Valuations and your Neighbourhood Market

A common complaint of PE investors is that valuations are a challenge. An old friend and experienced PE investor, Rajesh Khanna, once commented that valuations will always be a challenge; in his career he never did a deal where they believe they got a “cheap” price. This is why I have picked valuation mismatches as my first blog topic. And I am talking only about minority or majority investment deals where the entrepreneur continues to run the business; buy-out deals involve different deal dynamics.

I remember the post-midnight negotiations on our first infrastructure investment way back in 2003. The only comfort we got from that painful experience was that if this is the way they negotiated with us, we can be sure that they will work as hard when negotiating deals with other counterparties and our money is, therefore, safe with them. Let’s face it—if you came out of a discussion saying, “We got a sweet deal!” you should be worried because either (a) your new entrepreneur-partner is a poor negotiator, or (b) your new entrepreneur-partner has no interest in honouring your shareholder agreement. Investors want to invest in companies who can subsequently look after their interest by negotiating hard with others.

So much for trashing PE investors. But entrepreneurs are also to blame. Inebriated by the wealth creation that took place a few years back and excited by overenthusiastic investment bankers they believe that their companies are worth a lot more than what others think. As a result, they don’t want to sell “cheap” and wait like a crouching tiger for a sucker investor to walk in. And in many cases one walks in through the door. Hence deals take long to complete, if at all.

I think investors and entrepreneurs need to take a break and visit their neighbourhood market. Watch how women bargain with the vendor. And I am being deliberately sexist—my wife says I am useless at bargaining. The fruit seller knows that the woman wants to buy the apples and she knows that he has to get rid of his stock before it gets spoilt. They also have an idea of where the market price is. So the fun begins. A deal finally gets closed and both sides walk away happy with the outcome (at the same time grumbling loudly about the unfair price). And she will be back next week to buy from the same guy and the same process will be repeated. Our son learnt the same lesson recently on a school trip to Beijing—a simple lesson in price discovery after being thrown out of a few shops where their first bid was 10 percent of the offer price (they got so excited with their bargaining skills that they finally even tried to negotiate price at a KFC outlet and were told emphatically to “Get out!”).

So why do highly-educated PE investors find it so difficult to close deals? Is it because predator entrepreneurs know that there will always be a new victim waiting to get ensnared? Don’t entrepreneurs also know that high valuations lead to unnecessary pressure on meeting ridiculously exaggerated targets? I have recently been involved in discussions where investors are legally able to seize control of a company because targets have not been met.

It doesn’t make sense for investors to get a “cheap” deal or for entrepreneurs to con investors into paying too high a price. If this happens there is no true partnership and as the comedian Russell Peters said, “Somebody gonna get a hurt real bad”. India is a high-growth economy, irrespective of what foreign investors say and what the government does or does not do. And in a high growth economy it is even more difficult to predict future prices, volumes, competition, etc. So, if there is a serious valuation mismatch one has to look at structures to bridge the gap–if the entrepreneur wants too high a valuation, a structure can be worked out where if targets are not met, the investor’s shareholding in the company ratchets up.

Alternatively, and this is a framework that I prefer, the entrepreneur can agree on a lower valuation and earn out a higher shareholding based on meeting pre-set targets. The reason why I prefer this option is that it causes less stress on the company to meet tough targets (sometimes caused by external factors, like the 2008 global financial crisis). I have seen enough companies in recent times whose souls have been destroyed because the entrepreneurs are cutting corners to meet the high targets they set themselves up for when they closed their PE round at a high valuation. Entrepreneurs fail to realise that they can destroy their company or their relationship with an investor if they push for too high a valuation. If properly structured, they will end up with the same or higher shareholding if they meet their targets. And this is where investment bankers need to nudge both sides to close a “fair” deal. No one will grudge the other side if they both believe they have a “fair” deal.

So it is time that investors and entrepreneurs visited their neighbourhood market to learn the fine art of price discovery and closure.