The weird thing with fairness opinions is that the target company and their bankers have the incentive to make the company’s previous pre-deal market value look as full and juicy as possible. This way, when the buyout comes along, that premium price offered looks foolish to pass up.
In November, we brought you the story of tech company Aruba Networks that was sold to H-P by star banker Frank Quattrone. His firm, Qatalyst Partners, was accused by aggrieved shareholders of using an excessive “dilution factor” in its DCF valuation to dial back the theoretical value of Aruba in order to make the H-P buyout price look more favourable.
Qatalyst has some more valuation innovation to share with the world, this time coming from its work for LinkedIn who accepted a $26bn offer from Microsoft a few weeks ago.
While the details of the bidding war got the most attention from the preliminary merger proxy statement filed on Friday, the financial analysis detail raised our eyebrows.
Qatalyst is still using its seemingly unprecedented “dilution factor”, but now the earnings projections used in the valuation have been “adjusted” in novel way. Or, rather, “modified”. If Adjusted EBITDA isn’t offensive enough to you, LinkedIn wants to test your patience with Modified EBITDA.
Adjusted EBITDA adds back stock compensation expense. (Qatalyst would argue it already accounts for the economic cost of shares issued to employees through its dilution factor.) Modified EBITDA takes another leap by adding back charges for “capitalised software and website costs”.
From the proxy statement:
The outlays themselves are real. This from the Linked 10-k:
The Company capitalizes certain costs to develop its website, mobile applications, and internal-use software when planning stage efforts are successfully completed, management has committed project resourcing, and it is probable that the project will be completed and the software will be used as intended. Such costs are amortized on a straight-line basis over the estimated useful life of the related asset, which is generally two years. The Company capitalized website and internal-use software development costs of $97.4 million, $55.7 million and $39.3 million for the years ended December 31, 2015, 2014 and 2013, respectively.
If that spending is a genuine capital expenditure — and the company is indeed amortizing the cost over two years and running that expense through the income statement — it is strange the company would want to lower EBITDA on the P&L rather than, more conventionally, just have the charge only appear in the cash flow statement. On the other hand, lowering LinkedIn’s reported EBITDA could imply lower theoretical values for LinkedIn.
(The actual deal price was $196 per share in cash. The discounted cash flow range derived by Qatalyst was $156 to $238.)
The terminal value in the DCF relies on an EBITDA exit multiple, which you can get by comparing LinkedIn to comparable companies currently traded in the market. Similarly, you can compare the multiples of EBITDA paid on previous acquisitions against the multiple Microsoft was willing to pay to buy LinkedIn.
When Qatalyst compared LinkedIn to similar companies, earnings were, presumably, modified to account for capitalised software costs. However, interestingly, for precedent transaction multiples Modified EBITDA was not used. Instead, Qatalyst used Adjusted EBITDA multiples because capitalised software costs were likely unavailable.
LinkedIn and Qatalyst could argue the lower earnings in Modified EBITDA should be offset by higher multiples. But if the net impact was negligible, why go to the trouble of moving from Adjusted EBITDA to Modified EBITDA in the first place?
These projections were provided to Microsoft in their due diligence but “other than in connection with the preparation of this proxy statement, LinkedIn did not provide Microsoft with this reconciliation [pasted above].”
The proxy statement is subject to comments to the SEC before being declared effective, so we can see if future editions provide more explanation how and why these projections were prepared they way they were.
The document does reveal that Qatalyst will make $55m in total if the deal closes. Qatalyst declined to comment about its analysis when asked.