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21
Coinciding with the closing date, CCAC completed a private placement of 3.1 million common shares at a
purchase price of $5 to investors consisting of some CCAC’s existing shareholders realizing proceeds of $15.5
million. In connection with the private placement, CCAC agreed to register the shares with the Securities and
Exchange Commission within 120 days of closing. This activity is sometimes called private investment in public
equity or PIPE financing.
Concluding Comments
One Group had the choice of remaining private or taking STK public. Each ownership structure has its pros and
cons. For example, after twenty years as a publicly traded company, Dell Inc. converted from to a private
corporation. While gaining access to additional capital, STK will face new challenges as a public company. To go
public, One Group chose a reverse merger from a range of options. While sometimes effective, reverse mergers
often create more problems than alternative strategies.
Discussion Questions
1. What are common reasons for a private firm to go public? What are the advantages and disadvantages or
doing so? Be specific.
Answer: Common reasons for a firm to go public include the ability to obtain capital, to obtain an
acquisition currency, to liquidate some portion of the founder’s share holdings, and to offer incentive stock options
2. What are corporate shells, and how can they create value? Be specific.
Committed Capital
Acquisition Corporation
(The Company)
CCAC Acquisition Sub
One Group LLC
CCAC
Common
Shares
Cash & CCAC
Common Shares
One Group Becomes
Wholly-Owned CCAC Sub
22
3. What were the options available to One Group LLC to raise capital to finance their expansion plans? Discuss
the pros and cons of each. Be specific.
Answer: Options available to One Group included borrowing from banks or hedge funds, entering into a private
equity placement with a hedge fund or private equity investor group, undertaking an initial public offering, and
going public through a reverse merger. (Since One Group is a limited liability company, a private placement would
involve the sale of units rather than shares unless it converted to a C corporation before the sale.)
4. Discuss the pros and cons of a reverse merger versus an IPO.
Answer: Many small businesses fail each year. In a number of cases, all that remains is a business with no
significant assets or operations. Such companies are referred to as shell corporations. Shell corporations can be
used as part of a deliberate business strategy in which a corporate legal structure is formed in anticipation of future
financing, a merger, joint venture, spin-off, or some other infusion of operating assets. This may be accomplished
5. Why is it likely that shares trade at a discount from their value when issued if investors attempted to sell
such shares within one year following closing of the reverse merger?
23
Answer: Following a reverse merger, the operating company is technically public in that its shares once
registered with the SEC are traded on the Pink Sheets or OTC Bulletin Board. Such shares under current U.S.
security laws cannot be traded on the major exchanges until they have traded on the smaller exchanges for a year
6. What is the purpose of ultimately listing of a major stock exchange such as NASDAQ?
Answer: Larger public stock exchanges offer substantially larger trading volumes than the Pink Sheets and
Shell Game: Going Public through Reverse Mergers
___________________________________________________________________________________________
Key Points
Reverse mergers represent an alternative to an initial public offering (IPO) for a private company wanting to “go
public.”
The challenge with reverse mergers often is gaining access to accurate financial statements and quantifying current
or potential liabilities.
Performing adequate due diligence may be difficult, but it is the key to reducing risk.
______________________________________________________________________________
The highly liquid U.S. equity markets have proven to be an attractive way of gaining access to capital for both
privately owned domestic and foreign firms. Common ways of doing so have involved IPOs and reverse mergers.
While both methods allow the private firm’s shares to be publicly traded, only the IPO necessarily results in raising
capital, which affects the length of time and complexity of the process of “going-public.”
To undertake a reverse merger, a firm finds a shell corporation with relatively few shareholders who are
interested in selling their stock. The shell corporation’s shareholders often are interested in either selling their shares
for cash, owning even a relatively small portion of a financially viable company to recover their initial investments,
or transferring the shell’s liabilities to new investors. Alternatively, the private firm may merge with an existing
special-purpose acquisition company (SPAC) already registered for public stock trading. SPACs are shell, or
“blank-check,” companies that have no operations but go public with the intention of merging with or acquiring a
company with the proceeds of the SPAC’s IPO.
