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Harrington Corp

Harrington Corp. By Professor Clive Vlieland-Boddy. Group Discussion. As part of the management team, how would you fund this?. Key Issues. Who is to make the decision? What is the decision? What is the company? What is the industry?. Background. Reasons for sale - Retirement

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Harrington Corp

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  1. Harrington Corp By Professor Clive Vlieland-Boddy

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

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

  4. Background • Reasons for sale - Retirement • Valuation based on previous offers of $10m with $8m in cash. • MBO opportunity. • Personal resources of MBO team only $250k. • Therefore looking for $7,750k of financing. Had basic agreement with bank for $3m and now $3m from Baring. This left balance of $3.75m to find.

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

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

  7. Marketing • Non differentiable products. • 1800 different sales accounts. • Government and 6 large clients represent 30% of sales. • Low product costs made them highly competitive as a low cost provider. • 95% reorders.

  8. Finances • Owner occupier of the business. Uses Free cash to fund capital equipment. If none then dividends of up to 70% of Earnings. • Generous credit terms to Accounts Receivable. • No debt. Does have credit lines of $2m. • Accounts Payable always paid on time. • In summary... good working capital.

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

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

  11. Competition • Only two players. Harrington (65% and Algonquin 25%) However geographically not really in competition. • Otherwise fragmented industry. • Barriers to entry - price, economies of scale and capital investment. • Possible to attack some of Algonquin’s market share.

  12. Unexploited Opportunities • Dated products like appointed books. • Capital investment required of $100k and Marketing of $450k. • First year sales of $500k. Growing by 40% pa for years 2-4 the by 6%.

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

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

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

  16. So how do we do a deal? • Barings is prepared to sell for $10m. • He will vendor finance $3m over 5 years. • A bank will put up $3m of junior debt with some awkward covenants. • Management will finance $250k • We now have to establish how to get the balance of finance. Ie $3.750m.

  17. Venture ( Vulture ) Capitalists.. • But what will the new equity financiers want. • What % of the company will be required to be sold to attract $3.75m? Is there any way to reduce this? • Note expected return that VC would want is 20%-25%. With any debt then 8%-9% coupon rate. • Likely to take options or warrants on large % of the equity and a kicker.

  18. Lets look at valuations... • Balance Sheet. Net assets = $4,958k. • NPV of the free cash flow. • Earnings multiples • Price earnings. Based on Exhibit 5, average for industry is 7.2 - 10.5. Harrington’s should be much higher as it generates nearly twice the profits of average companies. See net profit margins. 12.9% as opposed to 4.1%-8.9%. • Industry multiples. We do not have any information on these.

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

  20. Lets spend a minute revisiting Working Capital Management.. • Exhibit 4 shows • cash balance of nearly $3m • Accounts receivable of $1.2m • and Current liabilities of $633. If you look at Exhibit 2 Accounts payable represents only $327k. • What if you managed this better. Could you not increase Accounts payable to say 60 days from 20. What about using the cash to fund part of the acquisition! • Note we have to keep bank balance of 20% of loan. Initially this would represent $600k.

  21. Lets return to the multiples.. • To establish the Earnings we would have to adjust the 1970 figures to add back the salary of Baring’s net of tax. Total was $200k less say tax at 30% = $140k. This would give ROE of $1,123k. • With a market price required by Baring’s of $10m. The P/E is 8.9. This compares to industry of 7.2 - 10.5.

  22. Price not negotiable... • So we have to accept that we will have to pay $10m. • The issue is therefore how and at what price would the venture capitalists assist? • We are told that they typically look for a return of 20%-25%.

  23. Exhibit 7 - The forecasts.. • The company appears to be able to fund the bank debt of $3m and repay it over 4 years as required. It can even take a small advantage of the discounts offered by Baring and repay the $3m by end of year 5 but will have to re-borrow $1.4m.

  24. What about financial risk? • How would this really sit with the venture capitalists. The company has moved from 0% debt to 65%. Financial leverage has been introduced and overbalancing the Capital Structure. • The bank loan already has many restrictions in its covenants. • Remember “Agency Costs…”

  25. So if you were the venture capitalist what would you require? • All equity position! Say 51% now but enable the management to get back control when all repaid. Even if the VC’s do not insist on control, they will be heavily involved. • Lend the $3.75m as that avoids the capital gain on the sum! • Combine Debt with Equity conversion/kicker. • Could we not use better Working Capital Management to reduce this?

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

  27. Likely outcome • Should use surplus working capital of say $1.250m to reduce VC’s exposure. ( Could with good planning substantially increase this) • Venture capitalists would provide the $2.5m primary debt but with a substantial equity kicker. They would require a golden share position until repaid in full and then be able to convert or exercise options to create a gain. • The fact that the company can finance and repay such high levels of debt would support its position with the venture capitalists.

  28. VC’s 20-25% return. • The cash flows show that we can pay interest to the primary debts of 9%. However, that still leaves a balance of between 11% - 16%. • We could start repayments in 1977 as by then we have repaid the bank and Baring. • So if you did a forecast from say year 7 to year 10 you should be able to evaluate a repayment proposal for the VC’s.

  29. Balance of VC’s return • If they lend $2.5m and receive say 9% as interest, the balance required is 11% ( Based on 20% and 16% based on 25%) • With no repayment until after year 5 when say $1m is repaid, then the balance that the VC’s would look for would be.

  30. What does this tell us? • By 1978, we have repaid the loan from the VC of $2,500k. By then the capital growth expectations based on 25% total yield would have grown to about $5.5m. ( At 20% it is $3.7m) • The equity kicker would have to represent a similar value!

  31. The End

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