VALUATION ISSUES IN ALLIANCES, JOINT VENTURES AND PARTNERSHIPS
PART II: A Case Study on Addressing the Issues

As we described in the Fall 2000/Winter 2001 issue of CPA Expert, corporate partnering through joint ventures or other strategic alliances has risen dramatically during the last few decades. The number of announcements of new joint endeavors roughly equals the number of completed mergers and acquisitions. The advantage to corporations of entering into a joint venture or other strategic alliance is it is often less costly and more flexible than other alternatives.

Valuation issues are often inherent in structuring a strategic alliance. The issues include:

• The relative values of technology and other assets contributed to a joint venture.
  
• The relative values of the ownership structure of the joint venture itself.
  
• The value of an investment by a corporate partner in a start-up entity in exchange for the use of the technology the start-up is developing.
  
• The value of the synergies in a marketing or distribution alliance.
  

An understanding of these valuation issues and the related values can be a key contributor to the success of a corporate alliance or joint venture.

To illustrate how the valuator might address the valuation issues that arise in structuring a joint venture, we present the following case study of a chain of retail stores in the Southeastern U.S. called RunSouth. Owned by Bill Gallow, age 46, RunSouth caters primarily to running and fitness enthusiasts.

RUNSOUTH.COM
RunSouth sells mainly running shoes, exercise clothing, and various fitness equipment. Gallow founded RunSouth twenty-three years ago after a successful career as a college track athlete, growing his business from one small shop to a total of twelve today. Recently, however, same store sales have been relatively flat.

In addition to running his business, Bill has become enamored with the Internet and its possibilities for helping his business grow. He believes that by expanding his store's Internet site into a full-scale retail Web site, he can reach customers from across the country at a fraction of the cost of expanding his 'bricks and mortar' retail locations.

Bill recently became friends with Stacy Mullins, who six months ago began attending a running clinic sponsored by RunSouth. Stacy is the president of Web Design, a Web development firm that specializes in design and implementation of business-to-consumer Web sites. Web Design has recently developed a successful Web site for a local furniture store chain, which was prominently featured in the local business press.

Bill presented to Stacy his idea of expanding his retail capabilities over the Internet and asked if Web Design would help with the implementation. Stacy believed RunSouth could increase sales over the Internet, but only under certain conditions.

First of all, selling to consumers over the Internet is an entirely new business model, which requires different organizational skills. Secondly, a direct sales Web site, while technologically feasible, requires a new method of marketing to potential customers. Stacy pointed out to Bill that neither of these conditions existed under the current organizational structure of RunSouth.

As discussions continued, both Bill and Stacy realized, if the Internet venture was to succeed, a separate entity would have to be created. Both of their companies could bring certain expertise to assist in making the new venture successful. RunSouth could provide the trade name, inventory, working capital, and office space to the new venture. Web Design could provide the technological and managerial expertise. Both Bill and Stacy believed that to have any chance of success, the new business, RunSouth.com, would have to be a joint venture between RunSouth and Web Design.

Bill and Stacy were excited about the possibilities of the new joint venture. As they structured the newly formed legal entity, however, they needed assistance with understanding the value that each corporate partner would bring to the new organization. Additionally, they wanted to understand the value of their individual ownership interests in the joint venture.

To help them with these issues, Bill and Stacy turned to Bill's CPA firm, particularly one of its partners, Grete Benoit, CPA/ABV, who specializes in business valuation. After Grete met with Bill and Stacy to understand their concerns, they retained her to assist them with the following two key valuation issues:

1. What are the relative values of what RunSouth and Web Design bring to the new joint venture, RunSouth.com?
   
2. What is the value of RunSouth's interest and Web Design's interest in RunSouth.com?
   

Grete's first step was to list the items that RunSouth and Web Design bring to the joint venture. Grete's list was as follows:

Grete planned to approach the engagement similarly to an allocation of a purchase price. She planned to identify the value of the assets contributed by each party to the joint venture and then compare those values to the proposed ownership structure. She based her analysis on a set of projections (see table 1) prepared by Bill and Stacy for the first five years of operations as Grete planned to estimate the relative value of each of the assets that RunSouth and Web Design would contribute to the new joint venture.

WORKING CAPITAL
To estimate the relative values of the assets contributed to the joint venture, Grete looked first at industry data on inventories and total working capital turns for similar companies. Based on this data, Grete estimated the joint venture would require initial working capital of $250,000, which would consist of $100,000 in cash and $150,000 in inventory. In addition, the joint venture would require an additional $550,000 in operations funding in the first year. Bill and Stacy agreed that RunSouth would provide the working capital and additional funding that RunSouth.com may require to fund operations during the first year.