In a merger, it is common for the surviving firm to be viewed as the acquirer, since its shareholders usually end
up with a majority ownership stake in the merged firms; the other party to the merger is viewed as the target firm
because its former shareholders often hold only a minority interest in the combined companies. In a reverse merger,
the opposite happens. Even though the publicly traded shell company survives the merger, with the private firm
becoming its wholly owned subsidiary, the former shareholders of the private firm end up with a majority ownership
stake in the combined firms. While conventional IPOs can take months to complete, reverse mergers can take only a
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.
24
The speed with which a firm can “go public” as compared to an IPO often is attractive to foreign firms desirous
of entering U.S. capital markets quickly. In recent years, private equity investors have found the comparative ease of
the reverse merger process convenient, because it has enabled them to take public their investments in both domestic
and foreign firms. In recent years the story of the rapid growth of Chinese firms has held considerable allure for
pine molding. Ceasing operations in September 2006 to become a shell corporation, Pinewood changed its name to
Mill Basin Technologies. The firm began to search for a merger partner and registered shares for public trading in
2006 in anticipation of raising funds.
The reverse merger process employed by Allied, the privately owned operating company and owner of Huiheng,
to merge with Mill, the public shell corporation, early in 2008 to become a publicly listed firm is described in the
following steps. Allied is the target firm, and Mill is the acquiring firm.
266,666 new preferred shares. All premerger Allied shares were cancelled. Mill Basin Technologies was renamed
4 Without the reduction in Mill’s premerger shares outstanding, total shares outstanding postmerger would have
been 23,150,000 [10,150,000 (Mill shares premerger) + 13,000,000 (Allied shares premerger)] rather than the
13,450,000 after the recapitalization.
25
While Huiheng traded as high as $13 in late 2008, it plummeted to $1.60 in early 2012, reflecting the failure of
the firm to achieve any significant revenue and income in the cancer market, an inability to get an auditing firm to
approve their financial statements, and the absence of any significant order backlog. Having reported net income as
high as $9 million in 2007, just prior to completing the reverse merger, the firm was losing money and burning
through its remaining cash. The firm was left looking at alternative applications for its technology, such as
enter the U.S. equity markets. Chardan Capital invested $10 million in Huiheng in exchange for more than 52,000
shares of the firm’s preferred stock. Chardan and Roth Capital Partners, a California investment bank, were co-
underwriters for a planned 2008 Huiheng stock offering that was later withdrawn. Chardan had been fined $40,000
for three violations of short-selling rules from 2005 to 2009. Roth is a defendant in alleged securities’ fraud lawsuits
involving other Chinese reverse merger firms.5
Common 450,000a
Series A Preferred 266,666
New Mill Shares Issued to Acquire 100% of Allied shares
Common 13,000,000
Series A Preferred 266,666
Former Mill Shareholders: 3.35%
aMill shareholders contributed 9,700,000 shares of their pre-merger holdings to treasury stock cutting the
number of Mill shares outstanding to 450,000 in order to reduce the total number of shares outstanding
postmerger, which would equal Mill’s premerger shares outstanding plus the newly issued shares. This also
could have been achieved by the Mill shareholders agreeing to a reverse stock split. The 10,150,000 pre-
c(13,000,000/13,450,000)
Huiheng ran into legal problems soon after its reverse merger. Harborview Master Fund, Diverse Trading Ltd.,
and Monarch Capital Fund, institutional investors having a controlling interest in Huiheng, approved the reverse
merger and invested $1.25 million in exchange for stock. However, they sued Huiheng and Chardan Capital in 2009
as Huiheng’s promise of orders failed to materialize. The lawsuit charged that Huiheng bribed Chinese hospital
5 McCoy and Chu, December 26, 2011
26
some of its stock. In 2011, the firm had difficulty in collecting receivables and generating cash. That same year,
Huiheng’s operations in China were struggling and were on the verge of ceasing production.
