Calculating Damages in Representations and Warranties Cases

Introduction

Mergers and acquisitions (“M&A”) can be a double-edged sword. When done right, M&A can allow acquirers to scale their businesses and create value through synergies. When done poorly, M&A can result in drastic overpayments for assets that are not nearly as valuable as believed and for economies of scale that are very difficult to achieve. 

One of the main risks in M&A is information asymmetry: simply put, the vendor knows much more about its business than the acquirer. While the acquirer is able to perform due diligence, time pressures to close the deal mean that this process can sometimes be imperfect; issues are sometimes missed.  This is where Representations and Warranties (R&W) insurance can come into play. This brief article provides a brief overview of R&W insurance, and discusses some of the issues we have encountered as forensic accountants and business valuators in quantifying losses under this type of insurance coverage.

What is R&W Insurance?

R&W insurance provides indemnity for “losses” related to overpayment by the acquirer resulting from breaches of representations and warranties as set out in the purchase agreement for the acquisition.

These types of policies are becoming increasingly popular. One global broker recently reported a 30% increase in deals written in 2018 compared with the prior year. The average policy limit was equal to 15% of the total enterprise value of the deal (e.g. a deal for $100M would have a policy limit of $15M); while deductibles were generally set at 1% of enterprise value. The same publication also reported that premiums have been declining over the past two years, as more insurers enter this market. Another publication by a leading insurer in the space mentions that the frequency of claims has been roughly one claim for every five transactions.

Two types of mistakes

Based on our experience quantifying losses under R&W coverage, there are two main types of misrepresentations: one-time misrepresentations and long-term misrepresentations.

One-time misrepresentations

These types of misrepresentations generally relate to the balance sheet. M&A transactions typically will set a target level of “net working capital”, based on an overall understanding of the subject company. If issues with this calculation are discovered following the closing, the economic loss to the purchaser is generally equal to the amount of the misstatement. 

Quantifying these types of issues involves first obtaining a detailed understanding of the components of the purchase price and ensuring that the alleged misrepresentations are not already factored into the price. For example, if the claim is that a large amount of inventory had to be written off following closing, one would need to make sure that the inventory balance included in the closing statements did not already consider a provision for obsolete inventory.

Long-term misrepresentations 

Long-term misrepresentations will tend to involve the income statement. For instance, in one case we were recently involved in, the seller had represented to the purchaser that it was not subject to a particular type of property tax. This turned out to be incorrect, and as a result the purchaser was liable to pay this additional, unexpected amount every year for the foreseeable future. In that case, the loss to the purchaser is equal to the present value of the ongoing annual tax liabilities.

How does one value these sorts of long-term misrepresentations? One shorthand approach might be to simply apply the acquisition multiplier to the value of the annual misstatement. For instance, if the deal multiplier was 10 times the seller’s trailing EBITDA, and the value of a misrepresentation (such as the unreported property tax issue) is $1M per year, then one might reasonably conclude that the value of the misstatement is $10M.

This approach can be appropriate in some cases, but sometimes it can lead to incorrect results, when the cash flows associated with the misrepresentation in question have different characteristics (term, riskiness or growth forecast) than the acquired business as a whole. Consider the following example:

·         The business being sold has two divisions, Rapid Robotics and Flat Pancakes. After-tax cash flows last year were $10M ($5M for each division), and the business recently sold for $200M, or 20 times after-tax cash flows.

·         It was discovered that due to regulatory changes in the pancake market (which were known to the seller prior to the deal), Flat Pancakes will need to eliminate a particular product line that accounted for $1M in after-tax cash flows. The purchaser advances a claim for $20M, equal to the annual value of the misrepresentation of $1M times the acquisition multiplier of 20 times.

·         The problem with this approach is the 20x multiplier may actually consist of a multiple of 30 times cash flows for the Rapid Robotics division, and only 10 times cash flows for the Flat Pancakes division. The higher multiplier for Rapid Robotics would represent the value attributed by the purchaser to the anticipated growth in that division.

