Joint Ventures, Partnerships, Strategic Alliances, and Licensing

Humility is not thinking less of yourself. It is thinking less about yourself. —Rick Warren

Course Layout: M&A & Other Restructuring Activities Part IV: Deal Structuring & Financing Part II: M&A Process Part I: M&A Environment Payment & Legal Considerations Public Company Valuation Financial Modeling Techniques M&A Integration Business & Acquisition Plans Search through Closing Activities Part V: Alternative Strategies Accounting & Tax Considerations Business Alliances Divestitures, Spin-Offs & Carve-Outs Bankruptcy & Liquidation Regulatory Considerations Motivations for M&A Part III: M&A Valuation & Modeling Takeover Tactics and Defenses Financing Strategies Private Company Valuation Cross-Border Transactions

Learning Objectives Primary learning objective: To provide students with a knowledge of how to plan, structure, and manage business alliances. Secondary learning objectives: To provide students with knowledge of How business alliances represent alternative business implementation strategies to M&As; Motivations for business alliances; Factors critical to the success of business alliances; Common valuation methodologies Alternative legal forms of business alliances Key business alliance deal structuring issues and challenges; and Financial performance of business alliances

Business Alliances as Alternatives to M&As Business alliances (as are M&As) are vehicles for implementing business strategies. They are not themselves business strategies. Business alliances may be informal agreements or highly complex legal structures Alternative forms of business alliances (including legal and informal relationships) Joint ventures Strategic alliances Equity partnerships Licensing Franchising Network alliances

Motivations for Forming Alliances Risk sharing Sharing proprietary knowledge (e.g., TiVo, Sematech, and Wintel) Management skills and resources (e.g., Dow Chemical/Cordis) Gaining access to new markets Using another firm’s distribution channels (e.g., AARP and Hartford Insurance) Globalization Gaining access to foreign markets where laws prohibit 100% foreign ownership or where cultural differences are substantial (e.g., China) Cost reduction Purchaser/supplier relationships (e.g., GM, Ford, and Daimler Chrysler online purchasing consortium) Joint Manufacturing (e.g., major city newspapers) Prelude to acquisition or exit (e.g., TRW/Redi, Bridgestone/Firestone) Favorable regulatory treatment (e.g., collaborative research shared with others)

Business Alliance Critical Success Factors Measureable synergy (e.g., economies of scale/scope; access to new products, distribution channels, and proprietary know-how) Risk reduction (e.g., Verizon and Vodafone share network costs to form Verizon Wireless) Cooperation (e.g, MCIWorldcom and Telefonica de Espana) Greatest when partners share similar cultures Clarity of purpose, roles, and responsibilities Win-win situation (e.g., TRW REDI, Merck and J&J) Compatible time frames for partners Support from the top Similar financial expectations

Discussion Questions 1. Discuss the advantages and disadvantages of a partnering arrangement compared to a merger or acquisition? Be specific. 2. Under what circumstances might it make sense to enter into a business alliance with a potential merger target before actually proposing a merger? 3. What do you believe are some of the major reasons business alliances often fail to satisfy expectations? 4. Do you believe that the likelihood of a firm achieving its business plan objectives is greater through a business alliance than through a merger, acquisition, or a solo venture? Explain your answer.

Common Methodology for Valuing Business Alliances Step 1: Parties to joint venture agree on a measure of value (e.g., EBITDA) Step 2: Determine contribution of each party to the measure of value Step 3: Estimate total value of JV by applying the prevailing industry multiple to the measure of value Step 4: Determine ownership distribution based on each partner’s contribution to the JV’s total asset value

Creating NBC Universal in 2002\3 Vivendi $14 Billion (1/3 of $42 Billion) General Electric $28 Billion (2/3 of $42 Billion) Step 1: EBITDA used as the measure of valuing assets contributed by GE and Vivendi Universal Entertainment (VUE) to the joint venture which together generated $3 billion EBITDA Step 2: GE contributed $2 billion of EBITDA and VUE $1 billion Step 3: Value of combined GE and VUE assets = $42 billion [$3 billion x 14 (Comparable entertainment company multiple)] Step 4: GE owns 2/3 and VUE 1/3 of NBC Universal based on the dollar value of their contributed assets as a percent of total JV assets

Comcast and General Electric Joint Venture Comcast and General Electric (GE)1 announced on 12/2/09 that they had agreed to form a JV that will be 51% owned by Comcast, with the remainder owned by GE. GE was to contribute NBC Universal (NBCU) valued at $30 billion and Comcast was to contribute TV networks valued at $7.25 billion. Comcast also was to pay GE $6.5 billion in cash. In addition, NBCU was to borrow $9.1 billion and distribute the cash to GE. GE has an option to sell one-half of its interest to Comcast at the end of 3 years and the remainder at the end of 7 years. 1Reportedly, Comcast was the only bidder for NBCU.