Discussion Questions
1. What are common reasons for a private firm to go public?
2. What is a corporate shell and how can they create value?
3. Who are the key participants in the case study and what are their roles in the reverse merger?
4. Discuss the pros and cons of a reverse merger versus an initial public offering for taking a company public.
Answer: Many small businesses fail each year. In a number of cases, all that remains is a business with no
significant assets or operations. Such companies are referred to as shell corporations. Shell corporations
can be used as part of a deliberate business strategy in which a corporate legal structure is formed in
anticipation of future financing, a merger, joint venture, spin-off, or some other infusion of operating
assets. This may be accomplished in a transaction called a reverse merger in which the acquirer forms a
27
5. What are the auditing challenges associated with reverse mergers? How can investors protect themselves
from the liabilities that may be contained in corporate shells?
Answer: Auditing challenges could include the following: collusion between local bank branches and
company executives in confirming the firm’s bank cash balances; collusion between vendors and customers
and company executives in the sales and purchase confirmation process; off book or unreported liabilities;
6. Mill was recapitalized just prior to completing its merger with Allied. What was the purpose of the
recapitalization? Did it affect the ability of the combined firm’s to generate future earnings? Explain your
answers.
Answer: The recapitalization of Mill was intended to reduce the number of Mill common shares that Allied
would have to acquire in the share for share exchange. In doing so, the total number of shares outstanding
Determining Liquidity Discounts: The Taylor Devices and Tayco Development Merger
____________________________________________________________________________________________
Key Points
Privately held shares or shares for which there is not a readily available resale market often can only be sold at a
discount from what is believed to be their intrinsic value.
However, estimating the magnitude of the discount often is highly problematic.
____________________________________________________________________________________________
This discussion6 is a highly summarized version of how a business valuation firm evaluated the liquidity risk
associated with Taylor Devices’ unregistered common stock, registered common shares, and a minority investment
in a business that it was planning to sell following its merger with Tayco Development. The estimated liquidity
discounts were used in a joint proxy statement submitted to the SEC by the two firms to justify the value of the offer
the boards of Taylor Devices and Tayco Development had negotiated.
Taylor Devices and Tayco Development agreed to merge in early 2008. Tayco would be merged into Taylor,
with Taylor as the surviving entity. The merger would enable Tayco’s patents and intellectual property to be fully
integrated into Taylor’s manufacturing operations, since intellectual property rights transfer with the Tayco stock.
Each share of Tayco common stock would be converted into one share of Taylor common stock, according to the
6 Source: SEC Form S4 filing of a proxy statement for Taylor Devices and Tayco Development dated 1/15/08.
terms of the deal. Taylor’s common stock is traded on the NASDAQ Small Cap Market under the symbol TAYD,
and on January 8, 2009 (the last trading day before the date of the filing of the joint proxy statement with the SEC),
the stock closed at $6.29 per share. Tayco common stock is traded over the counter on “Pink Sheets” (i.e., an
informal trading network) under the trading symbol TYCO.PK, and it closed on January 8, 2009, at $5.11 per share.
size, and they face high transaction costs. Based on the SEC and other prior 1990 studies, the liquidity discount for
this investment was expected to be between 30% and 35%. Pre-IPO studies could push it higher to a range of 40–
45%. The appraisal firm argued that the discount for most minority-interest investments tended to fall in the range of
25–45%. Because of the small size of the real estate development business, the liquidity discount is believed by the
appraisal firm to be at the higher end of the range.
Discussion Questions
1. Explain how the appraiser estimated the liquidity discount for Taylor’s unregistered shares.
Answer: The appraiser believed that the risk of Taylor’s unregistered shares is greater than for letter stocks,
2. What other factors could the appraiser have used to estimate the liquidity discount on the unregistered
stock?
3. In view of your answer to question 2, how might these factors have changed the appraiser’s conclusions?
Be specific.
4. Based on the estimated liquidity discount of 13 percent estimated by the business appraiser, what was the
actual purchase price premium paid to Tayco shareholders?
