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Chapter 10: Analysis and Valuation
of Privately Held Companies
Answers to End of Chapter Discussion Questions
10.1 What is a capitalization rate? When is it used and why?
10.2 What are the common ways of estimating capitalization multiples?
10.3 What is the marketability discount and what are common ways of estimating this discount?
10.4 Give examples of private company costs that might be understated and explain why.
10.5 How can an analyst determine if the target firm’s costs and revenues are understated or overstated?
10.6 Why might shell corporations have value?
10.7 Why might succession planning be more challenging for family owned firms?
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?
10.9 Why are family owned firms often attractive to private equity investors?
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.
10.11 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?
10.12 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.
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
3
10.13 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?
10.14 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. What is free cash flow to the firm in year 2?
c. What is the firm’s cost of equity?
d. What is the firm’s after-tax cost of debt?
e. What is the firm’s target debt-to-total capital ratio?
f. What is the weighted average cost of capital?
g. What is the business worth?
Solutions to Chapter Case Study Questions
Catalyst Acquires Targacept in Reverse Merger
Discussion Questions:
1. What are common reasons for a private firm to go public? What are the advantages and
disadvantages of doing so? Be specific.
2. Discuss the pros and cons of a reverse merger versus an IPO.
3. Discuss why Signal and Miragen may have chosen a reverse merger over an IPO.
4. What is the purpose of private firm in wanting to be listed on a major stock exchange such as
NASDAQ?
5. What is a shell corporation? Which firm is the shell corporation (Signal or Miragen) in the
case study? Why is it misleading to call Signal the acquirer and Miragen the target firm?
6. What are the auditing challenges associated with reverse mergers? How can investors protect
themselves from the liabilities that may be contained in corporate shells?
Examination Questions and Answers
1. Both public and private firms always attempt to maximize earnings growth. True or 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
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
4. Private firms are likely to understate revenue and understate costs in order to minimize their tax liabilities.
True or False
5. Revenue may be inflated by booking as revenue products shipped to resellers without adequately
adjusting for probable returns. True or False
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
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
8. Employee benefit levels in private firms are almost always mandated by state or federal law and
therefore cannot be changed. True or 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
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
11. Methodologies employed to value private firms are substantially different from those employed to value
public firms. True or False
12. Asset valuation includes specific business risks but ignores any adjustment for liquidity risk. True or 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
7
14. Shell corporations may have significant value to acquiring firms. True or False
15. Empirical evidence suggests that discounts have declined in recent years. True or False
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
17. The availability and reliability of data for public companies tends to be much greater than for small
private firms. True or False
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
19. Because of data limitations, valuation of private firms often requires more subjective adjustments than for
public firms. True or False
20. Private firms must file quarterly earnings reports with the Securities and Exchange Commission.
True or 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
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
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
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
25. Before selling a business, an owner may increase advertising expenses in order to inflate profits.
True or False
26. Intangible assets such as customer lists, intellectual property, licenses, distributorships agreements, leases,
regulatory approvals, and employment contracts may offer significant sources of value. True or False
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
28. Valuation of privately held businesses may involve substantial adjustment of the discount or capitalization
rate. True or False
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
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
31. A private corporation is a firm whose securities are not registered with state or federal authorities. True or
False
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
33. Very few closely held businesses are family owned. True or False
34. All family owned businesses are small. True or 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
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
37. Family owned businesses account for about 89% of all businesses in the U.S. True or False
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
39. Succession issues tend to be easier for small family owned firms than for large publicly traded firms. True
or False
40. The market model of corporate governance is readily applicable to privately held, family owned firms.
True or False
9
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
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
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
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
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
46. Private companies are generally not subject to the same level of rigorous controls and reporting systems as
are public companies. True or False
47. Small firms may lack product, industry, and geographic diversification, which add to their specific business
risk. True or False
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
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
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
51. EBITDA has become an increasingly popular measure of value for privately held firms in recent years.
True or False
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
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
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
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
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
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
58. Shell corporations rarely have any value. True or False
59. Private investment in public entities (PIPES) is a commonly used method of financing reverse mergers.
True or False
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
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
62. There is widespread agreement over the magnitude of the liquidity discount. True or 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
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
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
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
11
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.
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
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
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.
