Amazon Buys Whole Foods – Maybe the Only Bargain at Whole Foods is the Company Itself

In a bold move, Amazon acquired Whole Foods for $13.7 billion.  Yes, that Whole Foods, where groceries are pretty expensive.  For example, here’s what I had to go through to earn enough money to shop at Whole Foods.  Aside from the fascinating strategic implications, the news spawned all kinds of one-liners.  I can’t come up with anything better than what’s already been tweeted out, so I’ll just link to the best of them here.  At first blush, Amazon seems to have gotten a pretty good deal.  The premium paid over the closing share price on June 15th was only 21%.  In the last few years, we have observed the median control premium for take-private transactions on U.S. exchanges to be over 30%, per data from Mergerstat.  Come to think of it, it would be kind of cute if the only bargain ever associated with Whole Foods was buying the company itself… (OK, I got a joke in, so sue me.)

Given how important a company Amazon is in our economy, and how important grocery stores our in our day-to-day life, this deal has unsurprisingly garnered quite a bit of attention.  The question that interests me is, “Why did Amazon choose Whole Foods as their entry point into the physical retail market for groceries?”.  Amazon could easily buy any of the major grocery chains if it so chose (except for Wal-Mart, which was off the table after the acquisition).  Why did they choose Whole Foods?  Sure, there’s the argument that Whole Foods and Amazon share a common consumer base (I’m not sure I completely agree with that – do most Amazon shoppers buy into the magic of $11/lb chicken salad?) . But, I think the argument lies in something more fundamental – indeed, in something having to do with value.  

Let’s think about why Amazon buys a company like Whole Foods in the first place.  Amazon has been tinkering with physical retail a bit, even launching, ironically, some physical bookstores.  Amazon has also become slowly but increasingly involved in the grocery business.  There’s Amazon Prime Pantry.  There’s the ability to easily re-order products from Amazon via their wand, through the Alexa system, or their panic button.  Amazon could have created their own infrastructure, of course, but that takes time – and can be very challenging in a time when most major metropolitan real estate markets are tight.

Like The Bachelor, Amazon had many potential candidates from which to choose.  Kroger, Publix, and other companies had many more locations with broader market bases.  Even Target, now a major player in the grocery space, may have been within reach.  The membership club stores like Costco, et al. seem anathema to the Amazon way.  Amazon wants a wide variety of products, available in the quantities preferred by customers.  In other words, Amazon isn’t interested in making you buy 2 gallons of dill chips to save $3, so Costco likely wasn’t a match.  As you can see from the charts below, Amazon could have made a much larger splash with an acquisition (Source:  Each company’s 2016 SEC 10-K filing).


In the case of the number of locations, Whole Foods’ footprint is relatively small.  With respect to employees, the scale is somewhat larger, but neither feature is quantitatively superlative.  While a minimum footprint was likely a qualifying criteria (they weren’t about to buy a 12-location chain), Amazon was not necessarily looking at sheer volume.

I think the answer lies in two primary elements:  The nature (as opposed to the number) of Whole Foods’ locations (retail businesses are always dependent on location), and the features of the Whole Foods labor force.   The kinds of people Amazon hires and the culture of customer service are integral to Amazon’s DNA.  If you aren’t smart and/or don’t care about customer service, you can’t work for Amazon. Thus, for Amazon to make an acquisition, they need both the right locations and the right people to be part of the deal. Both would require billions of dollars of investment and years of time to build.  Jeff Bezos is patient, but even that would likely go beyond the limits of his patience, so an acquisition is the way to go.  But, how do we know, or at least guess in an educated way, that Whole Foods’ locations and employees are superlative?  The answer starts to become clearer when we look at the companies’ respective market capitalizations:

The next chart helps bring the discussion into focus, and is, in fact, the key to the analysis (Source: Pitchbook.  Adjusted market capitalization means that market capitalization is computed as price per share times shares floated.)


If you take a moment to compare the gaps between numbers of employees, market capitalization and locations, the market capitalization gap looks like it’s a bit less.  Is Whole Foods generating more value per location or per employee than its competition?  Let’s look at Whole Foods’ market capitalization/employee first (as of June 15, the day before the acquisition).

Whole Foods generates a staggering $157,000 of value per employee, second only to Sprouts Farmers Market, which is about half of Whole Foods’ size.  It’s interesting to compare with Kroger and even Publix.  If you wonder why shopping at Kroger can seem like a cattle call, here’s your answer.  Amazon wants high value employees and they seem to be getting them in Whole Foods.  Let’s look at location next – the story is even more pronounced.

Whole Foods may have relatively few locations compared to the Krogers and Publix’s of the world, but those locations generate a ton of value. In the Monopoly board of locations, Whole Foods seems to own every Boardwalk and Park Place.  If you’re going to make a play into physical retail, this is a great place to start.  Whole Foods generates twice the value per location of every other pure play grocery chain, and blows Target away as well, and they sell TV’s (By the way, this gives you a hint at Amazon’s strategy – Target sells many goods other than groceries, and their value/location is well into second place – that isn’t an accident, and Amazon knows it).

This relatively simple analysis makes sense when you think about how Amazon operates.  Yes, they are a big company, and they make big bets, but they think a few moves ahead as well as or better than anyone around.  In acquiring Whole Foods, Amazon selected a partner with whom to disrupt the grocery industry that wasn’t the biggest, but was the most effective at generating value from its assets.

So, is that it?  This is a purely strategic bet due to a good fit?  I don’t think that’s entirely right.  One other element comes to light when you look at number of employees per store (Source: Each company’s 2016 10-K filing) – Amazon likely sees a financial opportunity also.

Whole Foods has the highest number of employees per store in this group.  In other words, of all these companies studied, Whole Foods has scaled the least.  That’s a big reason why Whole Foods can deliver a highly artisanal shopping experience – there is an army of folks ready to take care of you when you walk in the door, which in turn, is a big reason that your chicken salad costs $12/lb.  I think it’s a lead-pipe cinch that Amazon has looked at this metric and concluded that, if they can just get the number of employees per store down to something approaching the median, they are going to make insane amounts of money – and they are basically going to get it for free (remember, they only paid a 21% premium over the stock price, which accounts for control privileges – nothing to do with post-acquisition restructuring).  Amazon is pretty good with product delivery and supply chain technology.  They will figure out how to replace labor with technology.  (Imagine an Amazon Echo on every aisle that will do price checks and tell you where every item in the store is located.)  Even with long odds, I wouldn’t bet against them being able to realize massive labor savings.  Amazon is trading at roughly 30 times EBITDA.  If Amazon can save $100 million in labor expenses, that’s $3 billion in value that is created, which pays for just under a quarter of the purchase price. (Amazon has said they don’t plan to cut the labor force, but I don’t buy it – the value of doing so is too high.  If you work at Whole Foods today and you aren’t planning your next career move, you’re being irresponsible.)

This looks like a great deal for Amazon, to the point where I think the biggest risk is that you may see some Whole Foods’ shareholder activist objections trying to hold up the deal or find a competing buyer.  The second biggest risk is that, on the surface, this acquisition looks like it would qualify as a “bargain purchase” under GAAP, which clients and auditors hate, not least of which because it could generate an instant tax liability.  Nevertheless, when you take into account the location story, the employee story, and the potential cost savings story, Whole Foods is as good a fit for Amazon as there is in the industry, and I predict this acquisition will leave Amazon shareholders pleased with the return, and will be transformative to Whole Foods, and potentially the grocery industry.  Ironically enough, it seems the only way to get a real deal at Whole Foods is not to go shopping there, but to buy the whole company.

What do you think? Did Amazon get it right.  How do you think Amazon will disrupt the retail grocery space.  Leave a comment here and also please follow the Arpeggio Facebook page for other market insights and M&A news.






Yik Yak Becomes Mute. The Difference Between Breaking the Laws of Finance, and Understanding Them

The market can stay irrational longer than you can stay solvent.”  John Maynard Keynes.

In April 2017, Yik Yak, the most important social networking startup founded in Atlanta since Social Fortress, threw in the towel, selling out to Square for $3 million – mainly to to “acquire” the company’s remaining software engineers.  This was, to put it mildly, a disappointment to investors like Sequoia Capital, who had invested $62 million at a $400 million in December 2014.  For those of you scoring at home, that is a return of negative 340%, annualized.  #ow.  There will be all kinds of post-mortem analysis about where Yik Yak went wrong, but that isn’t the goal of this article.  What’s interesting is the change in value and how it is perceived.  To be sure, there will be some schadenfreude out there from the “traditionalists” who don’t see the business case in social media.  Besides, who doesn’t like to see the smarty-pants venture capitalists taken down a peg?  Atlanta investors, who are generally baffled by the investment thesis of social media, will be sorely tempted to haul out the “I told you so’s”.

