Case Study 2 - Nancy, Rhonda, & John

1. What are (or should be) the needs and objectives of the owners of Xantrex at this juncture? What are the

risks and opportunities available from additional investment in Xantrex at this time from the perspectives of Xantrex and the investors?

Xantrex’s goals are to repay the FBDB loan and finance expansion into new markets. Their key problem is that sales are higher than expected and so carrying costs on the FBDB loan are too great (so Xantrex’s options are to pay off the principal—$600K—plus the NPV of the interest premiums i.e. $206,146 right now, or to pay the principal plus monthly installments for 3 years).

Clearly there is a risk that the company will be unable to grow and meet expansion demands if they do not seek additional funding. The founders agree that additional investment is necessary and will allow them to grow the company, but at the expense of giving up some control of the firm and dilution of their own equity standing. They are willing to do this, and recognize the need for additional knowledge in order to grow the company. However, accepting additional investment means accepting the risk that investors will have a different strategic vision for the organization. An additional opportunity associated with seeking investment funding is that it will position Xantrex to more than triple its operating line of credit through the bank should it accept an equity-based investment instead of a debt-based one.

From the investor’s perspective, the key risk is that the company may be unable to successfully expand, meet the aggressive sales targets it has set, and return value to the investors according to the desired timeline. There is a risk that the company valuation will not be high enough to yield desired return upon an exit event (e.g. IPO, sale of company, or sale of investor interest). However, there is a clear opportunity to capitalize on this rapidly growing company by investing at an early, relatively cheap stage. Xantrex has already significantly exceeded sales estimates, indicating that there is the potential for further rapid growth. Furthermore, Xantrex is currently the dominant player in the market outside North America, although other competitors are entering the global marketplace. There is therefore a window of investment opportunity at this stage that would help Xantrex retain and expand its global dominance, although this window is rapidly closing. Investing at this stage would give the investors the opportunity to participate in future funding rounds, and to position the company for a global exit event.

2. How much capital should be raised? How much equity should be given up in exchange for the investment?

$3 million in capital is needed to fund expansion into global markets and to pay off the FBDB loan immediately. However, the founders should be careful not to underestimate the capital required for this expansion; it would not want to have to return to investors for an additional investment because it had underestimated costs.

The present day valuation of Xantrex is $11.9 million, assuming an exit event in the year 2000, and that Mr. Elder’s experience that similar firms are able to achieve an 8x EBIT valuation in an exit event is correct. If this figure is used as the post-money valuation of Xantrex (because the company requires this expansion financing to make an exit event possible), then the company should be willing and expect to relinquish roughly 25% of the firm’s equity in exchange for expansion financing ($3M/$11.9M, based on the ‘most likely’ sales estimates agreed upon by the company Mr. Elder).

3. Would you recommend that Management proceed with the contemplated BDC deal? Explain.

The option on the table from BDC is to proceed with a roughly $3M investment (comprised of $1.5M from BDC itself and $1.5M from the Working Opportunities Fund). This investment would take the form of common or preferred shares (i.e. an equity investment). This investment would meet Xantrex’s targets of acquiring additional capital as well management expertise from which to draw for international expansion. The founders are willing to give up some of their equity to facilitate the investment, and the equity proposal is far less than majority control. Xantrex has a good working relationship with BDC and with Mr. Elder, who has many years of VC experience and deep industry connections with individuals having the electronics and marketing experience that Xantrex needs. Expanding the syndicate by bringing the WOF on board will expose Xantrex to additional expertise. We therefore recommend that Xantrex accept the BDC deal if they are confident that this investment will be sufficient to see them through to an exit event in 2000. However, Xantrex should be aware that should they require future rounds of financing before a liquidity event, they will not be able to seek this funding from the BDC or WOF because both cap total investment at $5M. It could be difficult to attract new venture capital to buy out BDC’s interest, and/or could further dilute the equity stake of Xantrex’s founders.

4. What are the significant criteria and constraints employed by the investors?

BDC funding can take the form of equity, warrants, debentures, or convertible debentures, and because the firm is currently cash flush, is willing to accept a longer payback period (3-10 years).

The most likely investment partner is WOF, which cannot use debt instruments in investments and which may have a shorter payback period arising from a more immediate need for cash flows than BDC. BDC’s target rate of return is 20-35% and both BDC and WOF typically cap investments at $5M. Both firms would require Xantrex to prepare a shareholder’s agreement, and would reasonably expect board representation.

5. Structure an ‘optimal’ deal that would meet investor criteria and Xantrex’s objectives and requirements. Summarize the major terms and any key clauses Xantrex should seek to include in a Shareholder’s Agreement.

The major terms that should be included in a shareholder’s agreement are summarized below (note this a non-exhaustive list).

Investment Structure: $3M investment comprised of $1.5M each from WOF and BDC. Investment will be in exchange for preferred shares (convertible to common shares upon a qualified IPO, or upon approval or the majority of preferred shareholders) amounting to 25% equity ownership of the company.

Capitalization Table:

Pre-money valuation $8,900,000

Investment $3,000,000

Post-money valuation $11,900,000 (11,900,000 shares)

% Equity = ($3,000,000/$11,900,000 = ~25%, or 3,000,000 shares @ $1/share to the investors)

Board of Directors: Shall be composed of 5 individuals: two founders, one investor representative, and two individuals mutually agreeable to both parties. The audit committee and compensation committee shall include investor and founder representation.

Liquidation Event: The company will seek a liquidation event (merger, reorganization or other transaction in which control of the company is transferred) within 5 years (IPO, sale, or sale of investor interests).

Antidilution Provisions: Investors preferred shares shall be subject to weighted average antidilution protection; no adjustment shall be made for share issuance to employees etc. for board-approved equity incentive plans.

Investor approval: Required for a liquidation event. Investors shall also retain rights of first refusal in the event of one or more of the founders seeking to liquidate (part of) their equity standing.

Performance Targets: The investment is structured around a $50M sales target by the year 2000. If this is not achieved, one of the independent directors shall be replaced by an investor representative.