Dealmaker;

Whether or not the plunge in stock prices drives the nation into a depression, it has already driven American business to rework many of its assumptions about finance, compensation, real estate, and company acquisitions. At year's end, we sought some new ideas from some old hands about surviving in the post-Wall Street economy.

 

What is your company worth today? As a generalization, the answer now is, "Less than it was a few months ago." For those companies involved in mergers and acquisitions, determining exactly how much less -- and how to structure deals to reflect that -- will undoubtedly be the subject of rather complex negotiations in the coming year. We spoke about some of the intricacies of such negotiations with an investment banker who's been going through them recently: Arthur H. Rosenbloom, chairman of MMG Patricor & Co., in New York City.

INC.: The market has obviously taken a bad hit. Has the full effect of those reduced values already been reflected in the prices you are seeing for private companies?

ROSENBLOOM: Yes and no. You are already seeing the market crash reflected in reduced P/E ratios used to price deals. Obviously, those vary from industry to industry, but they are down -- down from October, and in many instances down from a year ago. In addition, I think you are going to see downward pressure of another sort -- one driven more by supply and demand. Without a vigorous IPO or secondary public market for money, demand builds up rather quickly for what private money is available -- pension money, VC funds, insurance company financing, and bridge funds. As the demand for that money begins to outstrip the supply -- and we are already beginning to see that -- I think you can expect that valuations may come down still further.

INC.: How does the stock market reflect itself in the various ways you go about valuing a company?

ROSENBLOOM: It's a major factor. The three principle arbiters by which you price a deal are: one, price-earning multiples, in which public companies become the benchmark; or two, price in relation to book value, where the relationship tracks what is happening with public companies in that industry; or three, discounted cash flow.

INC.: Discounted cash flow would seem to be relatively immune to market fluctuations.

ROSENBLOOM: On the face of things, yes, but even then you will see market realities creeping in. Consider the case of a company that you expect will throw off $10 million, $15 million, $20 million, $25 million, and $30 million over the next five years. That adds up to $100 million. But if you're a buyer, you don't pay $100 million for the possibility of making $100 million over five years. You have to discount the net-free cash flows to reflect the time value of money and the fact that these cashflow projections are just that: projections. So you assign some sort of discount rate -- a higher rate for riskier cash flows, lower for less risky. Once you have a discounted cash flow, you have to apply some multiplier to it to come up with the terminal or residual value, which represents the theoretical perpetuity of the cash flows. And in coming up with both the discount rate and the terminal value multiplier, your perception of what's going on in the marketplace will affect your thinking.

INC.: So, no matter how you figure it, sellers can expect to get less money for their companies.

ROSENBLOOM: Asking for a reduction in purchase price is one way to do it, but there are more subtle ways to reprice a deal downward other than simply lopping off dollars. Some deals are being retraded so that the seller offers stricter representations and warranty provisions in contracts, which would make it easier for the buyer to collect damages if those representations are breached. Offering larger escrows is another tactic -- reserves against certain contingencies such as disputed tax claims or adverse judgments in product-liability lawsuits.

INC.: In other words, the sharing of risk might be renegotiated in rather than the price.

ROSENBLOOM: More likely it would be along with the price: the buyer might trade off some piece of the purchase price in exchange for getting more favorable terms. In the deal business we say, "Your price, my terms."

INC.: Any other variations on that theme?

ROSENBLOOM: Let's say you're a seller and were hoping to get 12 times earnings last summer, and now the market says you can only get 10 times earnings. You say to the buyer, "Hey, you can't reprice my 20-year-old business on the basis of a six-month aberration in that wacky stock market." And the buyer says, "OK, I'll give you your 2 points of multiple back -- but only if the earnings exceed a certain level over the next five years." That kind of contingent earnout would be a way of retrading the deal without necessarily retrading dollars.

INC.: But what about companies that have securities or real estate or pension assets and liabilities, or long-term debt that is locked in at a high rate -- would you want to make adjustments in prices for these that reflect the new realities?

ROSENBLOOM: Anytime, but especially now that you have a market that is characterized by uncertainty, you have greater scrutiny paid to specific assets. And what you do is go right down the balance sheet and mark each asset or liability up or down to its fair market value as opposed to t historical cost, which is what is generally reflected on the financial statements.

INC.: Let's back up in the process somewhat. You are running a company that you thought you were going to bring public sometime soon. Now, because of the changes in the market, you don't see an IPO as a real possibility, and you are looking for private sources of capital, or to sell all or part of the company privately. How does your financial and business strategy change?

ROSENBLOOM: It's the same, whether you are looking to private money or an IPO. Essentially you have to invest in taxes -- by which I mean you do nothing that will depress earnings, as many private companies do, in order to save on taxes. If you are going to go sell the company you pay the taxes, show the earnings, and hope that you can show a growth pattern that will fetch a higher price.

INC.: Is this the time to sell?

ROSENBLOOM: It's neither the best of times nor the worst of times. For those who have a choice in the matter, where the selling is not required or urgent, I'd say a wait-and-see attitude is the best advice.

INC.: If you have to sell, where are some good places to look?

ROSENBLOOM: For companies with lower risk profiles, there are still good chunks of venture capital money available, especially for LBOs. What we're finding is that venture capitalists now can get close to a venture capital return without having to take a venture capital risk. Let's take the case of a deal not unlike a couple we're working on now -- a $50-million, middle-market LBO of a company that earns approximately $7 million before interest and taxes. There's $5 million of equity that is going into the deal that is being supplied principally by venture capitalists. In the past, that would not have been a typical venture capital deal -- the company is up and running, it is a market leader, it has a real plant, genuine earnings, and good growth potential.

INC.: And presumably the VCs will be getting more than 10% of the company.

ROSENBLOOM: Darn right! They will probably wind up with a majority.

INC.: Ouch!

ROSENBLOOM: But don't forget, they're still taking the greatest risk. The long-term lenders get a lower return, but they may have a senior position that may be a collateralized position as well.

INC.: Any other, maybe less demanding, sources than VC?

ROSENBLOOM: Insurance companies typically aim for lower rates of return than VCs. And I'd look for non-U.S. buy-ers. This market has sensational buy-side opportunities for foreigners because they have a double play -- the dollar is weak and so is the stock market. It's a great time for them to do deals in the States.