Chapter 14

HARVESTING THE BUSINESS VENTURE INVESTMENT

FOCUS

This chapter in our entrepreneurial finance text focuses on how a successful entrepreneur
can harvest or exit the venture.

LEARNING OBJECTIVES

1. Plan an exit strategy

2. Understand the meaning of systematic liquidation
3. Describe outright sales of the venture to various potential buyers
4. Discuss the terms “leveraged buyouts” and “management buyouts”
5. Describe the process of going public
6. Identify what investment banking involves

CHAPTER OUTLINE

14.1 VENTURE OPERATING AND FINANCIAL DECISIONS REVISITED

14.2 PLANNING AN EXIT STRATEGY
14.3 VALUING THE EQUITY OR VALUING THE ENTERPRISE
A. Relative Valuation Methods
B. Dividing the Venture Valuation Pie
14.4 SYSTEMATIC LIQUIDATION
14.5 OUTRIGHT SALE
A. Family Members
B. Managers
C. Employees
D. Outside Buyers
14.6 GOING PUBLIC
A. Investment Banking
B. Some Additional Definitions
C. Other Costs in Issuing Securities
D. Post-IPO Trading
E. Contemplating and Preparing for the IPO Process
SUMMARY

DISCUSSION QUESTIONS AND ANSWERS

1. What is the meaning of harvesting a venture?

Harvesting a venture refers to the process of exiting a privately-held business venture

to unlock the owners’ investment value.

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224 Chapter 14: Harvesting the Business Venture Investment

2. What evidence exists as to whether entrepreneurs think about and/or develop

exit strategies?

Holmberg documented that over ½ of entrepreneurs have developed, or at least

though about exit strategies, at the start of their ventures.

3. What is a systematic liquidation of a venture? What are some of the advantages

and disadvantages of a systematic liquidation?

A systematic liquidation of a venture is the process of liquidating the firm by

distributing the cash flows of the firm to the owners. This usually happens when the
firm is in the mature stage and their free cash flow exceeds the amount need to
maintain sustainable growth.

Potential advantages include: (1) the entrepreneur and other owners maintain control
throughout the harvest period, (2) the harvesting of the investment value can be
spread out over a number of years, and (3) the time, effort, and cost of finding a buyer
for the venture can be avoided.

Potential disadvantages include: (1) the treatment and taxation of liquidation proceeds
as ordinary income (rather than capital gains), (2) the commitment of the
entrepreneur’s wealth, abilities, and focus to a dying venture, rather than other
venture pursuits that might be more lucrative, and (3) acceleration of the rate of
decline in the going concern value as other industry participants respond to the
reduction in investment.

4. Describe an outright sale of a venture. What are the four categories of possible
buyers?

An outright sale of a venture occurs when it is sold to others. The four categories of
outside buyers in an outright sale are family members, managers, employees, or
external buyers.

5. Describe what is meant by (a) a leveraged buyout (LBO), and (b) a

management buyout (MBO).

An LBO occurs when a firm is bought out by investors who finance the majority of it
with debt. An MBO is a type of LBO with the managers’ being a large part of the
equity investors.

6. What is an employee stock option plan (ESOP)? How is an ESOP used to buy
out a venture?

An ESOP is typically a benefit plan where employer and employee contributions are
combined with debt to purchase a venture’s equity. If the ESOP plan is sufficiently
 Chapter 14: Harvesting the Business Venture Investment 225

large in a mature firm, it can possibly take the role of the majority equity investor in
the venture after venture investors have exited.

7. Describe the terms (a) “control premium” and (b) “illiquidity discount” when
discussing possible external or outside buyers of a venture.

(a) A control premium is an additional dollar or percentage value on top of the base
value of the firm for the advantage of being able to control the firm instead of being a
minority shareholder.

(b) An illiquidity discount is a decrease in the price paid for unregistered shares that
cannot be easily sold or transferred.

8. Describe an initial public offering (IPO). What are the differences between a
primary offering and a secondary offering?

An IPO is the first public sale of a venture’s equity ownership. The primary offering
refers to the sale of new shares to their first owners. A secondary offering is the sale
of shares previously owned by others (typically founders and those still owning
shares from the time when the venture was privately held).

9. What is investment banking? What is an underwriting spread?

Investment banking facilitates the issue of new securities by creating markets for a
firm’s security.

An underwriting spread is the difference between the price paid in the market for the
new security and the amount given to the issuing firm. It is the investment bank’s
commission for creating the deal.

10. Describe the terms “tombstone ad” and “red herring disclaimer.”

A tombstone ad is an SEC requirement and an advertisement used to notify the public

of an upcoming offering,

A red herring disclaimer is a required statement on the tombstone ad (or elsewhere)

notifying the public that the ad (or preliminary prospectus) is not an offer to purchase
or a solicitation of an offer to buy. It also notifies the reader that the actual offer can
only be made upon delivery of the final prospectus.

11. What is meant by due diligence? How does a traditional registration differ from
a shelf registration?

Due diligence is the process whereby an investment bank investigates an issuing

company’s financial condition and investment intent.
226 Chapter 14: Harvesting the Business Venture Investment

A traditional registration specifies details ahead of time including date, price range
and underwriter, while the shelf registration procedure allows the firm more
flexibility by issuing within a two year period.

12. When an investment banking firm decides whether to underwrite or market a

securities issue, what is meant by a firm commitment and best efforts?

A firm commitment by an investment bank means that the bank will purchase the
security issue and then resell it in the market.

A “best efforts” by an investment banking firm is when they only provide marketing
and distribution efforts but do not guarantee a certain price.

13. Describe the two following terms that may be involved in underwriting a new
securities issue: (a) green shoe and (b) lockup provision.

A green show provision is a contract option for the investment bank to sell more
shares than allotted in the underwriting if the issue is broadly oversubscribed.

A lockup provision prohibits insiders in the company from selling their shares during
a certain period of time after the initial offering.

