Apex Investment Partners was founded in 1987 by James A. Johnson and the First Analysis Corporation. In its eight-year life, the VC had raised three funds. The two first which are already closed had, together, a committed capital of around $70M. There were mainly concentrated in four areas: • • • • Telecommunication, information technology and software. Environmental and industrial productivity-related technologies. Consumer products and specialty retail. Health-care and related technologies.
Usually, Apex sought to be the leading investor whatever the stage in order to have one of its representatives join the board of the financed companies. Furthermore, Apex pursues to balance its investments between start-up and already generating positive cash flows investments. Now (April 1995) in the process of raising its third fund of $75M committed capital target, the VC fund seeks for new opportunities on the market. In this context, they recently approached a firm which seems to have huge potential for rapid growth: AccessLine Technologies.
Based in Washington, AccessLine is an emerging telecommunication company that developed a high differentiation service called “One Person, One Number”. Basically, the concept is to assign one single number (an AccessLine number) which allows an individual to manage all of their different telecommunications. Realizing that it was less risky and far more costeffective to license their technology, the company extensively use strategic alliances with well-establish operators to commercialize its technology. To pursue its fast expansion, the firm undertook, in July 1994, a $15. M private placement from five investors and welcomed to the board, as part of the transaction, a representative of the first financing round. To keep up with its ambitions and meet its growth expectations (subscribers increase by 200% per year between 1995 and 1999), AccessLine wish to obtain an additional financing of approximately $16M. Even though Apex is convince in the firms’ potential and have already built a trustful relationship, the two parties have still two contentious that need to be resolved before any deal could proceed: • • The valuation of the company The term sheet conditions
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In order to give our own perspective on these contentious, we will construct, in this report, our own estimation of AccessLine value as well as the proposed deal for all claimants. Then, we will go through the eventual issues of the proposed term sheet on which Apex should focus its attention. Enterprise Value of AccessLine In the following section, we are going to value AccessLine conditional on a successful exit (here IPO).
We chose to use the discounted cash method (absolute valuation) which consist in making projection of the cash flows of the firm from the year of exit until infinity and discount them to the present.
The DCF approach is given by: = + + ? + + !? # = (1) $% Notice that one could prefer to impute what the market’s opinion of the firm will be at exit date to obtain the searched value. This is the so-called comparable analysis (relative valuation).
Table 1 shows the estimated input parameters used in our DCF analysis. It’s important to keep in mind that, according to Michael Roberts findings, entrepreneurial firms have very little leverage. Thus, we will suppose that AccessLine is an all equity entrepreneurial firm and consequently will avoid interest expenses as well as tax shield.
Moreover, notice that we will assume no excess cash. Table 1: Inputs parameters for the DCF Analysis Exit(T) Year until Graduation (S-T) Expected Inflation Industry Growth (avg, nominal) Extra Growth Revenue ($M) Operating Margin Tax Rate Operating Assets ($M) Stable Growth (nominal) Stable Growth (real) Discount rate (nominal) Discount rate (real) R(old) R(new) Depreciation % of book value of operating Assets 2. 0% 15. 7% 0. 0% 208. 0 32. 5% 30. 6% 54. 0 Graduation (S) 5 Incremental 11. 5% 9. 5% 1320. 1 39. 8% 30. 6% 1639. 9 3. 0% 1. 0% 11. 5% 9. 5% 22. % 9. 5% 1. 5% 317. 2 10. 0% Several additional assumptions were required when calculating the exit value for AccessLine. In a first step we have to postulate when the successful exit is going to happen. Normally this period is assumed to be between 3 and 7 years long. In our case, we make the assumption that a successful exit is going to happen in 1999. Since we are only concerned about the successful scenario, we go along with the projection of AccessLine, which is probably overoptimistic, and use its expected revenue of 208M at the time the exit happens.
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After the IPO, we presume the company will grow at a high rate for the next five years in the 75 percentile as proposed by Metrick, Andrew and Ayako Yasuda in their “Venture Capital and the Finance of innovation” book. We chose five years since the typical firm reaches maturity within five years after the IPO. Besides, we assume a tax rate of 30. 64% given by the industry average (Damodaran 2013).
