Mergers Acquisitions and Other

Restructuring Activities 7th Edition

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 Chapter 10: Analysis and Valuation
of Privately Held Companies

Examination Questions and Answers

True/False Questions: Answer true or false to the following questions:

1. Both public and private firms always attempt to maximize earnings growth. True or False
Answer: False

2. Financial information for both public and private firms is equally reliable because their statements are
audited by outside accounting firms to ensure that are developed in a manner consistent with GAAP.
True or False
Answer: False

3. For privately held firms, firm specific risk may include lack of product, industry, and geographic
diversification; limited management depth, volatile stock markets, and unionized workforces.
True or False
Answer: False

4. Private firms are likely to understate revenue and understate costs in order to minimize their tax liabilities.
True or False
Answer: False

5. Revenue may be inflated by booking as revenue products shipped to resellers without adequately
adjusting for probable returns. True or False
Answer: True

6. If a buyer expects that the target firm’s revenue has been overstated, the buyer can reconstruct revenue by
examining usage levels of the key inputs required to produce the product or service. True or False
Answer: True

7. The purpose of adjusting the target’s income statement is to provide an accurate estimate of the
current year’s reported operating income or operating cash flow. True or False
Answer: True

8. Employee benefit levels in private firms are almost always mandated by state or federal law and
therefore cannot be changed. True or False
Answer: False

9. An increase in the target firm’s reserves for doubtful accounts increases taxable income, while a
decrease reduces the firm’s taxable income. True or False
Answer: False

10. It is easier to obtain the fair market value of private companies than for public companies because of the
absence of volatile stock markets. True or False
Answer: False

11. Methodologies employed to value private firms are substantially different from those employed to value
public firms. True or False
Answer: False

12. Asset valuation includes specific business risks but ignores any adjustment for liquidity risk. True or False
Answer: False
13. The risk associated with an illiquid market for a specific stock is referred to as the liquidity or marketability
risk. True or False
Answer: True

14. Shell corporations may have significant value to acquiring firms. True or False
Answer: True

15. Empirical evidence suggests that discounts have declined in recent years. True or False
Answer: True

16. Private businesses may need to be valued to settle shareholder disputes, court cases, divorce, or the
payment of gift or estate taxes. True or False
Answer: True

17. The availability and reliability of data for public companies tends to be much greater than for small
private firms. True or False
Answer: True

18. Managers and owners in public companies are likely to have the same emotional attachment to their
businesses as those in private firms. True or False
Answer: False

19. Because of data limitations, valuation of private firms often requires more subjective adjustments than for
public firms. True or False
Answer: True

20. Private firms must file quarterly earnings reports with the Securities and Exchange Commission.
True or False
Answer: False

21. Membership or subscription businesses, such as health clubs and magazine publishers, may inflate
revenue by booking the full value of muliyear contracts in the first year of the contract. True or False
Answer: True

22. If the buyer believes that the seller has overstated revenue in a specific accounting period, the buyer
can reconstruct revenue by examining usage levels, in the same accounting period, of the key inputs
required to produce the product or service. True or False
Answer: True

23. The primary purpose of the buyer adjusting the seller earnings is to provide an accurate estimate of the
current year’s operating income or cash flow in the base year. True or False
Answer: True

24. In adjusting base year income, an appraiser must be aware of the implications of various accounting
methods for value. During periods of inflation, businesses frequently use the last-in, first out method to
value inventories. This approach results a reduction in the cost of sales and an increase in gross profits
and taxable income. True or False
Answer: False

25. Before selling a business, an owner may increase advertising expenses in order to inflate profits.
True or False
Answer: False

26. Intangible assets such as customer lists, intellectual property, licenses, distributorships agreements, leases,
regulatory approvals, and employment contracts may offer significant sources of value. True or False

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 Answer: True

27. Fair value is by necessity more subjective than the concept of fair market value, because it represents the
dollar value of a business based upon an appraisal of the tangible and intangible assets of the business.
True or False
Answer: True

28. Valuation of privately held businesses may involve substantial adjustment of the discount or capitalization
rate. True or False
Answer: True

29. The term capitalization refers to the conversion of a future income stream into a present value, and it is a
term often used by business appraisers when future income or cash flows are not expected to grow or to
grow at a constant rate. True or False
Answer: True

30. Restricted stock is often issued to employees of privately held firms as a significant portion of their total
compensation. Such stock is similar to other types of common stock except that its sale on the open market
is prohibited for a period of time. True or False
Answer: True

31. A private corporation is a firm whose securities are not registered with state or federal authorities. True or
False
Answer: True

32. Privately owned businesses are often referred to as “closely held” since they are usually characterized by a
small group of shareholders controlling operating and managerial policies of the firm . True or False
Answer: True

33. Very few closely held businesses are family owned. True or False
Answer: False

34. All family owned businesses are small. True or False

Answer: False

35. In many family owned firms, family influence is exercised by family members holding senior management
positions, seats on the board of directors, and through holding super-voting stock (i.e., stock with multiple
voting rights). True or False
Answer: True

36. The M&A market for employer firms tends to be concentrated among smaller firms, as firms in the United
States with 99 or fewer employees account for 98% of all firms with employees. True or False
Answer: True

37. Family owned businesses account for about 89% of all businesses in the U.S. True or False
Answer: True

38. Firms that are family owned but not managed by family members are often well managed, as family
shareholders with large equity stakes carefully monitor those charged with managing the business. True or
False
Answer: True

39. Succession issues tend to be easier for small family owned firms than for large publicly traded firms. True
or False
Answer: False

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40. The market model of corporate governance is readily applicable to privately held, family owned firms.
True or False
Answer: False

41. In many countries, family owned firms have been successful because of their shared interests and because
investors place a higher value on short-term performance than on the long-term health of the business. True
or False
Answer: False

42. The control model of corporate governance may be more applicable where ownership tends to be highly
diverse and the right to control the business is separate from ownership. True or False
Answer: False

