Mergers acquisitions and other restructuring activities 8th edition depamphilis test bank

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Chapter 10: Analysis and Valuation of Privately Held Companies Answers to End of Chapter Discussion Questions 10.1 What is the capitalization rate and how does it relate to the discount rate?

Answer: The terms discount rate and capitalization rate are often used interchangeably. Whenever the growth rate of a firm’s cash flows is projected to vary over time, the term discount rate generally refers to the factor used to convert the projected cash flows to present values. In contrast, if the cash flows of the firm are not expected to grow or are expected to grow at a constant rate indefinitely, the discount rate employed by practitioners is often referred as the capitalization rate.

10.2 What are the common ways of estimating the capitalization rate?

Answer: Capitalization rates may be estimated by using the Capital Asset Pricing Model, cost of capital, priceto-earnings ratios, accounting based returns such as the return on equity, and the build-up method.

10.3 What is the marketability discount and what are common ways of estimating this discount?

Answer: The risk associated with an illiquid market for the specific stock is often referred to as the marketability or liquidity discount. Liquidity is the ease with which an investor can sell their stock without a serious loss of value. An investor in a small company may find it difficult to sell quickly their shares because of limited interest in the company. Consequently, the investor may find it necessary to sell their shares at a significant discount from what they paid for the shares.

10.4 Give examples of private company costs that might be understated and explain why.

Answer: Examples may include employee training and the cost of complying with government regulation such as OSHA and the EPA. Small, privately owned firms tend to under-spend in these areas since they do not contribute directly to current profitability.

10.5 How can an analyst determine if the target firm’s costs and revenues are understated or overstated?

Answer: The analyst may determine that revenues have been overstated by comparing the accounting practices to GAAP guidelines and to other comparable firms. It may be determined that costs are understated by comparing the firm’s accounting practices with GAAP standards and by comparing the firm’s common size financial statements with those of similar firms.

10.6 Why might shell corporations have value?

Answer: Merging with an existing corporate shell of a formerly publicly traded company may be a reasonable alternative for a firm wanting to go public that is unable to provide the 2 years of audited financial statements required by the SEC or unwilling to incur the costs of going public through an initial public offering. Thus, merging with a shell corporation may represent an effective alternative to an initial public offering for a small firm. Shell corporations may also be attractive for investors interested in capitalizing on the intangible value associated with the existing corporate shell. This could include name recognition; licenses, patents, and other forms of intellectual properties; and underutilized assets such as warehouse space and fully depreciated equipment with some economic life remaining.

10.7 Why might succession planning be more challenging for family owned firms?

Answer: Succession planning is a critical activity in any firm. However, the challenge often is greater in family firms which wish to keep top management positions in the family. This restriction limits the total pool

of management talent available to the family owned firm, as some family members may have no interest in the firm and others simply do not have the credentials to step into a management role.

10.8 What are some of the reasons a family-owned or privately-owned business may want to go public? What are some of the reasons that discourage such firms from going public?

Answer: Private or family owned firms are more likely to go public when valuations are high or are increasing. Companies also are inclined to go public when they anticipate an inability to finance future investment opportunities or the outlook for the future profitability is unclear. In contrast, private firms are less likely to go public because of the increasing reporting requirements of Sarbanes-Oxley and the SEC, as well as concern about interference from public shareholders. Private firms also are less likely to go public when the special privileges that accrue to the controlling shareholders exceed the anticipated benefits from going public.

10.9 Why are family owned firms often attractive to private equity investors?

Answer: Family-owned firms often encounter succession problems. The founder wants to retire but either lacks confidence in existing family members as successors or cannot find a family member with the right credentials interested in taking control. Consequently, selling out to a private equity firm may be an attractive alternative. Such firms are interested in not only providing financing but also in providing board and management experience and expertise. They intend to invest for the long-term enabling the founder to cash out with some assurance the firm will continue to prosper.

10.10 Rank from the highest to the lowest the liquidity discount you would apply if you as a business appraiser had been asked to value the following businesses: a) a local, profitable hardware store, b) a money losing laundry, c) a large privately owned but marginally profitable firm with significant excess cash balances and other liquid short-term investments, and d) a pool cleaning service whose primary tangible assets consist of a 2-year old truck and miscellaneous equipment. Explain your ranking.

Answer: In descending order of magnitude, the liquidity discounts associated with these businesses would be as follows: d) The business is small, with few liquid assets of significant value; b) the business is small and unprofitable but does have some equipment that can be liquidated; a) the business is financially healthy; c) the business is large with substantial liquid assets.

Practice Problems and Answers 10.11 It is usually appropriate to adjust the financials received from the target firm to reflect any changes that you as the new owner would make in order to create an adjusted EBITDA. Using the Excel spreadsheet entitled “Adjusting Target Firm’s Financials” on the CDROM accompanying this book, make at least two adjustments to the target’s hypothetical financials to determine the impact on the adjusted EBITDA. (Note: The adjustments should be made in the section on the spreadsheet entitled “Adjustments to Target Firm’s Financials.”) Explain your rationale for each adjustment.

Answer: The student should submit the spreadsheet showing their adjustments and the rationale for each for credit. The answer will vary depending on what changes the student makes.

10.12 An analyst constructs a privately held firm’s cost of equity using the “build-up” method. The 10-year Treasury bond rate is 4% and the historical equity risk premium for the S&P 500 stock index is 5.5%. The risk premium associated with firms of this size is 3.8% and for firms within this industry is 2.4%. Based on due diligence, the analyst estimates the risk premium specific to this firm to be 2.5%. What is the firm’s cost of equity based on this information?

Answer: 4.0% + 5.5% + 3.8% +2.4% +2.5% = 18.2% 10.13 An investor is interested in making a minority equity investment in a small privately held firm. Because of the nature of the business, she concludes that it would be difficult to sell her interest in the business quickly.

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Therefore, she believes that the discount for the lack of marketability to be 25%. She also estimates that if she were to acquire a controlling interest in the business, the control premium would be 15%. Based on this information, what should be the discount rate for making a minority investment in this firm? What should she pay for 20% of the business if she believes the value of the entire business to be $1 million. Answer: Discount rate = 9.78% and Purchase price for a 20% interest = $180,440 Answer: The discounts are multiplicative since they are interdependent as the smaller the minority interest the greater the marketability discount. Therefore, the combined discount is (1 – 1/ (1+.15)) x (1-.25) = .0978. The value of a 20% investment is (1 - .0978) x .2 x $1,000,000 = .9022 x .2 x $1,000,000 = $180,440

10.14 Based on its growth prospects, a private investor values a local bakery at $750,000. She believes that cost savings having a present value of $50,000 can be achieved by changing staffing levels and store hours. Based on recent empirical studies, she believes the appropriate liquidity discount is 20 percent. A recent transaction in the same city required the buyer to pay a 5 percent premium to the asking price to gain a controlling interest in a similar business. What is the most she should be

willing to pay for a 50.1 percent stake in the bakery?

Answer: The investor should not offer more than $336,672.

Maximum Offer Price (50.1%) = ($750,000+$50,000) x (1-.2)(1+.05) x .501 = $336,672 10.15 You have been asked by an investor to value a restaurant. Last year, the restaurant earned pretax operating income of $300,000. Income has grown 4% annually during the last five years, and it is expected to continue growing at that rate into the foreseeable future. The annual change in working capital is $20,000, and capital spending for maintenance exceeded depreciation in the prior year by $15,000. Both working capital and the excess of capital spending over depreciation are projected to grow at the same rate as operating income. By introducing modern management methods, you believe the pretax operating income growth rate can be increased to 6% beyond the second year and sustained at that rate into the foreseeable future.

The ten-year Treasury bond rate is 5%, the equity risk premium is 5.5%, and the marginal federal, state, and local tax rate is 40%. The beta and debt-to-equity ratio for publicly traded firms in the restaurant industry are 2 and 1.5, respectively. The business's target debt-to-equity ratio is 1, and its pretax cost of borrowing, based on its recent borrowing activities, is 7%. The business-specific risk premium for firms of this size is estimated to be 6%. The liquidity risk premium is believed to be 15%, relatively low for firms of this type due to the excellent reputation of the restaurant. Since the current chef and the staff are expected to remain after the business is sold, the quality of the restaurant is expected to be maintained. The investor is willing to pay a 10% premium to reflect the value of control. a. What is free cash flow to the firm in year 1?

b.

Free cash flow to the firm in year 1 = $300,000 x 1.04 x (1 - .4) - $20,000 x 1.04 - $15,000 x 1.04 = $187,200 – $20,800 – $15,600 = $150,800 What is free cash flow to the firm in year 2?

c.

Free cash flow to the firm in year 2 = ($300,000 x 1.04 2) x (1-.4) - $20,000 x 1.042 - $15,000 x 1.042 = $194,688 – $21,632 – $16,224 = $156,832 What is the firm’s cost of equity?

d.

Industry’s unleveraged beta = 2 / (1 + .6 x 1.5) = 1.05 Restaurant’s leveraged beta = 1.05 (1 + .6 x 1.0) = 1.68 Cost of Equity = .05 + 1.68 (.055) + .06 = .2024 What is the firm’s after-tax cost of debt?

e.

After-tax cost of debt = .07 x (1-.4) = .042 What is the firm’s target debt-to-total capital ratio?

Restaurant’s target debt-to-total capital ratio = target D/E / (1 + target D/E) = 1 / 2 = .5

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f.

What is the weighted average cost of capital?

g.

Weighted average cost of capital = .5 x .2024 + .5 x .042 = .1012 + .0210 = .1222 What is the business worth?

PV = $150,800 + $156,832 + ($156,832 x 1.06)/(.1222 - .06) = (1.1222) (1.1222)2 (1.1222)2 = $134,379 + $124,536 + $2,122,313 = $2,381,228 (Note: The first two terms represent the PV of the firm’s operating cash flows before the application of modern management methods is fully implemented; the third term is the terminal value and reflects the anticipated sustained improvement in cash flows when the benefits of the new management techniques are fully realized.)

PV (after the liquidity discount & control premium) = $2,381,228 x (1 - .15) x (1 + .10) = $2,226,448

Solutions to Chapter Case Study Questions Shell Game: STK Steakhouse Chain Goes Public Through a Reverse Merger Discussion Questions 1.

What are common reasons for a private firm to go public? What are the advantages and disadvantages or doing so? Be specific.