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
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
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
12
d. Are more easily valued than public companies
e. Have limited ability to influence customers, suppliers, unions, and regulators
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.
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
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
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
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
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
13
d. Counting interest income as revenue
e. All of the above
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
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
OWNER’S DECISION TO RETIRE
FORCES SALE OF BORTZ HEALTH CARE
_____________________________________________________________________________________
Key Points
• Succession planning and insufficient capital are leading factors forcing the sale of privately held or family
owned businesses.
• Small businesses often are unable to adapt to rapid changes in the markets in which they compete.
• For many deals to take place, sellers must feel comfortable that prospective buyers share their operating
philosophy.
____________________________________________________________________________
After being honorably discharged from the U.S. Navy in 1946, Donald Bortz, Jr. went to work for his father in the
used car business. By 1957, his father wanted a greater challenge and together they bought a nursing home in
Orchard Lake, Michigan. This would be the first of many nursing homes to be acquired by the father and son
management team. They developed a reputation of buying poorly run facilities, some in bankruptcy and some in
financial distress, and rapidly improving their operations. The growing chain of nursing facilities was named Bortz
Health Care with the slogan “We Care” a prominent part of the firm’s culture.
Fast forward 58 years to 2015, Don Bortz found himself at a crossroads. At 89, he and his wife, Valerie, with the
reluctant consent of his three adult children all employees of the firm, decided to sell the family owned firm. When
he and his father started in the business almost six decades ago there were few regulations governing nursing home
operations other than a promise to patients that they would be cared for in their old age. But times had changed and
the business was having difficulty adapting. Don and his wife knew that the firm’s available cash flow was
insufficient to keep the business competitive and did not want to burden their children with a business that was
likely to lose value over time.
Bortz was not alone in selling, as a number of long-standing nursing facility owners in Michigan have sold their
businesses in recent years. While some retired, major changes in healthcare reimbursement and regulations are
accelerating the change in the industry. Unlike hospitals and physicians which are partially reimbursed by the
federal government, skilled nursing facilities have to bear the brunt of rising operating costs and expenditures to
14
meet government mandated technology such as electronic record keeping. Small nursing home chains are having
difficulty flourishing. Larger and better capitalized chains are necessary to diversify revenue sources into
rehabilitation and physical therapy and their own laboratories to generate sufficient profit to remain in business.
Patients are living longer and are sicker requiring more acute care. Fee for service reimbursement is ending and
other reimbursement models such as risk based managed care contracts and quality incentive withholds are being
evaluated.1 Time will tell whether these new reimbursement methods will lower patient costs while keeping the
skilled nursing facilities financially viable.
Bortz Healthcare in 2014 recorded $95 million in revenue and operated 11 nursing homes and assisted living
facilities: 10 in Michigan and one in Florida. In 2013, the firm had sold two other nursing homes located in
Michigan. The well managed operation was highly attractive to a number of larger nursing home chains hoping to
increase the scale of their operations through acquisition.
In mid-2015, the business was sold to Villa Healthcare, a Skokie, Illinois-based nursing home chain operating 10
long-term care and assisted living homes in Illinois, Wisconsin and Minnesota. According to Don Bortz, Villa was
selected from among 12-14 bids received over the last several years because they shared his philosophy and vison
for the business. While Villa has not committed contractually to retaining Bortz’s 1,500 employees, they recognized
the high quality of the staff and were likely to retain most of the employees. All of the Bortz children have been
given one year retention contracts to remain with the firm after closing. This would ease transition of the facilities
now under new ownership. Villa also has said that it will be spending several million dollars to update Bortz
facilities, health care information technology, and to expand rehabilitation services.
Like many things in life timing often is everything. Don and Valarie Bortz were ready to retire and saw in
Villa’s owners a willingness to manage Bortz Health Care the way they would have wanted to had they retained the
business. With the cost of operating skilled nursing facilities likely to continue to escalate, they knew that they
could not make the investment necessary to meet the changing industry environment. They reasoned that it was
better to sell now when the value of the business was likely to be highest.
CATALYST ACQUIRES TARGACEPT IN REVERSE MERGER
____________________________________________________________________________
Case Study Objectives: To illustrate
• Motivations for “going public,”
• The mechanics of reverse mergers, and
• Why reverse mergers may be preferred to IPOs for firms wanting to “go public.”
