International Joint Ventures and Strategic Investments
by Mark Cameron White of White & Lee LLP
One means by which Malaysian technology companies can achieve international recognition is to form strategic alliances with foreign corporate partners that have expertise and established distribution in key markets. Successful alliances will enable Malaysian companies to access new, emerging technologies that have commercial applications - import the technology and development expertise into Malaysia - and manufacture commercial products for distribution in Malaysia, in Southeast Asia and in other attractive markets. The objective in any alliance is to cut the time and expense that would normally be incurred by internal development, and to leverage off the resources and success of other firms in targeted technology sectors.
The Silicon Valley in Northern California; Austin, Texas; and Boston, Massachusetts are all recognized hot-beds for the development of critical new technologies in software and multi-media, computer platforms and peripheral products, electronics and bio-technology. In particular, the Silicon Valley benefits from an influx of (1) research conducted by prominent local universities Stanford University and the University of California at Berkeley and Davis, (2) venture capital from firms primarily located in Menlo Park and San Francisco, and (3) the entrepreneurial ethos of management and professionals in the Valley. To take advantage of this, many Pacific-rim and European technology firms have formed alliances with U.S. technology companies in these areas. These alliances have become an established means to more quickly develop and market leading-edge products in dynamic technology sectors that are continually evolving.
This paper will present a roadmap by which Malaysian technology companies can form strategic alliances with U.S. technology companies.
To begin the search for a strategic partner, Management must know what it is searching for. To know what it is searching for, Management must thoroughly understand its existing business. To determine this, Management must define its business, formulate a strategic vision, and to plan for the future. Planning for the future requires an understanding of the competitive environment, projecting micro and macro-economic trends, and having a clear understanding of the resources that the Malaysian Company has available to meet its strategic objectives. More specifically, this analysis should take into consideration the following:
1. Define Your Business. Here Management will want to broadly define its business based on the unique competitive advantages the Malaysian Company's products and services bring to the market. A narrow definition may result in missed opportunities that relate to the Malaysian Company's current business - and, more seriously - in not foreseeing competitive threats that may affect its core business. Having done this, Management will then want to prioritize all of the related businesses in which the Malaysian Company may possibly compete. The process of prioritization will enable Management to formulate a strategic vision and implementation plan, as described below.
2. Formulate a Strategic Vision. Formulating a strategic vision requires projections on how the industry and the Malaysian Company's business will change based on customer trends, macro-economic influences - and expected business expansion or retrenchment by competitors. Once these influences are understood, Management must realistically understand the competitive advantages and vulnerabilities of its existing business. This internal soul-searching should enable Management to set business/strategic objectives that leverage off of the Malaysian Company's resources, anticipate trends and competitive threats - and address certain weaknesses in the Malaysian Company's current business.
3. Implementation Plan. All the planning in the world will not help the Malaysian Company unless an implementation plan is followed that enables the Malaysian Company to achieve its objectives in incremental steps. This plan should consider the Malaysian Company's resources available to acquire or invest in new technologies, the impact the plan will have on the Malaysian Company's current business, and the priority of meeting identified objectives.
Once Management has completed this internal review of its own business, it will be ready to look outward to other partners that will enable the Malaysian Company to more quickly and effectively meet its objectives. This internal review should result in a clear profile of corporate partners or investments that fit with the Malaysian Company's objectives. Presumably, these Partners will have the technology, established commercial products and/or established distribution channels needed by the Malaysian Company. As a result of this process, the search for a Partner should be focused on particular industries, and competitors within the industry with desired characteristics.
- Another approach altogether is to cast the net broadly - and look at early stage companies that are in the process of developing innovative but untested technologies. Here, company valuation is low given the high amount of risk undertaken - but the financial return could potentially be enormous. Management might reduce the risk inherent in early stage companies by (a) using the raw technology or first generation products of the Partner in the Malaysian Company's existing business, and (b) establishing significant market share in a virgin industry without established competition. Further, if Management is merely interested in achieving high returns on its investments without being coupled to other strategic purposes - then Partners will be selected simply based on low valuation with promise for rapid growth and early investor liquidity. These types of investments are typically made by venture investors and institutional investors (that themselves invest through venture capital firms) - not be by technology companies looking for strategic relationships.
