FROM: The Aviator’s Group
CC: Ian Hand
DATE: November 23, 2009
RE: Xantrex Technology Inc. Expansion Initiative
Management of Biotechnology Program Segal Graduate School of Business Simon Fraser University
500 Granville Street, 3rd Floor
Vancouver, BC Canada
Dear Mr. Mulji,
Xantrex needs to grow to be able to successfully address its current opportunity. This opportunity will allow Xantrex to grow its current market share and enter new ones, provide a greater company valuation and firmly plant Xantrex as a central player in the power conversion industry. However, this growth must be fashioned to balance control of the company and financial flexibility in order to meet operational needs when actual revenues are either higher or lower than projections.
Specific needs that must be addressed:
· $540,254.17 funding to pay off the FDBD Loan
· Increasing connections in the electronics industry and / or increasing competencies in marketing through the addition of key talents to the management team
· $2.111 million to fund growth opportunities
· Continue to meet banking covenant constraints
· Use current opportunity to renegotiate banking covenants such as increasing the maximum value allowed to the inventory for margin purposes (currently at only $100,000)
Risks to Xantrex:
· Losing control of Xantrex
· Losing financial flexibility
· Effects of the addition of new management partners
· Effects on the relationship between current owners
· Increased likeliness of bankruptcy due to inaccurate assumptions
After reviewing the terms of the FBDB loan and the historical and proforma statements provided, we recommend that Xantrex raises $2,651,254.00 in equity to meet current best-case projections (refer to table #1). This would result in giving the new partners 62% of the company. We feel Xantrex should go with VC funding, allowing its current line of credit to grow based on current bank covenants. The existing line of credit would increase to $1.0 million resulting in $700,000 of new operating cash and a bigger safety net. In addition, Xantrex would be less financially leveraged as the current debt to equity ratio would be lowered. Hence they will have more flexibility and less risk. It should be noted that we feel that Xantrex’s proforma sales forecasts are overly optimistic. Therefore, raising the amount of equity listed above will allow a fair degree of financial flexibility that may be required to address this opportunity. Tables 3 through 6 provide our estimated optimistic, most likely, and worst case income statements and ratio calculation scenarios.
Given Xantrex’s current options, we recommend that negotiations proceed with the BDC. However, we also suggest that given Xantrex’s need for increased electronics industry contacts and marketing expertise, perhaps they may be able to find a third VC partner that is a better fit than WOF. On the other hand, the combination of BDC and WOF as the VC partners provides two benefits to Xantrex that may be hard to match with other firms. First as government-sponsored organizations, tax implications do not impact the choice of the type of shares offered. Second these VC firms would not require dividend payments allowing Xantrex to continue meeting current banking covenants.
Constraints of the BDC & WOF:
· As part of its charter, WOF can only provide equity finance, not debt financing
· BDC has a target of 20-35% rate of return depending on the perceived risk (refer to table #2)
· BDC requires formal shareholder agreement that addresses issues such as the make-up of the board of directors, audit and compensation committee, any actions require consent of the venture capitalists, restrictions on the sale or transfer of shares, and the rights of the management on departure from the firm
· BDC requires a re-structuring of the board of directors to proceed with investment
· WOF requires a sound business concept
· WOF requires an experienced management team with an equity interest in the firm
Proposed Structure:
a. Valuation, funding, and ownership
· Pre-funding Valuation = $1,592,000 (8 X EBIT)
· Funding = $2,651,254.00 (100% equity financing)
· % of ownership to VC = 62% in convertible preferred shares, non-voting (1632 shares @ $1625 / share)
· % to current owner = 38% in convertible preferred shares, non-voting (1000 shares @ $1625 / share)
· Note: it may be possible to increase valuation by increasing the EBIT multiplier based on knowledge of the variance in the industry
b. Board Members
· 1 BDC representative (~ 1/3 owner)
· 1 WOF/ OTHER VC representative (~ 1/3 owner)
· 1 Representative of current owners (~ 1/3 owner)
· 1 CEO as representative of the company
· 1 elected by VC and approved by company
c. Banking Covenants
· No dividends to comply with existing covenants
· Increase line of credit as debt to equity ratio improves
· Re-negotiate on the current caps on margin calculations
d. Exit Scenarios (including IPO, Sale, Merger, Acquisition, or Liquidation)
· Preference for the first 1.5 x original investment
· Cap at best case scenario (42% return as calculated in table 2)
e. Additional Points of Interest
· Terms related to job security, severance, termination and voting rights should be closely reviewed
· Dilution due to subsequent rounds of financing should be fair (No full ratchet, weighed average only).
