5A Consulting Consulting Group Recommendations for Xantrex

TO: Mr. Nazir Mulji, President of Xantrex
FROM: 5A Consulting Group
CC: Ian Hand
DATE: November 30, 2009
RE: Xantrex Expansion Initiative

This memo considers the current context where management believes there is a window of opportunity to expand the business, but additional investment capital is required. In this analysis, we consider the needs and objectives, risks & opportunities, funding requirements, investor criteria and constraints, recommendation and the optimal deal structure.

Needs and Objectives

The needs and objectives of Xantrex are as follows:

• Grow the business through new product development and market expansion
• Facilitate the growth of the business even if that means relinquishing some ownership control
• Lower the debt burden of the business and obtain renegotiate bank term loan covenants. See Table A for savings to be realized from repaying the FBDB loan.
• Secure investment from investors with an exit time horizon of 3 to 7 years. They need investors who are willing to fund the company through its growth phase before wanting ro exit.

Risks

Some strategic control over directing the company’s operations will have to be given up to the new investors. Furthermore, the board will be restructured. Other risks include:

• Investors may not get along with the current owners or believe the company should be taken in a different direction
• There are new market entry risks; one of the new markets being considered has a longer selling cycle, and there are general market unknowns that can only be learnt from experience in a market; the new investors may become impatient with management performance as they learn about how to succeed in the new market.

For the investors, the historical financial data from Xantrex covers a relatively short timeframe (1992-1995). In addition, the deal will most likely involve 2 external investors who must share similar goals for the business.

Opportunities

New owners could allow some of the founders to focus on what they do best and not have to deal with setting the strategic direction of the business. Furthermore, investors could bring expertise in the industry in addition to contacts and know how on how to develop the distribution and sales channels.

From an investor point of view, the company has a proven track record of generating revenues and a competent and stable management. The average yearly sales growth rate for the next 5 years is expected to be close to 50%. See Table B.

Funding Requirements

Xantrex needs to raise $3 Million. See Table C for use of funds. The funds should be used for the expansion and to repay the FBDB loan, as well as pay down some of the other loans. The company should take into consideration that the bank imposed constraints on their loan instruments are very restrictive, e.g. capital expenditure is limited to less than $100,000. This may impede the company’s expansion growth plan to enter the DC power products market which is likely to require new capital investments. As a result, adequate funds should be generated to pay down the bank loan and negotiate for less restrictive terms on the outstanding loan.

The equity that will be given up to obtain the $3 million depends on the specific valuation agreed to with the investors. Under the market multiplier method, investors would acquire 34% in equity (Table E). This is the most favorable valuation for the owners of Xantrex. Under the discounted cash flow method, investors would acquire 41% in equity (Table F). Ultimately, the valuation will be based on agreement with the investors and is expected to be between 34% and 41%.

Investor Criteria and Constraints

Investors take some ownership control of the company. In so doing, they will tend to want to understate the valuation of the company in order to increase their equity stake. Other considerations are:

• Investors will want to appoint a board member. In this case, with two separate VC firms, it is likely that each will want to appoint a member to the board to ensure they can exert control over the company.
• Investors will want shares with special rights (preferred shares) e.g. with special voting rights and anti-dilution provisions.
• Investors will want a high rate of return on their investment over a certain time period and with clear exit options; they may also want to increase membership on the board or increase their equity stake if the company fails to meet agreed upon performance targets.
• Investors will also want protection from share dilution.
  

As the company considers hiring a new sales manager for the US, and a new sales and marketing manager for its new product line, it will need to set up an employee options plan to be able to incentive existing employees and attract new employees. This has to be done prior to venture funding

Recommendation

The BDC deal is recommended for the following reasons:

• BDC has a good working relationship with management which is crucial for a venture capital relationship.
• BDC can bring both industry and market development expertise.
• BDC will value the company based on reasonably certain sales forecast and not attempt to undervalue company.
• BDC is a long term investor. They are willing to defer return to well into the future which will allow the company to use the funds to support its continued growth without needing to prematurely return to the equity market.

Optimal Deal Structure

The proposed major elements of the deal are as follows:

• Pre-Money valuation at $5.8 M
• Sell 34% equity stake for $3 million
• Offer Non-Participating Preferred Shares
• Allocate 30% of outstanding shares to the Employee Share Ownership Plan
• Appoint 5 members to the Board of Directors. 2 members will be nominated by the investors; 2 will be nominated by the founders, and 1 will be an independent member mutually agreed to by both the owners and the investors.
• The Audit and Compensation Committee will consist of 3 board members: 1 investor, 1 founder and 1 independent board member.
• Weighted average anti-dilution provision
• No redemption rights and right of first refusal on sale of shares
• Exit options through a qualified IPO or liquidation

See Appendix A for proposed Term Sheet.

