Attention Shoppers: Try Valuing This

When Enron Corp. put its trading operation on the block last December after filing for bankruptcy, creditors and shareholders alike held their breath. After all, the business accounted for 90 percent of the failed energy giant’s revenues (however inflated those might have been). The hope was that the proceeds from the sale would be substantial enough to satisfy a significant portion of Enron’s liabilities.

Alas, the business proved virtually worthless, as UBS Warburg paid nothing up front to Enron for it, agreeing merely to an “earn-out” arrangement under which UBS would pay Enron royalties equal to 20 percent of whatever profits it earned for the next 10 years. The structure is not surprising, given that the assets’ worth hinged on such intangibles as Enron’s now-tarnished brand name, says Stephen Wright, a finance professor at the University of London and the author of Valuing Wall Street. “The only other asset an operation like that has is its people, and, since the Civil War at least, these can’t really belong to a company.”

From a buyer’s perspective, the record-breaking number of business failures is making it necessary to at least think about bargain hunting. More than $250 billion worth of corporate assets ended up in bankruptcy proceedings last year, easily eclipsing the previous year’s record of $94.8 billion, according to Boston-based BankruptcyData.com. An untold number of businesses are currently in dire straits. However, since so much of that $250 billion was in such intangibles as brands and relationships, attaching worth to them is proving to be difficult. “On paper, the number of opportunities is clearly larger than in the [last downturn in the] early ’90s,” says Michael Petrick, managing director of Morgan Stanley. But because so few can show a reasonable return on invested capital, he says, there is “a vast amount of uncertainty [about valuations]. You’re essentially buying a platform, an opportunity to create value.”

Buying these intangibles out of bankruptcy requires an especially critical eye. “You go into the process with a cautious view because bankruptcy could tarnish a company’s intangibles,” says Lante Corp. CFO Bill Davis, who recently led his technology consulting firm’s acquisition of Luminant Corp., a competitor specializing in the energy industry. “The obvious question is, why are they in bankruptcy in the first place?” says Davis. “Then you’ve got to be mindful of whether the bankruptcy process itself creates a stability issue.”

To be sure, bankruptcy is a well-traveled route, given the opportunities it affords buyers to pick and choose among assets and to leave liabilities behind. Sales of assets from bankrupt companies neared $8 billion in 2001, nearly double the 2000 sales mark and more than a 350 percent jump from 1993 activity, according to investment bank Houlihan Lokey Howard and Zukin. However, the value of the average Chapter 11 deal last year was 17 percent lower than it was in 1993, indicating just how volatile the value of intangibles can be.

Here Today…

Making sure the value is for real, then, is one of the most crucial aspects of buying distressed assets. Granted, not all intangibles are as dicey as Enron’s. Consider Digimarc Corp.’s purchase of Polaroid’s photo-ID-card unit out of bankruptcy court last December for $56.5 million, a price roughly equivalent to the unit’s annual revenues. With it, Digimarc inherited long-term contracts with 37 state licensing agencies, along with numerous other customers. Plus, Digimarc gets the chance to set the security standard for ID systems.

Digimarc CFO E.K. Ranjit expects the acquisition to help the firm turn a profit this year, and boost its revenues from about $12 million last year to as much as $100 million by 2004. But Ranjit is the first to admit that the process wasn’t simple. He notes that Digimarc won out only after a “grueling” auction that went on for 30 hours straight and required the company to raise its starting bid by $20 million.

When customer relationships aren’t a given, though, companies have had to work especially hard to determine and preserve value. Lante, for instance, swooped in as soon as it heard in mid-November that Luminant would be filing for bankruptcy.

“One of the key things we did through the due-diligence process was to reach out to a large percentage of their clients, in part to ascertain the health of the relationship, but also to assure them that this was a company we were very interested in” and would continue to grow, says Lante CFO Davis. To retain employees, “we spent as much time selling Lante to [them] as we did evaluating Luminant,” rolling out employment offers shortly after the court proceedings were finalized.

Within about three weeks, Lante executives came up with a $3.1 million offer that they knew would have to face competing bids in bankruptcy court. The benefit of stepping out first–as the so-called stalking horse–is that it gave Lante a little more influence over the time line, as well as the conditions under which bids would be accepted. Lante also negotiated for the right to continuously monitor Luminant’s customer relationship operations throughout the bankruptcy process, since client losses would have lowered its valuation, says Davis.

In Luminant’s case, the structure and amount of debt made negotiating with creditors untenable. While the auction upped its price to $5.2 million, the opportunity to wash the deal through the courts meant Lante could buy the assets it wanted and leave the liabilities behind.

But in some cases, buyers may be able to avoid both bankruptcy and unwanted liabilities. “Conventional wisdom is that bankruptcy is always a necessity,” says Morgan Stanley’s Petrick, “but theoretically, you should be able to get the same outcome negotiating with creditors as you would through bankruptcy.” Minus the red tape of Chapter 11, he points out, creditors stand to get cash faster and buyers may find better success in retaining such intangibles as brand value, key employees, and customers.

This is particularly true if a target company is beholden only to equity holders. These days, “venture capitalists are willing to make deals in order to get something back” rather than lose their entire investment, says Bud Robertson, CFO of Progress Software Corp., a Bedford, Massachusetts, developer of technology platforms. With a $175 million cash stash, Robertson is looking to make the company’s largest acquisition ever this year, in the range of $20 million or more in revenue. While his three-person business-development team is not shying away from private companies’ bankruptcy cases, so far he’s found better pickings among venture-backed companies that are withering on the vine for lack of funding.

Test Your Skill?

In most cases, though, getting intangibles at a good value is likely to require learning the subtleties of Chapter 11. KB Toys CFO Robert J. Feldman, for instance, went through three separate bankruptcy transactions last year to buy various assets of Etoys–including the URL, a distribution center, and limited rights to its customer list–before eventually securing about $45 million worth of assets for $13 million. “It was a very lengthy, very painful process,” admits Feldman, “and I’m not necessarily trolling the bankruptcy courts for more assets.” But for the Etoys deal, he says, the pain was worth it. “It was obvious that these assets were going for a great discount.”

Sidebar: Be the Stalking Horse?

Bidding first on assets in bankruptcy–being the so-called stalking horse–has obvious advantages, but it isn’t without risk.

In general, the first potential buyer to submit a bid has the most time for due diligence, and sets the terms of the deal. In addition, a stalking horse can usually set minimum bid increments and negotiate for a breakup fee to compensate for its time should it lose the deal. However, such buyers need to be careful to avoid any appearance of predatory behavior. Since the original purpose of Chapter 11 is to maximize the returns to creditors and minimize the impact on employees, bankruptcy court judges “don’t like it when it looks like someone is trying to create the appearance of an auction but is in fact trying to steal the asset,” says Stephen H. Case, a bankruptcy expert and partner at law firm Davis Polk and Wardwell, in New York.

Hewlett-Packard’s failed bid for Comdisco’s disaster-recovery unit last fall provides a stark example. HP had submitted a $610 million bid before Comdisco filed Chapter 11 in July, but lost in court to SunGard Data Systems Inc., which offered $825 million. When antitrust concerns raised doubts that SunGard would be able to follow through, HP jumped in with unsolicited bids of $700 million and $750 million, hoping to win over impatient creditors. Savvy? Not really. In addition to losing the property after the Justice Department approved SunGard’s purchase, HP was deemed a “bad-faith purchaser” by the judge, leaving it vulnerable to losing its $4 million breakup fee.