Solution Manual For Entrepreneurial Finance, 7th Edition J. Chris Leach (Author), Ronald W. Melicher

Instructor Solution Manual For Entrepreneurial Finance, 7th Edition J. Chris Leach (Author), Ronald W. Melicher (Author) Chapter 1-16 With Cases [Products Special] Chapter 1 INTRODUCTION TO FINANCE FOR ENTREPRENEURS FOCUS The purpose of this first chapter is to present an overview of what entrepreneurial finance is about. In doing so we hope to convey to you the importance of understanding and applying entrepreneurial finance methods and tools to help ensure an entrepreneurial venture is successful.

We present a life cycle approach to the teaching of entrepreneurial finance where we cover venture operating and financial decisions faced by the entrepreneur as a venture progresses from an idea through to harvesting the venture.

LEARNING OBJECTIVES LO 1.1: Characterize the entrepreneurial process.

LO 1.2: Describe entrepreneurship and some characteristics of entrepreneurs.

LO 1.3: Indicate several megatrends providing waves of entrepreneurial opportunities.

LO 1.4: List and describe the seven principles of entrepreneurial finance.

LO 1.5: Discuss entrepreneurial finance and the role of the financial manager.

LO 1.6: Describe the various stages of a successful venture‘s life cycle.

LO 1.7: Identify, by life cycle stage, the relevant types of financing and investors.

LO 1.8: Understand the life cycle approach used in this book.

CHAPTER OUTLINE 1.1 1.2

THE ENTREPRENEURIAL PROCESS ENTREPRENEURSHIP FUNDAMENTALS A. Who is an Entrepreneur?

B. Basic Definitions C. Entrepreneurial Traits or Characteristics D. Opportunities Exist But Not Without Risks 1.3 SOURCES OF ENTREPRENEURIAL OPPORTUNITIES A. Societal Changes B. Demographic Changes C. Technological Changes D. Emerging Economies and Global Changes E. Crises and ―Bubbles‖ F. Disruptive Innovation 1.4 PRINCIPLES OF ENTREPRENEURIAL FINANCE A. Real, Human, and Financial Capital must be Rented from Owners (Principle #1) B. Risk and Expected Reward go Hand in Hand (Principle #2) 1

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1.5 1.6

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Chapter 6: Managing Cash Flow C. While Accounting is the Language of Business, Cash is the Currency (Principle #3) D. New Venture Financing Involves Search, Negotiation, and Privacy (Principle #4) E. A Venture‘s Financial Objective is to Increase Value (Principle #5) F. It is Dangerous to Assume that People Act Against Their Own Self-Interests (Principle #6) G. Venture Character and Reputation can be Assets or Liabilities (Principle #7) ROLE OF ENTREPRENEURIAL FINANCE THE SUCCESSFUL VENTURE LIFE CYCLE A. Development Stage B. Startup Stage C. Survival Stage D. Rapid-Growth Stage E. Early-Maturity Stage F. Life Cycle Stages and the Entrepreneurial Process FINANCING THROUGH THE VENTURE LIFE CYCLE A. Seed Financing B. Startup Financing C. First-Round Financing D. Second-Round Financing E. Mezzanine Financing F. Liquidity-Stage Financing G. Seasoned Financing LIFE CYCLE APPROACH FOR TEACHING ENTREPRENEURIAL FINANCE SUMMARY

DISCUSSION QUESTIONS AND ANSWERS 1. What is the entrepreneurial process?

The entrepreneurial process comprises: developing opportunities, gathering resources, and managing and building operations with the goal of creating value.

2. What is entrepreneurship? What are some basic characteristics of entrepreneurs?

Entrepreneurship is the process of changing ideas into commercial opportunities and creating value. While there is no prototypical entrepreneur, many are good at recognizing commercial opportunities, tend to be optimistic, and envision a plan for the future.

3. Why do businesses close or cease operating? What are the primary reasons why businesses fail?

Nearly one-half of businesses that fail do so because of economic factors including inadequate sales, insufficient profits, and industry weakness. Many of the economic factors are directly tied to financing concerns (e.g., insufficient profits for investors). Almost 40 percent of business failures not citing economic factors cite specifically financial causes like

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excessive debt and insufficient financial capital. The remaining cited reasons for failure include a lack of business and managerial experience, business conflicts, family problems, fraud, and disasters. Many businesses close and fail due to financial trouble which is mostly related to lack of sales and unsatisfactory profits.

4. What are five megatrend sources or categories for finding entrepreneurial opportunities?

We identify five megatrend categories. They are: (1) societal changes, (2) demographic changes, (3) technological changes, (4) emerging economies and global changes, and (5) crises and bubbles.

Under societal changes we discuss the gig economy and the sharing economy. The gig economy is where individuals accept short-term job assignments or ―gigs‖ instead of having full-time employment. The sharing economy is where individuals share their assets, such as homes, vehicles, and personal time, with others to provide a new way for distributing goods and services.

5. What asset and financial bubbles have occurred recently? How can bubbles and financial crises lead to entrepreneurial opportunities?

The ―dot.com‖ or Internet bubble burst in 2000. An economic recession that began in 2001 was exacerbated by the 9/11 terrorist attack. The housing asset bubble, fueled by sub-prime mortgages offered to borrowers who could not afford them, burst in 2006. By the second half of 2008, a ―perfect financial storm‖ erupted and possible financial collapse became a reality.

Alternative and renewable energy, accompanied by project credit subsidies, production and investment tax credits, and loan guarantees benefited as a result of the recent financial crisis.

These developments and other efforts to stimulate economic activity provided many new entrepreneurial opportunities.

6. What is e-commerce? Why are the Internet economy and e-commerce here to stay?

E-commerce involves the use of electronic means to conduct business online. Activities include marketing and selling online and electronic retailing.

The internet economy and e-commerce are here to stay. We will never do business the same way we did before the Internet and the Web. Many business plans were funded with the belief that part of the benefit could be captured by sellers (producers and retailers).

However, we now know that the Web so effectively facilitates price competition that it is hard for suppliers and retailers to protect margins. E-commerce may not deliver the margins once conjectured, but the Internet is still one of the most radical innovations in our lifetime.

7. What is meant by disruptive innovation? What is the ―sharing economy‖ societal trend?

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Chapter 6: Managing Cash Flow An innovation involves the introduction of a new idea, product, or process. A disruptive innovation is an innovation that creates a new market or network that disrupts and displaces an existing market or network.

8. Identify the seven principles of entrepreneurial finance.

The seven principles are: (1) Real, human, and financial capital must be rented from owners (2) Risk and expected reward go hand in hand (3) While accounting is the language of business, cash is the currency (4) New venture financing involves search, negotiation, and privacy (5) A venture‘s financial objective is to increase value (6) It is dangerous to assume that people act against their own self-interests (7) Venture character and reputation can be assets or liabilities 9. Explain the statement: ―The time value of money is not the only cost involved in renting someone’s financial capital.‖ The total cost of renting someone‘s financial capital is typically significantly higher than just the time value of money due to the possibility that the venture won‘t be able to pay. The rent is risky or uncertain requiring an expected compensation in addition to the time value of money for the renting agreement to be put in place.

10. How do public and private financial markets differ?

Public financial markets are markets where standardized contracts or securities are traded on organized securities exchanges. Private financial markets are markets where customized contracts or securities are negotiated, created, and held with restrictions on how they can be transferred.

11. What is the financial goal of the entrepreneurial venture? What are the major components for estimating value?

The venture‘s financial goal is to maximize the value of the venture to its owner(s). The major components of estimating value are projected free cash flow (cash generated in a specified time period that exceeds funds needed to operate, pay creditors, and invest in the assets needed to grow the venture) and its risk (including the timing and realized amount).

12. From an agency relationship standpoint, describe the possible types of problems or conflicts of interest that could inhibit maximizing a venture’s value.

There are two basic types of conflicts. Owner-manager (agency) conflicts occur when there are differences between managers‘ self-interests and the interests of the owners who hired the managers. There is also the possibility of owner-debtholder conflicts that take the form of a divergence of the owners‘ and lenders‘ self-interests as the venture gets close to bankruptcy.

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Agency relationships arise when ―principals‖ hire ―agents‖ to perform specified activities or services. Businesses are involved in two primary agency relationships: (1) owner-manager conflicts, and (2) manager-debtholder conflicts. The owner-manager agency problem exists when managers have personal goals that compete with maximizing the value of the venture.

The manager-debtholder conflict exists when debtholders make loans to firms but give responsibility to managers for deciding on the firm‘s risk of failure or bankruptcy. When loans are initially made, interest rates reflect the then current riskiness of the firm.

Subsequently, managers may, on behalf of the owners, make the firm riskier for the benefit of owners at the expense of debtholders.

13. Briefly discuss the likely importance of an entrepreneur’s character and reputation on the success of a venture. What role does social responsibility plan in the operation of an entrepreneurial venture?

A survey of successful entrepreneurs by Timmons and Stevenson indicated that a majority felt that having high ethical standards was the most important factor in the long-term success of their ventures. For discussion, see Timmons and Spinelli, New Venture Creation, 8th ed., 2009, Ch. 10. Taking the time and money to invest in the venture‘s character will help ensure that it is an asset rather than a liability.

Many entrepreneurial ventures provide great societal benefit through their introduction of new products and services. They also foster competition in existing markets providing more economically attractive prices for existing products and services. In many cases an entrepreneurial venture‘s social contribution is reflected in its commercial success. The two need not be mutually exclusive.

14. What is entrepreneurial finance and what are the responsibilities of the financial manager of an entrepreneurial venture?

Entrepreneurial finance is the application and adaptation of financial tools and techniques to the planning, funding, operations, and valuation of an entrepreneurial venture. The practice of financial management in entrepreneurial finance involves record keeping, financial planning, the management of operations and assets, and the acquiring of new assets and the financing of those assets necessary to grow the venture over its lifetime.

15. What are the five stages in the life-cycle of a successful venture?

They are: (1) Development Stage, (2) Startup Stage, (3) Survival Stage, (4) Rapid-Growth Stage, and (5) Early-Maturity Stage.

16. New ventures are subject to periodic introspection on whether they should continue or abandon. Explain the types of information you would expect to gather and how it would be used in each stage to aid an entrepreneur’s approach to the venture’s future.

Types of information to be gathered would be income statements, balance sheets, cash flow statements, general economic conditions, and product market conditions. These would all be

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Chapter 6: Managing Cash Flow stacked up against original projections to determine the feasibility of achieving the ventures goals.

17. Identify the types of financing that typically coincide with each stage of a successful venture’s life cycle.

Development Stage – Seed Financing Startup Stage – Startup Financing Survival Stage – First-Round Financing Rapid Growth Stage – Second-Round, Mezzanine and Liquidity-Stage Financing Maturity Stage – Obtaining bank loans, issuing bonds and issuing stocks 18. Identify the major sources, as well as the players, associated with each type of financing for each life cycle stage.

Development Stage – Entrepreneur‘s assets, family and friends Startup Stage – Entrepreneur‘s assets, family, friends, business angels, venture capitalists Survival Stage – Business operations, venture capitalists, suppliers, customers, government assistance programs, and commercial banks Rapid-Growth Stage – Business operations, suppliers, customers, commercial banks, and investment bankers Early-Maturity Stage – Business operations, commercial banks and investment bankers 19. Describe the life cycle approach for teaching entrepreneurial finance.

The life cycle approach to entrepreneurial finance considers major operating and financial decisions faced by entrepreneurs as they manage their ventures during the five life cycle stages that were previously identified. See Figure 1.6.

20. From the Headlines—PopSockets: Briefly describe the market PopSockets seeks to address and how PopSockets’ initial device addresses that market. Give some examples of how PopSockets can expand its market and tap additional sources of capital.

Answers will vary: ―PopSockets supplies products ―to increase the functionality of digital devices we use daily.‖ The addressable market includes anyone having such a device. Their product offerings have already expanded to include the PopTop, PopWallet, PopThirst, and PopMirror.‖ Through creative thinking and continued cost-effective innovation with a keen focus on affinity branding of its products for use as ―swag,‖ PopSockets‘ market expansion opportunities appear almost unbounded. Long-term (non-fad) adoption of PopSockets devices for enhancing the use of digital devices could lead to its becoming a public company (and IPO rumors have surfaced). Of course, in the dynamic global markets and supply chains, there is always the possibility that PopSockets will be acquired and assimilated into an entity having available capital for expansion.‖

INTERNET ACTIVITIES

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1. Web-surfing exercise: Develop your own list of the five most important societal or economic trends currently shaping our society and providing major business opportunities. Use the Web to generate potential venture ideas related to the trends and to gather commentary and statistics on them.

Students can be directed to do generic web searches on ―megatrends‖ or ―demographics‖ or ―emerging technologies‖ or similar terms to start their process of building their own list of five societal or economic trends. The instructor can draw on personal experiences, recent impressions from the Wall Street Journal and Bloomberg Businessweek to supplement any discussion of the students‘ lists.

2. Determining several ―resources‖ available from the Small Business Administration for entrepreneurs that might be useful in starting, financing, and managing an entrepreneurial venture. The SBA Web site in http://www.sba.gov/advo/ for information relating to recent annual numbers of employer firm births and the importance of small businesses to the U.S. economy.

The Instructor can use the provided link to update the textbook‘s data on the number of employer firm births and the impact of small businesses on the U.S. economy.

3. Following are some pairs of famous entrepreneurs. Using the Web if needed, associate the entrepreneurs with the companies they founded: 1.Steve Jobs and Steven Wozniak 2.Bill Gates and Paul Allen 3.Larry Page and Sergey Brin 4.Ben Cohen and Jerry Greenfield

A. Google B. Ben & Jerry’s C. Microsoft D. Apple, Inc.

Solutions: 1. Steve Jobs and Steven Wozniak 2. Bill Gates and Paul Allen 3. Larry Page and Sergey Brin 4. Ben Cohen and Jerry Greenfield

[D. Apple, Inc.] [C. Microsoft] [A. Google] [B. Ben & Jerry’s]

4. Search the Web for recent developments on the part of Airbnb and Uber to disrupt the lodging ad taxi industries, respectively. Also search the Web and attempt to identify other possible innovations that may be disrupting existing markets and networks.

Students can be directed to conduct specific web searches on recent Airbnb and Uber developments, write brief summaries of their findings, and be prepared to discuss their findings. The instructor also may ask students to conduct generic web searches in an effort to identify and be prepared to discuss examples of ―new‖ or ―different‖ innovations that are disrupting existing markets and networks. Differences of opinion among students hopefully will result in a lively discussion.

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EXERCISES/PROBLEMS AND ANSWERS 1.

[Financing Concepts] The following ventures are at different stages in their life cycles.

Identify the likely stage for each venture and describe the type of financing each venture is likely to be seeking and identify potential sources for that financing.

A. Phil Young, founder of Pedal Pushers, has an idea for a pedal replacement for children’s bicycles. The Pedal Pusher will replace existing bicycle pedals with an easy release stirrup to help smaller children hold their feet on the pedals. The Pedal Pusher will also glow in the dark and will provide a musical sound as the bicycle is pedaled.

Phil is seeking some financial help in developing working prototypes.

Since the venture is still in the idea stage and searching for prototype capital, the venture would be classified in the development stage. While in this stage, the venture will be making efforts to obtain seed financing, which typically comes from the entrepreneur‘s assets or from family and friends.

B. Petal Providers is a firm that is trying to model the U.S. floral industry after its European counterparts. European flower markets tend to have larger selections at lower prices. Revenues started at $1 million last year when the first ―mega‖ Petal Providers floral outlet was opened. Revenues are expected to be $3 million this year and $15 million next year after two additional stores are opened.

Since the venture has already established sizable revenue and is in the process of growing its venture by opening new stores, the firm has just entered the rapid growth stage.

2. [Life Cycle Financing] The following ventures have supplied information on how they are being financed. Link the type and sources of financing to where each venture is likely to be in its life cycle.

A. Voice River provides media-on-demand services via the Internet. Voice River raised $500,000 of founder’s capital in April 2019 and ―seed‖ financing of $1 million in September 2019 from the Sentinak Fund. The firm is currently seeking $6 million for a growth round of financing.

Voice River received development funds in the form of founders‘ capital and seed financing. It is currently seeking first round financing at the startup stage.

B. Electronic Publishing raised $200,000 from three private investors and another $200,000 from SOFTLEND Holdings. The financial capital is to be used to complete software development of e-mail delivery and subscription management services.

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Electronic Publishing is still in the development stage. It has raised funds from angels and an early stage venture capital firm.

3. [Venture Financing] Identify a successful entrepreneurial venture that has been in business at least three years.

The instructor can assign a specific entrepreneurial venture or allow students to identify and research ventures they are interested in. Alternatively, the instructor may choose to assign one of the two capstone cases (Eco-Products or Spatial Technology) presented at the end of this text for purposes of trying to answer the following questions.

A. Use historical revenues information to examine how this particular venture moved through its life cycle stages. Determine the length of the development stage, the startup stage, and so forth.

Answers will depend on the entrepreneurial venture being discussed.

B. Determine the financing sources used during the various stages of the venture’s life cycle.

Answers will depend on the entrepreneurial venture being discussed.

C. Identify the venture’s equity owners and how shares have been distributed among the owners. What portion of ownership has been allocated to management team members?

What, if any, agency conflicts can you identify?

Answers will depend on the entrepreneurial venture being discussed.

4. [Financial Risk and Return Considerations] Explain how you would choose between the following situations. Develop your answers from the perspective of the principles of entrepreneurial finance presented earlier in the chapter. You may arrive at your answers with or without making actual calculations.

A. You have $1,000 to invest for one year (this would be a luxury for most entrepreneurs).

You can earn a 4% interest rate for one year at the Third First bank or a 5% interest rate at the First Fourth bank. Which savings account investment would you choose and why?

Third First bank: $1,000 x 1.04 = $1,040 First Fourth bank: $1,000 x 1.05 = $1,050 The First Fourth bank loan would be preferred because you would receive $10 more ($1,050 versus $1,040) at the end of one year. This example illustrates the principle: ―real, human, and financial capital must be rented from owners.‖ The time value of money is an important component of the rent one pays for using someone else‘s financial capital.

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Chapter 6: Managing Cash Flow B. A ―friend‖ of yours will lend you $10,000 for one year if you agree to repay him $1,000 interest plus returning the $10,000 investment. A second ―friend,‖ has only $5,000 to lend to you but wants total funds of $5,400 in repayment at the end of one year. Which loan would you choose and why?

First friend: $1,000/$10,000 = 10% interest rate Second friend: $400/$5,000 = 8% interest rate The second friend is offering you a lower interest rate (8% versus 10%) which would be preferred, other things being equal. This example illustrates the principle: ―real, human, and financial capital must be rented from owners.‖ The time value of money is an important component of the rent one pays for using someone else‘s financial capital.

However, the dollar amount of financial that is needed also must be considered. For example, if you ―need‖ $10,000 then the lower interest rate $5,000 loan is not a viable option. The only viable choice might be to borrow $10,000 at the 10 percent rate of interest.

C. You have the opportunity to invest $3,000 in one of two investments. The first investment would pay you either $2,700 or $3,300 at the end of one year depending on the success of the venture. The second investment would pay you either $2,000 or $4,000 at the end of one year depending on the success of the venture. Which investment would you choose and why? Now, would your answer change if your investment were only $1?

Low Result First investment: $2,700 Second investment: $2,000

High Result $3,300 $4,000

Expected Value ($2,700 + $3,300)/2 = $3,000 ($2,000 + $4,000)/2 = $3,000

A second principle of entrepreneurial finance is: ―risk and expected reward go hand in hand.‖ ―Risk‖ is reflected in the dispersion or range of outcomes. Each investment amount is $3,000 and the expected return on average is $3,000 for each investment.

However, the second investment is considered to be riskier in that you might actually receive only $2,000 or two-thirds of your investment at the end of one year. Since the investment amounts and expected values are the same, risk-averse investors would prefer the first investment because it has less dispersion risk.

However, when investments are very small (or are perceived to be small by a specific investor), some investors might make the riskier investment in the ―hope‖ the highest return will occur. This is sometimes called the ―lottery‖ effect in that investors know there is a high probability that they will lose all of their investment but they are willing to undertake the investment in the hope they will receive the high payoff even though the odds of doing so are very, very small.

Bankruptcy or failure situations may also cause the investor (entrepreneur) to choose the riskier investment. For example, let‘s assume that you will need $3,500 in order to

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keep your business afloat. Since only the riskier second investment has the possibility of paying at least $3,500, the second investment might be selected.

D.

An outside venture investor is considering investing $100,000 in either your new venture or in another venture, or invest $50,000 in each venture. At the end of one year, the value of the venture might be either $0 or $1,000,000. The other venture is expected to be worth either $50,000 or $500,000 at the end of one year. Which investment choice (yours, the other venture, or half-and-half) do you think the venture investor would choose to invest in? Why?

Your venture: Other venture: Half-and-half:

Low Result $0 $50,000 $25,000

High Result $1,000,000 $500,000 $750,000

Expected Value ($0 + $1,000,000)/2 = $500,000 ($50,000 + $500,000)/2 = $275,000 ($25,000 + $750,000)/2 = $387,500

Under the half-and-half alternative, $50,000 is invested in each venture. The low result outcome is $25,000 ($0 + $25,000) and the high result outcome is $750,000 ($250,000 + $500,000).

In actuality there are two more possible outcomes under the half-and-half alternative.

They are: $250,000 ($0 + $250,000) and $525,000 ($25,000 + $500,000). Thus, the more complete half-and-half calculation would be: ($25,000 + $250,000 + $525,000 + $750,000)/4 = $387,500.

A venture investor who is not very risk averse might choose your venture to invest in since there is a possibility of receiving $1,000,000 in return for putting up $100,000.

Of course, such an investor could lose all of his/her investment if the low result occurs.

A more risk averse venture investor might choose to invest in only the other venture where he/she could lose only $50,000 of the $100,000 investment if the low result occurs with the possibility of receiving a maximum of $500,000 if the high result possibility occurs.

By combining the two venture investments in a ―portfolio,‖ the result is often less dispersion risk. In the above example, the lowest amount returned would be $25,000 (instead of zero for just your venture). However, the highest amount returned also would be lower at $750,000 (instead of the possibility of $1,000,000 for your venture).

The final decision will depend on the venture investor‘s willingness to trade off a lower expected return for less dispersion risk.

5. [Ethical Issues] Assume that you have been working on a first-generation ―prototype‖ for a new product. An angel investor is waiting in the ―wings‖ wanting to invest in a secondgeneration model or prototype. Unfortunately you have run out of money and aren’t able to finish the initial prototype. The business angel has previously said that she would ―walk‖ if you cannot produce a working first generation prototype.

A. What would you attempt to do to ―save‖ your entrepreneurial venture?

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Chapter 6: Managing Cash Flow Many entrepreneurs state that high ethical standards are one of a venture‘s most important assets and are critical to long-term success and value. Taking the time and money to invest in the venture‘s character will help ensure that it is an asset rather than a liability. Most would agree that the proper course of action would be one of being honest up front. That is, inform the business angel that you are out of money and thus can‘t finish the initial prototype. If this causes the business angel to ―walk,‖ so be it.

Of course, the first order of business is to secure necessary financing to complete the initial prototype.

B. Now let’s assume that the angel investor will advance you the financing needed for the second-generation prototype based on your ―word‖ that the first-generation prototype has been completed and is working? What would you do?

The situation has not changed from the suggested actions noted in Part A. Inform the business angel that the initial prototype has not yet been completed because you are out of money. Being honest up front is likely to be in the best interests of the venture (and entrepreneur) in the long-run. Confidence and trust in you (the entrepreneur) by the business angel will be in the best interests of a successful working relationship over time.

SUPPLEMENTAL EXERCISES/PROBLEMS AND ANSWERS [Note: These activities are for readers who have an understanding of financial statements.

Accountants record the flow of revenues and expenses over a time period such as a year in the income statement. Accounts also record the amount in asset accounts at the end of each accounting period in the balance sheet. For readers who need to review basic financial statements, the following problems can be completed after the materials in Chapter 4 have been covered.]

6. [Costs or Expenses] Phil Young, founder of Pedal Pushers, expects to spend the next onehalf year developing and testing prototypes for a pedal replacement for children’s bicycles.

(See Part A of Problem 1 for a description of the proposed product.) Phil anticipates paying monthly rent of $700 for space in a local warehouse where the Pedal Pusher product will be designed, developed, and tested. Utility expenses for power and heat are estimated at $150 per month. Phil plans to ―draw down‖ a salary of $1,000 per month. Materials needed to build and test an initial prototype product are expected to cost $9,500. In addition, each redesign and new prototype will require an additional $4,500 investment. Phil anticipates that before the final Pedal Pusher is ready for market at the end of six months, the initial plus two more prototypes will need to be built and tested. Costs associated with test marketing the Pedal Pusher are estimated at $7,000.

A. Determine the amount of financial capital that Phil Young will need during the sixmonths it will take to develop and test market the Pedal Pusher.

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B. What type of financial capital is needed and what are the likely sources of that capital for Phil Young?

The venture is in the development stage since it is still developing the product via prototypes. Therefore, it would be searching for seed financing as its source of capital, which will most likely be obtained through the entrepreneur‘s assets, family, or friends.

C. What would be your estimate of the amount of financial capital needed if the product development period lasted nine months?

The total expenses would be the $36,600 as in (A) plus an additional three months of expenses:

Total Nine-Month Expenses (Capital Needed): $36,600 + $5,550 = $42,150 D. What compensation arrangements would you recommend as he hires additional members of the management team?

Typically he would want to provide some base salary to provide normal living expenses plus an incentive compensation package in options or stock ownership that would be tied to the venture‘s progress and profitability.

7. [Expenses and Revenues] Let’s assume that Phil Young does indeed develop and successfully market the Pedal Pusher product discussed in Problems 1 and 6. Phil’s venture will purchase materials for making the product from others, assemble the products at the Pedal Pusher venture’s facilities, and hire product sales representatives to sell the Pedal Pushers through local retail and discount stores that sell children’s bicycles. The costs of plastic pedals and extensions; bolts, washers, and nuts; reflective material; and a ―micro-chip‖ to

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Chapter 6: Managing Cash Flow provide the ―music‖ when the bicycle is pedaled are expected to be $2.33 per pair of Pedal Pushers. Assembly costs are projected at $1.50 per pair. Shipping and delivery costs are estimated at $.20 per pair or set and Phil Young will have to pay commissions of $.30 per pair of pedals sold to the sales representatives.

A. What will it cost to produce and sell a pair of Pedal Pushers?

Unit Costs: Materials Assembly Shipping Commission Total Unit Costs

$2.33 $1.50 $0.20 $0.30 $4.33

B. What price will Phil Young have to charge for a pair of Pedal Pushers if he wants a ―markup‖ of 50 percent on each sale? Now, what would the retailers have to ultimately sell a pair of Pedal Pushers for if they, in turn, desired a mark-up before their expenses of 40 percent?

Phil Young‘s sale price to achieve a 50% markup would need to be $6.50 because $4.33 x 1.50 = $6.495 and prices are quoted in dollars and cents (not fractions of cents).

The retailers sale price to make a 40% markup is ($6.50) x (1.40) = $9.10.

C. Now that Pedal Pushers is up and operating, Phil Young feels he should be paid a salary of $5,000 per month. Other administrative expenses will be $2,500 per month. How many units (pairs) of Pedal Pushers will the venture have to sell to cover all operating and administrative costs during the first year of operation?

Unit contribution before additional expenses = $6.50 – $4.33 = $2.17 Fixed Expenses: Salary Administrative

12 months x $5,000 12 months x $2,500

$60,000 $30,000 $90,000

Units needed to be sold to reach breakeven: = (Fixed Expenses)/(Contribution Per Unit) = ($90,000)/($2.17) = 41,474.65 units (or 41,475 after rounding up to the next highest unit) To check that this is breakeven, note that: Revenue – Variable Cost – Fixed Cost = Profit.

In this problem, we have: (41,474.65 x $6.50) – (41,474.65 x $4.33) - $90,000 = $269,585 – 179,585 - $90,000 = 0.0. This is the smallest amount of units that does not result in a loss.

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MINI CASE: INTERACT SYSTEMS, INC. Interact Systems, Inc. has developed software tools that help hotel chains solve application integration problems. Interact‘s Application Integration Server (AIS) provides a two-way interface between central reservations systems (CRS) and property management systems (PMS).

At least two important trends in the hotel industry are relevant. First, hotels are shifting away from the manual booking of room reservations and electronic bookings will continue to increase as more bookings are made over the Internet. Second, competitive pressures are forcing hotels to implement yield management programs and to increase customer service. By integrating the CRS and PMS through Interact‘s AIS, inventories can be better managed, yields improved, and customer service enhanced.

All reservation traffic is routed from the CRS to individual hotel properties. This allows Interact Systems to create a database that can be used to track customers and to facilitate marketing programs, such as frequent stay or VIP programs, as a way of increasing customer satisfaction. Interact forecasts application integration expenditures in the hospitality industry exceeding $1 billion by 2022.

Greg Thomas founded Interact Systems in 2016 and developed the firm‘s middleware software and hospitality applications. He has twelve years of systems applications experience and currently is Interact‘s Chief Technology Officer. Eric Westskow joined Interact in early 2019 as President and CEO. Prior to that time, he worked in sales and marketing in the software industry for more than twenty years.

Interact Systems‘ AIS software development which began in 2016 went through several design changes in 2017. The first product was sold and installed in 2018. Sales were only $500,000 in 2018. However, now that the firm has dependable market-tested AIS products ready to be shipped, revenues are expected to reach $20.8 million in 2022.

Greg Thomas founded Interact Systems with $50,000 of his own savings plus $50,000 from friends. Two private investors provided an additional $200,000 in 2017. In addition, $1 million was obtained from a venture capital firm, Katile Capital Partners, in early 2019 in exchange for an equity position in Interact. The firm currently is seeking an additional $5 million to finance sales growth.

A. Verify the two important trends that are developing in the hotel industry.

1. Hotels are shifting away from the manual booking of room reservations to electronic bookings. This trend will continue to increase as more bookings are made over the Internet.

2. Competitive pressures are forcing hotels to implement yield management programs and to increase customer service.

B. Describe how Interact Systems’ AIS software products are to benefit the hotel industry from a profitability standpoint.

Interact‘s Application Integration Server (AIS) provides a two-way interface between central reservations systems (CRS) and property management systems (PMS). By integrating the

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Chapter 6: Managing Cash Flow CRS and PMS through Interact‘s AIS, inventories can be better managed, yields improved, and customer service enhanced.

C. Describe how Interact Systems’ AIS software is to help hotels improve customer satisfaction.

All reservation traffic is routed from the CRS to individual hotel properties. This allows Interact Systems to create a database that can be used to track customers and to facilitate marketing programs, such as frequent stay or VIP programs, as a way of increasing customer satisfaction.

D. Describe the life cycle stages that Interact Systems has progressed through to date.

Interact Systems‘ AIS software development which began in 2016, went through several design changes in 2017 (development stage). The first product was sold and installed in 2018 and sales were $500,000 in 2018 (startup stage). However, now that the firm has dependable market tested AIS products ready to be shipped, revenues are expected to reach $20.8 million in 2022 (survival stage and possibly rapid growth stage).

E. What types of venture financing have been obtained, or are being sought, by Interact?

Seed Financing: Greg Thomas founded Interact Systems in 2016 with $50,000 of his own savings plus $50,000 from friends. Two private investors provided $200,000 in 2017.

Startup Financing: $1 million was obtained from a venture capital firm, Katile Capital Partners, in early 2019 in exchange for an equity position in Interact.

First-Round Financing: The firm currently is seeking an additional $5 million to finance sales growth.

F. Relate major sources or players with the venture financing described in Part E. Major sources or players include: 2016: Entrepreneur‘s assets ($50,000) and friends‘ assets ($50,000).

2017: Two private investors (business angels) provided $200,000.

2019: Venture capital (Katile Capital Partners) provided $1 million.

G. What types of agency problems or conflicts should the founding entrepreneur have anticipated?

Agency relationships arise when principals hire agents to perform specified activities or services. Businesses are involved in two potentially conflicting relationships: (1) ownermanager conflicts and (2) manager-debtholder conflicts. At this time, the founding entrepreneur, Greg Thomas, does not have to worry about manager-debtholder conflicts. He, or the other equity investors, could have a possible owner-manager conflict with Eric Westskow who joined Interact in 2019 as president and CEO. Greg Thomas also could have possible conflicts with some or all three groups of investors (friends, business angels, and

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venture capitalists) if they believe he is not managing the venture in their best interests as investors.

H. What, if anything, should the founding entrepreneur have done in anticipation of agency conflicts?

In order to minimize a possible owner-manager conflict, the president and CEO, Erick Westskow, when hired in 2019 should have been given an equity stake in Interact so as to align his personal goals with the financial goal of maximizing the value of the venture.

I. Assuming the venture succeeds, what are the potential advantages to other stakeholders (customers, employees, and society more broadly)?

The goal of maximizing the entrepreneurial venture‘s value is not inconsistent with ethical behavior in business practices. Actions by entrepreneurs to increase the value of their ventures also can be consistent with the good of society. Customers benefit from the development of new ideas, products, and services. Employees benefit through stable employment, salary increases, and possibly from increased insurance, medical, and retirement benefits. Society benefits from higher employment levels and higher gross national product, as well as possibly through charitable contributions and other forms of venture philanthropy.

J. If internal sales growth projections are revised downward after the current financing round, what, if any, disclosure to stakeholders (investors, employees, customers, etc.) should occur?

Why? The entrepreneur-manager has the responsibility to inform investors in a timely and transparent manner about changing conditions or other factors (such as lower sales growth projections) that will lead to lower valuations. Other stakeholders should also be informed in a timely fashion if and when they may be affected. For example, if slower sales growth is expected to result in layoffs or fewer working hours, it is important to notify affected employees in a timely fashion. Customers should also be notified in a timely manner if and when product or service support is likely to be affected from a slow down in sales growth.

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Chapter 2 DEVELOPING THE BUSINESS IDEA FOCUS In this chapter we examine how one can move from an idea to a determination of the feasibility of the related business opportunity. We present an opportunity screening system to aid in determining whether an idea should be discarded or pursued. We conclude the chapter with an overview of a business plan.

LEARNING OBJECTIVES LO 2.1: Describe the process of moving from an idea to a business model/plan.

LO 2.2: Understand the components of a sound business model LO 2.3: Identify some of the best practices for high growth, high performance firms.

LO 2.4: Understand the importance of timing in venture success.

LO 2.5: Describe the use of a Strength-Weakness-Opportunity-Threats (SWOT) analysis as an initial ―litmus test.‖ LO 2.6: Describe the types of questions a feasibility assessment should address and identify quantitative criteria used in the screening process.

LO 2.7: Describe the primary components of a typical business plan.

CHAPTER OUTLINE 2.1 2.2

2.3

2.4 2.5 2.6

PROCESS FOR INDENTIFYING BUSINESS OPPORTUNITIES TO BE SUCCESSFUL YOU MUST HAVE A SOUND BUSINESS MODEL A. Component1: The Business Model must Generate Revenues B. Component 2: The Business Model must Make Profits C. Component 3: The Business Model must Produce Free Cash Flows LEARN FROM THE BEST PRACTICES OF SUCCESSFUL ENTREPRENEURIAL VENTURES A. Best Marketing Practices B. Best Financial Practices C. Best Management Practices D. Best Production or Operations Practices are also Important TIME-TO-MARKET AND OTHER TIMING IMPLICATIONS INITIAL ―LITMUS TEST‖ FOR EVALUATING THE BUSINESS FEASIBILITY OF AN IDEA SCREENING VENTURE OPPORTUNITIES A. An Interview with the Founder (Entrepreneur) and Management Team: Qualitative Screening B. Scoring a Prospective New Venture: Quantitative Screening C. Industry/Market Considerations D. Pricing/Profitability Considerations

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2.7

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E. Financial/Harvest Considerations F. Management Team Considerations G. Opportunity-Screening Caveats KEY ELEMENTS OF A BUSINESS PLAN A. Cover Page, Confidentiality Statement, and Table of Contents B. Executive Summary C. Business Description D. Marketing Plan and Strategy E. Operations and Support F. Management Team G. Financial Plans and Projections H. Risks and Opportunities I. Business Plan Appendix SUMMARY APPENDIX A: Applying the VOS IndicatorTM: An Example CSC Profile Market Opportunity Products Management Team CSC Assessment

DISCUSSION QUESTIONS AND ANSWERS 1. How do we know whether an idea has the potential to become a viable business opportunity?

The answer is that we don‘t know with absolute certainty. While there is no infallible screening process, there are tools and techniques that can help examine similarities between a new idea and previously successful ventures.

2. Identify three types of startup firms.

Salary-replacement firms are firms that provide their owners with income levels comparable to what they could have earned working for much larger firms.

Lifestyle firms are firms that allow owners to pursue specific lifestyles while being paid for doing what they like to do.

Entrepreneurial ventures are entrepreneurial firms that are flows and performance oriented as reflected in rapid value creation over time.

3. Briefly describe the process involved in moving from an idea to a business model/plan.

Refer to Figure 2.1 ―From Entrepreneurial Opportunities to New Businesses, Products, or Services.‖ Start with ―ideas,‖ then assess the ―feasibility‖ (finding an unfilled need), and then develop a ―business model/plan.‖

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4. What are the components of a sound business model?

The components of a sound business model are the abilities to generate revenues, create a profit, and produce free cash flow. These components must be achieved within a reasonable time frame as the venture progresses through the early stages of its life cycle.

5. Describe the differences between entrepreneurial ventures and other entrepreneurial firms.

Entrepreneurial ventures are entrepreneurial firms that are flows and performance oriented as reflected in rapid value creation over time. Such ventures strive for high growth in revenues, profits, and cash flows. In contrast, some small businesses may have some of the trauma and rewards of the entrepreneurial lifestyle, but remain centered on a small-scale format with limited growth and employment opportunities.

6. Identify some of the best marketing and management practices of high growth, high performance firms.

Successful high-growth, high-performance firms typically sell high quality products or provide high quality services. Such firms also generally develop and introduce new products or services considered the top or best in their industries; they are product and service innovation leaders. Their products typically command higher prices and profit margins. In summary, these firms‘ ―marketing profiles‖ are characterized by high quality, innovative leadership, and pricing power.

Best management practices include: (1) assemble a management team that is balanced in both functional area coverage and industry/market knowledge, (2) employ a decision-making style that is viewed as being collaborative, (3) identify and develop functional area managers that support entrepreneurial endeavors, and (4) assemble a board of directors that is balanced in terms of internal and external members.

7. Describe and discuss some of the best financial practices of high growth, high performance firms. Why is it also important to consider production or operations practices?

High-growth, high-performance firms consider their financial practices as important as their marketing and operating functions. To this end, they plan for future growth and unexpected contingencies that may develop as the firm operates. They prepare realistic monthly financial plans for at least the coming year, and also may prepare annual financial plans for the next three to five years. As rapid growth typically requires multiple rounds of financing, successful ventures anticipate financing needs in advance and seek to obtain financing commitments before the funds are actually needed. Financing sources that allow, whenever possible, the entrepreneur to maintain control over the firm, are highly desirable. Successful high growth firms devote the necessary resources and effort to manage the firm‘s assets, financial resources, and operating performance efficiently and effectively. They also develop preliminary harvest or exit strategies and may indicate potential liquidity events in their business plans.

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It is the production or operations area that carries the responsibility of delivering high-quality products or services on time. Customers want their products or services delivered when they are promised. Thus, the production or operations area is equally important to successful high-growth, high-performance firms.

8. Time to market is generally important, but being first to market does not necessarily ensure success. Explain. ―Time-to-market‖ is particularly critical when ideas involve information technology, as a few months might determine success or failure. EBay‘s rapid progression from concept to market dominance provides an example of the advantages of acting quickly in a technology market. ―First to market,‖ does not always result in success, as quite often companies entering the market later may achieve significant competitive advantages such as more efficient production, distribution, and service, superior product design, and a more sound financial position. The portable computer, first sold by Osborne, provides an example of a technology product that failed to achieve success by being ―first to market.‖ 9. What is meant by a viable venture opportunity?

A viable venture opportunity is one that creates or meets a customer need, provides an initial competitive advantage, is timely in terms of time-to-market, and offers the expectation of added value to investors.

10. Describe how a SWOT analysis can be used to conduct a first-pass assessment of whether an idea is likely to become a viable business opportunity.

A SWOT analysis is an examination of strengths, weaknesses, opportunities, and threats to determine the business opportunity viability of an idea. One typically ―begins‖ by asking whether there is an unfilled customer need. Other considerations that could be potential strengths or weaknesses include: intellectual property rights, first mover, lower costs and/or higher quality, experience/expertise, and reputation value. Areas to consider as potential opportunities or threats include: existing competition, market size/market share potential, substitute products or services, possibility of new technologies, recent or potential regulatory changes, and international market possibilities.

11. Describe the meaning of venture opportunity screening.

Venture opportunity screening is the assessment of an idea‘s commercial potential to produce revenue growth, financial performance, and value.

12. An analogy used relating to venture opportunity screening makes reference to ―caterpillars‖ and ―butterflies.‖ Briefly describe the use of this analogy.

Caterpillars are ideas that are likely to become butterflies which are successful business or venture opportunities.

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Chapter 6: Managing Cash Flow When conducting a qualitative screening of a venture opportunity, whom should you interview? What topics should you cover?

It is most important to interview the entrepreneur or founder. You might also want to interview the marketing manager, the operations manager, and the financial manager. In the event that a management team is not in place at the time of the qualitative screening, the entrepreneur or founder may have to play all of the roles.

The interviewing process with the entrepreneur should include questions aimed at understanding the big picture. Information should be sought regarding the intended customers, possible competition, intellectual property, challenges to be faced, etc.

The marketing manager interview seeks information on who makes the purchase decision for the venture‘s product or service, and who pays for the purchase. Others questions focus on market size and growth, channel and distribution challenges, and marketing and promotion needs.

The operations manager interview seeks information on the state of the idea in terms of prototypes and whether they have been tested. One should also attempt to assess what risks remain between now and successful market delivery and whether potential development or production concerns exist.

The financial manager interview seeks information on what length of time is projected before the venture will achieve breakeven, how will the venture be financed, and how much and when will outside financing be needed?

14. Describe the characteristics of a viable venture opportunity. What is a VOS Indicator?

A viable venture opportunity will meet a customer need, have a competitive advantage, be able to be brought to market quickly, and offer attractive investment returns compared to the risk associated with it. A VOS Indicator is a guide to help investors and entrepreneurs screen business opportunities. It contains a checklist for indicating the potential attractiveness of a proposed venture.

15.

Describe the factor categories used by venture capitalists and other venture investors when they screen venture opportunities for the purpose of deciding to invest.

The categories used by venture investors to screen are the industry or market, pricing and profitability, the management team, and financial harvest indicators. The market size of the industry, now or expected in the future, is a critical factor in the likelihood that a venture can become high growth, with potential sales or revenues of more than $100 million being required to scoring a ―high‖ in terms of potential attractiveness.

Profitability, indicated by the gross profit margin, is one of the most important metrics for judging the potential for a viable business opportunity, with a large gross profit margin providing a cushion for covering related business expenses while still providing sufficient

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return for investors. In general, a gross profit margin greater than 50 percent indicates that a venture has the potential to be a high growth, high performance opportunity. The net profit margin may also be used to evaluate ventures, with after-tax greater margins greater than 20 percent suggesting the potential for a high growth, high performance venture.

Venture screening usually begins with an assessment of the management team’s experience and expertise, with a high score being given to a management team having both expertise and experience in the proposed business opportunity‘s industry or market. Finally, venture investors give high scores to entrepreneurs who have given some thought in relation to providing investors with an exit from their venture investment.

Financial harvest indicators such as operating cash flow breakeven, free cash flow to equity, and internal rate of return (IRR) provide indications that a venture will be able to achieve an exit strategy, and returns to investors, in an acceptably short period of time.

16.

Describe return on assets (ROA). What are the two major components of the ROA model?

The return on assets is a metric calculated by dividing the venture‘s net after-tax profit by its venture total assets and it represents a measure of the firm‘s performance relative to its invested assets. The return on assets measure can also be viewed in terms of the return on assets (ROA) model that expresses the return on assets as the product of the net profit margin and the assets turnover metrics or ratios. This relationship is depicted as follows: Return on Assets = Net Profit Margin x Assets Turnover This also can be represented as: Net Profit/Total Assets = Net Profit/Revenues x Revenues/Total Assets.

Thus, the ROA of a venture is equal to its profit margin times its asset intensity.

17.

How do asset intensity and asset turnover differ? What is implied by a high asset intensity?

Asset intensity is calculated as total assets divided by total revenues. Asset turnover is calculated as revenues divided by total assets. Asset intensity is the reciprocal of asset turnover and asset turnover is the reciprocal of asset intensity.

A high asset intensity implies a large investment in fixed assets and/or net working capital is needed to support revenue growth. A high asset intensity also usually requires large amounts of external financial capital in order to support revenue growth.

18.

How do the concepts of operating cash flow and free cash flow to equity differ?

Operating cash flow is a measure of the cash generated by the daily operations of selling the company‘s product or service; it represents the figure that remains after the cost of goods sold and other business expenses (primarily general and administrative expenses along with

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Chapter 6: Managing Cash Flow marketing expenses or ―SG&A‖) are subtracted from revenues. It approximates the operating cash flows over a specified time period, such as a year.

Free cash flow to equity is the cash available to the entrepreneur and venture investors after operating cash outflows, financing and tax cash flows, required investment in assets needed to sustain the venture‘s growth, and net increases in debt capital. Free cash flow to equity is calculated as the venture‘s revenues minus operating expenses, minus financing costs and tax payments, after adjustment for changes in net working capital (NWC), physical capital expenditures (CAPEX) needed to sustain and grow the venture, and net additional debt issues to support the venture‘s growth. In short: Free cash flow to equity = net profit + depreciation charges - NWC – CAPEX + net new debt.

19. What is a business plan? Why is it important to prepare a business plan?

A business plan is a written document that describes the proposed venture in terms of the product or service opportunity, current resources, and financial projections. More formal business plan development is common in ventures moving from the development stage to the startup stage. The process of business planning is beneficial to the entrepreneur, who must be the first to believe the plan is reasonable. The entrepreneur must be convinced that starting this business is the right thing to do personally and professionally; the business plan reflects the excitement, opportunity, and reasonableness of the business idea to the members of the management team, potential investors, and other stakeholders.

20. What are the major elements of a typical business plan?

A typical business plan contains, in its Introduction, a cover page, confidentiality statement, table of contents, and executive summary. The Business Description section presents some of the considerations related to the venture opportunity-screening phase on industry/market factors. The Marketing Plan and Strategy section addresses the target market and customers, competition and market share, pricing strategy, and promotion and distribution. The Operations and Support section discusses how production methods or services will be delivered. The Management Team section presents the experience and expertise characteristics of the management team. In the Financial Plans and Projections, the business plan typically includes financial projections in the form of income statements, balance sheets, and statements of cash flows. These projections provide the basis for how the venture is expected to start up and operate over the next several years. The business plan should include a discussion of possible Problems or Risks.

The Appendix should contain the detailed assumptions underlying the projected financial statements in the Financial Plans and Projections section. It should also include a timeline with milestones indicating the amount and size of expected financing needs.

21. What are real options? What types of real option opportunities are available to entrepreneurs?

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Real options are real or non-financial options available to a venture‘s managers as the venture progresses through its life cycle. Examples of real options include growth options, flexibility options, learning options, and even exit options. Growth options represent the possibility that, if the venture‘s market begins to grow rapidly, an initial toehold position in a scalable technology or service may provide a platform for quick expansion to capture market share. Flexibility or learning options may develop when an investment in new technology has multiple potential applications and revenue streams. Exit options relate to the venture‘s ability to provide a return in a variety of ways other than remaining as a free-standing venture. The venture‘s intellectual property can be licensed or purchased by other firms, the venture can be absorbed into another public or private entity or the venture can remain independent and use its cash flow to provide a return for the investors.

22. From the Headlines—Diluting the Angels’ Share: Briefly describe how the idea of a shortened aging process can be the basis of financial profitability for Cleveland Whiskey.

Answers will vary: The barrel-aging process is extraordinarily time consuming, placing a large gap between when money is invested in an inventory and when that inventory is released to be sold. As with any business, in the whiskey business, time is money. The possibility of decreasing the barrel-aging time from 10 years to a few weeks represents a potentially disruptive technological improvement that can save a significant amount of the financing and storage costs for producing ―aged‖ whiskies. Until other distillers have adopted such techniques, Cleveland may have an ability to sell its whiskey at prices driven primarily by those who have to invest in their products for 10 years prior to realizing cash flows. This effectively increases the profitability of Cleveland Whiskey relative to other whiskeys (by decreasing the financial carrying and storage costs for the inventory)

INTERNET ACTIVITIES 1. Access the Inc. magazine Web site at www.inc.com. Identify a list of recent articles that relate to how business opportunities are evaluated by venture investors and/or articles discussing why venture investors chose not to invest in potential business opportunities.

Web-researched results vary due to constant updating of the related web sites.

2. Access the Center for Business Planning Web site at www.businessplans.org. The site provides examples of business plans prepared by MBA students from top business schools and presented to panels of investors at recent Moot Corp. competitions hosted by the University of Texas at Austin. Review one of the business plans. Write a brief summary comparing the segments or elements included in the business plan to the key elements of a typical business plan presented in the chapter.

Web-researched results vary due to constant updating of the related web sites.

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3. Access the Center for business Planning Web site at: www.businessplans.org. Find the reference to PlanWrite which is designed to help an entrepreneur to create a business plan.

Identify and briefly describe what this software product provides.

Web-researched results vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS 1. [Basic Financial Ratios] A venture recorded revenues of $1 million last year and net profit of $100,000. Total assets were $800,000 at the end of last year.

A. Calculate the venture’s net profit margin.

Net Profit Margin: net profit/revenues = $100,000/$1,000,000 = 10.0% B. Calculate the venture’s asset turnover.

Asset Turnover: revenues/total assets = $1,000,000/$800,000 = 1.25 times C. Calculate the venture’s return on total assets.

Return on Total Assets: net profit/total assets = $100,000/$800,000 = 12.5% 2. [Financial Ratios and Performance] Following is financial information for three ventures:

After-tax Profit Margins Asset Turnover

Venture XX 5% 2.0 times

Venture YY 15% 1.0 times

Venture ZZ 25% 3.0 times

A. Calculate the return on assets (ROA) for each firm.

Venture XX: 5% x 2.0 = 10% Venture YY: 15% x 1.0 = 15% Venture ZZ: 25% x 3.0 = 75% B. Which venture is indicative of a strong entrepreneurial venture opportunity?

Venture ZZ seems to represent a strong entrepreneurial venture opportunity based on a very high return on assets financial measure.

C. Which venture seems to be more of a commodity type business?

Venture XX seems to be more of a commodity type of business as indicated by a relatively low return on assets.

D. How would you place these three ventures on a graph similar to Figure 2.10?

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Venture ZZ would be a Case 1 type of venture opportunity (very high profit margin).

However, Venture ZZ‘s also high turnover would place the venture above the ROA curve (with an ROA of 75% as calculated in Part A.). Venture XX would be a Case 2 type of venture opportunity (low profit margin with a moderate asset turnover) resulting in a ROA of 10% (see Part A). Venture YY would fall between the other two ventures (a relatively high profit margin and a low asset turnover ratio) resulting in an ROA of 15% (see Part A).

E. Use the information in Figure 2.9 relating to pricing/profitability, and ―score‖ each venture in terms of potential attractiveness.

Pricing/Profitability Gross margins After-tax margins Asset intensity Return on assets Total points

Venture XX NA 1 2 2 5

Venture YY NA 2 2 2 6

Venture ZZ NA 3 2 3 8

3. [Revenues, Costs, and Profits] In early 2013, Jennifer (Jen) Liu and Larry Mestas founded Jen and Larry’s Frozen Yogurt Company, which was based on the idea of applying the microbrew or microbatch strategy to the production and sale of frozen yogurt. They began producing small quantities of unique flavors and blends in limited editions. Revenues were $600,000 in 2019 and were estimated at $1.2 million in 2020. Because Jen and Larry were selling premium frozen yogurt containing premium ingredients, each small cup of yogurt sold for $3 and the cost of producing the frozen yogurt averaged $1.50 per cup. Other expenses plus taxes averaged an additional $1 per cup of frozen yogurt in 2019 and were estimated at $1.20 per cup in 2020.

A. Determine the number of cups of frozen yogurt sold each year.

Revenue = Price per unit x units sold, and Revenue / Price per unit = units sold: Units Sold for 2019 = 600,000/3 = 200,000 units Units Sold for 2020 = 1,200,000/3 = 400,000 units B. Estimate the dollar amounts of gross profit and net profit for Jen and Larry’s venture in 2019 and 2020.

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Chapter 6: Managing Cash Flow C. Calculate the gross profit margins and net profit margins in 2019 and 2020.

Gross Profit Margin = Gross Profit/Revenues Net Profit Margin = Net Profit/Revenues Gross Profit Margin in 2019 = Gross Profit/Sales = 300,000/600,000 = 50% Net Profit Margin in 2019 = Net Profit/Sales = 100,000/600,000 = 16.7% Gross Profit Margin in 2020 = Gross Profit/Sales = 600,000/1,200,000 = 50% Net Profit Margin in 2020 = Net Profit/Sales = 120,000/1,200,000 = 10% D. Briefly describe what has occurred between the two years.

The gross profit margins are the same in the two years because the ―cost of goods sold per unit‖ stays the same. However, 2020‘s net profit margin declines because of the increase in the other expenses category.

4. [Returns on Assets] Jen and Larry‘s frozen yogurt venture described in Problem 3 required some investment in bricks and mortar. Initial specialty equipment and the renovation of an old warehouse building in Lower Downtown, referred to as LoDo, cost $450,000 at the beginning of 2019. At the same time, $50,000 was invested in inventories. In early 2020, an additional $100,000 was spent on equipment to support the increased frozen yogurt sales in 2020. Use information from Problem 3 and this problem to answer the following questions.

A. Calculate the return on assets in both 2019 and 2020.

Total Assets 2019 Total Assets 2020

= Warehouse + Inventory = $450,000 + $50,000 = $500,000 = Warehouse + Inventory + Additional Capital Expenditure = $450,000 + $50,000 + $100,000 = $600,000

Return on Assets (ROA) = Net Profit/Total Assets ROA for 2019 = 100,000/500,000 = 20% ROA for 2020 = 120,000/600,000 = 20% B. Calculate the asset intensity or asset turnover ratios for 2019 and 2020.

Asset Intensity = Total Assets/Revenues Asset Intensity Ratio for 2019 = 500,000/600,000 = .80 Asset Intensity Ratio for 2020 = 600,000/1,200,000 = .50 Assets Turnover = Revenues/Total Assets Asset Turnover Ratio for 2019 = 600,000/500,000 = 1.20 Asset Turnover Ratio for 2020 = 1,200,000/600,000 = 2.00 C. Apply the ROA Business Model to Jen and Larry’s frozen yogurt venture.

ROA Business Model = Net Profit Margin x Asset Turnover Ratio ROA for 2019 = 16.67% x 1.2 = 20%

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ROA for 2020 = 10% x 2.0 = 20% D. Briefly describe what has occurred between the two years.

The Returns on Assets were the same in the two years because the company‘s Net Profit Margins went down due to the increased operation expenses while Asset Intensity went up due to additional capital expenditure on equipment.

E. Show how you would position Jen and Larry’s frozen yogurt venture in terms of the relationship between net profit margins and asset turnovers depicted in Figure 2.10.

In relation to Figure 2.10, one should position Jen and Larry‘s frozen yogurt venture in Case 1 where the company has high profit margins and low assets turnovers.

In Case 2, companies compete on price, have very low profit margins and high asset turnovers. If the company is incapable of becoming a market leader, it will be squeezed out as the industry grows.

5.

[VOS IndicatorTM Screening] Jen Liu and Larry Mestas are seeking venture investors to help fund the expected growth in their Frozen Yogurt venture described in Problems 3 and 4. Use the VOS Indicator guidelines presented in Figures 2.8 and 2.9 to score Jen and Larry’s frozen yogurt venture in terms of the items in the pricing/profitability factor category.

Comment on the likely attractiveness of this business opportunity to venture investors.

Gross Margin: 50%, 50% (―High‖) After-Tax Margin: 16.7%, 10% (―Average‖) Asset Intensity: 1.2, 2 (―Average‖) ROA: 20%, 20% (―Average‖) This is an ―Average‖ opportunity.

6.

[Ethical Issues] Assume that you have just ―run-out-of-money‖ and are unable to move your ―idea‖ from its development stage to production and the startup stage. However, you remain convinced that with a reasonable amount of additional financial capital you will be a successful entrepreneur. While your expectations are low, you are meeting with a loan officer of the local bank in the hope that you can get a personal loan in order to continue your venture.

A. As you are about to enter the bank, you see a bank money bag lying on the street. No one is around to claim the bag. What would you do?

Many entrepreneurs state that high ethical standards are one of a venture‘s most important assets and are critical to long-term success and value. High ethical standards involve following laws, regulations, and treating others honestly and fairly. The money, if any, in the money bag does not belong to you—it is someone else‘s property. Most people would agree that you should turn the money bag in to the bank immediately.

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Chapter 6: Managing Cash Flow It is possible, but should not be expected and thus should not be part of your decision, that your high ethical standards might have an indirect impact on your being able to obtain a personal loan from the bank to continue your venture.

B. Now, let’s assume that what you found lying on the street was a $100 bill. The thought crosses your mind that it would be nice to take your significant other out for a nice dinner— something that you have not had for several months. What would you do?

Unless you see someone drop the $100 bill it will be very difficult to identify the owner of the bill. However, the money does not belong to you. Most people would agree that you should not just ―pocket‖ the $100 bill but should make an attempt to find its owner. Since you are outside the bank, you might enter the bank, indicate that you found a $100 bill outside the bank, and enquire whether someone has reported losing a $100 bill.

C. Now, instead of $100 you ―find‖ a $1 bill on the street. The thought crosses your mind that you could buy a lottery ticket with the dollar. Winning the lottery would certainly solve all your financing needs to start and run your venture. What would you do?

When the amount of money ―found‖ is very small, such as $1, people often behave differently than when the amount of money is large. First, it is virtually impossible to identify the owner unless you saw a specific person drop the $1 bill. Second, the time and energy involved in trying to find the rightful owner likely will outweigh the value of the money. Again, the money is not rightfully yours. Most people would probably say that if you can‘t immediately identify the rightful owner, the $1 becomes ―yours.‖ It is up to you to decide whether keeping the $1 bill jeopardizes your own personal high ethical standards. Purchasing a lottery ticket with the dollar represents another personal decision.

SUPPLEMENTAL EXERCISES/PROBLEMS AND ANSWERS [Note: These activities are for readers with an existing understanding of financial statements (i.e., income statements and balance sheets). For other readers, these exercises/problems can be worked after covering Chapter 4.]

7. [Revenues, Profits, and Assets] Refer to the information on the three ventures in Problem 2.

A. If each venture had net sales of $10 million, calculate the dollar amount of net profit and total assets for Venture XX, Venture YY, and Venture ZZ.

Venture XX Venture YY Venture ZZ

Net Profit $10,000,000 x .05 = $500,000 $10,000,000 x .25 = $2,500,000 $10,000,000 x .15 = $1,500,000

Total Assets $10,000,000/2.0 = $5,000,000 $10,000,000/3.0 = $3,333,333 $10,000,000/1.0 = $10,000,000

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B. Which venture would have the largest dollar amount of net profit?

Venture YY would have the largest net profit at $2,500,000.

C. Which venture would have to largest dollar amount of total assets?

Venture ZZ would have the largest total assets at $10,000,000.

8. [Ratio Calculations from Financial Statements] Ricardo Martinez has prepared the following financial statement projections as part of his business plan for starting the Martinez Products Corporation. The venture is to manufacture and sell electronic components that make standard overhead projectors ―smart.‖ In essence, through voice commands a projector can be turned on or off, and the brightness of the projection altered.

This will allow the user to avoid audience annoyances associated with a bright projection light during periods when no overhead transparency is being used. Venture investors usually screen prospective venture opportunities in terms of projected profitability and financial performance.

A. Use the following projected financial statements for Martinez Products and calculate financial ratios showing the venture’s projected: (a) gross profit margin, (b) net profit margin, (c) asset intensity, and (d) return on assets.

Gross Profit Margin = Gross Profit/Sales = 100,000/200,000 = 50% Net Profit Margin = Net Income/Sales = 15,000/200,000 = 7.5% Asset Intensity = Total Assets/Sales = 100,000/200,000 = .50 Asset Turnover = Sales/Total Assets = 200,000/100,000 = 2.0 Alternatively, 1/(Asset Intensity) = Asset Turnover. Thus, 1/.50 = 2.0 Return on Assets = Net Income/Total Assets = 15,000/100,000 = 15% B. The ratios calculated in Part A are found in the venture opportunity screening guide discussed in the chapter. Rate the potential attractiveness of the Martinez Products venture using the guidelines for the pricing/profitability factor category for the VOS Indicator.

The VOS Indicator shows that three of the pricing/profitability indicators are average while after-tax margins are low in attractiveness. The scoring suggests a low-to-average appraisal of this venture opportunity.

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Chapter 6: Managing Cash Flow

9. [Ratio Calculations] Ricardo Martinez, the founder of the Martinez Products Corporation (see Problem 8), projects sales to double to $400,000 in the second year of operation.

A. If the financial ratios calculated for Year 1 in Problem 8 remain the same in Year 2, what would be Martinez’s dollar amount projections in his business plan for: (a) gross profit, (b) net profit or income, and (c) total assets?

Gross Profit = Gross Profit Margin x Revenue = 50% x 400,000 = 200,000 Net Profit = Net Profit Margin x Revenue = 7.5% x 400,000 = 30,000 Total Assets = Total Revenue/Asset Intensity = 400,000/2.00 = 200,000 B. How would your answers change in Part A if the gross profit margin in the second year is projected to be 60%, the net profit margin 25%, and the asset intensity at a 5 times turnover?

Gross Profit = 400,000 x 60% = 240,000 Net Profit = 400,000 x 25% = 100,000 Total Assets = 400,000/5.00 = 80,000 C. Use the projected ratio information in Part B in the return on assets (ROA) model to determine the projected percentage rate of return on assets.

ROA = Net Profit Margin x Assets Turnover = 25% x 5.00 = 125% (Note that 125% is an unusually high ROA, but not necessarily uncommon given the optimism in many business plans).

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MINI CASE: LEARNRITE.COM CORPORATION LearnRite.com offers e-commerce service for children‘s ―edutainment‖ products and services. The word edutainment is used to describe software that combines ―educational‖ and ―entertainment‖ components. Valuable product information and detailed editorial comments are combined with a wide selection of products for purchase to help families make their kids‘ edutainment decisions. A team of leading educators and journalists provide editorial comments on the products sold by the firm. LearnRite targets highly educated, convenience oriented, and value conscience families with children under the age of 12, estimated to be about 35 percent of Internet users.

The firm‘s warehouse-distribution model results in higher net margins, as well as greater selection and convenience for customers, when compared to traditional retailers. Gross profit margins are expected to average about 30 percent each year. Because of relatively high marketing expenditures aimed at gaining market share, the firm is expected to suffer net losses for two years. Marketing and other operating expenses are estimated to be $3 million in 2020 and $5 million in 2021, respectively. However, during the third year operating cash flow breakeven should be reached. Net profit margins are expected to average 10 percent per year beginning in year 3. Investment in bricks and mortar is largely in the form of warehouse facilities and a computer system to handle orders and facilitate the distribution of inventories.

After considering the investment in inventories, the asset intensity or turnover is expected to average about two times per year.

LearnRite estimates that venture investors should earn about a 40 percent average annual compound rate of return and sees an opportunity for a possible initial public offering in about six years. If industry consolidation occurs, a merger might occur even sooner.

The management team is headed by Srikant Kapoor who serves as President of LearnRite.com and who personally controls about 35 percent of the ownership of the firm. Mr. Kapoor has more than twelve years experience in high-tech industries including previous positions with US West and Microsoft. He holds a B.S. degree in electrical engineering from an Indian technology institute and an MBA from a major U.S. university. Sean Davidson, Director of Technology has more than ten years of experience in software development and integration.

Walter Vu has almost ten years of experience in sales and business development in the software industry including positions at Claris and Maxis. Mitch Feldman, Director of Marketing, was responsible for six years for the marketing communications function and the Internet operations of a large software company. Management strives for continual improvement in ease of user interface, personalized services, and amount of information supplied to customers.

The total market for children‘s entertainment is estimated to be $35 billion annually.

Toys account for about $20 billion in annual spending. Summer camps are estimated to generate $6 billion annually. This is followed by children‘s videos and video games at $4 billion each.

Children‘s software sales currently generates about $1 billion per year in revenues and industry sales are expected to grow at a 30 percent annual rate over the next several years.

LearnRite has made the following five-year revenue projections: Year Revenues ($M)

2020 $1.0

2021 $9.6

2022 2023 2024 $30.1 $67.8 $121.4

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Chapter 6: Managing Cash Flow

A. Project industry sales for children’s software through the year 2024 based on the information provided above.

B. Calculate the year-to-year annual sales growth rates for LearnRite. [Optional: Estimate the compound growth rate over the 2020 through 2024 time period using a financial calculator or computer software program.]

Growth Rate = [(Next Year Sales – Current Year Sales)/Current Year Sales] x 100

Arithmetic average = (860% + 214% + 125% + 79%)/4 = 320% Compound average (using a financial calculator and point-to-point estimate between 2020 and 2024) = 232% [Enter: present value = -1.00; future value = 121.40; number of periods = 4; then solve for %i] Geometric average = [(1 + 860) x (1 + 214) x (1 + 125) x (1 + 79)]1/4 = 208% C.

Estimate LearnRite’s expected market share in each year based on the above data.

Note: use data for the kid‘s software industry from (A) and for LearnRite from (B).

Percent of

Chapter 6: Managing Cash Flow Year 2020 2021 2022 2023 2024 D.

35

Industry Sales 0.1% 0.7% 1.8% 3.1% 4.2%

Estimate the firm’s net income (loss) in each of the five years.

Year 2020: Gross profit is $0.30 million ($1.0 million sales x .30 margin) less marketing expenses of $3 million produces a loss of $2.70 million Year 2021: Gross profit is $2.88 million ($9.6 million sales x .30 margin) less marketing expenses of $5 million produces a loss of $2.12 million Years 2022-2024: Net profit is 10% of that year‘s forecasted sales E.

Estimate the firm’s return on assets beginning when the net or after-tax income is expected to be positive.

Note: Since the asset intensity or turnover is 2.00, total assets will be one-half of forecasted sales. Alternatively, return on assets = net profit margin (10.0%) times asset turnover (2.0 times) = 20.0% F.

Score LearnRite’s venture investor attractiveness in terms of the Industry/Market Factor Category using the VOS Indicator guide and criteria set out in Figures 2.8 and 2.9. If you believe there are insufficient data, indicate that decision with an ―N/A.‖ Industry/Market Market Size Potential: kid‘s software sales = $1 billion Venture Growth Rate: greater than 30% annually Market Share (Year 3): 1.8% of industry sales Entry Barriers: possible timing barriers

Score High High Low Average

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Chapter 6: Managing Cash Flow

G.

Score LearnRite’s venture investor attractiveness in terms of pricing/profitability factors.

Follow the instructions in Part F. Pricing/Profitability Gross Margins: 30% margins are estimated After-Tax Margins: 10% margins are estimated Asset Intensity: 2.0 asset turnovers are estimated Return on Assets: 20% returns are estimated

H.

Score Average Average Average Average

Score LearnRite’s venture investor attractiveness in terms of financial/harvest factors.

Follow the instructions in Part F. Financial/Harvest Cash Flow Breakeven: estimated to occur in Year 3 Rates of Return: 20% investor returns are estimated IPO Potential: estimated in Year 6 Founder‘s Control: 35% ownership by founder

I.

Score Average Average Low Average

―Score‖ LearnRite’s venture investor attractiveness in terms of management team factors.

Follow the instructions in Part F. Management Team Experience/Expertise: very good in software/tech industries Functional Areas: good except for finance Flexibility/Adaptability: experience suggests flexibility Entrepreneurial Focus: startup risks accepted by founder/team

J.

Score High Average Average Average

Determine overall total points and an average score for LearnRite as was done for the Companion Systems Corporation in the Appendix. Items where information is judged to be lacking and an NA is used should be excluded when calculating an average score.

The ―labels‖ assigned in (F) through (I) for LearnRite can be summarized as follows: Category High Average Low Totals

Number x 3 11 2 16

Points Per 3 2 1

=

Total Points 9 22 2 33

Average score = 33/16 = 2.06 K.

Provide a brief written summary indicating how you feel about LearnRite.com as a business opportunity.

We have ―scored‖ each of the 16 items. Of course, it could be argued that adequate information might be lacking for one or more of the items and an NA could have been

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37

assigned until the information was acquired. However, even after substantial due diligence efforts are completed, scoring ―judgments‖ will still have to be made. [We note that differences in industry knowledge, attitudes towards risk preferences, etc. might lead individual instructors and/or students to ―score‖ certain items differently than we have. Such differences in opinion should help enliven the discussion of the mini case and provide recognition that deciding to become an entrepreneur is not for everyone.]

We have assigned ―average‖ scores to about two-thirds of the items, which accounts for a score around 2. Of course, it is important we recognize that the venture opportunity-screening guide we are employing is very demanding due to its focus on venture investor expectations. While an idea/opportunity with an average score (1.67 to 2.33) may find it somewhat difficult to attract venture capital, it may still constitute a viable business opportunity. The risks associated with the LearnRite venture are potentially high, but the rewards are also potentially large. As a result, LearnRite could be very successful and generate substantial wealth for the founder and the management team.

Chapter 3 ORGANIZING AND FINANCING A NEW VENTURE FOCUS In this chapter, we focus on organizing the venture, obtaining and protecting intellectual property, and early stage financing. Although an entrepreneur can change the legal form of the venture in the future, the initial choice should carefully consider tax effects, liability implications, and the amount of financial capital needed to start and initially operate the firm.

Entrepreneurs who possess and protect intellectual property will increase the chance that their ventures will survive and create value.

LEARNING OBJECTIVES LO 3.1: Discuss how we will be progressing through the venture life cycle in this text.

LO 3.2: Describe the proprietorship, partnership, and limited liability company forms of business organizations.

LO 3.3: Describe the benefits, risks, and basic tax aspects of various organizational forms.

LO 3.4: Discuss the use of patents, trade secrets, trademarks, and copyrights to protect intellectual property.

LO 3.5: Describe seed, startup, and first-round financing sources.

CHAPTER OUTLINE 3.1 3.2

PROGRESSING THROUGH THE VENTURE LIFE CYCLE FORMS OF BUSINESS ORGANIZATION A. Proprietorships B. General and Limited Partnerships C. Corporations

38

3.3 3.4

3.5

Chapter 6: Managing Cash Flow D. Limited Liability Companies CHOOSING THE FORM OF ORGANIZATION: TAX AND OTHER CONSIDERATIONS INTELLECTUAL PROPERTY A. Protecting Valuable Intangible Assets B. What Kinds of Intellectual Property can be Protected?

1. Patents 2. Trade Secrets 3. Trademarks 4. Copyrights C. Other Methods for Protecting Intellectual Property Rights SEED, STARTUP, AND FIRST-ROUND FINANCING SOURCES A. Financial Bootstrapping B. Business Angel Funding C. First-Round Financing Opportunities SUMMARY

DISCUSSION QUESTIONS AND ANSWERS 1. Describe the major differences between a proprietorship and a partnership.

A proprietorship is individually owned while a partnership has two or more owners. Little time and low legal costs are involved with starting a proprietorship whereas a partnership requires moderate time and legal costs to start.

2. What is a limited partnership?

A limited partnership consists of at least one general partner with unlimited investor liability and limits limited partner liabilities to the amount of their equity capital contribution to the partnership.

3. Briefly describe the corporate form of business organization. What is meant by limited liability?

In a corporation the firm‘s assets are separated from the owners‘ personal assets. It provides for an unlimited life and it is usually easy to transfer ownership. Income taxes are paid at the corporate level and dividends are subject to personal tax rates. The limited investor liability of a corporation provides that the owners are only liable for the amount of their equity investments in the business and their other personal assets are not at risk for any business debts.

4. How does a subchapter S corporation differ from a regular corporation?

A subchapter S (or just S) corporation must have less than 75 owners [note: the limit has recently been increased to 100 or fewer owners]. An S corporation provides the same limited

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39

liability as a regular (or C) corporation but income flows through to the shareholders and is taxed at the personal tax rates of the owners instead of at a regular corporation‘s tax rate.

5. Describe the major characteristics of a limited liability company.

A limited liability company (LLC) is owned by its ―members‖ or shareholders who have limited investor liability. Its earnings flow through to the members with the earnings being taxed at the personal income tax rates of the members. High time and legal costs are involved in setting up an LLC. 6. Describe the major taxation advantages of a limited liability company or a subchapter S corporation over a regular corporation.

For LLCs and S corporations, income flows to the shareholders or owners and is taxed at their personal tax rates. Regular or C corporations pay corporate taxes and any cash dividend distributions to shareholders are also subject to personal income tax rates.

7. What is meant by the term ―intellectual property‖?

Intellectual property is a venture‘s intangible assets and human capital, including inventions that can be protected from being freely used or copied by others. Intangible assets can be protected through patents, trade secrets, trademarks, and copyrights.

8. Identify and briefly describe the types of patents used to protect valuable intangible assets.

Patents: intellectual property rights granted for inventions that are useful, novel, and nonobvious. There are four kinds of patents: (1) utility, (2) design, (3) plant, and (4) business method.

Utility patents cover most inventions pertaining to new products, services, and processes.

Design patents protect the ornamental designs of products.

Plant patents protect discoveries of asexual reproduction methods of new plant varieties.

Business method patents protect a specific way of doing business and the underlying computer codes, programs, and technology.

9. What was the purpose of the Leahy-Smith America Invents Act of 2011? Why is the U.S. Congress working on possible passage of an ―Innovation Act?‖ The Leahy-Smith America Invents Act of 2011 is the first major change in how the U.S. patent system operates since 1952. In part it was passed to alleviate the backlog of patentrelated lawsuits, particularly those relating to computer software patents.

The U.S. Congress continues to work on possible passage of an ―Innovation Act‖ that hopefully would reduce the negative impact of the large number of patent-related court cases many of which have been initiated by Patent Trolls (aggressive non-practicing entities).

10. What are the benefits and costs of having a patent?

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Chapter 6: Managing Cash Flow

In a tongue-in-cheek sense, having a patent gives the inventor a license to sue to protect his or her invention. However, legal enforcement is not necessarily easy and can be costly. The government does not enforce your rights. If you are an inventor with a patent, the burden of enforcing the patent is yours. In additional to possible large legal fees, some argue that the detail required in obtaining a patent can sometimes be used by others to ―design around‖ your patent.

11. What are trade secrets? How are they used to protect valuable intangible assets?

Trade secrets: intellectual property rights in the form of inventions and information not generally known to others that convey economic advantages to the holders.

There is no formal procedure for obtaining protection for an invention or information as a trade secret. Rather, protection under trade secrets law is established by the characteristics of the secret and efforts to protect it.

12. What are trademarks? Identify the four types of ―marks‖ used to protect intellectual property.

Trademarks: intellectual property rights that allow firms to differentiate their products and services through the use of unique marks. The four types of ―marks‖ are: trademarks, service marks, collective marks, and certification marks.

There is no formal government procedure for establishing a trademark. Rather, ownership is acquired by being first to use the mark on products.

13. What are copyrights and how are they used?

Copyrights: intellectual property rights to writings in written and electronically stored forms.

In a broad sense, copyright law protects the form of expression of an idea, not just words.

Today, the fact that a work was ―created‖ is enough to provide copyright protection.

However, a copyright can be registered with the U.S. Copyright Office. A registered copyright provides for an amount of statutory damages that can be recovered without proof of actual damages.

14. What are confidential disclosure agreements? What are employment contracts?

Confidential disclosure agreements: documents used to protect an idea or other forms of intellectual property when disclosure must be made to another individual or organization.

Employment contracts: employer employs the employee in exchange for the employee‘s agreeing to keep confidential information secret and to assign ideas and inventions to the employer.

15. What is seed and startup financing?

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41

Seed and startup financing are sources of financing available during the development and startup stages of a venture‘s life cycle. Included are the entrepreneur‘s physical and financial assets, family and friends, and business angels. Other venture investors, including venture capitalists, may also be sources of financial capital during the very early-stages of a venture‘s development and operation.

16. Describe the meaning of financial bootstrapping.

Financial bootstrapping involves minimizing the need for financial capital and finding unique ways of financing a new venture. The entrepreneur attempts to minimize costs during the very early stages of the venture in order to minimize the need for additional capital.

17. Describe some major characteristics of business angels.

Business angels are wealthy individuals who invest in early stage ventures in exchange for the excitement of launching a business and a share in any financial rewards. Business angels are self made, wealthy individuals with substantial business and financial experience who enjoy the thrill of being involved in new ventures.

18. What is first-round financing that occurs during the survival life cycle stage?

Refer to Figure 3.7. First-round financing, which occurs during the survival stage, includes financing from: business operations, venture capitalists, suppliers and customers, government assistance programs, and commercial banks.

19. From the Headlines – The Fantasticks: Describe the fundraising tactic for the producers of The Fantasticks. What were the driving motivations for the angel investors?

Answers will vary: Many of the original investors in 1960 were friends and neighbors of the artists and executives for the show. Their approach was the common one in the industry – seeking funding from (Off-) Broadway angels who had an affinity for the artistic endeavor, but also knew they would be buying tickets to the production.

INTERNET ACTIVITIES 1. Access the Inc. magazine Web site at http://www.inc.com. Identify a list of recent articles that relate to how to finance new ventures.

Web-researched results vary due to constant updating of the related web sites.

2. Access the http://www.garage.com Web site. Identify the angel matchmaking services that are provided. Determine the site’s focus in terms of early stage versus later stage financing, as well as the typical range of financing that is provided.

Web-researched results vary due to constant updating of the related web sites.

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Chapter 6: Managing Cash Flow

3. Access the Web sites of http://www.angeldeals.com, http://gatheringofangels.com, and http://www.vcfodder.com. Determine the scope and focus of these sites in terms of matchmaking financing services that are available for entrepreneurs.

