- Posted by jbehrendt on May 11, 2009
Last week the long-expected company valuation results were presented by the audit company thqt was commissioned with it. Although the intended transactions will be recorded at book value for accounting and especially for tax purposes in order to avoid the disclosure and taxation of hidden reserves, and although no cash will change hands, valuation of both carve-out objects is needed in order to défine the portion of shares according to the respective values of the carve-out objects each of the two companies will get.
According to the standards to be applied in Germany ("IdW-Standard #1", a standard defined by the association of certified auditors), company values are to be defined based on future cash inflows. Although two different methods are permitted, the more frequently used one is the internationally used DCF (discounted cash flows)-method. Valuations based on the values of individual assets ("substance value") are only allowed in exceptional cases, but not in case of carve-outs.
One part of the valuation work is related to the definition of WACC (weighted average cost of capital), where the major problems consists of defining the correct peer group, the cost of debt after consideration of the tax debt shield, and the (standarized) consideration of personal taxes in order to compare discounted cash inflows after taxes at shareholder level. The other part, however, is much more complicated: All relevant cash inflows and cash outflows at the level of the entities to be carved out are to be defined, comparing them over a longer time period from past to future. The last time period to be considered is the "eternity" period, in which the periodic cash flows considered to be realistic "until eternity" are recorded.
The main problems we faced during work were inconsistencies between past and future figures, and inconsistencies among planning figures itself. One example was a participation that showed continous losses, both in the past and in the future, including the "eternal" period. Why should a shareholder being interested in maximizing his share value continue to run a loss-making business? in this case, it was for "strategic" reasons, and because the opportunity cost of closing the unit would have been higher due to long-term contractual obligations - but it has to be evaluated and explained. Other examples dealt with issues like leasing contracts with a buying option and the possible value of this buying option in case it would be separated from the remaining leasing contract, with defining the value of brands (see our previous blog), or with the irritating effect that a participation that was piling up cash initially lost value due to an interest rate for investments being lower than WACC with which it was discounted.
It took considerable resources and one month longer than expected, with around 10-15 people working heavily, to sove these issues, but in the end they were solved, and the results were presented. The most striking result was that the market values calculated had nearly nothing to do with the book values recorded in the financial statements, and that the lower margin one of the two companies currently created with their supermarket business was properly reflected in valuations - a lower contribution margin was fully visible in a lower company valuation.
In this case, this is not a big surprise, and the shareholders of the two companies becoming shareholders of the new unit should be prepared for it - one company seems to "win" in terms of getting "more" shares, and the other one seems to "loose", although this is fully consistent with market valuations, and probably with prices that would be paid by third parties. The outcome of such a valuation, however, may not always be pleasing for one of the companies involved, since it means lower profit shares, and less rights in influencing the relevant decisions in the new joint venture for one of them. In the end, the carve-outs only will take place if the general assemblies of both companies approve them, therefore it is essential that the shareholders of both companies believe that the deal is in the interest of both parties.
In this stage, a carve-out project becomes rather political, and it is up to the relevant shareholder and top management groups to define a communication strategy that leads to the ultimate approval of the deal. What can be done on project level is to suggest a structure of the articles of association of the new company that considers the "minority rights" of the company getting less shares in a way that considers its concerns to be overruled in certain decisions. This may be done, for example, by defining a 75% majority for a certain set of decisions of the general assembly, or even by modifying the profit distibution rights in a way that the "smaller" company gets an overproportional share of the dividends. What can not be done is trying to "modify" the valuation results which, normally, are provided by an unbiased audit company. The moment the management starts to manipulate valuations, the door is open for litigation claims from shareholder claiming the management had shifted their wealth to other parties without proper compensation for it.
It has to be seen if the suggestions of the project team are considering these points sufficiently. Next week the board meeting for presenting the results of the detailed carve-out design, the valuation results, and the suggested carve-out contracts including the articles of association of the target company will take place, This will be the last opportunity for the board to stop the project before it becomes "official" in terms of being communicated to the relevant institutions within the group for their final decisionmaking process.