Case study Expanding a business - Free Essay Example

Halpern Engineering Ltd Introduction Halpern Engineering Ltd (HEL) is a highly successful engineering corporation, which has a significant share of the UK and global market, 70% and 6% respectively in the manufacturer of machines that produce biodegradable polythene bags. As a result of the business success and also to capture a greater share of the rising demand for the end product, John Helpern, CEO and major shareholder, is faced with a dilemma regarding whether the business should continue to expand, in which case there is the requirement for additional funding of approximately  £4 million. Alternatively, there are the options to sell the business of maintain business growth at a reduced level and therefore eliminate the need for addition help. This paper sets out to analyse the four main options that are available to the business, these being venture capitalism, bank funding, business sale or business takeover. 1 Venture Capitalist Venture capital is medium to long term finance provided by an individual or corporation, usually à ¢Ã¢â€š ¬Ã…“in return for an equity stake in potentially high growth unquoted companies.à ¢Ã¢â€š ¬Ã‚  However, in the case of Helpern Engineering Ltd, a venture capitalist has agreed to provide the required  £4 million of funding in the form of a loan, which will be subject to the following conditions: Interest, payable half yearly in arrears, to be set at 10% Loan repayable in full in 2011 Alternative option for venture capitalist to purchase 50.1% of the company shares, these being newly issued shares, in 2011 in exchange for the capital repayment. However, it is anticipated that the VC will want to protect his investments by imposing certain covenants upon the business and its management, which will need to be carefully considered (Pearce and Barnes 2006). It is anticipated that these will consist of the following. Directorà ¢Ã¢â€š ¬Ã¢â€ž ¢s commitment and confidentiality The VC is likely to include a covenant that restricts the directors ability to change their employment contracts and also imposes certain other management confidentiality condition that prohibit directors from leaving the business and setting up in competition, or enticing away suppliers and customers. Shares and Memorandum of Articles It is normal for there to be a condition that forbids directors from issuing shares or making changes to the business Memorandum of Articles without the agreement of the VC Borrowings Borrowing limits are also likely to feature as a condition of the VC investment in order to ensure that investment is not di minished or threatened. Underperformance Often a VC will impose an underperformance condition upon the business directors. This will state that, in the event that the business does not perform to agreed and pre-determined financial and performance targets, the VC will have the right to force a business sale or, alternatively appoint additional directors to the board and dispense with the services of the current directors. 2011 option As noted, in 2011 the VC has the option of cash or shares. The basis for making this decision will depend upon the return on equity employed (Reuvid 2002). This would especially be the case if the performance of the business does not match those forecasted as can be demonstrated if the following example of actual against budget is used (figure 1). Figure 1 Budget against actual EBITDA  £,000à ¢Ã¢â€š ¬Ã¢â€ž ¢s 2007 2008 2009 2010 2011 Forecast EBITDA 1,383 1,783 2,183 2,583 2,583 Actual EBITDA 1,383 1,700 2,030 2,340 2,380 Return on equity is calculated by using the following equation:- ROCE= Profit for the year Equity Shareholderà ¢Ã¢â€š ¬Ã¢â€ž ¢s funds Bearing in mind that the VC share of the business is 50.1%, which will cost  £4 million, the total equity value of the business would be  £7.984 million. Therefore, using this figure as the basis for the equity shareholders funds, the return on capital employed would be as follows: ROCE =  £2.380= 29.81%  £7.984 Although the ROCE on the forecast would have been 32.35%, even with the slightly reduced return, it is recommended that the VC would should convert the  £4 million to shares rather than retrieve the cash. This is because a) the previously agreed return on investment was only 10% and b) although an actual has not matched the projections the business has still returned a year on year growth pattern. Assuming this growth continues, this means that the value of the shares should increase as well as the return on capital employed. 2Bank funding The second alternative for Halpern is to seek bank assistance, by way of an overdraft and/or loan arrangement, a method chosen by around 52% of SMEà ¢Ã¢â€š ¬Ã¢â€ž ¢s (McLaney 2006, p.438). If this route is decided upon John Halpern will need to take into account the following issues. Maximum Funding Level With the funding being required for a project that is anticipated to require  £4 million of investment it is unlikely that the banks would advance the total amount, as they normally will require a commitment from the business and its owners (Watson and Head 2007). It is anticipated that, in this case the maximum the bank would be likely to advance is around 75% of the business requirement, this being  £3 million. Protective clauses To protect their funds the bank will attach some protective clauses to any