14. What is meant by initial public offering (IPO) underpricing?

IPO underpricing is when the offering price by the syndicate is lower than the first
trade in the secondary market or more generally under the prices during the first day
of trading.

15. Briefly describe how securities are traded on an organized stock exchange such
as the New York Stock Exchange.

Organized exchanges have specialized geographic (or electronic) places where

trading in a given security takes place. The official designation of “stock exchange”
within the U.S brings the trading venue under the regulatory authority of the SEC.
Typically such exchanges have publicly posted listing requirements, specific types of
orders (e.g. “market” and “limit”), standards for order processing and clearing, and
rules for maintaining orderly markets. Typically an individual places an order with a
broker who is a member of an exchange and who assumes responsibility for
executing and clearing the order according to the exchange’s rules.

16. Indicate some of the differences between the NASDAQ’s National Market System
and SmallCap listing requirements.

One listing option for IPOs is the National Association of Securities Dealers (NASD)
Automated Quotation (NASDAQ) system.
 Chapter 14: Harvesting the Business Venture Investment 227

[Note: The NASDAQ no longer uses the terms National Market System and
SmallCap listing requirements.] Tables 14.1 and 14.2 now provide NASDAQ Global
Market Initial Listing Requirements and NASDAQ Capital Market Initial Listing
Requirements. Differences exist in terms of stockholders’ equity and market value of
publicly held shares. Similarities exist in terms of bid price, publicly held shares, and
market makers.

17. Describe some of the preparations that a venture can undertake that may
increase the possibility of IPO success.

Typical preparations for an IPO include, but are not limited to: (i) cleaning up
confusing financing and compensation arrangements, (ii) clarifying the main business
strategy; (iii) eliminating potentially annoying special arrangements with insiders;
(iv) arranging for 2 years of audited financial statements by a major accounting firm;
(v) preparation for the scrutiny of ongoing research by establishing formal
communication channels for external dissemination of corporate news; and (vi)
establishing an investor relations function.

18. What are the steps or stages in a “typical” execution and time line schedule used
in planning and executing an IPO?

The execution and time line include:

1. Organization Meeting and Due Diligence
2. Drafting and attendant Activities
3. Initial 30-day SEC Review
4. Premarketing
5. Marketing
6. Pricing and Closing

19. From the Headlines – Tesla: Comment on Tesla’s trip from incorporating in 2003 to
its IPO in 2010. What impact do you think the IPO will have on competitors in the
electric car market?

Answers will vary: The trip has been a bumpy one and the road ahead is full of large
potholes. Scaling into competitive manufacturing will remain a challenge. There
are many competitors and close substitutes (for example hybrids and cars that run on
cleaner burning, more widely available fuels). Everyone will be watching if Tesla
can successfully develop its own products and prosper from its development
agreements with other car manufacturers.

EXERCISES/PROBLEMS AND ANSWERS

1. [DCF Valuation and Ownership Concepts] The venture investors and founders of the
ACE Products venture, a closely held corporation, are contemplating merging the
successful venture into a much larger diversified firm that operates in the same
228 Chapter 14: Harvesting the Business Venture Investment

industry. ACE estimates its free cash flows that will be available to the enterprise
next year at $5,200,000. Since the venture is now in its maturity stage, ACE’s free
cash flows are expected to continue to grow at a 6 percent annual compound growth
rate in the future. A weighted average cost of capital (WACC) for the venture is
estimated at 15 percent. Interest-bearing debt owed by ACE is $17.5 million. In
addition, the venture also has surplus cash of $4 million. ACE currently has 5
million shares outstanding with 3 million held by venture investors and 2 million held
by founders. The venture investors have an average investment of $2.50 per share
while the founders’ average investment is $.50 per share.

A.Based on the above information, estimate the enterprise value of ACE Products.
What would be the value of the venture’s equity?

Enterprise operating value = $5,200,000/(.15  .06) = $57,777,778

Total enterprise value = $57,777,778 + $4,000,000 in surplus cash = $61,777,778
Value of equity = $61,777,778  $17,500,000 = $44,277,778

B.How much of the value of ACE would belong to the venture investors versus the
founders. How much would the venture be worth on a per share basis?

Percent ownership: Venture investors = 3 million shares/5 million shares = 60%

Founders = 2 million shares/5 million shares = 40%
Venture investors value: $44,277,778  .60 = $26,566,667
Venture investors value per share: $26,566,667/3,000,000 shares = $8.856
Founders value: $44,277,778  .40 = $17,711,111
Founders value per share: $17,711,111/2,000,000 shares = $8.856
Total investors: $44,277,778/5,000,000 shares = 8.856

C. What would be the percentage appreciation on the stock bought by the venture
investors versus the investment appreciation for the founders?

Venture investors percentage appreciation = [($8.856  $2.50)/$2.50]  100 =

$6.06/$2.50  100 = 242.40%
Founders percentage appreciation = [($8.856  $.50)/$.50]  100 = $8.356/$.50 
100 = 1,671.20%

D.If the founders have held their investments for five years, calculate their compound
annual or internal rate of return on their investments. The venture investors
made a first round investment of 1.5 million shares at $2 per share four years
ago. What was the compound annual rate of return on the first round
investment? Venture investors made a second round investment of 1.5 million
shares at $3 per share two years ago. Calculate their compound rate of return on
this investment.

Founders investment (present value): $.50 x 2,000,000 shares = $1,000,000

Founders ending (future value) = $17,711,111
 Chapter 14: Harvesting the Business Venture Investment 229

Using a financial calculator: PV = 1,000,000; FV = 17,711,111; N = 5; solving

for %i (or I%) = 77.68% per year compound rate of return.

