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Printicomms Proposed acquisition of Digitech:Negotiation price and form of payment

October 6


Submitted by
1. Sayanti Sardar(M115/12) 2. Gaurav Kumar(M078/12) 3. Sarvasidhi Phaneendra Kumar(M033/12)

Printicomms Proposed Acquisition of Digitech

Case summary:
In December 1998, Jay Risher, VP of Printicomm, proposed an acquisition of Digitech. Risher negotiated a letter of intent for the exclusive rights to purchase Digitech; however, this would expire in two weeks. A discrepancy came when Risher believed the value of Digitech was no greater than $30 million and the two leaders of Digitech valued their firm at $40 million. It was crucial for Risher to decide on the correct deal structure as Risher hoped to maintain Digitech employees after the acquisition. Communication Industry: Highly fragmented industry (52,000 printing establishment) with highly concentrated structure as 1% amount for 34% of revenue hence better offering wins customers. Growing demand of E2E information and communication solution made the deal attractive as digitecch was having good offering. Evolving technological changes was a challenge for which Printicomm undertook the strategy of inorganic growth through acquisitions.

Favourable factors: Increasing U.S population Higher level of education attainment Increasing personal income Growing economy (2% inflation adjusted profit) Growing demand

Unfavourable factor: Growing cost of raw materials (papers, paints etc.) Evolving technology: Equipment becoming obsolete.

Acquisition -Strategic sense: Complementary of the companys product and market Potential of significant growth Risher thought that significant cost and revenue synergy can be realised after acquisition. Will help Printicomm realise the total digital pathway solution and be a one stop shop with latest service offerings. Acquisition will enhance capability by providing latest electronic marketing solution (Marketelegence).

Acquisition: Frank Greene, founder and owner of Digitech, hoped to sell Digitech and retire within the next few years while its value was attractive. Greene perspective on valuation of Digitech: Greene compared the sale of Digitech to many other recently sold firms that went for 10-12 times EBITDA. He believed firm to be of worth of above $40 million.

Risher perspective on valuation of Digitech: Risher was only willing to pay a maximum of $30 million for Digitech and remained firm on this price after his valuation calculation through a discounted-cash-flow analysis. Dead lock: Bidding negotiations continued and the Rishers final offering was $28 million for Digitech and a firm holding price by Greene was of of $40 million for the company. Alternatives: Risher was concerned he would lose the Digitech deal and other competitors would quickly acquire them. As a result of this, he proposed an earnout for the transaction. Two different earnout structures were proposed.

Problem Identification:
Printicomms strategy was to grow through acquisitions. Jay Risher, Vice President and Controller of Printicomm believed the acquisition of Digitech would have a significant and positive impact on the performance of their Journal Services and Point of Purchase divisions. Risher had to decide from several alternatives: 1. Develop Digitechs technology in-house if a purchase price could not be reached. 2. Printicomm may try to find another company to purchase. 3. Secure a fixed price (easiest alternative) - This only required a standard purchase and sale agreement; however, the two companies remained far apart on the fair valuation for Digitech. If Printicomm paid a premium price, then the management of Digitech may not stay to grow the business. It was essential to have the business knowledge passed from Digitech to Printicomm. 4. Pursue an earnout - this was an acquisition payment mechanism whereby some portion of the purchase price of the acquired company (Digitech) would be paid by the acquisition company (Printicomm) only if the agreed upon goals were reached. Alternatives for earnouts (negotiation on the lines of): 1. There were three elements for a successful earnout: the earnout should be based on achievable performance goals for Digitech after closing: Digitechs management should receive adequate compensation; Digitechs management should receive adequate resources and freedom to achieve these goals. 2. The second plan would only offer contingent payments over the next three years. The amounts would be lower as there was less uncertainty Concerns: Balance between operating ratio , Earout ratio and Capital expenditures is necessary for the deal to be profitable.

