We have reviewed your financial projections and have accumulated a list of recommendations in regards to your desire to enter into a new high growth phase for your company. Looking at your projected income statement, we agree that an injection of about $3M in cash would be useful to ensure that you can expand into new markets and meet your requirements.
We agree that paying off the FDBD loan would be worthwhile, even with the interest premiums you will need to pay in order to pay off the loan early. Paying off the BDC loan will cost $573,860, but is certainly worthwhile in that it will likely save you $130K in additional interest premiums because of the higher forecasted sales. (see appendix A for calculation)
We do have some concerns about your optimism with the numbers and your desire to enter into a new market with strong existing players, a long sales cycle and slim profit margins. However, since we are not experts in this industry we will defer to you for making these strategic decisions. You have shown a rather impressive ability to bring the company to where it is now, with three years of doubling your yearly revenues. This ability for your executive branch to show returns on investment should help with raising finances in this time of growth. Your company is in a strong position to negotiate good terms with a VC fund. However, we have adjusted your excel sheet to use the numbers accepted by the VC funds for our calculations, since your initial estimations may be a bit optimistic.
Xantrex does not need to raise all of the needed cash using equity financing. You need a total of approximately $3M in cash, but rather than dilute the company, you could use traditional debt financing for some of this money. By raising only $2.23M at the present moment in equity financing, you can avoid giving up around 5% of the company, which would result in as much as $2.3M in additional cash to the original shareholders on an exit event (see Appendix E for calculation).
Xantrex currently has a rather low debt to equity ratio. With the outstanding FDBD loan, there is a 2:1 debt to equity ratio, and by paying off the FDBD loan, it will drop to 1.72. This is well below the constraint imposed by your bank of a 3:1 ratio.
The most obvious place where you could secure debt financing is by leveraging your bank operating line. Your bank states that they will raise their operating line from $300K to $1M, as long as you secure a large amount of equity. This operating line might be the first place you turn to for paying off the FBDB loan. Although the interest rate of this operating line is not stated, it is likely below the rather high 13% of the FBDB loan. This additional $700K in available funds can pay off the FDBD loan and still provide $120K in operating cash.
Xantrex also has a large amount of inventory and accounts receivable available that could be used as collateral for short-term loans. Although this type of asset based lending typically has a high cost (typically 6 - 10% above prime rate, according to Cornwall's Entrepreneurial Financial Management), this would only be for short periods of time in order to ensure adequate liquidity in a tight period. As well, this is not much higher of a rate than what you are currently paying for the FDBD loan. Looking at the 1995 accounts receivable and inventory balance, Xantrex could potentially raise as much as $800K in emergency financing (see Appendix B). This would not be something you would want to do unless you are in a cash tight position, but does provide some flexibility for the next two years when your costs are going to be growing at a faster rate than revenue.
One of the bank imposed constraints is that Xantrex needs to get permissions before borrowing money. This might be one of the covenants that you ask to be removed once you have raised the venture capital financing, in order to ensure that Xantrex has some financial flexibility. With this in mind, we suggest doing an initial raise of venture capital, and then use debt financing through the larger operating line and the fall back on short term financing based on inventory and accounts receivable.
With the availability of a higher line of credit and the safety margin of asset-based short term financing, we can be comfortable with raising only $2.23M instead of the $3M you were initially considering. The next decision is what percentage of the company to offer for this amount, which requires determining the company valuation.
The investor BDC is expecting a 3-10 year investment length. We base our valuation assumptions on year 2000 EBIT, and so we are using the assumption that an exit will occur within a six year time period with expectation of IPO or private sale by approximately year 2000 (see Appendix D).
We decided on a 30% discount rate to account for the high amount of risk that a tech company often experiences. We are going to use the seven times projected EBIT approach for valuation since the investors seem comfortable with this, even though a multiple of 7 is a rather high multiple even for a tech company. By changing the projected revenue for Dec 2000 in the spreadsheet to the value of $50M, a more conservative value compared to Dr. Mulji's estimate, we are ensuring our estimations are more representative of the most likely scenario. This is also the value suggested by BDC, and translates into an increased ownership of 4% for the investors.
It would be preferrable if BDC could find a partner that does not have the need for short term cash flows in the form of a dividend. If a 5% dividend is part of the terms, we would offer 1% less of the company (see Appendix D). A 5% dividend would cost the company $115K in cash per year. In the first two years Xantrex will be the most cash strapped as you expand. Another option might be to start the dividend in 1998 when Xantrex becomes more liquid. With this term, we would offer 18% instead of 17%.