Web-researched results vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS Figure 3.6 (2018 Personal and 2018/2017 Corporate Federal Income Tax Rates) in the chapter is repeated here to support problem calculations involving federal income taxes.

Note: the 2017 corporate marginal income tax rates are included for the purpose of illustrating the magnitude of the reduction in corporate taxes in 2018 due to the passage of a flat 21% corporate income tax rate. An instructor may want to show how the amount of corporate income taxes would have differed between the actual 2018 corporate flat tax rate of 21% and a scenario that assumes the 2017 corporate marginal tax rates had continued in 2018.

Of course, when comparing actual income taxes, it is important to use the actual 2018 flat corporate tax rate of 21% relative to the personal marginal tax rates for 2018.

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43

Figure 3.6 2018 Personal and 2018/2017 Corporate Federal Income Tax Rates Panel A:

2018 CorporateFlat Tax Rate: 21%

Panel B:

2017 CorporateMarginal Income Tax Rates Ma rgi na l Over --- But not Over -- Ta x Ra te

0

50,000

15%

50,000

75,000

25%

75,000

100,000

34%

100,000

335,000

39%

335,000

10,000,000

34%

10,000,000

15,000,000

35%

15,000,000

18,333,333

38%

18,333,333

35%

Panel C: 2018 Personal Marginal Income Tax Rates Single

Married Filing Jointly

Ta xa bl e Income

Ma rgi na l

Ta xa bl e Income

Ma rgi na l

Over --But not over --

Ta x Ra te

Over --

But not over --

Ta x Ra te

0

9,525

10%

0

19,050

10%

9,525

38,700

12%

19,050

77,400

12%

38,700

82,500

22%

77,400

165,000

22%

82,500

157,500

24%

165,000

315,000

24%

157,500

200,000

32%

315,000

400,000

32%

200,000

500,000

35%

400,000

600,000

35%

37%

600,000

500,000

37%

We also provide in Table A the 2018 incremental and cumulative income tax calculations for estimating personal income taxes (for both single filers and married filing jointly).

Table A data can be used to reduce the number of calculations needed to estimate the amount of personal income taxes in end-of-chapter problems.

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Chapter 6: Managing Cash Flow

Table A: 2018 Corporate and 2018 Personal Federal Income Tax Rates 2018 Corporate Tax Rate:

Flat Tax Rate at 21%

2018 Personal Marginal Income Tax Rates: Single: Taxable Income Over--0 9,525 38,700 82,500 157,500 200,000 500,000

But not over --9,525 38,700 82,500 157,500 200,000 500,000

Married Filing Jointly: Taxable Income Over--- But not over --0 19,050 19,050 77,400 77,400 165,000 165,000 315,000 315,000 400,000 400,000 600,000 600,000

Difference 9,525 29,175 43,800 75,000 42,500 300,000

Marginal Tax Rate 0.10 0.12 0.22 0.24 0.32 0.35 0.37

Incremental Taxes 952.50 3,501.00 9,636.00 18,000.00 13,600.00 105,000.00

Cumulative Taxes 952.50 4,453.50 14,089.50 32,089.50 45,689.50 150,689.50

Difference 19,050 58,350 87,600 150,000 85,000 200,000

Marginal Tax Rate 0.10 0.12 0.22 0.24 0.32 0.35 0.37

Incremental Taxes 1,905.00 7,002.00 19,272.00 36,000.00 27,200.00 70,000.00

Cumulative Taxes 1,905.00 8,907.00 28,179.00 64,179.00 91,379.00 161,379.00

+

1. [Business Organization and Intellectual Property] Phil Young, founder of the Pedal Pushers Company, has developed several prototypes of a pedal replacement for children’s bicycles.

The Pedal Pusher will replace existing bicycle pedals with an easy release stirrup to help smaller children hold their feet on the pedals. The Pedal Pusher will glow in the dark and will provide a musical sound as the bicycle is pedaled.

Phil plans to purchase materials for making the product from others, assemble the products at the venture’s facilities, and hire product sales representatives to sell the Pedal Pushers through local retail and discount stores that sell children bicycles. Phil will need to

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45

purchase plastic pedals and extensions, bolts, washers and nuts, reflective material, and a ―micro-chip‖ to provide the ―music‖ when the bicycle is pedaled.

A. How should Phil organize his new venture? In developing your answer consider such factors as amount of equity capital needed, business liability, and taxation of the venture.

Phil’s proposed business is not likely to be very capital intensive. That is, little investment will be required for equipment and a production facility. The investment in inventories can probably be kept relatively low. Thus, organizing as a proprietorship will probably work due to a need for relatively low amounts of equity capital. Being taxed as a proprietorship also may be advantageous. Of course, the major advantage to Phil by choosing to organize as a corporation is to limit his liability to his business investment. If Phil has substantial personal assets, organizing as a corporation would help protect these assets in the event the business fails.

B. Phil is concerned about trying to protect the intellectual property embedded in his Pedal Pusher product idea and prototype. How might Phil consider protecting his intellectual property?

Possible ways to protect his intellectual property might include: applying for a utility patent to protect his product; a utility patent to protect his design; and a trademark to protect his company name.

2. [Income Taxes] Assume your new venture, organized as a proprietorship, is in its first year of operation. You expect to have taxable income of $50,000. Use the income tax rate information contained in Figure 3.6 to estimate the amount of income taxes you would have to pay.

A. Calculate the amount of your income taxes if you were filing as a single individual.

Personal Marginal Tax Rate 0.10 x 0.12 x 0.22 x

Personal Taxable Income $ 9,525 = 29,175 = 11,300 = $50,000

Personal Amount of Taxes $952.50 3,501.00 2,486.00 $6,939.50

[Note: 38,700 - 9,525 = 29,175] [Note: 50,000 – 38,700 = 11,300]

Note: This problem assumes there are no additional sources of personal taxable income.

Table A also can be used to reduce the number of calculations. The cumulative taxes for taxable income of $38,700 are $4,453.50. Taxes on the additional $11,300 ($50,000 $38,700) at a 22% rate equal $2,486.00. Total personal federal income taxes would be $6,939.50 ($4,453.50 plus $2,486.00).

B. Calculate the amount of your income taxes if you were married and filing jointly.

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Chapter 6: Managing Cash Flow

Personal Marginal Tax Rate 0.10 x 0.12 x

Personal Taxable Income $19,050 = 30,950 = $50,000

Personal Amount of Taxes $1,905.00 3,714.00 $5,619.00

[Note: 50,000 – 19,050 = 30,950]

C. If your venture had been organized as a standard corporation instead of a proprietorship, calculate your income tax liability.

Corporate Flat Tax Rate 0.21 x

Corporate Taxable Income $50,000 =

Corporate Amount of Taxes $10,500.00

It is interesting to note that since the marginal income tax rate on income of $50,000 was only 15% under the 2017 tax law, the amount of taxes would have been only $7,500 (.15 x $50,000) versus the 21% flat tax rate in place in 2018. Of course, for taxable income above $50,000 all the 2017 marginal tax rates would have been greater than the 2018 corporate flat tax rate of 21%.

3. [Income Taxes] Rework problem 2 under the assumption that in addition to your venture’s taxable income of $50,000, you expect to personally earn another $10,000 from a second job.

A. Filing as a single individual: Personal Marginal Tax Rate 0.10 x 0.12 x 0.22 x

Personal Taxable Income $ 9,525 = 29,175 = 21,300 = $60,000

Personal Amount of Taxes $952.50 3,501.00 4,686.00 $9,139.50

[Note: 38,700 - 9,525 = 29,175] [Note: 60,000 – 38,700 = 21,300]

B. Married filing jointly: Personal Marginal Tax Rate 0.10 x 0.12 x

Personal Taxable Income $19,050 = 40,950 = $60,000

Personal Amount of Taxes $1,905.00 4,914.00 $6,819.00

[Note: 60,000 – 19,050 = 40,950]

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C. Taxed as a Corporation plus personal taxable income:

Corporate taxes:

Marginal Tax Rate 0.21 x

Taxable Amount Income of Taxes $50,000 = $10,500.00

If filing as a single individual, the additional personal taxes would be: 0.10 0.12

x x

9,525 475 10,000

= =

952.50 57.00 $1,009.50

Total income taxes would be $11,509.50 ($10,500 + $1,009.50).

If married filing jointly, the additional personal taxes would be: Personal taxes:

0.10

x

10,000

=

$1,000.00

Total taxes would be $11,500 ($10,500 + $1,000).

$

4. [Intellectual Property] As your venture has moved from the development stage to the startup stage, a number of trade secrets have been developed along with an extensive client list. You are in the business of developing and installing computer networks for law firms.

A. Your marketing manager has recently resigned and you are in the process of interviewing new candidates for the position. How might you try to protect your venture’s intellectual property since the marketing manager must have access to the trade secrets and client list?

Trade secrets are intellectual property rights in the form of inventions and information (e.g., formulas, processes, customer lists, etc.) not generally known to others. Trade secret misappropriations frequently involve ex-employees. At issue is whether the employee exits with, and makes use of, his/her former firm‘s trade secrets. You should inform the new marketing manager that any trade secrets that he/she will come in contact with belong to the firm and must not be taken if he/she leaves the firm. Of course, trying to prove misappropriations in court may be very costly.

B. Your operations manager has developed a ―new‖ process and you have heard that he plans to personally apply for a business methods patent. What action(s) would you take?

Employment contracts are agreements between an employer and an employee about the terms and conditions of employment, including the employee‘s agreement to maintain confidentiality and assign the rights for ideas and inventions to the employer. Assuming an employment contract was previously signed, you should inform the operations

48

Chapter 6: Managing Cash Flow manager that the ―new‖ process that was developed, if in the scope of the firm‘s activities, likely belongs to the firm and any application for a business methods patent should be on behalf of the firm.

All ideas, inventions, and other forms of intellectual property developed by the employee that are deemed within the scope of the venture‘s activities should be assigned to the firm. Of course, an employee‘s development of intellectual property not related to the venture‘s scope of business belongs to the employee.

5. [Income Taxes] The Capital-Ideas Company is in its development stage and is deciding how to formally organize its business venture. The founder, Rolf Lee, is considering organizing as either a proprietorship or as a corporation. He expects revenues to be $2 million next year with total expenses amounting to $1.625 million resulting in a taxable income of $375,000. Rolf is interested in estimating his federal income tax liability based on the schedules contained in Figure 3.6.

A. Calculate the amount of federal income tax that Rolf would pay if Capital-Ideas is organized as a proprietorship. What would be the marginal tax rate on the last dollar of taxable income and what would be the average tax rate?

Assume Rolf files as a single tax payer.

Personal Taxable Income Over But not over

9,525 38,700 82,500 157,500 200,000

9,525 38,700 82,500 157,500 200,000 375,000

Dollar Amount

Marginal Tax Rate

Amount of Taxes

9,525 10.0% 29,175 12.0% 43,800 22.0% 75,000 24.0% 42,500 32.0% 175,000 35.0% Total Tax Liability

952.50 3,501.00 9,636.00 18,000.00 13,600.00 61,250.00 $106,939.50

Marginal Tax Rate = 35.0% Average Tax Rate = $106,939.50/$375,000 = 28.5% Table A presented above can be used to reduce the number of calculations. The cumulative taxes for $200,000 are $45,689.50. The additional taxes on $175,000 ($375,000 - $200,000) at 35% are $61,250.00. Total taxes would be $106,939.50 ($45,689.50 + $61,250.00).

B. Calculate the amount of federal income tax that the Capital-Ideas Company would have to pay if the venture is organized as a regular corporation. What would be the marginal tax rate on the last dollar of taxable income and what would be the average tax rate?

2018 Corporate Tax Law $375,000 x .21 = $78,750.00 Total Tax Liability

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49

Since the corporate tax rate is a flat rate, the marginal tax rate and the average tax rate would each be 21.0%.

For instructors interested in illustrating what the total tax liability as a corporation would have been if the 2017 income tax rates had been in place in 2018, we provide the following: 2017 Corporate Tax Law Corporate Taxable Income Over But not over

Marginal Tax Rate

Tax Amount

0 50,000 50,000 75,000 75,000 100,000 100,000 335,000 335,000 375,000

15.0% 25.0% 34.0% 39.0% 34.0%

7,500.00 6,250.00 8,500.00 91,650.00 13,600.00

Total Tax Liability 127,500.00 Marginal Tax Rate = 34.0% Average Tax Rate = $127,500.00/$375,000 = 34.0% C. If the Capital-Ideas Company is organized as a corporation and all after-tax profits are paid out as dividends to Rolf Lee, what additional personal income taxes would be paid? What would be the marginal tax rate and the average tax rate on this personal income received from the corporation?

Note: it is assumed that these dividends received would be taxed at ordinary income tax rates.

Corporate Level: $375,000 (taxable income) – $78,750 (income taxes) = $296,250 (after-tax net income) Personal Level: $296,250 in dividend income Assume: Rolf files as a single tax payer

Personal Taxable Income Over

9,525 38,700 82,500

Dollar

Marginal

Amount

But not over

Amount

Tax Rate

of Taxes

9,525 38,700 82,500 157,500

9,525 29,175 43,800 75,000

10.0% 12.0% 22.0% 24.0%

952.50 3,501.00 9,636.00 18,000.00

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Chapter 6: Managing Cash Flow 157,500 200,000

200,000 296,250

42,500 32.0% 96,250 35.0%8 Total Tax Liability

13,600.00 33,687.50 $79,377.00

Marginal Tax Rate = 35.0% Average Tax Rate = $79,377.00/$296,250 = 26.8% Using Table A, the cumulative taxes for $200,000 is $45,689.50. Additional taxes on $96,250 ($296,250 - $200,000) at a 35% rate are $33,687.50. This results in total taxes of $79,377.00 ($45,689.50 + $ 33,687.50).

6. [Income Taxes] In the second year of operation, the Capital-Ideas Company forecasts revenues to grow to $5 million dollars, and expenses before income tax to be 70 percent of revenues. Rework Parts A, B, and C of Problem 5 to reflect this new level of revenues and expenses.

A. Earnings before taxes = $5,000,000 x (1 - 0.70) = $1,500,000. Taxed as a proprietorship filing as a single tax payer.

Over

9,525 82,500 157,500 200,000 500,000

But not over

9,525 38,700 82,500 157,500 200,000 500,000 1,500,000

Dollar

Marginal

Amount

Amount

Tax Rate

of Taxes

9,525 10.0% 29,175 12.0% 43,800 22.0% 75,000 24.0% 42,500 32.0% 300,000 35.0% 1,000,000 37.0% Total Tax Liability

952.50 3,501.00 9,636.00 18,000.00 13,600.00 105,000.00 370,000.00 $520,689.50

From Table A: Cumulative taxes for $500,000 in taxable income = $150,689.50 Additional taxes: ($1,500,000 - $500,000)(.37) = $1,000,000(.37) = $370,000.00 Total income taxes: $150,689.50 + $375,000.00 = $520,689.50 Marginal Tax Rate = 37.0% Average Tax Rate = $520,689.50/$1,500,000 = 34.7% B. Taxed as a corporation.

2018 Corporate Tax Law $1,500,000 x .21 = $315,000.00 Total Tax Liability C. Corporate Level: $1,500,000 (taxable income) – $315,000 (income taxes) = $1,185,000 after-tax net income)

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51

Personal Level: $1,185,000 in dividend income Assume: Rolf files as a single tax payer From Table A (for a single individual): Cumulative taxes for $500,000 in taxable income = $150,689.50 Additional taxes: ($1,185,000 - $500,000).37 = $685,000(.37) = $253,450.00 Total income taxes: $150,689.50 + $253,450.00 = $404,139.50 Marginal Tax Rate = 37.0% Average Tax Rate = $404,139.50/$1,185,000 = 34.1% 7. [Income Taxes] Rolf Lee is now exploring whether it might be better to organize the Capital-Ideas Company as a subchapter S corporation based on information contained in Problem 5.

A. Calculate the amount of federal income tax that Capital-Ideas Company would pay next year.

A Subchapter S corporation has the same tax liability as a proprietorship. Therefore, the federal income tax liability would be $106,939.50 (see Part A of Problem 5 above for calculations).

Alternatively, (using cumulative tax amounts from Table A): The cumulative taxes for $200,000 are $45,689.50. The additional taxes on $175,000 ($375,000 - $200,000) at 35% are $61,250.00. Total taxes would be $106,939.50 ($45,689.50 + $61,250.00).

B. What would be the marginal tax rate on the last dollar of taxable income and what would be the average tax rate?

A Subchapter S corporation has the same tax liability as a proprietorship. Therefore, the marginal tax rate will be 35.0% and the average tax rate will be 28.5% (see Part A of Problem 5 for calculations).

Marginal Tax Rate = 35.0% Average Tax Rate = $107,356.25/$375,000 = 28.5% 8. [Income Taxes] Rolf Lee is also considering organizing the Capital-Ideas Company as a limited liability company.

A. Use information contained in Problem 6 to estimate the federal income tax liability in the second year of operation if Capital-Ideas is an LLC. A limited liability company (LLC) has the same tax liability as a proprietorship.

Therefore, the federal income tax liability will be $520,689.50 (see Part A of Problem 6 for calculations).

52

Chapter 6: Managing Cash Flow Earnings before taxes = $5,000,000 x (1 - 0.70) = $1,500,000. The LLC will be taxed the same as a proprietorship filing as a single tax payer.

From Table A: Cumulative taxes for $500,000 in taxable income = $150,689.50 Additional taxes: ($1,500,000 - $500,000)(.37) = $1,000,000(.37) = $370,000.00 Total income taxes: $150,689.50 + $375,000.00 = $520,689.50 B. What would be the marginal tax rate on the last dollar of taxable income and what would be the average tax rate?

A limited liability corporation (LLC) has the same tax liability as a proprietorship.

See Part A of Problem 6 for calculations: Marginal Tax Rate = 37.0% Average Tax Rate = $520,689.50/$1,500,000 = 34.7%

9.

[Intellectual Property] Francine Delgado, founder of the HairCare Products Company, has developed HairCarePlus which is a shampoo product containing healthy nutrients that are absorbed through the scalp when the product is used. She also believes that preliminary tests of HairCarePlus show that product residues are environmentally safe.

A. Francine was wondering whether she might be able to patent the HairCarePlus product. What are the characteristics of patents and what type of patent, if any, might Francine seek?

Francine can certainly apply to receive patent protection. However, in order to obtain protection, she would have to prove the requirements for a patent. First it must be proven that the product is useful, non-obvious, and novel. Most likely, she will apply for a utility patent to protect the chemical combination forming her product. If the design and appearance of the bottle it is sold in fulfills the patent requirements, she may also seek protection for that.

B. What other ways, other than through patents, might Francine explore to try to protect the HairCarePlus product?

To further protect her product, she may also attempt to obtain a copyright for the brand name. Also, if she is unable to receive patent protection for her product, she can probably protect her invention through trade secret law.

SUPPLEMENTAL EXERCISES/PROBLEMS [Note: These activities are for readers with an existing understanding of financial statements.]

10.

[Income Taxes and Ratios] Francine Delgado has developed a business plan for producing and selling a new hair care product that emits nutrients to the scalp when used and the product residues have been judged to be environmentally safe. Following are

Chapter 6: Managing Cash Flow

53

her projected partial financial statements for the first three years of operation of the HairCare Products Company. Francine, however, is unsure whether to organize her business as a proprietorship or a regular corporation.

C. Use the tax rate schedules presented in the chapter to estimate the dollar amount of taxes that would have to be paid in each year by the HairCare Products Company if the venture was initially formed as a corporation. Also calculate the after-tax net income for each year.

Taxable Income 20,000

Taxable Income 90,000

YEAR 1 Flat Corp.

Tax Rate 21.0% Total Tax Liability

Tax Payable 4,200.00

Net Income

15,800.00

YEAR 2 Flat Corp.

Tax Rate 21.0% Total Tax Liability Net Income

Tax Payable 18,900.00

4,200.00

18,900.00 71,100.00

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Chapter 6: Managing Cash Flow

Taxable Income 776,000

YEAR 3 Flat Corp.

Tax Rate 21.0% Total Tax Liability Net Income

Tax Payable 162,960.00 162,960.00 613,040.00

D. Use the tax rate schedules presented in the chapter to estimate the dollar amount of taxes that would have to be paid in each year if the HairCare Products Company was organized as a proprietorship, represented Francine’s only source of income, and she was single. Also calculate the after-tax net income for each year.

Year 1: Earnings before taxes = $20,000 From Table A: Tax on first $9,525 x .10 = $952.50 Additional taxes: ($20,000 - $9,525)(.12) = $10,475(.12) = $1,257.00 Total taxes: $952.50 + $1,257.00 = $2209.50 Net income: $20,000 - $2,209.50 = $17,790.50 Year 2: Earnings before taxes = $90,000 From Table A: Cumulative tax on first $82,500 = $14,089.50 Additional taxes: ($90,000 - $82,500)(.24) = $7,500(.24) = $1,800.00 Total taxes: $14,089.50 + $1,800.00 = $15,889.50 Net income: $90,000 - $15,889.50 = $74,110.50 Year 3: Earnings before taxes = $776,000 From Table A: Cumulative tax on first $500,000 = $150,689.50 Additional taxes: ($776,000 - $500,000)(.37) = $226,000(.37) = $102,120.00 Total taxes: $150,689.50 + $102,120.00 = $252,809.50 Net income: $776,000 - $252,809.50 = $523,190.50 E. Use ratios from Chapter 2 to calculate the return on assets (ROA) model and its net profit margin and asset intensity ratios.

Assuming Taxed as a Corporation: Return on Assets = Net Profit/Total Assets YEAR 1 = $15,800/$100,000 = 15.80% YEAR 2 = $71,100/$200,000 = 35.55% YEAR 3 = $613,040.50/$800,000 = 76.63% Net Profit Margin = Net Profit/Revenues YEAR 1 = $15,800/$200,000 = 7.90% YEAR 2 = $71,100/$400,000 = 17.78% YEAR 3 = $613,040/$1,800,000 = 34.06% Asset Turnover = Revenues/Total Assets = YEAR 1 = $200,000/$100,000 = 2.00 YEAR 2 = $400,000/$200,000 = 2.00

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55

YEAR 3 =$1,800,000/$800,000 = 2.25

Assuming Taxed as a Proprietorship: Return on Assets = Net Profit/Total Assets YEAR 1 = $17,790.50/$100,000 = 17.79% YEAR 2 = $74,110.50/$200,000 = 37.06% YEAR 3 = $523,190.50/$800,000 = 65.40% Net Profit Margin = Net Profit/Revenues YEAR 1 = $17,790.50/$200,000 = 8.90% YEAR 2 = $74,110.50/$400,000 = 18.53% YEAR 3 = $523,190.50/$1,800,000 = 29.07% Asset Turnover = Revenues/Total Assets = YEAR 1 = $200,000/$100,000 = 2.00 YEAR 2 = $400,000/$200,000 = 2.00 YEAR 3 =$1,800,000/$800,000 = 2.25 F. In order to grow sales, HairCare Products will need to invest in assets to support sales growth. How might the venture’s assets be financed?

Since this is a development stage firm that is about to enter its startup stage, Francine will need to rely on her own personal assets, as well as possibly funds from family and friends. She may also be able to obtain funds from a business angel, or even funds from venture capitalists if they are attracted to her business plan.

G. Would you recommend that the HairCare Products Company be initially formed as a proprietorship or as a corporation? Why? Should Francine consider changing the form of business organization for the HairCare Products Company as the firm grows over time?

By forming the business as a proprietorship, Francine may incur a lower tax liability when the firm is in its startup stage. Based on the 2018 income tax laws, personal marginal income tax rates would be lower than the flat 21% corporate tax rate for smaller amounts of taxable income but personal marginal rates would be higher than the corporate tax rate for larger amounts of taxable income.

Several additional factors also should be considered when choosing how to organize the business venture. For example, if Francine has substantial personal assets, she could risk the loss of all these assets in the event she organizes as a proprietorship and the business fails. On the other hand, if the firm becomes wildly successful, she may need access to large amounts of financial capital which is best obtained through a regular or C corporation. A compromise might be to form as an S corporation or limited liability company (LLC) to achieve the limited liability of a corporation but to avoid the double taxation that comes along with it. A switch to a regular corporation could be made if the need for financial capital becomes very large.

56 11.

Chapter 6: Managing Cash Flow [Income Taxes and Ratios] Now let’s assume that Francine Delgado (see Problem 10) organizes the HairCare Products Company as a proprietorship, is married, and files a joint tax return with her husband, Franco.

1. Calculate the tax liability (using tax tables presented in the chapter) and net income in each of the three years for the HairCare Products Company assuming no other personal income or deductions.

Year 1: Earnings before taxes = $20,000 From Table A: Tax on first $19,050 = $1,905.00 Additional taxes: ($20,000 - $19,050)(.12) = $950(.12) = $114.00 Total taxes: $1,905 + $114.00 = $2,019.00 Net income: $20,000 - $2,019.00 = $17,981.00 Year 2: Earnings before taxes = $90,000 From Table A: Cumulative tax on first $77,400 = $8,907.00 Additional taxes: ($90,000 - $77,400)(.22) = $12,600(.22) = $2,772.00 Total taxes: $8,907.00 + $2,772.00 = $11,679.00 Net income: $90,000 - $11,679.00 = $78,321.00 Year 3: Earnings before taxes = $776,000 From Table A: Cumulative tax on first $600,000 = $161,379.00 Additional taxes: ($776,000 - $600,000)(.37) = $176,000(.37) = $65,120.00 Total taxes: $161,379.00 + $65,120.00 = $226,499.00 Net income: $776,000 - $226,499.00 = $549,501.00 2. For this proprietorship scenario, calculate and make ratio comparisons with the calculations in Part C of Problem 10.

Return on Assets = Net Profit/Total Assets YEAR 1 = $17,981.00/$100,000 = 17.98% YEAR 2 = $78,321.00/$200,000 = 39.16% YEAR 3 = $549,501.00/$800,000 = 68.69% Net Profit Margin = Net Profit/Revenues YEAR 1 = $17,981.00/$200,000 = 8.99% YEAR 2 = $78,321.00/$400,000 = 19.58% YEAR 3 = $549,501.00/$1,800,000 = 30.53% Asset Turnover = Revenues/Total Assets = YEAR 1 = $200,000/$100,000 = 2.00 YEAR 2 = $400,000/$200,000 = 2.00 YEAR 3 =$1,800,000/$800,000 = 2.25 3. Would you recommend that the venture be organized as a proprietorship or as a regular corporation? Why?

Chapter 6: Managing Cash Flow

57

By forming the business as a proprietorship, Francine may incur a lower tax liability when the firm is in its startup stage. However, if she has substantial personal assets, she could risk the loss of all these assets in the event she organizes as a proprietorship and the business fails. On the other hand, if the firm becomes wildly successful, she may need access to large amounts of financial capital which is best obtained through a regular or C corporation.

4. What other forms of business organization might Francine consider when forming the HairCare Products Company? What are their pros and cons?

Francine might consider forming her business as an S corporation or limited liability company (LLC) to achieve the limited liability of a corporation but to avoid the double taxation that comes along with it. While these organizations are somewhat restricted in the amount of financial capital that can be raised, a switch to a regular (C) corporation could be made if the need for financial capital becomes very large.

MINI CASE 1: INTERACT SYSTEMS, INC. (REVISITED) Interact Systems, Inc. has developed software tools that help hotel chains solve application integration problems. Interact‘s Application Integration Server (AIS) provides a two-way interface between central reservations systems (CRS) and property management systems (PMS).

At least two important trends in the hotel industry are relevant. First, hotels are shifting away from the manual booking of room reservations and electronic bookings will continue to increase as more bookings are made over the Internet. Second, competitive pressures are forcing hotels to implement yield management programs and to improve customer service. By integrating the CRS and PMS through Interact‘s AIS, inventories can be better managed, yields improved, and customer service enhanced.

All reservation traffic is routed from the CRS to individual hotel properties. This allows Interact Systems to create a database that can be used to track customers and to facilitate marketing programs, such as frequent stay or VIP programs, as a way of increasing customer satisfaction. Interact forecasts application integration expenditures in the hospitality industry to exceed $1 billion by 2021.

Greg Thomas founded Interact Systems in 2015 and developed the firm‘s middleware software and hospitality applications. He has twelve years of systems applications experience and currently is Interact‘s Chief Technology Officer. Eric Westskow joined Interact in early 2018 as President and CEO. Prior to that time, he worked in sales and marketing in the software industry for over twenty years.

K. What are the advantages of having formed the company as a corporation?

An important advantage relates to investor liability whereby liability is limited to shareholders‘ investments. Although there is high time and legal cost associated with organizing as a corporation, there is the possibility of attracting large amounts of equity capital from venture investors and common shareholders. The corporate form of organization also has an unlimited life and it is usually easy to transfer ownership.

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Chapter 6: Managing Cash Flow

L. What other organizational structures would have been appropriate?

Interact Systems might also have been organized as a Subchapter S (or just S) corporation or as a limited liability company (LLC). Both organizational forms limit investor liability to shareholders‘ investments (S corporation) or owners‘ investments (LLC). However, compared to a regular (C) corporation, the ability to attract large amounts of equity capital is limited and it is often difficult to transfer ownership.

M. Could Interact Systems qualify for S corporation status with the IRS? Why or why not?

Probably yes. An S corporation must have 100 or fewer owners (the previous limit was less than 75 owners). This is not likely a constraint for Interact Systems as long as very large amounts of equity capital are not needed during the early part of its life cycle. Furthermore, during startup and survival life cycle stages when ventures often lose money or make small profits, it may be advantageous to be taxed at personal income tax rates rather than paying corporate taxes on venture profits. An S corporation provides for income to flow directly to shareholders who are then taxed at their personal tax rates N. What is the intellectual property involved in Interact Systems’ business model?

Interact Systems has developed software tools and programs that help hotel chains solve application integration problems through its Application Integration Server (AIS). The AIS provides a two-way interface between central reservations systems (CRS) and property management systems (PMS) that could lead to improved inventories management, higher yields, and customer service enhancements. Customers can be tracked and frequent stayrelated marketing programs can be developed to enhance customer satisfaction.

O. What methods of protection are available for Interact Systems’ intellectual property?

Intellectual property can be protected through (a) patents, (b) trade secrets, (c) trademarks, and (d) copyrights. Interact Systems might be able to seek ―utility‖ patents on its computer software programs. However, because most software products are copyrighted, Interact might consider obtaining copyrights on its intellectual property. Interact Systems does not seem to possess any trade secrets. However, it might also be possible to establish trademarks in general or registered ® relating to the venture‘s software products. In the end, efforts to copyright the software programs may be Interact‘s primary opportunity to protect its intellectual property.

P. What considerations are important in deciding whether to use an employment contract for the newly hired CEO? Eric Westskow joined Interact as CEO and president in early 2018. Greg Thomas had founded Interact Systems in 2015 and was responsible for developing the venture‘s software and hospitality applications. Since it is unclear as to whether existing software programs (intellectual properties) are protected, or the extent to which they may be undergoing changes

Chapter 6: Managing Cash Flow

59

and improvements, an employment contract with the new CEO would seem to be important.

Employment contracts are agreements between an employer and employee about the terms and conditions of employment. Of particular importance is the employee‘s agreement to keep confidential information secret and to assign ideas and inventions to the employer. The CEO would need to fully understand the venture‘s existing software products and new products under development. Interact would, in turn, want to protect its intellectual property in the event the CEO leaves the venture.

MINI CASE 2: COOPERATIVE CONSTRUCTS PART A Several years ago, Dick and Barbara Harris were asked to attend an organizational meeting for a newly-forming neighborhood baby-sitting cooperative. The idea was simple. Concerned and caring parents would join together in the cooperative and exchange baby sitting services.

Although they were not particularly interested in committing to trading baby sitting favors as their children were quickly approaching the age where babysitting services would be unnecessary, Dick and Barbara felt socially obliged to attend the meeting with their two children.

Eight other families came to the meeting.

After a brief period of social exchange, Dick and Barbara listened, as much as possible over the din of children playing, to the organizer, a CPA, explain how the formal accounting for exchanged sitting services would take place. Using specially marked, yet ordinary, poker chips as currency, members of the cooperative would receive an endowment of chips with various colors corresponding to an hour, 30 minutes, and 15 minutes. When baby-sitting services were received, payment was required, rounded to the nearest 15 minutes, in poker chips.

Conveniently, no family would need to keep records of whom or how much they owed. With the creation of baby-sitting currency and some serious remarks about screening other families prior to allowing them to join, the cooperative was launched although Dick and Barbara declined to join.

Reflecting on some bad previous experiences with not-for-profit organizations, the couple debated on the drive home what could be done to satisfy their concerns. Dick was wondering how the organization could formally barter services among themselves without organizing as a formal barter exchange and recognizing the receipt of poker chips as income.

Barbara was more concerned about babysitting for, or by, parents with which she had only a passing acquaintance. Even if the barter arrangement were shielded from taxation (an item also not discussed), they both contemplated who would be liable in the event of mishaps.

A. What type of an organization is necessary for the babysitting cooperative?

Although it is possible that the informally organized cooperative might be deemed an ―association‖ and thereby afforded some protection under state laws, it would be wise to seek legal counsel and formally organize, possibly even as a not-for-profit corporation. Other types of organization shielding the participants from liabilities for the acts of each other may also be worth considering.

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Chapter 6: Managing Cash Flow

B. Is there potential for liability for members other than those directly involved?

There is almost always potential liability for members unless they have organized in such a way to limit such liability. Of particular concern here is that members are performing a screening function and thereby authorizing some (and consequently not others) to exchange in the barter of babysitting services. This could open the door to liability for the acts of those admitted to the cooperative.

C. What are the non-tax differences between exchanging poker chips and charging $4 per hour?

The currency (poker chip) is really just a type of accounting for a joint liability of the many to the individual chip owner. It acts as a medium of exchange only for babysitting services.

The chips use as a currency is doubtful although there is no mention of agreements by participants not to buy and sell the chips. It is possible that when the chips can‘t be bought or sold that they may have a value that varies from time to time and may involve psychological costs as well as monetary value for the exchanged services. (Seeing a huge stack of chips may make some members feel guilty that one family is providing all of the services and deserves some concessions).

D. What is the difference between exchanging poker chips and charging $4 per hour from the perspective of the Internal Revenue Service (IRS)?

Possibly none! Assuming that the IRS were to bother to consider the cooperative at all, it would most likely be considered a type of barter exchange. Consequently, the exchange of chips would be treated as the exchange of services and the IRS would look to the substance rather than the form of the exchange. In barter exchanges, a fair market value (monetary equivalent) is imputed to the exchange.

E. Assuming you had appropriately aged children, would you be willing to join the cooperative?

Answers will vary according to students‘ understanding of the problem and the issues.

F. What, if any, are the intellectual property issues in an isolated cooperative?

In a given neighborhood or concentrated geographic area, there may be a ―natural monopoly‖ due to the notion that cooperatives need to be big enough to provide services on relatively short notice and throughout the week. Presuming that one cooperative in the area gets a functioning barter system and the highly desirable caregivers, then those would be assets to protect from plunder by an upstart competing cooperative or even a fee-for-service competitor (freelancing teenager).

PART B The organizers for Dick and Barbara‘s cooperative had great success and many inquiries from other neighborhoods on how to organize and operate. After helping several other groups organize, the time commitment grew to the point where the organizers decided to form a

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consulting practice, Cooperative Constructs, and charge fees for providing advice and materials to startup cooperatives. Based on its extensive experiences, Cooperative Constructs had accumulated many stories and experiences and some legal documents. After contracting a videographer to tape one of its organization sessions, a startup package with video and boilerplate agreement documents was ready for distribution.

A. Discuss different organizational structures for Cooperative Constructs and their (dis)advantages.

In this phase of CC‘s execution, it is even more critical that it be formally organized. It is now advocating the formation of cooperatives to outsiders and making materials publicly available. The potential for personal liability for the founders increases dramatically.

B. Identify the Cooperative Construct’s intellectual property.

Clearly, the cooperative‘s techniques, videos, materials and even approach are all aspects of its intellectual property. Which aspects are worth attempting to protect is a good question for legal counsel.

C. What intellectual property protection is appropriate for their materials, organization name, and approach?

Presumably, the videos and written materials would be easy to copyright. The entity and approach may also be a candidate for (registered) trademark status.

Chapter 4 PREPARING AND USING FINANCIAL STATEMENTS

FOCUS In this chapter, we introduce basic accounting and financial statements designed to help ventures monitor their progress. We stress the need to understand how cash is built and burned both in terms of financial statements and through operating breakeven analyses.

LEARNING OBJECTIVES LO 4.1: Describe the process for obtaining and recording resources needed for an early-stage venture.

LO 4.2: Describe and prepare a basic balance sheet.

LO 4.3: Describe and prepare a basic income statement.

LO 4.4: Briefly describe two important internal operating schedules: the cost of production schedule and the inventories schedule.

LO 4.5: Prepare a cash flow statement and explain how it helps monitor a venture‘s cash position.

LO 4.6: Describe operating breakeven analysis in terms survival revenues and identify major drivers on the amount of revenues needed to survive.

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LO 4.7: Describe operating breakeven analysis in terms of NOPAT breakeven revenues (Appendix A).

CHAPTER OUTLINE 4.1 4.2

4.3 4.4 4.5 4.6

OBTAINING AND RECORDING THE RESOURCES NECESSARY TO START AND BUILD A NEW VENTURE BUSINESS ASSETS, LIABILITIES, AND OWNERS‘ EQUITY A. Balance Sheet Assets B. Liabilities and Owners‘ Equity SALES, EXPENSES, AND PROFITS INTERNAL OPERATING SCHEDULES STATEMENT OF CASH FLOWS OPERATING BREAKEVEN ANALYSES A. Survival Breakeven B. Identifying Breakeven Drivers in Revenue Projections SUMMARY APPENDIX A: NOPAT Breakeven: Revenues Needed to Cover Total Operating Costs

DISCUSSION QUESTIONS AND ANSWERS 1. Describe the types of resources (assets) needed for a new product venture during its development and startup stages. Comment on the likely revenues and expenses during these early life cycle stages.

Refer to: Figure 4.1 Obtaining and Recording the Resources Necessary to Start and Build a New Venture Development Stage in Life Cycle: Assets: acquire initial assets (e.g., initial cash, office furniture, computer, etc.)

Revenues: no sales (consequently no money is coming in) Expenses: e.g., rent, utilities, subsistence salary for entrepreneur Startup Stage in Life Cycle: Assets: acquire production assets (e.g., inventories and equipment to produce products and give credit to customers) Revenues: making sales (money begins flowing in) Expenses: additional expenses to produce and market products and to record business transactions 2. What is accrual accounting? What are generally accepted accounting principles (GAAP)?

Accrual accounting is the practice of recording economic activity when it is recognized rather than waiting until it is realized.

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Generally accepted accounting principles (GAAP) are guidelines that set out the manner and form for presenting accounting information.

3. What is meant by the statement that a balance sheet provides a ―snapshot‖ of a venture’s financial position as of a point in time? Why must a balance sheet be in ―balance?‖ A balance sheet is known as a ―snapshot‖ because it is the value of all the accounts at a certain point in time. A balance sheet must be in balance because the amount of total assets must be equivalent to the sum of the firm‘s total liabilities and the owner‘s equity.

4. Briefly describe the typical types of accounts that are found in the current assets of a new venture.

Typical current asset accounts are cash, which includes cash accounts and marketable securities, accounts receivable, inventory and other current assts.

5. What is meant by the terms ―depreciation‖ and ―accumulated depreciation‖?

Depreciation refers to the amount of decrease in value of the firm‘s long-term depreciable assets based on a preset schedule of the individual assets. Accumulated depreciation is the accrued amount of depreciation the firm has on its existing assets.

6. What types of liabilities might show up on a venture’s balance sheet?

Liabilities might include: payables, accrued wages, bank loan, other current liabilities, longterm debts, and capital leases.

7. What does an income statement measure or track over time?

The income statement is a performance measure of a firm‘s operations over a period of time.

Many different accounts that make up the income statement are used to determine trends in costs and revenues.

8. Define the term ―EBIT.‖ How does EBIT differ from a firm’s net income or net profit?

EBIT is defined as the earnings of a company before accounting for any interest expense/income and the taxes to be paid. Net income results from subtracting interest expense and taxes from EBIT. 9. What are the three internal operating schedules that most firms must prepare?

The three internal operating schedules prepared by most firms are the ―cost of production schedule‖, the ―cost of goods sold schedule‖ and the ―inventories schedule.‖ 10. Briefly describe what is meant by a statement of cash flows.

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A statement of cash flows shows how cash, as reflected in accrual accounting, flowed into and out of a company during a specific period of operation.

11. What is meant by net cash build and net cash burn?

Net Cash Build: exists when the sum of cash flows from operations and investing is positive Net Cash Burn: occurs when the sum of cash flows from operations and investing is negative 12. Describe the differences between variable expenses and fixed expenses.

Variable expenses depend upon the level of production while fixed expenses are items that are independent from production levels and will be incurred regardless.

13. Define the term EBITDA. The acronym EBITDA stands for earnings before interest, taxes, depreciation, and amortization.

14. What is a venture’s contribution profit margin?

Contribution profit margin is the portion of the sale of a product that contributes to covering the fixed costs.

15. Define the term EBDAT. EBDAT is a firm‘s earnings before taxes, depreciation and amortization.

16. Describe the meaning of EBDAT breakeven and survival revenues.

EBDAT breakeven occurs when the firm‘s survival revenues cover all of its cash expenses.

17. Describe and illustrate how an EBDAT (survival) breakeven chart is constructed.

Refer to Figure 4.2. Costs and revenues are plotted on the vertical axis and revenues (in dollars and/or units) are plotted on the horizontal axis. Breakeven (in dollars or unit sales) exists when the total costs curve and the total revenues curve intersect or cross.

18. What is meant by breakeven drivers? Identify two important drivers affecting the amount of revenues needed for ventures to break even.

Breakeven drivers are key elements of the firm‘s financial statements that affect breakeven.

Two important drivers are the VCRR/contribution profit margin and the amount of fixed costs.

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19. From the Headlines -- ―Competing to Let the Light Shine‖: Describe three financial performance measures that d.light’s venture investors might use to examine whether d.light is measuring up financially as it achieves its ―lives touched‖ goals.

Answers will vary widely: Margins (revenues vs. costs) will be critical in providing the necessary internal capital to fund d.light‘s growth. In terms of overall efficiency, d.light will need to monitor its inventory levels and breakeven levels as it introduces new products or enhances the functionality of existing ones. With venture capital backers, d.light has no choice other than to watch all of the usual financial return measures (Net Income, growth of Net Income, and returns to investors).

INTERNET ACTIVITIES 1.

A number of Web sites are available to help young ventures to measure their financial performance and to help them when they are growing and ―ramping up‖ revenues. Access the http://money.cnn/magazines/business2/ Web site and identify sources helpful to growing firms.

Web-researched results vary due to constant updating of the related web sites.

2.

Access the Small Business Administration Web site at http://www.sba.gov and find information on estimating start-up costs, preparing financial statements, and conducting breakeven analysis.

SBA provided information can be compared and integrated with the materials presented in this chapter.

3.

Access the Nolo Press Web site at http://www.nolo.com, and other publishers’ Web sites, and identify software products designed to help the young venture with its legal and accounting problems.

Web-researched results vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS 1.

[Stockholders’ equity] The owners of a new venture have decided to organize as a corporation. The initial equity investment is valued at $100,000 reflecting contributions of the entrepreneur and her family and friends. One hundred thousand shares of stock were initially issued.

A. What dollar amount would initially be recorded in the common stock account?

Common stock (initial investment)

$100,000

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B. If a par value on the common stock was set at $.01 per share, show how the initial equity investment would be recorded.

C. Now assume that 20,000 additional shares of stock are sold to an angel investor at $5 per share six months after the initial incorporation. Show how your answer in Part A would change if the common stock did not have a par value. Also show how your answer in Part B would change given a par value of $.01 per share.

D. At the end of the first year of operation, the venture recorded an operating loss of $80,000. Show the dollar amounts in the common stock account, the additional paid-incapital account, and the retained earnings account at the end of one year. Also indicate the cumulative amount in stockholders’ equity at the end of one year.

2.

[Internal Operating Schedules] Assume you are starting a new business involving the manufacture and sale of a new product. Raw materials costs are $40 per product. Direct labor costs are expected to be $30 per product. You expect to sell each product for $110.

You plan to produce 100 products next month and expect to sell 90 products.

A. Prepare cost of production, cost of goods sold, and inventories schedules for next (the first) month.

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B. During the second month, you plan to produce 110 products but expect sales in the month to be 115 products. Prepare cost of production, cost of goods sold, and inventories schedules for the second month.

Note: the solutions for Part B are shown in Part A for Month 2.

3. [Internal Operating Schedules] Assume you have developed and tested a prototype electronic product and are about to start your new business. You purchase pre-programmed computer chips at $70 per unit. Other component costs include: plastic casings at $15 per unit and assembly hardware at $5 per unit. Direct labor costs are $15 per hour and three units can be produced per hour. You intend to sell each unit at a 50 percent mark-up over the total costs of producing each unit. The plan is to produce 500 product units per month in January, February, and March. Sales are expected to be: 200 units in January, 400 units in February, and 800 units in March.

A. Calculate the dollar amount of sales revenue expected in each month (i.e., January, February, and March) and for the first quarter of the year.

B. Prepare a cost of production schedule for January, February, and March.

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Cost of Production Schedule: Cost Per Unit Production (units) Production costs Computer chips $70 Plastic casings 15 Assembly hardware 5 Direct labor 5 Total costs $95

January 500

February 500

March 500

$35,000 7,500 2,500 2,500 $47,500

$35,000 7,500 2,500 2,500 $47,500

$35,000 7,500 2,500 2,500 $47,500

C. Prepare a cost of goods sold schedule for each of the three months and for the first quarter of the year. Using your cost of goods sold estimates and the sales revenues expected in Part A, calculate the gross earnings for January, February, and March, as well as for the first quarter of the year.

Cost of Goods Sold Schedule: January Sales (units) 200 Costs @ $95/unit $19,000

February 400 $38,000

March 800 $76,000

Total 1,400 $133,000

Gross Earnings Estimate: Sales (dollars) Less: cost of goods sold Gross earnings

$57,000 38,000 $19,000

$114,000 76,000 $38,000

$199,500 133,000 $66,500

$28,500 19,000 $9,500

D. Prepare an inventories schedule for January, February, and March.

Inventories Schedule: Beginning finished goods Production Materials Direct labor Additions Total (beg. + additions) Less: cost of goods sold Ending finished goods 4.

January $0

February $28,500

March $38,000

$45,000 2,500 47,500 47,500 19,000 $28,500

$45,000 2,500 47,500 76,000 38,000 $38,000

$45,000 2,500 47,500 85,500 76,000 $9,500

[Internal Operating Schedules] This problem is a continuation of Problem 3. Assume you ramp up production to 1,000 units per month in April, May, and June. Sales are expected to be 800 units in April and 1,100 units in each of May and June. Repeat the calculations requested in Problem 3 for the second quarter of the year (April, May, and June).

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A. Calculate the dollar amount of sales revenue expected in each month (i.e., April, May, and June) and for the second quarter of the year.

Computer chips Plastic casings Assembly hardware Direct labor ($15/3) Total costs

$70 15 5 5 $95

Mark-up = $95(1.5) = $142.50 Dollar Sales: April : 800 units x $142.50 = May : 1,100 units x $142.50 = June: 1,100 units x $142.50 = Second Quarter

$114,000 $156,750 $156,750 $427,500

B. Prepare a cost of production schedule for April, May, and June.

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C. Prepare a cost of goods sold schedule for each of the three months and for the second quarter of the year. Using your cost of goods sold estimates and the sales revenues expected in Part A, calculate the gross earnings for April, May, and June, as well as for the second quarter of the year.

D. Prepare an inventories schedule for April, May, and June.

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[Survival Revenues Breakeven] During its first year of operations, the SubRay Corporation produced the following income statement results:

Costs of goods sold are expected to vary with sales and be a constant percentage of sales. The general and administrative employees have been hired and are expected to remain a fixed cost.

Marketing expenses are also expected to remain fixed since the current sales staff members are expected to remain on fixed salaries and no new hires are planned. The effective tax rate is expected to be 30 percent for a profitable firm.

A. Estimate the survival or EBDAT breakeven amount in terms of survival revenues necessary for the SubRay Corporation to breakeven next year.

Survival revenues (SR), when EBDAT = 0, are calculated as: VCRR = (VC/R) = $180,000/$300,000 = .60 CFC = general and administrative + marketing + interest expense = $60,000 + $60,000 + $10,000 = $130,000 SR = [$130,000/(1 - .60)] = $130,000/.40 = $325,000

B. Assume that the product selling price is $50 per unit. Calculate the EBDAT breakeven point in terms of the number of units that will have to be sold next year.

Survival revenues (SR) for a zero EBDAT from Part A = $325,000 $325,000/ $50 = 6,500 units

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6. [Statement of Cash Flows and Cash Burn or Build] Cindy and Robert (Rob) Castillo founded the Castillo Products Company in 2018. The company manufactures components for personal decision assistant (PDA) products and for other hand-held electronic products.

Year 2018 proved to be a test of the Castillo Products Company’s ability to survive.

However, sales increased rapidly in 2019 and the firm reported a net income after taxes of $75,000. Depreciation expenses were $40,000 in 2019. Following are the Castillo Products Company’s balance sheets for 2018 and 2019.

A. Calculate Castillo’s cash flow from operating activities for 2019.

See spreadsheet calculations below.

B. Calculate Castillo’s cash flow from investing activities for 2019.

See spreadsheet calculations below.

C. Calculate Castillo’s cash flow from financing activities for 2019.

See spreadsheet calculations below.

D. Prepare a formal statement of cash flows for 2019 and identify the major cash inflows and outflows that were generated by the Castillo Company.

See spreadsheet calculations below.

E. Use your calculation results from Parts A and B above to determine whether Castillo was building or burning cash during 2019 and indicate the dollar amount of the cash build or burn.

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See spreadsheet calculations below.

F. If Castillo had a net cash burn from operating and investing activities in 2019 divide the amount of burn by 12 to calculate an average monthly burn amount. If the 2020 monthly cash burn continues at the 2019 rate, indicate how long in months it will be before the firm runs out of cash if there are no changes in financing activities.

CASTILLO PRODUCTS COMPANY Note: Because Retained Earnings increased by only $40,000 and Net Income was $75,000, Cash Dividends paid must have been $35,000.

Parts A-D: Statement of Cash Flows ($ Thousands) 2019 Cash from Operating Activities: Net income 75 Depreciation 40 Increase in accounts receivable -80 Increase in inventories -100 Increase in accounts payable 30 Increase in accrued liabilities 20 Net from Operating Activities -15 Cash from Investing Activities: Increase in gross fixed assets Net from Investing Activities Cash from Financing Activities: Increase in bank loan Increase in long-term debt Cash dividends paid Net from Financing Activities Total net cash increase (decrease) Cash at beginning of period Total net cash increase (decrease) Cash at end of period

-90 -90

10 100 -35 75 -30 50 -30 20

Part E: Operating activities (-15) + Investing activities (-90) = -105 (annual net cash burn) Part F: per Monthly burn rate = annual burn/12 -8.75 month Time to Out of Cash = Cash/Mthly Burn 2.3 months

7. [Variable Expenses and Survival Revenues Breakeven] The Castillo Products Company described in Problem 6 had a very difficult operating year in 2018 resulting in a net loss of

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A. Calculate each income statement item for 2018 as a percent of the 2018 sales level.

Make the same calculations for 2019. Determine which cost or expense items varied directly with sales for the two-year period?

See spreadsheet calculations below.

B. Use the information in Part A to classify specific expense items as being either variable or fixed expenses. Then estimate Castillo’s EBDAT breakeven in terms of survival revenues if interest expenses had remained at the 2018 level ($45,000) in 2019.

See spreadsheet calculations below.

C. Estimate the dollar amount of survival revenues actually needed by the Castillo Products Company to reach EBDAT breakeven in 2019 given that more debt was obtained and interest expenses increased to $60,000.

See spreadsheet calculations below.

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8. [Statement of Cash Flows and Cash Burn or Build] Salza Technology Corporation increased its sales from $375,000 in 2018 to $450,000 in year 2019 as is shown in the firm‘s income statements presented below. LeAnn Sands, chief executive officer (CEO) and founder of the firm expressed concern that the cash account and the firm‘s marketable securities declined substantially between 2018 and 2019. Salza‘s complete balance sheets are also shown below.

Ms. Sands is seeking your assistance in the preparation of a statement of cash flows for Salza Technology.

A. Prepare a statement of cash flows for 2019 for the Salza Technology Corporation.

See spreadsheet calculations below.

B. Provide a brief description of what happened in terms of cash flows (both inflows and outflows) for Salza between years 2018 and 2019.

See spreadsheet calculations below.

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C. Use your calculations from Part A for cash flows from operating and investing activities to indicate the extent to which Salza was building or burning cash in 2019.

See spreadsheet calculations below.

D. Convert the 2019 annual cash build or cash burn to a monthly rate. If cash flow activities relating to operations and investing for 2019 continue into 2020, indicate: (1) how long it will be before Salza runs out of cash (if Salza is burning cash), or (2) the expected 2020 year-end cash account balance if Salza is building cash. Assume no changes in cash flows from financing activities in 2020 for calculation purposes.

See spreadsheet calculations below.

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9. [Survival Revenues Breakeven] LeAnn Sands wants to conduct operating breakeven analyses of the Salza Technology Corporation for year 2019. Income statement information is shown in Problem 8. For year 2019, the firm’s cost of goods sold is considered to be variable costs and operating expenses are considered to be fixed cash costs. Depreciation expenses in year 2019 also are expected to be fixed costs. Calculate Salza’s EBDAT breakeven in terms of survival revenues for year 2019.

Variable costs: Cost of goods sold/Net sales = 270/450 = 60.0% Fixed costs: Operating expenses (46) and interest (4) = 50 EBDAT breakeven = 50/(1 - .60) = 50/.40 = 125 survival revenues (SR) 10. [Survival Revenues Breakeven] LeAnn Sands has reason to believe that year 2020 will be a replication of year 2019 except that cost of goods sold are expected to be 65 percent of the estimated $450,000 in revenues. Other income statement relationships are expected to remain the same in year 2020 as they were in year 2019. Calculate the EBDAT breakeven point for 2020 for Salza in terms of survival revenues.

Projected variable cost ratio: 65.0% Fixed costs: Operating expenses (46) and interest (4) = 50 EBDAT breakeven = 50/(1 - .65) = 50/.35 = 142.86 survival revenues (SR) MINI CASE: JEN AND LARRY’S FROZEN YOGURT COMPANY In 2019, Jennifer (Jen) Liu and Larry Mestas founded Jen and Larry‘s Frozen Yogurt Company, which was based on the idea of applying the microbrew or microbatch strategy to the production and sale of frozen yogurt. [The involved reader may recall that we first introduced this yogurt venture in the problems section at the end of Chapter 2.] Jen and Larry began producing small quantities of unique flavors and blends in limited editions. Revenues were $600,000 in 2019 and were estimated at $1.2 million in 2020.

Because Jen and Larry were selling premium frozen yogurt containing premium ingredients, each small cup of yogurt sold for $3 and the cost of producing the frozen yogurt averaged $1.50 per cup. Administrative expenses, including Brandie‘s salary and expenses for an accountant and two other administrative staff, were estimated at $180,000 in year 2020.

Marketing expenses, largely in the form of behind-the-counter workers, in-store posters, and advertising in local newspapers, were projected to be $200,000 in year 2020.

An investment in bricks and mortar was necessary to make and sell the yogurt. Initial specialty equipment and the renovation of an old warehouse building in Lower Downtown (known as LoDo) occurred at the beginning of 2019 and additional equipment needed to make the amount of yogurt forecasted to be sold in 2020 was purchased at the beginning of 2020. As a result, depreciation expenses were expected to be $50,000 in year 2020. Interest expenses were estimated at $15,000 in 2020. The average tax rate was expected to be 25 percent of taxable income.

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Note: For analysis and reference purposes Jen and Larry‘s Frozen Yogurt Company income statements and answers for (A) through (J) are shown below in spreadsheet format which should be referred to for answer details.

A. How many cups of frozen yogurt would have to be sold in order for the firm to reach its projected revenues of $1.2 million? $1,200,000/$3.00 per cup = 400,000 cups B. Calculate the dollar amount of EBDAT if Jen and Larry’s Frozen Yogurt Company achieves the forecasted $1.2 million in sales for year 2020. What would EBDAT be as a percent of revenues?

EBDAT = EBITDA – Interest = $220,000 - $15,000 = $205,000 EBDAT/Sales = $205,000/$1,200,000 = 17.08% C. Jen and Larry believe that under a worst-case scenario yogurt revenues would be at the 2019 level of $600,000 even after plans and expenditures were put in place to ramp up revenues in year 2020. What would happen to the venture’s EBDAT? See spreadsheet output for details.

EBDAT = -$80,000 - $15,000 = -$95,000 D. Jen and Larry also believe that under very optimistic conditions that yogurt revenues could reach $1.5 million in year 2020. Show what would happen to the venture’s EBDAT if this were to happen.

See spreadsheet output for details.

EBDAT = $370,000 - $15,000 = $355,000 E. Calculate the EBDAT breakeven point for year 2020 in terms of survival revenues for Jen and Larry’s Frozen Yogurt Company. How many cups of frozen yogurt would have to be sold to reach EBDAT breakeven?

EBDAT breakeven: SR = [CFC/(1 – VCRR) = $395,000/(1 - $600,000/$1,200,000) = $395,000/.500 = $790,000 Cups: $790,000/$3.00 = 263,333.33 cups F. Show what would happen to the EBDAT breakeven in terms of survival revenues if the cost of producing a cup of yogurt increased to $1.60 but the selling price remained at $3.00 per cup. How would the EBDAT breakeven change if production costs declined to $1.40 per cup when the yogurt selling price remained at $3.00 per cup?

1. SR = $395,000/(1 - .533) = $395,000/.467 = $845,824 (spreadsheet solution = $846,429)

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SR = $425,000/(1 - .500) = $425,000/.500 = $850,000 H. Now assume that due to competition, Jen and Larry must sell their Frozen Yogurt for $2.80 per cup in year 2020. The cost of producing the yogurt is expected to remain at $1.50 per cup and cash fixed costs are forecasted to be $395,000 ($180,000 in administrative, $200,000 in marketing, and $15,000 in interest expenses). Depreciation expenses and the tax rate are also expected to remain the same as projected in the initial discussion of Jen and Larry’s venture. Calculate the EBDAT breakeven point in terms of survival breakeven revenues.

SR = $395,000/(1 - .536) = $395,000/.464 = $851,293 (spreadsheet solution = $850,769)

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APPENDIX A: NOPAT Breakeven: Revenues Needed to Cover Total Operating Costs DISCUSSION QUESTIONS AND ANSWERS

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1. Define the terms EVA and NOPAT and describe the meaning of NOPAT breakeven and NOPAT breakeven revenues.

Economic Value Added is a measure of a firm‘s economic profit over a certain period of time. The two major components of EVA are the firm‘s net operating profit after taxes (NOPAT) and the aftertax dollar cost of financial capital used.

NOPAT breakeven is when EBIT is equal to zero. NOPAT breakeven revenues is the amount of revenues needed to cover a venture‘s total operating costs.

2. Identify and explain the formula for finding the NOPAT breakeven revenues. Relate this to breakeven in terms of EBIT. NOPAT breakeven revenues are calculated by dividing the total operating fixed costs by one minus the variable cost revenue ratio. Total operating fixed costs consist of cash operating fixed costs (excluding interest expenses) plus noncash fixed costs (e.g., depreciation). NOPAT breakeven coincides with EBIT = 0.

EXERCISES/PROBLEMS

1. Refer to Problem 5 in the chapter involving the SubRay Corporation.

A. Estimate the NOPAT breakeven amount in terms of revenues necessary for the SubRay Corporation to break even next year.

NOPAT breakeven revenues (NR) equals the amount of revenues needed to cover total operating costs.

Total operating fixed costs (TOFC) = cash operating fixed costs (excluding interest expenses) + noncash fixed costs (e.g., depreciation).

TOFC = general and administrative + marketing + depreciation = $60,000 + $60,000 + $20,000 = $140,000 NR = $140,000/(1 - .60) = $140,000/.40 = $350,000

B. Assume that the product selling price is $50 per unit. Calculate the NOPAT breakeven point in terms of the number of units that will have to be sold next year.

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NOPAT revenues (NR) for a zero NOPAT from Part A = $350,000 $350,000/ $50 = 7,000 units 2. Refer to Problems 9 and 10 in the chapter involving the Salza Technology Corporation (see Problem 8 for the firm’s financial statements).

A. Calculate Salza’s NOPAT breakeven in terms of NOPAT breakeven revenues for year 2019.

Variable costs: Cost of goods sold/Net sales = 270/450 = 60.0% TOFC = operating expenses (46) and depreciation (30) = 76 NOPAT breakeven = 76/(1 - .60) = 76/.40 = 190 NOPAT revenues (NR) B. Calculate the NOPAT breakeven point for 2020 for Salza in terms of NOPAT breakeven revenues.

Projected variable cost ratio: 65.0% TOFC = operating expenses (46) and depreciation (30) = 76 NOPAT breakeven = 76/(1 - .65) = 76/.35 = 217.14 NOPAT revenues (NR) 3. Refer to the Mini Case at the end of the chapter involving Jen and Larry’s Frozen Yogurt Company.

A. Calculate the dollar amount of NOPAT if Jen and Larry’s venture achieves her forecasted $1.2 million in sales in year 2020. What would NOPAT be as a percent of sales?

NOPAT = EBIT(1 - tax rate) = $170,000(1 - .25) = $170,000(.75) = $127,500 NOPAT/Sales = $127,500/$1,200,000 = 10.63% B. Calculate the NOPAT breakeven point for year 2020 in terms of NOPAT breakeven revenues for Jen and Larry’s venture. How many cups of frozen yogurt would have to be sold to reach NOPAT breakeven?

NOPAT breakeven: NR = TOFC/(1 – VCRR) = $430,000/(1 - $600,000/$1,200,000) = $430,000/.500 = $860,000 Cups: $860,000/$3.00 = 286,667 cups NOPAT breakeven revenues NR = $430,000/(1 - .536) = $430,000/.464 = $926,724 (spreadsheet solution = $926,154) Chapter 5 EVALUATING OPERATING AND FINANCIAL PERFORMANCE FOCUS

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In this chapter, we focus on identifying and understanding the financial ratios used to evaluate the venture‘s financial performance over time. Venture performance and efficiency is important to a variety of constituencies including lenders and creditors, equity investors, and the entrepreneur. Lenders and creditors want to be repaid in full and on time; investors want a sufficient return on their investments as compensation for the risks they are taking; the entrepreneur initially wants to survive and then build value in the venture.

LEARNING OBJECTIVES LO 5.1: Understand important financial performance measures and their users by life cycle stage.

LO 5.2: Describe how financial ratios are used to monitor a venture‘s performance.

LO 5.3: Identify specific cash burn rate measures and liquidity ratios and explain how they are calculated and used by the entrepreneur.

LO 5.4: Identify specific leverage ratios and explain their usage by lenders and creditors LO 5.5: Identify and describe measures of profitability and efficiency that are important to the entrepreneur and equity investors.

LO 5.6: Describe how comparable industry data are used.

LO 5.7: Describe limitations when using financial ratios.

CHAPTER OUTLINE 5.1 5.2 5.3

5.4

5.5

5.6 5.7

USERS OF FINANCIAL PERFORMANCE MEASURES BY LIFE CYCLE STAGE USING FINANCIAL RATIOS CASH BURN RATES AND LIQUIDITY RATIOS A. Measuring Venture Cash Burn and Build Amounts and Rates B. Beyond Burn: Traditional Measures of Liquidity C. Interpreting Cash-Related and Liquidity-Related Trends LEVERAGE RATIOS A. Measuring Financial Leverage B. Interpreting Changes in Financial Leverage PROFITABILITY AND EFFICIENCY RATIOS A. Income Statement Measures of Profitability B. Efficiency and Return Measures C. Interpreting Changes in Profitability and Efficiency INDUSTRY COMPARABLE RATIO ANALYSIS A HITCHHIKER‘S GUIDE TO FINANCIAL ANALYSIS SUMMARY

DISCUSSION QUESTIONS AND ANSWERS 1. Identify the types of financing typically used during each life cycle stage of the successful entrepreneurial venture.

Refer to Figure 5.1.

Development and Startup Stages: Type of Financing:

Chapter 6: Managing Cash Flow Seed and startup financing Survival Stage: Type of Financing: First-round financing Rapid-Growth Stage: Type of Financing: Second-round, mezzanine, and liquidity-stage 2. Describe the types of financial ratios and other financial performance measures that are used during a venture’s successful life cycle. Who are the users of financial performance measures?

Refer to Figure 5.1.

Development and Startup Stages: Financial Ratios and Measures: Cash burn rates and liquidity ratios Conversion period ratios Users of Financial Ratios and Measures: Entrepreneur Business angels Venture capitalists (VCs) Survival Stage: Financial Ratios and Measures: Cash burn, liquidity, and conversion ratios Leverage ratios Profitability and efficiency ratios Users of Financial Ratios and Measures: Entrepreneur, angels, and VCs Commercial banks Rapid-Growth Stage: Financial Ratios and Measures: Leverage ratios Profitability and efficiency ratios Users of Financial Ratios and Measures: Entrepreneur, angels, and VCs Commercial banks Investment bankers 3. What are financial ratios and why are they useful?

Financial ratios are measurements that show relationships between two or more financial variables.

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4. What are the three types of comparisons that can be made when conducting ratio analyses?

The three types of comparison that can be made with ratio analysis are trend analysis, crosssectional analysis, and industry comparables (benchmark) analysis.

5. What are the meanings of the terms ―cash build‖ and ―cash burn‖? How do we calculate net cash burn rates?

Cash build is the amount the firm receives on its sales calculated by net sales less the change in receivables. Cash burn is the amount of cash a firm uses on its operating and financing expenses and on its investments in assets.

6. How is the current ratio calculated and what does it measure? How does the quick ratio differ from the current ratio?

The firm‘s current ratio is calculated by dividing the current assets by the current liabilities.

This ratio measures the firm‘s ability to pay off its short term debt in the near term. The quick ratio differs in that it leaves out inventory in calibrating current assets.

7. Describe how a firm’s net working capital (NWC) is measured and how the NWC-to-totalassets ratio is calculated. What does this ratio measure?

Net working capital is measured by subtracting current liabilities from current assets. NWCto-total-assets ratio is calculated by dividing NWC by the firm‘s total assets (or average total assets). This calculation measures liquidity of the firm with a higher percentage indicating a greater liquidity.

8. What is the meaning of leverage ratios? What are typical ratios used for relating total debt to a venture’s assets and/or its equity?

Leverage ratios indicate the extent to which the venture is in debt and its ability to repay its debt obligations. Typical ratios used are the total-debt-to-total-assets-ratio, debt-to-equityratio, and the equity multiplier.

9. What is the importance of the relationship between a venture’s current liabilities and its total debt?

The portion of total debt that is ―current‖ represents those liabilities that will come due within the next year. The percentage of debt held in current liabilities is a reasonable glimpse of the venture‘s reliance on debt soon requiring an outlay of cash. Ventures with higher percentages are more likely to need to restructure their liabilities in the near future.

10. Describe the two types of ―coverage‖ ratios that are typically calculated when trying to assess a venture’s ability to meet its interest payments and other financing-related obligations?

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The two types of coverage ratios used are the interest coverage ratio and the fixed charges coverage ratio. The interest coverage ratio measures the venture‘s ability to pay its annual interest liability and is calculated by dividing EBITDA by the annual interest payment. The fixed charges ratio measures the venture‘s ability to cover interest and fixed charges. It is calculated by dividing the sum of the venture‘s EBITDA and lease payments by the sum of interest payments, rental or lease payments, and the before-tax cost of debt repayments.

11. What are four measures used to indicate how efficiently the venture is in generating profits on its sales? Describe how each measure is calculated.

The four ratios used are gross profit margin, operating profit margin, net profit margin, and NOPAT margin. Gross profit margin is calculated by dividing the gross profit by the venture‘s net sales. Operating profit margin is calculated by dividing earnings before interest and taxes (EBIT), by the venture‘s net sales. Net profit margin is calculated by dividing net income (or net profit) by net sales. NOPAT margin is calculated by: (EBIT x (1 minus the tax rate))/net sales.

12. Identify and describe four efficiency/return ratios that combine data from both the income statement and the balance sheet.

The four ratios are sales-to-total-assets, operating return on assets, return on assets, and return on equity. Sales-to-total-assets is net sales divided by average total assets. Operating return on assets is EBIT divided by average total assets. Return on assets is net profit divided by average total assets. Return on equity is net income (or net profit) divided by average owners‘ equity.

13. Identify and describe the two components of the ROA model both in terms of what financial dimensions they measure and how they are calculated.

The two components of the ROA model are the net profit margin and the sales-to-total-assets ratio. Net profit margin measures the amount of sales that become net profit and is calculated by dividing net income by sales. Sales-to-total-assets measures the how much the firm generates in sales with one dollar of assets. It is calculated by dividing net sales by the firm‘s average assets.

14. What are the three ratio components of the ROE model? How is each calculated and what financial dimensions do they measure?

The three ratio components of the ROE model are the net profit margin (net profit/sales), asset turnover (net sales/average total assets), and the equity multiplier (average total assets/average equity). Net profit margin measures profitability of sales. Asset turnover measures how well asset are utilized in the production of sales. The equity multiplier measures how the firm scales its assets on a base of equity (through liabilities and debt).

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15. Indicate some of the concerns or cautions that need to be considered when conducting ratio analysis.

When conducting ratio analysis, it is important to compare ―apples to apples‖ by consistent use of the same inputs to the ratios (e.g. annual sales or quarterly sales). It is also important to understand that certain ratios may simultaneously indicate undesirable and desirable aspects of the venture‘s strategy and risk position. For example, an efficient use of trade credit can be interpreted as advantageous use of inexpensive credit or as the assumption of a large amount of short-term financial risk (low current and quick ratios).

16. From the Headlines – bext360: Discuss the variable and fixed costs in a single installation and continuing operation of a ―bextmachine.‖ What are the critical factors in getting to ―breakeven?‖ Answers will vary: ―For a given installation, the main fixed costs are the bextmachine‘s cost and its related installation costs. Additionally, there are fixed and variable costs of maintenance (machine wear and tear). A potentially large component of variable costs is any human attending and monitoring of machine operations and local relations. Reporting, uploading and customer support expenses could also represent recurring variable costs (but may have a fixed component as well). Additionally, there will be variable costs associated with the generation of reports and responding to inquiries related to those reports. Given the potentially significant fixed bextmachine costs for a single installation, breakeven at the machine level will require some reach for supplier acceptance and volume. For the bext360 as a company, scale at each location and across locations will be critical in covering the additional fixed costs of corporate general and administrative expenses.‖

INTERNET ACTIVITIES 1.

Go to the Hoovers business online Web site at http://www.hoovers.com and click on ―Companies A-Z.‖ Identify a firm such as Google, Inc. (ticker symbol: GOOG) or Applebee’s International, Inc. (ticker symbol: APPB).

A. Obtain the most recent three years of income statements and balance sheets. Analyze the changes in operating and financial performance, if any, by applying the ratio analyses covered in the chapter.

Web-researched results vary due to constant updating of the related web sites.

B. Identify the industry that the firm being studied resides in and the major competitors.

Obtain financial statement information for one or more competitors and conduct a ratios analysis of each competitor analyzed.

Web-researched results vary due to constant updating of the related web sites.

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EXERCISES/PROBLEMS AND ANSWERS

Note: for readers who were introduced to financial statements for the first time in Chapter 4, you may want to first work the ―Supplemental Exercises/Problems‖ presented at the end of Chapters 1, 2, and 3 which were intended for readers who had a previous understanding of financial statements.

1. [ROA and ROE models and Ratio Components] The Salza Technology Corporation successfully increased its ―top line‖ sales from $375,000 in 2018 to $450,000 in 2019. Net income also increased as did the venture’s total assets. You have been asked to compare the financial performance between the two years.

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A. Calculate the net profit margin and the sales-to-total assets ratio for Salza for 2019 using average total assets. Also calculate the return on total assets in 2019 using average total assets.

Net profit margin: $70/$450 = 15.56% Sales-to-average-total-assets ratio: $450/(($345 + $465)/2) = $450/$405 = 1.1111 Return on average total assets: $70/$405 = 17.28%

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B. Calculate the ratios in the ROA model for both 2018 and 2019 using year-end total assets.

Comment on any financial ratio differences.

ROA model = Net income/Net sales x Net sales/Total assets = Net income/Total assets 2018: $55/$375 x $375/$345 = 14.67% x 1.0870 = 15.94% 2019: $70/$450 x $450/$465 = 15.56% x 0.9677 = 15.05% The net profit margin increased while the sales-to-assets ratio decreased in 2019 versus 2018 with the net impact being a decline in the return on total assets ratio.

C. Expand the 2019 ROA model discussed in Part A into an ROE model that includes financial leverage as measured by the equity multiplier. Use average owners’ or stockholders’ equity in your calculation.

ROE model = Net income/Net sales x Net sales/Average total assets x Average total assets/Average stockholders‘ equity = Net income/Average stockholders‘ equity Where: Average equity multiplier = Average total assets/Average stockholders‘ equity From Part A: ROA model = 15.56% x 1.1111 = 17.28% Average total assets = ($345 + $465)/2 = $405 Note: Owners‘ or stockholders‘ equity = Common stock + Retained earnings 2018: $85 + $ 185 = $270 2019: $120 + $245 = $355 Common stock amounting to $35 in ―net proceeds‖ ($120 - $85) was issued in 2019 Retained earnings increased by $50 in 2019 ($235 - $185) which resulted from a net income of $70 minus cash dividends paid of $20 Average stockholders‘ equity = ($270 + $355)/2 = $625/2 = $312.50 ROE model= $15.56% x 1.1111 x ($405/$312.50) = 15.56% x 1.1111 x 1.2960 = 22.41% D. Expand the 2018 and 2019 ROA model calculations in Part B into ROE models based on year-end owners’ or stockholders’ equity amounts.

ROA model from Part B: 2018: $55/$375 x $375/$345 = 14.67% x 1.0870 = 15.94% 2019: $70/$450 x $450/$465 = 15.56% x 0.9677 = 15.05% ROE model: Equity multiplier = Total assets/Stockholders‘ equity 2018: 14.67% x 1.0870 x $345/$270 = 14.67% x 1.0870 x 1.2778 = 20.38% 2019: 15.56% x 0.9677 x $465/$355 = 15.56% x 0.9677 x 1.3099 = 19.72% 2. [Liquidity and Financial Leverage Ratios] Refer to the Salza Technology Corporation in Problem 1.

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Chapter 6: Managing Cash Flow A. Using average balance sheet account data, calculate the (a) current ratio, (b) quick ratio, (c) total-debt-to-total-assets ratio, and (d) the interest coverage ratio for 2019.

Using average account balances: (a) Current ratio: Average current assets/Average current liabilities = (($240 + $300)/2) + (($60 + $95)/2) = $270/$77.50 = 3.48 times (b) Quick ratio: (Average current assets – Average inventories)/Average current liabilities = (($240 + $300)/2 - ($151 + $204)/2)/($60 + $95)/2 = ($270 - $177.50)/$77.50 = $92.50/$77.50 = 1.19 times (c) Total-debt-to-total-assets ratio: Average total debt/Average total assets = (($60 + $95)/2 + ($15 + 15)/2)/($345 + $465)/2 = ($77.50 + $15)/$405 = $92.50/$405 = 22.84% (d) Interest coverage ratio: Average EBITDA/Average interest EBITDA = Net sales – Cost of goods sold – Operating expenses 2018: $375 - $225 - $46 = $104 2019: $450 - $270 - $46 = $134 Interest coverage ratio = (($104 + $134)/2)/(($4 + $4)/2) = ($238/2)/($8/2) = $119/$4 = 29.75 times B. Repeat the ratio calculations requested in Part A separately for 2018 and 2019 using year-end balance sheet account data. What changes, if any, have occurred in terms of liquidity and financial leverage? (a) Current ratio: 2018: $240/$60 = 4.00 times 2019: $300/$95 = 3.16 times The current ratio declined but still exceeded 3.0 times in 2019. (b) Quick ratio: 2018: ($240 - $151)/$60 = $89/$60 = 1.48 times 2019: ($300 - $204)/$95 = $96/$95 = 1.01 times The quick ratio declined to just slightly above 1.0 in 2019. Liquidity has gotten poorer. (c) Total-debt-to-total-assets ratio: 2018: ($60 + $15)/$345 = $75/$345 = .2174 = 21.74% 2019: ($95 + $15)/$465 = $110/$465 = .2366 = 22.66% Total debt as a percentage of total assets increased in 2019 by less than one percentage point.

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(d) Interest coverage ratio: 2018: ($375 - $225 - $46)/$4 = $104/$4 = 26.00 times 2019: ($450 - $270 - $46)/$4 = $134/$4 = 33.50 times Interest coverage increased in 2019 to above 30.0 times. The firm uses a small amount of financial leverage (primarily from current liabilities) and maintains a very high interest coverage ratio.

3. [Financial Statements and Ratios] Bike-With-Us Corporation, a specialty bicycle parts replacement venture, was started last year by two former professional bicycle riders who had substantial competitive racing experience including competing in the Tour de France. The two entrepreneurs borrowed $50,000 from members of their families and each put up $30,000 in equity capital. Retail space was rented and $60,000 was spent for fixtures and store equipment. Following are the abbreviated income statement and balance sheet information for the Bike-With-Us Corporation after one complete year of operation.

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Chapter 6: Managing Cash Flow A. Prepare an income statement and a balance sheet for the Bike-With-Us Corporation using only the information provided above.

B. Calculate the current ratio, quick ratio, and NWC-to-total-assets ratio.

Current Ratio = Current Assets/Current Liabilities = $81,000/$21,000 = 3.86 Quick Ratio = (CA - Inventories)/CL = ($81,000 - $50,000)/$21,000 = 1.48 NWC to Total Assets Ratio = (CA - CL)/Assets = ($81,000 - $21,000)/$131,000 = .458 C. Calculate the total-debt-to-total-assets ratio, debt-to-equity ratio, and interest coverage Total Debt to Total Assets Ratio = Debt/Assets = $71,000/$131,000 = .542 Debt to Equity Ratio = Debt/Equity = $71,000/$60,000 = 1.183 Interest Coverage Ratio = EBITDA/Interest = $40,000/$5,000 = 8.00 D. Calculate the net profit margin, sales-to-total-assets ratio, and the return on total assets.

