VALUATION ISSUES IN ALLIANCES, JOINT VENTURES AND PARTNERSHIPS
PART I: RECOGNIZING THE ISSUES
"Four Airlines Form An International Alliance," "Barnes & Noble, Gemstar Form Alliance," "Converse Unit, Radware Form Broadband joint Ventures." Almost daily these or similar headlines jump out at us from the business press. Businesses, it seems, are constantly announcing new alliances and joint ventures.
The amount of corporate partnering (alliances, joint ventures, and corporate partnerships) in fact rose dramatically over the last decade. The number of new joint venture announcements roughly equals the number of completed mergers and acquisitions. The joint venture and the corporate alliance have become increasingly popular corporate business models because of their relative flexibility and specifically defined time frames. Whereas a merger or acquisition may be costly and is normally for an indefinite time period, a joint venture or strategic alliance can be structured to be flexible to meet the common goals of the parent companies for a defined time period at much less cost.
While alliances and joint ventures are becoming increasingly common business models, there are concerns about whether or not they actually achieve corporate goals. Key to alliances and joint ventures that are considered successful is a complete understanding of the valuation issues during the formation as well as the development of a plan for creating value from the alliances or joint ventures.
WHY BUSINESSES USE STRATEGIC ALLIANCES AND JOINT VENTURES
Corporate partnering such as joint ventures and strategic alliances take many forms, ranging from formation of a new corporate venture to a simple joint marketing agreement. One incentive for corporations to pursue a joint venture or other strategic alliance is that it is often much less costly than either internal development or acquisition of another company. Another benefit is that the flexible structures of corporate partnerships often allow each party to achieve its own corporate goals.
Recently Bertelsmann, the German media group, and Napster, the Internet-based music distributor, announced a strategic alliance to develop Internet file-sharing technologies. While Berteismann and Napster have very different corporate cultures and distinct business strategies (Bertelsmann is a 200-year-old European media giant and Napster is a California- based Internet startup), both companies believe that the strategic alliance will allow each to achieve individual corporate goals.
The proposed joint venture will develop a membership-based service, which will allow members to download music from the Internet for a fee. The service would then provide royalty payments to the holders of the music rights. Bertelsmann believes the alignment will allow them to jump to the forefront of the music industry while Napster believes they will benefit primarily by earning fees for the use of their technology without being pursued for copyright infringement. Both Bertelsmann and Napster believe this alliance will greatly benefit both companies at less cost than other types of structures.2
Joint ventures and strategic alliances are both common forms of corporate partnering. Because of their inherent flexibility, joint ventures and strategic alliances are sometimes difficult to differentiate. Both are a collaboration of two or more companies on a specific project. Often joint ventures are also referred to as strategic alliances. Joint ventures, however, are sometimes differentiated from strategic alliances in that they often require the establishment of a separate legal entity to form the relationship. Strategic alliances are more informal collaborations, often as simple as a joint marketing agreement.
One example of a strategic alliance is found in the airline industry where, in addition to code-sharing arrangements, there are often joint marketing agreements. Delta Airlines, Air France, Air Mexico, and Korean Air recently announced an alliance dedicated to "customer benefits." The new alliance, known as SkyTeam, provides code-sharing arrangements as well as joint advertising campaigns.
Participants enter into a joint venture or strategic alliance in order to achieve one or more of the following goals:
- Enhance competitiveness both domestically and globally.
- Develop new products more quickly and at a lower cost.
- Improve overall cost reductions.
- Share technologies and organizational skills.
- Enter a new line of business by utilizing another company's financial or technical resources.
- Improve distribution channels.
While a company may be able to achieve these same goals through a merger or acquisition, a strategic alliance or joint venture often provides the same results in a less costly manner with a more flexible operating structure. Each of these goals has a distinct valuation component.
HOW JOINT VENTURES AND OTHER STRATEGIC ALLIANCES CREATE VALUE
Joint ventures and strategic alliances create value through two key concepts: 1) maximize strategic advantages, and 2) minimize risk. The valuation issues are often related to the particular format of the venture or alliance.
