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Chapter 15: Harvesting the Business Venture Investment
223
Chapter 15 HARVESTING THE BUSINESS VENTURE INVESTMENT DISCUSSION QUESTIONS AND ANSWERS 1.
What is the meaning of harvesting a venture? Harvesting a venture refers to the process of exiting a privately-held business venture to unlock the owners’ investment value.
2.
What evidence exists as to whether entrepreneurs think about and/or develop exit strategies? Holmberg documented that over ½ of entrepreneurs have developed, or at least though about exit strategies, at the start of their ventures.
3.
What are unicorns? How might their exit values be impacted when they go public? Unicorns are highexpectedgrowth companies with valuations in excess of $1 billion. Such ventures have been questioned for not “going public” or, when they do, doing so at a price below previous rounds, creating concern that the private valuations in excess of $1 billion are inflated. Planning welcome exits is important even for exceptionally wellfunded ventures, including the rare unicorns.
4. Describe how the relative value method is used to value a firm’s equity. The relative value method estimates a firm’s value by examining how comparable firms are valued based on valuerelated multiples. Comparable firms are firms with lines of business, size, and growth characteristics similar to the firm being valued. Multiplesbased valuations may be used to value the firm’s enterprise value or its direct equity value similar to the application of DCF methods. Analysts often estimate a firm’s enterprise value by calculating multiples of earnings before interest, taxes, depreciation, and amortization (EBITDA). This works because EBITDA gives a “crude” estimate of cash flow available to both debtholders and equity holders.
Chapter 15: Harvesting the Business Venture Investment
224
5.
What is a systematic liquidation of a venture? What are some of the advantages and disadvantages of a systematic liquidation? A systematic liquidation of a venture is the process of liquidating the firm by distributing the cash flows of the firm to the owners. This usually happens when the firm is in the mature stage and their free cash flow exceeds the amount need to maintain sustainable growth. Potential advantages include: (1) the entrepreneur and other owners maintain control throughout the harvest period, (2) the harvesting of the investment value can be spread out over a number of years, and (3) the time, effort, and cost of finding a buyer for the venture can be avoided. Potential disadvantages include: (1) the treatment and taxation of liquidation proceeds as ordinary income (rather than capital gains), (2) the commitment of the entrepreneur’s wealth, abilities, and focus to a dying venture, rather than other venture pursuits that might be more lucrative, and (3) acceleration of the rate of decline in the going concern value as other industry participants respond to the reduction in investment.
6.
Describe an outright sale of a venture. What are the four categories of possible buyers? An outright sale of a venture occurs when it is sold to others. The four categories of outside buyers in an outright sale are family members, managers, employees, or external buyers.
7.
Describe what is meant by (a) a leveraged buyout (LBO), and (b) a management buyout (MBO). An LBO occurs when a firm is bought out by investors who finance the majority of it with debt. An MBO is a type of LBO with the managers’ being a large part of the equity investors.
8.
What is an employee stock option plan (ESOP)? How is an ESOP used to buy out a venture? An ESOP is typically a benefit plan where employer and employee contributions are combined with debt to purchase a venture’s equity. If the ESOP plan is sufficiently large in a mature firm, it can possibly take the role of the majority equity investor in the venture after venture investors have exited.
9.
Describe the terms (a) “control premium” and (b) “illiquidity discount” when discussing possible external or outside buyers of a venture.
Chapter 15: Harvesting the Business Venture Investment
225
(a) A control premium is an additional dollar or percentage value on top of the base value of the firm for the advantage of being able to control the firm instead of being a minority shareholder. (b) An illiquidity discount is a decrease in the price paid for unregistered shares that cannot be easily sold or transferred. 10.
Describe an initial public offering (IPO). What are the differences between a primary offering and a secondary offering? An IPO is the first public sale of a venture’s equity ownership. The primary offering refers to the sale of new shares to their first owners. A secondary offering is the sale of shares previously owned by others (typically founders and those still owning shares from the time when the venture was privately held).
11.
What is investment banking? What is an underwriting spread? Investment banking facilitates the issue of new securities by creating markets for a firm’s security. An underwriting spread is the difference between the price paid in the market for the new security and the amount given to the issuing firm. It is the investment bank’s commission for creating the deal.
12.