Net Profit Margin = Net Profit/Revenues = $19,000/$325,000 = 5.85% Sales to Total Assets Ratio = Sales/Assets = $325,000/$131,000 = 2.48 Return on Total Assets = Net Profit/Assets = $19,000/$131,000 = 14.50%

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E. Calculate the equity multiplier. Combine this calculation with the calculations in Part D to show the ROE model with its three components.

Equity Multiplier = Assets/Equity = $131,000/$60,000 = 2.183 ROE = Net Profit Margin x Asset Turnover x Equity Multiplier = 5.85% x 2.48 x 2.183 = 31.67% 4. [Financial Ratios] Use the financial statements data for the Bike-With-Us Corporation provided in Problem 3 to make the following calculations.

A. Calculate the operating return on assets.

Operating return on assets = EBIT/Assets = $30,000/$131,000 = 22.90% B. Determine the effective interest rate paid on the long-term debt.

Effective interest rate = Interest/Long-term debt = $5,000/$50,000 = 10.00% C. Calculate the NOPAT margin. How does this compare with the results for the net profit margin? Did the owners benefit from the use of interest-bearing long-term debt?

Tax Rate = Taxes/EBT = $6,000/$25,000 = 24.00% NOPAT Margin = [(EBIT)(1 – tax rate)]/Net Sales = [$30,000(1 - .24)]/$325,000 = $22,800/$325,000 = 7.02% The Net Profit Margin was lower at 5.85% Since the Operating Return on Assets (22.90%) was higher than the Effective Interest Rate (10.00%), the firm benefited from having interest-bearing long-term debt.

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5. [Cash Burn and Build] Following are two years of income statements and balance sheets for the Munich Exports Corporation.

A.

Calculate the cash build, cash burn, and net cash burn or build for Munich Exports in 2019.

Cash Build = Net Sales – Increase in Receivables = $1,600,000 – ($300,000 $200,000) = $1,500,000 Cash Burn = Income Statement-Based Operating, Interest, and Tax Expenses + Increase in Inventories – (Changes in Payables + Accrued Liabilities) + Capital Expenditures Operating Expenses = Cost of Goods Sold + Marketing + General and Administrative = $960,000 + $160,000 + $150,000 = $1,270,000 Other Cash Expenses = Interest + Taxes = $55,000 + $88,000 = $143,000

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Increase in Inventories = ($570,000 - $450,000) = $120,000 Changes in Payables and Accrued Liabilities = [($180,000 - $130,000) + ($70,000 - $50,000)] = $70,000 Capital Expenditures or Change in Gross Fixed Assets = Change in Net Fixed Assets plus Depreciation = ($380,000 - $300,000) + $55,000 = $135,000 Cash Burn = $1,270,000 + $143,000 + $120,000 - $70,000 + $135,000 = $1,598,000 Net Cash Burn = Cash Burn – Cash Build = $1,598,000 - $1,500,000 = $98,000 B. Assume that 2020 will be a repeat of 2019. If your answer in Part A resulted in a net cash burn position, calculate the net cash burn monthly rate and indicate the number of months remaining “until out of cash.” If your answer in Part A resulted in a net cash build position, calculate the net cash build monthly rate and indicate the expected cash balance at the end of 2020. $98,000/12 = $8,166.67 Cash balance at end of 2019 = $50,000 $50,000/$8,166.67 = 6.12 months (remaining “until out of cash”)

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6. [Liquidity Ratios and Cash Burn or Build] The Castillo Products Company was started in 2017. The company manufactures components for personal decision assistant (PDA) products and for other hand-held electronic products. A difficult operating year 2018 was followed by a profitable 2019. However, the founders (Cindy and Rob Castillo) are still concerned about the venture’s liquidity position and the amount of cash being used to operate the firm. Following are income statements and balance sheets for the Castillo Products Company for 2018 and 2019.

A. Use year-end data to calculate the current ratio, the quick ratio, and the net working capital (NWC) to total assets ratio for 2018 and 2019 for the Castillo Company. What changes occurred?

Current Ratio = Current Asset/Current Liabilities

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Year 2018: $650,000/$270,000 = 2.41 Year 2019: $800,000/$330,000 = 2.42 Quick Ratio = (CA - Inventories)/CL Year 2018: ($650,000 - $400,000)/$270,000 = 0.93 Year 2019: ($800,000 - $500,000)/$330,000 = 0.91 NWC to Total Assets Ratio = (CA - CL)/Assets Year 2018: ($650,000 - $270,000)/$1,000,000 = 0.38 Year 2019: ($800,000 - $330,000)/$1,200,000 = 0.39 B. Use Castillo’s complete income statement data and the changes in balance sheet items between 2018 and 2019 to determine the firm’s cash build and cash burn for 2019. Did Castillo have a net cash build or net cash burn for 2019?

Cash Build = Sales – Change in Accounts Receivable = $1,500,000 - $80,000 = $1,420,000 Cash Burn = Inventory-Related Purchases + Administrative Expenses + Marketing Expenses + Interest Expense - (Change in Accrued Liabilities + Change in Payables) + Capital Investments + Taxes = ($900,000 + + $250,000 + $150,000 + $60,000 + $25,000 + $100,000 - ($20,000 + $30,000) + $90,000 = $1,525,000 Net Cash Burn or Build = Cash Build – Cash Burn = $1,420,000 - $1,525,000 = -$105,000 = $105,000 Cash Burn C. Convert the annual cash build and cash burn amounts calculated in Part B to monthly cash build and cash burn rates. Also indicate the amount of the net monthly cash build or cash burn rate.

Monthly Cash Burn Rate Less: Monthly Cash Build Rate Monthly Net Cash Burn Rate

$1,525,000 12 $127,083.33 -$1,420,000 12 -$118,333.33 $8,750.00 $105,000 12

7. [ROA Model and Expenses Related to Sales] Use the financial statements data for the Castillo Products presented in Problem 6.

A. Calculate the net profit margin in 2018 and 2019 and the sales-to-total-assets ratio using yearend data for each of the two years.

Net profit margin 2018: -$65,000/$900,000 = -7.22% Net profit margin 2019: $75,000/$1,500,000 = 5.00% Sales-to-total-assets 2018: $900,000/$1,000,000 = .900 Sales-to-total-assets 2019: $1,500,000/$1,200,000 = 1.250

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B. Use your calculations from Part A to determine the rate of return on assets in each of the two years for the Castillo Products.

Rate of return on assets 2018: -7.22% x .900 = -6.50% Rate of return on assets 2019: 5.00% x 1.250 = 6.25% C. Calculate the percentage growth in net sales from 2018 to 2019. Compare this with the percentage change in total assets for the same period.

Percentage growth in net sales: ($1,500,000 - $900,000)/$900,000 = 66.67% Percentage change in total assets: ($1,200,000 - $1,000,000)/$1,000,000 = 20.00% D. Express each expense item as a percentage of net sales for both 2018 and 2019. Describe what happened that allowed Castillo Products to move from a loss to a profit between the two years.

The decline in general and administrative expenses as a percentage of sales (i.e., the spreading of fixed costs) was the major contributor to Castillo becoming profitable. The decline in depreciation expenses and in interest expenses as percentages of sales also contributed to the move to profitability. However, increased taxes on profits reduced some of the profitability gains.

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[ROE Component Ratios and Model] Refer to the financial statement data provided below for Safety-First, Inc. SAFETY-FIRST, INC.

Income Statements (in $ Thousands) Net sales Cost of goods sold Gross profit Operating expenses Interest Income before taxes Income taxes Net income

2018 3,750 2,250 1,500 670 30 800 250 550

2019 4,500 2,700 1,800 860 40 900 300 600

2018 400 500 1,450 2,350 2,000 -950 1,050 3,400

2019 150 800 2,000 2,950 2,800 -1,250 1,550 4,500

2018

2019

300 150 100 550 150 850 1,850 3,400

400 250 150 800 150 1,100 2,450 4,500

Balance Sheets (in $ Thousands) Cash Accounts receivable Inventories Total current assets Gross fixed assets Less accumulated depreciation Net fixed assets Total assets

Accounts payable Bank loan Accrued liabilities Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity A. Calculate

the net profit margin, the sales-to-total-assets ratio, and the equity multiplier for both 2018 and 2019 using year-end (rather than average) balance sheet data.

Net Profit Margin = Net Profit / Net Sales

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year.

Return on Equity = Net Profit Margin x Asset Turnover x Equity Multiplier 2018: 14.67% x 1.1029 x 1.2593 = 20.37% 2019: 13.33% x 1.0000 x 1.2676 = 16.90% C. Describe what happened in terms of the financial performance of the Safety-First,

Inc. between 2018 and 2019.

The net profit margin declined as did the asset turnover causing the return on assets (ROA) to decline: 2018: ROA = 14.67% x 1.2593 = 18.47% 2019: ROA = 13.33% x 1.0000 = 13.33% The equity multiplier increased slightly from 1.2593 to 1.2676. The net result was a decline in ROE from 20.37% in 2018 to 16.90% in 2019.

9.

[Profitability Ratios] Make use of the financial statements data provided in Problem 8 for

Safety-First, Inc. A. Calculate the operating profit margins and the NOPAT margins in 2018 and 2019

for Safety-First, Inc. What changes occurred?

Operating Profit Margin = EBIT / Net Sales 2018: (800 + 30)/3,750 = 22.13% 2019: (900 + 40)/4,500 = 20.89% NOPAT Margin = (EBIT(1 – Tax Rate)) / Net Sales 2018: [(800 + 30)(1- 250/800)]/3,750 = (830(1 -.3125))/3,750 = 570.63/3,750 = 15.22% 2019: [(900 + 40)(1- 300/900)]/4,500 = (940(1 - .3333))/4,500 = 626.70/4,500 = 13.93% Both profit margin measures declined indicated less efficient control of expenses.

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B.

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Calculate the operating return on assets (or the venture’s basic earning power) using year-end balance sheet information for both 2018 and 2019. Describe what happened in terms of operating return performance.

Operating Return on Assets = EBIT / Total Assets 2018: (800 + 30)/3,400 = 24.41% 2019: (900 + 40)/4,500 = 20.89% The operating return on assets declined as did the operating profit margin calculated in Part A.

C.

Did the venture benefit from using interest-bearing debt in the form of bank loans and long-term debt in 2018 and 2019?

Bank loans increased from $150,000 in 2018 to $250,000 in 2019 while long-term debt remained constant at $150,000 over both years. The net result was an increase in total interest-bearing debt of $100,000 between 2018 and 2019. At the same time, the amount of interest increased from $30,000 to $40,000.

Effective Interest Rate = Interest / Amount of Interest-Bearing Debt 2018: 30/300 = 10.00% 2019: 40/400 = 10.00% Since the effective interest rate was lower than the operating return on assets (see Part B), the venture benefited from the use of interest-bearing debt in both years. Since the operating return on assets was higher in 2018 and the effective interest rate was 10.00% in both years, the venture benefited relatively more from having interest-bearing debt in 2018.

MINI CASE: SCANDI HOME FURNISHINGS, INC.

Kaj Rasmussen founded Scandi Home Furnishings as a corporation during mid-2016. Sales during the first full year (2017) of operation reached $1.3 million. Sales increased by 15 percent in 2018 and another 20 percent in 2019. However, profits after increasing in 2018 over 2017 fell sharply in 2019 causing Kaj to wonder what was happening to his ―pride and joy‖ business venture. After all, Kaj has continued to work as close as possible to a 24/7 pace beginning with the startup of Scandi and through the first three full years of operation.

Scandi Home Furnishings, located in eastern North Carolina, designs, manufactures, and sells Scandinavian-designed furniture and accessories to home furnishings retailers. The modern Scandinavian design has a streamlined and uncluttered look. While this furniture style is primarily associated with Denmark, both Norway and Sweden designers have contributed to the allure of Scandinavian home furnishings. Some say that the inspiration for the Scandinavian design can be traced to the ―elegant curves‖ of art nouveau from which designers were able to produce aesthetically pleasing, structurally strong modern furniture. Danish furnishings and the home furnishings produced by the other Scandinavian countries—Sweden, Norway, and

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Finland—are made using wood (primarily oak, maple, and ash), aluminum, steel, and high-grade plastics.

Kaj grew up in Copenhagen, Denmark and received a college degree from a technical university in Sweden. As is typically in Europe, Kaj began his business career as an apprentice at a major home furnishings manufacturer in Copenhagen. After ―learning the trade,‖ he quickly moved into a management position in the firm. However, after a few years, Kaj realized that what he really wanted to do was to start and operate his own Scandinavian home furnishings business. At the same time, after traveling throughout the world including the U.S., he was sure that he wanted to be an entrepreneur in the United States. Thus, while it was hard to give up the Tivoli Gardens with its many entertainment and dining activities, as well as the other attractions in Copenhagen, Kaj moved to the U.S. in early 2016. With $140,000 of his personal assets, and $210,000 from venture investors, he began operations in mid-2016. Kaj, with a 40 percent ownership interest and industry-related management expertise, was allowed to operate the venture in a way that he thought was best for Scandi. Four years later, Kaj is sure he did the right thing.

Following are the three years of income statements and balance sheets for the Scandi Home Furnishings Corporation. Kaj has felt that in order to maintain a competitive advantage that he would need to continue to expand sales. After first concentrating on selling Scandinavian home furnishings in the northeast in 2017 and 2018, he decided to enter the west coast market.

An increase in expenses associated with identifying, contacting, and selling to home furnishings retailers in California, Oregon, and Washington. Kaj Rasmussen was hoping that you could help him better understand what has been happening to Scandi Home Furnishings both from operating and financial standpoints.

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Note: 30,000 shares of common stock were issued to Kaj Rasmussen and the venture investors when Scandi Home Furnishings was incorporated in mid-2016.

Part A Your first challenge is to advise Kaj on what has been happening with Scandi Home Furnishings from a liquidity perspective.

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Chapter 6: Managing Cash Flow A. Kaj was particularly concerned by the drop in cash from $50,000 in 2017 to $10,000 in 2019. Calculate the average current ratio, the quick ratio, and the networking capital to total assets ratio for 2017-2018 and 2018-2019. What has happened to Scandi’s liquidity position?

Note: ratio calculations involving asset items on the balance sheet are averages of the prior and current years. For example, the ratios for 2018 use average balance sheet account amounts for 2017 and 2018. Likewise, ratios for 2019 use average balance sheet account amounts for 2018 and 2019.

All three liquidity ratios declined.

B. Kaj should be interested in knowing whether Scandi has been building or burning cash.

Compare the cash build, cash burn, and the net cash build/burn positions for 2018 and 2019. What, if any, changes have occurred?

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The venture had a $36,000 net cash burn in 2018 and a larger $274,000 net cash burn in 2019. Operating expenses and interest expenses increased resulting in lower cash from operations. The net cash burn also increased due to the increase in accounts receivable and in inventories.

Part B Your second challenge is to advise Kaj on what has been happening to Scandi from a financial leverage, profitability, and efficiency perspective.

C. Creditors, as well as management, are also concerned about the ability of the venture to meet its debt obligations as they come due, the proportion of current liabilities to total debt, the availability of assets to meet debt obligations in the event of financial distress, and the relative size of equity investments to debt levels. Calculate average ratios in each of these areas for the 2017-2018 and 2018-2019 periods. Interpret your results and explain what has happened to Scandi.

Financial Leverage: 2018 Total-Debt-to-Total-Assets 0.5909 Equity Multiplier 2.444 Debt-to-Equity Ratio 1.444 Current-Liab.-to-Total Debt 0.4615 Interest Coverage 5.263

2019 0.6457 2.822 1.822 0.4490 2.000

Change Higher Higher Higher Lower Lower

Financial leverage (as measured by the total-debt-to-total-assets ratio, the equity multiplier, and the debt-to-equity ratio) increased in 2019 versus 2018. This indicates that financial risk also increased. The current-liabilities-to-total debt ratio improved (was lower in 2019) indicating a more than proportional use of long-term debt relative to shortterm debt to meet financing needs in 2019. The interest coverage dropped substantially due to an increase in the amount of interest and a drop in EBITDA. D. Of importance to Kaj and the venture investors is the efficiency of the operations of the venture. Several profit margin ratios relating to the income statement are available to help analyze Scandi’s performance. Calculate average profit margin ratios for 20172018 and 2018-2019 and describe what is happening to the profitability of Scandi Home Furnishings.

Profitability Ratios: Gross Profit Margin Operating Profit Margin Net Profit Margin NOPAT Margin

2018 0.4000 0.1593 0.0738 0.0956

2019 0.3500 0.1046 0.0397 0.0627

Change Lower Lower Lower Lower

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Chapter 6: Managing Cash Flow All profitability ratios decreased in 2019 versus 2018. For example, the gross profit margin decreased from 40.00% to 35.00% and the net profit margin decreased from 7.38% to 3.97%.

E. Kaj and the venture investors are also interested in how efficiently Scandi is able to convert their equity investment, as well as the venture’s total assets, into sales. Calculate several ratios that combine data from the income statements and balance sheets and compare what has happened between the 2017-2018 and 2018-2019 periods.

Efficiency and Return Ratios: 2018 Sales-to-Total-Assets 1.3636 Operating Return on Assets 0.2245 Return on Assets (ROA) 0.1036 Return on Equity (ROE) 0.2533

2019 1.3483 0.0599 0.0045 0.0127

Change Same Lower Lower Lower

The sales-to-total-assets ratio remained about the same at 1.3636 in 2018 to 1.3483 in 2019. Profitability was sharply lower in terms of the ROA results (from 10.36% to .45%) and the ROE results (from 25.33% to 1.27%).

F. A ROA model consisting of the product of two ratios provides an overview of a venture’s efficiency and profitability at the same time. A ROE model consists of the product of three ratios and simultaneously shows an overview of a venture’s efficiency, profitability, and leverage performance. Calculate ROA and ROE models for the 2017-2018 and 2018-2019 periods. Provide an interpretation of your findings.

ROA 2018: 10.36% = 7.60% x 1.3636 ROA 2019: 0.45% = 0.33% x 1.3483 ROE 2018: 25.33% = 7.60% x 1.3636 x 2.444 ROE 2019: 1.27% = 0.33% x 1.3483 x 2.822 Both the ROA and ROE model results show declining performance due to a large decline in the net profit margin combined with a relatively unchanged (slight decline) sales-toassets ratio. The financial leverage (as measured by the equity multiplier) increased from 2018 to 2019 during this period of declining operating performance.

Part C Your third challenge is to advise Kaj on what has been happening to Scandi relative to financial developments in the home furnishings industry.

G. Kaj has been able to obtain some industry ratio data from the home furnishings industry trade association of which he is a member. The industry association collects proprietary financial information from members of the association, compiles averages to protect the proprietary nature of the information, and provides averages for use by individual trade association members.

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Trade association data for the home furnishings industry shows an average net profit margin of 6.5 percent, a sales-to-assets ratio of 1.3 times, and a total-debt-to-total-assets ratio of 55 percent over the 2017-2018 and 2018-2019 time periods. Compare and contrast Scandi’s results with the industry average in terms of the ROA and ROE models.

Make sure you compare the components of each model as well as the product of the components.

If the total-debt-to-total-assets ratio is 55%, the equity-to-total-assets ratio is 45% (1 .55). If we calculate the inverse of this ratio (1/.45), we get an equity multiplier for the industry of 2.222. Thus, the industry ROE model is: ROE Industry: 18.78% = 6.50% x 1.300 x 2.222 From Part G: ROA 2018: 10.36% = 7.60% x 1.3636 ROA 2019: 0.45% = 0.33% x 1.3483 ROE 2018: 25.33% = 7.60% x 1.3636 x 2.444 ROE 2019: 1.27% = 0.33% x 1.3483 x 2.822 Scandi‘s ROE declined from above the industry average in 2018 to well below the industry average in 2019. The firm‘s net profit margin also declined from above the industry average to below the industry average. Also, while the turnover of assets declined slightly for the firm, the ratio remained above the industry average. Scandi‘s use of debt to finance its assets was above the industry average in 2018 and even more so in 2019.

Chapter 6 MANAGING CASH FLOW FOCUS In this chapter, we focus on short-term financial planning involving projecting monthly financial statements for one year or less. The availability of cash is what drives the entrepreneurial venture. Inadequate cash often constrains the venture‘s ability to grow, is a primary cause of financial distress, and can result in bankruptcy even though the venture may be profitable in an accounting sense. The process of preparing short-term projected financial statements also helps the entrepreneur anticipate and estimate additional external financial capital needed to support the business plan during the next year. We also cover a venture‘s operating cycle and its cash conversion cycle and their importance in managing cash flow.

LEARNING OBJECTIVES LO 6.1: Describe the types of financial planning needed at various stages in a venture‘s life cycle.

LO 6.2: Explain why cash is so important in early-stage ventures.

LO 6.3: Describe how short-term projected operating schedules are used to prepare cash budgets.

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LO 6.4: Describe how projected monthly income statements and balance sheets can be used to project monthly statements of cash flows LO 6.5: Explain how cash planning can be conducted from a projected monthly balance sheet.

LO 6.6: Identify and describe the use and value of conversion period ratios to the entrepreneur.

CHAPTER OUTLINE 6.1 6.2 6.3 6.4 6.5 6.6

FINANCIAL PLANNING THROUGHOUT THE VENTURE‘S LIFE CYCLE SURVIVING IN THE SHORT RUN SHORT-TERM CASH-PLANNING TOOLS PROJECTED MONTHLY FINANCIAL STATEMENTS CASH PLANNING FROM A PROJECTED MONTHLY BALANCE SHEET CONVERSION PERIOD RATIOS A. Measuring Conversion Times B. Interpreting Changes in Conversion Times SUMMARY

DISCUSSION QUESTIONS AND ANSWERS 1. What does short-term financial planning involve?

Short-term financial planning usually involves projecting monthly financial statements and concentrating on a venture's cash needs. Most initial business plans contain monthly projected (pro forma) financial statements for at least one year, and sometimes for two or more years. These short-horizon forecasts directly address whether a venture is expected to generate—or otherwise obtain—the required cash to meet its coming obligations.

2. Provide a description of the financing cost implications associated with a venture’s need for additional funds.

The cost of obtaining additional funds may be explicit, such as additional interest expense associated with debt. Interest expense shows up directly on the projected income statement and, in turn, impacts the AFN shown on the balance sheet. In contrast, added ―costs‖ associated with obtaining equity capital from venture capitalist and other investors are based on the expected rates of return the investors receive when they exit their investments. These implicit costs do not show up on the projected financial statements.

3. What is meant by a cash budget? Describe how a cash budget is prepared.

A cash budget is a financial tool showing the inflows and outflows of the firm’s cash balance over a period of time. It is calculated by determining all of the cash-basis expenses and revenues the firm has over a period of time to find out how cash is being built and burned.

4. Besides the cash budget, what additional financial statements are projected monthly in conjunction with short-term financial planning?

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Additional statements that can be prepared on a monthly basis to provide a clear financial picture of the firm include the income statement, balance sheet and a statement of cash flows.

1. What is meant by a venture’s operating cycle?

A venture‘s operating cycle is the time it takes to purchase raw materials, assemble a product, book a sale, and collect on it.

2. Describe the cash conversion cycle (C3).

The cash conversion cycle is the operating cycle less the days of short-term credit extended by suppliers, employees and government (the purchase-to-payment cycle).

3. What are the three components of the cash conversion cycle (C3)? How is each component calculated?

The three components of the cash conversion cycle are inventory-to-sale conversion period, sales-tocash conversion period, and purchase-to-payment conversion period. The inventory-to-sale conversion period is calculated by dividing average inventories by the venture‘s average daily cost of goods sold. The sale-to-cash conversion period is calculated by dividing the average receivables by the net sales per day. The purchase-to-payment conversion period is calculated by dividing the sum of average payables and accrued liabilities by the venture‘s cost of goods sold per day.

4. Briefly explain how changes in the conversion times of the components of the C3 can be interpreted.

A lengthening of the inventory-to-sale conversion period indicates less efficient inventory management. A lengthening of the sale-to-cash conversion period indicates less efficient collections or management of receivables. A decrease in the purchase-to-payment period indicates a less efficient use of the credit provided by suppliers, employees and the government.

9. From the Headlines – Sustainable Northwest: Describe Sustainable Northwest’s short-term inflows and outflows of cash. What would you expect to be the main ingredients of each part of the cash conversion cycle?

Sustainable Northwest is a nonprofit organization with a for-profit wholesale lumberyard called Sustainable Northwest Wood which supports its nonprofit parent‘s objectives. The wholesale lumberyard provides raw materials gathered by selective harvesting to small lumber mills for processing, with the processed products then being sold to home builders, suppliers of green building products, etc.

The inventory-to-sale conversion period would involve gathering raw wood, processing the raw wood into finished products, and carrying the finished products until sales are made.

Credit terms may need to be extended to home builders and other customers, who in turn may need to give credit to their retail customers. Thus, Northwest Wood is likely to incur a sale-to-cash conversion period. Furthermore, given that Northwest Wood is a wholesale lumber yard, any purchase-to-payment conversion period to offset the length of the venture‘s operating cycle would have to come from the owners of the forests from which the trees are harvested.

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INTERNET ACTIVITIES 1. Access the U.S. census bureau web site at http://www.census.gov. Find relevant information for trends in U.S. population growth for a specific business idea. Comment on the manufacturing statistics and regional or national statistics relevant for that business.

Web-researched results vary due to constant updating of the related web sites.

2. For a specific business idea, find labor wage data for the types of employees that will be involved. Examples of relevant web sites include the Bureau of Labor Statistics web site at http://www.states.bls.gov and career information sites like http://www.wetfeet.com.

Web-researched results vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS 1. [Short-Term Financial Planning] The Itsar Products Company has made the following monthly estimates of cash receipts and cash disbursements when preparing cash budgets for the next twelve months. Itsar Products has beginning cash on hand of $10,000 and wants to maintain this minimum cash level throughout the next year.

Month January February March April May June July August September October November December A.

Cash Receipts $100,000 $90,000 $80,000 $100,000 $120,000 $160,000 $200,000 $250,000 $250,000 $200,000 $140,000 $100,000

Cash Disbursements $100,000 $110,000 $110,000 $150,000 $180,000 $180,000 $180,000 $180,000 $150,000 $110,000 $100,000 $100,000

Determine whether Itsar Products will have a cash need during the next year.

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Note: the January beginning cash on hand is $10,000. Since the minimum end of cash month Is also $10,000, there will be no change in cash on hand (i.e., the $10,000 beginning cash – the $10,000 ending cash equals zero change).

Yes, Itsar will have a cash need as shown by monthly cash receipts less monthly cash disbursements.

B. If Itsar Products has a cash need, indicate the month when the need will begin and determine the month and amount when the maximum need will occur.

A cash need will occur in February when $20,000 will be needed. The largest monthly cash need occurs in May at $60,000. The maximum cumulative cash need will occur in June at $180,000.

C.

Determine whether the cash need (if any) can be repaid within the next year.

As previously noted, a cash need of $20,000 occurs in February and increases to a maximum cumulative monthly cash need of $180,000 in June. The cumulative September need turns to a surplus of $10,000 in September indicating that the need can be repaid before the end of the year.

2. Rework Problem 1 assuming minimum cash on hand requirements are $10,000 a month through May, increase to $15,000 in June and July, increase further to $20,000 in August and September, and return to the $10,000 per month level beginning in October.

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Note: Beginning cash on hand for January was $10,000. Since the target ending cash on hand amount also was $10,000, there was no change in monthly cash on hand need. In June, the beginning cash on hand was $10,000; however, the target ending cash on hand was $15,000, which meant that an additional $5,000 ($10,000 - $15,000) was needed.

As was the case in Problem 1, yes, there will be a cash need next year. The maximum cumulative cash need will be $185,000 in June. The need can be eliminated (reduced to zero) by September.

3. [Short-Term Financial Planning] The PDC Company was described during the early part of this chapter. Refer to the PDC Company’s projected monthly operating schedules in Table 6.2. PDC’s sales are projected to be $80,000 in September 2020.

[Note: An Excel spreadsheet for the PDC Company is available on the authors’ Web site for use by instructors.]

A. Prepare PDC’s sales schedule, purchases schedule, and the wages schedule for August 2020.

See the spreadsheet solution for Problem 11. Here we are focusing just on projecting the month of August.

Sales Schedule: Schedule 1: Sales Forecast Total sales = $92,000; Credit sales (40%) = $36,800; Cash sales (60%) = $55,200 Schedule 2: Cash Collections Cash sales = $55,200; Collection of July’s credit sales = $46,000; Total collections = $101,200

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Purchases Schedule: Ending inventory at end of August is estimated as: Forecasted September sales = $80,000 times .8 of sales coverage times .7 to reflect cost of goods sold. Thus, ($80,000 x .8 x .7) = $44,800. PDC adds a $46,000 inventory cushion to get to the target ending inventory for August of: $90,800. Cost of goods sold for August is $64,400 (i.e., $92,000 x .7).

Total inventory needed is $90,800 + $64,400 = $155,200 Schedule 3: Purchases $155,200 total inventory needed minus $97,520 beginning inventory (i.e., ending inventory from July) = $57,680 purchases Schedule 4: Disbursements for Purchases Calculated as 50% of July’s purchases plus 50% of August’s purchases: ($67,620 x .5) + ($57,680 x .5) = $33,810 + $28,840 = $62,650 Wages and Commissions Schedule: Schedule 5: Wages and Commissions Fixed portion = $5,750. Commissions = 15% of August sales ($92,000 x .15) = $13,800. Total wages and commissions = $5,750 + $13,800 = $19,550 Schedule 6: Disbursements (Wages and Commissions) Calculated as 50% of July’s total wages/commissions plus 50% of August’s total wages/commissions: ($23,000 x .5) + ($19,550 x .5) = $11,500 + $9,775 = $21,275 B. Prepare a cash budget for August 2020 for the PDC Company and describe how the forecast affects the end-of-month cash balance.

See the spreadsheet solution for August provided in the comprehensive spreadsheet output for Problem 11. The beginning cash balance for August was $29,487. Total cash receipts less total cash disbursements for August were $8,075 ($101,200 - $93,125) resulting in an ending cash balance of $37,562.

4.

[Short-Term Financial Planning] The PDC Company was described during the early part of this chapter. Refer to the PDC Company’s projected monthly operating schedules in Table 6.2. PDC’s sales are projected to be $80,000 in September 2020.

A. Prepare the PDC Company’s projected income statement for August.

See the spreadsheet solution for August provided in the comprehensive spreadsheet output provided in Problem 11.

B. Prepare the PDC Company’s projected balance sheet for August.

See the spreadsheet solution for August provided in the comprehensive spreadsheet output provided in Problem 11.

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Chapter 6: Managing Cash Flow C. Prepare the PDC Company’s projected statement of cash flow for August.

See the spreadsheet solution for August provided in the comprehensive spreadsheet output provided in Problem 11.

D. Compare your balance sheet at the end of August with the balance sheet in Table 6.1 in the chapter and apply the balance sheet method to determine cash flows over the March-August time period.

See the spreadsheet solution for August provided in the comprehensive spreadsheet output provided in Problem 11.

5.

[Short-Term Financial Planning] Rework Problem 3 based on the assumption that, because of an unexpected order, the PDC Company’s sales are forecasted to be $160,000 for September 2020.

March Schedule 1: Sales Forecast

April

May

June

July

Aug.

Sept.

92,000

115,000

184,000

138,000

115,000

92,000

Credit sales, 40%

36,800

46,000

73,600

55,200

46,000

36,800

Cash sales, 60%

55,200

69,000

110,400

82,800

69,000

55,200

Cash sales this month

69,000

110,400

82,800

69,000

55,200

100% of last month's credit sales

36,800

46,000

73,600

55,200

46,000

Total Collections

105,800

156,400

156,400

124,200

101,200

135,600

Schedule 2: Cash Collections

Ending inventory

110,400

149,040

123,280

110,400

97,520

Cost of goods sold

64,400

80,500

128,800

96,600

80,500

64,400

Total needed

174,800

229,540

252,080

207,000

178,020

200,000

Beginning Inventory

97,520

110,400

149,040

123,280

110,400

97,520

Purchases

77,280

119,140

103,040

83,720

67,620

102,480

160,000

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Schedule 4: Disbursements for Purchases 50% of last month's purchases

38,640

59,570

51,520

41,860

33,810

50% of this month's purchases

59,570

51,520

41,860

33,810

51,240

Disbursements for merchandise

98,210

111,090

93,380

75,670

85,050

Schedule 5: Wages and Commissions Wages, all fixed

5,750

5,750

5,750

5,750

5,750

5,750

Commissions (15% of current sales)

13,800

17,250

27,600

20,700

17,250

13,800

Total

19,550

23,000

33,350

26,450

23,000

19,550

50% of last month's expenses

9,775

11,500

16,675

13,225

11,500

50% of this month's expenses

11,500

16,675

13,225

11,500

9,775

Total

21,275

28,175

29,900

24,725

21,275

23,000

29,487

Schedule 6: Disbursements-Wages/Comm

Cash Budget Beginning cash balance Cash receipts Collections from customers Total cash available for needs, before fin.

Cash disbursements:

April

May 23,000

June 23,000

July 23,000

Aug.

0

0

0

0

105,800

156,400

156,400

124,200

101,200

128,800

179,400

179,400

147,200

130,687

0

0

0

0

Merchandise

98,210

111,090

93,380

75,670

85,050

Wages and commissions

21,275

28,175

29,900

24,725

21,275

Miscellaneous expenses

5,750

9,200

6,900

5,750

4,600

Rent

4,600

4,600

4,600

4,600

4,600

Truck purchase

6,900

0

0

0

0

Total disbursements

115,525

136,735

153,065

134,780

110,745

Minimum cash balance desired

23,000

23,000

23,000

23,000

23,000

Total cash needed

159,735

176,065

157,780

133,745

138,525

Excess of total cash

-30,935

3,335

21,620

13,455

-7,838

0

0

0

0

Financing New Borrowing Repayments Loan balance Interest

30,935

0

0

0

0

2,871

21,199

6,865

7,838 0

30,935

28,064

6,865

0

7,838

0

464

421

103

0

Total effects of financing

30,935

-3,335

-21,620

-6,968

7,838

Cash balance

23,000

23,000

23,000

29,487

23,000

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6. [Short-Term Financial Planning] Rework Problem 4 based on the assumption that, because of an unexpected order, the PDC Company’s sales are forecasted to be $160,000 for September 2020.

Budgeted Income Statements Sales

92,000

115,000

184,000

138,000

115,000

92,000

COGS

-64,400

-80,500

-128,800

-96,600

-80,500

-64,400

Gross Margin

27,600

34,500

55,200

41,400

34,500

27,600

0

0

0

0

0

Wages and commissions

-19,550

-23,000

-33,350

-26,450

-23,000

-19,550

Rent

-4,600

-4,600

-4,600

-4,600

-4,600

-4600

Miscellaneous expenses

-4,600

-5,750

-9,200

-6,900

-5,750

-4600

Insurance

-460

-460

-460

-460

-460

-460

Depreciation

-1,150

-1,150

-1,150

-1,150

-1,150

-1150

Total operating expenses

-30,360

-34,960

-48,760

-39,560

-34,960

-30,360

Income from operations

-2,760

-460

6,440

1,840

-460

-2,760

Operating Expenses

Interest expense

0

0

-464

-421

-103

0

-2,760

-460

5,976

1,419

-563

-2,760

Cash

23,000

23,000

23,000

23,000

29,487

23,000

Accounts receivable

36,800

46,000

73,600

55,200

46,000

36,800

Merchandise inventory

110,400

149,040

123,280

110,400

97,520

135,600

Unexpired insurance

4,140

3,680

3,220

2,760

2,300

1,840

174,340

221,720

223,100

191,360

175,307

197,240

Equipment, fixtures and other

85,100

92,000

92,000

92,000

92,000

92,000

Accumulated depreciation

-35,190

Net income

Balance Sheets Current Assets:

Total Current Assets Plant

-29,440

-30,590

-31,740

-32,890

-34,040

Net PPE

55,660

61,410

60,260

59,110

57,960

56,810

Total Assets

230,000

283,130

283,360

250,470

233,267

254,050

Accounts payable

38,640

59,570

51,520

41,860

33,810

51,240

Accrued wages and commissions payable

9,775

11,500

16,675

13,225

11,500

9,775

0

30,935

28,064

6,865

0

7,838

Total Current Liabilities

48,415

102,005

96,259

61,950

45,310

68,853

Owner's equity

181,585

181,125

187,101

188,520

187,957

185,197

Total equities

230,000

283,130

283,360

250,470

233,267

254,050

Current Liabilities

Loan

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Accounting Statement of Cash Flows Cash Flows From Activities Net Income

-460

5,976

1,419

-563

-2,760

Depreciation Expense

1,150

1,150

1,150

1,150

1,150

Decrease in Prepaids

460

460

460

460

460

1,725

5,175

-3,450

-1,725

-1,725

Decrease in Inventory

-38,640

25,760

12,880

12,880

-38,080

Decrease in A/P

20,930

-8,050

-9,660

-8,050

17,430

Increase in A/R

-9,200

-27,600

18,400

9,200

9,200

0

0

0

0

0

-23,575

-3,105

19,780

13,915

-11,565

-24,035

2,871

21,199

13,352

-14,325

Adjustments to Net Inc for CF

Increase in Accrued Liab.

Decrease in Def. Inc. Tax Total Adjustments Net Cash Flow From Opps (Acct.)

Cash Flows From Investing Capex

-6,900

0

0

0

0

-30,935

2,871

21,199

13,352

-14,325

Equity Issues

0

0

0

0

0

Dividends

0

0

0

0

0

Debt Issues

30,935

-2,871

-21,199

-6,865

7,838

30,935

-2,871

-21,199

-6,865

7,838

Net Cash Used by Ops/Investments Cash Flows from Financing

Net Cash Flows from Financing Net Decrease in Cash and Cash Equiv.

0

0

0

6,487

-6,487

Beginning Cash Balance

23,000

23,000

23,000

23,000

29,487

Ending Cash Balance

23,000

23,000

23,000

29,487

23,000

7. [Short-Term Financial Planning] Artero Corporation is a traditional toy products retailer that recently also started an Internet-based subsidiary that sells toys online. A markup is added on goods the company purchases from manufacturers for resale. Swen Artero, the company president, is preparing for a meeting with Jennifer Brown, a loan officer with First Banco Corporation, to review year end financing requirements. After discussions with the company’s marketing manager, Rolf Eriksson, and finance manager, Lisa Erdinger, sales over the last three months of 2020 are forecasted to be:

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Chapter 6: Managing Cash Flow Artero’s balance sheet as of the end of September, 2020 was as follows.

All sales are made on credit terms of net 30 days and are collected the following month and no bad debts are anticipated. The accounts receivable on the balance sheet at the end of September thus will be collected in October. The October sales will be collected in November, and so on. Inventory on hand represents a minimum operating level (or ―safety‖ stock), which the company intends to maintain. Cost of goods sold average 80 percent of sales. Inventory is purchased in the month of sale and paid for in cash. Other cash expenses average 7 percent of sales. Depreciation is $10,000 per month. Assume taxes are paid monthly and the effective income tax rate is 40 percent for planning purposes.

The annual interest rate on outstanding long-term debt and bank loans (notes payable) is 12%. There are no capital expenditures planned during the period, and no dividends will be paid. The company’s desired end-of-month cash balance is $80,000. The president hopes to meet any cash shortages during the period by increasing the firm’s notes payable to the bank. The interest rate on new loans will be 12 percent.

A. Prepare monthly pro forma income statements for October, November, and December, and for the quarter ending December 31, 2020.

Artero Corporation Solution Ch 6, Prob. 7 (In $ Thousands) Income Statements Sales Cost of Goods Sold (80% of Sales) Gross Profit Other Expenses (7% of Sales) Depreciation Earnings Before Int. & Taxes (EBIT) Interest (1%/mth--all borrowed debt) Earnings Before Taxes (EBT) Taxes (40% of EBT) Net Income

Actual Projected Projected Projected Sept. 2020 Oct. Nov. Dec. 700.0 1000.0 1500.0 3000.0 -560.0 -800.0 -1200.0 -2400.0 140.0 200.0 300.0 600.0 -49.0 -70.0 -105.0 -210.0 -10.0 -10.0 -10.0 -10.0 81.0 120.0 185.0 380.0 -12.0 -12.0 -14.6 -18.4 69.0 108.0 170.4 361.6 -27.6 -43.2 -68.2 -144.6 41.4 64.8 102.3 216.9

Quarter Ending Dec. 2020 5500.0 -4400.0 1100.0 -385.0 -30.0 685.0 -45.0 640.0 -256.0 384.0

Note: Interest is based on the amount of all borrowed debt (notes payable, cumulative amount of new bank loans, and long-term debt) outstanding at the end of the prior month times .01.

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B. Prepare monthly pro forma balance sheets at the end of October, November, and December, 2020.

Balance Sheets Required Cash Surplus Cash Accounts Receivable Inventories Current Assets Fixed Assets, Net Total Assets

Sept. 2020 50.0 0.0 700.0 500.0 1250.0 750.0 2000.0

Oct. 80.0 0.0 1000.0 500.0 1580.0 740.0 2320.0

Nov. 80.0 0.0 1500.0 500.0 2080.0 730.0 2810.0

Dec. 80.0 0.0 3000.0 500.0 3580.0 720.0 4300.0

0.0 800.0 0.0 800.0 400.0 800.0 2000.0

0.0 800.0 255.2 1055.2 400.0 864.8 2320.0

0.0 800.0 642.9 1442.9 400.0 967.1 2810.0

0.0 800.0 1916.0 2716.0 400.0 1184.0 4300.0

Accounts Payable Notes Payable New Bank Loans (total amounts) Current Liabilities Long-Term Debt Equity Total Liab. & Equity

C. Prepare both a monthly cash budget and pro forma statements of cash flows for October, November, and December 2020.

Cash Budget Collection of Receivables Purchases Other Cash Costs (7% of Sales) Payment of Interest Payment of Taxes Investment in Fixed Assets Net Monthly Cash Flow Beginning Cash Less: Target Cash Amount Ending Cash Before Borrowing New Bank Loans Ending (Required) Cash

Sept. 2020

Oct. 700.0 -800.0 -70.0 -12.0 -43.2 0.0 -225.2

Nov. 1000.0 -1200.0 -105.0 -14.6 -68.2 0.0 -387.7

Dec. 1500.0 -2400.0 -210.0 -18.4 -144.6 0.0 -1273.1

50.0 80.0 -255.2 255.2 80.0

80.0 80.0 -387.7 387.7 80.0

80.0 80.0 -1273.1 1273.1 80.0

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Chapter 6: Managing Cash Flow

Statement of Cash Flows Operating: Net Income Depreciation Change in Accts. Receivable Change in Inventories Change in Accts. Payable Cash Flow from Operations Investing: Change in Gross Fixed Assets Financing: New Bank Loans Net Monthly Cash Flow Beginning Cash Ending (Required) Cash Check: New Bank Loans Cumulative Bank Loans

Sept. 2020

Oct.

Nov.

Dec.

64.8 10.0 -300.0 0.0 0.0 -225.2

102.3 10.0 -500.0 0.0 0.0 -387.7

216.9 10.0 -1500.0 0.0 0.0 -1273.1

0.0

0.0

0.0

255.2 30.0 50.0 80.0

387.7 0.0 80.0 80.0

1273.1 0.0 80.0 80.0

255.2 255.2

387.7 642.9

1273.1 1916.0

D. Describe your findings and indicate the maximum amount of bank borrowing that is needed.

Based on the financial projection above, a maximum of $1,916,000 is needed.

8. Cash Conversion Cycle] Two years of financial statement data for the Munich Export Corporation are shown below.

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123

A. Calculate the inventory-to-sale, sale-to-cash, and purchase-to-payment conversion periods for Munich Exports for 2019.

Inventory-to-Sale Conversion Period = Average Inventories / (Cost of Goods Sold/365) = [($450,000 + $570,000)/2]/$960,000/365 = $510,000/$2,630.14 = 193.91 days Sale-to-Cash Conversion Period = Average Receivables / (Net Sales/365) = [($200,000 + $300,000)/2]/ ($1,600,000/365) = $250,000/$4,383.56 = 57.03 days Purchase-to-Payment Conversion Period = (Average Payables + Average Accrued Liabilities) / (Cost of Goods Sold/365) = [(($130,000 + $180,000)/2) + (($50,000 + $70,000)/2) / ($960,000/365) = ($155,000 + $60,000)/$2,630.14 = $215,000/$2,630.14 = 81.74 days B. Calculate the length of Munich Exports’ cash conversion cycle for 2019.

Cash Conversion Cycle = Inventory-to-Sale Conversion Period + Sale-to-Cash Conversion Period – Purchase-to-Payment Conversion Period Cash Conversion Cycle = 193.91 days + 57.03 days – 81.74 days = 163.20 days

9. [Cash Conversion Cycle] Castillo Products Company improved its operations from a net loss in 2018 to a net profit in 2019. While the founders, Cindy and Rob Castillo, are happy about these developments, they are concerned with trying to understand how long the firm takes to complete its cash conversion cycle in 2016. Use the following financial statements to make your calculations. Balance sheet items should reflect the averages of the 2015 and 2016 accounts.

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Chapter 6: Managing Cash Flow CASTILLO PRODUCTS COMPANY

INCOME STATEMENT Net sales Cost of goods sold Gross profit Marketing General and administrative Depreciation EBIT Interest Earnings before taxes Income taxes Net income (loss)

2018 $900,000 540,000 360,000 90,000 250,000 40,000 –20,000 45,000 –65,000 0 –$65,000

2019 $1,500,000 900,000 600,000 150,000 250,000 40,000 160,000 60,000 100,000 25,000 $ 75,000

BALANCE SHEET Cash Accounts receivable Inventories Total current assets Gross fixed assets Accumulated depreciation Net fixed assets Total assets

2018 $ 50,000 200,000 400,000 650,000 450,000 –100,000 350,000 $1,000,000

2019 $ 20,000 280,000 500,000 800,000 540,000 –140,000 400,000 $1,200,000

Accounts payable Accruals Bank loan Total current liabilities Long-term debt Common stock (0.05 par) Additional paid-in-capital Retained earnings Total liabilities and equity

$ 130,000 50,000 90,000 270,000 300,000 150,000 200,000 80,000 $1,000,000

$160,000 70,000 100,000 330,000 400,000 150,000 200,000 120,000 $1,200,000

A. A. Calculate the inventory-to-sale conversion period for 2019.

Inventory-to-Sale Conversion Period = Avg. Inventory/Avg. Daily COGS = (($400,000 + $500,000)/2)/($900,000/365) = 182.50 days B. Calculate the sale-to-cash conversion period for 2019.

Sale-to-Cash Conversion Period = Avg. Receivables/Avg. Daily Sales = (($200,000 + $280,000)/2)/($1,500,000/365) = 58.40 days

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125

C. Calculate the purchase-to-payment conversion period for 2019.

Purchase-to-Payment Conversion Period = (Avg. Payables + Avg. Accruals)/Avg. Daily CGS = (($130,000 + $160,000)/2 + ($50,000 + $70,000)/2)/($900,000/365) = 83.14 days D. Determine the length of the Castillo Product’s cash conversion cycle for 2019.

Length of the Cash Conversion Cycle = (Inventory-to-Sale Conversion Period) + (Salesto-cash Conversion Period) – (Purchase-to-Payment Conversion Period) = 182.50 days + 58.40 days – 83.14 days = 157.76 days 10. [Cash Conversion Cycle] Safety-First, Inc. makes portable ladders that can be used to exit second floor levels of homes in the event of fire. Each ladder consists of fire resistant rope and high strength plastic steps. A lightweight fire resistant cape with a smoke filter is included with Safety-First ladder. Each ladder and cape, when not in use, are rolled up and stored in a pouch the size of a back pack and can easily be taken on trips and vacations.

Jan Smithson founded Safety-First as soon as she graduated from a private liberal arts college in the northwest three years ago. After struggling for the first year, the venture seemed to be growing and producing profits. Following are the two most recent years of financial statements, expressed in thousands of dollars, for the Safety-First, Inc. SAFETY-FIRST, INC.

Income Statements (in $ Thousands) Net sales Cost of goods sold Gross profit Operating expenses Interest Income before taxes Income taxes Net income

2018 3,750 2,250 1,500 670 30 800 250 550

2019 4,500 2,700 1,800 860 40 900 300 600

2018 400 500 1,450 2,350 2,000 -950 1,050 3,400

2019 150 800 2,000 2,950 2,800 -1,250 1,550 4,500

Balance Sheets (in $ Thousands) Cash Accounts receivable Inventories Total current assets Gross fixed assets Less accumulated depreciation Net fixed assets Total assets

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Chapter 6: Managing Cash Flow

Accounts payable Bank loan Accrued liabilities Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

2018 300 150 100 550 150 850 1,850 3,400

2019 400 250 150 800 150 1,100 2,450 4,500

A. Using yearend data, calculate the inventory-to-sale conversion period, the sale-tocash conversion period, and the purchase-to-payment conversion period for 2018 and 2019.

Note: because inventories, accounts receivable, accounts payable, and accrued liabilities are not available for 2017, averages of these accounts cannot be calculated for 2018. So for 2018 versus 2019 comparative purposes, we use yearend data for these accounts.

Inventory-to-Sale Conversion Period = (Yearend Inventories) / (COGS / 365) 2018: 1450 / (2250 / 365) = 1450/6.1644 = 235.22 2019: 2000 / (2700 / 365) = 2000/7.3973 = 270.37 Note: the calculation for 2019 using average inventories would be: Inventory-to-Sale Conversion Period = (Average Inventories) / (COGS / 365) 2019: ((1450 + 2000) / 2) / (2700 / 365) = 1725/7.3973 = 233.19 Sale-to-Cash Conversion Period = (Yearend Receivables) / (Net Sales / 365) 2018: 500 / (3750 / 365) = 500/10.2740 = 48.67 2019: 800 / (4500 / 365) = 800/12.3288 = 64.89 Note: the calculation for 2019 using average receivables would be: Sale-to-Cash Conversion Period = (Average Receivables) / (Net Sales / 365) 2019: [(500 + 800) / 2] / (4500 / 365) = 650/12.3288 = 52.72 Purchase-to-Payment Conversion Period = (Yearend Payables + Yearend Accrued Liabilities) / (COGS / 365)

2018 (300 + 100) / (2250 / 365) = 400/6.1644 = 64.89 2019: (400 + 150) / (2700 / 365) = 550/7.3973 = 74.35 Note: the calculation for 2019 using average payables and average accruals would be: Purchase-to-Payment Conversion Period = (Average Payables + Average Accrued Liabilities) / (COGS / 365) 2019: ((300 + 400)/2) + ((100 + 150)/2) = 350 + 125 = 475 475 / (2700 / 365) = 475/7.3973 = 64.21 B. Determine the cash conversion cycle for each year and discuss the changes that took place, if any.

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127

Cash Conversion Cycle = Inventory-to-Sale Conversion Period + Sale-to-Cash Conversion Period – Purchase-to-Payment Conversion Period 2018: 235.22 + 48.67 – 64.89 = 219.00 2019: 270.37 + 64.89 – 74.35 = 260.91 Note: using average (2018 and 2019) balance sheet accounts for 2019 results in the following cash conversion cycle: 2019: 233.19 + 52.72 – 64.21 = 221.70 SPREADSHEET EXERCISES/PROBLEMS [Note: The following activities are for students with spreadsheet software skills.]

11. Short-term financial planning for the PDC Company was described during the early part of this chapter. Refer to the PDC Company‘s projected monthly operating schedules in Table 6.2.

PDC‘s monthly sales for the remainder of 2020 are expected to be: September October November December

$80,000 $100,000 $130,000 $160,000

A. Prepare PDC’s sales schedule, purchases schedule, and the wages schedule for each of the last four months of 2020.

See spreadsheet solution below.

B. Prepare cash budgets for each of the last four months of 2020 for the PDC Company and describe how the forecast affects the end of month cash balances.

See spreadsheet solution below.

C. Prepare the PDC Company’s projected monthly income statements for the August through December period.

See spreadsheet solution below.

D. Prepare the PDC Company’s projected monthly balance sheets for the August through December period.

See spreadsheet solution below.

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Chapter 6: Managing Cash Flow E. Prepare the PDC Company’s projected monthly statements of cash flow for the August through December period.

See spreadsheet solution below.

F. Compare your balance sheet at the end of December with the balance sheet in Table 6.1 in the chapter and apply the balance sheet method to determine cash flows over the March-December period.

See spreadsheet solution below.

March Schedule 1: Sales Forecast

April

May

June

July

Aug.

Sept.

Oct.

Nov.

Dec.

Jan. 100,000

92,000

115,000

184,000

138,000

115,000

92,000

80,000

100,000

130,000

160,000

Credit sales, 40%

36,800

46,000

73,600

55,200

46,000

36,800

32,000

40,000

52,000

64,000

Cash sales, 60%

55,200

69,000

110,400

82,800

69,000

55,200

48,000

60,000

78,000

96,000

Cash sales this month

69,000

110,400

82,800

69,000

55,200

48,000

60,000

78,000

96,000

100% of last month's credit sales

36,800

46,000

73,600

55,200

46,000

36,800

32,000

40,000

52,000

Total Collections

105,800

156,400

156,400

124,200

101,200

84,800

92,000

118,000

148,000

Schedule 2: Cash Collections

Schedule 3: Purchases Ending inventory

110,400

149,040

123,280

110,400

97,520

90,800

102,000

118,800

135,600

102,000

Cost of goods sold

64,400

80,500

128,800

96,600

80,500

64,400

56,000

70,000

91,000

112,000

Total needed

174,800

229,540

252,080

207,000

178,020

155,200

158,000

188,800

226,600

214,000

Beginning Inventory

97,520

110,400

149,040

123,280

110,400

97,520

90,800

102,000

118,800

135,600

Purchases

77,280

119,140

103,040

83,720

67,620

57,680

67,200

86,800

107,800

78,400

Schedule 4: Disbursements for Purchases 50% of last month's purchases

38,640

59,570

51,520

41,860

33,810

28,840

33,600

43,400

53,900

50% of this month's purchases

59,570

51,520

41,860

33,810

28,840

33,600

43,400

53,900

39,200

Disbursements for merchandise

98,210

111,090

93,380

75,670

62,650

62,440

77,000

97,300

93,100

Schedule 5: Wages and Commissions Wages, all fixed

5,750

5,750

5,750

5,750

5,750

5,750

5,750

5,750

5,750

5,750

Commissions (15% of current sales)

13,800

17,250

27,600

20,700

17,250

13,800

12,000

15,000

19,500

24,000

Total

19,550

23,000

33,350

26,450

23,000

19,550

17,750

20,750

25,250

29,750

50% of last month's expenses

9,775

11,500

16,675

13,225

11,500

9,775

8,875

10,375

12,625

50% of this month's expenses

11,500

16,675

13,225

11,500

9,775

8,875

10,375

12,625

14,875

Total

21,275

28,175

29,900

24,725

21,275

18,650

19,250

23,000

27,500

Schedule 6: Disbursements-Wages/Comm

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129

Cash Budget

April

May

June

July

Aug.

Sept.

Oct.

Nov.

Dec.

Beginning cash balance

23,000

23,000

23,000

23,000

29,487

37,562

32,672

18,822

5,422

105,800

156,400

156,400

124,200

101,200

84,800

92,000

118,000

148,000

128,800

179,400

179,400

147,200

130,687

122,362

124,672

136,822

153,422

Merchandise

98,210

111,090

93,380

75,670

62,650

62,440

77,000

97,300

93,100

Wages and commissions

21,275

28,175

29,900

24,725

21,275

18,650

19,250

23,000

27,500

Miscellaneous expenses

5,750

9,200

6,900

5,750

4,600

4,000

5,000

6,500

8,000

Rent

4,600

4,600

4,600

4,600

4,600

4,600

4,600

4,600

4,600

Truck purchase

6,900

0

0

0

0

0

0

0

0

Total disbursements

136,735

153,065

134,780

110,745

93,125

89,690

105,850

131,400

133,200

Cash receipts Collections from customers Total cash available for needs, before fin.

Cash disbursements:

Minimum cash balance desired

23,000

23,000

23,000

23,000

23,000

23,000

23,000

23,000

23,000

Total cash needed

159,735

176,065

157,780

133,745

116,125

112,690

128,850

154,400

156,200

Excess of total cash

-30,935

3,335

21,620

13,455

14,562

9,672

-4,178

-17,578

-2,778

Financing New Borrowing

30,935

0

0

0

0

0

0

0

0

2,871

21,199

6,865

0

0

0

0

0

30,935

28,064

6,865

0

0

0

0

0

0

0

464

421

103

0

0

0

0

0

Total effects of financing

30,935

-3,335

-21,620

-6,968

0

0

0

0

0

Cash balance

23,000

23,000

23,000

29,487

37,562

32,672

18,822

5,422

20,222

Repayments Loan balance Interest

Budgeted Income Statements Sales

92,000

115,000

184,000

138,000

115,000

92,000

80,000

100,000

130,000

160,000

COGS

-64,400

-80,500

-128,800

-96,600

-80,500

-64,400

-56,000

-70,000

-91,000

-112,000

Gross Margin

27,600

34,500

55,200

41,400

34,500

27,600

24,000

30,000

39,000

48,000

Operating Expenses Wages and commissions

-19,550

-23,000

-33,350

-26,450

-23,000

-19,550

-17,750

-20,750

-25,250

-29,750

Rent

-4600

-4600

-4600

-4600

-4600

-4600

-4600

-4600

-4600

-4600

Miscellaneous expenses

-4600

-5750

-9200

-6900

-5750

-4600

-4000

-5000

-6500

-8000

Insurance

-460

-460

-460

-460

-460

-460

-460

-460

-460

-460

Depreciation

-1150

-1150

-1150

-1150

-1150

-1150

-1150

-1150

-1150

-1150

Total operating expenses

-30,360

-34,960

-48,760

-39,560

-34,960

-30,360

-27,960

-31,960

-37,960

-43,960

Income from operations

-2,760

-460

6,440

1,840

-460

-2,760

-3,960

-1,960

1,040

4,040

0

0

-464

-421

-103

0

0

0

0

0

-2,760

-460

5,976

1,419

-563

-2,760

-3,960

-1,960

1,040

4,040

Interest expense Net income

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Chapter 6: Managing Cash Flow

Balance Sheets Current Assets: Cash

23,000

23,000

23,000

23,000

29,487

37,562

32,672

18,822

5,422

Accounts receivable

36,800

46,000

73,600

55,200

46,000

36,800

32,000

40,000

52,000

64,000

Merchandise inventory

110,400

149,040

123,280

110,400

97,520

90,800

102,000

118,800

135,600

102,000

Unexpired insurance Total Current Assets

20,222

4,140

3,680

3,220

2,760

2,300

1,840

1,380

920

460

0

174,340

221,720

223,100

191,360

175,307

167,002

168,052

178,542

193,482

186,222

Plant Equipment, fixtures and other

85,100

92,000

92,000

92,000

92,000

92,000

92,000

92,000

92,000

92,000

Accumulated depreciation

-29,440

-30,590

-31,740

-32,890

-34,040

-35,190

-36,340

-37,490

-38,640

-39,790

Net PPE

55,660

61,410

60,260

59,110

57,960

56,810

55,660

54,510

53,360

52,210

Total Assets

230,000

283,130

283,360

250,470

233,267

223,812

223,712

233,052

246,842

238,432

Accounts payable

38,640

59,570

51,520

41,860

33,810

28,840

33,600

43,400

53,900

39,200

Accrued wages and commissions payable

9,775

11,500

16,675

13,225

11,500

9,775

8,875

10,375

12,625

14,875

0

30,935

28,064

6,865

0

0

0

0

0

0

Total Current Liabilities

48,415

102,005

96,259

61,950

45,310

38,615

42,475

53,775

66,525

54,075

Owner's equity

181,585

181,125

187,101

188,520

187,957

185,197

181,237

179,277

180,317

184,357

Total equities

230,000

283,130

283,360

250,470

233,267

223,812

223,712

233,052

246,842

238,432

Current Liabilities

Loan

Accounting Statement of Cash Flows Cash Flows From Activities Net Income Adjustments to Net Inc for CF Depreciation Expense Decrease in Prepaids Increase in Accrued Liab.

Decrease in Inventory Decrease in A/P Increase in A/R Decrease in Def. Inc. Tax Total Adjustments

-460

5,976

1,419

-563

-2,760

-3,960

-1,960

1,040

4,040

1,150 460 1,725 -38,640 20,930 -9,200 0 -23,575

1,150 460 5,175 25,760 -8,050 -27,600 0 -3,105

1,150 460 -3,450 12,880 -9,660 18,400 0 19,780

1,150 460 -1,725 12,880 -8,050 9,200 0 13,915

1,150 460 -1,725 6,720 -4,970 9,200 0 10,835

1,150 460 -900 -11,200 4,760 4,800 0 -930

1,150 460 1,500 -16,800 9,800 -8,000 0 -11,890

1,150 460 2,250 -16,800 10,500 -12,000 0 -14,440

1,150 460 2,250 33,600 -14,700 -12,000 0 10,760

Net Cash Flow From Opps (Acct.)

-24,035

2,871

21,199

13,352

8,075

-4,890

-13,850

-13,400

14,800

Cash Flows From Investing Capex Net Cash Used by Ops/Investments

-6,900 -30,935

0 2,871

0 21,199

0 13,352

0 8,075

0 -4,890

0 -13,850

0 -13,400

0 14,800

Cash Flows from Financing Equity Issues Dividends Debt Issues Net Cash Flows from Financing

0 0 30,935 30,935

0 0 -2,871 -2,871

0 0 -21,199 -21,199

0 0 -6,865 -6,865

0 0 0 0

0 0 0 0

0 0 0 0

0 0 0 0

0 0 0 0

Net Decrease in Cash and Cash Equiv.

Beginning Cash Balance Ending Cash Balance

0 23,000 23,000

0 23,000 23,000

0 23,000 23,000

6,487 23,000 29,487

8,075 29,487 37,562

-4,890 37,562 32,672

-13,850 32,672 18,822

-13,400 18,822 5,422

14,800 5,422 20,222

12. Artero Corporation, discussed in Problem 7, is a retailer of toy products. The firm’s management team recently extended the monthly sales forecasts that were prepared for the last three months of 2020 for an additional 6 months in 2021. These forecasts were presented to Swen Artero, the firm’s president, as follows.

Chapter 6: Managing Cash Flow

131

A. Use the income statement related data and the balance sheet information from Problem 7 to prepare monthly income statements, balance sheets, and statements of cash flow for October through December of 2020. What is the maximum amount of bank borrowing that would be needed?

Artero Corporation Income Statement (Thousands of Dollars)

Sales Cost of Goods Sold Gross Margin Depreciation Other Expense Interest EBT Taxes (40%)

Sept. 2020 $ 700 560 140 10 49 12 69 28

Net Income

$

Oct. 2020 1,000 800 200 10 70 12 108 43

Nov. 2020 $ 1,500 1,200 300 10 105 15 170 68

Dec. 2020 $ 3,000 2,400 600 10 210 18 362 145

65

102

217

41

Balance Sheet (Thousands of Dollars)

Cash

Sept.30, 20 $ 50

Oct.31, 20 $ 80

Nov. 30, 20 $ 80

Dec. 31, 20 $ 80

700 500

1,000 500

1,500 500

3,000 500

1,250

1,580

2,080

3,580

Accounts Receivable Inventories Total Currents Assets Fixed Assets, Net

750

Total Assets

$

Accounts Payable

$

Notes Payable Long-term Debt Additional Funds Needed Total Liabilities Equity Total Liabilities & Equity

740

2,000

$

-

$

$

-

$

$

-

$

800 400

800 400

1,200

255 1,455

643 1,843

2,000

865 $

2,320

Statement of Cash Flow (Thousands of Dollars)

720

2,810

800 400

800 $

730

2,320

2,810

800 400 1,916 3,116

967 $

4,300

1,184 $

4,300

132

Chapter 6: Managing Cash Flow

10/31/2020 Cash Flow From Operations Net Income + Depreciation - Increase In A/R - Increase In Inventory Cash Flow From Operations Cash Flow from Investing Cash Flow from Financing Total Cash Flow

$

65 10 300 0 -225 0 0 -225

11/30/2020 12/31/2020 $

102 10 500 0 -388 0 0 -388

$

217 10 1,500 0 -1,273 0 0 -1,273

Beginning Cash Balance Required Balance

50 80

80 80

80 80

Additional Funds Needed Cumulative Funds Needed Ending Cash Balance

255 255 80

388 643 80

1,273 1,916 80

As shown in both Balance Sheet and Statement of Cash Flow, $1,916,000 was needed to support the projected sales in the coming three months.

B. Prepare monthly income statements, balance sheets, and statements of cash flow for the first six months of 2021. Assume the information and data relationships from Problem 7 will continue to hold for the first six months of 2021. Indicate if, and when, the additional bank borrowing needed during the last three months of 2020 can be repaid.

Chapter 6: Managing Cash Flow

133

Artero Corporation Pro Forma Statements 2021 Income Statement (Thousands of Dollars) Jan. 15

Sales Cost of Goods Sold Gross Margin Depreciation Other Expense Interest EBT Taxes (40%) Net Income

Feb. 15

Mar. 15 Apr. 15 May. 15 June. 15 July. 15 Aug. 15

Sep. 15

Oct. 15

Nov. 15

Dec. 15

2021

$1,500 $ 1,000 $ 700 $ 700 $ 700 $ 700 $ 900 $ 1,100 $ 1,400 $ 1,700 $ 2,800 $ 4,000 $ 17,200 1,200 800 560 560 560 560 720 880 1,120 1,360 2,240 3,200 $ 13,760 300 200 140 140 140 140 180 220 280 340 560 800 3,440 10 10 10 10 10 10 10 12 12 12 12 12 130 105 70 49 49 49 49 63 77 98 119 196 280 1,204 31 15 12 12 12 12 12 12 12 12 12 20 175 154 105 69 69 69 69 95 119 158 197 340 488 1,931 62 42 28 28 28 28 38 48 63 79 136 195 773 92

63

41

41

41

41

Jan. 15

Feb. 15

Mar. 15

Apr. 15

May. 15

$ 80 $

80 259 339 1,000 500 1,839

$

$ 80 662 742 700 500 1,942

$

57

71

95

118

204

293

1,159

Balance Sheet 2021 (Thousands of Dollars) Cash Required Cash Surplus Total Cash Accounts Receivable Inventories Total Currents Assets Fixed Assets, Net Total Assets

1,500 500 2,080

80 611 691 700 500 1,891

710 700 690 680 $ 2,790 $ 2,539 $ 2,581 $ 2,622

Accounts Payable $ - $ - $ - $ Notes Payable 800 800 800 800 Long-term Debt 400 400 400 400 Additional Funds Needed 314 Total Liabilities 1,514 1,200 1,200 1,200 Equity 1,276 1,339 1,381 1,422 Total Liabilities & Equity $ 2,790 $ 2,539 $ 2,581 $ 2,622

June. 15

July. 15

Aug. 15

Sep. 15

Oct. 15

Nov.15

Dec. 15

$ 80 765 845 700 500 2,045

$ 80 532 612 900 500 2,012

$ 80 415 495 1,100 500 2,095

$ 80 222 302 1,400 500 2,202

$ 80 52 132 1,700 500 2,332

$ 80

$ 80

80 2,800 500 3,380

80 4,000 500 4,580

80 713 793 700 500 1,993

670 $ 2,663

660 750 738 726 714 702 690 $ 2,705 $ 2,762 $ 2,833 $ 2,928 $ 3,046 $ 4,082 $ 5,270

$

$

800 400

1,200 1,463 $ 2,663

800 400

1,200 1,505 $ 2,705

$

- $ 800 400

- $ 800 400

- $ 800 400

800 400

$

- $ 800 800 400 400 832 1727 1,200 1,200 1,200 1,200 2,032 2,927 1,562 1,633 1,728 1,846 2,050 2,343 $ 2,762 $ 2,833 $ 2,928 $ 3,046 $ 4,082 $ 5,270

134

Chapter 6: Managing Cash Flow Statement of Cash Flow (Thousands of Dollars) 1/31/21 2/28/21 3/31/21 4/30/21 5/31/21 6/30/21 7/31/21 8/31/21 9/30/21 10/31/21 11/30/21 12/31/21

Cash Flow From Operations Net Income + Depreciation - Increase In A/R - Increase In Inventory Cash Flow From Operations Cash Flow from Investing Cash Flow from Financing Total Cash Flow

$ 92 10 -1,500 0

$ 63 10 -500 0

$ 41 10 -300 0

1,602 0 0 1,602

573 0 0 573

351 0 0 351

51 0 0 51

51 0 0 51

51 0 0 51

-133 -100 0 -233

-117 0 0 -117

-193 0 0 -193

-170 0 0 -170

-884 0 0 -884

-895 0 0 -895

Beginning Cash Balance Required Balance

80 80

80 80

80 80

80 80

80 80

80 80

80 80

80 80

80 80

80 80

80 80

80 80

Additional Funds Needed Cumulative Funds Needed Cash Surplus Ending Total Cash

1,602 314

573 0 259 339

351 0 611 691

51 0 662 742

51 0 713 793

51 0 765 845

-233 0 532 612

-117 0 415 495

-193 0 222 302

-170 0 52 132

-884 832

-895 1,727

80

80

80

$ 41 $ 41 10 10 0 0 0 0

$ 41 $ 57 $ 71 $ 95 $ 118 10 10 12 12 12 0 200 200 300 300 0 0 0 0 0

$ 204 $ 293 12 12 1,100 1,200 0 0

As shown on the company‘s balance sheet and statement of cash flow, started from February of 2021, the cash surplus account increased monthly through the first-half of the year (with a peak in June). This indicated that the positive cash flow from operations in January and through much of February were used to repay the $1.9 million additional bank borrowing needed during the last three months of 2020, and the borrowing will be paid off by February of 2021.

C. Based on your financial statement projections for the first six months of 2021, indicate whether new bank borrowing will be needed.

As previously noted, surplus cash continues to rise through June, 2021. Thus, no new bank borrowing will be needed during the first half of 2021.

13. Artero Corporation, discussed in Problems 7 and 12, is a retailer of toy products. This is a continuation of Problem 12. The firm’s management team recently extended the monthly sales forecasts through the last six months of 2021. Artero expects to spend $100,000 on fixed assets in July 2021 and depreciation charges will increase to $12,000 per month beginning in August 2021.

A. Prepare monthly income statements, balance sheets, and statements of cash flow for the last

six months of 2021.

Results for Problem 13 (last six months of 2021) are shown in the comprehensive financial projections provided in Problem 12 for all of 2021.

B. Based on your financial statement projections for the last six months of 2021 indicate (1) whether new bank borrowing will be needed to finance the seasonal sales pattern and (2) if a loan is needed, when does the need start occurring and what is the maximum amount needed?

(1) Yes, new bank borrowing will be needed to finance the seasonal sales pattern, and (2) Based on the projected balance sheet for last-half of 2021, Artero Corporation needs seasonal bank borrowing beginning in November of 2021 ($832,000) with a maximum cumulative need of $1,727,000 in December.

C. Assume that sales are forecasted for the first three months of 2022 as follows: January = $3 million, February = $2 million, and March = $1 million. Will Artero be able to pay off any bank borrowing that is needed in 2021? Based on your analyses, what type(s), if any, of bank loan(s) are needed in 2021?

Artero Corporation Pro Forma Income Statement 2022 (Thousands of Dollars)

Sales Cost of Goods Sold Gross Margin

Jan 2022 3000 2400 600

135

Feb 2022 2000 1600 400

Mar.2022 1000 800 200

136 Depreciation Other Expense Interest EBT Taxes (40%)

12 210 297 348.73 139.492

12 140 17.06 230.94 92.376

12 70 12 106 42.4

Net Income

209.238

138.564

63.6

Pro Forma Balance Sheet (Thousands of Dollars)

3000 500 3580

Feb. 2022 80 645 2000 500 3225

Mar. 2022 80 1720 1000 500 3300

Fixed Assets, Net Total Assets

678 4258

666 3891

654 3954

Accounts Payable Notes Payable Long-term Debt Additional Funds Needed Total Liabilities Equity Total Liabilities & Equity

0 800 400 506 1706 2552 4258

0 800 400

0 800 400

1200 2691 3891

1200 2754 3954

Cash required Cash Surplus Accounts Receivable Inventories Total Currents Assets

Jan. 2022 80

As indicated above in the projected 2022 pro forma statement, Artero will be able to pay off all borrowing of $1,727,000 in December, 2021 by February of 2022. A surplus cash of $645,000 will also appear in February of 2022. In this case, short-term borrowing will be sufficient for Artero to obtain all of the additional funds needed in 2021.

MINI CASE: SCANDI HOME FURNISHINGS, INC.

Kaj Rasmussen founded Scandi Home Furnishings as a corporation during mid-2016. Sales during the first full year (2017) of operation reached $1.3 million. Sales increased by 15 percent in 2018 and another 20 percent in 2019. However, profits after increasing in 2018 over 2017 fell sharply in 2019 causing Kaj to wonder what was happening to his ―pride and joy‖ business venture. After all, Kaj has continued to work as close as possible to a 24/7 pace beginning with the startup of Scandi and through the first three full years of operation.

Scandi Home Furnishings, located in eastern North Carolina, designs, manufactures, and sells Scandinavian-designed furniture and accessories to home furnishings retailers. The modern Scandinavian design has a streamlined and uncluttered look. While this furniture style is primarily associated with Denmark, both Norway and Sweden designers have contributed to the

137 allure of Scandinavian home furnishings. Some say that the inspiration for the Scandinavian design can be traced to the ―elegant curves‖ of art nouveau from which designers were able to produce aesthetically pleasing, structurally strong modern furniture. Danish furnishings and the home furnishings produced by the other Scandinavian countries—Sweden, Norway, and Finland—are made using wood (primarily oak, maple, and ash), aluminum, steel, and high-grade plastics.

Kaj grew up in Copenhagen, Denmark and received a college degree from a technical university in Sweden. As is typically in Europe, Kaj began his business career as an apprentice at a major home furnishings manufacturer in Copenhagen. After ―learning the trade,‖ he quickly moved into a management position in the firm. However, after a few years, Kaj realized that what he really wanted to do was to start and operate his own Scandinavian home furnishings business. At the same time, after traveling throughout the world including the U.S., he was sure that he wanted to be an entrepreneur in the United States. Thus, while it was hard to give up the Tivoli Gardens with its many entertainment and dining activities, as well as the other attractions in Copenhagen, Kaj moved to the U.S. in early 2016. With $140,000 of his personal assets, and $210,000 from venture investors, he began operations in mid-2016. Kaj, with a 40 percent ownership interest and industry-related management expertise, was allowed to operate the venture in a way that he thought was best for Scandi. Four years later, Kaj is sure he did the right thing.

Following are the three years of income statements and balance sheets for the Scandi Home Furnishings Corporation. Kaj has felt that in order to maintain a competitive advantage that he would need to continue to expand sales. After first concentrating on selling Scandinavian home furnishings in the northeast in 2017 and 2018, he decided to enter the west coast market.

An increase in expenses associated with identifying, contacting, and selling to home furnishings retailers in California, Oregon, and Washington. Kaj Rasmussen was hoping that you could help him better understand what has been happening to Scandi Home Furnishings both from operating and financial standpoints.

SCANDI HOME FURNISHINGS, INC.

138

SCANDI HOME FURNISHINGS, INC.

Note: 30,000 shares of common stock were issued to Kaj Rasmussen and the venture investors when Scandi Home Furnishings was incorporated in mid-2016.

H. An analysis of the cash conversion cycle should also help Kaj understand what has been happening to the operations of Scandi. Prepare an analysis of the average conversion periods for the three components of the cash conversion cycle for 2017-2018 and 20182019. Explain was has happened in terms of each component of the cycle.

Ratios are based on the current year‘s income statement amounts and average amounts (past year and current year) for balance sheet items.

Inventory-to-Sale for 2017-18: Average Inventories = (450,000 + 500,000)/2 = 475,000 Cost of Goods Sold per Day = 90,000/365 = 2,465.75 475,000/2,465.75 = 192.64 days Sale-to-Cash for 2017-18: Average Accounts Receivable = (200,000 + 260,000)/2 = 230,000 Sales per Day = 1,500,000/365 = 4,109.59 230,000/4,109.59 = 55.97 days Purchase-to-Payment for 2017-18: Average Accounts Payable = (130,000 + 170,000)/2 = 150,000 Average Accrued Liabilities = (50,000 + 70,000)/2 = 60,000

139 150,000 + 60,000 = 210,000 Cost of Goods Sold per Day = 900,000/365 = 2,465.75 210,000/2,465.75 = 85.17 days Inventory-to-Sale for 2018-19: Average Inventories = (500,000 + 600,000)/2 = 550,000 Cost of Goods Sold per Day = 1,260,000/365 = 3,452.05 550,000/3,452.05 = 159.33 days Sale-to-Cash for 2018-19: Average Accounts Receivable = (260,000 + 360,000)/2 = 310,000 Sales per Day = 1,800,000/365 = 4,931.51 310,000/4,931.51 = 62.86 days Purchase-to-Payment for 2018-19: Average Accounts Payable = (170,000 + 180,000)/2 = 175,000 Average Accrued Liabilities = (70,000 + 80,000)/2 = 75,000 175,000 + 75,000 = 250,000 Cost of Goods Sold per Day = 1,260,000/365 = 3,452.05 250,000/3,452.05 = 72.42 days Cash Conversion Cycle (in Days): 2017-18 Inventory-to-Sale 192.64 Sale-to-Cash 55.97 Purchase-to-Payment (85.17) Cash Conversion Cycle 163.44

2018-19 159.33 62.86 (72.42) 149.77

Change Better Worse Worse Better

The cash conversion cycle declined (improved) from 163.44 days in 2017-18 to 149.77 days in 2018-19 due to a sharp decline in the inventory-to-sale conversion period which more than offset an increase in the sale-to-cash conversion period and a decrease in the purchase-to-payment conversion period.