43. A family owned firm’s board faces the sometimes daunting challenge of achieving the proper balance
between monitoring and collaboration to minimize the emotionality and overlapping roles that often
characterize such firms. True or False
Answer: True

44. Because of the need to satisfy both the demands of stockholders and regulatory agencies, public companies
need to balance the desire to minimize taxes with the goal of achieving quarterly earnings levels consistent
with investor expectations. Failure to do so frequently results in an immediate loss in the firm’s market
value. True or False
Answer: True

45. Despite the lack of public exchanges for privately held firms, Wall Street analysts have ample incentive to
analyze such firms in search of emerging companies. True or False
Answer: False

46. Private companies are generally not subject to the same level of rigorous controls and reporting systems as
are public companies. True or False
Answer: True

47. Small firms may lack product, industry, and geographic diversification, which add to their specific business
risk. True or False
Answer: True

48. Owners of private businesses attempting to minimize taxes may overstate their contribution to the firm by
giving themselves or family members unusually low salaries, bonuses, and benefits. True or False
Answer: False

49. It is rare that the owner or a family member is either an investor in or an owner of a vendor supplying
products or services to the family owned firm. True or False
Answer: False

50. A sudden improvement in operating profits in the year in which the business is being offered for sale may
suggest that both revenue and expenses had been overstated during the historical period.
True or False
Answer: False

51. EBITDA has become an increasingly popular measure of value for privately held firms in recent years.
True or False
Answer: True

52. The fair value concept is applied when no strong market exists for a business or it is not possible to identify
the value of substantially similar firms. True or False
Answer: True

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53. If the cash flows of the firm are not expected to grow or are expected to grow at a constant rate indefinitely,
the discount rate used by practitioners often is referred to as the capitalization rate. True or False
Answer: True

54. If the discount rate is assumed to be 8% and the current cash flow is $1.5 million and is expected to remain
at that level in perpetuity, the implied valuation is $18.75 million. True or False
Answer: True

55. A control premium is the additional premium a buyer is willing to pay for the right to direct the activities of
a firm. True or False
Answer: True

56. An investor in a small company generally has little difficulty in selling their shares because of the high
demand for small businesses. True or False
Answer: False

57. It is generally easier to sell a minority interest than a majority interest in a business without loss of the
value of the original investment. True or False
Answer: False

58. Shell corporations rarely have any value. True or False

Answer: False

59. Private investment in public entities (PIPES) is a commonly used method of financing reverse mergers.
True or False
Answer: True

60. Shell corporations may be attractive for investors interested in capitalizing on the intangible value
associated with the existing corporate shell. This could include name recognition; licenses, patents, and
other forms of intellectual properties; and underutilized assets such as warehouse space and fully
depreciated equipment with some economic life remaining. True or False
Answer: True

61. Studies of restricted stock sales since 1990 indicate a median liquidity discount of about 20 percent with
several showing a decline to 13 percent after 1997 following the holding period change under Rule 144
from two years to one. True or False
Answer: True

62. There is widespread agreement over the magnitude of the liquidity discount. True or False
Answer: False

63. A minority discount is the reduction in the value of a minority investor’s investment because minority
owners have little influence in how the firm is managed. True or False
Answer: True

64. A pure control premium is the value the acquirer believes can be created by replacing the target firm’s
incompetent management, by changing the strategic direction of the target, by gaining a foothold in a
market not currently served, or by achieving unrelated diversification. True or False
Answer: True

65. Studies show that control premiums vary widely across countries reflecting the efficacy of shareholder
rights laws and how well such laws are enforced in each country. True or False
Answer: True

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66. Increasing market liquidity will reduce the value of control; an increasing value of control will reduce
market liquidity and contribute to increasing liquidity discounts. True or False
Answer: True

Multiple Choice Questions: Circle only one alternative.

1. Which of the following are often true about the challenges of valuing private firms?
a. There is a lack of analyses generated by sources outside of the company.
b. Financial reporting systems are often inadequate.
c. Management depth and experience is often limited.
d. Reported earnings are often understated to minimize taxes.
e. All of the above.
Answer: E

2. In valuing private businesses, the U.S. tax courts have historically supported the use of which valuation
method for purposes of estate valuation?
a. Discounted cash flow
b. Comparable company method
c. Tangible book value method
d. A combination of a and c
e. All of the above
Answer: B

3. All of the following are true of reverse mergers except for.

a. May be used to take a private firm public
b. May represent an effective alternative to an IPO
c. Commonly use private equity placements for financing
d. Requires 2 years of audited financial statements to take a private firm public
e. A and B
Answer: D

4. Which of the following is not true of liquidity or marketability risk or discount?

a. It is measurable.
b. It is believed to have declined in recent years
c. The magnitude of the discount or risk is inversely related to the size of the investor’s equity
ownership in the business.
d. The magnitude of the discount or risk is directly related to the size of the investor’s equity
ownership in the business.
e. It is important to adjust the discount rate for liquidity risk.
Answer: D

5. Corporate shells have value because they enable the buyer to

a. Avoid the cost of going public
b. Exploit intangible value such as brand name
c. A and D only
d. Provide limited liability
e. A, B, and D only
Answer: E

6. Leveraged employee stock ownership plans are frequently used by owners of private businesses to
a. Hide assets
b. Motivate employees
c. Sell the firm to the employees
d. B and C
e. A, B, and C
Answer: D

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7. All of the following are often true of privately held firms except for
a. Financial data is often inaccurate and out of date
b. Internal controls are ineffective
c. Have limited access to capital markets and product distribution channels
d. Are more easily valued than public companies
e. Have limited ability to influence customers, suppliers, unions, and regulators
Answer: D

8. Fair market value is

a. The cash or cash equivalent value that a willing buyer would pay or seller would accept for a
business
b. The cash or cash equivalent value that a willing buyer would pay or seller would accept for a
business, assuming each had access to all necessary information
c. The cash or cash equivalent value that a willing buyer would pay or seller would accept for a
business, assuming each had access to all necessary information and that neither party is under
duress.
d. The discounted value of free cash flow to the firm
e. The discounted value of free cash flow to equity investors.
Answer: C

