Funding Strategy for MBO at Harrington Corp: Opportunities and Challenges

1. Harrington Corp By Professor Clive Vlieland-Boddy

2. Group Discussion • As part of the management team, how would you fund this?

3. Key Issues • Who is to make the decision? • What is the decision? • What is the company? • What is the industry?

4. Background • Reasons for sale - Retirement • Valuation based on previous offers of $10m with $8m in cash. • MBO opportunity. • Personal resources of MBO team only $250k. • 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.

5. Why are MBO attractive • Management skills retained. • Previous knowledge of existing business.

6. Summary of the business • Manufactures calendars and • Highly seasonal trading. • High write-off on left-over stocks. • Risks from level production against no firm orders minimised. • Tax holiday in Puerto Rico. ( Another 12 yrs ) • Up to date equipment. • No further capital expenditure required for 5 yrs. • Non union workforce.

7. Marketing • 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.

8. Finances • 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 Receivable. • No debt. Does have credit lines of $2m. • Accounts Payable always paid on time. • In summary... good working capital.

9. Management • The MBO team consists of the 4 key management. However, it will not obviously include Baring. But would this matter?

10. Company Prospects • Steady maintainable growth in excess of economy. ( Estimated at 5%-6% per annum ) • Profit margins expected to improve by better use of Puerto Rico.

11. Competition • 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 market share.

12. Unexploited Opportunities • 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%.

13. Exit Strategy • Looking to take company public. • Note that any venture capitalist would be looking for an intelligent way out.

14. Purchase Proposal • $250k of personal cash. • Wanted to maintain 51% control. • Purchase price not re-negotiable.

15. Financing the Purchase ( MBO) • $250k equity from the management. • $3m loan from the bank. 6 year with 20% compensating balance. • $3m loan from Baring. ( 5 year 4% junior subordinated) • Balance of $3.75m. This would have to come from Venture Capital finance.( or elsewhere!)

16. 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.

17. Venture ( Vulture ) Capitalists.. • But what will the new equity financiers want. • 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% coupon rate. • Likely to take options or warrants on large % of the equity and a kicker.

18. 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%-8.9%. • Industry multiples. We do not have any information on these.

19. Harrington’s Group after MBO • Current Equity = $5m • New Equity = $250k • New debt = $9,750k • Debt equity ratio = 65%

20. 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 $327k. • 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! • Note we have to keep bank balance of 20% of loan. Initially this would represent $600k.

21. 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.

22. Price not negotiable... • So we have to accept that we will have to pay $10m. • 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%.

23. 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.

24. 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 Capital Structure. • The bank loan already has many restrictions in its covenants. • Remember “Agency Costs…”

25. So if you were the venture capitalist what would you require? • 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 heavily involved. • Lend the $3.75m as that avoids the capital gain on the sum! • Combine Debt with Equity conversion/kicker. • Could we not use better Working Capital Management to reduce this?

26. Group Sessions Each Group is a venture capitalist or investment banker. • Put forward a proposal to a proposal to the MBO team.

27. Likely outcome • Should use surplus working capital of say $1.250m to reduce VC’s exposure. ( Could with good planning substantially increase this) • 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 gain. • The fact that the company can finance and repay such high levels of debt would support its position with the venture capitalists.

28. 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.

29. 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.

31. 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!

32. The End