I. Kaj has been able to obtain some industry ratio data from the home furnishings industry trade association of which he is a member. The industry association collects proprietary financial information from members of the association, compiles averages to protect the proprietary nature of the information, and provides averages for use by individual trade association members. Over the 2017-2018 and 2018-2019 periods, the inventory-to-sale conversion period has averaged 200 days, while the sale-to-cash conversion period (days of sales outstanding) for the industry has averaged 60 days. How did Scandi’s operations compare with these industry averages in terms of these two components of the cash conversion cycle?

140 Conversion Periods (in Days):

Inventory-to-Sale Sale-to-Cash

Scandi Corporation 2017-18 2018-19 192.64 159.33 55.97 62.86

Industry Average 200 60

Scandi Compared to Industry Better Worse

Scandi‘s inventory-to-sale conversion period was consistently better than the industry average and showed substantial improvement in 2018-19. Scandi‘s sale-to-cash conversion period decreased from better than the industry average in 2017-18 to worse than the industry average in 2018-19. This change in sale-to-cash (accounts receivable collection time) conversion time for Scandi from about 56 days to almost 63 days should be investigated.

Chapter 7 TYPES AND COSTS OF FINANCIAL CAPITAL FOCUS In this chapter, we characterize financial markets and focus on developing an understanding of the how one obtains and pays for financial capital. Without adequate capital, even the best ideas and ventures cannot succeed. The cost of debt is relatively easy to understand and apply because it is primarily captured in the stated interest rate for a loan or bond. In contrast, the cost of equity is more difficult to grasp. One typically pays only a small part, if any, of the cost of equity through cash payments (dividends). More often, the majority, if not all, of the cost of equity is ―paid‖ to the providers of equity capital by increases in the value of equity (capital gains).

LEARNING OBJECTIVES LO 7.1: Describe implicit and explicit financial capital costs.

LO 7.2: Identify and discuss some basic characteristics of the financial markets.

LO 7.3: Describe how the cost of debt capital is determined starting with a default risk-free rate and then adjusting for default, liquidity, and maturity risk components.

LO 7.4: Explain investment risk and describe historical return-risk relationships for bonds versus stocks.

LO 7.5: Describe the process for estimating the cost of equity capital for public corporations and for private ventures.

CHAPTER OUTLINE 7.1 7.2 7.3

IMPLICIT AND EXPLICIT FINANCIAL CAPITAL COSTS FINANCIAL MARKETS DETERMINING THE COST OF DEBT CAPITAL A. Determinants of Market Interest Rates B. Risk-Free Interest Rate

141

7.4

7.5

7.6

C. Default Risk Premium D. Liquidity and Maturity Risk Premiums E. A Word on Venture Debt Capital WHAT IS INVESTMENT RISK? A. Measuring Risk as Dispersion around an Average B. Historical Return Versus Risk Relationships ESTIMATING THE COST OF EQUITY CAPITAL A. Cost of Equity Capital for Public Corporations B. Cost of Equity Capital for Private Ventures C. Sources and Costs of Venture Equity Capital WEIGHTED AVERAGE COST OF CAPITAL B. A Life Cycle-Based WACC Example SUMMARY APPENDIX A: Using WACC to Complete the Calibration of EVA

DISCUSSION QUESTIONS AND ANSWERS 1. Describe how the costs of debt and equity differ from the perspective of accounting measures.

While accountants recognize that financial capital has a cost and recommend its complete inclusion in performance appraisal and decision making, historical accounting for this cost is incomplete, at least in formal financial statements. Unlike debt, much of equity‘s cost is not an expense in a traditional accounting sense (with documentation); only a part of this cost (e.g., dividends) is reflected in historical financial statements. There is virtually no historical accounting for the nondividend component of equity cost, even though it is clear that the nondividend cost component increases with cuts in dividends.

2. How do private and public financial markets differ?

Private financial markets are those involving direct two-party negotiations over illiquid nonstandardized contracts. Public financial markets are those where transactions involve more liquid securities with standardized contract features.

3. Briefly describe venture debt capital and venture equity capital.

In general, early-stage ventures raise debt capital from individuals, venture lenders, and when profitably entering rapid-growth, possibly other financial institutions.

The founding entrepreneurial team, business angels, and venture capitalists are the primary sources of early-stage equity capital. In some instances, debt and/or preferred stock convertible into shares of common equity is held by venture investors.

4. What is an interest rate? What is default risk?

142 An interest rate is the rate one must pay to borrow capital. Default risk is risk that a borrower will not pay the interest and/or principal on a loan.

5. What is a nominal interest rate? Describe a risk-free interest rate and a real rate of interest.

A nominal interest rate is stated rate of interest. The risk-free interest rate is interest rate for a debt security that is virtually free of default risk. A real rate of interest is rate of return adjusted for the expected inflation.

6. Define inflation. What is meant by an inflation premium?

Inflation is the general rise in prices that is not due to increases in product quality. An inflation premium is the additional interest required due to the expectation of future inflation 7. Define the term default risk premium.

Default risk premium is the additional premium required to compensate for the possibility of the firm‘s defaulting on the loan.

8. What is meant by a prime rate?

Prime rate: interest rate charged by banks to their highest quality (lowest default risk) business customers 9. What is a bond rating?

Bond rating: reflects the default risk of a firm‘s bonds as judged by a bond-rating agency 10. What is a liquidity risk premium? What is a maturity risk premium?

Liquidity risk premium is the additional rate charged when a debt instrument cannot be sold quickly at a fair price.

Maturity risk premium is charged for the inherent increased risk in long-term debt contracts.

11. What is meant by the term structure of interest rates? What is a yield curve?

Term structure of interest rates: relationship between nominal interest rates and time to maturity when default risk is held constant Yield curve: graph of the term structure of interest rates 12. Describe the differences between senior debt and subordinated debt.

Senior debt: debt secured by a venture‘s assets

143 Subordinated debt: debt with an inferior claim (relative to senior debt) to venture assets 13. Explain the meaning of investment risk of loss and describe how risk can be defined relative to an average value.

Risk is the chance or probability of financial loss from a venture investment. More generally, investment risk is the chance that a security‘s future value will differ from what it is expected to be.

14. Describe the following: (a) expected rate of return, (b) standard deviation, and (c) coefficient of variation. (a) (b) (c)

Expected rate of return is the probability-weighted average of possible rates of return.

Standard deviation is a measure of the dispersion of possible outcomes around the expected return.

Coefficient of variation shows the dispersion risk per unit of expected rate of return.

15. Describe the historical average annual return relationships among long-term U.S. government bonds, corporate bonds, small firm common stocks, and large firm common stocks.

Over the long-run (90 or so years) in the U.S., small firm common stocks had the highest average annual return followed by large firm common stocks. The third highest return is corporate bonds, and the lowest is long-term U.S. government bonds.

16. What is the difference between private equity investors and publicly traded stock investors?

Private equity investors own firms that are typically closely held while investors in publicly traded stocks own firms whose shares trade in a public secondary market.

17. How does an organized securities exchange differ from an over-the-counter market?

Organized securities exchanges have a specific place to trade while an over-the-counter market is a network of dealers connected via computer.

18. What is meant by an investment risk premium? What is a market risk premium?

An investment risk premium is the additional return above the risk-free rate that investors can expect to earn by investing in a risky common stock.

The market risk premium is the additional return above the risk free rate per unit of beta risk that a stock investor can expect.

19. What rates of returns have venture capitalists earned on average in recent years? How do these returns compare against the average venture capitalists returns over the past twenty years?

144

As shown in Table 7.1, venture capital holding period returns (all stages) ending in 2018 averaged 18.07% for 1-year, 9.5% for 3-year, and 12.92% for 5-year periods. These nearterm returns have been less than the 20-year (21.36%) and 25-year (30.73%) holding period returns for all stages of venture capital. Early-stage U.S. venture capital typically provides the highest returns over most holding periods.

Holding period returns for publicly-traded common stocks included in the Dow Jones Industrial Average Index and the Dow Jones U.S. Small Cap Index reflect the volatility of stock prices over recent 1, 3, and 5 year holding periods. Recovery from the financial crisis of 2007-2008 and the great recession of 2008-2009 is reflected in the 10-year holding period returns which were about 13% for venture capital (all stages) and the two Dow Jones indexes. For 20-year and 25-year holding periods, the Dow Jones indexes were substantially lower than the holding period returns for venture capital (all stages).

20. How do we estimate the cost of equity capital for private ventures? In developing your answer describe the major components that are considered when estimating the rates of return required by venture investors.

Equity capital for private ventures is estimated by adding together the risk free rate, an inflation premium, an advisory premium, a liquidity premium, and a hubris projections premium.

21. What discount rates are typically used for development- stage, startup-stage, survival-stage, and early-growth-stage ventures?

The discount rate for the development stage is typically above 40%, between 30% and 50% for the startup stage, between 25-45% for the survival stage, and between 25-35% for the early growth-stage.

22. What is meant by the weighted average cost of capital or WACC? Weighted average cost of capital (WACC): weighted average of the cost of the individual components of interest-bearing debt and common equity capital.

23. How is a venture’s WACC likely to change as it moves through a successful life cycle?

Most early-stage financing is high-cost equity capital. However, the opportunity to use usually less-costly debt increases as a successful venture progresses through its life cycle.

Thus, the WACC is likely to decrease over time for a successful venture.

24. From the Headlines—Ecosphere: You have been retained as a consultant for Ecosphere and tasked with assessing the financial viability of their commercial ventures. What types of

145 financial ratios would you enlist in your report to Ecosphere? What approach would you take to determining a relevant cost of capital for those ventures?

Answers will vary: Ecosphere has a great deal of variety in the types of products and services it targets. As it grows from tourism and handicrafts toward biofuels and other more capital-intensive operations, it would be beneficial to monitor its inventory turns and other operating efficiencies (particularly in its existing handicrafts operations) while taking some notice of trends in overall asset efficiency (as it adds property, plant and equipment) for newer operations (biofuels, etc.). Profit margins should be monitored (overall and line item) as it expands into new areas.

INTERNET ACTIVITIES 1. Access the Federal Reserve Board of Governors web site at http://www.federalreserve.gov/releases/ to find current interest rates (and foreign exchange rates) relevant for your business venture.

Web-researched results vary due to constant updating of the related web sites.

2. Access http://www.bloomberg.com for interest rates and financial market news. Summarize the current financial market conditions.

Web-researched results vary due to constant updating of the related web sites.

3. Access http://www.pwcmoneytree.com for a summary of recent venture capital investment performance. Summarize the return experience for the various venture-investing rounds.

Web-researched results vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS 1. [Inflation and Risk Premiums] Voice River, Inc. provides media-on-demand services via the Internet. Management has been studying current interest rates. A lender is willing to make a two-year loan to Voice River at a 12 percent annual interest rate. The U.S. government is currently paying 8 percent annual interest on its two-year securities.

A. If the real rate of interest is expected to be 3 percent annually, what is the inflation premium expected at this time?

Risk free rate = real rate + inflation premium Inflation premium = risk free rate – real rate = 8% - 3% = 5% B. What is the amount of the total risk premium that Voice River will have to pay?

146 Risk premium = nominal interest rate – risk free interest rate = 12% - 8% = 4% C. If a 1 percent liquidity premium is built into the 12 percent rate, what is the default risk premium on the loan?

Risk premium = liquidity premium + default risk premium Default risk premium = risk premium – liquidity premium = 4% – 1% = 3% 2. [Maturity and Default Risk Premiums] Following is interest rate information currently being observed by the Electronic Publishing Corporation.

One-year U.S. government securities One-year bank loans Five-year U.S. government securities Five-year bank loans

4.5% 6.0 7.0 9.5

A. What is the amount of the maturity risk premium on one-year versus five-year U.S. government securities?

7% - 4.5% = 3.5% B. What is the amount of the maturity risk premium on one-year versus five-year bank loans?

9.5% - 6% = 3.5% C. What is the default risk premium on one-year bank loans and on five-year bank loans?

1 Year; 6% - 4.5% = 1.5% 5 Year; 9.5% - 7% = 2.5% 3. [Expected Rate of Return and Risk Measures] A venture investor, BKAngel, is considering investing in a software venture opportunity. However, the rate of return to be realized next year is likely to vary with the economic climate that actually occurs.

Following are three possible economic outcomes, the probability that each one will occur, and the rate of return projected for each outcome: Economic Probability of Rate of Climate Occurrence Return Recession .25 -20.0% Normal .50 15.0 Rapid Growth .25 30.0 A. What is the expected rate of return on the software venture?

Expected rate of return = (.25) x (-20%) + (.50) x (15%) + (.25) x (30%) = 10%

147

B. Calculate the variance and standard deviation of the rates of return for the software venture?

Variance = (.25) x (-20% - 10%)^2 + (.5) x (15% - 10%)^2 +(.25) x (30% - 10%)^2 = 337.5 Standard deviation = (Variance)^(1/2) = (337.5)^(1/2) = 18.37% C. Calculate the coefficient of variation of the rates of return for the software venture. If the coefficient of variation of rates of return for BKAngel’s prior venture investments is 1.5, would the software venture be considered as being less or more risky?

Coefficient of variation = (standard deviation)/(expected return) = (18.37%)/(10%) = 1.837. The coefficient of variation for this venture would be considered to be more risky since it is above 1.5.

4. [Expected Rate of Return and Risk Measures] A potential venture investment has the following possible outcomes: Performance Probability of Rate of Outcome Occurrence Return Home Run (Success) .15 500.0% Breakeven .35 15.0 Strikeout (Failure) .50 -100.0 A. What is the expected rate of return on the venture?

Expected rate of return = (.15)(500.0%) + (.35)(15.0%) + (.50)(-100.0%) = 75% + 5.25% + (-50%) = 30.25% B. Calculate the variance and standard deviation of the rates of return for the venture.

Variance = (.15) x (500% - 30.25%)^2 + (.35) x (15% - 30.25%)^2 + (.50) x (-100% 30.25%)^2 = .15 x 220,665.06 + .35 x 232.56 + .50 x 16,965.06 = 33,099.76 + 81.41 + 8,482.53 = 41,663.69 Standard deviation = (Variance)^(1/2) = (41,663.69)^(1/2) = 204.12% C. Calculate the coefficient of variation of the rates of return for the venture. If the coefficient of variation of rates of return for your prior venture investments is 4.0, would the new venture be considered as being less or more risky?

Coefficient of variation = (standard deviation)/(expected return) = (204.12%)/(30.25%) = 6.748. The coefficient of variation for this new venture would be considered to be more risky relative to prior venture investments since it is above 4.0.

148 5. [Portfolio Expected Rate of Return and Risk Measures] Three venture investments previously made by BKAngel, a venture investor, achieved the following outcomes for the year just completed: Venture Opportunity Ven1 Ven2 Ven3

Initial Value $300,000 $400,000 $300,000

Cash Flow $75,000 $50,000 -$60,000

Ending Value $600,000 $300,000 $360,000

A. Calculate the percentage rate of return for each of the venture investments. % Return = (cash flow + ending value – beginning value)/(beginning value) Return on VEN1 = ($75,000 + $600,000 - $300,000)/ $300,000 = 125.00% Return on VEN2 = ($50,000 + $300,000 - $400,000)/ $400,000 = -12.50% Return on VEN3 = (-$60,000 + $360,000 - $300,000)/ $300,000 = 0.00% B. Calculate an expected rate of return for a ―portfolio‖ of these three venture investments ―weighted‖ by each venture’s investment share of a total $1,000,000 investment.

Expected return = (.3) x (125%) + (.4) x (-12.5%) + (.3) x (0.0%) = 32.50% C. Calculate the variance and standard deviation of the rates of returns for the portfolio investment.

Variance = (.3) x (125% - 32.5%)^2 + (.4) x (-12.50% - 32.5%)^2 + (.3) x (0% 32.5%)^2 = 3,693.75 Standard deviation = (Variance)^.5 = (3,693.75)^.5 = 60.78% D. Calculate the coefficient of variation of the rates of returns for the portfolio investment.

Is this portfolio investment less or more risky than another investment opportunity with a coefficient of variation of 1.5?

Coefficient of variation = (standard deviation) / (expected return) = (60.78%/32.50%) = 1.870 6. [Portfolio Expected Rate of Return and Risk Measures] Refer to Problem 5. Assume that BKAngel’s initial investments in the three ventures had been Venture 1 = $500,000, Venture 2 = $300,000, and Venture 3 $200,000 with each investment having achieved the same cash flows and ending values shown in Problem 5.

A. Calculate the percentage rate of return for each of the venture investments. % Return = (cash flow + ending value – beginning value)/(beginning value) Return on Venture 1 = ($75,000 + $600,000 - $500,000)/ $500,000 = 35.00% Return on Venture 2 = ($50,000 + $300,000 - $300,000)/ $300,000 = 16.67%

149 Return on Venture 3 = (-$60,000 + $360,000 - $200,000)/ $200,000 = 50.00% C. Calculate an expected rate of return for a portfolio of these three venture investments weighted by each venture’s investment share of a total $1,000,000 investment.

Expected rate of return: (.50)(35.00%) + (.30)(16.67%) + (.20)(50.00%) = 17.50% + 5.00% + 10.00% = 32.50% C. Calculate the variance, standard deviation, and coefficient of variation of the rates of returns for the portfolio investment.

Variance = (.50) x (35.0% - 32.5%)^2 + (.30) x (-16.67% - 32.5%)^2 +(.20) x (10.0% 32.5%)^2 = 3.13 + 725.31 + 101.25 = 829.68 Standard deviation = (Variance)^.5 = (829.68^.5 = 28.80% Coefficient of variation = 28.80%/32.50% = 0.886 7. [Loan Present Values] Jerry’s Tree Services is trying to raise debt funds from a prospective venture investors, SureWay LLC. SureWay indicated to Jerry Lau that the annual interest rate on risky venture loans is currently 15 percent. Jerry is seeking a 3-year loan with annual payments. He is willing to pay back $100,000 at the end of 3 years. However, due to cash flow problems, he can afford to pay interest at a 12 percent annual rate.

A. Calculate the dollar amount that SureWay venture investors would lend to Jerry’s Tree Services.

N=3 I%/Yr = 15% PMT = $12,000 FV = $100,000 PV = ? = $93,150.32 B. What would be the dollar amount of the loan if the loan was made for only two years?

N=2 I%/Yr = 15% PMT = $12,000 FV = $100,000 PV = ? = $95,122.87 8. [Loan Present Values] Refer to Problem 7. Show how your answer to Part A of Problem 7 would change if Jerry were willing to pay 16 percent annual interest and a principal payment of $100,000 at the end of three years.

N=3 I%/Yr = 16% PMT = $16,000 FV = $100,000 PV = ? = $100,000

150

151 9. [Expected Rate of Return and Hubris Premiums] Following is rate of return component information for FirstVenture investors.

A. Calculate the expected rate of return before considering premiums for illiquidity, advisory activities, and hubris projections.

Expected rate of return = 6% + 11.5% = 17.5% B. Estimate the hubris projections premium for this FirstVenture investment.

Hubris projections premium = 40.0% - 17.5% - 5.5% - 9.0% = 8.0% 10. [Cost of Equity Capital] Use the following information to estimate the rate of return expected by the VentureBanc Investors:

A. VentureBanc uses a systematic risk measure of 2.0. Based on the information shown, estimate VentureBanc’s investment risk premium. Then, estimate the cost of equity capital for VentureBanc.

Investment risk premium = (MRP) x (B) = (7.5%) x (2.0) = 15% Cost of Equity = (Risk free rate) + (MRP) x (B) = (6%) + (7.5%) x (2.0) = 21% B. Determine the rate components and their returns that a venture investor like VentureBanc would require to be covered beyond a traditional cost-of-equity estimate.

Liquidity Premium, Advisory Premium, Hubris Projections Premium. See part C for the levels of these premia.

C. What overall venture investment discount rate would be used by the VentureBanc?

Venture Investment Discount Rate = (Cost of Equity) + (LP) + (AP) + (HPP) = (21%) + (5%) + (9%) + (15%) = 50% 11. [Weighted Average Cost of Capital] Kareem Construction Company has the following amounts of interest-bearing debt and common equity capital:

152

Financing Dollar Source Amount Rate Short-Term Loan $200,000 12% Long-Term Loan $200,000 Equity Capital $600,000

Interest Cost of Capital 14% 22%

Kareem Construction is in the 30 percent average tax bracket.

A. Calculate the after-tax (WACC) for Kareem.

Total value (interest-bearing debt plus equity capital) = $200,000 + $200,000 + $600,000 =$1,000,000 WACC = (short-term debt rate) x (1– tax rate) x (short-term debt-to-value) + (long-term debt rate) x (1– tax rate) x (long-term debt-to-value) + (equity rate) x (1– debt-to-value) WACC = [(12%) x (1 – .30) x ($200,000/$1,000,000)] + [(14%) x (1 – .30) x ($200,000/$1,000,000)] + [(22%) x ($600,000/$1,000,000)] = (8.4%)(.200) + (9.8%)(.200) + (22.0%)(.600) = 1.68% + 1.96% + 13.20% = 16.84% B. Show how Kareem’s WACC would change if the tax rate drops to 25 percent and the estimated cost of equity capital is based on a risk-free rate of 7 percent, a market risk premium of 8 percent, and a systematic risk measure or beta of 2.0.

Cost of Equity = 7% + (8%) x 2.0 = 23% WACC = [(12%) x (1 – .25) x ($200,000/$1,000,000)] + [(14%) x (1 – .25) x ($200,000/$1,000,000)] + [(23%) x ($600,000/$1,000,000)] = (9.00%)(.20) + (10.50%) (.20) + (23.00%)(.60) = 1.80% + 2.10% + 13.80% = 17.70% 12.

[CAPM Estimate of the Cost of Equity Capital] Voice River, Inc. has successfully moved through its early life cycle stages and now is well into its rapid growth stage. However by traditional standards this provider of media-on-demand is still considered to be a relatively small venture. The interest rate on long-term U.S. government securities is currently 7 percent. Voice River’s management has observed that over the long-run the average annual rate of return on small firm stocks has been 17.3 percent while the annual returns on longterm U.S. government securities has averaged 5.7 percent. Management views Voice River as being an average small company venture at its current life cycle stage.

A. Determine the historical average annual market risk premium for small firm common stocks.

Avg. historical MRP = (Avg. historical return) – (Avg. historical risk free rate) = (17.3%) – (5.7) = 11.6% MRP

153 B. Use the capital asset pricing model (CAPM) to estimate the cost of common equity capital for Voice River.

CAPM = (rf) + (MRP) x (B) = (7%) + (11.6%) x (1.0) = 18.6% 13. [Weighted Average Cost of Capital] Voice River, Inc. is interested in estimating its weighted average cost of capital (WACC) now that it is in its rapid growth stage. Voice River has a $500,000, 10 percent interest, short-term bank loan, a $1.5 million, 12 percent long-term debt issue, and 42 million in common equity. The venture is in a 35 percent income tax bracket.

A. Determine the after-tax costs of the bank loan and the long-term debt issue.

After-tax cost of short-term bank loan = (10%) x (1 – 35%) = 6.5% After-tax cost of long-term debt issue = (12%) x (1 - 35%) = 7.8% B. Calculate the WACC for Voice River, Inc., using the cost of common equity capital estimated in Problem 12.

Total value of firm = ($500,000) + ($1.5 million) + ($42 million) = $44 million WACC = ($500,000/$44,000,000) x (6.5%) + ($1,500,000/$44,000,000) x (7.8%) + ($42,000,000/$44,000,000) x (18.6%) = (.0114)(6.5%) + (.0341)(7.8%) + (.9545)(18.6%) = .0739+ .2660 + 17.75 = 18.09% 14. Weighted Average Cost of Capital] Refer to Problem 13 for Voice River, Inc.

A. Estimate the WACC if the cost of common equity capital is 20 percent.

WACC = (.0114)(6.5%) + (.0341)(7.8%) + (.9545)(20.0%) = .0739 + .2660 + 19.09 = 19.43% B. Estimate the WACC if the cost of common equity capital is at the representative target rate of 25 percent for typical ventures in their late rapid-growth life cycle state.

WACC = (.0114)(6.5%) + (.0341)(7.8%) + (.9545)(25.0%) = .0739 + .2660 + 23.86 = 24.20%

MINI CASE: CASTILLO PRODUCTS COMPANY The Castillo Products Company was started in 2017. The company manufactures components for personal decision assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2018, was followed by a profitable 2019. The founders (Cindy and Rob Castillo) are interested in estimating their cost of financial capital since they are expecting to secure additional external financing to support planned growth.

Short-term bank loans are available at an 8 percent interest rate. Cindy and Rob believe that the cost of obtaining long-term debt and equity capital will be somewhat higher. The real interest rate is estimated to be 2 percent and a long-run inflation premium is estimated at 3 percent. The interest rate on long-term government bonds is 7 percent. A default-risk premium

154 on long-term debt is estimated at 6 percent; plus Castillo Products is expecting to have to pay a liquidity premium of 3 percent due to the illiquidity associated with its long-term debt. The market risk premium on large-firm common stocks over the rate on long-term government bonds is estimated to be 6 percent. Cindy and Rob expect that equity investors in their venture will require an additional investment risk premium estimated at two times the market risk premium on large-firm common stocks.

Following are income statements and balance sheets for the Castillo Products Company for 2018 and 2019.

Castillo Products Company Net sales Cost of goods sold Gross profit Marketing General and administrative Depreciation EBIT Interest Earnings before taxes Income taxes Net income (loss)

2018 $900,000 540,000 360,000 90,000 250,000 40,000 -20,000 45,000 -65,000 0 -$ 65,000

2019 $1,500,000 900,000 600,000 150,000 250,000 40,000 160,000 60,000 100,000 25,000 $ 75,000

Cash Accounts receivable Inventories Total current assets Gross fixed assets Accumulated depreciation Net fixed assets Total assets

2018 $ 50,000 200,000 400,000 650,000 450,000 -100,000 350,000 $1,000,000

2019 $ 20,000 280,000 500,000 800,000 540,000 -140,000 400,000 $1,200,000

Accounts payable Accruals Bank loan Total current liabilities Long-term debt Common stock (.05 par) Additional paid-in-capital Retained earnings Total liabilities and equity

$ 130,000 50,000 90,000 270,000 300,000 150,000 200,000 80,000 $1,000,000

$ 160,000 70,000 100,000 330,000 400,000 150,000 200,000 120,000 $1,200,000

155 A. Calculate the: net profit margin; total-sales-to-total-assets ratio; the equity multiplier; and the return on equity for both 2018 and 2019 for the Castillo Products Corporation. Describe what happened in terms of financial performance between the two years.

2018 net profit margin = -65,000/900,000 = -.0722 = -7.22% 2019 net profit margin = 75,000/1,500,000 = .500 = 5.00% 2018 total-sales-to-total-assets = 900,000/1,000,000 = .9000 times 2019 total-sales-to-total-assets = 1,500,000/1,200,000 = 1.2500 times 2018 equity multiplier = 1,000,000/(150,000 + 200,000 + 80,000) = 1,000,000/430,000 = 2.3256 times 2019 equity multiplier = 1,200,000/(150,000 + 200,000 + 120,000) = 1,200,000/470,000 = 2.5532 times 2018 return on equity = -65,000/430,000 = -.1522 = -15.22% 2019 return on equity = 75,000/470,000 = .1596 = 15.96% Castillo Products improved from an operating loss in 2018 to profitability in 2019. The net profit margin went from negative to positive. The asset turnover (total-sales-to-total-assets) increased indicating improved utilization of assets to support sales. The equity multiplier also increased indicating a higher usage of debt funds. The combined result was a change in the return on equity of -15.22% in 2018 to a positive 15.96% for 2019.

B. Estimate the cost of short-term bank loans, long-term debt, and common equity capital for the Castillo Products Corporation.

Cost of short-term bank loans: Current interest rate is given at 8.00% Cost of default-risk free long-term government bonds: current interest rate is given at 7.00% [Note: the sum of the expected real rate of 2.00% and expected inflation rate of 3.00% is 5.00%. Since this is less than the current 7% long-term government bond rate, current government bond investors are expecting different real interest rates and/or inflation rates amounting to a total of 2.00%.]

Cost of risky long-term debt: Cost of risky debt = long-term government bond rate + default-risk premium + liquidity premium = 7.00% + 6.00% +3.00% = 16.00% Large-firm common equity capital: Large firm cost of common equity (CAPM method) = default-risk free rate on long-term government bonds + (large firm market risk premium) x (market beta) = 7.00% + (6.00%)(1.00) = 13.00% Castillo Products common equity capital: Capital asset pricing model (CAPM) = 7.00% + (6.00%)(2.00) = 7.00% + 12.00% = 19.00%

156 C. Although, Castillo Products paid a low effective tax rate in 2019, a 30 percent income tax rate is considered more appropriate when looking to the future. Estimate the after-tax cost of shortterm bank loans, long-term debt, and the venture’s common equity.

Note: before-tax costs of debt funds were calculated in Part B. After-tax cost of short-term bank loans: 8.00% x (1 – .30) = 8.00% x .70 = 5.60% After-tax cost of risky long-term debt: 16.00% x (1 - .30) = 16% x .70 = 11.20% After-tax cost of Castillo Products‘ common equity: 19.00% [Note: the estimated cost of common equity capital is on an after-tax basis.]

D. Estimate the weighted average cost of capital (WACC) for the Castillo Products Corporation using the book values of interest-bearing debt and stockholders’ equity capital at the end of 2019.

Book Values Bank loan Long-term debt Common equity Total

$ Amount 100,000 400,000 470,000 970,000

Percent Weight .1031 .4124 .4845 1.000

x

After-tax Component Cost = Cost 5.60% .58% 11.20 4.62 19.00 9.21 WACC = 14.41%

Or, WACC = 5.6%(.1031) + 11.20%(.4124) + 19.00%(.4845) = 0.58% + 4.62% + 9.21% = 14.41% E. Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end of 2019. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2019. Estimate the market value-based weighted average cost of capital for Castillo Products.

Market Values Bank loan Long-term debt Common equity Total

$ Amount 100,000 400,000 900,000 1,400,000

Percent Weight .0714 .2857 .6429 1.000

x

After-tax Component Cost = Cost 5.60% .40% 11.20 3.20 19.00 12.22 WACC = 15.82%

Or, WACC = 5.6%(.0714) + 11.20%(.2857) + 19.00%(.6429) = 0.40% + 3.20% + 12.22% = 15.82% F. Would you recommend to Cindy and Rob that they use the book value-based WACC estimate or the market value-based WACC estimate for planning purposes? Why?

157 Cindy and Rob should use market value-based WACCs for planning purposes. Investors expect entrepreneurs and/or managers to earn expected risk-adjusted rates of return on the current values of their investments. While market values of debt tend to fluctuate around the book values of debt, successful entrepreneurs and/or managers often are able to achieve market values that are multiples of common equity book values. Further gains in market values will depend on the ability to earn risk-adjusted rates of return on current market values.

MINI CASE: ALPHA ONE SOFTWARE CORPORATION

[Note: This Mine Case incorporates the calculation of a weighted average cost of capital (WACC) to determine whether the Alpha One Software Corporation added economic value in 2019. The Appendix to Chapter 7 will need to be covered first in order to complete this Mini Case.]

The Alpha One Software Corporation was organized to develop software products that would provide Internet-based firms with information about their customers. As a result of initial success, the venture‘s premier product allows firms with subscriber bases to predict customer profiles, retention, and satisfaction.

Arlene Io received an undergraduate degree in computer sciences and information systems from a major northeastern university four years ago. The Omega Subscriber Software Product was developed, test marketed with the help of two of her classmates; Alpha One Software Corporation was up and running within one year. Venture capital was obtained to start up operations; a second round of venture financing helped Alpha One to move through its survival stage. Product success in the marketplace has allowed the venture to achieve such rapid sales growth that it now is able to get bank loans and issue long-term debt.

The interest rate on the bank loan is 10 percent. For long-term debt, the real interest rate is estimated to be 3 percent; the inflation premium is 4 percent; and Alpha One‘s default/liquidity risk premium over government bonds is estimated to be 7 percent. The cost of common equity was estimated using the risk-free long-term government bond rate and a stock investment risk premium of 13 percent.

Arlene Io has now reached the point of being able to consider whether Alpha One is adding economic value in terms of its net operating profit after taxes (NOPAT) and its weighted average cost of capital (WACC). Following are the financial statements for 2019.

Alpha One Software Corporation

158

Income Statement

Net Sales Cost of Goods Sold Gross Profit General & Administrative Expenses Marketing Depreciation Earnings Before Interest and Taxes Interest Earnings Before Taxes Income Taxes (40% rate) Earnings After Taxes

2019

$1,500,000 -850,000 650,000 -250,000 -206,000 -50,000 144,000 -84,000 60,000 -24,000 $36,000

Alpha One Software Corporation Balance Sheet Cash Accounts Receivable Inventories Total Current Assets Fixed Assets, Net Total Assets Accounts Payable Accrued Liabilities Notes Payable Total Current Liabilities Long-Term Debt Common Stock (20,000 shares) Retained Earnings Total Liabilities & Equity

2019 $20,000 250,000 350,000 620,000 480,000 $1,100,000 125,000 125,000 100,000 350,000 500,000 100,000 150,000 $1,100,000

A. Calculate Alpha One’s net operating profit after taxes (NOPAT). Why does the NOPAT differ from the earnings after taxes?

NOPAT = 144,000 x (1 - .40) = 86,400 EAT = 36,000 NOPAT excludes interest financing costs on an after-tax basis (i.e., 84,000 x .60 = 50,400). Check: 86,400 – 36,000 = 50,400 B. Estimate the effective before-tax cost of the long-term debt.

159

Cost of long-term government bond = real interest rate + inflation premium = 3% + 4% = 7% Cost of long-term risky debt = long-term government bond rate + default/liquidity premium = 7% + 7% = 14% C. Estimate the effective after-tax cost of the bank loan and the long-term debt.

Cost of bank loan (notes payable) = 10% After-tax cost of bank loan = 10% x (1 - .40) = 6.0% After-tax cost of long-term debt = 14% x (1 - .40) = 8.4% D. Estimate the cost of common equity capital.

Default risk-free rate = long-term government bond rate = 7% Stock investment risk premium = 13% (i.e., expected return over the long-term government bond rate) Using a risk-premium model: Cost of Equity = 7% + 13% = 20.0% E. Determine the financial structure weights from Alpha One’s 2019 financial statements for the two interest-bearing debt components and the common equity.

Note: the following WACC estimates are based on the use of book value-based weights since no information is provided to estimate the market value of the venture‘s equity.

Book Values Bank loan Long-term debt Common equity Total

$ Amount % Weight 100,000 11.8% 500,000 58.8 250,000 29.4 850,000 100.0%

Note: notes payable = bank loan; and common equity = common stock + retained earnings (100,000 + 150,000 = 250,000) F. Calculate Alpha One’s weighted average cost of capital (WACC).

WACC = 6.0%(.118) + 8.4%(.588) + 20.0%(.294) = .71% + 4.94% + 5.88% = .1153 = 11.5% (rounded) G. Determine the dollar cost of financial capital used.

Dollar cost of financial capital used = amount of financial capital x WACC 850,000 x .115 = 97,750 H. Estimate Alpha One’s economic value added (EVA). Did Alpha One build or destroy economic value in 2019?

160

EVA = NOPAT - $ cost of financial capital used EVA = 86,400 – 97,750 = -11,350 Economic value declined (was destroyed) in 2016.

APPENDIX A: Using WACC to Complete the Calibration of EVA [Note: We first introduced the EVA and NOPAT concepts in Chapter 4, Appendix A.] EXERCISES/PROBLEMS 1.

[Economic Value Added] Kareem Construction Company has the following amounts of interestbearing debt and common equity capital: FINANCING DOLLAR INTEREST COST OF SOURCE AMOUNT RATE CAPITAL Short-term $200,000 12% loan Long-term $200,000 14% loan Equity capital $600,000 22% Kareem Construction is in the 30 percent average tax bracket.

A. Calculate the after-tax weighted average cost of capital (WACC) for Kareem.

[Note: This is the same answer as was provided in the end-of-chapter Problem 11, Part A.] Total value (interest-bearing debt plus equity capital) = $200,000 + $200,000 + $600,000 =$1,000,000 WACC = (short-term debt rate) x (1– tax rate) x (short-term debt-to-value) + (long-term debt rate) x (1– tax rate) x (long-term debt-to-value) + (equity rate) x (1– debt-to-value) WACC = [(12%) x (1 – .30) x ($200,000/$1,000,000)] + [(14%) x (1 – .30) x ($200,000/$1,000,000)] + [(22%) x ($600,000/$1,000,000)] = (8.4%)(.200) + (9.8%)(.200) + (22.0%)(.600) = 1.68% + 1.96% + 13.20% = 16.84% B. Determine the after-tax dollar cost of financial capital used by Kareem.

Financial Capital Used: $1,000,000 x .1684 = $168,400 C. Kareem’s EBIT was $300,000. Calculate Kareem’s NOPAT.

161 NOPAT = $300,000(1 - .30) = $210,000 D. Calculate Kareem’s EVA. Did the venture build or destroy value?

EVA = NOPAT – dollar amount of financial capital used = $210,000 - $168,400 = $41,600 The venture produced a $41,600 build in value.

Chapter 8 SECURITIES LAW CONSIDERATIONS WHEN OBTAINING VENTURE FINANCING FOCUS In this chapter we introduce several major legal aspects of fundraising for the new venture. We discuss the central role of the Securities Act of 1933 and the exemptions available to ventures seeking to issue securities without having to register them with the Securities and Exchange Commission.

LEARNING OBJECTIVES LO 8.1: Discuss the types and sources of external financing available by life cycle stage.

LO 8.2: Identify five relevant components of the federal securities laws and explain what is meant by blue sky laws.

LO 8.3: Describe the process for determining whether securities must be registered.

LO 8.4: Describe what is involved in registering securities with the SEC. LO 8.5: Identify some of the securities that are exempt from registration with the SEC. LO 8.6: Identify some transaction exemptions granted under the Securities Act of 1933.

LO 8.7: Describe and discuss how the SEC‘s Regulation D serves as a securities registration ―safe harbor‖ and explain differences in Rules 504 and 506.

LO 8.8: Describe Regulation A and explain how and when it is used.

LO 8.9: Explain how the JOBS Act of 2012 impacted several SEC registration exemptions.

CHAPTER OUTLINE 8.1 8.2

8.3

REVIEW OF SOURCES OF EXTERNAL VENTURE FINANCING OVERVIEW OF FEDERAL AND STATE SECURITIES LAWS A. Securities Act of 1933 B. Securities Exchange Act of 1934 C. Investment Company Act of 1940 D. Investment Advisers Act of 1940 E. Jumpstart Our Business Startups Act of 2012 F. State Securities Regulation: ―Blue-Sky‖ Laws PROCESS FOR DETERMINING WHETHER SECURITIES MUST BE REGISTERED

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8.4 8.5 8.6

8.7

8.8 8.9

A. Offer and Sale Terms B. What is a Security?

REGISTRATION OF SECURITIES UNDER THE SECURITIES ACT OF 1933 SECURITY EXEMPTIONS FROM REGISTRATION UNDER THE 1933 ACT TRANSACTION EXEMPTIONS FROM REGISTRATION UNDER THE 1933 ACT A. Private Offering Exemption B. Accredited Investor Exemption SEC‘S REGULATION D: SAFE-HARBOR EXEMPTIONS A. Rule 504: Exemption for Limited Offerings and Sales of Securities Not Exceeding $1 Million B. Rule 506: Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering REGULATION A SECURITY EXEMPTION JOBS ACT INNOVATIONS SUMMARY APPENDIX A: Schedule A (Securities Act of 1933, as Amended) Requirements for Registration of Securities other than a Security Issued by Foreign Government or Political Subdivision Thereof APPENDIX B: Selected Regulation D Materials Regulation D‘s ―Preliminary Notes‖ Rule 501: Definitions and Terms used in Regulation D Rule 502: General Conditions to be Met Rule 503: Filing of Notice of Sales Rule 507: Reg D Disqualification Provisions Rule 508: Reg D Insignificant Deviations Clause Rule 144 (§ 230.144) APPENDIX C: Other Forms of Registration Exemptions and Breaks Rule 701 Rule 1001 Regulation SB

DISCUSSION QUESTIONS AND ANSWERS 1. Briefly define the Securities Act of 1933 and Securities Exchange Act of 1934.

The Securities Act of 1933 is the main body of federal law governing the creation and sale of securities. The Securities Exchange Act of 1934 deals with the mechanisms and standards for public security trading.

2. Briefly discuss the Investment Company Act of 1940 and Investment Advisers Act of 1940.

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The Investment Company Act of 1940 provides a definition of an ―investment company.‖ The Investment Advisers Act of 1940 focuses on people and organizations that seek to provide financial advice to investors and defines ―investment adviser.

3. Describe the Jumpstart Our Business Staertups Act of 2012.

The JOBS Act of 2012 is a federal law passed to stimulate the initiation, growth and development of small business companies. The JOBS Act has six Titles (I through VI) which we briefly cover in the chapter. We highlight three of the Titles here as follows: Title II: lifts restrictions on general solicitation and advertising for Reg D 506 accredited investor offerings; SEC implemented the related rules on July 10, 2013 Title III: establishes a small offering registration exemption and calls for SEC rules relating to the sales of securities to an Internet ―crowd‖ (securities crowdfunding); SEC adopted the final rules on October 30, 2015 Title IV: changes the maximum raise under a Regulation A-like offering (a Section 3(b)2 offering) from $5 million to $50 million while softening the Reg A’s solicitation provisions; SEC implemented the rules on June 19, 2015 4. What is securities crowdfunding?

The term ―crowdfunding‖ is sometimes used to refer to a general set of possible approaches to raising money from the crowd, including donation solicitations, advanced payment for tobe-manufactured products, as well as the sale of securities. We use the term securities crowdfunding to specifically refer to the use of The JOBS Act Title III’s small offering registration exemption from SEC registration requirements involving crowdfunding for the sale of securities.

5. What is meant by the term ―blue sky‖ laws and how do these laws apply when issuing securities?

Blue Sky Laws are the state laws designed to protect individuals from investing in fraudulent securities offerings. They are the state equivalent of the federal securities laws.

6. Describe the meaning of a ―security‖ in terms of the Securities Act of 1933.

The term ―security‖ means any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities

164 exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ―security,‖ or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

7. Why does it matter if an investment is, or is not, viewed as being a security?

Any investment considered to be a security under the 1933 Act comes under its provisions.

In particular, unless an exemption is secured, it must be registered with the SEC prior to being offered to the public.

8. Briefly describe what is meant by the statement ―Registering securities with the Securities and Exchange Commission (SEC) is both costly and a time-consuming process.‖ There is a great deal of expertise involved in preparing the documents and filings associated with a public offering. Most ventures do not have the resources to employ a staff specializing in this area. Consequently the venture will retain legal and investment banking experts to assist in the offering. The associated costs are substantial and require much of the information be provided by venture insiders (the time element) who typically have been working on the non-financial aspects of growing the venture.

9. Identify some of the types of securities that are ―exempt‖ from registration with the SEC. Some of the exempt securities are: government securities (federal and state), securities issued by banks, certain securities issued by insurance companies and certain securities of not-forprofit issuers.

10. Briefly describe what is meant by an intrastate offering. What are the major difficulties in assuring that an offer is intrastate?

An intrastate offering is one where the issuer and investors are considered by federal securities law to be confined to one state. SEC Rule 147 lays out guidelines under which the SEC will consider the offering to be intrastate.

11. Identify and briefly describe two basic types of transactions that are exempt from registration with the SEC. The most widely used exemption is the private placement exemption: transactions by an issuer not involving any public offerings. The accredited investor exemption is a second transaction exemption and lays much of the groundwork for the types of exemptions that involve a certain type of investor.

12. What does the term accredited investor mean in terms of the Securities Act of 1933? Why does the designation matter?

165 Accredited investors under the 1933 Act are assumed to have sufficient financial expertise and wherewithal to make an intelligent and informed investment decision. Formally: 2(a)(15) The term ―accredited investor‖ shall mean: (i) A bank as defined in Section 3(a)(2) whether acting in its individual or fiduciary capacity; an insurance company as defined in paragraph (13) of this subsection; an investment company registered under the Investment Company Act of 1940 or a business development company as defined in Section 2(a)(48) of that Act; a Small Business Investment Company licensed by the Small Business Administration; or an employee benefit plan, including an individual retirement account, which is subject to the provisions of the Employee Retirement Income Security Act of 1974, if the investment decision is made by a plan fiduciary, as defined in Section 3(21) of such Act, which is either a bank, insurance company, or registered investment adviser; or (ii) Any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor under rules and regulations which the Commission shall prescribe.

13. Briefly describe the importance of the 1953 SEC vs. Ralston Purina case in terms of securities registration requirements.

The U.S. Supreme Court took an important step toward defining a private (nonpublic) offering in SEC v. Ralston Purina. The case involved the sale of securities to employees.

The court found that because Ralston Purina‘s offering included employees who would not necessarily have access to the appropriate type of information, it did not fall within the private placement exemption of the 1933 Act. 14. What is the purpose of the SEC’s Regulation D? Reg D provides a set of safe harbor conditions under which an issuer can shield themselves from SEC action for failure to register securities.

15. What are the restrictions on general solicitation and advertising covered in Rule 504?

Rule 504 is the most lenient and the only exemption in Reg D that allows for any conditions under which the solicitation can be to the general public. The specific conditions under which general solicitation and advertising are allowed, in the current form of Reg D, relates to state registrations and information dissemination. Issuers considering general solicitation in connection with a 504 offering would be well-advised to seek specific legal counsel on the current conditions required in a 504 offering.

16. How do Rules 504 and 506 of Reg D differ from one another?

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Rule 504 has a $5 million limit on the amount raised but no limit on the number or sophistication of investors. Rule 506 has no limits on the amount raised, but has a limit of 35 unaccredited investors that must have financial knowledge. There is no limit on accredited investors.

17. Provide a brief description of the use of Regulation A when issuing securities.

Regulation A is technically an exemption from full registration, but in practice is like a limited registration where the process involves many of the same types of activities in doing a full registration. The monetary limit was increased from $5 million to $50 million under the JOBS Act of 2012. The issuer is allowed to ―test the waters‖ for the offering, and the shares can be issued to the public and eventually trade freely.

[Note: The following questions 18 through 26 relate to the material presented in Appendixes B and C.] 18. Briefly describe how the SEC’s Regulation D expanded the original Securities Act of 1933 definition of an ―accredited investor.‖ For the purposes of Reg D, investors are considered accredited if they fall into one of eight categories. Rather than leaving the notion of ―accredited‖ as vague (thus making the safe harbor less certain), the SEC chose to provide specific criterion whereby an individual can be designated as ―accredited.‖ 19. What are the income and net worth requirements for being an accredited investor? What in the requirements for designation as an accredited investor relates to the level of sophistication? Do the criteria act as good proxies for sophistication?

The income requirements are currently $200,000 for single filers and $300,000 for married filers. The wealth requirement is $1,000,000 not including a primary residence. While the requirements for accredited investor status do not necessarily reflect ―sophistication‖, they appear to create categories highly correlated with sophistication or the ability to hire sophisticated advisers during the investment decision process.

20. What are the four conditions of a Reg D offering that are covered under Rule 502?

Rule 502 (§ 230.502) deals with four conditions of a Reg D offering: integration (when multiple issues count as one), information (what you need to disclose when you must formally disclose), solicitation (what you can‘t do when promoting the offering) and resale (serious restrictions).

21. What is integration as it applies to securities offerings and why does it matter?

167 Integrated offerings are those that may be treated as combined into one offering. For integrated offerings it is the aggregated total dollar amount which must not exceed the dollar limits of the Reg D exemption being sought.

22. What types of information need to be disclosed to offerees under Reg D? When required, the type of information to be disclosed varies by the venture‘s status and size. Summarizing from the Reg D text: The issuer shall furnish to the purchaser, to the extent material to an understanding of the issuer, its business, and the securities being offered: (A) non-financial statement information similar to that required in a Reg A (or registered) offering.

(B) financial statement information depending on the size of the offering and ranging from S-B and S-B2 type information up to the same financial statements as required in a regular registration.

23. What is a restricted security? Why does this designation matter? What types of buyers must the owner of restricted securities find?

Restricted securities cannot be freely resold. This is the typical status of securities sold in a private placement. The resale of restricted securities typically requires locating an accredited investor as a buyer.

24. Briefly describe the purpose of Rule 144 of Reg D. To provide conditions under which restricted securities can be resold.

25. Briefly describe Rule 508 of Reg D. Rule 508 allows for the possibility that an offering will be granted safe harbor when the only deviations from Reg D‘s requirements are deemed to be ―insignificant.‖ 26. Briefly describe the types of exemptions from registration of securities covered under Rules 701 and 1001.

Rule 701 is an exemption for certain types of employee compensation arrangements involving the issue of the employer‘s securities. Rule 1001 is a ―qualified purchaser‖ exemption for the State of California that assures certain California issuers that their exemption under California law will receive concurrent exemption from federal registration.

27. From the Headlines – Sock It to Me: The ―Internet of Feet‖: Discuss the role that Indiegogo played in the initial funding of Sensoria. Do you believe it was important in leading up to the $5 million A round?

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Answers will vary: One aspect that crowdfunding plays in the launch of niche products is that of a credible approach to elementary market research for that niche. While not as elaborate or scientific as a full-blown market research study, the willingness of consumers to lay out money in advance of a product‘s availability can send a strong signal regarding the size of the addressable market. However, for very specific narrow niches, the crowdfunding approach may also represent more of the entirety of that niche market rather than the likelihood that a randomly selected individual at a mall would want to buy the niche product. Sensoria products are likely not for everyone and crowdfunding may be a useful way to identify the affinity group most likely to buy Sensoria products. The data produced by the crowdfunding could very well be important in driving venture investors to invest beyond the amount of the crowdfunding.

INTERNET ACTIVITIES 1.

Access the Securities and Exchange Commission Web site at http://www.sec.gov.

Identify recent developments and changes in Rule 504 of the SEC’s Regulation D. Web-researched results vary due to constant updating of web sites.

2.

NYPPEX is ―one of the world’s leading secondary agents for transfers of large single interests in private funds, unregistered securities in companies.‖ Summarize their regulation-related posting at http://nyppex.com/regulatory.php.

Web-researched results vary due to constant updating of web sites.

3.

Access the Nolo Press Web site at http://www.nolo.com. Develop a list of legal references relating to securities laws.

Web-researched results vary due to constant updating of web sites.

EXERCISES/PROBLEMS AND ANSWERS

[Accredited Investors] The NetCare Company, which operates living assistance facilities, is planning to issue or sell shares of stock to ―accredited investors.‖ Briefly explain whether each of the following individuals would qualify as an ―accredited investor‖ under the SEC’s Regulation D. [Note: Materials in Appendix B are useful in answering this exercise.]

A. Amy Smith is the chief executive officer (CE0) of the NetCare Company.

Yes. All officers and directors of the company are accredited.

B. Bruce Jones, who has a net worth of $750,000, is planning to purchase shares of stock to be issued by the NetCare Company.

169 Not on the basis of net worth: a minimum net worth of $1 million is needed to be accredited.

C. Jean Wu also is considering purchasing shares of stock that will be issued by the NetCare Company. Jean’s annual income has been $250,000 in each of the past two years and she expects to have a comparable amount of income next year.

Yes. A minimum of $200,000 annually over the past two years and the expectation of earning above the threshold next year is one criterion for being accredited.

D. James Shastri is a software programmer for the NetCare Company.

Not on the basis of his employment status: employees are not automatically accredited unless they are officers or directors.

E. Julie Kukoc recently inherited some financial assets and now has a net worth of $2 million with an annual income of $35,000.

Yes. She has a net worth above the $1 million threshold [Securities Law] The CareAssist Company, a web-based provider of information for the elderly, is planning to sell $4 million in securities. Management is trying to decide which, if any, securities laws must be complied with. For each of the following situations, describe the securities laws that might apply.

A. A private placement For the $4 million offering, CareAssist can consider a Rule 504 or 506, or a general Section 4(2) exemption or accredited investor exemption. Absent securing an exemption, the firm will be subject to the full registration requirements of U.S. securities law.

B. An interstate public offering Rule 504 permits an offering or sale to the general public up to $5 million.

A Reg A offering also is a possibility for CareAssist.

C. An intrastate public offering If the offering were only to investors in the single state in which CareAssist operates, it might be possible to consider an intrastate exemption. Ben & Jerry‘s Vermont offering is an example of an offering that used the intrastate exemption.

[Regulation D Exemptions] Two Rules (504 and 506) under Regulation D relate to the (a) amount of offerings and (b) number of investors. Match Rules 504, 506, or ―none‖ with each of the following:

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$5 million offering limit (in a 12-month period) $1 million offering limit (in a 12-month period) No limit on the amount of offering (in a 12-month period) No limit on the number of investors No limit on number of accredited investors; limit of 35 unaccredited investors Solutions: $5 million offering limit (in a 12-month period) [Rule 504] $1 million offering limit (in a 12-month period) [none] No limit on the amount of offering (in a 12-month period) [Rule 506] No limit on the number of investors [Rule 504] No limit on number of accredited investors; limit of 35 unaccredited investors [Rule 506]

MINI CASE: THE VIRTUALSTREAM COMPANY The VirtualStream Company has developed proprietary server and control software for providing communication and media-on-demand services via the Internet. The company is in the process of collecting prerecorded video and audio content from clients and then digitally transferring and storing the content on network servers. The content then is available for replay by customers via the Internet. VirtualStream’s mission is to provide the most dependable and user-friendly multimedia streaming service worldwide.

The Internet technology service industry is characterized by rapid revenue growth with industry revenues predicted to exceed $300 billion in three years. Market participants include companies engaged in video and audio teleconferencing, corporate training, computer-based training, and distance learning. VirtualStream is attempting to focus on helping large companies to communicate more effectively, using both archived and live communications content, via the Internet. Video and audio content is digitally stored in a central location and is available on demand to clients. This approach will save time and money required to duplicate and ship materials. The company also offers a service that enables transmission of live broadcasts via the Internet.

VirtualStream raised $500,000 in the form of founder’s capital last year. The firm is now seeking additional financial capital from investors by issuing or selling ―securities‖ in the form of stock in the firm. The firm is planning to obtain $750,000 as soon as possible from private investors.

A. Discuss whether you would recommend ―registering‖ these ―securities‖ with the Securities and Exchange Commission (SEC).

Paying all of the costs (present and future) of a full public registration would most likely not be advantageous to VirtualStream. Consequently, they should initially seek the less expensive and faster option of a private placement.

B. Some ―securities‖ are exempt from the SEC registration requirement. Is it likely that VirtualStream’s ―stock‖ would qualify for such an exemption? Why, or why not?

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Virtual Stream‘s issue of stock is potentially covered by the transactions exemption features of the 1933 Act and Regulation D. C. Would you recommend that the initial $750,000 be obtained through an ―intrastate‖ offering? Explain.

Intrastate offerings present serious challenges to ventures seeking to acquire large amounts of funding in stages. While it is possible that VirtualStream‘s current offering might be eligible for an intrastate exemption, it seems unlikely in their line of business with their growth prospects.

D. Briefly describe the two basic types of ―transaction‖ exemptions that may be available to VirtualStream that would allow the firm not to have to register its securities with the SEC. The two more likely transaction exemptions for VirtualStream are the private placement exemption (Section 4(2) broadly and its Regulation D extensions) and the accredited investor exemption (Section 4(6)). Both would allow VirtualStream to avoid full registration costs, at least at present. Note, however, that both require that VirtualStream screen the types of investors they allow to purchase the securities.

E. The SEC’s Regulation D offers a ―safe harbor‖ exemption to firms from having to register their securities with the SEC. Describe how the VirtualStream Company could use Reg D for issuing $750,000 in stock to private investors. In developing your answer, describe the Reg D ―rules‖ that would likely apply to this security issue.

Assuming that the previous round of funding falls outside the time interval where integration is an issue, the $750,000 offering potentially falls under the guidelines of Reg D‘s 504 and 506. The least restrictive of these (with respect to investor qualification and solicitation restrictions) is Rule 504 with a limit of $5 million.

F. Now, assume VirtualStream also is planning to issue an additional $2 million in stock towards the end of the year. Would this decision have an impact on the Reg D ―rules‖ which would govern the issuance of the firm’s securities? Describe. [Note: The material in Appendix B may be helpful in developing an answer to this question.]

Since the future issue is for the same securities and could potentially be integrated into the current offering (from the SEC‘s viewpoint assuming that its ―6-months-either-side‖ safe harbor is not satisfied), VirtualStream needs to consider the impact of integration. With this said, either a 504 offering (with a $5 million limit over a 12-month period) or a more restrictive 506 offering could be issued.

G. The other alternative is to seek to raise the total $2,750,000 amount now by selling securities to investors. Which Reg D ―rules‖ and/or other securities laws would be ―triggered‖ by such a plan? Describe why and how.

172 Reg D‘s 504 and 506 apply, but much care needs to be taken with a 506 offering as the 35 unaccredited investor limit could be binding. If the offering is not targeting accredited investors, VirtualStream might seriously consider a Regulation A filing or even an SB registration.

Chapter 9 PROJECTING FINANCIAL STATEMENTS FOCUS In this chapter, we focus on projecting financial statements for several years into the future.

Inadequate financial resources often constrains the venture‘s ability to grow, is a primary cause of financial distress, and can result in bankruptcy even though the venture may be profitable in an accounting sense. The process of preparing projected financial statements based on percentof-sales relationships helps the entrepreneur anticipate and estimate additional external financial capital needed to support the business model/plan. We also cover estimating sustainable sales growth rates and estimating additional financing needed to support growth in this chapter.

LEARNING OBJECTIVES LO 9.1: Discuss the role of long-term financial planning over the venture‘s life cycle.

LO 9.2: Explain differences in forecasting sales for seasoned firms versus early stage ventures.

LO 9.3: Describe the process for estimating sustainable sales growth rates.

LO 9.4: Explain the process of identifying the quantity and timing of additional funds needed to support the venture‘s sales forecast.

LO 9.5: Describe the percent-of-sales method for preparing financial plans.

CHAPTER OUTLINE 9.1 9.2

9.3 9.4

9.5

LONG-TERM FINANCIAL PLANNING THROUGHOUT THE VENTURE‘S LIFE CYCLE BEYOND SURVIVAL: SYSTEMATIC FORECASTING C. Forecasting Sales for Seasoned Firms D. Forecasting Sales for Early-Stage Ventures ESTIMATING SUSTAINABLE SALES GROWTH RATES ESTIMATING ADDITIONAL FINANCING NEEDED TO SUPPORT GROWTH A. The Basic Additional Funds Needed Equation B. Impact of Different Growth Rates on AFN C. Estimating The AFN for Multiple Years PERCENT-OF-SALES PROJECTED FINANCIAL STATEMENTS B. Forecasting Sales C. Projecting the Income Statement D. Projecting the Balance Sheet E. Forecasting the Statement of Cash Flows

173 F. Financing Cost Implications Associated with the Need for Additional Funds SUMMARY DISCUSSION QUESTIONS AND ANSWERS 1. Why is it usually easier to forecast sales from seasoned firms in contrast with early-stage ventures?

It is usually easier to forecast a seasoned firm‘s sales compared to early-stage ventures because a seasoned firm generally has an operating history. The forecast of the firm‘s financials therefore could begin with the firm‘s historical sales and the past relationships between sales and the other asset and liability accounts. Early-stage ventures have little or no useful historical operating performance against which to benchmark. Competitors‘ operating histories, however, may provide a useful reference. Nonetheless, when a venture is the pioneer in an industry, it is especially difficult to forecast its financials, since there are no historical or competitor benchmarks to act as a guide to the projections.

2. Explain how projected economic scenarios can be used to help forecast a firm‘s sales growth rate.

Since future state of the economy cannot be known, sales forecasts should be based on specific macroeconomic scenarios that reflect expected values based on probabilities assigned to possible outcomes.

3. Identify and describe the four-step process typically used to forecast sales for seasoned firms.

Forecasting sales or revenues for a firm that has been in operation for a number of years usually begins with a review of the firm‘s sales for the past several years. Typically, a fiveyear period is used, if possible. The four steps are : (1) forecast future growth rates based upon multiple scenarios and their likelihoods; (2) check the results of the first step with industry growth rates and expected market shares – the ―top-down‖ or ―market-share-driven‖ approach to projecting growth rates; (3) refine the sales forecast using direct contact with existing and potential customers – the ―bottom-up‖ or ―customer-driven‖ approach to projecting growth rates; and (4) consider the likely impact of major strategic changes including changes in pricing policy, credit policies, marketing approach and R&D developments and strategy.

4. What are the three steps typically used to forecast sales for early-stage ventures?

A new venture usually begins its forecast with a ―top-down‖ market-driven approach. First, an estimate is made of what the overall industry or market demand is likely to be next year and over the following four years. The second step is to estimate a market share that the venture believes it could attain. The third step should be an attempt to further refine the sales forecast by working with existing and potential customers.

174 5. Describe the general relationship between the life cycle stage and the ability to accurately forecast sales for a firm.

Venture capitalists and other seasoned investors know that forecasting sales usually gets easier as a firm matures. See Figure 9.4. Sales forecasting accuracy is usually low during the development stage, low to moderate during the startup stage, moderate during the survival stage, moderate to high during the rapid-growth stage, and high during the maturity stage.

6. How do venture investors adjust for the belief that entrepreneurs tend to be overly optimistic in their sales forecasts?

Entrepreneurs tend to be exceedingly optimistic in their sales and cash flow forecasts. Venture capitalists and other seasoned outside investors know that the ability to forecast sales, and thus cash flows, accurately, tends to be inversely related to where the firm is in its life cycle.

In general, the more difficult it is to forecast sales accurately, the greater the venture’s riskiness. Venture capitalists and other seasoned outside investors will adjust for this greater difficulty by adjusting the expected value of the entrepreneur’s sales forecasts downwards or by using higher discount rates to value the venture’s cash flows.

7. What is meant by a sustainable sales growth rate?

The sustainable sales growth rate is the rate at which a venture can grow based on its retention of profits. In other words, assuming that a venture replicates itself in all aspects and does not distribute any returns to investors, the venture can grow at the accounting rate of return on equity where the equity base is measured at the beginning of a period.

8. Identify and describe the two equations that can be used to estimate a firm’s sustainable growth rate.

A firm‘s sustainable growth rate ‗g‘ can be calculated by:

g

Ending Equity  Beginning Equity Change In Equity ΔE   Beginning Equity Beginning Equity E beg

g=

NI x RR Ebeg

The following expanded model which provides greater detail in terms of operating performance and financial policy metrics also can be used: g = (Net income/Net sales) x (Net sales/Total assets) x (Total assets/Beginning common equity) x Retention rate Where: Retention Rate = (1 – Cash dividends/Net income)

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9.

Describe the basic additional funds needed (AFN) equation.

The ―additional funds needed‖ is the financial funds still needed to finance asset growth after spontaneously generated funds and the increase in retained earnings have been used. It is calculated by subtracting Spontaneously Generated Funds and the Increase in Retained Earnings from the Required Increase in Assets.

AFN = Required Increase in Assets – Spontaneously Generated Funds – Increase in Retained Earnings =

TA0 AP  AL0 NI (NS )  0 (NS )  ( NS1 ) 0 ( RR0 ) NS 0 NS 0 NS0

10. List the major sources of funds typically available to ventures that have successfully entered into their rapid-growth life cycle stage.

Refer to Figure 9.6. The types of financing available during the rapid-growth life cycle stage are: second-round financing, mezzanine financing, and liquidity-stage financing. The major sources of financing during the rapid-growth stage are: business operations, suppliers and customers, commercial banks, and investment banks.

11. Explain how the AFN equation can be used to forecast the amount of funds that will be needed over a several year period.

To use the AFN equation to forecast the amount of the funds needed over a several year period, one must estimate the venture’s asset intensity. This provides an estimate of the relationship between sales growth and required assets. The asset intensity is reduced by the amount of funds that can be obtained spontaneously, or from vendors and other sources of working capital. Finally, the AFN is also reduced by the earnings that the venture is able to retain.

All three terms of the AFN equation can be estimated to forecast the venture’s required funding.

12. What is the percent of sales forecasting method?

The percent of sales forecasting method makes the projections based on the assumption that certain costs and selected balance sheet items are best modeled as a percentage of sales.

This method naturally leads to a model of the mature firm that, in all of its aspects, grows at a smooth rate.

13. After forecasting sales, describe how the income statement is projected.

Once one has projected sales, one can project the income statement by modeling the costs as fixed costs, semi-fixed costs, and variable costs, expressing them as a percent of sales.

Typically, the cost of goods sold and marketing expenses vary directly with changes in sales.

176 Other expenses such as G&A may be fixed over a certain range of sales, but will vary with the venture‘s scale (sales) in the long run.

14. Describe how balance sheets are projected once a sales forecast has been made.

The balance sheet projection typically separates into Asset Projections and Liabilities and Equity Projections. The Asset forecast is usually consistent with estimating the necessary increase in total assets in the AFN model. It is expected that an increase in assets is required to support the increase in sales. Each item on the balance sheet is then expressed as a percentage of sales. While in the short run, this percent of sales may vary as the venture gains efficiencies, in the long run it will settle to a level consistent with mature firm sales growth. The projections in the liabilities and equity side of the balance sheet include the financing provided spontaneously through trade credit and accrued liabilities and incorporates retained earnings from the projected income statement. The AFN then can be thought of as a ―plug‖ that makes the total liabilities and equity equal to the firm’s total assets.

15. What role does the statement of cash flows play in long-term financial planning?

Most long-term financial planning efforts set cash as a percentage of sales or as a fixed dollar amount for planning purposes. Thus, the statement of cash flows is primarily used as a ―check‖ on the projected income statement and projected balance sheet. A complete balance sheet and income statement mechanically imply a working statement of cash flows.

The projected cash flow statement alternatively could be used as a dynamic forecasting financial statement.

16. From the Headlines – Automox: Describe how cash budgets and projected financial statements could be used in estimating how far $9 million could take Automox after its Series A round.

Answers will vary: While $9 million seems like a lot of money for a venture, in reality, one cannot determine the distance that such funding will take a venture without more detailed knowledge of the venture‘s expected ―burn rate‖ depletion of that funding. The duration could be a few months, or more than a year. Even rough estimates of the elements of Automox‘s burn rate factors like payroll, R&D, marketing expenses, fixed asset purchases etc., could help set a framing of how long the $9 million would be expected to last. Cash budgets are a quick cash-focused approach to such estimations. Projected financial statements are more formal exercises requiring more accounting familiarity. However, both properly executed provide the same cash bottom line – a projected remaining cash balance at some point in the future.

INTERNET ACTIVITIES

177 1. Using a Web search, what is an expected long-term growth rate for the U.S. economy? What are the current and longer-term expectations of inflation?

Web-researched results may vary due to the forecasting organization and sources used.

2. Using a Web search, find an industry report for an industry of your choosing. What are that industry’s expected near-term and longer-term growth rates?

Web-researched results will vary by industry and existing near-term economic conditions.

EXERCISES/PROBLEMS AND ANSWERS 1. [Sales Growth Rates, Sales, and Profits] Petal Providers Corporation opens and operates “mega” floral stores in the U.S. The idea behind the super store concept is to model the U.S. floral industry after its European counterparts whose flower markets generally have larger selections at lower prices. Revenues were $1 million with net profit of $50,000 last year when the first “mega” Petal Providers floral outlet was opened. If the economy grows rapidly next year, Petal Providers expects its sales to growth by 50 percent. However, if the economy exhibits average growth, Petal Providers expects a sales growth of 30 percent. For a slow economic growth scenario, sales are expected to grow next year at a 10 percent rate. Management estimates the probability of each scenario occurring to be: rapid growth (.30); average growth (.50), and slow growth (.20). Petal Providers net profit margins are also expected to vary with the level of economic activity next year. If slow grow occurs, the net profit margin is expected to be 5 percent. Net profit margins of 7 percent and 10 percent are expected for average and rapid growth scenarios, respectively.

A. Estimate the average sales growth rate for Petal Providers for next year.

Average sales growth rate = Rapid growth rate x Rapid probability + Average growth rate x Average probability + Slow growth rate x Slow probability = (.50 x .30) + (.30 x .50) + (.10 x .20) = 32% B. Estimate the dollar amount of sales expected next year under each scenario, as well as the expected value sales amount.

Sales with rapid growth = 1,000,000 x (1 + 50%) = 1,500,000 Sales with average growth = 1,000,000 x (1 + 30%) = 1,300,000 Sales with slow growth = 1,000,000 x (1 +10%) = 1,100,000 Expected value sales = 1,000,000 x (1 + 32%) = 1,320,000 C. Estimate the dollar amount of net profit expected next year under each scenario, as well as the expected value net profit amount.

178

Net profit with rapid growth = 1,500,000 x 10% = 150,000 Net profit with average growth = 1,300,000 x 7% = 91,000 Net profit with slow growth = 1,100,000 x 5% = 55,000 Expected value net margin = (.10 x .30) + (.07 x .50) + (.05 x .20) = 7.5% Expected value net profit = 1,320,000 x 7.5% = 99,000 2. [Sustainable Sales Growth Rates] Petal Providers Corporation, described in Problem 1, is interested in estimating its sustainable sales growth rate. Last year revenues were $1 million, the net profit was $50,000, the investment in assets was $750,000, payables and accruals were $100,000, and equity at the end of the year was $450,000 (i.e., beginning of year equity of $400,000 plus retained profits of $50,000).

The venture did not pay out any dividends and does not expect to pay dividends for the foreseeable future.

A. Estimate the sustainable sales growth rate for Petal Providers based on the information provided in this problem. g= Or:

E Ending  E Beginning E Beginning



450,000  400,000  12.5% 400,000

g = (Net Income/Common equity beginning) x Retention rate = 50,000/400,000 x 1.00 = .125 x 1.00 = .125 = 12.5%

Expanded model solution: g = 50,000/1,000,000 x 1,000,000/750,000 x 750,000/400,000 x 1.0000 = .0500 x 1.3333 x 1.8750 x 1.0000 = .0667 x 1.8750 = 12.5% B. How would your answer in Part A change if economic growth is average and Petal Providers’ net profit margin is 7 percent?

Note (Historical View): The 12.5% sustainable growth rate in Part A is based on last year‘s operating performance and financial policy relationships holding for this year. If we just revise last year‘s operating and financial relationships to reflect a net profit margin increase from 5% to 7%, we would have: Net income = 1,000,000 x .07 = 70,000 Other operating performance and financial policy relationships are assumed to remain the same g = [(400,000 + 70,000) – 400,000]/400,000 = 70,000/400,000 = .175 = 17.5% Note (Forward-Looking View): If sales grow at 30% this year to $1,300,000 ($1,000,000 x .30) based on information in Problem 5, Petal Providers will need to improve its operating performance, change its financial policies, and/or obtain additional equity funds

179 to support the ―gap‖ between a forecasted growth rate of 30% and the 12.5% sustainable growth rate calculated in Part A. Looking forward and assuming the 30% sales growth rate can be funded this year and the asset turnover ratio will remain the same, the sustainable sales growth rate for next year can be estimated as follows: Expected sales = 1,000.000 x 1.30 = 1,300,000 Expected net income = 1,300,000 x 7% = 91,000 Expected total assets = 750,000 x 1.30 = 975,000 Expected retained profit = 91,000 x 1.0000 = 91,000 Beginning equity this year (last year‘s ending equity) = $450,000 g = [(450,000 + 91,000) – 450,000]/450,000 = 91,000/450,000 = .2022 = 20.22% Or:

g = 91,000/450,000 x 1.00 = .2022 x 1.00 = .2022 = 20.22%

Expanded model solution: g = 91,000/1,300,000 x 1,300,000/975,000 x 975,000/450,000 x 1.0000 = .0700 x 1.3333 x 2.1667 x 1.0000 = .0933 x 2.4375 = .2022 = 20.22% 3. [Additional Funds Needed] Petal Providers Corporation, described in Problem 1, is interested in estimating its additional financing needs to support a rapid increase in sales next year. Last year revenues were $1 million, the net profit was $50,000, the investment in assets was $750,000, payables and accruals were $100,000, and equity at the end of the year was $450,000. The venture did not pay out any dividends and does not expect to pay dividends for the foreseeable future.

A. What would be your estimate of the additional funds needed next year to support a 30 percent increase in sales?

Forecasted Sales = 1,000,000 x 1.3 = 1,300,000 Change in Sales = 300,000 AFN =

AP  AL0 NI TA (NS )  0 (NS )  ( NS1 ) 0 ( RR0 ) NS 0 NS 0 NS0

= (750,000/1,000,000 x 300,000) – (100,000/1,000,000 x 300,000) – (1,300,000 x 50,000/1,000,000) x 1.00 = (.75 x 300,000) – (.10 x 300,000) – (1,300,000 x .05) x 1.00 = 225,000 – 30,000 – 65,000 = 130,000 B. How would your answer in Part A change if the expected sales growth were only 15 percent?

180

Forecasted Sales = 1,000,000 x 1.15 = 1,150,000 Change in Sales = 150,000 AFN = (750,000/1,000,000 x 150,000) – (100,000/1,000,000 x 150,000) – (1,150,000 x 50,000/1,000,000) x 1.00 = (.75 x 150,000) – (.10 x 150,000) – (1,150,000 x .05) x 1.00 = 112,500 – 15,000 – 57,500 = 40,000 4. [Sustainable Sales Growth Rates and Additional Funds Needed] The Minoso Corporation anticipates a 20 percent increase in sales for 2020 over its 2019 level. Minoso is currently operating at full capacity and thus expects to increase its investment in both current and fixed assets in order to support the increase in forecasted sales.

Minoso Corporation

A. Estimate Minoso’s sustainable sales growth rate based on the financial data relationships for 2019. In making your estimate, calculate each component of the firm’s operating performance and financial policies. g = operating performance x financial policies = (net profit margin x asset turnover (or ROA)) x [(total assets/beginning common equity) x (1 – dividend payout policy)

181 g = (960/15000) x (15000/12000) x (12000/(2400 + 2800 – 576)) x (1 - .40) = .064 x 1.250 x 2.595 x .600 = .1246 = 12.46% Note: the beginning equity is the ending equity of 5200 (2400 + 2800) less the additional retained earnings of 576 which equals 4624).

B. Estimate the additional funds needed (AFN) for 2020 using the formula or equation method that is based on constant ―percent of sales‖ relationships.

2020 sales = 15000 x 1.20 = 18000; change in sales = 3000 (i.e., 18000 – 15000) AFN = [(12000/15000) x 3000] – [((1600 + 1200)/15000) x 3000] – [18000 x (960/15000) x (1 - .40)] = .800(3000) - .1867(3000) – 18000(.064)(.60) = 2400 -560.1 – 691.2 = 1148.7 C. Briefly describe differences in calculation assumptions between Part A and Part B. The sustainable sales growth rate calculation assume a constant financial leverage policy such that all forms of debt (current liabilities and long-term debt) will change with changes in sales. The AFN equation assumes only accounts payables and accrued liabilities will change with changes in sales. That is notes payable (bank loans) and longterm debt changes must be negotiated and thus will not automatically change with sales.

Thus, if the 12.46% sustainable sales growth percentage is inserted in the AFN equation (instead of 20%), the AFN will not be zero because of the differences in the financial leverage assumptions between the two equations.

5. [Sustainable Sales Growth Rates and Additional Funds Needed] Following are two years of income statements and balance sheets for the Munich Exports Corporation.

Munich Exports Corporation Cash Accounts receivable Inventories Total current assets Fixed assets, net Total assets Accounts payable Accruals Bank loan Total current liabilities Long-term debt Common stock ($.05 par) Additional paid-in-capital

2018 $ 50,000 200,000 450,000 700,000 300,000 $1,000,000 130,000 50,000 90,000 270,000 400,000 50,000 200,000

2019 $ 50,000 300,000 570,000 920,000 380,000 $1,300,000 $ 180,000 70,000 90,000 340,000 550,000 50,000 200,000

182 Retained earnings Total liabilities and equity

80,000 $1,000,000

160,000 $1,300,000

Net sales Cost of goods sold Gross profit Marketing General and administrative Depreciation EBIT Interest Earnings before taxes Income taxes (40% rate) Net income

2018 $1,300,000 780,000 520,000 130,000 150,000 40,000 200,000 45,000 155,000 62,000 $ 93,000

2019 $1,600,000 960,000 640,000 160,000 150,000 55,000 275,000 55,000 220,000 88,000 $ 132,000

$37,000

$52,000

Cash dividends

A. Munich has a target dividend payout of 40 percent of net income. Based on the 2019 financial statements relationships, estimate the sustainable sales growth rate for the Munich Corporation for 2020.

2018 total common (stockholders‘) equity = 50,000 + 200,000 + 80,000 = 330,000 Actual 2019 total common equity = 50,000 + 200,000 + 160,000 = 410,000 Note: actual dividend payout ratio was 39.39% (52,000/132,000) with a retention rate of 60.61% (1 – 39.39%) or, 80,000 (132,000 x .6061) g = (410,000 – 330,000)/330,000 = 80,000/330,000 = .2424 = 24.24% Revised 2019 total common equity (with 40% target dividend payout): Net Income times (1 - .40) = 132,000 x .60 = 79,200 in added retained earnings Beginning equity of 330,000 + 79,200 = 409,200 ending equity g = (409,200 – 330,000)/330,000 = 79,200/330,000 = .2400 = 24.00% Expanded model: g = 132,000/1,600,000 x 1,600,000/1,300,000 x 1,300,000/330,000 x (1 - .40) = .0825 x 1.2308 x 3.9394 x .6 = .2400 = 24.00% B. Show how your answer in Part A would change if Munich decided not to pay any dividends in 2020.

Retention rate = 1.00 or 100% Retention amount = 132,000 x 1.00 = 132,000 Revised 2019 total common equity = 330,000 + 132,000 = 462,000

183

g = (462,000 – 330,000)/330,000 = 132,000/330,000 = .4000 = 40.00% Expanded model: g = 132,000/1,600,000 x 1,600,000/1,300,000 x 1,300,000/330,000 x (1 - 0.00) = .0825 x 1.2308 x 3.9394 x 1.00 = .4000 = 40.00% C. Assume the Munich Corporation wants to grow its sales by 40 percent in 2020 over its 2019 level. Estimate the additional funds needed that will be necessary to support this rapid increase in sales.

