This guest post is written by Mike Gasparro of AxialMarket. You can also view the post on AxialMarket’s blog.

In this blog posting, we explore the concept of accretion/dilution. What is it? How is it calculated? Why and how is it relevant for strategic buyers and what does it mean for sellers negotiating with strategic buyers.

The accretion/dilution concept refers to the impact an acquisition has on the buying firm’s Earnings Per Share (“EPS”). An acquisition is accretive when the combined EPS (known as pro forma EPS) is greater than the buyer’s standalone EPS. An acquisition isdilutive when pro forma EPS is less than the standalone EPS.

For example, suppose analysts expect 3M’s EPS to be $6.12 in 2011. If they were to acquire Company ABC, pro forma EPS in 2011 is now expected to be $6.18 — $0.06 higher than if 3M had not acquired Company ABC. In this case, the deal is $0.06 accretive to 2011 EPS. On the other hand, if after acquiring Company ABC, 3M’s pro forma 2011 EPS is expected to be less than the original $6.12, the transaction is dilutive.

The calculations can get complicated as there are a number of variables which are interrelated. A qualified investment banker/M&A advisor can quickly help with the intricacies and the necessary calculations.

Here are the basics:

• Estimate the Net Income of the Combined Firm – Although simple in theory, the calculation is more complicated than just adding both firms’ net incomes. The combined net income should take into consideration expected synergies. Typical synergies include additional revenue from cross-selling products/services, economies of scale in sourcing and/or elimination of redundant functions. Additionally, the net income has to be adjusted for other transaction related items such as changes in interest expense due to debt being issued, changes in depreciation or amortization deductions due to write-ups or downs in assets, changes in tax rates, etc.
• Calculate the New Share Count - If the strategic buyer is going to finance a portion of the purchase price with stock, they will be issuing new shares which should be added to the current share count.
• Divide the Estimated Net Income of the Combined Firm by the New Share Count – Compare this new pro forma EPS to the buyer’s original standalone EPS to determine whether the transaction is accretive or dilutive.

Accretion/dilution is relevant to a strategic buyer as it can be regarded as a proxy for whether the acquisition creates or destroys value for shareholders. EPS serves as an indicator of a company’s profitability. If a transaction is going to decrease the company’s profitability (i.e. it is dilutive), the value of the buyer should theoretically decrease following the transaction.

However, there are significant limitations to this analysis. First, accretion/dilution is looking at the transaction over a fixed period of time. Strategic buyers generally intend to own an acquired business indefinitely. Additionally, EPS is impacted by numerous accounting decisions (which can be manipulated) and does not necessarily reflect the economic reality or the combined company’s ability to generate cash flow.

We recently participated in a seminar hosted by Investment Dealers’ Digest , “Corporate Development and Strategic Buyers: How to Make M&A Pay for You in Today’s Market.” During the seminar, strategic buyers discussed whether they would acquire a company that was dilutive to earnings. The results were similar to what we have found with our AxialMarket Members: some strategic buyers will not do a dilutive transaction; others require the transaction to be accretive after a certain period time; still others are not concerned with this issue and focus on strategic fit.

As a seller, it’s important for you to be aware of the concept of accretion/dilution, understand the basics, and realize that it can potentially impact decisions made by strategic buyers. However, it’s not the be-all end-all for all buyers. As we discussed in “5 Major Differences Between Strategic and Financial Buyers,” strategic buyers focus heavily on synergies and integration capabilities. So while accretion/dilution may be a factor for some potential strategic buyers, there are many other issues which will influence their decision.

(Image courtesy of Ricardo Carmona)

In a private equity term sheet, indemnification most often refers to the company indemnifying the board and investors against any cases brought against the company. This is a standard term that private equiteers will rarely (never) negotiate. With that said, it’s a reasonable term given that directors hold advisory rather than operational roles. You could debate otherwise, but abolishing the term would mean you attract far less directorial talent. You’d be hard pressed to find quality directors willing to join your board without indemnification.

In addition to the indemnity term, private equiteers will often require directors and officers (D&O) insurance. As with most insurance, it’s important that you understand the nuances of the policy, because you may find you’re not covered for obvious events. And if you’re a CEO who is also on the board, then you are also covered and should particularly attentive to the policy wording. Just as the limited liability structure of a company doesn’t protect against everything, neither does a D&O policy.