____________________________________________________________________________
Biotech companies often partner with major pharmaceutical firms to fund the development of new drugs. Biotech
firms can attract talent and unlike big pharmaceutical firms have relatively little bureaucracy which often impedes
research and development activities at bigger firms. Without funding from the big drug companies, small biotech
firms must find alternative sources of funds often by listing on a major stock exchange. This is commonly done by
taking a private biotech company public through an initial public offering or by merging with an existing public
company through a reverse merger.
In the years following the 2008-2009 recession, biotech firms have been able to successfully go public through
IPOs due to the robust rise in stock prices and the desire for investors to achieve greater returns in the wake of
record low interest rates. However, when the stock market stalled in 2015 investors were less receptive to IPOs.
1 Risk based managed care involves the payment of a fixed fee per insured to managed care providers with the
provider at risk if their patient care costs exceed the reimbursement rates. Under quality incentive withholds
government agencies retain a portion of reimbursement for services provided by health care providers until certain
performance based measures have been satisfied. These measures involve predetermined quantitative improvements
in patient care and outcomes in such areas as prevention and screening and patient access.
15
Biotech firms, wanting to go public, have had to seek alternative means of doing so. Reverse mergers represented
one such alternative.
Biotech firm Catalyst Biosciences (Catalyst) had early success in partnering with Pharmaceutical giant, Wyeth,
having reached an agreement to license its drug designed to control bleeding in late 2009. But the results of the
partnership in the ensuing years were modest. Catalyst had drugs in development (in the so-called pipeline) and
other drugs that were at various stages of clinical testing. But the firm needed money and was unable to get
financing from big pharmaceutical firms. By 2015, Catalyst went public in a reverse merger with publicly traded
Targacept, the beleaguered biotech that had suffered a number of clinical trial failures in recent years. Targacept had
little to attract investment from big drug companies and in late 2014 its partnership with AstreZeneca fell apart
diminishing its royalty revenue stream. Targacept was left to search for a new role for itself in the biotech industry.
Targacept still had substantial cash on hand but few attractive investment opportunities. Its prospects were to
continue to burn cash by going it alone, seek a partner, or merge with a firm having significant growth opportunities.
The firm projected that at the current rate of usage it would exhaust its cash on hand in 18 to 24 months and few
parties seemed interested in investing in the foundering company. A merger seemed like the best hope. Targacept
tried to conserve cash by cutting back on its operations. But this would simply extend the day of reckoning. By the
time it was able to find a merger partner, it had laid off most of its employees. By early 2015, Targacept had just 18
full time employees down from a peak of 144 in 2012.
In contrast to Targacept, Catalyst had a series of promising new drugs but was running short of cash. The long-
lead time required to bring drugs to market means that many biotech firms experience an inability to finance
aggressive R&D projects. To finance future research and development, it too had to partner with a large
pharmaceutical firm, or to go public through an IPO or a reverse merger. Cutbacks at large drug companies made
the likelihood of finding an investment partner slim and the lackluster stock market made an IPO impractical.
Therefore, the firm decided it needed to merge with a cash flush public firm which offered the opportunity to attract
new R&D talent with the offer of stock options and the ability to raise cash through future equity issues.
Early in 2015, biotech firm Tobira Therapeutics tested the waters by going public through a reverse merger after
its IPO fizzled. This successful reverse merger seemed to pave the way for Catalyst to pursue this means of going
public during the choppy 2015 stock market. The merger between Catalyst and Targacept was announced in May
2015 and represented the creation of a new company named Catalyst Biosciences. The new firm contained
Catalyst’s protease therapeutics pipeline and financial resources came mostly from Targacept. It represented a well-
funded firm hoping to develop new treatment options for patients with bleeding disorders.
While conventional IPOs can take months to complete, reverse mergers can take only a 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 at the time it
goes public.
At closing, the combined firms had a pipeline of protease therapeutics, four other promising drug candidates, and
cash and cash equivalents of $40 million. Of the cash on hand, $35 million came from Targacept and the remaining
$5 million came from Catalyst, Existing Targacept shareholders received a special dividend prior to closing of about
$20 million distributed from Targacept’s cash on hand and redeemable convertible notes (convertible into Catalyst
Biosciences common shares) totally $37 million. The notes are guaranteed by the new firm Catalyst BioSciences.