Unless the Malaysian Company has its own staff that follows industry trends, is aware of developments in the Silicon Valley, and travels there often - or has an office in the Valley (like the Singapore Economic Development Board) - to make direct contact with prospective Partners, Management should work with one of the following professional organizations to locate and qualify Partners:
1. Investment Banking Firms. Most investment banking ("IB") firms focus on specific technology sectors, or if investments are broader-based, then individual partners within the firms tend to handle investments in specific sectors. These firms typically are organized by function - such that there is a separate "mergers and acquisition" department that handles the purchase and sale of companies and business assets; and an "institutional investment" department that arranges private investments by institutions (such as banks, insurance companies, pension funds and high net worth individuals) in private companies. Management can consider becoming a client of the IB firm - under which the firm would recommend investments and/or potential acquisitions to the Malaysian Company and other investors. Here, the investment bankers will receive a fee for managing and recommending investments to a pool of like-minded investors (which would include the Malaysian Company). Alternatively, Management can engage the firm to conduct a specific search for a Partner. This is far more expensive, typically requiring payment of a monthly retainer and a success fee on closing of a transaction - including an acquisition, equity or debt investment or license of rights to technology. IB firms represent both sellers of technology and buyers. The majority of firms are based in San Francisco, New York and Boston - and they tend to work with more established technology companies, both public and private. These firms are not usually aware of investment possibilities in early-stage companies. These firms should primarily be considered for exploring investment in more mature companies and established technologies.
2. Venture Capital Firms. Unlike IB firms, venture capital ("VC") firms typically manage and invest pools of investment capital provided by institutional investors. As with IB firms, VC firms (a) focus on specific industries, (b) tend to invest in companies having a specific level of maturity (early-stage, emerging growth or late-stage investments, and (c) are, typically, actively involved in the company as members of the Board of Directors. These firms are solely interested in the financial return on investment - and institutional investors are not free to refuse to participate in financings in which the firm itself is participating. VC firms often syndicate their investments to spread risk - and it is here where Malaysian Companies might participate in investments as a member of the financing syndicate. It is possible that Companies may align themselves with specific VC firms that have the same profile for investments as the Malaysian Company. The Malaysian Company can attempt to negotiate its own terms for the investment - including the license of technology, a seat on the Board of Directors, or manufacturing or distribution rights to commercial products - all of which might not be possible unless the Malaysian Company makes an equity investment in the Partner. Further, the VC firm will tend to look after the Malaysian Company's interest in the Partner - if the Malaysian Company does not have staff in the United States for this purpose. Management will want to explore an investment relationship with a select number of firms so that trust can be built over a series of investments.
3. Smaller Investment Banking Firms. There are also a select number of smaller investment banking firms that will conduct searches on a retainer basis for purchasers of technology and/or technology companies. These firms typically have from 1 to 10 professionals, they may charge lower fees - and they tend to focus on less visible, middle-market companies with annual sales ranging from $1 million to $30 million. Management should consider working with these firms for earlier-stage opportunities, and more personalized service.
4. Doing It Yourself. Larger Malaysian Companies, particularly those with offices and staff in the United States, might consider conducting their own search for prospective Partners. The advantage of this approach is that costs may be lower, internal staff tends to know more about what Management is looking for, and due diligence can be conducted on Partners more easily. The disadvantage is that internal staff may not know where to look for good companies, how to value the company - and how to close the transaction. On this point, leads might come from law firms, accounting firms and other service providers, and these professionals should always be consulted for what are ordinary and usual terms in the transaction that the Malaysian Company might expect.
Valuation is critical in setting (a) the percentage ownership of investors in financings, (b) the purchase price of technology assets or a technology-based business as a going concern, and (c) the consideration to be paid under a license of manufacturing and/or distribution rights. An extensive discussion of methods used to value technology companies is found in our accompanying paper entitled "The Valuation of Newly-Formed Technology Companies" distributed by our affiliate law firm, "White & Lee LLP". In determining the value of technology, Management should be aware of the following:
1. Value is Negotiated. The valuation process is a negotiation between buyer and seller. Value is not set by plugging numbers into a formula (though, admittedly, this is part of the process). The techniques described below are used by investors as tools for setting a range of possible valuations.