While indemnification is a standard non-negotiable term, consider how indemnification affects the rest of your business. Entrepreneurs without legal nous often sign contracts without understanding the full extent of indemnification. You may think you have minimal exposure, but you must also consider the exposure of the other party. That’s what’s really in play here. And when it comes time for someone to sue, it’s all about the deepest pockets, which hopefully are yours, if all is going well.

Rather than get too obsessed, just keep an eye/ear out for the term indemnify. If it appears in anything you’re about to sign, pay particular attention. People have lost everything by unknowingly (or unconsciously) indemnifying others.

It generally comes down to the purpose and use of your investment. There are two broad options:

1. Existing Capital – e.g. buy-out an existing stockholder, retire some debt, etc.
2. New Capital – e.g. invest for growth, invest to make an acquisition, etc.

If you swap your new capital for existing capital (buying out another shareholder or paying down debt), then there’s generally no change to the valuation. However, if you are investing cash as new equity (for growth and/or acquisitions), then you’re increasing the equity value of the business and hence, increasing the EV and overall valuation.

Image: Pre- and post-money not always equal [source: Shutterstock]

A quick example: we value a company with EBIT of $20m using a multiple of 5x. It has debt of $50m, no material amount of cash and therefore, equity value of $50m and EV of $100m.

In scenario 1, I’m paying down $50m debt. This means I’m swapping my $50m of equity for the $50m of debt. This transfer of capital means we now have $100m of equity , but $0 of net debt, so still an EV of $100m. As you can see, the EV and overall value didn’t change.

In scenario 2, I’m investing $50m to make a new acquisition. My investment enters the business as new equity to fund the acquisition. Total equity is now $100m, net debt is still $50m and hence EV is $150m.

In scenario 1, the pre- and post-money valuations were the same, both $100m. In scenario 2, pre-money was $100m, whereas post-money was $150m. This is all due to the new equity injection.

Like most things, there’s a caveat to this. In scenario 1, we swapped different types of capital, which mean they have different risk and return profiles. Most financial analysts would argue the value of the business changed due to the change in capital structure. However, we tend not to go into this detail in private equity for a few reasons (e.g. we’re not operating in efficient markets, our preference equity more closely resembles debt, we do the deals we can irrespective of theoretical nuances, etc.)

So, at least for simplicity, pre- and post-money valuations only differ if new equity is invested in a business.

Like most things, there are shades of grey. At one end, we have short-term one-way earnings-based ratchets that go against the mantra of private equity and pin executives to short-term performance. At the other end, we have long-term two-way returns-based ratchets that create much better alignment across the entire stock register.

So, let’s check out these characteristics:

• One-way vs. Two-way - A two-way ratchet simply means that executives aren’t only punished for underperformance, but they’re rewarded for outperformance. A two-way ratchet supplants the need for executive option schemes and further encourages executives to invest their own cold hard cash. The only other consideration here is the rates at which the ratchet moves in each direction (more on this later).
• Shorter-term vs. Longer-term - we can link our one-way ratchet to something that makes more sense for everyone… the exit. We lament public markets for their short-termism, so why do the same by using short-term ratchets? If we are going to align interests and have longer-term investment horizons, then we should use longer-term ratchets and give executives a chance to make a difference.
• Earnings-based vs. Return-based - continuing with the concept of aligning interests, private equiteers are rewarded for returns, not earnings. Higher earnings certainly help boost returns, but there’s much more to a great return, like higher exit multiples and good leverage. If you want executives to maximise your exit return, then it makes sense to incentivise them on the return-side via a ratchet linked to IRR or cash multiple (thanks to a recent reader for this suggestion).

There’s one more consideration for two-way ratchets… the ratchet rate. Should the rate be equal for the downside and upside? Well, it depends. In all fairness it should, but sometimes the ratchet rate is adjusted to bridge valuation gaps. Managers may opt for a higher ratchet rate in exchange for a lower initial valuation, or vice versa. Also, the private equiteer must ensure the upside ratchet rate isn’t so aggressive as to eat into their target return (I’ve seen this happen).

So, it’s best to plot out a range of scenarios before agreeing to a ratchet to make sure that,  a) everyone is sufficiently incentivised, b) your target returns are possible in most scenarios, and c) misalignment and adversarial terms are minimised. Good luck.