The Catalyst stockholders will initially own approximately 65% of the combined company, with Targacept
shareholders owning the remainder.
The notes will be convertible into the combined company’s common stock at any time within two years
following closing at the discretion of those holding the notes. The conversion price of the notes is equal to $1.31,
which represents 130 percent of the negotiated per-share value of Targacept’s assets following the anticipated
distribution of the dividend of approximately $20 million and $37 million principal amount of the notes. The
conversion price was determined along with the valuation of Targacept’s shares during pre-closing negotiations.
The notes have implications for future investment capital for the firm and for the distribution of ownership. The
notes represent potentially a future source of cash for the new company, which will contribute from current cash
flow money into an escrow fund in an amount sufficient for repayment of any notes that are not converted to stock
during the two-year conversion period. Catalyst has positive cash flow from royalty payments on drugs licensed to
pharmaceutical firms prior to the merger. If the redeemable convertible notes are fully converted in common shares,
an additional $37 million held in escrow would be made available to the new company within the first two years
following closing. Targacept shareholders ownership would increase to 49% from 35% at closing if the notes are
fully converted.
Figure 10.1 illustrates how ownership is transferred in a typical reverse merger. Catalyst creates a wholly owned
subsidiary shell corporation (Merger Sub) and exchanges the shares of the Merger Sub for $20 million in cash and
redeemable notes with a face value of $37 million. Merger sub is merged with Targacept in a reverse triangular
merger with Targacept surviving as a wholly owned subsidiary of Catalyst. The reverse triangular merger preserves
valuable licenses, contracts and intellectual property owned by Targacept. Targacept is then merged with Catalyst in
a backend merger and the firm is renamed as Catalyst BioSciences.
Figure 10.1 Reverse Merger Process
Shares of Targacept common stock were listed on the NASDAQ Global Select Market under the symbol
“TRGT.” Prior to completion of the merger, Targacept filed an initial listing application with the NASDAQ Global
Select Market relating on behalf of the combined company, subject to NASDAQ “reverse merger” rules. After
completion of the merger, Targacept was renamed “Catalyst Biosciences, Inc.” and trades on the NASDAQ Global
Select Market under the symbol “CBIO.”
Both Catalyst and Targacept had needs that could be satisfied by combining their resources. Stock market
volatility during much of 2015 made it difficult to price Catalyst shares that could be issued through an IPO.
Targacept was burning through its cash on hand with few attractive investment opportunities. These complementary
needs illustrate the conditions in which reverse mergers often take place. While providing access to capital,
converting from a private to a public corporation represents a new array of challenges. While firms often have
several options for going public, stock market conditions probably dictated the use of the reverse merger in this
instance.
Discussion Questions
1. What is the purchase price of Targacept and how is it financed? How does this financing structure
potentially help the combined firm Catalyst BioSciences fund future spending? How would Catalyst’s
original shareholders be impacted by a conversion of the notes?
Catalyst
Catalyst Merger Sub
Targacept
Cash &
Redeemable
Notes
Merger Sub
Shares
Cash & Redeemable
Notes Exchanged for
Targacept Shares
Targacept Becomes Wholly
Owned Sub of Catalyst
2. What are common reasons for a private firm to go public? What are the advantages and disadvantages or
doing so? Be specific.
3. What are corporate shells, and how can they create value? Be specific.
4. Discuss the pros and cons of a reverse merger versus an IPO.
5. What is the purpose of private firm in listing of a major stock exchange such as NASDAQ?
18
Privately Owned La Boulange Café & Bakery Goes Nationwide
_____________________________________________________________________________________
Key Points
• Financing growth represents a common challenge for most small businesses.
• Selling a portion of a business either to other investors, in a public offering, or to a strategic buyer
represents common ways for small businesses to finance major expansion plans.
____________________________________________________________________________
Founded in 1999 as La Boulangerie, the business started as a store front with an oven in the back room. The
founder, Pascal Rigo who started baking in France at age seven, lived above that store for nine years. The first store
became a prototype for what was to become La Boulange Café & Bakery with nineteen sites across the San
Francisco bay area, with the business eventually sold to Starbucks in 2013.