Answer: Common reasons for a firm to go public include the ability to obtain capital, to obtain an acquisition currency, to liquidate some portion of the founder’s share holdings, and to offer incentive stock options to the firm’s management that can be exercised with the shares easily sold in a liquid market. The disadvantages of becoming a public company are significant and include the additional administrative and reporting requirements and their associated expenses. Also, public company management and boards often are forced by their shareholders to focus more on the short than the longer term. Common trade-offs include decisions to pay dividends or to buy-back shares (short-term considerations) versus using available funds to make acquisitions and capital investments in an attempt to bolster longer term cash flow growth.

2.

What are corporate shells, and how can they create value? Be specific.

Answer: A corporate shell is a corporation usually without any significant operating assets and liabilities. Such legal entities may have value if they are listed on public stock exchanges. Private firms may be able to more rapidly and less expensively go public by merging with a SEC registered shell company through a reverse merger than through an IPO.

3.

What were the options available to One Group LLC to raise capital to finance their expansion plans? Discuss the pros and cons of each. Be specific.

Answer: Options available to One Group included borrowing from banks or hedge funds, entering into a private equity placement with a hedge fund or private equity investor group, undertaking an initial public offering, and going public through a reverse merger. (Since One Group is a limited liability company, a private placement would involve the sale of units rather than shares unless it converted to a C corporation before the sale.)

Additional borrowing has the advantage of satisfying financing requirements without diluting current owners’ interests. However, it may burden the business with excessive debt, which has contributed to the demise of so many rapidly growing businesses in the past. Furthermore, borrowing often comes with substantial restrictions

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imposed by the lender on how the business may be operated. Equity could be sold directly in the private placement market or to the public. While this would avoid the risk associated with borrowing, private equity placements could be expensive and may not provide the amount of financing needed; tapping the public markets directly through an IPO requires significant underwriting expense and would leave the timing of the IPO largely to the vagaries of the stock market. That is, IPOs become more frequent when the stock market is growing and are delayed when the stock market falters. A reverse merger offers the prospect of going public more rapidly and possibly less expensively than an IPO. However, the risks are high that the private firm owners would be taking on unknown liabilities held by the public company without proper due diligence.

Further, the shares of companies taken public in this manner often are highly illiquid.

4.

Discuss the pros and cons of a reverse merger versus an IPO. Answer: Many small businesses fail each year. In a number of cases, all that remains is a business with no significant assets or operations. Such companies are referred to as shell corporations. Shell corporations can be used as part of a deliberate business strategy in which a corporate legal structure is formed in anticipation of future financing, a merger, joint venture, spin-off, or some other infusion of operating assets. This may be accomplished in a transaction called a reverse merger in which the acquirer forms a new shell subsidiary, which is merged into the target in a statutory merger. While the shell is the surviving firm, the former shareholders of the private firm usually own a majority interest in the combined firms.

Merging with an existing corporate shell of a publicly traded company may be a reasonable alternative for a firm wanting to go public that is unable to provide the two years of audited financial statements required by the SEC or unwilling to incur the costs of going public. Thus, merging with a shell corporation may represent an effective alternative to an IPO for a small firm.

Direct issuance costs associated with going public include the underwriter spread and administrative and regulatory costs. The underwriter spread represents the difference between the price the underwriter receives for selling a firm’s securities to the public and the amount it pays to the firm. The underwriter spread can range from less than 1% of gross proceeds for a high-quality company to more than 8% for lower quality companies.

Administrative and regulatory fees consist of legal and accounting fees, taxes, and the cost of SEC registration.

For offerings less than $10 million in size, total direct issuance costs may exceed 10% of gross proceeds. For equity issues between $20 million and $50 million in size, these costs average less than 5% of gross proceeds and less than 3% for those issues larger than $200 million. Reverse mergers typically cost between $50,000$100,000, about one-quarter of the expense of an IPO and can be completed in about 60 days or one-third of the time to complete a typical IPO (Sweeney: 2005).

5.

Why is it likely that shares trade at a discount from their value when issued if investors attempted to sell such shares within one year following closing of the reverse merger?

Answer: Following a reverse merger, the operating company is technically public in that its shares once registered with the SEC are traded on the Pink Sheets or OTC Bulletin Board. Such shares under current U.S. security laws cannot be traded on the major exchanges until they have traded on the smaller exchanges for a year and have maintained a minimum price for at least 30 to 60 days. However, shares traded on the smaller exchanges are likely to be thinly traded, if at all. As such, they are likely to be relatively illiquid, resulting in a discount from their value when issued.

Unlike an IPO, there is no post-deal underwriter to support the shares by making an active secondary market with the underwriter standing ready to buy shares when offered. Therefore, it is difficult for company insiders to cash out. Moreover, the company’s shares will not be attractive as an acquisition currency or for employee incentive plans. Finally, shares from companies having gone public through a reverse merger often trade at a lower price than those of a comparable IPO firm due to investor perception that only lower quality firms go public in this manner and that they have not been adequately vetted by a recognized underwriter.

6.

What is the purpose of ultimately listing of a major stock exchange such as NASDAQ?

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Answer: Larger public stock exchanges offer substantially larger trading volumes than the Pink Sheets and OTC Bulletin Board. Therefore, they are likely to offer greater liquidity for One Group’s shares offering greater ease of sale and potentially a higher selling price. In addition, if One Group hopes to raise additional funds in the future through new equity issues, it is likely to be able to do so at an overall lower cost because of the greater liquidity of the NASDAQ. Examination Questions and Answers True/False Questions: Answer true or false to the following questions: 1.

Both public and private firms always attempt to maximize earnings growth. True or False Answer: False

2.

Financial information for both public and private firms is equally reliable because their statements are audited by outside accounting firms to ensure that are developed in a manner consistent with GAAP. True or False Answer: False

3.

For privately held firms, firm specific risk may include lack of product, industry, and geographic diversification; limited management depth, volatile stock markets, and unionized workforces.

True or False Answer: False

4.

Private firms are likely to understate revenue and understate costs in order to minimize their tax liabilities.

True or False Answer: False

5.

Revenue may be inflated by booking as revenue products shipped to resellers without adequately adjusting for probable returns. True or False Answer: True

6.

If a buyer expects that the target firm’s revenue has been overstated, the buyer can reconstruct revenue by examining usage levels of the key inputs required to produce the product or service. True or False Answer: True

7.

The purpose of adjusting the target’s income statement is to provide an accurate estimate of the current year’s reported operating income or operating cash flow. True or False Answer: True

8.

Employee benefit levels in private firms are almost always mandated by state or federal law and therefore cannot be changed. True or False Answer: False

9.

An increase in the target firm’s reserves for doubtful accounts increases taxable income, while a decrease reduces the firm’s taxable income. True or False Answer: False

10.

It is easier to obtain the fair market value of private companies than for public companies because of the absence of volatile stock markets. True or False Answer: False

11.

Methodologies employed to value private firms are substantially different from those employed to value public firms. True or False Answer: False

12.

Asset valuation includes specific business risks but ignores any adjustment for liquidity risk. True or False

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Answer: False 13.

The risk associated with an illiquid market for a specific stock is referred to as the liquidity or marketability risk. True or False Answer: True

14.

Shell corporations may have significant value to acquiring firms. True or False Answer: True

15.

Empirical evidence suggests that discounts have declined in recent years. True or False Answer: True

16.

Private businesses may need to be valued to settle shareholder disputes, court cases, divorce, or the payment of gift or estate taxes. True or False Answer: True

17.

The availability and reliability of data for public companies tends to be much greater than for small private firms. True or False Answer: True

18.

Managers and owners in public companies are likely to have the same emotional attachment to their businesses as those in private firms. True or False Answer: False

19.

Because of data limitations, valuation of private firms often requires more subjective adjustments than for public firms. True or False Answer: True

20.

Private firms must file quarterly earnings reports with the Securities and Exchange Commission.

True or False Answer: False

21.

Membership or subscription businesses, such as health clubs and magazine publishers, may inflate revenue by booking the full value of muliyear contracts in the first year of the contract. True or False Answer: True

22.

If the buyer believes that the seller has overstated revenue in a specific accounting period, the buyer can reconstruct revenue by examining usage levels, in the same accounting period, of the key inputs required to produce the product or service. True or False Answer: True

23.

The primary purpose of the buyer adjusting the seller earnings is to provide an accurate estimate of the current year’s operating income or cash flow in the base year. True or False Answer: True

24.

In adjusting base year income, an appraiser must be aware of the implications of various accounting methods for value. During periods of inflation, businesses frequently use the last-in, first out method to value inventories. This approach results a reduction in the cost of sales and an increase in gross profits and taxable income. True or False Answer: False

25.

Before selling a business, an owner may increase advertising expenses in order to inflate profits.

True or False Answer: False

26.

Intangible assets such as customer lists, intellectual property, licenses, distributorships agreements, leases,

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regulatory approvals, and employment contracts may offer significant sources of value. True or False Answer: True 27.

Fair value is by necessity more subjective than the concept of fair market value, because it represents the dollar value of a business based upon an appraisal of the tangible and intangible assets of the business.

True or False Answer: True

28.

Valuation of privately held businesses may involve substantial adjustment of the discount or capitalization rate. True or False Answer: True

29.

The term capitalization refers to the conversion of a future income stream into a present value, and it is a term often used by business appraisers when future income or cash flows are not expected to grow or to grow at a constant rate. True or False Answer: True

30.

Restricted stock is often issued to employees of privately held firms as a significant portion of their total compensation. Such stock is similar to other types of common stock except that its sale on the open market is prohibited for a period of time. True or False Answer: True

31.

A private corporation is a firm whose securities are not registered with state or federal authorities. True or False Answer: True

32.

Privately owned businesses are often referred to as “closely held” since they are usually characterized by a small group of shareholders controlling operating and managerial policies of the firm . True or False Answer: True

33.

Very few closely held businesses are family owned. True or False Answer: False

34.

All family owned businesses are small. True or False Answer: False

35.

In many family owned firms, family influence is exercised by family members holding senior management positions, seats on the board of directors, and through holding super-voting stock (i.e., stock with multiple voting rights). True or False Answer: True

36.

The M&A market for employer firms tends to be concentrated among smaller firms, as firms in the United States with 99 or fewer employees account for 98% of all firms with employees. True or False Answer: True

37.

Family owned businesses account for about 89% of all businesses in the U.S. True or False Answer: True

38.

Firms that are family owned but not managed by family members are often well managed, as family shareholders with large equity stakes carefully monitor those charged with managing the business. True or False Answer: True

39.

Succession issues tend to be easier for small family owned firms than for large publicly traded firms. True or False Answer: False

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40.

The market model of corporate governance is readily applicable to privately held, family owned firms.