It is tempting to conclude that the valuation of $400 million back in 2014 was dumb, crazy, ill-advised, or just plain wrong.  That may be unfair, and the key to understanding this lies in understanding the nature of risk and return.  Over the years, I’ve come to observe what appear to be three “universal laws” of valuation.  It’s not exactly Newton’s Prinicipa Mathematica (in which he published his three laws of motion), but they have served me well when I encounter tough valuation problems in order to simplify thought process.  Come to think of it, maybe these are more guidelines than rules…

Law #1 – The prospect of a sustained high return must always be accompanied by sustained high risk

In a “reasonably” efficient market, meaning that buyers and sellers pretty much know what’s going on and can react to information in real-time, buyers and sellers bid up prices of low-risk assets and bid down the prices of high-risk assets.  The low entry price of a high-risk asset offers a high return when that asset’s risk profile reduces over time.  Can you catch lighting in a bottle and receive an outsized return one in a while – buying a low risk asset at a high risk price?  Sure, but not sustainably, unless you’re Warren Buffett (and if you are, thanks for reading, Warren!)

It is illustrative to review the relationship between market returns and risk.  Historically, observing the relationship between risk and return in the private markets has been difficult due to the absence of reliable data.  Fortunately, there is now a fantastic program at Pepperdine University called the Private Capital Markets Project, and one of their key products is the annual Private Cost of Capital Report (“Report”).  I’m a huge fan of the Report – the researchers survey actual capital providers, including angel investors and venture capitalists, among others to identify their respective target rates of return.  And the price is right – free.  Reviewing the chart below, you can see the ranges of return required by various capital providers in 2014, with data for returns for certain public securities juxtaposed.

As you can see, venture capitalists, and their cousins, angel capitalists and private equity investors, play in a different return universe from the conventional investment markets.  Whereas bank loans, asset-based loans (usually secured by inventory and/or accounts receivable) and even mezzanine debt carries with them an investment thesis in which the risk of total loss is very low, venture capital, private equity, and especially angel capital, make there livings in a world where the prospect of total loss is a constant companion, and the required returns are much elevated in order to induce investors to assume that risk.  The price of greed is high.

Law #2 – There is no such thing as a risk-free asset

All assets are subject to the risk of loss.  While academicians and financial practitioners often refer to U.S. Treasury securities as risk-free to make their models work, even they bear risk that is above zero.  However, debating this lies beyond the scope of this note.  I mean, they even killed The Enterprise…   And again… … and again.

The Yik Yak investment was, of course, never perceived to be a risk-free asset – far from it.  The possibility of loss and even outright failure was priced into the investment valuation.  Let’s look at how that works:

If Sequoia et al invested in Yik Yak at a valuation of $400 MM, it’s reasonable to assume that their goal was that Yik Yak would achieve unicorn status (i.e. a valuation of $1 billion) in three years.  If we agree that that is the case, then the implied required return is 36%.  (Just in case you don’t agree with the timeline, a 2-year time horizon would imply a return of 58% and a 4-year horizon would imply a return of 26%.) . Recalling the prior chart, let’s see what that puts us relative to the market:
As you can see, while the 2-year horizon to reach unicorn status would have required an outside-market rate of return, the 3- and 4-year horizons were quite reasonable, yet are still much greater than the investment types where all-out loss is generally not supposed to happen.  All of this adds up to a recognition that Sequoia and its fellow investors were under no illusions about Yik Yak.   The return they thought they were getting was commensurate with a very high risk investment, justifiable only with a commensurately high return.

Law #3 – All investments are based on forecasts, and forecasts of more than 6 months into the future are wrong

While we don’t know what the actual forecasts used to formulate Yik Yak’s valuation in 2014 were, it’s a good bet they were far away from what actually happened.  Of course, all forecasts are wrong – the variables are the degree of wrong-ness and the timing of wrong-ness.  Even analysts of public companies, with relatively luxurious data to work with, rarely venture to provide forecasts more than 6 months out, and are typically loath to go that far.  Unless you’ve got a souped-up DeLorian and some plutonium, wrong forecasts are a fact of life.

In the venture capital industry, failure is not only an option, it is expected.  Their business is to invest in companies that are not profitable, are in immature markets, and depend on technologies that are not fully baked.  In other words, in every investment they make, the possibility (or even likelihood) of failure is priced into the valuation.
In the implausible scenario where Yik Yak was considered very low risk, including a very low likelihood of failure, it would have already been a unicorn, perhaps with a valuation somewhere between $2 billion and $3 billion.  Of course, the $400 million valuation falls well short of these lofty heights, which indicates that the risk associated with the venture was recognized and accounted for (whether sufficiently is, of course, open to debate).

Was Yik Yak Overvalued?
It’s easy, perhaps even entertaining, to look back on Yik Yak’s outcome and conclude that there was catastrophic failure – from valuation, to deal selection, to operations – all of it.  But that’s the intellectually easy way out.  Failure is part of the equation in the venture capital game, and the valuation contemplates the possibility (likelihood) of failure.  If you believe Harvard University, up to 75% of venture-backed startups fail.  If you believe the National Venture Capital Association, the failure rate is 20%-30%.  Yik Yak’s investors were not blind to these facts.  If you thought the $400 million valuation of Yik Yak was formulated under the assumption that Yik Yak couldn’t fail, I think that is factually inaccurate.  You don’t demand a 30%+ return on investment if you don’t think #fail can happen (well, perhaps you do, but no sane investor would agree.) . On the other hand, if you just flat-out didn’t believe in the Yik Yak business case, then the value (to you) is $0.
Ultimately, we don’t know if Yik Yak was appropriately valued at $400 million or not.  We don’t have the data to formulate a credible analysis.  However, the fact that Yik Yak ultimately failed does not necessarily mean that the valuation was bad.  Being the “greater fool” is actually integral to the venture capital business model.
What do you think?  Did the investors in Yik Yak make a terrible error, or is failure just part of the game?  Leave a comment and start some discussion!
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409a Stock Option Valuations – Should You Hate the Player or the Game?

On March 8, 2017, the New York Times published a piece addressing practice of stock option valuations.  This article, by William D. Cohan, trashes the law that requires stock option valuations and the people (like us) who perform the valuations.   Even the Securities Exchange Commission gets sideswiped.  Predictably, the business valuation community has reacted negatively.  There’s no way around it – this article accuses the entire stock option valuation “system” of being a great, big, fat con.    If you make a living off of performing these valuations, it is, frankly, a piercingly hurtful piece.  If you want to view the outrage first-hand, do visit the Valuation LinkedIn Group.  The article rings true to me because for years I have heard many of the same comments made directly to me by investors, founders, and board members.  However, I don’t view this article as a sneak attack – but rather a call to action for our profession to be reminded of our responsibility to the public trust, and an opportunity to educate the market on the strategic intelligence value that credible appraisals offer.

For those of you who aren’t up to speed on what 409a is and why it exists, here is the elevator pitch.  At the height of the the first dot-com bubble, thousands of people were making millions of dollars by foregoing salary and accepting stock options instead.  Many companies achieved liquidity relatively quickly (and with seemingly low risk), and billions of dollars of income went under-taxed or not taxed at all.

Accordingly, the government introduced Section 409a of the Internal Revenue Code.  What 409a says is this: if you issue stock options, they will be considered current compensation if they are in the money at the time of issue.  In other words, if you issue options at a strike price of $12, and the value of the underlying stock is $14, the $2 in theoretical profit you’d make by exercising (called intrinsic value) is taxable as current income.  Cash tax payable on a non-cash income item.  Yeah – it’s as bad as it sounds.  However, the tax is deferred if you make them incentive stock options, meaning that they are underwater at issue.  If you issue those same options at a strike price of $12 and the value of the stock is $10, you only pay tax when you do ultimately exercise the options – typically when the company achieves liquidity and the employee option holders receive payouts.

The accounting world, concerned that the compensation expense for stock options was being under-reported on income statements, issued new rules in parallel – requiring that all options issued be recorded as an expense at their fair value as of their date of issue.  Originally, this was called Section 123R (I never did figure out if there was just a “Section 123” at some point) and now is called Accounting Standards Codification Topic 718.  Mercifully, you can generally use the same valuation to comply with IRC 409a as ASC 718.

Now, here’s the kicker.  The valuation in practice adds virtually no real compliance value because enforcement is so rare.  SEC/PCAOB (the folks that oversee accountants’ audit practices) actions on stock option values are quite rare.  You are more likely to be mauled by an escaped gorilla from your local zoo than you are to face a 409a action by the IRS, especially if you haven’t gone public yet.

