Why Microsoft Uses Debt for Linkedin


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Microsoft will issue debt to purchase Linkedin. We learned that this month along with the nuances of tax repatriation.  A lot in taxes will be paid if Microsoft buys Linkedin with overseas cash. Most of Microsoft’s $107 Billion in cash and cash equivalents are held outside the United States. But to avoid taxes, Microsoft could have use stock to purchase Linkedin.

Overseas cash wasn’t a problem in the past when Microsoft acquired Nokia, Skype, and recently Mojang Synergies (Minecraft). All those acquisitions were done, not with stock, but with cash: $3 Billion for Mojang, $7 Billion for Nokia, and $9 Billion for Skype. Using cash made sense, because all three companies were overseas and so need to repatriate any cash. Now Microsoft will do the same, buy Linkedin with cash.  

The tech press touted the sheer genius of Microsoft: the interest on the debt is tax deductible! Yes it could be, but it really isn’t that much. Last November 2015, Microsoft issued $13 billion in debt, paying an average interest rate of 3.00%. Using the same interest rate means Microsoft will pay $780 million in interest expense to acquire Linkedin. But since Microsoft’s effective tax rate is 27%, the tax deduction is only $210 million per year.

Generally, the tax department is not a profit center.  Microsoft makes money selling software and services; tax savings are extra. From a financial perspective, Microsoft is just moving cash from overseas to here. In the end, Microsoft breaks even. Interest income earned overseas is offset by the interest paid on newly issued debt. In fact and surprising, a majority of the overseas cash is invested U.S. government and affiliated debt, which may not pay the highest rate.

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Taxes aside, the biggest surprise is that any of this is news. In its annual report, Microsoft said it will continue to use debt, instead of repatriating cash, as long as interest rates remain low (Liquidity Section of the 2015 Annual Report). In addition, Microsoft said back in November 2015, that the $13 billion debt offering could be for the following (italicized):

Microsoft intends to use the net proceeds from the offering for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt.

Instead of cash, Linkedin could have taken stock. Maybe Reid Hoffman didn’t want stock, despite the tax savings to him of receiving stock instead of cash. Maybe Microsoft just wanted to use cash or maybe, as Microsoft said, issuing stock would result in a “dilution of our earnings” (See Liquidity Section of the 2015 Annual Report)

More stock lowers Microsoft’s stock price, which it doesn’t want. In fact, Microsoft has been doing the opposite. Borrowing IBM’s strategy, Microsoft has been buying back its stock. By reducing the supply of stock and increasing earnings per share, Microsoft magically increases the stock price for a company that is no longer a growing one.

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Beware of Facebook’s New C Class?

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Everyone said, “Facebook’s Class C stock is no big deal, don’t worry about”. To the average shareholder, it means more stock. Every Class A and Class B shareholder, receives Class C stock as a dividend. And then there are three: three classes of stock. Only founders and venture capitalists should really care.

Since going public, Facebook used stock in part to acquire three companies: Instagram, Whatsapp, and Oculus. For example, Facebook used Class B stock and cash to get Oculus back in 2014.  The advantage of Class A or B stock to the seller – founder or venture capitalist – is any taxes on the deal are paid later, not now. This is not the case with non-voting stock, such as the Class C stock.

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When voting stock is used, taxes can be delayed. This occurs when the buyer (Facebook) exchanges its voting stock for the assets or stock of the seller (Whatsapp, Instagram, or Oculus). When the non-voting stock is used, there is no tax deferral. So if you want to do the deal, you may need to find another way. And if you can’t, maybe the deal does not get done. Facebook said the following:

Sellers may have a preference for a transaction in which they can defer taxes owed, in which case we may have to structure the acquisition in a different manner or may be precluded from using shares of Class C capital stock to fund the acquisition.

Think about, if Mark Zuckerberg really wants another company, then he may need to issue more Class A or Class B stock. That gives more voting stock to others, as was done with Instagram, Oculus, and Whatsapp. This would defeat the purpose of the Class C stock: maintaining voting control for Mark Zuckerberg.

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New Score: Uber Won and Saudis Lost

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Uber recently received more money. This time, the amount of $3 billion was received from the Saudi Public Investment Fund or PIF. Reaction was varied and mixed due to the source of the money (Saudi) and use of the money (China) by Uber. Overlooked in the discussion were the poor people of Saudi Arabia. It’s the Saudi citizens who are expected to benefit from the performance of the Fund.

Sovereign wealth funds are investments established and run by Governments. In the Gulf, Qatar, Kuwait and Abu Dhabi set up such funds with oil and natural gas revenue.  One the earliest and and largest is the Abu Dhabi Investment Authority which manages nearly $800 billion. Now the Saudi Royal Family plans to increase its sovereign wealth fund, the PIF, with an IPO of Saudi Aramco.