True or False Answer: False

41.

In many countries, family owned firms have been successful because of their shared interests and because investors place a higher value on short-term performance than on the long-term health of the business. True or False Answer: False

42.

The control model of corporate governance may be more applicable where ownership tends to be highly diverse and the right to control the business is separate from ownership. True or False Answer: False

43.

A family owned firm’s board faces the sometimes daunting challenge of achieving the proper balance between monitoring and collaboration to minimize the emotionality and overlapping roles that often characterize such firms. True or False Answer: True

44.

Because of the need to satisfy both the demands of stockholders and regulatory agencies, public companies need to balance the desire to minimize taxes with the goal of achieving quarterly earnings levels consistent with investor expectations. Failure to do so frequently results in an immediate loss in the firm’s market value. True or False Answer: True

45.

Despite the lack of public exchanges for privately held firms, Wall Street analysts have ample incentive to analyze such firms in search of emerging companies. True or False Answer: False

46.

Private companies are generally not subject to the same level of rigorous controls and reporting systems as are public companies. True or False Answer: True

47.

Small firms may lack product, industry, and geographic diversification, which add to their specific business risk. True or False Answer: True

48.

Owners of private businesses attempting to minimize taxes may overstate their contribution to the firm by giving themselves or family members unusually low salaries, bonuses, and benefits. True or False Answer: False

49.

It is rare that the owner or a family member is either an investor in or an owner of a vendor supplying products or services to the family owned firm. True or False Answer: False

50.

A sudden improvement in operating profits in the year in which the business is being offered for sale may suggest that both revenue and expenses had been overstated during the historical period.

True or False Answer: False

51.

EBITDA has become an increasingly popular measure of value for privately held firms in recent years.

True or False Answer: True

52.

The fair value concept is applied when no strong market exists for a business or it is not possible to identify the value of substantially similar firms. True or False

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Answer: True 53.

If the cash flows of the firm are not expected to grow or are expected to grow at a constant rate indefinitely, the discount rate used by practitioners often is referred to as the capitalization rate. True or False Answer: True

54.

If the discount rate is assumed to be 8% and the current cash flow is $1.5 million and is expected to remain at that level in perpetuity, the implied valuation is $18.75 million. True or False Answer: True

55.

A control premium is the additional premium a buyer is willing to pay for the right to direct the activities of a firm. True or False Answer: True

56.

An investor in a small company generally has little difficulty in selling their shares because of the high demand for small businesses. True or False Answer: False

57.

It is generally easier to sell a minority interest than a majority interest in a business without loss of the value of the original investment. True or False Answer: False

58.

Shell corporations rarely have any value. True or False Answer: False

59.

Private investment in public entities (PIPES) is a commonly used method of financing reverse mergers.

True or False Answer: True

60.

Shell corporations may be attractive for investors interested in capitalizing on the intangible value associated with the existing corporate shell. This could include name recognition; licenses, patents, and other forms of intellectual properties; and underutilized assets such as warehouse space and fully depreciated equipment with some economic life remaining. True or False Answer: True

61.

Studies of restricted stock sales since 1990 indicate a median liquidity discount of about 20 percent with several showing a decline to 13 percent after 1997 following the holding period change under Rule 144 from two years to one. True or False Answer: True

62.

There is widespread agreement over the magnitude of the liquidity discount. True or False Answer: False

63.

A minority discount is the reduction in the value of a minority investor’s investment because minority owners have little influence in how the firm is managed. True or False Answer: True

64.

A pure control premium is the value the acquirer believes can be created by replacing the target firm’s incompetent management, by changing the strategic direction of the target, by gaining a foothold in a market not currently served, or by achieving unrelated diversification. True or False Answer: True

65.

Studies show that control premiums vary widely across countries reflecting the efficacy of shareholder rights laws and how well such laws are enforced in each country. True or False Answer: True

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66.

Increasing market liquidity will reduce the value of control; an increasing value of control will reduce market liquidity and contribute to increasing liquidity discounts. True or False Answer: True

Multiple Choice Questions: Circle only one alternative.

1.

Which of the following are often true about the challenges of valuing private firms? a.

There is a lack of analyses generated by sources outside of the company. b.

Financial reporting systems are often inadequate. c.

Management depth and experience is often limited. d.

Reported earnings are often understated to minimize taxes. e.

All of the above.

Answer: E

2.

In valuing private businesses, the U.S. tax courts have historically supported the use of which valuation method for purposes of estate valuation? a.

Discounted cash flow b.

Comparable company method c.

Tangible book value method d.

A combination of a and c e.

All of the above Answer: B

3.

All of the following are true of reverse mergers except for. a.

May be used to take a private firm public b.

May represent an effective alternative to an IPO c.

Commonly use private equity placements for financing d.

Requires 2 years of audited financial statements to take a private firm public e.

A and B Answer: D

4.

Which of the following is not true of liquidity or marketability risk or discount? a.

It is measurable. b.

It is believed to have declined in recent years c.

The magnitude of the discount or risk is inversely related to the size of the investor’s equity ownership in the business. d.

The magnitude of the discount or risk is directly related to the size of the investor’s equity ownership in the business. e.

It is important to adjust the discount rate for liquidity risk.

Answer: D

5.

Corporate shells have value because they enable the buyer to a.

Avoid the cost of going public b.

Exploit intangible value such as brand name c.

A and D only d.

Provide limited liability e.

A, B, and D only Answer: E

6.

Leveraged employee stock ownership plans are frequently used by owners of private businesses to a.

Hide assets b.

Motivate employees c.

Sell the firm to the employees d.

B and C e.

A, B, and C Answer: D

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7.

All of the following are often true of privately held firms except for a.

Financial data is often inaccurate and out of date b.

Internal controls are ineffective c.

Have limited access to capital markets and product distribution channels d.

Are more easily valued than public companies e.

Have limited ability to influence customers, suppliers, unions, and regulators Answer: D

8.

Fair market value is a.

The cash or cash equivalent value that a willing buyer would pay or seller would accept for a business b.

The cash or cash equivalent value that a willing buyer would pay or seller would accept for a business, assuming each had access to all necessary information c.

The cash or cash equivalent value that a willing buyer would pay or seller would accept for a business, assuming each had access to all necessary information and that neither party is under duress. d.

The discounted value of free cash flow to the firm e.

The discounted value of free cash flow to equity investors.

Answer: C

9.

The discount rate may be estimated using all but the one of the following: a.

The capital asset pricing model b.

The share exchange ratio c.

The cost of capital d.

Return on total assets e.

Price-to-earnings ratio Answer: B

10.

All of the following represent common sources of value in appraising private or publicly owned businesses except for a.

Intellectual property b.

Customer lists c.

Licenses d.

Contingent liabilities e.

Employment contracts Answer: D

11.

Revenue Ruling 59-60 describes the general factors that the IRS and tax courts consider relevant in valuing private businesses. Of the following valuation methods, which do the IRS and tax courts view as the most important? a.

Discounted cash flow b.

Comparable company methods c.

Tangible book value d.

Replacement cost method e.

All of the above Answer: B

12.

The most important element(s) in selecting a business valuation professional include which of the following: (Select only one) a.

Overall experience b.

Demonstrated ability in the industry in which the firm to valued competes c.

Degree of specialization d.

Number of professional degrees e.

A and B only Answer: E

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13.

A business owner may overstate revenue by a.

Failing to deduct from revenue products returned by customers b.

Billing customers for products not ordered c.

Booking the entire value of a multiyear contract in the current year d.

Counting interest income as revenue e.

All of the above Answer: E

14.

A business owner may overstate revenue and understate actual expenses when a.

The business is about to be sold b.

They are being audited by the IRS c.

They are trying to minimize tax liabilities d.

All of the above e.

None of the above Answer: A

15.

A corporate shell may have value because a.

It may enable the owner to avoid the costs of going public b.

The name is widely recognized c.

It could own the rights to various forms of intellectual property d.

All of the above e.

None of the above Answer: D Short Case Study Essay Questions:

Shell Game: Going Public through Reverse Mergers ___________________________________________________________________________________________ Key Points Reverse mergers represent an alternative to an initial public offering (IPO) for a private company wanting to “go public.”

The challenge with reverse mergers often is gaining access to accurate financial statements and quantifying current or potential liabilities.

Performing adequate due diligence may be difficult, but it is the key to reducing risk. ______________________________________________________________________________ The highly liquid U.S. equity markets have proven to be an attractive way of gaining access to capital for both privately owned domestic and foreign firms. Common ways of doing so have involved IPOs and reverse mergers.

While both methods allow the private firm’s shares to be publicly traded, only the IPO necessarily results in raising capital, which affects the length of time and complexity of the process of “going-public.”

To undertake a reverse merger, a firm finds a shell corporation with relatively few shareholders who are interested in selling their stock. The shell corporation’s shareholders often are interested in either selling their shares for cash, owning even a relatively small portion of a financially viable company to recover their initial investments, or transferring the shell’s liabilities to new investors. Alternatively, the private firm may merge with an existing special-purpose acquisition company (SPAC) already registered for public stock trading. SPACs are shell, or “blank-check,” companies that have no operations but go public with the intention of merging with or acquiring a company with the proceeds of the SPAC’s IPO. In a merger, it is common for the surviving firm to be viewed as the acquirer, since its shareholders usually end up with a majority ownership stake in the merged firms; the other party to the merger is viewed as the target firm because its former shareholders often hold only a minority interest in the combined companies. In a reverse merger, the opposite happens. Even though the publicly traded shell company survives the merger, with the private firm becoming its wholly owned subsidiary, the former shareholders of the private firm end up with a majority ownership stake in the combined firms. While conventional IPOs can take months to complete, reverse mergers can take only a

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few weeks. Moreover, as the reverse merger is solely a mechanism to convert a private company into a public entity, the process is less dependent on financial market conditions because the company often is not proposing to raise capital.

The speed with which a firm can “go public” as compared to an IPO often is attractive to foreign firms desirous of entering U.S. capital markets quickly. In recent years, private equity investors have found the comparative ease of the reverse merger process convenient, because it has enabled them to take public their investments in both domestic and foreign firms. In recent years the story of the rapid growth of Chinese firms has held considerable allure for investors, prompting a flurry of reverse mergers involving Chinese-based firms. With speed comes additional risk.