Describe the terms “tombstone ad” and “red herring disclaimer.” A tombstone ad is an SEC requirement and an advertisement used to notify the public of an upcoming offering, A red herring disclaimer is a required statement on the tombstone ad (or elsewhere) notifying the public that the ad (or preliminary prospectus) is not an offer to purchase or a solicitation of an offer to buy. It also notifies the reader that the actual offer can only be made upon delivery of the final prospectus.
13.
What is meant by due diligence? How does a traditional registration differ from a shelf registration? Due diligence is the process whereby an investment bank investigates an issuing company’s financial condition and investment intent. A traditional registration specifies details ahead of time including date, price range and underwriter, while the shelf registration procedure allows the firm more flexibility by issuing within a two year period.
Chapter 15: Harvesting the Business Venture Investment
226 14.
When an investment banking firm decides whether to underwrite or market a securities issue, what is meant by a firm commitment and best efforts? A firm commitment by an investment bank means that the bank will purchase the security issue and then resell it in the market. A “best efforts” by an investment banking firm is when they only provide marketing and distribution efforts but do not guarantee a certain price.
15.
Describe the two following terms that may be involved in underwriting a new securities issue: (a) green shoe and (b) lockup provision. A green show provision is a contract option for the investment bank to sell more shares than allotted in the underwriting if the issue is broadly oversubscribed. A lockup provision prohibits insiders in the company from selling their shares during a certain period of time after the initial offering.
16.
What is meant by initial public offering (IPO) underpricing? IPO underpricing is when the offering price by the syndicate is lower than the first trade in the secondary market or more generally under the prices during the first day of trading.
17.
Briefly describe how securities are traded on an organized stock exchange such as the New York Stock Exchange. Organized exchanges have specialized geographic (or electronic) places where trading in a given security takes place. The official designation of “stock exchange” within the U.S brings the trading venue under the regulatory authority of the SEC. Typically such exchanges have publicly posted listing requirements, specific types of orders (e.g. “market” and “limit”), standards for order processing and clearing, and rules for maintaining orderly markets. Typically an individual places an order with a broker who is a member of an exchange and who assumes responsibility for executing and clearing the order according to the exchange’s rules.
18.
Indicate some of the differences between the NASDAQ’s National Market System and SmallCap listing requirements. One listing option for IPOs is the National Association of Securities Dealers (NASD) Automated Quotation (NASDAQ) system. [Note: The NASDAQ no longer uses the terms National Market System and SmallCap listing requirements.] Tables 15.1 and 15.2 now provide NASDAQ Global Market Initial Listing Requirements and NASDAQ Capital Market Initial Listing
Chapter 15: Harvesting the Business Venture Investment
227
Requirements. Differences exist in terms of stockholders’ equity and market value of publicly held shares. Similarities exist in terms of bid price, publicly held shares, and market makers. 19.
Describe some of the preparations that a venture can undertake that may increase the possibility of IPO success. Typical preparations for an IPO include, but are not limited to: (i) cleaning up confusing financing and compensation arrangements, (ii) clarifying the main business strategy; (iii) eliminating potentially annoying special arrangements with insiders; (iv) arranging for 2 years of audited financial statements by a major accounting firm; (v) preparation for the scrutiny of ongoing research by establishing formal communication channels for external dissemination of corporate news; and (vi) establishing an investor relations function.
20.
What are the steps or stages in a “typical” execution and time line schedule used in planning and executing an IPO? The execution and time line include: 1. Organization Meeting and Due Diligence 2. Drafting and attendant Activities 3. Initial 30-day SEC Review 4. Premarketing 5. Marketing 6. Pricing and Closing
21. From the Headlines – Tesla: Comment on Tesla’s trip from incorporating in 2003 to its IPO in 2010. What impact do you think the IPO had on competitors in the electric car market? Answers will vary: The trip has been a bumpy one and the road ahead is full of large potholes. Scaling into competitive manufacturing will remain a challenge. There are many competitors and close substitutes (for example hybrids and cars that run on cleaner burning, more widely available fuels). As the updated story indicates the market is growing with multiple brands and approaches. It is not clear that the IPO forestalled competitors, including those subsidized by foreign governments. There appears to be a continuing bumpy road ahead.