·         This means that the value of the $1M misrepresentation in the slow-growth Flat Pancakes division is only $10M, not $20M.

In order to perform a proper analysis of these longer-term misrepresentations, it is therefore generally very beneficial to obtain a copy of the valuation model used by the acquirer in the transaction in order to understand how the transaction multiplier was arrived at and to reverse engineer the impact of the particular misrepresentation on business value.

Closing

This article has only scratched the surface of the types of issues that, in our experience, can arise from post-acquisition M&A disputes. As M&A insurance becomes, in the words of one insurer, “the new normal”, we will no doubt have the opportunity to revisit this topic in future articles.

This article first appeared in the July 25, 2019 edition of Lawyer's Daily, published by LexisNexis Canada

Award

It was an honour to receive the CBV Institute's "Communicator of the Year" award last week at its annual conference in Montreal.

 

My wife still doesn't believe me, but here is the proof:

 

 

 

Canada's Fall Economic Update and Its Impact on Valuations

A couple of days ago, the federal government of Canada came out with its Fall Economic Update. One aspect of the update that impacts businesses (and business valuations) is the changes to the Capital Cost Allowance (“CCA”) system by which businesses get to write-off their capital assets for tax purposes. This brief article discusses some aspects of this change.

CCA and the Half-Year Rule

For non-manufacturing equipment, we used to have the “half-year rule”, whereby a purchaser of a new asset only got to apply half of the normal CCA rate in the first year; for example, if you bought an asset for $100,000 and the normal CCA rate is 20%, you’d only get to write off 10% (or $10,000) in the first year for tax purposes.

The half-year rule has now been replaced with a new first year rule which allows purchasers to apply 1.5 times the normal CCA rate in the first year; to continue the example from the previous paragraph, the CCA in year 1 would now by $30,000.

For valuators, this means that the tax shield formula on new capital expenditures will change from:

UCC x Tax Rate x CCA Rate / (Discount Rate + CCA Rate) x (1- (Discount Rate / (2 x (1 + Discount Rate))))

to

UCC x Tax Rate x CCA Rate / (Discount Rate + CCA Rate) x (1+ (Discount Rate / (2 x (1 + Discount Rate))))

Does this matter?

So, will this change impact a) actual capital expenditures and b) valuations in Canada going forward? The short answer is: in many cases, "not really".

The amount of CCA that businesses can take over the life of the asset in question does not change based on the new rules; all that is affected is the timing of CCA. By accelerating the CCA in the first year of the asset’s life, businesses will get to reduce their taxes in the first year, but their taxes will be slightly higher in subsequent years. The value of this timing difference depends on the discount rate one uses.

A common practice in valuations is to use a firm’s pre-tax cost of debt as the discount rate to calculate the present value of CCA. The reason for this is that the odds that a firm will have at least some taxable income against which to apply the CCA are fairly good, certainly less risky than the overall returns to equity holder as a whole.

Using a discount rate of 8%, I calculate that the impact of the new tax changes to the cost of asset purchases will be less than 1%, regardless of the CCA asset class. 

This is not to say that these changes will not spur a sudden rash of equipment purchases – they may have some psychological effect. But the actual savings, at least in most cases I can envision, are pretty marginal.
  

Springboard Profits/Damages in Canadian Intellectual Property Litigation

A few weeks ago, I co-presented at the Intellectual Property Institute of Canada’s annual conference in Vancouver on the topic of financial remedies in patent litigation. My portion of the talk focused on springboard profits as part of the accounting of profits remedy. In this post, I’ll share some of my thoughts from the presentation, as well as some other ideas that were suggested to me by my co-panelists and audience members.