29
Taking Advantage of a “Cupcake Bubble”
__________________________________________________________________________________________
Key Points
Financing growth represents a common challenge for most small businesses.
Selling a portion of the business either to private investors or in a public offering represents a common way for
small businesses to finance major expansion plans.
____________________________________________________________________________
When Crumbs first opened in 2003 on the upper west side of Manhattan, the bakery offered three varieties of
cupcakes among 150 other items. When the cupcakes became increasingly popular, the bakery began introducing
cupcakes with different toppings and decorations. The firm’s founders, Jason and Mia Bauer, followed a
straightforward business model: Hold costs down, and minimize investment in equipment. Although all of Crumbs’
cupcake recipes are Mia Bauer’s, there are no kitchens or ovens on the premises. Instead, Crumbs outsources all of
many as 200 new locations by 2014. The challenge was how to finance such a rapid expansion.
The Bauers were no strangers to raising capital to finance the ongoing growth of their business, having sold one-
half of the firm to Edwin Lewis, former CEO of Tommy Hilfiger, for $10 million in 2008. This enabled them to
reinvest a portion in the business to sustain growth as well as to draw cash out of the business for their personal use.
However, this time the magnitude of their financing requirements proved daunting. The couple was reluctant to
positions, and utilize the financial expertise of others to tap the public capital markets and to share in any future
value creation.
The 57th Street General Acquisition Corporation (57th Street), a special-purpose acquisition company, or SPAC,
appeared to meet their needs. In May 2010, 57th Street raised $54.5 million through an IPO, with the proceeds
placed in a trust pending the completion of planned acquisitions.7 One year later, 57th Street announced it had
acquired Crumbs for $27 million in cash and $39 million in 57th Street stock. On June 30, 2011, 57th announced
that NASDAQ had approved the listing of its common stock, giving Crumbs a market value of nearly $60 million.
Panda Ethanol Goes Public in a Shell Corporation
In early 2007, Panda Ethanol, owner of ethanol plants in west Texas, decided to explore the possibility of taking its
ethanol production business public to take advantage of the high valuations placed on ethanol-related companies in
30
were interested in selling their stock. The investment banker identified Cirracor Inc. as a potential merger partner.
Cirracor was formed on October 12, 2001, to provide website development services and was traded on the over-the-
counter bulletin board market (i.e., a market for very low-priced stocks). The website business was not profitable,
and the company had only ten shareholders. As of June 30, 2006, Cirracor listed $4,856 in assets and a negative
shareholders' equity of $(259,976). Given the poor financial condition of Cirracor, the firm's shareholders were
Ethanol common outstanding stock and for Cirracor shareholders to own 4 percent of the newly issued and
outstanding common stock of the surviving company. Panda Ethanol shareholders would own the remaining 96
percent. At the end of 2005, Panda had 13.8 million shares outstanding. On June 7, 2007, the merger agreement was
amended to permit Panda Ethanol to issue 15 million new shares through a private placement to raise $90 million.
This brought the total Panda shares outstanding to 28.8 million. Cirracor common shares outstanding at that time
million shares outstanding, with the Cirracor shareholders owning 1.2 million shares. The following table illustrates
the effect of the reverse stock split.
Effects of Reverse Stock Split
Shares
Outstanding*
Ownership
Distribution (%)
Shares
Outstanding*)
Ownership
Distribution (%)
Before Reverse Split
After Reverse Split
incorporated) in view of the substantial number of new shares that were to be issued as a result of the merger. The
proxy statement filed with the Securities and Exchange Commission and distributed to Cirracor shareholders
indicated that Grove Panda, a 78 percent owner of Cirracor common stock, had already indicated that it would vote
its shares for the merger and the reverse stock split. Since Cirracor's articles of incorporation required only a simple
majority to approve such matters, it was evident to all that approval was imminent.
Cirracor shareholders had similar dissenting rights under Nevada law. While Cirracor is the surviving corporation,
Panda is viewed for accounting purposes as the acquirer. Accordingly, the financial statements shown for the
surviving corporation are those of Panda Ethanol.
