By Professor Clive Vlieland-Boddy
• As part of the management team, how
would you fund this?
• Who is to make the decision?
• What is the decision?
• What is the company?
• What is the industry?
• Reasons for sale - Retirement
• Valuation based on previous offers of $10m
with $8m in cash.
• MBO opportunity.
• Personal resources of MBO team only
• Therefore looking for $7,750k of financing.
Had basic agreement with bank for $3m
and now $3m from Baring. This left
balance of $3.75m to find.
Why are MBO attractive
• Management skills retained.
• Previous knowledge of existing business.
Summary of the business
• Manufactures calendars and
• Highly seasonal trading.
• High write-off on left-over stocks.
• Risks from level production against no firm
• Tax holiday in Puerto Rico. ( Another 12 yrs
• Up to date equipment.
• No further capital expenditure required for 5
• Non differentiable products.
• 1800 different sales accounts.
• Government and 6 large clients represent
30% of sales.
• Low product costs made them highly
competitive as a low cost provider.
• 95% reorders.
• Owner occupier of the business. Uses Free
cash to fund capital equipment. If none then
dividends of up to 70% of Earnings.
• Generous credit terms to Accounts
• No debt. Does have credit lines of $2m.
• Accounts Payable always paid on time.
• In summary... good working capital.
• The MBO team consists of the 4 key
management. However, it will not
obviously include Baring. But would this
• Steady maintainable growth in excess of
economy. ( Estimated at 5%-6% per
• Profit margins expected to improve by
better use of Puerto Rico.
• Only two players. Harrington (65% and
Algonquin 25%) However geographically
not really in competition.
• Otherwise fragmented industry.
• Barriers to entry - price, economies of
scale and capital investment.
• Possible to attack some of Algonquin’s
• Dated products like appointed books.
• Capital investment required of $100k and
Marketing of $450k.
• First year sales of $500k. Growing by 40%
pa for years 2-4 the by 6%.
• Looking to take company public.
• Note that any venture capitalist would be
looking for an intelligent way out.
• $250k of personal cash.
• Wanted to maintain 51% control.
• Purchase price not re-negotiable.
Financing the Purchase (
• $250k equity from the management.
• $3m loan from the bank. 6 year with 20%
• $3m loan from Baring. ( 5 year 4% junior
• Balance of $3.75m. This would have to come
from Venture Capital finance.( or elsewhere!)
So how do we do a deal?
• Barings is prepared to sell for $10m.
• He will vendor finance $3m over 5 years.
• A bank will put up $3m of junior debt with
some awkward covenants.
• Management will finance $250k
• We now have to establish how to get the
balance of finance. Ie $3.750m.
Venture ( Vulture ) Capitalists..
• But what will the new equity financiers
• What % of the company will be required to
be sold to attract $3.75m? Is there any
way to reduce this?
• Note expected return that VC would want
is 20%-25%. With any debt then 8%-9%
• Likely to take options or warrants on large
% of the equity and a kicker.
Lets look at valuations...
• Balance Sheet. Net assets = $4,958k.
• NPV of the free cash flow.
• Earnings multiples
– Price earnings. Based on Exhibit 5, average
for industry is 7.2 - 10.5. Harrington’s should
be much higher as it generates nearly twice
the profits of average companies. See net
profit margins. 12.9% as opposed to 4.1%-
– Industry multiples. We do not have any
information on these.
Harrington’s Group after MBO
• Current Equity = $5m
• New Equity = $250k
• New debt = $9,750k
• Debt equity ratio = 65%
Lets spend a minute revisiting
Working Capital Management..
• Exhibit 4 shows
– cash balance of nearly $3m
– Accounts receivable of $1.2m
– and Current liabilities of $633. If you look at
Exhibit 2 Accounts payable represents only
• What if you managed this better. Could you
not increase Accounts payable to say 60
days from 20. What about using the cash
to fund part of the acquisition!
Lets return to the multiples..
• To establish the Earnings we would have
to adjust the 1970 figures to add back the
salary of Baring’s net of tax. Total was
$200k less say tax at 30% = $140k. This
would give ROE of $1,123k.
• With a market price required by Baring’s of
$10m. The P/E is 8.9. This compares to
industry of 7.2 - 10.5.
Price not negotiable...
• So we have to accept that we will have to
• The issue is therefore how and at what
price would the venture capitalists assist?
• We are told that they typically look for a
return of 20%-25%.
Exhibit 7 - The forecasts..
• The company appears to be able to fund
the bank debt of $3m and repay it over 4
years as required. It can even take a small
advantage of the discounts offered by
Baring and repay the $3m by end of year 5
but will have to re-borrow $1.4m.
What about financial risk?
• How would this really sit with the venture
capitalists. The company has moved from
0% debt to 65%. Financial leverage has
been introduced and overbalancing the
• The bank loan already has many
restrictions in its covenants.
• Remember “Agency Costs…”
So if you were the venture
capitalist what would you
• All equity position! Say 51% now but
enable the management to get back
control when all repaid. Even if the VC’s
do not insist on control, they will be
• Lend the $3.75m as that avoids the
capital gain on the sum!
• Combine Debt with Equity
Each Group is a venture capitalist or
• Put forward a proposal to a proposal to the
• Should use surplus working capital of say
$1.250m to reduce VC’s exposure. ( Could
with good planning substantially increase
• Venture capitalists would provide the $2.5m
primary debt but with a substantial equity
kicker. They would require a golden share
position until repaid in full and then be able
to convert or exercise options to create a
VC’s 20-25% return.
• The cash flows show that we can pay
interest to the primary debts of 9%.
However, that still leaves a balance of
between 11% - 16%.
• We could start repayments in 1977 as by
then we have repaid the bank and Baring.
• So if you did a forecast from say year 7 to
year 10 you should be able to evaluate a
repayment proposal for the VC’s.
Balance of VC’s return
• If they lend $2.5m and receive say 9% as
interest, the balance required is 11% (
Based on 20% and 16% based on 25%)
• With no repayment until after year 5 when
say $1m is repaid, then the balance that
the VC’s would look for would be.
NPV of Venture Capitalists Required Return of say 25% per annum - 9% = 16%
Also 20% per annum = net of 11%
Opening Paid Return 16% Closing Return 11% Closing
1971 2,500 400 2,900 275 2,900
1972 2,900 464 3,364 319 3,219
1973 3,364 538 3,902 370 3,589
1974 3,902 624 4,527 429 4,018
1975 4,527 724 5,251 498 4,516
1976 5,251 840 6,091 578 5,094
1977 6,091 1,500 975 5,566 670 4,264
1978 5,566 1,000 890 5,456 469 3,733
What does this tell us?
• By 1978, we have repaid the loan from the
VC of $2,500k. By then the capital growth
expectations based on 25% total yield
would have grown to about $5.5m. ( At
20% it is $3.7m)
• The equity kicker would have to represent
a similar value!