As a discount rate, we use simply the industry average. Alternatively, we could use the Betas of the comparable companies.
This gives us an unlevered average beta of 0. 5*(1. 39+2. 03) since both companies are completely equity financed. The risk free rate was given by 7. 1%, if we assume a risk premium of 5. 79% (Damodaran for 1. 4. 13) we get a cost of capital of 16. 9% using the CAPM equation. Because we only have two comparable companies we opt to do our calculations with the industry wide average discount rate. The operating margin at the exit date is estimated in a way that we reach a Net Income of approximately 22% of revenues as projected by AccessLine for the year 1999.
Holding everything else constant, we get an expected operating margin of 32. 5% at the time of the exit date. After that we assume that the margin converts in equal steps to the industry average at the graduation date. Concerning the operating assets, we expected them to remain constant relative to the revenue. In 1993, we observe operating assets of $2. 20M (Total – Other assets, net) and revenue of $8. 36M resulting in a percentage of approximately 26%. In consequence, this gives us operating assets of $54M in 1999.
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After that, we believe assets to change in a way that the return on assets converges to the return on assets for the graduation year. As we expect AccessLine to be a successful and mature company after 5 years, this value is assumed to be the industry average. We expect Inflation to be around 2% for the “foreseeable” future in the United States, which is in line with estimations of the IMF. We us the figure of the United States as an approximation since it seems the most relevant for AccessLine. Furthermore we assume the nominal growth rate to be equal to a conventional rate of 3%.
Thus, at the time of the graduation value, the real growth rate reaches 1%. After having experienced extraordinary growth for 5 years, a lot of the competitive advantage due to having a new innovative product will disappear and thus the company will tend to perform similar to other companies in the same industry. Therefore, regarding the graduation value, all the inputs are assumed to be industry averages (We took the numbers from the statistics provided in the excel sheet).
Note that this is only the case because we assume a successful scenario.
We assume the return on old capital (i. e. return on the capital in place before graduation) is going to be equal to the industry average and return on new capital (meaning return for capital created by new investments after graduation) is going to be equal to the real cost of capital. This is justified, once again, by the fact that it will be difficult to have a competitive advantage after an extraordinary growth period. When taking all these assumption into consideration we obtain the following values: Table 2: Outputs parameters for the DCF Analysis ($M)
Sum of the Cash Flows* PV (Sum of the CF) Graduation Value PV (Graduation Value) NPV of firm at exit (end of 1999) -493. 1 -551. 3 3865. 7 2240. 1 1688. 8 *CF=EBIT(1-tax) + Depreciation – Capex – NWC The last step in the valuation process of the firm at current time is to adjust the exit value with the probability of success and to actualize this product by the VC discount rate. We based our choice of the probability of success on the findings of John L. Nesheim. According to his research, compiled in the book “High Tech Start Up”, High Tech start-ups tend to have a probability of success of around 10%.
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However, as we believe AccessLine to be in a really good position, we decided to use 15%. For the VC discount rate, we opted for 15% as recommended in the lectures of professor Theodosios Dimopoulos (lecture 4, slide 13).
In conclusion we get that: &” (() * ( * + , 1995 = $1688. 84 ? 15% = $131. 94924 1 + 15% 78/ : Proposed deal value for all claimants According to the term sheets, both investors have the right to get back their investment in preference. Furthermore, we assume that the Series A shareholders are making use of their warrants.
Table 3: Shareholders’ key information Series A Series B Common Shares Liquidation Preference $17. 88M* $16M None % of Ownership 17%** 13% 70%*** *(2’220’726 + 333’110)*7; **Incl. warrants; ***53% Investors + 17% Employees/Directors/Management As we can see in figure 1, since there is no preference between series A and B (pari passu), both split equally the proceedings until the liquidation preference of the Series B holders of $16M is reached at W=32M. After that point everything goes to the Series A holders until they reach their own liquidation preference of $17. 88M.