There are instances, however, in which a 409a valuation can be important.  If you have a stickler financial statement auditor (not all are), the ASC 718 side of the compliance exercise will be more carefully scrutinized.  Getting a bad valuation of any kind through a good audit is painful and expensive.  You’d rather be Han Solo in the Force Awakens than go through that.  Also, if you plan to raise money from professional sources, the 409a valuation is often an important (I think overblown) due diligence issue.  I  have seen instances in which a gong-show valuation has made raising money from venture capitalists harder.  

These exceptions notwithstanding, Mr. Cohan’s frustration with the entire 409a enterprise is justified.  True – we didn’t write the rules.  We didn’t even lobby for them.  We didn’t invent the game – we are just the players.  BUT, where we, as practitioners, must accept some responsibility lies in the fact that increasingly, an increasing number of the 409a valuations being performed barely (or fail to) meet professional standards (such as the Uniform Standards of Professional Appraisal Practice), and that reflects badly on all of us in the profession.  Mr. Cohan is right – many 409a valuations don’t match up well with how the market prices early stage investments, and much of this has to do with cutting corners to make money on lousy fees (and also that some practitioners aren’t as good at understanding real-world transactions as they ought to be.) I’ve heard colleagues blame the clients for refusing to pay the fees necessary for a “good” work product, but nobody is forcing us to take the engagements.  When people who make investment decisions for a living routinely complain (or joke) about how our work products are off the mark, that is something to which we need to listen carefully – not just blow off as complaining from a fee-sensitive cheapskate client or venture capitalist.

Our profession has a responsibility to do better, because the 409a exercise is undermining our collective credibility.  It is already sufficiently difficult to convince clients that we can provide an informed understanding of the value of any privately-held company, especially startups (Arpeggio’s stiffest competition is the notion that business appraisers don’t know what they are doing.)  Giving in to provide stripped-down, check-the-box valuations for race-to-the-bottom fees simply reinforces the hack image our profession struggles to shed.  If we want to be more than the parking meter enforcement agents of the accounting world, we must position the 409a as an opportunity to inform the client about important and hard-to-see strategic intelligence regarding their businesses.

In order to restore our credibility in the eyes of the venture community, we must do the following:

If we do as I suggest, some of us (Arpeggio included) will lose work.  Not every client wants to be educated – or can afford to be.  Not every 409a client will seek funding or has a stickler auditor (or any at all).  Checking the box may serve that client just fine.  

We will have to overcome doubt in the market that we really can deliver on making a 409a valuation a strategically relevant investment.  Doing so will require time and grit.  I think it’s worth the investment; our profession and our livelihoods will be better off if we decide we can live without McValuations in our services suite, and stick to producing appraisals.

Cohan’s article is a bit of a hatchet job, but it’s also a wake-up call. The 409a business has been damaging to the business appraisal profession because, over time, some of our peers have collectively cast all of us in the b.s. business.  When market participants scoff at our work and call us walking Magic 8-balls, we shouldn’t be blaming them – we should be prompted to self-examination.   Business appraisers should be respected for knowing as much as anyone about how assets are priced in illiquid markets.  The fact the opposite seems to be true in a critical segment of the market ought to be cause for reflection, reform, and re-focus.

Is Your Business Simply a High-Stress Job?

A client of mine is about to deliver some bad news.  The company they want to acquire has no value.  Not less value than expected.  Not just a little value.  Not value that can only be seen with an electron microscope.  No value.  Zero.  Nada.  Bupkis.  A professional service company that has been around for over a decade in a highly technical and specialized field, with 10 employees, $3+ MM in revenue, has little debt, pays each of its founders over a quarter of a million bucks a year, and even makes a bit of profit above and beyond has no value.  

Where did the value go?  On the surface, this company should easily have value – millions of dollars of revenue, high-profile clients, a good reputation in the market, and services that are hard to compete with.  They even have a pretty decent web site. The answer is that even Sherlock Holmes isn’t going to find the company’s value because the value was likely never there to begin with. The owners think their company has a lot of value.  Millions of dollars.  Convincing the owners to “sell” isn’t going to be easy.  This isn’t telling parents their baby is ugly.  It’s telling the parents their baby is really a stuffed platypus and was switched with their real baby at the hospital by accident and nobody noticed until just now, and their real baby is sitting on some platypus eggs somewhere in New Queensland.  Sadly, this scenario where company owners are surprised to find they don’t have a business happens frequently. The consequences can be devastating.  Families that thought they had created a legacy for their children and employees, or at least a secure and comfortable retirement discover with no recovery time that they have built zero value over a period of years or decades of sacrifice, risk, and hard work.  It’s kind of like watching Indiana Jones and the Crystal Skull all the way to the end.  Not all companies are meant to be sold.  Lots of companies are lifestyle businesses and that’s all the owner wants.(You may not want to change it, and that’s OK, as long as you understand the implications – just as some people prefer dating to marriage, some business people prefer a transient business to one that has a transferable economic foundation.) But if you are working toward a big payday when you’re ready to end the run, you will benefit tremendously from taking steps to ensure that you have something to sell.

Let’s take a step back and think about what identifies a company as an asset.  To be an asset, a company must possess the following characteristics:

  1. The company must consistently earn more for the owners than they could earn with the same effort and expertise if they were working as employees elsewhere (adjusted for the risk assumed as a shareholder);
  2. The company must earn a return on equity that is greater than could be earned if the retained earnings were invested in an asset of similar risk;
  3. The company’s key assets (tangible and intangible) must be exploitable to roughly the same level of profitability that they can achieve under the current ownership;
  4. The company must be able to carry on its operations if the owner(s) were suddenly not available to the company for an extended period of time;
  5. A new owner can reasonably be expected to continue the company’s operations after a change in ownership; and
  6. The sale of the company must be legally permissible.

The absence of just one of these features likely excludes the notion that the economic entity in question is, in fact, a true business. In such a case, the company isn’t really a business, but a high-stress job.  Businesses can be sold.  Jobs generally cannot.

The first five features are indicative of a company that provides financial gain beyond the efforts of the shareholders.  The final one is simply a legal constraint that is rare. There is a multiplier effect in which value beyond the company’s annual (monthly? weekly?) cash flow is accumulated.  This stored value may not be reflected on the balance sheet.  Cash can be distributed, inventory liquidated, accounts receivable collected or factored.  Equipment and real estate can be sold.  Value arises from the company’s ability to produce profit and growth exogenously from its shareholders’s actions.  Value also is created when the return on an asset is greater than the market returns for similar assets with a similar risk profile.  Economists and some consultants call this concept “economic value added”, or EVA.

It’s worthwhile diverting to explore the concept of EVA.  Let’s say that you invest $100 and are promised $10 in a year, plus your $100 principal.  There is a risk of losing the principal, but you also are offered upside in that, if the investment performs better than expected, you will receive a bonus return.  You decide the 10% rate of return is worth the risk of making the investment and would be considered “fair”.  You don’t think you are being overpaid for the risk you are taking, and you certainly don’t think you are taking on too much risk for the return offered.  A year later, your $100 dollar original investment is returned and instead you receive a $10 return.  You made your money back at the level offered, but there is no economic value added.  In effect, your investment performed on par with expectations.  However, let’s say that the investment made $15 instead – a healthy bonus!  Let’s say further that you are offered and decide to re-invest that $5 back into the company, hoping for future returns.  That $5 is economic value added.  To you, as a passive shareholder, you now have a bonus $5 asset that can generate additional return.  Over time, economic value added is compounding, just as with other investments, and the impact of EVA is powerful indeed.

Note that profitability is not part of this discussion.  Silicon Valley is built on the premise that unprofitable businesses create EVA, and many profitable companies (such as our example) produce no EVA.  Silicon Valley companies are extreme in that they actively shun profits in order to build EVA, usually through technology, branding and barriers to entry, but they serve well to illustrate the point.

Profitable firms that are owner-centric frequently build no EVA, even as they often support their owners with very comfortable lifestyles.  When an owner or owners hold sway over key areas of the company’s operations, such as sales and customer relationships, technology, supplier relationships, branding, and vendor relationships, no value is injected into the company itself.  Profits are great, of course,  At some point, every company must earn them, but the mere existence of profit does not mean that the company has value.  Succinctly, if every dollar of profit is directly descended from the ownership, then the business has little or even no value.  The most frequent culprit of the missing value is captive customer relationships.  It’s great when customers say they only want you to solve their important problems  – great for the ego, anyway.  That same esteem for you personally is also potentially suppressing the business’s value-creating energy.  When you can’t turn over the customer relationship to someone else, you have a grounded asset, and an asset that can’t be transferred can’t be sold, except to someone willing to take a flyer by paying a super low-ball price – think pennies on the dollar.

If you find yourself in this situation and you want to change it, so that you are building value, creating something that someone else will pay you for, how do you go about it? 