Theory required for solving problem:

Earn-Outs and Other Contingent Payments Earn-outs and warrants frequently are used whenever the buyer and seller cannot agree on the probable performance of the sellers business over some future period or when the parties involved wish to participate in the upside potential of the business. Earn-out agreements may also be used to retain and motivate key target firm managers. An earn-out agreement is a financial contract whereby a portion of the purchase price of a company is to be paid in the future, contingent on realizing the future earnings level or some other performance measure agreed upon earlier. The terms of the earnout are stipulated in the agreement of purchase and sale. A subscription warrant, or simply warrant, is a type of securityoften issued with a bond or preferred stockthat entitles the holder to purchase an amount of common stock at a stipulated price. The exercise price is usually higher than the price at the time the warrant is issued. Warrants may be converted over a period of many months to many years. The earn-out typically requires that the acquired business be operated as a wholly-owned subsidiary of the acquiring company under the management of the former owners or key executives. Both the buyer and the seller are well advised to keep the calculation of such goals and resulting payments as simple as possible because the difficulty of measuring actual performance against the goals often creates disputes. Earn-outs may take many forms. Some are payable only if a certain performance threshold is achieved; others depend on average performance over several periods; and still others may involve periodic payments, depending on the achievement of interim performance measures rather than a single, lump-sum payment at the end of the earn-out period. The value of the earn-out is often capped. In some cases, the seller may have the option to repurchase the company at some predetermined percentage of the original purchase price if the buyer is unable to pay the earn-out at maturity.

List of alternative solutions

There are some lists of alternatives that Risher had proposed in the case 1. Internally developed capability-One alternative for Printicomm was to pursue developing Digitechs technology in-house at Printicomm. The time and expense of creating a viable software program with the capabilities of Marketelegence were likely to be high, but a failure to reach a reasonable purchase price for Digitech may have made this a good option. According to some rough calculations performed by Risher, it would have cost Printicomm $50 million to develop the technology. Additionally, it would take approximately 2 years until Printicomm would have a working prototype that could compete in the marketplace. 2. Find another company to purchase-Risher knew that it was not too late to pursue an alternative company to acquire. There were a number of other small software companies that had developed their own forms of digital technology for the commercial printing industry, but Risher felt that the Digitech technology was superior to the current competition and was worth a premium price if necessary. Risher also knew that Greene possessed strong managerial skills and that his level of qualifications would be difficult to find in another target company. In addition, it would be frustrating to have to start negotiations with a new company given the time and energy already spent on the Digitech transaction. 3. Fixed price deal-Negotiations up to this point had focused on determining a fixed sales price for the acquisition of Digitech. A fixed price deal would certainly be the easiest to consummate, requiring only a standard purchase and sale agreement that highlighted the total consideration in amount and form. Unfortunately, the two parties remained relatively far apart

on their respective notions of a fair valuation for Digitechs business. Risher was also concerned that if Printicomm paid a premium price for Digitech that Digitech management would have little incentive to stay on at Digitech and continue to grow the business. Risher thought that the retention of Greene and Buckingham was critical to integrating the companies and transferring business knowledge between the two companies. 4. Earnout- Given his concerns about valuation and management retention, Risher had begun to consider the idea of using an earnout to move this potential transaction forward. Risher recalled that an earnout was an acquisition payment mechanism where some portion of the purchase price of the acquired company (Digitech) would only be paid by the acquiring company (Printicomm) if Digitech attained certain agreed-upon performance goals after the closing Risher knew that there were three key elements in creating a successful earnout. First, the earnout should be based on achievable performance goals that increase the value of Digitech in the hands of Printicomm after the closing. Second, Digitechs management should receive adequate compensation for creating that value. Third, the earnout should provide Digitechs management with the resources and operating freedom necessary to achieve its performance goals. Risher knew that an earnout made a lot of sense from an economic perspective, and if designed appropriately, could be viewed as a win-win situation for both parties. He also knew that the two key drivers that could be negotiated in designing an earnout were the time period and the earnout targets. As a result, Risher decided to develop two different earnout structures to present to Greene at their next meeting. The two proposals would offer alternatives that were on either side of the spectrum with regard to time period and earnout targets. The first earnout structure would extend payments to Greene and Buckingham over the next five years based on Digitech achieving certain operating income targets. Since this five year plan left Printicomm exposed for a long time Risher wanted to incorporate high earnout targets into this structure .Risher decided to set the targets as follows: 1999 $2.5 million; 2000$3.0 million; 2001$3.0 million 2002$3.5 million; 2003$3.5 million. These targets were purposely set close to Printicomms projected operating income numbers for Digitech so that Printicomm would only pay additional monies for performance above the expected level. Risher also believed that the dollars paid out at closing could be set at a relatively low value of $20 million because of the potential future value offered to Digitech with a 5 year earnout period. The second earnout structure would only provide for contingent payments over the following three years. Risher felt that the earnout targets should be lower for this structure since there was less uncertainty about the future in this shorter time frame. Risher decided to set the targets as follows: 1999$2.0 million; 2000$2.5 million; 2001$2.5 million. These relatively low targets provided Digitech with a good opportunity to earn additional monies in the earnout, but were still not expected to cost Printicomm much over the shorter time horizon. Since the shortened earnout provided Digitech with less time to capture value from the earnout, Risher believed that the dollars at closing would need to approximate the $28 million fixed price offer that was already on the table.