This is best demonstrated with an example. So, we have a 70% stake in an investee with 2009 EBIT of $30m. We invest with the proviso that a ratchet applies to 2010 earnings, whereby, for every $100k the EBIT drops below $30m in 2010, our equity ratchets up 0.1%. There is a cap on this to prevent us taking over the entire company in a bad year. The cap is at a maximum of an extra 15% of equity, which translates to a range of $15-30m. Therefore, if EBIT in 2010 drops all the way to $15m, our equity ratchets up 15% to a total of 85%.

The first thing you’ll notice here is that in practice, a ratchet rarely achieves a perfect equilibrium around your original paid multiple. What I mean is, if you invested $105m for your 70% stake (which equals a 5x EBIT multiple), the ratchet doesn’t help you keep your original 5x multiple. If EBIT did drop to $15m and your equity ratcheted up to 85%, then you’re effectively invested at an 8.2x multiple (all else equal and no applicable debt).

You may ask… why can’t the ratchet maintain our original multiple? Put simply, other investors just wouldn’t go for it because the risk of losing their entire stock-holding is very likely. Plus, why do you deserve this protection anyway?

There are many ways you can value this ratchet, but in the example above, you can see with the ratchet your effective multiple is 8.2x if EBIT drops to $15m. Whereas, without the ratchet, the multiple would be 10x. The enterprise values in these two instances differ by about $26.5m. Of course, the ratchet isn’t worth $26.5m because one would hope the probability of EBIT dropping by 50% is less than 100%. If you want to get really technical, you could value the ratchet at each interval and apply a probability to each scenario and then sum the results. But, that’s way too much work and you can’t really use the calculation in negotiations because it draws attention to the fact that ratchets are evil.

With all of this said, I recently posted on the concept of the equity ratchet and the  pros and cons of equity ratchets.

Pros of equity ratchets:

• If the investment doesn’t turn out the way you planned, you receive more of the business for the same original investment. E.g. if you pay 5x for a business with earnings of $20m, and then earnings drop to $10m, that original 5x multiple is now a 10x multiple. If you only purchased 20% of the business originally, a ratchet could increase that to 40%, in which case you’ve still only paid 5x (all else equal).
• Often a ratchet can give you a greater share of a business due to short term hiccups, even if the business outperforms in the long term. So taking the example above, earnings could have dropped to $10m due to the GFC, but next year they could return and grow to $25m. Now you own 40% of a business doing $25m even though you only purchased 20% at an original multiple of 5x.
• A ratchet can motivate managers if they’ve invested along side you. If they know they own a lesser class of equity and are at risk of being ratcheted down, they may work harder to keep earnings up.

Cons of equity ratchets:

• A ratchet creates misalignment with other investors since you’re essentially punishing them for underperformance of which you’re partly responsible for. It makes any pitch about aligned interests weak.
• Once a ratchet is enforced and a private equiteer’s ownership is increased, an adversarial relationship is often born. If the other investors include executives in the business, it can lead to lasting effects on performance and morale. This is especially likely if the executives’ ownership ratchets down to almost nothing.
• Private equiteers talk about their focus on long-term performance and differentiate themselves from public markets for this reason. However, ratchets are inherently short- or medium-termed. The idea that other investors (sometimes executives) are punished for short-term performance doesn’t sit too well with private equity traditionalists.
• The misalignment and short-term focus of ratchets motivates managers to report higher earnings, which in turn motivates manipulation. While this may sound fraudulent, in practice it’s more about debating normalisations to reported earnings. You’ll find yourself spending days negotiating the timing of sales, the timing of costs, the cases behind numerous normalisations (transaction costs, advisory costs, etc.), and a plethora of other things.

Overall, I’m not a fan of ratchets. They motivate on the downside, they create misalignment and they abdicate private equiteers of their usual responsibilities.

An equity ratchet works around the executive team achieving a predetermined level of earnings (the budget). If they underperform the budget, you’re granted free stock and a higher ownership percentage of the business. If they perform according to budget, then the equity ratchet expires and everyone remains happy.

So, let’s say you own 75% of Acme Inc. and the executive team owns 25%. Your original investment terms state by year-end EBIT must be at least $20m, otherwise your equity will increase by 1 point for every $1m of budget underperformance. Usually, there’s a cap to prevent the private equiteer from taking complete control in a bad year. So, let’s say the cap is at EBIT of $10m. That means if Acme’s EBIT is $10m or below, your firm’s ownership increases to a maximum of 85% in 2009 (gratis). If it is somewhere in between, your equity increases accordingly.