Shell company shareholders may simply be looking for investors to take over their liabilities, such as pending litigation, safety hazards, environmental problems, and unpaid tax liabilities. To prevent the public shell’s shareholders from dumping their shares immediately following the merger, investors are required to hold their shares for a specific period of time. The recent entry of Chinese firms into the U.S. public equity markets illustrates the potential for fraud. Of the 159 Chinese-based firms that have been listed since 2006 via a reverse merger, 36 have been suspended or have halted trading in the United States after auditors found significant accounting issues.

Eleven more firms have been delisted from major U.S. stock exchanges.

Huiheng Medical (Huiheng) is one such firm that came under SEC scrutiny, having first listed its shares on the over-the-counter (OTC) market in early 2008. The firm claimed it was China’s leading provider of gamma-ray technology, a cancer-fighting technology, and boasted of having a strong order backlog and access to Western management expertise through a joint venture. What follows is a discussion of how the firm went public and the participants in that process. The firms involved in the reverse merger process included Mill Basin Technologies (Mill), a Nevada incorporated and publicly listed shell corporation, and Allied Moral Holdings (Allied), a privately owned Virgin Islands company with subsidiaries, including Huiheng Medical, primarily in China. Mill was the successor firm to Pinewood Imports (Pinewood), a Nevada-based corporation, formed in November 2002 to import pine molding. Ceasing operations in September 2006 to become a shell corporation, Pinewood changed its name to Mill Basin Technologies. The firm began to search for a merger partner and registered shares for public trading in 2006 in anticipation of raising funds.

The reverse merger process employed by Allied, the privately owned operating company and owner of Huiheng, to merge with Mill, the public shell corporation, early in 2008 to become a publicly listed firm is described in the following steps. Allied is the target firm, and Mill is the acquiring firm.

Step 1. Negotiate terms and conditions: Premerger, Mill and Allied had 10,150,000 and 13,000,000 common shares outstanding, respectively. Mill also had 266,666 preferred shares outstanding. Mill and Allied agreed to a merger in which each Allied shareholder would receive one share of Mill stock for each Allied share they held. With Mill as the surviving entity, former Allied shareholders would own 96.65% of Mill’s shares, and Mill’s former shareholders would own the rest.

Step 2. Recapitalize the acquiring firm: Prior to the share exchange, shareholders in Mill, the shell corporation, recapitalized the firm by contributing 9,700,000 of the shares they owned prior to the merger to Treasury stock, effectively reducing the number of Mill common shares outstanding to 450,000 (10,150,000 – 9,700,000). The objective of the recapitalization was to limit the total number of common shares outstanding postmerger in order to support the price of the new firm’s shares. Such recapitalizations often are undertaken to reduce the number of shares outstanding following closing in order to support the combined firms’ share price once it begins to trade on a public exchange.1 The firm’s earnings per share are increased for a given level of earnings by reducing the number of common shares outstanding.

Step 3. Close the deal: The terms of the merger called for Mill (the acquirer) to purchase 100% of the outstanding Allied (the target) common and preferred shares, which required Mill to issue 13,000,000 new common shares and 266,666 new preferred shares. All premerger Allied shares were cancelled. Mill Basin Technologies was renamed Huiheng Medical, reflecting potential investor interest at that time in both Chinese firms and in the healthcare Without the reduction in Mill’s premerger shares outstanding, total shares outstanding postmerger would have been 23,150,000 [10,150,000 (Mill shares premerger) + 13,000,000 (Allied shares premerger)] rather than the 13,450,000 after the recapitalization.

1

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industry. See Exhibit 10.4 for an illustration of the premerger recapitalization of Mill, the postmerger equity structure of the combined firms, and the resulting ownership distribution.

While Huiheng traded as high as $13 in late 2008, it plummeted to $1.60 in early 2012, reflecting the failure of the firm to achieve any significant revenue and income in the cancer market, an inability to get an auditing firm to approve their financial statements, and the absence of any significant order backlog. Having reported net income as high as $9 million in 2007, just prior to completing the reverse merger, the firm was losing money and burning through its remaining cash. The firm was left looking at alternative applications for its technology, such as preserving food with radiation.

Huiheng’s SEC filings state that the firm designs, develops, and markets radiation therapy systems used to treat cancer and acknowledge that the firm had experienced delays selling its technology in China and had no international sales in 2009 or 2010. The filings also show the reverse merger was directed by Richard Propper, a venture capitalist and CEO of Chardan Capital, a San Diego merchant bank with expertise in helping Chinese firms enter the U.S. equity markets. Chardan Capital invested $10 million in Huiheng in exchange for more than 52,000 shares of the firm’s preferred stock. Chardan and Roth Capital Partners, a California investment bank, were counderwriters for a planned 2008 Huiheng stock offering that was later withdrawn. Chardan had been fined $40,000 for three violations of short-selling rules from 2005 to 2009. Roth is a defendant in alleged securities’ fraud lawsuits involving other Chinese reverse merger firms.2 Exhibit 10.4 Mill Basin Technologies (Mill) Pre-Merger Equity Structure: Common 10,150,000 Series A Preferred 266,666 Recapitalized Equity Structure Common 450,000a Series A Preferred 266,666 New Mill Shares Issued to Acquire 100% of Allied shares Common 13,000,000 Series A Preferred 266,666 Post-Merger Equity Structure: Common 13,450,000b Series A Preferred 266,666 Post-Merger Ownership Distribution of Common Shares: Former Allied Shareholders: 96.65% c Former Mill Shareholders: 3.35% a

Mill shareholders contributed 9,700,000 shares of their pre-merger holdings to treasury stock cutting the number of Mill shares outstanding to 450,000 in order to reduce the total number of shares outstanding postmerger, which would equal Mill’s premerger shares outstanding plus the newly issued shares. This also could have been achieved by the Mill shareholders agreeing to a reverse stock split. The 10,150,000 premerger Mill shares outstanding could be reduced to 450,000 through a reverse split in which Mill shareholders receive 1 new Mill share for each 22.555 outstanding prior to the merger. b Post-Merger Mill Basin Technologies’ capital structure equals the 450,000 premerger Mill common shares resulting from the recapitalization plus the 13,000,000 newly issued common shares plus 266,666 Series A preferred shares. c (13,000,000/13,450,000) Huiheng ran into legal problems soon after its reverse merger. Harborview Master Fund, Diverse Trading Ltd., and Monarch Capital Fund, institutional investors having a controlling interest in Huiheng, approved the reverse merger and invested $1.25 million in exchange for stock. However, they sued Huiheng and Chardan Capital in 2009 as Huiheng’s promise of orders failed to materialize. The lawsuit charged that Huiheng bribed Chinese hospital officials to win purchasing deals. The firm’s initial investors forced the firm to buy back their shares as a result of a legal settlement of their lawsuit in which they argued that the firm had committed fraud when it “went public.” The 2

McCoy and Chu, December 26, 2011

15

lawsuit alleged that the firm’s public statements about the efficacy of its technology and order backlog were highly inflated. Huiheng and its codefendants settled out of court in 2010 with no admission of liability by buying back some of its stock. In 2011, the firm had difficulty in collecting receivables and generating cash. That same year, Huiheng’s operations in China were struggling and were on the verge of ceasing production.

Discussion Questions 1.

What are common reasons for a private firm to go public?

Answer: Common reasons for a firm to go public include the ability to obtain capital, to obtain an acquisition currency, to liquidate some portion of the founder’s share holdings, and to offer incentive stock options to the firm’s management that can be exercised with the shares easily sold in a liquid market.

2.

What is a corporate shell and how can they create value?

Answer: A corporate shell is a firm usually without any significant operating assets and liabilities. Such legal entities may have value if they are listed on public stock exchanges. Private firms may be able to more rapidly and less expensively go public by merging with a SEC registered shell company through a reverse merger than through an IPO.

3.

Who are the key participants in the case study and what are their roles in the reverse merger?

Answer: Mill Basin Technologies and Allied Moral Holdings are the publicly listed shell corporation and the private firm that is taken public through the reverse merger process, respectively. Ross and Charden Capital are investment banks that were instrumental in finding a shell corporation for Allied Moral Holdings and in raising capital once Allied was taken public.

4.

Discuss the pros and cons of a reverse merger versus an initial public offering for taking a company public.

Answer: Many small businesses fail each year. In a number of cases, all that remains is a business with no significant assets or operations. Such companies are referred to as shell corporations. Shell corporations can be used as part of a deliberate business strategy in which a corporate legal structure is formed in anticipation of future financing, a merger, joint venture, spin-off, or some other infusion of operating assets. This may be accomplished in a transaction called a reverse merger in which the acquirer forms a new shell subsidiary, which is merged into the target in a statutory merger. While the shell is the surviving firm, the former shareholders of the private firm usually own a majority interest in the combined firms.

Merging with an existing corporate shell of a publicly traded company may be a reasonable alternative for a firm wanting to go public that is unable to provide the 2 years of audited financial statements required by the SEC or unwilling to incur the costs of going public. Thus, merging with a shell corporation may represent an effective alternative to an IPO for a small firm.

Direct issuance costs associated with going public include the underwriter spread and administrative and regulatory costs. The underwriter spread represents the difference between the price the underwriter receives for selling a firm’s securities to the public and the amount it pays to the firm. The underwriter spread can range from less than 1% of gross proceeds for a high-quality company to more than 8% for lower quality companies. Administrative and regulatory fees consist of legal and accounting fees, taxes, and the cost of SEC registration. For offerings less than $10 million in size, total direct issuance costs may exceed 10% of gross proceeds. For equity issues between $20 million and $50 million in size, these costs average less than 5% of gross proceeds and less than 3% for those issues larger than $200 million (Hansen: 1986). Reverse mergers typically cost between $50,000-$100,000, about one-quarter of the expense of an IPO and can be completed in about 60 days or one-third of the time to complete a typical IPO (Sweeney: 2005).

Despite these advantages, reverse takeovers may take as long as IPOs and are sometimes more complex.

The acquiring company must still perform due diligence on the target and communicate information on the

16

shell corporation to the exchange on which its stock will be traded and prepare a prospectus. Public exchanges often require the same level of information for companies going through reverse mergers as those undertaking IPOs. As illustrated through the Chinese firms taken public in the case study through reverse mergers, the principal concern is that the shell company may contain unseen liabilities such as unpaid bills or taxes which in some instances can make the reverse merger far more costly than an IPO. 5.

What are the auditing challenges associated with reverse mergers? How can investors protect themselves from the liabilities that may be contained in corporate shells?

Answer: Auditing challenges could include the following: collusion between local bank branches and company executives in confirming the firm’s bank cash balances; collusion between vendors and customers and company executives in the sales and purchase confirmation process; off book or unreported liabilities; problematic ownership of land and equipment, widespread use of false tax invoices or even legitimate substitute invoices used in collusion with external companies to obscure what they actually owe, and revenue inflation by using a network of undisclosed related parties. Due diligence is particularly difficult when the parent firm is in another country in which questions are frequently raised about the transparency of a firm’s financial statements.

