A VC in Vacationland

" Cash in the hand is worth more than promises in the spreadsheet"

I coined this phrase during a long set of negotiations involving the sale of one of my portfolio companies. The Board faced a difficult decision about maximizing shareholder value in light of two very different offers for the company.  The discussions, negotiations and evaluations lasted months.

We had two preliminary letters of interest from two excellent acquirers.  One was for an all cash deal and the other involved extensive earn out and uneven payout conditions–all detailed in extensive spreadsheets detailing the deal.  The more complex deal (with all the earn outs) was potentially worth a lot more money (25% higher payout) to both investors and employees, but was fraught with all sorts of market as well as goal attainment risks.  Many spreadsheets were felled in the process of evaluating the alternatives.  Discount factors flew back and forth. Net Present Value calculations were compared to probabilistic models.  No analysis technique was left untried.

In the end, we took the all cash deal.  Macroeconomic conditions, such as the current or pending world-wide recession (depending on your forecast), were certainly considered, but the deciding factors were more focused on deal structure than on environmental factors.  I won’t bore you with all details of the decision process and will instead share some key learnings from the process.

1. Who comes first? Customers, management and shareholders all have a stake in a potential acquisition.  One of the key decisions a Board has to consider is how will each constituency be best served going forward.  The best way to view this process, I believe, is through a doctor’s eyes–Do No Harm, or in this case, make sure that all groups are treated fairly. The biggest issue often revolves around the investors, who seek to maximize their returns.  Any clauses that would increase shareholder value are prized by the investors but can be detrimental to management.  In our case, the more complex acquisition would have paid the investors mostly up front and forced the management team to work for three more years to get their cash.  Not a great way to do no harm.
2. Encapsulate Due Diligence. Even in a straightforward, all-cash offer, the due diligence that follows the signing of a letter of intent can be used by an acquirer to reduce the acquisition price.  On one hand, an acquirer has a right to verify the management and board assertions about the value of the company, the happiness of the customer and the quality of the financials.  On the other hand, the due diligence period can be risky for the company.  If for any reason, good or bad, the potential acquirer walks away from the deal, the company may be looked on as "damaged goods" to other potential acquirers, resulting in a lower valuation.  Smart players add clauses to the letter of intent that can protect the company from such events, or restrict the ability of the acquirer to lower the acquisition price.  For example, one ploy is to only take any price reduction out of management’s share.  Few acquirers want to risk an angry or unmotivated management team going forward, unless they planned to get rid of them anyway.
3. The (Bad) Karma of Spreadsheets. The ubiquity of the spreadsheet has given them a God-like status in the hands of many investor professionals.  The most afflicted tend to be the MBA’s that work for the investment bankers.  Let’s admit it up front–you can "prove" anything with a spreadsheet. It’s numbers masturbation at it’s worst. A little tweak of the discount rate, a higher post acquisition growth forecast, synergy revenues, phony cost savings, etc. etc. can all add to the confusion. This may sound silly, but I do most of my NPV’s in my head using simple discount factors off the ultimate purchase price, with higher discount factors for complex deals and lower ones for cash deal.  Most of the time I am within 5% of the complex spreadsheet calculations.
4. It’s the Intangibles, Stupid. If everyone has done what they were supposed to do–primarily management producing a company worthy of a strategic (or at least normal) exit, then the purchase price offers should be in the ballpark of market valuations. It is the Board (and the investors) responsibility to send the company to a good home, one where the successes of the past will be built upon and result in even greater ones in the future. Many of the key factors that need to be discussed in the Board meetings about the acquistion relate to intangibles–will management be treated fairly going forward, does the acquirer share the same vision for the emerging marketplace, what levels of invesmtent monies will be available, for example. Often, investors want to skip these steps, preferring to get to the money questions. All parties must remember that they will continue to be judged in the market about the success of a sale, well beyond after the checks have been cashed. 

I am not sure if I answered the original question–Is Cash King?  I am sure that there is no easy answer and that careful evaluations, following the above guidelines, will usually lead to the right answer.  In a previous acquisition of one of my portfolio companies, the Board decided that an extended earn out of the purchase price for both investors and management was the right answer, even though we had an all-cash deal on the table. The situation was different, but the offer terms  were similar to the current deal.

Letting it ride will hopefully be better than taking the cash.  We’ll see next year when that deal matures.