Joint ventures often fall under one of three formats related to common strategic reasons for entering into an arrangement:
1. Two partners of a joint venture combine their technological efforts to create a new product. For example, Texas Instruments and Hitachi Ltd., both semi-conductor chip manufacturers, entered into an agreement to build jointly a $500 million plant near Dallas, Texas, using the technological advantages of both companies to manufacture memory chips.3
2. One partner with a technology product enters into a joint venture arrangement or other strategic alliance with a partner who may have a strong distribution capability within a given market or geographic region. Phillips NV of the Netherlands and John Fluke Manufacturing of the U.S., for example, have set up a regional distribution network agreement for each company's testing and measurement equipment products in both the U.S. and Europe.4
3. A startup company in the process of developing a new technology requiring additional capital seeks a relationship with an existing firm in a larger more established company in the same industry. The startup benefits from the capital investment and possibly the management expertise of the larger established company while the established company gains access to new technology at a much lower cost than through either an acquisition or internal development. IBM is an example of a company that has developed a program to invest in startup technology companies that need financing for promising technologies.5
VALUATION ISSUES
The uniqueness of structure of such corporate alliances often creates issues related to valuation. In the case of a joint venture formed to develop a new product, the joint venture partners typically contribute the working capital, management, and technology to the newly formed venture. These assets can be contributed by one or both parties. The first valuation issue that typically arises is determining the relative value of each asset contributed by the participants to the joint venture, particularly in relation to structuring the relative ownership interests.
One possible solution is to value independently each asset contributed by each party to the joint venture. Standard valuation methodologies can be used to estimate the relative value of the assets including the technology to be contributed, the management team, and the fixed assets as well as any other assets, including intangible assets, contributed to the joint venture.
A second valuation issue in a joint venture is the relative value of the ownership interests. After the total net worth is determined, the relative value of the ownership can also be determined, which may or may not be the same as the relative value of the assets contributed. In analyzing the relative values of the ownership structure, the valuer would have to consider the rights and privileges attached to the ownership interest.
Often an established technology company will provide funding to a startup entity in exchange for rights to use the technology. The relationship can be more beneficial for both parties than typical venture capital financing. For the startup, the rate of return required on the investment by a corporate sponsor is often less than that required by a venture capital fund. Consequently, the cost of funding is cheaper. Additionally, the corporate sponsor often may provide managerial expertise. For the corporate sponsor, the investment is beneficial in that it receives the use of a certain technology for less cost than internal development or an acquisition.
Valuation issues arise in determining the percentage of the equity that the corporate sponsor should receive for the investment. Careful thought should be given to the value of the investment in relation to the rights received in exchange. Issues to be considered that have an impact on the valuation in this area are:
- Size of the equity interest.
- Dejure or defacto control of the company.
- Liquidity of the investment.
- Exit strategy.
- Preference rights.
- Liquidation rights.
- Conversion rights of refinance.
- Rights to use the technology.
One common corporate partnering arrangement is either a manufacturing or distribution alliance with another organization. In these alliances, a technology company, for example, will "subcontract" the manufacture of a product with another organization. The first organization may have developed the technology initially but forms a relationship with another company to produce the product. Similarly, an organization may enter into a marketing or distribution alliance. The valuation issues related to these types of alliances often concern the value of aligning with another organization versus the cost of developing an internal marketing or distribution system.
RISK REDUCTION
Another way to increase value is to reduce risk. A common benefit of corporate alliances is that they can be structured to focus the relative strengths or competitive advantages each partner brings to the alliance. A second risk reduction benefit is that the alliances can be structured for a limited purpose or a defined time frame.
By focusing on competitive advantages, a properly structured alliance can reduce risk. Toshiba and Siemens recently announced an alliance to “jointly research, produce, and market high-speed" mobile phone handsets capable of sending and receiving video images. Siemens is the third largest mobile phone manufacturer in Europe. Toshiba is a leader in imaging technology. The two companies are expected to share an estimated $370 million in research and development costs as well as production facilities and distribution networks under the alliance.6
The alliance should allow Toshiba and Siemens to focus on each organization's own competitive advantages, which should reduce the risk of the project. The alliance also reduces the risk by sharing costs of development, manufacturing, and distribution of the new technology.
A key part of a successful corporate alliance or joint venture is understanding the valuation issues that arise and the potential value results whether they are associated with the expected synergies, the relative values of technology or other assets contributed to the joint venture or of the ownership structure of the venture, or the value of an investment partner in a startup entity.
1Reed, Stanley Froster, and Alexandra Reed Lajoux, The Art of M&A: A Merger Acquisition Buyout Guide, 3rd ed., page 825
2"Bertelsmann and Napster Form Strategic Alliance," www.ft.com, published October 31, 2000
3Reed, Stanley Froster, and Alexandra Reed Lajoux, The Art of M&A: A Merger Acquisition Buyout Guide, 3rd ed., page 825
4The Mergers & Acquisition Handbook, 2nd ed., McGraw-Hill, Inc., 1994, page 90
5Ibid., page 89
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