REAL ESTATE
Grete spoke to Bill and Stacy about their plan to initially operate RunSouth.com in extra space in the back of Bill's main store. Bill and Stacy estimated that the new venture would employ five people full time and operate in approximately 1,500 square feet. RunSouth would contribute the space rent-free for the first five years of operations. Grete estimated the value of the office space contributed to the joint venture by simply multiplying 1,500 square feet by the lease rate of $17 per square foot. She then discounted this for these values on an after-tax basis at an estimated cost of capital of 20% for the five-year period.

Grete's calculation of the value of the office space contributed to the joint venture is shown in table 2.

TRADE NAME
Grete understands that one of the most valuable assets contributed to the joint venture is the trade name and reputation of Bill Gallow of RunSouth. Bill and his company have become known nationally through his participation in coaching and expert advice columns in running magazines. Both Bill and Stacy believe the name RunSouth will contribute greatly to the success of the joint venture.

One approach to estimating the value of a trade name is commonly known as a "relief from royalty' analysis. The idea behind this approach is that having a trade name already established saves an organization from licensing a similarly established name.

Researching the marketplace for similar trade names that are licensed, Grete found that the royalty rates for trade names related to athletes range from 1% to 10% of net revenues, with most between 1% and 3% of net revenues. After reviewing publicly available documents related to these license agreements, Grete estimated that the name RunSouth, because of its reputation, would warrant a 3% royalty.

Grete estimated the value of RunSouth's trade name through a relief from royalty method as illustrated in table 3.

TECHNOLOGY AND COMPUTER EQUIPMENT
Another key asset that will determine the success of the joint venture is the technology to be provided by Web Design. To succeed, Web sites that focus on consumers have to be user friendly and create trust for the consumer.

Grete knows there are several different approaches to estimating the value of technology, the most common two being the income approach and the cost approach. Through her discussions with Bill and Stacy, Grete determined that the cost approach was the most appropriate to value the technology contributed to the joint venture. Since Web Design had developed technology for companies with needs similar to RunSouth.com, Grete met with Stacy and her management team to determine the cost of the development of the technology.

Grete learned that Web Design completed five similar projects, charging fees between $225,000 and $300,000. She analyzed the time-and-materials time sheets for each of these projects and compared them with the specs for RunSouth.com. Grete estimated that to develop a similar Web site for a third party, Web Design would bill approximately $300,000. Consequently, she estimated that the value of the technology contributed by Web Design was approximately $300,000.

In addition to contributing the technology to the joint venture, Web Design agreed to contribute the computer equipment required as well. Grete discussed the computer needs with Bill and Stacy and agreed with their determination that the joint venture would require computer and other equipment costing approximately $100,000.

MANAGEMENT TEAM AND WORKFORCE
One of the competitive advantages that Web Design has over similar Web designers is that it supplies a trained management team and work force as part of its service to its business- to-consumer clients. Bill and Stacy agreed that Web Design would provide the management team and workforce to the joint venture.

Grete estimated the value of the management team and workforce using a cost-to- replace approach, assuming that having a trained workforce in place provides a benefit to the joint venture in that RunSouth.com would be alleviated of any hiring and training costs.

Grete estimated the value of the management team and workforce as illustrated in table 4.

CONCLUSIONS OF VALUE
After completing her analysis, Grete presented her conclusions to Bill and Stacy as shown in table 6. After Grete presented her initial conclusions of value, Bill and Stacy agreed to divide the equity interest in RunSouth.com in the same proportions as the value of the assets each of their companies contributed to the joint venture. Also, Bill and Stacy agreed that RunSouth would have voting control of the new joint venture. To protect the minority position, however, Bill and Stacy agreed that Web Design would have preferential rights in terms of cash flows to the owners as well as a put option under certain conditions to minimize the risk of minority ownership.

Based upon these factors, Grete then estimated the relative values in RunSouth.com to be $1,777,500 for RunSouth and $650,250 for Web Design. Grete presented these conclusions to Bill and Stacy as is shown in table 7 on page 5.

Bill and Stacy were grateful to Grete for assisting them in understanding both the value of what each of their organizations contributed to the new joint venture as well as the indicated value of each ownership interest.

Both Bill and Stacy feel that for RunSouth.com to have any chance for success, it is imperative for the both of them to understand these valuation issues while planning the structure of the joint venture.