funds that are advanced. In the case of an overdraft, by its very nature, this will always i nclude a repayment on demand condition (Watson and Head 2007, p.70). In the case of a loan an additional protective clause will be added in the form of a charge over any assets that the funds have been used to purchase. For example, if a property is purchased by the business the bank will require a charge over the property in return for the advance. In the past the banks use to require a fixed and floating charge over all of the assets of the business, which gave them a preferential position in the event of a business failure. However, this practice has been stopped in recent years as it disadvantaged other creditors (McLaney 2006). However, in a private limited company the bank will often insist upon additional protection in the form of a personal guarantee from the owners of the business (McLaney 2006), which in this case would be the Halpern family. It is important if this is the case that the person providing the guarantee ensures that it is limited to the extent of the de bt of the bank and, where possible attached to a specific asset. 3Business sale If John Halpern and his family decide to sell the business rather than seek to fund its expansion, a realistic value for the business will need to be decided. In this respect there are a number of valuation options. These include the à ¢Ã¢â€š ¬Ã…“rule of thumbà ¢Ã¢â€š ¬Ã‚  (Lipman 2005, p.12) and à ¢Ã¢â€š ¬Ã…“net assetsà ¢Ã¢â€š ¬Ã‚  methods or, alternatively, one a method that is based upon expected future profits (Reuvid 2002, p.173). The rule of thumb method simply bases the valuation upon the number of locations and revenue sources available to the business and is determined by a multiple of gross revenue. The net asset valuation is based upon the balance sheet values of the business and is predominately used where the profitability of the business is volatile (Watson and Head 2007). However, as Lipman (2005) observes, neither of these methods take into account the future profitability of the business. It is considered that the most appropriate method for valuing Helpern Engineering would be the discounted cash flow. This method of calculation anticipates the future cash flow of the business based upon the profitability and then arrives at a valuation, which is discounted according to the risk attached. The value calculation is determined at what is known as a terminal period, which is usually five years (Lipman 2005, p.16). In applying this method, the following assumptions have been used: An tax rate of 30% is applicable throughout Working capital 2007500,000 2008400,000 2009300,000 2010200,000 2011100,000 Depreciation based upon 20% of cost. DepnCost 2007250,0001,250,000 2008360,0001,800,000 2009380,0001,900,000 2010380,0001,900,000 2011360,0001,800,000 Capital expenditure is as follows: 20070 2008550,000 2009100,000 20100 2011(100,000) A discount value of 12% has been assumed, as limited data is available for this calculation to be made. Market value of debt  £150,000 at terminal period. As can be seen from the following table, the sale value of the business based upon a five year discounted cash flow equation is  £3,089 million. DISCOUNTED CASH FLOW  £,000à ¢Ã¢â€š ¬Ã¢â€ž ¢s Year 1 Year 2 Year 3 Year 4 Year 5 Terminal Value EBITDA 1,383 1,783 2,183 2,583 2,583 Income Tax 340 427 541 660 667 Net operating income 1,722 2,210 2,724 3,244 3,250 13,150 Plus Working capital (500) (400) (300) (200) (100) Capital expenditure 0 (550) (100) 0 100 Free cash flows 1,223 1,260 2,324 3,044 3,250 Net Present value at 12% 1,092 1,125 2,075 2,718 2,902 9,911 Corporate Value 3,239 Less: debt 150 Net value 3,089 4Business takeover In the event, John Halpern decided to continue to operate the business without taking advantage of external capital, a task which he successfully achieved until the beginning of 2008, although growth was limited and potentially the business was losing market share. However, in March 2008 an indirect industry supplier indicated an interest in acquiring HEL. However, before accepting this offer it is important for John to assess, based upon the financial results of the business, the anticipated price required for the acquisition to become acceptable to the board of Helpern Engineering Ltd. It is generally agreed that in an acquisition situation, one of the most used methods for valuing the target company, in this case HEL, is by using what is known as EBITDA[1] multiplier method (Lipman 2005, p.12). To achieve a business valuation using this method one firstly has to look at any adjustments that might not be a cost for the new owners, such as ownersà ¢Ã¢â€š ¬Ã¢â€ž ¢ dividends and remuneration. In addition, adjustment might be required if the business has long term debt (Lipman 2005, p.14). Once the net EBITDA has been calculated, the multiplier will need to be decided upon. Lipman (2005) suggests that the normal multiplier would be between 4 and 6 times. However, this can vary significantly depending upon the strategic value of the business to the future of the acquirer (McLaney 2006) and the target corporationà ¢Ã¢â€š ¬Ã¢â€ž ¢s position within their particular market. In the case of Helpern it is known that the business enjoys a 70% share of the UK market and 6% of the world market for the machines that it manufactures. Therefore, based upon the above considerations, and