2. Value is Based the Future Market for Products. Virtually all valuation is based on an analysis of the future market for the Partner's products. Except in asset purchase transactions, valuation typically assumes that the Malaysian Company is a "going concern". Given this, it is inappropriate to value a company based on its book or liquidation value, except for the purpose of establishing a floor price, setting a "residual value" under the Discounted Cash Flow technique (described below), or determining the investor's return in the event of insolvency.
3. The Discounted Cash Flow Technique. The Discounted Cash Flow ("DCF") technique is the most commonly used valuation method that accounts for the "going-concern" value of the Partner as indicated by the present value of the Partner's projected pre-interest cash flows for a determined period of 3 to 5 years (corresponding to the expected date of an IPO or acquisition). These cash flow projections are derived from (a) assumed revenue generation on product sales, less (b) operating costs and debt repayment on capital investments (not including interest payments), plus (c) an estimate of the Partner's residual value at the end of the 3 to 5 year period. These projections are then discounted back to the present by the risk-adjusted, weighted-average cost of capital. This cost of capital accounts for interest payments and/or equity returns expected by investors in the Partner over the projection period.
Critical to DCF analysis is a determination of 4 key areas, including (a) the assumptions underlying the projections, (b) the length of the projection period, (c) the Partner's residual value at the end of the projection period, and (d) the discount rate (cost of capital) - each of which are further described below:
(a) Underlying Assumptions. The Partner should have a model for conducting its business which is the basis for assumptions on operating the business. These assumptions must take into account the historical growth of similar companies and products (if any); prevailing economic and industry-specific business conditions; competitive pressures; the costs of technology development and continuing innovation; anticipated working capital needs based on operational requirements; market penetration and expected revenue generation and profitability. Specific attention should be directed to the following categories:
* Sales, based on anticipated buyer demand, growth of specific product categories, the need and timing of new product introduction, product pricing relative to competitive products, production capacity, seasonal demand (if any) and market penetration.
* Continuing technology and new product development, which is necessary to adjust to anticipated market shifts - or simply to take advantage of established distribution pipelines to the market.
* Administrative and selling expenses that are tied to the development of new technology and products - and generation of sales. G&A staff must not be hired too far in advance of development and operational requirements - or lag too far behind these requirements (indicating that these requirements might never be met).
(b) Projection Period. For venture investors, the projection period is typically from 3 to 5 years, reflecting that period of time that VCs expect to hold the Partner's securities before the Partner goes public or is acquired. In addition, beyond the 3 to 5 year period the accuracy of projected cash flows is increasingly speculative. Inasmuch as these cash flows are inherently speculative, and the effect of discounting these cash flows to the present minimizes their impact on current valuation - it does not make sense to project cash flow beyond 5 years.
(c) Residual Value. Residual value is the "going-concern" value given to the Partner at the end of the projection period. Two techniques that are frequently applied include the "income capitalization" and the "market multiple" techniques. Under the income capitalization technique, the Partner's final year earnings are divided by the discount rate (or cost of capital). This method sets value at the established earnings of the Partner at that time in consideration of the cost of capital required to sustain earnings. The market multiple technique is a more appropriate method of setting terminal value if the assumption is that the Partner will be an IPO or acquisition candidate at the end of the projection period. Under the market multiple technique the Partner's earnings are multiplied by an appropriate P/E ratio of comparable publicly-traded companies.
4. Discount Rate. This rate is critical to the analysis, as it determines the present value of all of the Partner's projected cash flows. Quite simply, the discount rate is the expected rate of return of the investor; the higher the discount rate, the lower the present value of the Partner. The return sought by many venture capital firms is that they are looking for investments in companies in which they will multiply their investment (a) by 3 times in 5 years (resulting in a compounded annual ROI of 71%), or (b) by 10 times in 5 years (resulting in a compounded annual ROI of 58%). Examples of discount rates resulting from different payoff requirements include the following:
TABLE ONE: SAMPLE VC DISCOUNT RATES FROM EXPECTED PAYOFFS
|
Payoff
|
Compounded Annual ROI
|
|
3 times investment in 3 years
|
44%
|
|
5 times investment in 3 years
|
71%
|
|
7 times investment in 3 years
|
91%
|
|
4 times investment in 4 years
|
41%
|
|
3 times investment in 5 years
|
25%
|
|
5 times investment in 5 years
|
38%
|
|
7 times investment in 5 years
|
48%
|
|
10 times investment in 5 years
|
58%
|
Management should also consider that payoff requirements, and corresponding ROI expectations, should typically lessen with the maturity of the Partner in which they invest. Examples of the ranges of ROIs that VCs typically expect for maturing private companies include the following:
TABLE TWO: SAMPLE VC ROI EXPECTATIONS
|
Partner Stage
|
Compounded Annual ROI*
|
|
Seed or Startup
|
40% and up
|
|
First and Second Stage
|
30% to 50%
|
|
Third Stage and Mezzanine
|
20% to 30%
|
With these general guidelines, management should generate several valuations for the Partner under a variety of best-case, worst-case and expected-case scenarios. This sensitivity analysis is useful in determining changes in valuation based on differences in management and investor assumptions on cash flow.