Venture investors first round investment: 1,500,000 shares  $2.00 = $3,000,000

1,500,000 shares/3,000,000 shares = .50
.50  $26,566,667 = $13,283,334
Using a financial calculator: PV = 3,000,000; FV = 13,283,334; N = 4; solving
for %i = 45.06%

Venture investors second round investment: 1,500,000 shares  $3.00 =

$4,500,000
1,500,000 shares/3,000,000 shares = .50
.50  $26,566,667 = $13,283,334
Using a financial calculator: PV = -4,500,000; FV = 13,283,334; N = 2; solving
for %i = 71.81%

2. [Acquisition Valuation Concepts] The BETA firm is proposing to acquire the ACE
Products venture described in Problem 1. BETA estimates that ACE’s free cash flow
for next year could be improved to $5.5 million because of synergistic benefits in the
form of operating or distribution economies. The potential acquirer also believes
that ACE’s perpetuity growth rate could be increased to 7 percent annually.
However, the riskiness of the cash flows would be increased causing the appropriate
WACC to increase to 16 percent. Interest-bearing debt owed by ACE is $17.5
million. In addition, the venture also has surplus cash of $4 million. ACE Products
has five million shares of common stock outstanding.

A. Determine ACE’s enterprise value from the perspective of BETA. What is ACE’s
equity worth to BETA in dollar amount and on a per share basis?

Enterprise operating value = $5,500,000/(.16  .07) =

$61,111,111
Total enterprise value = $61,111,111 + $4,000,000 surplus
cash = $65,111,111
Equity value = $65,111,111  $17,500,000 = $47,611,111
Equity value per share = $47,611,111/5,000,000 = $9.522

B. Use the per share value of ACE from Problem 1 and the per share value from this
problem and establish a range of values (i.e., without and with expected
synergistic benefits). If one-half of the synergy derived benefits were allocated to
ACE’s venture investors and founders, what price per share would the merger
take place?

With synergy: $9.522

Without synergy: $8.856
Synergy benefits: $9.522  $8.856 = $.666
Merger share price: $8.856 + ($.666/2) $9189
230 Chapter 14: Harvesting the Business Venture Investment

C. BETA has thirty million shares of stock outstanding with a market capitalization
value of $600 million. What is BETA’s stock price? Determine the exchange ratio
between ACE’s stock value and BETA’s stock price at each of ACE’s values
established in Part B. That is, what would ACE’s venture investors and founders
receive in BETA’s shares for each share of common stock they currently hold in ACE
Products?

BETA stock price: $600 million/30 million shares = $20.00 per share
$8.856/$20.00 = .4428 shares of BETA for each share of ACE

$9.522/$20.00 = .4761 shares of BETA for each share of ACE

$9.189/$20.00 = .4595 shares of BETA for each share of ACE

3. [Relative Value Concepts Using Multiples] The WestTek privately held venture is
considering the sale of the venture to an outside buyer. WestTek has net sales =
$21.2 million, EBITDA = $11.1 million, net income = $2.9 million, and interest-
bearing debt = $12 million. Three publicly-traded comparable firms or competitors
in the industry have the following net sales, EBITDA, net income, equity value or
market capitalization (stock price times number of shares of common stock
outstanding), and interest-bearing debt information:

EastTek

SouthTek

NorthTek
Net sales
$25,000,000 $37,500,000 $80,000,000
EBITDA
12,500,000 20,000,000 37,500,000
Net Income 2,500,000 3,000,000
10,000,000
Equity Value 45,000,000
60,000,000 160,000,000
 Chapter 14: Harvesting the Business Venture Investment 231

Interest-bearing
15,000,000

20,000,000

40,000,000
Debt

No surplus cash is being held by WestTek or by any of the three comparable firms.

A. Calculate the enterprise value to net sales ratios for each of the three competitors
(EastTek, SouthTek, and NorthTek), as well as the average ratio for the
competitors.

Enterprise value = equity value + interest-bearing debt

Equity value = market capitalization (i.e., stock price times shares outstanding)

EastTek: ($45,000,000 + $15,000,000)/$25,000,000 = 2.40

SouthTek: ($60,000,000 + $20,000,000)/$37,500,000 = 2.13
NorthTek: ($160,000,000 + $40,000,000)/$80,000,000 = 2.50
Average: (2.40 + 2.13 + 2.50)/3 = 7.03/3 = 2.34

B. Calculate the enterprise value to EBITDA ratios for each of the three
competitors, as well as the average ratio for the competitors.

EastTek: $60,000,000/$12,500,000 = 4.80

SouthTek: $80,000,000/$20,000,000 = 4.00
NorthTek: $200,000,000/$37,500,000 = 5.33
Average: (4.80 + 4.00 + 5.33)/3 = 14.13/3 = 4.71

C. Calculate the equity value or market “cap” to net income ratios for each of the
three competitors, as well as the average ratio for the competitors.

EastTek: $45,000,000/$2,500,000 = 18.00

SouthTek: $60,000,000/$3,000,000 = 20.00
NorthTek: $160,000,000/$10,000,000 = 16.00
Average: (18.00 + 20.00 + 16.00)/3 = 54.00/3 = 18.00

D. Estimate the enterprise and equity values for WestTek using the individual net
sales multiples from EastTek, SouthTek, and NorthTek, as well as for the average
of the three competitors or comparable firms. Show the valuation ranges from
high to low.

Enterprise Value Estimates:

232 Chapter 14: Harvesting the Business Venture Investment

Using EastTek sales multiple: $21,200,000  2.40 =

$50,880,000
Using SouthTek sales multiple: $21,200,000  2.13 =
$45,156,000
Using NorthTek sales multiple: $21,200,000  2.50 =
$53,000,000
Using average sales multiple: $21,200,000  2.34 =
$49,608,000
The enterprise valuation range based on a sales multiple was from a high of
$53,000,000 to a low of $45,156,000.

Equity Value Estimates:

Equity value = enterprise value – interest-bearing debt
Since WestTek has interest-bearing debt of $12,000,000, this amount must be
subtracted from the enterprise value estimates calculated above to provide equity
value estimates.

