Fall Semester, 2009
Business 764, Applied Finance
Instructor: Ian Hand
Case Study #2, Xantrex Technology Inc. Expansion Initiative
Submitted on behalf of:
Alison Fitch, James Herdy, Andrew Marles, Aruna Somasiri, Angelo Sozzi
Summary of Conclusions
The primary reason for the owners of Xantrex Technology to be seeking additional funding is that they need cash in order to achieve the significant growth they predict is possible for their business. The proposed BDC Venture Capital investment arrangement will provide this necessary funding, while also leveraging the strong working relationship that already exists between these two firms. Further, this investment will also provide Xantrex with the ability to pay off their existing term loan, which includes sales premiums that represent significant additional cost if future sales rise to projected levels. There are some key terms that need to be re-negotiated in order for the financing to be acceptable to both parties, but these requirements should be beneficial to both sides so the likelyhood of consensus is high.1.a) Key Objectives
The key needs and objectives of Xantrex at this juncture are:- Xantrex’s main objective is to fund the key expansion opportunities their management has identified, as this will allow them to increase sales volumes, revenues and market penetration both nationally and abroad.
- In order to maximize profits from projected increases in sales, Xantrex needs to repay the current FBDB loan and thereby avoid excessive interest premiums.
- Xantrex also needs to bring in additional business expertise to help successfully direct their growing company into new markets, without risking loss of control.
- In order to enable additional financing from VCs, Xantrex’s management needs to create a formal shareholder's agreement and amend the structure for the Board of Directors.
- Xantrex’s management also needs to ensure that there is a clear exit strategy for both the VCs and their current owners. This will facilitate the VCs being able to discharge their investment with the maximum rate of return and allow owners to take profits out of the company when they want to leave.
1.b) Key Risks & Opportunities
From Xantrex’s perspective:
Risks
Opportunities
- Additional financing will allow Xantrex to reach sales levels and growth that could not be done through internal funds alone.
From the VC’s perspective:
Risks- Xantrex management is proposing to enter a new market area of telecommunications where they do not have an established customer base or a clear assurance of market share. This aspect of the expansion plan contains significant market entry risk.
- One of their largest current customers is having cash flow problems and is not paying accounts in a timely manner. As a result, Xantrex may suffer short term cash flow problems that could create need for emergency financing and/or delay of expansion plans.
- The eventual exit strategy (IPO, acquisition or buy-out) may not be an option within the timeframe that the VCs wish to be able to realize their profits from the investment. This may force them to realize a lower return or leave their money tied up for a longer period of time than originally planned.
- Investment in Xantrex provides a very desirable return if the upside potential of increased sales is fully met.
- BDC has had a positive relationship with Xantrex in the first 3 years of its operation and therefore this funding presents opportunity to capitalize on a corporation where there is less agency risk than in a new business relationship.
2.a) Financing Required
The amount of capital to be raised by Xantrex is: $3,092,000
This value was calculated by adding the following values:
Required Financing (taken from Proforma Balance Sheet)
1996 - $2,053,000
1997 - $58,000
BDC (FBDB) Term Loan Repayment (see notes)
Outstanding principal: $414,338
Interest premium due on early payment of term loan: $82,604
Repayment of Operating Line (see note)
$484,000
Total = $2,053,000 + 58,000 + 414,338 + 82,604 + 484,000
Total = $3,091,942
Notes:
- The current principal outstanding for the $600,000 term loan was calculated by setting up a loan payment schedule from 1994 – 1998. As the case stated the loan was for five years, three years would be left and the principle outstanding at 13% annual interest is $414,338
- The interest premiums due on early payment of the term loan were calculated as 0.45 percent of the originally estimated sales for 1996, 1997 and 1998, discounted to present value using the 20% discount rate provided. The sum of these values is $82,604
- The current bank covenants list the operating line limit to be $300,000. As the outstanding line as of December 31, 1995 was 784,000, the difference would need to be repaid. This should facilitate the limit increase to $1,000,000 as promised by the bank upon significant equity finance, and then allow for a source of immediate operating cash as the expansion plan is implemented.
2.b) Equity to be Provided
Using eight times EBIT as the terminal value of Xantrex (as provided in the case), and EBITDA to represent cash flows from 1996 to 2000, and a 35% discount rate, the present value of Xantrex as of January 1, 1996 is: $24,680,000Based upon this valuation, the BDC Venture Capital investment of $3,092,000 represents 12.5% of the company (pre-money).
In order for BDC Venture Capital to realize a 35% IRR, Xantrex needs to offer them 19.5% equity for their investment.
3) Recommendation to Management
With respect to the Venture Capital deal tabled by BDC, we recommend that Xantrex proceed for the following reasons:- Accepting the investment proposal offered by BDC meets the financing needs of Xantrex and facilitates the planned expansion in distribution and product lines. This is necessary to achieve the projected growth in sales and revenues.
