The Challenge: Economical Evaluation of a Proposed Transaction

A Stout client in the veterinary health space (the “Client”) had an agreement with a third-party veterinary biotechnology company (the “Target”) to distribute newly developed veterinary monitoring devices.

The Client had previously invested in the Target via the purchase of unsecured convertible promissory notes, which contained an additional feature whereby the Client was granted an irrevocable option to acquire all rights for the use of the Target’s intellectual property and technology. The exercise of the option would allow the Client to acquire the Target at a fixed price that had been agreed upon as of the issuance date of the unsecured convertible promissory notes. In order to obtain internal consensus, the client required independent advisory support in connection with its pending decision to exercise the option. However, due to the relatively small size of the acquisition, obtaining a fairness opinion and/or a quality of earnings report was not cost-effective for the Client.

The Solution: Returns-Based Sensitivity Analysis to Establish Consensus

We were engaged by the Client to assist in evaluating the purchase price in the transaction and analyzing the expected returns for the Target to help management establish internal consensus around whether to exercise its option to purchase the Target. As part of this exercise, management provided its internally prepared deal model, which we evaluated to understand the key drivers of returns in the transaction. These drivers included:

• The evolving market for the product
• Potential shifts in market share
• Price per unit sold
• Growth rate of the unit price
• Recurring revenue associated with ongoing maintenance services post-unit sale
• Usage (adoption) rates
• Customer retention
• Operating costs

Based on the identified drivers, we prepared an IRR model that could be sensitized based upon each of the above key drivers. As part of our diligence into management’s model, we also identified and corrected several value-changing errors within management’s model that had gone unnoticed.

Key conclusions arrived at in our sensitivity analysis included:

• The identification of the most critical customer group in achieving the forecasted return
• The impact of margins on returns, particularly if realized margins were more consistent with comparable public companies
• The impact of a lower-than-expected unit price, as the historical unit prices were lower than what management was projecting
• Reductions in returns if the unit prices were to decline over time, as could be expected with the continued development and improvement of a new technology
• Potentially weaker international sales owing to significantly lower pet care expenditures in foreign markets as compared to the U.S. market
• Competition in foreign markets, as the product relies on patents to protect the technology

The Outcome

We provided an executive summary to the Client’s management team, highlighting the potential impact on realized returns if the expectations for key transaction drivers differed from management’s base-case expectations. Through this analysis, management gained unbiased, independent insight into the aspects of the deal which carried the greatest risk profiles while gaining a better understanding of the most impactful drivers of deal returns.