Xantrex currently has four primary shareholders. They have expressed concern about giving up their control, and thus would all like to maintain a seat on the board of directors. Since Xantrex is exchanging approximately one fifth of the company for the equity financing, we would recommend a five-person board with the final member being a representative elected by BDC and their partner. Xantrex should express a preference for this board member to be someone with marketing and electronics industry experience that would inject some additional strategic experience into their organization.
The $2.23M will be exchanged for preferred shares that will be convertible to regular shares at the exit event for the company. These shares should not need any special voting rights above the rights of the appointed member of the board.
Using the projected revenues, BDC and partner would expect to make $8.4M on the liquidation of their preferred shares in 2000. This is well within the target returns that BDC hopes to make in their investments. Xantrex shareholders will make $38.1M.
We wish you luck in this exciting new phase in the evolution of your company. Please feel free to contact us if you have additional questions on these calculations.
Best Regards,
Kitchy Financial Consulting Services
Appendix A:
Calculation of FDBD Loan Repayment Cost (Numbers in thousands)
| Year | Forecasted Sales | Present Value of Forecast (20% discount) | Interest Premium on Sales (0.45%) | Regular Interest on Loan |
| 1996 | 7500 | 6250 | 28 | 45.8 |
| 1997 | 9100 | 6319.45 | 28.4 | 29.51 |
| 1998 | 10000 | 5787 | 26 | 10.98 |
| Total | | | 82.4 | 86.29 |
Paying off the loan will require paying 168,690 in interest fees. Including the outstanding balance on the loan of $405,170, that would total $573,860.
Assumption: loan taken out at the end of 1993 (so amortization repayment starts in 1994). This seems to be correct, since it matches the Exhibit 2 FDBD loan balance in 1995.
| Year | Interest | Principal | Balance |
|---|---|---|---|
| 1994 | $72.70 | $91.12 | $508.88 |
| 1995 | $60.12 | $103.70 | $405.17 |
| 1996 | $45.80 | $118.02 | $287.15 |
| 1997 | $29.51 | $134.31 | $152.85 |
| 1998 | $10.98 | $152.85 | $0.00 |
Hypothetical Real Cost of Loan if not repaid:
| Year | Forecasted Sales | Present Value of Forecast (do we need to discount??) | Interest Premium on Sales |
| 1996 | 14000 | 11666.67 | 52.50 |
| 1997 | 22000 | 15277.78 | 68.75 |
| 1998 | 35000 | 20254.63 | 91.12 |
| | | | 212.37 |
Real Forecasted Interest Premium - Agreed upon Interest Premium (212.37 - 82.4) = 130K.
They would save an estimated $130K by paying off the bank loan early. It will cost them 168,690 to pay the loan now.
Appendix B: Possible Asset-Based Short Term Debt
One of the bank imposed constraints is a margin of 50% inventory and 75% A/R.
A/R as of 1995 = 1112 * 0.5 = $556K
Inventory as of 1995 = 974 * 0.25 = $243K
Total available for short term 'emergency' financing = $800K
Appendix C: Calculation of Required Funds (in 000s)
Required Financing = Total Assets - Total Liabilities - Equity - Retained Earnings
Total assets as of 1996 = $6,743K
Total liabilities as of 1996 = $2,676K
Total shareholders' equity as of 1996 = $1K
Retained earnings as of 1996 = $2,014K
| YE'96 | YE'97 | YE'98 | YE'99 | YE'00 |
| $2,053 | $58 | -$539 | -$2519 | -$6247 |
Required equity = liquidation terminal value / (1+discount rate) ^ #yrs
Assuming required equity of ~$2.3M, this would yield a liquidation terminal value of $8.3M; thus, percent offered to BCD/co-investor would be 17%.
1. $50,000K revenue in Year-End (YE) 2000
2. 5% dividend available for YE1998, YE1999, YE2000
3. No dividends for YE1996 and YE1997
4. New Preferred Equity of $2,300K
5. Discount rate of 30%
6. Earnings Before Interest and Taxes Multiplier of 7
7. Percentage of firm offered = 17%
| IRR: BDC and WOF | | Purchase/Sale | Dividend | Total Cash | Present Value |
| Year-end 1996 | | (2,300) | 0 | (2,300) | (2,300) |
| Year-end 1997 | | 0 | 0 | 0 | 0 |
| Year-end 1998 | | 0 | 0 | 0 | 0 |
| Year-end 1999 | | 0 | 0 | 0 | 0 |
| Year-end 2000 | | 0 | 0 | 0 | 0 |
| Terminal | | 7,910 | 345 | 8,255 | 2,223 |
At 18% of equity provided, the terminal value for investors would be $8.375M, with present value of $2.349M.