- BDC does not require or request short-term liquidity for their investment and this complements the timeline for any future exit strategy of the current owners.
- BDC is working to split the venture deal with WOF, a move that will bring desired additional management expertise and due diligence to Xantrex.
- Xantrex management has already developed a good working relationship with BDC and this will help when negotiating the shareholder's agreement necessary for this round of financing.
- Finally, both BDC and WOF have stated they will accept common shares for their equity investments and this reduces the risk of the investment causing loss of control for Xantrex management.
4) Significant Criteria and Constraints
The significant criteria and constraints employed by BDC and WOF are:- A shareholder's agreement must be implemented including an employee agreement for the management team.
- A Board of Directors must be formalized and the new investors will require representation on it.
- WOF's rules prohibit them from engaging in any debt financing arrangements and this limits the potential financing options with this investment partner.
- The co-investment requirement by the BDC may complicate the transaction as Xantrex has no working relationship with WOF.
- An expected rate of return of 20-35%
Additionally, some of the current limitations imposed by the bank on the operating line of credit will need to be re-negotiated to allow expansion to move forward. This discussion can be initiated concurrent with the equity interactions to assure the potential investors of a functional cash flow for Xantrex, and complete dependent on the receipt of the BDC and WOF funds. Critical terms for operating LOC re-negotiation are:
- The capital expenditure limit needs to be re-evaluated annually to accomodate the planned increases in capital expenses.
- Management salary limits will need to be increased to allow Xantrex to attract qualified personnel for the new management positions.
- The operating line will need to be extended to $1 million to accomodate fluctuations in operating cash flows.
5) Optimal Deal Structure
It is proposed that the deal be structured as follows:BDC and WOF will each provide 50% of the $3,092,000 required financing to Xantrex, in exchange for 19.5% of the company in the form of common shares, split between the two investing groups. This financing will be used to support development of the product line, expansion of distribution, early payment of the outstanding term loan and repayment of the operating line that is currently in excess of the bank covenant.
Major Terms to be Included
Equity Financing
Shareholder’s Agreement – Key Clauses
Xantrex Valuation:
$24,689,000 (pre-money)
Venture Capital Investment:
$3,092,000 invested in exchange for 19.5% equity in the form of common shares.
Stock Issuance:
All shares will be issued as common stock.
Board Representation:
It is proposed that a Board of Directors be created with six members. Xantrex will select four members (one acceptable to each current owner) and each VC firm (BDC and WOF) will also select one member.
Anti-dilution rights:
Weighted average anti-dilution will be implemented.
Operating Line of Credit
The required amount of venture capital financing was calculated based upon the optimistic case sales projections. In the event that sales do not meet these projections, it may be the case that the amount raised is not sufficient to fund all growth plans. Therefore, it is critical that Xantrex renegotiate their operating line of credit to $1,000,000 from the current $300,000. This increased operating line should be sufficient to cover any financing deficiency between the optimistic and worst case sales projections. That is, the operating line will be used as additional financing to cover any shortfalls.
Also, as the expansion plans include significant yearly investment in capital assets, the yearly cap on expenditures must also be negotiated up from the current limit of $100,000. This should be reviewed annually with the bank.
Finally, as expansion requires that additional key management personnel is hired, the yearly cap on combined management salaries must also be negotiated up from the current limit of $400,000. This should be reviewed annually with the bank.
* Appendix A - Key Assumptions
The following key assumptions were made in preparing this case:
- The BDC term loan of $600,000 was provided as a single payment on January 1, 1994. This assumption is based upon the fact that no FBDB loan amount is shown on the historical income statement until 1994, although a single payment of $600,000 is also not shown in this year.
- Early payment of the term loan involves only repayment of the outstanding principle and the interest premium on sales, and not any additional interest penalty on early payment of principle.