using the financial information as attached in appendix 1, it is suggested that the following calculations could be deemed appropriate for determining an acquisition price for the business. In reaching this valuation the following assumptions have been incorpor ated into the calculations: EBITDA That the acquiring corporation would not require to replace the directors That the current business pays 10% interest on HP debt, valuing the HP capital at ten times the interest payment. That it is assumed the acquirer will take over the HP debt. Therefore the EBITDA for Halpern Engineering can be calculated as follows: Item  £,000à ¢Ã¢â€š ¬Ã¢â€ž ¢s EBITDA (2008) 1,783 Add: Directors Remuneration 60 Revised EBITDA 1,843 MULTIPLIER Based upon the fact that the acquisition is a strategic move on the part of the acquirer and that Halpern Engineering Ltd has a dominant UK and market share and a significant world market presence, it is suggested that the multiplier to use in this case should be set at 6, thus producing a sale value of  £11.058 million. However this needs to be adjusted as follows to give the final net sale price. EBIDTA sale value £11.058 million Adjust for HP debt £ 1,900 million Net sale value £ 9.158 million Bibliography Berkery. D (2008). Raising Venture Capital for the Serious Entrepreneur, McGraw Hill, New York, US Business Link (2008). Loans and Overdrafts. Business Link. Available from: https://www.businesslink.gov.uk/bdotg/action/layer?topicId=1073868460r.lc=en (Accessed 31 October 2008). BVCA (2004) A Guide to Private Equity. BVCA, London, UK Lipman, F.D (2005). Valuing Your Business: Strategies to Maximise the Sale Price . John Wiley Sons Inc, New York, US. McLaney, E (2006). Business Finance: Theory and Practice. Pearson Education, Harlow, UK Pearce, R and Barnes, S (2006). Raising Venture Capital. John Wiley Sons, Chichester, UK. Reuvid, J (2002). The Corporate Finance Handbook. 3rd edition, Kogan Page, London, UK Reuvid, J (2007). Start up and run your own business. 7th edition Kogan Page, London, UK Watson, D and Head, Anthony (2007). Corporate Finance: Principles and Practice. Pearson Education, Harlow, UK Appendix 1 Halpern Engineering Ltd financials Figure 2 Halpern Ltd Actual and Forecasts  £,000à ¢Ã¢â€š ¬Ã¢â€ž ¢s 2007 2008 2009 2010 2011 Sales 10,000 12,000 14.000 16,000 16,000 EBITDA 1,383 1,783 2,183 2,583 2,583 Interest on HP 125 180 190 190 180 Other information Share ownership in Feb 2008 was: Charles Harpern (Dad) 25% Jane Halpern (Mum) 25% John Halpern 40% Tracey Smith (daughter) 5% Sharon Jones (daughter) 5% Charles, Jane and John are the three directors, with directors fees (each) of  £20,000 per year. Halpern Engineering Ltd Presentation Introduction Halpern Engineering Ltd (HEL) is a highly successful engineering corporation making special purpose polythene bag making machines. It has 70% of the UK market share and 6% of the global market share in this industry. However, the business has reached a crucial stage of development. To continue growth it required a  £4 million investment, which it could seek from a venture capitalist or through bank funding. Alternatively, the business could be sold or maintain current performance and risk losing market share or a sale of the business. This presentation discusses these options. 1 Venture Capitalist investment A venture capitalist ha s offered to advance the  £4 million in the form of a loan. However, this is subject to the following conditions Interest, payable half yearly in arrears, to be set at 10% Loan repayable in full in 2011 Alternative option for venture capitalist to purchase 50.1% of the company shares, these being newly issued shares, in 2011 in exchange for the capital repayment. It is also anticipated that the venture capitalist will impose covenants upon the business. These will include ensuring directorà ¢Ã¢â€š ¬Ã¢â€ž ¢s commitment to the business by restricting their ability to change employment contracts or the Memorandum of Articles. Similarly, a clause preventing the directors from setting up in competition or enticing customers and suppliers away from the business will be included in the agreement. Limitations are also likely to be imposed regarding the level of external borrowings the business can secure. Finally, there is a possibility that an à ¢Ã¢â€š ¬Ã…“underperformanceà ¢Ã¢â€š ¬Ã‚  clause might be included. This will give the VC the right to remove existing directors and appoint a new board should pre-agreed business targets not be achieved. 2011 option With regard to the 2011 option of shares or cash, this choice will be ultimately be decided by comparing the return on capital for the loan against the return on capital if in vested as equity in the business. Return on equity is calculated by dividing business annual profits by the shareholders equity. However, it should be noted that actual profits have underperformed forecasts but it is the actual profit results that need to be used in the calculations. Similarly, as the VC will only own 50.1% of the business, this means that the total shareholders funds will be  £7.984 million If we divide the 2011 profits of  £2.38 million by the share value of  £7.984 million, the return on capital equates to 29.81%. As this is considerably more than the 10% being returned on the loan, and the profit growth has been constant, it is suggested that the VC will opt for conversion of the loan to shares at the end of the agreement period. 