Discussion Questions:
1. Who were Panda Ethanol, Grove Street Investors, Grove Panda, and Cirracor? What were their roles in the
case study? Be specific.
Answer: Panda Ethanol owned ethanol manufacturing plants in West Texas and was interested in going
public either through a reverse merger or IPO. Grove Street Investors was the investment bank hired by
31
2. Discuss the pros and cons of a reverse merger versus an initial public offering for taking a
company public.
Answer: Many small businesses fail each year. In a number of cases, all that remains is a business with no
significant assets or operations. Such companies are referred to as shell corporations. Shell corporations
can be used as part of a deliberate business strategy in which a corporate legal structure is formed in
anticipation of future financing, a merger, joint venture, spin-off, or some other infusion of operating
assets. This may be accomplished in a transaction called a reverse merger in which the acquirer forms a
exceed 10% of gross proceeds. For equity issues between $20 million and $50 million in size, these costs
average less than 5% of gross proceeds and less than 3% for those issues larger than $200 million (Hansen:
1986). Reverse mergers typically cost between $50,000-$100,000, about one-quarter of the expense of an
IPO and can be completed in about 60 days or one-third of the time to complete a typical IPO (Sweeney:
2005).
Despite these advantages, reverse takeovers may take as long as IPOs and are sometimes more complex.
3. Why did Panda Ethanol undertake a private equity placement totaling $90 million shortly before
implementing the reverse merger?
Answer: Private investment in public entities (PIPES) is a commonly used method of financing reverse
mergers. In such transactions, a public company sells equity at a discount to private investors, often hedge
funds. As the issuer, it is up to the company to register its shares with the SEC within 120 days. Once
32
4. Why do you believe Panda did not directly approach Cirraco ? How were the Panda Grove investment
holdings used to influence the outcome of the proposed merger?
Answer: Note that Panda could have approached Ciracco directly. However, this may have alerted the
Ciracco shareholders to the Panda’s intentions and could have encouraged them to hold out for a higher
Note: Total Panda shares outstanding (including 15 million newly issued shares in the private placement) equaled
28.8 million shares. As a result of negotiations, Panda shareholders would own 96% of the merged firms and
Cantel Medical Acquires Crosstex International
On August 3, 2005, Cantel Medical Corporation (Cantel), as part of its strategic plan to expand its infection
prevention and control business, announced that it had completed the acquisition of Crosstex International
Incorporated (Crosstex). Cantel is a leading provider of infection prevention and control products. Crosstex is a
privately owned manufacturer and reseller of single-use infection control products used primarily in the dental
market.
As a consequence of the transaction, Crosstex became a wholly owned subsidiary of Cantel, a publicly traded
firm. For the fiscal year ended April 30, 2005, Crosstex reported revenues of approximately $47.4 million and pretax
income of $6.3 million. The purchase price, which is subject to adjustment for the net asset value at July 31, 2005,
was $74.2 million, comprising $67.4 million in cash and 384,821 shares of Cantel stock (valued at $6.8 million).
Furthermore, Crosstex shareholders could earn another $12 million payable over three years based on future
operating income. Each of the three principal executives of Crosstex entered into a three-year employment
agreement.
James P. Reilly, president and CEO of Cantel, stated, "We continue to pursue our strategy of acquiring branded
niche leaders and expanding in the burgeoning area of infection prevention and control. Crosstex has a reputation for
quality branded products and seasoned management." Richard Allen Orofino, Crosstex's president, noted, "We have
built Crosstex over the past 50 years as a family business and we continue growing with our proven formula for
success. However, with so many opportunities in our sights, we believe Cantel is the perfect partner to aid us in
accelerating our growth plans."
Discussion Questions and Answers:
1. What were the primary reasons Cantel wants to acquire Crosstex? Be specific.
33
2. What do you believe could have been the primary factors causing Crosstex to accept Cantel’s offer?
Answer: Crosstex’s president noted the firm was confronted with a host of opportunities. The firm
could have believed that it did not have the capital to fund such growth opportunities. Furthermore, the
3. What factors might cause Crosstex’s net asset value to change between signing and closing of the
agreement of purchase and sale?
