Goldman Sachs and the $580 Million Black Hole
nytimes.com
nytimes.com
Don't swap your stock for another.
Don't deal with anyone with a question mark over their head.
Take the lower valuation with the company you trust more.
Don't celebrate until the cash is in the bank.
Reasons?
When someone swaps a stock - they implicitly value it less than what they get. Hence if you swap your stock with someone else, the buyer implicitly states that your stock is worth more than theirs. Losing deal.
Would you marry someone you didn't trust? No. Then why would you swap your baby for theirs?
Certain return with someone you trust is 10x better than a "certain" return from a flaky agent.
Nullify any agreements that don't put cash in the bank and give you more risk than reward. Take the breaker clause. Or lose everything.
Don't deal with anyone with a question mark over their head.
Life is too short to deal with shady characters - no matter how much money they give you.
Not worth the risk.
When there's doubt, there is no doubt.
It's done on the buyer's side, the seller company's partners get buyer's stock instead.
It's not "your baby for theirs", it's more complicated
How so? Use the baby analogy (as it was indeed Baker's child), what was it in this case in your view?
And you're potentially getting a stock with more potential than the ones you have (which are most likely going away).
And most stock are not materialized as a physical certificate, so it's mostly "on paper" (and on controlling power of course)
But all-stock deals? That suggests something is horribly amiss.
This is not a good sign.
Part-stock deals make some sense - to tie people up (vesting/milestones/lock-up) and align them with your interests. However it really should be a mostly cash deal (say 80-20 or 60-40 cash/stock) if it's public liquid stocks in a great company (but they usually do straight cash deals - e.g. Facebook/Google/Apple).
Trading private illiquid stock for private illiquid stock is a big no-no, unless it's a small amount (10-20%) with a high probability of a near-future liquid exit (IPO/public-cash acquisition).
If a business is unwilling to part with significant operating capital for a purchase, that means either they can't be bothered (yeah, this might be valuable in the long run, why not? but not worth putting hard cash into now) or more likely that they can't afford to, which was pretty obviously the case regarding L&H..... Either way it's bad and shows either a lack of commitment or a financial hardship.
In other words, I don't care too much about how much stock is purchased. I want to see the cash impact of the transaction because that is an important indicator of the health of the purchaser. "You want to go from 20% stock to 80% stock? Fine as long as I get the same amount of cash directly from you either way! You can just give me additional stock if you like..." ;-)
Even if I was just an investor, if I heard a publicly traded firm bought another in an all stock transaction I'd be selling my shares.
Correct. But sometimes you don't get that option as a small company being acquired - so getting public liquid stock in good companies is perfectly fine (so long as the lock-up isn't too tight - and it's a part cash deal).
Berkshire Hathaway used this to great effect when acquiring Gen Re in 1998. As the stock market was racing, Warren Buffett swapped his overvalued Brk.A stock for all of Gen Re in a mostly stock deal. After the 2000 dot-com crash he just bought back Brk.A stock cheap with the large cash holdings he held due to the previously frothy market. Sell high and buy low people.
So if someone is trying to sell you some stock - remember - "You are the sucker!".
Unless of course they are Google. Then you're a genius. You win some - you lose some!
It still tells me that something is amiss. Why not use working capital? What's wrong there? Not enough cash or cash equivalents on hand to do it? Or the company isn't worth committing to by parting with cash?
Either way if I am a stockholder in the purchasing entity, it's a bad deal for me.
An all-stock deal is basically a merger. The seller doesn't necessarily value the buyer's stock way more, they might value the combined entity more than they value the sum of the parts. "Synergy" is the buzzword of the day.
For example, the merger of Confinity and X.com (i.e., paypal) was certainly worth more than either of the individual companies.
> When someone swaps a stock - they implicitly value it less than what they get. Hence if you swap your stock with someone else, the buyer implicitly states that your stock is worth more than theirs. Losing deal.
If you're implying that M&A is a zero sum game and that every win for the acquirer is a loss for the seller then no, you're wrong. Your argument really applies to any sale (of anything): for the buyer to buy they have to value the goods more than the price, but the beautiful thing in trade is that the seller can still value the price higher than the goods, without anybody being wrong. Voluntary trade can create value out of thin air.
In an M&A type stock swap deal the reason this works out is that the merger itself can create value. Merge a company with traction in the market with one with a killer product and you have something that's more valuable than the two separate companies.
> In an M&A type stock swap deal the reason this works out is that the merger itself can create value
This is the exception not the rule. If you think you are a) sophisticated and b) in this rare situation - then disregard everything I have said.
> Voluntary trade can create value out of thin air.
If and only if both parties are sophisticated and value the exchanged items correctly. Trade can create value out of thin air. It can also turn value into thin air (booms/busts/fraud etc.).