In 2005, Rigo was able to expand the number of locations by partnering with Next World Group, a privately
held investment firm that provided much needed financing. The business was managed as a subsidiary of Bay
Bread Group, a holding company, which also operated the Bay Bread Company. The long-term business objective
was to take the La Boulange Café & Bakery nationwide. However, limited resources meant that the roll out would
take a long time.
While an additional cash infusion from an initial public offering or a private investor would have accelerated the
process, partnering with or selling the business to a strategic buyer seemed to make more sense. An attractive
strategic buyer for the business would have deep pockets, an existing nationwide distribution channel, and a widely
recognized brand name.
Enter Starbucks. The firm had been crisscrossing the country looking for new bakeries and soon became
enamored with La Boulange. The deal took six months to negotiate. The prospects of better benefits and training
quickly got support from La Boulange’s employees, and retaining Rigo to run the operations was a key condition
of closing the sale. Agreement was reached in early April 2013 in which Starbucks would buy the business for
$100 million in cash. The deal finally closed in December of the same year.
With food current accounting for about 20 percent or $1.5 billion of the firm’s total annual revenue, Starbucks
looked at the acquisition as an opportunity to bring high-quality pastries and bread into its locations nationwide.
The acquisition provides an entrée into the casual restaurant industry, putting the firm potentially in direct
competition with the likes of Panera Bread Co. and its 1500 locations across the country. Starbuck’s believes that
the inclusion of La Boulange-branded French pastries, croissants, breads, and muffins will drive traffic and cause
clientele to increasingly associate Starbucks with high quality food. Longer-term, Starbuck plans to build La
Boulange into a national brand with its own retail outlets as well as to move into groceries and other consumer
goods sporting the Starbucks’s brand. Starbucks also saw the opportunity for La Boulange to start selling its own
special Starbucks coffee blend.
The potential seems limitless. Starbucks has 17,000 stores worldwide, and 10,000 in the U.S. Starbucks and
also owns Seattle’s Best Coffee, Tazo Tea, and Evolution Fresh fruit juices. La Boulange will be the only bakery in
the firm’s business portfolio. In early 2014, Starbucks replaced their current baked goods offering with La
Boulange’s French croissants, initially in the San Francisco area and then began to roll out the offering to other
locations in major metropolitan areas nationwide.
Shell Game: STK Steakhouse Chain Goes Public
Through a Reverse Merger
_____________________________________________________________________________________
Case Study Objectives: To illustrate
• Some of the motivations for “going public,”
• The mechanics of reverse mergers, and
• Risks and rewards associated with reverse mergers.
19
Introduction
With growth slowed by limited resources, a robust stock market, and intensifying investor interest in high-end
restaurant dinning chains, One Group LLC, the owner of steakhouse chain STK faced a critical decision. Should
the firm go public now and dilute their ownership stake or continue to rely on their financial resources and risk
missing an opportunity to enter the public stock market? This is a choice commonly faced by fast growing
successful privately held firms.
One Group is a hospitality holding company that develops and operates upscale restaurants and lounges. It
opened its first restaurant in New York City in 2004. Its primary brand is STK. Managing member,2 Jonathan
Segal, owns about 35% of the firm and has additional ownership stakes in subsidiaries operated by the holding
company. With annual revenue of more than $130 million (up from $6 million in 2006), STK is a New York-based
steakhouse restaurant that markets itself to women with the mantra “STK is not your daddy’s steakhouse.” In a
departure from steakhouses typically serving huge steaks, STK focuses on serving smaller portions to its targeted
female clientele. STK has seven locations in major metropolitan areas and a hospitality business providing food
service for restaurants, bars, and hotels. STK plans locations in Washington D.C., Chicago, Dubai, London, and
Montreal. Longer-term, the firm intends to launch a chain of smaller, less expensive restaurants under the name
Rebel STK. To realize these objectives, One Group knew it needed additional funding.
The Decision
The timing appeared to be right. The broad stock market indices were up by almost 30% during the first nine
months of 2013 over the same period the prior year. Niche high-end restaurant chains appeared to be in vogue. In
mid-2013, Del Frisco’s Restaurant Group undertook an IPO at $13 per share. Since then its shares have risen by
40%. In early October 2013, hedge fund Barrington Capital took a 2.8% stake in Darden Restaurants Inc. urging
the dining conglomerate to separate its faster growing Capital Grille and Eddie V’s from its larger restaurant chains
through spin-offs or divestitures.