Answer: During the period between signing and closing various components of net asset value could
4. Speculate why Cantel may have chosen to operate Crosstex as a wholly-owned subsidiary following
closing. Be specific
5. The purchase price consisted of cash, stock, and an earnout. What are some of the factors that might
have determined the purchase price from the seller’s perspective? From the buyer’s perspective?
Answer: The buyer may have been unwilling to meet the seller’s price expectation and thought it could
do so by adding an earn-out option and by offering stock to allow the sellers to participate in any future
.
Deb Ltd. Seeks an Exit Strategy
In late 2004, Barclay's Private Equity acquired slightly more than one half the equity in Deb Ltd. (Deb), valued at
about $250 million. The private equity arm of Britain's Barclay's bank outbid other suitors in an auction to acquire a
controlling interest in the firm. PriceWaterhouseCooper had been hired by the Williamson family, the primary
stockholder in the firm, to find a buyer.
The sale solved a dilemma for Nick Williamson, the firm's CEO and son of the founder, who had invented the
firm's flagship product, Swarfega. The company had been founded some 60 years earlier based on a single product,
a car cleaning agent. Since then, the Swarfega brand name had grown into a widely known brand associated with a
broad array of cleaning products.
In 1990, the elder Williamson wanted to retire and his son Nick, along with business partner Roy Tillead, bought
the business from his father. Since then, the business has continued to grow, and product development has
accelerated. The company developed special Swarfega-dispensing cartridges that have applications in hospitals,
clinics, and other medical faculties.
After 13 years of sustained growth, Williamson realized that some difficult decisions had to be made. He knew
he did not have a natural successor to take over the company. He no longer believed the firm could be managed
successfully by the same management team. It was now time to think seriously about succession planning. So in
34
early 2004, he began to seek a buyer for the business. He preferably wanted somebody who could bring in new
talents, ideas, and up-to-date management techniques to continue the firm's growth.
The terms of the agreement called for Williamson to work with a new senior management team until Barclays
decided to take the firm public. This was expected some time during the five-to-seven year period following the
sale. At that point, Williamson would sell the remainder of his family's stock in the business (Goodman, 2005).
Discussion Questions
1. Succession planning issues are often a reason for family-owned businesses to sell. Why do you believe it may
have been easier for Nick than his father to sell the business to a non-family member?
2. What other alternatives could Nick have pursued? Discuss the advantages and disadvantages of each.
Answer: Nick could have tried to partner with another firm with the intent of passing on control of the firm
Nick to exit the firm.
3. What do you believe might be some of the unique challenges in valuing a family-owned business? Be specific.
Answer: The challenges of valuing a family owned business include the absence of audited financial
GHS Helps Itself by Avoiding an IPO
In 1999, GHS, Inc., a little known supplier of medical devices, engineered a reverse merger to avoid the time-
consuming, disclosure-intensive, and costly process of an initial public offering to launch its new internet-based self-
help website. GHS spun off its medical operations as a separate company to its shareholders. The remaining shell is
being used to launch a ‘‘self-help’’ Website, with self-help guru Anthony Robbins as its CEO. The shell corporation
will be financed by $3 million it had on hand as GHS and will receive another $15 million from a private placement.
With the inclusion of Anthony Robbins as the first among many brand names in the self-help industry that it hopes
to feature on its site, its stock soared from $.75 per share to more than $12 between May and August 1999. Robbins,
who did not invest anything in the venture, has stock in the new company valued at $276 million. His contribution to
the company is the exclusive online rights to his name, which it will use to develop Internet self-help seminars, chat
rooms, and e-commerce sites.
Discussion Questions:
1. What are the advantages of employing a reverse merger strategy in this instance?
2. Why was the shell corporation financed through a private placement?
Valuing a Privately Held Company
Background
BigCo is interested in acquiring PrivCo, whose owner desires to retire. The firm is 100% owned by the current
owner. PrivCo has revenues of $10 million and an EBIT of $2 million in the preceding year. The market value of the
firm’s debt is $5 million; the book value of equity is $4 million. For publicly traded firms in the same industry, the
average debt-to-equity ratio is .4 (based on the market value of debt and equity), and the marginal tax rate is 40%.