But having lots of money, doesn’t necessarily make you the smart money. Case and point here is the King Abdullah Financial District (KAFD) on the fringes of Riyadh. In better times, the idea was to create a financial international center to rival Dubai. After being completed or near completion, the project is now in need of tenants. When the project opened back in 2013, the vacancy rate was 90%. That’s probably worse than the vacancy rate for Hotels on Baltic Avenue.

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And now the Saudi Public Investment Fund is the proud owner of at least part of the KAFD. Sovereign wealth funds are active investors in real estate due the steady rents and opportunity for appreciation. Unlike people, sovereign wealth funds have an unlimited life. People need to save for retirement and some day the money is needed back. Sovereign wealth funds can invest for longer periods of time. The Saudi Public Investment Fund will need to wait a long, long time before its sees a return on its money from the KFAD.

In the investment realm, you judge money managers by alpha and beta returns. Beta returns are earned by riding the wave, being on the bandwagon, or following the herd. Here the money manager doesn’t need to have any special knowledge, other than know the direction of the market.  Alpha returns are those generated by people with skill, knowledge, or insight about a market. Alpha returns in the venture space could be those earned by early Facebook investors, such as the near legendary, Peter Thiel and the Russian, Yuri Milner.

Beta returns are average and alpha returns are above average. For Uber, the alpha investors (Chris Sacca) are those who  recognize the immense value to be created by Travis Kalanick, Garrett Camp, and the rest of the management team. Beta investors are those who are along for the ride. The returns of the later, beta investors depends on the price paid for their Uber stock. If the price is near the top value for Uber, the of chance of loss is greater.

In this situation, the later, beta investors now include the Saudi people.


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Salesforce’s Linkedin Bid Masks Cash Flow Issues

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Salesforce made an attempted bid for LinkedIn. That news makes sense since Salesforce grows through acquisitions rather than internally. But Salesforce’s acquisitions limits the free-cash flow available to shareholders. In its most recent filings, Salesforce disclosed along with other non-GAAP metrics, its free-cash flows. After adjustments, there is no so much cash left.

For fiscal years 2014 through 2016, Salesforce’s free-cash flows was approximately $600 million, $900 million, and $1.3 billion.  To arrive free-cash flows amounts, Salesforce started with cash generated by operations and then subtracted capital expenditures. And what is left, is the cash available to investors.

Capital expenditures need to be subtracted because the company needs to re-invest in order to grow future cash flows. For 2014-2016, Salesforce spent approximately $300 million per year on capital expenditures. Normally, that would be end of the calculation, but Salesforce is not a normal company. So we must continue on.


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Professors Charles W. Mulford and Eugene E. Comiskey propose in Creative Cash Flows Reporting, that a company’s free cash flow should be adjusted when numerous acquisitions are made during the year. They argue that the “ growth the operating cash flow and free cash flow may depend more on the acquiring firm’s ability to close numerous transactions than its ability to grow its cash flows internally”.

Salesforce has made ten acquisitions in FY 2014 to FY 2016; the largest was the acquisition of ExactTarget for $2.6 billion. In addition, Salesforce makes investments in early stage companies, which could be seen seen as an option on future acquisitions.

Taken together, both amounts would need to deducted following the two Professors’ reasoning. When subtracting Salesforce’s strategic investments and acquisitions, the free-cash flow from FY 2014 to FY 2016 is now ($2 billion), $500 million, and $900 million.

Also subtracted from free cash flows is stock used in acquisitions. Normally a non-cash item,  stock used in acquisitions should also subtracted, the two Professors argue. In FY 2015, Relate IQ, Inc. was acquired with mostly stock valued at $340 million.

For the most recent quarter, Salesforce purchased Steelbrick for $314 million in cash and stock. For the quarter ended April 20, 2016, Salesforce’s reported free-cash flow of $968 million.  After deducting the amounts associated with acquisitions, the free cash flow is $665 million, or 30% less.

Next quarter may not be any better – Salesforce announced in June the purchase of  Demandware for $ 2.8 billion.

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Marc Benioff Now Has More Fund at Salesforce

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Early this month, Salesforce established another venture fund; this time it is the $50 million Lighting Fund to accelerate app development. Salesforce already has a large venture capital unit with 150 portfolio companies, so why another fund?

Traditional venture capital is about earning financial return for investors. For corporations, venture capital can be financial and also strategic. Investment in early stage companies can give mature corporations a window on new markets such as fintech.

Salesforce currently has an investments of approximately $500 million made through its venture capital unit, Salesforce Ventures. And at the end of April 2016, the fair market value of the portfolio companies was approximately $707 billion. So Salesforce is sitting on an unrealized gain of $207 million on all its investments and most companies would be happy.

But Salesforce does not have an investment in 150 portfolio companies; rather it has a portfolio of 15o stock options to be exercised when the time and opportunity are right. By making early stage investments, Salesforce gets the opportunity to follow a business and it if likes, it can purchase the company.