9. The discount rate may be estimated using all but the one of the following:
a. The capital asset pricing model
b. The share exchange ratio
c. The cost of capital
d. Return on total assets
e. Price-to-earnings ratio
Answer: B

10. All of the following represent common sources of value in appraising private or publicly owned businesses
except for
a. Intellectual property
b. Customer lists
c. Licenses
d. Contingent liabilities
e. Employment contracts
Answer: D

11. Revenue Ruling 59-60 describes the general factors that the IRS and tax courts consider relevant in valuing
private businesses. Of the following valuation methods, which do the IRS and tax courts view as the most
important?
a. Discounted cash flow
b. Comparable company methods
c. Tangible book value
d. Replacement cost method
e. All of the above
Answer: B

12. The most important element(s) in selecting a business valuation professional include which of the
following: (Select only one)
a. Overall experience
b. Demonstrated ability in the industry in which the firm to valued competes
c. Degree of specialization
d. Number of professional degrees
e. A and B only
Answer: E

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13. A business owner may overstate revenue by
a. Failing to deduct from revenue products returned by customers
b. Billing customers for products not ordered
c. Booking the entire value of a multiyear contract in the current year
d. Counting interest income as revenue
e. All of the above
Answer: E

14. A business owner may overstate revenue and understate actual expenses when
a. The business is about to be sold
b. They are being audited by the IRS
c. They are trying to minimize tax liabilities
d. All of the above
e. None of the above
Answer: A

15. A corporate shell may have value because

a. It may enable the owner to avoid the costs of going public
b. The name is widely recognized
c. It could own the rights to various forms of intellectual property
d. All of the above
e. None of the above
Answer: D

Short Case Study Essay Questions:

Panda Ethanol Goes Public in a Shell Corporation

In early 2007, Panda Ethanol, owner of ethanol plants in west Texas, decided to explore the possibility of taking its
ethanol production business public to take advantage of the high valuations placed on ethanol-related companies in
the public market at that time. The firm was confronted with the choice of taking the company public through an
initial public offering or by combining with a publicly traded shell corporation through a reverse merger.

After enlisting the services of a local investment banker, Grove Street Investors, Panda chose to "go public"
through a reverse merger. This process entailed finding a shell corporation with relatively few shareholders who
were interested in selling their stock. The investment banker identified Cirracor Inc. as a potential merger partner.
Cirracor was formed on October 12, 2001, to provide website development services and was traded on the over-the-
counter bulletin board market (i.e., a market for very low-priced stocks). The website business was not profitable,
and the company had only ten shareholders. As of June 30, 2006, Cirracor listed $4,856 in assets and a negative
shareholders' equity of $(259,976). Given the poor financial condition of Cirracor, the firm's shareholders were
interested in either selling their shares for cash or owning even a relatively small portion of a financially viable
company to recover their initial investments in Cirracor. Acting on behalf of Panda, Grove Street formed a limited
liability company, called Grove Panda, and purchased 2.73 million Cirracor common shares, or 78 percent of the
company, for about $475,000.

The merger proposal provided for one share of Cirracor common stock to be exchanged for each share of Panda
Ethanol common outstanding stock and for Cirracor shareholders to own 4 percent of the newly issued and
outstanding common stock of the surviving company. Panda Ethanol shareholders would own the remaining 96
percent. At the end of 2005, Panda had 13.8 million shares outstanding. On June 7, 2007, the merger agreement was
amended to permit Panda Ethanol to issue 15 million new shares through a private placement to raise $90 million.
This brought the total Panda shares outstanding to 28.8 million. Cirracor common shares outstanding at that time
totaled 3.5 million. However, to achieve the agreed-on ownership distribution, the number of Cirracor shares
outstanding had to be reduced. This would be accomplished by an approximate three-for-one reverse stock split
immediately prior to the completion of the reverse merger (i.e., each Cirracor common share would be converted
into 0.340885 shares of Cirracor common stock). As a consequence of the merger, the previous shareholders of

8
Panda Ethanol were issued 28.8 million new shares of Cirracor common stock. The combined firm now has 30
million shares outstanding, with the Cirracor shareholders owning 1.2 million shares. The following table illustrates
the effect of the reverse stock split.

Effects of Reverse Stock Split

Shares Ownership Shares Ownership
Outstanding* Distribution (%) Outstanding*) Distribution (%)
Before Reverse Split After Reverse Split
Panda Ethanol 28.8 89.2 28.8 96
Cirracor Inc. 3.5 10.8 1.2 4
* In millions of dollars.

A special Cirracor shareholders' meeting was required by Nevada law (i.e., the state in which Cirracor was
incorporated) in view of the substantial number of new shares that were to be issued as a result of the merger. The
proxy statement filed with the Securities and Exchange Commission and distributed to Cirracor shareholders
indicated that Grove Panda, a 78 percent owner of Cirracor common stock, had already indicated that it would vote
its shares for the merger and the reverse stock split. Since Cirracor's articles of incorporation required only a simple
majority to approve such matters, it was evident to all that approval was imminent.

On November 7, 2007, Panda completed its merger with Cirracor Inc. As a result of the merger, all shares of
Panda Ethanol common stock (other than Panda Ethanol shareholders who had executed their dissenters' rights
under Delaware law) would cease to have any rights as a shareholder except the right to receive one share of
Cirracor common stock per share of Panda Ethanol common. Panda Ethanol shareholders choosing to exercise their
right to dissent would receive a cash payment for the fair value of their stock on the day immediately before closing.
Cirracor shareholders had similar dissenting rights under Nevada law. While Cirracor is the surviving corporation,
Panda is viewed for accounting purposes as the acquirer. Accordingly, the financial statements shown for the
surviving corporation are those of Panda Ethanol.
Discussion Questions:

1. Who were Panda Ethanol, Grove Street Investors, Grove Panda, and Cirracor? What were their roles in the
case study? Be specific.