Committed Capital Acquisition Group (CCAC), a special purpose acquisition company (SPAC), seemed to offer
an immediate vehicle for entering the public stock market. SPACs are shell or so-called blank-check companies
that have no operations but which raise funds through an initial public offering with the intention of merging with
or acquiring companies. SPACs often raise additional funds by issuing warrants enabling investors to buy
additional shares in the SPAC at a later date at a preset price.3 On October 16, 2013, One Group LLC merged with
CCAC in a deal that converted the privately held firm to a public company in which CCAC investors paid One
Group owners a combination of CCAC common shares and cash. The merger occurred simultaneously with a
private equity placement (often referred to as private investment in public equity) to raise cash.
The investors valued the deal at $5 per share giving the firm a market value of about $118 million or as much as
$147 million if warrants are exercised before expiration. Warrants are issued by firms and grant their holders the
option but not the obligation to buy stock in the issuing firm at a predetermined price during some future time
period. The shares initially traded over the counter, although the longer term objective is to list the firm on the
NASDAQ Stock Exchange. The cash will initially be used to open new restaurants, retire existing debt, and to buy
out minority investors in individual restaurants.
The Process
The combination of One Group and CCAC involved a process called a reverse merger. To undertake a reverse
merger, a firm finds a shell corporation with relatively few shareholders who are interested in selling their stock.
2 Limited liability company owners are called members. The managing member is organizationally equivalent to a
chief executive officer.
3 SPACs and reverse mergers are similar in that they both use shell companies to take private firms public. However,
they differ in how they are created. In a SPAC, a shell is created and funded through an IPO with the specific intent
of acquiring or merging with a private firm. With a reverse merger, a private firm is merged into an existing publicly
listed shell company as a means of taking the private firm public. For a detailed discussion of SPACs and reverse
mergers, see Cumming et. al., 2014.
20
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 in transferring the
shell’s liabilities to new investors. Alternatively, the private firm may merge with an existing special-purpose
acquisition company already registered for public stock trading.
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 as
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 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.
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. 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 by U.S. law to hold their shares for a specific
period of time following closing.
What follows is a description of a reverse merger with a shell corporation. The shell corporation in this instance
is a SPAC established by the investment group Committed Capital Acquisition Corporation through an initial
public offering in 2011. The expressed purpose of the SPAC, which holds only cash raised from the public offering
and its own common shares, is to acquire operating companies. SPAC shareholders make money when the SPAC
liquidates through a public offering or sale to strategic investors at a later date.
The Deal
On October 16, 2013, Committed Capital Acquisition Corporation (CCAC), a publicly traded Delaware
Corporation, agreed to merge its wholly-owned CCAC Acquisition Sub (Merger Sub) into One Group LLC.
CCAC had created Merger Sub transferring cash and its common shares in exchange for all of Merger Sub’s
shares. One Group was the surviving legal entity of the merger. As such One Group became a wholly-owned
subsidiary of CCAC. See Figure 10.1.
Simultaneously, CCAC issued 12.6 million shares of its common shares having a par value of $.0001 per share
plus $11.8 million in cash for their ownership interest (membership interest) in One Group LLC. CCAC also issued
one million common shares to the former managing member of One Group, Jonathan Segal, as a control premium.
These shares are in addition to the 7.7 million common shares issued to Mr. Segal for his ownership stake in One
Group and his interest in certain One Group operating subsidiaries.
The total merger consideration paid to One Group owners was $118.4 million consisting of shares with a market
value of $106.6 plus cash of $11.8 million. Warrants set to expire two years from the date of closing to purchase
5.8 million in new common shares with an exercise price of $5 per share could boost the merger consideration to as
much as $147 million.
Committed Capital Acquisition Corporation announced the change in its ticker symbol (CCAC) to STKS. The
common shares trade under that symbol over the counter. The firm’s name also was subsequently changed to The
One Group, Inc.
Committed Capital
Acquisition Corporation
(The Company)
One Group LLC