The Concept

The concept behind springboard profits is that, by virtue of having infringed a patent, the infringer has achieved a financial advantage that continues beyond the expiry of the patent. This can occur for several reasons:

• A valid patent prohibits not only the sale, but also the manufacture and offering for sale of an invention covered by the patent. This means that had the infringer not infringed during the life of the patent, it would have taken some time to develop its product, to build up inventory, to market the product and build distribution channels. In short, it would have taken months, if not years, to build up their sales to a steady plateau. By infringing, the infringer is able to “hit the ground running” following the expiry of the patent.
• If the patented product is a durable good, then the benefits to the infringer in selling that good may include not only the initial sale, but also the sale of replacement parts, maintenance services, or other associated revenue streams. While the initial sale of the good may have taken place during the life of the patent, there will be additional benefits accruing to the infringer well beyond the life of the patent.
• In some instances, there may be an even longer-lasting benefit to the infringer. The existence of multiple firms already selling the patented product by the time of the patent’s expiry may dissuade additional firms from joining the market following the patent’s expiry, firms who may otherwise have entered the market if there had been only a single incumbent with whom to compete. In situations like this, the infringer’s benefit will continue into the indefinite future.

Are such post expiry springboard profits recoverable in an accounting of profits? In Dow Chemical Company v. Nova Chemicals Corporation, 2017 FC 350 (CanLII), Justice Fothergill found that they were. He was persuaded by Dow’s argument that if the incremental profits earned by the infringer following the expiry of the patent are not also disgorged, then the infringer will be left in a better financial position than if it had not infringed, a result that is antithetical to the very concept of the accounting of profits remedy.

Nova’s Argument

While they were ultimately rejected, the arguments raised by Nova also deserve some comment. Nova advanced several arguments. Conceptually, the most interesting arguments was the following:

• An infringer who disgorges its profits from infringement is implicitly acting as the agent of the patentee, and such payments implicitly serve to effectively condone the infringing activities themselves.
• The difficulty with this argument is that the profits remedy is not necessarily equal to the amount that, in the real world, the plaintiff would have agreed to in exchange for use of its patented technology. In many cases (such as the Dow case) the plaintiff would clearly never have agreed to license the technology under those terms, as its Minimum Willingness to Accept would be based on the damages it would suffer by reason of losing its monopoly over the invention in question.

The same argument would hold if the remedy awarded was lost profits (i.e. damages). The damages award compensates the patentee for its losses during the patent period only; any losses beyond that period would also need to be considered insofar as they are causally connected to the infringement.

Could Nova’s argument work in a damages context?

Is there a situation in which Nova’s argument would have carried more weight? Perhaps.

Suppose a plaintiff elects a damages remedy, which it measures based on a reasonable royalty since it is unable to prove it suffered any loss of sales as a result of the infringement.  In that scenario, the plaintiff’s MWTA is less than the defendant’s MWTP; that is, the benefit to the defendant from licensing is greater than the value to the plaintiff of its monopoly. This arises most commonly where the plaintiff is a smaller firm, while the defendant is much larger and able to scale to market.

In that case, a hypothetical royalty rate (and a fortiori an empirically based royalty rate, measured based on comparable transactions) should incorporate the fact that the defendant will thereby gain a springboard advantage. If so, then there should be no award of springboard damages.

This conclusion is implicit in the words of Justice Fothergill at paragraph 123 of the Dow decision:

[123]      Dow is entitled to awards under both ss 55(1) and 55(2) of the Patent Act. Even if the royalty rates calculated by Dr. Heeb and Dr. Leonard can be said to include the period following the expiration of the ’705 Patent, the royalty compensates Dow only for Nova’s infringement during the period December 9, 2004 to August 21, 2006. The accounting of profits extends over a much longer period.

Happy Belated Bobby Bonilla Day! Some Valuation-Related Thoughts on MLB Contracts

With the World Series upon us, I thought I’d do a post or two on valuation and investment principles involved in baseball player contracts. In this post I'll talk about fixed income valuation and interest rates, through the vehicle of the infamous Bobby Bonilla contract.

Bobby Bonilla was a fine player for the Pittsburgh Pirates in the early 1990s, and he and fellow "Killer B", Barry Bonds (who was a lot skinnier back then) went to three straight National League Divisional Series, losing all three.