Purchase Price Determination and Resulting Control Premium and Minority Discount NBC Universal Joint Venture (NBCU) Valuation1 $37.25 billion Comcast Purchase Price for 51% of NBC Universal JV Cash from Comcast paid to GE Cash proceeds paid to GE from NBCU borrowings2 Contributed assets (Comcast network) Total $6.50 9.10 7.25 $22.85 billion GE Purchase Price for 49% of NBC Universal JV Contributed assets (NBC Universal) Cash from Comcast Paid to GE Cash proceeds paid to GE from NBCU borrowings $30.00 (6.50) (9.10) $14.40 billion Implied Control / Purchase Price Premium (%)3 Implied Minority/Liquidity Discount (%)4 20.3 (21.1) 1Equals the sum of NBCU ($30 billion) plus the fair market value of contributed Comcast properties ($7.25 billion) and assumes no incremental value due to synergy. These values were agreed to during negotiation. 2The $9.1 billion borrowed by NBCU and paid to GE will be carried on the consolidated books of Comcast, since it has the controlling interest in the JV. In theory, it reduces Comcast’s borrowing capacity by that amount and should be viewed as a portion of the purchase price. In practice, it may reduce borrowing capacity by less if lenders view the JV cash flow as sufficient to satisfy debt service requirements. 3The control premium represents the excess of the purchase price paid over the book value of the net acquired assets and is calculated as follows: [$22.85 / (.51 x $37.25] -1. 4The minority/liquidity discount represents the excess of the fair market value of the net acquired assets over the purchase price and is calculated as follows: [$14.40/(.49 x $37.25)] -1.

Discussion Questions Suppose two firms, each of which was generating operating losses, wanted to create a joint venture. The potential partners believed that significant operating synergies could be created by combining the two businesses resulting in a marked improvement in operating performance. How should the ownership distribution of the JV be determined? Discuss the advantages and disadvantages of your answer to question one. Should the majority owner always be the one managing the daily operations of the business? Why? Why not?

Legal Form Follows Business Strategy Business strategy provides direction If management determines a business alliance is best way to implement strategy, an appropriate legal form must be selected. Legal form affects: taxes, limitations on liability, control, duration, ease of transferring ownership, and ease of raising capital Why do partners often spend more time developing a legal structure than a business strategy?

Alternative Legal Forms of Business Alliances: Corporate Structures Generalized C Corporation Advantages: Continuity of ownership, limited liability, provides operational autonomy, facilitates funding; facilitates tax-free merger Disadvantages: Subject to double-taxation, inability to allocate losses to shareholders; relatively high setup costs Sub-Chapter S Corporation Advantages: Avoids double taxation; limited liability Disadvantages: Maximum of 100 shareholders, excludes corporate shareholders, must distribute 100% of earnings; can issue only one class of stock, lacks continuity; difficult to raise large sums of money

Alternative Legal Forms of Business Alliances: Partnerships General Partnerships: Advantages: Profits/losses and responsibilities allocated to partners; avoids double taxation Disadvantages: Partners have unlimited liability, partners jointly/severally liable, each partner has authority to bind partnership to contracts, lacks continuity; partnership interests illiquid Private limited partnerships: Advantages: Profits/losses allocated to partners, liability limited if one partner has unlimited liability; avoids double taxation Disadvantages: Lacks continuity, interests illiquid; lacks financing flexibility as limited to 35 partners (Note: Public LPs can have an unlimited number of partners)

Alternative Legal Forms of Business Alliances: Limited Liability Companies Advantages: Offers limited liability, owners can be managers without losing limited liability protection, avoids double taxation, allows unlimited number of members (owners), allows corporate shareholders, can own more the 80% of another firm; and offers flexibility in allocating investment, profits, losses Disadvantages: Structure lacks continuity, ownership shares illiquid as transfer subject to approval of all members; members must be active participants in the firm