Analysis and Identification of right alternative

We did analysis of four different scenarios

1. Scenario-1:-We have taken growth of 10% (average growth rate) as per Printicomms perspective and calculated the present value of earn-out for 5 years

1998 Sales(in thousand) 23450 Net Profit(thousand) Target Earning Earn-Out Present value discount factors PV of Earn-outs Sum of PV (in million) 0.155

1999 25795 2579.5 2500 79.5

2000 28374.5 2837.45 3000 -162.55

2001 31211.95 3121.195 3000 121.195

2002 34333.15 3433.315 3500 -66.6855

2003 37766.46 3776.646 3500 276.646

0.909091 72.27273

0.826446 -134.339

0.751315 91.0556

0.683013 -45.5471

0.620921 171.7754

*(discount rate=10%) 2. Scenario-2:-We have taken growth of 10% (average growth rate) as per Printicomms perspective and calculated the present value of earn-out for 3 years

1998 Sales(in thousand) 23450 Net Profit(thousand) Target Earning Earn-Out Present value discount factors PV of Earn-outs Sum of PV (in million) 1.272

1999 25795 2579.5 2000 579.5 0.909091 526.8182

2000 28374.5 2837.45 2500 337.45 0.826446 278.8843

2001 31211.95 3121.195 2500 621.195 0.751315 466.713

*(discount rate=10%) 3. Scenario 2:- We have taken growth of 10% (average growth rate) as per Digitechs perspective and calculated the present value of earn-out for 5 years

1998 Sales(in thousand) Net Profit(thousand) Target Earning 23450

1999 28140 5628 2500

2000 33768 6753.6 3000

2001 40521.6 8104.32 3000

2002 48625.92 9725.184 3500

2003 58351.1 11670.22 3500

Earn-Out Present value discount factors PV of Earn-outs Sum of PV (in million)

3128 0.909091 2843.636 19.106

3753.6 0.826446 3102.149

5104.32 0.751315 3834.951

6225.184 0.683013 4251.884

8170.221 0.620921 5073.064

*(discount rate=10%) 4. Scenario 2:- We have taken growth of 10% (average growth rate) as per Digitechs perspective and calculated the present value of earn-out for 3 years
1998 Sales(in thousand) Net Profit(thousand) Target Earning Earn-Out Present value discount factors PV of Earn-outs Sum of PV (in million) 23450 1999 28140 5628 2000 3628 0.909091 3298.182 11.024 2000 33768 6753.6 2500 4253.6 0.826446 3515.372 2001 40521.6 8104.32 2500 5604.32 0.751315 4210.609

*(discount rate=10%) From here we take scenario 3 as the right alternative for Printicomm

Findings and Recommendation

According to scenario 3 as mentioned above, we see that the PV of the earn-out is coming around 19.81 million which is more or less near to 20 million. For all the other three scenarios, the PV of the earn-out are coming less than 19.81 Recommendation
We think that out of all the alternatives, earn-out method would be the best one because 1. In scenario 3,the PV of the earn-out is coming around 19.81 million. Thus Risher needs to pay only 20 million at the start of the deal and distribute the earn-out to Digitech (which is approx. 20 million) when they achieve the required target. In this case Printicomm is fulfilling Digitechs desire of paying them 40 million by following this alternative 2. Since the extra 20 million is obtained only after Digitech achieves the target, this will in turn force Digitech to perform as per their predicted growth rate(which is average 20%) .Failure to do this will bring loss to Digitech which they will try hard to avoid 3. In order to fulfil the highly optimistic growth rate, Digitech employees will always work efficiently to fulfil the target operating margins. 4. Since the PV of earn-out is high, Printicomm will have additional tax benefit as this will come as an expense in their balance sheet.