If you don’t have a long time horizon (say 0-3 years) to when you want/need to sell, you need to think about exit structure – heavy earn-outs, seller notes (possibly without recourse), long post-sale employment agreements, or simply joining the acquirer as a senior employee with some kind of deferred compensation plan.  At this point, you’re basically looking to get a payment boost for a few extra years in your job – like Phil Jackson’s tenure as GM of the Knicks, except productive.  Alternatively, you may want to think about buying a company that does have positive EVA, and integrating your unique value into it (this will be a separate blog post.)

If you have a longer time horizon, here are some steps you can take to transfer value from yourself into your company.

Recognizing whether or not your company is a business or a job is critical to setting proper expectations for an exit, and for meeting your wealth goals.  Specific steps will vary from case to case, and you may find it worthwhile to bring in subject matter experts to help set detailed plans. Whatever you do, don’t be surprised.  Don’t be the company that receives the bad news.

What else?  Do you agree with this framework?  Can you offer any other suggestions on how to tell a business from a job?  Leave a comment and raise your own SEO profile as well!

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Value-at-Risk – the Ugly Duckling of Finance that Should be the Beautiful Swan

A friend and client of mine called me last week with a question, which was, “We are about to make an acquisition, but one of our shareholders is concerned with downside.  Our company is doing great right now and he’s at a point where he is more concerned with loss than he is with growth.  How do we talk him off the ledge?”  This is a classic risk analysis problem that is often addressed with sensitivity analyses, decision tree analysis, and/or gut instinct – none of which individually or collectively offers a very satisfying answer.  The reason why those approaches are unsatisfying is that they are, essentially, just made up.

Think about it – most sensitivity analyses are nothing more than robotically varying inputs (e.g. growth (+/- 1%), profit margins (+/- 1%), input prices (+/- $10), discount rates (+/- 1%)) and charting the outputs as these inputs are varied.  Most decision trees are put together with “subjective” (let’s face it, this means “made up”) probabilities, and gut instinct is just that.  Gut instinct is the Russian Roulette of M&A.  In other words, we do some more work, but we really don’t have a much greater understanding of the risk involved in the transaction.

What if there were a technique you could use to answer the downside risk question with precision and rigor?  Wouldn’t it be useful to know, for example, what is the likelihood that this M&A deal will result in a loss of (say) $5 MM in shareholder value?  Or, what if we could answer the question of what the baseline loss of value would be in the bottom 5% of outcomes?  We do have such a tool, and it’s called Value-at-Risk (VaR) analysis, and it’s been around for decades.

Value-at-Risk analysis is an elegant tool that enables us to quantify downside risk in terms of probabilities and dollars.  VaR involves modeling out the range of foreseeable outcomes within the framework of a probability distribution of those outcomes, and then selecting the risk threshold in terms of the probability of a certain value of losses or greater.  An illustration of a 5% loss threshold might look something like the following, assuming a normal distribution.


Our model results tell us that there is a 5% chance that the loss associated with this decision or commitment will be $1 million or greater.  That is a much more useful framework for identifying and considering risk in a business context than the standard toolbox.

Because VaR requires some understanding of (fairly basic) statistics to understand, VaR has been an underutilized tool, primarily the purview of hedge funds, and financial academicians.   But is VaR simply an overly-elaborate process for accomplishing something relatively simple?

In our M&A case, the VaR model may be used to quantify the downside risk to shareholder value and better inform the dialogue and decision-making around the proposed acquisition.  You can ask the reluctant shareholder, “How much value are you afraid of losing?”  He might respond, “One million dollars.”  The VaR model can quantify the likelihood of such a loss and see whether that either meets or exceeds the shareholder’s risk tolerance threshold.  Alternatively, the VaR may reveal that the deal is riskier than previously believed, causing a re-think.

Here’s another example that is an actual client case study.  A friend of mine is an attorney who was writing an indemnification agreement for a client.  The client was not willing to offer full indemnification, but was willing to provide indemnification for up to 95% of loss cases.  We ran a VaR model to find out what was the amount of damages that represented the 95% threshold, and that was the value of the indemnification limitation written into the contract.  Rather than guessing, there was a data-supported methodology to set an indemnification limit, and the deal was consummated.

Finally, and this is an older example, a client retained my practice at a prior firm to analyze the risk associated with purchasing a portfolio of distressed real estate loans.  The client wanted to know what the loss threshold was in the worst 5% of outcomes.  We built a relatively simple econometric model to link loan default rates with a relatively small number of  market and macroeconomic factors.  Because of the nature of the model and the market, the loss level at the 5% level was unacceptably high to the client, and they walked away from the deal.

  • Some other VaR analyses I think are plausible, but I have not been called upon to perform include:
  • Determining the value of the worst 5% case of outcomes in a lawsuit;
  • Determining the value of the worst 5% case of outcomes in an investment or investment portfolio;
  • Determining the value of the worst 5% case of outcomes in a currency hedge;
  • Determining the value of the worst 5% case of outcomes in a tax audit;
  • Determining the credit risk of a borrower by associating credit risk with the worst 5% case of business outcomes (such as earnings, or cash flow) for the borrower;
  • Determining the exposure on a loan guarantee with the worst 5% case of business outcomes for the ultimate borrower;
  • Determining the financial exposure for the worst 5% case of outcomes associated with a data breach;
  • Determining the financial exposure for the worst 5% case of outcomes associated with a corporate crisis (such as a plant accident, produce failure, act of employee violence, natural disaster);

I hope I have convinced you that VaR is a tool that can be used to produce satisfying and fact-based answers to numerous business questions.

Implementing VAR requires determining the range of value (loss) outcomes and the probability for each.  Technically, you could simply assign (for example) a 5% probability to an outcome and bang, you have a VaR analysis.  However, if this somehow seems a bit too easy – rather cold, if you will, I agree.  Most robust VaR analyses are accomplished using a technique called Monte Carlo simulation.

Monte Carlo simulation is one of the few cool vocabulary elements in finance.  This is fitting as I think Monte Carlo simulation is one of the coolest tools we have in finance.  Instructions on performing a Monte Carlo simulation run well beyond the scope of this blog (we may write a white paper on it later), but it’s enough if you understand that a simulation produces a range of outcomes by varying model inputs.  The model inputs have features such as mean, standard deviation, and nature of distribution, such as a “standard normal” distribution, as with a bell curve.  The inputs are then randomized, perhaps thousands of times, and the model output is calculated, recorded, and plotted for each trial.  Monte Carlo simulations are typically performed with the assistance of software, such as Crystal Ball or @Risk.  If you are comfortable with programming, you can write about a page of Visual Basic code to perform the simulation.

The parameters of the inputs (mean, standard deviation, shape of distribution) might be determined using the company’s or asset’s own historical data (e.g. revenue, margins, input costs, growth).  Alternatively, the inputs’ parameters may be estimated by analyzing similar inputs of publicly traded companies.  In some cases, you may be able to identify empirical research performed by third parties and utilize that information.  In rare cases, you may have to perform your own research.  The point is, once you determine which inputs need to be varied, it is likely simply a matter of research and analysis to determine how your inputs should be defined in your simulation model.

Once we believe we have the model correctly defined, we can run the simulation and perform the VaR analysis.  If we are seeking to identify the VaR in the 5% worst scenario, we simply identify and use the model result where 95% of the other results are higher, and 5% are lower.  In effect, a Monte Carlo simulation is the ultimate sensitivity analysis tool, and you can vary as many of the inputs as you deem necessary to produce a robust result.

VaR analysis, in spite of its powerful risk analysis capabilities, remains overlooked by executives when making critical decisions.  VaR offers answers to many high-stakes business questions that conventional models simply can’t provide in a convincing, independent way.  By using VaR, you can gain elegant and informative insight into your critical decisions.  Using VaR won’t prevent a bad outcome from happening, but it enables you to accept the risk of a given decision with eyes wide open.  Whether you decide to perform a VaR analysis yourself or seek help, the critical takeaway is that there is a tool available that can enable you to quantify your risks, empowering you to make fact-based, and likely better decisions on risk.

If you are confronted with a significant decision and are struggling with coming to terms with the risk involved, consider engaging the VaR framework.  In the right circumstances, the VaR analysis, properly performed, will give you an additional level of comfort with whichever decision you choose.

Do you have any questions about Value-at Risk analysis, or any experience using it?  Do you wish you had better tools to manage risk for yourself or for a client?  Leave a comment, or contact us to discuss your question in depth.

HP Acquires SimpliVity – A Case Study on Why Headline Valuations May be Fake News

On January 17, 2017, Hewlett-Packard acquired SimpliVity, a hybrid IT services firm, for $650 million.  On the surface of it, the deal is unremarkable enough.   At $650 MM, the deal would be considered mid-market.  SimpliVity is a company you probably have never heard of before, and HP is, well HP.  Most of us know HP for their printers – some of us may know them for their underrated Omen computer line.  But, like so many “computer” companies, HP’s bread is increasingly buttered with IT services, so the rationale for the acquisition is fairly clear.  For the record, “hybrid IT” means IT services that are partially rendered on-site and partially provided in the cloud.