Bonilla eventually arrived with the New York Mets (after stops in Baltimore, Florida, and the Mets themselves (in a previous go-round)), and by the year 2000 his skills were in severe decline. The Mets owed Bonilla $5.9M on the last year of his contract. Instead of paying Bonilla the $5.9M that year, however, the Mets and Bonilla agreed to a series of payments whereby the Mets would pay Bonilla $1.193M per year every year for a 25-year period, beginning on July 1, 2011 and ending in the year 2035, when Bonilla is 72 years old. The nominal value of the total payments will be just shy of $30M.

July 1 is now sadly observed by Mets fans every year as “Bobby Bonilla Day”. The sadness is due to three main reasons:

• It seems ridiculous that the team is still paying a former player, now in his early 50s, over $1M a year.
• Bonilla was somewhat of a disappointment even while he played for the Mets. While he made a couple of All Star teams in his first stint with the team, by 1999 he was producing a negative WAR value.
• It is commonly known that then-Mets owner Fred Wilpon was a major investor of disgraced Ponzi-schemer Bernie Madoff, and it is believed that the outsized “returns” Madoff was generating led to what was, objectively speaking, a foolish financial decision.

I’m not here to dispute the first two points, but I do want to talk a little about the financial principles of the third point. 
Discounting and Interest Rates in the Year 2000

It is often pointed out that the interest rate, or discount rate, on the Bonilla deal is 8%.  This is true, as I show in the table below. Thus, from the Mets’ perspective if they could invest the $5.9M at a rate of 8% per year for the next 35 years, they would earn exactly enough money to pay off the annual payments to Bonilla, leaving them with no balance owing at the end of the 35 years. 

Is it crazy for the Mets to have made that assumption? It would appear that the answer may be “no”. While it may be hard to remember based on the current low-yield environment, the US T-bond rate back in 2000 was in the range of 6.5% to 7% in the first part of 2000, while the 30-year “High Quality Market Corporate Bond Rate” at the time was around 8%. While that is a pre-tax rate, it nonetheless appears true that the Mets could have taken their money and invested it in a fairly safe investment and been none the worse for wear. So the deferral seems to make some sense from the Mets' point of view.

Another way to look at the deal is from Bonilla’s perspective. Effectively, Bonilla was agreeing to lend the Mets $5.9M for a long period of time, eventually getting paid back at an annual interest rate of 8%. Given the overall steadiness of Major League Baseball – no teams have folded for over 100 years - this would be similar to lending money to a high quality corporation. The one difference is that for Bonilla, there has been a significant tax advantage to a) spreading more of his earnings across lower tax brackets, and b) being taxed now as a resident of Florida (which has no state taxes) rather than New York (which does). So at the time, this was a win-win deal.

 

Interest Rates in 2018

There is a belief that bonds (lower case, the financial instruments, not the allegedly HGH-infused home run king) are a safe investment. After all, unlike the stock market they provide a fixed, knowable series of payments over time.

This is, in many ways, a mistake. While it is true that the payments on a bond are prescribed, the value of those payments will vary based on changes in rates of return on other investments. Bonds will fluctuate very significantly in value based on changes in nominal interest rates. Thus, if a ten-year bond with face value of $1,000 is issued with a coupon of 5% and the market interest rate at the time is 5%, the bond will sell for $1,000. If interest rates drop the next day to 3%, the same bond (paying a 5% coupon) will become much more valuable, and investors will be willing to pay almost $1,200 for the same bond.

If you think of Bobby Bonilla's contract as a bond with a coupon of 8%, it is clear that the cost of honouring that bond has gone up, with long-term interest rates in the 4% range now. Because the Mets did not (it would appear) secure the future Bonilla payments by matching them to a long-term fixed income investment back in 2000, the value of their liability has not been declining by nearly as much as it should have over time. The present value of the Mets' remaining payments to Bonilla is currently several million dollars higher than it should have been had interest rates remained high.