Answer: Panda Ethanol owned ethanol manufacturing plants in West Texas and was interested in going
public either through a reverse merger or IPO. Grove Street Investors was the investment bank hired by
Panda Ethanol to evaluate their options and to locate a suitable public shell corporation if the decision was
made to go public via a reverse merger. Acting on behalf of Panda Ethanol, Grove Street Investors formed
Grove Panda LLC to serve as a “front” for Panda Ethanol in approaching Cirracor. By making Panda
Ethanol less visible to the Cirracor shareholders, Grove Street reasoned that they might be able to buy
Cirracor shares at a lower price than if the shareholders realized the profit potential of the Panda Ethanol
strategy. As a publicly-traded shell corporation whose shareholders appeared interested in “cashing out,”
Cirracor was to be the surviving entity of the reverse merger. By merging Panda Ethanol into Cirracor, with
Cirracor surviving, Panda Ethanol would become a public corporation.

2. Discuss the pros and cons of a reverse merger versus an initial public offering for taking a
company public.

Answer: Many small businesses fail each year. In a number of cases, all that remains is a business with no
significant assets or operations. Such companies are referred to as shell corporations. Shell corporations
can be used as part of a deliberate business strategy in which a corporate legal structure is formed in
anticipation of future financing, a merger, joint venture, spin-off, or some other infusion of operating
assets. This may be accomplished in a transaction called a reverse merger in which the acquirer forms a
new shell subsidiary, which is merged into the target in a statutory merger. The target is the surviving entity
which must hold the assets and liabilities of both the target and shell subsidiary.

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 Merging with an existing corporate shell of a publicly traded company may be a reasonable alternative for a
firm wanting to go public that is unable to provide the 2 years of audited financial statements required by
the SEC or unwilling to incur the costs of going public. Thus, merging with a shell corporation may
represent an effective alternative to an IPO for a small firm.

Direct issuance costs associated with going public include the underwriter spread and administrative and
regulatory costs. The underwriter spread represents the difference between the price the underwriter
receives for selling a firm’s securities to the public and the amount it pays to the firm. The underwriter
spread can range from less than 1% of gross proceeds for a high-quality company to more than 8% for
lower quality companies. Administrative and regulatory fees consist of legal and accounting fees, taxes,
and the cost of SEC registration. For offerings less than $10 million in size, total direct issuance costs may
exceed 10% of gross proceeds. For equity issues between $20 million and $50 million in size, these costs
average less than 5% of gross proceeds and less than 3% for those issues larger than $200 million (Hansen:
1986). Reverse mergers typically cost between $50,000-$100,000, about one-quarter of the expense of an
IPO and can be completed in about 60 days or one-third of the time to complete a typical IPO (Sweeney:
2005).

Despite these advantages, reverse takeovers may take as long as IPOs and are sometimes more complex.
The acquiring company must still perform due diligence on the target and communicate information on the
shell corporation to the exchange on which its stock will be traded and prepare a prospectus. Public
exchanges often require the same level of information for companies going through reverse mergers as
those undertaking IPOs. The principal concern is that the shell company may contain unseen liabilities such
as unpaid bills which in some instances can make the reverse merger far more costly than an IPO.

3. Why did Panda Ethanol undertake a private equity placement totaling $90 million shortly before
implementing the reverse merger?

Answer: Private investment in public entities (PIPES) is a commonly used method of financing reverse
mergers. In such transactions, a public company sells equity at a discount to private investors, often hedge
funds. As the issuer, it is up to the company to register its shares with the SEC within 120 days. Once
approved by the SEC, the stock may be traded on public exchanges. PIPES often are used in conjunction
with a reverse merger to provide companies with not just an alternative way to go public but also with
financing once they are listed on the public exchange. For example, assume a private company creates a
shell corporation which is subsequently merged into a public company through a reverse merger. As the
surviving entity, the public company raises funds through a privately placed equity issue (i.e., PIPE
financing) to fund future investments.

PIPES offer the advantage of being able to be completed more quickly, cheaply and confidentially than a
public stock offering, which requires registration up front and a more elaborate investor “road show” to sell
the securities to public investors. As private placements, PIPEs are most suitable for raising small amounts
of financing, typically in the $5 to 10 million range. Firms seeking hundreds of millions of dollars are
more likely to be successful in going directly to the public financial markets in a public stock offering.

4. Why do you believe Panda did not directly approach Cirraco ? How were the Panda Grove investment
holdings used to influence the outcome of the proposed merger?

Answer: Note that Panda could have approached Ciracco directly. However, this may have alerted the
Ciracco shareholders to the Panda’s intentions and could have encouraged them to hold out for a higher
purchase price for their stock. As an agent for Panda, Grove was able to buy the stock less expensively
since Ciracco’s shareholders, desperate to recover a portion of their original investment, would have
welcomed almost any alternative to bankruptcy.

Nevada, the state in which Cirracor was incorporate, state law requires that given the significant number of
new share issued a shareholders vote was required to approve the new issue. Approval required a simple
majority vote. Since Panda Grove let other shareholders know that it owned 78% and that in proxy

10
 materials indicated that it would vote for the merger and reverse split, it was evident to all shareholders that
approval was imminent.

Note: Total Panda shares outstanding (including 15 million newly issued shares in the private placement) equaled
28.8 million shares. As a result of negotiations, Panda shareholders would own 96% of the merged firms and
Cirracor shareholders 4%. This implied that total shares outstanding of the merged firms could not exceed 30
million shares (i.e., 28.8/.96). Consequently, Cirracor shareholders would own 1.2 million shares (i.e., 30 – 28.8).
Since Cirracor shares outstanding totaled 3.5 million before the merger, a reverse split was implemented
coincidental to the reverse merger using a ratio of .340885 shares of Cirracor stock for each share of Panda stock
(i.e., .340885 x 3.5 = 1.19). Note the 1.2 reflects rounding error due to rounding the number of shares outstanding
for both firms.

