Exam 10: Analysis and Valuation of Privately Held Companies

. Case Study Short Essay Examination Questions 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. 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). -What do you believe might be some of the unique challenges in valuing a family-owned business? Be specific.

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.

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

A business owner may overstate revenue and understate actual expenses when

A control premium is the additional premium a buyer is willing to pay for the right to direct the activities of a firm.

Case Study Short Essay Examination Questions 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 $\beta$ 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 $\beta$ . This requires an estimate of the firm's unleveraged $\beta$ which can be obtained by estimating the unleveraged $\beta$ 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: Case Study Short Essay Examination Questions 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, high-profit 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 of goods sold when compared with the competition. Pacific's major weakness is that it does not possess any cutting-edge/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 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. :" -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.

Case Study Short Essay Examination Questions 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." and Answers: -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?

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

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.

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.

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

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

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

Case Study Short Essay Examination Questions 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. 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-the-counter bulletin board market . 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. * In millions of dollars. 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. : -Why did Panda Ethanol undertake a private equity placement totaling $90 million shortly before implementing the reverse merger?

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

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.

Shell corporations may have significant value to acquiring firms.

An increase in the target firm's reserves for doubtful accounts increases taxable income,while a decrease reduces the firm's taxable income.

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.

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.