Forecasted Sales = 1,600,000 x 1.40 = 2,240,000 Change in Sales = 2,240- 1,600,000 = 640,000 Assume target dividend payout of 40% AFN = (1,300,000/1,600,000 x 640,000) – ((180,000 + 70,000)/1,600,000 x 640,000) – (2,240,000 x 132,000/1,600,000) x (1 – .40) = (.8125 x 640,000) – (.15625 x 640,000) – (2,240,000 x .0825) x .60 = 520,000 – 100,000 – (184,800 x .60) = 520,000 - 100,000 – 110,880 = 309,120 D. Sales are forecasted to increase an additional 20 percent in 2021 over 2020. Estimate the two-year AFN that the Munich Corporation will need to finance its 2020 and 2021 sales growth plans.

Estimated 2021 sales = 1,600,000 x 1.40 x 1.20 = 2,688,000 Or, Estimated 2020 sales = 1,600,000 x 1.40 = 2,240,000 Estimated 2021 sales = 2,240,000 x 1.20 = 2,688,000 Change in 2020 sales = 2,240,000 – 1,600,000 = 640,000 Change in 2021 sales = 2,688,000 – 2,240,000 = 448,000 Total Two-Year sales = 2,240,000 + 2,688,000 = 4,928,000 Change in Two-Year Sales = 2,688,000 – 1,600,000 = 1,088,000 [or, 640,000 + 448,000 = 1,088,000] Assume target dividend payout of 40% AFN = (1,300,000/1,600,000 x 1,088,000) – ((180,000 + 70,000)/1,600,000 x 1,088,000) – (4,928,000 x 132,000/1,600,000) x (1 – .40) = (.8125 x 1,088,000) – (.15625 x 1,088,000) – (4,928,000 x .0825) x .60 = 884,000 – 170,000 – (221,760 x .60) = 884,000 - 170,000 – 243,936 = = 470,064 Alternatively, the AFN could be calculated separately for each of the two years.

AFN 2020 = 309,120 (see Part C)

184 Change in sales for 2021 over 2020 = 2,688,000 – 2,240,000 = 448,000 AFN 2021 = (.8125 x 448,000) – (.15625 x 448,000) – (2,688,000 x .0825 x .6) = 364,000 – 70,000 – 133,056 = 160,944 AFN Combined for 2020 & 2021 = 309,120 + 160,944 = 470,064

SPREADSHEET EXERCISES/PROBLEMS [Note: The following activities are for students with spreadsheet software skills.]

6. [Multi-Year Financial Statement Projections] The Minoso Corporation anticipates a 20 percent increase in sales for 2020, 2021, and 2022. Minoso is currently operating at full capacity and thus expects to increase its investment in both current and fixed assets in order to support the increase in forecasted sales. The Minoso Corporation’s 2019 income and balance sheet statements are given in problem 4.

A. Prepare an Excel spreadsheet model that projects the income statement, balance sheet, and statement of cash flows for 2020 prior to obtaining any additional financing. Use a separate AFN long-term financing (liability/equity) account to show the amount of financing needed to make the balance sheet balance.

Financial statement projections for 2020 (as well as 2021 and 2022) are presented under Part B below. The AFN for 2020 is 1120 prior to obtaining any additional debt and/or equity financing.

B. Extend your 2020 spreadsheet-based financial statement projections for two additional years (2021 and 2022). What is the total amount of AFN needed over the three-year period?

The total (cumulative) amount of AFN needed over the 2020-22 three-year period is 3984.6 (almost 4000, or nearly $4 million since the data are presented in thousands of dollars) prior to making any financing decisions.

185 MINOSO CORPORATION Financial Statement Projections Note: Projections are Prior to New Financing Decisions Ch 9, Prob 6 Sales Growth Rates------> Income Statements Actual Percent 2019 of Sales Forecast Basis Net Sales 15000 100.0% 1.20 x Current Sales Operating Expenses -13000 86.7% .867 x Forecast Sales Interest* -400 Initially Held Fixed EBT 1600 Taxes (40%) -640 40% of EBT Net Income (NI) 960 6.4% Cash Dividends (40% of NI) Added Retained Earnings

-384 576

Balance Sheets Required Cash Surplus Cash Accounts Rec Inventories Total Current Assets Fixed Assets, Net Total Assets

2019 1000 0 2000 2200 5200 6800 12000

Accounts Pay Bank Loan Acc Liab Total Current Liab Additional Funds Needed (AFN) Long-Term Debt Common Stock Retained Earnings Total Iiab & Equity

1600 1800 1200 4600 0 2200 2400 2800 12000

40% of NI

6.7%

.067 x Forecast Sales

13.3% 14.7%

.133 x Forecast Sales .147 x Forecast Sales

45.3% 80.0%

.453 x Forecast Sales .800 x Forecast Sales

10.7%

.107 x Forecast Sales

8.0%

.080 x Forecast Sales

[+ Inc in Forecast RE]

*[Bank loan (1800) + long-term debt (2200)] times 10% interest rate = 400

20% Forecast 2020 18000.0 -15600.0 -400.0 2000.0 -800.0 1200.0

20% Forecast 2021 21600.0 -18720.0 -400.0 2480.0 -992.0 1488.0

20% Forecast 2022 25920.0 -22464.0 -400.0 3056.0 -1222.4 1833.6

-480.0 720.0

-595.2 892.8

-733.4 1100.2

2020 1200.0 0.0 2400.0 2640.0 6240.0 8160.0 14400.0

2021 1440.0 0.0 2880.0 3168.0 7495.2 9792.0 17280.0

2022 1728.0 0.0 3456.0 3801.6 8994.2 11750.4 20736.0

1920.0 1800.0 1440.0 5160.0 1120.0 2200.0 2400.0 3520.0 14400.0

2304.0 1800.0 1728.0 5832.0 2435.2 2200.0 2400.0 4412.8 17280.0

2764.8 1800.0 2073.6 6638.4 3984.6 2200.0 2400.0 5513.0 20736.0

186 MINOSO CORPORATION Additional Funds Needed (AFN) Note: Financial Statement Projections are Prior to New Financing Decisions MINOSO CORPORATION Statement of Cash Flows Net Income Change in A/R Change in Inv. Change in A/P Change in Acc. Liab.

CF from Operations

2020 1200.0 -400.0 -440.0 320.0 240.0 920.0

2021 1488.0 -480.0 -528.0 384.0 288.0 1152.0

2022 1833.6 -576.0 -633.6 460.8 345.6 1430.4

Change in Fixed Assets, Net CF from Investments

-1360.0 -1360.0

-1632.0 -1632.0

-1958.4 -1958.4

Change in Bank Loan Change in Long-Term Debt Change in Common Stock Payment of Cash Dividends CF from Financing

0.0 0.0 0.0 -480.0 -480.0

0.0 0.0 0.0 -595.2 -595.2

0.0 0.0 0.0 -733.4 -733.4

Net Cash Flow Beginning Cash Ending Cash Before Borrowing Target Ending Cash Additional Funds Needed (AFN)

-920.0 1000.0 80.0 1200.0 1120.0

-1075.2 1200.0 124.8 1440.0 1315.2

-1261.4 1440.0 178.6 1728.0 1549.4

Cumulative AFN

1120.0

2435.2

3984.6

C. Show how your spreadsheet model projections will change if the AFN from Part B is financed by issuing additional long-term debt at a 10% interest rate.

The AFN for 2020 increases from 1120 prior to obtaining any additional debt and/or equity financing to 1160.3 after financing the initial 1120 with long-term debt at a 10 percent interest rate. For the initial calculation, 1120 x .10 = 112 which is added to the existing 400 of interest for 512. However, more than 1120 would have to be borrowed to pay the additional 112 in interest. While this first pass interest estimate captures most of the total additional interest amount (and avoids circularity problems with simultaneously estimating financing needs and interest costs), several additional iterations or the Excel goal seek function could be used to find a final slightly higher interest amount.

The total (cumulative) amount of AFN needed over the 2020-22 three-year period assuming the AFN is financed with long-term debt (LTD) at a 10 percent interest rate is estimated to be 4256.1 or an additional 271.5 (4256.1 - 3984.6) to cover financing the AFN with LTD at a 10 percent interest rate.

187 MINOSO CORPORATION Financial Statement Projections Note: Projections Assume New 10% LTD Financing Ch 9, Prob 6 Sales Growth Rates------> Income Statements Actual Percent 2019 of Sales Net Sales 15000 100.0% Operating Expenses -13000 86.7% Interest -400 EBT 1600 Taxes (40%) -640 Net Income (NI) 960 6.4% Cash Dividends (40% of NI) Added Retained Earnings

-384 576

Balance Sheets Required Cash Surplus Cash Accounts Rec Inventories Total Current Assets Fixed Assets, Net Total Assets

2019 1000 0 2000 2200 5200 6800 12000

Accounts Pay Bank Loan Acc Liab Total Current Liab New LTD Borrowing (AFN) Long-Term Debt (Old Loan) Common Stock Retained Earnings Total Iiab & Equity

1600 1800 1200 4600 0 2200 2400 2800 12000

20% 20% 20% Forecast Forecast Forecast Forecast Basis 2020 2021 2022 1.20 x Current Sales 18000.0 21600.0 25920.0 .867 x Forecast Sales -15600.0 -18720.0 -22464.0 10% Interest Rate** -512.0 -643.5 -798.5 1888.0 2236.5 2657.5 40% of EBT -755.2 -894.6 -1063.0 1132.8 1341.9 1594.5 40% of NI

-453.1 679.7

-536.8 805.1

-637.8 956.7

2020 1200.0 0.0 2400.0 2640.0 6240.0 8160.0 14400.0

2021 1440.0 0.0 2880.0 3168.0 7488.0 9792.0 17280.0

2022 1728.0 0.0 3456.0 3801.6 8985.6 11750.4 20736.0

1920.0 1800.0 .080 x Forecast Sales 1440.0 5160.0 1160.3 2200.0 2400.0 [+ Inc. in Forecast RE] 3479.7 14400.0

2304.0 1800.0 1728.0 5832.0 2563.2 2200.0 2400.0 4284.8 17280.0

2764.8 1800.0 2073.6 6638.4 4256.1 2200.0 2400.0 5241.5 20736.0

6.7%

.067 x Forecast Sales

13.3% 14.7%

.133 x Forecast Sales .147 x Forecast Sales

45.3% 80.0%

.453 x Forecast Sales .800 x Forecast Sales

10.7%

.107 x Forecast Sales

8.0%

**[bank loan (1800) + long-term debt (2200) + cumulative AFN estimated before financing] times 10%

188 MINOSO CORPORATION Additional Funds Needed (AFN) Note: Financial Statement Projections With New 10% LTD Financing MINOSO CORPORATION Statement of Cash Flows Net Income Change in A/R Change in Inv. Change in A/P Change in Acc. Liab.

CF from Operations

2020 1132.8 -400.0 -440.0 320.0 240.0 852.8

2021 1341.9 -480.0 -528.0 384.0 288.0 1005.9

2022 1594.5 -576.0 -633.6 460.8 345.6 1191.3

Change in Fixed Assets, Net CF from Investments

-1360.0 -1360.0

-1632.0 -1632.0

-1958.4 -1958.4

Change in Bank Loan Change in Long-Term Debt Change in New L-T Debt Change in Common Stock Payment of Cash Dividends CF from Financing

0.0 0.0 1160.3 0.0 -453.1 707.2

0.0 0.0 1402.9 0.0 -536.8 866.1

0.0 0.0 1692.9 0.0 -637.8 1055.1

Net Cash Flow Beginning Cash Ending Cash Before Borrowing Target Ending Cash Additional Funds Needed (AFN)

200.0 1000.0 1200.0 1200.0 0.0

240.0 1200.0 1440.0 1440.0 0.0

288.0 1440.0 1728.0 1728.0 0.0

0.0

0.0

0.0

Cumulative AFN

MINI CASE: PHARMA BIOTECH CORPORATION The Pharma Biotech Corporation spent several years working on developing a DHA product that can be used to provide a ―fatty acid‖ supplement to a whole variety of food products. DHA stands for docsahexaenoic acid, an omega-3 fatty acid found naturally in cold water fish. The benefits of fatty fish oil have been cited in studies of the brain, eyes, and the immune system.

Unfortunately, it is both difficult to consume enough fish to get the benefits of DHA and most individuals might be concerned about the taste consequences associated with adding fatty fish oil to eggs, ice cream, or chocolate candy. To counter these constraints, Pharma Biotech and several competitors have been able to grow algae and other plants that are rich in DHA. The resulting chemical compounds then are used to enhance a variety of food products.

Pharma Biotech‘s initial DHA product was designed as additives to dairy products and yogurt. For example, the venture‘s DHA product was added to cottage cheese and fruit-flavored yogurts to enhance the health benefits of those products. After the long product development period, Pharma Biotech began operations in 2018. Income statement and balance sheet results for 2019, the first full year of operations, have been prepared.

189 Pharma Biotech, however, is concerned with forecasting its financial statements for next year because it is uncertain as to the amount of additional financing of assets that will be needed as the venture ramps up sales next year. Pharma Biotech expects to introduce a DHA product that can be added to chocolate candies. Not only will consumers get the satisfaction of the taste chocolate candies they will benefit from the DHA enhancement. Since this is expected to be a ―block buster‖ new product, sales are expected to increase 50 percent next year (2020) even though the new product will come on line in mid-year. An additional 80 percent increase in sales is expected the following year (2021).

Part A Pharma Biotech is interested in developing an initial ―big picture‖ of the size of financing that might be needed to support its rapid growth objectives for 2020 and 2021.

A. Calculate the following financial ratios (as covered in Chapter 5) for Pharma Biotech for 2019: (a) net profit margin, (b) sales-to-total-assets ratio, (c) equity multiplier, and (d) total-debt-to-total-assets. Apply the return on assets and return on equity models.

Discuss your observations.

190 (a) net profit margin: 960/15,000 = .0640 = 6.40% (b) sales-to-total-assets: 15,000/12,000 = 1.2500 times (c) equity multiplier: 12,000/5,200 = 2.3077 times [Where total common (stockholders‘) equity =2,400 + 2,800 = 5,200] (d) total-debt-to-total assets: (4,600 + 2,200)/12,000 = 6,800/12,000 = .5667 = 56.67% ROA Model = 6.40% x 1.2500 = 8.00% [check: 960/12,000 = 8.00%] ROE Model: 6.40% x 1.2500 x 2.3077 = 18.46% [check: 960/5,200 = 18.46%] Pharma Biotech‘s net profit margin is less than double digits. Hopefully as the venture grows the net profit margin will improve through the spreading of fixed costs. Sales-tototal-assets is greater than 1.00 times. Rapidly growth high tech firms would be expected to improve this ratio as sales ―ramp up‖ over time. Through the use of financial leverage, the 8.00% ROA is improved to an 18.46% ROE. B. Estimate Pharma’s sustainable sales growth rate based on its 2019 financial statements.

[Hint: you need to estimate the beginning of period stockholders’ equity based on the information provided.] What financial policy change might Pharma Biotech make to improve its sustainable growth rate? Show your calculations.

Beginning stockholders‘ equity = ending stockholders‘ equity – added 2019 retained earnings = (2,400 + 2,800) – 576 = 5,200 – 576 = 4,624 g = (960/15,000) x (15,000/12,000) x (12,000/4,624) x (1 - .40) = .064 x 1.2500 x 2.5952 x .6 = .1246 = 12.46% The payment of cash dividends at a 40% of net income rate restricts Pharma Biotech from being able to crow more rapidly without having to issue more equity capital. For example, a policy of no cash dividends payout (i.e., a 100% retention rate) would result in a sustainable sales growth rate of: g = .064 x 1.2500 x 2.5952 x 1.00 = .2076 = 20.76% C. Estimate the additional funds needed (AFN) for 2020, using the formula or equation method presented in the chapter.

2020 sales = 15,000 x 1.50 = 22,500 Change in sales = 22,500 – 15,000 = 7,500 Retention Rate (RR) = 1 – Dividend Payout Ratio = 1 - .40 = .60 AFN 2020 = ($12,000/$15,000) x $7,500 – (($1,600 + $1,200)/$15,000) x $7,500 – $22,500 x ($960/$15,000) x .60 = .8000($7,500) - .1867($7,500) - $22,500(.0640)(.60) = $6,000 - $1,400 - $864 = $3,736

191 D. Also, estimate the AFN using the equation method for Pharma Biotech for 2021. What will be the cumulative AFN for the two-year period?

2020 sales = 22,500 (from Part C) 2021 sales = 22,500 x 1.80 = 40,500 Change in sales = 40,500 – 22,500 = 18,000 2020 Net profit = 22,500 x .064 = 1,440 2020 total assets = 12,000 x 1.50 = 18,000 2020 non-interest bearing current liabilities = (1,600 + 1,200) x 1.50 = 4,200 AFN 2021 = (18,000/22,500) x 18,000 – (4,200/22,500) x 18,000 – 40,500 x (1,440/22,500) x (1 - .40) = .80(18,000) - .1867(18,000) – 2,592(.6) = 14,400 – 3,361 – 1,555 = 9,484 Cumulative two-year (2020 & 2021) AFN = $3,736 + $9,484 = $13,220 Or, Total Net Sales = $22,500 + $40,500 = $63,000 Total change in Net Sales = $40,500 - $15,000 = $25,500 Total AFN = .8000($25,500) - .1867($25,500) - $63,000(.0640)(.60) = $20,400 - $4,761 - $2,419 = $13,220 Part B Pharma Biotech is seeking your assistance in preparing its projected financial statements using the percent-of-sales method. Initial projected financial statements can be prepared by hand using a financial calculator or by constructing spreadsheet–based solutions.

A. Prepare a projected income statement for 2020 for Pharma Biotech before obtaining any additional financing. [Hint: for those who need help, follow the projected income statement shown in Table 9.1 for the GameToy Company.]

Spreadsheet results are provided below.

B. Prepare a projected balance sheet for 2020 for Pharma Biotech before obtaining any additional financing. [Hint: for those who need help, follow the projected balance sheet shown in Table 9.2 for the GameToy Company.]

Spreadsheet results are provided below.

C. Based on your projected balance sheet for Pharma Biotech for 2020, what is your estimate of the additional funds needed? Why does the AFN from your initial percent-ofsales projected financial statements differ from the AFN estimated using the formula method in Item C above?

The spreadsheet solution shows an AFN of $3,664 for 2020. This is less than the AFN formula method result of $3,736 because the interest expense was held constant since

192 additional financing has not been obtained. The AFN formula assumes that the profit margin will remain constant, which means that all expenses are variable or move directly with sales.

D. Prepare a projected statement of cash flows for Pharma Biotech for 2020. [Hint: for those who need help, follow the projected statement of cash flows shown in Table 9.3 for the GameToy Company.]

Spreadsheet results are provided below.

Part C The following tasks or challenges are best handled by setting up spreadsheet–based methods projecting financial statements.

A. Prepare projected income statements, balance sheets, and statements of cash flows for Pharma Biotech for 2021 that build upon the projections for 2020 prepared in Part B above. What is the cumulative (2020 and 2021) amount of additional funds needed?

Spreadsheet results are provided below. The amount of funds needed is $3,664 in 2020 and $9,240 in 2021. The two-year total is $12,903. The $1 difference ($12,903 versus $12,904) is due to rounding each of the annual AFN to the nearest dollar. Recall that the equation or formula method for estimating AFN was $13,220. As noted in Part B, interest is being held constant in the spreadsheet calculation since the decision as to how to finance and the associated financing costs have not yet been determined. The formula method assumes interest is a constant percentage of sales.

B. Calculate the total-debt-to-total-assets ratio and the equity multiplier ratio (covered in Chapter 5) assuming the cumulative AFN is financed with debt funds. How would these ratios compare with the same ratios calculated for 2019 in [Part A] Item A above?

2020 total-debt-to-total-assets ratio = (current liabilities + long-term debt + 2017 AFN) = (6,001 + 2200 + 3664)/18,000 = 11,865/18,000 = .6592 = 65.92% 2020 equity multiplier ratio = total assets/common equity = 18,000/(2,400 + 3,736) = 18,000/6,136 = 2.9335 times 2021 total-debt-to-total-assets ratio = (9,361 + 2,200 + 12,903)/32,400 = 24,464/32,400 = .7551 = 75.51% 2021 equity multiplier ratio = 32,400/(2,400 + 5,535) = 32,400/7,935 = 4.0832 times 2019 total-debt-to-total-assets ratio = 56.67% [from Part A, Item A] 2019 equity multiplier = 2.3077 times [from Part A, Item A] Summary: Total-debt-to-total-assets ratio

2019 56.67%

2020 65.92%

2021 75.51%

193 Equity multiplier

2.3077 times 2.9335 times 4.0832 times

Because of the large amounts of AFN required to support rapid sales growth, financing the AFN with debt funds would cause both the total-debt-to-total-assets and equity multiplier ratios to increase rapidly. It is not likely that lenders would provide such large amounts of debt funds (3,664 in 2020 plus 9,240 in 2021 for a total 12,903).

MINI CASE Pharma Biotech Corporation [$ Thousands] Income Statements Net Sales Operating Expenses Interest EBT Taxes (40%) Net Income (NI) Cash Dividends (40% of NI) Added Retained Earnings Balance Sheets

Actual 2019 15000 -13000 -400 1600 -640 960

Percent of Sales 100.00% 86.67%

Cash & Mkt Sec Accounts Rec Inventories Total Current Assets Fixed Assets, Net Total Assets Accounts Pay Bank Loan Acc Liab Total Current Liab Additional Funds Needed Long-Term Debt Common Stock Retained Earnings Total Iiab & Equity

1600 1800 1200 4600 0 2200 2400 2800 12000

50%

80%

Forecast Basis (1+growth rate) x Sales .8667 x Forecast Sales Initially Fixed

2020 22500 -19501 -400 2599 -1040 1560

2021 40500 -35101 -400 4999 -1999 2999

-624 936

-1200 1800

2020 1501 2999 3301 7801 10199 18000

2021 2701 5399 5941 14041 18359 32400

2401 1800 1800 6001 3664 2200 2400 3736 18000

4321 1800 3240 9361 12903 2200 2400 5535 32400

40% of EBT 6.40%

-384 576 Actual 2019 1000 2000 2200 5200 6800 12000

Sales Growth Rates

40% of NI

6.67% 13.33% 14.67%

Forecast Basis .0667 x Forecast Sales .1333 x Forecast Sales .1467 x Forecast Sales

45.33%

.4533 x Forecast Sales

10.67%

.1067 x Forecast Sales

8.00%

.0800 x Forecast Sales

[+ Inc. in Forecast RE]

[Note: Forecasts are prior to any new interest-bearing debt or equity financing.]

194

Pharma Biotech Corporation Statement of Cash Flows Net Income Change in A/R Change in Inv. Change in A/P Change in Acc. Liab.

CF from Operations

2020 1560 -999 -1101 801 600 860

2021 2999 -2399 -2641 1921 1440 1320

Change in Fixed Assets, Net CF from Investments

-3399 -3399

-8159 -8159

Change in Bank Loan Change in Long-Term Debt Change in Common Stock Payment of Cash Dividends CF from Financing

0 0 0 -624 -624

0 0 0 -1200 -1200

Net Cash Flow Beginning Cash Ending Cash Before Borrowing Target Ending Cash Additional Funds Needed (AFN) Cumulative AFN

-3163 1000 -2163 1501 3664 3664

-8039 1501 -6539 2701 9240 12903

Chapter 10 VALUING EARLY-STAGE VENTURES FOCUS In this chapter, we introduce basic concepts of valuation, the process of estimating values. We consider the owner of a growing business who is beginning negotiations with a potential investor. We introduce the mechanics of valuation and some mathematical simplification that can be used to value the venture. By dividing the venture‘s future into an explicitly forecast period and a subsequent constant growth period, we can greatly simplify the valuation problem faced by the venture‘s entrepreneur. We discuss two valuation methods that differ in how projected financial statements are created and when credit for creating surplus cash is granted.

LEARNING OBJECTIVES LO 10.1: Explain why it is important to look to the future when determining a venture’s value.

LO 10.1: Describe the need to consider both forecast period and terminal value cash flows when determining a venture’s value.

195 LO 10.3: Discuss the difference between required cash and surplus cash.

LO 10.4: Describe the process for developing the projected financial statements used in a valuation.

LO 10.5: Describe how pseudo dividends are incorporated into the discounted cash flow equity valuation method.

LO 10.6: Discuss the differences between accounting and equity valuation cash flow.

CHAPTER OUTLINE 10.1 WHAT IS A VENTURE WORTH? F. Does the Past Matter?

G. Looking to the Future H. Vested Interests in Value: Investor and Entrepreneur 10.2 BASIC MECHANICS OF VALUATION: MIXING VISION AND REALITY C. Present Value Concept D. If You‘re Not Using Estimates, You‘re Not Doing a Valuation E. Divide and Conquer with Discounted Cash Flow 10.3 REQUIRED VERSUS SURPLUS CASH 10.4 DEVELOPING THE PROJECTED FINANCIAL STATEMENTS FOR A DCF VALUATION 10.5 JUST-IN-TIME EQUITY VALUATION: PSEUDO DIVIDENDS 10.6 ACCOUNTING VERSUS EQUITY VALUATION CASH FLOW A. Origins of Accounting Cash Flows B. From Accounting to Equity Valuation Cash Flows

SUMMARY LEARNING SUPPLEMENT 10A: Value Maximization and the First Entrepreneurial Team LEARNING SUPPLEMENT 10B: Discounting Growing Perpetuities

DISCUSSION QUESTIONS AND ANSWERS 1. What is meant by sweat equity?

Sweat equity is an individual‘s work-related, non-financially compensated, contribution to the enhancement of a venture‘s value.

2. What is a venture’s present value? Does the past matter?

A venture‘s present value is the value today of all future cash flows discounted to the present at the rate of return required by investors.

The value of the venture is not directly related to the quantity of past efforts in cash or sweat.

While accounting for the past is all well and good, an investor seeks to quantify and value the future.

3. Describe what is meant by the statement ―If you’re not using estimates, it’s not a valuation.‖

196 It is important to recognize that projected financial statements needed to calibrate value reflect ―best guesses‖ of future revenues, expenses, timing, and investment requirements.

4. Define the terms (a) explicit forecast period and (b) terminal or horizon value as they relate to a venture’s discounted cash flow valuation.

Explicit forecast period: two- to ten-year period in which the venture‘s financial statements are explicitly forecast Terminal (or horizon) value: the value of the venture at the end of the explicit forecast period 5. What is meant by a capitalization (or cap) rate in reference to calculating a terminal value?

What other types of terminal values might be appropriate (i.e., other than smooth growth procedures)?

Dividing by the cap rate (r – g) in the perpetuity formula is the appropriate mathematical simplification for discounting (at rate r) a perpetual series of cash flows growing smoothly (at rate g). It is mathematically equivalent to the infinite sum of the discounted value of all the future cash flows.

Rather than projecting a smooth growth, one could project no growth, multiple stages of growth, liquidation value (with tax benefits, if any) or predict the terminal value using the multiple methods that will be introduced in Chapter 10.

6. What is a venture’s reversion value?

Reversion Value: the present value of the terminal value.

7. What is a stepping stone year? Why is it important in determining a venture’s value?

Stepping-stone year: first year after the explicit forecast period The stepping stone year forces the evaluator to ramp revenue growth down to the long term rate while making sure that the investment flows going forward are at a level appropriate for that long-term growth rate. This level is lower than in the previous years where investment supports much higher revenue growth rates.

8. Explain the difference between pre-money valuation and post-money valuation.

Pre-Money valuation: present value of a venture prior to a new money investment Post-money valuation: pre-money valuation of a venture plus money injected by new investors 9. Describe the equity valuation method.

197

Equity valuation method (equity method): process of projecting and then discounting the relevant cash flows available to equity investors 10. Define required cash and surplus cash. Why does it matter how we treat surplus cash for valuation purposes?

Required cash: amount of cash needed to cover a venture‘s day-to-day operations Surplus cash: cash remaining after required cash, all operating expenses, and reinvestments are made To get an appropriate valuation, we separate required cash (treated as an investment) from surplus cash (allowed to flow through to equityholders).

11. Briefly describe the process for projecting financial statements.

The process begins by projecting top-line sales forecasts annually for a specified forecast period and for a stepping-stone year. We then generally use a percent-of-sales method (described in Chapter 6) to first forecast annual income statements. This is followed by a forecast of annual balance sheets and annual statements of cash flows.

12. What is net operating working capital?

Net operating working capital: current assets less surplus cash less non-interest-bearing current liabilities 13. Identify and describe the major components that are used to calculate the equity valuation cash flow.

Equity valuation cash flow = net income + depreciation and amortization expense – change in net operating working capital (without surplus cash) – capital expenditures + net debt issues 14. Describe how pseudo dividends are used in the equity valuation method.

Pseudo dividend: excess cash not needed for investment in the assets or operations to carry out the business plan Pseudo dividends can be used to conduct an equity-method valuation (1) by altering the projected financial statements to pay out the maximum dividend feasible each period, and incorporating the recovery of those dividends when the capital is needed for the execution of the business plan, or (2) by using a formula approach to directly calculate the pseudo dividends.

198 Sometimes the pseudo dividend in an equity method valuation is referred to as the ―free cash flow to equity.‖ However, we use a more specific terminology because the term ―free cash flow‖ has different meanings to different people.

15. What is the relationship between equity valuation cash flows and dividends?

If you were to project the maximum possible dividend the venture could afford to pay while maintaining all other asset investments, that resulting maximum dividend would coincide with the equity valuation cash flow calculated by the approach given in the textbook.

16. Why do the numerical examples of this chapter involve a large dividend in the last year of the explicit forecast period?

The large ―dividend‖ (or pseudo dividend in the equity valuation cash flow) derives from the cash freed up by the assumed recapitalization through a debt issue. While there need not be an explicitly forecast dividend when using the equity valuation cash flow approach, there is a large equity valuation cash flow due to the recapitalization.

17. Why do net income and cash flow in the numerical examples in this chapter both grow at the same rate (g) in the terminal value period? Why is this important?

After the explicit forecast period, the stepping-stone year provides the first step into the infinite future. After the stepping-stone year, the assumption is that everything grows at the same rate g due to the assumption that operating and financing ratios are constant. Divergent growth rates are not permitted in estimating cash flow perpetuities when determining terminal or horizon value.

18. From the Headlines -- Foursquare: What ingredients would you need to conduct a traditional equity method valuation for Foursquare? If you had the necessary projections, do you think that they would also suggest the $80 to $100 million valuations mentioned in the article? Comment on the warnings you would provide to accompany your projections and valuation if you completed them.

Answers will vary: Ingredients for a traditional equity method valuation include projections of the income statement, balance sheet and statement of cash flows for an explicit projections period and some projection of how the firm will grow on average past that explicitly projected period, and required returns for equity now and in the period beyond the explicit projections. The $80 to $100 million valuations are most likely due to the anticipation of extremely high growth rates and quickly improving revenue and profit streams for Foursquare. Whether they are justified depends on one‘s subjective beliefs regarding the prospects for success and its immediacy. General warnings on Foursquare (and any other ventures in a similar situation) include that projections and valuation include ―garbage in – garbage out‖ and ―hockey stick revenue hype is nothing new – sometimes it happens; most times it doesn‘t‖ and ―costs are seldom kept to the level originally projected.‖

199 INTERNET ACTIVITIES 1. Web surfing exercise: Find a fast growth publicly traded firm with financial statements posted on the firm’s web page. Relate that firm’s financial statements to those of the examples in this chapter. Formulate the process by which you would project that firm’s financial statements into the future in order to conduct a valuation.

Web-researched results vary due to constant updating of the related web sites.

2. Using a free stock quoting and research site on the Web (e.g. http://www.bloomberg.com or http://money.cnn.com), examine the current price for an Internet company. Relate the financial data you can find on the firm to the current stock price.

Web-researched results vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS 1. [Present Value Valuation Concepts] Assume you sell for $100,000 a 10 percent ownership stake in a future payment one year from now of $1.5 million.

A. What are you saying about the implied return for the 10 percent owner?

Investment of $100,000 for a dollar return of $150,000 ($1.5 million x .10) one year from now.

Implied return = ($150,000 - $100,000)/$100,000 = $50,000/$100,000 = 50% Implied current (present) value of venture = $ Investment / Percentage Ownership = $10,000/.10 = $1,000,000 Expected venture return = ($1,500,000 - $1,000,000)/$1,000,000 = 50% B. What is the present value of the entire $1.5 million, using the implied return from Part A? PV = $1,500,000/(1.50) = $1,000,000 C. What is 10 percent of the value determined in Part B? $1,000,000 x .10 = $100,000 F. Does it matter whether you grow the $100,000 at 50 percent to $150,000 and note it is 10 percent of $1.5 million, or discount the $1.5 million at 50 percent to get $1 million and note that $100,000 is 10 percent of this present value?

No. Both approaches provide the same result:

200 a) $100,000 x 1.50 = $150,000 future value [which is 10% of the $1,500,000 total FV] b) $1,500,000/(1.50) = $1,000,000 present value [$100,000 is 10% of total PV] 2. [Venture Present Values] The TecOne Corporation is about to begin producing and selling its prototype product. Annual cash flows for the next five years are forecasted as:

[Note: Following is a spreadsheet solution for Problem 2 (TecOne Corporation) and Problem 3 (LowTec Corporation).]

TecOne Corporation Solutions Problem 1 Part A: Yr 0 Annual Cash Flow Terminal Value Total Flow to Discount Present Value @ 40% $615,264.47

Yr 1 Yr 2 Yr 3 (50,000) (20,000) 100,000

Yr 4 400,000

(50,000) (20,000) 100,000

400,000

Yr 1 Yr 2 Yr 3 (50,000) (20,000) 100,000

Yr 4 400,000

(50,000) (20,000) 100,000

400,000

Yr 5 800,000 2,000,000 2,800,000

Yr 6 800,000

Yr 5 800,000 2,812,500 3,612,500

Yr 6 900,000

Part B: Yr 0 Annual Cash Flow Terminal Value Total Flow to Discount Present Value @ 40%

$766,336.20

201 Part C: Yr 0

Yr 1 (50,000)

Yr 2 Yr 3 (20,000) 100,000

Yr 4 400,000

(50,000)

(20,000) 100,000

400,000

Annual Cash Flow Terminal Value Total Flow to Discount Present Value @ 40%

$1,637,903.85

Part D: Pre-money valuation = Investor investment Post-money valuation = % ownership to investor

$1,637,903.85 $3,000,000.00 $4,637,903.85 ($1,637,903.85 + $3,000,000) 64.7% ($3,000,000/$4,637,903.85)

Yr 5 800,000 7,500,000 8,300,000

Yr 6 900,000

LowTec Corporation Solutions Problem 2 Note: It is assumed that the cash flows in Part C of Problem 1 exist for the LowTec Corporation Part A: Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Annual Cash Flow (50,000) (20,000) 100,000 400,000 800,000 900,000 Terminal Value 8,181,818 Total Flow to Discount (50,000) (20,000) 100,000 400,000 8,981,818 Present Value @ 30% $2,554,336.65 Part B: Pre-money valuation = Investor investment Post-money valuation = % ownership to investor

$2,554,336.65 $1,500,000.00 $4,054,336.65 37.0%

A. Assume annual cash flows are expected to remain at the $800,000 level after Year 5 (i.e., Year 6 and thereafter). If TecOne investors want a 40 percent rate of return on their investment, calculate the venture’s present value.

DCF PV = -$50,000/1.4 + -$20,000/1.42 + $100,000/1.43 + $400,000/1.44 + [$800,000 + ($800,000/(.4 - .0))]/1.45 = $615,264.47 See TecOne Corporation spreadsheet solution for Part A. B. Now assume that the Year 6 cash flows are forecasted to be $900,000 in the stepping stone year and are expected to grow at an 8 percent compound annual rate thereafter. Assuming that the investors still want a 40 percent rate of return on their investment, calculate the venture’s present value.

See TecOne Corporation spreadsheet solution for Part B. C. Now extend Part B one step further. Assume that the required rate of return on the investment will drop from 40 percent to 20 percent beginning in Year 6 to reflect a drop in operating or business risk. Calculate the venture’s present value.

202 See TecOne Corporation spreadsheet solution for Part C. D. Let’s assume that TecOne investors have valued the venture as requested in Part C. An outside investor wants to invest $3,000,000 in TecOne now (at the end of Year 0). What percentage of ownership in the venture should the TecOne investors give up to the outside investor for a $3,000,000 new investment?

See TecOne Corporation spreadsheet solution for Part D. 3. [Present Value Valuation Concepts] Assume the forecasted cash flows presented in Problem 2 for the TecOne Corporation venture also hold for the LowTec venture.

However, investors in LowTec have an expected rate of return of 30 percent on their investment until Year 6 when the rate of return is expected to drop to 18 percent.

The perpetuity growth rate for cash flows after Year 6 is expected to be 7 percent.

A. Determine the present value for the LowTec venture.

See LowTec Corporation spreadsheet solution for Part A (presented under Problem 2).

B. If an outside investor offers to invest $1,500,000 dollars today, what percentage ownership in LowTec should be given to the new investor?

See LowTec Corporation spreadsheet solution for Part B (presented under Problem 2).

4. [Venture Present Values] Ben Toucan, owner of the Aspen Restaurant, wants to determine the present value of his investment. The Aspen Restaurant is currently in the development stage but hopes to ―begin‖ operations early next year. After-tax cash flows during the next five years are expected to be as follows: Year 1 = 0, Year 2 = 0, Year 3 = 0, Year 4 = $2.5 million, and Year 5 = $3 million. Cash inflows are expected to be $3.18 million in Year 6 and are expected to grow at a 6 percent annual rate thereafter. Recall from Chapter 7 that venture investors often use different discount rates when valuing ventures at various stages of their life cycles. For example, target discount rates by life cycle stage are development stage, 50 percent; startup stage, 40 percent; survival stage, 35 percent; and early rapidgrowth stage, 30 percent. As ventures move from their late rapid-growth stages and into their maturity stages, a 20 percent discount rate is often used.

A. Determine the Aspen BrewPub’s terminal or horizon value at the end of five years.

VCF5 1  .06  3,180,000 Terminal Value = = = 22,714,285.71 rg 20%  6% B. What is the present value of the Aspen BrewPub? PV =

VCF3 VCF1 VCF2 VCF4 VCF5  TermnalVal ue     2 3 (1  r ) (1  r ) (1  r ) (1  r ) 4 (1  r ) 5

203

=0+0+0+

2,500,000 3,000,000  22,714,285 .71  = 3,880,070.55.

(1  50%) 4 (1  50%) 5

C. What percent ownership interest should Ben Toucan be willing to give to a venture investor, Sherri Isitar, for her $1,000,000 investment?

Under the assumption, (consistent with the textbook treatment in Section 9.2) that the cash flow in years 4 and 5 are fixed and have already incorporated the use of the new financing (in operating expenses), then the percent of this fixed $3,880,070.55 ―pie‖ is:

1,000,000  25.77% 3,880,070.55 Some students will assume that the $1,000,000 is not already projected as being used to generate the $3,880,070.55 ―pie.‖ (This is the type of conjecture that is suggested in founder‘s initial ―thinking‖ in Section 9.1, but is not consistent with the story elsewhere.)

Accordingly, they will assume that that pie is enhanced by the $1,000,000 in present value or equivalently that the future value of the $1,000,000 will survive to be added to $22,714,285.71 terminal value currently conjectured. The percent of this larger enhanced pie is therefore smaller at

1,000,000  20.49% 1,000,000  3,880,070.55 5. [Venture Present Value Concepts] Refer to the FrothySlope microbrewery example at the beginning of this chapter.

A. How does the $500,000 piece of the terminal value relate to the future value of the $100,000? That is, the brewpub investor was looking for a 40% return. The five-yearout future value of $100,000 growing at 40% is 100,000*(1.4)5 =$537,824, slightly more than $500,000. Does this mean the investor is not really expected to make 40% on the $100,000, even though we used that discount rate to arrive at the initial $5,856,935 valuation? (Hint: What about explicit forecast period flows?)

The investor actually does make a 40% return. The $500,000 future value only takes into account the terminal value of venture. It does not take into account the present value of the cash flows in years 4 and 5.

B. Returning to the brewpub spreadsheet with all flows included, how much more of the venture’s ownership of surplus cash flows would have to be sold for the $100,000 if the investor expected to make 70% (given Jim’s utopian vision of his future)?

204 PV of Venture @ 70% discount =

0 0 0 2,500,000     2 2 1.7 1.7 1.7 1.7 4 = $2,271,355.50

3,500,000 (20%  6%) 1.7 5

3,000,000 

Percent ownership with investment = $100,000/$2,271,355.50 = 4.40% C. What percentage of the brewpub’s present value is contained in the present value of the terminal value (the venture’s ―reversion value‖)? $3,500,000 = $4,648,360.80 (1  40%) 5 (20%  6%) PV of the Brewpub = $5,856,935 $4,648,360.8 Percent of PV in the Terminal Value = = 79.37% 5,856,935

PV of Terminal Value =

D. How much ownership of the brewpub cash flows would need to be sold to an investor demanding 40% but agreeing that the mature brewpub venture would terminally grow at a rate of 8% with a risk profile requiring a discount rate of 16%? What if the terminal growth rate were 10% and the discount rate 18%? (The spread between the discount rate and the growth rate is sometimes referred to as the ―capitalization rate‖ for the terminal flows or just the ―cap rate.‖) With a 40% discount rate, and 8% terminal growth with 16% discount:

Firm Value =

0 0 0 2,500,000  2  2   1.4 1.4 1.4 1.4 4

3,500,000 (16%  8%) 1.4 5

3,000,000 

= $9,343,205 % of the Ownership with $100,000 investment = $100,000/$9,343,205 = 1.07% With 10% terminal growth rate and 18% discount rate: Firm Value =

0 0 0 2,500,000  2  2   1.4 1.4 1.4 1.4 4

3,500,000 (18%  10%) 1.4 5

3,000,000 

= $9,343,205 As indicated above, the firm has the same value as with 16% discount and 8% terminal growth rate, therefore the 1.07% of the ownership should be sold in exchange for $100,000 investment. (Note that this would not normally be the case because the cash

205 flow in period (T+1) would normally be determined by CF at time T multiplied by (1+g).

In this example the cash flow in time (T+1) was given.)

6. [Equity Valuation Cash Flows] Following are financial statements (historical and forecasted) for the Global Products Corporation.

GLOBAL PRODUCTS CORPORATION

A. Assume that the cash account includes only required cash. Determine the dollar amount of equity valuation cash flow for 2020.

206 Equity Valuation Cash Flow = Net Income: $132,000 + Depreciation: $55,000 - Change in NOWC: [($60,000 + $290,000 + $570,000 - $180,000 - $70,000) – ($50,000 + $200,000 + $450,000 - $140,000 - $50,000)] = $670,000 - $510,000 = $160,000 - Change in Gross Fixed Assets: ($380,000 - $300,000 + depreciation of $55,000) = $135,000 + Net Debt Issues: ($90,000 + $550,000) – ($80,000 + $400,000) = $640,000 - $480,000 = $160,000 Equity Valuation Cash Flow = $132,000 + $55,000 - $160,000 - $135,000 + $160,000 = $52,000 B. Now assume that Global Product’s required cash is set at 3 percent of sales. Any additional cash would be surplus cash. Re-estimate the dollar amount of equity valuation cash flow for 2020.

Required Cash: 2019 = $1,300,000 x .03 = $39,000 Surplus Cash: $50,000 - $39,000 = $11,000 Required Cash: 2020 = $1,600,000 x .03 = $48,000 Surplus Cash: $60,000 - $48,000 = $12,000 Change in NOWC (without surplus cash): [($48,000 + 290,000 + $570,000 - $180,000 $70,000) – ($39,000 + $200,000 + $450,000 - $140,000 - $50,000)] = $658,000 - $499,000 = $159,000 Equity Valuation Cash Flow = $132,000 + $55,000 - $159,000 - $135,000 + $160,000 = $53,000. The 2020 stripping of the additional $1000 of surplus cash leads directly to a $1000 increase in the valuation cash flow.

C. Let’s assume that investors in Global Products want to estimate the venture’s present value at the end of 2019. Forecasted financial statements reflect the stepping stone year. Cash flows are expected to grow at a perpetual 8 percent annual rate beginning in 2021. Assume that all cash is required cash as was done in Part A. What is the Global Products venture’s present value if investors want an annual rate of return of 25 percent?

Present Value @ 25% = $52,000/(.25 - .08) = $305,882.35 D. Work with the assumptions in Part B about Global Products required cash being 3 percent of sales. Calculate the present value of the Global Products venture at the end of 2019 if investors want an annual rate of return of 25 percent and cash flows are expected to grow at a perpetual 8 percent annual rate beginning in 2021.

Present Value @ 25% = $53,000/(.25 - .08) = $311,764.71

207 7. Return to the discussion of the FrothySlope venture at the beginning of the chapter. Formulate an answer for each of the five questions that are posed under the heading ―What Is a Venture Worth?

(1) What are the benefits and disadvantages of his approach to determining the investor’s percent ownership?

The benefit of Jim‘s approach is that it accounted for his sweat equity (in reality sunk costs,) and that it was a rather simplistic way of looking at the past as a method to value a venture. The disadvantages are that it under-estimated the value of the firm and also ignored the fact that the investor is willing to pay for future profits as the basis to his return on investment. By ignoring the firm‘s further growth opportunities in his valuation model, Jim was prepared to give away 43% of its ownership for $100,000, a percentage that would be much smaller for a valuation that incorporated the growth opportunities of his business.

For valuation, there are little or no benefits to approaching the venture‘s value from the perspective of historical costs or (modified) book value. While it does present some idea of what it might take another entrepreneur to get to the current stage, value is vested in the venture‘s future. The disadvantages of this approach are numerous including the potential to distort the reasonable negotiation process with a prospective investor and create unrealistically high or low expectations on the percent to be sold to raise a given amount of money.

(2) What role, if any, does the $50,000 cash and the $81,900 sweat equity play in determining the post-financing ownership structure? Would the investor want less ownership if there had been two years of history rather than a year-and-a-half?

All of this investment is sunk. While it may affect the bargaining attitude of the founder and investor, these amounts and imputed amounts are ―water under the bridge.‖ How the actual bargain turns out may reflect some appreciation for the founder‘s previous hard work. More likely, however, the founder will be given credit for the venture‘s potential future and will be placed in a compensation or contingent ownership arrangement to emphasize a large return for past and future efforts when success is achieved. Regarding the length of time, the important point is how past efforts, risk reduction, learning and clarity of future prospects makes investors more clearly see future value.

(3) How will the investor make a return on the $100,000 investment? Does this relate to the existing investment?

The investor‘s return will come in the form of some future cash flows to his ownership security, either in the form of dividends or capital gains (appreciated selling price on his ownership). The investor‘s willingness to pay today is conditioned on the expectations of being paid back more in the future.

208 (4) How would you structure an approach to answering Jim’s question regarding how much the new investor should own in exchange for the $100,000 investment?

With an idea of the size and timing of future cash flows to the venture‘s owners, one can use discounting to convert the amounts to their associated current investment (present) values. The ownership percentage for the new investment can thus be viewed as a portion of the current investment (present) value for all of the current ownership.

(5) Comment on the casual remark, ―Investors pay for the future, entrepreneurs pay for the past.‖ This is the difficulty faced by most of the entrepreneurs and investors in the valuation process. Entrepreneurs are intimately familiar with the struggle and sacrifice of the past. Nonetheless, the past efforts in cash outlays and sweat equity are sunk costs.

They are not the basis of investor willingness to pay. While accounting for the past is all well and good, it is the future that an investor seeks to quantify for valuation.

What really matters to the valuation is whether these past efforts produced a product or brand that can be the basis for the future profits to repay the investor. What the entrepreneur has added to the venture is worth only as much as it adds to the venture‘s ability to build and distribute returns to investors. What matters is how the past helps predict the future, if at all.

SPREADSHEET VALUATION PROBLEM 8. [Venture Present Value Concepts] The Biometrix Corporation has been in operation for one full year (2019). Financial statements follow. Biometrix’s management is interested in determining the value of the venture as of the end of 2019. Sales are expected to grow at a 20 percent annual rate for each of the next three years (2020, 2021, and 2022) before settling down to a long-run growth rate of 7 percent annually. The cost of goods sold is expected to vary with sales. Operating expenses are expected to grow at 75 percent of the sales growth rate (i.e., be semi-fixed) for the next three years before again growing at the same rate as sales beginning in 2023. Individual asset accounts are expected to grow at the same rate as sales. Depreciation can be forecasted either as a percentage of sales or as a percentage of net fixed assets (since net fixed assets are expected to grow at the same rate as sales growth).

Accounts payable and accrued liabilities are also expected to grow with sales.

Biometrix’s management is interested in determining the equity value of the venture as of the end of 2019. Because Biometrix is in its startup life cycle stage, management and venture investors believe that 40 percent is an appropriate discount rate until the firm reaches its long-run or perpetuity growth rate. At that time it will have survived and will become a more typical firm with an estimated cost of equity capital of 20 percent. One million shares of common stock are outstanding.

209 BIOMETRIX CORPORATION Income Statement for December 31, 2019 (Thousands of Dollars)

Balance Sheet as of December 31, 2019 (Thousands of Dollars)

A. Project the financial statements for the next four years (2020-2023).

The spreadsheet solution shows the projection of annual income statements, balance sheets, and statements of cash flow for the years 2020 through 2023. Following are some highlights: Item Sales Net Income Excess Cash on Balance Sheet

2020 $24,000 1,677 177

2021 $28,800 2,283 660

B. Calculate the valuation cash flow for each year.

2022 $34,560 3,049 1,549

2023 $36,979 3,267 3,909

210 The spreadsheet solution produces the following annual amounts of free cash flow available to the equity investors: Year 2020 2021 2022 2023

Free Cash Flow $177 483 889 2,360

C. Determine Biometrix’s equity value at the end of 2019.

The horizon or terminal cash flow at the end of 2022 is estimated using the projected 2023 free cash flow of $2,360 (actually $2,359.80), a 20% discount rate, and a 7% perpetuity growth rate for cash flows. The horizon value is = $2,359.80/(.20 - .07) $2,359.80/.13 = $18,152.28 or $18,152 rounded.

The total free cash flows to equity shown below were then discounted at a 40% rate to arrive at a present value of $7,312 for the firm‘s equity.

Year 2020 2021 2022

Annual Free Cash Flow $177 483 889

Horizon + Free Cash Flow =

+ $18,152

=

Total Free Cash Flow $177 483 19,042

Since the firm has 1 million shares of common stock outstanding, the value per share would be $7.312 or $7.31 ($7,312,000/1,000,000 shares).

See spreadsheets below.

211 BIOMETRIX, INC. [Equity Valuation Method] Percent Sales Increase------> Chapter 10; Problem 8 Income Statements Sales Cost of goods sold Gross profit Operating expenses Depreciation EBIT Interest EBT Taxes (40%) Net income Balance Sheets Cash Excess cash Accounts receivable Inventories Total current assets Gross fixed assets Accumulated depreciation Net fixed assets Total assets Accounts payable Accrued liabilities Bank loan Total current liabilities Common stock Retained earnings Total equity Total liabilities & equity

% of 2019 Sales 100.0% -50.0% 50.0% -37.5%

5.0% 10.0% 10.0%

25.0% 50.0% 7.5% 5.0%

Actual I<---------- Projected ---------------------------->I 20.0% 20.0% 20.0% 7.0% Thousands of Dollars 2019 2020 2021 2022 2023 20000 24000 28800 34560 36979 -10000 -12000 -14400 -17280 -18490 10000 12000 14400 17280 18490 -7500 -8625 -9919 -11407 -12205 -400 -480 -576 -691 -740 2100 2895 3905 5182 5545 -100 -100 -100 -100 -100 2000 2795 3805 5082 5445 -800 1118 1522 2033 2178 1200 1677 2283 3049 3267 1000 0 2000 2000 5000 5400 -400 5000 10000 1500 1000 1000 3500 5300 1200 6500 10000

1200 177 2400 2400 6177 6880 -880 6000 12177 1800 1200 1000 4000 5300 2877 8177 12177

1440 660 2880 2880 7860 8656 -1456 7200 15060 2160 1440 1000 4600 5300 5160 10460 15060

1728 1549 3456 3456 10189 10787 -2147 8640 18829 2592 1728 1000 5320 5300 8209 13509 18829

1849 3909 3698 3698 13154 12132 -2887 9245 22399 2773 1849 1000 5622 5300 11476 16776 22399

212 BIOMETRIX, INC. Statements of Cash Flows Net income Depreciation Change in accts receivable Change in inventories Change in accts payable Change in accrued liabilities CF from operations Change in gross fixed assets CF from investments Change in bank loan Change in common stock CF from financing Net change in cash Beginning cash Required ending cash Cumulative free CF to equity Annual change in free CF Horizon cash flow (20% disc rate) Total free cash flows to equity Present Value (40% disc rate) Per Share Value (1 million shares)

2020 1677 480 -400 -400 300 200 1857 -1480 -1480 0 0 0 377 1000 1200 177 177

2021 2283 576 -480 -480 360 240 2499 -1776 -1776 0 0 0 723 1377 1440 660 483

2023 3267 740 -242 -242 181 121 3825 -1344 -1344 0 0 0 2481 3277 1849 3909 2360

483

2022 3049 691 -576 -576 432 288 3309 -2131 -2131 0 0 0 1177 2100 1728 1549 889 18152 19042

177

2020

2021

2022

2023

1677 480

2283 576

3049 691

3267 740

3000 500 1480

3600 600 1776

4320 720 2131

4622 302 1344

0

0

0

0

1677 480 -500 -1480 0 177

2283 576 -600 -1776 0 483

3267 740 -302 -1344 0 2360

177

483

3049 691 -720 -2131 0 889 18152 19042

$7,312 $7.31

BIOMETRIX, INC. Alternative Equity Valuation Process: 2019 Income Statement Flows: Net Income Depreciation Required Investments: Required net working capital Change in NWC Change in gross fixed assets Financing Activities: Change in financing activities Free Cash Flows to Equity: Net income Depreciation Increase in NWC CAPEX Increase in financing inflows Annual change in free CF Horizon cash flow (20% disc rate) Total free cash flows to equity Present Value (40% disc rate) Per Share Value (1 million shares)

2500

$7,312 $7.31

213

MINI CASE: SOFTTEC PRODUCTS COMPANY The SoftTec Products Company is a successful small, rapidly growing, closely held corporation.

The equity owners are considering selling the firm to an outside buyer and want to estimate the value of the firm. Following is last year‘s income statement (2019) and projected income statements for the next four years (2020-2023). Sales are expected to grow at an annual 7 percent rate beginning in 2024 and continuing thereafter.

[$ Thousands] Net Sales Cost of Goods Sold Gross Profit SG&A Expenses Depreciation EBIT Interest EBT Taxes (40% rate) Net Income

.

Actual Projected ----------------------2019 2020 2021 2022 2023 150.0 200.0 250.0 300.0 350.0 -75.0 -100.0 -125.0 -150.0 -175.0 75.0 100.0 125.0 150.0 175.0 -30.0 -40.0 -50.0 -60.0 -70.0 -7.5 -10.0 -12.5 -15.0 -17.5 37.5 50.0 62.5 75.0 87.5 -3.5 -3.5 -3.5 -3.5 -3.5 34.0 46.5 59.0 71.5 84.0 -13.6 -18.6 -23.6 -28.6 -33.6 20.4 27.9 35.4 42.9 50.4

Selected balance sheet accounts at the end of 2019 were as follows. Net fixed assets were $50,000. The sum of the required cash, accounts receivable, and inventories accounts was $50,000. Accounts payable and accruals totaled $25,000. Each of these balance sheet accounts was expected to grow with sales over time. No changes in interest-bearing debt were projected and there were no plans to issue additional shares of common stock. There are currently 10,000 shares of common stock outstanding.

Data have been gathered for a ―comparable‖ publicly-traded firm in the same industry that SoftTec operates in. The cost of common equity for this other firm, Wakefield Products, was estimated to be 25 percent. SoftTec has survived for a period of years. Management is not currently contemplating a major financial structure change and believes a single discount rate is appropriate for discounting all cash flows.

A. Project SoftTec’s income statement for 2024.

See the spreadsheet base case results below. Net sales grow to $374.5 thousands in 2024. This amount is 7% greater than the 2023 level. Net income increases to $54.1 thousands in 2024.

B. Determine the annual increases in required net working capital and capital expenditures (CAPEX) for SoftTec for the years 2020 to 2024.

214 Annual increases in required NWC and in CAPEX are shown below in the spreadsheet base case output.

C. Project annual operating free cash flows for the years 2020 to 2024.

The annual operating free cash flow to equity is calculated as: net income + depreciation – CAPEX – increases in required NWC + increases in interest-bearing debt. Note: No changes in interest-bearing debt were projected and there were no plans to issue additional shares of common stock. Annual operating free cash flows are shown below in the spreadsheet base case output.

D. Estimate SoftTec’s terminal value cash flow at the end of 2023.

The terminal cash flow is estimated to be $232.4 thousands (rounded). This is estimated by dividing $41.8 thousands (rounded) by .18 (.25 - .07). See the spreadsheet base case output below.

E. Estimate SoftTec’s equity value in dollars and per share at the end of 2019.

The equity value at the end of 2019 is $123.7 thousands and since there are 10 thousand shares outstanding, the value per share is $12.37. See the spreadsheet base case output below.

F. SoftTec’s management was wondering what the firm’s equity value (dollar amount and on a per share basis) would be if the cost of equity capital was only 20 percent. Recalculate the firm’s value using this lower discount rate.

By changing the discount rate from 25% to 20%, to calculate the terminal value cash flows and the present value of the total free cash flows, results in a 2019 present value of $187.4 thousands and a value per share of $18.74. See the last section (Part F) of spreadsheet base case output shown below for these calculations.

G. Now assume that the $35,000 in long-term debt (and therefore interest expense at 10%) is expected to grow with sales. Recalculate the equity using the original 25% discount rate.

See the spreadsheet revised case results (Part G) shown below. One difference between this solution and the base case results solution is the increasing interest expense on the income statement causes the net income to decline. However, this decline in net income is more than offset by the free cash flows contributed by the issuing of more long-term debt. The result is a higher terminal value cash flow as well as higher operating free cash flows. Discounting these cash flows at 25% produces an equity value of $153.4 thousands and a value per share of $15.34.

215 SOFTTEC PRODUCTS COMPANY Base Case Results [Parts A, B, C, D, & E]: Chapter 10 Mini Case % of [Thousands of Dollars] 2019 Actual Income Statements Sales 2019 Net Sales 100.0% 150.0 Cost of Goods Sold -50.0% -75.0 Gross Profit 50.0% 75.0 SG&A Expenses -20.0% -30.0 Depreciation -5.0% -7.5 EBIT 25.0% 37.5 Interest -2.3% -3.5 EBT 22.7% 34.0 Taxes (40% rate) -9.1% -13.6 Net Income 13.6% 20.4 Required Net Working Capital: Req Cash+Receivables+Inventories Minus: Payables+Accruals Req Net Working Capital (RNWC) Increase in RNWC Fixed Assets Schedule: Net Fixed Assets (NFA) Increase in NFA Plus: Depreciation CAPEX

33.3% -16.7%

50.0 -25.0 25.0

66.7 -33.3 33.3 8.3

83.3 -41.7 41.7 8.3

100.0 -50.0 50.0 8.3

116.7 -58.3 58.3 8.3

124.8 -62.4 62.4 4.1

33.3%

50.0

66.6 16.7 10.0 26.7

83.3 16.7 12.5 29.2

100.0 16.7 15.0 31.7

116.7 16.7 17.5 34.2

124.8 8.2 18.7 26.9

27.9 10.0 -26.7 -8.3 2.9

35.4 12.5 -29.2 -8.3 10.3

42.9 15.0 -31.7 -8.3 17.9

50.4 17.5 -34.2 -8.3 25.4

54.1 18.7 -26.9 -4.1 41.8

2.9

10.3

17.9

232.4 257.8

2.9

10.3

17.9

2.9

10.3

17.9

Free Cash Flows to Equity: Net Income Plus: Depreciation Minus: CAPEX Minus: Increase in NWC Operating Free Cash Flows Terminal Value CF (r=.25, g =.07) Total Free Cash Flows PV of TFCF (25% Discount Rate) Value Per Share (10,000 shares) Part F: Operating Free Cash Flows Terminal Value CF (r=.20, g =.07) Total Free Cash Flows PV of TFCF (20% Discount Rate) Value Per Share (10,000 shares)

Percent Change in Net Sales 33.3% 25.0% 20.0% 16.7% 7.0% Pro forma -------------------------------------------2020 2021 2022 2023 2024 200.0 250.0 300.0 350.0 374.5 -100.0 -125.0 -150.0 -175.0 -187.3 100.0 125.0 150.0 175.0 187.3 -40.0 -50.0 -60.0 -70.0 -74.9 -10.0 -12.5 -15.0 -17.5 -18.7 50.0 62.5 75.0 87.5 93.6 -3.5 -3.5 -3.5 -3.5 -3.5 46.5 59.0 71.5 84.0 90.1 -18.6 -23.6 -28.6 -33.6 -36.1 27.9 35.4 42.9 50.4 54.1

$123.7 $12.37

$187.4 $18.74

25.4 321.7 347.2

41.8

216

SOFTTEC PRODUCTS COMPANY Revised Case Results [Part G]: Chapter 10 Mini Case [Thousands of Dollars] Income Statements Net Sales Cost of Goods Sold Gross Profit SG&A Expenses Depreciation EBIT Interest EBT Taxes (40% rate) Net Income Required Net Working Capital: Req Cash+Receivables+Inventories Minus: Payables+Accruals Req Net Working Capital (RNWC) Increase in RNWC Fixed Assets Schedule: Net Fixed Assets (NFA) Increase in NFA Plus: Depreciation CAPEX Long-Term Debt Financing: Amount of Long-Term Debt Increase in Long-term Debt

% of 2019 Sales 100.0% -50.0% 50.0% -20.0% -5.0% 25.0% -2.3% 22.7% -9.1% 13.6%

Actual 2019 150.0 -75.0 75.0 -30.0 -7.5 37.5 -3.5 34.0 -13.6 20.4

7.0% 2024 374.5 -187.3 187.3 -74.9 -18.7 93.6 -8.7 84.9 -34.0 50.9

33.3% -16.7%

50.0 -25.0 25.0

66.7 -33.3 33.3 8.3

83.3 -41.7 41.7 8.3

100.0 -50.0 50.0 8.3

116.7 -58.3 58.3 8.3

124.8 -62.4 62.4 4.1

33.3%

50.0

66.6 16.7 10.0 26.7

83.3 16.7 12.5 29.2

100.0 16.7 15.0 31.7

116.7 16.7 17.5 34.2

124.8 8.2 18.7 26.9

23.3%

35.0

46.7 11.7

58.3 11.7

70.0 11.7

81.7 11.7

87.4 5.7

27.2 10.0 -26.7 -8.3 11.7 13.9

34.0 12.5 -29.2 -8.3 11.7 20.6

40.8 15.0 -31.7 -8.3 11.7 27.5

47.6 17.5 -34.2 -8.3 11.7 34.3

50.9 18.7 -26.9 -4.1 5.7 44.4

13.9

20.6

27.5

246.7 281.0

Free Cash Flows to Equity: Net Income Plus: Depreciation Minus: CAPEX Minus: Increase in NWC Plus: Increase in L-T Debt Operating Free Cash Flows Terminal Value CF (r=.25, g =.07) Total Free Cash Flows PV of TFCF (25% Discount Rate) Value Per Share (10,000 shares)

Percent Change in Net Sales 33.3% 25.0% 20.0% 16.7% Pro forma -------------------------------------------2020 2021 2022 2023 200.0 250.0 300.0 350.0 -100.0 -125.0 -150.0 -175.0 100.0 125.0 150.0 175.0 -40.0 -50.0 -60.0 -70.0 -10.0 -12.5 -15.0 -17.5 50.0 62.5 75.0 87.5 -4.7 -5.8 -7.0 -8.2 45.3 56.7 68.0 79.3 -18.1 -22.7 -27.2 -31.7 27.2 34.0 40.8 47.6

$153.4 $15.34

217

MINI CASE: RxDELIVERY SYSTEMS, INC. RxDelivery Systems is an R&D venture specializing in the development and testing of new drug delivery technologies. The market for alternative drug delivery systems grew rapidly during the 1990s. Driving factors behind this growth include efforts to reduce drug side effects through site-specific delivery, the need to maintain the activity of new biopharmaceutical compounds, and the extension of drug patent life. Improved drug delivery methods are expected to reduce the number of surgical interventions and the length of hospital stays, and improve patient compliance in taking prescribed drugs.

A large world market for biopharmaceuticals (including peptide, protein, RNA, and DNA drugs) exists today. Sales of polymer-based drug delivery systems continue to grow rapidly.

Pulmonary delivery systems represent an important segment of the drug delivery market.

RxDelivery Systems believes it can compete effectively in both the polymer-based and the pulmonary drug delivery areas. The venture‘s delivery technology is expected to utilize hydrophobic ion pairing and supercritical carbon dioxide precipitation to incorporate watersoluble drug molecules into biodegradable controlled-release microspheres. The resulting microspheres will take the form of dry powders and will contain drug molecules small enough to allow for intravenous, intranasal, or pulmonary delivery. It is anticipated that this technology will be incorporated into products for controlled release applications including treatment of cancer, infectious diseases, and gene therapy.

RxDelivery Systems, through an agreement with its pharmaceutical parent, a major drug company, will initially operate as an independent corporation but will be merged into the parent at the end of its second year. At that time, RxDelivery Systems‘ entrepreneurial team will be paid a lump sum of $2,500,000 as the terminal value for the venture.

Following are limited financial statement projections for the next two years for RxDelivery Systems:

A. Construct the venture’s income statements for Years 1 and 2.

See spreadsheet below

218 B. Construct the venture’s balance sheets at startup and at the end of Years 1 and 2. Put initial fixed asset investments in Year 0 and initial working capital investments in Year 1. Assume the initial $50,000 is equity financed.

See spreadsheet below.

C. Construct the pseudo dividend method equity valuation cash flow including the $2,500,000 terminal payment.

See spreadsheet below.

D. Using a 30% discount rate for the first two years and a $2,500,000 terminal value, what is the value of the venture at its launch?

[Note: Answers use cash taxes (without tax credit and deferred tax asset investment)] Income Statements Revenue Expenses Including Depreciation EBIT -Interest EBT - Cash Taxes Net Income Depreciation

Year 1 12,500 -125,000 -112,500 0 -112,500 0 -112,500

Year 2 16,000 -125,000 -109,000 0 -109,000 0 -109,000

5,000

4,500

Balance Sheets Assets Required Cash Surplus Cash Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets Liabilities and Equity Accounts Payable Accrued Expenses Debt Equity Total L+E

Startup

Year 1

Year 2

0 0 50,000 0 50,000 50,000

3,000 -109,450 50,000 -5,000 45,000 -61,450

3,000 -213,950 50,000 -9,500 40,500 -170,450

0 50,000 50,000

750 300 0 -62,500 -61,450

750 300 0 -171,500 -170,450

Accounting Cash Flows NI +Depr -dAR -dInv +dAP +dAccrd -Capex +Principal -Dividend Acct CF Beg Cash End Cash

Year 0 0 0 0 0 0 0 -50,000 0 50,000 0 0 0

Year 1 -112,500 5,000 0 0 750 300 0 0 0 -106,450 0 -106,450

Year 2 -109,000 4,500 0 0 0 0 0 0 0 -104,500 -106,450 -210,950

Discussion Note:

Valuation (PDM) NI +Dep -Capex -dNWC +Principal Proc.

Equity VCF Terminal Flow Total Flow

(Surplus Cash is Zero for Valuation Purposes) Year 0 Year 1 Year 2 0 -112,500 -109,000 0 5,000 4,500 -50,000 0 0 0 -1,950 0 0 0 0 -50,000 -109,450 -104,500 2,500,000 -50,000 -109,450 2,395,500

NPV

1,283,263

Valuation (DDA) NI +Dep -Capex -dNWC +Principal Proc.

Equity VCF Terminal Flow Total Flow

(Surplus Cash Situation Affects Terminal Flow) Year 0 Year 1 Year 2 0 -112,500 -109,000 0 5,000 4,500 -50,000 0 0 0 107,500 104,500 0 0 0 -50,000 0 0 2,286,050 -50,000 0 2,286,050

NPV

1,302,692

Difference in EqCF NPV of Difference DDA Value Increase

0 109,450 -109,450 19,429 19,429 (=1,302,263-1,283,263) due to timing differences on surplus cash

Sum 0

219 In this example, the firm is currently projected to run at large unfunded losses and the plan is not a feasible financial plan. One point of this exercise is to show that the methods work even when there is a large deficit in the funding (represented here by the large negative surplus cash account balances). The valuation methods still work.

The equity valuation method charges for capital when it is used in the venture‘s operations.

While many finance academics and practitioners are content with using actual tax cash outlays (as in the previous spreadsheet), others are more careful to provide accounting-friendly versions that incorporate a tax credit and a deferred tax asset investment. As the cash flows are identical, it is not surprising that the valuations are the same.

Answers using tax credit and booking deferred tax asset investment: Income Statements Revenue -Non-Interest Expenses EBIT -Interest EBT -Tax Credit Net Income Depreciation

Year 1 12,500 -125,000 -112,500 0 -112,500 33,750 -78,750

Year 2 16,000 -125,000 -109,000 0 -109,000 32,700 -76,300

5,000

4,500

Balance Sheets Assets Required Cash Surplus Cash Deferred Tax Asset Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets Liabilities and Equity Accounts Payable Accrued Expenses Debt Equity Total L+E

Startup

Year 1

Year 2

0 0 0 50,000 0 50,000 50,000

3,000 -109,450 33,750 50,000 -5,000 45,000 -27,700

3,000 -213,950 66,450 50,000 -9,500 40,500 -104,000

0 50,000 50,000

750 300 0 -28,750 -27,700

750 300 0 -105,050 -104,000

Accounting Cash Flows NI +Depr -dDTA -dAR -dInv +dAP +dAccrd -Capex +Principal -Dividend Acct CF Beg Cash End Cash

Year 0 0 0 0 0 0 0 0 -2,500 5,000 10,000 12,500 0 12,500

Year 1 -78,750 5,000 -33,750 0 0 750 300 0 0 0 -106,450 12,500 -93,950

Year 2 -76,300 4,500 -32,700 0 0 0 0 0 0 0 -104,500 -93,950 -198,450

Valuation (PDM) NI +Dep -dDTA -Capex -dNWC +Principal Proc.

Equity VCF Terminal Flow Total Flow

(Surplus Cash is Zero for Valuation Purposes) Year 0 Year 1 Year 2 0 -78,750 -76,300 0 5,000 4,500 0 -33,750 -32,700 -50,000 0 0 0 -1,950 0 0 0 0 -50,000 -109,450 -104,500 2,500,000 -50,000 -109,450 2,395,500

NPV

1,283,263

Valuation (DDA)

(Surplus Cash Situation Affects Terminal Flow) Year 0 Year 1 Year 2 0 -78,750 -76,300

NI +Dep -dDTA -Capex -dNWC +Principal Proc.

Equity VCF Terminal Flow Total Flow NPV

5,000 -33,750 0 107,500 0 0

-50,000

0

4,500 -32,700 0 104,500 0 0 2,286,050 2,286,050

1,302,692 Sum 0

Difference in EqCF NPV of Difference DDA Value Decline

0 109,450 -109,450 19,429 19,429 (=1,302,692-1,283,263) due to timing differences on surplus cash

Chapter 11 A. VENTURE CAPITAL VALUATION METHODS FOCUS

0 0 -50,000 0 0 -50,000

220 In this chapter, we present several variations on the simplified valuation procedures and rules of thumb frequently grouped under the designation ―venture capital methods.‖ We introduce a three-scenario approach to examining the value of different possible future venture outcomes.

LEARNING OBJECTIVES LO 11.1: Discuss how venture capital shortcut valuation methods differ from basic cash flow-based equity valuations.

LO 11.2: Describe the use of estimated terminal cash flows in the basic venture capital valuation method.

LO 11.3: Explain how earnings multipliers and discounted dividends can be used to estimate terminal values.

LO 11.4: Describe how venture capital shortcut methods are adjusted for multiple rounds of financing.

LO 11.5: Explain how venture capital shortcut methods are adjusted for incentive ownership financing.

LO 11.6: Describe the process for adjusting venture capital shortcut methods for payments to senior security holders.

LO 11.7: Describe the use of scenario outcomes to estimate venture capital values.

CHAPTER OUTLINE 11.1BRIEF REVIEW OF BASIC CASH FLOW-BASED EQUITY VALUATIONS 11.2BASIC VENTURE CAPITAL VALUATION METHOD A. Using Present Values B. Using Future Values 11.3 EARNINGS MULTIPLIERS AND DISCOUNTED DIVIDENDS 11.4AJUSTING VCSCs FOR MULTIPLE ROUNDS 11.5ADJUSTING VCSCs FOR INCENTIVE OWNERSHIP 11.6ADJUSTING VCSCs FOR PAYMENTS TO SENIOR SECURITY HOLDERS 11.7 INTRODUCING SCENARIOS TO VCSCs A. Utopian Approach B. Mean Approach SUMMARY LEARNING SUPPLEMENT 11A: Sustainable Growth LEARNING SUPPLEMENT 11B: PDC‘S Equity Valuation: Synthesizing Equity Methods and VCSC Valuations (Advanced) DISCUSSION QUESTIONS AND ANSWERS 1. What is meant by ―finding the value of a venture’s assets is the same as finding the value of a venture’s debt plus equity‖?

221 This is just a statement of the accounting identity expressed in market values: Market Value of Assets = Market Value of Debt + Market Value of Equity.

2. Describe the basic venture capital (VC) method for estimating a venture’s value.

Venture capital (VC) method: estimates the venture‘s value by projecting only a terminal flow to investors at the exit event.

3. Describe the process for estimating the percentage of equity ownership that must be given up by the founder when a new equity investment is needed.

Estimate the value of the exit event. Discount that value at the venture capital discount rate to get a present value. Divide the amount the new investor will contribute by that present value to determine the percentage of the venture’s ownership that must be sold.

4. How does a present value venture valuation pie differ from a future value valuation pie?

The present value valuation pie is the present value of the future valuation pie where the discounting is done at the venture capital discount rate.

5. What is meant by pre-money valuation? What is post-money valuation?

Pre-money valuation: present value of a venture prior to a new money investment Post-money valuation: pre-money valuation of a venture plus money injected by new investors.

6. What is staged financing? Describe how the capitalization (cap) rate is calculated.

Staged financing: financing provided in sequences of rounds rather than all at one time Capitalization (cap) rate: spread between the discount rate and the growth rate of the cash flow in terminal value period 7. How is multiplying a projected earnings by a P/E ratio similar to discounting a perpetuity of earnings starting at that level?

Both convert a projected earnings number into a present value. The P/E multiple approach does so by multiplication (P/E*E=P) and the discounting approach does so by division (E/(rg)). When P/E=1/(r-g), these give the same answer for a given projected E. 8. How would one expect P/E ratios to vary with a venture’s risk and growth opportunities?

222

P/E should increase with valuable growth opportunities and decrease with risk, other things being equal.

9. What are the common ways to estimate a terminal value for a venture?

A few common ways to estimate terminal value for a venture would be to use a P/E or other multiple or to divide final cash flow by the cap rate (r-g).

10. What is the difference between the direct comparison method and the direct capitalization method?

Direct comparison applies a direct comparison ratio to the related venture quantity and need not have any discounting interpretation. Direct capitalization capitalizes earnings by discounting using a cap rate (r-g) implied by a comparable ratio. There is a direct discounting interpretation. Direct comparison can be used with stock variables (like ―dollars per square foot‖) whereas direct capitalization is really restricted to flow variables (like earnings, cash flow and dividends).

11. Describe two important motives for having an equity component in employee compensation.

One reason is that the expected deferred and tax-preferred compensation allows the venture to pay a lower current compensation, thereby lowering the current need for external financing.

A second reason is the substantial impact it can have in motivating employees toward the founders’ and venture investors’ shared goal of a high value for the company’s equity.

12. Describe the following terms from the perspective of venture performance: black hole, living dead, and venture utopia. In what sense is the typical business plan utopian?

A black hole venture is a venture that results in a 100 percent loss to venture investors. A living dead venture is a venture that provides minimal, if any, returns to venture investors. A venture utopia venture is a venture that provides phenomenal returns the venture investors.

The typical business plan is utopian because most plans forecast the high end of the possible success spectrum. In other words, they typically are overly optimistic in their projections.

13.

What is meant by the utopia discount process? Describe how expected present value is calculated.

223 Utopia discount process: allows the venture investors to value their investment using only the business plan’s explicit forecasts.

The PV is calculated by discounting utopian projections at utopian required returns 14. Describe how expected present value is calculated when there are two or more scenarios.

The alternative to a “utopian” venture valuation approach is a “mean” venture valuation approach which considers that two or more outcomes could occur. First, the present value of each outcome would be calculated. Second, each outcome’s present value would be multiplied by the probability that the outcome would occur.

Third, the resulting probability-weighted outcomes would be summed to get an expected present value for the venture.

15. Discuss the type of data and the procedural changes necessary to implement a fivescenario expected PV valuation for a venture investment.

To conduct a five scenario expected PV valuation, we would need to start with an idea about what the five levels of possible success or failure are. To each scenario, we would need to assign a probability (likelihood) that that scenario would be the outcome. Using a single discount rate for all five scenarios, we would project and discount the VCFs for each scenario. After multiplying the scenario PV by its likelihood we would sum to get the expected PV across all five scenarios. Of course, we could just apply the probabilities to each of the five scenarios‘ periodic VCFs to get an expected cash flow and then discount these amalgamated cash flows by the single discount rate to arrive at the same value.

16. What is the difference between discounting expected cash flows from multiple scenarios at a constant rate and averaging the scenarios’ PVs calculated with that single discount rate?

These are the same when a single fixed discount rate is used and all other assumptions are the same.

17.

From the Headlines -- Excaliard: What ingredients would you need to conduct a VCSC valuation for Excaliard? Does your calculation suggest that a $15.5 million Series A round is reasonable?

Answers will vary: Typical ingredients in a VCSC valuation are a projection of the series of fundraising rounds necessary prior to a liquidity/terminal event, the size of that liquidity event and the required return for investors as it applies to business plan (or altered) projections culminating in that liquidity event. Whether a $15.5 million valuation is justified depends entirely on one‘s subjective beliefs about the size and timing of the liquidity event and the current and future required returns necessary to entice the projected funding necessary to reach the liquidity event.