The idea behind the equity ratchet is to motivate the executive team on the downside (opposed to motivating on the upside, as option schemes are designed to do). This is controversial because it goes against the concept of positive reinforcement. But as parents, we all know how well talking nicely works.

And, why is it called a ratchet? Because it only goes one way; in favour of you.

If I achieve a 10x return on my fund, LPs, other PEs and most others will say “they were lucky”. If I achieve a 0.5x return for the fund, everyone will say “they suck”. Both terms are pejorative (hey, life’s unfair), but in one scenario you get to boast 10x returns and in the other you don’t get to boast at all.

So, back to the title of this post, equity returns for debt risk. Private equiteers essentially want all of the upside in a deal and none of the downside.

In public markets, you can achieve this by buying put options against a portfolio or through investing in call options. But we all know there’s a cost, and even with that cost, you rarely mitigate risk 100%.

To achieve the same in private equity, we invest via preferred stock, demand preferred coupons, have veto rights over many business decisions, take a board majority, have the right to fire  senior executives, demand that managers invest, sometimes even demand redeemable preferred stock, etc. We are simply hedging our bets. But, like option strategies in public markets, the hedge isn’t perfect.

Where this idea of equity returns for debt risk really matters, is within a portfolio of assets. Public equity fund managers invest in equity returns for equity risk and that equity risk means that some investments succeed and some fail (and then transaction costs ensure most fund managers achieve sub-market returns).

In a private equity portfolio, our quasi-debt investments don’t incur as much loss from poor performing investments, so portfolio returns can conceivably be above public equity portfolio returns without investee performance being above average. Of course, this doesn’t hold when private equiteers overgear their investments, but think about this one without above-average debt. Especially in current markets, I see private equity characterised more by strict legal terms than mountains of debt. We have made two investments this year that are completely debt-free.

This is just another aberrant thought (following my response to The Economist article) on how private equity can beat public markets.

This scenario is what a CNC attempts to stop. It attempts to restrict the vendors from competing with the business, in similar regions, over a relatively lengthy time-frame. However, in certain regions (such as California) there is a CNC prohibition, and in other regions where a CNC is enforceable, the level of enforceability is open to debate. In some ways, CNC enforceability is similar to garden leave enforceability; courts often rule that barring someone from earning a living is not just. Exceptions exist if there is a blatant intent to operate in competition.

In regions where enforceability can be relied upon, term sheets generally include a CNC as standard. From the perspective of the private equiteer, the vendor shouldn’t expect fair value if they plan on destroying that value later with proprietary knowledge. And, from the perspective of the vendor, they shouldn’t be barred from their field if all doesn’t go according to plan. However, as with most terms, it’s about balancing preferences.

A private equity offer is the most valuable to vendors, yet the lowest priced. This refers to private equiteers priding themselves on being the lowest bidders in a business sale (hence, entering at a low price), but at the same time believing their offer is the most valuable to the vendors.

How is this possible? Through the creation of future value; value in addition to the prima facie purchase price.

The implication  is that private equiteers look for deals in which vendors don’t want to sell all of their stock. Because, if they do sell down completely, they’ll mostly focus on the purchase price rather than future value creation. Private equiteers generally can’t compete with strategic buyers on purchase price because they don’t have as much access to synergistic value creation. (See this post for my formulaic explanation of private equity versus trade player deals.) So, it helps if a private equiteer can make a case for future value creation.

To recap this post with previous posts, here are the main reasons you’ll witness private equiteers urging vendors not to sell all of their stock:

1. Because it’s more risky if the people with the greatest knowledge of the business leave the business
2. Because the more left invested in the business, the more motivated the vendors will be to ensure the success of the transaction
3. Because it provides a way for a private equiteer to demonstrate greater deal/offer value

Unless the deal is a spectacular standout, a private equiteer will generally move to lower hanging deal fruit if the vendors aren’t willing to remain in the business. This makes sense because if the vendors are fixated on the initial purchase price and there is a likely strategic buyer offering a higher price, there’s little point in wasting time on negotiating the deal.

