Techniques to help take complex JV valuation issues off the table.
COMPANIES ROUTINELY FIND themselves in painful joint venture negotiations, reaching “walk-away points” and failing to close deals because of hard-to-value contributions, differences in key assumptions, or valuations that do not support the desired ownership or control split. Relief lies in a paradox: While JVs often introduce more complex valuation challenges than other transactions, the flexibility inherent in JVs simultaneously offers dealmakers a range of techniques “to take valuation issues off the table” or otherwise help the counterparties get to yes.
On the surface, JV valuation looks a lot like M&A valuation, only harder. What makes JV valuation so hard? To begin with, most JVs include a range of important contributions that are not bundled into an easy-to-value business with existing cash flows – but rather are hard-to-value “pieces” of a business, such as market relationships, capabilities, technologies, proprietary data and processes, skilled people, support services, and privileged assets that do not have an external market price. What’s more, unlike in M&A, the ownership of many of these contributions (e.g., services, technologies, brands) is not transferred to the venture, but rather is provided by one partner under some exclusive or otherwise privileged basis to the venture. And, unlike M&A, few situations lend themselves to an auction process – i.e., negotiating with multiple partners in parallel – which in effect creates a market valuation where one may not have existed naturally before.
Given these challenges, how should companies approach JV valuation? At Water Street Partners, we suggest companies adopt a four-step approach designed to take complex valuation issues off the table, and ultimately get to a good yes or a quick no.
Step 1: Inventory and map the contributions necessary to deliver on the intent and scope of the proposed joint venture, differentiating between (a) contributions that will impact the partner’s equity interest in the venture versus those that will not and (b) for contributions impacting ownership, those that are easy- versus hard-to-value. By the end of this step, the parties should agree on what each partner will be contributing – or at least have a good starting point.
Step 2: Test whether a quick agreement can be reached. In many JVs, the parties come to the transaction with a target ownership level or range already in mind. As a result, rather than doing a bottom-up valuation of all the contributions and using the resulting answer to “mathematically” generate an ownership split, JV partners often also take a top-down view, “managing” the list of contributions and their valuations to arrive at the target ownership level or range. While that sounds complicated, it often makes it much easier to get a good deal done quickly. If the parties agree they are “close enough” to the target ownership range, then the valuation work is complete – and the negotiators’ attention should turn to other deal and launch items.
Step 3 (if needed): Test various options to bridge valuation gaps. If the parties cannot agree on the valuation of contributions, then there are a number of options that should be considered to bridge the gaps. These include true-ups, contractualized contributions, scope alterations, creative ownership and economic arrangements, other valuation techniques, and offsetting contributions. Creative ownership and economic arrangements would include models that depart from the standard-form venture agreement where each company’s level of control and economic flows are directly proportionate to its ownership stake and are fixed. Other valuation techniques for consideration may include expected monetary value (EMV), intangibles triangulation, royalty rate capitalization, or benchmark factoring.
Step 4: Select an ownership construct. If the parties are able to ultimately agree on ownership and valuation, then the last step is to select an ownership construct and agree to the value-sharing terms. This requires choosing a corporate form (e.g., single JV verses multiple legal entities, LLC verses C-Corp) and how control and economic flows will relate to the ownership split.
Before walking away from a promising JV because of hard-to-value contributions, consider whether the value created by the deal warrants using a creative approach to valuation. While Albert Einstein may have not have structured many JVs, he may have said it best: “Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.”