Using EastTek: $50,880,000 - $12,000,000 = $38,880,000

Using SouthTek: $45,156,000 - $12,000,000 = $33,156,000
Using NorthTek: $53,000,000 - $12,000,000 = $41,000,000
Using average multiple: $49,608,000 - $12,000,000 = $37,608,000
The equity valuation range based on a sales multiple was from a high of
$41,000,000 to a low of $33,156,000.

E. Estimate the enterprise and equity values for WestTek using the individual
EBITDA multiples from each comparable firm, as well as the average multiple
for the three competitors. Show the valuation ranges from high to low.

Enterprise Value Estimates:

Using EastTek EBITDA multiple: $11,100,000  4.80 = $53,280,000
Using SouthTek EBITDA multiple: $11,100,000  4.00 =
$44,400,000
Using NorthTek EBITDA multiple: $11,100,000  5.33 =
$59,163,000
Using average EBITDA multiple: $11,100,000  4.71 =
$52,281,000
The enterprise valuation range based on an EBITDA multiple was from
$59,163,000 to $44,400,000

Equity Value Estimates:

Since WestTek has interest-bearing debt of $12,000,000, this amount must be
subtracted from the enterprise value estimates calculated above to provide equity
value estimates.

Using EastTek: $53,280,000 - $12,000,000 = $41,280,000

Using SouthTek: $44,400,000 - $12,000,000 = $32,400,000
 Chapter 14: Harvesting the Business Venture Investment 233

Using NorthTek: $59,163,000 - $12,000,000 = $47,163,000

Using Average: $52,281,000 - $12,000,000 = $40,281,000
The equity valuation range based on a sales multiple was from a high of
$47,163,000 to a low of $32,400,000.

F. Estimate the equity values for WestTek using the individual net income multiples
from each comparable firm, as well as the average multiple for the three firms.

Equity Value Estimates:

Using EastTek net income multiple: $2,900,000  18.00 = $52,200,000
Using SouthTek net income multiple: $2,900,000  20.00 =
$58,000,000
Using NorthTek net income multiple: $2,900,000  16.00 =
$46,400,000
Using average net income multiple: $2,900,000  18.00 =
$52,200,000
The valuation range based on a net income multiple was from a high of
$58,000,000 to a low of $46,400,000.

G. Establish a range of equity value estimates for WestTek based on the highest and
lowest overall values generated from the multiples analyses in Parts D, E, and F.
Also establish a range of market value estimates for WestTek based on the highest
and lowest average values from the multiples analyses in Parts D, E, and F.

Part D: High = $41,000,000; Low = $33,156,000

Part E: High = $47,163,000; Low = $32,400,000
Part F: High = $58,000,000; Low = $46,400,000
Highest High = $58,000,000: Lowest Low = $32,400,000

Equity Value based on Average Sales Multiple: $37,608,000 (lowest)

Equity Value based on Average EBITDA Multiple: $40,281,000
Equity Value based on Average Net Income Multiple: $52,200,000 (highest)

H. From the perspective of the selling venture investors and founders, would you
recommend that they negotiate for the final selling price be based on the use of
top-line valuation multiples (i.e., using net sales) or bottom-line valuation
multiples (i.e., using net income)?

A selling price based on bottom-line (net income) multiples will produce the
highest value for the selling venture investors and founders.

4. [Venture Capital (VC) Method Valuation Concepts] Benito Gonzalez, founded and grew
the BioSystems Manufacturing Corporation over a several year period. However, Benito
has decided to exit BioSystems as of the end of 2010 with the intention of starting a new
entrepreneurial venture. The Fuji Electronics Company is considering acquiring
BioSystems which is 60 percent owned by Benito Gonzalez with the other 40 percent of the
 234 Chapter 14: Harvesting the Business Venture Investment

equity being held by venture investors who also desire to exit the venture. BioSystems’
sales are expected to grow from the 2010 level at a 20 percent annual compound rate over
each of the next three (2011, 2012, 2013) years. Cost of goods sold, marketing,
depreciation, and interest expenses are expected to move or vary with sales (i.e., they are
variable expenses). General and administrative (G&A) expenses are expected to remain
constant each year (i.e., are fixed expenses). The income tax rate is expected to be 35
percent.

BIOSYSTEMS MANUFACTURING CORPORATION

Income Statement for 2010 ($ Thousands)

Net Sales

$10,000
Cost of Goods Sold

6,000
Gross Profit

4,000
Marketing Expenses

1,000
G&A Expenses

2,000
Depreciation
 Chapter 14: Harvesting the Business Venture Investment 235

200
Interest

100
Income Before Taxes
700
Taxes (35%)

245
Net Income $455

A. Prepare BioSystems’ income statements for 2013.

Note: Income statements are projected annually for 2011 and 2012 in order to provide
the 2013 projections. Data are presented in Thousands of Dollars. See spreadsheet
solution shown below.
236 Chapter 14: Harvesting the Business Venture Investment

Income Statement for 2010 ($ Thousands)

Actual Projected ----------------------------------------
2010 2011 2012 2013
Net Sales 10,000 12,000 14,400 17,280
Cost of Goods Sold 6,000 7,200 8,640 10,368
Gross Profit 4,000 4,800 5,760 6,912
Marketing Expenses 1,000 1,200 1,440 1,728
G&A Expenses 2,000 2,000 2,000 2,000
Depreciation 200 240 288 346
Interest 100 120 144 173
Income Before Taxes 700 1,240 1,888 2,666
Taxes (35%) 245 434 661 933
Net Income 455 806 1,227 1,733

B. Fuji Electronics has examined other recent acquisitions in BioSystems’ industry

and believes that a 17 times price-earnings multiple would be appropriate for
determining BioSystems value in the future. Calculate the value of BioSystems as of
the end of 2013.

P/E Multiple for 2013: 17

Firm value at end of 2013: $1,733 net income times 17 = $29,461

C. How much should Fuji Electronics be willing to pay for BioSystems

Manufacturing at the end of 2010 if Fuji’s management believes the appropriate
discount rate is 25 percent?

