It is usually difficult to obtain generic product information comparable to the branded product to be valued.

Economic value

This methodology is based on financial measures provided through market and financial information of the brand to be valued. The Economic Value approach was developed in 1988 and has become the most accepted method in the market for brand valuation. This method is based on the following principles:

A) Principle of Marketing: “Brands work within a business”. Consumer demand translates into purchasing, price and frequency volumes and brands ensure long-term demand through loyalty and product repurchase.

B) Financial Principle: “The net present value of expected future earnings”. The future earnings of a brand are identifiable and are discounted at an appropriate rate that reflects the risk that those gains will be realized.

This methodology is developed in five steps:

1.- Market segmentation 

The brand is valued in each market segment and the sum of the valuations of the segments constitutes the total value of the brand.

2.- Financial analysis

The sales revenues and profits of the intangibles generated by the brand in each segment are identified and projected. Intangible gains are defined as brand sales revenue less operating costs, taxes and capital charges.

3.- Demand analysis 

It determines the role of the brand in achieving the demand for the products and services offered in the markets in which it operates and determines what proportion of the intangible profits are attributable to the brand, measured by an indicator called ” brand””.

4.- SWOT Analysis

The brand’s competitive strengths and weaknesses are determined to calculate an appropriate discount rate that reflects the risk profile of expected future earnings (this is measured by an indicator called “Brand Strength Score”) that allows the calculation of the  Discount rate brand valuation. Establishing this indicator includes an extensive work of competitors analysis, the structure of the brand market, its stability, leadership position, growth trends, geographical coverage and legal protection of the brand, among others.

5.- Calculation of brand value

The value of the brand is calculated as the present value projected intangible gains of the brand, discounted by the Discount rate brand valuation. The Net Present Value of the brand includes both the explicit projection period and the value beyond that period, reflecting the brand’s ability to continue generating future profits.

It is becoming more frequent for companies, the need for valuing brands both from the management point of view and for transactions. The economic value approach is a  useful tool in the financial management of brands.

Despite the differences in focus on brand valuation and the difficulty of determining what portion of a company’s cash flows are attributable to the brand, the brand valuation process is very useful for management teams because it helps them to identify and analyze the brand value drivers when comparing them with other brands or companies or as a measure of accomplishment of  the company’s goals in a given period of time.

Based on the working paper “Brand valuation,  A chapter from brands and branding, An economist book” Interbrand, april,  2004.

Experts suggest four methodologies that work for angels and startups.

These offer an excellent starting point to assess the value of a startup:

Berkus method:

Valuation based on the assessment of 5 key success factors. It attributes a range of monetary values to the progress startup entrepreneurs have made in their commercialization activities.

First, you have to know how much a similar startup is worth. Then, you assess how you perform in the 5 key criteria for building your company:

The Berkus Method is meant for pre-revenue startups and  will give you a rough idea of how much your company is worth (pre-money valuation) and what you should improve.

Risk factor summation:

Valuation based on a base value adjusted for 12 standard risk factors. Compares 12 characteristics of the target company to what might be expected in a fundable seed/startup company.

It is a slightly more evolved version of the Berkus Method. First, you determine an initial value for your company. Then you adjust said value for 12 risk factors inherent to company -building.

Initial value is determined as the average value for a similar company in your area, and risk factors are modelled as multiples of $250k, ranging from $500k for a very low risk, to -$500k for a very high risk.

The Risk Factor Summation Method is meant for pre-revenue startups.

Scorecard Method:

Valuation based on weighted average value adjusted for a similar company. It adjusts the median pre-money valuation for seed/startup deals in a particular region and in the business vertical of the target based on seven characteristics of the company.

It starts the same way as the RFS method i.e. you determine a base valuation for your startup, then you adjust the value for a certain set of criteria. Nothing new, except that those criteria are themselves weighed up based on their impact on the overall success of the project.

This method can also be found under the name of Bill Payne Method, considering 6 criteria: Management (30%), Size of opportunity (25%), Product or Service (10%), Sales channels (10%), Stage of business (10%) and Other factors (15%).

The Scorecard Valuation Method is meant for pre-revenue startups.

Venture capital Method:

Valuation based on the ROI expected by the investor. Calculates valuation based on expected rates of return at exit. It stands from the viewpoint of the investor.

An investor is always looking for a specific return on investment, let’s say 20x. Besides, according to industry standards, the investor thinks that your company could be sold for $100M in 8 years. Based on those two elements, the investor can easily determine the maximum price he or she is willing to pay for investing in your startup, after adjusting for dilution.

The Venture Capital Method is meant for pre- and post-revenue startups.

The most difficult part in most of these valuation methods is finding data about similar companies.

There is no perfect methodology to establish the pre-money valuation of pre-revenue ventures, making it even more important for investors and entrepreneurs to know how the number is derived.

Since most startups have little-to-no history, revenue and earnings, there isn’t much information to analyze or plug into a spreadsheet. To close this gap, angels can look for clues from similar startup deals in the same region and industry. Valuations could go up and down depending on market forces, may also be adjusted up or down based on the strength of the management team, location of the business, industry or market.