Cantel Medical Acquires Crosstex International

On August 3, 2005, Cantel Medical Corporation (Cantel), as part of its strategic plan to expand its infection
prevention and control business, announced that it had completed the acquisition of Crosstex International
Incorporated (Crosstex). Cantel is a leading provider of infection prevention and control products. Crosstex is a
privately owned manufacturer and reseller of single-use infection control products used primarily in the dental
market.
As a consequence of the transaction, Crosstex became a wholly owned subsidiary of Cantel, a publicly traded
firm. For the fiscal year ended April 30, 2005, Crosstex reported revenues of approximately $47.4 million and pretax
income of $6.3 million. The purchase price, which is subject to adjustment for the net asset value at July 31, 2005,
was $74.2 million, comprising $67.4 million in cash and 384,821 shares of Cantel stock (valued at $6.8 million).
Furthermore, Crosstex shareholders could earn another $12 million payable over three years based on future
operating income. Each of the three principal executives of Crosstex entered into a three-year employment
agreement.
James P. Reilly, president and CEO of Cantel, stated, "We continue to pursue our strategy of acquiring branded
niche leaders and expanding in the burgeoning area of infection prevention and control. Crosstex has a reputation for
quality branded products and seasoned management." Richard Allen Orofino, Crosstex's president, noted, "We have
built Crosstex over the past 50 years as a family business and we continue growing with our proven formula for
success. However, with so many opportunities in our sights, we believe Cantel is the perfect partner to aid us in
accelerating our growth plans."
Discussion Questions and Answers:

1. What were the primary reasons Cantel wants to acquire Crosstex? Be specific.

Answer: Crosstex fits Cantel’s strategy as a leading provider of healthcare products in niche markets
such as the dental care infection prevention market. Crosstex’s 13.3% pre-tax margin, strong brand
recognition, and experienced management were also significant sources of value.

2. What do you believe could have been the primary factors causing Crosstex to accept Cantel’s offer?

Answer: Crosstex’s president noted the firm was confronted with a host of opportunities. The firm
could have believed that it did not have the capital to fund such growth opportunities. Furthermore, the
3-year employment contracts meant that the senior managements could continue with the firm, as a
wholly owned subsidiary of Cantel’s implying that Cantel may have intended to let Cantel operate
largely as an independent entity. The stockholders also had the opportunity to reap and additional $12
million if they were able to achieve certain operating income targets.

3. What factors might cause Crosstex’s net asset value to change between signing and closing of the
agreement of purchase and sale?

Answer: During the period between signing and closing various components of net asset value could
change. These most often include items such as receivables, inventory and short-term obligations. The

11
 purchase price would be revised up or down following a post-closing audit to reflect increase or
decrease in net asset value.

4. Speculate why Cantel may have chosen to operate Crosstex as a wholly-owned subsidiary following
closing. Be specific

Answer: Cantel may have chosen to operate Crosstex in this manner to preserve the firm’s culture and
(or) to allow the firm to operate without interference during the period of the earn-out.

5. The purchase price consisted of cash, stock, and an earnout. What are some of the factors that might
have determined the purchase price from the seller’s perspective? From the buyer’s perspective?

Answer: The buyer may have been unwilling to meet the seller’s price expectation and thought it could
do so by adding an earn-out option and by offering stock to allow the sellers to participate in any future
appreciation of the Cantel stock. Moreover, the sellers may have needed some cash to pay tax
liabilities resulting from the sale of their stock. The seller in accepting a portion of the purchase price
in stock may also have been interested in deferring taxes on a portion of their compensation as well as
participating in any future appreciation of the shares of the combined companies.
.
Deb Ltd. Seeks an Exit Strategy
In late 2004, Barclay's Private Equity acquired slightly more than one half the equity in Deb Ltd. (Deb), valued at
about $250 million. The private equity arm of Britain's Barclay's bank outbid other suitors in an auction to acquire a
controlling interest in the firm. PriceWaterhouseCooper had been hired by the Williamson family, the primary
stockholder in the firm, to find a buyer.
The sale solved a dilemma for Nick Williamson, the firm's CEO and son of the founder, who had invented the
firm's flagship product, Swarfega. The company had been founded some 60 years earlier based on a single product,
a car cleaning agent. Since then, the Swarfega brand name had grown into a widely known brand associated with a
broad array of cleaning products.
In 1990, the elder Williamson wanted to retire and his son Nick, along with business partner Roy Tillead, bought
the business from his father. Since then, the business has continued to grow, and product development has
accelerated. The company developed special Swarfega-dispensing cartridges that have applications in hospitals,
clinics, and other medical faculties.
After 13 years of sustained growth, Williamson realized that some difficult decisions had to be made. He knew
he did not have a natural successor to take over the company. He no longer believed the firm could be managed
successfully by the same management team. It was now time to think seriously about succession planning. So in
early 2004, he began to seek a buyer for the business. He preferably wanted somebody who could bring in new
talents, ideas, and up-to-date management techniques to continue the firm's growth.
The terms of the agreement called for Williamson to work with a new senior management team until Barclays
decided to take the firm public. This was expected some time during the five-to-seven year period following the
sale. At that point, Williamson would sell the remainder of his family's stock in the business (Goodman, 2005).

Discussion Questions

1. Succession planning issues are often a reason for family-owned businesses to sell. Why do you believe it may
have been easier for Nick than his father to sell the business to a non-family member?

Answer: Nick did not have the same emotional attachment that his father, as the firm’s founder, did. Such
situations are commonplace. For example, the heirs of Anheuser Busch were willing to sell at the “right
price” to ImBev in 2008.

2. What other alternatives could Nick have pursued? Discuss the advantages and disadvantages of each.

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 Answer: Nick could have tried to partner with another firm with the intent of passing on control of the firm
to the partner at some point in the future. The primary advantage is that it gives both parties the opportunity
to assess the viability of the relationship; however, it has the disadvantage of deferring the decision for
Nick to exit the firm.

3. What do you believe might be some of the unique challenges in valuing a family-owned business? Be specific.

Answer: The challenges of valuing a family owned business include the absence of audited financial
statements, a tendency for such firms to be operated for reasons other than for profit, the dependency of the
firm on a few customers, lack of leverage with suppliers and customers, and the lack of documentation of
trade secrets and key protocols.