224 INTERNET ACTIVITIES Web-surfing exercise: Using a particular industry as a focus, find an industry report that covers several ventures having various levels of maturity and/or performance. Compare their performances in recent years. Develop a model of how you would conduct a multiplescenario valuation for a newcomer in that industry. What type of discount rate would be appropriate for your approach?

Discussion and findings will depend on the industry chosen. Chapter 7 provides a discussion of possible discount rates by life cycle stage (see Figures 7.6 and 7.7).

Visit one of the venture economics data collection services (e.g., http://www.pwvmoneytree.com) and examine a recent report on the short- and long-term performance of venture capital funds. Relate what you find to a typical discount rate of 50 percent.

Chapter 7 provides information on venture capital holding period returns (see Table 7.1).

Discussion of professional venture capital is covered in Chapter 12.

EXERCISES/PROBLEMS AND ANSWERS 1. [Discount Rates] Calculate the discount rate consistent with a cap rate of 12% and a growth rate of 6%. Show how your answer would change if the cap rate dropped to 10 percent while the growth rate declined to 5 percent.

Cap Rate = (r – g), so r = Cap Rate + g r = 12% + 6% = 18% r = 10% + 5% = 15% 2. [Venture Present Values] A venture investor wants to estimate the value of a venture. The venture is not expected to produce any free cash flows until the end of year 6 when the cash flow is estimated at $2,000,000 and is expected to grow at a 7 percent annual rate per year into the future.

A. Estimate the terminal value of the venture at the end of year 5 if the discount rate at that time is 20 percent. $2,000,000/(.20 - .07) = $15,384,615.38 B. Determine the present value of the venture at the end of year 0 if the venture investor wants a 40 percent annual rate of return on the investment. $15,384,615.38/1.405 = $2,860,529.72

225 3. [Venture Capital Valuation Method] A venture capitalist wants to estimate the value of a new venture. The venture is not expected to produce net income or earnings until the end of year 5 when the net income is estimated at $1,600,000. A publiclytraded competitor or “comparable firm” has current earnings of $1,000,000 and a market capitalization value of $10,000,000.

A. Estimate the value of the new venture at the end of year 5. Show your answer using both the direct comparison method and the direct capitalization method.

What assumption are you making when using the current price-to-earning relationship for the comparable firm?

P/E of comparable firm = $10,000,000/$1,000,000 = 10 times New Venture Value: $1,600,000 net income times 10 = $16,000,000 Assumptions: 1. The “comparable firm” is really comparable to the new venture.

2. The current price-to-earning relationship of 10 will still be the appropriate multiple to use 5 years from now.

B. Estimate the present value of the venture at the end of year 0 if the venture capitalist wants a 40 percent annual rate of return on the investment. $16,000,000/1.405 = $2,974,950.91 4. [Multiple Financing Rounds] Ratchets.com anticipates that it will need $15,000,000 in venture capital to achieve a terminal value of $300,000,000 in five years.

Assuming it is a seed stage firm with no existing investors, what annualized return is embedded in their anticipation? r = (300,000,000/15,000,000)^(1/5)-1 = 82.0564% Suppose the founder wants to have a venture investor inject $15,000,000 in three rounds of $5,000,000 at time 0, 1 and 2 with time 5 exit value of $300,000,000. If the founder anticipates returns of 70%, 50% and 30% for round 1, 2 and 3, respectively, what percent of ownership is sold during the first round? During the second round? During the third round? What is the founders’ year-five ownership percentage?

First Round FV: 5,000,000 x (1.7)^5 = 70,992,850 Second Round FV: 5,000,000 x (1.5)^4 = 25,312,500 Third Round FV: = 5,000,000 x (1.3)^3 = 10,985,000 Total FV = 107,290,350 First Round % of Total FV = 23.66% = 70,992,850/300,000,000

226 Second Round % of Total FV = 8.44% = 25,312,500/300,000,000 Third Round % of Total FV = 3.66% = 10,985,000/300,000,000) Founder final ownership = 1 – 23.66% - 8.44% - 3.66% = 64.24% = 192,709,650/300,000,000 Assuming the founder will have 10,000 shares, how many shares will be issued in rounds 1, 2 and 3 (at times 0, 1 and 2)?

Founder shares = 10,000 Total shares at year 5: =10,000 / .6424 = 15,567 Round one shares = .2366 x 15,567 = 3684 Round two shares = .0844 x 15,567 = 1313 Round three shares = .0366 x 15,567 = 570 What is the second round share price derived from the answers in Parts B and C? Second Round Price = 5,000,000 / 1313 =3808/share How does the answer to part D change if 10% of the year-five firm is set aside for incentive compensation? How many total shares are outstanding (including incentive shares) by year 5?

Founder final ownership = 1 -23.66% - 8.44% - 3.66% -10% = 54.24% Total shares at year 5 = 10,000 / .54.24 = 18,438 Round two shares = .0844 x 18,438 = 1556 Round two price = 5,000,000 / 1556 = 3213/share 5.

[Rates of Return] Suppose a venture fund wishes to base its required return (used in discounting future terminal values) on its historical experience and suggests merely averaging the rates on the last three concluded deals. These deals realized total returns of – 67% at the end of 2 years, 50% at the end of 5 years and 70% at the end of three years, respectively.

Assuming no intermediate flows before the terminal payoff, verify that the associated annualized rates are –42.55%, 8.45% and 19.35%.

2 years: (1-.67)^.5 – 1 = -42.55% 5 years: (1+.50)^.2 -1 = 8.45% 3 years: (1+.7)^(1/3) -1 = 19.35% What is the equally weighted average annualized return?

(-42.55% + 8.45% +19.35%) / 3 = -4.92%

227 Does it make sense to use this as a single discount rate to apply across scenarios involving different durations?

The returns have been realized over a total of 10 investment years. However, the simple average here is only dividing by the three outcomes (not their years). Consequently, it is open for debate whether this simple project averaging is the best way to calibrate a required return for projects of widely varying known durations. However, at the time the venture is funded, it is not known what the duration will be and if it is like a small replication of all of the previous funded ventures, it is reasonable to use the hybrid discount rate for all of the venture‘s possible outcomes.

6. [Multiple Financing Rounds] Rework the two-stage example of section 11.4 with 1,000,000 initial founders’ shares (instead of the original 2,000,000 shares). What changes?

Total Shares After Financing 

1,000,000  11,851,852. .084375

First Round Shares Issued  .759375 *11,851,852  9,000,000 Share Price  $1,000,000 / 9,000,000  $.1111 per share Pre - Money Valuation  $.1111  1,000,000  $111,111 Post - Money Valuation  $.1111 *10,000,000  $1,111,111 Founder % Between First and Second Rounds  1,000,000/ 10,000,000  10% First Round Investor % Between First and Second Rounds  9,000,000/ 9,000,000  90%

Second Round Shares Issued  .15625  11,851,852  1,851,852 Share Price  1,000,000 / 1,851,852  $.54 per share Pre - Money Valuation  .54  10,000,000  5,400,000 Post - Money Valuation  .54 *11,851,852  6,400,000 Founder % Between Second Round and Exit  1,000,000/ 11,851,852  8.4375% First Round Investor % Betweeen Second Round and Exit  9,000,000/ 11,851,852  75.9375% Second Round Investor % Between Second Round and Exit  1,851,852/ 11,851,852  15.625% 7. [Multiple Financing Rounds] Rework the two-stage example of section 11.4 with first- and second-round required returns of 55% and 40% (instead of the original 50% and 25%).

Interpret your results as they relate to the founders’ ownership and the feasibility of the financing.

228 I * 1  r  1,000,000 * 1  .40  Second Round Acquired %    19.60% P 10 * E5 * 1,000,000 E 1 T

I * 1  r  1,000,000 * 1  .55    89.47% P 10 * E5 * 1,000,000 E 1 T

First Round Acquired % 

2

5

This venture is not financially feasible with these required returns.

8. [Pre-money and Post-money Valuations] Suppose you are considering a venture conducting a current financing round involving an issue of 100,000 new shares at $3. The existing number of shares outstanding is 200,000. What are the related pre-money and post-money valuations?

Share price = $3.

Pre-money = Share Price * Pre-money shares = 3 * 200,000 = 600,000 Post-money = Share Price * Post-money shares = 3 * 300,000 = 900,000 Proceeds = Post-money – Pre-money = 900,000 – 600,000 = 300,000 = 3 * 100,000 9. [Venture Capital Valuation Method] A venture capitalist firm wants to invest $1.5 million in your NYDeli dot.com venture that you started six months ago. You do not expect to make a profit until year four when your net income is expected to be $3 million. The common stock of BioSystems, a ―comparable‖ firm, currently trades in the over-the-counter market at $30 per share. BioSystems’ net income for the most recent year was $300,000 and the firm has 150,000 shares of common stock outstanding.

A. Apply the VC method to determine the value of the NYDeli at the end of four years.

Comparable‘s EPS = $300,000 / 150,000 = 2 Comparable‘s P/E = 30/2 = 15 Venture‘s projected value at year 4 = 15 * 3,000,000 = 45,000,000 B. If VCs want a 40% compound annual rate of return on similar investments, what is the present value of your NYDeli venture?

45,000,000 / 1.4^4 = 11,713,869 C. What percentage of ownership of the NYDeli dot.com venture will you have to give up to the VC firm for its $1.5 million investment?

1,500,000 / 11,713,869 = 12.81% 10. [Present Values and Investor Ownership] Vail Venture Investors, LLC is trying to decide how much percent equity ownership in Black Hawk Products, Inc. it will need in exchange for a $5 million investment. Vail Venture Investors has a target compound rate of return of

229 25 percent on venture investments like Black Hawk Products. Depending on the success of products currently under development, Vail Venture’s investment in Black Hawk could turn out to be a complete failure (black hole), barely surviving (living dead), or wildly successful (venture utopia). Vail Venture assigns probabilities of .20, .50, and .30, respectively, to the three possible outcomes. Following are the 3 cash flow scenarios or outcomes for the Black Hawk Products investment that Vail Venture expects to exit at the end of five years.

Outcome Yr1 Yr2 Yr3 Yr4 Yr5 Black Hole 0 0 0 0 $0 Living Dead 0 0 0 0 $10 million Venture Utopia 0 0 0 0 $50 million Part A A. Calculate the present value of each scenario or outcome for Black Hawk Products.

PV of Black Hole PV of Living Dead PV of Venture Uptopia

0 $3,276,800 $16,384,000

B. Calculate the weighted average of the present values for the three scenarios. What is the total equity value for the Black Hawk Products venture?

Weighted Average Present Value

$6,553,600

C. Determine the acquired percentage of final ownership of Black Hawk Products that Vail Venture Investors would need for its $5 million proposed investment.

Amount Invested Firm Value Equity percentage

$5,000,000 $6,553,600 76.29%

Part B Now assume under the venture utopia scenario that, in addition to the $50 million cash inflow in year 5, there will be an annual $1million preferred dividend (to be paid to Vail Venture Investors but not other equity investors). Vail Venture expects to receive this $1 million dividend under the venture utopia scenario in each of the five years that the Black Hawk investment will be maintained. No preferred annual cash flows are expected under either the black hole or the living dead scenarios.

D. Calculate the acquired percentage of final ownership of Black Hawk Products that Vail Venture Investors would need to earn a 25 percent compound rate of return on its investment. Use the ―mean flow method‖ described in the chapter. [Hint: use ―goal seek‖ in a spreadsheet software program to find the necessary percentage ownership.]

230 Outcome Black Hole Living Dead Venture Utopia Mean Flow Interest Rate PV



Yr1

Yr2 $1,000,000 $1,000,000 300,000 300,000 25% $5,000,000 63.98%

Yr3

Yr4

Yr5

$1,000,000 300,000

$1,000,000 300,000

$6,398,340 $32,991,699 13,096,680

Probability 0.2 0.5 0.3

E. Use the ―expected present value (PV) method‖ described in the chapter when solving for the acquired percentage of final ownership in the Black Hawk to Vail Venture needs to earn its 25 percent target rate of return.

Outcome Black Hole Living Dead Venture Utopia Interest Rate Expected PV



PV

Yr1 $0.00 0 $2,096,608 0 $13,172,320 $1,000,000 25% $5,000,000.00 63.98%

Yr2 0 0 $1,000,000

Yr3 0 0 $1,000,000

Yr4 0 0 $1,000,000

Yr5 $0 $6,398,340 $32,991,699

Probability 0.2 0.5 0.3

11. [Internal Rates of Return] Vail Venture Investors, LLC has recently acquired a 40 percent equity ownership in Black Hawk Products, Inc. in exchange for a $5 million investment.

Vail Venture Investors is interested in estimating an expected compound rate of return on its investment. Depending on the success of products currently under development, Vail Venture’s investment in Black Hawk could turn out to be a complete failure (black hole), barely surviving (living dead), or wildly successful (venture utopia). Vail Venture has assigned probabilities of .20, .50, and .30, respectively, to the three possible outcomes.

Following are the 3 cash flow scenarios or outcomes for the Black Hawk Products investment that Vail Venture expects to exit at the end of five years.

Outcome Yr1 Yr2 Yr3 Yr4 Yr5 Black Hole 0 0 0 0 $0 Living Dead 0 0 0 0 $10 million Venture Utopia 0 0 0 0 $50 million Part A A. Calculate the internal rate of return (IRR) for each scenario or outcome for Black Hawk Products.

Black Hole: -100% (assuming that the loss is realized in the first year) Living Dead: -4.36% Venture Utopia: 31.95% B. Calculate the weighted average of the IRRs for the three scenarios. What is the expected IRR for the Black Hawk Products venture?

Weighted average IRR = .2*(-100%)+.5*(-4.36%)+.3*(31.95%) = -12.6%

231 While this number can be calculated once we tie down the IRR for the Black Hole, the interpretation of this ―Expected IRR‖ is far from obvious since we‘re mixing horizons and values without weightings. Nowhere in the main text is this calculation advocated or promoted. Students can be asked why not.

C. What would be Vail Venture Investors expected IRR if its $5 million investment in Black Hawk Products bought only a 35 percent interest in the venture?

Black Hole: -100% (assuming that the loss is realized in the first year) Living Dead: -6.89% Venture Utopia: 28.47% Weighted average IRR = .2*(-100%)+.5*(-6.89%)+.3*(28.47%) = -14.9% Again, while this number can be calculated once we tie down the IRR for the Black Hole, the interpretation of this ―Expected IRR‖ is far from obvious since we‘re mixing horizons and values without weightings. Nowhere in the main text is this calculation advocated or promoted. Students can be asked why not.

D. Show how your answer in Part C would change if Vail Ventures received a 51 percent ownership stake in the Black Hawk Products venture for $5 million.

Black Hole: -100% (assuming the loss is realized in the first year) Living Dead: 0.40% Venture Utopia: 38.52% Weighted average IRR = .2*(-100%)+.5*(0.40%)+.3*(38.52%) = -8.24% Again, while this number can be calculated once we tie down the IRR for the Black Hole, the interpretation of this ―Expected IRR‖ is far from obvious since we‘re mixing horizons and values without weightings. Nowhere in the main text is this calculation promoted.

Students can be asked why not.

At least all of the ―Expected IRRs‖ are negative here suggesting that investment be avoided. In the next part (Part B), there are still major challenges in interpreting ―Expected IRR.‖ Part B Now assume under the venture utopia scenario that, in addition to the $50 million cash inflow in year 5, there will be an annual $1million preferred dividend (to be paid to Vail Venture Investors but not other equity investors). Vail Venture expects to receive this $1 million dividend under the venture utopia scenario in each of the five years that the Black Hawk investment will be maintained. No preferred annual cash flows are expected under either the black hole or the living dead scenarios.

E. Calculate the revised internal rate of return for the venture utopia scenario if Vail Venture’s equity ownership stake in Black Hawk Products is 40 percent.

232

IRR = 44.97% F. What would be Vail Venture’s expected IRR on the Black Hawk Products venture?

Weighted average IRR = .2*(-100%)+.5(-4.36%)+.3*(44.97%) =-8.69% While we have provided this ―Expected IRR‖ exercise as an illustration of what many students will conjecture as interesting, neither of the authors promotes the use of Expected IRRs in such a context. While using ―Expected PV‖ across scenarios makes sense with a constant discount rate, ―Expected IRR‖ has no simple interpretation as the average is being taken over different return periods and amounts remaining invested for those time periods. If students ask about calculating Expected IRR rather than Expected PV, it can be useful to point to how portfolio returns typically need to be value-weighted and horizon-matched to calibrate a portfolio‘s return. The type of averaging across IRRs in this problem is likely to lead to improper inference regarding the value of an investment in cases where there is a small probability of a large multi-year annual return where probability-weighting annual returns ―underweights‖ the wealth creation in that scenario. It is safer to stick to true PV (expected flows discounted at expected rates) or Expected PV (scenario PVs averaged) to calibrate the investment‘s wealth impact. This caveat is a variation of the usual one regarding using IRR rather than NPV. For the inquiring student, pointing them to this exercise and then discussing the challenges would likely clarify why taking expectations across scenarios of PVs is clean (with a constant discount rate) while doing the same across IRRs is likely problematic.

MINI CASE: R.K.MAROON COMPANY R.K. Maroon is a seed-stage web-oriented entertainment company with important intellectual property. RKM‘s founders, all technology experts in the relevant area, are anticipating a quick leap to dot-com fortune and believe that their unique intellectual property will allow them to achieve a subsequent (year 3) $100,000,000 venture value with a one-time initial $2,000,000 in venture financing.

In contrast, similar dot-commers in their niche are currently seeking multistage financing amounting to $10,000,000 to achieve comparable results. The founders have organized with 1,000,000 shares and are willing to ―grant‖ venture investors a 100% return on their business plan projections.

A. What percent of ownership must be sold to ―grant‖ the 100% three-year return?

2,000,000*(1+1)^3=16,000,000 Percent owned by investors = 16,000,000 / 100,000,000 = 16% B. What is the resulting configuration of share ownership (starting from the 1,000,000 founders’ shares?

233 1,000,000 / .84 = 1,190,476 total shares 190,476 new shares issued to investors 1,000,000 founder shares C. Suppose the venture investors don’t buy the business plan predictions and want to price the deal assuming a second round in year 2 of $8,000,000 with a 40% return. What changes?

8,000,000(1.4)^1=11,200,000 Second round investor final ownership = 11,200,000 / 100,000,000 = 11.2% Founder final ownership = 1 - .16 -.112 = .728 Total shares outstanding at exit = 1,000,000 / .728 = 1,373,626 Second round shares = 153,846; final ownership = .112 First round shares = 219,780; final ownership = 219,780 / 1,373,626 = .16 Founder shares = 1,000,000; final ownership = 1,000,000 / 1,373,626 = .728 D. Suppose the venture investors agree with the founders’ assessment, price the deal accordingly (as in Part B) and turn out to be wrong (an additional $8,000,000 at 40% must be injected for the final year).

1. What is the impact on the founders’ and round one investors’ final ownership assuming the second round is funded by outsiders?

Founder shares + First Round Shares = 1,000,000 + 190,476 = 1,190,476 Shares percent owned by Founder + First Round = 1 - .112 = .888 Total shares at exit = 1,190,476 / .888 = 1,340,626 Second Round final ownership = .112 First Round final ownership = 190,476 / 1,340,626 = .1421 Founder final ownership = 1,000,000 / 1,340,626 = .7459 2. Compare these to your results for Part C. First round investors get less shares. Founders retain more percent ownership.

3. Who bears the dilution from an anticipated round?

Founders bear the costs of all rounds anticipated by the first round investor.

4. Who bears the dilution from an unanticipated round?

Instead of shifting second round dilution entirely onto the founders, the first round investor‘s failure to anticipate a second round causes the first round investor to bear some of the dilution costs.

234 E. Suppose that the deal is priced assuming the second round (as in Part C) and it turns out to be unnecessary. Comment on the final ownership percentages at exit (year 3). What do you conclude about the impact of anticipated but unrealized subsequent financing rounds?

When first round investors get a share allocation that protects them from second round dilution, the founders bear the cost of the first round investor‘s hedging. Consequently, if the second round never arrives, the first round investors greatly benefit from not bearing the anticipated dilution. While the founders would also not like to have the second round unless they have to, the deal is not as sweet as it would have been had they been able to convince the first round investor that a second round would not be needed. First round investors and the founders have an incentive to enter into a bonus or incentive arrangement for avoiding a second round. Perhaps this incentive will move the allocation of shares back closer to what t it would have been had the founders convinced the first round investors that a second round was not needed.

Chapter 12 PROFESSIONAL VENTURE CAPITAL FOCUS In this chapter, we consider the highest profile segment of the venture investing markets: professional venture capital. We discuss the origins of venture capital and the periodic fluctuations accompanying major new technologies. We give special attention to the professional venture capital screening and investment processes.

LEARNING OBJECTIVES LO 12.1: Discuss the history and current status of venture investing in the United States.

LO 12.2: Identify the seven stages of a typical professional venture investing cycle.

LO 12.3: Describe some of the specializations of venture capital firms.

LO 12.4: List major elements in the design and structure of a new venture capital fund.

LO 12.5: Indicate the major suppliers of venture capital.

LO 12.6: Explain the use of capital calls in a new venture.

LO 12.7: Describe the venture investing due diligence process and identify typical issues covered in a term sheet.

LO 12.8: Discuss the need to arrange the harvest or liquidation of the venture.

LO 12.9: Identify factors to consider when deciding how exit proceeds will be distributed to investors.

CHAPTER OUTLINE 12.1 12.2 12.3 12.4 12.5

HISTORICAL CHARACTERIZATION OF PROFESSIONAL VENTURE CAPITAL PROFESSIONAL VENTURE INVESTING CYCLE: OVERVIEW DETERMINING (NEXT) FUND OBJECTIVES AND POLICIES ORGANIZING THE NEW FUND SOLICITING INVESTMENTS IN THE NEW FUND

235 12.6 12.7 12.8 12.9

OBTAINING COMMITMENTS FOR A SERIES OF CAPITAL CALLS CONDUCTING DUE DILIGENCE AND ACTIVELY INVESTING ARRANGING HARVEST OR LIQUIDATION DISTRIBUTING CASH AND SECURITIES PROCEEDS SUMMARY

DISCUSSION QUESTIONS AND ANSWERS 1. What is a professional venture capitalist? How does this occupation differ from that of an angel investor?

A professional venture capitalist is one who invests not only his own money but also other capital from other investors while an angel investor is a wealthy individual who invests just his own money.

2. Briefly describe how professional venture capital got started after World War II. See section 12.1 for details. Professional venture capital, as we know it today did not exist before World War II. A group of people including Georges Doriot and Ralph Flanders believed that WWII technologies could be commercialized and joined to form the first professional venture capital fund called American Research and Development (ARD) in 1946.

3. What was the early role of the Small Business Administration (SBA) in fostering venture investing?

The SBA initially helped small businesses get government contracts and then moved into guaranteeing small business loans. The SBICs chartered by the SBA became the primary structure for professional venture capital very quickly after their inception.

4. Describe the development of professional venture investing in the 1960s, 1970s, and early 1980s.

After the overheated SBIC market, private venture capital partnerships became the predominant form for organizing a professional venture capital fund. This structure remains the dominant form. The growth of VC investing came along with technology investing in minicomputers and microcomputers.

5. What has happened to professional venture investing since the mid-1990s?

Much of the growth in VC investing during the second-half of the 1990s was associated with internet technology‘s phenomenal boom that peaked in early 2000 before bursting. Annual VC investments declined rapidly and fell back to approximately the 1998 level in 2003.

Since then, annual VC investments have trended upward until by 2018 they were again at

236 about the same investment level previously reached in 2000. See Figure 12.1 for historical levels of VC annual investments.

6. What are the components or stages in the professional venture investing cycle from inception to funding?

(1) Determine (Next) Fund Objectives and Policies; (2) Organize New Fund (usually partnership; (3) Solicit Investments in New Fund; (4) Obtain Commitments for Series of Capital Calls.

7. What are the components or stages in the professional venture investing cycle after funds have been raised until closure?

(5) Conduct Due Diligence and Actively Invest; (6) Arrange Harvest or Liquidation; (7) Distribute Cash and Securities Proceeds (as available).

8. Who are the major suppliers of venture capital by type and size of commitment?

Refer to Figure 12.4 which shows Suppliers of Venture Capital as determined by Bloomberg in 2014. Major suppliers are: (1) Public Pension Funds = 20%; (2) Endowments and Foundations = 17%; (3) Financial and Insurance = 14%; (4) Family Offices = 14%; (5) Funds of Funds = 13%; and (6) Other (including professionally managed venture capital) = 22%.

9. What is meant by the terms (a) capital call, (b) deal flow, and (c) venture investing due diligence? (a) capital call: when the venture fund calls upon the investors to deliver their investment funds; (b) deal flow: flow of business plans and term sheets involved in the venture capital investing process; (c) due diligence: process of ascertaining the validity of a business plan.

10. What is meant by the terms (a) lead investor, (b) SLOR, and (c) term sheet? (a) lead investor: venture investors taking the lead for a group (syndicate) of other venture investors; (b) SLOR: standard letter of rejection; (c) term sheet: summary of the investment terms and conditions accompanying an investment.

11. Why should entrepreneurs care what pressures venture capitalists face in carrying out their professional money management (intermediation) function?

Entrepreneurs should care about the outside pressures because venture capitalists have time frames and financial goals to reach in order to satisfy their investors. Receiving more capital from venture capitalists depends on meeting their timing and financial goals.

12. Why do venture capitalists make quick decisions on the infeasibility of some business plans?

When a business plan is not quickly determined to be infeasible, what happens next and why?

237 Venture capitalists screen a large number of business plans in any given year. Due to limited staffing and their receiving many plans that fall outside of their field for investing, VCs learn to make quick and decisive scans at the initial screening stage. Typically the VC screening process looks for reasons not to fund a venture. Assuming that the venture passes this initial screen, it is then subjected to additional screening and the beginning of the due diligence phase.

13. What should be the goal of the financial projections in a business plan submitted to a venture capitalist?

The goal of financial plans submitted to a VC is to provide evidence that the business plan has, to the extent possible, been reflected in a timeline and set of financial events. The financial projections provide initial estimates of important screening criteria like capital needs, time to market (first revenues) and prospects for profitability. The absence of financial projections can signal that the entrepreneurial team has not given sufficient thought to the true viability of the business plan.

14. Is the compensation paid to venture capitalists (e.g. 2% management fee and 20% carried interest) reasonable? What are a fund’s investors buying with this compensation?

While the determination of reasonableness of VC compensation is somewhat subjective, there is widespread evidence that VCs services are valuable and sought after. The investors pay the venture capitalists a portion of their earnings in order to give them incentive to make sure they invest in worthy ventures.

15. Why are venture capital funds typically organized as limited partnerships? In particular, why are they private firms instead of public firms?

VC funds are typically private in part due to their ability to avoid registration with the SEC. The limited partnership structure provides limited liability for their investors who are typically ―accredited.‖ The publicly-traded form for venture capital funds has not met with as much success possibly due to the difficulty of creating an understanding in the general public that venture investments are of indefinite length and involve a high probability of complete loss.

16. What can be learned from the SBA’s creation and the Internal Revenue Service’s subsidy of venture investing through SBICs? Typically tax subsidies attract investors. The SBIC structure subsidizes capital costs for SBIC investors and at least historically may have contributed to funding ventures past the point where they would have been funded were it not for the subsidy. Whether this additional investment provided a net social benefit remains to be seen.

17. Discuss why it is important to have an exit event for each investment held by a venture investment fund.

238 An exit event for each investment is necessary to bring a venture capital fund to closure. The VCs must arrange for the liquidation or harvest of each investment and distribute cash and securities proceeds to investors. When a venture fund’s last investment reaches the exit event and all the proceeds have been distributed, the firm calculates the return achieved for investors over the entire life of the fund. Venture capitalists will if necessary make adjustments in strategy, organization, or marketing necessary to launch the next fund. Thus, the professional venture investing cycle continues.

18. From the Headlines – Tabula: Describe the role venture capitalists played in the founding and expansion of Tabula. Comment on possible reasons for the involvement of multiple VC firms.

Answers will vary: Tabula was founded with venture capital and has completed multiple VC-backed investment rounds to support its development and expansion. The involvement of multiple VCs can arise from diversification motives of the VC investors, limitations on the abilities of early-stage VC investors to bankroll a long development cycle prior to revenue and profit, and a desire to engage the resources available from multiple VC firms, among other things.

INTERNET ACTIVITIES 1. Summarize the nationwide venture capital investing by industry for the last available quarter using a data source available on Web sites such as http://www..pwcmoneytree.com or http://www.nvca.org.

Web-researched results will vary due to constant updating of the related web sites.

2. Visit a venture capital fund’s web site and summarize the fund’s history and current activities.

Web-researched results will vary due to constant updating of the related web sites.

EXERCISE/PROBLEMS AND ANSWERS 1. [Venture Capital Firms] List three venture capital firms active in your region and describe their investing style and restrictions.

As a starting point for this question, students can access the site http://www.pwcmoneytree.com for a listing of VC investments in their region. Thomson Financial‘s Venture Xpert database (if the school has access) will give even more complete information on local VC firms. A historically important provider of VC information is Pratt‘s Guide to Venture Capital (text and web site link from http://www.venturexpert.com ).

In addition, http://www.nvca.org also provides VC listings and http://www.evca.com has similar listings for European VCs.

239 2. [Venture Capital Fund Raising] Locate a recent study covering venture capital fundraising (not investing) for the previous year. Determine what the current sources of funds tend to be. http://www.nvca.org typically provides recent reports on fundraising activities by VCs. There may be many other sources including the general financial press.

3. [Venture Funding Attributes] Interview a local venture capitalist regarding what s/he looks for in a promising venture seeking funding. Summarize your discussion.

Answers will vary.

4. [Venture Capital Firms] Determine the three largest venture capital firms in the U.S. How much money do they have under management? In what areas, if any, do they specialize?

Where are they located? Where are their branch offices?

The venture capital sites (on the WWW) and annual reports (in libraries) typically offer industry overview and may include the amount of assets under management. Individual VC firm web pages typically also disclose the size of the funds under management. This task may be tedious and perhaps better restricted to a region where the students can look up all of the local firms on the firms‘ web pages.

5. [Conducting Due Diligence] Suppose you become an intern at a local VC firm and are asked to assist in due diligence on a proposed investment in a telecommunication company.

Explain how you would approach such a task and where and how you would structure your investigation. What data sources would you use?

First, one typically would read the business plan/pitch submitted for consideration. After identifying strengths and weaknesses on a first pass, assuming that there are significant strengths, it would be appropriate to find market reports relevant to the product or service.

Assuming these still indicate a favorable outlook, the due diligence process would also involve interviewing members of the entrepreneurial team and contacting customers, etc. and others in the industry to get a more complete view of the venture‘s prospects. Students may make reference to Figure 12.5 for typical VC screening criteria.

6. [Term Sheet Terms] List ten terms you might find in a venture capital fund’s terms (see Figure 12.6). Explain what they are and why it might make sense to structure them the way they are.

Refer to Figure 12.6 for a guideline on how to evaluate student answers.

7. [Venture Investing Example] Find a recent Wall Street Journal article on venture investing and summarize it.

Answers will vary.

240 8. [Recent VC Investment Levels] Update Figure 12.1 in terms of recent levels of VC investments Answers will vary.

9. [Venture Capital Investing Information] List ten web sites or hardcopy magazines that contain venture capital investing information that might be of use to entrepreneur’s seeking venture capital.

For example: http://www.pwcmoneytree.com http://www.nvca.org http://www.evca.com http://www.ventureeconomics.com http://www.venturexpert.com http://www.vfinance.com http://www.ventureone.com Entrepreneurship Inc. Pratt‘s Guide to Venture Capital 10. [Recent IPO Example] Locate a venture-capital-backed firm that recently completed an initial public offering (IPO). Provide a summary of the venture’s history and success through the IPO and to date.

Answers will vary. The Spatial Technology, Inc. Capstone Case at the end of the text provides an in-depth case of the IPO of a venture-backed company.

MINI CASE: INTERACT SYSTEMS, INC. Interact Systems, Inc. has developed software tools that help hotel chains solve application integration problems. Interact‘s Application Integration Server (AIS) provides a two-way interface between central reservations systems (CRS) and property management systems (PMS).

At least two important trends in the hotel industry are relevant. First, hotels are shifting away from the manual booking of room reservations and electronic bookings will continue to increase as more bookings are made over the Internet. Second, competitive pressures are forcing hotels to implement yield management programs and to increase customer service. By integrating the CRS and PMS through Interact‘s AIS, inventories can be better managed, yields improved, and customer service enhanced.

All reservation traffic is routed from the CRS to individual hotel properties. This allows Interact Systems to create a database that can be used to track customers and to facilitate marketing programs, such as frequent stay or VIP programs, as a way of increasing customer satisfaction. Interact forecasts application integration expenditures in the hospitality industry to exceed $1 billion by 2021.

241 Greg Thomas founded Interact Systems in 2014 and developed the firm‘s middleware software and hospitality applications. He has 12 years of systems applications experience and currently is Interact‘s Chief Technology Officer. Eric Westskow joined Interact in early 2018 as President and CEO. Prior to that time, he worked in sales and marketing in the software industry for over 20 years.

Interact Systems‘ AIS software development which began in 2014 went through several design changes in 2015. The first product was sold and installed in 2014. Sales were only $500,000 in 2015. However, now that the firm has dependable market tested AIS products ready to be shipped, revenues are expected to reach $20.8 million in 2021.

Greg Thomas founded Interact Systems with $50,000 of his own savings plus $50,000 from friends. Two private investors provided an additional $200,000 in 2016. In addition, $1 million was obtained from a venture capital firm, Katile Capital Partners, in early 2018 in exchange for an equity position in Interact. The firm currently is seeking an additional $5 million to finance sales growth.

A. A VC is considering providing the additional $5 million. What type of fund (stage specialization, industry focus, etc.) would you approach? In what part of their investing cycle would you hope to approach them?

The VC‘s funding criteria need to include this venture‘s industry (software, administrative software, etc.) and stage (early but for sales growth). It would be nice to find a firm that had recently closed, or was in the process of closing, a new fund large enough to cover their ongoing portfolio company needs with some left over for to add this venture (and others) to their portfolio.

B. Discuss how Interact Systems would be expected to fare in the VC screening process involving each element of Figure 12.5.

Venture capital firm requirements: giving up equity position anyway; previous VC investment; size is not unreasonable for this stage with sales in place Characteristics of the proposal: need stage match with VC firm; staging needs are wellspecified.

Characteristics of the entrepreneur and team: reasonable; attracted VC firm and input before; specific qualifications for some team members have been included and appear appropriate for this stage.

Nature of the proposed industry: general overview seems reasonable; need to match industry/approach with specific VCs. Strategy of the proposed business: proprietary software; potential first mover/early adopter advantages; not clear on barriers to entry but would be barriers to others for those who adopt Interact‘s software and commit to using it.

242 C. Discuss typical issues that might be addressed in a term sheet using Figure 12.6 as a reference.

Answers will vary depending on students‘ perceptions from the description and how they see it relates to Figure 12.6. For ventures at this stage it will be important to assure that the team that has brought the venture to this point of rapid growth be committed to a grand scale rollout (in using the requested $5 million). The venture‘s concept and plan for an investor exit will be important.

Chapter 13 OTHER FINANCING ALTERNATIVES FOCUS In this chapter, we consider a variety of government and private sources of new venture funding.

We also consider financing traditionally available only to more mature ventures including commercial banking loans.

LEARNING OBJECTIVES LO 13.1: Describe the benefits to entrepreneurs of belonging to business incubators and seed accelerators.

LO 13.2: Explain how business crowdsourcing can be used and how rewards-based crowdfunding and equity crowdfunding differ.

LO 13.3: Discuss how commercial bank and venture bank lending differ as possible financing sources.

LO 13.4: Describe reasons why bank debt may not be available to startup ventures.

LO 13.5: Discuss the possible use of credit cards as a source of venture funding.

LO 13.6: Describe possible foreign investor funding sources.

LO 13.7: Discuss the role of the Small Business Administration and identify some of its programs for assisting small businesses.

LO 13.8: Identify some additional government financing programs that might be available to small businesses.

LO 13.9: Describe factor financing and compare it to receivables financing through a bank.

LO 13.10: Explain what differentiates venture lending and leasing from traditional lending and leasing.

CHAPTER OUTLINE 13.1 BUSINESS INCUBATORS, SEED ACCELERATORS, AND INTERMEDIARIES A. Business Incubators and Seed Accelerators B. Intermediaries, Facilitators, and Consultants 13.2BUSINESS CROWDSOURCING AND CROWDFUNDING 13.3COMMERCIAL AND VENTURE BANK LENDING 13.4UNDERSTANDING WHY YOU MAY NOT GET DEBT FINANCING

243 13.5CREDIT CARDS 13.6FOREIGN INVESTOR FUNDING SOURCES 13.7SMALL BUSINESS ADMINISTRATION PROGRAMS A. Overview of what the SBA does for Small Businesses B. Selected SBA Loan and Operating Specifics 13.8 OTHER GOVERNMENT FINANCING PROGRAMS 13.9 FACTORING, RECEIVABLES LENDING, AND CUSTOMER FUNDING 13.10 DEBT, DEBT SUBSTITUTES, AND DIRECT OFFERINGS A. Vendor Financing: Accounts Payable and Trade Notes B. Mortgage Lending C. Traditional and Venture Leasing D. Direct Public Offers SUMMARY APPENDIX A: Summary of Colorado Business Financial Assistance Options

DISCUSSION QUESTIONS AND ANSWERS 1. What are business incubators and seed accelerators? How do they differ?

A business incubator is an organization that helps startup companies develop by providing management, operating, and financial services.

A seed accelerator is an organization that usually provides both an equity investment and a mentoring and educational fixed-term, cohort program to help startup companies succeed.

Business incubators and seed accelerators generally differ in how they are organized, the type of funding help they provide to entrepreneurs, and type and length of their support and educational programs.

While most incubator programs do not make equity investments in their client firms, they do help entrepreneurs obtain private and public loan funds, and in some cases help them meet with angel investors. Business incubators are usually formed as nonprofit organizations that are operated by either private firms or public entities including government-funded programs, economic development organizations, and universities. Entrepreneurs must apply for admittance to a business incubation program by providing their business ideas and business plans. The length of time that a client (accepted entrepreneur) can stay in an incubator program varies depending on the complexity of the business model and predetermined revenue or other benchmark targets.

Most seed accelerators, also called startup accelerators, make seed investments in exchange for equity capital in the startups they accept into their programs. Startups in seed incubators must complete their programs in about 3 months, at which time they make a pitch to

244 prospective investors. Seed accelerators admit new startups in cohort groups or classes to encourage peer support and feedback as an important part of the education mission.

2. What is meant by the terms business crowdsourcing and crowdfunding?

Business crowdsourcing is the process of obtaining business ideas, development support, and operating services from a large network of nonemployees.

Crowdfunding is the process of financing ideas, ventures, and projects by gathering funds from a large network of people.

3. Describe the two major types of crowdfunding.

There are two types of crowdfunding: rewards-based crowdfunding and equity crowdfunding.

Rewards-based crowdfunding involves soliciting non-equity funds to finance specific business products and services or requesting donations for a specific purpose.

Equity crowdfunding involves soliciting funds from a large number of small investors in exchange for an equity position in the venture requesting the funding.

4. What are the five C’s of Credit Analysis?

The five C‘s of credit analysis are capacity, capital, collateral, conditions, and character. See Figure 13.1.

5. Name three of the common loan restrictions and explain their relation to new venturing financing. What are some additional common loan restrictions?

While many different restrictions can be placed on businesses, a few are described here: (1) Limits on total debt are placed on venture firms to limit the amount of leverage the firm has; (2) Dividend restrictions are placed on firms to prevent the firm from paying out the newly issued debt in the form of a dividend; and (3) Maintenance of financial statements may be required to provide the lending institution with a current representation of the company‘s financial situation.

See Figure 13.2 for some additional common loan restrictions including: (4) restrictions on additional capital expenditures, (5) restrictions on sale of fixed assets, (6) performance standards on financial ratios, and (7) current tax and insurance payments.

6. What is meant by venture banks? How do they differ from traditional commercial banks?

The term ―venture banks‖ refers to a type of debt investor (lender) that will consider lending to early stage ventures that do not have proven cash flows. They typically offer debt to accompany venture equity and will look for compensation in both interest payments and

245 equity positions (including call options) in the venture. Commercial banks typically do not consider this type of very risky lending.

7. Why are new ventures at a disadvantage in receiving debt financing?

They are at a disadvantage because they usually do not have large amounts of assets to provide as collateral, and the risk associated with the loan is not normally in a risk-averse bank‘s goals.

8. Why is credit card financing attractive to entrepreneurs? What are the risks?

It is attractive because it is quite easy to obtain and also provides interest rates lower than prime for the introductory period, but is also risky due to high interest rates charged after the teaser period.

9. What is the EB-5 immigrant visas program?

The Immigration and Nationality Act (INA) of 1990 provided an opportunity for foreign nationals to obtain a ―green card‖ through the EB-5 immigrant visas program. A foreign national may seek Lawful Permanent Resident (LPR) status by investing $1 million in the U.S. that will preserve or create at least 10 jobs for U.S. workers. The minimum requirement is reduced to $500,000 if the investment is in a designated rural or high unemployment area.

10. What is the Small Business Administration (SBA), when was it organized, and what was its purpose?

The SBA is the Small Business Administration which was created by Congress in 1953 to provide small businesses help in startup and growth.

11. Identify and briefly describe four basic SBA credit programs.

Refer to Figure 13.3. The four basic SBA credit programs: 1) 7(a) Loan: can be used for most business purposes including the financing of working capital (up to $5,000,000).

2) CDC/504 Loan: can be used to purchase fixed assets and certain soft costs (up to $5,000,000).

3) Microloan: to very small firms for general business needs (up to $50,000).

4) Venture Capital: this credit program works through Small Business Investment Companies (SBICs) which are private for-profit investment firms (no limit on loan amounts).

12. Compare the characteristics in terms of loan amounts, lenders, and SBA role in 7(a) loans versus 504 loans.

Refer to Figure 13.3.

246 7(a) Loan: Lenders include commercial bank, credit union, or financial services firm. Loans can be up to $5 million. Up to 10 years on a working capital revolving credit line and up to 25 years for real estate loans. The SBA approves 7(a) loans and guarantees up to 85% of loan value.

CDC/504 Loan: Lenders include a commercial bank jointly with a not-for-profit Certified Development Company CDC). Loans are up to $5 million for fixed assets and certain soft costs. The SBA role approves and guarantees the CDC‘s portion of the debt.

13. What is a Small Business Investment Company (SBIC)?

SBIC stands for Small Business Investment Company and is a private, for-profit financing company that provides capital of diverse types.

14. What types of advisory services are available from the SBA? The SBA provides advisory services (including technical, financial, and contracting) to many small and disadvantaged businesses. The SBA provides advice through the Service Corps of Retired Executives (SCORE), Small Business Development Centers (SBICs), and Women‘s Business Centers.

15. What is a debt guarantee and how does the SBA back a small business loan?

A debt guarantee is an assurance that a certain portion of the debt principal (and/or interest) will be repaid even in the event of default. The SBA guarantees part of the loan that a local SBA-participating lender makes through an SBA program.

16. In which research areas does the SBA provide supplemental programs?

Refer to Section 13.7. The SBA provides technical assistance, financial assistance, contracting assistance, disaster assistance recovery, supports special interests, provides advocacy, laws & regulations assistance, and works to provide civil rights compliance.

Technical assistance is provided for entrepreneurial development, management assistance to small business owners, efforts to help small businesses to export, etc. Financial assistance includes loan programs, provides venture capital through Small Business Investment Companies (SBICs), manages surety bond guarantees, etc. Contracting assistance includes working to create an environment for maximum participation by small, disadvantaged, and woman-owned business in federal government contract awards.

17. What are some characteristics of a Community Development Financial Institutions (CDFI) loan?

In 1994, Congress created the Treasury Department‘s Community Development Financial Institutions (CDFI) Fund. Most CDFIs currently still focus on promoting affordable housing and homeownership. However, CDFIs are increasing their financing of small businesses through the making of microloans as well as larger loans. The SVA makes direct loans to

247 CDFIs, which, in turn, make microloans to small businesses. See Figure 13.4 for factors to review when considering a CDFI loan.

18. What are factoring and receivables lending?

Factoring is selling receivables to a third party at a discount from their face value in order to have an immediate cash flow instead of a deferred cash flow when the receivable is collected.

Receivables lending involves pledging receivables as collateral against a loan.

19.

Describe examples of customer funding used to reduce financing needs.

Depending on the type of business venture, funds from customers may be used to help finance startups. Several models or approaches may be considered by entrepreneurs. ―Pay-in-advance‖ is a very common model. For example, many service businesses require at least a partial payment in advance before the service is provided. Home remodeling projects usually require partial up-front payments, while tickets for sporting and entertainment events are usually paid in full prior to the actual event.

Subscription models are another way customer funds can be used to help finance startup ventures. Subscriptions to purchase wine or computer services on a monthly basis are examples of obtaining financing from customers.

Acting as a matchmaker to bring together buyers and sellers is another way to make use of customer funding. One example is the matching of the demand for hotel rooms with the supply of available hotel rooms, for which transaction fees are charged. Another example is the matching of available short-term apartment or house rentals with people wanting shortterm non-hotel lodging.

20. What is venture leasing? How does it differ from traditional leasing?

Venture leasing involves leasing assets to high-growth ventures typically backed by venture investors. The return to the lessor involves lease payments and a portion of the venture‘s equity.

Traditional leasing targets returns only from the lease payments and the sale of salvaged assets.

21. What is a direct public offering?

A direct public offering is a security offering made directly to a large number of investors.

It is often done over the internet but the success rate is still debatable.

248 22.

From the Headlines – Solix: Describe the alternative financing Solix arranged for the launch of its biofuels production facility. Comment on your impressions of what attracted the investors.

Answers will vary: Solix‘s technology and development were initially subsidized by Colorado State University and government grants. Then, to produce its large-scale algal oil production facility, it partnered with the Southern Ute Alternative Energy fund for a plant location and contributed capital. It also secured funding from private investors and government-funded entities. Among other things, the attraction to investors appears to have been a combination of affinity for the new technology and its promise, public policy and funding for related initiatives, and the possibility of investment returns.

INTERNET ACTIVITIES 1. Locate your state’s small business credit facilitation web page. Describe the resources you state makes available in broad categories.

Web-researched results will vary due to constant updating of the related web sites.

2. Find the web solicitation for a direct public offering under the new crowdfunding regulations. (You might start at http://www.seedinvest.com/ offerings or other similar sites.) Describe the venture and its prospects.

Web-researched results will vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS 1. [Bank Loan Considerations] Assume you started a new business last year with $50,000 of your own money that was used to purchase equipment. Now you are seeking a $25,000 loan to finance the inventory needed to reach this year’s sales target. You have agreed to pledge your venture’s delivery truck and your personal automobile as support for the loan. Your sister also has agreed to cosign the loan. During your initial year of operation, you paid your suppliers in a timely fashion.

A. Analyze the loan request from the viewpoint of a lender who uses the ―five Cs‖ of credit analysis as an aid in deciding whether to make loans.

Capacity to pay: depend on the venture‘s ability to generate profits and cash flow from the business activities Capital: $50,000 personal capital has been invested in the venture.

Collateral: The delivery truck and the entrepreneur‘s personal automobile have been pledged as collateral. A sister has agreed to cosign the loan.

249

Conditions: The loan is to finance the inventory. Consequently the conditions would relate to this inventory use.

Character: The venture has a history of paying creditors in a timely fashion.

B. Assume you are currently carrying an accounts receivable balance of $10,000. How might you use accounts receivables to obtain an additional bank loan?

You could approach a bank with the receivables and your track record of collections and ask if they could be collateral for a loan. You could also contact a factor and see if you could ―sell‖ the receivables for cash.

C. Assume at the end of next year, you will have an accounts receivable balance of $15,000 and an inventories balance of $30,000. If a bank normally lends an amount equal to 80 percent of accounts receivable and 50 percent of inventories pledged as collateral, what would be the amount of a bank loan a year from now? $15,000  .80 = $12,000 $30,000  .50 = $15,000 Total = $27,000 2. [Factor Financing] Assume the operation of your business resulted in sales of $730,000 last year.

Year-end receivables are $100,000. You are considering factoring the receivables to raise cash to help finance your venture’s growth. The factor imposes a 7 percent discount and charges an additional 1 percent for each expected ten-day average collection period over thirty 30 days.

A. Estimate the dollar amount you would receive from the factor for your receivables if the collection period was thirty 30 days or less.

If the collection period is 30 days or less, the factor will pay .93 x $100,000 = $93,000.

B. Estimate the dollar amount you would receive from the factor for your receivables if the average collection period was sixty days.

If the collection period is 60 days, the factor will pay 90% of the value (i.e., .07 for 30 days plus an additional .01 for 31-40 days, plus an additional .01 for 41-50 days, and an additional .01 for 51-60 days. Thus, the dollar amount paid would be: .90 x $100,000 = $90,000.

C. Show how your answer in Part B would change if the factor charges an 8 percent discount and charges an additional .5 percent for each expected fifteen-day average collection period over thirty days. .08 + .005 +.005 = .09 1.00  .09 = .91 .91  $100,000 = $91,000

250 Or, (1(.08 + (.005  2)))  $100,000 = $91,000 D. If the $730,000 in sales last year were evenly distributed throughout the year, an average $100,000 in receivables outstanding would imply what average collection period? Given the original terms stated in the problem, what dollar amount would you expect to receive for your receivables?

Recall from Chapter 5 that the average collection period is also referred to as the days of sales outstanding; and in Chapter 6, the ―sale-to-cash conversion period.‖ $100,000 / ($730,000 / 365) = $100,000/$2,000 = 50.0 days average collection period Original terms: for 50 days, the discount would be .07 + .01 +.01 = .09 1.00  .09 = .91 .91  $100,000 = $91,000 Or, (1(.07 + (.01  2)))  100,000 = 91,000 MINI CASE: JEN AND LARRY’S FROZEN YOGURT COMPANY (Revisited) In 2019, Jennifer (Jen) Liu and Larry Mestas founded Jen and Larry‘s Frozen Yogurt Company, which was based on the idea of applying the microbrew or microbatch strategy to the production and sale of frozen yogurt. Jen and Larry began producing small quantities of unique flavors and blends in limited editions. Revenues were $600,000 in 2019 and were estimated at $1.2 million in 2020.

Since Jen and Larry were selling premium frozen yogurt containing premium ingredients, each small cup of yogurt sold for $3. The cost of producing the frozen yogurt averaged $1.50 per cup. Administrative expenses, including Jen and Larry‘s salary and expenses for an accountant and two other administrative staff, were estimated at $180,000 in 2020. Marketing expenses, largely in the form of behind-the-counter workers, in-store posters, and advertising in local newspapers, were projected to be $200,000 in 2020.

An investment in bricks and mortar was necessary to make and sell the yogurt. Initial specialty equipment and the renovation of an old warehouse building in lower downtown (known as LoDo) of $450,000 occurred at the beginning of 2019 along with $50,000 being invested in inventories. An additional equipment investment of $100,000 was estimated to be needed at the beginning of 2020 to make the amount of yogurt forecasted to be sold in 2020. Depreciation expenses were expected to be $50,000 in 2020 and interest expenses were estimated at $15,000.

The tax rate was expected to be 25 percent of taxable income.

A. How much net profit, before any financing costs, is the venture expected to earn in 2020?

What would be the net profit if sales reach $1.5 million? What would be the net profit if next year’s sales are only $800,000?

Note: Cost of goods sold is: $1.50/$3.00 per unit = 50% of sales.

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Note: a venture‘s profits can be measured in a number of different ways: before interest and taxes (EBIT); net profit (or income) after financing and taxes; or net operating profit after taxes (NOPAT) calculated as EBIT times (1 – tax rate).

Profit Measures: EBIT

$170,000

$320,000

-$30,000

Net Profit

$116,250

$228,750

-$45,000

NOPAT = (EBIT)(1 – tr)

$127,500

$240,000

-$30,000

Note: the tax rate is considered to be zero under Scenario 3 which indicates a negative EBIT or loss.

B. If inventories are expected to turn over ten times a year (based on cost of goods sold), what will be the venture’s average inventories balance next year if sales are $1.2 million? How much might the venture be able to borrow if a lender typically lends an amount equal to 50 percent of the average inventories balance? If the borrowing rate is 12 percent, how much dollar amount of interest would have to be paid on the loan?

Recall from Chapter 6 the discussion of the ―inventory-to-sale conversion period‖ which shows the average number of days to turnover inventories. By dividing the inventory-to-sale conversion period into a 365 day year we have the inventories turnover. Thus, if we know the turnover, 365/10 gives the inventory-to-sale conversion period of 36.5 days.

Cost of goods sold = 50% ($1.50/$3.00) of sales. At sales of $1,200,000, cost of goods sold would be $600,000 ($1,200,000 x .5). ($600,000) / 10 = $60,000 average inventory balance $30,000 = 50% of average inventory balance (i.e., $60,000 x .50) .12 x $30,000 = $3,600

252 Note: the $3,600 interest expense estimated here is substantially less than the $15,000 estimated in Part A. Jen and Larry might also borrow against its receivables and fixed assets.

At interest of $15,000 and a 12% borrowing rate, total borrowing would be $125,000 (i.e., $15,000/.12) C. How might the venture acquire and finance the new equipment that is needed?

Leasing and secured equipment lending are possibilities.

D. Identify potential government credit resources for the venture.

As co-owner, Jen may qualify for SBA and other special financing. Given the venture‘s location, there also could be incentives related to downtown business restoration.

E. Prepare a summary of the benefits and risks of Jen and Larry’s continued use of credit card financing.

While credit cards may appear inexpensive and readily available, managing teaser rate periods, transferring balances and avoiding penalties and paying high initial catch-up interest charges if full balances are not paid impose large time costs and potentially high financing costs. Therefore credit cards are not a recommended long term source of capital.

F. Prepare a summary of how the venture might benefit from receivables financing if commercial customers are extended credit for thirty days on their purchases.

Jen and Larry are operating a retail business and are not likely to have receivables from their day-to-day customer flow. If, however, Jen and Larry begin a larger scale catering operation dealing with corporate customers and purchase orders, they may easily find themselves involved in the extension of trade credit to those corporate customers. If this aspect of Jen and Larry‘s business model was to become sufficiently large, they might benefit from seeking receivables financing.

G. Discuss the impact of potential loan restrictions should the venture seek commercial loan financing.

It is likely that Jen and Larry will have to maintain and provide (to the lender) accurate and complete financial statements. They will also probably have to agree to restrictions on other financing that they may obtain and on the use of the proceeds. Their ability to withdraw money or assets from the venture will also be limited.

H. Comment on how the venture might be evaluated in terms of the five C’s of credit analysis.

Capacity to pay: Jen and Larry have past revenues and a demonstrated ability to produce profits. Their capacity to pay appears to be reasonable. Depending on their continued ability to produce profits and their expansion plans, their ability to pay may vary.

253 Capital: Jen and Larry‘s personal investment in the business is not known (here) but they do have some reputational capital in the business from previous successful operations.

Collateral: Jen and Larry‘s collateral possibilities are not known but inventory and machinery could provide some form of collateral. They will probably have to personally guarantee the loan and that guarantee may involve personal assets.

Conditions: Jen and Larry will probably have to support working capital investments from the proceeds of the loan which will most likely have to be paid off as revenues are realized. It is also likely that their loan will be seasonal, have some requirement that it be ―cleaned up‖ to a zero balance at least once a year.

Character: Jen and Larry‘s character is not indicated but they do appear to have some business reputation and may also have some reputation with their employees that could provide insights more generally.

Chapter 14 SECURITY STRUCTURES AND DETERMINING ENTERPRISE VALUES FOCUS In this chapter, we discuss important concepts in structuring securities a venture uses to raise funds. We introduce the notion of primitive securities (like bonds and common stocks) and consider other more complex securities (like warrants and convertible preferred) that derive their value from the primitive securities. We introduce the enterprise valuation method, a straightforward technique for valuing a venture using complex financial securities.

LEARNING OBJECTIVES LO 14.1: Discuss why common stock or common equity in a venture reflects residual ownership.

LO 14.2: Describe characteristics of preferred stock or preferred equity and why convertible preferreds are often issued.

LO 14.3: Explain basic differences between convertible debt and convertible preferred equity securities.

LO 14.4: Describe why warrants and options are issued by ventures and be able to diagram payoffs.

LO 14.5: Explain how voting, registration rights, and negative covenants may impact the design of a venture‘s securities.

LO 14.6: Describe how to value a venture as a complete enterprise and relate that value to the value of the securities involved in supporting the enterprise.

CHAPTER OUTLINE 14.1 COMMON STOCK OR COMMON EQUITY 14.2 PREFERRED STOCK OP PREFERRED EQUITY

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14.3 14.4 14.5 14.6

A. Selected Characteristics B. Convertible Preferreds C. Conversion Value Protection D. Conversion Protection Clauses CONVERTIBLE DEBT WARRANTS AND OPTIONS OTHER CONCERNS ABOUT SECURITY DESIGN VALUING VENTURES WITH COMPLEX CAPITAL STRUCTURES: THE ENTERPRISE METHOD SUMMARY LEARNING SUPPLEMENT 14A: Alternative Enterprise Valuation Method LEARNING SUPPLEMENT 14B: Application of Black-Scholes Option-Pricing Formula

DISCUSSION QUESTIONS AND ANSWERS 1. What is common stock or common equity? What is the purpose of preemptive rights?

Common stock: the least senior claim on a venture’s assets (residual ownership) Pre-emptive rights: the right for existing owners to buy sufficient shares to preserve their ownership share 2. What is preferred stock? What is participating preferred stock, and what is meant by paid in kind (PIK) preferred stock?

Preferred stock: equity claim senior to common stock and providing preference on dividends and liquidation proceeds Participating preferred stock: preferred stock with rights to participate in any dividends paid to common stockholders; or, stock with an investment repayment provision that must be met before distribution of returns to common stockholders Paid in kind (PIK) preferred stock: preferred stock that has the option of paying preferred dividends by issuing more preferred stock 3. What are the basic design features for financial securities used in venture investing?

Typically, venture investing securities need to address the type of financial claim (equity, debt, convertible) and the voting rights assigned. It is common for the security to have debtlike seniority in promised payments and be convertible in to an equity claim in successful ventures. There is almost always some claim of equity-like ownership.

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4. Why is the conversion feature in convertible preferred important for venture investors?

The conversion features allows the venture investor to participate in the venture‘s success as reflected in equity appreciation. This is where the majority of return on investment in a successful venture will come.

5. What is meant by a (a) full ratchet clause, and (b) down (reset) round?

A full ratchet clause provides that existing investors will receive enough postconversion shares to protect their pre-issue conversion value.

Down (reset) round: venture round priced below most recent previous price 6. Which is more favorable to the founders, the Market Price Formula (MPF) or the Conversion Price Formula (CPF)?

It depends. However in many cases, the MPF is typically more favorable because it only adjusts for issues below a certain market price. The CPF adjusts for any issue below the existing conversion price. When the market price is below the conversion price, the MPF makes no adjustment as long as the shares are issued at or above the ―market price.‖ For an example of where the CPF is softer than the MPF (market price is significantly above conversion price and the offering is priced below both, see problem 4 below).

7. How does convertible debt differ from convertible preferred stock?

Convertible debt is debt with the option to exchange it into stock.

Convertible preferred stock: preferred stock with option to exchange into common stock Convertible debt holders have bankruptcy rights that can kick in when coupon payments are missed. These rights are much stronger than those of preferred shareholders, who don’t receive a scheduled dividend. Convertible debt holders also have a security interest in the venture’s assets that is senior to preferred shareholders’ interests. Unlike preferred equity, debt can be structured to provide senior interest in specific assets such as inventory or property, plant, and equipment (collateral).

8. What are convertible notes? Why are convertible notes issued, and who typically issues them?

Convertible notes are debt allowing for conversion into stock at a price set by a future financing round.

256 Convertible notes are issued to allow for a delayed valuation until the time of a future financing round. Ventures needing seed financing are increasingly issuing convertible notes.

Typically, convertible notes convert into equity securities (frequently convertible preferreds) using a formula based on a future round’s price. That formula can include maximum valuation ―caps‖ (setting up a minimum number of shares the converted note creates) or discounts to the eventual offering price.

9. Why are options to buy additional shares of stock used in venture financing? What are warrants?

Options to buy additional shares at specified prices are common “sweeteners” or “equitykickers” use to increase the attractiveness of a securities offering. Options are also a common component of venture employee incentive compensation.

Warrants: call options issued by a company granting the holder the right to buy common stock at a specific price for a specific period of time 10. How do (a) American-style options, (b) European-style options, and (c) Bermudanstyle options differ?

American-Style Option: an option that can be exercised at any time until expiration European-Style Option: an option that can be exercised only at the expiration date Bermudan-Style Option: an option that can be exercised only at a specific set of dates 11. How are put and call options similar? How are they different?

Put and call options are similar in that they provide the holder the right to buy (call) or sell (put) at a specified price. They are different because a call option holder has the right to buy and gains if the price goes up and a put option holder has the right to sell and gains if the stock price goes down.

12. What are the “factors” that influence the values of American-style options?

The factors are:  Underlying Asset  Exercise (or Strike) Price  Time to Maturity  Volatility  Interest Rate  Payouts, if any 13. Why is price protection an issue when convertibles or warrants are used?

257 If an investor has a fixed conversion or exercise price, then new issues at prices below that fixed price can effectively make the conversion or option less valuable. Price protection clauses allow for some compensating adjustment in conversion or exercise prices to allow the investor to retain more of the value when the venture is facing a down round.

14. Why is it important that convertible securities also be callable (redeemable)?

It is important for convertible securities to also be callable because they can ―hang‖ otherwise. That is, there may be little incentive to convert them if they can always be subsequently converted. The unconverted value will be at least as high as the conversion value. Leaving the security unconverted softens any downside from a decline in venture value because the security retains its superior claims. Forcing conversion with a redemption or call feature makes the investor give up this downside protection in order to continue to participate in venture upside.

15. Is the sale of an out-of-the-money warrant a future sale of equity at a favorable price?

It is not a guaranteed sale at all. It is a contingent ―sale‖ when the venture‘s value per share exceeds the warrant exercise price. However, at that time the company will be selling the share at less than its value. It is still true that this future contingent sale may be at more favorable prices than a current sale of the same security.

16. What is the enterprise (entity) method of valuation and how does it differ from the equity methods of Chapters 10 and 11?

The enterprise method attempts to value the entire firm, value to debt holders and equity holders, while the equity method attempts to just determine the value to equity holders.

17. Describe how the enterprise valuation cash flow is determined. That is, identify the components included in determining the enterprise valuation cash flow.

Enterprise Valuation Cash Flow =  EBIT x (1 – Enterprise Tax Rate)  +Depreciation and Amortization Expense  - Change in Net Working Capital (w/o Surplus Cash)  - Capital Expenditures 18. What is meant by (a) NOPAT, and (b) EBIAT? How do they compare with each other?

NOPAT is net operating profit after taxes EBIAT is earnings before interest after taxes NOPAT and EBIAT will have the same values and are also the same as after-tax EBIT

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19. Why is the weighted average cost of capital (WACC) used as the discount rate in the enterprise method?

The WACC is used in the enterprise method because the enterprise method values flows to all security holders. The average return that must be achieved to keep this group of investors happy requires weighting the individual securities‘ required return in proportion to their (market) weight in funding the venture. The resulting overall average required return is called the Weighted Average Cost of Capital (WACC).

20. How do debt investors get paid in the enterprise method?

The enterprise method values all possible payments to investors and then subtracts the market value of debt to arrive at the market value of equity. Consequently, debt holders are paid with a ―slice‖ of the pie allocated directly to them.

21.

From the Headlines – Fuel3D: What would you need if you wanted to conduct an enterprise valuation for a hypothetical Round D for Fuel3D? Discuss the relationship between Fuel3D and MakerBot. How might it affect the terminal value used in the enterprise valuation?

Answers will vary: An enterprise valuation of Fuel3D would typically involve projections of the income statement, balance sheet and statement of cash flows over an explicit period with a conjecture for the growth and capital structure it will sustain after that explicit period.

Additionally, one would need estimates of the required returns for equity and debt. With an estimated WACC calculated using the projected structure and rates, the enterprise valuation can be completed. If the 3D world follows that of the 2D world, one would expect there to be a variety of scanning software providers that sell their software to hardware (3D printer) firms like MakerBot to distribute with their hardware. Acquisition by a hardware firm seems likely in the resulting shake out.

INTERNET ACTIVITIES 1. Web surfing exercise: Search the web for a direct offering of a convertible preferred security. Possible search words include ―direct public offering‖ or ―small corporate offering registration‖ (SCOR). Analyze the conversion and dilution clauses offered in the security.

Web-researched results will vary due to constant updating of the related web sites.

2. Get a current price for a traded call option on a publicly traded security having publicly traded options (e.g., http://www.cboe.com). Compare the option price to the value of exercise (stock price – exercise price) and comment on the difference.

Web-researched results will vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS

259 1. [Preferred Stock Characteristics] A share of a venture’s preferred stock is convertible into 1.5 shares of its common stock. The dividend on the preferred stock is $.50 per share.

A. If the firm’s common stock is currently trading at $9.75, what is the conversion value of a share of the preferred stock? $9.75(1.5) = $14.625 The convertible preferred stock’s value should be directly related to the common stock price B. What would be the dividend yield on the preferred stock based on its conversion value? $.50/$14.625 = 3.42% C. What explanation would you give if the venture’s preferred stock currently trades at $15? What would be the dividend yield? $15 - $14.625 = $.375 The convertible preferred stock is trading at a premium relative to the current common stock price. This may reflect a higher dividend yield on the preferred stock and/or there may be a current price anomaly. $.50/$15 = 3.33% D. If the venture doubles the number of shares of its common stock that is outstanding (and cutting its stock price in half) but increases the conversion terms on its preferred stock to 2.5 shares of common stock, what would be the conversion value of a share of preferred stock after the new common stock issue? What would be the dividend yield on the preferred stock based on this new conversion value? $9.75/2 = $4.875 new common stock price Or, 1.0/2.0 = .50; $9.75(.50) = $4.875 $4.875(2.5) = $12.1875 The preferred stock’s value would decline $.50/$12.1875 = 4.10% E. If the venture increased its common stock offering by 50 percent (instead of 100 percent), what common stock conversion ratio would be needed on a share of preferred stock to keep its conversion value the same as it was before the new common stock issue? $9.75/1.5 = $6.50

260 Or, 1.0/1.5 = $.667; $9.75(.667) = $6.50 $14.625/$6.50 = 2.25 That is, one share of preferred stock would have to be convertible into 2.25 shares of common stock.

2. [convertible Preferred Stock Concepts] The CCC (triple C) Venture has issued convertible preferred stock to its venture investors. Each share of preferred stock is convertible into .80 shares of common stock and pays an annual cash dividend of $.25.

A. If each share of preferred stock has a market value of $4.00, what is the minimum price that a share of the CCC Venture’s common stock should be selling for (ignore the dividend yield on the preferred stock)? $4.00/.80 = $5.00 B. If a share of the CCC Venture’s common stock is actually trading at $3.00 per share, what are the implied conversion terms? Given the above actual conversion terms, explain how the common stock could be trading at $3.00 per share while the preferred stock is trading at $4.00 per share. $4.00/$3.00 = 1.3333 implied conversion terms That is, one share of preferred stock should be convertible into 1.3333 shares of common stock Actual conversion value: $3.00(.80) = $2.40 implied value of preferred stock Even considering the expected $.25 dividend on the preferred stock results in a value of $2.65 ($2.40 + $.25). Thus, there is an unexplainable current price anomaly between the preferred stock’s value in terms of its worth in common stock and its current trading price. Possibly very little trading of one or both of these securities occurs. Arbitrageurs will soon cause these price differentials to converge by purchasing the common stock and selling the preferred stock short.

3. [Conversion Price and Market Price Formulas] Calculate the conversion price formula (CPF) and market price formula (MPF) prices for an offering involving an existing conversion price of $1, a hypothesized market price of $2, and a new offering price of $.95 for 1,000 shares with 2,000 shares outstanding prior to the new issue. Relate the new conversion price to the implied new conversion ratio.

CPF = [(Shares before issue)(Old Conversion Price) + (New Issue Price)(New Shares)]/(Total shares after issue) = [(2000)($1.00) + ($0.95)(1000)]/3000 = $2,950/3,000 = $0.9833 MPF = (Old Conversion Price) x [(Shares before issue) + ((New issue price)(New shares)/(Share value w/o new))/(Total shares after issue)]

261

= ($1.00)[(2000) + (($0.95)(1000)/($2.00))/3000] = $1.00[$2,475/3,000] = $0.825 4. [Conversion Price and Market Price Formulas] Show how your answers for Problem 3 would change if the new offering price was $.80 for 1,500 shares. Assume other things remain the same.

CPF = [(2000)($1.00) + ($0.80)(1500)]/(3500) = $3,200/3,500 = $0.9143 MPF = ($1.00) x [(2000) + (($0.80)(1500)/($2.00))/(3500)] = $1.00[$2,600/3,500] = $0.7429 5. [Stock Option Concepts] Draw the payoff diagram for the following options: A. Call option to buy a venture’s stock at $3

B. Put option to sell a venture’s stock back to the venture at $15

6. [Stock Option Concepts] Draw the payoff for a portfolio of a share of venture equity and a short call option to buy that share at $5.

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7. [Stock Unit Concepts] Sometimes the combination of a share and a warrant is called a ―stock unit.‖ What does the payoff diagram look like for such an investment?

8. [Enterprise Valuation Cash Flows] Find the enterprise valuation cash flow expected for the current year given the following information: Capital expenditures (CAPEX) = $150,000 Depreciation and amortization expenses = $40,000 Earnings before interest and taxes = $400,000 Effective income tax rate = 30%

Required cash Surplus cash Accounts receivable Inventories Accounts payable Accrued liabilities Bank loan (short-term)

Last Year $50,000 20,000 200,000 300,000 100,000 40,000 90,000

Solution: Enterprise Valuation Cash Flow = a. $400,000(1 - .30) = $280,000 b. + $40,000

Current Year $75,000 40,000 250,000 360,000 120,000 50,000 110,000

263 c. – [($75,000 + $250,000 + $360,000 - $120,000 - $50,000) – ($50,000 + $200,000 + $300,000 - $100,000 - $40,000)] = - ($515,000 - $410,000) = - $105,000 d. - $150,000 Enterprise Valuation Cash Flow = $280,000 + $40,000 - $105,000 - $150,000 = $65,000 9. [Enterprise Valuation Cash Flows] Rework Problem 8 assuming that the earnings before interest and taxes are only $320,000 while CAPEX is $110,000. Assume the other information remains the same.

Enterprise Valuation Cash Flow = a. $320,000(1 - .30) = $224,000 b. + $40,000 c. – [($75,000 + $250,000 + $360,000 - $120,000 - $50,000) – ($50,000 + $200,000 + $300,000 - $100,000 - $40,000)] = - ($515,000 - $410,000) = - $105,000 d. - $110,000 Enterprise Valuation Cash Flow = $224,000 + $40,000 - $105,000 - $110,000 = $49,000 10.

[WACC Calculations] Calculate the after-tax WACC for a firm with a 25 percent tax rate, a 10 percent cost of debt, a 30 percent cost of equity and a target debt-to-value of .30.

Explain how investing to provide the WACC returns keeps the debt and equity investors happy. (Review Chapter 7) WACC = (10%)*(.3)*(1 - .25) + (30%)*(1 - .3) = 23.25% If the venture earns 23.25% on its capital base, it can pay the debtholders‘ cost (after tax) and the required equity returns will be achieved.

11. [WACC Concepts] Why is the (1-tax rate) in the WACC? How does the government pay the tax rebate on interest – through a flow or in the rate? (Review Chapter 7) The ―(1-tax rate)‖ is included in the WACC to provide for the tax savings the firm receives due to the tax deductibility of interest. In this case, the required rate is being adjusted down for the tax rebate. We say that this rebate is paid through the discount ―rate.‖ If we had included a line in the financial statements (and valuation cash flows) for the tax rebate on interest, then we would have said that we were taking the tax rebate as a ―flow.‖ 12. [WACC Concepts] Given a WACC of 15 percent, a target debt-to-value of .5, a tax rate of 28 percent and a cost of debt of 10 percent, what is the implied cost of equity?

WACC = (cost of debt)*(Debt/Value)*(1 – Tax rate) + (cost of equity)*(Equity/Value)

264 So, Cost of Equity = ((WACC) – ((cost of debt)*(Debt/Value)*(1 – Tax rate)))/ (Equity/Value) Cost of Equity = ((15%) – ((10%)*(.5)*(1 - .28)))/(.5) = 22.8% 13. [Enterprise and Equity Value Concepts] Assume a venture has a perpetuity enterprise value cash flow of $800,000. Cash flows are expected to continue to grow at 8 percent annually and the venture’s WACC is 15 percent.

A. Calculate the venture’s enterprise value. $800,000/(.15 - .08) = $11,428,571.43 B. If the venture has $2,000,000 in interest-bearing debt obligations, what would be the venture’s equity value? $11,428,571.43 - $2,000,000 = $9,428,571.43 C. Show how your answers to Parts A and B would change if the perpetuity cash flow growth rate was only 6 percent and the WACC was 16 percent. $800,000/(.16 - .06) = $8,000,000 enterprise value $8,000,000 - $2,000,000 = $6,000,000 equity value 14. [Enterprise and Equity Value Concepts] A venture has a $500,000 bank loan outstanding, a long-term debt obligation of $900,000, accounts payable of $200,000, and accounts receivable of $350,000.

A. If the venture’s equity value is $2,450,000, what would be the associated enterprise value?

Enterprise value = $2,450,000 + $500,000 + $900,000 = $3,850,000 B. Assume the venture’s enterprise value has been estimated to be $5,300,000 (ignore any information from Part A). What would be the venture’s equity value?

Equity value = $5,300,000 - $500,000 - $900,000 = $3,900,000 C. Now assume that the venture has surplus cash of $700,000. Show how your answers (it at all) would change for Parts A and B. In each case, the surplus cash would add $700,000 to the value: Revised Part A: Enterprise value = $3,850,000 + $700,000 = $4,550,000 Revised Part B: Equity value = $3,900,000 + $700,000 = $4,600,000 15.

[Enterprise Value Concepts] Why is the market value of currently issued debt

265 subtracted from the enterprise value (in a debt-and-equity-only firm) to arrive at the value of equity? Why are future debt issues ignored by the process?

The enterprise value is the value of all of the securities (debt and equity). To get what‘s left for the market value of equity, we have to subtract the market value of debt. This type of formulation assumes all future debt offerings are NPV=0. (Debt is fairly priced and the tax implications of future debt payments are already incorporated in the discount rate).

16.

[Enterprise Valuation Method] The Datametrix Corporation has been in operation for one full year (2019). Financial statements are shown below. Sales are expected to grow at a 30 percent annual rate for each of the next three years (2020, 2021, and 2022) before settling down to a long-run growth rate of 7 percent annually. The cost of goods sold is expected to vary with sales. Operating expenses are expected to grow at 75 percent of the sales growth rate (i.e., be semi-fixed) for the next three years before again growing at the same rate as sales beginning in 2023. Interest expense is expected to grow with sales. Depreciation can be forecasted either as a percentage of sales or as a percentage of net fixed assets (since net fixed assets are expected to grow at the same rate as sales growth). Individual asset accounts are expected to grow at the same rate as sales. Accounts payable and accrued liabilities are also expected to grow with sales.

Because Datametrix is in its start-up life cycle stage, management and venture investors believe that 35 percent is an appropriate weighted average cost of capital (WACC) discount rate until the firm reaches its long run or perpetuity growth rate. At that time it will have survived, recapitalized its capital structure, and will become a more typical firm in the industry with an estimated WACC of 18 percent. Calculate Datametrix’s enterprise value as of the end of 2019. Also indicate what the equity would be worth.

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Solutions: See spreadsheet solutions presented below.

Market Value of Firm (Enterprise Value) = $13,128,000 Less: Long-Term Debt = $1,000,000 Market Value of Equity = $12,128,000 [Note: While not stated in the problem, the instructor may want to inform students that there are 1,000,000 shares of common stock outstanding so that market value can be stated on a per share basis.]

Thus, assuming 1,000,000 shares of stock are outstanding, results in a per share value = $12.13.

267 DATAMETRIX, INC. [Enterprise Valuation Method] Ch 14, Prob 16 Actual Projected ------------------------------------------>I Percent Sales Increase------> 30.0% 30.0% 30.0% 7.0% % of 2019 [Thousands of Dollars] Income Statements Sales 2019 2020 2021 2022 2023 Sales 100.0% 20000 26000 33800 43940 47016 Cost of goods sold -50.0% -10000 -13000 -16900 -21970 -23508 Gross profit 50.0% 10000 13000 16900 21970 23508 Operating expenses -7500 -9188 -11255 -13787 -14752 Depreciation -2.0% -400 -520 -676 -879 -940 EBIT 2100 3293 4969 7304 7816 Interest -0.5% -100 -130 -169 -220 -235 EBT 2000 3163 4800 7085 7580 Taxes (40%) -800 -1265 -1920 -2834 -3032 Net income 1200 1898 2880 4251 4548 Balance Sheets Cash 5.0% 1000 1300 1690 2197 2351 Surplus cash 0 -53 293 1248 4797 Accounts receivable 10.0% 2000 2600 3380 4394 4702 Inventories 10.0% 2000 2600 3380 4394 4702 Total current assets 5000 6448 8743 12233 16550 Gross fixed assets 5400 7420 10046 13460 15169 Accumulated depreciation -400 -920 -1596 -2475 -3415 Net fixed assets 25.0% 5000 6500 8450 10985 11754 Total assets 50.0% 10000 12948 17193 23218 28304 Accounts payable 7.5% 1500 1950 2535 3296 3526 Accrued liabilities 5.0% 1000 1300 1690 2197 2351 Total current liabilities 2500 3250 4225 5493 5877 Long-term debt 1000 1300 1690 2197 2351 Common stock 5300 5300 5300 5300 5300 Retained earnings 1200 3098 5978 10228 14777 Total equity 6500 8398 11278 15528 20077 Total liabilities & equity 10000 12948 17193 23218 28304

268

DATAMETRIX, INC. [Enterprise Valuation Method] Work Sheet for Estimating Free Cash Flows to the Enterprise: 2019 2020 Income Statement Flows: NOPAT 1976 Depreciation 520 Required Net Working Capital: Required Cash Accounts Receivable Inventories Accounts payable Accrued liabilities Required NWC Increase in Required NWC Capital Expenditures (CAPEX): Net fixed assets Increase in net fixed assets Depreciation Increase in gross fixed assets

2021

2022

2023

2982 676

4383 879

4689 940

1000 2000 2000 -1500 -1000 2500

1300 2600 2600 -1950 -1300 3250 750

1690 3380 3380 -2535 -1690 4225 975

2197 4394 4394 -3296 -2197 5493 1268

2351 4702 4702 -3526 -2351 5877 384

5000

6500 1500 520 2020

8450 1950 676 2626

10985 2535 879 3414

11754 769 940 1709

2019

2020 1976 520 -750 -2020 -275

2021 2982 676 -975 -2626 57

2023 4689 940 -384 -1709 3536

-275

57

2022 4383 879 -1268 -3414 580 32144 32724

Free Cash Flows to Enterprise: NOPAT Plus: Depreciation Less: Increase in Required NWC Less: CAPEX (Inc in GFA) Annual Free Cash Flows Horizon Cash Flow Value (18% disc rate) Total Free Cash Flows to Enterprise PV of Operations (35% disc rate) Plus: Existing Surplus Cash Market Value of Firm Less: Long-term Debt Market Value of Equity Per Share Value (1 million shares)

$13,128 $0 $13,128 $1,000 $12,128 $12.13

Note:To find Per Share Value, students will have to be told there are 1 million shares outstanding.

