No guarantee in life.

Recently in an investment briefing by a company going for an IPO, we were told in an “unofficial” way that the buying company can’t really rely on profit guarantees issued by ex-shareholders of the company that was acquired, especially if the target companies were from third world countries.

Take for example.
When Company A (who is going for IPO) buys Company B in China for a price tag of $50 million (with questionable assets with minimal book value) that come with a profit guarantee of $10 million a year for two years (when the real price could be $30 million).

Investors to an IPO also cannot be sure whether profit guarantees will result in actual profits or are merely used to make a purchase look good by playing the “PE game” and allow the buyer to have a decent-looking income statement for a few years while having purchased poorly performing assets.

What is the “PE game”? If Company A were to go for IPO at a PE of 8, the $10mio profit guarantee would translate to an additional $80mio in its valuation.

What could Company A do if the acquired entity did not achieve the guaranteed profit? In BT dated Nov 13, 2007, R Sivanithy asked what remedies investors have when guarantees fail to materialise.

They could try going after the sellers after 2 years’ of operating the business and possibly spend another few more years of being entangled in Courts with legal procedures. Assuming the buyers were to be finally successful in the Courts (after incurring heavy legal fees), the sellers may have disappeared completely or the sellers may have conveniently lost the ability to pay for the profit guarantee.

So we, the poor shareholders, end up with an emptied pocket.