Capitalism and trade are double edged swords - all I want people to do is watch the downside while they grab the upside.
I feel sorry for the vendors in this case, but you don't do an all-share deal without being extremely cautious about the shares you're taking as payment. Even a pair of PhDs should have known that.
What interests me here is that we have a lot of news stories floating around at the moment lambasting financial companies for relatively minor misdeeds, because that's all journalists can pin on them without getting sued. If the real truth about what goes on begins to leak out the public reaction could be very interesting.
This.
Cash is king. Unless your acquirer is Intel, Google, Apple, Microsoft, Amazon or anyone of the other big boys.
One must remember: If someone is swapping their stock for yours - then they, by definition, value their stock less than they do yours. That's a losing deal in anyone's books. If they say they need the cash for growth - call BS - since if they grow that fast they should hold onto every last bit of their stock.
Cash or big boy stock. Everything else is a lie.
How many times, when buying a car, are you minutes from closing the deal when suddenly a new fee appears. Or suddenly an issue with your trade-in and it's not worth what they "thought" it was. It only changes your monthly payment by $10... do you really want to walk away after the effort you've put in to this point?
So not necessarily anything nefarious going on (though not discounting the possibility entirely).
Can you afford not to? The company you're dealing with has now proven to be unwilling to stick to the points you spent all that time negotiating. They're counting on you conceding the $10 because it's easy.
Unless you show that you're willing to walk away and start all over from scratch (preferably with someone else), they'll push as hard as they think they can get away with.
A serious VC partner would have been more likely to realize that Goldmans sent out the junior varsity here, and would have the standing and confidence to insist they do better or be fired. They would have asked better questions about the due diligence and been more attentive to valuing the buyer -- valuation is what VC firms do -- and might have spotted the problems themselves. In the worst case, where this disaster still strikes, Goldmans would be far more likely to be reasonable about its responsibilities, lest it spoil its reputation with a well-connected VC.
But maybe I exaggerate the business and financial knowledge of tech VC types?
I don't much like the idea of allowing big VC firms to collect rents based on their reputation. But you cannot expect fee-based labor to be as careful and paranoid as you must be on this sort of thing. Only partnership brings that level of attention. When the stakes get this high, you need a partner capable of taking these responsibilities. If your financial partner or CFO isn't up to the task -- and Dragon's CFO was not -- then you have to fill that gap in the _partnership_.
Another solution would be bringing in a CFO with an equity stake, but this raises the same problem of financial expertise evaluation that sank the founders here.
None of which excuses Goldmans.
"The deal closed on June 7. By Aug. 8, the merged companies were in crisis amid reports that L.& H. had cooked its books."
During the late 90s boom, EVERYONE was snared in. KP, Sequoia, pretty much all the VCs lost a ton of money. Doubtful that their so-called expertise would have saved the Bakers.
Re-reading the article again, it seems like the Bakers did in fact have their suspicions. The mystery memo should have been a huge warning sign. The fact that Goldman sent bankers in diapers should have been an even bigger sign. There was one comment from the founder of Dragon: "If L&H was able to make so much money out of a lousy product they'd be able to make more out of ours.." which was a little painful to read.
There are too many stories of founders who built a successful company and then let the "experts" run it into the ground. In almost every case, the founder(s) felt like something wasn't right, but they swept their concerns aside, because they had hired "experts" and felt compelled to listen to them.
The reality is that no one has more expertise in your company than you do, and more importantly (particularly in this case), no one cares as much as you do. So yes, surround yourself with experts and seek as much wisdom as you can from them, but (almost) never go against your gut to follow their advice. Your instincts are usually what got you to that point in the first place.
Doctors get really peeved at people who research online and self-diagnose. On the other hand no-one cares about your health as much as you do, and no-one has access to as much information about what the root causes of malady could be.
Although Christopher Hitchens hated the expression 'X is battling with cancer', the phrase implies a personal engagement (as opposed to delegating) which can indeed make all the difference in the world.
Good doctors encourage patients to understand their condition. Let's not conflate that with exasperation over people who have a week old cough that they've decided is lung cancer because they've spent too much time on wrongdiagnosis.com.
No matter who you hire, in any context, it is up to you to make sure they do a good job with the tools available to you.
You are completely right about the "wrongdiagnosis.com" conclusion. Be aware of your health, and the general statistical chance of various diseases (heart/diabetes/alzheimers etc.). Also get a second or third opinion from other reputable doctors if you disagree. The chances of them all being wrong is very small.
Those examples you hear of people going to "10 doctors who all say they're fine when they in fact have a rare disease" are, by definition, insanely rare.
It's usually the flu :D.
Basically whether you pay a $5M fee or $100K fee. Your business should be your business and not somebody else's business.
