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Chapter 15
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
15.1 VENTURE OPERATING AND FINANCIAL DECISIONS REVISITED
15.2 PLANNING AN EXIT STRATEGY
15.3 VALUING THE EQUITY OR VALUING THE ENTERPRISE
A. Relative Valuation Methods
B. Dividing the Venture Valuation Pie
15.4 SYSTEMATIC LIQUIDATION
15.5 OUTRIGHT SALE
A. Family Members
B.Managers
C.Employees
D. Outside Buyers
15.6 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?
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6. Describe an outright sale of a venture. What are the four categories of possible
buyers?
7. Describe what is meant by (a) a leveraged buyout (LBO), and (b) a management
buyout (MBO).
8. What is an employee stock option plan (ESOP)? How is an ESOP used to buy out a
venture?
9. Describe the terms (a) “control premium” and (b) “illiquidity discount” when
discussing possible external or outside buyers of a venture.
10. Describe an initial public offering (IPO). What are the differences between a
primary offering and a secondary offering?
11. What is investment banking? What is an underwriting spread?
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12. Describe the terms “tombstone ad” and “red herring disclaimer.”
A tombstone ad is an SEC requirement and an advertisement used to notify the public
13. What is meant by due diligence? How does a traditional registration differ from a
shelf registration?
14. When an investment banking firm decides whether to underwrite or market a
securities issue, what is meant by a firm commitment and best efforts?
15. Describe the two following terms that may be involved in underwriting a new
securities issue: (a) green shoe and (b) lockup provision.
16. What is meant by initial public offering (IPO) underpricing?
17. 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
18. 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)
19. 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
20. 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:
21. 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 had 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
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
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?
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?
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C. What would be the percentage appreciation on the stock bought by the venture
investors versus the investment appreciation for the founders?
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
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
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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?
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?
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?
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
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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
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.
B. Calculate the enterprise value to EBITDA ratios for each of the three competitors,
as well as the average ratio for the competitors.
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.
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:
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Equity Value Estimates:
Equity value = enterprise value – interest-bearing debt
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:
Equity Value Estimates:
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:
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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.
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)?
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 2016 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
equity being held by venture investors who also desire to exit the venture. BioSystems’
sales are expected to grow from the 2016 level at a 20 percent annual compound rate over
each of the next three (2017, 2018, 2019) 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 2016 ($ Thousands)
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Gross Profit 4,000
Marketing Expenses 1,000
A. Using the percent-of-sales relationships indicated above, prepare BioSystems’
income statements for 2019.
Note: Income statements are projected annually for 2017 and 2018 in order to provide
the 2019 projections. Data are presented in Thousands of Dollars. See spreadsheet
solution shown below.
Biosystems Manufacturing Corporation
Income Statement for 2016 ($ Thousands)
Actual Projected —-——-——-——-—–
2016 2017 2018 2019
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
2019.
percent?
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D. What is Gonzalez’s portion of the exit proceeds? What is the venture investors’
portion of the exit proceeds?
2019 Exit Proceeds:
Present Value of Exit Proceeds:
E. Benito Gonzalez invested $50,000 of his own funds in BioSystems at the end of 2011.
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 2016?
F. The venture investors contributed $500,000 at the end of 2012. What would be their
compound rate of return on their investment if BioSystems is sold at the end of 2016?
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
2015
2016