One could take a cynical view and ask whether this is simply the latest in a long line of HP acquisitions which have turned out to be tire fires.  There was Compaq in 2001 – thought to be HP’s path to sustainability in the PC space – the Compaq brand now lies in the dustbin of history. (Remember when Compaq had the coolest PDA’s? – for you kids out there, PDAs, or personal digital assistants, where smart phones that couldn’t make phone calls).  There was EDS in 2008, which turned out to be vulnerable to low barriers to entry in the enterprise computing support space – they were written down to half the purchase value in just four years.  There was Autonomy in 2011, written down by nearly $9 billion (of an $11 billion acquisition) in just a year due to allegedly dodgy accounting discovered after the acquisition and let to indictments of Autonomy’s executives.  These were all much larger acquisitions than this one.  This SimpliVity acquisition falls in CEO Meg Whitman’s playbook for relatively small acquisitions, less than $1.5 billion in price tag.  Such deals are, presumably, lower risk, easier to manage and assess, and are aimed at relatively marginal improvements for HP, as opposed to paradigm-shifting, shockwave transactions.  HP’s shareholders are likely holding their breath to see if this acquisition model fares better than those of Whitman’s predecessors.  Perhaps we’ll revisit this deal in a year or two and see how it’s working (or not).

The real story here is the valuation.  It turns out that SimpliVity was a venture-backed company, and, as recently as as March 2015 had joined the unicorns club with a $1 billion valuation on an investment led by Waypoint Capital.   On the face of it, within 14 months, SimpliVity lost 35% of its value or a negative return of 30%.  Ouch.  Like the Red Sox signing Pablo Sandoval to a long-term contract ouch.  That’s more than a little short of what venture investors are typically targeting.  On the surface of it, to be caught with that low a valuation relative to a recent round with a strategic buyer, and a buyer with a history of being a sucker, by the way, must be viewed as a disaster – like a Mariah Carey New Year’s performance kind of disaster.  Oh, and by the way, the deal was rumored to be worth nearly $4 billion just a few months ago.

What went on here? Here seem to be the most plausible scenarios.

  1. The latest (Series D) investors were banking on SimpliVity going IPO, but the IPO market dried up on them.  I think this is highly unlikely.  The markets are steadily climbing, and look set to continue to do so with a Trump Administration.  Further, venture capitalists who have raised enough money to make $175 MM investments are too smart to try to time markets like that.  Timing markets is generally a bad idea even in a fully liquid market.  Timing markets with privately held companies is financial Russian roulette with multiple bullets in the magazine.  That having been said, I do think the dried-up IPO market did motivate the deal.  I’ll explain a bit later why these statements are not contradictory.
  2. SimpliVity’s value fundamentals dropped by 35% (or more) in a 14-month period.  This could occur due to changes within the company – possibly losing key personnel or customers, or (more likely) intensified market competition as it is very hard for IT services businesses to create and sustain meaningful barriers to entry.  I think there is some probability that this is the case.  Market conditions change frequently and it’s not uncommon for businesses to sell only after they realize that their sales market conditions have turned against them due to “incumbency bias”, the concept that our psychology leads us to over-value the assets we already possess.  Hoarders are extreme examples of incumbency bias.
  3. The Series D investors blundered – and simply fundamentally mispriced the investment in SimpliVity.  I suppose that’s possible, but venture capitalists are pretty smart.  While venture capitalists are not as infallible as they often like to project themselves to be, a mistake of that magnitude in pricing a relatively mature company seems highly unlikely.
  4. The reported valuation of $1 billion was inaccurate.  Private companies are not obligated to report their valuations, and when they do, they are not strictly obligated to tell the truth.  I ascribe some probability to this scenario, but a relatively low one.  When companies do reveal their valuations, you can be they only do so because they think it is to their advantage.
  5. The $1 billion headline valuation was only nominal, not reflecting the terms of the investment that offer preferential returns to institutional investors.  I think this was very likely.

Having no facts other than what is publicly available, the following scenario seems highly plausible:  I think there was a deliberate effort by all parties in the Series D transaction to manufacture a $1 billion headline valuation.  There are good reasons to do so, beyond ego (the ego was certainly present in the calculus).  First, being part of the unicorn club is great publicity.  Being one of the startups that is worth 10 figures is something of which customers, employees, vendors and investors take notice.  Second, being part of the unicorn club can create a mindset in the market of a company’s value, generating excitement among investors, bankers, and potential acquirers.  Third, being in the unicorn club can be a great too for recruiting top talent – combining the stability of a relatively large company with the return of a high-flying venture-backed startup.  There are plenty of great reasons to make the market believe you are worth a billion dollars.

But wait – why would investors play this game?  Why would investors subsidize this facade – creating a Potemkin unicorn?  The answer almost certainly lies in the terms of the investment.  Not all valuations are created equal.  I haven’t seen a term sheet, but it’s a good bet that the Series D investors thought the appropriate value of SimpliVity was around the $550-$600 million range on a plain vanilla terms basis.   The investors agreed to the $1 billion valuation but made darned sure that their own return on exit would be as if the the company were valued in that $550-$600 million range.  This split personality of value is accomplished through terms such as liquidation preference, participation multiples, and full-ratchet anti-dilution rights.  All of these terms mean that the later investors secure their returns first in any liquidity event, and receive a disproportionate return (i.e. better than simply a one-for-one share basis) relative to the junior shareholders, and the threshold for making any return at all for the common shareholders is quite high.  Thus, investors exchanged the unicorn valuation for preferential returns – the early shareholders would only benefit from an exit if the exit actually realized matched or exceeded the headline valuation.  The early investors and founders assumed nearly all of the financial risk.

In this case, where the exit was effectively a down round, the Series D almost certainly drove the transaction through their board seats and voting rights, and the common shareholders felt like Charlie after being read the riot act by Willy Wonka.  If you’re wondering why the founders/common shareholders agreed to this, the answer is they may not have had a choice in the matter.  By the time you get to Series D investments and beyond, it can feel a little like you’re making a contract with Darth Vader.  And that feeling can be somewhat justified.

Even if the founders did have a choice in the matter, they may have gone along anyway.  The founders may have had employment agreements that paid out cash bonuses for a successful exit.  SimpliVity’s founders may have cashed much of their respective shares out in previous rounds and were ready to do something else.  The founders may have realized that the $650 million was as good a real valuation as they would get due to changing financial and customer market conditions.  As a founder or early executive, putting a 9-figure exit on the board all but ensures good press, lucrative employment in your next opportunity, and/or relatively easy financing for your next venture.  Note that none of these considerations are part of a fair value discussion – the founders might have been acting on personal considerations unrelated (well, loosely related, anyway) to shareholder value.  If this is the case, one can make the argument that the conditions of fair value did not exist for at least a segment of SimpliVity’s shareholders.

As a decision-maker, it’s important not to put too much stock in headline valuations.  They may not be telling you what you think you are, and may be a grave mistake to decide to sell (or not) based on the published valuations of so-called comparables, unless you know a good deal more detail about the transaction than is generally widely known.  While it’s possible the SimpliVity transaction reflected sharply deteriorating market conditions for the company at the time it was sold, it’s more likely that the headline $1 billion valuation was a mirage all along.  Not exactly Fake News, perhaps, but not gospel either.

What do you think? Do you agree that headline valuations can be Fake News?  Or is the whole thing overblown?  Leave a comment and join the discussion!  Not only does it help us, but it raises your own social media profile!

Did you know that Arpeggio now has a Facebook Page?  Like us so you can follow our M&A news updates!

Ten Things I’m Thinking About Heading into 2017

Hi Everyone, and Merry/Happy whatever-it-is-you-celebrate (or not!).  When writing an end-of-year blog post, it is tempting to write something about “reflecting on accomplishments”, or “setting goals”..   Those topics don’t happen to be something that I’m terribly into.  Instead, here are 10 specific topics I find interesting and I think we will all learn about as 2017 matures.

#10 – What Kind of Company is Apple?  The new Macbook Pros, the silence on updates to the Mac Pro and Mac Mini desktops, reports that Macs are not an area of focus for engineers within the company, along with Apple exiting the router and monitor businesses, have people  inside Apple wondering whether the Macintosh is important to the company – to the extent that Tim Cook felt compelled to respond.  One can’t help but think that this is akin to the dreaded “vote of confidence” given to so many coaches right before they are fired…  Whether Apple offers a meaningful update to the Mac Pro and/or Mac Mini will tell us if they are still in the desktop computer business at all.  Note – 90% of Apple’s profits come from the iPhone.  You can easily make the case right now that it’s a phone company.  That feels weird to say — “the phone company” must be the harshest insult you can hurl at a company like Apple – but there it is.