Valuations are a good starting point when considering fundraising; they help building up the reasoning behind the figures and objectify the discussion. But in the end, the game of supply and demand is significant.

This post is based on Stephane Nasser post published in www.starupsventurecapital.com

EBITDA is useful for analysts and users in general, because:

1. It works to compare the performance of a business with others within the same sector and with the same business in other periods due to the fact that it shows the resources obtained from the operations and excludes any extraordinary or non-recurrent item,
2. It measures the performance of the business by isolating the influence of financing decisions or the fiscal framework in which the entity operates, that could affect its economic results but have no direct connection with the business itself.

Being a non-standardized measure, sometimes the EBITDA brings misunderstandings and misinterpretations.

For example, many analysts use EBITDA as an expression of the cash flow generated by an entity in a period. For this to be the case, changes in the current working capital of the entitty in the analyzed period (current operating assets less current operating liabilities) would have to be taken into account, in addition to the adjustments for impairment of current assets and the change in the operating provisions, whether short-term or long-term. Another example that EBITDA could lead to a misinterpretation of an entity’s situation at any given time, could be when in calculating it non-recurring revenues or expenses have been considered, bringing distortions and making the entity incomparable with others within the same sector, or with the same entity in different periods.

These reasons have led the AECA (Spanish Association of Accounting and Business Administration), in December 2016, to express its Opinion No.4 Concept and use of EBITDA as a measure of Gross Operating Income, with the purpose of offering recommendations regarding the presentation and use of the EBITDA.

The Opinion of the AECA Accounting Principles and Standards Committee has two parts:

1. In the first, recommendations are made to ensure that the EBITDA figures are calculated and presented in a consistent manner from period to period, explaining their composition from the items in the Profit and Loss Account for the year.
2. In the second part, EBITDA is formulated to help entities that want to use it on a regular basis, calculating and presenting measures based on recurring resources generated by the entity.

Presentation of EBITDA

In order to be useful to analysts of financial statements and other financial reports, the entity that includes the EBITDA as an information measure of its performance, must first of all select only the recurring revenues and expenses related to the operating activities excluding the consumption of fixed capital.

Any financial or fiscal result such as interests on debts or financial income, as well as income tax, should be excluded when calculating EBITDA, since they are not part of the results of the business operation in itself.

Sufficient information should be included to present a reconciliation table, where should be clear that EBITDA is obtained from other items usually included in the financial statements and defined in the conceptual framework that applies to it.

The usual way to make the reconciliation with the items that appear in the financial statements has a profile, in general, such as the following:

RESULTS OF THE YEAR (continued operations)

+/- Income tax

– Financial income

+ Financial expenses

= RESULTS FROM OPERATIONS

+ Depreciation and amortization (net)

– Non-recurring operating income

+ Non-recurrent operating expenses

= GROSS OPERATING INCOME (EBITDA)

It is recommended that the calculation procedure used, as well as the resulting figure, when presented, be made in line with the Opinion document, expressly stating that the calculation of the EBITDA has been made following the recommendations of the Commission of Principles And AECA Rules -OE 4 / 2016-.

If the procedure differs  in a period, that is to say that different variables are used or the procedure of calculation has changed, the entity should treat it like a change in the accounting criteria, which means that:

1. Will explain,  both the nature and the cause that caused the change made,
2. Will explain the reasons the change made produce more reliable and relevant information about the entity’s performance and,
3. Will apply the change retroactively for all comparative figures presented together with those for the current period or period, as well as for all derived measures (percentages, coefficients, ratios or differences) based on EBITDA.

Calculation of  EBITDA

To calculate EBITDA, the entity must select the recurring revenues and expenses from operations, which implies identifying or delimiting the business activity. Recurring activities include all those that are repeated or may be repeated period after period, as a result of the usual management efforts and actions of those responsible for the operations of the entity, excluding any financial or fiscal results.

The procedure chosen is the indirect method, adjusting the result of the year by items that do not related to the business in itself or are not recurrent. The adjustments are as follows (earnings or profits are subtracted, while expenses or losses are added up):

(I) Results of the year for discontinued operations, net of taxes.

(Ii) Income tax.

(Iii) Financial result.

(Iv) Impairment and result from disposal of property, plant and equipment.

(V) Non-financial fixed assets and other subsidies.

(Vi) Depreciation of property, plant and equipment.

(Vii) Amortization / Impairment of goodwill or consolidation.

(Viii) Negative difference of business combinations.

(Ix) Work performed by the company for its assets (amortizations).

(X) Other non-recurring results.

The purpose of Opinion No. 4 is not to establish a specific procedure for calculating EBITDA, but it does include a summary model so that interested companies can calculate it based on the data used by Spanish companies, acording to the codes of the Individual Profit and Loss Account of the General Chart of Accounts, contained in the models of deposit of Annual Accounts in the Commercial Registries.

In addition to the purpose of clarifying and standardizing the EBITDA calculation by entities, especially those that begin to publish and spread EBITDA, these guidelines facilitate a common framework of interpretation for analysts and other users of financial statements, both to analyze the measures that include the entities, as to build their own using general acceptance procedures.

To download Opinion No, 4 and attachment, click here.