5. Venture Capital Valuation Techniques. Sophisticated investors such as VCs, institutional investors and corporate investors generally begin the valuation analysis by examining management's cash flow projections to test the underlying assumptions and business model. Once the investor has developed a certain comfort level in the projections, a variety of techniques are used to determine the percentage ownership the investor will require. Each of these methods start with the management's projections under the DCF technique. The VC investor then imposes its own ROI, as indicated in each of the methods described below - to meet its own investment parameters irrespective of the Partner's analysis of the cost of capital. By applying its own ROI, the investor can then determine the percentage ownership it will require to reach this ROI assuming a certain market valuation for the Partner.
(a) The Hockey Stick Method. Simply stated, in the "Hockey Stick" method the investor (a) first decides what return on investment it seeks through the projection period, (b) applies a price/earnings ratio to earnings at the end of the projection period to determine the market valuation of the Partner, and (c) then determines percentage ownership as the ratio of the investor's expected return on investment to the market valuation for the Partner as a whole. The formula for the Hockey Stick Method consists of the following: (initial investment) x (expected payoff) = Percent investor
(after tax earnings) x (comparable P/E) = ownership
To apply this method, assume (a) the Partner requires an investment of $800,000, (b) the projection/liquidity period is 3 years, (c) the investor expects to earn 5 times its investment over the 3-year liquidity period, (d) the Partner's 3rd year after-tax earnings are expected to be $1 million, and (e) an appropriate P/E ratio based on a composite of comparable stocks is 12. By applying the formula above, the investor will ask for approximately 33% of the Partner - or whatever higher percentage the investor is able to coax out of management, as follows: ($800,000 investment) x (payoff of 5 times) = 33% investor
($1 million earnings) x (12 P/E ratio) ownership
(b) The Conventional VC Method. This method is identical to the Hockey Stick Method, with the exception that the future market valuation of the Partner is discounted to the present before the investor percentage of ownership is determined. To illustrate how the Conventional Method works, consider the example of the Partner described under the Hockey Stick Method above. Under the Conventional Method, the following steps would be followed:
Step One: The 3rd year after tax earnings of $1 million is multiplied by the accepted P/E ratio of 12 for a market valuation of $12 million.
Step Two: The market valuation of $12 million achieved over 3 years is then discounted to its present value of $2,400,000, using a discount rate of 71% (which is the rate resulting from a desired payoff of 5 times investment over 3 years).
Step Three: The investor's ownership in the Partner is determined by taking the initial investment of $800,000 as a percentage of the $2,400,000 present value of the Partner - which equal 33%. This is the same equity ownership derived under the Hockey Stick Method.
(c) The First Chicago Method. Similar to "decision-tree analysis" where decisions are analyzed based on the probability of certain events occurring - the First Chicago Method values the Partner based on the cumulative impact of the probability of different earnings scenarios. While different scenarios can be generated under the either the DCF, Hockey Stick or Conventional Methods - the First Chicago Method requires management and the investors to consider the likelihood of earnings scenarios, thereby accounting for a range of possible outcomes in a single analysis.
6. Negotiating the Purchase Price. In the valuation process, the Malaysian Company must review the Partner's business plan, conduct its own due diligence investigation on the business model and assumptions presented in the plan, and present a pricing proposal to the Partner. Negotiation of price focuses on the critical components of the pricing formula described above, including: (a) the price/earnings ratio, (b) the expected ROI, (c) the earnings projections, (d) the projection period, and (e) the extent of the down-side risk.
