After being hassled by JD on Tuesday I thought I should write my first Blog post of the year. The list of potential topics seemed endless. The mega merger of tech giants Microsoft and Yahoo!, the future of the Auckland Airport takeover offer or the latest developments in the proposed Fonterra restructuring. All of these stories pale into insignificance compared to the local media coverage being allocated to the liquidation of real estate company The Joneses.
Established in September 2006 The Joneses is a residential real estate company with an alternative business model to the traditional commission based approach. The Joneses charged clients a fixed fee ($8,995) independent of the sale price of the property and paid their agents a salary. The business model has been successfully implemented overseas but was dismissed (as expected) by existing NZ players. In December 2007 The Joneses announced plans to list on the NZAX via reverse listing vehicle RLV No. 3 Ltd (RLV3) and maintained that was the plan as recently as the start of February. This all changed on Monday morning with the announcement that the reverse listing had been cancelled. Later in the day The Joneses were placed into voluntary liquidation.
This episode has raised a number of questions:
1. What is a reverse listing?
2. Why were The Joneses listing in the first place?
3. How does a company valued at ~$14 million go from preparing to list at breakfast to liquidation by lunchtime?
1. The two conventional approaches to listing on an exchange are an IPO or a compliance listing. Both of these approaches involve working through a process with the exchange and meeting specific requirements before the company can be listed. A backdoor listing involves a company that is already listed on an exchange and typically does not involve meeting the same requirements of the conventional approach. There are a number of variations on the reverse listing process but in this case RLV3 was going to acquire The Joneses for approximately $14 million. This acquisition would be facilitated by issuing shares in RLV3 to The Joneses’ shareholders and no cash would be involved. Due to the pre-transaction value of RLV3 (~$500k) the process is effectively a reverse takeover where existing RLV3 shareholders would have owned 3-5% of the merged entity and The Joneses shareholders (including a pre-transaction capital raising) would hold 95-97%. This process is still subject to the Takeovers Code, Companies Act, Securities Act and standard NZAX regulations for listed companies but circumvents the specific NZX regulations associated with new listings. A number of international exchanges do not allow reverse listings. The NZX is currently reviewing their position on reverse listings.
2. It is not clear from the information available why The Joneses were pursuing a listing. The agreement with RLV3 required The Joneses to raise the $1.5 – $4.0 million prior to the purchase. This cash was to fund the company’s working capital requirements. The capital was being raised based on a confidential information memorandum and share offer which presumably was being presented to existing shareholders and private investors. Unless The Joneses were looking to raise money from the public via an IPO or subsequent capital raising through the market there appears to be no compelling reason to list.
3. RLV3 engaged WHK Gosling Chapman (WHK) to conduct an independent valuation of The Joneses as a precursor to the planned “acquisition” of The Joneses. WHK estimate a valuation range of $12.25 – $16.6 million for the equity of The Joneses. This valuation is based on management projections and discounted cash flow (DCF) analysis. The valuation range appears to have been generated by sensitivity analysis incorporating the cost of capital (Valuecruncher is hypothesizing here as there is no explicit explanation of the source of the range). This valuation report is a classic example of how not to apply the DCF methodology to early stage companies. Single scenarios with simplistic sensitivity analysis provide little or no insight into the fundamental uncertainty associated with early stage companies and produces an output of limited use. Valuecruncher has discussed previously the importance of scenario analysis when using the DCF methodology for valuing early stage and high growth companies.
Irrespective of the valuation, whether it is $3 million or $17 million the methodology used does not address how a company can go from a multi-million valuation and proposed listing to liquidation so quickly. Finance theory separates the financing decision (how can/should I raise capital? Debt or equity and on what terms?) from the investment decision (is this opportunity worthy of investment at all?) and assumes that any positive NPV project (a project with a present value greater than zero) will be funded. Finance theory assumes that everybody will agree on the value of the opportunity (this is often called the intrinsic value). Observation shows these assumptions are often violated. Without being privy to The Joneses process it is impossible to identify what caused the breakdown in this instance.
An obvious cause of these assumptions not holding is the market (either public or private) not accepting the company’s (and independent advisor’s) view that the opportunity is NPV positive. As a result the opportunity will not be able to raise the required capital.
Even when both the company and the market agree that the opportunity is NPV positive funding may not be achieved due to an inability to reach agreement on the terms of the capital raising. This disagreement may result from the valuation at which the equity is to be raised at or the conditions associated with the investment (e.g. interest rates on debt, structure of financial instruments – preference shares or governance conditions). Where these disagreements cannot be resolved a potentially positive NPV project will go unfunded.
A fragmented capital market may result in a positive NPV project going unfunded. In a fragmented capital market owners are not able to present the opportunity to investors with the appropriate risk profile and resources. This is often a case for early stage companies who do not know where to start looking for the appropriate investors. Networks such as Ice Angels look to address this issue by building a profile in entrepreneurial and investment communities and bringing the parties together.
An incomplete capital market can contribute to NPV positive projects going unfunded. In an incomplete capital market investors with the appropriate risk profile and resources don’t exist. This issue is often cited by NZ companies forced to seek capital overseas. When considering the capital markets in a global context they are assumed to be complete but issues such as geography, transaction costs and regulation create a second type of fragmentation that limits the ability for NPV positive projects to be funded.
This inability to raise funds made it impossible for The Joneses to continue trading and executing their business plan. Having decided to cease trading the company was forced to consider the status of their balance sheet and in particular their liabilities. Having considered this they have decided the most appropriate course of action is to enter voluntary liquidation and resolve their liabilities.
Putting aside company restructurings, misguided advice and finance theory, an opportunity to revamp the real estate industry has slipped by. This experience will be costly and frustrating for clients and gutting for the staff, investors and founders who have invested considerable time and capital into the business. The process highlights the importance of financing for early stage companies, the costs associated with facilitating rapid growth and questions the high cost marketing strategy adopted. Financing and capital structure needs to be considered as part of the wider strategic planning process not independently. Perhaps these lessons will be incorporated by a future entrant looking to implement a fixed fee real estate model.
Note: One issue I see with the fixed fee/salary model is the ability to effectively reward the best agents. Some portion of the agents remuneration will have to reflect performance (i.e. how many listings and sales are they generating). Addressing this issue may impact on the economics and the much touted teamwork component of the model.