Investors in reverse mergers must demand more rigorous audits involving direct access to the shell corporation’s financial statements and records, as well as onsite visits, customer discussions, and actual evaluation of the efficacy of the firm’s technologies and products.

6.

Mill was recapitalized just prior to completing its merger with Allied. What was the purpose of the recapitalization? Did it affect the ability of the combined firm’s to generate future earnings? Explain your answers.

Answer: The recapitalization of Mill was intended to reduce the number of Mill common shares that Allied would have to acquire in the share for share exchange. In doing so, the total number of shares outstanding of the merged firms would be significantly less than would have been the case had the recapitalization not taken place. Consequently, the merger resulted in higher EPS for the combined firms for a given level of earnings.

The recapitalization did nothing to impact the ability of the combined firm to generate future earnings because it did not change the determinants of the firm’s profitability. Such determinants would include the demand for their current product offering, product quality, the availability of new products, the rate of innovation, productivity, cost structure, etc.

Determining Liquidity Discounts: The Taylor Devices and Tayco Development Merger ____________________________________________________________________________________________ Key Points Privately held shares or shares for which there is not a readily available resale market often can only be sold at a discount from what is believed to be their intrinsic value.

However, estimating the magnitude of the discount often is highly problematic. ____________________________________________________________________________________________ This discussion3 is a highly summarized version of how a business valuation firm evaluated the liquidity risk associated with Taylor Devices’ unregistered common stock, registered common shares, and a minority investment in a business that it was planning to sell following its merger with Tayco Development. The estimated liquidity discounts were used in a joint proxy statement submitted to the SEC by the two firms to justify the value of the offer the boards of Taylor Devices and Tayco Development had negotiated.

Taylor Devices and Tayco Development agreed to merge in early 2008. Tayco would be merged into Taylor, with Taylor as the surviving entity. The merger would enable Tayco’s patents and intellectual property to be fully 3

Source: SEC Form S4 filing of a proxy statement for Taylor Devices and Tayco Development dated 1/15/08.

17

integrated into Taylor’s manufacturing operations, since intellectual property rights transfer with the Tayco stock.

Each share of Tayco common stock would be converted into one share of Taylor common stock, according to the terms of the deal. Taylor’s common stock is traded on the NASDAQ Small Cap Market under the symbol TAYD, and on January 8, 2009 (the last trading day before the date of the filing of the joint proxy statement with the SEC), the stock closed at $6.29 per share. Tayco common stock is traded over the counter on “Pink Sheets” (i.e., an informal trading network) under the trading symbol TYCO.PK, and it closed on January 8, 2009, at $5.11 per share.

An appraisal firm was hired to value Taylor’s unregistered shares, which were treated as if they were restricted shares because there was no established market for trading in these shares. The appraiser believed that the risk of Taylor’s unregistered shares is greater than for letter stocks, which have a stipulated period during which the shares cannot be sold, because the Taylor shares lacked a date indicating when they could be sold. Using this line of reasoning, the appraisal firm estimated a liquidity discount of 20%, which it believed approximated the potential loss that holders of these shares might incur in attempting to sell their shares. The block of registered Taylor stock differs from the unregistered shares, in that they are not subject to Rule 144. Based on the trading volume of Taylor common stock over the preceding 12 months, the appraiser believed that it would likely take less than one year to convert the block of registered stock into cash and estimated the discount at 13%, consistent with the Aschwald (2000) studies.

The appraisal firm also was asked to estimate the liquidity discount for the sale of Taylor’s minority investment in a real estate development business. Due to the increase in liquidity of restricted stocks since 1990, the business appraiser argued that restricted-stock studies conducted before that date may provide a better proxy for liquidity discounts for this type of investment. Interests in closely held firms are more like letter-stock transactions occurring before the changes in SEC Rule 144 beginning in 1990, when the holding period was reduced from three years to two and later (after 1997) to one. Such firms have little ability to raise capital in public markets due to their small size, and they face high transaction costs. Based on the SEC and other prior 1990 studies, the liquidity discount for this investment was expected to be between 30% and 35%. Pre-IPO studies could push it higher to a range of 40– 45%. The appraisal firm argued that the discount for most minority-interest investments tended to fall in the range of 25–45%. Because of the small size of the real estate development business, the liquidity discount is believed by the appraisal firm to be at the higher end of the range.

Discussion Questions 1. Explain how the appraiser estimated the liquidity discount for Taylor’s unregistered shares.

Answer: The appraiser believed that the risk of Taylor’s unregistered shares is greater than for letter stocks, which have a stipulated period during which the shares cannot be sold, because the Taylor shares lacked a date indicating when they could be sold. Using this line of reasoning, the appraisal firm estimated a liquidity discount of 20%, which it believed approximated the potential loss that holders of these shares might incur in attempting to sell their shares.

2.

What other factors could the appraiser have used to estimate the liquidity discount on the unregistered stock?

Answer: The appraiser could have considered a variety of adjustments to the 20 percent discount rate.

These could have included firm size, financial returns relative to the industry, leverage relative to the industry, cash flow growth rate relative to the industry, and the firm’s liquidity.

3.

In view of your answer to question 2, how might these factors have changed the appraiser’s conclusions?

Be specific.

Answer: Without more information about the firm and the industry, it is difficult to estimate the amount of change. However, it is possible that the liquidity discount could have been significantly larger or smaller than the 20 percent used.

4.

Based on the estimated liquidity discount of 13 percent estimated by the business appraiser, what was the actual purchase price premium paid to Tayco shareholders?

18

Answer: Assuming the shares exchanged were to be valued as of January 8, 2008, Tayco shareholders were to receive one share of Taylor common valued at $6.29. Adjusted for a liquidity discount of 13 percent, the value of such shares would be $5.47 (i.e., $6.29 x. 1- .13). Therefore, the purchase price premium paid to Tayco shareholders would be 7.1 percent based on the January 8, 2008 Tayco closing share price of $5.11 (i.e., $5.47 / $5.11).

Taking Advantage of a “Cupcake Bubble” __________________________________________________________________________________________ Key Points Financing growth represents a common challenge for most small businesses.

Selling a portion of the business either to private investors or in a public offering represents a common way for small businesses to finance major expansion plans. ____________________________________________________________________________ When Crumbs first opened in 2003 on the upper west side of Manhattan, the bakery offered three varieties of cupcakes among 150 other items. When the cupcakes became increasingly popular, the bakery began introducing cupcakes with different toppings and decorations. The firm’s founders, Jason and Mia Bauer, followed a straightforward business model: Hold costs down, and minimize investment in equipment. Although all of Crumbs’ cupcake recipes are Mia Bauer’s, there are no kitchens or ovens on the premises. Instead, Crumbs outsources all of the baking activities to commercial facilities. The firm avoids advertising, preferring to give away free cupcakes when it opens a new store and to rely on “word of mouth.” By keeping costs low, the firm has expanded without adding debt. The firm targets locations with high daytime “foot traffic,” such as urban markets. In 2010, the firm sold 13 million cupcakes through 34 locations, accounting for $31 million in revenue and $2.5 million in earnings before interest, taxes, and depreciation. Crumbs’ success spawned a desire to accelerate growth by opening up as many as 200 new locations by 2014. The challenge was how to finance such a rapid expansion.

The Bauers were no strangers to raising capital to finance the ongoing growth of their business, having sold onehalf of the firm to Edwin Lewis, former CEO of Tommy Hilfiger, for $10 million in 2008. This enabled them to reinvest a portion in the business to sustain growth as well as to draw cash out of the business for their personal use.

However, this time the magnitude of their financing requirements proved daunting. The couple was reluctant to burden the business with excessive debt, well aware that this had contributed to the demise of so many other rapidly growing businesses. Equity could be sold directly in the private placement market or to the public. Private placements could be expensive and may not provide the amount of financing needed; tapping the public markets directly through an IPO required dealing with underwriters and a level of financial expertise they lacked. Selling to another firm seemed to satisfy best their primary objectives: Get access to capital, retain their top management positions, and utilize the financial expertise of others to tap the public capital markets and to share in any future value creation.

The 57th Street General Acquisition Corporation (57th Street), a special-purpose acquisition company, or SPAC, appeared to meet their needs. In May 2010, 57th Street raised $54.5 million through an IPO, with the proceeds placed in a trust pending the completion of planned acquisitions. 4 One year later, 57th Street announced it had acquired Crumbs for $27 million in cash and $39 million in 57th Street stock. On June 30, 2011, 57th announced that NASDAQ had approved the listing of its common stock, giving Crumbs a market value of nearly $60 million.

Panda Ethanol Goes Public in a Shell Corporation In early 2007, Panda Ethanol, owner of ethanol plants in west Texas, decided to explore the possibility of taking its ethanol production business public to take advantage of the high valuations placed on ethanol-related companies in the public market at that time. The firm was confronted with the choice of taking the company public through an initial public offering or by combining with a publicly traded shell corporation through a reverse merger.

4

SPACs are shell, or blank-check, companies that have no operations but go public with the intention of merging with or acquiring a company with the proceeds of the SPAC’s initial public offering.

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After enlisting the services of a local investment banker, Grove Street Investors, Panda chose to "go public" through a reverse merger. This process entailed finding a shell corporation with relatively few shareholders who were interested in selling their stock. The investment banker identified Cirracor Inc. as a potential merger partner.

Cirracor was formed on October 12, 2001, to provide website development services and was traded on the over-thecounter bulletin board market (i.e., a market for very low-priced stocks). The website business was not profitable, and the company had only ten shareholders. As of June 30, 2006, Cirracor listed $4,856 in assets and a negative shareholders' equity of $(259,976). Given the poor financial condition of Cirracor, the firm's shareholders were interested in either selling their shares for cash or owning even a relatively small portion of a financially viable company to recover their initial investments in Cirracor. Acting on behalf of Panda, Grove Street formed a limited liability company, called Grove Panda, and purchased 2.73 million Cirracor common shares, or 78 percent of the company, for about $475,000.

The merger proposal provided for one share of Cirracor common stock to be exchanged for each share of Panda Ethanol common outstanding stock and for Cirracor shareholders to own 4 percent of the newly issued and outstanding common stock of the surviving company. Panda Ethanol shareholders would own the remaining 96 percent. At the end of 2005, Panda had 13.8 million shares outstanding. On June 7, 2007, the merger agreement was amended to permit Panda Ethanol to issue 15 million new shares through a private placement to raise $90 million.