Also who in their right mind would agree for a 100% all stock acquisition. Looks like they were also desperate and did not trust their business completely. But still heart goes out to them. Since they clearly were the pioneers in that space, and Nuance became so popular, that even general people having tech interest heard about them, and not many heard of Dragon Systems.
Given that GS is now using this memo to cover their asses, it makes me wonder whether someone there knew what was going on...
Everyone in finance who is not a fish knows this, but they still deal with Goldman, why? Because they're making more money than anyone else, so you still have better odds with them than anyone else.
It's a heart breaking story, but the shareholders of Dragon did it to themselves, they went to the meeting (without Goldman advisors) and they signed the contracts which traded their valuable stock for stock that ended up being worthless (although nobody knew it at the time due to fraud). Why didn't Dragon insist on a thorough auditing of L&H's books before agreeing to a deal? They went ahead and traded what they had without even looking at what they were getting in return. They made a blunder out of greed, it's common, and it's not anyone's fault but theirs.
If Goldman had certified that L&H was solid, then there might be a leg to stand on here, but they explicitly punted and said it wasn't the job of a banker to audit a companies books. This seems logical to me, and if Dragon didn't like that answer they could have gone and found another investment banking firm to advise them.
What was the 'right' thing for Goldman to do here? Drive to the Dragon office and put a gun to their head, tell them they weren't allowed to go to a meeting with L&H that was set up directly between Dragon and L&H?
As the saying goes, "never attribute to malice what can be sufficiently explained by incompetence". The Bakers themselves say the worst part was not being able to complete their work on the technology... I'd rather schalk this one down to naiveté.
Weren't they already in the hole for $5M at this point, though?
The article lets the founders completely off the hook, however, which I believe is also unfair. A $580M all-stock deal at the height of the bubble? Signing away your life's work without calling your acquirer's customers? Come on.
I hope the founders get paid (on Goldman's dime) but they have to carry some of the blame here.
I'm totally biased against Goldman to begin with and based on what I read in this article (assuming it is truth) I do think they should be on the hook for dropping the ball here (though I don't think they should be on the hook anywhere near $1 billion, maybe $100-200 million or so).
However, it sounds like this was a clusterfuck across the board, and the founders and their then-CFO aren't totally blameless here.
> Signing away your life's work without
> calling your acquirer's customers
Places where I do think that they deserve some blame:
1. They seemed to have some reservations about the company. They questioned the Goldman Sachs' bankers about them. It doesn't seem like they got a very satisfactory answer, but instead of pushing for one, they just assumed that the bankers knew what they were doing.
2. They let that phantom memo fall between the cracks. No one followed up on finding out who sent it. No one followed up on this idea that the accountants need to do the due diligence instead of the bankers, even though the suggestion 'shocked' them.
3. They went to meetings, and made agreements without consulting the bankers. Sure the bankers probably should have warned them about (e.g.) taking the all-stock deal over the half-cash/half-stock deal, but I find it odd that they would make this agreement without consulting the bankers. They could have either gone over the possibilities prior to going into the meeting, or made the agreements contingent on a review by the bankers.
Proceeding without the DD questions being resolved and going ahead with a last minute change to the deal doesn't seem like incredibly good judgement on the founders' part, but then again, shouldn't GS have - in their advisory role - warned them about any of this? And, while the founders being non-business type people may excuse them from some of the blame here, their CFO really doesn't have a similar excuse and probably didn't do them any favors.
Where was Seagate at in all of this? Unless I missed something, they owned 25% and could have at least been useful in helping with due diligence on the supposed Asian customers.
If all of this is true, GS really doesn't look good here, but a lot of people had a hand in this getting so screwed up.
OT: Was anyone else surprised by how much vacation the supposed junior level associate was able to take at GS?
What CFO does not insist on rigorous due diligence when dealing with a potential merger? This is basic finance.
It is rarely the responsibility of the M&A adviser to conduct due diligence themselves. They recommend and sometimes oversee accountants and legal bodies on behalf of the client.
So, this NY piece is missing a fair bit of key info about who, if anyone did due diligence on behalf of the client.
In addition, the proposed changes to the terms of the deal should have been obvious flags to the CFO that there was something very wrong (if you have due diligence concerns why would you give up even more/all the cash in a deal?).
Finally, anyone, but especially the CFO, should understand the incentives of the kind of advisor and buyer you hire:
- if you hire a bulge bracket adviser, you can expect their primary motivation are upfront and transaction completion fees for a tiny deal and little future prospects.
- if you are targetted by a buyer who is aggressive in offering a share deal, it is a clear indication that they consider their shares overvalued at that time.