GHS Helps Itself by Avoiding an IPO

In 1999, GHS, Inc., a little known supplier of medical devices, engineered a reverse merger to avoid the time-
consuming, disclosure-intensive, and costly process of an initial public offering to launch its new internet-based self-
help website. GHS spun off its medical operations as a separate company to its shareholders. The remaining shell is
being used to launch a ‘‘self-help’’ Website, with self-help guru Anthony Robbins as its CEO. The shell corporation
will be financed by $3 million it had on hand as GHS and will receive another $15 million from a private placement.
With the inclusion of Anthony Robbins as the first among many brand names in the self-help industry that it hopes
to feature on its site, its stock soared from $.75 per share to more than $12 between May and August 1999. Robbins,
who did not invest anything in the venture, has stock in the new company valued at $276 million. His contribution to
the company is the exclusive online rights to his name, which it will use to develop Internet self-help seminars, chat
rooms, and e-commerce sites.

Discussion Questions:

1. What are the advantages of employing a reverse merger strategy in this instance?

Answer: Reverse mergers may provide a faster and less expensive way of taking a firm public than an
initial public offering.

2. Why was the shell corporation financed through a private placement?

Answer: The private placement is often faster and cheaper than raising funds in the public debt markets
which require registration with the SEC and may have significant issuance (flotation) costs associated with
raising the funds.

Valuing a Privately Held Company

Background

BigCo is interested in acquiring PrivCo, whose owner desires to retire. The firm is 100% owned by the current
owner. PrivCo has revenues of $10 million and an EBIT of $2 million in the preceding year. The market value of the
firm’s debt is $5 million; the book value of equity is $4 million. For publicly traded firms in the same industry, the
average debt-to-equity ratio is .4 (based on the market value of debt and equity), and the marginal tax rate is 40%.
Typically, the ratio of the market value of equity to book value for these firms is 2. The average  of publicly traded
firms that are in the same business is 2.00. Capital expenditures and depreciation amounted to $0.3 million and $0.2
million in the prior year. Both items are expected to grow at the same rate as revenues for the next 5 years. Capital
expenditures and depreciation are expected to be equal beyond 5 years (i.e., capital spending will be internally
funded). As a result of excellent working capital management practices, the change in working capital is expected to
be essentially zero throughout the forecast period and beyond. The revenues of this firm are expected to grow 15%
annually for the next 5 years and 5% per year thereafter. Net income is expected to increase 15% a year for the next

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5 years and 5% thereafter. The 10-year U.S. Treasury bond rate is 6%. The pretax cost of debt for a nonrated firm is
10%. No adjustment is made in the calculation of the cost of equity for a marketability discount. Estimate the
shareholder value of the firm.

Note: To estimate the WACC for a leveraged private firm, it is necessary to calculate the firm’s leveraged . This
requires an estimate of the firm’s unleveraged  which can be obtained by estimating the unleveraged  for similar
firms in the same industry. In addition, the value of debt and equity in calculating the cost of capital should be
expressed as market rather than book values.

Calculating COE and WACC:

1. Unlevered Beta for publicly traded firms in the same industry = 2.00 / (1 + .6 x .4) = 1.61, where 2.00 is the
levered beta, .6 is (1-tax rate), and .4 is the average debt ratio for firms in this industry.

2. Debt/Equity ratio for the private firm = 5 / (2 x 4) = .625 where 5, 4, and 2 are the private firm’s debt, book
value of equity, and the ratio of market value to book value for similar firms.

3. Levered beta for the private firm = 1.61 x (1 + .6 x .625) = 2.21

4. Cost of equity for the private firm = 6 + 2.21 x 5.5 = 18.16

5. After-tax cost of debt = .10 x (1 - .4) = 6.0

6. WACC for the private firm = 18.16 x 2x4 + 6.00 x 5__

2x4+5 2x4+5
= 18.16 x. 615 + 6.00 x. 385
= 13.48

Valuing the business using the FCFF model:

Year 1 2 3 4 5 6

EBIT (EBIT grows at 15% for the first $2.30 $2.65 $3.04 $3.50 $4.02 $4.22
five years and 5% thereafter.)
EBIT (1-Tax Rate) $1.38 $1.59 $1.82 $2.10 $2.41 $2.53
Less
(Cap. Expenditures-Depreciation) grows $.115 $.132 $.152 $.175 $.201 $0.00
at same 15% annual rate as revenue
for 5 years and are offsetting
thereafter)
Equals
Free Cash Flow to the Firm $1.26 $1.46 $1.67 $1.93 $2.21 $2.53

Terminal value = $2.53 / (.1348 - .05) = $29.83

Present Value of FCFF = $1.26 + $1.46 + $1.67 + $1.93 + $2.21 + $29.83

1.1348 1.13482 1.13483 1.13484 1.13485 1.13485
= $1.11 + $1.13 + $1.14 + $1.16 + $1.17 + $15.85
= $21.56

Value of Equity = $21.56 (MV of the firm) - $5 (MV of debt) = $16.56

Pacific Wardrobe Acquires Surferdude Apparel

by a Skillful Structuring of the Acquisition Plan

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Pacific Wardrobe (Pacific) is a privately owned California corporation that has annual sales of $20 million and
pretax profits of $2 million. Its target market is the surfwear/sportswear segment of the apparel industry. The
surfwear/sportswear market consists of two segments: cutting-edge and casual brands. The first segment includes
high-margin apparel sold at higher-end retail establishments. The second segment consists of brands that sell for
lower prices at retail stores such as Sears, Target, and J.C. Penney. Pacific operates primarily as a U.S.
importer/distributor of mainly casual sportswear for young men and boys between 10–21 years of age. Pacific’s
strategic business objectives are to triple sales and pretax profits during the next 5 years. Pacific intends to achieve
these objectives by moving away from the casual sportswear market segment and more into the high-growth, high-
profit cutting-edge surfer segment. Because of the rapid rate at which trends change in the apparel industry, Pacific’s
management believes that it can take advantage of current trends only through a well-conceived acquisition strategy.