#9 – Is Microsoft the New Apple?  After years of missteps and customer vitriol (much of it, to be fair, unearned), Microsoft is now relevant in the consumer hardware space in a big way.  That the Xbox and successors quickly vanquished Nintendo and compete well with Sony’s Playstation is remarkable.  Microsoft is steadily getting it more right with the Surface computer line.  The Surface Book and Surface 4 do many of the things Apple users wish a Mac would.  Touch screen, stylus interface, detachable screen.  The Surface Studio is the kind of groundbreaking product Apple used to make.  The Surface Dial is kind of a device looking for problems to solve, but they will be found.   Windows 10 works extremely well and incorporated many of the things that make Mac OS work well.   Windows 8 and Vista are basically Thoughtcrime now.  I remain perplexed that Microsoft can’t figure out the phone market. Microsoft phones seem like they have been exiled like Napoleon to the Island of Elba. The (incomplete) integration of Windows and Xbox will cement Microsoft’s hold on the home network, but will not dominate home automation because…

#8 – Is the Amazon Echo Going to Become the Home Appliance Control Device of Choice?  Early signs are encouraging, and Amazon flat-out ran out of both the Echo and her little sister, Dot.  I can’t imagine the odd Tap will be around much longer.  Here’s the thing – once you get one of these things in your home, you’re going to want one in almost every room.  We do – they control many of our lights, our Nest thermometer, they are a great timer, music player, bluetooth speaker, news briefer, and can do a bunch of other stuff.  I think there is a good chance that Google is too late to the market (by the way, saying “OK Google” is surprisingly awkward) – and if there’s one thing we know about Google, if they think they are failing, they will wave the white flag faster than Rick Perry did in the 2016 Republican Primary race.

#7 – Can Tesla Stand Up to Real Competition?  Teslas are cool.  They have become the 1st place medal you get anytime you exit your VC-backed startup.  But, Tesla has just taken too darned long to make enough cars to satisfy demand and to make a mass-market car.  They had a nice lead, but were unable to sustain it.  Steve Wozniak just received his Chevy Bolt – built by a company that has been in the auto business about 115 years longer than Tesla – with longer range and more practical applications.  Many more electric vehicles are on the way.  Has Tesla effectively served as the world’s most expensive focus group company for the auto industry to prove out the viability of electric vehicles?  One thing’s for sure – Elon Musk doesn’t have the road to himself anymore.  Once Mike Tyson ran into a fighter who wasn’t afraid of him, his career quickly declined.  Is Tesla the same?

#6 – Is Virtual/Augmented Reality for Real?  Pokemon-Go seems to have went, though not without racking up asphyxial data charges for families.  Now, we see commercials all over the place for VR glasses for your phone, for your (very powerful) PC, your Playstation 4.  I picked up a VR Gear for cheap last year from someone who didn’t use it, and now we don’t use it.  Fitting.  I can’t help but wonder if VR is similar to the odd 3-D movie and TV craze we had a few years ago.  The trouble is, people who don’t wear glasses don’t like to wear them to watch TV or play a game.  People who do wear glasses don’t want to wear a second pair to watch TV or play a game.  Unless that game is truly a killer app – like Avatar (no, don’t ask – never saw it – I’ve never seen almost any movie you can think of).  By the way, did you notice? – the old Viewmaster is back, in a VR goggle form factor

#5 – Will Tech Initial Public Offerings Come Back?  Tech IPO’s slowed in 2016, big-time.  2017 may be a rebound.  There was no, single reason why tech IPO’s slowed – rather a multitude of contributing factors.  Instability in oil prices.  Uncertainty over the elections.  Ultimately, I think the companies going IPO were just not going to attract their desired value in the market. It’s great to be a unicorn, unless you’re the last money in.  In that case, it’s hard to find that one, last, bigger fool…  If you put your last money in at a $60 billion valuation, you need a $70 billion valuation in your IPO to make it worth your while.  That’s hard to do.  Some of the businesses just aren’t up to t he task when Wall Street looks at them closely.  Blue Apron just cancelled their IPO – Buzzfeed’s report makes their fulfillment facility sound like a Mad Max Thunderdome.   Uber, despite their model, their brand, and making nice with regulators, continues to leak cash like the Edmund Fitzgerald.

#4 – Will Coal Come Back?  The U.S. is the Saudi Arabia of coal.  Except, we don’t want it.  President-elect Trump seems to want to make coal great again.  Of course, the coal companies want it.  The miners and their families want it.  The states where those mines are located want it.  However, it seems that, unless natural gas and renewables are massively taxed, the best case scenario is for coal to “hold it’s ground.’ (I couldn’t resist!).  Natural gas has already overtaken coal in terms of energy generation in the U.S., and you can’t just switch back.  You can’t put food in coal’s mouth without taking it out of natural gas, and the U.S. is the Saudi Arabia of natural gas also.

#3 – Will Private Companies Be in Reach of Putting Humans in Orbit?  Blue Origin plans suborbital test flights in 2017.   Virgin Galactic plans passenger suborbital flights in 2017.  I don’t mean to debase these accomplishments, but what excites me is putting humans in orbit and finally replacing the Space Shuttle program (we could not have possibly invented a more expensive way of transporting humans to space).  SpaceX claims they will do so by 2018.  Yeah yeah we can make jokes about Elon Musk and delays, but they did have a rocket blow up on the pad earlier this year, so we can forgive them for being careful.  Private space stations may go into service as soon as 2020.  We are tantalizingly close to a tangible space age, and my hope is that we will stay on track.

#2 – What Will the Russia-U.S. Relationship Look Like?  The CIA is blaming the Russian Federation and Vladimir Putin for handing Donald Trump the Presidency. (By the way, doesn’t the CIA know a thing or two about making sure the “right person” rises to or stays in power?)  Russia, incredibly, did not respond after the U.S. expelled as many as 35 Russian diplomats – clearly President Putin is waiting to see how The Donald is going to pursue U.S.- Russian relations.  My guess is that we will go back to a Cold War-like mutual recognition of spheres of interest.  I’m going to deliberately sidestep the comparisons between Trump and Putin as “authoritarians”, “nationalists”, etc.  One area where I do think they agree is that they want to make deals, and everything they do is about anticipating making a deal, and giving themselves the greatest leverage.  If you want to know why Trump or Putin says or does anything, I think you ask yourself, “what kind of deal do they think is on the table, or needs to be on the table?”

#1 – What Are We Going to Do With the Newly-Discovered American Heartland?  Many of us, including yours truly, were offered a potent lesson throughout the 2016 Presidential Campaign about the state of the American Heartland – notably, that much of it has badly-clogged arteries.  Through a combination of trade and technology, the middle class working economy in the United States has been decimated, and their woes were exacerbated by the 2008-2009 recession and financial crisis, and those populations found their voice in a quasi-third party candidate.  As a result of the Donald Trump victory, we are (or ought to be) much more aware of these structural issues – each generation in working class America seems, on balance, doomed to be financially worse off than the previous one.  Whether those jobs are being bid down or taken away by China, immigrants, robots or web sites is almost immaterial.  We need new ways of thinking about preserving the dignity and opportunity of a large section of the population that may not have the desire or aptitude to become engineers, programmers, nurses, doctors, or accountants, or they will behave with increasing despair and/or desperation (the last major revolution that wasn’t basically a bread riot was the American Revolution), and I have become convinced that these problems cannot be structurally fixed by a) taxing the wealthy and increasing welfare benefits, b) reducing taxes and regulation, c) building roads, bridges, airports, and bullet trains, or d) criminalizing trade.  None of those approaches will address the fundamental truth that in the next 20 years, almost every manual labor job can and will be replaced by automation.  Are we headed for a Blade Runner society (another movie I have not seen?) No, but I will be interested to see how much recognition there of this fundamental fact.

2017 looks like a ripe your for thinking, and we will start to learn important things about our economy and our world.  Maybe you agree or disagree.  There are lots of other important things to think about.  What’s on your list?  What should be taken off of mine?




“Value is What Someone is Willing to Pay” – the Most Toxic Phrase in Business

The title is a strong statement.  I’m sure your mind is racing right now, thinking of candidates for even more toxic statements.  “Toxic”, in this case is, of course, subjective.  There’s no cobra venom or turpentine to swallow.  However, I’m going to convince you that this phrase does as much damage to your business as such gems as, “We’ve always done it that way”, “that’s not in my job description”, or, “there’s just one last question I need to ask before we complete this interview – are you pregnant?”  The hits just keep on comin’.

The aforementioned phrases are exemplary of lousy employees and might even get you sued.  They still aren’t as damaging to you as “Value is what someone is willing to pay.”  Yet, this phrase is one that I hear over and over again – often uttered by folks I know to otherwise be very intelligent and sophisticated.  I nearly have to bite through my tongue to not raise issue so as not to start a fistfight at a Chuck E. Cheese’s.