269 MINI CASE: WOK YOW IMPORTS, INC. Wok Yow Imports, Inc., is a rapidly growing, closely held corporation that imports and sells oriental style furniture and accessories at several retail outlets. The equity owners are considering selling the venture and want to estimate the enterprise or entity value and then determine the value of the venture‘s equity. Following is last year‘s income statement (2019) and projected income statements for the next four years (2020-2023). Sales are expected to grow at an annual 6 percent rate beginning in 2024 and thereafter.

[$ Thousands] Net Sales Cost of Goods Sold Gross Profit SG&A Expenses Depreciation EBIT Interest EBT Taxes (40% rate) Net Income

Actual 2019 $150.0 -75.0 75.0 -30.0 -7.5 37.5 -3.5 34.0 -13.6 20.4

Projected -----------------------------------------------2020 2021 2022 2023 $200.0 $250.0 $300.0 $350.0 -100.0 -125.0 -150.0 -175.0 100.0 125.0 150.0 175.0 -40.0 -50.0 -60.0 -70.0 -10.0 -12.5 -15.0 -17.5 50.0 62.5 75.0 87.5 -3.5 -3.5 -3.5 -3.5 46.5 59.0 71.5 84.0 -18.6 -23.6 -28.6 -33.6 27.9 35.4 42.9 50.4

Selected balance sheet accounts at the end of 2019 are as follows: Required cash, accounts receivable, and inventories accounts totaled $50,000, net fixed assets were $50,000, and accounts payable and accruals totaled $25,000. Each of these balance sheet accounts was expected to grow with sales over time. Long-term debt was $30,000 and there were 10,000 shares of common stock outstanding at the end of 2019.

Data have been gathered for a ―comparable‖ publicly traded firm, Fine Furniture Products, in Wok Yow‘s industry. Fine Furniture‘s risk index is judged to be 2.00 compared to a risk index of 1.00 for firms of average riskiness. Management believes that a 2.00 adjustment factor should be multiplied times the expected market risk premium for average firms to reflect Wok Yow‘s (and Fine Furniture‘s) relatively greater riskiness. Wok Yow‘s long-term debt to long-term capital (long-term debt plus equity) ratio was 40 percent at the end of 2019. The interest rate on long-term U.S. government bonds is 7 percent, Wok Yow could issue new longterm debt at a 12 percent rate, and the average expected market risk premium (common stocks over government bonds) is 7.5 percent for average firms.

A.

Project Wok Yow’s net operating profit after-tax (NOPAT) statements for 2020-2024.

The NOPAT results are shown below in the spreadsheet solution. NOPAT amounts were: 30.0 (2020), 37.5 (2021), 45.0 (2022), 52.5 (2023), and 55.7 (2024).

B.

Determine the annual increases in required net working capital and capital expenditures (CAPEX) for Wok Yow for the years 2020 through 2024.

270 Results are shown below in the spreadsheet solution. The increases in RNWC were: 8.3 (2020), 8.3 (2021), 8.3 (2022), 8.3 (2023), and 3.5 (2024). The increases in CAPEX were: 26.7 (2020), 29.2 (2021), 31.7 (2022), 34.2 (2023), and 25.5 (2024).

C.

Project annual operating free cash flows to the entity for the years 2020 through 2024.

Results are shown below in the spreadsheet solution. Operating free cash flows were: 5.0 (2020), 12.4 (2021), 20.0 (2022) and 27.5 (2023). An operating free cash flow of 45.2 was estimated for 2024.

D.

Management initially thought that an 18 percent discount rate was reasonable.

Estimating an appropriate required rate of return on an equity investment is critical to the valuation effort. For very early stage ventures, various VC ―rules-of thumb‖ might be used ranging from development stage discount rates of 50% down to 20% discount rates for relatively mature, but small ventures. The alternative is to estimate an appropriate discount rate using the security market line approach described in Chapter 7. A venture that employs some interest-bearing debt will have a weighted average cost of capital WACC that is less than the cost of equity capital. Management has made a rough estimate of the firm‘s WACC or enterprise (entity) discount rate to be 18%.

E.

Use the information from Part D above to estimate Wok Yow’s terminal value cash flow at the end of 2023.

The terminal value cash flow is estimated to be 376.3 and is calculated by dividing the estimated operating free cash flow for 2023 of 45.2 by .12 which is the difference between the discount rate (r = .18) and the perpetuity growth rate (g = .06). See the spreadsheet solution presented below. In greater detail, the calculation is: 45.152/(.18 .06) = 376.267.

F.

Estimate the firm’s enterprise or entity value at the end of 2019.

The enterprise or entity value at the end of 2019 is estimated to be 233.6 (thousands of dollars). See the spreadsheet solution presented below.

G.

Adjust the enterprise value to determine Wok Yow’s equity value in dollars and on a per share basis at the end of 2019.

The enterprise value of $233.6, minus the long-term debt value of $20, results in an equity value of $203.6. On a per share basis, the value is $20.36. See the spreadsheet solution presented below.

H.

Now, estimate Wok Yow’s after-tax cost of long-term debt. Use the risk free rate, the expected market risk premium, and the risk index for the Fine Furniture Company to estimate Wok Yow’s cost of equity capital. Determine Wok Yow’s weighted average cost of capital (WACC).

271

Cost of common equity capital = 7% + (7.5%)2.00 = 7% + 15% = 22% After-tax cost of debt = 12%(1 - .40) = 7.2% WACC = 7.2%(.40) + 22%(.60) = 2.88% + 13.20% = 16.08% or 16.1% rounded.

See the second spreadsheet solution presented below for answers to Parts H and I. I.

Re-estimate Wok Yow’s enterprise value using the WACC calculated in Part H. Then, adjust the enterprise value to determine Wok Yow’s equity value in dollars and on a per share basis at the end of 2019.

Revised terminal value = $447.1 [i.e., actually $45.152/(.161 - .06)] Revised enterprise value = $270.1 Revised equity value = $240.1 (i.e., $270.1 - $30.0) Revised per share value = $24.01 See the second spreadsheet solution presented below for answers to Parts H and I.

272 WOK YOW IMPORTS, INC. Enterprise (Entity) Valuation Solution [Parts A through G]: Chapter 14 Mini Case Percent Change in Net Sales % of 33.3% 25.0% 20.0% 16.7% 6.0% [Thousands of Dollars] 2019 Actual Pro forma -------------------------------------------NOPAT Statements Sales 2019 2020 2021 2022 2023 2024 Net Sales 100.0% 150.0 200.0 250.0 300.0 350.0 371.0 Cost of Goods Sold -50.0% -75.0 -100.0 -125.0 -150.0 -175.0 -185.5 Gross Profit 50.0% 75.0 100.0 125.0 150.0 175.0 185.5 SG&A Expenses -20.0% -30.0 -40.0 -50.0 -60.0 -70.0 -74.2 Depreciation -5.0% -7.5 -10.0 -12.5 -15.0 -17.5 -18.6 EBIT 25.0% 37.5 50.0 62.5 75.0 87.5 92.8 Interest 0.0% 0.0 0.0 0.0 0.0 0.0 0.0 EBT 25.0% 37.5 50.0 62.5 75.0 87.5 92.8 Taxes (40% rate) -10.0% -15.0 -20.0 -25.0 -30.0 -35.0 -37.1 NOPAT 15.0% 22.5 30.0 37.5 45.0 52.5 55.7 Required Net Working Capital: Req Cash+Receivables+Inventories Minus: Payables+Accruals Req Net Working Capital (RNWC) Increase in RNWC Fixed Assets Schedule: Net Fixed Assets (NFA) Increase in NFA Plus: Depreciation CAPEX

33.3% -16.7%

50.0 -25.0 25.0

66.7 -33.3 33.3 8.3

83.3 -41.7 41.7 8.3

100.0 -50.0 50.0 8.3

116.7 -58.3 58.3 8.3

123.7 -61.8 61.8 3.5

33.3%

50.0

66.6 16.7 10.0 26.7

83.3 16.7 12.5 29.2

100.0 16.7 15.0 31.7

116.7 16.7 17.5 34.2

123.7 7.0 18.6 25.5

30.0 10.0 -26.7 -8.3 5.0

37.5 12.5 -29.2 -8.3 12.4

45.0 15.0 -31.7 -8.3 20.0

52.5 17.5 -34.2 -8.3 27.5

55.7 18.6 -25.5 -3.5 45.2

5.0

12.4

20.0

376.3 403.8

Free Cash Flows to Entity: NOPAT Plus: Depreciation Minus: CAPEX Minus: Increase in NWC Operating Free Cash Flows Terminal Value CF (r =.18, g =.06) Total Free Cash Flows (TFCF) PV of TFCF (18% Discount Rate) Less: LTD Value Equity Value Value Per Share (10,000 shares)

$233.6 $30.0 $203.6 $20.36

273

WOK YOW IMPORTS, INC. Enterprise (Entity) Valuation Solution [Parts H and I]:

[Thousands of Dollars] NOPAT Statements Net Sales Cost of Goods Sold Gross Profit SG&A Expenses Depreciation EBIT Interest EBT Taxes (40% rate) NOPAT Required Net Working Capital: Req Cash+Receivables+Inventories Minus: Payables+Accruals Req Net Working Capital (RNWC) Increase in RNWC Fixed Assets Schedule: Net Fixed Assets (NFA) Increase in NFA Plus: Depreciation CAPEX

% of 2019 Sales 100.0% -50.0% 50.0% -20.0% -5.0% 25.0% 0.0% 25.0% -10.0% 15.0%

Actual 2019 150.0 -75.0 75.0 -30.0 -7.5 37.5 0.0 37.5 -15.0 22.5

Cost of Capital Worksheet: "Comparable Firm" Risk Index Cost of Equity Capital A-T Cost of LTD Capital WACC

6.0% 2024 371.0 -185.5 185.5 -74.2 -18.6 92.8 0.0 92.8 -37.1 55.7

33.3% -16.7%

50.0 -25.0 25.0

66.7 -33.3 33.3 8.3

83.3 -41.7 41.7 8.3

100.0 -50.0 50.0 8.3

116.7 -58.3 58.3 8.3

123.7 -61.8 61.8 3.5

33.3%

50.0

66.6 16.7 10.0 26.7

83.3 16.7 12.5 29.2

100.0 16.7 15.0 31.7

116.7 16.7 17.5 34.2

123.7 7.0 18.6 25.5

30.0 10.0 -26.7 -8.3 5.0

37.5 12.5 -29.2 -8.3 12.4

45.0 15.0 -31.7 -8.3 20.0

52.5 17.5 -34.2 -8.3 27.5

55.7 18.6 -25.5 -3.5 45.2

5.0

12.4

20.0

447.1 474.6

Free Cash Flows to Entity: NOPAT Plus: Depreciation Minus: CAPEX Minus: Increase in NWC Operating Free Cash Flows Terminal Value CF (r = .161, g = .06) Total Free Cash Flows (TFCF) PV of TFCF (16.1% Discount Rate) Less: LTD Value Equity Value Value Per Share (10,000 shares)

Percent Change in Net Sales 33.3% 25.0% 20.0% 16.7% Pro forma -------------------------------------------2020 2021 2022 2023 200.0 250.0 300.0 350.0 -100.0 -125.0 -150.0 -175.0 100.0 125.0 150.0 175.0 -40.0 -50.0 -60.0 -70.0 -10.0 -12.5 -15.0 -17.5 50.0 62.5 75.0 87.5 0.0 0.0 0.0 0.0 50.0 62.5 75.0 87.5 -20.0 -25.0 -30.0 -35.0 30.0 37.5 45.0 52.5

$270.1 $30.0 $240.1 $24.01

2.00 0.220 0.072 0.161

274 MINI CASE 2: RxDELIVERY SYSTEMS, INC. (Revisited) RxDelivery Systems is an R&D venture specializing in the development and testing of new drug delivery technologies. The market for alternative drug delivery systems grew rapidly during the past several years. Driving factors behind this growth include efforts to reduce drug side effects through site-specific delivery, the need to maintain the activity of new biopharmaceutical compounds, and the extension of drug patent life. Improved drug delivery methods are expected to reduce the number of surgical interventions and the length of hospital stays, and improve patient compliance in taking prescribed drugs.

A large world market for biopharmaceuticals (including peptide, protein, RNA, and DNA drugs) exists today. Sales of polymer-based drug delivery systems continue to grow rapidly.

Pulmonary delivery systems represent an important segment of the drug delivery market.

RxDelivery Systems believes it can compete effectively in both the polymer-based and pulmonary drug delivery areas. The venture‘s delivery technology is expected to utilize hydrophobic ion pairing and supercritical carbon dioxide precipitation to incorporate water soluble drug molecules into biodegradable controlled-release microspheres. The resulting microspheres will take the form of dry powders and will contain drug molecules small enough to allow for intravenous, intranasal, or pulmonary delivery. It is anticipated that this technology will be incorporated into products for controlled release applications including treatment of cancer, infectious diseases, and gene therapy.

RxDelivery Systems, through an agreement with its pharmaceutical parent, a major drug company, will initially operate as an independent corporation but will be merged into the parent at the end of its second year. At that time, RxDelivery Systems‘ entrepreneurial team will be paid a lump sum of $2,500,000 as the terminal value for the venture. Following are limited financial statement projections for the next two years for the RxDelivery Systems Corporation:

E. Construct the venture’s balance sheet at startup. Then construct financial statements for Years 1 and 2. [Put initial fixed asset investments in Year 0 and initial working capital investments in Year 1. Assume the initial $50,000 is equity financed.]

See spreadsheet below.

F. Construct the enterprise valuation cash flows including the $2,500,000 terminal payment.

Treat existing liabilities at the terminal time as though the pharmaceutical firm assumes

275 them. (The $2,500,000 is ―free and clear.‖) Strip all non-required cash out of net working capital (effectively declaring a pseudo dividend).

See spreadsheet below.

G. What is the value of the enterprise at time 0 assuming a discount rate of 30%?

The venture has no debt and therefore WACC is the same as the discount rate for equity.

See spreadsheet below.

H. What is the value of the equity at time 0?

See spreadsheet below.

I. Why does this value differ from the value for the equity method in the RxDelivery Systems mini case at the end of Chapter 10?

The venture has no debt and therefore WACC is the same as the discount rate for equity.

There is no debt to subtract from the enterprise value. Thus, the equity and enterprise values would be the same.

If one uses the delayed dividend approximation (DDA) method (discussed in Chapter 11, Learning Supplement 11B) the answer would be different than the answer produced by the equity valuation method. See the spreadsheet below for more information.

From the solutions in Chapter 10 and the DDA (Ch. 11) approach:

276 Income Statements Revenue Expenses Including Depreciation EBIT -Interest EBT - Cash Taxes Net Income Depreciation

Year 1 12,500 -125,000 -112,500 0 -112,500 0 -112,500

Year 2 16,000 -125,000 -109,000 0 -109,000 0 -109,000

5,000

4,500

Balance Sheets Assets Required Cash Surplus Cash Gross Fixed Assets Accumulated Depreciation Net Fixed Assets Total Assets Liabilities and Equity Accounts Payable Accrued Expenses Debt Equity Total L+E

Startup

Year 1

Year 2

0 0 50,000 0 50,000 50,000

3,000 -109,450 50,000 -5,000 45,000 -61,450

3,000 -213,950 50,000 -9,500 40,500 -170,450

0 50,000 50,000

750 300 0 -62,500 -61,450

750 300 0 -171,500 -170,450

Accounting Cash Flows NI +Depr -dAR -dInv +dAP +dAccrd -Capex +Principal -Dividend Acct CF Beg Cash End Cash

Year 0 0 0 0 0 0 0 -50,000 0 50,000 0 0 0

Year 1 -112,500 5,000 0 0 750 300 0 0 0 -106,450 0 -106,450

Year 2 -109,000 4,500 0 0 0 0 0 0 0 -104,500 -106,450 -210,950

Valuation (PDM) NI +Dep -Capex -dNWC +Principal Proc.

Equity VCF Terminal Flow Total Flow

(Surplus Cash is Zero for Valuation Purposes) Year 0 Year 1 Year 2 0 -112,500 -109,000 0 5,000 4,500 -50,000 0 0 0 -1,950 0 0 0 0 -50,000 -109,450 -104,500 2,500,000 -50,000 -109,450 2,395,500

NPV

1,283,263

Valuation (DDA) NI +Dep -Capex -dNWC +Principal Proc.

Equity VCF Terminal Flow Total Flow

(Surplus Cash Situation Affects Terminal Flow) Year 0 Year 1 Year 2 0 -112,500 -109,000 0 5,000 4,500 -50,000 0 0 0 107,500 104,500 0 0 0 -50,000 0 0 2,286,050 -50,000 0 2,286,050

NPV

1,302,692

Difference in EqCF NPV of Difference DDA Value Increase

0 109,450 -109,450 19,429 19,429 (=1,302,263-1,283,263) due to timing differences on surplus cash

Sum 0

The enterprise valuation approach is: Enterprise Value Method (Cash Taxes) EBIT -tc*EBIT EBIAT +Depr -Capex -dNWC Enterprise VCF Terminal Flow Total Enterprise Flow

0 0 0 0 -5,000 -5,000

-11,250 0 -11,250 500 0 -195 -10,945

-5,000

-10,945

NPV @ 30% -Market Value ' Debt' Market Value Equity

128,326 0 128,326

-10,900 0 -10,900 450 0 0 -10,450 250,000 239,550

The deferred tax asset (accrued taxes) approach would give the same enterprise valuation cash flows after adding a tax credit and taking out the investment in a deferred tax asset.

Chapter 15 HARVESTING THE BUSINESS VENTURE INVESTMENT

277

FOCUS This chapter in our entrepreneurial finance text focuses on how a successful entrepreneur can harvest or exit the venture.

LEARNING OBJECTIVES LO 15.1: Discuss financial decisions faced by ventures during their rapid-growth and early-maturity stages.

LO 15.2: Plan an exit strategy.

LO 15.3: Describe the use of relative value methods to value a venture‘s equity or enterprise.

LO 15.4: Explain the meaning of systematic liquidation.

LO 15.5: Describe outright sales of the venture to various potential buyers and explain how ―leveraged buyouts‖ and ―management buyouts‖ differ.

LO 15.6: Describe the process of going public and explain what investment banking involves.

CHAPTER OUTLINE 15.1 VENTURE OPERATING AND FINANCIAL DECISIONS REVISITED 15.2 PLANNING AN EXIT STRATEGY 15.3 VALUING THE EQUITY OR VALUING THE ENTERPRISE A. Relative Valuation Methods B. Dividing the Venture Valuation Pie 15.4 SYSTEMATIC LIQUIDATION 15.5 OUTRIGHT SALE A. Family Members B. Managers C. Employees D. Outside Buyers 15.6 GOING PUBLIC A. Investment Banking B. Some Additional Definitions C. Other Costs in Issuing Securities D. Post-IPO Trading E. Contemplating and Preparing for the IPO Process SUMMARY

DISCUSSION QUESTIONS AND ANSWERS 1.

What is the meaning of harvesting a venture?

278 Harvesting a venture refers to the process of exiting a privately-held business venture to unlock the owners‘ investment value.

2.

What evidence exists as to whether entrepreneurs think about and/or develop exit strategies?

Holmberg documented that over ½ of entrepreneurs have developed, or at least though about exit strategies, at the start of their ventures.

3.

What are unicorns? How might their exit values be impacted when they go public?

Unicorns are high-expected-growth companies with valuations in excess of $1 billion.

Such ventures have been questioned for not ―going public‖ or, when they do, doing so at a price below previous rounds, creating concern that the private valuations in excess of $1 billion are inflated. Planning welcome exits is important even for exceptionally well-funded ventures, including the rare unicorns.

4. Describe how the relative value method is used to value a firm’s equity.

The relative value method estimates a firm’s value by examining how comparable firms are valued based on value-related multiples.

Comparable firms are firms with lines of business, size, and growth characteristics similar to the firm being valued. Multiples-based valuations may be used to value the firm’s enterprise value or its direct equity value similar to the application of DCF methods. Analysts often estimate a firm’s enterprise value by calculating multiples of earnings before interest, taxes, depreciation, and amortization (EBITDA). This works because EBITDA gives a ―crude‖ estimate of cash flow available to both debtholders and equity holders.

5.

What is a systematic liquidation of a venture? What are some of the advantages and disadvantages of a systematic liquidation?

A systematic liquidation of a venture is the process of liquidating the firm by distributing the cash flows of the firm to the owners. This usually happens when the firm is in the mature stage and their free cash flow exceeds the amount need to maintain sustainable growth.

Potential advantages include: (1) the entrepreneur and other owners maintain control throughout the harvest period, (2) the harvesting of the investment value can be spread out over a number of years, and (3) the time, effort, and cost of finding a buyer for the venture can be avoided.

Potential disadvantages include: (1) the treatment and taxation of liquidation proceeds as ordinary income (rather than capital gains), (2) the commitment of the entrepreneur‘s wealth, abilities, and focus to a dying venture, rather than other venture pursuits that might be more

279 lucrative, and (3) acceleration of the rate of decline in the going concern value as other industry participants respond to the reduction in investment.

6.

Describe an outright sale of a venture. What are the four categories of possible buyers?

An outright sale of a venture occurs when it is sold to others. The four categories of outside buyers in an outright sale are family members, managers, employees, or external buyers.

7.

Describe what is meant by (a) a leveraged buyout (LBO), and (b) a management buyout (MBO).

An LBO occurs when a firm is bought out by investors who finance the majority of it with debt. An MBO is a type of LBO with the managers‘ being a large part of the equity investors.

8.

What is an employee stock option plan (ESOP)? How is an ESOP used to buy out a venture?

An ESOP is typically a benefit plan where employer and employee contributions are combined with debt to purchase a venture‘s equity. If the ESOP plan is sufficiently large in a mature firm, it can possibly take the role of the majority equity investor in the venture after venture investors have exited.

9.

Describe the terms (a) ―control premium‖ and (b) ―illiquidity discount‖ when discussing possible external or outside buyers of a venture. (a) A control premium is an additional dollar or percentage value on top of the base value of the firm for the advantage of being able to control the firm instead of being a minority shareholder. (b) An illiquidity discount is a decrease in the price paid for unregistered shares that cannot be easily sold or transferred.

10.

Describe an initial public offering (IPO). What are the differences between a primary offering and a secondary offering?

An IPO is the first public sale of a venture‘s equity ownership. The primary offering refers to the sale of new shares to their first owners. A secondary offering is the sale of shares previously owned by others (typically founders and those still owning shares from the time when the venture was privately held).

11.

What is investment banking? What is an underwriting spread?

Investment banking facilitates the issue of new securities by creating markets for a firm‘s security.

280 An underwriting spread is the difference between the price paid in the market for the new security and the amount given to the issuing firm. It is the investment bank‘s commission for creating the deal.

12. Describe the terms ―tombstone ad‖ and ―red herring disclaimer.‖ A tombstone ad is an SEC requirement and an advertisement used to notify the public of an upcoming offering, A red herring disclaimer is a required statement on the tombstone ad (or elsewhere) notifying the public that the ad (or preliminary prospectus) is not an offer to purchase or a solicitation of an offer to buy. It also notifies the reader that the actual offer can only be made upon delivery of the final prospectus.

13. What is meant by due diligence? How does a traditional registration differ from a shelf registration?

Due diligence is the process whereby an investment bank investigates an issuing company‘s financial condition and investment intent.

A traditional registration specifies details ahead of time including date, price range and underwriter, while the shelf registration procedure allows the firm more flexibility by issuing within a two year period.

14. When an investment banking firm decides whether to underwrite or market a securities issue, what is meant by a firm commitment and best efforts?

A firm commitment by an investment bank means that the bank will purchase the security issue and then resell it in the market.

A ―best efforts‖ by an investment banking firm is when they only provide marketing and distribution efforts but do not guarantee a certain price.

15. Describe the two following terms that may be involved in underwriting a new securities issue: (a) green shoe and (b) lockup provision.

A green show provision is a contract option for the investment bank to sell more shares than allotted in the underwriting if the issue is broadly oversubscribed.

A lockup provision prohibits insiders in the company from selling their shares during a certain period of time after the initial offering.

A direct listing is a private company‘s public, but secondary, offering of already owned shares without the issue of any new shares.

16. What is meant by initial public offering (IPO) underpricing?

281

IPO underpricing is when the offering price by the syndicate is lower than the first trade in the secondary market or more generally under the prices during the first day of trading.

17. Briefly describe how securities are traded on an organized stock exchange such as the New York Stock Exchange.

Organized exchanges have specialized geographic (or electronic) places where trading in a given security takes place. The official designation of ―stock exchange‖ within the U.S brings the trading venue under the regulatory authority of the SEC. Typically such exchanges have publicly posted listing requirements, specific types of orders (e.g. ―market‖ and ―limit‖), standards for order processing and clearing, and rules for maintaining orderly markets. Typically an individual places an order with a broker who is a member of an exchange and who assumes responsibility for executing and clearing the order according to the exchange‘s rules.

18. Indicate some of the differences between the NASDAQ’s National Market System and SmallCap listing requirements.

NYSE Initial Listing Requirements are presented in Table 15.1. Another listing option for IPOs is the National Association of Securities Dealers (NASD) Automated Quotation (NASDAQ) system.

[Note: The NASDAQ no longer uses the terms National Market System and SmallCap listing requirements.] Tables 15.2 and 15.3 provide NASDAQ Global Market Initial Listing Requirements and NASDAQ Capital Market Initial Listing Requirements, respectively.

Differences exist in terms of stockholders‘ equity and market value of publicly held shares.

Similarities exist in terms of bid price, publicly held shares, and market makers.

19. Describe some of the preparations that a venture can undertake that may increase the possibility of IPO success.

Typical preparations for an IPO include, but are not limited to: (i) cleaning up confusing financing and compensation arrangements, (ii) clarifying the main business strategy; (iii) eliminating potentially annoying special arrangements with insiders; (iv) arranging for 2 years of audited financial statements by a major accounting firm; (v) preparation for the scrutiny of ongoing research by establishing formal communication channels for external dissemination of corporate news; and (vi) establishing an investor relations function.

20. What are the steps or stages in a ―typical‖ execution and time line schedule used in planning and executing an IPO? The execution and time line include: 1. Organization Meeting and Due Diligence 2. Drafting and attendant Activities 3. Initial 30-day SEC Review

282 4. Premarketing 5. Marketing 6. Pricing and Closing 21. From the Headlines – Boom Supersonic: Comment on Boom Supersonic’s potential to eventual provide liquidity to its investors through an IPO or a sale. Which one seems more likely to you? Why? Answers will vary: Substantial amounts of additional funding will be needed to develop a supersonic passenger plane. In addition, the economics of commercial supersonic passenger plane travel required to produce profitability and positive cash flow still need to be worked out. These funding and economic issues are also complicated by the fact that the major commercial plane manufacturing industry is a duopoly (Boeing and Airbus) making it very difficult for a new manufacturer to enter and succeed.

While a potential IPO may be possible, the long lead time involving development, testing, and actual production of a viable supersonic plane would require Boom Supersonic to generate substantial additional rounds of financing before undertaking an IPO. Possibly the sale of Boom Supersonic may be a more desirable outcome. However, given the fact that Boeing is also developing its own supersonic passenger plane, probably only a sale to Airbus would be feasible. While a sale could possibly be made to an existing manufacturer of military planes, it is questionable whether such a manufacturer would want to enter the commercial plane production industry.

EXERCISES/PROBLEMS AND ANSWERS 1. [DCF Valuation and Ownership Concepts] The venture investors and founders of the ACE Products venture, a closely held corporation, are contemplating merging the successful venture into a much larger diversified firm that operates in the same industry. ACE estimates its free cash flows that will be available to the enterprise next year at $5,200,000.

Since the venture is now in its maturity stage, ACE’s free cash flows are expected to continue to grow at a 6 percent annual compound growth rate in the future. A weighted average cost of capital (WACC) for the venture is estimated at 15 percent. Interest-bearing debt owed by ACE is $17.5 million. In addition, the venture also has surplus cash of $4 million. ACE currently has 5 million shares outstanding with 3 million held by venture investors and 2 million held by founders. The venture investors have an average investment of $2.50 per share while the founders’ average investment is $.50 per share.

A. Based on the above information, estimate the enterprise value of ACE Products.

What would be the value of the venture’s equity?

Enterprise operating value = $5,200,000/(.15  .06) = $57,777,778 Total enterprise value = $57,777,778 + $4,000,000 in surplus cash = $61,777,778 Value of equity = $61,777,778  $17,500,000 = $44,277,778

283 B. How much of the value of ACE would belong to the venture investors versus the founders. How much would the venture be worth on a per share basis?

Percent ownership: Venture investors = 3 million shares/5 million shares = 60% Founders = 2 million shares/5 million shares = 40% Venture investors value: $44,277,778  .60 = $26,566,667 Venture investors value per share: $26,566,667/3,000,000 shares = $8.856 Founders value: $44,277,778  .40 = $17,711,111 Founders value per share: $17,711,111/2,000,000 shares = $8.856 Total investors: $44,277,778/5,000,000 shares = 8.856 C. What would be the percentage appreciation on the stock bought by the venture investors versus the investment appreciation for the founders?

Venture investors percentage appreciation = [($8.856  $2.50)/$2.50]  100 = $6.06/$2.50  100 = 242.40% Founders percentage appreciation = [($8.856  $.50)/$.50]  100 = $8.356/$.50  100 = 1,671.20% D. If the founders have held their investments for five years, calculate their compound annual or internal rate of return on their investments. The venture investors made a first round investment of 1.5 million shares at $2 per share four years ago. What was the compound annual rate of return on the first round investment? Venture investors made a second round investment of 1.5 million shares at $3 per share two years ago. Calculate their compound rate of return on this investment.

Founders investment (present value): $.50 x 2,000,000 shares = $1,000,000 Founders ending (future value) = $17,711,111 Using a financial calculator: PV = 1,000,000; FV = 17,711,111; N = 5; solving for %i (or I%) = 77.68% per year compound rate of return.

Venture investors first round investment: 1,500,000 shares  $2.00 = $3,000,000 1,500,000 shares/3,000,000 shares = .50 .50  $26,566,667 = $13,283,334 Using a financial calculator: PV = 3,000,000; FV = 13,283,334; N = 4; solving for %i = 45.06% Venture investors second round investment: 1,500,000 shares  $3.00 = $4,500,000 1,500,000 shares/3,000,000 shares = .50 .50  $26,566,667 = $13,283,334 Using a financial calculator: PV = -4,500,000; FV = 13,283,334; N = 2; solving for %i = 71.81%

284 2. [Acquisition Valuation Concepts] The BETA firm is proposing to acquire the ACE Products venture described in Problem 1. BETA estimates that ACE’s free cash flow for next year could be improved to $5.5 million because of synergistic benefits in the form of operating or distribution economies. The potential acquirer also believes that ACE’s perpetuity growth rate could be increased to 7 percent annually. However, the riskiness of the cash flows would be increased causing the appropriate WACC to increase to 16 percent. Interestbearing debt owed by ACE is $17.5 million. In addition, the venture also has surplus cash of $4 million. ACE Products has five million shares of common stock outstanding.

A.

Determine ACE’s enterprise value from the perspective of BETA. What is ACE’s equity worth to BETA in dollar amount and on a per share basis?

Enterprise operating value = $5,500,000/(.16  .07) =

$61,111,111 Total enterprise value = $61,111,111 + $4,000,000 surplus cash = $65,111,111 Equity value = $65,111,111  $17,500,000 = $47,611,111 Equity value per share = $47,611,111/5,000,000 = $9.522 B.

Use the per share value of ACE from Problem 1 and the per share value from this problem and establish a range of values (i.e., without and with expected synergistic benefits). If one-half of the synergy derived benefits were allocated to ACE’s venture investors and founders, what price per share would the merger take place?

With synergy: $9.522 Without synergy: $8.856 Synergy benefits: $9.522  $8.856 = $.666 Merger share price: $8.856 + ($.666/2) $9189

C. BETA has thirty million shares of stock outstanding with a market capitalization value of $600 million. What is BETA’s stock price? Determine the exchange ratio between ACE’s stock value and BETA’s stock price at each of ACE’s values established in Part B. That is, what would ACE’s venture investors and founders receive in BETA’s shares for each share of common stock they currently hold in ACE Products?

BETA stock price: $600 million/30 million shares = $20.00 per share $8.856/$20.00 = .4428 shares of BETA for each share of ACE $9.522/$20.00 = .4761 shares of BETA for each share of ACE $9.189/$20.00 = .4595 shares of BETA for each share of ACE 3. [Relative Value Concepts Using Multiples] The WestTek privately held venture is considering the sale of the venture to an outside buyer. WestTek has net sales = $21.2 million, EBITDA = $11.1 million, net income = $2.9 million, and interest-bearing debt = $12

285 million. Three publicly-traded comparable firms or competitors in the industry have the following net sales, EBITDA, net income, equity value or market capitalization (stock price times number of shares of common stock outstanding), and interest-bearing debt information:

EastTek

SouthTek

NorthTek Net sales $25,000,000 EBITDA 12,500,000 Net Income Equity Value 60,000,000 Interest-bearing

$37,500,000

$80,000,000

20,000,000 37,500,000 2,500,000 3,000,000 10,000,000 45,000,000 160,000,000 15,000,000

20,000,000 40,000,000 Debt No surplus cash is being held by WestTek or by any of the three comparable firms.

A. Calculate the enterprise value to net sales ratios for each of the three competitors (EastTek, SouthTek, and NorthTek), as well as the average ratio for the competitors.

Enterprise value = equity value + interest-bearing debt Equity value = market capitalization (i.e., stock price times shares outstanding) EastTek: ($45,000,000 + $15,000,000)/$25,000,000 = 2.40

286 SouthTek: ($60,000,000 + $20,000,000)/$37,500,000 = 2.13 NorthTek: ($160,000,000 + $40,000,000)/$80,000,000 = 2.50 Average: (2.40 + 2.13 + 2.50)/3 = 7.03/3 = 2.34 C. Calculate the enterprise value to EBITDA ratios for each of the three competitors, as well as the average ratio for the competitors.

EastTek: $60,000,000/$12,500,000 = 4.80 SouthTek: $80,000,000/$20,000,000 = 4.00 NorthTek: $200,000,000/$37,500,000 = 5.33 Average: (4.80 + 4.00 + 5.33)/3 = 14.13/3 = 4.71 C. Calculate the equity value or market “cap” to net income ratios for each of the three competitors, as well as the average ratio for the competitors.

EastTek: $45,000,000/$2,500,000 = 18.00 SouthTek: $60,000,000/$3,000,000 = 20.00 NorthTek: $160,000,000/$10,000,000 = 16.00 Average: (18.00 + 20.00 + 16.00)/3 = 54.00/3 = 18.00 D. Estimate the enterprise and equity values for WestTek using the individual net sales multiples from EastTek, SouthTek, and NorthTek, as well as for the average of the three competitors or comparable firms. Show the valuation ranges from high to low.

Enterprise Value Estimates: Using EastTek sales multiple: $21,200,000  2.40 = $50,880,000 Using SouthTek sales multiple: $21,200,000  2.13 = $45,156,000 Using NorthTek sales multiple: $21,200,000  2.50 = $53,000,000 Using average sales multiple: $21,200,000  2.34 = $49,608,000 The enterprise valuation range based on a sales multiple was from a high of $53,000,000 to a low of $45,156,000.

Equity Value Estimates: Equity value = enterprise value – interest-bearing debt Since WestTek has interest-bearing debt of $12,000,000, this amount must be subtracted from the enterprise value estimates calculated above to provide equity value estimates.

Using EastTek: $50,880,000 - $12,000,000 = $38,880,000 Using SouthTek: $45,156,000 - $12,000,000 = $33,156,000 Using NorthTek: $53,000,000 - $12,000,000 = $41,000,000

287 Using average multiple: $49,608,000 - $12,000,000 = $37,608,000 The equity valuation range based on a sales multiple was from a high of $41,000,000 to a low of $33,156,000.

E. Estimate the enterprise and equity values for WestTek using the individual EBITDA multiples from each comparable firm, as well as the average multiple for the three competitors. Show the valuation ranges from high to low.

Enterprise Value Estimates: Using EastTek EBITDA multiple: $11,100,000  4.80 = $53,280,000 Using SouthTek EBITDA multiple: $11,100,000  4.00 = $44,400,000 Using NorthTek EBITDA multiple: $11,100,000  5.33 = $59,163,000 Using average EBITDA multiple: $11,100,000  4.71 = $52,281,000 The enterprise valuation range based on an EBITDA multiple was from $59,163,000 to $44,400,000 Equity Value Estimates: Since WestTek has interest-bearing debt of $12,000,000, this amount must be subtracted from the enterprise value estimates calculated above to provide equity value estimates.

Using EastTek: $53,280,000 - $12,000,000 = $41,280,000 Using SouthTek: $44,400,000 - $12,000,000 = $32,400,000 Using NorthTek: $59,163,000 - $12,000,000 = $47,163,000 Using Average: $52,281,000 - $12,000,000 = $40,281,000 The equity valuation range based on a sales multiple was from a high of $47,163,000 to a low of $32,400,000.

F. Estimate the equity values for WestTek using the individual net income multiples from each comparable firm, as well as the average multiple for the three firms.

Equity Value Estimates: Using EastTek net income multiple: $2,900,000  18.00 = $52,200,000 Using SouthTek net income multiple: $2,900,000  20.00 = $58,000,000 Using NorthTek net income multiple: $2,900,000  16.00 = $46,400,000 Using average net income multiple: $2,900,000  18.00 = $52,200,000 The valuation range based on a net income multiple was from a high of $58,000,000 to a low of $46,400,000.

G. Establish a range of equity value estimates for WestTek based on the highest

288 and lowest overall values generated from the multiples analyses in Parts D, E, and F. Also establish a range of market value estimates for WestTek based on the highest and lowest average values from the multiples analyses in Parts D, E, and F. Part D: High = $41,000,000; Low = $33,156,000 Part E: High = $47,163,000; Low = $32,400,000 Part F: High = $58,000,000; Low = $46,400,000 Highest High = $58,000,000: Lowest Low = $32,400,000 Equity Value based on Average Sales Multiple: $37,608,000 (lowest) Equity Value based on Average EBITDA Multiple: $40,281,000 Equity Value based on Average Net Income Multiple: $52,200,000 (highest) H. From the perspective of the selling venture investors and founders, would you recommend that they negotiate for the final selling price be based on the use of top-line valuation multiples (i.e., using net sales) or bottom-line valuation multiples (i.e., using net income)?

A selling price based on bottom-line (net income) multiples will produce the highest value for the selling venture investors and founders.

4. [Venture Capital (VC) Method Valuation Concepts] Benito Gonzalez, founded and grew the BioSystems Manufacturing Corporation over a several year period. However, Benito has decided to exit BioSystems as of the end of 2019 with the intention of starting a new entrepreneurial venture. The Fuji Electronics Company is considering acquiring BioSystems which is 60 percent owned by Benito Gonzalez with the other 40 percent of the equity being held by venture investors who also desire to exit the venture. BioSystems’ sales are expected to grow from the 2019 level at a 20 percent annual compound rate over each of the next three (2020, 2021, 2022) years. Cost of goods sold, marketing, depreciation, and interest expenses are expected to move or vary with sales (i.e., they are variable expenses). General and administrative (G&A) expenses are expected to remain constant each year (i.e., are fixed expenses). The income tax rate is expected to be 35 percent.

BIOSYSTEMS MANUFACTURING CORPORATION Income Statement for 2019 ($ Thousands)

289

A.

Using the percent-of-sales relationships indicated above, prepare BioSystems’ income statements for 2022.

Note: Income statements are projected annually for 2020 and 2021 in order to provide the 2022 projections. Data are presented in Thousands of Dollars. See spreadsheet solution shown below.

Biosystems Manufacturing Corporation Income Statement for 2019 ($ Thousands) Actual 2019 Net Sales 10,000 Cost of Goods Sold 6,000 Gross Profit 4,000 Marketing Expenses G&A Expenses Depreciation Interest Income Before Taxes Taxes (35%) Net Income B.

1,000 2,000 200 100 700 245 455

Projected ---------------------------------------2020 2021 2022 12,000 14,400 17,280 7,200 8,640 10,368 4,800 5,760 6,912 1,200 2,000 240 120 1,240 434 806

1,440 2,000 288 144 1,888 661 1,227

1,728 2,000 346 173 2,666 933 1,733

Fuji Electronics has examined other recent acquisitions in BioSystems’ industry and believes that a 17 times price-earnings multiple would be appropriate for determining BioSystems value in the future. Calculate the value of BioSystems as of the end of 2022.

P/E Multiple for 2022: 17 Firm value at end of 2022: $1,733 net income times 17 = $29,461

C.

How much should Fuji Electronics be willing to pay for BioSystems Manufacturing at the end of 2019 if Fuji’s management believes the appropriate discount rate is 25 percent?

290

Discount rate: 25% Firm value at end of 2022: $29,461 Present Value of Firm: $29,461/(1.25)^3 = $29,461/1.953125 = $15,084 D.

What is Gonzalez’s portion of the exit proceeds? What is the venture investors’ portion of the exit proceeds?

Benito‘s percentage portion: 60% Venture investors‘ percentage portion: 40% 2022 Exit Proceeds: Gonzalez‘s portion of exit proceeds: $29,461  .60 = $17,677 Venture investors‘ portion of exit proceeds: $29,461  .40 = $11,784 Present Value of Exit Proceeds: Gonzalez‘s portion of exit proceeds: $15,084  .60 = $9,050 Venture investors‘ portion of exit proceeds: $15,084  .40 = $6,034

E.

Benito Gonzalez invested $50,000 of his own funds in BioSystems at the end of 2014. What would be the compound rate of return on his investment when the exit (sale to Fuji Electronics) from BioSystems occurs at the end of 2019?

Initial investment at end of 2014: $50,000 Exit proceeds at end of 2019: $9,050,000 Holding period: 5 years Using a financial calculation: PV = 50,000; FV = 9,050,000; N = 5; solving for %i = 182.84% compound annual rate of return

F.

The venture investors contributed $500,000 at the end of 2015. What would be their compound rate of return on their investment if BioSystems is sold at the end of 2019?

Initial investment at end of 2015: $500,000 Exit proceeds at end of 2019: $6,034,000 Holding period: 4 years Using a financial calculation: PV = 500,000; FV = 6,034,000; N = 4; solving for %i = 86.38% compound annual rate of return

5. [Terminal or Horizon Period Valuation Concepts] The Gamma Systems Manufacturing Corporation has reached its maturity stage and its net sales are expected to grow at a 6 percent compound rate for the foreseeable future. Management believes that as a mature venture the appropriate equity discount rate for Gamma Systems is 18 percent.

291

A.

Estimate the free cash flows available to the equity investors for 2020.

The following spreadsheet assumes that most accounts are a constant percent of sales (starting in 2020). We have balanced the balance sheets by raising the dividends (the Maximum Dividend Method) until the cash reaches its specified percent of sales (for required cash). All surplus cash has been paid out as a dividend. We provide 2021 as a stepping stone or ―check‖ year to convince the reader that the cash flows, etc. are growing at the assumed terminal growth rate (of 6%).

292

293 GAMMA SYSTEMS MANUFACTURING CORPORATION [Chapter 15, Problems 5-7] Problem 5: Balance Sheets 2018 2019

2020

2021 Check Year 42,400 44,944 275,600 292,136 530,000 561,800 848,000 898,880 530,000 561,800 1,378,000 1,460,680

Cash Accounts Receivables Inventories Total Current Assets Fixed Assets, Net Total Assets

50,000 200,000 450,000 700,000 400,000 1,100,000

40,000 260,000 500,000 800,000 500,000 1,300,000

Accounts Payable Accruals Bank Loan Total Current Liabilities Long-Term Debt Common Stock ($10 par) Capital Surplus Retained Earnings Total Liab. & Equity

130,000 130,000 50,000 90,000 270,000 300,000 300,000 50,000 180,000 1,100,000

170,000 $170,000 180,200 70,000 74,200 90,000 95,400 330,000 349,800 400,000 424,000 300,000 300,000 50,000 50,000 220,000 254,200 1,300,000 1,378,000

2018 Net Sales Cost of Goods Sold Gross Profit Marketing General & Administrative Depreciation EBIT Interest Earnings Before Taxes Income Taxes (40%) Net Income Dividends Retained Earnings Growth Rate Discount Rate

191,012 78,652 101,124 370,788 449,440 300,000 50,000 290,452 1,460,680

2019

2020

2021

1,400,000 1,600,000 780,000 900,000 620,000 700,000 130,000 150,000 150,000 150,000 40,000 0 40,00053,00053,000 300,000 347,000 45,000 57,000 255,000 290,000 102,000 116,000 153,000 174,000 134,000 40,000 Sales g =

1,696,000 954,000 742,000 159,000 159,000 56,180 367,820 60,420 307,400 122,960 184,440 150,240 34,200 6.00%

1,797,760 1,011,240 786,520 168,540 168,540 59,551 389,889 64,045 325,844 130,338 195,506 159,254 36,252 6.00%

6% 18%

294 A)

Statement of Cash Flows Approach Operating: Net Income +Depreciation -Inc. in Accts. Receivable -Inc. in Inventories +Inc. in Accts. Payable +Inc. in Accruals

184,440 56,180 -15,600 -30,000 10,200 4,200

CF from Operations Investing: -Inc. in Fixed Assets Financing: +Increase in Bank Loans +Increase in Long-Term Debt

209,420

Change in Cash Balance Before Dividends Dividends Change in Balance Sheet Cash Account

152,640 -150,240 2,400

-86,180 5,400 24,000

FCF (from Statement of Cash Flows)

150,240 (Same as Dividends here)

Shortcut Method: NI +Depr -Capex -Change NWC +Debt Proc FCF (from shortcut method) Value (End of 2019)

B.

2020

184,440 56,180 -86,180 -28,200 24,000 150,240 $ 1,252,000

Estimate the value of Gamma Systems equity at the end of 2019 by applying the terminal value perpetuity equation that was presented in Chapter 10.

Value at end of 2019 = 150,240/(.18  .06) = $1,252,000

C.

By applying the terminal value equation at the end of 2019, what are we assuming about the future?

295 That the VCF will growth smoothly at 6% for the remainder of eternity and that the required return will remain constant at 18%.

6. [Valuation Sensitivities to Changes in Growth Rates and Discount Rates] Assume that some of the information relating to the Gamma Systems Manufacturing Corporation has changed.

Using the financial statement data in Problem 5, answer the following questions.

A. How would your valuation estimate change if the sales growth rate had been 6 percent but the discount rate had been 20 percent?

Value = 150,240/(.20  .06) = $1,073,143.

B.

How would your valuation estimate change if the sales growth rate had been 5 percent and the discount rate 18 percent?

To use a 5% terminal growth rate, we must construct a new stepping stone or ―check‖ year. The remainder is analogous to the solution to Problem 5 above.

Rather than calculate FCF/VCF as before, since we are using the MDM, can just pull the 2020 dividend level as the starting point for the perpetuity valuation. Value = 154,200/(.18  .05) = 1,186,154.

we

See spreadsheet solution below.

C. How would your valuation estimate change if the perpetuity growth rate had been 7 percent and the discount rate 20 percent?

Value = 146,280/(.20  .07) = $1,125,231.

See spreadsheet solution below.

296

297 GAMMA SYSTEMS MANUFACTURING CORPORATION Problem 6: A) $ 1,073,143 [Based on growth rate = 6.00% and discount rate = 20%]

B)

Balance Sheets

2018

Cash Accounts Receivables Inventories Total Current Assets Fixed Assets, Net Total Assets

2021 Check Year 50,000 40,000 42,000 44,100 200,000 260,000 273,000 286,650 450,000 500,000 525,000 551,250 700,000 800,000 840,000 882,000 400,000 500,000 525,000 551,250 1,100,000 1,300,000 1,365,000 1,433,250

Accounts Payable Accruals Bank Loan Total Current Liabilities Long-Term Debt Common Stock ($10 par) Capital Surplus Retained Earnings Total Liab. & Equity

130,000 170,000 178,500 50,000 70,000 73,500 90,000 90,000 94,500 270,000 330,000 346,500 300,000 400,000 420,000 300,000 300,000 300,000 50,000 50,000 50,000 180,000 220,000 248,500 1,100,000 1,300,000 1,365,000

2018 Net Sales Cost of Goods Sold Gross Profit Marketing General & Administrative Depreciation EBIT Interest Earnings Before Taxes Income Taxes (40%) Net Income Dividends Retained Earnings Growth Rate Discount Rate Value (End of 2019)

5% 18%

1,186,154

2019

2019

2020

187,425 77,175 99,225 363,825 441,000 300,000 50,000 278,425 1,433,250

2020

2021

1,400,000 1,600,000 1,680,000 780,000 900,000 945,000 620,000 700,000 735,000 130,000 150,000 157,500 150,000 150,000 157,500 40,000 53,000 55,650 300,000 347,000 364,350 45,000 57,000 59,850 255,000 290,000 304,500 102,000 116,000 121,800 153,000 174,000 182,700 134,000 154,200 40,000 28,500 Sales g = 5.00%

1,764,000 992,250 771,750 165,375 165,375 58,433 382,568 62,843 319,725 127,890 191,835 161,910 29,925 5.00%

298

GAMMA SYSTEMS MANUFACTURING CORPORATION C)

Balance Sheets

2021 Check Year 50,000 40,000 42,800 45,796 200,000 260,000 278,200 297,674 450,000 500,000 535,000 572,450 700,000 800,000 856,000 915,920 400,000 500,000 535,000 572,450 1,100,000 1,300,000 1,391,000 1,488,370 0 130,000 170,000 181,900 194,633 50,000 70,000 74,900 80,143 90,000 90,000 96,300 103,041 270,000 330,000 353,100 377,817 300,000 400,000 428,000 457,960 300,000 300,000 300,000 300,000 50,000 50,000 50,000 50,000 180,000 220,000 259,900 302,593 1,100,000 1,300,000 1,391,000 1,488,370

Cash Accounts Receivables Inventories Total Current Assets Fixed Assets, Net Total Assets Accounts Payable Accruals Bank Loan Total Current Liabilities Long-Term Debt Common Stock ($10 par) Capital Surplus Retained Earnings Total Liab. & Equity

Net Sales Cost of Goods Sold Gross Profit Marketing General & Administrative Depreciation EBIT Interest Earnings Before Taxes Income Taxes (40%) Net Income Dividends Retained Earnings Growth Rate Discount Rate Value

7% 20%

1,125,231

2018

2019

2020

2018

2019

2020

2021

1,400,000 1,600,000 1,712,000 780,000 900,000 963,000 620,000 700,000 749,000 130,000 150,000 160,500 150,000 150,000 160,500 40,000 53,000 56,710 300,000 347,000 371,290 45,000 57,000 60,990 255,000 290,000 310,300 102,000 116,000 124,120 153,000 174,000 186,180 134,000 146,280 40,000 39,900 g= 7.00%

1,831,840 1,030,410 801,430 171,735 171,735 60,680 397,280 65,259 332,021 132,808 199,213 156,520 42,693 7.00%

299

7. [Valuation Impact of Changes in Forecast Period Growth Rates] New information for the Gamma Systems Manufacturing Corporation has been brought to the management’s attention. Use the financial statement information in Problem 5 and take into consideration that sales will grow at a 15 percent rate in 2020 and a 10 percent rate in 2021 before settling down to a 6 percent perpetuity growth rate.

A. Estimate the free cash flows available to equity investors for 2020, 2021, and 2022.

Free cash flow is the same as ―dividends‖ in the MDM used in the spreadsheet below.

B. Estimate the terminal value of all future cash flows at the end of 2021.

See spreadsheet below. The discount rate is 18% for all periods and the terminal growth rate is 6%.

C. Estimate of the value of Gamma Systems at the end of 2019 under these assumptions.

See spreadsheet solution below.

300 GAMMA SYSTEMS MANUFACTURING CORPORATION Problem 7: Balance Sheets 2018 2019 2020 Cash Accounts Receivables Inventories Total Current Assets Fixed Assets, Net Total Assets

50,000 200,000 450,000 700,000 400,000 1,100,000

40,000 260,000 500,000 800,000 500,000 1,300,000

46,000 299,000 575,000 920,000 575,000 1,495,000

50,600 328,900 632,500 1,012,000 632,500 1,644,500

Accounts Payable Accruals Bank Loan Total Current Liabilities Long-Term Debt Common Stock ($10 par) Capital Surplus Retained Earnings Total Liab. & Equity

130,000 50,000 90,000 270,000 300,000 300,000 50,000 180,000 1,100,000

170,000 70,000 90,000 330,000 400,000 300,000 50,000 220,000 1,300,000

195,500 80,500 103,500 379,500 460,000 300,000 50,000 305,500 1,495,000

215,050 88,550 113,850 417,450 506,000 300,000 50,000 371,050 1,644,500

2023 Check Year 53,636 56,854 348,634 369,552 670,450 710,677 1,072,720 1,137,083 670,450 710,677 1,743,170 1,847,760 0 0 227,953 241,630 93,863 99,495 120,681 127,922 442,497 469,047 536,360 568,542 300,000 300,000 50,000 50,000 414,313 460,172 1,743,170 1,847,760

2018

2019

1,400,000 780,000 620,000 130,000 150,000 40,000 300,000 45,000 255,000 102,000 153,000

1,600,000 900,000 700,000 150,000 150,000 53,000 347,000 57,000 290,000 116,000 174,000 134,000 40,000

2020 g=15% 1,840,000 1,035,000 805,000 172,500 172,500 60,950 399,050 65,550 333,500 133,400 200,100 114,600 85,500 g=

2021 g=10% 2,024,000 1,138,500 885,500 189,750 189,750 67,045 438,955 72,105 366,850 146,740 220,110 154,560 65,550 34.87%

2022 g=6% 2,145,440 1,206,810 938,630 201,135 201,135 71,068 465,292 76,431 388,861 155,544 233,317 190,054 43,263 22.96%

114,600

1,583,780 1,738,340

Sales g =

Net Sales Cost of Goods Sold Gross Profit Marketing General & Administrative Depreciation EBIT Interest Earnings Before Taxes Income Taxes (40%) Net Income Dividends Retained Earnings Dividend growth 2021 Terminal Value VCF 2019 NPV

1,345,567

2021

2022

2023 g=6% 2,274,166 1,279,219 994,948 213,203 213,203 75,332 493,210 81,017 412,193 164,877 247,316 201,457 45,859 6.00%

301 MINI CASE: MINIDISCS CORPORATION Brian Motley founded the MiniDiscs Corporation at the end of 2014. After nearly one year of development, the venture produced an optical storage disk about the size of a silver dollar that could store more than 500 megabytes of data along with a mechanism allowing the device to be integrated into a variety of portable consumer electronic devices including ebooks, music discs, and video games.

In addition to Brian Motley‘s role as the venture‘s CEO, Susan Sharpe, with 6 years of prior financial management experience at two high technology ventures, was hired as the CFO. The Vice-President of Marketing was Steven Davis and the Vice-President of Operations was Sanjay Chavarti. Before being hired by MiniDiscs, Davis had 12 years of marketing experience in the technology area. Chavarti worked in high tech operations for eight years before pursuing the opportunity with MiniDiscs.

Leading electronic manufacturers were anxious to incorporate the minidisk in their products.

Brian Motley obtained $7 million financing at the end of 2015 from venture investors in exchange for 43 percent of the stock in the venture. After this round of venture financing, Brian retained 50 percent ownership in MiniDiscs and the other three members of the management team (Sharpe, Davis, and Chavarti) owned 7 percent of the venture.

Over a four-year period (2016-2019), MiniDiscs moved quickly through its startup and survival stages and is now in the midst of its rapid growth stage. Brian Motley has recently decided to harvest his investment by selling the firm. However, the other three members of the management team want to continue on and proposed a leveraged buyout to Brian Motley.

An external valuation firm estimated that $45 million represented a fair price for all of the equity in the MiniDiscs Corporation.

An abbreviated balance sheet in thousands of dollars for yearend 2019 follows:

It is the beginning of 2020, and the management team has $5 million of their own capital, including their share of the sales price, available to purchase all of the venture‘s existing equity capital. The intent is to retire all of the old stock and issue 2 million shares of common stock in the ―new‖ venture to the management team. LBO financiers will put up $20 million in 8 percent, 5-year subordinated debt funds plus 1.9 million warrants that can be converted into 1.9 million shares of common stock. A bank will also offer a $10 million, 14 percent interest rate, 4-year fully amortized loan. To make the deal work, Brian Motley was asked to provide seller financing in the form of a below market 10 percent, 5-year, seller‘s note. The amount of the note was to be for the difference between the $45 million selling price and the amount of funds raised from management, the LBO financiers, and the bank.

In exchange for the seller financing by Brian Motley, the existing venture capitalists agreed to reduce their ownership rights from 43 percent to 40 percent. The management team also lowered their claim on the existing venture from 7 percent to 5 percent. Thus, as the result of agreeing to provide seller financing, Brian‘s percentage ownership of the $45 million selling price was 55 percent. Brian estimated that the interest rate being paid on similar risk subordinated seller loans was currently at 16 percent.

302

A. What will be the dollar amount of seller financing that Brian Motley will need to provide to complete the financing of the $45 million selling price?

Management team = $5 million LBO financiers = $20 million Bank loan =

$10 million Brian Motley =

$10 million

Total =

$45 million B. How much cash will be available to distribute to the existing owners of the MiniDiscs Corporation? What will be the dollar breakdown for Brian Motley, the management team, and the venture capitalists?

303

Original Percent Equity Owners

Exit Percent

Ownership Ownership Brian Motley

50%

55% Management Team Venture Investors

7 43 100%

5 40 100%

If Brian Motley provides $10 million seller financing, at the time of exit ownership percentages would result in the following dollar breakdown: Brian Motley: .55  $45 million = $24.75 million Management team: .05  $45 million = $2.25 million Venture capitalists: 0  $45 million = $18.00 million $45.00 million C. What compound rate of return did Motley earn on his $1 million end of 2014 investment?

The $1million original investment bought only 50% of the 2019 equity value. The additional $10 million below-market loan (negative NPV loan) was the consideration for the additional 5% to bring Motley’s total ownership to 55%. For the original $1 million, 50% of the final $45 million is $22.5 million. If we turn $1 million into $22.5 million in 5

304 years, the formula for the rate of return is (22.5/1)1/5 - 1 = 86.4%. Verifying, 1*(1+.864)5= 22.5.

Or, using a financial calculator: PV= 1,000,000; FV = 22,500,000; N = 5; solving for %i = 86.4%.

While the annual compound rate of return on his original $1 million investment exceeds 86%, Brian Motley has agreed to an expected 10% annual return on his $10 million seller financing note over the next five years. The overall return including the additional 5% purchased by this below-market (negative NPV) loan would be more complicated and its calculation would require valuing the loan.

D. What compound rate of return did the venture capitalists earn on their $7 million investment at the end of 2015?

The $7 million VC investment at the end of 2015 turned into an $18 million share of the exit value at the end of 2019. Thus: (18/7)^(1/4)-1 = 26.63% Or, using a financial calculator: PV= 7,000,000; FV = 18,000,000; N = 4; solving for %i = 26.63% E. After five years of operating as a private venture owing to the LBO, assume that the common equity in the MiniDiscs Corporation could be sold for $60 million at the end of 2024. What compound rate of return would the management team earn on its $5 million investment?

The VCs were given warrants to purchase 1.9 million shares of stock. Thus, at exit there would be 3.9 million total shares of common stock outstanding.

The management team‘s ownership stake at the $60 million exit (from the LBO) is (2 million shares) / (3.9 million shares outstanding) = 51.28%.

5*(1+r)^5=.5128*60 implies that r = 43.82% Using a financial calculator: PV = 5,000,000; FV = 30,768,000 (i.e., .5128 x $60,000,000); N = 5; solving for %i = 43.82% F. Assume that when MiniDiscs is sold at the end of 2024 for $60 million that the LBO financiers will have their debt retired and will sell their share of interest in the venture.

What compound rate of return would the LBO financiers receive?

As the exercise price of the warrants is not specified, we will provide two possible scenarios:

305 1)

The warrants are exercised by surrendering the VC‘s claim to the principal on the subordinated debt it holds. This structure is like assuming the bond plus the warrants is a convertible bond. The return in that scenario does not involve the return of the $20,000,000 principal. The related IRR equation is: -20,000,000 + 1,600,000/(1+irr) + 1,600,000/(1+irr)^2 + 1,600,000/(1+irr)^3 + 1,600,000/(1+irr)^4 + 1,600,000/(1+irr)^5 + .4872*60,000,000/(1+irr)^5 = 0 This results in a compound rate of return for the VCs of: irr = 14.86%.

Using a financial calculator: PV = 20,000,000; FV = 29,232,000; PMT or payment = 1,600,000; N = 5; solving for %i = 14.86%.

Of course, this is not a very good overall rate of return. Consequently, if the VCs actually thought the final exit value wouldn‘t include the $20,000,000 return of principal on the bond, they would have negotiated for a much larger portion of the equity in the firm.

2) The warrants have some trivial (close to zero) exercise price that is negligible for the purpose of the analysis (as was the assumption in the example solution presented in Section 15.5 of the textbook) and the $20,000,000 in bond principal is repaid.

-20,000,000 + 1,600,000/(1+irr) + 1,600,000/(1+irr)^2 + 1,600,000/(1+irr)^3 + 1,600,000/(1+irr)^4 + 1,600,000/(1+irr)^5 + 20,000,000/(1+irr)^5 + .4872*60,000,000/(1+irr)^5 = 0 This results in a compound rate of return for the VCs of: irr = 25.60%, a more reasonable return for this type of financing.

Using a financial calculator: PV = 20,000,000; FV = 49,232,000; PMT or payment = 1,600,000; N = 5; solving for %i = 25.60%.

Chapter 16 FINANCIALLY TROUBLED VENTURES: TURNAROUND OPPORTUNITIES? FOCUS We direct attention in this chapter toward recognizing and managing financial distress. An inability to pay creditor obligations as they come due typically poses a major financial threat and

306 certainly distracts the venture from its primary mission. A successful entrepreneur copes with such financial distress and finds a way to turn the situation around. The alternative to a successful turnaround is venture liquidation.

LEARNING OBJECTIVES LO 16.1: Identify possible options available to struggling or troubled ventures.

LO 16.2: Define financial distress and explain how balance sheet insolvency and cash flow insolvency differ.

LO 16.3: Describe how troubled ventures might emerge from financial distress.

LO 16.4: Explain how private reorganizations and liquidations take place.

LO 16.5: Describe reorganization under Chapter 11 and liquidation under Chapter 7 of the U.S. bankruptcy laws.

CHAPTER OUTLINE 16.1VENTURE OPERATING AND FINANCING OVERVIEW 16.2 THE TROUBLED VENTURE AND FINANCIAL DISTRESS A. Balance Sheet Insolvency B. Cash Flow Insolvency C. Temporary Versus Permanent Cash Flow Problems 16.3 RESOLVING FINANCIAL DISTRESS SITUATIONS D. Operations Restructuring E. Asset Restructuring F. Financial Restructuring 16.4 PRIVATE WORKOUTS AND LIQUIDATIONS A. Private Workouts B. Private Liquidations C. Venture Example: Jeremy‘s Microbatch Ice Creams, Inc. 16.5 FEDERAL BANKRUPTCY LAW A. Bankruptcy Reorganizations B. Reasons for Legal Reorganizations C. Legal Reorganization Process D. Bankruptcy Liquidations SUMMARY

DISCUSSION QUESTIONS AND ANSWERS 1. What are the three types or methods of restructuring available when trying to turn around financially troubled ventures?

The three basic types/methods are: (a) operations restructuring, (b) asset restructuring, and (c) financial restructuring 2. Identify major factors that cause ventures to get into financial trouble.

307

Ventures get into trouble by mishandling strategic issues, failing to unite management on key initiatives, and having poor finance and accounting practices and controls. Since we are primarily examining entrepreneurial finance, we concentrate on the finance and accounting origins of vent5ure troubles, including overextension of credit, excessive use of financial leverage (borrowed funds), and lack of adequate cash planning and financial forecasting.

Factors that cause ventures to get into financial trouble are very similar to those that bring about venture failure. The U.S. Business Administration found that two-thirds of business failures are due to either economic factors (inadequate sales, insufficient profits, etc.) or financial factors (excessive debt, insufficient financial capital, etc.).

3. What is meant by financial distress?

Financial distress refers to when cash flow is insufficient to meet current debt obligations.

4. What is meant by loan default? Also, describe (a) an acceleration provision and (b) a crossdefault provision.

A loan default is when there is a failure to meet interest or principal payments when due on the loan. (a) An acceleration provision makes all future obligations of the loan due immediately upon default, and (b) a cross-default provision provides that if one loan defaults, it places all loans of the firm in default. (A ―technical default‖ typically refers to the violation of a loan covenant other than a failure to make a payment that is due.)

5. What is foreclosure?

Foreclosure is a legal process used by creditors to try to collect amounts owed on loans in default.

If there is reason to believe that the financial distress situation is temporary, it may be in the best interests of owners and creditors to move quickly to initiate negotiations with the creditors to try to restructure the venture and avoid foreclosure. As discussed later in the chapter, these negotiations can be handled informally (privately) or formally (legally) under the U.S. Bankruptcy Code.

6. What do we mean when we say a venture is insolvent?

An insolvent venture is one where equity is negative and/or the cash flow of the firm is unable to meet debt obligations.

7. Compare and contrast (a) balance sheet insolvency and (b) cash flow insolvency.

Balance sheet insolvency is when the firm has negative equity (or the debt is greater than the assets) and is usually attributable to multiple years of operating losses. Cash flow insolvency is when a venture‘s cash flow is insufficient to meet its current contractual debt obligations.

308

8. Use the concept of cash flow insolvency over time and describe what would happen if the problem is temporary rather than permanent.

Continued cash flow insolvency over time relates to a sustained inability for cash flow to meet debt obligations. A temporary insolvency is transient in the sense that nearby future cash flows, sufficient to meet debt obligations, are expected (and arrive). See Figure 16.1 for a graphical depiction of the two.

9. What are some of the basic requirements of a successful turnaround plan?

A successful turnaround plan should provide immediate remedial actions (once serious financial problems are recognized) and detail the financial ramifications expected given the remedial actions.

Often the immediate goal of a turnaround plan is raising survival cash quickly and beginning to restore creditor confidence. Components of the plan may involve employee unpaid leaves or layoffs, the sale of receivables at deep discounts, and the liquidation of finished goods inventories. The turnaround plan needs to explain credibly how both short-term survival and long-term financial health will result for such actions.

10. Define operations restructuring and describe how it can be implemented to escape financial distress.

Operations restructuring is either growing the firm‘s revenues relative to cost or cutting the firms costs relative to revenue. See Figure 16.2 for this and other ways to address financial distress.

11.

Define asset restructuring and describe how it can be implemented to escape from financial distress.

Asset restructuring involves either selling off assets and/or improving the firm‘s working capital. See Figure 16.2 for this and other ways to address financial distress.

12.

Define financial restructuring and describe what is meant by debt payments extension and debt composition change.

Financial restructuring involves changing the contractual terms or composition of the firm‘s debt obligations to help the firm meet those obligations. Debt payment extension is allowing the firm to pay their interest or principal payments at a later date. Debt composition change is when the creditor reduces its claim (typically interest or principal) against the firm.

See Figure 16.2 for the use of financial restructuring and other ways to address financial distress.

309 13.

What is a private workout? Also, describe some of the characteristics of ventures that are likely to engage in private workouts.

A private workout is a voluntary restructuring of the firm in lieu of declaring bankruptcy.

Ventures engaging in private workouts typically have few creditors and/or are early stage ventures. They also rarely have public bonds outstanding.

14.

What is a private liquidation? What does the process of assignment mean?

A private liquidation is selling the pieces of a venture. The process of assignment is the distribution of assets to a third party to liquidate them and distribute the proceeds to the creditors.

15.

What is Chapter 11 bankruptcy and how is it used by ventures?

Chapter 11 bankruptcy is an attempt by the firm to receive protection from creditors as it tries to reorganize itself.

16.

Describe a venture bankruptcy. Also, indicate the difference between (a) a voluntary bankruptcy petition and (b) an involuntary bankruptcy petition.

A venture is bankrupt when a petition for bankruptcy is filed with a federal court. Voluntary bankruptcy is a petition filed by the venture‘s management. An involuntary bankruptcy is one where the petition is filed by the venture‘s creditors.

17.

Briefly describe the common pool and holdout problems that often make it necessary for a venture to enter into a court-supervised reorganization.

A common pool problem exists because individual creditors have an incentive to foreclose on the venture even though it is worth more as a going concern. The holdout problem exists when one or more of the creditors refuse to agree to the reorganization terms because of the potential for a larger individual recovery.

18.

Briefly define the following terms: cram down procedure, debtor-in-possession financing, and prepackaged bankruptcy.

A cram down procedure is when a bankruptcy court accepts a reorganization plan for all creditors including dissenting creditor classes. Debtor-in-possession financing is short-term financing to help meet liquidity needs during the reorganization process. A prepackaged bankruptcy is an initial private attempt to convince a majority of the creditors to go along with a reorganization plan that will be proposed after the venture files under Chapter 11.

19.

Describe the absolute priority rule.

The absolute priority rule is a hierarchal chain of priority when a firm files for bankruptcy starting with senior creditors and ending with the existing common stockholders.

310

20.

What is the purpose of Chapter 7 of the U.S. Bankruptcy Code? What are some of the characteristics of ventures that use Chapter 7 instead of private liquidation?

The purpose of Chapter 7 is quickly to shut down the operations of a venture and start to liquidate the firm. Firms that use Chapter 7 are firms that do not see feasible operations in the future for their company, and using Chapter 7 allows the owners to remove themselves from the bankruptcy process.

21.

From the Headlines – Necton: Describe the business model turnaround Necton undertook.

Comment on what you think would have been the challenges and your perceptions about the likelihood the new business model will succeed.

Answers will vary: While the market for Necton‘s products appears promising, the number of producers distributing their gourmet salts worldwide is increasing rapidly. Then number of consumers willing to pay $20 a pound for salt products may also be limited. Nonetheless, the business model may succeed. At the time we went to press, Necton products were listed on Amazon, along with many other gourmet salt products.

INERNET ACTIVITIES 1. Go to the Web site for Wall Street Journal or some other financial publication such as Inc. magazine and identify a venture that has recently filed for reorganization or liquidation with the U.S. bankruptcy courts. Then, access the Securities and Exchange Commission’s Web site at http://www.sec.gov/edgar/searchedgar/webusers.htm and find recent financial statements for the venture you identified as being in financial distress. By way of a hint, you will probably want to access the most recent Form 10Q which provides quarterly information. Determine whether the venture was suffering from balance sheet insolvency, cash flow insolvency, or both. Explain the bases for your insolvency assessments.

Web-research results will vary due to constant updated of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS 1. [Balance Sheet Restructuring Concepts] It was shown earlier in the chapter that Northland Industries was suffering from balance sheet insolvency. Two scenarios are possible for Northland in year 3. In scenario 1, year 3 for Northland is expected to result in an additional $150,000 operating loss. On the other hand, scenario 2 is expected to be a ―breakout‖ year for Northland where higher sales and lower costs due to economies of scale are forecasted to produce operating profits of $250,000 in year 3. Total assets are expected to remain at $200,000 under either scenario. Total debt will be increased to finance additional operating losses. On the other hand, operating profits will be used to reduce total debt.

311 A. Show Northland’s basic balance sheets under both scenarios.

YEAR 3

Current Assets Fixed Assets Total Assets Total Debt Equity: Common Stock Retained Earnings Total Equity Total Debt & Equity

Year 0 Year 1 Year 2 Scenario 1 Scenario 2 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 200,000 200,000 200,000 200,000 200,000 $0

$100,000

$250,000

200,000 200,000 200,000 0 -100,000 -250,000 200,000 100,000 -50,000 $200,000 $200,000 $200,000

$400,000

$0

200,000 200,000 -400,000 0 -200,000 200,000 $200,000 $200,000

B. Based on your analysis, will Northland Industries still be balance sheet insolvent in year 3 under scenario 1? If this trend continues, would you describe Northland’s financial distress as a temporary or permanent problem?

Northland is balance sheet insolvent in Scenario 1. If this continues, it would be a permanent problem.

C. Based on your analysis, will Northland Industries still be balance sheet insolvent in year 3 under scenario 2? If this trend continues, would you describe Northland’s financial distress as a temporary or permanent problem?

Northland is projected to be balance sheet solvent (positive equity) in Scenario 2. If this projection is accurate, the insolvency is only a temporary problem.

2. [Cash Flow Restructuring Concepts] It was shown earlier in the chapter that Westland Industries was suffering from cash flow insolvency in terms of its earnings before interest, taxes, and depreciation (EBITDA). Two scenarios are possible for Westland in year 3.

Scenario 1 suggests that the results from operations for year 2 are expected to be repeated in year 3 and thereafter. In scenario 2, Westland is expected to have a breakout year in terms of sales of $400,000 and operating expenses prior to depreciation being 60 percent of sales.

Interest is expected to remain at $40,000 because of the need to finance the venture’s growth.

Prepare the basic income statements (from sales to EBIT) under both scenarios. Comment on your findings.

YEAR 3

Sales -Operating Expenses EBITDA -Interest EBIT

Year 0 50,000 -50,000 0 0 0

Year 1 100,000 -75,000 25,000 -20,000 5,000

Year 2 100,000 -75,000 25,000 -40,000 -15,000

Scenario 1 Scenario 2 100,000 400,000 -75,000 -240,000 25,000 260,000 -40,000 -40,000 -15,000 220,000

312 If scenario 1 occurs, the cash flow insolvency will continue. Under scenario 2, the venture moves into substantial cash flow solvency position.

3. [Cash Flow Restructuring Concepts] It was shown earlier in the chapter that Eastland Industries was suffering from cash flow insolvency. Let’s assume that scenario 1 projects that year 3 and following years will be like the results incurred for year 2 where profitability is low and continued large investments in net working capital is required. In contrast, an optimistic scenario for Eastland Industries for year 3 suggests that a sales breakout year will lead to operating efficiencies will lead to net income projections of $100,000. Improved management of working capital also will result in a net working capital increase of only $30,000. Estimate the net cash build or burn after a $50,000 debt repayment under both scenarios. Comment on your findings.

YEAR 3

Net Income +Depreciation -Increase in NWC -Increase in GFA +Equity/Debt Issues -Debt Repayment Net Cash Build/Burn

Year 0 0 0 -100,000 -100,000 200,000 0 0

Year 1 -70,000 20,000 -50,000 0 100,000 0 0

Year 2 20,000 20,000 -70,000 0 0 -50,000 -80,000

Scenario 1 Scenario 2 20,000 100,000 20,000 20,000 -70,000 -30,000 0 0 0 0 -50,000 -50,000 -80,000 40,000

If scenario 1 occurs, the cash flow insolvency will continue. Under scenario 2, the venture moves into substantial cash flow solvency position.

4. [Turnaround Opportunity: Restructuring Issues] Following are the financial statements for the Chenhai Manufacturing Corporation for 2018 and 2019. The venture is in financial distress and hopes to turn around its financial performance in the near future.

313

A. Calculate the sale-to-cash conversion period for Chenhai in both 2018 and 2019.

Refer to Chapter 6 for calculating the cash conversion cycle and its three components. Note: use “yearend” balance sheet data instead of averages so that 2018 and 2019 can be compared. Note: the sale-to-cash conversion period also is referred to as the days sales outstanding (DSO) or the average collection period.

2018 sale-to-cash conversion period = $200,000/($1,400,000/365) = $200,000/$3,835.62 = 52.14 days 2019 sale-to-cash conversion period = $250,000/($1,000,000/365) = $250,000/$2,739.73 = 91.25 days

314 B. Calculate the inventory-to-sale conversion period for Chenhai in both 2018 and 2019.

Note: the inventory-to-sale conversion period also is referred to as the inventory conversion period (ICP).

2018 inventory-to-sale conversion period = $450,000/($780,000/365) = $450,000/$2,136.99 = 210.58 days 2019 inventory-to-sale conversion period = $490,000/($700,000/365) = $490,000/$1,917.81 = 255.50 days C. Calculate the purchase-to-payment conversion period for Chenhai in both 2018 and 2019. Also determine the length of the cash conversion cycle for both 2018 and 2019.

The purchase-to-payment conversion period is the third component in the cash conversion cycle.

2018 purchase-to-payment conversion period = ($130,000 + $50,000)/($780,000/365) = $180,000/$2,136.99 = 84.23 days 2019 purchase-to-payment conversion period = ($170,000 + $70,000)/($700,000/365) = $240,000/$1,917.81 = 125.14 days 2018 cash conversion cycle (CCC) = 210.58 days + 52.14 days – 84.23 days = 178.49 days 2019 cash conversion cycle (CCC) = 255.50 days + 91.25 days – 125.14 days = 221.61 days D. What type of working capital restructuring might Chenhai undertake to turn around its financial performance? What other type of asset restructuring might Chenhai consider undertaking?