Table A
Present Value of Interest Premium
	1996	1997	1998
Revenues: Est.	7,500,000	9,100,000	10,000,000
Interest Premium	33,750	40,950	45,000
Discount Factor	1	1.44	1.728
Present Values	33,750	28,438	26,042
Net Present Value	88,229
Present Value of Interest Premium: New Forecast
	1996	1997	1998
Revenues: Act.	14,000,000	20,000,000	35,000,000
Interest Premium	63,000	90,000	157,500
Discount Factor	1	1.44	1.728
Present Values	63,000	62,500	91,146
Net Present Value	216,646
Savings from Refinancing	128,417

Table B
Year	% Growth
1996	70.2
1997	50
1998	72.2
1999	29
2000	25
Average	49.28

Table C: Use of Funds
Financing for 1996	$ 2,053,000
Financing for 1997	$ 58,000
FBDB Loan Repayment	$ 405,000
Interest Premium Penalty	$ 88,229
Bank term loan	$ 133
	$ 2,604,362

Table E: Market Multiple Valuation Method
Adjusted EBIT	FY96	FY97	FY98	FY99	FY00
Revenues Optimistic	14,000,000	20,000,000	35,000,000	50,000,000	65,000,000
Revenues Likely	12,000,000	18,000,000	31,000,000	40,000,000	50,000,000
% Revenue Likely	86%	90%	89%	80%	77%
EBIT Optimistic	851,000	2,440,000	4,680,000	6,664,000	8,891,000
Adjusted EBIT Likely	729,429	2,196,000	4,145,143	5,331,200	6,839,231
Multipler*	8	8	8	8	8
Pre-Money Value	5,835,429	17,568,000	33,161,143	42,649,600	54,713,846
Venture Money	3,000,000
Post Money Valuation	8,835,429	17,568,000	33,161,143	42,649,600	54,713,846
Venture Ownership %	34%	34%	34%	34%	34%
Value of Venture Equity	3,000,000	5,965,076	11,259,604	14,481,335	18,577,654
% YOY Growth in Venture Equity		99%	89%	29%	28%
Avg. 5 Yr. Growth	61%
*Elder's BDC Network calculates 8 times EBIT in this market

Table F: Discounted Cash Flow Valuation Method

Appendix A:Summary of Terms for a Private Placement of Series A Preferred Stock

Amount and Securities: 3,000,000 shares of Series A Non participating Preferred stock for aggregate proceeds of $3,000,000

Pre-money Valuation: $5,835,429, assuming an employee option plan with 2,297,212 reserved shares. The Issue price will be $1.00 per share..

Dividend: The holders of Series A Preferred shall be entitled to receive non-cumulative dividends in preference to any dividend on the Common Stock in the amount $0.20 on all Series A Preferred outstanding, when and as declared by the Board of Directors.

Liquidation: Initial pay issuance Price plus declared but unpaid dividends on each share of Series A Preferred Stock. Thereafter each share of Series A Preferred Stock and Common Stock share on an as-converted basis until such time as each share of Series A Preferred Stock has received three times the initial pay issuance Price. A merger, reorganization or other transaction in which control of the Company is transferred will be treated as liquidation.

Conversion: The holders A Preferred shall have the right to convert the Series A Preferred, at any time, into shares of Common Stock. The initial conversion rate shall be 1:1. The Series A Preferred shall be automatically converted into Common Stock, at the then applicable conversion price, (i) in the event that the holders of at least a majority of the outstanding Series A Preferred consent to such conversion or (ii) upon the closing of a firmly underwritten public offering of shares of Common Stock of the Company at a per share price not less than $5.00 per share and for a total offering of not less than $15 million (before deduction of underwriters commissions an expenses) (a “Qualified IPO”)

Anti-dilution Provisions: The Series A Preferred shall have broad-based weighted average anti-dilution protection on issuances of shares. No adjustment will be made for the issuance of up to 2,297,212 shares of Common Stock (or any options for Common Stock) to employees, directors or consultants pursuant to board-approved equity incentive plans.

Voting Rights: Series A Preferred votes on an as-converted basis, but also has class vote as provided by law. Also, approval of at least 60% of Series A Preferred is required for (I) the creation or issuance of any senior or pari passu security; (ii) an increase in the number of authorized shares of Preferred Stock; (iii) any adverse change to the rights, preferences and privileges of the Preferred Stock; (iv) an increase in the size of the Board of Directors; (v) repurchase of Common Stock except upon termination of employment; (vi) repurchase or redemption of any Preferred Stock (except pursuant to redemption provisions of Articles); (vii) any transaction in which control of the Company is transferred; (viii) any amendment to the Bylaws or Articles of Incorporation; (ix) any dividend or distribution on capital stock of the Company; and (x) any sale, pledge, license or transfer of all or substantially all of the Company’s assets.

Nondisclosure and Development Agreements: Each officer, employee and consultant of the Company will have entered into a proprietary information and inventions agreement in a form acceptable to the Investors.

Right of First Refusal: The Investors shall have a pro rata right, based on their percentage equity ownership of Preferred Stock, to participate in subsequent equity financings of the Company. If any shareholder of Common stock (or equivalents) wants to sell shares, he must offer them first to the holders of Series A Preferred.

Co-Sale Rights: If a shareholder of Common or equivalent wants to transfer shares, holders of Series A Preferred have a right to participate on a pro rata basis (based on their percentage ownership of the Series A Preferred ) in the sale. This does not apply to sales in a Qualified IPO or afterward.

Board of Directors: Five total. The founders will be entitled to elect two representatives; the investors shall also be entitled to elected two representatives; and one outsider recommended by the Founders and acceptable to Investors.

Compensation Committee: Three total. One representative of the Series A Preferred, one representative from the founders, and one outside director. All senior management compensation will be approved by the Compensation Committee.

Restriction on Common Stock Transfers: (a) No transfers allowed prior to vesting. (b) Right of first refusal on vested shares until initial public offering. (c) No transfers or sales permitted during lock-up period of up to 180 days required by underwriters in connection with stock offerings by the Company.