Here’s the deal – value is not “what someone is willing to pay.”  It’s an absurd statement that reflects a fundamental lack of understanding of value – at a minimum, of anything approaching what we might consider “fair” value.  I’ll come back to what that statement really means.  But first, the legitimate question is, “OK, smarty-pants.  You’re so smart, tell me what value really is.”  I will dispense with the banal definitions or “standards” of value that govern my profession.  They are useful for many purposes, but for you, the reader, they constitute semantic junk.

Value is the price that would most frequently be paid and accepted (you know this is important, because I put this phrase in bold, italic and underlined) for an asset at a given point of time if it were traded a large number (call it 1,000+) times in a short time frame.   You’d likely get a bell curve distribution (well, more likely a logarithmic distribution, but I don’t want to get too mathy) of prices.  The peak of that bell curve is value.


(No, as a matter of fact, I didn’t go to art school.  Whyever do you ask?) Pushing the point more forcefully home – value is the price where the neither the buyer nor the seller gained an objective financial advantage at the expense of the other in the transaction.  To the right of the peak, the seller got a good deal, selling more dearly than value.  To the left, the buyer got the good deal, buying more cheaply than value.  When the tug-of-war between buyer and seller turns out to be a draw, and a transaction takes place, that’s where you find value.

Where does this phrase, “Value is what someone is willing to pay” come from?  We hear the phrase all the time, but with just a little thought, the entire concept is easily refuted  The buyer is either a) ignorant as to the nature of value, or b) trying to manipulate you into selling (to him/her) at their price.  What the phrase implies is, this buyer is right here, and you’re probably not going to do better than the offer this buyer (investor) is proposing, so you might as well take it, because the buyer’s offer, ipso facto, constitutes value.  More poignantly, the implication is this particular buyer, and this buyer alone, is going to actually part with his or her money – it’s like a financially-themed version of The Bachelorette.

In a real-world context, let’s say 1,000 Chevy Volts (a marvel of American auto engineering, by the way) with identical features in a confined geography with homogeneous demographics are sold in a 3-month period.  Further, let’s say the value of a Chevy Volt is $30,000 (not sticker price – it’s around $35,000).  Not every Volt is being sold at $30,000.  Some are being sold for $31,000.  Others for $26,500.  Still others are sold for $29,000.  A bunch are sold for $30,000 or very close to that price.  In fact, a plurality (or majority) are sold at $30,000.  That’s what the value of the Volt is.  Some buyers got a good deal and bought for less than value.  Others paid more dearly than they might have and the dealers won out.  Most markets are not so efficient that everyone buys and receives “fair” or “market” value.  If a Volt is with what the “buyer is willing to pay”, how do you reconcile the varying prices actually paid?  I’ll save you the Tylenol.  You can’t reconcile because the statement is inherently flawed.  “Value” is a point in financial space.  Value not a range (although professional standards allow value to be expressed as such), and value doesn’t have a split personality.

What makes value so challenging from a conceptual standpoint is that value is almost never observed directly.  Although value won’t burn your retinas like looking directly at a solar eclipse will, they are both typically observed indirectly.  I suppose that is why the business appraisal profession is held in such relatively low regard (I think we are the guys that lawyers make jokes about.)  Unlike in accounting, where numbers can and must be tied out to fact and record, value cannot be completely tied to fact, and therefore, the popular perception of the appraisal industry is that the Ouija board, Magic 8-Balls and Tarot decks are as important tools as calculators, reference materials and Excel in our craft.

But that doesn’t excuse the widespread use of this horrific phrase, “Value is what someone is willing to pay.”  Here’s an example I use in classes frequently.  Let’s say I have a half bottle of Coke Zero, my beverage of choice.  There is only half a bottle remaining because I drank the other half.  Now, someone offers me $20 for the remaining half, and I gladly oblige with the sale.  Was that half bottle of Coke Zero with my nasty germs in the remaining soda and on the bottleneck “worth” $20?   Was the value of the half bottle of Coke Zero $20?  You are almost certainly rejecting that assertion in your mind.  But wait – someone was willing to pay the $20 for this quantity of potentially contaminated Coke Zero.  If value is what “someone is wiling to pay”, then that half bottle of Coke Zero’s value was $20.  Of course, rationally, you’re thinking, there’s no way the value was $20.  The value should have been zero or pretty close to it.  Common business sense inexorably leads us to that conclusion.

Now, we get into the “why”.  Why was someone willing to pay $20 for that half bottle of Coke Zero?  Perhaps the buyer was very thirsty – hadn’t had a drink in 2 days.  Perhaps the buyer was of the believe that this particular half bottle of Coke had some sort of magical properties, to cure illness, or grow a giant beanstalk into the clouds.  Perhaps the buyer confused this Coke Zero with some other version that was far more desirable.  Maybe the buyer thought Adele had drunk from it and was getting some DNA to clone.

Now, let’s take the other side.  Someone comes into my neighborhood in Chamblee looking to purchase a house.  They find one for sale and that person offers the owner $100 – and that is the maximum amount the buyer is willing to pay.  Not $100K (which would still be laughably low for this neighborhood), but $100.  The bill with Ben Franklin on it.  If value is, in fact, what someone is willing to pay, that house now has a market value of $100.  Again, common sense tells us that the notion is absurd.  Such an offer would be immediately rejected, probably with a laugh – yet that is precisely the snake oil into which you buy if you accept that “Value is what someone is willing to pay” as an axiom.

The final stake in the heart of the “buyer willing to pay” argument is this:  When was the last time you heard, “Value is what someone is willing to sell for?”  Never, right?  This isn’t an accident.  What makes the discussion so insidious is that you most frequently here the phrase from people who are positioned as experts:  the venture capitalist, the private equity buyer, the strategic buyer, the investment banker.   Buyers tend to do many more transactions than sellers, so it makes sense that buyers tend to have an elevated level of expertise in the transaction world.  But in this case, they are wrong.  Not only do you have every right to articulate value, but there’s no such thing as value if you don’t argue your value case.

That doesn’t mean the price you are being offered in a deal is necessarily a bad one, but the way to test that notion is to either attract additional bids or to undertake a formal business valuation process.  Only then will you get a sense of where the offer price lies on the price/value continuum.

So, why is the phrase, “Value is what a buyer is willing to pay” so damaging?  Because you are being manipulated into potentially selling your business, or your shares in your business more cheaply than their value.  That can cost you millions of dollars, and once you sell, you’re generally done.

Value is much more complex than a pithy sound bite, and accepting this “fake news” can cost you dearly.  Don’t buy into the lie.  Don’t allow someone in a position of so-called expertise push you into the trap.  As a seller, you have just as much to say about the value of your business as the buyer.  Stand up for your right to value.

What do you think?  Have I convinced you, or do you have some arguments to make of your own?  Leave a comment and raise your own social media profile as well as mine!





TimeWarner Sells to AT&T – Sometimes You Just Are What You Are

AT&T bought TimeWarner (“TWX”) for $85 billion on October 22 – or at least it will if the U.S. government approves the deal, which is hardly a slam-dunk (though maybe a lay-up under a Donald Trump administration).  AT&T shareholders were not amused – their stock price fell 7% in the wake of the announcement of the deal.  While it’s not uncommon for an acquirer’s share prices to fall after a big acquisition (in fact, it’s common and supported by numerous empirical studies), 7% is a big number.

But I’m not going to focus on that aspect of the deal here.  To me, the interesting narrative for this deal is that TimeWarner rejected an $80 billion offer From FOX back in 2014.  I argued then in a newsletter to which I no longer have publication rights that the $80 billion deal seemed light because it offered no premium for obtaining a controlling interest. The market has indicated clearly that it’s time to re-think that position.  Either a) the market has priced in a high likelihood of an acquisition for some time, or b) somehow, TimeWarner has been overpriced in the market by at least 20% (a typical, if conservative discount for minority interests).  A little of column (a) and a little of column (b) are likely at work here.

Here’s the chart of TWX’s stock price since Rupert Murdoch’s bid:


Since FOX’s bid (that was quickly rejected), TWX’s stock price dropped, recovered for a bit as the market expected more M&A bids (which never came – even Murdoch stayed away, which was shocking to me).  When those bids failed to materialize in mid 2015, TWX’s stock price slumped again and only recovered its footing when rumors of the AT&T deal surfaced and was finally agreed.