At 23% of equity provided, the terminal value for investors would be $10.7M, with present value of $2.975M.
Therefore, by not giving up 5% of the company and using debt financing instead for the extra $650K, Xantrex shareholders would receive an extra (10.7-8.375 = ) 2.3M in cash on the company liquidation in year 2000.
Our group consists of myself, Gabe, Gareth, Gord, Michael, Farhan, and Dylan
ReplyDeleteIt is interesting that while most of the team suggest equity financing, your team suggest the combination of both. This is absolutely a great insight that our team have not thought about. I also like your explanation on the discount rate and the multiplier, since Dr. Mulji is very optimistic on the company and he should be able to negotiate a better valuation using a lower discount rate and higher multiple.
ReplyDeleteIt seems that you have spent a lot of effort in the calculation, but I worry the executives will be overwhelmed by the amount of technical data. A further explanation of the numbers or a better organization might be beneficial.
Eric L :-)
I have to say I like the approach of hybrid financing a lot, and I agree it is very attractive for the owners if it is feasible.
ReplyDeleteThere are several comments here.
1. You have used 7 times of EBIT for calculation. In the artical, it has been mentioned that firms similar to Xantrex has received about 8 times of EBIT.
2. For the FBDB loan, I believe you only need pay the interest minimum if Xantrax chooses to repay the loan, not both the 13% interests and 0.45% of projected sales.
3. I understand that you decide to take $700,000 operaton line from the bank; however, comparing with other numbers you have provided, I still find it is not very clear how you came up with the exact $2.3M equity financing to justify why $3 million would be the right amount.
4. 17% ownership is not much. Xantrex might be in a good position to bargain. However, I am not too sure that VC will find the ownership ratio is attractive.
Has there been any consideration on the terms that BDC may impose on the composition of the board should Xantrex not meet its performance projections? I would be a little concerned as possible measures to protect the founders in the event of not meeting performance projections.
ReplyDeleteWell done Kitchy Financial Consulting Services,
ReplyDeleteI have to say I agree with the consensus in the comments so far regarding the use of both equity and debt financing. My group honed in on an equity approach from the onset and we really didn't stop to consider utilizing aspects of debt financing - especially considering that Xantrex appeared to be in a good position to do so. It was nice to see a group “think outside the box” a little more than other groups, so to speak.
Judging by Gareth’s comment on my group’s analysis of the case, the proposed structure of the Board of Directors after the equity investment from BDC/WOF is something that we would likely have to “agree to disagree on”. I just do not think it is quite realistic enough to propose that BDC/WOF only gets one member on the Board with the other four being from Xantrex itself. I do think that one or two individuals from outside of Xantrex or BDC/WOF, but mutually agreeable to both parties, would be necessary from an Investor standpoint. The 4 to 1 ratio of Xantrex to Investor representation on the Board would really make it difficult for BDC/WOF have any control, so I’m not sure if they would be agreeable to such a term. Although it is worth noting that in our analysis we were suggesting that the Investors would have 25% control, and Kitchy Financial Consulting Services suggested 20% party due to the debt financing recommendations. Regardless, our two groups definitely have differing opinions on the appropriate representation on the Board.
Certainly the four primary shareholders are concerned about giving up control; however, it appears that they realize that it would be necessary as in the case it states, “The four shareholders agreed that they would prefer to have a reduced level of ownership in a large and growing company as opposed to owning 100 per cent of a firm that could not afford to grow” and, “Because the venture capitalists would undoubtedly want to change the composition of the board of directors, several of the existing shareholders might lose their current places on the board.” Simply, I think losing a couple of spots on the Board of Directors is something that the shareholders of Xantrex have begrudgingly accepted. Having said that, I commend you for developing terms that take into account your perception of the best interests of the shareholders of Xantrex.
An interesting point of discussion in my group’s analysis was with respect to future rounds of equity financing. We were concerned with the role of BDC/WOF in future rounds of equity financing in order to fund further growth of Xantrex given their investment constraints. To our group, such a scenario would exclude the involvement of BDC/WOF in future rounds and we were concerned with the mechanics of such an arrangement. Given Kitchy’s Financial Consulting services’ hybrid approach to financing and pro-Xantrex recommendations, I would be curious to hear Kitchy's recommendations in that respect.