Salesforce has grown mostly through acquisitions – borrowing John Chambers’ strategy of expanding Cisco Systems in the late 1990s. Like Cisco Investments, Salesforce Ventures can be seen as a merger and acquisition strategy rather than a desire to help entrepreneurs and early stage companies.

A case and point is Salesforce’s recent acquisition of Steelbrick in February 2016. Steelbrick became a portfolio company of Salesforce Venture after receiving approximately $14 million in two rounds of financings. Salesforce Inc. finally purchased all of Steelbrick for approximately $315 million in cash and stock.

For Salesforce Venture, the return on its investment was less than the normally 10x returns sought in traditional venture capital. At the time of the acquisition, Salesforce Ventures owned six percent of Steelbrick worth $24 million; so the realized gain was approximately $10 million.

In the end, Salesforce invested $14 million and got back less 2x its money. But seen as an option, the $14 million was worth it to Salesforce. In the acquisition of Steelbrick, Salesforce got apps which expands the value of its own platform. So the new Lighting Fund is not about investments, but about providing more options to Salesforce.

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Twitter Is Not For Sale!!!

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Twitter’s stock price is down, way down. And the announcement of Microsoft’s acquisition of LinkedIn, has many speculating if Twitter is next.

Twitter is not for sale or at least it is difficult to be acquired. If Twitter was to be acquired, the buyer would not get  Twitter’s most valuable assets – its tax losses (called net operating loss carry-forwards).

Twitter has not yet made a profit and has not ever paid any taxes. But someday, hopefully, Twitter will be profitable and when it does, it can use it accumulated losses to reduce any taxable income and consequently any taxes owed to the Federal Government.

At the end of the last year, the tax losses were $3.4 billion dollars. Said another way, Twitter can have taxable profits of $3.4 without paying taxes. But that tax benefit would be lost if the company was acquired, if you want to read it, here it is (page 33):

…….if a corporation undergoes an “ownership change,” the corporation’s ability to use its pre-change net operating loss carryforwards and other pre-change tax attributes, such as research tax credits, to offset its post-change income and taxes may be limited…

That means the tax benefits will be gone if there is a more than 50% change in ownership. The loss of tax benefits may not matter to an entity that does not pay taxes, but it would be an important issue to an acquirer who is profitable and does pay taxes, such as Microsoft.

LinkedIn has been profitable and has no net operating loss carry-forwards, so it’s not a deal breaker for Microsoft.


Workday Invests $100K in Scoop

download (6)Here’s a Scoop: Workday invests another $100,000 into Scoop Technologies. That amount is on top of the $700,000 invested last year. Scoop makes an “automated carpooling app” and now has a total investment of $800,000 from Workday.  That’s the last information come from Workday’s most recent quarterly filing on June 1st.

Workday’s 1Q16 filings show a minority investment of $100,000; it’s in the same period that Workday made another seed investment in Scoop. The first reported investment occurred in November 2015, close to another minority investment of $700,000 made in quarter ending October 30, 2015. So due to the proximity of the seed investment and the filings, it appears Workday has made two investments in Scoop Technologies.

These startup investments are part of Workday Venture’s focuses on machine learning and big data. Workday Ventures began officially in July 2015 as Workday’s venture capital unit. At that time there were four announced portfolio companies: Jobr, Thinair, Unbabel, and Metanautix.

Workday Venture invested approximately $17 million in the three months ended July 31, 2015. At the same time, it was announced that Workday had invested in four companies. So the average investment was $4 million. And before the year end, Workday Ventures’ had its first exit with the acquisition of Metanautix by Microsoft.

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Due to the enthusiasm for tech by many investors, corporate venture capital is now in vogue. Intel Capital has been one of the oldest; others like Workday Venture are more recent. Workday Ventures is run Adeyemi Ajao. Mr. Ajao started, along with Brendan Wallace, Identified. The company uses social data to build more acquire picture of job candidates. In 2014, Identified was purchased by Workday for approximately $26 million.

Workday Venture’s mission may be strategic, but it’s not difficult to think the motivation is also financial. For example, the financials for the quarter ended July 31, 2015 revealed a 10 x return for Workday. Workday’s minority investment of $300,000 resulted in $3 million gain. It’s not possible to identify the company, only the great returns.

Returns for corporate venture capital are different than traditional venture capital.  At a minimum, a venture capital firm must invest one company which will return at least the entire fund. For example, in a $10 million fund, if there are ten portfolio companies, one investment of $1 million must return $10 million, so at least the limited partners break even.

For corporate venture capital, it’s different. The minimum rate of return is the corporation’s cost of capital. Very simply, it’s the cost of money coming from the selling stock and issuing debt. To be successful, a corporation, like Workday, must invest the money at higher rate than it’s cost of capital. Workday’s cost of capital is 16%.  

Due to the recent bull market in tech, hitting that rate may not so difficult. In 2014, Workday invested $10 million in the SaaS later-stage company, Anaplan. Workday received 1.4 million of D preferred shares. At the time, the value was $10 per share for share. Anaplan is expected to go public in 2016.

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