Alternative Legal Forms of Business Alliances: Other Franchise alliances: Advantages: Allows repeated application of a successful business model, minimizes start-up expenses; facilitates communication of common brand and marketing strategy. Disadvantages: Royalty payments (3-7% of revenue) Equity partnerships: Advantages: Facilitates close working relationship; limits financial risk, potential prelude to merger; may not require financial statement consolidation Disadvantages: Limited tactical and strategic control Written contracts: Advantages: Less complex; no separate legal entity established; potential prelude to merger Disadvantages: Limited control, may lack close coordination; potential for limited commitment

Alliance Deal Structuring Issues Defining scope in terms of included/excluded products and duration (Amgen/J&J litigation over who has rights to future products) Determining control and management (how are decisions made?:steering or joint management committee, majority/minority, equal division of power, or majority rules framework. How are resources to be contributed (form and value) and how is ownership determined? Tangible contributions (cash or cash commitments and assets required by the business) Intangible contributions (services, patents, brand names, and technology)

Alliance Deal Structuring Issues Continued Governance (protecting stakeholder interests)--board or partnership committee Profit/loss and tax benefits allocation and dividend determination Dispute resolution and termination (Who owns assets following dissolution?) Financing ongoing capital requirements (What happens if additional capital is needed?; Can the alliance borrow? Target debt/equity ratio?) Performance criteria (How is performance to plan measured and monitored?)

Empirical Studies of Business Alliances Abnormal returns to business alliance partners average about 2% during the 60 days preceding the alliance’s announcement. Partner share prices often increase prior to announcement for alliances involving firms within the same industry as well as in different industries However, the increase is greatest for firms to the same industry involving technical knowledge transfer. Alliances often account for 6-15% of the market value of large firms. While the number of alliances is growing rapidly, about two-thirds fail to meet participant expectations. Financial returns on investment tend to be higher for those firms with significant experience in forming alliances.

Discussion Questions Why should the development of a business strategy precede concern about the form of legal arrangement (e.g., corporation, limited liability company, partnership, etc.)? Discuss the circumstances under which it might make more sense to use a C-Corporation rather than a partnership as a acquisition vehicle or post-closing organization? Be specific. Why is defining the scope of a business alliance critical before legal agreements are signed? Be specific.

Application: Overcoming Political Risk in Cross-Border Deals Cross-border transactions often are subject to considerable political risk. In emerging countries, this risk reflects the potential for expropriation of property or civil strife. However, as Chinese efforts to secure energy supplies in recent years have shown, foreign firms have to be highly sensitive to political and cultural issues in any host country, developed or otherwise. In addition to a desire to satisfy future energy needs, the Chinese government has been under pressure to tap its domestic shale gas deposits due to the clean burning nature of such fuels to reduce its dependence on coal. However, China does not currently have the technology for recovering gas and oil from shale. To gain access to the needed technology and to U.S. shale gas and oil reserves, China National Offshore Oil Corporation (CNOOC) Ltd. in October 2010 agreed to invest up to $2.16 billion in selected reserves of U.S. oil and gas producer Chesapeake Energy Corp (Chesapeake), a leader in shale extraction technologies and an owner of substantial oil and gas shale reserves in the southwestern U.S.

Application Questions The deal grants CNOOC the option of buying up to a third of any other fields Chesapeake acquires in the general proximity of the fields the firm currently owns. The terms of the deal call for CNOOC to pay Chesapeake $1.08 billion for a one-third stake in a South Texas oil and gas field. CNOOC could spend an additional $1.08 billion to cover 75 percent of the costs of developing the 600,000 acres included in this field. Chesapeake will be the operator of the JV project in Texas, handling all leasing and drilling operations, as well as selling the oil and gas production. Discussion Questions: 1. Describe some of the ways in which CNOOC could protect its rights as a minority investor in the joint venture project with Chesapeake? Be specific. 2. What strategic flexibility do the terms of this deal offer CNOOC?

Things to Remember… Alliances often represent attractive alternatives to M&As. Motivations for forming alliances include risk sharing, gaining access to new markets, accelerating new product introduction, technology sharing, cost reduction, globalization, a desire to acquire or exit a business, or their perceived acceptability to regulators. Alliances may assume a variety of different structures from highly formal to highly informal, handshake agreements. As is true for M&As, a business plan should always precede concerns about how the transaction should be structured. Business alliance deal structuring focuses on the fair allocation of risks, rewards, resource requirements, and responsibilities of participants. While business alliances are expected to remain highly popular, their success rate in terms of meeting participants’ expectations is about the same as M&As.