Conclusion

Trying to predict interest rates is a bit of a mug's game., and in any event the financial landscape in Major League Baseball has shifted so dramatically in the past 18 years that the money remaining on the Bonilla deal is really small change at this point, remarkable more for its strangeness and symbolism than its monetary significance. 

Bobby Bonilla has done well with his contract (assuming he did not sell or assign it!), but if interest rates had risen he would have been singing a different tune. The real advantage to this sort of a long term deal exemplified by Bonilla's is a) the tax savings, and b) the enforced savings and the knowledge that he will have over $1M coming to him for the next 17 years.

 



 

Buying Shares in an NFL Player? Business Valuation Principles Still Apply

In my last post, I argued that an investor in Kylie Jenner’s cosmetics company was essentially investing in Ms. Jenner’s personal brand, and that the earnings stream for that brand was of a finite life.

The post got me thinking: is it actually possible to invest in the future earnings of a specific, individual celebrity? Has anyone ever done that, and if so, how did it go?

The short answer is “yes” and “not very well”. For the longer answer, keep reading.

Fantex

In 2012, a company called Fantex Inc. was incorporated. Fantex’s business was to invest in minority stakes (typically 10% ) of the future earnings (from both on-field performance and endorsements) of professional athletes. It would raise money from the public in exchange for athlete-specific classes of common shares, and would pay the athletes a lump sum in exchange for the right to a share of their future earnings. Shareholders would receive dividends based on the pro-rata performance of their athletes.

The following table shows a list of some of Fantex’s early investments in National Football League players.

 

How have these investments done? Well, it depends.

The investment in Mohammed Sanu has turned out nicely. Sanu, who earned fairly little on his rookie contract with the Cincinnati Bengals, signed a big contract with Atlanta in 2016 (following his deal with Fantex), earning a base salary of $6M per year the past few years. His tracking stock has already paid out $1.41M in dividends to shareholders (close to the initial $1.63M raised), and he stands poised to earn over $6M per year over the next three years with the Falcons, although none of the money is guaranteed.

 

On the other hand, if you invested in the E.J. Manuel stock issue – well, let’s just say that your investment worked out about as well as every Buffalo Bills quarterback since the Doug Flutie era. The E.J. Manuel tracking stock has issued total dividends of only $0.41M, a mere fraction of the $5.2M that was raised to acquire a 10% stake in Manuel’s future earnings.

Overall, it appears that Fantex’s investments have underperformed; the company had a deficit of $14M as at September 30, 2016, the last published financial statement date before the company was delisted.

 

Valuing Fantex's contracts is really no different that valuing shares in a company: it is a function of three factors: the size, duration and risk of the future projected cash flows of the investment.

Fantex’s public filings make for interesting reading, and they talk about each of these valuation inputs. As part of its financial reporting, Fantex would need to re-value its contracts with its roster of athletes each year, adjusting its assessments of fair market value based on its estimates of future performance in light of how the athlete fared in the previous year; the deficit of $14M is largely a function of the write-down in value of underperforming contracts.

What sorts of assumptions does Fantex apply in its valuations? Here are some of the key ones for NFL players, based on Fantex’s 2015 10-K annual report:

• Discount rate of 4.5% to 20%, with a weighted average of 14.6%.
• Career length (I assume this means from the beginning of the player’s career: 5 to 16 years, with a weighted average of 9.7 years.
• Size of contract: $0.4M to $81.4M, with a weighted average of $23.9M.

My initial sense is that these assumptions seem fairly optimistic, given the average length on an NFL career is only 2.6 years, and has been decreasing recently, although of course once a player becomes more established the expected career length will tend to increase.

Let’s return to the Mohammed Sanu tracking stock. Before, I had presented my analysis without applying a discount rate. What if we apply a 15% discount rate to reflect the risk of the investment in Sanu (who was still a young player when Fantex invested) versus investing in a public company stock? You can see that whereas investors paid $1.4M for Sanu’s stock, the present value of dividends thus far has been only $927,000:

 

 

Based on the above, Mr. Sanu will need to remain healthy and avoid being cut by the Falcons the next couple of seasons in order for his investors to break even.