Of course, this also works well with the fact that we like to invest in businesses in which the managers invest cold hard cash (see my recent post on this topic). This isn’t to say a vendor can’t sell out while new managers invest, but typically it’s less risky if the current vendor/manager stays around with money at risk. With all of this in mind, you can see why private equiteers often prefer partial sales.

Private equiteers often insist on investing via preferred equity, which includes a preferred coupon (see this post for info on preferred equity). The preferred coupon creates a return on the investment prior to the exit event; so, if there are any issues with the exit or the company sinks, the cumulative preferred coupons can help soften the blow. Some coupons are so high that they pay back the original investment before an exit occurs.

Another way to create a return is through management fees. The fees are charged to investees for helping to manage them. These fees are usually in addition to preferred coupons and can represent millions of dollars a year. The case put forward to the founders, or other investors, is that the private equiteers need to be paid a pseudo-salary for their ongoing work. This may also encompass board fees if they aren’t stipulated separately.

Let’s try an example. I invest $10m into a business as preferred equity with a 12% coupon and management fees of $0.25m per quarter. Therefore, I receive $2.2m per year from the coupon and fees combined. Add to that an initial signup fee of $0.5m and acquisition fees over the life of the investment of $1m. In the first year, the return is $2.7m; second year, the cumulative return is $4.9m; third year, $7.1m; and the last year, $9.3m, plus total acquisition fees of $1m, and we have $10.3m returned before we’ve even exited the investment. Plus there are any ordinary dividends  earned along the way, depending on the terms.

Compared to ordinary dividends, preferred coupons and management fees shift the return away from other investors (since they aren’t participating in these terms). If things fall to pieces in say year three of my example, the private equiteer has received approx $7m of the original $10m investment back. If there were no coupon or fees, the entire $10m would have vanished. It’s a form of risk mitigation.

Like many components of a private equity deal, this may seem a little unfair… okay, very unfair. But, as I’ve discussed many times, a private equity investment must be viewed with all of the terms in mind. There’s no denying that private equiteers drive hard bargains, and that founders in the past have resented such deals, but we’re all consenting adults. In many cases, aggressive terms such as high fees offset an unusually high valuation. Often founders, and especially their merchant bankers (whom receive a commission based on the top-line price), prefer higher top-line multiples.

(By the way, this is hardly deceptive because anyone will see it for what it is. The reason it works is that it creates a higher top-line figure that appeals to egos and emotions of both entrepreneurs and advisers.)

Just to recap, you want $100m (5x) for your business and I want to pay $80m (4x). One method I can use to get to your headline number of $100m is by constructing an earn-out. I’ve talked about earn-outs ad nauseam in previous posts (see funding earn-outs, are earn-outs fair), but here’s a quick and dirty use for them.

My offer to you will look something like this:

My firm, Acme Private Equity, proposes to pay up to $100m for 100% of your business. This includes an upfront payment of $80m and an earn-out of $20m. You will receive the earn-out if your EBITDA reaches $25m in the next financial year.

What I’ve done is offered $100m, but with conditions. The main condition being that your ongoing EBITDA increases from $20m to $25m. So really, I’m offering to pay $100m for a business with EBITDA of $25m, which is a multiple of 4x; the multiple I wanted to pay in the first place. If EBITDA stays at $20m, I don’t have to pay the earn-out. So, I’ve only paid $80m, which is still only 4x EBITDA.

Being honest with ourselves though, if the earn-out is paid, I am actually paying 5x for the business. This is because the extra $5m of EBITDA was created under my watch and I shouldn’t be paying anyone for earnings created while I owned the business. So sure, I’m paying you 5x. But, I protected myself on the downside and I received a guaranteed $5 EBITDA increase (if EBITDA didn’t increase, I would have only paid 4x). Either way you look at it, this scenario is better than me just flat out paying you $100m on $20m of EBITDA; better for me, not you.

However, in private equity transactions, the lock-up period is often for the duration of the investment. That means, the entrepreneurs cannot sell or transfer their shares until a planned exit event unless approved by the private equity investor. In instances where approval is granted, the shares typically have to be offered to the private equity investor first (this is referred to as Right of First Refusal). If the private equity investor refuses to participate, they may allow a sale to an approved investor.

This term may seem overly onerous, but considering the expected investment horizon, private equity firms want to keep share register disruption to a minimum. Allowing shares to be traded freely causes unnecessary overhead and has the potential of allowing devisive investors onto the register.