Discount rate: 25%

Firm value at end of 2013: $29,461
Present Value of Firm: $29,61/(1.25)^3 = $29,461/1.953125 = $15,084

D. What is Gonzalez’s portion of the exit proceeds? What is the venture investors’
portion of the exit proceeds?

Benito’s percentage portion: 60%

Venture investors’ percentage portion: 40%

2013 Exit Proceeds:

Gonzalez’s portion of exit proceeds: $29,461  .60 = $17,677
Venture investors’ portion of exit proceeds: $29,461  .40 = $11,784

Present Value of Exit Proceeds:

Gonzalez’s portion of exit proceeds: $15,084  .60 = $9,050
Venture investors’ portion of exit proceeds: $15,084  .40 = $6,034
 Chapter 14: Harvesting the Business Venture Investment 237

E. Benito Gonzalez invested $50,000 of his own funds in BioSystems at the end of
2005. What would be the compound rate of return on his investment when the exit
(sale to Fuji Electronics) from BioSystems occurs at the end of 2010?

Initial investment at end of 2005: $50,000

Exit proceeds at end of 2010: $9,050,000
Holding period: 5 years
Using a financial calculation: PV = 50,000; FV = 9,050,000; N = 5; solving
for %i = 182.84% compound annual rate of return

F. The venture investors contributed $500,000 at the end of 2006. What would be
their compound rate of return on their investment if BioSystems is sold at the end of
2010?

Initial investment at end of 2006: $500,000

Exit proceeds at end of 2010: $6,034,000
Holding period: 4 years
Using a financial calculation: PV = 500,000; FV = 6,034,000; N = 4; solving
for %i = 86.38% compound annual rate of return

5. [Terminal or Horizon Period Valuation Concepts] The Gamma Systems Manufacturing

Corporation has reached its maturity stage and its net sales are expected to grow at a 6
percent compound rate for the foreseeable future. Management believes that as a mature
venture the appropriate equity discount rate for Gamma Systems is 18 percent.

Gamma Systems Manufacturing Corporation

Balance Sheets 2009 2010

Cash $50,000 $40,000
Accounts receivable 200,000 260,000
Inventories 450,000 500,000
Total current assets 700,000 800,000
Fixed assets, net 400,000 500,000
Total assets $1,100,000 $1,300,000

Accounts payable $130,000 $170,000

Accruals 50,000 70,000
Bank loan 90,000 90,000
Total current liabilities 270,000 330,000
Long-term debt 300,000 400,000
Common stock ($10 par) 300,000 300,000
Capital surplus 50,000 50,000
Retained earnings 180,000 220,000
Total liabilities and equity $1,100,000 $1,300,000
238 Chapter 14: Harvesting the Business Venture Investment

Income Statements 2009 2010

Net sales $1,400,000 $1,600,000
Cost of goods sold 780,000 900,000
Gross profit 620,000 700,000
Marketing 130,000 150,000
General and administrative 150,000 150,000
Depreciation 40,000 53,000
EBIT 300,000 347,000
Interest 45,000 57,000
Earnings before taxes 255,000 290,000
Income taxes (40%) 102,000 116,000
Net income $153,000 $174,000

A. Estimate the free cash flows available to the equity investors for 2011.

The following spreadsheet assumes that most accounts are a constant percent
of sales (starting in 2011). We have balanced the balance sheets by raising the
dividends (the Maximum Dividend Method) until the cash reaches its
specified percent of sales (for required cash). All surplus cash has been paid
out as a dividend. We provide 2012 as a check year to convince the reader
that the cash flows, etc. are growing at the assumed terminal growth rate (of
6%).
 Chapter 14: Harvesting the Business Venture Investment 239

Balance Sheets 2009 2010 2011 2012

Check Year
Cash 50,000 40,000 42,400 44,944
Accounts Receivables 200,000 260,000 275,600 292,136
Inventories 450,000 500,000 530,000 561,800
Total Current Assets 700,000 800,000 848,000 898,880
Fixed Assets, Net 400,000 500,000 530,000 561,800
Total Assets 1,100,000 1,300,000 1,378,000 1,460,680

Accounts Payable 130,000

130,000 $170,000
170,000 180,200 191,012
Accruals 50,000 70,000 74,200 78,652
Bank Loan 90,000 90,000 95,400 101,124
Total Current Liabilities 270,000 330,000 349,800 370,788
Long-Term Debt 300,000 400,000 424,000 449,440
Common Stock ($10 par) 300,000 300,000 300,000 300,000
Capital Surplus 50,000 50,000 50,000 50,000
Retained Earnings 180,000 220,000 254,200 290,452
Total Liab. & Equity 1,100,000 1,300,000 1,378,000 1,460,680

2009 2010 2011 2012

Net Sales 1,400,000 1,600,000 1,696,000 1,797,760

Cost of Goods Sold 780,000 900,000 954,000 1,011,240
Gross Profit 620,000 700,000 742,000 786,520
Marketing 130,000 150,000 159,000 168,540
General & Administrative 150,000 150,000 159,000 168,540
Depreciation 40,000
0 40,000
53,000 53,000 56,180 59,551
EBIT 300,000 347,000 367,820 389,889
Interest 45,000 57,000 60,420 64,045
Earnings Before Taxes 255,000 290,000 307,400 325,844
Income Taxes (40%) 102,000 116,000 122,960 130,338
Net Income 153,000 174,000 184,440 195,506
Dividends 134,000 150,240 159,254
Retained Earnings 40,000 34,200 36,252
g= 6.00%
Growth Rate 6%
Discount Rate 18%
240 Chapter 14: Harvesting the Business Venture Investment

A) Statement of Cash Flows Approach to FCF/VCF 2011

Operating:
Net Income 184,440
+Depreciation 56,180
-Inc. in Accts. Receivable -15,600
-Inc. in Inventories -30,000
+Inc. in Accts. Payable 10,200
+Inc. in Accruals 4,200
CF from Operations 209,420
Investing:
-Inc. in Fixed Assets -86,180
Financing:
+Increase in Bank Loans 5,400
+Increase in Long-Term Debt 24,000

Change in Cash Balance Before Dividends 152,640

Dividends -150,240
Change in Balance Sheet Cash Account 2,400

FCF (from Statement of Cash Flows) 150,240

(Same as Dividends here)
Shortcut Method:
NI 184,440
+Depr 56,180
-Capex -86,180
-Change NWC -28,200
+Debt Proc 24,000
FCF (from shortcut method) 150,240

Value $ 1,252,000.00

B. Estimate the value of Gamma Systems equity at the end of 2010 by applying
the terminal value perpetuity equation that was presented in Chapter 9.