The Aviator’s Group believes Xantrex has a window of opportunity to capitalize on a current opportunity. Due diligence needs to be exercised with the venture capital financing to ensure that Xantrex positively benefits from the transaction. Please feel free to call us to further discuss our analysis of your business opportunity.
Sincerely,
The Aviator’s Group
Table 1 – Assumes valuation of 8 x EBIT
Table 2 – Assumes valuation of 8 x EBIT
Table 3
Table 4
Table 5
Table 6
Just a heads up that the Aviator's Group includes Sanja Taraillo, Ava Parissay, Jeff Brown, Peter Krestov, and Viren Thaker. :)
ReplyDeleteThere seems to be quite a wide difference between the terms that each of our groups has come to. This seems to be based mostly on the approach to company valuation, which I suspect reflects the difficulties out there in the real world. Our group seems to have valued the company the highest and thus offered the lowest amount of equity to the VCs (only 20%). We were basing this on the excel document which had a valuation tab. This was using 7 times the projected EBIT for 2000. Personally I found this insanely optimistic, partly with the idea that you could value a company at 7 times projected revenue, and partly with projecting six years into the future and having any sort of confidence in those 'educated guesses'. Maybe that ‘7 times EBIT’ was valid in the gold rush years before the bubble popped. Jarrod from Bean Services was talking about 4 times EBIT which seems a bit more realistic these days. At any rate, judging from the fact that Xantrex has an estimated market cap of $200M today, it seems like it turned out to be a good investment (although I don’t know if there were any speed bumps along the way over the past 12 years).
ReplyDeleteI think you guys did an excellent analysis and have provided some good recommendations. I agree with Dylan that method used to determine valuation plays a critical role in deciding whether or not to use equity financing or not, and if so what terms to offer to the VC's.
ReplyDeleteYou may want to calculate the valuation based on projected revenues instead of current. This will make your valuation more attractive and it gives you the ability to offer less ownership for the same amount of funds raised. As Dylan mentioned, BEAN did this using 4 x EBIT of forecasted revenues, so it seems reasonable that you can do the same.
I'm sure you guys have talked this through many times, but I am curious to know why you guys decided to go with 100% equity financing when you are give up 62% of your company. With that much control, the VC's have the power to change the direction of the company and even change management. This is consistent with the number of board seats given to the VC's. I'm not so sure the owners would be willing to give up that much control as the case says that the four owners agreed to give up some of the ownership in exchange for equity a VC partner(s) that is able to add value to the company.
I noticed the issue price for the preferred shares is $1625. You didn't mention the conversion clause in your post outlining how shares can be converted to common, and at what price. Furthermore, the current outstanding shares (or the shares that are going to be given to the founders) are also preferred, meaning the VC's may not get as much of a return as they would like, or the IPO would have to be worth much higher than if you you had common shares. Lastly, you may want to keep some reserved shares aside to give to current and future employee's as stock options.
Overall, the I thought the analysis was well laid out.