The Malaysian Company may form a strategic alliance with a Partner under (a) a license grant, (b) an equity investment conditioned on the grant of certain license rights, (c) or the formation of a joint venture company as a new corporation or partnership. The attributes of each of these structures is examined below:
1. Grant of License. This is the simplest arrangement, usually involving the smallest up-front investment by the Malaysian Company. The advantages of a license grant include (a) a clear description of the scope of rights to be granted to the Malaysian Company, (b) usually compensation is tied to back-end unit sales, thereby avoiding a heavy up-front investment until commercial products have been successfully introduced, and (c) the risk and costs associated with technology development are assumed by the licensor - and not by the Malaysian licensee. There are, however, several major disadvantages to a strategic alliance based on a license, including (a) licensors of technology can easily breach the license and withhold technology and on-going support, thereby causing the Malaysian licensee to become totally dependent on the licensor, (b) depending on the scope of the license, the Malaysian licensee may not be aware of new technology developed by the licensor, (c) rights can be lost by the licensee for failure to met certain distribution objectives, and (d) the Malaysian licensee may not be able to prevent the licensor from granting rights to the technology to competitors.
2. Equity Investment Conditioned on License Rights. A strategic investment conditioned on the grant of license rights avoids several of the disadvantages of a license grant alone. For example, licensors are not likely to withhold license rights if the licensee is an equity holder in the Partner. Further, if the Malaysian licensee has a seat on the Board of Directors - the Malaysian Company can monitor and help direct new technology development by the Partner. Finally, if the Partner has a unique technology with large market potential -then the investment may result in a large step-up in value and liquidity by way of an IPO or acquisition. The disadvantages include the risk that a potentially large initial investment in equity may not result in a beneficial strategic relationship if the technology developed by the Partner has no commercial applications or will is not accepted by the market. Further, an equity investment ties up the Malaysian Company's resources that might be better spent elsewhere. Then there is the risk that the investment will never become liquid, and the strong possibility that follow-on investments will be required in order to mature the Partner so that it might go public or be acquired.
3. Formation of a New Joint Venture Company or Partnership. This alternative is attractive for several reasons. First, each of the investors in the JV typically bring in some unique resource, expertise or market access that is not duplicated by the other investors. This creates a strong dependence on each investor/participant in the JV - and generally requires that investors become active in the JV in some way, rather than merely being passive investors. Second, the investment or participation is being made in a new organization without an established management team or work ethos. This is an advantage in creating the opportunity for the investors, including the Malaysian Company, to create the work environment, select the management team - and generally make its own imprint on the operations and direction of the JV. Setting up a JV does, however, involve far more hands-on planning and continued participation in the JVs business. Issues that must be addressed include (a) the business form of the JV, (b) the mechanics for decision-making within the JV, (c) the ownership of technology developed by the JV, and (d) the on-going requirements that each partner/investor has to make capital contributions to the JV as necessary to sustain operations and take advantage of opportunities.
In summary, structuring the investment through a JV makes sense when the Malaysian Company wishes to actively participate and control the direction of the entity. It does not make sense if the Malaysian Company is merely looking for a passive investment, or a limited license right to use identified technology.
Regardless of the form of the investment, the Malaysian Company can build certain protections into the conditions of the investment so that the investment might be monitored and controlled, to a certain degree, prior to achieving liquidity:
1. If the investment is made in the form of a license grant to the Malaysian Company, then the Malaysian Company should require the following:
- a broadly worded license grant that gives license rights to "affiliates", and gives perpetual rights that do not terminate on a technical breach under the license;
- ownership of derivative technology and products developed by the Malaysian Company to be with the Malaysian Company;
- a limited definition of royalty-triggering events (such as not imposing royalties on a broadly defined product line in which the technology may be used); and
- permitting assignment of the license in a merger, acquisition or other corporate consolidation.
2. If an equity investment is made in an emerging growth company, then the Malaysian Company should require:
- Board representation, either by sitting on the Board directly, or through other investors with similar interests;
- Information rights, which may include (a) copy of all materials sent to Board members (if the Malaysian Company does not have a seat on the Board), (b) copy of monthly, quarterly and annual financial statements, and (c) periodic written reports by Management on the status of the industry and the company's business;
- A special "class vote" which requires super-majority approval of all of the investors holding a specific class of securities - such as "Class A Preferred Stock"; and
- "Registration rights" - including "demand" and "piggy-back" registration rights that provide investors the opportunity to compel the company to publicly register its stock - or permit investors to include their shares in public offerings being made by the company.