* Appendix B - FBDB Term Loan – Early Payment Savings
Early payment of the FBDB term loan will save Xantrex: $188,560
This value was calculated as follows:
Original Sales Estimates – Interest Premiums
1996 – $7,500,000 x 0.45% = $33,750; PV = $28,125
1997 – $9,100,000 x 0.45% = $40,950; PV = $28,437
1996 – $10,000,000 x 0.45% = $45,000; PV = $26,041
Total = $82,604
Revised Optimal Case Sales Estimates – Interest Premiums
1996 – $14,000,000 x 0.45% = $63,000; PV = $55,500
1997 – $20,000,000 x 0.45% = $90,000; PV = $62,500
1996 – $35,000,000 x 0.45% = $157,500; PV = $91,146
Total = $206,146
Therefore, savings on Interest Premiums = $206,146 - $82,604 = $123,542
Savings on interest not paid on outstanding term loan balance = $65,018
Total savings = $123,542 + $65,018 = $188,560
* Appendix C - Valuation Calculation
Present Value of Xantrex
Discount Rate = 35.00%
Year – $ Cash (EBITDA) - $ PV
1996 – $1,115,000 - $826,000
1997 – $2,800,000 - $1, 536,000
1998 – $5,161,000 - $2,098,000
1999 – $7,300,000 - $2,198,000
2000 – $9,725,000 - $2,169,000
Terminal (8 x EBIT) – $71,130,000 - $15,863,000
Value if kept $24,689,000
IRR to Venture Capitalists
Current Case
1996 payment: ($3,092,000)
Terminal: $13,870
IRR: 35.01%
Best Case
1996 payment: ($3,092,000)
Terminal: $24,246
IRR: 50.97%
Worse Case
1996 payment: ($3,092,000)
Terminal: $5,871
IRR: 13.68%
Most Likely Case
1996 payment: ($3,092,000)
Terminal: $12,684
IRR: 32.62%
I like your analysis. I just have a few comments.
ReplyDelete1) Your required financing added on the Term Loan Repayment and Repayment of the Operating Line. But since these amounts were not on the 1996 balance sheet, it would have been a fair to assume the required financing covers repaying these loans. In addition, a cash flow statement would help to show the sources and uses of funds over the year.
2) Your valuation appears to use top line revenues from the best case sales growth forecast scenario. As much as I think this is what Xantrex ‘s owners would prefer, in reality, the valuation should probably be more balanced and reflective of what both the investors and Xantrex owners will be able to agree to. Mr. Elder and Nazir Mulji agreed on the Most Likely Sales Growth Scenario instead of the Optimistic case. Therefore, the Most Likely Sales Growth Scenario forecast is expected to drive the investor’s valuation unless Xantrex can show other evidence to support using the Optimistic case projections.
3) Your valuation uses the PV of the discounted EBITDA. However, the investors may be more inclined to want to use discounted cash flows instead of discounted EBITDA. There was some additional information provided that could be used to determine the yearly cash flows.
4) The shares you intend to offer are common shares. For a $3 million high risk investment in equity, I would imagine the investors will want some kind of preferential shares.
5) Your proposal has the board of directors remaining fully under the control of the founders. Surely the investors will want more control over the board. It will be a hard sell to convince the investors to accept minority representation on the board. But this could probably be rectified easily by opening up a board seat to an independent 3rd party mutually acceptable to both the board and the investors. So, you would keep your 6 board members, but only 3 would be founders, 2 investors, and 1 independent external.
In general, your analysis is straight forward and easy to follow. It just seems weighted heavily towards making this deal look good for Xantrex. But the investors are not likely to agree to that. So it should be made attractive to both parties.
Dear AJAAA,
ReplyDeleteGreat analysis! I like the opening evaluation of risks, it is very insightful and highlights the importance of keeping an eye on the cash flows during expansion in an new market segment (telecom). This is especially important given the recent history of account receivable with the large customers. The identification of the limitation on management salary is also important, as they need additional leadership to help them make the move to a global market with the new product lines.
I concur with the above comment that the proposed deal highly favours Xantrex, but also agree with your suggestions to attempt to provide the best structure for the current owners. Striking the right deal is about compromise, and that comes from the negation process. The important conclusion here is that VC funding is the right direction for Xantrex, which has a lot of up-side potential.
Marinko
I really like how you guys have presented your analysis. It was very easy to read and follow.
ReplyDeleteTerm Sheet Feedback:
I agree with the above posts that the valuation of your company is high, and based on your best scenario. My comment to that is your strategy is go into negotiations with your VCs high, and be negotiated down by them. It can be a good strategy to set a initial high ceiling so that you do not do your company in-justice at the negotiating table.
Having said that, I would have liked to see the floor of where you would like to take this during negotiations. That way I would know how low it would be possible to go in my negotiations. It also puts things into perspective in the high level view of the negotiations.
VC Perspective Risks Feedback:
I also enjoyed the analysis from your customer's perspective. It is always good to put yourself in the other person's shoe. I particularly liked how you identified how the cash flow problems from one large customers can significantly impact the financial situation at Xantrex, and potentially require additional financing in the future. Very good catch!
Additional info to add:
One thing I didn't think you guys addressed is how this financing will impact control over Xantrex. Is this something the management team is willing to do. Surely, I think they would be concerned about giving up control. I believe this would have become more apparent had an analysis been completed for the valuation of the company based upon the worst case scenario income projections.