Value at end of 2010 = 150,240/(.18  .06) = $1,252,000

C. By applying the terminal value equation at the end of 2010, what are we
assuming about the future?

That the VCF will growth smoothly at 6% for the remainder of eternity and
that the required return will remain constant at 18%.
 Chapter 14: Harvesting the Business Venture Investment 241

6. [Valuation Sensitivities to Changes in Growth Rates and Discount Rates] Assume

that some of the information relating to the Gamma Systems Manufacturing
Corporation has changed. Using the financial statement data in Problem 5, answer
the following questions.

A. How would your valuation estimate change if the sales growth rate had been 6
percent but the discount rate had been 20 percent?

Value = 150,240/(.20  .06) = $1,073,143.

B. How would your valuation estimate change if the sales growth rate had been 5
percent and the discount rate 18 percent?

To use a 5% terminal growth rate, we must construct a new stepping stone

year. The remainder is analogous to the solution to Problem 5 above.
242 Chapter 14: Harvesting the Business Venture Investment

Balance Sheets 2009 2010 2011 2012

Check Year
Cash 50,000 40,000 42,000 44,100
Accounts Receivables 200,000 260,000 273,000 286,650
Inventories 450,000 500,000 525,000 551,250
Total Current Assets 700,000 800,000 840,000 882,000
Fixed Assets, Net 400,000 500,000 525,000 551,250
Total Assets 1,100,000 1,300,000 1,365,000 1,433,250

Accounts Payable 130,000 170,000 178,500 187,425

Accruals 50,000 70,000 73,500 77,175
Bank Loan 90,000 90,000 94,500 99,225
Total Current Liabilities 270,000 330,000 346,500 363,825
Long-Term Debt 300,000 400,000 420,000 441,000
Common Stock ($10 par) 300,000 300,000 300,000 300,000
Capital Surplus 50,000 50,000 50,000 50,000
Retained Earnings 180,000 220,000 248,500 278,425
Total Liab. & Equity 1,100,000 1,300,000 1,365,000 1,433,250

2009 2010 2011 2012

Net Sales 1,400,000 1,600,000 1,680,000 1,764,000

Cost of Goods Sold 780,000 900,000 945,000 992,250
Gross Profit 620,000 700,000 735,000 771,750
Marketing 130,000 150,000 157,500 165,375
General & Administrative 150,000 150,000 157,500 165,375
Depreciation 40,000 53,000 55,650 58,433
EBIT 300,000 347,000 364,350 382,568
Interest 45,000 57,000 59,850 62,843
Earnings Before Taxes 255,000 290,000 304,500 319,725
Income Taxes (40%) 102,000 116,000 121,800 127,890
Net Income 153,000 174,000 182,700 191,835
Dividends 134,000 154,200 161,910
Retained Earnings 40,000 28,500 29,925
g= 5.00%

Value 1,186,154

Rather than calculate FCF/VCF as before, since we are using the MDM, we can just
pull the 2011 dividend level as the starting point for the perpetuity valuation. Value
= 154,200/(.18  .05) = 1,186,154.
 Chapter 14: Harvesting the Business Venture Investment 243

C. How would your valuation estimate change if the perpetuity growth rate had
been 7 percent and the discount rate 20 percent?
244 Chapter 14: Harvesting the Business Venture Investment

Balance Sheets 2009 2010 2011 2012

Check Year
Cash 50,000 40,000 42,800 45,796
Accounts Receivables 200,000 260,000 278,200 297,674
Inventories 450,000 500,000 535,000 572,450
Total Current Assets 700,000 800,000 856,000 915,920
Fixed Assets, Net 400,000 500,000 535,000 572,450
Total Assets 1,100,000 1,300,000 1,391,000 1,488,370
0
Accounts Payable 130,000 170,000 181,900 194,633
Accruals 50,000 70,000 74,900 80,143
Bank Loan 90,000 90,000 96,300 103,041
Total Current Liabilities 270,000 330,000 353,100 377,817
Long-Term Debt 300,000 400,000 428,000 457,960
Common Stock ($10 par) 300,000 300,000 300,000 300,000
Capital Surplus 50,000 50,000 50,000 50,000
Retained Earnings 180,000 220,000 259,900 302,593
Total Liab. & Equity 1,100,000 1,300,000 1,391,000 1,488,370

2009 2010 2011 2012

Net Sales 1,400,000 1,600,000 1,712,000 1,831,840

Cost of Goods Sold 780,000 900,000 963,000 1,030,410
Gross Profit 620,000 700,000 749,000 801,430
Marketing 130,000 150,000 160,500 171,735
General & Administrative 150,000 150,000 160,500 171,735
Depreciation 40,000 53,000 56,710 60,680
EBIT 300,000 347,000 371,290 397,280
Interest 45,000 57,000 60,990 65,259
Earnings Before Taxes 255,000 290,000 310,300 332,021
Income Taxes (40%) 102,000 116,000 124,120 132,808
Net Income 153,000 174,000 186,180 199,213
Dividends 134,000 146,280 156,520
Retained Earnings 40,000 39,900 42,693
g= 7.00%

Value 1,125,231
Value = 146,280/(.20  .07) = $1,125,231.