The CCC has increased from 178.49 days to 221.61 days. An effort should be made to reduce the inventory-to-sale conversion period as well as the sale-tocash conversion period. At the same time, Chenhai must be careful not to alienate suppliers and those who provide accruals since the purchase-topayment conversion period also was increased sharply between 2018 and 2019.

Chenhai might also considering selling any non-core fixed assets.

E. What type(s) of operations restructuring might Chenhai attempt during 2020?

Cost of goods sold increased from 55.7% ($780,000/$1,400,000) in 2018 to 70.0% in 2019 ($700,000/$1,000,000). Better control of the cost of production is needed. Marketing expenses increased (from $130,000 to $150,000) as sales decreased between 2018 and 2019. An improved link between marketing

315 expenses and sales needs to be developed. General and administrative expenses remained fixed at $150,000 even though sales declined. Sales levels need to be improved relative to G&A or G&A expenses must be reduced.

F. What type(s) of financial restructuring might Chenhai attempt during 2020?

Chenhai might attempt to reduce the amount of long-term debt that is outstanding through debt-forgiveness. The firm might also attempt to get maturity extensions on its long-term debt and/or negotiate a lower interest rate on the debt. Similar negotiations with the provider of the bank loan could be attempted.

G. What prevailing conditions (economic, competitive, etc.) might cause you to believe that Chenhai’s situation may be a turnaround opportunity versus a permanent problem?

Of major concern is the decline in sales from $1,400,000 to $1,000,000. If the decline is due to a general decline in economic activity (and industry competitors have suffered similarly), the financial distress may only be temporary. However, if the sales decline is due to loss of market share to competitors, Chenhai may find itself unable to overcome such a competitive disadvantage and the financial distress might become permanent.

5. [Financial Restructuring Issues] EnCal is a small West Coast-based power company specializing in power generation methods that use clean burning fuels and renewable natural resources. However, due to complex and confusing power pricing structure, EnCal is reeling from the aftereffects of the state government's attempt at power deregulation. EnCal has been unable to pass its operating costs on to its consumers. To make matters worse, EnCal has recently completed construction on several power production centers in efforts to double its capacity and to help diminish the frequency of power outages that are wreaking havoc on local commerce. As a result, they have accumulated a massive debt load to help finance these facilities and are on the verge of default. However, raising the prices of the power it supplies to its consumers involves a slow and laborious bureaucratic process and regulatory approval. EnCal is forced to reorganize its financing. EnCal's partial income statements and balance sheets for the 2018 and 2019 fiscal years follow. An incomplete income statement for 2020 is also provided.

A financial restructuring that would reduce EnCal's debt burden has been proposed. The proposal is to reduce the interest rate on its bank loan to 6% and loan principal to $100 million, to reduce the interest rate on its mortgage loans to 8%, and to replace all of its subordinated loan balance with a 50% equity stake in the company.

Income Statement ($ Millions)

2018

2019

2020

Revenue COGS (70% - 2018, 80% - 2019/2020) Gross Profit

$240 -168 72

$360 -288 72

? ? ?

316 SG&A EBITDA Depreciation EBIT Interest Earnings Before Taxes Taxes (40%) Net Income

A.

-30 42 -20 22 -22 0 0 $0

-35 37 -30 7 -92 -85 0 -$85

Balance Sheet ($ Millions) Assets Cash Accounts Receivable Inventories Fixed Assets, Net Total Assets

$10 20 10 510 $550

$10 30 15 1,080 $1,135

Liabilities and Equity Accounts Payable Notes Payable (8% Bank Loan) Accrued Liabilities (Wages & Taxes) Long-Term Mortgage Loans (10%) Long-Term Subordinated Loans (12%) Common Stock Retained Earnings Total Liabilities & Equity

$14 50 4 180 0 300 2 $550

$24 140 4 460 290 300 -83 $1,135

-35 ?

-40 ? ? ? ? ?

Assuming a 25% increase in revenue with no additional capital investment, what will EnCal's new income statement and balance sheet look like in the business as usual and financial restructuring scenarios?

317

EnCal Corporation Income Statement ($ Millions)

2020 2018

2019

2020 Restructure

BAU

Revenue

$240

$360

$450

$450

COGS (70% - 2015, 80% - 2016 & 2017)

-168

-288

-360

-360

Gross Profit

72

72

90

90

SG&A

-30

-35

-35

-35

EBITDA

42

37

55

55

Depreciation

-20

-30

-40

-40

EBIT

22

7

15

15

Interest

-22

-92

-92

-43

0

-85

-77

-28

Earnings Before Taxes

0

-85

-77

12

Taxes (40%)

0

0

0

0

Net Income

$0

-$85

-$77

$12

Cash

$10

$10

-$32

Accounts Receivable

20

30

38

Inventories

10

15

19

Fixed Assets, Net

510

1,080

1,040

Total Assets

$550

$1,135

$1,064

$17 38 19 1,040 $1,113

Accounts Payable

$14

$24

$30

$30

Notes Payable (8% to 6% Bank Loan)

50

140

140

100

Earnings Before Extraordinary Item Debt Foregiveness in Restructure

40

Balance Sheet ($ Millions) Assets

Liabilities

Accrued Liabilities (Wages & Taxes)

4

4

4

4

Long-Term Mortgage Loans (10% to 8%)

180

460

460

460

Long-Term Subordinated Loans (12%)

0

290

290

0

300

300

300

590

Common Stock Retained Earnings Total Liabilities & Equity

2

-83

-160

$550

$1,135

$1,064

-71 $1,113

11 46 35 92

6 37 0 43

Note: Interest Calculations Notes Payable (Bank Loan) 8% to 6% Long-Term Mortgage Loans (10% to 8%) Long-Term Subordinated Loans (12%) Total Interest (subtraction in Inc. Stmt.)

318 B.

Will EnCal be able to service its debt under either scenario?

Under the restructured 2020 projection they can service the debt. Under the original BAU plan, they would not have been able to service the debt.

C.

Would EnCal be a likely candidate for Chapter 7 bankruptcy?

EnCal would probably avoid liquidation under Chapter 7 if these projections are credible and accepted by the bankruptcy trustee.

D. Suppose the governor has called an emergency legislative session on the utility's behalf to prevent its eventual bankruptcy. If the governor is able to get a bill passed supporting a rate hike on electrical power, how much must the EnCal charge per kilowatt if it is going to be able to cover its interest payments under the new financial restructuring plan.

Assume EnCal's power generation facilities have a maximum capacity of 800 megawatts with an average capacity utilization of 50%. ($450M)/[(800,000kW)*(50%)*(365days)*(24hrs/day)] = $.128 per kWh

MINI CASE: ENDCO, INC. Endco is a wireless solutions provider that facilitates wireless Internet access through small remote devices that connect to portable computers. During the past several years, Endco was lavished with an abundance of equity financial capital from a variety of venture investors.

Although initial adoption rates for this new service were far below expectations, most were confident that expanding the service area and thus increasing the service's availability to new and existing users would result in rapid increases in the volume of new subscribers. Helping to fund this massive expansion, Endco arranged tremendous amounts of debt financing, much of which was secured by the expansion assets themselves (i.e. wireless towers and transmission facilities).

However, recently it became clear that Endco would not be profitable and would only continue to burn large amounts of cash if it continued to operate. Using the financial data provided, answer the following questions regarding Endco's Chapter 7 bankruptcy liquidation.

Administrative and legal fees are $370,000, and the bank underwriting the notes payable have the "right of offset" on cash deposits, the amount indicated in the cash account on the balance sheet.

Balance Sheet ($ Millions) Assets

319 Liquidation Receipts Cash Inventory Accounts Receivable Net Plant Net Equipment Total Assets

$2.4 16.0 5.6 200.0 100.0 $324.0

Liabilities & Equity Accounts Payable Notes Payable (12% Bank Loan) Accrued Liabilities (Wages & Taxes) Long-Term Mortgage Loans (12%, 10 years) Long-Term Subordinated Loans (14%, 15 years) Debentures (Subordinated to Notes Payable) Preferred Stock Common Stock Retained Earnings Total Liabilities

$2.4 5.0 3.0 165.0 57.0 $232.4

$3.5 29.0 1.5 140.0 80.0 20.0 300.0 100.0 -350.0 $324.0

A. Who are considered to be the priority claimants in this liquidation?

The priority claimants are the government, employees and mortgage holders.

B. Who are considered to be general creditors?

The general creditors are the other remaining claimants, with the exception of the preferred and common stock holders, who are considered claimants of last resort.

C. Create a table indicating the cash distribution to each creditor and the percentage of the original liability that is satisfied.

Priority Payments 0.37 1.50 140.00 0.00

Claimant Administrative and Legal Wages & Taxes Long-Term Mortgage Loan Long-Term Subordinated Loan Accounts Payable Notes Payable 2.40 Debentures Totals $144.27 Excluding Debentures Remaining balance Pay rate to general creditors

Remaining Claims

80.00 $3.5 26.60 20.00 $130.10 $110.10 $88.13 80.05%

Payments on Remaining Claims

64.04 2.80 21.29 0.00 $88.13

Total 0.37 1.50 140.00 64.04 2.80 23.69 0.00

% Liability Satisfied 100.00% 100.00% 80.05% 80.05% 81.70% 0.00%

320

CAPSTONE CASE 1: ECO-PRODUCTS, INC.

End-of-Case Assignments: Suggested Discussions and Analyses A. Describe Eco-Products’ early history (1990 through 2003). Would you view the firm during that period as being a life-style business, an entrepreneurial venture, or? Why? Steve Savage and his father founded the company in 1990 with the intent to provide eco-friendly paper and janitorial supplies. They chose to locate the business in Boulder, Colorado, a community known for its support of environmental initiatives and natural products. However, consumers were slow to adopt eco-friendly products. Margins were low and salaries were small.

Friends and family supplied funds for business operations. This early history was suggestive of a life-style business.

B. Discuss Eco-Products’ revenue growth-based ―business model‖ that evolved over the 2004 through early 2008 period in terms of (a) production versus distribution, (b) product line development, (c) branding, etc.

The company remained a local marketer of green janitorial paper and building supplies until 2004 when the company was set on a new course with both business supply and building supply divisions. The management team was expanded and sales in the business supply division grew rapidly as a result of a focus on brand and Internet strategies. a) In 2004-05 Eco-Products remained primarily a distributor of eco-friendly products such as biodegradable disposable drinking cups, etc. that were purchased from a variety of manufacturers. As the business focus shifted from retail sales to wholesale distribution, pressure increased to produce their own brand of eco-friendly products. Product suppliers were selected in China and Taiwan. b) Steve Savage emphasized the development of a signature Eco-Products line from a Polylactide (PLA) resin from renewable resources such as corn and sugarcane. This allowed the firm to offer a full, uniquely designed line of environmentally friendly products. However, lead times were long since orders from the Asian original equipment manufacturers took from 7 to 12 weeks to be filed. c) As wholesale distribution grew, existing product manufacturers restricted Eco-Products‘ ability to sell many products in the wholesale marketplace. After identifying Asian manufacturers, the ―Eco-Products‖ branded line of compostable cups and food containers hit the market in March, 2007.

321 C. What is the size of the domestic and global markets for foodservice disposable packaging? Who are the major competitors producing/selling environmentally-friendly food service products.

What intellectual property or competitive advantages does Eco-Products, Inc. possess?

The global food service disposable industry produces an estimated $30 billion in sales annually.

Biodegradable products represented the fastest growing segment of the industry and had sales estimated to exceed $700 million in 2008. Eco-Products previously carried the Fabri-Kal, International Paper, and Georgia Pacific paper product lines. These firms became direct competitors when Econ-Products decided to produce its own eco-friendly products line. It is difficult to produce intellectual property or competitive advantages in an industry where product production technology is reasonable simple and where there are several major competitors. EcoProducts had an available Asian production source for producing products from a PLA resin, as well as their own ―brand‖ of compostable products.

D. Exhibits 2 and 3 present Eco-Products’ financial statement information for 2005, 2006, and 2007. Prepare a ratio analysis of the firm’s financial performance over the 2005-07 period.

Note: the financial statements for 2005 and 2006 were unaudited. For 2007, the income statement and statement of cash flow were “reviewed” while the balance sheet was “audited.” As a result, some discrepancies exist when trying to reconcile changes in some of the numbers across financial statements. Students should understand that it is not uncommon for small, closely-held firms not to have their financial statements professionally ―audited‖ by a Certified Public Accountant (CPA).

Note: we are using end-of-year balance sheet items (rather than averages) in order to have three comparison years and to recognize that the firm‘s business model (from a retailer of products manufactured by others to a manufacturer/wholesaler of eco-friendly products.

2005 COGS/Revenues = 2,584,326/3,649,799 = .708 = 70.8% 2006 COGS/Revenues = 3,684,492/5,751,787 = .641 = 64.1% 2007 COGS/Revenues = 7,726,455/10,867,104 = .711 = 71.1% 2005 Gross Profit Margin = 1,065,473/3,649,799 = .292 = 29.2% 2006 Gross Profit Margin = 2,067,295/5,751,787 = .359 = 35.9%% 2007 Gross Profit Margin = 3,140,649/10,867,104 = .289 = 28.9% 2005 Operating Profit Margin = 239,519/3,649,799 = .066 = 6.6% 2006 Operating Profit Margin = 98,333/5,751,787 = .017 = 1.7% 2007 Operating Profit Margin = 128,443/10,867,104 = .012 = 1.2% 2005 Net Profit Margin = 237,336/3,649,799 = .065 = 6.5% 2006 Net Profit Margin = 41,946/5,751,787 = .007 = 0.7% 2007 Net Profit Margin = -36,199/10,867,104 = -.003 = -0.3% 2005 Sales to Total Assets = 3,649,799/795,465 = 4.588 times 2006 Sales to Total Assets = 5,751,787/2,103,478 = 2.734 times

322 2007 Sales to Total Assets = 10,867,104/5,647,015 = 1.924 times 2005 Return on Assets = 237,336/795,465 = .298 = 29.8% 2006 Return on Assets = 41,946/2,103,478 = .020 = 2.0% 2007 Return on Assets = -36,199/5,647,015 = -.006 = -0.6% 2005 Total Debt to Total Assets = 435,696/795,465 = .548 = 54.8% 2006 Total Debt to Total Assets = 1,781,218/2,103,478 = .847 = 84.7% 2007 Total Debt to Total Assets = 4,111,887/5,647,015 = .728 = 72.8% 2005 Return on Equity = 237,336/359,769 = .660 = 66.0% 2006 Return on Equity = 41,946/322,260 = .130 = 13.0% 2007 Return on Equity = -36,199/1,535,128 = -.024 = -2.4% As Eco-products moved from being a distributor/retailer of other manufacturers‘ products to producing/wholesaling its own products, its profit margins declined from 2005 to 2007. In fact, the firm had a net loss in 2007 due in large part to the nearly $200,000 (actually $186,726) in interest expense associated with the obtaining of a line of credit which was $2,843,242 at the end of December, 2007. As sales ―ramp up‖ in the future, it is important to ―spread‖ the ―fixed‖ and ―semi-fixed‖ operating expenses in order to improve the operating profit margin and the firm‘s value.

An accompanying Excel spreadsheet provides the following ratio calculations for 2007 and 2008 (data were not available until 2009).

Selected Ratios: GOGS/Revenues Gross Profit Margin Operating Profit Margin Net Profit Margin

2007 71.1% 28.9% 1.2% -0.3%

2008 75.7% 24.3% 3.2% 1.6%

Sales or Revenues/Total Assets Return on Assets Total Debt to Total Assets Return on Equity

1.924 -0.6% 72.8% -2.4%

1.819 2.8% 71.2% 9.9%

E. Exhibit 4 presents Eco-Products’ Statement of Cash Flows for 2007. Was the firm building or burning cash in its operating activities? When also considering cash flows from investing activities, was Eco Products in a net cash build or burn position in 2007?

In Chapters 4 and 6 we discussed the preparation of the Statement of Cash Flows. We use the indirect method which begins with an accounting period‘s (usually one year) net income (or loss) and adds back non-cash deductions (depreciation and amortization). We then adjust these income statement amounts by changes (between last year and this year) in non-interest bearing working capital accounts shown on the balance sheet to get net cash flow from operations. We

323 also calculate cash flows from investing activities and cash flows from financing activities. In actual practice, accountants use the direct method for preparing the statement of cash flows which aggregates all individual transactions made throughout the year that impact accounting cash flows. Thus, because of the lack of detail, the indirect method for preparing the statement of cash flows is sometimes difficult to exactly reconcile with the more detailed results provided from the direct method.

Also, as noted in the prior question, only the 2007 balance sheet was audited. Other financial statements were only ―reviewed by a CPA firm. This makes it more difficult to separately prepare (using the indirect method) a statement of cash flows for Eco-Products for 2007. While many of the changes in balance sheet accounts between 2006 and 2007 match with the amounts presented in the consolidated statements of cash flow in Exhibit 4, others do not. Thus, for this question we suggest that students concentrate on Exhibit 4 to determine the extent to which EcoProducts was building or burning cash in 2007.

In Chapter 4 we presented a short method for determining whether a firm had been building or burning cash. The short method sums the net cash used in operating activities and the net cash used in investing activities.

2007 Cash Build/Burn = net cash used in operating activities + net cash used in investing activities = -2,891,887 + -356,745 = -3,248,632 Thus Eco-Products had a cash burn of over $3 million in 2007.

A more detailed method for estimating cash build or burn was provided in Chapter 5.

Cash Build = Net Sales – Increase in Receivables = 10,867,104 – 965,683 = 9,901,421 Cash Burn = Income Statement-Based Operating, Interest, and Tax Expenses + Increase in Inventories - (Changes in Payables and Accrued Liabilities) + Capital Expenditures Note: there may be deferred income taxes as well as changes in other less common current asset and current liability accounts (as shown in Exhibit 4) that must be accounted for in determining net cash used in operating activities. These include prepaid expenses and other assets, income tax receivable, deposits, other current liabilities, deferred lease liability, and deferred revenue and are considered below.

Cash Burn = 10,786,740 [i.e., 7,726,455 + 1,822,206 +1,102,437 + 187,918 (interest & other expenses) + -23,276 - 29,000 (deferred income tax)] + 1,553,188 + 664,003 (i.e., 589,743 + 64,260 + 10,000) - 84,156 (44,800 + 39,356) - 126,467 (i.e., 3,966 + 16,913 + 105,588) + 356,745

324 = 13,150,053 Net Cash Burn = Cash Burn – Cash Build = 13,150,053 – 9,901,421 = 3,248,632 F. Describe the early rounds of financing that occurred from Eco-Products’ inception in 1990 through 2006. Beginning in 2007, the need for external financing began increasing. Describe the sources, amounts, and types of financing obtained during 2007and the early part of 2008.

Exhibit 5 in the case summarizes previous rounds of financing. Eco-Products was started with $8,000 in seed money in 1990. Additional equity investments from the founders, family, friends, and employees for purchase of inventory and to support the building supply division occurred in 1995, 1999, and 2003.

As sales began increasing rapidly in 2007, there was a need to finance more working capital, particularly inventory. In 2007, $220,000 was raised from 14 investors which included friends, family, and angels. An additional $2.5 million was raised from 30 angel investors in late 2007 and during the spring of 2008 through a private placement memorandum. Excerpts from the memorandum are shown in Appendix A. G. In mid-2007, Eco-Products’ management prepared a five-year (2007-2011) projection of revenues and expenses (see Exhibit 1). What annual rates of growth were projected for net sales? Make a ―back-of-the-envelope‖ estimate of the amounts of additional assets needed to support the sales forecasts. How might these assets be financed? Prepare a ―rough‖ estimate of the possible size of external financing needed to support these sales projections.

First, let‘s review recent actual sales growth rates: Year 2005 2006 2007

Sales/Revenues $3,649,799 $5,751,787 $10,867,104

Percent Increase 57.6% 88.9%

Financial Projections (made in mid-2007) in Thousands of Dollars:

Year 2007 2008 2009 2010 2011

Sales/Revenues $9,200 22,000 38,000 55,000 78,000

Change in Sales

Percent Increase

$12,800 16,000 17,000 23,000

139.1% 72.7 44.7 41.8

Actual revenues for 2006 were 5,751,787 or in Thousands of Dollars rounded to 5,752. The five-year compound rate of growth between 2006 actual revenues and projected 2011 revenues of 78,000 is: PV = -5752

325 FV = 78,000 N= 5 I%Yr = 68.44% It is also worth noting that actual sales or revenues for 2007 of $10,867,104 substantially exceeded the mid-2007 forecast of $9.2 million.

Over the 2005-2007 period, Eco-Products changed from being primarily a retail distributor of eco-friendly paper and plastic products produced by other manufacturers to a wholesale distributor of its own ―branded‖ eco-friendly products. If we assume that the sales to assets relationship that existed at the end of 2007 would hold going forward, we have: 2007 Sales to Total Assets = 10,867,104/5,647,015 = 1.924 times And, 2007 Total Assets/Sales = 5,647,015/10,867,104/= .5196 = 52.0% Thus, it will take approximately a $.52 investment in assets to support each $1.00 increase in sales.

Using the actual 2007 revenues, we have the following estimates for the change in both sales and assets:

Based, on these estimates, Eco-Products will need to acquire nearly $6 million in assets in 2008 and nearly $35 million over the 2008-2011 period. Recently 2008 sales forecasts have been revised to 45 million which would more than double the amount of assets needed for 2008.

Additional assets can be financed in part through the generation of net profits or income and the retention of those profits in the business. Some spontaneous financing will also occur through an expected increase in accounts payable and accrued liabilities. Any remaining asset financing needs will need to be met through the raising of external debt and equity funds.

In Chapter 6, we introduced a basic additional funds needed (AFN) equation which can provide a quick ―back-of-the-envelope‖ estimate of future external financing needs.

AFN = (Total Assets/Sales)(Change in Sales) – (Accounts Payable + Accrued Liabilities)/(Change in Sales) – (Next Year‘s Sales)(Net Income/Net Sales)(Retention Rate) 2007 Total Assets/Sales = 5,647,015/10,867,104 = .5196 = .520 (rounded) 2007 (Accounts Payables & Accrued Expenses)/Sales = 568,131/10,867,104 = .052 2007 Net Income/Sales = -36,199/10,867,104 = -.003

326

Note: Eco-Products must return to profitability in order to finance its sales growth and to add to firm value. Exhibit 1 projects an EBITDA/Sales margin of 8.5%. A net profit margin of 4.25% (8.5% x .50) might be achievable and is used here for illustrative purposes. A 100% retention rate also is assumed.

Two AFN estimates are prepared for 2008: 1) 2008 sales estimate (in $ Thousands) made in mid-2007 = $22,000; with a change of $11,133 ($22,000 - $10,867) 2) 2008 sales estimate (in $ Thousands) made in early-2008 = $45,000; with a change of $34,133 ($45,000 - $10,867) 1) 2008 AFN for Sales of $22,000 = .520(11,133) - .052(11,133) – 22,000(.0425)(1.00) = 5,789 – 579 – 935 = 4,275 2) 2008 AFN for Sales of $45,000 = .520(34,133) - .052(34,133) – 45,000(.0425)(1.00) = 17,749 – 1,775 – 1,913 = 14,061 The 2008 AFN ranges from $4.275 million for $22 million in sales to $14.061 million for $45 million in sales or revenues.

The large AFN estimates are due in large part to working capital needs primarily in the form of higher accounts receivable and inventory. The amount of funds tied up in inventory is problematic due to supply chain lead times and supplier terms (see Figure 2). Furthermore, relatively little supplier financing is provided and the business does not generate large profit margins. As a result, Eco-Products will likely need to improve its supply chain model.

Note: An accompanying Excel spreadsheet provides basic financial statement projections for 2008 for three different revenue projections. The results follow.

327 Eco-Products, Inc. Financial Statements and Projections [Dollars] Income Statements Net Revenues Cost of Goods Sold Gross Profit Operating Expenses Bad Debt Depreciation and Amortization Employee Benefits General and Administrative Payroll Taxes Occupancy Expense Repairs and Maintenance Salaries and Wages Selling and Marketing Expenses Total Operating Expenses Operating Profit Other Income and (Expenses) Interest Expense Other Income Other Expense Net Other Income & (Expenses) Net Income (Loss) Before Taxes Provision for Income Taxes Estimated Taxes Current Tax Benefit Deferred Tax Expense Total Provision of Income Taxes Net Income (Loss)

Balance Sheets Assets Current Assets Cash Accounts Receivable, Net Prepaid Expenses & Other Cur. Assets Income Tax Receivable Inventory Deferred Income Tax Asset Total Current Assets Property and Equipment Machinery and Equipment Building Improvements Vehicles Total Property and Equipment Less Accumulated Depreciation Net Property and Equipment Intangible Assets Trademarks Other Intangible Assets Total Intangible Assets Less Accumulated Amortization Net Intangible Assets Other Assets Deposits Total Assets

Actual 2007 10,867,104 7,726,455 3,140,649

Forecast Basis: Mid-2007 Moderate Early-2008 Percent of Forecast Forecast Forecast 2007 Revenues (Sales) 2008 2008 2008 Estimated Amounts 22,000,000 35,000,000 45,000,000 0.711 x sales forecast 15,642,000 24,885,000 31,995,000 6,358,000 10,115,000 13,005,000

141 87,563 114,011 494,061 117,557 349,668 27,140 1,778,282 43,783 3,012,206 128,443

0.000 x sales forecast 0 0 0 0.008 x sales forecast 176,000 280,000 360,000 0.010 x sales forecast 220,000 350,000 450,000 0.045 x sales forecast 990,000 1,575,000 2,025,000 0.011 x sales forecast 242,000 385,000 495,000 0.032 x sales forecast 704,000 1,120,000 1,440,000 0.002 x sales forecast 44,000 70,000 90,000 *0.123 x sales forecast 2,706,000 4,305,000 5,535,000 *0.016 x sales forecast 352,000 560,000 720,000 5,434,000 8,645,000 11,115,000 924,000 1,470,000 1,890,000

-186,726 0 -1,192 -187,918 -59,475

*(0.009) x sales forecast 0.000 x sales forecast (0.001) x sales forecast

(198,000) (22,000) -220,000 704,000

(315,000) (35,000) -350,000 1,120,000

(405,000) (45,000) -450,000 1,440,000

*Assumes 35% Tax Rate

(246,400)

(392,000)

(504,000)

-246,400 457,600

-392,000 728,000

-504,000 936,000

Forecast 2008

Forecast 2008

Forecast 2008

52,276 -29,000 23,276 -36,199

Actual 2007

Percent of Sales

51,667 1,330,562 728,776 54,506 2,415,916 42,000 4,623,427

0.5% 12.2% 6.7% 0.5% 22.2% 0.4% 42.5%

0.005 x sales forecast 0.122 x sales forecast 0.067 x sales forecast 0.005 x sales forecast 0.222 x sales forecast Held Constant

104,598 166,405 213,950 2,684,000 4,270,000 5,490,000 1,474,000 2,345,000 3,015,000 110,000 175,000 225,000 4,884,000 7,770,000 9,990,000 42,000 42,000 42,000 9,298,598 14,768,405 18,975,950

641,773 479,481 228,448 1,349,702 -360,304 989,398

5.9% 4.4% 2.1% 12.4% -3.3% 9.1%

*0.039 x sales forecast *0.029 x sales forecast *0.014 x sales forecast

858,000 638,000 308,000 1,804,000 -484,000 1,320,000

1,365,000 1,015,000 490,000 2,870,000 -770,000 2,100,000

1,755,000 1,305,000 630,000 3,690,000 -990,000 2,700,000

20,800 5,440 26,240 -2,050 24,190

0.2% 0.1% 0.2% 0.0% 0.2%

0.002 x sales forecast 0.001 x sales forecast 0.002 x sales forecast 0.000 x sales forecast

44,000 22,000 44,000 0 44,000

70,000 35,000 70,000 0 70,000

90,000 45,000 90,000 0 90,000

10,000 5,647,015

0.1% 52.0%

0.001 x sales forecast

*(0.022) x sales forecast

22,000 35,000 45,000 10,684,598 16,973,405 21,810,950

328

Liabilities and Equity Current Liabilities Accounts Payable & Accrued Expenses Accrued Payroll & Payroll Taxes Accrued Vacation Lines of Credit Current Portion of Long-Term Debt Current Portion of Capital Leases Deferred Revenue Loan from Stockholder Other Current Liabilities Total Current Liabilities Deferred Income Tax Liability Deferred Lease Liability Long-Term Capital Leases, Net of Current Por. Long-term Debt, Net of Current Portion Total Liabilities Stockholders' Equity Common Stock, $.001 Par Value 50,000,000 Shares Authorized 16,935,000 Shares Issued & Outstanding Preferred Stock, $.001 Par Value 1,750,000 Shares Authorized 1,366,666 Shares Issued & Outstanding Additional Paid-In-Capital Retained Earnings Total Stockholders' Equity *Additional Financing Needed Total Liabilities & Stockholders' Equity

Actual 2007

Percent of Sales

568,131 6,712 39,865 2,843,242 39,356 37,919 105,588 93,394 21,523 3,755,730 54,000 36,383 141,228 124,546 4,111,887

5.2% 0.1% 0.4% 26.2% 0.4% 0.3% 1.0% 0.9% 0.2% 34.6% 0.5% 0.3% 1.3% 1.1% 37.8%

0.052 x sales forecast 0.001 x sales forecast 0.004 x sales forecast *0.262 x sales forecast 0.004 x sales forecast 0.003 x sales forecast Held Constant Held Constant 0.002 x sales forecast

156,300

1.4%

Held Constant

0 1,269,908 108,920 1,535,128 0 5,647,015

11.7% 1.0% 14.1% 52.0%

Forecast 2008

0.005 x sales forecast 0.052 x sales forecast Held Constant Held Constant

Held Constant Held Constant [+2008 Net Income]

Forecast 2008

Forecast 2008

1,144,000 1,820,000 2,340,000 22,000 35,000 45,000 88,000 140,000 180,000 5,764,000 9,170,000 11,790,000 88,000 140,000 180,000 66,000 105,000 135,000 105,588 105,588 105,588 93,394 93,394 93,394 44,000 70,000 90,000 7,414,982 11,678,982 14,958,982 110,000 175,000 225,000 66,000 105,000 135,000 141,228 141,228 141,228 124,546 124,546 124,546 7,856,756 12,224,756 15,584,756

156,300

156,300

156,300

0 0 0 1,269,908 1,269,908 1,269,908 566,520 836,920 1,044,920 1,992,728 2,263,128 2,471,128 835,114 2,485,521 3,755,066 10,684,598 16,973,405 21,810,950

Notes on Projected Financial Statements Income Statement: *Salaries and Wages--reduced by 25% from the 16.4% 2007 relationship to reflect expected economies *Selling and Marketing Expenses--increased 4 times the .4% 2007 relationship to reflect the need for higher expenditures *Interest Expense was projected at one-half the 2007 percent of sales rate due to a likely slower growth rate for interest-bearing debt *Assumes 35% Tax Rate for 2008 projections (Deferred Taxes were not projected due to insufficient data) Balance Sheet: *Property and Equipment was reduced to two-thirds of 2007 rate due to production being outsourced *Lines of Credit were increased with sales under the assumption they would be available to finance working capital *Additional Financing Needed is the amount of long-term debt and equity funds needed to finance projected sales growth

Note: Actual 2008 operating results are presented in the Epilogue (What Happened) at the end of this teaching note: 2008 Actual Sales/Revenues: $34,378,138 (well below the early 2008 estimate of $45 million due to a slowing economy, greater competition, and supply chain issues) 2008 Net Income: $538,344 (resulting in a 1.6% net profit margin) 2008 Year-end Inventory: $12,222,801 (excess inventory was produced in anticipation of higher sales which did not materialize) H. Eco-Products’ management developed a Confidential Private Placement Memorandum (PPM) dated October 16, 2007 in an attempt to raise $3,500,000. Appendix A contains excerpts from the PPM.

329 1. What is meant by a Regulation D offering? What is an accredited investor and how many investors can participate in the PPM? [You may wish to review materials from Chapter 8 and its appendices when answering these PPM-related questions.]

Regulation D (or Reg D) is a registration that offers a safe harbor from registration of securities with the SEC. Due to uncertainty about what constitutes a nonpublic offering, the SEC provided some ―safe-harbor‖ conditions that will result in guaranteed exemption as a private placement.

An ―accredited investor‖ was first defined under the Securities Act of 1933 and Section 4(6) provided that there is no limit to the number of accredited investors so long as the offering amount does not exceed $5 million. The definition of an ―accredited investor‖ was expanded to include eight categories of accredited investors under Rule 501 of Regulation D (see Chapter 8, Appendix B). Banks, private business development companies, and other specified organizations are considered to be accredited investors. Directors, executive officers, or general partners of the issuer of the securities being offered or sold are considered to be accredited investors. A natural person with individual net worth (or joint net worth with that person‘s spouse) exceeding $1,000,000 is deemed an accredited investors. Also, a natural person who had individual income in excess of $200,000 in each of the two most recent years (or $300,000 of joint income with one‘s spouse) and who has a reasonable expectation of the same income level in the current year also is considered to be an accredited investor.

There is no limit as to the number of investors (accredited or unaccredited) under Reg D: Rule 504 which has an offering limit of $1 million. Under Reg D: Rule 505 (offering limit of $5 million) and Reg D: Rule 506 (no offering limit) there may be a maximum of 35 unaccredited investors but no limit on the number of accredited investors.

2. Considering the planned use of proceeds, discuss the pros and cons of trying to raise $3,500,000 in increments as small as $50,000 each.

A $3.5 million private placement memorandum fall under Reg D: Rule 505 which has a $5 million offering limit in a 12-month period. While there is no limit on the number of accredited investors, there is a limit of 35 unaccredited investors. At the extreme, raising $3.5 million all in minimum $50 thousand amounts would require 70 different investors. At this minimum amount, only $1.75 million could be generated from the maximum 35 unaccredited investors (i.e., 35 x $50 thousand). Raising funds in small amounts requires more time, effort, and cost. Since there is a need to quickly build up working capital, particularly inventory, raising funds in relatively small amounts over an extended period of time could impede the firm‘s ability to grow its sales.

3. Summarize the risk factors listed by management in the Private Placement Memorandum.

Which factors do you believe are the most crucial in determining the future success of EcoProducts?

330 Appendix A provides excerpts for Eco-Products 2007 Private Placement Memorandum. Risk factors include: a) Need for new product development b) Being subject to patent infringement laws c) Reliance on importing products from overseas suppliers d) Competition will continue to increase e) Supply could be constrained by raw material availability f) Subject to federal and state, as well as foreign, regulations g) Subject to product liability claims h) Need to hire and retain skilled personnel i) Need to successfully manage growth j) Impact by general economic conditions k) Restrictions on the transferability of, and no pubic market, for firm‘s stock l) Determination of offering price was arbitrarily determined by current owners m) No expectation to pay dividends in foreseeable future Supply chain-related risks (availability to obtain raw materials and reliance on importing products from overseas suppliers), the need for new product development, and increasing competition clearly will be important if Eco-Products is able to achieve profitable sales growth and added to firm value in the future. Of course, the ability to avoid/manage the other risk factors listed by management also will have a major impact on the firm‘s future success.

I. Identify and discuss the factors and developments that led to the previously unexpected revenue growth during the first-half of 2008 by Eco-Products. Is such growth likely to be sustainable in the near future? What possible developments might interrupt or change this rapid rate of sales growth?

In mid-2007, management forecasted full-year 2007 sales to be $9.2 million with a sales forecast of $22 million for 2008 (refer to Exhibit 1). Then, the ―perfect storm‖ hit. Oil prices spiked to new heights and general awareness of environmental issues intensified. Orders for products made from renewable resources skyrocketed and Eco-Products experienced large and sudden increases in sales.

In early 2008, forecasted 2008 full-year sales were increased to $45 million. The ability to meet and maintain such growth targets would depend on consumer demand for eco-friendly products, the ability to fulfill orders given the firm‘s long inventory cycle, how competitors (particularly some very large firms) will react, and overall economic conditions.

Actual 2008 sales were a little under $35 million (see the Epilogue, What Happened, at the end of this teaching note). This over $10 million short-fall in sales from the early 2008 forecast of $45 million was associated with a decline in economic activity (recession), increased competition, and a supply chain problem that made it difficult to first avoid stocking out of inventory and then accumulating excess inventory. By the end of 2008, inventory had increased to more than $12 million compared to $2.4 million at the end of 2007.

331 J. Explain Eco-Products’ supply chain model that existed in early 2008. Describe the strengths and weaknesses of such a model from an operations viewpoint. What are the implications of this supply chain model on Eco-Products working capital financing needs and its cash conversion cycle?

The supply chain model used by Eco-Products resulted in a long inventory cycle (for a relatively simple production process). Raw materials were often purchased in the U.S. or from suppliers in other countries, shipped to manufacturers in Asia, with the final products being shipped back for sale in the U.S. This long inventory cycle tied up cash and made it difficult to stock adequate inventory in some time periods, or produce excess inventory at other times. A long supply chain cycle involves larger asset financing requirements, particularly in the form of inventory.

As shown below, both assets to sales and inventory to sales increased dramatically as the firm changed from a seller of products manufactured by other firms to a business model whereby Eco-Products became a manufacturer and wholesaler of eco-friendly products.

2005 Total Assets/Sales = 795,465/3,649,799 = .2179 = 21.8% 2006 Total Assets/Sales = 2,103,478/5,751,787 = .3657 = 36.6% 2007 Total Assets/Sales = 5,647,015/10,867,104 = .5196 = 52.0% 2005 Inventory/Sales = 361,906/3,649,799 = .0992 = 9.2% 2006 Inventory/Sales = 862,728/5,751,787 = .1499 = 15.0% 2007 Inventory/Sales = 2,415,916/10,867,104 = .2223 = 22.2% Actual 2008 Results: 2008 Total Assets/Sales = 18,903,838/34,378,138 = .5499 = 55.0% 2008 Inventory/Sales = 12,222,801/34,378,138 = .3555 = 35.6% Total assets to sales increased from 52.0% for 2007 to 55.0% in 2008. Of course, the primary reason for the need to finance more assets relative to sales was due to the increase in the inventory to sales ratio which increased from 22.2% in 2007 to 35.6% in 2008. The inability to efficiently manage inventory levels was due, at least in part, to the supply chain model being employed by Eco-Products.

An examination of the Cash Conversion Cycle (CCC) also helps illustrate the working capital problem faced by Eco-Products.

CCC Calculations: Inventory-to-Sale Conversion Period (Inv. CP): 2005 Inv. CP = 361,906/(2,584,326/365) = 361,906/7,080.4 = 51.1 days 2006 Inv. CP = 862,728/(3,684,492/365) = 862,728/10,094.5 = 85.5 days 2007 Inv. CP = 2,415,916/(7,726,455/365) = 2,415,916/21,168.4 = 114.1 days Sale-to-Cash Conversion Period (Rec. CP): 2005 Rec. CP = 101,690/(3,649,799/365) = 101,690/9,999.5 = 10.2 days

332 2006 Rec. CP = 862,728/(5,751,787/365) = 862,728/15,758.3 = 54.8 days 2007 Rec. CP = 1,330,562/(10,867,104/365) = 1,330,562/29,772.9 = 44.7 days Purchase-to-Payment Conversion Period (Pmt. CP): 2005 Pmt. CP = 123,429/(2,584,326/365) = 123,429/7,080.4 = 17.4 days 2006 Pmt. CP = 526,555/(3,684,492/365) = 526,555/10,094.5 = 52.2 days 2007 Pmt. CP = 568,131/(7,726,455/365) = 568,131/21,168.4 = 26.8 days Cash Conversion Cycle (CCC): 2005 CCC = 51.1 days + 10.2 days – 17.4 days = 43.9 days 2006 CCC = 85.5 days + 54.8 days – 52.2 days = 88.1 days 2007 CCC = 114.1 days + 44.7 days – 26.8 days = 132.0 days The dramatic increase in the cash conversion cycle from 43.9 days in 2005 to 132.0 days in 2007 reflects the change in the firm‘ business model from a seller of products manufactured by other firms to a manufacturer/wholesaler of eco-friendly products, as well as the firm‘s supply chain model which resulted in a long inventory conversion period which was 114.1 days in 2007.

Dividing 365 days by 114.1 days results in an inventory turnover of 3.2 times per year. This is a very low turnover for products that require very short production times.

For reference, the actual CCC calculations for 2008 were as follows: 2008 Inv. CP = 12,222,801/(26,041,166/365) = 12,222,801/71,345.7 = 171.3 days 2008 Rec. CP = 3,109,920/(34,378,138/365) = 3,109,920/94,186.7 = 33.0 days 2008 Pmt. CP = 3,804,210/(26,041,166/365) = 3,804,210/71,345.7 = 53.3 days 2008 CCC= 171.3 days + 33.0 days – 53.3 days = 151.0 days This further increase in the CCC meant that even more financing was required to support the actual 2008 sales.

An accompanying Excel spreadsheet provides the following ratio calculations for 2007 and 2008 (data not available until 2009).

Cash Conversion Cycle (in Days): Inventory-to-Sale Conversion Period Sale-to-Cash Conversion Period Purchase-to-Payment Conversion Period Cash Conversion Cycle

2007 114.1 44.7 26.8 132.0

2008 171.3 33.0 53.3 151.0

K. In mid-2008, Eco-Products management sought to quickly (hopefully) raise an additional $2 million in external financing through a single private equity investment. The term sheet prepared by Greenmont Capital is presented in Appendix B.

333 1. After considering a number of possible private equity investors, Greenmont Capital was selected by Eco-Products’ management. Discuss the pros and cons of selecting a small locally-based private equity firm relative to a larger private equity investor?

Large private equity firms have large amounts of funds to invest and will have a portfolio of several projects being simultaneously financed. Large private equity firms also usually can move quickly in providing funds to specific ventures and are likely to have broad industry and managerial expertise to offer in support of the venture‘s management team. However, given multiple investments, their working arrangements with a specific venture may be more impersonal.

A small private equity firm will invest in fewer ventures and thus can devote more specific focus on understanding the business model of each of their venture investments. While a small private equity firm may have limited overall industry and managerial expertise, they will concentrate their investments in industries and firms they know and understand.

However, small private equity firms likely will have smaller amounts to invest and may take longer to raise funds from their investors. As a result, ventures needing large amounts of immediate financial capital may be hindered if they try to work with a small private equity firm.

2. Review the investment terms presented in Appendix B and comment on any factors in the term sheet that might be ―deal breakers.‖ If you were representing Eco-Products top management, which terms might you want deleted or modified from the term sheet? Now, if you were representing Greenmont Capital, which terms would be important in protecting its investment capital?

It might be helpful to first review Chapter 11, Figure 11.6 which provides a list of ―Typical Issues Addressed in a Term Sheet.‘ A term sheet should summarize the proposed principal terms with respect to a specific financing vehicle to be used to finance a venture. Included should be an identification of the issuer, the investor(s), the type of security being used, the price of the security being offered, and the amount of financing to be raised and an agreed to ownership position.

In the proposed term sheet shown in Appendix B, Eco-Products is issuing Series A Convertible Preferred Stock (initially convertible on a 1:1 basis into shares of the company‘s common stock) at a price of $1.50 per share to Greenmont Capital Partners. A total of $2 million will be raised in exchange for a 7.8% ownership position on a fully-diluted basis (including shares reserved for any employee option pool including additional warrants being offered to Greenmont). The proposed terms of the Series A Preferred Stock are spelled out in Appendix B and include: dividends, liquidation preference, conversion, automatic conversion, anti-dilution provisions, voting rights, board of directors, board meetings, protective provisions, information rights, registration rights, right of participation, purchase agreement, employee pool, stock vesting, restrictions on sales, co-sale agreement, and employment agreements.

334 The term sheet also addresses ―other matters‖ that include: confidentiality, indemnification, legal fees and expenses, and conditions precedent to financing.

A possible ―deal breaker‖ would be the number of warrants being offered to Greenmont Partners in the term sheet proposal. The July 18, 2008 term sheet proposal provides for Greenmont to receive 1.5 million shares of Series A Convertible Preferred Stock initially convertible on a 1:1 basis into shares of Eco-Products common stock. The term sheet proposal also provides for a 25% warrant coverage (i.e., warrants to purchase additional Series A Preferred Shares at an exercise price of $1.50 per share). This would amount to 333,333 warrants ($1.5 million shares times .25) which potentially dilutes Eco-Products equity ownership.

Eco-Products likely would want the proposed ―warrants‖ provision to be modified downwards or even deleted. Eco-Products also may want to modify downwards the proposed ―dividends‖ provision for the Series A Preferred Stock which provides for cumulative dividends of 8% of the original purchase price per annum.

Greenmont Capital, in an effort to protect its investment capital, would want to maintain the warrants provision. Anti-dilution provisions also are very important since additional equity capital will be needed to finance Eco-Products growth and this capital is likely to come from other private equity investors.

3. Some analysts employ a relative value method that uses multiples from comparable firms to estimate the value of a target venture. Exhibit 9 contains enterprise value-to-sales information for a number of possible comparable firms for the purpose of valuing EcoProducts. Estimate the enterprise value of Eco-Products. What portion of equity ownership should Eco- Products be willing to give up for the $2 million Greenmont Capital investment?

Although Eco-Products had been in business since 1990, its business model changed between 2005 and 2007. Eco-Products became a manufacturer and wholesaler of eco-friendly products at a time when oil prices were at record highs and concern about the environment reached new heights. Sales grew rapidly in 2007. However, the firm operated at a loss in 2007. Thus, by 2008 Eco-Products possessed characteristics of a high sales growth venture that needed to still find a way to produce bottom line profitability and ultimately free cash flows for the equity investors. When trying to value such a venture, analysts may differ widely as to what they believe are reasonable values.

As discussed in the text, ventures may be valued using a discounted cash flow (DCF) method (see Chapters 9 and 13), a venture capitalist (VC) short-cut method (see Chapter 10), or a relative valuation method (see Chapter 14). Analysts often attempt to value a firm on the basis of its top line (sales), its rough cash flow (as reflected in EBITDA), and/or its bottom line (net income).

Here we concentrate on examining the relative valuation data provided by Greenmont Capital Partners in Exhibit 9 which included financial information on 7 ―possible‖ transactions. Five of the transactions occurred While some analysts might argue for including all available

335 transactions, a case could be made for including the five transactions that occurred during 2007 and which may be more representative of the valuation multiples that prevailed in mid2008. The Insulair acquisition was in July, 2006 and had an enterprise value to revenue multiple that was several times higher than any of the other transactions. The Newspring acquisition occurred in March, 2005 and thus was over three years prior to the current mid2008 valuation date. The average enterprise value to revenue multiple for the Tendercare International, Waddington, Van Houtte, Matrix Packaging, and Prairie Packaging transactions was 1.55 times.

Unfortunately, no information was available for EBITDA (except for the dated Newspring transaction) or net income multiples.

As noted in the case, sales estimates changed rapidly in the case. Eco-Products management in mid-2007 had forecasted 2008 sales to be $22 million. By early 2008, the 2008 sales estimates were revised upwards to $45 million. Trailing twelve months revenues for the twelve months ended in June, 2008 were $19.7 million. Exhibit 8 shows quarterly revenues increasing rapidly over the past three quarters with revenues amounting to almost $13.5 million for the first-half of 2008. Thus, to reach the $45 million in forecasted sales for all of 2008, the second-half of the year sales would need to be $31.50 million. However, as EcoProducts entered the second-half of 2008, there was reason for some concern due to an inventory-related problem and the fact that consumer spending and overall economic activity were slowing considerably.

A range of possible values for Eco-Products using an enterprise value to sales multiple of 1.55 might be: Sales or Rev. x Multiple = Value 12-Month Trailing Sales $19.7 million 1.55 $30.535 million Management‘s Forecast $45.0 million 1.55 $69.750 million Actual 2008 Results

$34.4 million

1.55

$53.320 million

At the end of 2007, Eco-Products had a line of credit outstanding of $2,843,242, long-term debt (including the current portion) of $164,411, and long-term capital leases (including the current portion) of $215,530 for an interest-bearing debt plus capital leases total of $3,223,183 or approximately $3.2 million rounded. Thus, the enterprise values shown above should be reduced by about $3.2 million each. The equity value using trailing sales would be $27.3 million while the equity value using management‘s $45 million sales forecast would be about $66.5 million.

Furthermore, it was likely that even more interest-bearing debt was outstanding as of mid-2009.

For example, the $4 million line-of-credit (of which $2.8 million was outstanding at the end of 2007) was increased to $8 million on July 1. Larger interest-bearing debt obligations would have further reduced the equity value of the firm.

Note: As can be seen from the actual 2008 results, the lines of credit at the end of 2008 amounted to slightly more than $8 million, long-term debt (including the current portion) was nearly $.5 million, and long-term capital leases (including the current portion) was

336 nearly $.3 million. Thus, the total interest-bearing debt plus long-term capital leases amounted to approximately $8.8 million.

In the proposed term sheet (see Appendix B), Greenmont Partners valued Eco-Products equity at $29.6 million as of mid-2008. This amount was about $2.3 million more than the equity value of $27.3 million (30.5 million - $3.2 million) estimated based on 12-month trailing sales.

Greenmont Partners‘ post-money ownership (including shares reserved for the employee option pool but not the warrants to be issued to Greenmont) can be estimated as: $2,000,000/($29,587,500 + $2,000,000) = $2,000,000/$31,587,500 = 6.33% Or, using pre-money and post-money shares the calculations would be: Pre-money shares (fully diluted to account for the employee option pool) = $29,587,500/$1.50 = 19,725,000 shares Shares issued to Greenmont = $2,000,000/$1.50 = 1,333,333 Post-money shares = 19,725,000 + 1,333,333 = 21,058,333 Greenmont Partners‘ ownership = (1,333,333 shares)/(21,058,333 shares) = 6.33% Of course, the potential dilution impact of the 333,333 (1,333,333 x .25) warrants to be issued to Greenmont also need to be taken into consideration in determining Greenmont‘s ownership percentage on a fully diluted basis.

Greenmont‘s potential total shares = 1,333,333 + 333,333 = 1,666,666 Total post-money fully-diluted shares = 21,058,333 + 333,333 = 21,391,666 Greenmont‘s ownership position on a fully-diluted basis = 1,666,666 shares/21,391,666 shares = .0779 = 7.8% rounded As noted in the following epilogue, Greenmont Partners negotiated a larger percentage ownership as Eco-Products struggled to meet its revenue targets due to inventory-related problems and the rapidly slowing economy during the last-half of 2008. According to the 2008 balance sheet, 1,366,666 shares of preferred stock were actually issued to Greenmont, instead of the previously negotiated 1,333,333 shares (an increase of 33,333 shares). Adding the 333,333 warrants resulted in Greenmont Partners having potential 1,699,999 fullydiluted shares.

EPILOGUE: What Happened Finance deal. Steve Savage and Greenmont Capital Partners signed a $2 million Series A investment round on July 1, 2008. Greenmont‘s valuation was not the highest of those Savage received, but it was close. Savage chose Greenmont over others because the valuation was fair and provided the intangible benefits of a strategic partnership, and the Greenmont team was beset with industry veterans. Greenmont‘s terms sheet contained what Savage considered were standard provisions and covenants and negotiations went smoothly. Ellie‘s Organic Home

337 Center, the retail operation, was the main sticking point for Greenmont because they felt the retail operation distracted from the company‘s core competencies. The valuation excluded Ellie‘s and the terms contained a provision preempting any activity involving ―the investment of funds in Ellie‘s Organic Home Center in excess of $200,000 beyond its current approved operating budget.‖ Recession. Following the investment, Eco-Products struggled to meet revenue targets. Prior to the Greenmont deal, Eco-Products had never been accountable to outside investors for its performance and, at that time, introducing new products impeded accurate sales forecasts. The company faltered when a recession hit the market in late 2008 and sales slumped by as much as 30% industry wide. Greenmont ended up with nearly 8% of Eco-Products, shares fully diluted including an employee pool, up from its original 6.3% share prior to adding the 333,333 warrants as part of the deal. Savage continued to believe he made the right decision, regardless of these difficulties, but ―I should have kept the PPM going,‖ he stated.

Recovery. Eco-Products overcame the decline in spending that most consumer good companies and manufacturers experienced beginning in the fall of 2008. The 2008 financial statements are given in Exhibits 1 and 2.One year later Eco-Products‘ ―GreenStripe‖ product line was being sold through than 450 distributors and the company launched a retail product line. In June of 2009, Savage resigned as CEO. The company replaced its CEO-Founder with an executive accomplished in growing established companies, the former CEO of Corporate Express who took that company from $50 million to $5 billion in revenue. Savage became Executive Chairman and looked to planned to conduct another round of private equity financing, this time for $5 million to operations. He stated: This $5 million in financial capital is more than enough unless the core business really takes off, or the new products lines really take off, or an attractive merger and acquisition comes along. Then that money could go up in smoke. I figure a pre-valuation equity stake of $9.5 million and still in the single-digits. I hope to give myself and some others that have been part of the five previous rounds an opportunity to take money off the table. I never have….and I hold 9 million of the 21 million shares.

In August 2009, the company reported revenues had more than doubled over the last three years and more than 54 new jobs had been created since 2006. As for its founder and former president, Steve Savage remained interested in leading early stage ventures. He became the majority owner of Ellie‘s Eco Home Store, the former building division of Eco-Products, with plans to open at least one more location and double revenue within one year. In early 2010, he was also in the early stages of launching a new business to distribute natural, organic and environmentally friendly home and garden products.

In November 2012, Waddington North America (Waddington Group), which produces upscale plastic tableware and packaging, acquired Eco-Products for an undisclosed amount. EcoProducts surpassed $100 million in sales in 2014. The Jarden Corporation, a global consumer products company, acquired the Waddington Group in late 2015.

Following are the Eco-Products 2007 and 2008 financial statements that are available in the accompanying Excel spreadsheet.

338

Eco-Products, Inc. Financial Statements and Projections [In Dollars] Income Statements Net Revenues Cost of Goods Sold Gross Profit Operating Expenses Bad Debt Depreciation and Amortization Employee Benefits General and Administrative Payroll Taxes Occupancy Expense Repairs and Maintenance Salaries and Wages Selling and Marketing Expenses Total Operating Expenses Operating Profit Other Income and (Expenses) Interest Expense Other Income Other Expense Net Other Income & (Expenses) Net Income (Loss) Before Taxes Provision for Income Taxes Current Tax Benefit Deferred Tax Expense Total Provision of Income Taxes Net Income (Loss)

Actual Actual Yearend Yearend 2007 2008 10,867,104 34,378,138 7,726,455 26,041,166 3,140,649 8,336,972

Common-Size Financial Statements [Percent of Revenues] 2007 2008 100.0% 100.0% 71.1% 75.7% 28.9% 24.3%

141 87,563 114,011 494,061 117,557 349,668 27,140 1,778,282 43,783 3,012,206 128,443

44,735 214,066 106,401 1,957,315 269,032 265,610 45,447 3,216,385 1,133,334 7,252,325 1,084,647

0.0% 0.8% 1.0% 4.5% 1.1% 3.2% 0.2% 16.4% 0.4% 27.7% 1.2%

0.1% 0.6% 0.3% 5.7% 0.8% 0.8% 0.1% 9.4% 3.3% 21.1% 3.2%

-186,726 0 -1,192 -187,918 -59,475

-253,242 35,984 -25,045 -242,303 842,344

-1.7% 0.0% 0.0% -1.7% -0.5%

-0.7% 0.1% -0.1% -0.7% 2.5%

52,276 -29,000 23,276 -36,199

0 -304,000 -304,000 538,344

0.5% -0.3% 0.2% -0.3%

0.0% -0.9% -0.9% 1.6%

339

Balance Sheets Assets Current Assets Cash Accounts Receivable, Net Prepaid Expenses & Other Cur. Assets Income Tax Receivable Inventory Deferred Income Tax Asset Total Current Assets Property and Equipment Machinery and Equipment Building Improvements Vehicles Total Property and Equipment Less Accumulated Depreciation Net Property and Equipment Intangible Assets Trademarks Other Intangible Assets Total Intangible Assets Less Accumulated Amortization Net Intangible Assets Other Assets Deposits Total Assets

2007

2008

[Percent of Total Assets] 2007 2008

51,667 235,618 1,330,562 3,109,920 728,776 1,010,028 54,506 193,148 2,415,916 12,222,801 42,000 127,000 4,623,427 16,898,515

0.9% 23.6% 12.9% 1.0% 42.8% 0.7% 81.9%

1.2% 16.5% 5.3% 1.0% 64.7% 0.7% 89.4%

641,773 479,481 228,448 1,349,702 -360,304 989,398

1,161,317 983,396 299,178 2,443,891 -571,166 1,872,725

11.4% 8.5% 4.0% 23.9% -6.4% 17.5%

6.1% 5.2% 1.6% 12.9% -3.0% 9.9%

20,800 5,440 26,240 -2,050 24,190

21,564 84,920 106,484 -5,254 101,230

0.4% 0.1% 0.5% 0.0% 0.4%

0.1% 0.4% 0.6% 0.0% 0.5%

10,000 31,368 5,647,015 18,903,838

0.2% 100.0%

0.2% 100.0%

340 2007 Liabilities and Equity Current Liabilities Accounts Payable & Accrued Expenses Accrued Payroll & Payroll Taxes Accrued Vacation Lines of Credit Current Portion of Long-Term Debt Current Portion of Capital Leases Deferred Revenue Loan from Stockholder Other Current Liabilities Total Current Liabilities Deferred Income Tax Liability Deferred Lease Liability Long-Term Capital Leases, Net of Current Por. Long-term Debt, Net of Current Portion Total Liabilities Stockholders' Equity Common Stock, $.001 Par Value 50,000,000 Shares Authorized 16,935,000 Shares Issued & Outstanding Preferred Stock, $.001 Par Value 1,750,000 Shares Authorized 1,366,666 Shares Issued & Outstanding Additional Paid-In-Capital Retained Earnings Total Stockholders' Equity Total Liabilities & Stockholders' Equity

2008

2007

2008

568,131 3,804,210 6,712 253,094 39,356 84,755 2,843,242 8,043,568 39,865 166,310 37,919 88,856 105,588 43,975 93,394 28,825 21,523 0 3,755,730 12,513,593 54,000 443,000 36,383 0 141,228 201,299 124,546 293,474 4,111,887 13,451,366

10.1% 0.1% 0.7% 50.3% 0.7% 0.7% 1.9% 1.7% 0.4% 66.5% 1.0% 0.6% 2.5% 2.2% 72.8%

20.1% 1.3% 0.4% 42.5% 0.9% 0.5% 0.2% 0.2% 0.0% 66.2% 2.3% 0.0% 1.1% 1.6% 71.2%

169,350

2.8%

0.9%

0 13,667 1,269,908 4,622,191 108,920 647,264 1,535,128 5,452,472 5,647,015 18,903,838

0.0% 22.5% 1.9% 27.2% 100.0%

0.1% 24.5% 3.4% 28.8% 100.0%

156,300

CAPSTONE CASE 2: SPATIAL TECHNOLOGY, INC.

341 End-of-Case Assignments: Suggested Discussions and Analyses A. Describe Spatial Technology’s ―business model‖ in terms of revenues, profits, and cash flows.

Spatial is the originator of a 3D modeling file format (SAT) and object manipulation protocol intended to facilitate general 3D modeling and animation. Its revenues historically have been due to prepaid royalties, licensing fees, and maintenance and training for users of its 3D products and formats. Exhibit 6c displays the statement of cash flows for the past three years. Only recently have operating cash flows become positive. Spatial still faces cash flow challenges.

B. What intellectual property, if any, does Spatial Technology possess?

Spatial‘s file format (SAT) and modeling approach are its primary intellectual property.

Although parts of this IP are protected, Spatial, in an attempt to have its approach adopted as an industry standard has published its file format, making it readily available to adopters and competitors.

C. Describe the experience and expertise characteristics of the management team.

The management team has a founder that is well known in the field with previous successful experience. The operations and financing members of the team have been subject to turnover. The team seems to be stronger on technical expertise.

D. Describe Spatial Technology’s pricing and marketing strategy.

Spatial has adopted a strategy of forward-funding itself by taking large amounts of prepaid royalties. Historically, its two primary revenue areas were royalties and licenses.

More recently, much of its revenue has been from ―maintenance and training.‖ Spatial‘s marketing strategy has varied, including some historical efforts to sell to the retail market. Spatial‘s marketing strategy is primarily to sell to software vendors who incorporate Spatial‘s technology in their own shipped products.

E. Discuss the competition faced by Spatial Technology in conjunction with 3D modeling technology in general and specifically with it ACIS product.

Spatial competes with others firms trying to win the adoption race for formats and approaches in mathematical 3D modeling and animation. It also competes with some of its adopters where the line is gray between what Spatial provides and what some of its competitors provide (e.g. Autocad).

F. Describe the four successful rounds of venture financing (A through D) achieved by Spatial Technology in terms of sources and amounts. What additional financing sources have been used?

342 Round A for $1,000,000 was raised from Nazem & Co. shortly after organization. Round B for $7,300,000 was from institutional investors and a potential customer (Hewlett Packard). Round C for $3,100,000 was again raised from the institutional investors.

Round D for $2,742,557 was raised from 3 of the institutional investors and Hewlett Packard.

G. Conduct a ratio analysis of Spatial Technology’s past income statements and balance sheets. Note any performance strengths and weaknesses and discuss any ratio trends.

As the project at hand will involve valuing Spatial, we have chosen to concentrate our ratio analysis on ―percent of sales.‖ The following is the historical presentation of the income statement and balance sheet percent-of-sales ratios.

Income Statement

1993

1994

1995

1996

1996 (Projected)

1996 Ratios

(half year) Revenue License fees Royalties Prepaid royalties Maintenance and training Total Revenue Cost of Sales Gross Profit Operating Expenses Sales and marketing Research and development General and administrative Severence costs Total operating expenses Earnings (loss) from operations Other expense, net Earnings (loss) before taxes and extraordinary item Income tax expense Earnings (loss) before extraordinary item Extraordinary item Net earnings (loss) Earnings growth rate Noninterest part of "other" Interest Income Interest Expense ProForma rate on interest inc.

ProForma rate on interest exp.

Balance Sheet

3687 562 1475 1657 7381 -1150 6231

50.0% 7.6% 20.0% 22.4% 100.0% -15.6% 84.4%

3087 876 448 2137 6548 -705 5843

47.1% 13.4% 6.8% 32.6% 100.0% -10.8% 89.2%

4850 1207 0 2572 8629 -677 7952

56.2% 14.0% 0.0% 29.8% 100.0% -7.8% 92.2%

2348 1228 0 1461 5037 -403 4634

4773 1831.5 0 2747 9351.5 -741.5 8610

51.04% 19.59% 0.00% 29.37% 100.00% -7.93% 92.07%

-3220 -3843 -1776 -300 -9139

-43.6% -52.1% -24.1% -4.1% -123.8%

-2710 -3166 -950 0 -6826

-41.4% -48.4% -14.5% 0.0% -104.2%

-2942 -3123 -1210 0 -7275

-34.1% -36.2% -14.0% 0.0% -84.3%

-1674 -1913 -767 0 -4354

-3145 -3474.5 -1372 0 -7991.5

-33.63% -37.15% -14.67% 0.00% -85.46%

-2908 -61 -2969 -42 -3011 0 -3011

-39.4% -0.8% -40.2% -0.6% -40.8% 0.0% -40.8%

-983 -42 -1025 -137 -1162 298 -864

-15.0% -0.6% -15.7% -2.1% -17.7% 4.6% -13.2%

677 -115 562 -174 388 0 388

7.8% -1.3% 6.5% -2.0% 4.5% 0.0% 4.5%

280 -51 229 -45 184 0 184

618.5 -108.5 510 -132 378 0 378

6.61% -1.16% 5.45% -25.88% 4.04% 0.00% 4.04%

-67 40 -34

-0.9% 0.5% -0.5%

16 24 -82

0.2% 0.4% -1.3%

-53 21 -83

-0.6% 0.2% -1.0%

1 12 -64

-25.5 22.5 -105.5

-0.27% 0.24% -1.13%

1994

30.5%

1995

23.1%

1996

1996 (Projected)

1996 Ratios

1993

(mid-year) Current assets Required Cash Excess Cash Accounts receivable Prepaid expenses, etc.

Total current assets Equipment, net Purchased software, net Total assets

288

4.4%

153

1.8%

390

1742 185 2215 256 292 2763

26.6% 2.8% 33.8% 3.9% 4.5% 42.2%

1893 179 2225 377 246 2848

21.9% 2.1% 25.8% 4.4% 2.9% 33.0%

2293 171 2854 373 410 3637

390 0 2293 171 2854 373 410 3637

24.5% 1.8% 30.5% 4.0% 4.4% 38.9%

Current liabilities Notes payable Accounts payable Accrued royalties pble.

Other accrueds Deferred revenue Total current liabilities Noncurrent notes payable (ad hoc about 31%MVEntity) Total liabilities

0 279 286 1130 1726 3421 500 3921

0.0% 4.3% 4.4% 17.3% 26.4% 52.2% 7.6% 59.9%

500 585 455 848 1220 3608 0 3608

5.8% 6.8% 5.3% 9.8% 14.1% 41.8% 0.0% 41.8%

0 410 398 1231 1779 3818 0 3818

0 410 398 1231 1779 3818 0 3818

0.0% 4.4% 4.3% 13.2% 19.0% 40.8% 0.0% 40.8%

14155 11 419 -14688 0 -78 -181

0 52 14533 -14688 0 -78 -181

3637

3637

Convertible preferred Par common Additional paid-in cap Deficit/Retained earnings Treasury stock Foreign currency trans.

Total Equity Balance

14155 10 143 -15260 -176 -30 -1158

Total Liabilities & Equity

2763

-0.5%

14155 11 183 -14872 -176 -61 -760 2848

-0.7%

4.2%

N/A

H. Use cash flow statements for Spatial Technology, Inc. to determine whether the venture has been building or burning cash, as well as possible trends in building or burning cash.

343 It is pretty clear that the venture has been burning large amounts of cash in the past three years. Although the operations have recently been a net source of cash, recent investing and debt reduction activities have consumed most of the cash provided by operations.

Spatial is positioned to go cash flow positive.

I. Discuss possible reasons why the plan by Spatial Technology for an initial public offering (IPO) of common stock at the end of 1992 was withdrawn.

The primary issues resulting in pulling the 1992 IPO were an insufficiently broad management team and instability in Spatial‘s core product along with customer frustration and complaints.

J. Describe the IPO market conditions in 1996 and discuss possible reasons why the proposed IPO at a price of about $10 per share planned for October 1996 and involving Dain Bosworth as lead underwriter failed.

The official reason for the failure was insignificant demand for the shares. However, there were several contributors to the underwriter‘s failure including insufficient knowledge of the investor base prior to attempting to ―close the book.‖ There appears to be some belief by Spatial‘s management that the investment bankers did not sufficiently understand the technology and business model to provide a proper pitch for Spatial (to attract the right clientele of investors).

K. Evaluate the compound return on investments made at startup, Round A, Round B, Round C, and Round D if the acquired shares eventually sell at $10 and $5. Evaluate the compound return on all investments of each existing investor. Analyze the incentives of each investor and founder for taking the Cruttenden Roth offer to execute a $5 IPO. This exercise can be done in a number of ways depending on how in depth the instructor wants the students to go. We typically explain the use of the ―XIRR‖ function which conducts an IRR analysis given specific dates (rather than assuming columns are exactly one period apart). In Excel, this function is found in the ―Analysis Tool Pack‖ add-ins.

Depending on how the instructor wants the warrants treated for the management team (as return on investment or compensation for services rendered), there can be a variety of different numbers.

Sowar

7/15/86 $ (2,000.00) $ (2,000.00)

9/15/86

6/15/89

4/15/91

2/15/93

10/10/96 $ 1,069,996.50 (at $5) $ 2,819,991.50 (at $10)

XIRR 84.62% 102.93%

This analysis treats Sowar's warrants as part of his return on investment (rather than as compensation) and treats all options as exercised. As 19,999 of the options have exercise price of $5, the answer will be the same if one assumes that these are not exercised in the $5 scenario.

L. Using the provided financial statements as a starting point:

344 1. Prepare and present a DCF valuation and pro forma financials with five years of explicit forecasts using license fees and royalties growth rates consistent with recent history (e.g., two to three years) at Spatial.

2. Modify your analysis to consider a more successful scenario where Spatial’s main revenue sources (combined) grow at 50 percent for five years and then flatten to a more sustainable growth rate.

3. Prepare and present DCF valuations and pro forma financial statements (fiveyear explicit period) that justify a $10 and a $5 share price at the IPO. Make sure the ratios embedded in your projections conform to reasonable operating ratio assumptions.

4. In all cases be sure to explain your modeling assumptions on revenue and costs and provide a summary comparison of the four scenarios.

Once a student (or instructor) has constructed an initial working set of financial statements and valuation, it is relatively easy to mutate the spreadsheet into the three other alternative scenarios. We present one scenario below and have made the electronic spreadsheet available on the web page for manipulation in producing three alternatives of the instructor‘s own choosing.

Income Statement

1996

1996 (Projected)

1996 Ratios

2348 1228 0 1461 5037 -403 4634

4773 1831.5 0 2747 9351.5 -741.5 8610

-1674 -1913 -767 0 -4354 280 -51 229 -45 184 0 184

(half year) Revenue License fees Royalties Prepaid royalties Maintenance and training Total Revenue Cost of Sales Gross Profit Operating Expenses Sales and marketing Research and development General and administrative Severence costs Total operating expenses Earnings (loss) from operations Other expense, net Earnings (loss) before taxes and extraordinary item Income tax expense Earnings (loss) before extraordinary item Extraordinary item Net earnings (loss) Earnings growth rate Noninterest part of "other" Interest Income Interest Expense ProForma rate on interest inc.

ProForma rate on interest exp.

1 12 -64

1997

1998

1999

2000

2001

SS

SS+1

Growth

51.04% 19.59% 0.00% 29.37% 100.00% -7.93% 92.07%

10,249 -820 9,429

11,233 -899 10,335

12,312 -985 11,327

13,493 -1,079 12,414

14,789 -1,183 13,606

15,676 -1,254 14,422

16,617 -1,329 15,287

6.00% 6.00% 6.00%

-3145 -3474.5 -1372 0 -7991.5

-33.63% -37.15% -14.67% 0.00% -85.46%

-3,382 -3,792 -1,537 0 -8,712

-3,707 -4,156 -1,685 0 -9,548

-4,063 -4,555 -1,847 0 -10,465

-4,453 -4,993 -2,024 0 -11,469

-4,880 -5,472 -2,218 0 -12,571

-5,173 -5,800 -2,351 0 -13,325

-5,484 -6,148 -2,493 0 -14,124

6.00% 6.00% 6.00%

618.5 -108.5 510 -132 378 0 378

6.61% -1.16% 5.45% -25.88% 4.04% 0.00% 4.04%

717 -28 690 -172 517 0 517

786 -24 763 -191 572 0 572

862 -22 840 -210 630 0 630

945 -21 923 -231 693 0 693

1,035 -23 1,012 -253 759 0 759

1,097 -255 842 -211 632 0 632

1,163 -270 893 -223 670 0 670

6.00% 6.00% 6.00% 6.00% 6.00%

-28 0 0

10.55% -30 7 0

10.19% -33 12 0

9.90% -36 15 0

9.63% -40 17 0

-16.80% -42 0 -213

6.00% -45 0 -225

-25.5 22.5 -105.5

-0.27% 0.24% -1.13%

6.00%

6.00%

6.00% 6.00%

345 Balance Sheet

1996

1996 (Projected)

1996 Ratios

1997

1998

1999

2000

2001

SS

SS+1

Growth

390

390 0 2293 171 2854 373 410 3637

4.2% 24.5% 1.8% 30.5% 4.0% 4.4% 38.9%

430 131 2,511 184 3,257 410 451 4,118

472 234 2,752 202 3,660 449 494 4,604

517 307 3,016 222 4,062 492 542 5,097

567 342 3,306 243 4,457 540 594 5,591

621 0 3,623 266 4,511 592 651 5,753

658 0 3,841 282 4,781 627 690 6,098

698 0 4,071 299 5,068 665 731 6,464

6.00%

2293 171 2854 373 410 3637

0 410 398 1231 1779 3818 0 3818

0 410 398 1231 1779 3818 0 3818

0.0% 4.4% 4.3% 13.2% 19.0% 40.8% 0.0% 40.8%

0 451 441 1,353 1,537 3,782 0 3,782

0 494 483 1,483 1,236 3,696 0 3,696

0 542 529 1,625 862 3,558 0 3,558

0 594 580 1,781 405 3,360 0 3,360

0 651 636 1,952 0 3,239 1,418 4,657

0 690 674 2,069 0 3,433 1,503 4,936

0 731 715 2,193 0 3,639 1,593 5,232

Convertible preferred Par common Additional paid-in cap Deficit/Retained earnings Treasury stock Foreign currency trans.

Total Equity Balance

14155 11 419 -14688 0 -78 -181

0 52 14533 -14688 0 -78 -181

0 52 14,533 -14,171 0 -78 336

0 52 14,533 -13,599 0 -78 908

0 52 14,533 -12,969 0 -78 1,538

0 52 14,533 -12,276 0 -78 2,231

0 52 14,533 -13,411 0 -78 1,096

0 52 14,533 -13,345 0 -78 1,162

0 52 14,533 -13,275 0 -78 1,232

6.00%

Total Liabilities & Equity

3637

3637

4,118

4,604

5,097

5,591

5,753

6,098

6,464

6.00%

Net earnings +D&A -Change in AR -Change in prepaids +Change in AP +Change in accrueds +Change in def. rev -Capex +Exercise proceeds +Notes proceeds -Currency transl. losses -Cash dump (dividend) Change in cash Beginning cash Ending cash Check

517 243 -218 -13 41 165 -242 -321 0 0 0 0 172 390 561.814 561.814

572 267 -241 -18 43 172 -302 -350 0 0 0 0 144 562 706.053 706.053

630 293 -264 -19 47 189 -374 -383 0 0 0 0 118 706 824.391 824.391

693 321 -290 -21 52 207 -457 -420 0 0 0 0 84 824 908.708 908.708

759 351 -317 -23 57 227 -405 -460 0 1,418 0 -1,894 -288 909 621.133 621.131

632 385 -217 -16 39 155 0 -460 0 85 0 -566 37 621 658.400 658.399

670 408 -230 -17 41 165 0 -487 0 90 0 -600 40 658 697.902 697.903

6.00% 6.00% 6.00% 6.00% 6.00% 6.00%

Valuation Cash Flows (marginal tax rate used)

25%

25%

25%

25%

25%

25%

25%

Net Income +D&A -Capex -Change in NWC (incl. all cash) -Currency translation losses +Debt Proceeds Equity VCF from operations Check = Dividends

517 243 -321 -439 0 0 0 0

572 267 -350 -489 0 0 0 0

630 293 -383 -540 0 0 0 0

693 321 -420 -593 0 0 0 0

759 351 -460 -174 0 1,418 1,894 1,894

632 385 -460 -76 0 85 566 566

670 408 -487 -81 0 90 600 600

r= 0 23.93%

23.93% 0 23.93%

g= 0 23.93%

6.00% 0 23.93%

3,156 5,051 23.93%

3,346

3,546

23.93%

23.93%

$2,141 5,937,223 $0.36

$2,653 5,937,223 $0.45

$3,288 5,937,223 $0.55

$4,075 5,937,223 $0.69

$3,156 5,937,223 $0.53

$3,346 5,937,223 $0.56

$3,546 5,937,223 $0.60

(mid-year) Current assets Required Cash Excess Cash Accounts receivable Prepaid expenses, etc.

Total current assets Equipment, net Purchased software, net Total assets Current liabilities Notes payable Accounts payable Accrued royalties pble.

Other accrueds Deferred revenue Total current liabilities Noncurrent notes payable (ad hoc about 31%MVEntity) Total liabilities

N/A

6.00% 6.00% 6.00% 6.00% 6.00% 6.00%

6.00% 6.00% 6.00% 6.00% 6.00% 6.00%

Statement of cash flow

Terminal Value Total Equity VCF Discount Rates End of Year Equity Value Premoney Shares (Fully-Full Diluted including warrants) Share Price

$1,728 5,937,223 $0.29

6.00% 6.00% 6.00% 6.00% 6.00% 6.00%

6.00%

6.00%

6.00% 6.00%

M. Discuss the $5 and $10 IPO prices for Spatial within the context of comparable firms and their multiples. (There are some glimpses of multiples in the case materials, but you may wish to use some outside reference materials. Please state your sources.)

Typically, students find a $5 valuation possible but only under optimistic scenarios and improved ratios. The $10 valuation is typically seen as impossibly optimistic. This is a good example of how softer valuation methods based on temporarily inflated P/E or other multiples may not provide values that can be supported by any foreseeable rational projections for the firm. It is important, however, that students see how the simple comparisons (like P/E multiples) and more rigorous financial projections interact with each other for a more balanced overall view of the firm‘s prospects and value.

N. Prepare an executive summary discussing the events and decisions (technological and financial) leading to its current situation, the options it currently has, and your

346 recommendations for Spatial’s near future. Would (could) you have done anything differently?

Typically, the students‘ executive summaries discuss the implausibility of the $10 valuation and the serious concerns related to achieving the future required to substantiate a $5 valuation. Students also discuss Spatial‘s turbulent past with its products and customers and its managerial challenges (which continued after the IPO).

O. Take a position on whether you would recommend the $5 IPO. Take a position on whether, as an investor, you would have purchased shares in the $5 IPO. Answers will vary, but some students will recommend investing at the $5 price. Perhaps surprisingly, some will say they wouldn‘t personally invest but might recommend it to others. Of course, this could be the beginning of an interesting discussion on exactly why they would arrive at such a potential conflict.

P. Discuss what you believe will be the strategic (product lines, licensing, competitors, etc.) outlook for Spatial and what you believe will be the financial market’s view of a publicly traded Spatial Technology.

In many cases, students will research the post-IPO Spatial, which was publicly traded for several years before being acquired. The market that Spatial tried to develop has continued to provide opportunities, challenges and segmentation. The financial markets treated Spatial somewhat typically for a while with ups and downs before settling, like many recently IPO‘d firms at a price significantly below the IPO price. Spatial was subsequently acquired but has continued in its mission to the current time.