Great job on your thorough analysis of the Xantrex case, I just have a few comments:
ReplyDelete1. For risks & opportunities, I agree with you but also feel that in order to help Xantrex's growth, obtaining equity-based financing will provide the opportunity to increase their operating line of credit 3-fold. As well another opportunity provided by expansion plans will be that Xantrex will be able to retain its dominance in the global marketplace.
2. For the shareholder's agreement, I agree with Paul that the terms favor Xantrex and may be a difficult sell to the investors. They would definitely ask for preferred shares as well as greater control of the company in the form of an increase in % equity and board representation.
Alison, James, Andrew, Aruna and Angelo:
ReplyDeletePart 1 of my comment...
Well done on the analysis. I'd like to add my $0.25 cent on why I think that the financing amounts were off between the different groups.
In question 2(a) for your answer, you stated...
The amount of capital to be raised by Xantrex is: $3,092,000
This value was calculated by adding the following values:
Total = $2,053,000 + 58,000 + 414,338 + 82,604 + 484,000 = $3,091,942
However, the way the proforma worksheet model supplied for Case 2 works, the Required Financing row 47 (in particular see cell I47 for Dec-1996) is calculated to show what financing is needed (i.e. the delta) to make the Assets side of the balance sheet match the Liabilities plus Shareholders Equity side of the ledger. Consider the values in cell ranges H25:I25 (operating line) and H27:I27 (FBDB Loan). If you enter 0 for the operating line in I25 (where it was previously $784 in the previous year), then the Financing Required value of $2053 ALREADY reflects the fact that the loan has been cleared off the books as a liability.
Part 2 of my comment...
ReplyDeleteLikewise, if you have 0 for the FBDB loan in cell I27 where it was $405 in Dec 1995, then the Financing Required value of $2053 ALREADY reflects that the FBDB loan has been cleared off the books from the previous year. Just as a double check, enter 784 in cell I25 to assume that the operating line is the same as at Dec-95. Do the same with I27 -- enter $405 to make it the same as the previous year (i.e. so it is still on the books as if unpaid). The financing required value is much lower. So when you are adding the FBDB loan and the operating line to the financing required value of $2053, you are double counting the FBDB and operating line figures (since the Financing Required value already reflects the amounts to ensure that the loan and operating line are paid off).
Where you are correct however is the amount for the interest premiums figure in your calculation. The spreadsheet does not include that in the calculation. The Interest premiums penalty would show as an expense on the income statement, which flows into the retained earnings on the balance sheet.
Part 3 of my comment.
ReplyDeleteWhen I enter 300 into I25 for the maximum principal outstanding allowed under rules, and place 0 in I27 to pay off the FBDB loan, then if I enter 1871 in I41 for New Preferred Equity, then the financing required is 0. Effectively, $1871 is the financing needed if you only pay off part of the loan leaving $300 on the books. I get $2161 as the financing required to completely eliminate the loan from the books.
Of course, the financing and valuation requirements are only part of the story for this case. Your analysis of the cost of capital was well done.
Cheers,
Gordon
Dear Alison, James, Andrew, Aruna and Angelo,
ReplyDeleteI would like to mention that your summary stands out from the rest of papers. It has the highest pre-money evaluation and the biggest number of board members.
I like the analysis. Especially I like the detailed risk assessment for both: prospective investors and present owners.
However, there are some points I would like to criticize:
With current recommendations VCs do not get any control over the company. I tend to think that for money invested, VCs would like to have either secured income (in form of preferred shares) or control over major decisions or both.
I do not think that potential financiers would agree with proposed evaluation and representation on the board (2 board members representing VCs and 4 for current owners).
My belief is that VCs would prefer either to have bigger stake in the company and/or bigger representation on the board and/or to receive preferred shares instead of common.
Also, I (for myself) do not like even numbers of board members as statistically are less efficient for apparent reason of potential deadlock in votes. I would recommend limiting board to five members 2 for current owners 2 for VCs and one acceptable to both.
Giving higher level of control to the investors does not suggest bad impact. As it was stated in one of your key objectives: “Xantrex also needs to bring in additional business expertise to help successfully direct their growing company into new markets…”
VCs would be interested appoint experienced and well connected people as the board members which would be beneficial for the enterprise.
Perusing renegotiation for line of credit to be increase to $1,000,000 from the current $300,000 is definitely good suggestion.
But I would also recommend having some shares in reserve for stock option in case limit of $400,000 management salaries cannot be renegotiated or will not be increased significantly.
I noticed some inconsistency in numbers: e.g. for pre-money evaluation of $24,689,000 - $3,092,000 will represent 11.13% of ownership after investment not 19.5%.
I would not suggest using 35% (the highest) discount rate in calculations and evaluating company on the best case. I would rather recommend using “most likely” case scenario. May be considering all three possible forecasts while doing proposal.
Overall: analysis is logical and easy to read.
Best regards,
Peter Krestsov