Harvesting

1. Harvesting Frank MoyesLeeds College of Business University of ColoradoBoulder, Colorado Harvesting

2. This Week’s Agenda • Harvest strategy • Visitor – Bob Gill • Hand in Feasibility Plan • FCQ’s Harvesting

3. 0 Harvesting • Definition: “Method for achieving terminal after-tax cash flows on investment.” Bygrave • You harvest because? • Investors require rate of return. For high growth ventures, won’t come from dividends. • Entrepreneur wants a new challenge • Become part of the problem • “I can’t stand it any more.” Harvesting

4. 0 Lifestyle Business • Perfect life style business • Independence, autonomy & control • Make sufficient income for your requirements • Good at it & enjoy • Quiet desperation • Don’t see an alternative • Marginal income • Not good at it, family destroyed, alcoholic Harvesting

5. 0 When Should Entrepreneur Step Aside? • Do you have the skills to continue? • When does it stop being exciting and fun? • Examples • John Walker of AutoDesk founder return to full time programming • Steve Jobs of Apple, replaced by John Scully of PepsiCo Harvesting

6. 0 You Are Ready When • Company generating steady earnings • Company is at a stage where it must make a transition • Your company has value, but is not liquid • Becoming cautious - represents your entire net worth • No longer working 80 hours per week (or the thought of continuing is daunting) • Founding team interests are changing • You are becoming bored • Your family is becoming restless Stolze: Start-up Harvesting

7. 0 Harvesting Alternatives • Increase the free cash flows • Management buy-out • Leveraged buy-out • Employees – ESOP’s • Sell entire business • Initial public offering Harvesting

8. 0 Increase Free Cash Flows • Cash cow • Pros • Not necessary to exit the business • Retain ownership • Don’t need to find buyer • Cons • Tax implications • Sustainable competitive advantage • Takes time Harvesting

9. 0 Management Buy-out (MBO)? • Pros • Management understands business & are motivated • Founder knows & trusts • Management likely to maintain culture & retain employees • Bankers understand & willing to fund equity and/or debt • Cons • Management must put up large amounts and/or • Founder willing to accept installment payments • High amount of debt affects cash flows • Risk of default Harvesting

10. 0 Leveraged Buy-out (LBO)? • Pros • Managers from large companies looking to become entrepreneurs • Bring experience and new perspective • Credibility with lenders • Cons • Founder doesn’t know new owners • May not maintain culture and retain employees • Final payment depends on earn-out (may be required in order to agree on valuation) Harvesting

11. 0 Employee Stock Ownership Plan (ESOP) I • Leveraged ESOP • ESOP borrows money from a lender to buy owner’s stock. Held in trust. • Company make tax-deductible contribution to trust to repay loan. • Company guarantees debt of ESOP Harvesting

12. ESOP II • Pros • Tax advantages • If ESOP owns > 30%, then owner can avoid capital gain tax by purchasing stocks or bonds of another US company • If ESOP owns> 50%, then lender is taxed on only 50% of income; therefore can offer lower interest rate. • Dividends are tax deductible, i.e. like interest • Employees own share of company • Suitable for companies in industries where acquisition is not likely, e.g. construction • Cons • Owner may not want employees to control company • Must disclose information such as exec salaries Harvesting

13. Sale of Entire Business • Company needs to finance growth • Company at a transitions stage • Founder wants • Diversify investment • Change for personal reasons • Another challenge Harvesting

14. Sale Issues I • Owners naiveté • Expectations towards value • Selling your soul • Founder negotiating deal • Deal structure • Valuation • Cash or shares - risk of holding shares • Lock-up period • Tax implications • Earn out Harvesting

15. Earn-Outs I • Final purchase price depends on how the company performs in the years subsequent to the purchase • Buyer: • Wants company to perform well • Doesn’t want to buy a cat in a bag • Management to be motivated to make a success • Seller: • Believes the business is worth more • Willing to take a risk to increase amount receives Harvesting

16. Earn-outs II • Inherent conflicts • Buyer wants to pay lowest price • Seller wants to receive highest price • Works when Buyer and Seller interests are aligned • Buyer can manipulate earnings to reduce final purchase price • Accounting policies • Inter-company transactions Harvesting

17. Sale Issues II • Can take a long time (up to 18 months) • Deal may fall through • Devastation • Impact on employees • Loss of momentum • What do I do now? • Continue in management? – become a manager, decision making, culture • Sail your boat Harvesting

18. Valuing the Company for Harvest • Multiple of • Earnings • Net Income • EBITDA • Cash flow • Revenues • Net Assets • Present Value of Free Cash Flows • Importance of intangibles Harvesting

19. 0 Intangibles • Inventory undervalued • Replacement value of assets is high • Company has been run to minimize income taxes FastTrac Harvesting

20. Carmel Art Gallery • 20 years in business, profitable • Established wealthy client and art buyer from all over world • 10 year lease in prime location with heavy traffic • Well trained sales people who understand the customers’ needs • Excusive rights to 6 famous local artists • Operating permit – moratorium on art gallery licenses Harvesting

21. How Find a Buyer? • Investors, Board of Directors • Accountants, bankers, attorneys • Investment banker – Lehman formula • Brokers - fee is based on sale price • Founder’s industry contacts • Be proactive – identify potential buyers early Harvesting

22. Preparing Your Company for Sale I • Window of opportunity • Record of growth and profitability • Luck • Strong management team & Board of Directors & Advisors • Clean ownership structure • Minority shareholders Harvesting

23. Preparing Your Company for Sale II • Avoid legal hassles • Ready for due diligence process • Audited financials by a top firm • Management controls & information systems • Representations and warranties • What tell employees? Harvesting

24. Consider Going Public 0 Company Has All the Power IPO Process Choose Underwriter Prepare Prospectus Investment Banker Gains Power Road Show Pricing Meeting Market & Investment Banker In Control Market Takes Over Consequence Teaching Notes, CML (B) & (C) Harvard College 1985

25. 0 Initial Public Offering Cons? • Not suitable for most companies: size, history, management • Timing is everything – hot issues • Difficult for founders to sell shares – lock up period • Cost is high: legal fees, underwriters Harvesting

26. IPO Cons II • Time required from management before, during, and after – 6 to 18 months • Roadshows • Underwriters, lawyers, accountants • Disillusionment • Price of shares may fall below offer price. Market “under values” • Shareholder suits • Disclosure requirements – Sorbaine • Pressure for short term profits Harvesting

27. 0 Initial Public Offering Pros? • Pressure for short term profits • Liquidity • Alternative to venture capital • Higher valuation • Flavor of the month Harvesting

28. IPO Pros II • Company more visible • Easier to hire employees • Credibility with bankers, suppliers, customers • Impact on competition, funding • More fun for top management, if going well • If decide to merge with a larger company, will get higher valuation Harvesting

29. Harvesting Conclusions • Should plan for harvesting? It may not happen. • Don’t take actions that preclude selling to the highest bidder, e.g. strategic alliances • A company with an exit strategy is easier to manage • Motivating force • Set high standards • Required actions help run the business Harvesting