7. [Valuation Impact of Changes in Forecast Period Growth Rates] New information

for the Gamma Systems Manufacturing Corporation has been brought to the
 Chapter 14: Harvesting the Business Venture Investment 245

management’s attention. Use the financial statement information in Problem 5 and

take into consideration that sales will grow at a 15 percent rate in 2011 and a 10
percent rate in 2012 before settling down to a 6 percent perpetuity growth rate.

A. Estimate the free cash flows available to equity investors for 2011, 2012, and
2013.

Free cash flow is the same as “dividends” in the MDM used in the spreadsheet
below.

B. Estimate the terminal value of all future cash flows at the end of 2012.

See spreadsheet below. The discount rate is 18% for all periods and the
terminal growth rate is 6%.

C. Estimate of the value of Gamma Systems at the end of 2010 under these
assumptions.

See spreadsheet below.

246 Chapter 14: Harvesting the Business Venture Investment

Balance Sheets 2009 2010 2011 2012 2013 2014

Check Year
Cash 50,000 40,000 46,000 50,600 53,636 56,854
Accounts Receivables 200,000 260,000 299,000 328,900 348,634 369,552
Inventories 450,000 500,000 575,000 632,500 670,450 710,677
Total Current Assets 700,000 800,000 920,000 1,012,000 1,072,720 1,137,083
Fixed Assets, Net 400,000 500,000 575,000 632,500 670,450 710,677
Total Assets 1,100,000 1,300,000 1,495,000 1,644,500 1,743,170 1,847,760
0 0
Accounts Payable 130,000 170,000 195,500 215,050 227,953 241,630
Accruals 50,000 70,000 80,500 88,550 93,863 99,495
Bank Loan 90,000 90,000 103,500 113,850 120,681 127,922
Total Current Liabilities 270,000 330,000 379,500 417,450 442,497 469,047
Long-Term Debt 300,000 400,000 460,000 506,000 536,360 568,542
Common Stock ($10 par) 300,000 300,000 300,000 300,000 300,000 300,000
Capital Surplus 50,000 50,000 50,000 50,000 50,000 50,000
Retained Earnings 180,000 220,000 305,500 371,050 414,313 460,172
Total Liab. & Equity 1,100,000 1,300,000 1,495,000 1,644,500 1,743,170 1,847,760

2009 2010 2011 2012 2013 2014

g=15% g=10% g=6% g=6%
Net Sales 1,400,000 1,600,000 1,840,000 2,024,000 2,145,440 2,274,166
Cost of Goods Sold 780,000 900,000 1,035,000 1,138,500 1,206,810 1,279,219
Gross Profit 620,000 700,000 805,000 885,500 938,630 994,948
Marketing 130,000 150,000 172,500 189,750 201,135 213,203
General & Administrative 150,000 150,000 172,500 189,750 201,135 213,203
Depreciation 40,000 53,000 60,950 67,045 71,068 75,332
EBIT 300,000 347,000 399,050 438,955 465,292 493,210
Interest 45,000 57,000 65,550 72,105 76,431 81,017
Earnings Before Taxes 255,000 290,000 333,500 366,850 388,861 412,193
Income Taxes (40%) 102,000 116,000 133,400 146,740 155,544 164,877
Net Income 153,000 174,000 200,100 220,110 233,317 247,316
Dividends 134,000 114,600 154,560 190,054 201,457
Retained Earnings 40,000 85,500 65,550 43,263 45,859
Dividend growth g= 34.87% 22.96% 6.00%

2012 Terminal Value 1,583,780

VCF 114,600 1,738,340
2010 NPV 1,345,567
 Chapter 14: Harvesting the Business Venture Investment 247

MINI CASE: MINIDISCS CORPORATION

Brian Motley founded the MiniDiscs Corporation at the end of 2005. After nearly
one year of development, the venture produced an optical storage disk about the size
of a silver dollar that could store more than 500 megabytes of data along with a
mechanism allowing the device to be integrated into a variety of portable consumer
electronic devices including e-books, music discs, and video games.
In addition to Brian Motley’s role as the venture’s CEO, Susan Sharpe, with 6
years of prior financial management experience at two high technology ventures, was
hired as the CFO. The Vice-President of Marketing was Steven Davis and the Vice-
President of Operations was Sanjay Chavarti. Before being hired by MiniDiscs,
Davis had 12 years of marketing experience in the technology area. Chavarti worked
in high tech operations for eight years before pursuing the opportunity with
MiniDiscs.
Leading electronic manufacturers were anxious to incorporate the minidisk in
their products. Brian Motley obtained $7 million financing at the end of 2006 from
venture investors in exchange for 43 percent of the stock in the venture. After this
round of venture financing, Brian retained 50 percent ownership in MiniDiscs and the
other three members of the management team (Sharpe, Davis, and Chavarti) owned 7
percent of the venture.
Over a four-year period (2007-2010), MiniDiscs moved quickly through its
startup and survival stages and is now in the midst of its rapid growth stage. Brian
Motley has recently decided to harvest his investment by selling the firm. However,
the other three members of the management team want to continue on and proposed a
leveraged buyout to Brian Motley. An external valuation firm estimated that $45
million represented a fair price for all of the equity in the MiniDiscs Corporation.
An abbreviated balance sheet in thousands of dollars for yearend 2010 follows:

Current Assets

$15,000

Payables & Accruals

$5,000
Fixed Assets, Net 15,000

Long-Term Debt

10,000
248 Chapter 14: Harvesting the Business Venture Investment

Common Equity

15,000
Total $ 30,000

Total

$30,000

It is the beginning of 2011, and the management team has $5 million of their own
capital, including their share of the sales price, available to purchase all of the
venture’s existing equity capital. The intent is to retire all of the old stock and issue 2
million shares of common stock in the “new” venture to the management team. LBO
financiers will put up $20 million in 8 percent, 5-year subordinated debt funds plus
1.9 million warrants that can be converted into 1.9 million shares of common stock.
A bank will also offer a $10 million, 14 percent interest rate, 4-year fully amortized
loan. To make the deal work, Brian Motley was asked to provide seller financing in
the form of a below market 10 percent, 5-year, seller’s note. The amount of the note
was to be for the difference between the $45 million selling price and the amount of
funds raised from management, the LBO financiers, and the bank.
In exchange for the seller financing by Brian Motley, the existing venture
capitalists agreed to reduce their ownership rights from 43 percent to 40 percent. The
management team also lowered their claim on the existing venture from 7 percent to 5
percent. Thus, as the result of agreeing to provide seller financing, Brian’s
percentage ownership of the $45 million selling price was 55 percent. Brian
estimated that the interest rate being paid on similar risk subordinated seller loans was
currently at 16 percent.
 Chapter 14: Harvesting the Business Venture Investment 249

A. What will be the dollar amount of seller financing that Brian Motley will need to
provide to complete the financing of the $45 million selling price?