Pacific’s Operations and Competitive Environment

Pacific imports all of its apparel from factories in Hong Kong, Taiwan, Nepal, and Indonesia. Its customers consist
of major chains and specialty stores. Most customers are lower-end retail stores. Customers include J.C. Penney,
Sears, Stein Mart, Kids “R” Us, and Target. No one customer accounts for more than 20% of Pacific’s total revenue.
The customers in the lower-end market are extremely cost sensitive. Customers consist of those in the 10–21 years
of age range who want to wear cutting-edge surf and sport styles but who are not willing or able to pay high prices.
Pacific offers an alternative to the expensive cutting-edge styles.

Pacific has found a niche in the young men’s and teenage boy’s sportswear market. The firm offers similar styles
as the top brand names in the surf and sport industry, such as Mossimo, Red Sand, Stussy, Quick Silver, and Gotcha,
but at a lower price point. Pacific indirectly competes with these top brand names by attempting to appeal to the
same customer base. There are few companies that compete with Pacific at their level—low-cost production of
‘‘almost’’ cutting-edge styles.

Pacific’s Strengths and Weaknesses

Pacific’s core strengths lie in their strong vendor support in terms of quantity, quality, service, delivery, and
price/cost. Pacific’s production is also scaleable and has the potential to produce at high volumes to meet peak
demand periods. Additionally, Pacific also has strong financial support from local banks and a strong management
team, with an excellent track record in successfully acquiring and integrating small acquisitions. Pacific also has a
good reputation for high-quality products and customer service and on-time delivery. Finally, Pacific has a low cost
of goods sold when compared with the competition. Pacific’s major weakness is that it does not possess any cutting-
edge/trendy labels. Furthermore, their management team lacks the ability to develop trendy brands.

Acquisition Plan

Pacific’s management objectives are to grow sales, improve profit margins, and increase its brand life cycle by
acquiring a cutting-edge surfwear retailer with a trendy brand image. Pacific intends to improve its operating
margins by increasing its sales of trendy clothes under the newly acquired brand name, while obtaining these clothes
from its own low-cost production sources.

Pacific would prefer to use its stock to complete an acquisition, because it is currently short of cash and wishes to
use its borrowing capacity to fund future working capital requirements. Pacific’s target debt-to-equity ratio is 3 to 1.
The firm desires a friendly takeover of an existing surfwear company to facilitate integration and avoid a potential
‘‘bidding war.’’ The target will be evaluated on the basis of profitability, target markets, distribution channels,
geographic markets, existing inventory, market brand recognition, price range, and overall ‘‘fit’’ with Pacific.
Pacific will locate this surfwear company by analyzing the surfwear industry; reviewing industry literature; and
making discrete inquiries relative to the availability of various firms to board members, law firms, and accounting
firms. Pacific would prefer an asset purchase because of the potentially favorable impact on cash flow and because it
is concerned about unknown liabilities that might be assumed if it acquired the stock.

Pacific’s screening criteria for identifying potential acquisition candidates include the following:
1. Industry: Garment industry targeting young men, teens, and boys
2. Product: Cutting-edge, trendy surfwear product line

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3. Size: Revenue ranging from $5 million to $10 million
4. Profit: Minimum of break-even on operating earnings for fiscal year 1999
5. Management: Company with management expertise in brand and image building
6. Leverage: Maximum debt-to-equity ratio of 3 to 1

After a review of 14 companies, Pacific’s management determined that SurferDude best satisfied their criteria.
SurferDude is a widely recognized brand in the surfer sports apparel line; it is marginally profitable, with sales of $7
million and a debt-to-equity ratio of 3 to 1. SurferDude’s current lackluster profitability reflects a significant
advertising campaign undertaken during the last several years. Based on financial information provided by
SurferDude, industry averages, and comparable companies, the estimated purchase price ranges from $1.5 million to
$15 million. The maximum price reflects the full impact of anticipated synergy. The price range was estimated using
several valuation methods.

Valuation

On a standalone basis, sales for both Pacific and SurferDude are projected to increase at a compound annual average
rate of 20% during the next 5 years. SurferDude’s sales growth assumes that its advertising expenditures in 1998 and
1999 have created a significant brand image, thus increasing future sales and gross profit margins. Pacific’s sales
growth rate reflects the recent licensing of several new apparel product lines. Consolidated sales of the combined
companies are expected to grow at an annual growth rate of 25% as a result of the sales and distribution synergies
created between the two companies.

The discount factor was derived using different methods, such as the buildup method or the CAPM. Because this
was a private company, the buildup method was utilized and then supported by the CAPM. At 12%, the specific
business risk premium is assumed to be somewhat higher than the 9% historical average difference between the
return on small stocks and the risk-free return as a result of the capricious nature of the highly style-conscious
surfware industry. The marketability discount is assumed to be a relatively modest, 20% because Pacific is acquiring
a controlling interest in SurferDude. After growing at a compound annual average growth rate of 25% during the
next 5 years, the sustainable long-term growth rate in SurferDude’s standalone revenue is assumed to be 8%.

The buildup calculation included the following factors:

Risk-Free Rate: 6.00%
Market Risk Premium to Invest in Stocks: 5.50%
Specific Business Risk Premium: 12.00%
Marketability Risk Premium: 20.00%
Discount Rate 43.50%
Less: Long-Term Growth Rate 8.00%
Capitalization Rate 35.50%

The CAPM method supported the buildup method. One comparable company, Apparel Tech, had a ß estimated
by Yahoo.Marketguide.com to be 4.74, which results in a k e of 32.07 for this comparable company. The weighted
average cost of capital using a target debt-to-equity ratio of 3 to 1 for the combined companies is estimated to be
26%.