Here’s where we find out if you are a glass half-full or glass half-empty person.  The half-full investor is happy they at least get a second chance at an M&A deal at more or less the same price as before – even a bit better.   Basically, they got off the Titanic and found a lifeboat.  The half-empty investor says, “Hold on – I held on to this stock for 26 months and I got an annualized return of 2.7%.  That’s a lousy return.”  Those investors are upset that the “unsinkable ship” sank.   Granted, the S&P 500 return over the same period was only 3.6%, and that’s lousy, too, but 90 basis points’ better return on a fully diversified portfolio still beats what TWX did any day of the week (returns were adjusted for dividends – Source: Yahoo! Finance).  The acquisition by AT&T is a capitulation by TWX’s management, any way you slice it.  There was no apparent bidding war, and TWX at least salvages value much better than, say Yahoo! did after famously spurning the offer from Microsoft several years ago.  (Apparently, Microsoft’s offer to throw in several free copies of Windows Vista failed to seal the deal.)  If you’re a capital asset pricing model (CAPM) person, the news is even worse if you were long TWX.  TWX’s beta is around 1.  Where long-term treasury bill rates are around 2%, and the equity risk premium is 6%, the expected return on TWX is 8% per year, or a little over 16% in 26 months.  In other words, for the risky roller coaster ride that Time Warner took its shareholders on, those shareholders were compensated for risk at about 30 cents on the dollar).  An investor who had $1,000 in TWX in 2014 wound up with about $1,005 after 26 months.  The risk that investor took ought to have been at $1,016.

How did Time Warner become such a lousy investment?  I think two forces were at work.  1.  TWX’s management misread their desirability in the market.  They must have thought that an initial bid by Rupert Murdoch would have begotten additional bids, both from Murdoch himself and other parties.  I must admit that I was a bit surprised myself that Murdoch made a sort of “hit and run” bid.  One bid, one rejection, and crickets.  The market priced in an acquisition, and when it failed to materialize, investors dropped the stock like a hot Galaxy Note 7.  2. TWX had some notion that they had the wherewithal to withstand the crushing forces that are confronting the conventional media industry.  CNN is pretty much watched only by the elderly in between Matlock re-runs.  Cord cutting is real.  And we aren’t even sure what news is anymore.  Judge for yourself how they did:



The chart pretty much speaks for itself.  After a nice bump in Q4 2014, TWX’s revenue was stagnant or even slightly falling.  In fact, it is entirely possible that TWX forecasted its Q4 2014 revenue and figured that would be a launching pad to new heights, and that’s why they turned down the Fox bid.  As it turns out, Q4 2014 was the high mark in revenue.  TWX’s management ultimately realized that they had bought into a mirage and found someone (AT&T) to bail them out.

I have to admit that I’m dying of curiosity on one front – once TimeWarner’s management realized that they had screwed up, did they consider going back to Mr. Murdoch and ask if he’d consider discussing the purchase?   I’m guessing the response would not have been that charitable.  And, if so, what was his response, or what would it have been?  FOX has the National Football League, Major League Baseball, MLS Soccer, and The Simpsons.  TimeWarner has Game of Thrones through HBO.  And HBO’s special spot in the TV market is being rapidly dissolved by Netflix, Hulu and Amazon as they have created some terrific proprietary programming.   TWX needed FOX more than FOX needed TWX.

The object lesson here is to know when you’re licked – as a founder or as an investor.  TimeWarner thought that they had a viable option to being acquired by FOX but they were flat-out wrong.  TimeWarner was fortunate that someone else gave them the same deal they could have had 2 years previous, but that still added up to effective loss (on a risk-adjusted basis) for the investors who stuck it out.  Waiting 2 years to get the same deal you could have had the first time around is not a win.  TimeWarner certainly fared better than did Yahoo after spurning an offer from Microsoft, but they still cost their investors money by thinking they were more valuable than they are.  It’s hard to admit – and I imagine doubly so as the CEO of a publicly traded corporation – but sometimes your time is just up and someone else needs a turn.  Sometimes you just are who you are.



Samsung’s Galaxy Note 7 – When “Blowing Up Your Phone” Isn’t Good

“One death is a tragedy, a million is a statistic,” is one of Josef Stalin’s more sinister quotes (and he had a lot of them).  Samsung is witnessing not the deaths of people (thank goodness) but of its phones and has a bad statistic for its shareholders.   The Galaxy Note 7 was released on August 19, 2016, skipping the Note 6 moniker for some reason, and making my Note 5 obsolete 6 months after I purchased it. Thanks a lot.  When released, the Note 7 received many, highly positive reviews.  The Note 7 improved upon the Note 5 by giving it the edge glass that the Galaxy series has, and by returning to removable batteries and expandable memory, features that Samsung omitted in the Note 5 – apparently trying to do an Apple impression.  Looking back, perhaps the compromises were necessary in the last-generation Note…  

This generation of Note, of course, has an unexpected “feature”.  They catch on fire.  And not just when you charge them, either.  They just like to burn.  Galaxy Note 7’s were declared safety hazards on passenger aircraft and passengers were not allowed to use them on airplanes.  After a failed recall, Samsung determined they were unable to fix the problem, and Samsung has taken the phone off the market.  You don’t often see product introductions this bad, but the do happen.  Remember the Apple Newton?  Microsoft’s Zune?  Google Glass?  For sports fans, how about the Extreme Football League? (though the XFL did give us Rod “He Hate Me” Smart, perhaps the strangest name ever put on the back of a jersey.)  I wonder if Hillary Clinton will ever get around to mentioning the New Jersey Generals of the USFL as one of Donald Trump’s business ventures…

But the difference between all of these failed market introductions and the Note 7 is that none of these ventures were central to their respective companies’ businesses.  These other market introductions were, for lack, of a better word, experiments.  The Newton was nearly 10 years ahead of the requisite technology to make it work.The Zune was a half-hearted attempt to jump into the portable music market that Apple conquered with an innovative blitzkrieg, and in any event, wasn’t taking away from Microsoft’s Windows platform.  Google Glass was perhaps as much about market validation as it was an actual product initiative.  The WWE and NBC were not staking their futures on the XFL, and Donald Trump’s real estate and bankruptcy attorneys would be kept plenty busy whether the Generals succeeded or not (spoiler alert – they didn’t).  The Galaxy Note 7 is different.  The Note is a flagship product line for Samsung, one of two product lines that go head to head with iPhones.  Now, that product is dead, and Samsung is likely to find itself 2-3 years behind its innovation schedule.

What happens to your company’s value when one of your flagship products crashes and (literally) burns?  You lose $17 billion of market capitalization, or 8% of your value.  Measured against the cost of the recall ($920 million, or a little over 0.5% of annual revenue), that’s a multiplier of over 18x.  If you think this conclusion is obvious – I suggest you reconsider.  Rarely does a new product flop result in this dramatic a stock move.  Even The Coca-Cola Company’s stock increased in value in the years after the introduction of New Coke.

Interestingly, the bulk of those losses occurred right after Samsung made the announcement that it would quit making the Note 7.0.  The market clearly had confidence in Samsung’s ability to correct the problem and move forward, and was surprised when Samsung threw in the towel.  The 18x multiplier implies that more was at stake than making or missing earnings targets.  There was reputational damage, doubts about Samsung’s ability to continue to innovate at the highest level, a years’ worth of phone buyers that would move to competitors or, in a best-case scenario, wait until a new Galaxy Note that isn’t a blow torch that makes phone calls and plays PokemonGo is available.

A key beneficiary of the Note 7.0 fiasco is, of course, Apple.  Apple just introduced its own device, the iPhone 7, and a strong competitor has been removed from the market.  When Samsung made its announcement that it was pulling the Note 7 from the market, Apple’s shares jumped 1.5%, adding roughly $9.0 billion to Apple’s market capitalization.  That’s a $26 billion value swing for those two companies alone (and you can bet that Apple, in the midst of a high-stakes fight with Samsung over intellectual property infringement is collectively smiling somewhere).  We haven’t even considered other phone makers, such as Google with its recent introduction of the Pixel.  Windows phones, as is generally the case, are not relevant to this (or any other) discussion.

Painful though the decision to pull the Note 7 from the market must have been, it’s clearly the right thing to do.  There’s liability for injury, and the reputational damage that Samsung would have suffered would have been magnified are more and more phone failures were reported, and more YouTube videos surfaced of the devices becoming silicon torches.  Now, Samsung can get out of the headlines, figure out what went wrong, and step up efforts to introduce the Note 8.  Plus, you wouldn’t want to suffer the fate of the Whizzo Chocolate Company

Anyway you slice it, the Note 7.0 introduction and subsequent cancellation is a full-on disaster for Samsung.  However, thanks to its size and product diversification (two factors to be explicitly explored in the valuation of a business), Samsung will weather this storm.  They make lots of products other than the Note phone series, including the Galaxy phone series, which is actually even more important than the Note to Samsung.  Still there was significant damage done to the Company by this incident.  The company’s risk is up, now that technical risk is on the table.  Growth will be slowed as Samsung is left with a gaping hole in its product lineup, but there will be some successor phone for sure.  But, if you’re a Samsung shareholder, you’re definitely not left with burning love.

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