This brought the total Panda shares outstanding to 28.8 million. Cirracor common shares outstanding at that time totaled 3.5 million. However, to achieve the agreed-on ownership distribution, the number of Cirracor shares outstanding had to be reduced. This would be accomplished by an approximate three-for-one reverse stock split immediately prior to the completion of the reverse merger (i.e., each Cirracor common share would be converted into 0.340885 shares of Cirracor common stock). As a consequence of the merger, the previous shareholders of Panda Ethanol were issued 28.8 million new shares of Cirracor common stock. The combined firm now has 30 million shares outstanding, with the Cirracor shareholders owning 1.2 million shares. The following table illustrates the effect of the reverse stock split.

Panda Ethanol Cirracor Inc. * In millions of dollars.

Effects of Reverse Stock Split Shares Ownership Shares Ownership Outstanding* Distribution (%) Outstanding*) Distribution (%) Before Reverse Split After Reverse Split 28.8 89.2 28.8 96 3.5 10.8 1.2 4

A special Cirracor shareholders' meeting was required by Nevada law (i.e., the state in which Cirracor was incorporated) in view of the substantial number of new shares that were to be issued as a result of the merger. The proxy statement filed with the Securities and Exchange Commission and distributed to Cirracor shareholders indicated that Grove Panda, a 78 percent owner of Cirracor common stock, had already indicated that it would vote its shares for the merger and the reverse stock split. Since Cirracor's articles of incorporation required only a simple majority to approve such matters, it was evident to all that approval was imminent.

On November 7, 2007, Panda completed its merger with Cirracor Inc. As a result of the merger, all shares of Panda Ethanol common stock (other than Panda Ethanol shareholders who had executed their dissenters' rights under Delaware law) would cease to have any rights as a shareholder except the right to receive one share of Cirracor common stock per share of Panda Ethanol common. Panda Ethanol shareholders choosing to exercise their right to dissent would receive a cash payment for the fair value of their stock on the day immediately before closing.

Cirracor shareholders had similar dissenting rights under Nevada law. While Cirracor is the surviving corporation, Panda is viewed for accounting purposes as the acquirer. Accordingly, the financial statements shown for the surviving corporation are those of Panda Ethanol.

Discussion Questions: 1.

Who were Panda Ethanol, Grove Street Investors, Grove Panda, and Cirracor? What were their roles in the case study? Be specific.

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Answer: Panda Ethanol owned ethanol manufacturing plants in West Texas and was interested in going public either through a reverse merger or IPO. Grove Street Investors was the investment bank hired by Panda Ethanol to evaluate their options and to locate a suitable public shell corporation if the decision was made to go public via a reverse merger. Acting on behalf of Panda Ethanol, Grove Street Investors formed Grove Panda LLC to serve as a “front” for Panda Ethanol in approaching Cirracor. By making Panda Ethanol less visible to the Cirracor shareholders, Grove Street reasoned that they might be able to buy Cirracor shares at a lower price than if the shareholders realized the profit potential of the Panda Ethanol strategy. As a publicly-traded shell corporation whose shareholders appeared interested in “cashing out,” Cirracor was to be the surviving entity of the reverse merger. By merging Panda Ethanol into Cirracor, with Cirracor surviving, Panda Ethanol would become a public corporation.

2.

Discuss the pros and cons of a reverse merger versus an initial public offering for taking a company public.

Answer: Many small businesses fail each year. In a number of cases, all that remains is a business with no significant assets or operations. Such companies are referred to as shell corporations. Shell corporations can be used as part of a deliberate business strategy in which a corporate legal structure is formed in anticipation of future financing, a merger, joint venture, spin-off, or some other infusion of operating assets. This may be accomplished in a transaction called a reverse merger in which the acquirer forms a new shell subsidiary, which is merged into the target in a statutory merger. The target is the surviving entity which must hold the assets and liabilities of both the target and shell subsidiary.

Merging with an existing corporate shell of a publicly traded company may be a reasonable alternative for a firm wanting to go public that is unable to provide the 2 years of audited financial statements required by the SEC or unwilling to incur the costs of going public. Thus, merging with a shell corporation may represent an effective alternative to an IPO for a small firm.

Direct issuance costs associated with going public include the underwriter spread and administrative and regulatory costs. The underwriter spread represents the difference between the price the underwriter receives for selling a firm’s securities to the public and the amount it pays to the firm. The underwriter spread can range from less than 1% of gross proceeds for a high-quality company to more than 8% for lower quality companies. Administrative and regulatory fees consist of legal and accounting fees, taxes, and the cost of SEC registration. For offerings less than $10 million in size, total direct issuance costs may exceed 10% of gross proceeds. For equity issues between $20 million and $50 million in size, these costs average less than 5% of gross proceeds and less than 3% for those issues larger than $200 million (Hansen: 1986). Reverse mergers typically cost between $50,000-$100,000, about one-quarter of the expense of an IPO and can be completed in about 60 days or one-third of the time to complete a typical IPO (Sweeney: 2005).

Despite these advantages, reverse takeovers may take as long as IPOs and are sometimes more complex.

The acquiring company must still perform due diligence on the target and communicate information on the shell corporation to the exchange on which its stock will be traded and prepare a prospectus. Public exchanges often require the same level of information for companies going through reverse mergers as those undertaking IPOs. The principal concern is that the shell company may contain unseen liabilities such as unpaid bills which in some instances can make the reverse merger far more costly than an IPO.

3.

Why did Panda Ethanol undertake a private equity placement totaling $90 million shortly implementing the reverse merger?

before

Answer: Private investment in public entities (PIPES) is a commonly used method of financing reverse mergers. In such transactions, a public company sells equity at a discount to private investors, often hedge funds. As the issuer, it is up to the company to register its shares with the SEC within 120 days. Once approved by the SEC, the stock may be traded on public exchanges. PIPES often are used in conjunction with a reverse merger to provide companies with not just an alternative way to go public but also with financing once they are listed on the public exchange. For example, assume a private company creates a shell corporation which is subsequently merged into a public company through a reverse merger. As the

21

surviving entity, the public company raises funds through a privately placed equity issue (i.e., PIPE financing) to fund future investments.

PIPES offer the advantage of being able to be completed more quickly, cheaply and confidentially than a public stock offering, which requires registration up front and a more elaborate investor “road show” to sell the securities to public investors. As private placements, PIPEs are most suitable for raising small amounts of financing, typically in the $5 to 10 million range. Firms seeking hundreds of millions of dollars are more likely to be successful in going directly to the public financial markets in a public stock offering.

4.

Why do you believe Panda did not directly approach Cirraco ? How were the Panda Grove investment holdings used to influence the outcome of the proposed merger?

Answer: Note that Panda could have approached Ciracco directly. However, this may have alerted the Ciracco shareholders to the Panda’s intentions and could have encouraged them to hold out for a higher purchase price for their stock. As an agent for Panda, Grove was able to buy the stock less expensively since Ciracco’s shareholders, desperate to recover a portion of their original investment, would have welcomed almost any alternative to bankruptcy.

Nevada, the state in which Cirracor was incorporate, state law requires that given the significant number of new share issued a shareholders vote was required to approve the new issue. Approval required a simple majority vote. Since Panda Grove let other shareholders know that it owned 78% and that in proxy materials indicated that it would vote for the merger and reverse split, it was evident to all shareholders that approval was imminent.

Note: Total Panda shares outstanding (including 15 million newly issued shares in the private placement) equaled 28.8 million shares. As a result of negotiations, Panda shareholders would own 96% of the merged firms and Cirracor shareholders 4%. This implied that total shares outstanding of the merged firms could not exceed 30 million shares (i.e., 28.8/.96). Consequently, Cirracor shareholders would own 1.2 million shares (i.e., 30 – 28.8).

Since Cirracor shares outstanding totaled 3.5 million before the merger, a reverse split was implemented coincidental to the reverse merger using a ratio of .340885 shares of Cirracor stock for each share of Panda stock (i.e., .340885 x 3.5 = 1.19). Note the 1.2 reflects rounding error due to rounding the number of shares outstanding for both firms.

Cantel Medical Acquires Crosstex International On August 3, 2005, Cantel Medical Corporation (Cantel), as part of its strategic plan to expand its infection prevention and control business, announced that it had completed the acquisition of Crosstex International Incorporated (Crosstex). Cantel is a leading provider of infection prevention and control products. Crosstex is a privately owned manufacturer and reseller of single-use infection control products used primarily in the dental market.

As a consequence of the transaction, Crosstex became a wholly owned subsidiary of Cantel, a publicly traded firm. For the fiscal year ended April 30, 2005, Crosstex reported revenues of approximately $47.4 million and pretax income of $6.3 million. The purchase price, which is subject to adjustment for the net asset value at July 31, 2005, was $74.2 million, comprising $67.4 million in cash and 384,821 shares of Cantel stock (valued at $6.8 million).

Furthermore, Crosstex shareholders could earn another $12 million payable over three years based on future operating income. Each of the three principal executives of Crosstex entered into a three-year employment agreement.

James P. Reilly, president and CEO of Cantel, stated, "We continue to pursue our strategy of acquiring branded niche leaders and expanding in the burgeoning area of infection prevention and control. Crosstex has a reputation for quality branded products and seasoned management." Richard Allen Orofino, Crosstex's president, noted, "We have built Crosstex over the past 50 years as a family business and we continue growing with our proven formula for success. However, with so many opportunities in our sights, we believe Cantel is the perfect partner to aid us in accelerating our growth plans."

Discussion Questions and Answers:

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1.

What were the primary reasons Cantel wants to acquire Crosstex? Be specific.

Answer: Crosstex fits Cantel’s strategy as a leading provider of healthcare products in niche markets such as the dental care infection prevention market. Crosstex’s 13.3% pre-tax margin, strong brand recognition, and experienced management were also significant sources of value.

2.

What do you believe could have been the primary factors causing Crosstex to accept Cantel’s offer?

Answer: Crosstex’s president noted the firm was confronted with a host of opportunities. The firm could have believed that it did not have the capital to fund such growth opportunities. Furthermore, the 3-year employment contracts meant that the senior managements could continue with the firm, as a wholly owned subsidiary of Cantel’s implying that Cantel may have intended to let Cantel operate largely as an independent entity. The stockholders also had the opportunity to reap and additional $12 million if they were able to achieve certain operating income targets.

3.

What factors might cause Crosstex’s net asset value to change between signing and closing of the agreement of purchase and sale?