3. If the investment is being structured as a Joint Venture, then the Malaysian Company should consider:
- requiring that the Malaysian Company's approval be separately obtained on certain critical Management decisions;
- requiring the JV to employ key management and technical personnel from the Malaysian Company - so that the direction of the JV can be controlled, and the development of technology be understood (note here that the ownership of technology is a key issue, and that the Malaysian Company will not be entitled to use that technology unless that right is specifically written into the JV documents); and building into the JV all of the investor protection mechanisms described above for equity investments in emerging growth companies.
As described in the paper entitled "The Investor-Friendly Startup Company" written by White & Lee LLP, liquidity can be achieved through private stock sales, an IPO or an acquisition of the company for cash or other publicly traded shares. Liquidity must be identified early on as an objective of investors, and the obstacles to liquidity must be removed early so that the company will increase the chances of maturing quickly so that liquidity might be obtained.
As a result, the Malaysian Company should understand that compelling Management to take the company public through a demand registration right will not achieve liquidity if the public markets will not accept the company - or if the company does not meet the listing requirements of the national market exchanges (such that a public market for the stock might be created). Instead, liquidity is best achieved in companies that have pre-planned for liquidity by taking the following precautions:
Corporate Precautions:
1. Software companies must properly account for (a) the expense and amortization of software development costs, and (b) for revenue recognition;
2. Companies which are acquisition candidates should attempt to qualify for "pooling of interest" accounting treatment rather than "purchase accounting treatment";
3. In technology companies, Management should issue incentive equity compensation to key employees in order to hold on to persons critical to continued product development and marketing innovation. In particular, Management must be sensitive to the tax implications of granting vesting stock and issuing options; and>
4. Finally, companies that are more mature and closer to going public should be concerned about restrictions that might be placed on the registration of securities in the various states if (a) "cheap stock" is deemed to have been issued to insiders or promoters, typically at a price less than 85% of the IPO price; or (b) "excessive options" are issued by the company prior to the IPO that typically represent greater than 10% of all outstanding securities on a fully-diluted basis following the IPO.
Technology Precautions:
1. Inasmuch as "Employee Noncompetiton Agreements" are generally not enforceable in the United States, companies should have all key employees execute "Invention Assignment and Non-Disclosure Agreements" that provide (a) that all inventions discovered by the employee belong to the company, (b) that the employee may not disclose the confidential information of the company, and (c) that broadly defines what, in fact, belongs to the company. In the absence of this type of agreement, the legal argument may be made that the company has lost rights to its trade secret information inasmuch as the company has not taken steps to protect it;
2. Third parties that develop technology for the company, such as independent contractors, must all assign this technology to the company in a written agreement. If this is not done, the work created by the contractor may not be a "Work for Hire" under the U.S. Copyright Act - and it may belong to the contractor despite the fact that the company paid for it;
3. All copyrights and trademarks should be registered with the proper U.S. government agencies. Registration, though not required in the U.S., does afford certain rights, such as (a) a presumption of ownership in the event of litigation, (b) the preemptive effect registration has on infringers, and (c) with respect to trademarks, protection for the mark in all 50 states (and not merely in those states in which the mark is actually used, as is the case with common law rights only); and
4. As mentioned above, in the event that the company is a licensee of technology from another licensor - the license agreement should provide for (a) broad license rights that extend to affiliates and do not terminate on breach, (b) restrictions on royalties so that they do not apply to the products of potential acquirors, and (c) the right to assign the agreement to subsequent purchasers of the technology or the company.
All of the steps listed above should be followed, or a least considered, whenever a Malaysian Company is considering an investment in or strategic relationship with a U.S. company. While these points must be considered, too much analysis and study may cause inordinate time delays in the investment. Such delays may cause the U.S. Partner to look elsewhere for strategic help and assistance. Typically, investments in the U.S. are concluded within 3 to 6 months of when the company first approaches investors. Particularly attractive companies are sometimes fully subscribed within 1 to 2 months. Given this, Malaysian Companies must understand that too much analysis may kill a deal – such that the investment will never be made.