The standalone values of SurferDude and Pacific assume that fixed expenses will decrease as a percentage of
sales as a result of economies of scale. Pacific will outsource production through its parent’s overseas facilities, thus
significantly reducing the cost of goods sold. SurferDude’s administrative expenses are expected to decrease from
25% of sales to 18% because only senior managers and the design staff will be retained. The sustainable growth rate
for the terminal period for both the standalone and the consolidated models is a relatively modest 6%. Pacific
believes this growth rate is reasonable considering the growth potential throughout the world. Although Pacific and
SurferDude’s current market concentration resides largely in the United States, it is forecasted that the combined
companies will develop a global presence, with a particular emphasis in developing markets. The value of the
combined companies including synergies equals $15 million.

Developing an Initial Offer Price

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 Using price-to-cash flow multiples to develop an initial offer price, the target was valued on a standalone
basis and a multiple of 4.51 for a comparable publicly held company called Stage II Apparel Corp. The standalone
valuation, excluding synergies, of SurferDude ranges from $621,000 to $2,263,000.

Negotiating Strategy

Pacific expects to initially offer $2.25 million and close at $3.0 million. Pacific’s management believes that
SurferDude can be purchased at a modest price when compared with anticipated synergy, because an all-stock
transaction would give SurferDude’s management ownership of between 25% and 30% of the combined companies.

Integration

A transition team consisting of two Pacific and two SurferDude managers will be given full responsibility for
consolidating the businesses following closing. A senior Pacific manager will direct the integration team. Once an
agreement of purchase and sale has been signed, the team’s initial responsibilities will be to first contact and inform
employees and customers of SurferDude that operations will continue as normal until the close of the transaction. As
an inducement to remain through closing, Pacific intends to offer severance packages for those SurferDude
employees who will be terminated following the consolidation of the two businesses.

Source: Adapted from Contino, Maria, Domenic Costa, Larui Deyhimy, and Jenny Hu, Loyola, Marymount
University, MBAF 624, Los Angeles, CA, Fall 1999 .

Discussion Questions:

1. What were the key assumptions implicit in Pacific Wardrobe’s acquisitions plan, with respect to the
market, valuation, and integration? Comment on the realism of these assumptions.

Answer: Market-related assumptions include consolidated sales growth of 25% per year during the five
years beginning n 1999 due to sales and distribution synergies created by combining the two firms. The
growth in sales is expected to be supported without additional advertising expenses because of the extent of
the pre-1999 advertising campaign and its impact on building a brand image. Industry studies show that
sustaining brand image often requires continuous advertising in various types of media. Valuation
assumptions include an assumed capitalization rate of 35%, which includes a relatively modest
marketability discount of 20%. Fixed and administrative expenses are projected to decline, as Pacific
Waredrobe’s existing overhead is assumed to be able to support the projected growth in volume. The
projected drop in administrative expenses as a percent of revenue from 25% to 18% in five years may
prove to be unsupportable. Pacific’s management is assuming that the target can be acquired with a
relatively small premium and with stock. The success of this offer will be largely dependent on how the
owners of SurferDude view the growth potential of the combined firms. Finally, Pacific is assuming
relatively little customer attrition during integration and that key employees can be kept by using retention
bonuses.

2. Discuss some of the challenges that Pacific Wardrobe is likely to experience during due diligence.

Answer: SurferDude’s lackluster profit performance is largely attributable to its heavy advertising
campaign in the years just prior to the proposed acquisition. Pacific needs to verify this key assumption.
Moreover, they need to determine if the firm’s growth can continue without advertising in the future.
Pacific’s due diligence team would have to reconstruct SurferDude’s historical financials to determine what
profitability would have been if the aggressive advertising had not taken place.

3. Identify alternative deal structures Pacific Wardrobe might have employed in order to complete the
transaction. Discuss why these alternatives might have been superior or inferior to the one actually chosen.

Answer: Pacific was primarily interested in obtaining the rights to produce and sell another brand of
clothing focused on what they believed would be a high growth market. They may have accomplished the

17
 same objective by licensing the rights to the brand rather than buying the entire company. Similarly,
Pacific and SurferDude could have created a joint venture into which Pacific could have contributed
management expertise and access to its overseas production sources and distribution channels and
SurferDude could have contributed selected product brands.

Cashing Out of a Privately Held Enterprise

When he had reached his early sixties, Anthony Carnevale starting reducing the amount of time he spent managing
Sentinel Benefits Group Inc., a firm he had founded. He planned to retire from the benefits and money management
consulting firm in which he was a 26 percent owner. Mr. Carnevale, his two sons, and two nonfamily partners had
built the firm to a company of more than 160 employees with $2.5 billion under management.

Selling the family business was not what the family expected to happen when Mr. Carnevale retired. He believed
that his sons and partners were quite capable of continuing to manage the firm after he left. However, like many
small businesses, Sentinel found itself with a succession planning challenges. If the sons and the company's two
other nonfamily partners bought out Mr. Carnevale, the firm would have little cash left over for future growth. The
firm was unable to get a loan, given the lack of assets for collateral and the somewhat unpredictable cash flow of the
business. Even if a loan could have been obtained, the firm would have been burdened with interest and principal
repayment for years to come.

Over the years, Mr. Carnevale had rejected buyout proposals from competitors as inadequate. However, he
contacted a former suitor, Focus Financial Partners LLC (a partnership that buys small money management firms
and lets them operate largely independently). After several months of negotiation, Focus acquired 100 percent of
Sentinel. Each of the five partners—Mr. Carnevale, his two sons, and two nonfamily partners—received an
undisclosed amount of cash and Focus stock. A four-person Sentinel management team is now paid based on the
company's revenue and growth.

The major challenges prior to the sale dealt with the many meetings held to resolve issues such as compensation,
treatment of employees, how the firm would be managed subsequent to the sale, how client pricing would be
determined, and who would make decisions about staff changes. Once the deal was complete, the Carnivales found
it difficult to tell employees, particularly those who had been with the firm for years. Since most employees were
not directly affected, only one left as a direct result of the sale. 1

1Adapted from Simona Covel, "Firm Sells Itself to Let Patriarch Cash Out," Wall Street Journal, November 1, 2007, p. B8

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