Typically, the ratio of the market value of equity to book value for these firms is 2. The average of publicly traded
firms that are in the same business is 2.00. Capital expenditures and depreciation amounted to $0.3 million and $0.2
million in the prior year. Both items are expected to grow at the same rate as revenues for the next 5 years. Capital
expenditures and depreciation are expected to be equal beyond 5 years (i.e., capital spending will be internally
funded). As a result of excellent working capital management practices, the change in working capital is expected to
be essentially zero throughout the forecast period and beyond. The revenues of this firm are expected to grow 15%
annually for the next 5 years and 5% per year thereafter. Net income is expected to increase 15% a year for the next
5 years and 5% thereafter. The 10-year U.S. Treasury bond rate is 6%. The pretax cost of debt for a nonrated firm is
10%. No adjustment is made in the calculation of the cost of equity for a marketability discount. Estimate the
shareholder value of the firm.
Note: To estimate the WACC for a leveraged private firm, it is necessary to calculate the firm’s leveraged . This
requires an estimate of the firm’s unleveraged which can be obtained by estimating the unleveraged for similar
firms in the same industry. In addition, the value of debt and equity in calculating the cost of capital should be
expressed as market rather than book values.
Calculating COE and WACC:
1. Unlevered Beta for publicly traded firms in the same industry = 2.00 / (1 + .6 x .4) = 1.61, where 2.00 is the
levered beta, .6 is (1-tax rate), and .4 is the average debt ratio for firms in this industry.
6. WACC for the private firm = 18.16 x 2x4 + 6.00 x 5__
2x4+5 2x4+5
= 18.16 x. 615 + 6.00 x. 385
= 13.48
(Cap. Expenditures-Depreciation) grows $.115 $.132 $.152 $.175 $.201 $0.00
at same 15% annual rate as revenue
for 5 years and are offsetting
Pacific Wardrobe Acquires Surferdude Apparel
by a Skillful Structuring of the Acquisition Plan
Pacific Wardrobe (Pacific) is a privately owned California corporation that has annual sales of $20 million and
pretax profits of $2 million. Its target market is the surfwear/sportswear segment of the apparel industry. The
surfwear/sportswear market consists of two segments: cutting-edge and casual brands. The first segment includes
high-margin apparel sold at higher-end retail establishments. The second segment consists of brands that sell for
lower prices at retail stores such as Sears, Target, and J.C. Penney. Pacific operates primarily as a U.S.
importer/distributor of mainly casual sportswear for young men and boys between 10–21 years of age. Pacific’s
strategic business objectives are to triple sales and pretax profits during the next 5 years. Pacific intends to achieve
these objectives by moving away from the casual sportswear market segment and more into the high-growth, high-
profit cutting-edge surfer segment. Because of the rapid rate at which trends change in the apparel industry, Pacific’s
The customers in the lower-end market are extremely cost sensitive. Customers consist of those in the 10–21 years
of age range who want to wear cutting-edge surf and sport styles but who are not willing or able to pay high prices.
Pacific offers an alternative to the expensive cutting-edge styles.