Cheers,
John
Just in case JWB III = John
ReplyDeleteI have to applaud the recommendations made by the Kitchy team. As it has been said by others already, the idea of recommending both debt and equity financing is a great idea when it is married with paying off the FDBD loan. Not only is Xantrex getting the capital financing it needs it can do so by staying within the debt to equity covenant set by the bank while maintaining additional ownership (and future profitability for the founders) rather than handing it over to the VC's.
ReplyDeleteYou mentioned in your analysis that one of the sources of the debt financing would be to use some of the room afforded in the existing line of credit if it was bumped up to $1 million. A couple questions I have about this are:
1. With the assumed high interest rate of the line of credit did the Kitchy team consider the cost of financing this ~$700k as an acceptible operational expense.
2. What other debt options were discussed as alternatives to using the high interest line of credit?
3. Was there any discussiuon that the bank may not allow the line of credit to be used as a long term loan vehicle?
As it related to the equity financing what are your thoughts on the following:
1. As the funding was being sought in 1995 why was the forecasted EBIT in the year 2000 used for the company valuation in your calculations? I believe using this forecasted EBIT from 4 years in the future would not been seen as a reasonable valuation by the VC community. I believe the 1995 EBIT should have been used for the company valuation. With the 1995 EBIT used for the company valuation the percentage ownership of Xantrex by the VC's would have been significantly higher.
Overall I found the analysis of the case to be thorough and well laid out. The appendixes were well formatted and easy to read. I completely agree with the idea of a split of financing with both debt and equity to allocate more ownership of the company to the founders; however, as I mentioned above I do not agree with the way the valuation of Xantrex was derived.
Hello Kitchy-ites:
ReplyDeleteThis was a good analysis—well constructed, easy to follow, and giving attention to the key issues at hand. We didn’t consider the option of debt directly, although like you we recognized that adding more equity funding to the financial structure of Xantrex could be used as leverage to increase the operating line of credit. The trade-off in selecting more debt within the company’s financial structure is that with debt comes obligations without advice!! In other words, while debt wouldn’t dilute the equity base of the founders (although I understood the case to suggest that the founders had accepted equity dilution was necessary at this stage), it also would not offer any additional expertise that the company is in need of for its expansion. You have proposed a hybrid debt/equity structure so there would still be opportunity to draw on the expertise of BDC/WOF (I believe the case mentioned a specific need for marketing and electronics expertise). However, with greater equity standing, VCs would undoubtedly be more involved in and motivated to utilize their experience to help ensure the successful entry of Xantrex into international markets. Greater utilization of short-term debt is, as you suggest, probably a good strategy for Xantrex as its sales (and, by correlation, its inventory and A/R) continue to grow. I liked your suggestion that this round of financing be used as an opportunity to revisit some of the contractual obligations that the company has with its bank—this was something we talked about too, but I think forgot to include in our analysis☺
Well done,
Rhonda
I love this proposal because it has considered not only equity financing which many other group did. I this proposal saved the high cost of FDBD loan, raise money for Xantrex, didn't give up much control of the company and provide many flexibility for Xantrex in the future to raise more funds.
ReplyDeleteThe group does not mention many details in the optimal deal (i.e. anti-dilute, etc) which I think is perfectly fine because this is not suppose to be a VC term sheet.
However, I am not sure if VC would agree to have a 5 to 1 (Xantrex vs BDC) board members. I assumed most of the VC would like fair amount of control on the board.
I think this is very well done =)
Team Kitchy,
ReplyDeleteI'd like to join the other individual posters in commending you on a thoughtful and readable analysis of the Xantrex Case.
Like you, the 5A team also considered financing alternatives to reduce the amount required from equity. We initially thought the operating line of credit would provide this solution, but then observed that in the historical balance sheet for YE 1995, the operating line was already drawn at $784000.
Therefore, because Xantrex was already overdrawn on the line of credit, we thought it would be best to pay it down completely through the equity round. In that way, if the company did not meet sales expectations or continued to have issues in receiving payment from Sorensen, they would have a ready source of immediate cash. It would indeed be key to renegotiate the operating line to make it an even more flexible source of "just in time" funds.
With the reliance on debt financing for unforseen needs, the Kitchy team might want to consider what sort of controls the VC firms may wish to place on Xantrex. For example, the VC firm would likely prefer to issue further financing if needed, rather than place their investment under extra risk since debt financing would be serviced before equity in the event of a liquidation event. Although I will admit that in this case Xantrex can likely use the BDC as their source of both equity and debt financing which would mitigate the concerns of the VC.
ReplyDelete