At the same time I think that there are some important lessons here. The big one that comes to my mind is always have an exit strategy. For example, if I am able to make my business take off great. If it gets acquired and I end up not liking the new bosses, great, I can quit. But what can I take with me? What do I do after that?
I am fortunate in this area to have a lot of people who, while not aware of the whole situation can still nonetheless provide some help with that question. And I am grateful to those who have pushed a greater open source angle here.
And of course we can find how many missed opportunities there were to notice that this deal was bad on everyone's side. But the question for the rest of us not involved in litigation is what we take away from it.
I take away from it:
1) Be very careful about M&A. If something doesn't look right, it probably isn't.
2) Always have an exit strategy.
The objective of anyone with a single position composing a majority of their value, or even anything much larger than a double-digit-percentage, should be to get out as quickly as possible. Why? Tail risk associated with your position introduces volatility cost into your portfolio, and the risk alone chips away at the value. That $580 million was probably already worth less than $500 million the instant that they decided to do a stock swap, just because of the volatility risk of being that undiversified.
Lesson learned: get a third party financial adviser who will mediate with Goldman for you on your half-a-billion-dollar deal. Don't pay Goldman a flat fee disincentivized from performance. And NEVER leave all that equity tied into a single position. Yes, Goldman could be at fault here, but it would in the same capacity that a negligent driver is at fault for rear-ending someone who let their brake-lights burn out without replacement.
The only reasons I can think of are:
1) The stock of the purchaser is overvalued and the purchaser knows it,
2) The purchaser doesn't want to spend operating capital on the acquisition...., or
3) The purchaser doesn't have the operating capital to spend on the acquisition.....
1 and 3 seem likely in this case.
I can only hope that if, in the course of the trial, it is established that these are the facts. That Goldman pays dearly for it.
Illustrating why you don't want to be a small fish in a big ocean. Should have gone with a smaller, hungrier firm.
Wikipedia confirms L&H had gone public on NASDAQ in 1995:
1. If the company was worth $1B before as X before selling it to Y, wouldn't Y+X be at least worth $1B?
2. If L&H made fraudulent claims, why not make a claim against L&H to recover the software, brand, intellectual property? According to the Wikipedia page (http://en.wikipedia.org/wiki/Lernout_%26_Hauspie) their software ended up being bought by Nuance (Siri).
X = acquiring company, worth $2B ($1B in debt, but future earnings valued at $3B) Y = acquired company, worth $1B ($0 debt, $1B future earnings)
Merger:
X+Y = $3B (+ some factor account for cost savings or new revenue streams)
Company X was lying about their sales:
X+Y = $0B ($0B from future earnings, $1B in debt + $1B from company Y)
Company declares bankruptcy and debtors come in and get every asset with any value. Shareholders value = $0.
If a big law firm did the kind of questionable things toward a client that Goldman Sachs did with Dragon, there would be people up for disbarment.
The provision of these products and services at all levels may or may not involve:
A) Either a vendor or customer of the business desiring or actively seeking to harm said business (i.e., the opposite of the businesses best interest)
B) Either a vendor or customer of the business having no opinion or and no interaction whatsoever with said business outside of the provision of product and/or services (i.e., having no interest in the business)
C) Either a vendor or customer of the business intending to help and/or provide worthwhile help to said business (i.e., having the businesses best interests in mind)
It is quite possible that a businesses vendors and/or customers do have said businesses best interests in mind (example C above). Examples A and B are also possible.
Saying that "only -you-" have your best interests in mind is certainly a possibility in some dealings, but my guess that other scenarios are also common.
I agree that it may be wise to assume negligence and double check extremely important matters to a much greater degree than normal. The scenarios outlined in the linked article are a perfect example of negligence, inexperience and lack of communication at many levels. But, at some time, you simply must trust others and can only use your wits, experience and the expertise of even more parties to ensure that those involved in your dealings are doing what they should to the highest professional standards.
The article says Dragon agreed to pay Goldman a flat fee of $5 million. What if Goldman did perform due diligence, reported the issues to Dragon, and caused the deal to get cancelled, would Goldman still get $5 million? I don't think so, but if their agreement says they should and I were in Goldman's shoes, I would find reasons to recommend against the deal, because, to earn $5 million, it seems much easier to just advise against the deal than to assist the transaction and bear the risk of a bad outcome. On the other hand, if Goldman gets nothing (or a fraction of the $5 million fee) in the event that the deal gets cancelled, it would be in Goldman's best interests to see the deal go through and avoid performing any potentially deal-breaking services (e.g. due diligence) not specified in the written agreement.
There are scenarios where vendors or customers do have the business's best interests in mind. One such scenario is when the vendor or customer has very close family relationship with the business owner (e.g. husband-wife, father-son, etc.) These scenarios are uncommon. To be on the safe side, I agree with the sentiment that only you have your own best interests in mind.