Subsequent, all the proceeds are distributed to the common shareholders (the green line).
First we calculate the order of conversion, given by APP/#Shares. Series A has the lower value and thus converts first. Depending on the order we can determine the following conversion conditions: for A 0. 17*(W-16)>17. 88 and for B thus 0. 13W>16 since A should already have converted. Figure 1: Exit Diagram 120 100 80 60 40 20 0 1 8 15 22 29 36 43 50 57 64 71 78 85 92 99 106 113 120 127 134 141 148 Series A value Series B value Common Table 4: Slopes (W=) PA PB Employees 0-32 0. 0. 5 0 32-34 1 0 0 34-121 0 0 1 121-124 0. 17 0 0. 83 >124 0. 17 0. 13 0. 7 We rounded the conversion points for convenience. Using the changes in the slopes, we determine the exit equations for all the involved parties: • • • Exit Equation A=1/2*V+1/2*C(32)-C(34)+0. 17*C(121)+2. 5*BC(124)=24. 84M(Partial value for A) Exit Equation B=1/2*V-1/2*C(32)+0. 13*C(124)=19. 91M(Partial value for B) Exit Equation Common Shareholders = C(34)-0. 17*C(121)-0. 13*C(124)-2. 5*BC(124=87. 25M(Partial value common) To calculate the corresponding price we used: 1. 2. 3. 4. 5.
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The Value we determined for AccessLine of $132M A volatility of 90% as an approximation based on historical evidence presented by Metrick and Yasuda Since we expect the exit to happen at the end of 1999, we have an expected holding period of 4. 67 years The risk free rate used is the one given in the case study of 7. 1% The binary option is used because, after the Series B converts, Series A will get a jump. This path is explained by the fact that the Liquidation preference of Series B does not exist anymore at W=124 since the Series B shareholders have converted.
To calculate the prices of the options, the Flex calculator on vcvtools. com is used. 6. Note: The calculator uses the Black and Scholes formula to calculate the option prices. This means that stock prices are assumed to follow a lognormal distribution and trading can take place at all time. Furthermore no taxes, transaction costs, and arbitrage opportunities are assumed. These are very strong and unrealistic assumptions, however we do not care that much since they still give us a useful approximation. Issues in the proposed term sheet
We understand from the case that Apex is deeply concerned about the particulars they have been proposed in the term sheet. Their fear is mostly related to the alignments of interest between them and the management team. They believe the incentives of the managers to be too week to insure that they will pursue a mutually satisfactory outcome. Therefore, they would preconize the use of some mechanisms such as provision that required punitive interest if the firm did not go public and/or being giving rights of first refusal on future financing.
In this section, we will identify some issues contained in the proposed term sheet on which Apex should have a particular consideration. For starters, Series B holders have no warrants attached to their shares unlike Series A holders that can use it until the 3 of June 1999. This is problematic for Apex since it allows current holders to lower the proportionate weight of Series B preferred stock. In the same vein, Series A holders can increase their % of ownership since they are allowed, unlike Series B holders, to buy Class A Common Stock from the current shareholders at a ratio of 0. 83 (option to buy common stock).
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Another important risk for Apex to consider is the lack of the Right of Co-sale in the Series B term Sheet. Indeed, this means that in the event that one or both key personalities of the firm (Mr. Kranzler and Mr. Fuller) sale their stock to exit the company, Apex won’t be able to lower their holdings even though the company won’t probably have the same dynamics (and thus valuation).
This is even more dramatic when considering that Mr. Fuller is the full owner of patents and patents pending for the technology he invented on which the AccessLine System is based.
Indeed, in a worst case scenario, Mr. Fuller could take is patent, recruit Mr. Kranzler and Mr. Epler which are long-standing business relations and start another company. Finally, even though they have the ability to vote on the compensation package increase of any insider who holds 5% or more of the company stock, Series B holders do not have the right to elect one director to the Board. Therefore, there is no guarantee that Apex will be able to have an official in the Board of Director when investing in Series B shares. This is probably the key issue for Apex as they clearly prefer to have influence on the Board. rd