2Bank funding Bank funding is the second alternative that is available for the business. This could be negotiated either in the format of an overdraft, loan, or a combination of the two. In essence, the dec ision will probably be based upon the level of capital expenditure required for the projects as overdrafts are usually chosen as a means of working capital. In either case there will be certain factors needed to be taken into account by the directors. Maximum Funding Level Banks are unlikely to offer the full funding requirements for a project of the type that Halpern Engineering is anticipating. It is normal for banks to seek an element of commitment from existing business owners before they consider a funding request. In this case it is anticipated that this commitment is likely to be around 25%. This means the bank would be advancing around  £3 million, leaving the owners to secure the remaining million from their own resources. Protective clauses However, these funds will not be granted without conditions. In terms of any overdraft facility provided this will automatically include a repayment on demand clause, which might be enforced in time of bank financi al crises such as is currently being experienced. In addition, the bank is likely to seek to take a charge over any capital item that the funds advanced are used to purchase. For example, it is used for property purchase they might require a legal mortgage over that asset. Furthermore, with private limited companies like Helpern Engineering Ltd, the banks will invariably ask for personal guarantees from the business owners, who are usually also the directors of the business. It is important to take legal advice about these personal guarantees as they effective put at risk all of the personal assets of the owners in the event of a business failure. 3Business sale John Helper, the CEO, has also considered the sale of the business as an alternative to seeking funds for further expansion purposes. If this option is pursued of course, there most important factor is to assess the value of the business and the price that might be achieved on the open market. There are a number of ways to calculate business value. Some, such as the à ¢Ã¢â€š ¬Ã…“rule of thumb,à ¢Ã¢â€š ¬Ã‚  method which simply uses a multiplier of gross revenue or a valuation based upon the net balance sheet assets. However, neither of these methods takes into account the current and future profitability of the business. It has therefore been decided to use the discounted cash flow method to arrive at an appropriate value for the business. This method works based on using projected profits, usually for a period that terminates after five years, for assessing the gross value of the business. This value is then discounted by a pre-determined percentage which has been calculated to take into account the level of risk that exists within the business. When applying this method the Helpern Engineering, because of the limitations in terms the amount of historical financial information available, as can be seen a number of assumptions have been used, such as working capital movement and d epreciation. However, it is considered that these assumptions have been based upon sound estimations. Nevertheless, the results of this calculation show that a realistic present value for the business if sold would be  £3.089 million. 4Business takeover In the event John Halpern decided against any of the options previously discussed and opted to continue to run the business as a going concern but with the knowledge that, without the funding this would curtail the rate of growth, although this would still be sufficient for the family needs. However, in March 2008, a supplier in a related industry approached John with a proposal to take over the business and asked what price Helpern would consider attractive for this event. From the target companyà ¢Ã¢â€š ¬Ã¢â€ž ¢s viewpoint there are several factors to take into account in a takeover price. The most important of these is the position of the business in its marketplace and the strategic purpose of the acquirer. In this case Helpern has significant market shares and the acquisition would give the acquirer an immediate competitive advantage in a new market sector. These factors will influence the value of the target company Halpern. The most used method of valuing a target corporation is the EBITDA multiplier method. The calculation start with the business EBITDA results and then makes adjustments for costs that might not be incurred by the new owners, for example the need to retain the directors as management processes will be merged. Once the adjusted EBITA has been worked out the decision about the multiplier needs to be addressed. In most cases this would be defined between a band of 4 to 6, although it can go a lot higher dependent upon the strategic advantage of the target business and other considerations for the acquirer. Although it could be argued that Halpern deserves to be valued higher, for this calculation of 6 has been used. This takes into account the fact that the business growth and market share has reduced in recent years. The result of this calculation indicates that the takeover price should be  £9.158 million 1 Footnotes [1] Earnings before interest, taxes, depreciation and amortisation