228
Chapter 15: Harvesting the Business Venture Investment
223
Chapter 15 HARVESTING THE BUSINESS VENTURE INVESTMENT DISCUSSION QUESTIONS AND ANSWERS 1.
What is the meaning of harvesting a venture? Harvesting a venture refers to the process of exiting a privately-held business venture to unlock the owners’ investment value.
2.
What evidence exists as to whether entrepreneurs think about and/or develop exit strategies? Holmberg documented that over ½ of entrepreneurs have developed, or at least though about exit strategies, at the start of their ventures.
3.
What are unicorns? How might their exit values be impacted when they go public? Unicorns are highexpectedgrowth companies with valuations in excess of $1 billion. Such ventures have been questioned for not “going public” or, when they do, doing so at a price below previous rounds, creating concern that the private valuations in excess of $1 billion are inflated. Planning welcome exits is important even for exceptionally wellfunded ventures, including the rare unicorns.
4. Describe how the relative value method is used to value a firm’s equity. The relative value method estimates a firm’s value by examining how comparable firms are valued based on valuerelated multiples. Comparable firms are firms with lines of business, size, and growth characteristics similar to the firm being valued. Multiplesbased valuations may be used to value the firm’s enterprise value or its direct equity value similar to the application of DCF methods. Analysts often estimate a firm’s enterprise value by calculating multiples of earnings before interest, taxes, depreciation, and amortization (EBITDA). This works because EBITDA gives a “crude” estimate of cash flow available to both debtholders and equity holders.
Chapter 15: Harvesting the Business Venture Investment
224
5.
What is a systematic liquidation of a venture? What are some of the advantages and disadvantages of a systematic liquidation? A systematic liquidation of a venture is the process of liquidating the firm by distributing the cash flows of the firm to the owners. This usually happens when the firm is in the mature stage and their free cash flow exceeds the amount need to maintain sustainable growth. Potential advantages include: (1) the entrepreneur and other owners maintain control throughout the harvest period, (2) the harvesting of the investment value can be spread out over a number of years, and (3) the time, effort, and cost of finding a buyer for the venture can be avoided. Potential disadvantages include: (1) the treatment and taxation of liquidation proceeds as ordinary income (rather than capital gains), (2) the commitment of the entrepreneur’s wealth, abilities, and focus to a dying venture, rather than other venture pursuits that might be more lucrative, and (3) acceleration of the rate of decline in the going concern value as other industry participants respond to the reduction in investment.
6.
Describe an outright sale of a venture. What are the four categories of possible buyers? An outright sale of a venture occurs when it is sold to others. The four categories of outside buyers in an outright sale are family members, managers, employees, or external buyers.
7.
Describe what is meant by (a) a leveraged buyout (LBO), and (b) a management buyout (MBO). An LBO occurs when a firm is bought out by investors who finance the majority of it with debt. An MBO is a type of LBO with the managers’ being a large part of the equity investors.
8.
What is an employee stock option plan (ESOP)? How is an ESOP used to buy out a venture? An ESOP is typically a benefit plan where employer and employee contributions are combined with debt to purchase a venture’s equity. If the ESOP plan is sufficiently large in a mature firm, it can possibly take the role of the majority equity investor in the venture after venture investors have exited.
9.
Describe the terms (a) “control premium” and (b) “illiquidity discount” when discussing possible external or outside buyers of a venture.
Chapter 15: Harvesting the Business Venture Investment
225
(a) A control premium is an additional dollar or percentage value on top of the base value of the firm for the advantage of being able to control the firm instead of being a minority shareholder. (b) An illiquidity discount is a decrease in the price paid for unregistered shares that cannot be easily sold or transferred. 10.
Describe an initial public offering (IPO). What are the differences between a primary offering and a secondary offering? An IPO is the first public sale of a venture’s equity ownership. The primary offering refers to the sale of new shares to their first owners. A secondary offering is the sale of shares previously owned by others (typically founders and those still owning shares from the time when the venture was privately held).
11.
What is investment banking? What is an underwriting spread? Investment banking facilitates the issue of new securities by creating markets for a firm’s security. An underwriting spread is the difference between the price paid in the market for the new security and the amount given to the issuing firm. It is the investment bank’s commission for creating the deal.
12.