Pacific has found a niche in the young men’s and teenage boy’s sportswear market. The firm offers similar styles
as the top brand names in the surf and sport industry, such as Mossimo, Red Sand, Stussy, Quick Silver, and Gotcha,
price/cost. Pacific’s production is also scaleable and has the potential to produce at high volumes to meet peak
demand periods. Additionally, Pacific also has strong financial support from local banks and a strong management
team, with an excellent track record in successfully acquiring and integrating small acquisitions. Pacific also has a
good reputation for high-quality products and customer service and on-time delivery. Finally, Pacific has a low cost
of goods sold when compared with the competition. Pacific’s major weakness is that it does not possess any cutting-
Acquisition Plan
Pacific’s management objectives are to grow sales, improve profit margins, and increase its brand life cycle by
acquiring a cutting-edge surfwear retailer with a trendy brand image. Pacific intends to improve its operating
margins by increasing its sales of trendy clothes under the newly acquired brand name, while obtaining these clothes
1. Industry: Garment industry targeting young men, teens, and boys
2. Product: Cutting-edge, trendy surfwear product line
3. Size: Revenue ranging from $5 million to $10 million
4. Profit: Minimum of break-even on operating earnings for fiscal year 1999
5. Management: Company with management expertise in brand and image building
6. Leverage: Maximum debt-to-equity ratio of 3 to 1
After a review of 14 companies, Pacific’s management determined that SurferDude best satisfied their criteria.
SurferDude is a widely recognized brand in the surfer sports apparel line; it is marginally profitable, with sales of $7
1999 have created a significant brand image, thus increasing future sales and gross profit margins. Pacific’s sales
growth rate reflects the recent licensing of several new apparel product lines. Consolidated sales of the combined
companies are expected to grow at an annual growth rate of 25% as a result of the sales and distribution synergies
created between the two companies.
38
The standalone values of SurferDude and Pacific assume that fixed expenses will decrease as a percentage of
sales as a result of economies of scale. Pacific will outsource production through its parent’s overseas facilities, thus
significantly reducing the cost of goods sold. SurferDude’s administrative expenses are expected to decrease from
25% of sales to 18% because only senior managers and the design staff will be retained. The sustainable growth rate
for the terminal period for both the standalone and the consolidated models is a relatively modest 6%. Pacific
believes this growth rate is reasonable considering the growth potential throughout the world. Although Pacific and
SurferDude’s current market concentration resides largely in the United States, it is forecasted that the combined
employees who will be terminated following the consolidation of the two businesses.
Source: Adapted from Contino, Maria, Domenic Costa, Larui Deyhimy, and Jenny Hu, Loyola, Marymount
University, MBAF 624, Los Angeles, CA, Fall 1999.
Discussion Questions:
1. What were the key assumptions implicit in Pacific Wardrobe’s acquisitions plan, with respect to the
market, valuation, and integration? Comment on the realism of these assumptions.
Answer: Market-related assumptions include consolidated sales growth of 25% per year during the five
years beginning n 1999 due to sales and distribution synergies created by combining the two firms. The
growth in sales is expected to be supported without additional advertising expenses because of the extent of
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2. Discuss some of the challenges that Pacific Wardrobe is likely to experience during due diligence.
Answer: SurferDude’s lackluster profit performance is largely attributable to its heavy advertising
3. Identify alternative deal structures Pacific Wardrobe might have employed in order to complete the
transaction. Discuss why these alternatives might have been superior or inferior to the one actually chosen.
Answer: Pacific was primarily interested in obtaining the rights to produce and sell another brand of
Cashing Out of a Privately Held Enterprise
When he had reached his early sixties, Anthony Carnevale starting reducing the amount of time he spent managing
Sentinel Benefits Group Inc., a firm he had founded. He planned to retire from the benefits and money management
consulting firm in which he was a 26 percent owner. Mr. Carnevale, his two sons, and two nonfamily partners had
built the firm to a company of more than 160 employees with $2.5 billion under management.
Selling the family business was not what the family expected to happen when Mr. Carnevale retired. He believed
that his sons and partners were quite capable of continuing to manage the firm after he left. However, like many
company's revenue and growth.
The major challenges prior to the sale dealt with the many meetings held to resolve issues such as compensation,
treatment of employees, how the firm would be managed subsequent to the sale, how client pricing would be
determined, and who would make decisions about staff changes. Once the deal was complete, the Carnivales found
it difficult to tell employees, particularly those who had been with the firm for years. Since most employees were
not directly affected, only one left as a direct result of the sale.8
8Adapted from Simona Covel, "Firm Sells Itself to Let Patriarch Cash Out," Wall Street Journal, November 1, 2007,
p. B8
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