Management team =
$5 million
LBO financiers =

$20 million
Bank loan =

$10 million
Brian Motley =

$10 million

Total =

$45 million

B. How much cash will be available to distribute to the existing owners of the
MiniDiscs Corporation? What will be the dollar breakdown for Brian Motley,
the management team, and the venture capitalists?
250 Chapter 14: Harvesting the Business Venture Investment

Original Percent Exit Percent

Equity Owners

Ownership Ownership
Brian Motley

50%

55%
Management Team 7 5
Venture Investors 43 40
100% 100%
 Chapter 14: Harvesting the Business Venture Investment 251

If Brian Motley provides $10 million seller financing, at the time of exit
ownership percentages would result in the following dollar breakdown:

Brian Motley: .55  $45 million = $24.75 million

Management team: .05  $45 million = $2.25 million
Venture capitalists: 0  $45 million = $18.00 million
$45.00 million

C. What compound rate of return did Motley earn on his $1 million end of 2005
investment?

The $1million original investment bought only 50% of the 2010 equity value. The
additional $10 million below-market loan (negative NPV loan) was the
consideration for the additional 5% to bring Motley’s total ownership to 55%.
For the original $1 million, 50% of the final $45 million is $22.5 million. If we
turn $1 million into $22.5 million in 5 years, the formula for the rate of return is
(22.5/1)1/5 - 1 = 86.4%. Verifying, 1*(1+.864)5= 22.5.

Or, using a financial calculator: PV= 1,000,000; FV = 22,500,000; N = 5;

solving for %i = 86.4%.

While the annual compound rate of return on his original $1 million investment
exceeds 86%, Brian Motley has agreed to an expected 10% annual return on his
$10 million seller financing note over the next five years. The overall return
including the additional 5% purchased by this below-market (negative NPV) loan
would be more complicated and its calculation would require valuing the loan.

D. What compound rate of return did the venture capitalists earn on their $7 million
investment at the end of 2006?

The $7 million VC investment at the end of 2006 turned into an $18 million share
of the exit value at the end of 2010. Thus:
(18/7)^(1/4)-1 = 26.63%
Or, using a financial calculator: PV= 7,000,000; FV = 18,000,000; N = 4;
solving for %i = 26.63%

E. After five years of operating as a private venture owing to the LBO, assume that
the common equity in the MiniDiscs Corporation could be sold for $60 million at
the end of 2015. What compound rate of return would the management team
earn on its $5 million investment?

The VCs were given warrants to purchase 1.9 million shares of stock. Thus, at
exit there would be 3.9 million total shares of common stock outstanding.
252 Chapter 14: Harvesting the Business Venture Investment

The management team’s ownership stake at the $60 million exit (from the LBO)
is (2 million shares) / (3.9 million shares outstanding) = 51.28%.

5*(1+r)^5=.5128*60 implies that r = 43.82%

Using a financial calculator: PV = 5,000,000; FV = 30,768,000 (i.e., .5128 x
$60,000,000); N = 5; solving for %i = 43.82%

F. Assume that when MiniDiscs is sold at the end of 2015 for $60 million that the
LBO financiers will have their debt retired and will sell their share of interest in
the venture. What compound rate of return would the LBO financiers receive?

As the exercise price of the warrants is not specified, we will provide two possible
scenarios:

1) The warrants are exercised by surrendering the VC’s claim to the principal
on the subordinated debt it holds. This structure is like assuming the bond
plus the warrants is a convertible bond. The return in that scenario does not
involve the return of the $20,000,000 principal. The related IRR equation is:

-20,000,000 + 1,600,000/(1+irr) + 1,600,000/(1+irr)^2 + 1,600,000/(1+irr)^3

+ 1,600,000/(1+irr)^4 + 1,600,000/(1+irr)^5 +
.4872*60,000,000/(1+irr)^5 = 0

This results in a compound rate of return for the VCs of: irr = 14.86%.
Using a financial calculator: PV = 20,000,000; FV = 29,232,000; PMT or
payment = 1,600,000; N = 5; solving for %i = 14.86%.

Of course, this is not a very good overall rate of return. Consequently, if the
VCs actually thought the final exit value wouldn’t include the $20,000,000
return of principal on the bond, they would have negotiated for a much larger
portion of the equity in the firm.

2) The warrants have some trivial (close to zero) exercise price that is negligible
for the purpose of the analysis (as was in the example solution on page 506-
508 of the textbook) and the $20,000,000 in bond principal is repaid.

-20,000,000 + 1,600,000/(1+irr) + 1,600,000/(1+irr)^2 + 1,600,000/(1+irr)^3

+ 1,600,000/(1+irr)^4 + 1,600,000/(1+irr)^5 + 20,000,000/(1+irr)^5
+ .4872*60,000,000/(1+irr)^5 = 0

This results in a compound rate of return for the VCs of: irr = 25.60%, a more
reasonable return for this type of financing.

Using a financial calculator: PV = 20,000,000; FV = 49,232,000; PMT or

payment = 1,600,000; N = 5; solving for %i = 25.60%.
Chapter 14: Harvesting the Business Venture Investment 253