Describe the terms “tombstone ad” and “red herring disclaimer.” A tombstone ad is an SEC requirement and an advertisement used to notify the public of an upcoming offering, A red herring disclaimer is a required statement on the tombstone ad (or elsewhere) notifying the public that the ad (or preliminary prospectus) is not an offer to purchase or a solicitation of an offer to buy. It also notifies the reader that the actual offer can only be made upon delivery of the final prospectus.
13.
What is meant by due diligence? How does a traditional registration differ from a shelf registration? Due diligence is the process whereby an investment bank investigates an issuing company’s financial condition and investment intent. A traditional registration specifies details ahead of time including date, price range and underwriter, while the shelf registration procedure allows the firm more flexibility by issuing within a two year period.
Chapter 15: Harvesting the Business Venture Investment
226 14.
When an investment banking firm decides whether to underwrite or market a securities issue, what is meant by a firm commitment and best efforts? A firm commitment by an investment bank means that the bank will purchase the security issue and then resell it in the market. A “best efforts” by an investment banking firm is when they only provide marketing and distribution efforts but do not guarantee a certain price.
15.
Describe the two following terms that may be involved in underwriting a new securities issue: (a) green shoe and (b) lockup provision. A green show provision is a contract option for the investment bank to sell more shares than allotted in the underwriting if the issue is broadly oversubscribed. A lockup provision prohibits insiders in the company from selling their shares during a certain period of time after the initial offering.
16.
What is meant by initial public offering (IPO) underpricing? IPO underpricing is when the offering price by the syndicate is lower than the first trade in the secondary market or more generally under the prices during the first day of trading.
17.
Briefly describe how securities are traded on an organized stock exchange such as the New York Stock Exchange. Organized exchanges have specialized geographic (or electronic) places where trading in a given security takes place. The official designation of “stock exchange” within the U.S brings the trading venue under the regulatory authority of the SEC. Typically such exchanges have publicly posted listing requirements, specific types of orders (e.g. “market” and “limit”), standards for order processing and clearing, and rules for maintaining orderly markets. Typically an individual places an order with a broker who is a member of an exchange and who assumes responsibility for executing and clearing the order according to the exchange’s rules.
18.
Indicate some of the differences between the NASDAQ’s National Market System and SmallCap listing requirements. One listing option for IPOs is the National Association of Securities Dealers (NASD) Automated Quotation (NASDAQ) system. [Note: The NASDAQ no longer uses the terms National Market System and SmallCap listing requirements.] Tables 15.1 and 15.2 now provide NASDAQ Global Market Initial Listing Requirements and NASDAQ Capital Market Initial Listing
Chapter 15: Harvesting the Business Venture Investment
227
Requirements. Differences exist in terms of stockholders’ equity and market value of publicly held shares. Similarities exist in terms of bid price, publicly held shares, and market makers. 19.
Describe some of the preparations that a venture can undertake that may increase the possibility of IPO success. Typical preparations for an IPO include, but are not limited to: (i) cleaning up confusing financing and compensation arrangements, (ii) clarifying the main business strategy; (iii) eliminating potentially annoying special arrangements with insiders; (iv) arranging for 2 years of audited financial statements by a major accounting firm; (v) preparation for the scrutiny of ongoing research by establishing formal communication channels for external dissemination of corporate news; and (vi) establishing an investor relations function.
20.
What are the steps or stages in a “typical” execution and time line schedule used in planning and executing an IPO? The execution and time line include: 1. Organization Meeting and Due Diligence 2. Drafting and attendant Activities 3. Initial 30-day SEC Review 4. Premarketing 5. Marketing 6. Pricing and Closing
21. From the Headlines – Tesla: Comment on Tesla’s trip from incorporating in 2003 to its IPO in 2010. What impact do you think the IPO had on competitors in the electric car market? Answers will vary: The trip has been a bumpy one and the road ahead is full of large potholes. Scaling into competitive manufacturing will remain a challenge. There are many competitors and close substitutes (for example hybrids and cars that run on cleaner burning, more widely available fuels). As the updated story indicates the market is growing with multiple brands and approaches. It is not clear that the IPO forestalled competitors, including those subsidized by foreign governments. There appears to be a continuing bumpy road ahead.
228
Chapter 15: Harvesting the Business Venture Investment
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