Conclusion

I'll have more to say about the idea behind Fantex , which more recently has expanded into other sports such as golf and baseball. But given that Fantex is no longer publicly traded, would-be NFL investors may need to suffice with the less expensive option of fantasy football.

 

 

Is Kylie Jenner Really a Billionaire, Or Even Close?

A few weeks ago, Forbes created a social media storm when it proclaimed that Kylie Jenner was poised to become the world’s youngest self-made billionaire. Many thumbs were worn out debating the appropriateness of the term “self-made”, and apparently a GoFundMe page was set up to try to get Kylie over the hump into official billionairedom, although mercifully this was only a gag.

As someone who is only peripherally aware of who Ms.Jenner is, I am perhaps not the best person to comment on all this. But as a business valuator, I do feel I should comment on the basic premise of Forbes' assessment that Ms. Jenner is worth anything close to $1B. So here it goes.

Inputs for Determining Value

In order to value a company or asset, we need four main inputs:

• Current level of cash flows
• Expected growth rate
• Expected capital reinvestment rate
• Discount rate

According to the Forbes article, the following are basic facts about Ms. Jenner’s business.

• Total sales in 2017 were $330M. Revenue growth that year was only 7%
• Production and fulfillment are outsourced to third parties, and overhead is minimal. Forbes estimates the cost of sales at 55%.
• Her mother takes a 10% cut (of profits? Or sales? The article is unclear) as a management fee.

The Forbes article seems to assume that Kylie’s net profit margins are in the range of 40%. This seems quite high, even given her lack of overhead costs. L’Oreal and Estee Lauder both have pre-tax net operating margins in the range of 15% to 20%. Given that Kylie appears to run a leaner operation, let’s assume a net operating margin of 25%.

Revenue growth last year was 7%, which seems very low for a business that started less than 3 years ago. I’m going to assume that growth will simply equal inflation going forward.

Capital reinvestment seems, in this instance, to be zero, given the image-based nature of the business. You would figure that at a certain point her manufacturer would pass along any such costs to her, but let’s ignore them for now.

For a discount rate, I estimate a rate of 10%, based on an estimated cost of equity consisting of:

• Risk free rate of 2%
• Cost of equity of 5%
• Firm-specific risk 3%

If I apply a basic Gordon growth model, I get ($337M x 25%) / (10%-2%) = $1,052M. So far, Forbes looks to be on solid ground.

The Problems

But there are two problems with this analysis.

First, most businesses are valued based on the assumption that they are going to operate into perpetuity.  Thus, L’Oreal has been around since 1909, while Estee Lauder has been in existence since 1946. Of course, when taken literally this is generally not a valid assumption; nothing is "forever". But it is normally valid to assume that a business will be around for the next 20 years. Any projected cash flows after that timespan have a fairly low present value, so the assumption of a perpetuity makes sense.

Will Ms. Jenner’s personal brand persist for the next 20 years? It is difficult to say, given the vagaries of celebrity culture. To give some context, here are the highest earning celebrities from 1998: http://www.wemakethefunny.com/?p=2116

If we assume that Ms. Jenner’s remaining shelf life is 5 years, the present value of her cash flows falls to $347M; even a 10-year forecast gives a valuation of $585M.

There are obviously a lot of assumptions in the above table, and in many ways that is precisely the point.

The more basic problem with Forbes’ analysis, however, is simply the question of what exactly one would be buying if one purchased Ms. Jenner’s company. It owns no physical assets, it doesn’t really have much of a labour force, and it does not seem to own much IP. Its ability to generate cash flows is tied solely to Ms. Jenner’s personal fan base. In theory, Ms. Jenner could sign some sort of contract to guarantee continual promotion of the company, which might tie her compensation to the continued success of her brands. But that is a far cry from being able to liquidate her company, right now, for $1B.