Answer: During the period between signing and closing various components of net asset value could change. These most often include items such as receivables, inventory and short-term obligations. The purchase price would be revised up or down following a post-closing audit to reflect increase or decrease in net asset value.

4.

Speculate why Cantel may have chosen to operate Crosstex as a wholly-owned subsidiary following closing. Be specific Answer: Cantel may have chosen to operate Crosstex in this manner to preserve the firm’s culture and (or) to allow the firm to operate without interference during the period of the earn-out.

5.

The purchase price consisted of cash, stock, and an earnout. What are some of the factors that might have determined the purchase price from the seller’s perspective? From the buyer’s perspective?

Answer: The buyer may have been unwilling to meet the seller’s price expectation and thought it could do so by adding an earn-out option and by offering stock to allow the sellers to participate in any future appreciation of the Cantel stock. Moreover, the sellers may have needed some cash to pay tax liabilities resulting from the sale of their stock. The seller in accepting a portion of the purchase price in stock may also have been interested in deferring taxes on a portion of their compensation as well as participating in any future appreciation of the shares of the combined companies.

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Deb Ltd. Seeks an Exit Strategy In late 2004, Barclay's Private Equity acquired slightly more than one half the equity in Deb Ltd. (Deb), valued at about $250 million. The private equity arm of Britain's Barclay's bank outbid other suitors in an auction to acquire a controlling interest in the firm. PriceWaterhouseCooper had been hired by the Williamson family, the primary stockholder in the firm, to find a buyer.

The sale solved a dilemma for Nick Williamson, the firm's CEO and son of the founder, who had invented the firm's flagship product, Swarfega. The company had been founded some 60 years earlier based on a single product, a car cleaning agent. Since then, the Swarfega brand name had grown into a widely known brand associated with a broad array of cleaning products.

In 1990, the elder Williamson wanted to retire and his son Nick, along with business partner Roy Tillead, bought the business from his father. Since then, the business has continued to grow, and product development has accelerated. The company developed special Swarfega-dispensing cartridges that have applications in hospitals, clinics, and other medical faculties.

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After 13 years of sustained growth, Williamson realized that some difficult decisions had to be made. He knew he did not have a natural successor to take over the company. He no longer believed the firm could be managed successfully by the same management team. It was now time to think seriously about succession planning. So in early 2004, he began to seek a buyer for the business. He preferably wanted somebody who could bring in new talents, ideas, and up-to-date management techniques to continue the firm's growth.

The terms of the agreement called for Williamson to work with a new senior management team until Barclays decided to take the firm public. This was expected some time during the five-to-seven year period following the sale. At that point, Williamson would sell the remainder of his family's stock in the business (Goodman, 2005).

Discussion Questions 1. Succession planning issues are often a reason for family-owned businesses to sell. Why do you believe it may have been easier for Nick than his father to sell the business to a non-family member?

Answer: Nick did not have the same emotional attachment that his father, as the firm’s founder, did. Such situations are commonplace. For example, the heirs of Anheuser Busch were willing to sell at the “right price” to ImBev in 2008.

2. What other alternatives could Nick have pursued? Discuss the advantages and disadvantages of each.

Answer: Nick could have tried to partner with another firm with the intent of passing on control of the firm to the partner at some point in the future. The primary advantage is that it gives both parties the opportunity to assess the viability of the relationship; however, it has the disadvantage of deferring the decision for Nick to exit the firm.

3. What do you believe might be some of the unique challenges in valuing a family-owned

business? Be specific.

Answer: The challenges of valuing a family owned business include the absence of audited financial statements, a tendency for such firms to be operated for reasons other than for profit, the dependency of the firm on a few customers, lack of leverage with suppliers and customers, and the lack of documentation of trade secrets and key protocols.

GHS Helps Itself by Avoiding an IPO In 1999, GHS, Inc., a little known supplier of medical devices, engineered a reverse merger to avoid the timeconsuming, disclosure-intensive, and costly process of an initial public offering to launch its new internet-based selfhelp website. GHS spun off its medical operations as a separate company to its shareholders. The remaining shell is being used to launch a ‘‘self-help’’ Website, with self-help guru Anthony Robbins as its CEO. The shell corporation will be financed by $3 million it had on hand as GHS and will receive another $15 million from a private placement.

With the inclusion of Anthony Robbins as the first among many brand names in the self-help industry that it hopes to feature on its site, its stock soared from $.75 per share to more than $12 between May and August 1999. Robbins, who did not invest anything in the venture, has stock in the new company valued at $276 million. His contribution to the company is the exclusive online rights to his name, which it will use to develop Internet self-help seminars, chat rooms, and e-commerce sites.

Discussion Questions: 1.

What are the advantages of employing a reverse merger strategy in this instance?

Answer: Reverse mergers may provide a faster and less expensive way of taking a firm public than an initial public offering.

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2.

Why was the shell corporation financed through a private placement?

Answer: The private placement is often faster and cheaper than raising funds in the public debt markets which require registration with the SEC and may have significant issuance (flotation) costs associated with raising the funds.

Valuing a Privately Held Company

Background BigCo is interested in acquiring PrivCo, whose owner desires to retire. The firm is 100% owned by the current owner. PrivCo has revenues of $10 million and an EBIT of $2 million in the preceding year. The market value of the firm’s debt is $5 million; the book value of equity is $4 million. For publicly traded firms in the same industry, the average debt-to-equity ratio is .4 (based on the market value of debt and equity), and the marginal tax rate is 40%.

Typically, the ratio of the market value of equity to book value for these firms is 2. The average  of publicly traded firms that are in the same business is 2.00. Capital expenditures and depreciation amounted to $0.3 million and $0.2 million in the prior year. Both items are expected to grow at the same rate as revenues for the next 5 years. Capital expenditures and depreciation are expected to be equal beyond 5 years (i.e., capital spending will be internally funded). As a result of excellent working capital management practices, the change in working capital is expected to be essentially zero throughout the forecast period and beyond. The revenues of this firm are expected to grow 15% annually for the next 5 years and 5% per year thereafter. Net income is expected to increase 15% a year for the next 5 years and 5% thereafter. The 10-year U.S. Treasury bond rate is 6%. The pretax cost of debt for a nonrated firm is 10%. No adjustment is made in the calculation of the cost of equity for a marketability discount. Estimate the shareholder value of the firm.

Note: To estimate the WACC for a leveraged private firm, it is necessary to calculate the firm’s leveraged . This requires an estimate of the firm’s unleveraged  which can be obtained by estimating the unleveraged  for similar firms in the same industry. In addition, the value of debt and equity in calculating the cost of capital should be expressed as market rather than book values.

Calculating COE and WACC: 1.

Unlevered Beta for publicly traded firms in the same industry = 2.00 / (1 + .6 x .4) = 1.61, where 2.00 is the levered beta, .6 is (1-tax rate), and .4 is the average debt ratio for firms in this industry.

2.

Debt/Equity ratio for the private firm = 5 / (2 x 4) = .625 where 5, 4, and 2 are the private firm’s debt, book value of equity, and the ratio of market value to book value for similar firms.

3.

Levered beta for the private firm = 1.61 x (1 + .6 x .625) = 2.21

4.

Cost of equity for the private firm = 6 + 2.21 x 5.5 = 18.16

5.

After-tax cost of debt = .10 x (1 - .4) = 6.0

6.

WACC for the private firm = 18.16 x 2x4 + 6.00 x 5__ 2x4+5 2x4+5 = 18.16 x. 615 + 6.00 x. 385 = 13.48

Valuing the business using the FCFF model: Year EBIT (EBIT grows at 15% for the first five years and 5% thereafter.)

1

2

3

4

5

6

$2.30 $2.65 $3.04 $3.50 $4.02 $4.22

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EBIT (1-Tax Rate) $1.38 $1.59 $1.82 $2.10 $2.41 $2.53 Less (Cap. Expenditures-Depreciation) grows $.115 $.132 $.152 $.175 $.201 $0.00 at same 15% annual rate as revenue for 5 years and are offsetting thereafter) Equals Free Cash Flow to the Firm $1.26 $1.46 $1.67 $1.93 $2.21 $2.53 Terminal value = $2.53 / (.1348 - .05) = $29.83 Present Value of FCFF = $1.26 + $1.46 + $1.67 + $1.93 + $2.21 + $29.83 1.1348 1.13482 1.13483 1.13484 1.13485 1.13485 = $1.11 + $1.13 + $1.14 + $1.16 + $1.17 + $15.85 = $21.56 Value of Equity = $21.56 (MV of the firm) - $5 (MV of debt) = $16.56

Pacific Wardrobe Acquires Surferdude Apparel by a Skillful Structuring of the Acquisition Plan Pacific Wardrobe (Pacific) is a privately owned California corporation that has annual sales of $20 million and pretax profits of $2 million. Its target market is the surfwear/sportswear segment of the apparel industry. The surfwear/sportswear market consists of two segments: cutting-edge and casual brands. The first segment includes high-margin apparel sold at higher-end retail establishments. The second segment consists of brands that sell for lower prices at retail stores such as Sears, Target, and J.C. Penney. Pacific operates primarily as a U.S. importer/distributor of mainly casual sportswear for young men and boys between 10–21 years of age. Pacific’s strategic business objectives are to triple sales and pretax profits during the next 5 years. Pacific intends to achieve these objectives by moving away from the casual sportswear market segment and more into the high-growth, highprofit cutting-edge surfer segment. Because of the rapid rate at which trends change in the apparel industry, Pacific’s management believes that it can take advantage of current trends only through a well-conceived acquisition strategy.

Pacific’s Operations and Competitive Environment Pacific imports all of its apparel from factories in Hong Kong, Taiwan, Nepal, and Indonesia. Its customers consist of major chains and specialty stores. Most customers are lower-end retail stores. Customers include J.C. Penney, Sears, Stein Mart, Kids “R” Us, and Target. No one customer accounts for more than 20% of Pacific’s total revenue.

The customers in the lower-end market are extremely cost sensitive. Customers consist of those in the 10–21 years of age range who want to wear cutting-edge surf and sport styles but who are not willing or able to pay high prices.

Pacific offers an alternative to the expensive cutting-edge styles.

Pacific has found a niche in the young men’s and teenage boy’s sportswear market. The firm offers similar styles as the top brand names in the surf and sport industry, such as Mossimo, Red Sand, Stussy, Quick Silver, and Gotcha, but at a lower price point. Pacific indirectly competes with these top brand names by attempting to appeal to the same customer base. There are few companies that compete with Pacific at their level—low-cost production of ‘‘almost’’ cutting-edge styles.

