Parting is Such Sweet Sorrow: The End of Joint Ventures and Staged Acquisitions, and the Implications for Valuations

When companies create a joint venture, they’re not usually aiming for the long term. The more typical scenario[1] is to operate for a fixed amount of time, then have one side take over the whole business. This is true not only for joint ventures, but also for partial acquisitions—meaning situations where a company starts with a small stake, but can take over the rest later.

Companies have infinite flexibility in how they choose to wind down a partnership. The key is to make these decisions ahead of time so you can avoid valuation headaches down the road.

Considerations for winding the partnership down

When setting the joint venture up, you’ll want to determine whether there’s a benefit to keeping the joint operation over the long term. If you’re considering an eventual takeover, some of the questions to ask include:

• Do we want assurance that one company will acquire the joint venture, or should it only have the option to do so?

• Is the seller able to capture the value that the joint venture creates?

• Who controls the end buyout? Is it mandated by the contract, do both parties have the option, or does a single party own the decision?

• Are we aiming for a clean break with a one-time payment, or are subsequent payments called for? If the latter, how long should the payments continue and how should they be structured?

• Do we want to charge a fixed price for the eventual sale of our share in the joint venture, or do we want the price to vary if the venture turns out to be more valuable than we expect?

These questions are important because the way you structure a joint venture can significantly impact the value of the agreement.

To illustrate, suppose BigCo and SmallCo are investing in a joint venture called TeamCo. BigCo will contribute 51% of the assets and SmallCo will invest the remaining 49%. BigCo intends to purchase the remainder of TeamCo, plus all remaining economic rights, in five years. Let’s take a look at the multiple ways BigCo can operationalize the takeover.

Forward Contracts: Forcing the Issue

Let’s say BigCo is required to purchase the remaining 49% from SmallCo at the end of five years. One option is to require an independent appraisal of the joint venture at the end of the five-year period, and set the purchase price based on this appraisal.

In this case, BigCo has agreed to buy an asset—the remaining 49% of TeamCo—and pay a fair price for it. Under GAAP, the ability or requirement to purchase an asset at its fair value carries no value. In other words, because BigCo can never directly benefit and stands to simply pay a fair price for the remaining stake, the value of this contract is zero. To be clear, there can be significant strategic value to their purchase (just imagine if SmallCo decided to sell the stake to a competitor of BigCo). However, this strategic value is ignored under GAAP.

Similarly, we often see these contracts specify a fixed multiple of EBITDA or revenue. In this case, dealmakers typically work to determine what they believe will be a fair multiple in the future. If the selection is reasonable, BigCo may win or lose at the end based on actual market conditions. However, at inception, they’re just as likely to gain as lose, which results in a valueless contract from a GAAP perspective (assuming the initial multiple is fair).

Oftentimes, a contract does not specify that BigCo must buy out the remainder. Instead, BigCo has a call (or the option to buy the remaining portion of TeamCo) while SmallCo has a put (or the option to sell their stake in TeamCo). As long as the price is the same for both the call and put options, the economics follow that of a forward contract. The reason is simple: If the value is higher for BigCo, it behooves them to exercise. But if the value is lower than the price, SmallCo will use their put, resulting in the same outcome. Such a contract is sometimes referred to in finance as a “synthetic forward.” Keep in mind that some potential complications, such as the put and call activating at different times, rarely result in value to the contract.

Timing or price differences in put/call agreements can change this conclusion. Even so, consider the end value of the transaction. If all avenues lead to BigCo holding the shares and paying the same price to SmallCo, and the price to be paid is indicative of fair value, then there is no value under ASC 820.

Option Contracts: Building in a Choice

While forward contracts reflect a position where BigCo must purchase the remainder of TeamCo, option-style contracts reflect a situation where the company can choose whether to make the purchase. The result is a contract where you can decide not to buy when the price is too high.

Going back to our first scenario, if the price is set based on a future appraisal, the same rules apply. One common version of this is the right of first refusal, where a company can match any other offers for the target entity. In this case, the offer creates a market price and all value is purely strategic.

If the buyout price is fixed in advance, the valuation is straightforward, as this resembles a plain vanilla stock option. The fixed price option is useful as it allows BigCo to complete the purchase when things are going well, while lowering the risk associated with the transaction. However, there’s also risk associated with setting the fixed price in advance, and SmallCo may require BigCo to pay a price significantly higher than their current value, R&D expenses, etc. From a valuation perspective, this is pushing the exercise price associated with the stock option higher, but to BigCo it may be worth it from a strategic, risk management, and upside perspective.

As with forward contracts, some companies use an in-between method where the sales price is based on a fixed multiple of sales, net revenue, or earnings. These models aim to capture the future value changes of SmallCo post-joint venture, while skipping a future appraisal. Unfortunately, these also are the most challenging items to value. An option based on a future earnings multiple needs to consider both the value of TeamCo in the future and the relationship to earnings five years from today. Because the two are linked, this must be done in a Monte Carlo simulation capturing the estimated and often imperfect correlation between the two.

Contingent Payouts: It’s Not Over Until We Say It Is

A final wrinkle is when there are contingent payments after the exercise. Like traditional earnouts, these are often incorporated to capitalize on future proceeds from the transaction.

From a valuation perspective, earnouts need to be considered as part of the option to purchase. As an example, if the buyout of TeamCo will trigger a payment of $1 million upon a future milestone, BigCo would consider the probability and amount in the purchase price of the remainder of the company, and perhaps shy away from the transaction. Typically this is handled through an adjustment to the strike price of the option, similar to the option contract method we discussed earlier.

When weighing a joint venture or staged acquisition, it’s important to plan ahead and understand the implications. Of course, the deal team is always thinking about the best economics for the transaction in general, but the accounting team often gets to pick up some complicated pieces later on. You can help to clear the road ahead by designing and staging the joint venture now in a way that reflects each participant company’s intentions.

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[1] We’re talking about any entity with multiple companies investing, not necessarily a joint venture as defined by control rights under GAAP.