To: Xantrex Board of Director
From: Ellen Chin, Gord Finlay, Sameer Khushal, Eric Leung, Marinko Sarunic
Date: November 29, 2009
Subject: Expansion Financing for Xantrex
After reviewing financial case and related analysis, our recommendation is to pursue the VC investment. The reasons behind this decision are to pay off the bank loan and lift the growth inhibiting restrictions. Also, the venture capitalist will share in our risk by investing. Debt financing is deemed to be too risky at this stage because ability to repay the loan is dependent on uncertain performance projections, and Xantrex needs to mitigate concerns about maintaining short-term liquidity while growing.
The key parameters to consider when negotiating the deal are:
- Discount rate: BDC requires a value between 20-35%. Within this range, we feel that Xantrex's expansion strategy is relatively low risk, and a rate of 28% or less is appropriate.
- Free cash multiple: The BDC suggestion of eight is realistic.
- The valuation, based on the most likely growth scenario, is $8,726,000.
- The amount of capital investment required is $1,883,000.
- The percentage of control of Xantrex to be offered to the VC is 21.6%
We feel that the optimistic valuation of Xantrex of $11,183,000 is achievable based on Mr. Mulji's in depth knowledge. Additional capital would be required to fund the even higher growth of this scenario. We feel that if the company exceeds performance of the most likely case additional capital can be obtained by selling more shares on an as required basis to the investors at a more favorable valuation (because of strong performance), or through short-term debt. A shareholder agreement needs to be developed for the venture capital deal. The key terms for Xantrex include maintaining control through number of voting shares and seats on the Board of Directors.
A detailed analysis is attached to this Memo. Please consult the spread sheets in the appendix for Xantrex valuations based on the best, worst, and most likely scenarios. Also included in the spreadsheets is a subordinated debt option which is considered less favourable based risk and cost.
The risk of investing in Xantrex is low, among many other reason, Xantrex only requires financing for the next 2 years, which is fairly short-term. I would be tempted to negotiate for an even lower discount factor.
ReplyDelete28% is a good average number that meets the expectation of BDC.
Michael Tsao
Debt financing may be considered risky as a result of the cash flow. However, the use of assets (thar are accounted for or will be converted into revenue or cash) e.g. inventory and accounts receivables) can be strategic in minimizing the required amount of equity given up to investors.
ReplyDeleteAnother means of financing can be to utilize the $1 million operating line of credit. I would also suggest that Xantrex look at reducing their Cash Conversion Cycle to improve their current and on going cash flow issues.
Hi Everyone,
ReplyDeleteFirstly, I wanted to say that this is a very well thought out analysis. I think you guys did a great job. One of the points I noted was your final valuation of the company. There are several different valuations considered within this blog. Our group arrived at a value of 7x EBIT, and other groups have considered varying amounts. Within our classes, one of our guest speakers also mentioned a value of 4x EBIT which may prove to be more accurate in a recession.
I very much like your idea of a subordinated debt option, and I was curious as to what (if any) convertible debt scenarios you had looked into. Short term cash infusions prove to be very efficienctly structured when packaged as convertible debt, particularly where features of the investment allow for reasonable protection from the downside and a reasonable expectation to profit from any upside potential. The key here is to negotiate an agreement which is a win-win situation for both the founders and the investors.
Lastly, I noted that even the worst case scenario of your subordinated debt option within your analysis is still relatively optimistic. I'm curious whether Xantrax's projections of the worst case scenario still have an element of blue sky in them. The worst case scenarios we projected in our group tended to be much more conservative. I'm curious if you considered an element of founder's bias in your analysis of the balance sheet projections.
To conclude on the case, I do agree with the criteria and constraints you associated with the VC investment, and also agree that one should include a relatively high discount rate when calculating future values (20-35%). Your analysis was very well organized and clear.
Great work!
Viren
Hi guys,
ReplyDeleteI agree with Viren that this a great analysis. Good job :-)
So far there has been some good comments about the numbers you guys used. I wanted to add to that analysis by commenting on some of the softer recommendations.
Your paper comments on some of the synergies that the VC can bring in. You recommended things like "Connections" and "leadership experience". I completely agree with you guys that as Xantrex enters a new market they should be mitigating their risk by adding the knowledge base through the VCs. But I guess my comment is that it is unclear how they will do so with the BDC.
As a bank, it is very likely that the BDC doesn't have such connections or expertise and probably doesn't want to be that involved with their investments. In general, I would think that VCs either want to invest in companies that are in their area of expertise so that they can be very involved, or companies that already have the expertise so they can be very hands off.
Either way, it seems to me that the recommendation is almost contradictory. The ideal situation of finding a VC that has a lot of knowledge and connections but will accept less control of the company is probably hard to find. I would guess that the VC with a lot of industry connection and knowledge wants control over their investment so that they can influence it.
Then the same question is true from the company's perspective. Is it realistic not to give the expert control and expect them to have a large influence on the performance of your company? And if the expert has less control, they will probably either get less information, or get the information too late.
In my humble opinion, if you believe as a company that you lack expertise in a specific area, then you must be willing to give the expert some authority. If you were hiring the expert you would put them in a position of authority. If you bring the expert in the form of a venture capital partner, then you should be willing to give them some control.
Thanks,
Ava
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