Pacific’s Strengths and Weaknesses Pacific’s core strengths lie in their strong vendor support in terms of quantity, quality, service, delivery, and price/cost. Pacific’s production is also scaleable and has the potential to produce at high volumes to meet peak demand periods. Additionally, Pacific also has strong financial support from local banks and a strong management team, with an excellent track record in successfully acquiring and integrating small acquisitions. Pacific also has a good reputation for high-quality products and customer service and on-time delivery. Finally, Pacific has a low cost

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of goods sold when compared with the competition. Pacific’s major weakness is that it does not possess any cuttingedge/trendy labels. Furthermore, their management team lacks the ability to develop trendy brands.

Acquisition Plan Pacific’s management objectives are to grow sales, improve profit margins, and increase its brand life cycle by acquiring a cutting-edge surfwear retailer with a trendy brand image. Pacific intends to improve its operating margins by increasing its sales of trendy clothes under the newly acquired brand name, while obtaining these clothes from its own low-cost production sources.

Pacific would prefer to use its stock to complete an acquisition, because it is currently short of cash and wishes to use its borrowing capacity to fund future working capital requirements. Pacific’s target debt-to-equity ratio is 3 to 1.

The firm desires a friendly takeover of an existing surfwear company to facilitate integration and avoid a potential ‘‘bidding war.’’ The target will be evaluated on the basis of profitability, target markets, distribution channels, geographic markets, existing inventory, market brand recognition, price range, and overall ‘‘fit’’ with Pacific.

Pacific will locate this surfwear company by analyzing the surfwear industry; reviewing industry literature; and making discrete inquiries relative to the availability of various firms to board members, law firms, and accounting firms. Pacific would prefer an asset purchase because of the potentially favorable impact on cash flow and because it is concerned about unknown liabilities that might be assumed if it acquired the stock.

Pacific’s screening criteria for identifying potential acquisition candidates include the following: 1. Industry: Garment industry targeting young men, teens, and boys 2. Product: Cutting-edge, trendy surfwear product line 3. Size: Revenue ranging from $5 million to $10 million 4. Profit: Minimum of break-even on operating earnings for fiscal year 1999 5. Management: Company with management expertise in brand and image building 6. Leverage: Maximum debt-to-equity ratio of 3 to 1 After a review of 14 companies, Pacific’s management determined that SurferDude best satisfied their criteria.

SurferDude is a widely recognized brand in the surfer sports apparel line; it is marginally profitable, with sales of $7 million and a debt-to-equity ratio of 3 to 1. SurferDude’s current lackluster profitability reflects a significant advertising campaign undertaken during the last several years. Based on financial information provided by SurferDude, industry averages, and comparable companies, the estimated purchase price ranges from $1.5 million to $15 million. The maximum price reflects the full impact of anticipated synergy. The price range was estimated using several valuation methods.

Valuation On a standalone basis, sales for both Pacific and SurferDude are projected to increase at a compound annual average rate of 20% during the next 5 years. SurferDude’s sales growth assumes that its advertising expenditures in 1998 and 1999 have created a significant brand image, thus increasing future sales and gross profit margins. Pacific’s sales growth rate reflects the recent licensing of several new apparel product lines. Consolidated sales of the combined companies are expected to grow at an annual growth rate of 25% as a result of the sales and distribution synergies created between the two companies.

The discount factor was derived using different methods, such as the buildup method or the CAPM. Because this was a private company, the buildup method was utilized and then supported by the CAPM. At 12%, the specific business risk premium is assumed to be somewhat higher than the 9% historical average difference between the return on small stocks and the risk-free return as a result of the capricious nature of the highly style-conscious surfware industry. The marketability discount is assumed to be a relatively modest, 20% because Pacific is acquiring a controlling interest in SurferDude. After growing at a compound annual average growth rate of 25% during the next 5 years, the sustainable long-term growth rate in SurferDude’s standalone revenue is assumed to be 8%.

The buildup calculation included the following factors: Risk-Free Rate: 6.00% Market Risk Premium to Invest in Stocks: 5.50%

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Specific Business Risk Premium: Marketability Risk Premium: Discount Rate Less: Long-Term Growth Rate Capitalization Rate

12.00% 20.00% 43.50% 8.00% 35.50%

The CAPM method supported the buildup method. One comparable company, Apparel Tech, had a ß estimated

by Yahoo.Marketguide.com to be 4.74, which results in a k e of 32.07 for this comparable company. The weighted average cost of capital using a target debt-to-equity ratio of 3 to 1 for the combined companies is estimated to be 26%.

The standalone values of SurferDude and Pacific assume that fixed expenses will decrease as a percentage of sales as a result of economies of scale. Pacific will outsource production through its parent’s overseas facilities, thus significantly reducing the cost of goods sold. SurferDude’s administrative expenses are expected to decrease from 25% of sales to 18% because only senior managers and the design staff will be retained. The sustainable growth rate for the terminal period for both the standalone and the consolidated models is a relatively modest 6%. Pacific believes this growth rate is reasonable considering the growth potential throughout the world. Although Pacific and SurferDude’s current market concentration resides largely in the United States, it is forecasted that the combined companies will develop a global presence, with a particular emphasis in developing markets. The value of the combined companies including synergies equals $15 million.

Developing an Initial Offer Price Using price-to-cash flow multiples to develop an initial offer price, the target was valued on a standalone basis and a multiple of 4.51 for a comparable publicly held company called Stage II Apparel Corp. The standalone valuation, excluding synergies, of SurferDude ranges from $621,000 to $2,263,000.

Negotiating Strategy Pacific expects to initially offer $2.25 million and close at $3.0 million. Pacific’s management believes that SurferDude can be purchased at a modest price when compared with anticipated synergy, because an all-stock transaction would give SurferDude’s management ownership of between 25% and 30% of the combined companies.

Integration A transition team consisting of two Pacific and two SurferDude managers will be given full responsibility for consolidating the businesses following closing. A senior Pacific manager will direct the integration team. Once an agreement of purchase and sale has been signed, the team’s initial responsibilities will be to first contact and inform employees and customers of SurferDude that operations will continue as normal until the close of the transaction. As an inducement to remain through closing, Pacific intends to offer severance packages for those SurferDude employees who will be terminated following the consolidation of the two businesses.

Source: Adapted from Contino, Maria, Domenic Costa, Larui Deyhimy, and Jenny Hu, Loyola, Marymount University, MBAF 624, Los Angeles, CA, Fall 1999 .

Discussion Questions: 1.

What were the key assumptions implicit in Pacific Wardrobe’s acquisitions plan, with respect to the market, valuation, and integration? Comment on the realism of these assumptions.

Answer: Market-related assumptions include consolidated sales growth of 25% per year during the five years beginning n 1999 due to sales and distribution synergies created by combining the two firms. The growth in sales is expected to be supported without additional advertising expenses because of the extent of the pre-1999 advertising campaign and its impact on building a brand image. Industry studies show that sustaining brand image often requires continuous advertising in various types of media. Valuation

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assumptions include an assumed capitalization rate of 35%, which includes a relatively modest marketability discount of 20%. Fixed and administrative expenses are projected to decline, as Pacific Waredrobe’s existing overhead is assumed to be able to support the projected growth in volume. The projected drop in administrative expenses as a percent of revenue from 25% to 18% in five years may prove to be unsupportable. Pacific’s management is assuming that the target can be acquired with a relatively small premium and with stock. The success of this offer will be largely dependent on how the owners of SurferDude view the growth potential of the combined firms. Finally, Pacific is assuming relatively little customer attrition during integration and that key employees can be kept by using retention bonuses.

2.

Discuss some of the challenges that Pacific Wardrobe is likely to experience during due diligence.

Answer: SurferDude’s lackluster profit performance is largely attributable to its heavy advertising campaign in the years just prior to the proposed acquisition. Pacific needs to verify this key assumption.

Moreover, they need to determine if the firm’s growth can continue without advertising in the future.

Pacific’s due diligence team would have to reconstruct SurferDude’s historical financials to determine what profitability would have been if the aggressive advertising had not taken place.

3.

Identify alternative deal structures Pacific Wardrobe might have employed in order to complete the transaction. Discuss why these alternatives might have been superior or inferior to the one actually chosen.

Answer: Pacific was primarily interested in obtaining the rights to produce and sell another brand of clothing focused on what they believed would be a high growth market. They may have accomplished the same objective by licensing the rights to the brand rather than buying the entire company. Similarly, Pacific and SurferDude could have created a joint venture into which Pacific could have contributed management expertise and access to its overseas production sources and distribution channels and SurferDude could have contributed selected product brands.

Cashing Out of a Privately Held Enterprise When he had reached his early sixties, Anthony Carnevale starting reducing the amount of time he spent managing Sentinel Benefits Group Inc., a firm he had founded. He planned to retire from the benefits and money management consulting firm in which he was a 26 percent owner. Mr. Carnevale, his two sons, and two nonfamily partners had built the firm to a company of more than 160 employees with $2.5 billion under management.

Selling the family business was not what the family expected to happen when Mr. Carnevale retired. He believed that his sons and partners were quite capable of continuing to manage the firm after he left. However, like many small businesses, Sentinel found itself with a succession planning challenges. If the sons and the company's two other nonfamily partners bought out Mr. Carnevale, the firm would have little cash left over for future growth. The firm was unable to get a loan, given the lack of assets for collateral and the somewhat unpredictable cash flow of the business. Even if a loan could have been obtained, the firm would have been burdened with interest and principal repayment for years to come.

Over the years, Mr. Carnevale had rejected buyout proposals from competitors as inadequate. However, he contacted a former suitor, Focus Financial Partners LLC (a partnership that buys small money management firms and lets them operate largely independently). After several months of negotiation, Focus acquired 100 percent of Sentinel. Each of the five partners—Mr. Carnevale, his two sons, and two nonfamily partners—received an undisclosed amount of cash and Focus stock. A four-person Sentinel management team is now paid based on the company's revenue and growth.

The major challenges prior to the sale dealt with the many meetings held to resolve issues such as compensation, treatment of employees, how the firm would be managed subsequent to the sale, how client pricing would be determined, and who would make decisions about staff changes. Once the deal was complete, the Carnivales found

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it difficult to tell employees, particularly those who had been with the firm for years. Since most employees were not directly affected, only one left as a direct result of the sale. 5

5Adapted from Simona Covel, "Firm Sells Itself to Let Patriarch Cash Out," Wall Street Journal, November 1, 2007, p. B8

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