I have to agree with Farhan with the regards to calculating the valuation based on the projected sales. This will make the company lot more attractive and give the ability to retain more of the company shares. Also a post money evaluation rather than a pre money evaluation will be helpful in getting a better value for the company and giving out less of the company. If not all most of the VCs are interested in growing their investment to a larger return upon exit. Hence, they will make any changes necessary including changing the management and the direction of the company. Having to give up 62% is highly risky for the owners and there is a good chance of completely losing control of the company. I agree that some loss of control is good in order to bring the external expertise that Xantrax needs when expanding into new markets, but the price you are willing to pay is too high. Looking at the company financials, I would be more comfortable giving up 20-40%.
ReplyDeleteAlso in my opinion the 2.6 Million you chose to raise is not adequate. The proforma balance sheet indicates a funding requirement of ~2.1M and the BDC loan repayment of ~0.5M, which gives no financial flexibility to Xantrax. They are also breaking bank covenants by over extending the Operating Line by about $484,000, which need to be paid right away. Then further negotiating to extend the operating line to 1M will give additional flexibility with operating cash flow. This would be further useful given that AR is talking longer than expected due to financial difficulties Xantrax customers are going through.
I also wondered what are your thoughts on the bank covenants regarding total compensation cap on the Management team? This would make it difficult to attract expertise needed for executing the expansion/growth plan.
Over all good analysis and was easy to follow. It’s interesting to see how each team used the same information and analysis techniques to come up with different valuations.
I like the presentation format of your analysis. The logics is clear and easy to follow. I notice that you used the same multiple (8) for your valuation in all of worst, most likely, and most optmistic scenario, which I don't think should be the case. Higher multiple should be given to better condition and vise versa. In addition, I am confused by the discount factor you used to calculate the % discount to VC in the table 2. It seems you used 40% discount factor, but why this number?
ReplyDeleteFor our group we thought the spreadsheet already take into account the retirement of the loan since the FBDB value on the balance sheet is $405K in 95 but dropped to $0 in 96. That is the main reason why our group actually require less funding than others.
I think the valuation of the company is a bit too low, so Xantrex needs to gave up too much control to get the required funding. I think the valuation of the company should not only EBIT for 95 but also the PV of possible income stream in the future.
ReplyDeleteI like Ellen's idea of using different multiplier for valuation in worse, most likely and best case scenario.
Other than that I like the rest of the presentation.
Agree with Farhan about the valuation. It seems way too low and with the 62% investor ownership offer you guys are essentially planning on giving control to the VCs. They essentially will own Xantrex and since you do not seem to have protective covenants for the founders I feel you could rapidly be out on the street whether Xantrex turns out profitable or not. Since VCs (BDC) would generally expect Xantrex to present upside potential, downside risk, management, potential anti-dilution, and negotiate down liquidity issues, your offering would definitely give them pause for thought. While typically the amount requested, prospects for the business and anticipated investment return are factors affecting ownership it is uncommon for offers over 30% to 40% - especially for companies that are not distressed or have totally unproven technology [then family & friends, Angels are appropriate – which is not the case here]. VCs would want Xantrex to remain motivated and have the incentive to keep building the business and also have wriggle room in terms of valuation if additional financing rounds are required. BDC would be investing in Xantrex’s management team and I feel they would rather this team remains in control. A deal could be worked out based on the ‘Kitchy teams’ hybrid model of debt and equity.
ReplyDeleteIf your valuation is at the levels you indicate, then multiplier value aside you are probably better of looking at debt, lower VC control and lower 1st round. Although the new market risk is high and VCs look to hedge their risk - this should be balanced by the relatively strong existing market for Xantrex existing products and the risks in setting up the sales channels needed are somewhat lower than the new market investment. Maybe you could have considered this somewhat.
As it is typical to have higher multipliers as the return period is pushed out further and lower multipliers for near term returns you could also maybe look into providing clauses that guarantee Xantrex can earn back controlling interest if key predetermined milestones are met.
It would also be helpful to Xantrex if some clarification on the type of stock (probably convertible preferred) and dilutions was provided – I’m assuming you intended to advice on a ‘broad based’ weighted average to account for preferred as well as common stock.
Great charts and stuff though - very concise and clear!